The financial markets are still working through the implications of the crisis that saw the collapse of Lehman Brothers – both in understanding the full extent of its impact and implementing measures to avoid its repeat. In the hedge fund arena, a major issue that arose was a liquidity mismatch between the redemption terms offered by the fund and the actual liquidity of the assets held.
All hedge funds, irrespective of their size, performance or strategy, were suddenly faced with a plethora of redemption requests from investors needing to raise their own liquidity profile, which in turn often had a detrimental impact on shareholder value as managers sold or attempted to sell assets in order to meet redemptions.
More recently, regulators and policymakers have sought to introduce rules which encourage financial institutions to increase the liquidity profile of their balance sheets, thereby making them more resilient to external pressures. The Basel III and Solvency II initiatives are increasing the capital charges associated with the retention of less liquid investments by banks and insurers.
Increasingly fund directors and liquidators are taking a hands-on approach in such matters, especially in high quality off-shore centres such as the Cayman Islands under the oversight of regulator CIMA. The Securities and Exchange Commission's recent comment on so-called "zombie" funds has highlighted fund directors' focus on ensuring investors' interests are pursued and protected.
This can often mean investigating optimal exits from low-liquidity positions which can avoid firesales at distressed levels through the discrete identification of targeted, experienced buyers who are comfortable with the asset's liquidity profile, and who will maximise bids. Liquidators are similarly focussed upon maximising value for their clients.
Many large-scale long-term investors (sovereign funds, family offices and pension funds) have realised that assets with reduced liquidity offer significant opportunity – either through the return of liquidity or by tapping into the yields available. This has helped create a mechanism through which those holding assets with longer liquidity profiles can access capital that would otherwise have been closed to them.
Recovery from the 2008 liquidity crisis has been impacted by a sequence of damaging events, most notably the prolonged and as yet unresolved problems in the Eurozone. The exact implications of a market event, such as an individual national credit "event", or worse an environment of contagion across several countries, are not fully known. As such it is important that managers and advisers of likely impacted portfolios are prepared and aware of their options.
The list of such “at-risk” assets is of course extensive – in theory any asset has the potential to have its liquidity profile reduced. Chart 1 illustrates a sample breakdown of assets currently held in low-liquidity hedge funds. In particular, be aware of those assets which may see a fundamental change in their profile as a result of a financial crisis. For example, private, non-tradable loans collateralised against real estate, physical assets such as machinery or an equity stake in a privately-owned business. In a liquidity crunch, the chance of default increases, meaning that the manager may have to take charge of the collateral.
So what steps can funds take to mitigate such eventualities? Since Gamma started operating in 2009, we have seen significant developments in the secondary hedge fund market, and our focus on low-liquidity investments has highlighted five steps that can help safeguard portfolios from the worst case scenario.
First, understand the risks of leverage. Warren Buffett's observation that utilising leverage is like "picking up pennies in front of a steam roller" is well known but its warning was largely ignored leading up to the crisis, as is demonstrated by the considerable number of leverage desks which are still unwinding their lending books due to crisis-driven defaults. Investors should ensure that liabilities to creditors can be met even if the liquidity profile of their underlying assets worsens. Otherwise any available liquidity will flow to the leverage provider, instead of the investor.
Be aware that diversification is not always a hedge against correlation risk. Whilst in a normalised environment, asset classes exhibit their own distinct characteristics, during periods of severe economic pressure, all capital markets can experience decrease in liquidity. As such, diversification is a portfolio construction technique that can mitigate the dynamics between different areas of the capital markets – but does not hedge against major macro-economic downturns, when usually uncorrelated assets can exhibit a high correlation in terms of deteriorating liquidity profile.
A third step is to constantly re-evaluate your exit strategies. Assets change over time – as does the position of potential buyers. As such, planned exit strategies need to be constantly revisited and re-assessed, so if the situation arises, an investor is able to sell.
A corollary of this is to “know where the exits are” – the last few years have seen an increase of the diversity and number of potential providers of capital to holders of low liquidity assets.
However identifying and accessing these parties is challenging. Over the last 18 months, we have found ourselves increasingly providing a bridge between hedge fund asset owners and private equity buyers – and previously this bridge simply did not exist. Specialist buyers have very wide-ranging investment mandates – we have identified appetite for low-liquidity assets in most regions, across the majority of industrial sectors, and for positions throughout companies' capital structure.
There is also appetite for complex assets ignored by more mainstream buyers, such as those with associated legal claims.
Finally, ensure that there is a sensible match between redemption terms offered to investors, and the liquidity of assets in a reduced liquidity environment within a portfolio. That will ensure investors' expectations are managed with regard to the intrinsic liquidity of their investment.