When the financial crisis hit in 2008, many hedge funds, faced with liquidity problems, limited the ability of investors to redeem their investment. The resulting problem for investors transformed the secondary market for hedge fund shares. Three to four years post-crisis the market remains undeveloped but there is considerable unmet demand both for hedge fund shares and the underlying assets in a fund, says Ben Keefe, director at advisory firm Gamma Finance.
Compared to the equity markets, which see buyers and sellers making informed decisions based on similar levels of information and capital as well as number of market participants on both the demand and supply side, the secondary hedge fund market is characterised by only a limited number of buyers and informational imbalances. While the secondary hedge fund market has moved on a great deal since the crisis, it still remains a fairly immature and undeveloped market, says Keefe.
Prior to 2008, hedge fund shares were traded mainly to buyers seeking access to successful and sought-after but closed funds, by paying a premium on the net asset value. In the current market conditions these transactions are very rare. “There have been literally one or two transactions since 2008 at a premium to NAV,” he says.
After 2008 every fund, no matter how successful it was, received redemption requests and experienced NAV write-downs as their assets lost value. Fresh capital was welcome. The need for a secondary market not only changed but exponentially increased, when 15 per cent of all hedge funds became liquidity impaired in some form, irrespective of whether funds exercised gates, structured assets in side pockets, commenced a wind down or went into liquidation, says Keefe.
Secondary market for hedge fund shares
With about $200 billion of illiquid hedge fund assets looking for buyers, a new market developed. In 2009 the market was governed by considerable distress and sellers were willing to exit their hedge fund positions at very low levels. Although very few investors had capital to allocate and even fewer had capital to allocate to low liquidity assets, several dedicated buyers of hedge fund shares emerged. These could demand relatively high yields.
Today the sell side is no longer characterised by distress, but rather by administrative or operational decisions. “For example,” says Keefe, “if you take a leverage desk that has issued financing to certain hedge funds. That leverage desk has been very patient and has not foreclosed on the underlying assets, but it now gets to a stage where may be a new head of that desk has come in and they want to wipe the slate clean and move on.”
As holding illiquid stock comes with a regulatory capital charge that is increasing under Solvency II and Basel III, insurers and banks are also motivated to offload illiquid hedge fund positions. When fund liquidations are added to the picture, the market is taking a different shape.
Overall the size of the market has declined from $200 billion to $70 billion and is dominated by only 20 specialist, long-term institutionally-backed buyers of secondary market positions. Of these only five to 10 conduct about 80 per cent of the transactions, estimates Keefe. Over the past year investors allocated $2-3 billion to dedicated illiquid portfolios. Yet, there is still significant unmet demand for secondary market shares, because buyers have so far focused on blue chip hedge funds that are more transparent and include high quality assets in their portfolio.
The investor preference is reflective of the difficulties in determining the underlying assets of funds to arrive at a fair value for secondary market positions. Many funds that were originally invested in asset backed loans ended up with the collateral that secured the loans when the borrowers defaulted or the funds accepted equity payments instead. As a result funds can have a markedly different portfolio of assets than originally pursued by the investment strategy.
New market for hedge fund assets
In addition to the secondary market for hedge fund shares, attention is shifting to the underlying fund assets.
“A particularly interesting development has been that the buy side in the illiquid hedge fund space has really identified that not only are there decent yields that can be generated from buying secondary market hedge fund shares but also by looking at the assets that are actually held by those hedge funds,” Keefe says.
Rather than selling the hedge fund shares for 20 cents on the dollar, the sale of specific individual assets from the balance sheet of the fund to targeted buyers with appetite for these assets could bring 40 or 50 cents, he adds.
Keefe, whose firm Gamma Finance advises the buyers of hedge fund shares and sellers of assets, says there is a real, global demand for non-vanilla assets, such as real estate, life settlements, structured products, equity shares and legal claims, which increasingly replaces the focus on secondary market hedge fund shares.
“So in terms of returning capital to investors it makes far more sense for the assets to be sold, rather than the investors themselves exiting in the secondary market,” he argues.