“My colleagues and I are heartbroken for anyone who has lost a family member to the virus and for those who have lost or are losing their livelihood as a result of everything shutting down. Our prayers are with each of you.” – Ron Geffner
From the perspective of the hedge fund industry and financial markets in general, one of the most important developments resulting from the Covid-19 pandemic is the historic destruction of jobs. Nearly twenty percent of the labor force in the United States has filed for unemployment since mid-March. In general, the overall human, social and economic toll of this disaster is unknown – and its severity has justifiably caused fear around the globe and its impact may affect generations to come.
What is known, at least initially, is the financial markets’ response to the coronavirus crisis. The speed and volatility of the market in response to the global lockdowns implemented in an effort to flatten the curve and save lives has caused extreme, unprecedented dislocations across almost every asset class. While actions taken by the United States government have been effective to date in helping to stabilize the stock markets in the United States, it is still unclear as to when the volatility caused by the coronavirus will end and where the markets will find balance.
There is significant data in relation to hedge fund performance and liquidity data in response to the coronavirus. Hedge Fund Research’s first-quarter data through March, while incomplete, indicated that the average hedge fund was down about 7% for the calendar year, while the S&P 500 lost roughly 20% of
its value during the same time period. The fact that hedge funds for the most part have outperformed the market during the recent market volatility makes hedge funds more relevant.
The speed and volatility of the market in response to the global lockdowns implemented in an effort to flatten the curve and save lives has caused extreme, unprecedented dislocations across almost every asset class.
During the first quarter of 2020, hedge funds experienced their largest quarterly withdrawals since 2008, netting upwards of $33 billion in redemption. These redemptions only represent a withdrawal of approximately one percent of the assets under management in the hedge fund industry. Nevertheless, while the aggregate redemptions in Q1 2020 may seem large, they are modest when compared to the redemptions in 2008. In the fourth quarter of 2008, investors redeemed approximately $150 billion. Further, keep in mind that the assets under management in the hedge fund industry were far less in 2008 than 2020. JP Morgan reaffirms this analysis. According to JP Morgan, even if redemptions accelerate in the second quarter of 2020, we are unlikely to see the aggressive level of asset outflows from hedge funds witnessed during the financial crisis.1
While the implications to the hedge fund industry from the Great Slowdown of 2020 and the Great Financial Crisis of 2008 may seem similar, make no mistake, they are materially different. Although it is still early to assess, we expect that there were far more hedge fund closures in 2008 then there will be in 2020. In 2008 approximately 1,500 hedge funds closed. Redemptions may also be far less on a percentage basis in 2020 than 2008, in part, because the investor base is far different. In 2008, the hedge fund investor community was primarily comprised of high net worth individuals, family offices and fund of funds. Institutional investors reflect the majority of assets invested in the hedge fund universe post 2008. Institutions tend to take much longer to act than high net worth investors and family offices. Further, Bernard Madoff’s fraud, which became public in December 2008, crippled the hedge fund industry. As a result of Madoff, investors started to conduct greater due diligence, assessing operational and portfolio risk controls. As a result, the hedge fund industry has matured and become far more institutionalized.
While we are collectively experiencing psychological and economic stress during this pandemic, this period of time also presents unique opportunities for hedge fund managers to propose specific trades, strategies, and create new vehicles to exploit genuine anomalies. During a period of dislocation, especially one caused by a black swan event such as this, investors initially focus on assessing and mitigating the damage. After assessing and mitigating damage, we can expect that investors will investigate alternative methods of investing. Investors and their advisers have already started to see opportunities in this environment.
The market sell-off in March 2020 has led us into a bear market after the longest bull market in history. The economic downturn is causing investors to question whether they are implementing the best investment strategy for their portfolio and must consider how to best adapt or reposition their portfolios. The long-debated argument in the investing world of whether active or passive management is best is being called into question yet again. Given the fact that: (i) active management seeks to take advantage of volatility and market fluctuations by finding opportunity resulting from mispricing and undervalued securities; and (ii) historically, active managers performed well in market downturns and are believed to perform better during a bear market, in the current environment, it would therefore seem likely that the hedge fund industry should anticipate growth in assets.
During the first quarter of 2020, hedge funds experienced their largest quarterly withdrawals since 2008, netting upwards of $33 billion in redemption.
In fact, on April 24, 2020, Bloomberg reported that prime brokers shared that several managers are expediting their start dates in an attempt to take advantage of the recent market downturn, even if they will launch with less money under management.2 Various industry publications over the last few weeks have also announced that many managers are setting up new vehicles to take advantage of the dislocation. By way of example, several blue-chip hedge funds, which have been closed to raising new money for years, are now raising funds in an effort to take advantage of the market volatility. Pricing dislocations between companies, industries, regions and asset classes due to the global impact of Covid-19 has provided specific opportunities for select strategies commonly employed by hedge funds. While there are compelling outliers of managers employing all strategies, alternative investment strategies currently expected to outperform the market include: (i) event driven; (ii) distressed debt; (iii) fixed income arbitrage and convertible arbitrage; (iv) debt related funds such as asset backed loans, credit long only funds and mortgage back securities; (v) equity market neutral funds with exposure from as much as 20% net long to 20% net short; and (vi) global macro.
In particular, as the impact of the Covid-19 further diminishes economic growth and company balance sheets, strategies focusing on the lending sector have identified specific investment opportunities. Similarly, both hedge fund and private equity managers who focus on distressed investment in particular have been waiting for this robust opportunity set for their strategies.
As the world continues to be impacted by the Covid-19 crisis, managers and investors are facing much uncertainty. Early on during the coronavirus crisis, distribution channels froze to a standstill. Over the last few weeks, however, our clients have indicated that these channels have started to thaw. Managers have said that one of the benefits of people working from home is that investors are more attentive and available than prior to the coronavirus lockdown. One manager stated that he was receiving “instant responses” from chief investment officers of foundations and endowments that he contacted directly, whereas in the past, he may not have heard back from them as quickly.3 Morgan Stanley sponsored a virtual capital introduction event during this period and people familiar with the event indicated that almost three times the number of investors participated in the event than Morgan Stanley had originally anticipated.
The manager’s pedigree and/or investment strategy materially influence the types of prospective investors who may be interested in investing with the manager. Portfolio managers and traders from well-known asset managers who were sufficiently senior within those organizations to have had contact with investors are best positioned to attract a meaningful amount of assets on the date of launch. Generally, these managers attract assets from institutional investors. Nonetheless, there are prospective investors for emerging managers, mid-sized managers, as well as institutionalized managers.
In order to succeed, a hedge fund manager must provide his or her investors stellar returns on an absolute basis rather than a relative basis. Another key element in establishing and maintaining a successful hedge fund venture, is to identify the types of prospective investors best suited for the manager and the strategy employed by the manager. Private fund managers, more than ever, should approach capital raising and capital maintenance with two focal points: (i) identifying the message that they would like to communicate, and (ii) determining the method(s) of delivering the message. Seems simple but it’s not. Both the message and the means of communication not only require commercial knowledge, but must also comply with a labyrinth of laws in the jurisdiction(s) in which prospective investors reside which may include not only complying with the laws of the United States but the laws of one or more other countries (e.g. European Union’s Alternative Investment Fund Managers Directive). In connection with identifying the message, the communication targeting persons residing in the United States may require legal disclaimers and comply with the anti-fraud provisions of the Investment Advisers Act of 1940 and various no-action letters. Further, certain statements and representations should be carefully reviewed against other fund related communication in an effort to root out any inconsistencies between the message and the fund’s offering documents, marketing materials, due diligence questionnaires and regulatory filings.
Over the last several years, fund managers have increasingly been getting their message out by speaking at conferences, writing white papers, conducting interviews with the media and even using social media. For the foreseeable near future due to coronavirus, conferences will either be cancelled or lightly attended. While virtual conferences may seek to fill this void, despite Morgan Stanley’s recent success, it is too early to tell if virtual conferences over the next twelve months will fill the void of the traditional conferences.
Managers have said that one of the benefits of people working from home is that investors are more attentive and available than prior to the coronavirus lockdown.
For managers using these methods of communication, it is important to keep in mind that most managers of private funds seeking investment from investors domiciled in the United States rely on Rule 506(b) (“Rule 506”) under Regulation D of the Securities Act of 1933 (“Securities Act”) to avoid registering their offerings with the U.S. Securities & Exchange Commission (“SEC”) under the Securities Act. Rule 506(b) prohibits general advertising of the fund, such as placing an advertisement through television, newspaper, radio and publicly available websites seeking new investors – this is referred to as the “prohibition against general solicitation”. Some notable exceptions to the prohibition are: (x) an offer to a prospective investor with whom the manager or its agent has a substantive pre-existing relationship, or (y) the dissemination of factual business information excluding opinion, predictions or projections as to the valuation of a security or the fund’s past performance. Prior to using television, radio, internet or social media to share their message, private fund managers should consult with legal counsel. Guidance is fact specific. Violating the prohibition against general solicitation has severe consequences. Due to interpretation of law and the application of fact, lawyers’ opinions vary regarding the specific limitations imposed by the prohibition against general solicitation.
On July 10, 2013, the SEC approved final rules in connection with The Jumpstart Our Business Startups Act (the “JOBS Act”). Rule 506(c) of the JOBS Act enables private fund managers to engage in general solicitation provided that such funds only accept investment from accredited investors and that managers take reasonable steps to verify the accredited investor’s status. Self-certification via subscription documents does not satisfy Rule 506(c)’s requirements. The JOBS Act may ultimately prove useful to both small and large private funds. Managers of smaller funds operate their businesses at a competitive disadvantage against managers of larger funds with mature distribution channels or investor relations teams. Provided that they comply with the law, smaller private funds may be able to utilize the internet to reduce this disadvantage. Larger private funds may consider operating pursuant to Rule 506(c) not only in connection with distributing their product, but also as a prophylactic protection against an unintended breach of the prohibition against general solicitation.
As of today, the impact of the JOBS Act does not appear significant. Based upon filings of Form D with the SEC reflecting Rule 506(c) and the scarcity of advertisements by private funds, both emerging and established fund managers have made limited use of Rule 506(c). Offerings made pursuant to Rule 506(b) remained the most popular during 2019.
The market sell-off in March 2020 has led us into a bear market. The economic downturn is causing investors to question the effectiveness of their current investment strategy and they are considering repositioning their portfolios and market volatility has provided opportunities for select hedged strategies. The JOBS Act may ultimately prove useful to both small and large private funds to take advantage of this opportunity to communicate more effectively with prospective investors and expand their reach.
1. Financial Times, April 29, 2020, The hedge fund class of 2020 is more resilient than in 2008.
2. Bloomberg, April 27, 2020, New Hedges Funds Beg for Cash With Kids in Background.
3. Bloomberg, April 27, 2020, New Hedges Funds Beg for Cash With Kids in Background.