Hedge Fund Listings

Undemocratic and remove the incentive to perform

Originally published in the June 2007 issue

How do investors benefit by accessing funds of hedge funds through London-listed permanent capital funds? Whilst I have held my views on this question for a considerable amount of time, I am often asked it since it is my job and the job of my team to advise our clients on how to best invest in hedge funds.

I believe investors in many permanent capital funds would be better off seeking uncorrelated returns directly through open-ended offshore vehicles, rather than London-listed vehicles. This is because, I believe, the permanent capital structure unfairly penalises investors, is undemocratic and de-motivates the fund management team to perform.

Before entering into a technical discussion over the faults of the permanent capital structure, it is worthwhile discussing the evolving relationship between UK High Net Worth Individuals and the hedge fund market in general.

When we established the ARjENT Alternative Investments desk two years ago, our fieldwork resulted in findings which pointed to the fact that few HNWIs outside of London were investing in hedge funds. This is primarily due to the fact that the wealth management market is dominated by local IFAs, and IFAs typically recommend instruments with daily liquidity and low minimums – in other words OEICs that invest in UK stocks and bonds rather than more sophisticated investment strategies such as hedge funds. This one-dimensional investment approach is compounded by a property culture in Britain and the unfortunate perception that property, as an investment has ‘no downside’. Hence a significant number of UK investors are typically overweight in both domestic stocks and UK property.

ARjENT’s business objective has always been to broaden what we believe to be the under-diversified British investment portfolio. Our proposition has consisted of facilitating access to the high quality FoHFs and blue chip singlemanager funds. Part of the rationale behind these investments has always been delivering a level of portfolio protection and diversification, which is unavailable to the long-only investor. And we believe the most effective method of meeting this objective is through hedge fund investing but more specifically through the offshore open-ended vehicle rather than through permanent capital.

Permanent capital is being sold to investors on the basis of its liberal liquidity terms, accessible minimums and favourable tax treatment.

The principal advantage of investing in permanent capital hedge funds, as claimed by managers, is ready liquidity. For the investment manager, a listed investment vehicle provides the ultimate ‘lock-up’ for invested capital because by definition, it is permanent.

For the investor it is supposed to provide ‘immediate’ liquidity since, assuming the LSE is open, one can sell shares (unlike an offshore open-ended vehicle, which typically offer monthly or quarterly liquidity). We believe that the threat of redemption helps to keep a manager accountable and that this motivation is absent from permanent capital funds but present with the open-ended structure because when an investor redeems from an open-ended fund, the fund manager loses their mandate, and the relevant revenue associated with managing that capital.

Furthermore, holders of permanent capital funds cannot necessarily liquidate their shares for the same price as all other investors since the price of the share fluctuates and rarely equates to the NAV of the underlying fund – receiving whatever the open market will pay for them. We believe that current price action evidences that the permanent capital structure is weighted in favour of the manager, rather than the investor. In addition, an investor’s ‘liquidation’ value is further affected by the impact of the bid offer spread, which will be wider if the shares are illiquid and difficult to execute if the size of the position is large.

For example, the number of hedge funds trading at a discount increased from 14 to 17 of 26 (65%) of sterling listed funds from January to April 2007 with the average discount increasing to 4.1% from 3.1%. Of these funds only 3 have produced negative returns over the past three, six or twelve months implying that discounts on funds could be a feature of their structure rather than the ability of the manager to deliver performance .

We have not allocated any client money to permanent capital hedge funds because by investing in them we would be exposing our clients to an additional unwanted risk, namely the risk of a discount. If an investor wishes to offload permanent capital they receive what the market will offer to pay, not the NAV of the fund. The facts show that a manager does not need to generate negative returns for a fund to trade at a discount further.

If the discount persists, this will translate into a very strong chance that the investor will face an ‘exit penalty’ on the value of their investment when the trade is closed. Add any initial charge going into the trade along with the bid-offer spread and an investor may need to gross as much as 10% in order to break-even on the trade round trip.

Managers of permanent capital funds ‘pound the table’ about the tax benefits. We recognise that there are certain tax benefits, but fundamentally we invest in an asset because we have compelling reasons to believe that the investment will appreciate in value not because it ‘makes sense’ from a tax perspective. It is for this reason we work closely with the IFAs of our clients to determine whether the hedge fund component of the portfolio can be allocated on a tax deferred basis, via a pension fund for example.

With respect to the third argument for permanent capital, namely enabling smaller investment amounts, we have asked ourselves whether investments of as little as a few thousand pounds should be allocated to hedge funds in the first place.

Investment at such levels raises the question of who will be giving the investment advice. Do investors understand the underlying strategies? Have they met the managers? What information is available to them to back up that investment decision? Do they recognise how their investment fits within their overall investment strategy and how will they know when to close their position if needed? The amount of due diligence and investor education required pre- trade and the level of coverage we give to clients post-trade is considerable, as we want investors to understand what they are actually investing in.

We do not believe that investors should be allocating to hedge funds without this level of advice or attention. Indeed, we have argued for some time that the welcomed increase in investor access to hedge funds should be accompanied by more rigorous training on the part of financial advisers in the same way that an adviser can only advise on pension transfers after obtaining a specific qualification.

In conclusion, we fundamentally believe that an investor should be able to remove his or her capital from a manager at not only the NAV but also at the same price as everybody else. For this reason we opt for the offshore open-ended structure, where the process is much more democratic, investors redeem their units at the same price on the next dealing day.

Gregory Perdon is Head of Alternative Investments, ARjENT