Listed Hedge Funds 2008 Review

Threats and opportunities

TOM SKINNER, CAZENOVE

The listed hedge fund sector looked set for another year of exceptional growth at the start of 2008. However, by the end of the year it was evident that the sector was set to shrink and consolidate. Indeed, having previously been seen as something of a paragon for discountcontrol in the closed-end fund sector, discounts have widened dramatically. With investors disappointed by performance in 2008, and several funds of hedge funds (FOHF) being forced to abandon currency hedging due to a lack of available cash, the sector finds itself under intense pressure as funds conduct tenders and face continuation votes in 2009. Yet current discounts also provide exciting opportunities for investors who are optimistic about the prospects for hedge fund performance next year.

In 2008, there were four new fund launches and thirteen existing funds were able to raise additional capital through follow-on fundraisings. In total an estimated £1.69 billion was raised during the year, of which 56% was from multi-manager FOHFs. One of the most notable new launches was BH Global (raising £534 million), as Brevan Howard became the first single manager to list a second fund on the London market. Funds of funds launched by FRM (FRM Diversified Alpha) and BlackRock (BlackRock Absolute Return Strategies) demonstrated the increased institutional quality of the listed asset class. As it has transpired, the performance of Brevan Howard’s funds has been one of the few notable positives in a torrid year.

For the 10 months to the end of October, only three funds achieved positive Net Asset Value (NAV) returns: BH Macro (US$ return of 19%), BlueCrest AllBlue (US$ return of 8.7%), and Cazenove Absolute Equity (£ return of 10.9%). No multi-manager FOHF managed to make a positive return although Dexion Trading (£ return of -7.2%), FRM Credit Alpha
(£ return of -10.5%) and Absolute Return Trust (£ return of -10.8%) deserve some credit on a relative basis. The average listed fund (FOHFs and single manager funds) returned -20.6% to the end of October, with the average ungeared fund of hedge funds down 17.0% and the average single manager fund down 20.6%. (see Table 1).

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Given their listed structure, share price performance is ultimately what investors in listed funds enjoy. Unfortunately, on a share price basis, performance was substantially worse than at an NAV level as discounts (the percentage difference between the share price and the NAV) widened out dramatically in the final quarter of the year (see Fig 1).

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Share prices had generally traded close to NAV or at a slight premium for the majority of the year, facilitating fundraising in the sector. By the end of October, however, the average discount on FOHFs had moved to around 20% and continued to move wider in November. Dexion Absolute (the largest listed FOHF) traded as wide as 36% during November.
The main reasons for the widening of discounts included uncertainty over NAV values, reduced liquidity of underlying investments, concerns over the prospects for hedge funds, and the effects of large foreign exchange movements. Taking all these factors together, wide discounts are the market’s response to a significant increase in the perceived risk of the investment.

Uncertainty over NAV values increased markedly as a consequence of increased volatility of hedge fund performance, speculation over specific hedge funds getting into difficulty, increased volatility of euro or sterling adjusted NAVs (from imperfect FX hedges and, in some cases, the removal of FX hedges) and significant revisions between estimated and final NAVs. The raising of gates and the suspension of redemptions at underlying funds has reduced the potential wind-up value of FOHFs and suggests an illiquidity discount is being applied to the FOHF on the basis of the liquidity of the underlying assets. In the event of a FOHF being liquidated the timescale to obtain a full repayment of capital has become extended and the capital returned is subject to increased performance risk. Indeed, concerns over near-term performance, due to hedge fund deleveraging and redemptions, have also been a contributing factor to discount levels. Moreover, given the divergence between expectations and outcomes in 2008, confidence in hedge funds to generate consistently superior performance has undoubtedly been diluted.

The dramatic appreciation of the dollar in October and November caught many FOHFs by surprise. The initial reaction of FOHFs to widening discounts in September and early October had been to buy back shares, mainly funded through short-term borrowing facilities, prior to receiving redemptions proceeds from underlying funds. Unfortunately, not only did buy backs have little effect on discounts levels, but they also consumed available cash, which became precious as the dollar rapidly appreciated. The appreciation of the dollar required FOHFs to make large margin payments on the FX forward positions used to hedged non-dollar share classes (80% of sector AUM is denominated in non-dollar currencies).

This triggered a cash crunch for many funds which was more severe for those that had already used some of the available cash to buy back shares. In the main, borrowing was used to meet margin calls and, in the absence of sufficient redemption proceeds at the end of the month, most FOHFs became modestly geared into falling asset values. As asset values continued to decline, and the dollar continued to appreciate, several funds became in danger of breaching borrowing limits. As a consequence, several funds were forced to suspend or reduce FX hedging, including Dexion Absolute, Dexion Alpha, Dexion Equity Alternative, GS Dynamic Opportunities, KGR Absolute Return, Gottex Market Neutral and Thames River Hedge+. The lack of cash, expected to persist until early 2009, prevents FOHFs from buying back shares, removing a potential discount floor from the market.

Discounts were expected to be kept narrow by “Discount Control Mechanisms” (DCM). These are commonly structured so that if the average discount (predominately based on month-end data points) over a 12 month period is wider than 5% (or some other trigger level), then investors are automatically offered either a tender or the chance to wind-up the fund (through a continuation vote). During 2008, two funds (Dexion Equity Alternative and Dexion Alpha Strategies) survived continuation votes triggered as part of a DCM. However, both of these funds, in addition to another nine funds, looked set to have triggered DCMs by the end of the year. In response, many funds proactively announced tender opportunities (scheduled for both prior and post expected continuation votes). As such almost £3 billion of net assets in the sector look set to be on the chopping block in early 2009.

This represents around a third of sector net assets, consistent with the likely reduction of AUM of the wider hedge fund universe. The most high profile of those funds offering investors an exit will be Marshall Wace TOPS, where investors will be able to redeem their entire holding at NAV in early January. The largest FOHF, Dexion Absolute, will also offer shareholders tender opportunities (based on December and June NAVs) as well as a continuation vote in March 2009. More funds, therefore, look likely to join the listed funds which liquidated or commenced winding-up during 2008: New Star Absolute Return, HSBC European Absolute, PSolve Niche Opportunities, F&C Event Driven and Close Man Hedge. Indeed, monthly sector net inflows (issuance minus buybacks, announced tenders and liquidations) turned negative from August onwards (see Fig.2).

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Listed hedge funds will enter 2009 fearing for their survival but offering appealing opportunities for investors positive on the outlook for hedge funds. Despite strong performance and discount control mechanisms, the three best performing funds of 2008: BH Macro, BlueCrest AllBlue and Cazenove Absolute Equity, all trade on meaningful discounts (between 11% and 20%). Those single manager funds that have endured a difficult year languish on even wider discounts (c. 40% for some) and offer the potential for a double benefit should performance bounce back and discounts narrow (as a response to performance or due to corporate actions). Within FOHFs, there are opportunities to play the special situations around continuation votes and exit opportunities. Even funds that have already announced timetables for tenders or continuation votes remain at wide discounts (e.g. Dexion Absolute on a discount of circa 30%). The best performing FOHFs are also on wide discounts and offer appealing entry points for long-term investors confident in a recovery in hedge fund performance.

The sector will undoubtedly shrink significantly in 2009 through tenders, wind-ups and buybacks (once cash flow permits). ‘Permanent Capital’ will, therefore, prove transitory for many funds. Indeed, the sector is likely to consolidate around the best performing funds with a core offering. Those that have tried to differentiate themselves from core multi-strategy FOHFs through gearing, more adventurous strategy exposure or a more narrow strategy focus seem most at risk. Nevertheless, the favourable structural characteristics of the listed sector, not least the tax benefit for UK private investors, should ensure that the best funds survive. These funds will then be able to grow in strength by profiting from the growing hedge fund opportunity set.

ABOUT THE AUTHOR

Tom Skinner is an Investment Companies Research Analyst at Cazenove, leading coverage of Listed Hedge Funds. Prior to joining Cazenove, he worked as a Government Economist, having graduated from Merton College, Oxford with a first class degree in Economics and Management.