Trading Hedge Fund Shares

Originally published in the September 2011 issue

Holdings in hedge funds can be bought and sold, though not freely traded. Tullett Prebon, one of the world’s largest inter-dealer brokers, matches buyers and sellers and its Alternative Investments division has been a growing business for the firm since 2009. Tullett Prebon has seen widespread changes in the hedge fund secondary market over the course of the last three years.

One of the most pronounced changes has been the growing acceptance of the market amongst institutional investors and general partners (GPs) of hedge funds alike. Whereas once, secondary limited partner trading was a marketplace for small family offices and funds of funds seeking short-term liquidity fixes, today there is barely a large institutional hedge fund investor who has not either traded or at the least investigated the market in order to divest illiquid positions or to purchase positions. Indeed, the size and scale of the market has expanded to such an extent that many of the buying entities in the market are not even traditional hedge fund investors, such as private equity funds, or even single manager hedge funds.

In the same vein, whereas a few years ago a significant number of major hedge funds would refuse secondary transfers of ownership in their funds, that position has gradually become harder and harder to justify as more large institutions are entering the market to become investors in those funds through secondary purchases. Furthermore, it has become difficult to explain to investors that have been lumbered with side pockets of investments (many that were never going to align with the fund’s original liquidity terms), that they cannot transfer their position even though there may be a willing buyer.

Indeed, many large funds have now started running auctions or other similar processes in order to create more liquidity and transparency in the trading of their funds. What was once seen as a ‘dirty secret’ of the hedge fund community has now become a widely accepted practice, and GPs are embracing the opportunity to have new investors with longer-term liquidity horizons in their funds to replace existing investors that are cash-starved and with whom the potential to do further business has, in many cases, largely diminished.

Identifying the opportunity
During the financial crisis of 2008, whilst managing several hedge fund portfolios on behalf of a private bank, it was very clear to me that the secondary market for hedge funds could and should be institutionalised. Due to the liquidity crisis, it was clear that the market would necessarily have to evolve into something more robust and structured, as the clearing of illiquid LP interests would likely take several years to complete and be larger in scale than anything seen before.

Having overseen the early stages of the interest rate swaps market in the 1990s as a broker and having participated in secondary trading since 2006, I was already familiar with broking in illiquid, nascent markets. This, combined with knowledge of the hedge fund industry as an allocator, brought the right blend of ingredients to start the desk and develop the market at Tullett Prebon. The opportunity to build the business within the institutional framework that Tullett Prebon provided gave more comfort and transparency to investors, in what was often a difficult and opaque market to transact in. The global reach of Tullett Prebon also helped to provide institutional order flow and a trusted name in execution.

The Tullett Prebon Alternative Investments team realised from the outset that the secondary market is inherently cyclical in nature, and so we have developed other revenue streams that can leverage off existing client relationships. One natural progression that is counter-cyclical to secondaries is primary placements, where the Alternative Investments group is currently working with a roster of managers in order to raise capital from institutions.

There are several other opportunities that have arisen in other illiquid markets as a by-product of the secondary business. For example, the group has been approached several times to work with managers directly in sourcing investors who can either co-invest in deals or even provide financing on projects. For instance, the group is currently working on two deals to source debt financing for funds involved in real estate projects in Russia and China respectively. These are the type of deals it would have been straightforward to find investors for five years ago, but for which there is reduced appetite now due to their illiquid and highly visible nature, and specialist brokers will increasingly be required to identify suitable and willing investors in these projects. We see this as a growth area for the business, where continuing dialogue with managers can lead to various other special situation-type opportunities with direct assets.

The market today
Whereas in the early stages of the market there were few buyers with the ability and experience to execute transactions, today that has changed dramatically. As GPs have become more accessible and open to sharing information and facilitating transactions, there has subsequently been a boom in the number of new buyers entering the market. Whereas in the past there might have been no more than two or three buyers of a particular fund, today there are often more than 10 different buyers that are willing to bid on a name or even a portfolio of funds. Furthermore, in the past many buyers would have a set list of names they would bid on, but today they have learnt to use a more flexible approach and act quickly with limited information – which is now a necessity. As the market has become so competitive, there is also no longer always time for full scale due diligence on every name. Today, an agreement on price can take as little as 48 hours or even less if it is a more liquid name, compared to several days or even weeks a few years ago.

Since 2011, the secondary market has entered a new phase where a greater number of portfolio trades are being done. There are multiple reasons for this trend. One, sellers are looking to clear their illiquid positions in their entirety – both for liquidity and strategic reasons. Second, leverage providers and liquidators are also becoming active sellers of portfolios, which they have wrested out of the hands of fund managers who were mostly incentivized to run them as long as possible so that they could continue to clip fees based on the notional, and generally overstated, asset values. Third, in light of tightened lending standards globally, leverage providers to funds of funds cannot wait any longer for underlying managers to implement complicated workouts on their most troubled investments and are hence taking charge of portfolios themselves.
Should liquidators enter the market as sellers in even a moderate capacity, we feel that the potential size of the supply available could flood the market, even despite the growth in the number of buyers. Certain institutions often provided leverage to several funds of funds on a similar basket of popular names – therefore, when they now aggregate the size of their illiquid holdings in that fund across different accounts, it is not unusual for them to own very large stakes in the managers. Subsequently, should they ever come into the market as serious sellers the supply may be accordingly sizeable.

Frauds generate legal claims
Another hotspot for 2011 has been legal claims based on fraudulent and now defunct fund entities. Encouraged by the successes of trustee Irving Picard to claw back money from issuers of feeder funds and the like, buyers of claims linked to Bernie Madoff’s Ponzi scheme expect them to be worth more in the future than what they can buy them for today. Yet they are pricing a high degree of risk into these Madoff claims, which impacts their pricing. Claims related to the now bankrupt Lancelot and Palm Beach funds, which were exposed to the Thomas Petters investment fraud, and London-based Weavering Capital’s bankruptcy, have also been active. Generally, prices of Madoff claims have been better than those for other claims, though, trading in double as opposed to single digits.

In terms of the broader picture, the continuing clear out of illiquid assets into the hands of institutions that are structured to hold long-term assets, can only help to free up capital and give transparency on what these assets are worth and how they should be valued. End-investors will now have closure on the value of their positions and the subsequent cash to allocate it elsewhere – this will ultimately reduce uncertainty and can only help the industry in future. However, it will not only benefit the hedge fund industry but should also have some knock-on positive effect on the economy as a whole as capital is freed, debts are paid down, and there can ultimately be re-investment in new businesses.

Illiquid holdings substantial
As time passes, and notwithstanding any further major liquidity problems, many assume that the size of the secondary market should theoretically grow smaller and smaller as more positions transact. However, it is worth noting that the aggregate size of illiquid holdings in hedge funds outstanding still runs into tens of billions of dollars – so even a small increase in participants could still grow the market significantly.

Moreover, as the market evolves, we do not see any reason why the trading of secondary interests should remain a ‘distressed’ play in the long term. We feel that the market is good business for investors and managers alike, especially those that are trying to raise capital on a longer-term basis. The facilitation of secondary transactions provides investors with comfort that they will be able to find liquidity for their positions if needed, and therefore encourages them to deploy capital into funds they may not otherwise have.

Managers also gain long-term investors with capital to allocate to more illiquid strategies, and are under significantly less pressure to sell positions as the result of a large investor redeeming, as their holding can simply be replaced by a new entity rather than the underlying positions having to be liquidated. Overall, we feel that the secondary market is a win-win proposition for both investors and managers alike on the basis of sound economic and business principles, and are fully convinced that the market will continue to have a significant future role to play in both good times and bad.