discretionary liquidity: hedge funds, side pockets, and gates

Adam AikenQuinnipiac University

Chris CliffordUniversity of Kentucky

Jesse EllisUniversity of Alabama

Discretionary liquidity: Hedge funds, side pockets, and gates

Liquidity

Mutual fund

Private equity fund

Motivation:

Tension between the liquidity of the fund’s assets and the liquidity of the fund’s redeemable claims

Liquidity

Motivation:

Hedge funds and the liquidity premium

-Funds that load on liquidity risk subsequently outperform low-loading funds by 6%/year (Sadka, 2010)

-Funds with more restricted share liquidity outperform less restricted funds by 4-7%/year (Aragon, 2007)

Mutual fund

Private equity fund

Hedge fund

Liquidity

How do hedge funds manage share liquidity?

LockupAverage: 179.3 days

Redemption frequencyAverage: 98.8 days

Redemption notice periodAverage 53.9 days

Mutual fund

Private equity fund

Hedge fund

What happens when these liquidity restrictions aren’t enough?

-Aggregate net outflows for hedge funds ≈ 25% Q4 2008:Q1 2009

-Withdrawal requests during the crisis led HFs to sell their most-liquid assets (Ben-David, Franzoni, and Moussawi, 2011)

-Outflows from hedge funds with higher share liquidity lead to worse performance (Teo, 2011)

-Hedge fund dependence on outside financing can lead to loss spiral (Shleifer and Vishny, 1997), (Brunnermeier and Pedersen, 2009)

GP sells assets to

meet redemptions

Prices fall further

Loss on existing

positions

LPs withdraw funding

Initial loss occurs

Loss spiral

GP sells assets to

meet redemptions

Prices fall further

Loss on existing

positions

LPs withdraw funding

Initial loss occurs

What if the manager could use discretion to suspend redemptions and stop the spiral?

Discretionary liquidity restrictions (DLR)

Gate:

-Limit the ability of investors to withdraw capital

-Fund-level vs. investor-level gates

-Typically continue to charge both management and performance fees

-Redemptions are met on a pro-rata basis and residual withdrawal requests are rolled over to next redemption period

Discretionary liquidity restrictions (DLR)

Side pocket:

-Separate account used to segregate illiquid or hard-to-value assets

-Typically remains illiquid for a lengthy period of time

-May continue to charge both management and performance fees (although they are typically accrued until assets are liquidated)

-New investors in the fund do not buy in to the side pocket. Thus, returns to old and new investors will differ.

DLR fund = 1 if side pocket or gate in the quarter, and = 0 otherwise

DLR

freq

uenc

y

DLR: Liquidity story

-Allows fund to unwind illiquid positions in an orderly manner

-Allows fund to create an NAV from which to contract with investors

-Prevents remaining investors from holding an increasing share of illiquid assets

DLR: Agency story

-Dulls the monitoring function of demand deposits (Fama and Jensen, 1983), (Diamond and Rajan, 2001), (Ang and Bollen, 2010)

-Allows fund to preserve capital and continue to charge management fees

-Used to obscure fund returns and earn performance fees

-Allows fund to segregate poorly performing assets and stay above high-water mark in main fund

-Creates option for how the fund markets its returns in commercial databases

Research questions

-What are the determinants of DLRs?

-Following a DLR, what are the performance implications to the fund?

-What are the reputational effects to the fund and its family affiliates?

Data1. Union of 5 commercial databases (Kosowski, et al.

2012) Lipper TASS, HFR, Barclay Hedge, Morningstar, Eurekahedge

2. Funds of hedge funds (FoFs) registered with the SEC pursuant to the Investment Company Act of 1940 from 2006-2011 57 unique FoFs 1,411 unique HFs 15,133 unique FoF-HF quarterly holdings

739 funds are in both 1. and 2. 672 are in 2. only

Summary Stats

Variable N Mean Median 10% 90% Std. Dev.DLR fund (0|1) 739 24.36% 0.00% 0.00% 100.00% 42.95%

Duration of illiquidity event (qtrs.) 180 7.94 7.00 1.00 15.00 5.70AUM ($MM) 629 932.0 422.0 65.8 2,350.0 1,360.0

Quarterly % flow 558 4.34% 1.63% -7.55% 18.13% 14.34%Age (years) 739 6.9 5.6 2.0 14.1 4.8

Management fee (%) 732 1.55 1.50 1.00 2.00 0.51Incentive fee (%) 737 19.58 20.00 20.00 20.00 3.23

Leverage (0|1) 691 64.11% 100.00% 0.00% 100.00% 48.00%Lockup (days) 692 179.3 0.0 0.0 365.0 246.0

Notice period (days) 717 53.9 45.0 20.0 90.0 33.2Redeem frequency (days) 714 98.8 90.0 30.0 180.0 99.3

Return (quarterly) 673 0.27% 0.96% -4.79% 4.63% 6.17%

Research questions




Determinants of DLR Estimate 3 types of liquidity risk (Aragon, Liang, and Park,

2012): Share liquidity

withdrawal frequency (Teo, 2011)

Asset liquidity 36-month AR(1) model (Getmansky, Lo, Makarov, 2004)

Market liquidity 36-month rolling regression of market and liquidity factor (Sadka,

2010)

Fees (management and performance) Other firm characteristics Time and style fixed effects Std. errors clustered at fund level

, ∗ , ∗ ,

∗ , ∗ , ,

1 2 3 4Share illiquidity(t-1) 2.1040*** 1.6901**

[0.004] [0.040]Asset illiquidity(t-1) 1.9904*** 1.3516**

[0.001] [0.018]Market illiquidity(t-1) 0.3518*** 0.2650**

[0.003] [0.031]Management fee 0.3823** 0.3607** 0.2762 0.4079**

[0.014] [0.039] [0.107] [0.017]Incentive fee 0.0694** 0.0686*** 0.0865*** 0.0772***

[0.017] [0.005] [0.002] [0.004]Log size(t-1) -0.1445 -0.1173 -0.0843 -0.1377

[0.103] [0.207] [0.351] [0.141]Log age(t-1) 0.2228 0.3004 0.0613 0.0939

[0.355] [0.331] [0.853] [0.776]Return(t-1) -3.1561*** -2.9401*** -3.3314*** -3.2290***

[0.000] [0.000] [0.000] [0.000]Time FE Yes Yes Yes YesStyle FE Yes Yes Yes Yes

Observations 5,531 4,681 4,279 4,050pseudo r-squared 0.308 0.302 0.315 0.345

Research questions




Performance of DLR funds What would performance have been if the fund didn’t

enact a DLR?

Naïve approach Event time, portfolio approach centered around the DLR event Return in excess of an equal-weighted hedge fund index

Matched sample approach Untreated fund with the closest propensity score using the DLR

determinants logit model

-25%

-20%

-15%

-10%

-5%

0%

5%

-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

A naïve approach: Buy and hold excess returns for DLR funds

Propensity score matchingDLR Event Funds Control Funds Difference in

mean returnsDifference in mean cumulative returnsPeriod Mean Cumulative Mean Cumulative

-2 -0.94% - -0.16% - -0.78% --1 -4.66% - -3.33% - -1.33% -

Event Quarter -4.49% - -4.57% - 0.07% -+1 -2.13% -2.13% 0.47% 0.47% -2.59% ** -2.59% **+2 0.97% -0.97% 3.55% 4.78% -2.58% ** -5.74% ***+3 0.13% 0.04% 4.44% 9.80% -4.30% *** -9.76% ***+4 2.03% 3.36% 3.40% 14.78% -1.37% -11.43% ***+5 0.39% 4.58% 2.90% 18.55% -2.51% ** -13.97% ***+6 -1.21% 2.36% -0.32% 18.54% -0.89% -16.18% ***+7 0.05% 2.59% 2.26% 22.48% -2.21% * -19.90% ***+8 -0.41% 0.87% 2.78% 28.73% -3.19% ** -27.86% ***

Research questions




Reputational impact of DLRs DLR funds restrict liquidity to investors and exhibit

abnormally low performance in the process

What effect did the DLR decision have on the fund’s reputation?

Flows to DLR funds and their families

Changes in fees and liquidity restrictions to DLR families

Fund flows Standard, normalized quarterly net flows post-crisis

period

Piecewise linear, lagged performance specification (Ben-David, et al., 2012)

Lagged fund characteristics

Indicator variable if the fund was: DLR fund DLR family DLR flagship

Include DLR funds Exclude DLR funds1 2 3 4 5

DLR fund -0.0347** -0.0412***[0.012] [0.003]

DLR family -0.0264*** -0.0268***[0.000] [0.000]

DLR flagship -0.0461*** -0.0527***[0.002] [0.000]

DLR non-flagship -0.0239***[0.002]

Controls Yes Yes Yes Yes YesTime FE Yes Yes Yes Yes YesStyle FE Yes Yes Yes Yes Yes

Observations 7,458 7,458 7,118 7,118 7,118Adj. R-squared 0.0402 0.0429 0.0443 0.0426 0.0446

Fees and share restrictions If DLR funds have a harder time retaining/raising

capital due to reputational penalty, we expect the fund to lower fees and reduce liquidity restrictions going forward

Repeated snapshots of BarclayHedge and Lipper Tass (Agarwal and Ray 2013) Performance fee Management fee Lockup Redemption frequency Redemption notice period

Incentive fee Management fee Lockup Redeem freq. Redeem notice

DLR family 1.5369** 1.2845*** 0.4203 1.1185*** -0.4170

[0.024] [0.002] [0.431] [0.008] [0.318]

Controls Yes Yes Yes Yes Yes

Observations 519 519 514 492 519

Adj. R-squared 0.351 0.251 0.278 0.0999 0.0702

Decision to lower fees and liquidity in the post-crisis period

Conclusion Agency costs associated with DLRs appear to

outweigh the liquidity-based rationale for restricting investor liquidity

Funds that enact a DLR underperform both a passive benchmark, as well as an untreated matched sample

Investors, however, appear to rationalize these agency costs, as funds and their families incur costs for enacting a DLR

EXTRA SLIDES

Registered Funds of Hedge Funds Closed end investment company that invest assets

primarily in hedge funds

Registered with SEC under Investment Company Act 1940

Upside: registering with SEC gives funds more flexibility: allows FOF to advertise, can more easily accept ERISA money

Downside: registered funds must make regular public disclosures of their underlying holdings and performance to SEC

Registered Funds of Hedge Funds Like “typical” FoFs: lockups, irregular liquidity,

performance based fees, marketed to qualified investors

Unlike “typical” FoFs: small initial investment, higher standard of disclosure

Generating Returns

Returns From Cost and Value

6.04% 117,406,063

018,466,124

Table 1Panel A: Full Sample

Variable N Mean Median 10% 90% Std. Dev.DLR fund (0|1) 1411 26.08% 0.00% 0.00% 100.00% 43.92%

Duration of illiquidity event (quarters) 368 8.04 7.00 1.00 15.00 5.54Holding period (quarters) 1411 11.13 10.00 2.00 23.00 7.45Holding size (% of AUM) 1411 3.26% 2.84% 0.60% 5.97% 3.44%

Holding size ($MM) 1411 11.90 5.56 1.08 26.80 18.80Redeem frequency (days) 1056 125.16 90.00 30.00 360.00 116.40


Panel B: Database SampleVariable N Mean Median 10% 90% Std. Dev.

DLR fund (0|1) 739 24.36% 0.00% 0.00% 100.00% 42.95%Duration of illiquidity event (quarters) 180 7.94 7.00 1.00 15.00 5.70

AUM ($MM) 629 932.0 422.0 65.8 2,350.0 1,360.0Quarterly % flow 558 4.34% 1.63% -7.55% 18.13% 14.34%

Age (years) 739 6.9 5.6 2.0 14.1 4.8Management fee (%) 732 1.55 1.50 1.00 2.00 0.51

Incentive fee (%) 737 19.58 20.00 20.00 20.00 3.23Leverage (0|1) 691 64.11% 100.00% 0.00% 100.00% 48.00%Lockup (days) 692 179.3 0.0 0.0 365.0 246.0

Notice period (days) 717 53.9 45.0 20.0 90.0 33.2Redeem frequency (days) 714 98.8 90.0 30.0 180.0 99.3


Selection issues of registered FoFs

Registered FoF Database FoF Difference

Quarterly Return (%) 0.89 0.82 0.08

AUM ($MM) 273 208 65**

Age (years) 4.2 3.5 0.6***

Minimum Investment ($) 528,559 727,619 -199,060***

Mgmt. Fees (%) 1.31 1.35 -0.04**

Incentive Fees (%) 8.45 7.48 0.97***

Liquidity

Mutual fund

Private equity fund

Tension between the liquidity of the fund’s assets and the liquidity of the fund’s redeemable claims

Grosvenor Multi-Strategy FoF

Fund name Cost Value% of

portfolio

Canyon Value Realization Fund, L.P. (k) 12,551,734 10,560,517 2.40HBK Fund, L.P. (l) 6,773,877 5,964,665 1.35OZ Domestic Partners, L.P. 12,215,226 12,297,000 2.79Sandelman Partners Multi-Strategy Fund, L.P. (m) 4,134,367 2,259,699 0.51Stark Investments, L.P. 13,022,119 11,427,666 2.59SuttonBrook Capital Partners, L.P. 9,075,698 10,549,011 2.39

(k) The Portfolio Fund has restricted redemption rights by creating a liquidating entity to hold its illiquid assets.

(l) The Portfolio Fund invoked the mandatory 10% fund-level gate on withdrawals.

(m) As a result of significant withdrawal requests, the Portfolio Fund implemented a reorganization plan which included an ongoing class and a liquidation option. The Fund selected the liquidation option.

Case law Lerner Master Fund vs. Paige Capital Management Settled in August 2011 “You cannot win because you will spend more

litigating than we’re fighting over … we decide the best way to protect the funds, and your opinion is irrelevant.”

discretionary liquidity: hedge funds, side pockets, and gates

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