Hedge funds have $100 billion still locked up

Despite assurances to the contrary, a segment of hedge funds still has as much as $100 billion locked up and won't allow redemptions.

Most hedge fund managers that stopped all redemptions or put illiquid assets into emergency side pockets in 2008 and 2009 told investors they needed two to three years to clear their portfolios so they wouldn't have to sell hard-to-value assets at fire-sale prices.

Industry observers said time's up for hedge fund managers that aren't finished liquidating their portfolios and honoring redemption requests.

Most hedge funds that had liquidity problems “have gotten to the point where 95% to 99% of their portfolios are cleaned up,” said a hedge fund-of-funds manager who asked for anonymity. “There are these small dregs left in their portfolios, hedge fund rumps that don't go away, that you don't forget about, that are distracting and annoying, but which aren't headline news.”

But there remains “a sliver” of funds stubbornly hanging on to more than a slight percentage of their portfolios, and those funds aren't returning money to investors who want it back, said Geoff Varga, a partner and leader of the insolvency and distressed practice of Kinetic Partners US LLP, New York, a business consultant to money managers.

“The percentage of hedge funds that still are illiquid is small compared to the universe of tens of thousands of funds, but at a notional $100 billion, this is a significant amount of money,” Mr. Varga said in a telephone interview.

The problem, Mr. Varga said, arose because “everyone had so much money to put to work in 2005 and 2006 that they turned to non-standard investments like life settlements, direct lending arrangements and asset-backed lending, among other exotics, that turned toxic.”

The number of gated funds or those with emergency side pockets is impossible to tally, and the dollar value of their illiquid portfolios is only an estimate, Mr. Varga said. That's because “there is so little transparency available about what managers are locked up, what they have in their portfolios and whether the managers' valuations of their illiquid assets are at all realistic.”

Significant assets

Among the open and closed hedge funds with significant assets to liquidate, sources say, are those managed by GLG Partners, now a part of Man Group PLC; Harbinger Capital Management LLC; Highland Capital Management LP; and RAB Capital PLC.

Indefinite redemption suspensions, unsuccessful restructuring attempts, valuation controversies and slow, ineffective wind-down practices nearly three years after the liquidity crisis have driven investors to take action, Mr. Varga said.

Among those actions: a sharp rise in the number of targeted legal actions designed to force hedge fund managers to liquidate their funds and return assets, said Mr. Varga, who serves as an appointed liquidator of hedge funds, including those of Bear Stearns & Co.

“Investors who had no reason to disbelieve a hedge fund manager back in 2008 and 2009 when he said the assets could be sold over two to three years at better than fire-sale prices now are getting restive. Antsy investors are saying, `I want my money back,' so they can put it to work in new hedge fund opportunities in the extended market rally,” Mr. Varga said.

Added Alan Alzfan, a partner in the financial services group of McGladrey & Pullen LLP, Bloomington, Minn., a tax and compliance consultant: “What's probably causing the most frustration for investors is the set of hedge fund managers who could, but won't, liquidate their portfolios because they think they're worth more than the market says they are.”

The market has not been generous in valuing some of these portfolios, judging from the deep discounts seen in trading on hedge fund secondary markets.

While brokers such as Tullett Prebon and Hedgebay Trading Corp. report an increase in volume of illiquid hedge fund side pockets being listed on their markets, trading is slow and what's selling is at a very deep discount. For example, London-based Tullett Prebon reported that the average monthly discount of hedge funds shares sold in its secondary market was 58% in February.

Part of the reason for the deep discount and buyer disinterest in secondary market offerings is the lack of transparency, said Patrick Adelsbach, a partner at specialist hedge fund consultant Aksia LLC, New York.

“The hedge fund manager probably didn't show the original investor what is really in the portfolio and has absolutely no incentive to show a potential buyer on the secondary market what's in the stake that's for sale. There are some great deals to be found in the secondary market, but it's procedurally complicated to go through these ... offerings and you have to ask whether it's worth the time to go through pages and pages of potential deals. Most share offerings are (between $1 million and $3 million) and these share allotments just aren't large enough to make it worth the time,” Mr. Adelsbach said.

That said, Neil Campbell, Tullett Prebon's head of alternative investments, noted that there have been “some fantastic deals in the secondary market over the past two years and some buyers have made a lot of money. But you often have to wait it out until these portfolios come back.”

That makes some of these distressed portfolios ideal for institutional investors because of their “long-term investment horizons,” Mr. Campbell said, adding that pension fund, endowment, foundation and sovereign wealth fund investors “are definitely interested in and buying on the secondary market. If you like Cerberus (Capital Management) at $1, you'll love it at 75 cents.”

Sources said many hedge funds-of-funds managers, including those with institutional clients, were hurt by the illiquidity of the underlying hedge funds in their portfolios and had to institute redemption gates themselves as a result.

Morgan Creek Capital Management LLC, Chapel Hill, N.C., will make the last distribution to investors in July from a side pocket of illiquid assets it added to the onshore version of its flagship Morgan Creek Absolute Return Fund in 2008. The side pocket in the offshore version already has been distributed, said Mark W. Yusko, president, CEO and chief investment officer.

About 31% of the aggregate portfolio was illiquid post-crisis; that's down to 21% now and doesn't impact Morgan Creek's ability to meet client redemption requests, Mr. Yusko said. Assets managed in both funds total $310 million. The firm manages a total of $9.4 billion.

Mr. Yusko said Morgan Creek actually got more money back faster than expected from underlying hedge fund managers by “being creative about how we've unwound the portfolio. No one is proud of being in this situation, but if we had sold at a discount right away, it would not have been the best thing for our investors.”

Hedge funds-of-funds manager Silver Creek Capital Management LLC, Seattle, offered clients the choice of redeeming or remaining invested in its low volatility strategy funds after the liquidity crisis in 2008. Redeeming clients have received steady distributions from the fund's side pocket of illiquid assets totaling about 50% of the gated assets in the first two years, said Bryan J. Weeks, president and chief operating officer. Mr. Weeks declined to give the size of assets managed in the firm's low-volatility strategy funds.

Mr. Weeks said it might take three more years before the side pocket is completely liquidated, although strong performance in the fund is creating more liquidity that could lead to faster distribution.

Silver Creek manages about $6.6 billion and has had inflows of $400 million over the last nine months into in a new core multistrategy hedge fund of funds that offers quarterly liquidity and no side pocket.

Liquidity problems

Treesdale Partners LLC, New York, received redemption requests following the financial crisis that totaled 15% to 20% of its $1.6 billion fixed-income hedge fund of funds, and ran into big liquidity problems with the underlying hedge fund managers, said Dennis Rhee, managing member and founder.

“We used mostly commingled funds, and many of those managers gated their funds, which created a lot of liquidity problems for us, given the level of redemption requests we received. We could have stayed open, but we gave our investors, all of which are institutions, a say in the decision and they all agreed that we should go through an orderly wind-down,” Mr. Rhee said.

About 90% of the assets have been returned to investors, but Mr. Rhee said he expects that “there may be a tail for another year or two because the last underlying hedge funds are long lock-up commingled funds. We tried unsuccessfully to sell the shares on the secondary market.”

The experience has convinced Mr. Rhee and his management team to get out of the hedge funds-of-funds business entirely and to concentrate on building a family of internally managed fixed-income hedge funds using separate accounts. The company already has attracted $170 million to a residential mortgage-backed/asset-backed securities single strategy hedge fund and plans to recruit fixed-income teams to launch more funds.