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Sharpe Thoughts – March 2020

Welcome to Sharpe Thoughts, a quarterly newsletter produced by MJ Hudson’s Hedge Fund Team.

Alternative Liquidity Management

 

As covered in a previous edition of Sharpe Thoughts, the tools that manage how and when investor money is returned have always been a part of the fund documentation for liquid alternative strategies. These tools were road tested extensively between 2008 and 2011 and the result is a far better understanding of how best to use them.

Well, a decade on, we find ourselves in the midst of a messianic thunderclap, which has reverberated around global markets and brought us to a similar juncture in the relationships between funds, fund managers and investors.

This time, with the tools sharpened, it may be less of a test of the liquidity management mechanisms themselves, but more of a test of how intelligently, creatively and pragmatically they can be used.

Those of us that care to reflect on those heady days in 2008/2009 will remember that they were characterised by panic, confusion and almost no communication, in many cases, between managers and investors – at its best a “Dear Investor” letter sent as an afterthought, probably too late and nearly always delivering bad news.

It may prove to be temporary, but as we head into the quarter/month end for funds, we appear to be seeing a more thoughtful, less frantic and generally more measured approach to managing this crisis. Some rebalancing of portfolios and reallocation of assets is inevitable, and we may see some redemptions, but we haven’t, as yet, seen the rush of defensive redemptions that characterised 2008/2009.

Maybe, if our industry has learned anything from 2008/2009, it is that after-sales service matters. The “pay and pray” approach to investment is long dead and if the number of update emails, calls and video conferences we are seeing is any indication, fund managers have understood that, they need to be engaging more with their investors.

As quarter/month end approaches, there may be some modest improvement in performance data from the mid-March numbers and this may be enough, in some cases, to avert redemptions in the short-term. However, this may prove to be temporary if further negative economic data drives markets deeper into bear territory. We may see an alignment of interests emerging here between fund managers and investors: the risk of large outflows at present doesn’t suit either party, not least because large outflows in the short-term risk crowding the market and forcing down further disposal prices for assets.

Liquidity management can benefit both parties by averting the risk of large outflows, but fund managers will need to be thoughtful, creative and pragmatic in shaping the solutions.

It is not always the most obvious tools that are best suited for the job at hand. Whereas liquidity management in 2008/2009 focussed primarily on short-term solutions to address immediate cash management requirements, fund managers have the opportunity, this time around, to be a bit more forward thinking and, perhaps, take a slightly longer-term view.

Would an investor prefer to delay redemptions and have the fund sell into a better market? Would an investor be prepared to stay invested if they could get assurances on key concerns? How about lower fees while the fund is underwater? We know, from past experience, that investors will switch from return on capital to return of capital, in a crisis, but this situation is proving different in many respects and so we might expect investors to take a different approach to protecting their investments, too.

In addition to the use of more traditional liquidity tools, fund managers should also consider alternatives, such as the creation of bespoke new share classes, side letters, or spinning out some or all of an investor’s capital into parallel vehicles or separately managed accounts, the terms of which the manager may be able to vary with reduced operating costs and/or reset fees. All of the above offer ways of deferring (or, perhaps, even avoiding) large scale redemptions, stabilising the AUM in turbulent times and giving investors more control of what happens to their investment.

Like more traditional liquidity management tools, these alternatives also require a careful and considered review of the fund documents. Most fund documents should provide for these solutions in the same way that they provide for gating or suspending of redemptions. The analysis will be complicated and will need to take into account a range of complex issues, ranging from the fiduciary duties of the fund directors to the variation or modification of rights attaching to shares and the various statutory, regulatory and constitutional frameworks, in which the fund operates.

Well advised fund managers may find that these solutions are exactly what they need right now.

If you would like further advice on this topic, please contact Sean Scott at sean.scott@mjhudson.com.