Viability Challenges to Funds of Hedge Funds, Cogency

Viability Challenges to Funds of Hedge Funds
Jeffrey Axelrod, CEO, Cogency

Aug 2009

In the wake of portfolio pressures coming from hedge funds with questionable prime brokers (Lehman, Bear), credit facilities and liquidity, combined with investor pressures arising from the Madoff scandal and the quest for quick cash, funds of hedge funds found themselves at the beginning of 2009 with portfolios spotted with quicksand and landmines, and a capital drain threatening with the force to swallow them.

The sandbags
As a first line of defense, all that a FOHF could do was to mimic what their HF investments were doing to them: dropping gates and suspending redemptions. But if they were going to regain investor trust and stand a chance of getting new money into the fund, they would need to be more creative.

The better dam
What many FOHFs did was to create a protected bucket within the fund, fill it with illiquid and questionable investments and with an equal proportion of investor capital. Within this bucket they could control investor redemptions, charge different fees (often none or reduced), change the high-water mark, and handle forced-redemptions when any money came in from the underlying investments. This allowed the remainder of the fund to continue business as usual – allowing redemptions, reporting good returns as the market improved, and even pulling in new money as the flow of liquid capital changed direction.

Engineering the solution
Words like special purpose vehicle, redemption in kind, side-pocket, and liquidating-trust all began to take on life outside the offering documents. The legal and accounting form of this solution for each firm took on a shape determined by the wording of the fund’s offering documents and the capabilities of their fund administrator’s accounting system.

There were many new transactions and concepts that needed to be tracked and reported on. The rebalancing transactions that create the new entity can take many forms and be quite complex, transferring liquidity terms, fees, high-water marks, and effective dates. There must be ongoing accounting of the illiquid entity. Portfolio redemptions into the illiquid bucket must be monitored, and distributed to investors according to the terms of the new legal structure. And the investor reporting requirements on the balance in their main and illiquid holdings (sometimes separate, sometimes merged) can be complex.

In cases where the fund administrators could not accommodate the structures and reporting that the fund required, they either provided workaround solutions in Excel spreadsheets, or worked with the fund to restructure the solution to fit the available tools.

Long term environmental impact
The FOHF environment is forever impacted by the events of the past 9 months. First off, FOHFs that have been successfully self-administered for years now feel the pressure from investors to have an outside fund administrator. Regardless of the actual value, the perceived value is undisputable.

Even with an administrator, FOHFs now need to show their investors solid accounting controls - tracking valuation direct from the HF managers and cross-checking the administrator numbers with internal shadow accounting systems. And even beyond direct knowledge of HF valuation, FOHFs need to show that they understand the content of the investment portfolio of their HF managers. This is leading toward greater usage of managed accounts which, besides providing transparency into the portfolio, also provide quicker liquidity, albeit at the cost of additional oversight.

Recovery prognosis
By May 2009, the FOHF year-to-date returns were some of the best in their long-term history. With time passing and lessons learned, the industry is adjusting and recovering. FOHFs are showing a stronger interest in manager due-diligence and shadow accounting, with more attention placed on showcasing internal controls to investors. On the investor front, there is cash sitting in the portfolio of pension funds, endowments, family offices, and high-net-worth individuals, soon to be looking for a better home than the mattress.