Hedge funds are roach motels….once you check in, you can never check out. Well, the Wall Street Journal says so, so it must be true.
A couple of days ago, the WSJ ran an article on the ongoing trials and tribulations of Ritchie Capital, described as a “high-profile hedge fund.”
Ritchie has suspended redemptions on its flagship fund, meaning that investors are locked in with no direct control over when and how they will receive proceeds back from their investment. The WSJ sums up the dilemma for investors in Ritchie and plenty of other funds:
“Amid a continuing credit crunch, a growing number of hedge funds are restricting people from withdrawing their money for a period of time. Funds say they have no choice: to return the money, they’d have to sell off assets, leading to deeper losses for all their investors. But critics say locking down investors’ stakes chiefly benefits fund managers, who get to keep earning hefty management fees.”
The Ritchie case raises a number of issues beyond redemption gates and suspension of the NAV. These include alleged style drift, a plan to freeze assets for three years and then a failed plan to sell assets to another fund.
There is also the ongoing question of whether hedge fund offering documents can provide a manager with complete latitude to do absolutely anything (e.g. “notwithstanding the above, nothing in this offering document shall be construed to restrict the potential investments and strategies which may be employed by the Investment Manager on behalf of the Fund in any way.”) This is, of course, a topic very familiar to Amaranth’s investors – despite being sold as a “multi strategy” fund, Amaranth’s legal counsel claim, in essence, that the fund’s offering documents provided complete, indemnified ability for the manager to turn the fund into a bet on gas options. This is a topic we’ll return to in another post.
Getting back to Ritchie and the WSJ article, however, we wanted to focus this discussion on funds which suspend redemptions. Ritchie is not alone: there have been several other, well-known funds which have had high profile meltdowns, but, when investors headed for the exit, they found the doors suddenly locked. These include DB Zwirn and Drake.
We see quite a few issues here.
On balance, redemption gates and the ultimate sanction of suspending redemptions can be a good idea. It is clearly bad for a portfolio, especially one holding hard to value assets, to be held hostage by the most nervous investors: this creates a situation where the portfolio is controlled by the lowest common denominator. If a majority of investors have confidence in the fund’s strategy – or, more pragmatically, a majority believe that it would be a bad idea to dump the portfolio onto the market at the worst possible time, and believe that a liquidation would be better managed over a reasonable period of time – gates can act to preserve value to the benefit of investors.
As the WSJ says, the biggest problem is to figure out who gates and suspensions protect. In our view, gates are emphatically only valid when they demonstrably protect the investor and can be shown to preserve value in the portfolio. The disconnect, then, is self-evident - current hedge fund structures allow the Manager to remain in control of the Fund’s ongoing destiny, even in situations where the Manager has lost major amounts of money and, as a result, lost the confidence of investors.
To add insult to injury, such situations can be drawn out and become highly litigious. Per the WSJ, Ritchie first got into trouble in 2005 – three years later, investors are still waiting for material amounts of cash. Similarly, investors at Zwirn and to a lesser extent Drake are also reported to be looking at lengthy pay out periods. This is a very bad situation: investors are left in a limbo where they lack transparency and have absolutely no control over when they will finally receive their cash.
The litigation angle adds insult to injury. Under management agreements, hedge fund managers are typically indemnified by the Fund against everything except gross negligence, willful default and fraud (and some even try to get round the gross negligence provision.) It is extremely difficult to prove that someone was incompetent to the levels of gross negligence: legal actions in this area are lengthy and costly. As a result of the indemnification provisions, however, the Manager can use cash from the Fund to defend himself, with an obligation to repay only if the suit finally goes against him, after all (expensive) appeals are exhausted. Investors, therefore, are left in the bizarre position of having to foot the bill to pay for the Manager’s own defense when they launch any legal action. Amaranth, for example, was very quick to point out the financial harm to shareholders as a whole when one group of shareholders did launch a suit against Brian Hunter et al.
We do see a solution here: corporate governance. In our view, at the point when a gate is imposed or redemptions are suspended, a fund’s operations move from business as usual to, at best, emergency damage control and quite likely to liquidation. In this mode, the objective of the fund should be solely that of value maximization and equitable treatment amongst investors: the purpose of the gate is to protect the portfolio, not the manager's business. If gates are to work well, therefore, control needs to pass from the manager to the investors once the decision is taken to block the exits.
There are two options available: either the portfolio is managed in accordance with investor preferences, expressed by majority vote of the shareholders (in the offshore world, at least), or the Board of Directors should be tasked with supervision of the portfolio – which could very well be an orderly liquidation.
In this situation, the Director’s first decision should be to consider whether it is necessary to appoint a transition manager – the management company that will supervise the ongoing direction and possibly the liquidation of the portfolio. That may be the existing hedge fund manager, but, objectively, it is pretty likely that it will not be: in many of these circumstances, we would expect the shareholders to prefer a new pair of hands.
Unfortunately, this remains a fantasy, at least for present. It is quite bizarre that transition management can be such a well-known concept in the long only world, but utterly alien to hedge funds. Indeed, we are only aware of one instance where a new management company was appointed to supervise a portfolio liquidation – this was Beacon Hill, where Ellington was hired to liquidate that firm’s mortgage backed book.
The real problem, then, is self evident – the negligible level of corporate governance in today’s hedge fund industry. For onshore LP investors there simply isn’t any corporate governance at all – the GP controls all activities of the investment partnership.
In the offshore world, we have already touched on the poor level of oversight provided by typical board directors in jurisdictions such as the Cayman Islands. These corporate secretarial providers clearly do not have the investment expertise to protect investors, particularly in challenging circumstances where the interests of the hedge fund manager and hedge fund investor are no longer aligned. Moreover, as the offshore directors are hired – and fired – by managers, not investors, there is a clear lack of independence. More practically, a director who serves on 500 plus boards obviously does not have the time to provide effective oversight over a “problem child.”
What is the solution? Evidently, investors need to be prepared to invest the time and effort to create a more effective corporate governance framework.
The cost of not doing this is starting to become prohibitive. By the time a fund has suspended redemptions, it’s too late – investors will likely have several years while waiting for their money to rue the lack of truly independent oversight over a fund’s activities.