Deleveraging by Leveraged Funds-of-funds

The calling of Allianz’s EUR300 million Phenix CFO -- purportedly the first to be liquidated -- augurs poorly for the hedge fund industry, adding a further redemption burden to their tally of existing difficulties: staving off general investor fear and redemption requests; reserving against price markdowns and margin/haircut postings; deleveraging in a difficult market; establishing new and maintaining current sources of funding; combating higher funding costs; complying with increased accounting and regulatory demands; mitigating against rating agency downgrades; ...

And now a new source of redemption requests - by CFOs

CFOs -- collateralized fund obligations -- are essentially leveraged bets against the performance of a (oftentimes managed) portfolio of hedge funds. As is the case with CDOs, investors in CFOs go "long" the performance of a set of receivables (usually from debt). For CBOs, these receivables are the coupons of bonds (hence the "B" in CBO). For CLOs, loans. For ABS CDOs, the underlying are ABS (really, RMBS) tranches. For CFOs, the return of the funds, with the underlying typically comprising direct purchases in hedge funds or referenced exposures via total return swaps.

CFOs differ from typical CDOs in a few ways (e.g., similar to market-value CDOs, overcollateralization tests measure market value coverage - as opposed to par/principal coverage; there's no real notion of interest coverage ratios; existence of minimum net worth tests with various curing and/or liquidation procedures, such as the issuance of additional preference shares).

In the case of Phenix CFO, according to Bloomberg, more than 75 of the 80 hedge funds invested in by the structure have either liquidated or limited (or completely suspended) client withdrawals from their funds. With this in mind, Phenix's bondholders voted to liquidate the deal.

This notification, which came out on Friday, ends a tough month for hedge funds and banks in general, as can be seen from the graph below (click on it to enlarge).


UPDATE - February 2, 2009: Fitch Ratings Announcement

To address short-term volatility in CFO performance as well as reporting delays from underlying hedge fund investments, Fitch's [newly updated] analysis applies a 10% haircut upfront to the most recent reported portfolio NAV. The 10% haircut was derived using the worst monthly return decline reported by Fitch-rated CFOs.

...

Hedge fund returns, as represented by several multi-strategy indices, declined approximately 20 to 25% in 2H 2008. As well, Fitch has observed reductions to hedge fund CFO liquidity (including gating, restructuring, side pockets) in a range of approximately 5% to 40% of net asset value(NAV) in fourth-quarter 2008.

Interestingly, this final paragraph bring us back to our October '08 piece (Jack of All Trades?), highlighting the underperformance of multi-strategy hedge funds.

UPDATE - March 26, 2009: Moody's downgrades all tranches issued by SVG Diamond Private Equity II. SVG is a CDO somewhat similar to CFOs, but is backed by returns to shares of (principally) private equity (PE) funds, as opposed to a diversified pool of hedge funds.

Unequal Hedge Fund Disclosure - How "Fair Value" May Become Unfair

The Problem

All hedge fund disclosures are equal, but some investors apparently have more equal transparency than others.

Perhaps, for a tough sale, a hedge fund manager may be inclined to show certain procedural documents to a certain investor, while the less inquisitive investor may not be privy to the same information. That's just a guess, but whatever the case may be, let's call this situation "Preferential Treatment."

For example, fund-of-funds ABC knows that hedge fund HF would exit strategy STR if situation XYZ occurs. Suppose fund-of-funds DEF doesn't isn't privy to this exit strategy.

An Accident Waiting to Happen

From a fair value perspective, should ABC's investment in HF be accounted for equally with DEF's investment?

I would argue they're not equal, even though the HF's NAV is obviously the same for both funds-of-funds. ABC clearly has optionality that DEF lacks. Knowledge of HF's procedures gives ABC the option to either invest more or redeem, as it may see fit, whereas DEF is unaware of any changes. For the financial engineers out there, you all know that options cost money. ABC is long an additional option in this example, and so ABC's investment in HF should be greater than or equal to that of DEF.

Similarly, as an investor, knowing about your hedge fund's side pockets or ability to ring-fence part of its portfolio is crucial knowledge, as it affects your "redeemability."

Whereas the imposition of gates is highly publicized, the usage of side pockets is not well publicized: GLG Partners, and to an extent JB Global Rates Hedge Fund, being notable exceptions (see, for example Side Pockets - Keeping Hedge Fund Capital in Their Pockets).

A Litigation Disaster

Here's how this all went wrong for some firms (including Bear Stearns), according to certain excerpts from the SEC's: "Lessons Learned from Significant Examination Findings and Recent Enforcement Actions."

TRANSCRIPT

November 13, 2008

SECURITIES AND EXCHANGE COMMISSION

DELMAGE: ... we've seen situations where firms have failed to consistently apply these redemption policies.

Again, this is primarily in private funds. As everyone's well aware, firms have opposed gates. They've curtailed other abilities for people to extract liquidity from their underlying investments.

And again it comes out to disclosure. The [SEC] staff is gonna be looking at what's in the private offering documents, what's in the marketing materials, what's been in the ADV regarding the process for handling redemptions.

Timing, you know -- when certain times, certain dates, how much notice people need to give before they want their -- get their redemption proceeds -- and I guess, as part of that, one thing we will be looking at is to make sure there is no preferential treatment. Obviously, one of our concerns is, you know, maybe in days leading up to the announcement of the gate being imposed -- certainly the insiders of the investment advisor or maybe larger investors who have
a sizable stake in -- in the underlying funds -- are allowed to get their money out on different terms than other investors before the gates have been imposed.

And we've actually been seeing that in a number of examinations where, in this situation, the firm didn't impose the gate but they created a side pocket for a pretty sizable portion of the portfolio and had informed investors, and I believe they actually had sent out notice and people agreed to it, that they would be able only to redeem from the liquid portion of their investments up to a certain percentage.

And what we actually had seen -- looking at journals, e-mails again -- we had seen, you know, certain investors being able to redeem 100 percent of their investment. We had seen -- or saw situations where redemption requires had been backdated to certain investors.

Again, in certain situations, certain funds, depending on their asset class, have suffered some liquidity problems. There were other funds that didn't have that same problem and it appeared that the more liquid fund was funding the illiquid fund's redemption request; again, not disclosed to investors, nowhere in the offering documents.

... I think the lesson to be learned is, obviously, when the [SEC] staff sees a fund -- has imposed gates or somehow curtailed liquidity -- we are going to be looking at the disclosure documents. We're gonna be looking at how redemption requests have been handled, especially the period leading up to the announcement of that event.

... obviously, you have a fiduciary duty -- giving people preferential treatment, you know -- engaging in practices, you know -- backdating and other things, obviously, does not meet that test.

CHRETIEN-DAR: Just to emphasize Bill's point about preferential redemption not only is that a problem, in terms of your fiduciary obligation to your clients, but your insider [trading] procedures probably should be affected by this type of activity. There were -- in private litigation -- we saw that there were shareholders in the reserve fund made claims of inside information, in that some investors got out before the money markets fund broke the buck.

So there were a lot of private claims about insider training. The commission brought an action against the two portfolio managers of the Bear Stern hedge funds that invested in subprime-related securities.

And redemptions were also a big issue in that case, not only in terms of the commission's allegations regarding the representations on the status of redemptions, which was important to investors to know about, but on the criminal side there were allegations that the portfolio manager pulled out of the fund as he was reassuring investors about the fund.

So not only is it, you know, what you tell your investors, in terms of the status of redemptions, but also what you were doing with your own stake in those funds. Bear, apparently, had a policy at the time that portfolio managers in the funds that they mentioned should have a personal stake.

Side Pockets - Keeping Hedge Fund Capital in Their Pockets

In the light of increased regulation, we’re seeing a fair share of interest in side pockets. Without further ado, here’s the low-down:

Side pockets are essentially segregated sub-accounts used by some funds (think hedge funds) to allow them flexibilities in dealing with, and accounting for, illiquid and non-marketable instruments (think CDOs), and potentially other assets.

How, Why?
The fund’s offering and organizational documents should disclose pro forma the extent to which it may transfer fund investments to side pockets.

Side pockets provide a structural mechanism for transferring certain (typically illiquid or hard-to-value) investments into a separate class of the fund. The fund investors’ participation interests are separated in tandem with the assets: only those investors having ownership interests at the time the side pocket is created for a specific investment are exposed to the performance of that “side-pocketed” investment.

This accounting arrangement allows the fund to defer valuation of side-pocketed securities until a valuation or liquidation event occurs, such as the disposal of the security, the bankruptcy of the issuer, or the manager’s transfer of the side-pocketed security back into the fund’s main pool of (liquid) securities.

Caveats…

Importantly, an investor’s liquidity is limited while any investment to which she is exposed is side pocketed.
In other words, an investor cannot fully withdraw from the fund until all side-pocketed investments to which she is exposed are removed from the side pockets. She retains her proportionate share in these side-pocketed investments -- even after completely withdrawing from the fund’s primary investment portfolio -- and is subject to an unlimited lock-up period on this portion, during which she will generally not receive any distribution proceeds.

Management Fees, Accounting Repercussions…

Side pocket investments have typically been valued at cost (as opposed to being marked-to-market) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When side-pocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket.

UPDATE - November 7, 2008: Public announcement that GLG Partners ringfenced illiquid investments from its European equities hedge fund