Sunday, March 9, 2014

Nine reasons for the shift to bigger funds

Alfred Winslow Jones was the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors, and a compensation system based on investment performance.  

The Hedge fund management business has evolved offering clear advantages for the big money to move to the largest firms like Ozm.  These are nine concerns of Hedge fund investors that propel this trend.

1. Abrupt closures 
Hedge funds can close because of the loss of large investors, untimely investments or simply bored managers that have more than enough money and are sick of meeting client expectations.

2. Holdback
When a client cashes out, funds can retain 10 percent to 20 percent of assets until its annual audit is completed.  Investors can be forced to sit and wait as the money earns nothing while they make sure the NAV is correct.  The other 10-20% “holdback” doesn’t come back until the hedge fund’s annual audit which could be up to a year later.

3. Gate provisions
Making contributions to hedge funds is easy.  They want your money, so you can usually invest on a monthly basis without much notice.  But try getting your money out.  You usually need at least 90 days’ notice and even then you can only redeem on a quarterly or annual basis.  The purpose of the provision is to prevent a run on the fund, which could cripple its operations, as a large number of withdrawals from the fund would force the manager to sell off a large number of positions.

4. Opportunity cost
One Investor confesses that their institution was invested in a hedge fund that decided to return capital to investors.  They were given the choice of taking a huge write-down up front or getting the money back as the investments were sold off.  They decided to wait, and it ended up taking four years to get the entire investment back.   Each time they sent chunks of money back, the remaining funds got marked down even further.  The risk that  greater “benefits” could have been obtained with another option is the lost opportunity.

5. Lock-up
Many funds have at least a 1 year lock-up with your initial investment but it is possible that the lock-up can be 3-5 years in some cases before you can pull your money out.  The lock-up period helps portfolio managers avoid liquidity problems while capital is put to work in sometimes illiquid investments.

6. Investment period
Private equity also comes with huge opportunity costs.  You don’t simply hand over the amount you commit to the fund on day one and start investing.  With extensions, the investment period could last up to 10 years.

7. Capital call
Plus, you might only get about 2 weeks’ notice before a capital call is due for investment with no idea about the size so you cannot plan your liquidity ahead of time.

8. Commitments
With the majority of funds, you don’t pay management fees on your invested capital.  That would make too much sense.  You pay on your committed capital.  So if you have $30 million committed to a fund but they only call $500,000 in year one, your 2% management fee is over 100% of invested capital.   Committed capital, is usually not invested immediately, it is “drawn down” and invested over time as investments are identified.

9. Redemption suspension
Similar to Gate provisions but doesn’t allow for withdrawals at all.  Depending on the terms of the hedge fund, a manager generally has the ability to implement this at anytime. 

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