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The Liquidity Fetish

In his influential book, Pioneering Portfolio Management, Yale University's chief investment officer, David Swenson, makes the case for illiquidity. Swenson notes that on Oct. 19, 1987, the day the stock market dropped by more than 22 percent, a presidential task force found that market-makers simply couldn't keep doing their jobs and so the efficiency with which the equity market functioned deteriorated

In his influential book, Pioneering Portfolio Management, Yale University's chief investment officer, David Swenson, makes the case for illiquidity. Swenson notes that on Oct. 19, 1987, the day the stock market dropped by more than 22 percent, a presidential task force found that market-makers simply couldn't keep doing their jobs and so the “efficiency with which the equity market functioned deteriorated markedly.”

That's jargon for, “Liquidity dried up.”

Swenson argues, “Just when investors most needed liquidity, it disappeared.” He concludes (after quoting Keynes, saying that no maxim is more dangerous than the “fetish of liquidity”), “Investors should pursue success, not liquidity. If private, illiquid investments succeed, liquidity follows as investors clamor for shares of the hot initial public offering.”

Swenson clearly knows what he's talking about. Over the past 14 years, he has been responsible for growing Yale's $6 billion endowment by 16 percent on average annually. And he did so by steering a sizeable amount of Yale's assets into illiquid investments, dropping Yale's U.S. domestic stock exposure to below a third. And that was in the 1990s, during the bull market.

While Swenson may have an excellent point, financial advisors need to approach illiquid investments carefully. Hedge funds, private equity — there are any number of ways to get accredited clients exposure to private companies. Since retail investors have been following institutions in seeking alternative investments — particularly hedge funds and hedge fund of funds, because they can dampen overall risk while improving returns — it is important to understand how illiquidity can affect clients' hedge fund investments.

Most hedge funds don't allow investors to pull their money out at will. There are lockups, 30-day notices to liquidate and all manner of restrictions for bailing out. “If anyone has any liquidity issues of any kind, he shouldn't invest in a hedge fund,” says Johan Wong of “It's that simple.”

But that's not the only kind of illiquidity we're talking about. Very often, hedge fund managers invest in illiquid, nonmarketable investments, like private companies for example. These have no public track record and cannot be valued in the same manner as common stock on the open exchange. And it can take years to realize a return on the investment.

The Segregationist

When a hedge fund manager invests in nonmarketable equity or debt securities he must segregate the performance of this investment from the performance of the fund's marketable securities. The segregation of nonmarketable securities is needed because the time horizon for the investment is much longer than that of marketable securities and because limited partners in the fund, participating in the nonmarketable investment, generally cannot liquidate their position at will. The hedge fund accounts for the investment in a nonmarketable security through what is called a “side pocket.”

This side pocket allows the manager to segregate an investment within the portfolio that may either be outside the overall strategy of the fund or require a different method of valuation. In addition, the limited partners' ownership allocation in the side pocket is not adjusted as limited partners enter or exit the fund. Likewise, a new investor to the fund cannot obtain an ownership interest in the investment that has been segregated into a side pocket prior to that investor coming into the fund. The ability of the fund to invest in nonmarketable investments must be outlined within the provisions of the private placement memorandum.

Although many funds may have the option to invest in nonmarketable securities written into their private placement memorandum, not all exercise it. And when they do, it often represents only a small portion of the hedge fund's assets. But the issue is worth noting — especially in the current market.

The number of hedge funds continues to grow, while the universe of potential liquid investments remains stagnant. This means more funds competing for the same pieces of pie. So a growing number of fund managers (pressed to produce greater returns) are looking at opportunities outside of their fund's traditional trading strategies. It is these investments that likely will be segregated into side pockets.

What's important is how this might impact clients. Some funds offer investors the option to elect participation in these illiquid investments. Others mandate the automatic allocation of a percentage of your client's investment to their fund's side pocket. Voluntary or not, participating in hedge funds that invest in nonmarketable securities can impact clients' flexibility in exiting from the fund.

With a Bullet

Valuing nonmarketable securities can be difficult. Clearly, the overall performance of the industry in which a privately held company operates is a key benchmark, as is the financial growth of the company itself. Other factors to consider include:

  • Any extraordinary contracts that might increase investors' share value; i.e., did the company in question sign a significant piece of new business recently?

  • Restrictions on the disposition of the investment.

  • Third-party liquidation analysis.

  • Movement of the investment-cost per share resulting from an increased purchase price — has someone just paid more to buy similar securities in the nonmarketable investment?

  • Miscellaneous factors, such as the prospect of an IPO.

    Questions that a registered rep should ask of fund managers who invest in illiquid securities include:

  • What percentage of the fund's assets is invested in illiquid securities?

  • Has the fund manager invested in private companies in the past?

  • What experience does the fund manager have in the industry in which the company operates?

  • How is the fund manager going to monitor the company? Is he going to be involved in the managerial decisions of the day-to-day operations or have a seat on the board of directors?

  • How are and how often are these investments valued?

  • Can an investor in a hedge fund elect not to participate in the side pocket containing the illiquid investment?

  • If the investor does not participate in the side pocket initially, is he free to do so later in other side pockets?

  • How often does the fund have realization events in the illiquid investments that they hold?

  • Can investors take out their investments from the side pockets once a realization has occurred?

  • What type of fees are charged to the investor and when?

Some hedge fund managers, who regularly deal with securities that present a “valuation challenge,” may create committees for the specific purpose of resolving questions of valuation.

Usually investments that are segregated into side pockets are not revalued (“marked to market”) until the fund actually pulls out. This is due to the difficulty of valuing nonmarketable investments. Which in turn makes it difficult for investors to value their investment in the hedge fund. Regardless, it is imperative that the fund documents all aspects of its ability to invest in nonmarketable securities meticulously.

Making for the Exit

Hedge funds without investments in nonmarketable securities and hedge funds with a combination of liquid investments and nonmarketable securities frequently have scheduled points of investor entry and exit for the liquid assets. These can be quarterly, monthly or bi-monthly.

But those funds with holdings in nonmarketable securities remain in the fund until the investment is liquidated and the proceeds from the particular investment are distributed. How might this play out? Out of an investor's $10 million investment in a fund with a side pocket, $8 million might be allocated to liquid investments (which this fund permits to be withdrawn at the beginning of each month). The remaining $2 million is allocated to the fund's nonmarketable investment. This $2 million only can be withdrawn when the investment is liquidated (a realization event), generally over a period of between three to five years.

For investors requiring more flexibility, there are many hedge funds that permit investors to elect not to participate in side pockets containing illiquid investments or to elect to participate at a later date.

Nicholas Tsafos is a CPA and a partner in Eisner LLP, a top accounting and consulting firm specializing in middle-market clients.

Happy Returns

Performance of SEC-registered hedge funds with December fiscal year-end.
Name of Fund Annual Return
Advantage Advisers Stratigos Fund LLC 39.53%
Antenor Fund LLC 37.99
UBS Aspen Fund LLC 37.11
Advantage Advisers Xanthus Fund LLC 33.33
UBS Eucalyptus Fund LLC 31.18
BACAP Opportunity Strategy LLC 30.72
UBS Sequoia Fund LLC 28.88
UBS Willow Fund 27.22
UBS Tamarack Int'l Fund LLC 25.19
Advantage Advisers Sawgrass Fund LLC 25.00
UBS Credit & Recovery Fund LLC 18.81
Beaumont Fund LLC 16.76
ACP Strategic Opportunity Fund II 14.16
UBS Event & Equity Fund LLC 14.07
Advantage Advisers Wynstone Fund LLC 13.98
UM Invst. Trust/Undiscovered Managers 10.44
UBS Equity Opportunity Fund II LLC 10.00
Morgan Stanley Inst'l Fund of Funds LP 9.94
UBS Health Sciences Fund LLC 9.10
UBS Equity Opportunity Fund LLC 8.29
ACP Continuum Return II 6.76
UBS Technology Partners LLC 3.02
Curan Fund LLC 0.95
UBS Redwood Fund LLC -0.57
Index Annual Return
CSFB/Tremont Hedge Fund Index 15.44%
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