Wednesday, November 30, 2016

Liquidations Hurting Hedge Funds?

Amy White of Chief Investment Officer reports, How Liquidations Hurt Hedge Fund Returns (h/t, Ken Akoundi, Investor DNA):
It’s not just pension funds that have to worry about liability risks.

Hedge funds with high exposures to funding level risks “severely underperform” less exposed funds, according to research from the Copenhagen Business School.

“A good hedge fund follows alpha-generating strategies and simultaneously manages the funding risk that arises from the liability side of its balance sheet, that is, the risk of investor withdrawals and unexpected margin calls or increasing haircuts,” wrote PhD candidate Sven Klinger.

“If not managed properly,” he continued, “these funding risks can transform into severe losses because they can force a manager to unwind otherwise profitable positions at an unfavorable early point in time.”

At a time when many institutional investors are pulling out of hedge funds, proper management of liability risk is particularly essential—and failure to manage those risks can lead to a slippery slope, Klinger argued.

“If a fund generates higher losses than expected, investors get concerned about the possibility of unexpected future losses,” he wrote. “These concerns lead a fraction of the investors to withdraw their money from the fund, which, in turn, causes further losses for the bad fund.”

For the study, Klinger analyzed hedge fund returns between January 1994 and May 2015 using data from the TASS hedge fund database. He found that funds with low exposures to common funding shocks earned a monthly risk-adjusted return of 0.5%—while hedge funds taking higher liability risks earned zero risk-adjusted returns.

“Hedge funds that are exposed to more funding risk generate lower returns,” he wrote. “More precisely, hedge funds that generate lower returns when funding conditions deteriorate generate subsequent lower returns.”

These hedge funds also face larger withdrawals than hedge funds with lower exposure to liability risks, Klinger added—though they can temper risks by imposing strict redemption terms on investors.

“Higher risk should correspond to higher (expected) returns,” Klinger concluded. “Although this rule may hold for traded assets, it can be violated for hedge funds… a situation in which more risk-taking indicates less managerial skill.”

Read the full paper, “High Funding Risk, Low Return.”
There is nothing earth-shattering in these findings. Hedge funds have always been exposed to "redemption risk" which Klinger calls liability risk. The more concentrated a hedge fund is to any particular client, the higher the redemption risk, especially after a fund experiences significant losses.

A couple of months ago, I discussed why Ontario Teachers' cut allocations to computer-run hedge funds. A few hedge funds were forced to close shop after this move.

This is why most institutional investors cap their allocations to represent no more than 5% of the total assets under management and will typically never invest in any hedge fund where one client has more than  a 10% or 20% stake in the fund (I am giving you rough figures).

Obviously it varies and there are exceptions to this rule (like seeding a new fund) but why would anyone invest in a hedge fund knowing another big client can materially impact performance if they pull out? Also, from the hedge fund's standpoint, just like any business, it wants to properly diversify its client base so that it isn't exposed to liability risk if someone big pulls out.

But some hedge fund "superstars" have tight redemption clauses buying them time in case their performance gets hit. Case in point, Bill Ackman of Pershing Square.

Alexandra Stevenson and Matthew Goldstein of the New York Times recently reported, William Ackman’s 2016 Fortune: Down, but Far From Out:
William A. Ackman is a big-moneyed, swaggering hedge fund manager with a long list of accomplishments.

He played tennis against Andre Agassi and John McEnroe. He bought one of the most expensive apartments in Manhattan because he thought it would “be fun.” And three years ago, his hedge fund beat the competition to the pulp.

Now the silver-haired billionaire is on the verge of notching another accomplishment, but it is a dubious one. He is on pace to record a hefty double-digit loss for investors in his firm, Pershing Square Capital Management, for the second year in a row.

It is a rare accomplishment in hedge funds, as investors like public pension funds have grown impatient with disappointing returns and more than a handful of well-known firms have been forced to shut down as a result.

Yet Mr. Ackman is not like most of his peers. He has brushed off questions about whether his investors were worried and frustrated with his steep losses, countering that over time his firm had “a good batting average.” Together with his analysts, he told clients last week that the companies in which he has made big bold bets remain “unique,” “successful,” “fantastic” and “terrific.”

“We all know someone like him,” said Doug Kass of Seabreeze Partners Management, a small hedge fund firm. “Ackman is the smartest guy in the room who tells you he is the smartest guy in the room.”

It has helped that Mr. Ackman has structured Pershing Square so that investors have to wait as long as two years to take their money out. While some big investors have withdrawn their money recently, others believe that his firm will turn the corner.

The question is how much latitude investors will give to a man who fancies himself the next Warren E. Buffett. Over the last two years, investors have either withdrawn or announced plans to redeem more than $1 billion from his hedge fund, including New Jersey’s state pension fund, the Public Employees Retirement Association of New Mexico and the Fire and Police Pension Association of Colorado.

There is one mistake Mr. Ackman has admitted to making: Valeant Pharmaceuticals International. The drug company has come under political attack for its pricing policy and has faced regulatory scrutiny over its accounting practices. In April, Mr. Ackman was called to Washington to testify at a Senate hearing, where he was questioned over his aggressive support of the company. A flustered Mr. Ackman was forced to concede, “I regret that we didn’t do more due diligence on pricing.”

His investors have regretted it, too. Shares of the troubled pharmaceutical company have plunged to about $18 a share from the average $190 a share he said his firm paid in 2015 to acquire a big stake. As shareholders began to question the company and the stock plummeted, he bought a bigger stake in a show of confidence. Mr. Ackman has secured two board seats to try to position a turnaround.

“I have an enormous stomach for volatility,” he told an audience last week at the DealBook conference sponsored by The New York Times.

Privately, Mr. Ackman has told some investors that in six months or so, Valeant’s situation should start to look better as it sells off divisions to pay down debt obligations.

But now Pershing Square Holdings, a publicly traded version of his private hedge fund, is on course for a second year of double-digit annual loss and is currently down 20.7 percent, after dropping 20.5 percent last year. The losses are somewhat smaller at the private portfolios in his hedge fund in part because differences in leverage can magnify losses.

“He’s 50 years old. He has no boundaries to his ambitions,” said Ruud Smets of Theta Capital Management, an investment firm in the Netherlands. “So he is someone who will make his way back and is realistic about the mistakes he’s made and what they should do better,” he said, referring to Pershing.

Making its way back to positive territory will be challenging for Pershing, however. Its position in Valeant has helped wipe out a nearly 40 percent gain that the firm had in 2014.

Pershing started 2015 with more money than it had ever managed — $18.5 billion — including money raised from the public listing in Amsterdam of Pershing Square Holdings. Today the firm’s assets are down to $11.6 billion, and two years of losing performances threatens to chip away at Mr. Ackman’s reputation as one of the more successful investors in the $3 trillion hedge fund industry.

But Mr. Ackman has a knack for turning things around. He had to wind down his first hedge fund firm, Gotham Partners, after an investment in a golf course went sour. With Pershing, a remarkable run of lucrative payoffs from investments in General Growth Properties, the Howard Hughes Corporation and Canadian Pacific made him a celebrity and helped him raise huge sums of money from big state pension plans and other institutional investors.

And he can change. While he has long been known for favoring liberal causes and contributing mainly to Democrats, Mr. Ackman spoke glowingly of Donald J. Trump last week at the DealBook conference after his election.

“I woke up bullish on Trump,” Mr. Ackman said, surprising some in the audience. He clarified later in an interview that he was referring to Mr. Trump’s approach to the economy, adding, “I don’t agree with his views on immigration, on deportation and certain other social issues.”

His flexibility when it comes to national politics is at odds with the reputation he has earned at times of being a stubborn investor and a firm believer in his own views — qualities his Wall Street critics contend have informed his firm’s money-losing investment in Valeant.

Some on Wall Street have quietly compared him to another hedge fund hotshot, John Paulson, who made nearly $15 billion for his investors by betting on the collapse of the housing market during the financial crisis, but has struggled at times since then. Mr. Paulson’s firm now manages about $12 billion in assets, down from $36 billion five years ago.

Mr. Paulson, who is also bullish on Mr. Trump and was an economic adviser to him during the campaign, is the second-biggest shareholder in Valeant after Mr. Ackman.

But while predicting Mr. Ackman’s downfall has become something of a sport for some of his enemies on Wall Street, the prediction has yet to come true.

Over all, Mr. Ackman’s hedge fund firm has had more success than failure. Since 2004, the firm has registered nine winning years and four losing years, including the partial results for 2016. In four of those years, one of the firm’s main funds showed an annual gain more than 30 percent.

He also scored a moral victory this year with his bet against shares of the food supplement company Herbalife. The Federal Trade Commission took the company to task over its marketing and sale practices. The agency’s order endorsed many of Mr. Ackman’s claims that Herbalife had taken advantage of consumers, but regulators stopped short of declaring the company an illegal pyramid scheme, as Mr. Ackman had hoped.

Four years ago, Mr. Ackman announced at a conference that he had wagered $1 billion that Herbalife would either collapse on its own or be forced to close by regulators. But so far neither has happened, and Herbalife shares trade above the price they were at when he first disclosed his bearish trade.

“You can either view it as he has the courage of his convictions or he is being foolish,” said Damien Park, managing partner at Hedge Fund Solutions, who specializes in analyzing activist investors.

Still, some investors have put new money into Pershing Square recently. In August, Privium Fund Management, in a note to clients, said it had reinvested in Mr. Ackman’s publicly traded fund.

“He didn’t become stupid overnight,” said Mark Baak, a director at Privium, an Amsterdam-based investment firm that manages about $1.4 billion. “His prevailing track record wasn’t luck. Even if he was overrated prior to Valeant, he is still a very good investor.”

Maybe next year will be different for Mr. Ackman, who recently took a large stake in the burrito chain Chipotle Mexican Grill.

If nothing else, he will be on the move. His firm plans to relocate from its perch in Midtown Manhattan overlooking Central Park to a new office on the Far West Side near the Hudson River. Mr. Ackman’s new hedge fund home will be in Manhattan’s so-called auto dealership row.

One of the selling points of the new office is a rooftop tennis court that Mr. Ackman asked for.
I went over how Valeant (VRX) cost the hedge fund industry billions in my recent comment going over top funds' Q3 activity, noting there are some elite hedge funds that have followed Ackman buying big stakes in this pharmaceutical.

But thus far, it hasn't paid off for any of them as the stock is down 8% at this writing on Wednesday mid-day and is hovering near its 52-week low (click on image):


Like I stated, there is no rush to buy Valeant shares and I sure hope for the sake of Bill Ackman's investors that he turns out to be right on this company because from my vantage point, it still looks like a dog's breakfast.

I also noted the following in that comment going over top funds' activity in Q3:
In their Bloomberg article, Hedge-Fund Love Affair Is Ending for U.S. Pensions, Endowments, John Gittelsohn and Janet Lorin note the following:

While the redemptions represent only about 1 percent of hedge funds’ total assets, the threat of withdrawals has given investors leverage on fees.

Firms from Brevan Howard to Caxton Associates and Tudor Investment Corp. have trimmed fees amid lackluster performance.

William Ackman’s Pershing Square Capital Management last month offered a new fee option that includes a performance hurdle: It keeps 30 percent of returns but only if it gains at least 5 percent, according to a person familiar with the matter.

The offer came after Pershing Square’s worst annual performance, a net loss of 20.5 percent in 2015. Pershing Square spokesman Fran McGill declined to comment.

“They had a terrible year and they have to be extremely worried about a loss of assets under management,” said Tom Byrne, chairman of the New Jersey State Investment Council, which had about $200 million with Pershing Square as of July 31. “You’re losing clients because your prices are too high? Lower your price. That’s capitalism.”
Let me put it bluntly, Bill Ackman's fortunes are riding on Valeant, it's that simple. Luckily for him, he's not the only one betting big on this company. Legendary investor Bill Miller appeared on CNBC three days ago to say battered Valeant stock worth double the current price.
If Ackman is offering a new fee option that includes a performance hurdle, it's definitely because he's worried about big redemptions coming in before Valeant shares turn around (if they turn around).

When I was investing in hedge funds, I invested in directional hedge funds that were typically very liquid and didn't put up gates. Nothing pissed me off more than hearing some hedge fund manager recite lame excuses to explain his pathetic performance (and poor risk management).

Having said this, sometimes there are good reasons behind a hedge fund's bad performance and the illiquidity of the strategy might warrant investors to be patient and take a wait and see approach.

When Ken Griffin's Citadel closed the gates of hedge hell after suffering losses of 35% in its two core funds - Kensington and Wellington - during global financial crisis, I went on record stating investors who were redeeming were making a huge mistake because they didn't understand what was going on and why some of the strategies were getting clobbered after credit markets seized up.

Another example closer to home is Crystalline Management run by Marc Amirault, one of the oldest and most respected hedge funds in Canada. Its core convertible arbitrage strategy got whacked hard in 2008 and came roaring back the following year. There wasn't a market for these convertible bonds in the midst of the crisis and the fund's long-term investors understood this and stuck with it during this difficult time.

[Note: I recently visited the offices of Crystalline Management  and they told me there is some capacity left (roughly $50 million) in their core strategy which is up double-digits this year.]

Anyways, all this to say that there are no hard rules as to when to redeem, especially if you don't understand the drivers of the underperformance.

One last thought came to my mind. I remember Leo de Bever telling me that AIMCo offered its balance sheet to some external hedge funds to mitigate against the effects of massive redemptions during the crisis so that "funds wouldn't be forced to sell positions at the worst time."

I am not sure if this was actually done or if they were toying with the idea but it obviously makes sense even if it's a risky strategy during the thick of things.

Below, CNBC’s Gemma Acton discusses how CTA Strategies weighed on hedge returns in October. And Andrew McCaffery, global head of alternatives at Aberdeen Asset Management, talks about how hedge funds will prove their worth during a volatile 2017.

That all remains to be seen. One institutional hedge fund investor shared this with me today: "I think as everybody else, we're permanently exploring creative ways to ensure better commercial alignment of interest and improve capital efficiency." Well put.


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