It seems that many hedge fund managers and institutional investors used to work in the pest-control industry. The most popular analogy at this year’s un-named institutional hedge fund conference (see posting below) is “A Roach Motel”. Many readers will remember the famous insect trap where “Roaches check in, but they don’t check out”. Well, it turns out there may be a few investments out there with similar characteristics (say, um, Amaranth).
As we have discussed in these pages, alpha hunting is best carried out in new and/or inefficient markets. But the inefficiencies that give rise to alpha-generating opportunities often exist because these new markets lack liquidity (Amaranth aside). A lack of liquidity can be particularly painful in times of distress when what little liquidity exists virtually dries up. As a result, you can’t “check out” of your trade.
Several speakers have touched on the fact that portfolio management theory describes only a “normal day” in the life of markets – not a time of extreme distress. After all, market mayhem does not facilitate an orderly run for the exits (witness the scene in the movie Airplane when the passengers were told to “assume the crash position!”). Unfortunately, liquidity only exists when you don’t need it.
The recent convergence of hedge funds and private equity has led to a building boom in (potential) Roach Motels. When a hedge fund manager wants to add a private equity position to her public equity portfolio, she will usually create a “side pocket” where investors are given special units in exchange for units of the main fund. Generally, these side pockets are immediately closed to new investors. In other words, the “no vacancy” sign is put up at the motel. While side pockets can be very profitable and participation is voluntary, the question might linger: “Is this a Roach motel?”
As a result, investors might want to sub-divide their hedge fund holdings into buckets according to different levels of liquidity. Some have argued that this “liquid/illiquid” paradigm is more descriptive than a superficial equity/fixed income/private equity classification.
Thankfully, there is a way to extricate one’s self from a potential Roach Motel: through a burgeoning secondary market in illiquid hedge funds. This concept has been around for years in the private equity industry, but is now taking hold in the hedge fund space. Want out? No worries. For a few percent discount to NAV, a firm called Hedge Bay will arrange for someone else to take your room at the Inn.
Of course, most motels don’t turn out to be of the Roach variety. And, in general, investors will receive a greater illiquidity premium the longer they stay. So illiquidity is not an inherently bad thing. But still, investors and managers seem a little more cognoscente this year about its potential pitfalls.
So the bottom line is that you can always get off a trade (or a fund) at the right discount, but you might live to regret it if things eventually turned around. In this way, illiquid positions may not be a “Roach Motel”, but rather “The Hotel California”, where “You can check out any time you like…But you can never leave.”
– Alpha Male