Unsurprisingly, the rout that took global markets back to end 2009 levels has aroused the concern of secondary market makers. The fear is that time frames for realizing illiquid positions could be pushed even further into the future, burning a hole in the already shabby side pocket valuations of many hedge funds.
Perhaps more surprisingly, one market maker even foresees softer secondary market prices – under their “bullish macro” scenario whereby liquidity and macro variables rebound rapidly. The table below flags up a 5% hit to secondary valuations under this bullish scenario, a 15% gouge under the bearish scenario, and a 10% haircut applying even with their “base case,” “more of the same” projection.
Tradition’s method of “shadow pricing” the secondary market in side pockets, is to take a look at the marks of 50 distressed securities dating back to 2008 that are believed to feature frequently in the segregated compartments of hedge funds. Tradition points out that the corporate issuers behind these lowly rated securities have been the ‘Cinderellas’ of the recent recovery, lagging behind large caps of a broad spectrum of metrics.
In fact during this very bifurcated recovery these corporates have missed the party to such an extent that Tradition fear they may soon start returning to the capital markets, cap in hand, asking for fresh cash infusions.
Another perspective comes from Hedgebay. After years and years of trading near to net asset values, hedge fund secondary market valuations plunged to a trough of 72 and subsequently recovered to 84, according to this paper, based on transactions executed by Hedgebay. Yet side pockets are a special case that come under Hedgebay’s “illiquid assets index” which traded at 26% of NAV in June of 2011. However headline averages belie a huge range: for illiquids, Hedgebay recorded prices from 2% all the way to 82% of NAV in June 2011 !
And the persistency of premium valuations for closed hedge funds has been well documented by academics such as Tarun Ramadorai, in this very soon-to-be-published paper . Ramadorai research has been cited in AAA postings including these.
He now views the “closed-end fund premium puzzle” as having entirely rational explanations, one of which is that investors will pay a premium, not demand a discount, for illiquid assets with high expected returns ( and not every single one of these may appear in a hedgebay or any other index, since some such transactions take place on a bilateral basis )
Moreover, Traditions foreboding research does not even touch upon another facet of the secondary market: the market for shares in the revenue of hedge fund management companies, as opposed to shares in the hedge funds themselves. These revenue shares involve investors, who typically seed emerging hedge funds , monetising their venture capital stakes by selling part or all of the revenue share, either back to the manager they seeded, or to a third party. This market for annuity-like income streams, combined with scope for upside through equity kickers, is reported to be growing as more anchor investors negotiate these sweeteners, according to this report.
With 10,000 hedge funds out there, generalisations can be hazardous. There is plenty of space for sought after side pockets to strut their stuff at premiums, whilst others may indeed languish at growing discounts. Ultimately the key lesson of the Tradition research is that investors need to lift up the bonnet and work out what sits inside any side pocket – and whether the whole trades above or below the sum of its parts.