fohf liquidity - nov 2008

Indjic – 6 November 2008

Modelling Redemption Risk in Funds of Hedge Funds Drago IndjicHedge Fund Centre6 November 2008, Quant Europe


Overview

• Origin of the study: hedge fund data quality surveys• Fund of hedge funds products

o Inaccurate redemption termso Unenthusiastic industry response in 2007

• Autumn 2008o Rapid shrinkage of hedge fund industry

• Market mismatch• Discussion


Is is too late to save FoHF?

• Quant Europe 2003: hedge fund risk factors• Today: liquidity• Quant tools became irrelevant in new regime


Fund of Hedge Funds Products

• Distribute over 40% of HF assets ($0.8t)o Regulatory artefact: exclusive retail distribution (risk)o Not “absolute return” - losing money and AUMo Not agile, almost passive exposure to Beta factorso ~$20b in fees shared between >1000 productso Over-concentration: AUM of Top 50 FoF firms > $450b

yet limited capacity • We know about their Beta - what about liquidity risk?


IOSCO – June 2008

• “The provision of a regulatory requirement that there be a real consistency between a fund of hedge funds’ liquidity and that of its underlying hedge funds (..) It is noteworthy that in the opinion of a few experts, the funds of hedge funds’ liquidity is not always an issue and may be a means to protect retail investors’ interests”

• Protecting FoHF from “fund runs”? Or clients?


Positive Returns and Flows Have Stopped


October 2008

• Fund is legal entity with contractual liquidity obligations• “Pre-emptive redemptions”

o FoHF have put redemption notices anticipating the redemptions from their retail clients or as requested by leverage providers

o Hedge funds have responded “gates”, fund restructurings, liquidating accounts, in-

kind redemptions etc• In many cases redemptions suspended


FoHF - What If?

HF n

FoF Class CHF n-1

…

…

FoF Class B…

…

…

HF 2

FoF Class AHF 1

LiabilitiesAssets If (with non-zero probability)Net Flows <0 D(Assets)>D(Liabilities)And

ShockThenLiquidity crisisReputation riskPossiblyinsolvency → bankruptcy


No Big Picture

• Firms focus on currently invested funds onlyo Internal data rarely reconciled with external data

sources; private Placement Memorandums not accurately mapped

o No entity is responsible for reference data • Fragmented, delayed and contradictory data universe• London Business School and Imperial College London

have better data analytic systems than industryo Multi-year academic research partnerships produced

tailor made software tools


Risky Data

• Aggregated, multi vendor data base o Macro (#management companies; %

Strategies) and micro data (flows, %counterparties)

o “According to X, Y and Z vendors”

• Leading “Rosetta stone” created at LBS using tailor made Soft Finance tools (since 2005)


Status and Strategy Data

• “Alive” or not?

• Doing exactly what?

• Hedge fund index “averages” do not make sense


Data quality

• Redemption conditionso Notice/Redemption Frequency/Lockup periodso Inaccurate and insufficient: >10% fields are blanko No FoHF holdings or strategy allocation data

• Visualise stylised datao Simple “duration” = notice + redemption frequencyo Mature FoHF portfolios – outside lock-up


HFR Database Example

• Most FoHF are designed around long/short equity


CISDM Database Example

• As in HFR it appears that “durations” are matched


Liquid strategies


Least liquid strategies


Strategies & Durations

• FoHF median “duration” is 97 days(14 days mismatch) but FoHF <> “market”

no standard hedge fund strategy classification, de-funct AIMA committee (2003)


Market Mismatch (AUM, lockup)


Reality: Highly Evolved Ladders

• Monthly redemptions, 45 days notice• Quarterly, 65 bd, 12 month Lockup• Quarterly, 120d, 20% gate• Quarterly, 60d OR Monthly 35d @ 2%• 1y hard Lockup, 2.5y soft lockup @ 6%, 1/3 per year, 2/3

@ 6% with 20% gate• …• Anniversaries, side pockets, side letters …


Real Redemption Rules


Best Redemption Policy


A Real Case Study (t)


Liquidity Stress

• Unexpected funding risk of FoHF – beyond investor redemptions

Redemptions were normally offset by subscriptions

<10%

Liquidation – Board request100%

Leverage halved at daily notice50%

Limits of (expensive) cash facility25%

Covered by portfolio cash or credit facility10%

Event and remedy%AUM Loss


Instant Liquidity

• Cash, marketable assets or robust facility• (Re)action preferences

o (i) Credit facility / Leverageo (ii) Activate gateso (iii) Sell most liquid fundso (iv) Suspend redemptionso (v) Sell funds on Hedgebayo (vi) Seek parent (bank) helpo (vii) Restructure or close fund


Fair Deal for Beta?

○ β(“first out”) ○ β(all others)


Shipping

• Navigate in the long shadow of illiquidity

risk and optimisation tools are irrelevant


Impact

• FoHF – unrolling funding crisis• Investors - Portfolio rebalancing “agility”

o Strategies: δ(weights)/δ(time) → 0o => weights * risk_factors ~ constant for many monthso Quality of portfolio – loss of control over Beta

• Market – collateral damage of forced selling, influencing many other funds and markets


FSA – September 2008

• “What has been highlighted for individual funds is the importance of monitoring redemption risk profiles and managing mismatches between funding/notice periods and the underlying liquidity of funds”

Hector Sants, 17 Sep 2008


Quantitative Methods

• Formal language to describe redemption• Simultaneous risk and liquidity optimisation

o “cheapest, fastest Beta” o Partial and optimal liquidation vs risk transfer

• Stochastic analysis and optimisation Cash flow timing and fees scenario analysis Contingency finance and collateral management


Review

• The end of traditional FoHF business modelo Focus on [Liquidity, Beta, Costs] products

• Lessonso Extensive stress testing necessaryo Audit contingency asset redemption schedules: NAV

liquidity adjustments in stressed conditionso Alpha/Beta separation: liquid (possibly synthetic

“clones”) and illiquid Alpha satellites• Future of open ended, listed products investing in illiquid

funds – private equity “capital call” model?


Product Dimensions

Fees

Liquidity

BetaHF

Capacity

Counterparty

•

References: www.london.edu/hedgefunds

fohf liquidity - nov 2008

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