Hedge Fund Liquidity Discount

According to the Q4 2008 HFN Hedge Fund Industry Asset Flow/Performance report, the Hedge Fund Industry finished the year with $1.932 trillion asset under management down from its peak of nearly $3 trillion at the end of the second quarter. HFN reports that the total net outflow from the industry was $446.6 billion for the year including $6.5 billion in fund liquidation. The decline resulted in total assets falling 32.5% in 2008 compared to an increase of 32.9% in 2007.

The unprecedented level of redemption requests received by hedge fund managers during the second half of the year, in a market that was already not very liquid, has led a lot of funds to face a liquidity mismatch. Some funds were unable to sell their assets to meet shareholders redemption when other would have been forced sellers in a sharply down market. Following this situation, managers handling as much as half the industry in investments have imposed some sort of withdrawal restrictions according to UBP. The restrictions included the creation of side pockets, the suspension of NAVs, the suspension of redemption, the use of gate ....

The result of this crisis has been to further restrict the liquidity of hedge funds. This situation has created a big opportunity for providers of liquidity as the "secondary market platforms" like HedgeBay and the new comers like CogentMarkets and Tullet Prebon. On the other side, the liquidity crisis has led to a nightmare situation for the AIM listed closed-end Funds of hedge funds that experienced sharp price declined leading for some of them to a 50% discount from their reported NAV.

Hedgebay is publishing every month a secondary market index (SMI) based on the past month activity. As shown in the graph below, the level of discount sharply increased from September 2008 with the index reaching a low of 80.31 at the end of March corresponding to around 20% discount over the funds' NAV. This level of discount usually apply to funds with liquidity terms between 12 and 24 months. The index does not include funds that have suspended redemption rights. An investor may wish to use the index as a sentiment indicator to describe hedge fund investors’ future expectations for performance, a benchmarking tool for hedge fund investors to assess latent value in their portfolios or as indicators of the cost of liquidity according to Hedgebay.

Another interesting indicator to measure the liquidity discount applied to hedge funds is the level of discount on closed-ended funds of hedge funds quoted on the London Stock Exchange. In the graph below, showing the performance of the Thames River Hedge+ fund, we see a sharp increase of the discount from the month of September which reached a low of around 40% in mid-December followed by a rebound until mid-January. As of April 27th, 2009 the fund was trading at a discount more in line with the above SMI of 22%. A similar pattern is found with other funds. The discount has gone as far as 58% for the CMA Global Hedge Fund.

The current level of discount cannot be explained only by a lack of liquidity of the underlying funds since closed-ended fund do not allow redemption and therefore are not subject to the same selling pressure like their open-ended peers. However, the listed funds had anyway to sell assets in an attempt to reduce the discount to avoid triggering the discount protection clauses usually embedded in the fund's prospectus. Most of them were not very successful in reducing the discount and had to seek a continuation vote from their shareholders.

A reversal in the above mentioned indicators should be watched carefully as a signal of the industry reaching the end of the tunnel with the investors getting more confident on the future prospect for investing in hedge funds.