Lawbitrage

How Basel III May Reduce Bond Market Liquidity: The Hedge Fund Link

A recent Risk magazine story by Kris Devasabai notes that hedge fund borrowing costs from prime brokers may increase due to higher bank regulatory capital requirements under Basel III.

One important effect of potentially higher funding costs is undermining the borrowing-dependent business model of fixed income hedge funds. As Devasabai explains,

In private, some bankers are talking tougher and warning some strategies may simply not work anymore, such as relative value fixed income, which relies heavily on borrowed money to generate big returns from small pricing discrepancies. ...

According to research from Barclays, the average hedge fund could see a drop in returns of around 10–20 basis points if financing rates for less liquid assets rise by 25–50bp.

Fixed income arbitrage funds – which have generated annualised returns of around 10% since 2009, according to BarclayHedge – would be hit hardest, with returns falling an estimated 40–80bp. 

The problem with fewer fixed income hedge funds is that the liquidity of credit markets may decrease. This is because hedge funds account for a large portion of trading across a wide variety of fixed income assets, from corporate and government bonds to structured credit. As a Reuters story from 2012 noted:

U.S. hedge funds accounted for nearly a quarter of bond trading in the U.S. between April 2011 and April 2012, the most in five years and highlighting the greater presence of hedge funds in the U.S. bond industry . . .. Hedge funds generated 24 percent of the overall volume of fixed-income trading in the U.S. over the year period, a more than 30 percent increase from 18 percent in April 2011.

And fixed income trading hedge funds do not just contribute to the liquidity of bond markets. Indeed, the funds that trade bonds often trade stocks and thus contribute to their liquidity as well. An academic study by Petri Jylhä, Kalle Rinne, and Matti Suominen found evidence of fixed income funds often supplying liquidity in stock markets. The authors noted that

[o]ne of the main strategies of fixed income arbitrage funds is...so called “capital structure arbitrage,” where long/short positions in fixed income securities are hedged with balancing positions in the equity markets. Because of these equity linked strategies, at least, it is understandable that fixed income arbitrage funds act either as liquidity demanders or suppliers at NYSE and Amex.

Few may shed tears for fixed income arbitrageurs, as the Risk story notes. But if credit markets become less liquid, the negative impact on financing costs and price efficiency could be substantial. For over a decade, credit markets have been highly dependent on hedge funds, as a 2005 Fitch report makes clear.

Reducing Hedge Fund Fees Could Cost Investors

Earlier this week, the Wall Street Journal's Gregory Zuckerman, Juliet Chung, and Michael Corkery published an insightful and well-researched article about hedge funds reducing fees in response to pressure from investors.

The article notes that the two main drivers of fee cuts are poor fund performance and the growing preference by investors to invest in large hedge funds--leading smaller funds to cut fees to remain competitive. It also notes that the standard 2% management fee--which is supposed to cover overhead costs and base salaries--is more difficult to justify for funds that have now grown in size to manage billions.

It is true that a general reduction in fees seems like a welcome trend in an industry that keeps growing and is increasingly facing competition from lower cost alternatives such as "hedged" mutual funds and hedge fund-like exchange traded funds.

However, it is a great oversimplification to think that any cut in fees will benefit investors. This is because fees have an important impact on hedge fund manager incentives. Academic studies often find an association between higher fees and better performance. For example, a 2011 article (working paper version) that studied the performance of over 3,500 hedge funds over a 15 year period found that hedge "[f]unds that charge a high performance fee appear to outperform those that charge a relatively low fee."

Higher performance fees may help investors because higher fees may in fact get managers to produce better returns. A higher performance fee also means that a managers have more to miss out on if they don't perform well. Better managers may also require high performance fees as part of their compensation package.

Accordingly, the savings hedge investors obtain from lower fees may come with the cost of reducing incentives for managers to perform well or even want to be employed by the fund in the first place. While fees are probably too high on an industry-wide basis, not every reduction in the fees investors pay will help their returns.

SAC Capital May Be Violating its Fiduciary Duty to Investors By Not Returning Their Funds

Katherine Burton and Saijel Kishan of Bloomberg report that investors in the the recently embattled hedge fund SAC Capital are being refused their request for an early redemption of their capital.

Steven Cohen’s $14 billion SAC Capital Advisors LP, which last month was indicted by the government as a “veritable magnet for market cheaters,” has refused clients’ requests that the firm speed up payouts on the billions of dollars earmarked for withdrawals, according to three people familiar with the discussions.

SAC, which faces a midnight deadline for redemption requests from investors who want to pull money from the firm, has told clients that final payments will be made at the end of the year. Some investors have pushed Cohen to give clients their money back before then....

An expert quoted in the story states that the manager is under no obligation to return capital to investors on terms more generous than what is required from the express terms of the investment. However, a failure to return capital even if not contractually required to do so may actually lay the basis for a breach of fiduciary duty claim.

Hedge fund managers generally owe a fiduciary duty under state limited partnership law to exercise their discretion in deciding whether to return funds in the best interests of the fund and its investors. In the 2011 decision of Paige Capital Management, LLC v. Lerner Master Fund, LLC, the Delaware Court of Chancery found a hedge fund manager in breach of its fiduciary duties when it decided not to waive a gating provision and release capital back to the fund's sole investor. The court stated that

I conclude that it was a breach of fiduciary duty for the hedge fund manager to use the Gates solely for a selfish reason. The only rational reason for the failure to take down the Gates was to enable the manager to continue to receive management fees for as long as possible. The manager's purported rationale was based on the manager's unconvincing assertion that the Gates in the Partnership Agreement are not only designed to protect the Fund and its investors from harm, but also as a contractual provision intended to guarantee a cash flow to the manager for a longer period of time. But that is a rationale that was never advanced in the contractual negotiations. The discretion granted to the hedge fund manager to determine whether to waive the Gates is a fiduciary authority that must be used for the benefit of those whom the Hedge Fund is intended to benefit, and not for the selfish interest of the manager.

SAC Capital likely has justifiable ("nonselfish") reasons to not return more capital to investors than their investment agreements require. It is also unclear whether the funds in question are organized in a jurisdiction that follows Delaware's approach or whether the fund's organizing documents waive any fiduciary duty owed by the manager (as a general partner) to the investors (as limited partners).

Nonetheless, the failure to return capital to investors may implicate fiduciary duties that go above and beyond the express terms of investors' negotiated redemption rights. It is not a simple matter of what rights investors had previously negotiated.

15 Things You Should Know About Hedge Fund Governance

I recently uploaded my new working paper on hedge fund governance. The paper provides the first comprehensive scholarly analysis of the internal governance of hedge funds. It will be published by the Stanford Journal of Law, Business & Finance in the fall. Click the link above to download the paper or read the full abstract.

Unlike corporations, hedge funds are structured as limited partnerships and don't have the governance mechanisms typically associated with corporations, such as an independent board or the ability to obtain permanent capital from equity investors.

Below are 15 important points or observations about hedge fund governance that I make in the paper:

• hedge fund investors are not being systematically ripped off by managers;
  
  
• hedge fund managers have more control over their firms than managers of corporations, mutual funds, and other private investment funds;
  
  
• investors have hedge fund managers on a much shorter leash than managers of public corporations and other types of investment funds;
  
  
• the oversight role played by hedge fund directors is not substantial;
  
  
• hedge fund investors are often better off with less transparency, higher fees, and less access to their capital;
  
  
• only a small portion of hedge funds calculate performance fees on a multi-year basis;
  
  
• institutional hedge fund investors often refuse to invest in funds that lack good governance;
  
  
• successful hedge fund managers often increase fees when starting new funds;
  
  
• the biggest source of hedge fund agency costs is the manipulation of performance returns by managers;
  
  
• hedge fund investors price in the risk of fraud and other operational problems by demanding lower fees;
  
  
• secondary markets for hedge fund shares help to discipline managers;
  
  
• hedge fund leverage results in the funds being closely monitored by creditors and derivatives counterparties;
  
  
• hedge funds as a whole are about as leveraged as public corporations;
  
  
• clawbacks or deferred performance fee payments may better align the incentives of hedge fund managers and investors;
  
  
• when the stock of public corporations rises by 1%, median CEO compensation rises by $200k, but for hedge fund managers, that number is $2 million. 

Download the full paper here. Comments are welcome.

In SAC's Potential Struggle for Investors, Hedge Fund Governance in the Spotlight

Amidst increasing scrutiny by regulators for insider trading, the hedge fund group SAC Capital Advisors runs the risk that its investors will begin to ask for their money back in such massive amounts that the firm will be forced to close. Last week, Wall Street Journal reporters Dana Cimilluca, Juliet Chung, and Jenny Strasburg reported that SAC expects investors to withdraw (redeem) at least $1 billion in 2013.

But the fund's ability to escape collapse thus far reveals a lot about the unique issues that face hedge funds, and also how the funds are governed.

The roots of SAC's problems plagues all hedge funds. Unlike other investment funds, hedge funds are always at the risk of a collapse from investor withdrawals, much like a bank run. Private equity and venture capital funds, by contrast, lock in their investors' capital for several years. And while mutual funds are required by federal law to meet investor redemption requests immediately, their investors are less fickle.

So why is SAC still in business despite all the regulatory attention?

First is the fact that hedge funds are often indistinguishable from their top manager. In the case of SAC, that's Steven A. Cohen. Since it is unlikely that Cohen will be implicated in any regulatory wrongdoings, investors can remain fundamentally confident in the fund.

And then there's SAC's returns, which have been 30 percent a year on an annualized basis since the fund group was launched in 1992. With returns like those, investors are unlikely to abandon ship in large numbers. As academic research makes clear, hedge fund investors certainly care a lot about returns. And the best hedge fund performers, like SAC, tend to keep performing well over time.

In addition to personality and performance, though, SAC has governance tools that help prevent an investor exodus.

Like most hedge funds, SAC uses contract-based redemption restrictions. According to the WSJ story, investors are limited to quarterly withdrawals of no greater than 25 percent of their own investment. More commonly, hedge funds use so-called "gates" that limit total investor withdrawals to around 15 to 25 percent of the fund's value.

Investors are also probably very comforted by the fact that SAC principals personally invest in the funds they manage, an arrangement common in the hedge fund industry. SAC, however, has an unusually large amount of capital that comes directly from Cohen and SAC employees. Of the $14 billion SAC manages, $8 billion (57 percent) comes from Cohen and SAC employees. By contrast, a 2010 study found that of the 32 percent of hedge fund managers in its sample that personally invested in their funds, the top co-invested amount was $300 million.

And although SAC charges some of the highest fees in the industry (3 percent management and 30 percent performance fees), it is unlikely that SAC will lower its fees to placate investors anytime soon. This is not only because SAC investors are likely more than satisfied with their returns even after the fees, but also because they believe, as some academic studies suggest, that higher fees create incentives for the best hedge funds to keep on outperforming.

The counter-intuitive conclusion is that, when it comes to funds like SAC, higher fees may actually be a governance device that protects investors against the losses and mediocre returns found in other funds.