Alternative Intelligence Quotient - Issue #31

Investing in hedge Funds in Emerging Markets
Written by: Sundar Arumugam (Revised and updated by Peter Douglas, CAIA and Chin Yingwen, CAIA, GFIA, Singapore.)

GFIA has been researching Asian and emerging market hedged and absolute return funds since 1998. Based in Singapore, GFIA’s sole activity is the research of skill-based managers (those seeking alpha from public markets), and it sells this research through advisory contracts and discretionary money management of its Wittenham funds of funds and managed accounts. The firm is fully independent.

Emerging market equity investing has typically been characterised by dramatic price movements through market cycles in both directions. In addition, the inefficient, diverse and often rapidly developing nature of emerging capital markets creates challenges which can create unexpected risks for non-specialist investors.

In this article, GFIA analyses and discusses how hedge funds specialising in emerging market investing can both exploit these market inefficiencies and protect themselves from extremes of price movements, thereby generating stronger risk-adjusted returns over time. The article further evaluates the performance of emerging markets hedge funds against the traditional investment methods, including long-only funds, using various metrics. The key conclusions of the study are:
1. on a risk-adjusted basis (whether risk is measured as volatility or drawdown), emerging market hedge fund aggregates have performed better than both the broader emerging market equity indices, and developed market indices;
2. emerging market hedge funds have relatively low correlation with developed market asset classes for most time periods in the last eight years;
3. adding emerging market hedge funds to traditional portfolios creates powerful diversification benefits which can expand portfolios’ efficient frontiers;
4. during periods of falling markets, hedge funds exhibit lower drawdowns than their underlying markets. This, in turn, enables them to recover more swiftly when markets return to an upward trend, providing more powerful compounding than unhedged investing; and
5. finally, a terminal wealth study of hedge fund returns versus mutual fund returns demonstrates that, over holding periods of both five years and three years, terminal wealth from portfolios of hedge funds is superior to that from mutual funds, regardless of the starting year of investment.

Emerging markets

Emerging markets, as defined in the MSCI EM Index, encompass 25 developing countries. At the practical level, emerging markets may, in fact, include more than twice the number of countries in the index. They include economies from the majority of Asia, Eastern Europe (including Russia) Latin America, the Middle East, North and sub-Saharan Africa (please see the map in Appendix I of this article). It is an extremely diverse opportunity set.

Though there is no universal definition of emerging market economies, there are some common key attributes that define these countries or regions. The majority of them display some, or all, of the characteristics of: significant economic activity and productivity growth; driven by economic and/or market reforms; stabilising macro environments and increasing political stability; increasing sophistication of financial markets; and improving transparency. Emerging capital markets, however, are characterised by high volatility, and inefficiencies. A snapshot of emerging markets’ stock returns over the past 15 years in Exhibit 1 demonstrates the extreme fluctuations in returns.

Hedge funds may be the most appropriate way to invest in emerging markets

It is generally accepted that, over time, investing in emerging markets should give a higher level of return compared with developed markets, driven largely by higher levels of economic growth, as emerging economies play ‘catch-up’ (and, arguably, as developing capital markets become more sophisticated). However, each country/region in the emerging market domain is at a different stage of growth driven by its specific economic, social and political landscape and, therefore, returns vary widely by geography and time period. So, while on an aggregate level and over longer time horizons, emerging market returns outperform developed markets, those returns exhibit high volatility levels and accentuated market cycles, due to structural inefficiencies and unidirectional liquidity flows. Inevitably, therefore, there are periods of substantial under-performance or negative performance within the emerging markets, dependent on geography and market cycle.

The Hedge Fund Redemption
Written by: Alex Potts, Conyers Dill & Pearman, Bermuda.

Conyers Dill & Pearman advises on the laws of the Cayman Islands, British Virgin Islands, Bermuda and Mauritius, and comprises over 550 staff in 11 jurisdictions with more than 150 lawyers. Alex Potts is a litigation associate in the firm's Bermuda office, and has a wide-ranging commercial litigation and arbitration practice, with particular experience of banking, funds and financial services disputes, as well as insurance and reinsurance disputes.

Can a hedge fund make redemption payments ‘in kind’ by way of the issue of ‘participation interests’ in its own illiquid assets, and what is the status of a redeeming investor who has not received any payment at all?

Overview

Hedge funds incorporated in Bermuda, the Cayman Islands and the British Virgin Islands have faced substantial legal challenges in 2008 and 2009, especially in meeting liquidity needs for redeeming investors. These challenges are far from over.

Many hedge fund assets and investments have declined both in value and in liquidity. Some assets are hard to value. Other investments are illiquid. Many investors have been seeking to withdraw their investments in hedge funds and to have their shares redeemed for value. It is unlikely, however, that there will be enough cash or liquid assets available to pay all of them, at the same time.

How can a hedge fund deal with a rush of redemption requests?

There are a variety of defensive strategies potentially available to hedge funds holding illiquid assets when faced with a rush of redemption requests and requests for payment. Such strategies might include:
a) reliance on a ‘lock-up’ or ‘lock-in’ period;
b) the alteration of provisions as to redemption notice periods, redemption dates, or their frequency;
c) the suspension of determination of the hedge fund’s net asset value (NAV), along with a suspension of subscriptions and redemptions;
d) the suspension of the date for payment of the redemption proceeds;
e) the imposition of a ‘gate’ on redemptions;
f) the creation of a ‘side pocket’ or a special purpose vehicle (‘a synthetic side pocket’) for illiquid investments;
g) the retention of a percentage of any redemption proceeds as ‘reserves’ against contingent or prospective liabilities;
h) the payment of redemption proceeds ‘in kind’;
i) the restructuring of the hedge fund; and
j) the voluntary or compulsory liquidation of the hedge fund.

The availability or suitability of any of these strategies will depend on the terms of each hedge fund’s constitutional documents, and the facts and commercial considerations of each particular case.

Scope for legal disputes

A potential problem with all of these defensive strategies is that there may not be a common interest, or consensus, between the hedge fund’s directors and managers on the one hand, and the hedge fund’s investors and creditors on the other. There is also likely to be some conflicts of interest between a hedge fund’s redeeming investors (who want to leave the fund) and its non-redeeming investors (who want to remain in the fund).

As a result, there is inevitably some scope for legal dispute regarding the validity and implementation of any such strategy. The scope for dispute may be enhanced if the hedge fund’s constitutional documents are not explicit, are unclear or ambiguous.

Synthetic side pockets and redemption payments ‘in kind’

One of the defensive strategies referred to above is the creation of a ‘synthetic side pocket’, to effect redemption payments ‘in kind’. Under this strategy, the hedge fund creates a special purpose vehicle (SPV) to which it conveys the hedge fund’s illiquid assets in return for shares or security interests. It then transfers those shares or security interests to its redeeming investors as payment ‘in kind’ of the redemption price that is owed to those investors. The SPV would liquidate the illiquid assets at some point in the future, when market conditions are more favourable and it is able to do so, and then distribute the proceeds to the SPV’s shareholders or beneficial owners.

Stewardship Credit Arbitrage Fund Ltd.

In the matter of Stewardship Credit Arbitrage Fund Ltd, two judges of the Supreme Court of Bermuda’s Commercial Court recently considered a payment ‘in kind’ strategy which had a number of similarities to a ‘synthetic side pocket’ arrangement, although there were some important differences. The hedge fund in that case, Stewardship Credit Arbitrage Fund Ltd (Stewardship), attempted, unsuccessfully, to use a trust structure, with participation interests, rather than establishing a corporate SPV with shares.

How Regulation and Tax are Creating the Perfect Storm for Hedge Fund Managers
Written by: Nathan Hall and Paul Valente, KPMG LLP, UK

Nathan Hall and Paul Valente are UK-based tax specialists and are part of KPMG’s Global Investment Management and Funds practice.

Introduction

As the European Union (EU) hedge fund industry has grown, the favourite model has been to manage a Cayman fund from the United Kingdom (UK). This traditional model is now coming under pressure from significant regulatory and tax change.

UK managers are frustrated at the 50% tax change, but the proposal for a Directive on Alternative Investment Fund Managers (the AIFM Directive, or the Directive)1 does not make the decision to move to Geneva a straightforward one.

In this article, we consider the effect that the Directive could have on the location of managers and hedge funds. We also look at recent UK tax changes in this context, and explain how regulation and tax are pushing managers in different directions: the Directive favours EU jurisdictions; UK tax changes are causing managers to look outside of the UK.

Overview of the AIFM Directive

At the beginning of 2008, the global hedge fund industry was managing assets in the region of US $2.7 trillion on the back of a period of tremendous growth. However, 2008 saw the industry shrink, with losses and redemptions pushing down global assets under management to $1.8 trillion2 by the end of the year. In what was primarily a banking crisis, the hedge fund industry found itself, and activities such as short selling, under the spotlight.

Shortly after the April 2009 G20 summit in London, the European Commission released its proposed AIFM Directive. This Directive proposes direct regulation and supervision on the alternative investment fund management sector. It applies to all managers of funds that are not UCITS (ie, not governed by the ‘Undertakings for Collective Investment in Transferable Securities’ Directive)3. As well as hedge fund managers, it also includes managers of private equity funds, commodity funds, real estate funds, infrastructure funds and other alternative funds.

The Directive is expected to take effect in July 2011, assuming that political agreement is reached this year. Its objectives are to:
• ensure that all fund managers are subject to appropriate authorisation and registration;
• provide a framework for the enhanced monitoring of macro-prudential risks;
• improve risk management and organisational safeguards;
• enhance investor protection;
• improve public accountability for funds holding controlling stakes; and
• develop a single market for fund managers4.

These are laudable aims, but it is the Directive’s approach that is causing concern; it is unsympathetic to how managers may conduct business.

The Financial Services Authority’s Overhaul of Liquidity Regulation
Written by: William Yonge, Proskaur Rose LLP, London

William Yonge is a partner in Proskauer Rose LLP’s London office where he specialises in issues of financial services regulation and advises on the structuring, establishment and marketing of a range of investment vehicles including hedge funds, private equity funds, funds of funds, UCITS and UK authorised funds.

Background to the overhaul

The current liquidity crisis, in its initial manifestation also known as the ‘Credit Crunch’, is often regarded as a wholly exceptional, even a once-in-a generation event. While the intensity and duration of the current crisis does make it remarkable, the fact is liquidity crises occur more regularly than widely assumed. Previous UK liquidity crises include the Secondary Banks Crisis (early 1970s), the Small Banks Crisis (early 1990s) and the failure of Barings Bank (1995). Non-UK liquidity crises include the collapse of Drexel Burnham Lambert (1990), the Asian Crisis and Yamaichi (1997), the Russian Crisis (1998), Long Term Capital Management Crisis (1998) and the Argentine Crisis (2001).

Notwithstanding this history of liquidity crises, regulators and supervisors, in their prosecution of prudential regulation in recent years, concentrated their efforts on implementation of the Basel II capital adequacy requirement, first published in June 2004. Lord Turner, Chairman of the UK Financial Services Authority (FSA), acknowledges this was mistaken, since it followed that insufficient attention was paid both to growing risks in trading books and liquidity risks which proved fundamental to the crisis. In Lord Turner’s view, ‘This failure to spot emerging issues was rooted in the paucity of macro-prudential, systemic- and system-wide analysis’. The FSA itself is currently fighting a turf battle of its own in order to preserve its role as supervisor of banks in the UK, with the Bank of England enthusiastic to take that role back. Since before the FSA’s creation, the Bank of England has been responsible for guarding against systemic risk, and there is high level debate as to whether the status quo should continue or whether the FSA should have a joint role alongside the Bank in monitoring and dealing with systemic risk.

The regulators and supervisors must shoulder their share of the blame for the crisis alongside the banking sector. Regulators, led by the FSA in particular, are broadly contrite and understand the need for thoughtful and robust change in their approach to regulation and systemic risk in order to avert, or at least mitigate, the next potential liquidity crisis. It is not yet clear whether the banks will move as quickly to put their own houses in order.

Liquidity risk and regulation — a cause of the crisis

In October 2008, the Chancellor of the Exchequer asked Lord Turner to review the causes of the financial crisis, and to make recommendations on the changes and the regulatory and supervisory approach needed to create a more robust banking system for the future. In March 2009, Lord Turner published his review. In considering the causes of the crisis, under the characteristically frank and transparent title, ‘What went wrong?’, Lord Turner identifies and describes the spectrum of causes, one of which was liquidity risk and regulation in the context of the growth of ‘shadow banking’.

To elaborate, a main function of the banking system is maturity transformation, ie, holding longer term assets than liabilities and thus enabling the non-bank sector to hold shorter term assets than liabilities. This function delivers major social and economic value, since maturity transformation absorbs the risks arising from uncertainties in the cashflows of households and corporates. This results in a term structure of interest rates more favourable to long-term capital investment than would be the case if banks did not perform maturity transformation.