Hedge Fund Liquidity? Perhaps...

According to "Hedge Funds Gird for Withdrawals As Redemption Requests Roll In, Principals Scramble to Soothe Anxieties" (June 12, 2008), Wall Street Journal reporter Jenny Strasburg describes June 30 as a date to watch. Anticipating a flurry of requests, she writes that hedge funds are bracing for a slew of redemption requests, reaching unprecedented levels. Unfortunately for investors, requests to withdraw partially or fully from a fund may not necessarily equate to cash in hand.

As CNN.com reporter Grace Wong wrote last summer ("Hedge-fund redemption shock Investors looking to cash out this fall may be met with an unpleasant surprise"), a liquidity event may be wishful thinking in some situations. For one thing, myriad hedge funds have long "lock-up" periods during which no withdrawals are permitted. Second, some require that advance notice of 45 to 90 days be given. When markets are volatile, even a day may seem like an eternity. Third, hedge funds may slow withdrawals or ignore them altogether, urging investors to be patient. In certain cases, the goal is to forestall a collapse that could occur if a manager has too little cash on hand. Fourth, even when redemptions are permitted, they don't always take the form of cash.

For pension funds, problems with redemptions might potentially cascade, wreaking serious havoc in other areas. For example, suppose a plan sponsor has combined an interest rate swap with an investment in a hedge fund (perhaps as part of a Liability-Driven Investing strategy). If the portable alpha generator falls short and the retirement plan wants out, the all-in performance likely suffers, for everyone. What then?

• Does the plan sponsor move away from LDI?
• Does the plan sponsor lick its wounds with the first hedge fund and find a substitute?
• How does the plan sponsor take transaction costs into account?
• Do fiduciaries switch to a different, more redemption-friendly asset allocation mix?

Other questions abound. If a hedge fund cannot easily redeem shares because its portfolio consists of "hard to value" assets, do pension investors make matters worse by pulling out? What are the fiduciary implications related to liquidity risk? (Hint: Fiduciaries don't get a free pass. Most legal experts will confirm that decision-makers MUST ask hedge fund managers lots of questions about the redemption process and worst case liquidity scenarios.)

Liquidity risk is real. To pretend otherwise, makes no sense. The ability to unwind a stake in a hedge fund is very much a function of negotiating favorable terms at the outset. Equally important, fiduciaries are urged to pay attention to hedge fund liquidity risk drivers along the way. What you see on paper may not be what you get later on.