Heads I win, tails you lose
The hedge fund meltdown is making many investors reflect on their strategy for one of the most alluring alternative asset classes.
At the very least, they need to look anew at some of the practices of fund managers. In particular, side pockets which frequently invest in assets the managers are fi nding hard to sell.
Investors, rightly, worry about headline fees – the ubiquitous 2% of assets and 20% of performance – but they do not worry enough about some of the practices behind these fees.
Hedge funds create side pockets to house assets that they cannot easily value or sell. They argue that it insulates the good assets in the fund from the bad assets and allows them to continue to trade and meet redemptions.
How does it work?
You own five shares in a fund, each with a net asset value of 10. The hedge fund manager decides that 20% of the fund has become hard to value or sell. It redeems one of your five normal shares and gives you one side pocket share. You have four normal shares and one side pocket share.
BAD ASSETS
All is fine, or is it? Despite the bad assets, the manager has neither adjusted his net asset value nor his high water mark – the level at which the hedge fund manager can start charging a performance fee.
If the high water mark on each share was also 10, the manager will be able to charge performance fees on four of our five original shares as if nothing had happened. The manager has insulated himself from the fall in value that the creation of a side pocket implies. “Hard to value or sell” is a euphemism for “no one will pay my price”.
The manager could have kept the bad assets in the main fund and written them down to zero. But then the value of our five normal shares would be eight and, with a high water mark of 10, the manager would have to earn back the writedown on the bad assets before charging a performance fee.
Managers often forego the right to charge performance fees on assets in side pockets. They forego the right to charge performance fees, in the future, on bad assets in exchange for being able to charge performance fees now on good assets.
Assets are bought: if it goes right, fees are charged and if it goes wrong, the problem assets are handed to investors.
Heads I win, tails you lose!
Ian Barnard is founding partner of Capital Generation Partners, a private investment office
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