Can liquid alternatives be illiquid?
2008 was known as the "year of the gate." That's the year when most hedge fund investors learned about a small-print provision that allowed hedge fund managers, at their own discretion, to renege on any previously agreed-upon withdrawal terms. Institutions and high-net-worth investors alike were forced to keep their money locked up in losing investments while continuing to pay management fees. Some hedge funds are still gated from the crisis, or at least some of their investors' assets are gated, having been siphoned off into "side pockets." It's not known how much of investors' assets are still tied up in gated hedge funds or side pockets, but despite hedge fund investors' resistance and a few SEC enforcement cases (Ram Capital Resources, Baystar Capital Management, and PEF Advisors), these unfavorable arrangements have not gone away.
Can Liquid Alternatives Be Illiquid?
In 2003, Salient Partners, along with Mark Yusko, former CIO of the University of North Carolina Endowment and founder of Morgan Creek Capital Management, launched a registered fund of hedge funds for the high-net-worth masses who wanted to invest like David Swenson (creator of the Yale or Endowment Model). The Endowment Registered Fund invests in hedge funds and private equity funds, but it is registered under the 1940 act (as a closed-end interval fund, not to be confused with an open-end mutual fund), has lower minimum investment thresholds, and allows a certain amount of liquidity on a quarterly basis (a percentage of assets). Why wouldn't anyone want to invest?
In late October, Salient announced to its investors that it would begin limiting withdrawals.1 Even worse, there is no apparent reason for this gating, other than the fund has been performing poorly since 2010 and investors are leaving ($1.37 billion has been withdrawn from the registered fund, a feeder of the master fund, over the past eight quarters per SEC filings, and net assets have dropped from $2.5 billion as of November 2010 to $1.75 billion as of May 2012). The fund invests in almost 200 underlying hedge funds and private equity funds, none of which comprise a particularly large portion of the assets; as of June 30, 2012, more than 24% of the fund was invested in liquid exchange-traded funds or mutual funds. Furthermore, since 2008, the markets have not experienced the type of extreme duress that might be used to rationalize gating.
To Gate or Not to Gate
In theory, funds are supposed to use gates to protect investors. If the fund's underlying investments are illiquid, and a large redemption request forces the hedge fund to sell the underlying investments at an inopportune time, the remaining investors get burned. In practice, however, hedge fund managers have used gates to protect themselves; if the value of the hedge fund's underlying assets is falling, management can no longer charge performance fees, and if most of the fund's investors are leaving, management only earns a small fixed fee on a small percentage of assets. There should be some recourse for this unscrupulous practice.
One option is to take legal action. In 2011, a hedge fund manager, Paige Capital Management, was sued by its seed investor for erecting a withdrawal gate (in 2010) solely for benefit of the hedge fund manager rather than the investor. The court found that the hedge fund manager was not entitled to establish a gate and found the hedge fund manager breached its fiduciary duty to the investor by doing so for selfish reasons.2
Not all hedge fund managers are fiduciaries; many hedge funds are unregistered and structured as offshore entities. But now that the largest hedge funds are required to be registered under the Dodd-Frank Wall Street Reform and Consumer Protection Act, many hedge funds are now fiduciaries in the eyes of the SEC (more than 1,500 funds have registered3). And the Endowment Fund has been SEC registered from day one. As fiduciaries, hedge fund managers should only be acting in the best interests of investors when invoking gates.
But investors shouldn't leave this to the SEC to police. The SEC obviously has too much on its plate. Investors should know their liquidity constraints and preferences prior to entering into investments that have gating provisions, and investors should expect more-illiquid investment strategies (fixed-income arbitrage, for example) to have a higher likelihood of gating than others. Most individual investors, however, should avoid funds with gating provisions at all costs.