James Williams interviews Andrew Lawrence (pictured) of Rosebrook Capital Partners, a firm which finds opportunities in hedge fund redemptions…
A recent report by secondary market broker Setter Capital found that hedge fund secondaries were down 13.1 per cent this year to USD410 million as side pocket supply continues to evaporate. But one hedge fund manager that expects to see more opportunities going forward as investors lose confidence in hedge fund performance, is New York-based Rosebrook Capital Partners.
Rosebrook profits when hedge funds suffer poor performance and investors try to exit through the back door as quickly as possible. Rosebrook’s Chief Executive Officer, Andrew Lawrence, concedes that while the amount of side pocket supply has been falling over the last six years, since the end of 2015, “we have entered into a new cycle of hedge fund redemption pressure and subsequent suspensions. Net redemptions are now at around USD80 billion for the year, which is a record since 2009. In addition, there have been a high number of share suspensions, which we really haven’t seen since 2009.”
Between 2008 and 2009, following the financial crisis, there was a tremendous amount of side pocket supply, since when supply has monotonically decreased and the reason is simple: side pockets have been remitting redemption proceeds back to the holders and there have been no new side pockets produced, says Lawrence.
“Even though supply has been falling, there has still been a tremendous supply/demand imbalance over that period of time. At any given time there has probably been approximately USD2 billion of dry powder; however, to put that into context, there were USD300 billion of suspended redemptions in 2009.”
Rosebrook’s modus operandi is to buy share classes that have no redemption privileges; i.e. redemptions that existed previously but have since been suspended. It buys illiquid assets from investors who have become forced sellers, which are being managed to realisation by the fund manager. As this can be a lengthy process given that these are hard to sell assets, some investors need to expedite the process and find a quick solution. This is where Rosebrook steps in.
“We’re not interested in buying gated shares where there’s ongoing investment or taking respective manager risk; although we’re buying hedge funds, Rosebrook is essentially an asset purchasing business,” explains Lawrence. “All the funds that we buy have a fixed pool of assets that are being managed to liquidation.
“The fact is, the number of potential problems that people could have in this business by holding stuff they didn’t expect to hold are manifold. The important point, from our perspective, is that these problems are more than just, ‘Geez, I thought I had something liquid and it’s illiquid’. It could be a mandate or charter problem, a regulatory problem, a problem on the board of directors; there are lots of issues that could prompt investors to redeem.”
Rosebrook makes it abundantly clear to forced sellers that pick up the phone that they should only proceed to sell if they have no other option. This is because an investor can only expect to be offered a price way below the value of the asset, as this is how Rosebrook makes its money. Based on the cost of capital it is willing to put to work, Lawrence aims to target more than a 20 per cent internal rate of return.
A new report by the Office of Financial Research (OFR) shows that there has been an uptick in the use of side pockets and redemption suspensions among fund managers on the back of market volatility. Recent examples include Claren Road Asset Management, Third Avenue Management and Stone Lion Capital Partners. Last December, Third Avenue prevented investors from redeeming in its USD788 million credit fund by moving some of its assets into a liquidating trust, giving Third Avenue the ability to sell the assets over time and avoid a fire sale.
This is typically why redemption suspensions occur as the last thing a manager wants to do is liquidate positions and negatively impact the performance of their fund.
That redemptions are now coming back to the fore, which could in turn lead to far greater numbers of side pockets, is the product of a number of factors. The most obvious of which is performance.
If one looks at the broad hedge fund index over five years they’ve generated low single digit returns and all the while the S&P 500 has nearly doubled in size (1,219 in 2012 compared to 2,204 at the time of writing). This has led to negative investor sentiment.
“We’ve been operating in a world of complete alpha deficit for the last five years, for the most part. And US investors in particular have been throwing in the towel.
“The most florid expression of dissatisfaction I heard recently came from the chairman of a US pension fund who said, ‘I think we should drive up to the petrol station with these hedge fund managers, tell them to get something to eat, and drive off’,” Lawrence remarks candidly.
In his view, the more interesting question is, ‘Why do hedge fund returns disappoint?’ The people who cannot generate returns now are the very same people who were making great returns prior to the financial crisis. These managers are not stupid. They haven’t suddenly lost their ability to trade.
“My strong conviction is the reason why no one can generate alpha anymore is because global policy makers, in particular central bankers, are intervening so consistently and regularly in the capital markets, buying up corporate bonds (ECB) or equities (BoJ), that prices at the margin are no longer being set by economic actors.
“What we are experiencing here is a massive capital allocation problem. Inefficiencies of a substantial magnitude are being introduced by these policy makers and it’s no surprise to me that my hedge fund peers are crying into their whisky at the bar,” says Lawrence.
To some extent the ship has already sailed. Performance has been so bad for so long that the momentum has created this new wave of redemptions. When one looks at debt: GDP in the US, tepid GDP growth, income inequality, etc, Lawrence believes the likelihood that governments are going to become less involved in the markets is “very low”.
“To me the problem is structural not cyclical. It’s probably not going away and it explains why hedge funds like Perry Capital, who have been trading for 28 years, have decided to close. If Perry Capital have decided they can no longer make money that’s a problem,” warns Lawrence.
To demonstrate just how bad things have become, Lawrence co-hosts a bi-monthly dinner. These dinners include a diverse bunch of hedge fund managers, policy makers, a certain theme is explored and then, at the end of the evening, everyone around the table shares their thoughts on interesting opportunities they see in the marketplace.
“These dinners have been happening for 15 or 20 years. The last couple of years no one has had any good ideas. All anybody wants to talk about is whether Janet Yellen’s foot will be on the accelerator or the brake. Trying to guess that is not a very effective use of hedge fund capital.
“We can talk about abstract capital inefficiencies, but it what boils down to is the only way to make money today is to bet on what the central banks will do. It shouldn’t therefore be a surprise that alpha has disappeared from the market,” says Lawrence.
A second reason for the recent wave in redemptions is because there is a wholesale pension crisis. Due to the baby boomer demographics in the G7 economies, pension plans like CalPERS went from positive to negative cash flows in 2015 and the US Social Security System went negative six years ago; nine years ahead of schedule.
This is worrying because pension plans are the biggest investors in hedge funds; they account for roughly USD1 trillion of the USD3 trillion in AUM.
“After the financial crisis, policy makers saved the banks but ended up destroying the pension plans, which you could argue are bigger (and more systemically important) than the banks. The unfunded liabilities of pension plans have gone through the roof.
“I would say the approximate cause of almost all focused redemption pressure on hedge funds is performance. No manager is going to suspend a redemption right until you make the redemption request and the trigger for this, by and large, is poor performance. This five-year period of underperformance is creating very focused redemption pressures,” suggests Lawrence.
He thinks this is part of the zeitgeist; it’s not just that investors are fed up with returns, they are upset by how rich hedge fund managers are. It feeds in to the same anti-establishment populist sentiment that has led to Brexit, the Trump election victory and so on.
All of this turmoil works to Rosebrook’s advantage. When assessing an opportunity, the strategy of the hedge fund is not important as Rosebrook takes no ongoing investment risk. What is more important is the nature of the assets; oftentimes assets held in side pockets have nothing to do with the strategy. The types of assets that Rosebrook buys include: underlying private equity assets; private debt; public debt; public equity; real estate; intellectual property rights; natural resources and litigation claims.
“We are sensitive to the assets we buy. The sources of the returns we make are two-fold: firstly, the return attributed to the purchase discount and secondly the return attributable to the return on the underlying assets.
“Usually the return on the underlying assets is zero. They should have some return associated with them, but everybody knows they are for sale so most of the return actually derives from the purchase discount. One of our primary goals is portfolio diversification because we don’t want to introduce any other unsystematic risk into the portfolio. Our returns are pure alpha, derived from the purchase discount,” confirms Lawrence.
Before agreeing an asset purchase with an investor, Rosebrook will look to check that the underlying assets in the fund meet its investment criteria and portfolio construction goals and that the vehicle they are in is sound.
“We don’t want a side pocket vehicle with explicit or contingent liability, a law suit attached, etc. We also seek out what the manager’s motivations are for realising the assets and remitting the proceeds back to us. There is unlikely to ever be a complete alignment of interests, but we want to be as closely aligned as possible.
“Often, our alignment with the manager is greater than the outgoing investor. All of our investment vehicles tend to have a five-year life cycle. Our requirements are therefore much more aligned with the manager as they try to work their way out of illiquid assets,” remarks Lawrence.
Currently, Rosebrook has a strong preference for US assets and US-denominated assets close to the top of the credit stack. This is in contrast to previous years when “we would have taken periphery risk lower down the capital stack,” says Lawrence.
