The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Wider Choice and Better Markets

Ian Plenderleith

BH Macro

Q1 2008

Turmoil in the financial system has inevitably brought intensified focus on issues of regulation and transparency. In that context, it is worth looking at the experience of hedge funds who have extended their activities into precisely those areas that entail more demanding regulatory requirements and more extensive disclosure – the use of the listed securities markets as a source of funds for their investment management activities. A number of hedge funds have floated separate listed investment companies as closed-end feeder funds whose purpose is to invest wholly in the hedge fund itself. Why are hedge funds doing this? What sort of opportunities are provided for the investor and are there also benefits for the wider markets as a whole?

The interest that hedge funds have in pursuing this avenue is fairly straightforward. The listed feeder fund provides it with a source of quasi-permanent capital. If and when the investor in the listed feeder fund wants to liquidate his investment, he can do so by selling his shares in the secondary market, as with any other listed investment. The capital invested in the hedge fund by the feeder fund remains in place. By contrast, when money is placed directly in a hedge fund, the exposure to withdrawals at relatively short notice can constrain the type of investment strategies the hedge fund can pursue. Listed feeder funds can thus give hedge funds access to a more stable funding base and thereby extend the range of strategies that a hedge fund can pursue in order to earn superior returns for its investors.

For the investor. too, there can be significant attractions in investing in listed feeder funds, though it is crucial that investors understand clearly the nature of the risks inherent in the investment they are making.

One obvious attraction to investors is that listed feeder funds provide a means for a wider range of investors to access alternative investment strategies. Direct investment in a hedge fund typically requires a much larger minimum investment than the mainstream of investors can contemplate. Through buying shares in a listed feeder fund, investors with an interest in diversifying part of their portfolio into alternative investment strategies can do so on whatever scale suits their investment portfolio.

Another attraction to investors is that along with listing goes the liquidity provided by daily trading in the listed feeder fund’s shares. Of course, as with any share, the depth of liquidity will vary from fund to fund. The existence of a secondary market gives investors flexibility in managing their investment that is not available to investments placed directly in a hedge fund.

A further advantage is that listed feeder funds are subject, like any other listed company, to the regulatory safeguards of the market in which they list – for listing on the London Stock Exchange, the UK Listing Rules. These rules lay down specific and stringent requirements in relation to corporate governance, disclosure and the full range of safeguards for shareholders’ interests, which are essential for an orderly market and thereby provide considerable assurance to shareholders investing in listed feeder funds.

Corporate governance itself is a further reason why listed feeder funds have proved attractive to investors. The feeder funds are not creatures of the hedge funds in which they invest but free-standing investment companies whose responsibility is to answer to the interests of their shareholders, not those of the hedge funds in which they invest. To ensure this, listed feeder funds have their own independent boards of directors elected by their shareholders and, as I can testify (declaring an interest as myself the chairman of a listed feeder fund), the boards have shown themselves to take their responsibility for maintaining high standards of independent corporate governance extremely seriously.

Moreover, high standards of corporate governance have brought with them a major increase in transparency, not just in relation to the feeder funds themselves, but also in relation to the hedge funds in which they invest. Like any other listed companies, listed feeder funds must publish regular and timely audited financial accounts and must promptly disclose significant events affecting their shareholders’ interests. Beyond the feeder fund itself, they also provide regular information on the activities of the hedge fund in which they invest – a significant advance in transparency that is not always fully recognised.

These are material attractions for investors who wish to invest part of their portfolio in
alternative investment strategies, and they have indeed proved attractive to a wide range of such investors, as evidenced by the support seen for the listed feeder funds that have come to market over the past couple of years. Notably, investment in listed feeder funds has come not just from investors familiar with placing money with hedge funds but much more widely from conventional investment management institutions such as pension funds, insurance companies, endowments and charities. For them, listed feeder funds have provided the opportunity to invest in a new sector – hedge funds – through a familiar channel – shares in an investment company listed and traded on the stock exchange.

Before entering into investment in listed feeder funds, however, investors need to give serious consideration to two significant features.

The first is that the hedge fund in which the feeder fund invests will typically charge it a management fee of 2 percent per annum and a performance fee of 20 percent per annum. These fees are arguably not unreasonable for the access investors are gaining to high-intensity professional investment management expertise and the extensive investment in advanced IT systems that go to support it. In contemplating investment in a listed feeder fund, investors need to consider the level of fees and decide whether or not they are justified by the return they expect to earn.

A second consideration for prospective investors in listed feeder funds is more fundamental. Hedge funds are, of course, a risk investment and, in the case of many hedge funds, the risks may be higher than for more conventional investment outlets. The prospective investor needs therefore to consider very carefully the nature of the risks inherent in the fund in which he is contemplating investment and be sure that he understands the character of those risks and the impact they may have on the risk profile of his portfolio as a whole.

In practice, different hedge funds display different risk characteristics. A critical risk, common to all funds, on which investors need to focus, is operational risk: Does the fund have the operational capability, in terms of trading skills and risk controls, to manage the risks it is taking? The key requirement here is risk management – not meaning taking low risks but meaning the ability to decide on appropriate levels of risk exposure and to conduct active and effective management oversight of those risks on a continuous real-time basis.

Here lies the rub, for how can the mainstream investor gain this degree of insight into the inner workings of a hedge fund? One route which has been developed to meet this need is by investing in a fund of hedge funds, where the managers of the fund of funds themselves provide the expertise in scrutinising hedge funds and determining which meet the necessary standards of operational control and risk management. Quite reasonably, managers of funds of funds charge for this service.

Listed feeder funds offer the possibility of an alternative approach. Because they are listed, they are subject to the full panoply of disclosure and reporting requirements that goes with public listing. This will not tell the prospective investor in any automatic way whether or not the hedge fund in which the feeder fund invests is soundly run, although it will provide a good deal of the crucial information that prospective investors need in order to be able to make their own assessment on an informed basis.

Thus, for hedge funds, listed feeder funds are a source of quasi-permanent capital that can provide a stable base for the fund to extend the range of its investment strategies. For investors, listed feeder funds provide a more regulated and transparent route through which mainstream investors can consider the merits of investment in alternative strategies.

Are there also advantages for the financial markets as a whole? Arguably, by utilising a stable base of funding to enable them to pursue investment strategies over a more extended horizon, hedge funds can contribute to giving greater depth to markets and thereby help to alleviate some of the volatility and disturbance markets have been experiencing in the past eighteen months. This double benefit – offering wider choice for investors and contributing to better markets for their investments – is a reason to welcome the greater use hedge funds have been making of the listed securities markets.

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