A Swan Song?

Hedge fund redemptions have hit the asset class hard, as one study reports that $210 billion of capital exited the hedge fund asset class in the third quarter.

No asset class is exempt from the blood bath that took place on Wall Street in the second half of last year, and the redemptions being experienced by the population of hedge funds makes it pretty clear that private equity's more liquid cousin took the dislocation square on the chin. According to Chicago-based Hedge Fund Research, almost $210 billion of capital exited the asset class in the third quarter, while in October alone, $115 billion evaporated in performance-based losses, and another $40 billion was redeemed by investors.

Outwardly, onlookers may be wondering what all of this means to the decision by many hedge funds to invest in private equity. It would stand to reason that that trend died around October, when limited partners began angling hedge funds for their money. In fact, the most often heard criticism of the hedge funds move into LBOs and venture capital was that the asset class wouldn't have the patience to commit for the long term.

However, with much of the capital dedicated to private equity tucked away safely in side pockets, it turns out that the move to PE could in the long term pay off.

"When things were good, the hedge fund universe expanded and it became harder to make money on the most liquid strategies, Stephanie Breslow, a partner with Schulte Roth & Zabel, says. "The obvious trades were saturated so there was a movement toward tapping into value that wasn't fully exploited yet."

As a result of hedge funds, many hedge funds created side pockets and dove headlong into private equity. And as it turns out creating side pockets-which may or may not pay off in the long run-was still a good strategy. At the very least, maybe it provides a long term hedge to many of the short term bets that were made.

When the credit crisis hit full swing in the fall of 2008, hedge funds faced a multitude of problems including margin calls they could not pay and a high number of redemptions as investors looked to pull their money out of the asset classes. In fact, the sheer number of investors looking to redeem left some fund managers calling for a private equity-like model in which redemptions can only given when the investments are cashed in. For this reason, side pockets have been a saving grace to some extent.

Side pockets are used for a range of different activity. "Some hedge funds use them for classic private equity investments or thinly traded securities; fund of funds are also sometimes using them to house troubled underlying funds  or the side-pocketed assets and in-kind distributions of underlying funds," Breslow describes. "If the asset is in a side pocket, investors  remain in the side pocket even if they otherwise redeem from the fund.  This gives the manager flexibility to ride out the market."

Ivan Zinn, founder of Atalaya Capital agrees, though he notes that at times they can result in headaches for both the hedge fund and its investors. "The side pockets are serving their purpose, but they are being tested," Zinn says.

While the side pockets seem to be holding their own, they do not come without issues. End investors have become highly sensitive to the use of side pockets, which is causing problems because investors aren't able to realize cash because they can't be redeemed immediately.

Additionally, while frequent redemption is permitted in a hedge fund, private equity investments have a longer time horizon and such disparity creates a liquidity mismatch. If investors look to redeem a large amount of assets, the hedge fund will only take money out of the liquid portion of the portfolio, while a portion will remain retained in the side pocket. Assuming that the investors have large investments, their redemptions cause the side pocket to increase relative to what it was before as the liquid portion shrinks. 

"The ability to redeem is not good right now," Zinn says, adding that there is an obvious mismatch between realizing cash. Because of that, he anticipates some hedge funds will seek out liquidity by selling their private equity investments on the secondary market.