| Illustration by the Project Twins |
Forget about traditional longs and shorts: A growing number of hedge fund firms are racking up their biggest gains from private investments, many of them in start-ups or pre-IPO technology and Internet companies based in India and China.
Despite the high returns, however, some hedge fund investors are concerned. That’s because these illiquid investments could cause enormous pain in an extended market decline if managers are forced to unload them to meet rising redemptions — as investors learned the hard way during the financial crisis of 2008.
“You don’t want a very liquid fund with a large amount of private holdings,” warns Ray Nolte, chief investment officer of New York fund-of-funds firm SkyBridge Capital.
Still, the gains from these private investments are compelling. While hedge funds managed by Chris Hansen’s San Francisco–based Valiant Capital Management returned a little more than 2 percent for the first six months of this year, its side-pocket portfolio of private investments was up about 8.5 percent. In 2014 the hedge funds’ liquid portfolio was up 6.6 percent while the side pockets — one quarter of the firm’s $2.4 billion in assets — returned 19.90 percent, boosting the overall fund’s return for both liquid and side pocket investments to 9.30 percent.
Falcon Edge Capital’s portfolio of private investments gained 20 percent through May; the New York firm’s $3 billion hedge fund portfolio declined 3.3 percent over the same period, while investors who chose to invest in both the liquid fund and the side pockets got a 0.3 percent return for the year. Last year the three classes of Greenwich, Connecticut–based Glade Brook Capital Partners’ Glade Brook Private Funds — which are dedicated to investing in private companies — gained between 62 and 77 percent while the firm’s hedge fund, the Global Offshore Fund, lost 1.3 percent.
Though investors no doubt are pleased with the performance of these private investments, experts warn that valuing private companies can be more of an art than a science.
“Some managers use internal evaluations, which are subject to biases,” says Charles Krusen, chief executive officer of New York–based Krusen Capital Management, investment adviser to the LionHedge Platform of alternatives strategies, which include hedge funds.
During an overall stock market downturn, investors in hedge funds must make sure the funds’ liquidity is not vulnerable to a massive redemption revolt. At the height of the 2008 crisis, more than 30 percent of hedge fund managers restricted investor liquidity through the use of gates or side pockets, according to a 2012 academic study.
Some managers are taking steps to prevent that from happening again. Greenwich-based Viking Global Investors’ new hybrid public-private fund, which opened at the beginning of this year, has an initial five-year lockup, while most of New York–based Tiger Global Management’s $10 billion-plus in private venture capital partnerships is contained in ten-year private equity funds. That said, at the end of the first quarter of 2015, private equity also accounted for 7.6 percent of equity investments in the firm’s three hedge funds. Still, the firm has long-dated capital that could take several years for investors to redeem.
Krusen says investors should pay the manager a performance fee on these investments when they exit the strategy and money is returned, “and, importantly, with a hurdle rate commensurate with the beta of the investment and the illiquidity.” Adds Krusen, “Most financial crises are caused when an unexpected event occurs in a market that is both highly levered and illiquid.”
