04 March 2008 - Tammer Kamel

There is a particular risk that is increasingly prevalent within hedge funds that is poorly understood by many investors and is destined, I think, to become quite relevant in the near future. The risk, which I have dubbed “The Artificial Liquidity Trap”, is an artifact of the ever increasing prevalence of illiquid investments by hedge funds.

The trap is innate to modern strategies especially trade finance, asset backed lending, PIPEs, and structured credit. It is less common in the classic strategies, but can appear in some such as distressed investing. I call it a trap because it literally can ensnare a naive investor.

The trap is created any time a hedge fund structure is wrapped around an illiquid portfolio. Consider a hedge fund holding a portfolio of illiquid investments like asset backed loans or life settlements which mature many months or years in the future. The fund may have relatively conservative liquidity terms like quarterly redemptions with 90 days notice with perhaps a 1 year lock up and gates at 25%. (Liquidity terms similar and more liberal than this are the industry norm.)

What is actually happening here is a completely illiquid portfolio has been wrapped in a layer of artificial liquidity. The fund offers liquidity beyond that available in its portfolio which is simply not sustainable. Of course, as long as net inflows to the fund exceed net redemptions, the façade will hold. Over the last 5 years, since the advent of some of these less liquid hedge fund strategies, this is exactly what has happened. This has given investors a specious affirmation that hedge funds can sustain illiquid portfolios.

But what happens when net inflows no longer exceed redemption requests? The only possibility is that the fund’s investors start becoming liquidity providers for each other. The first or first few to redeem might get paid from the fund’s limited cash supply. The first investors out enjoy liquidity that does not really exist at the expense of her co-investors who have effectively had to buy her out and in doing so have reduced the liquidity of their portfolio. Soon the liquidity runs out entirely and the remaining investors hold complete illiquidity, though the gates will go up quickly once the manager realizes what is happening. But notice that the first investors out enjoyed the lion’s share of liquidity at the expense of everyone else; the non-redeemers were uncompensated liquidity providers for the early departees.

The important risk axiom here is this: by participating in any pooled capital investment into illiquid securities, an investor necessarily takes the risk that she gets stuck holding the totally illiquid remnants of a portfolio if she is slow to redeem. She takes the risk that she might be an uncompensated liquidity provider for another investor. Notice what is happening here: All investors take a risk for which there is zero aggregate compensation. And of course competent investors never take uncompensated risks.

Fiascos from artificial liquidity have occurred before but only idiosyncratically and therefore quietly. It is why the risk is not well understood. But if and when we see systemic redemptions in these illiquid spaces, I suspect many investors will gain first hand experience with the artificial liquidity trap. The astute will take liquidity measurements now, because it is not too late to be the investor who gets out first.