A liquidity mismatch occurs when a fund is unable to generate sufficient capital to satisfy investor redemption requirements and any further obligations it has through the liquidation of assets or the utilisation of credit lines, presenting severe consequences for the fund, investor relationships and the reputation of the fund’s manager.
So, what strategies can hedge fund managers use to strike a balance between meeting their redemption obligations and protecting the integrity of their funds?
Management tools to avoid liquidity mismatch
To achieve superior returns, a hedge fund’s investment strategy may involve the purchase of illiquid securities that are difficult to liquidate quickly or value accurately at a point in time, which presents a challenge when attempting to determine the value of a redeeming investor’s share.
For this reason, a robust liquidity management strategy and a complete understanding of the fund’s risk-return profile, the liquidity of its investments and its redemption policy are vital for hedge fund managers.
Some of the liquidity management tools utilised by hedge funds when a high number of redemption requests threaten the liquidity of the fund include:
Swing pricing is an anti-dilution strategy which allows the manager of an open-end fund to adjust its net value asset up or down to reflect the dealing costs of buying and selling investments for the fund, effectively passing on transaction costs to the shareholders associated with that activity.
This technique passes the cost of trading activity along to subscribing and redeeming investors, protecting other investors from a potential dilution of value of their assets and reducing the risk of liquidity mismatch.
Dual pricing involves offering a different unit price for redemptions and subscriptions, offsetting dilution costs with the difference between them. The unit dealing prices are at the manager’s discretion, which means they are able to set the fund’s unit dealing prices at a tighter spread than the full spread between the issue and cancellation prices.
A hedge fund manager may impose a dilution levy in isolation or conjunction with partial or full swing pricing. This is a charge, set at a certain threshold, that is imposed on specific redeeming or subscribing investors to offset the price impact of their redemption or subscription.
Sometimes referred to as gates, deferred redemptions are a temporary measure that limits the amount a shareholder can redeem. With this tool, a daily dealing fund allows redemptions to be referred to the following day if net outflows exceed a predetermined threshold.
Deferrals can also be activated on a pro-rata basis, whereby a part of each order is executed at the first dealing point and the remainder is fulfilled at a later dealing point.
Redemptions in Kind
At the hedge fund manager’s discretion, in-kind redemption payments can be made to institutional investors. This allows funds to distribute underlying assets to investors on a pro-rata basis instead of honouring redemptions by paying cash.
Temporarily Reduced Dealing Frequency
Moving the fund to a reduced dealing frequency (such as daily to weekly) is a long-term measure used to prevent liquidity mismatch. The fund prospectus must be adapted ahead of this change and investors must be provided with sufficient advance notice.
In cases of extreme investor redemptions, a fund may establish a new borrowing facility or use an existing facility similar to an overdraft.
Lock-ins prevent investors from redeeming for a determined period, beginning from either the date the fund was launched or the date the investors entered the fund.
Current regulations on liquidity mismatch
From a regulatory perspective, liquidity mismatch in open end funds has been a topic of interest within the industry in recent years, with high profile cases of liquidity mismatch coming into light.
One notable example is a case in which an equity income fund stopped taking redemption requests, leading to them eventually being wound up and preventing 300,000 investors from accessing their investments.
Another, more recent, example from 2019 is a global investment manager which suspended dealing on its £2 billion property fund as a result of £1 billion of redemptions within a 12-month period and the subsequent difficulties the firm had with selling assets to honour all of its redemption requests.
The Financial Policy Committee (FCA) has since judged that ‘the mismatch between redemption terms and the liquidity of some funds’ assets has the potential to become a systemic risk’.
FCA and The Bank of England (BoE) launched a consultation in August 2020 on proposals to limit the potential for harm to investors from liquidity mismatch in open-ended property funds.
In response to the findings of the consultation and to address the vulnerabilities associated with liquidity mismatch in certain types of investment funds, the FCA set out three key principles to create greater consistency between funds’ redemption obligations and their underlying assets.
Redeeming investors should receive a price for their units in the fund that reflects the discount needed to sell the required portion of a fund’s assets in the specified redemption notice period.
The liquidity of funds’ assets should be assessed either as the price discount needed for a quick sale of a representative sample (a ‘vertical slice’) of those assets or the time period needed for a sale to avoid a material price discount; and
Notice Periods/Redemption Frequency
Redemption notice periods and/or redemption frequency should reflect the time period needed to sell the required portion of a fund’s assets.
In essence, open ended funds will need to:
- Ensure that the time it takes investors to redeem their money matches the fund’s ability to sell its assets to meet redemptions
- Classify their assets according to how easy they are to sell
- Adjust prices to reflect market conditions
These regulations are designed to improve hedge funds’ managers relationships with investors by reducing the risk of liquidity mismatch, which could potentially prevent investors from being able to access their investments. A partnership with a trusted, market-leading prime broker optimises the performance of hedge funds, therefore limiting the potential for harm caused to investors by an inability to meet redemption requirements.