A Tougher Gate at DE Shaw: Investor Protection vs. Opportunism

I caught a story in Marketwatch concerning a material change in the gating provisions around one of DE Shaw's major funds, the Oculus global macro fund. Although not in possession of all the facts, I find this whole story-line very interesting and worthy of some discussion and analysis. The Marketwatch story is provided here:

DE Shaw's multi-billion dollar global macro Oculus fund is lowering its "gate" to 1/12th of assets from 1/8th of assets starting Jan. 1, 2007, two investors said on condition of anonymity. A representative at the $25 billion New York-based firm declined to comment.

A gate limits the proportion of a fund's capital that can be withdrawn by investors. By lowering its gate for Oculus, D.E. Shaw is trying to make sure the fund is not forced to sell positions if a large number of investors all want their money back at once.

There's no sign that D.E. Shaw is lowering the gate in response to more redemptions, but one investor in Oculus who declined to be identified said the move was a concern because it increased the risk that they won't be able to get their money out as quickly as expected if needed.

Other investors said D.E. Shaw's move could be spurred by the firm's expansion into private-equity investing. These types of investments are less liquid than things like stocks and bonds, so hedge funds entering the private-equity world often try to secure investors' money for longer.

As some hedge fund managers have begun investing in private companies, "fund terms are modified to address reduced liquidity by incorporating some of the terms traditionally used by private equity funds," Stephanie Breslow and Paul Gutman, partners at law firm Schulte Roth & Zabel LLP, wrote in a 2005 report on hedge funds and private equity. "The gate provision allows the manager to increase exposure to illiquid assets without facing liquidity crises as a redemption date approaches."

D.E. Shaw, founded by former Columbia University computer science professor David E. Shaw in 1988, is mainly known as a quantitative specialist using computer models to generate trading and investment ideas.

However, much of the firm's growth in recent years has come from an expansion into other types of investing, such as private equity and distressed debt and lending.

D.E. Shaw agreed in October to invest up to $500 million in The ERORA Group LLC, a private company that owns and develops coal gasification projects.

Hotel and casino operator Riviera Holdings said in November that it received a buyout offer from D.E. Shaw and real estate developer Ian Bruce Eichner.

Hmmm. There is a lot going on here, so let's look at the issues one by one.

1. Is Oculus a hedge fund or a private equity fund?

Or some kind of hybrid hedge fund/private equity mix? I would assume it is closer to being a hedge fund if it is referred to as being "global macro." I generally haven't thought of global macro funds as having much illiquid asset exposure, or anything remotely akin to private equity. I would want to understand Oculus' asset mix much better before knowing whether the "illiquid asset" excuse is valid or a bunch of smoke.

2. Do global macro investors want and/or know about quasi-private equity investing activity?

This gets to the issue of style purity and investor communication. How does one combine the characteristics of global macro and private equity in a package that represents the wants and desires of institutional investors, regardless of the flexibility inherent in one's fund document? Now this might not be what's happening, but if it's not, then why the change in gating provision?

3. Is DE Shaw securing Private Equity liquidity protection for Hedge Fund liquidity risks?

I know that DE Shaw has expanded into other investment styles such as distressed debt (Laminar) and private equity (like its coal gasification and casino buyout projects), but are activities like this also being done through Oculus or other vehicles? I can see how Laminar and its investors, for example, would benefit from more stringent gating provisions due to the (potentially) illiquid nature of a significant portion of the fund's investments. I can also see how this principle would apply to a book of deals akin to the coal gasification and casino transactions mentioned above. But global macro?

The Punch Line

My friend Greg and I were emailing about this issue earlier today, and I think he said it very elegantly: "Just as so many investors are paying alpha fees for beta returns, you can also say that they are giving in to PE lockups for HF liquidity.  The game remains the same." I wonder if this is what's going on here. David Shaw is a tremendous investor and has built a great firm that I respect a great deal, but I want to know if this move represents one of opportunism ("I can get away with it because hey, I'm DE Shaw, and there is more demand for my funds than I know what to do with") or investor protection ("In a panic with a fund holding significant illiquid assets, everyone gets hurt if they run for the exit at the same time, and I want to protect all those involved"). We may never know for sure. But is certainly is an interesting question, isn't it? 

Comments

[Greg Battle]

Great thread folks. I'll throw my hat in again for good measure.

There are a few classic things here that should raise our eyebrows.

HF Marketing 101 or "The Art of Misdirection" - D.E. Shaw (and its brethren) are repackaging classic "style drift" and selling it as "multi-strategy" or worse, "diversification." As is often the case, the best way to get away with something shady is to do it in the wide open, but just name it differently. Keep white-washing those fences Tom Sawyer.

HF Marketing 102 "Obfuscation and Parlor Games" - After reading (and writing) my fair share of HF marketing materials, I've determined that HF liquidity is a ruse. They sell investors on how liquid the strategies are - how long it will take to unwind all the positions - but that never translates into liquidity for investors. To hide its true nature, investor liquidity is split into three sections; the lockup period, the redemption notice window (45, 60, 90 or worse days) and the gating provision. The first two only concern the individual investor, however, the third takes into account all LPs on a pro-rata basis and is sold as, get this, a protection measure! This game kills me, it's hilarious. Yes, HF's tell people that "we are protecting you by NOT giving you access to your money....now bend over." What HFs are really protecting is their management fee income and a lifeline to turn around bad performance. How many investors account for this illiquidity in their risk adjusted performance measures? Few if any. Trust, the sharpe ratio in the monthly LP letter you get from the HF certainly doesn't. More white-washing. It's a BIG fence. [I'm not EVEN going to touch the "side-letters" and "side pocket" issues, which can be a fourth and fifth way of limiting investor liquidity.]

HF Marketing 103 "The Illusion of Scarcity" - I'd love to go back in time and look at the marketing materials of these burgeoning mega-funds and note exactly what the capacity constraints were. Did they simply "sell" the lack of capacity as a means of raising capital early? And now, by the laws of supply and demand combined with a little good performance, miraculously, capacity has reappeared and increased ridiculously? Despite every mention to the contrary, this is still an asset gathering business (just with LESS liquidity and more fees). I don't know about you guys, but this game makes me double over in laughter.

HF Prognostication or "What would Ms. Cleo say?" - For the retailization of the HF biz to happen, the validity of the gating clause as a "protection" measure will have to be questioned. If the industry wants to become a real asset class, these shenanigans will have to cease (my kingdom for transparency!). My guess is that with all this fee income at stake, it will get much worse before it gets any better, so smoke 'em if you got 'em boys.

[aa]

Roger,

You and I both know that global macro does not require constraints on liquidity the way that private equity might. Given that DE Shaw also is rumored to have fees in the 3/30 range, I would put this move purely in the camp of "opportunism". Also, as I remember, DE Shaw developed its reputation as a hugely quant/stat arb type of place (a la Renaissance). Private Equity is a totally different animal requiring a completely different type of organization. For one thing, any good private equity partner will need to own some part of the GP. From the SEC filings, it does not appear that anyone besides David Shaw owns any part of DE Shaw. Since it is so secretive, we will never know. But if that's true, I don't see how a long-term private equity effort will work out over there.

Thus, for all these reasons, this new gating requirement is yet another way of locking investors in to pay the high 3/30 fee for a lot longer period.

[Yaser Anwar]

RE- interesting and key points.

The point Greg has made is very valid. One reason I believe has led to the asymmetry is investor complacency.

As you pointed out that majority of the investors viewed Amaranth as a blue chip fund but those who did their homework noticed the concentration you're talking about.

The fund that did notice the concentration was Blackstone Alternate Investments. Did you know they pulled out their funding once they visited the Alberta offices and saw the huge leeway provided by Maounis to Hunter? Homework always pays of.

Blackstone's pullout goes to show that they smelled trouble and reacted immediately by pulling the funding out. Now after the blow-up it compliments their superior management alongside attention to detail, who deserve every bit of their bonus this season (if I was a HF investor I'd give my money to them after having knowledge of their pull-out from the blow up).

You'd think the Blackstone pull-out would have lead investors to think twice and assess the risk being undertaken, especially considering AA was comprised of institutional investors who took pride in being "good asset allocators". Nop. Its all couda wouda shoulda now.

The saying "its better to be lucky than good" applied to LTCM investors who were returned their assets only to see LTCM collapse a year later but that saying applies the other way to Blackstone- its better to be good than lucky. Either way- kudos to them.

I've got an interesting question for you. What if AA had a lockup period and Blackstone couldn't have taken out their assets, given the massive concentration they noticed. AA would be liable to BAI, right? Probably yes but given the liquidation of the positions to JP and CIG- AA would have had no benjamins left- how would they repay the 100s of millions of BAI money, assuming the scenario played out as it did?

At the end of the day the onus lies on the investors. Requirements of more disclosure will often be resisted, no matter how good or bad the HF, on the grounds that it would disclose proprietary information that would lead to market going against you no matter how apparent the inefficiency. [read: When Genius Failed- Meriwether and his cadre knew the inefficiency was there and kept doubling down, not knowing who will they sell to if they are the market?]

HF guys need to realize that no matter what disclosure policy you have it won't help (the top 20% of HFs know this) when you are the market- Barings, LTCM, Amaranth found that out the hard way. As someone who aims to be a trader I'm going to make sure its ingrained in my brain with a post-it note on the trading turret to serve as a reminder.

[Roger]

Yaser, it sounds like your experience at Permal was fruitful. You learned a lot of good (and critical) stuff.

Concerning DE Shaw's moves, I really hate to speculate, but suffice it to say that regardless of the intellectual purity of the move (read: essential for investor protection vs. "I can get it so I'll take it") they have a sufficiently happy investor base that they can make it happen without a hiccup.

I think the bigger issue is the point my friend Greg made. The kind of asymmetry between liquidity-vs-risk or performance-vs-fees is simply not sustainable long-term. While the very top performing funds with institutional brands can exploit this asymmetry right now, when does it stop and where do you draw the line?

Before Amaranth blew up most (though not all) investors and outsiders perceived it as a blue-chip, $9 billion+ multi-strategy fund. They could pretty much get the terms they wanted. Clearly, in retrospect, an investor wouldn't have wanted to give them the flexibility to run the massively concentrated (and inappropriate) positions they ran. At some point investors will push back and the barbell-shape of the hedge fund industry will become more pronounced - the DE Shaws, Farallons and Fortress' of the world and everyone else. When this happens, who knows.

[Yaser Anwar]

Usually funds with greater liquidity risk impose longer lockup periods for investors in order to balance liquidity risk on both sides of their balance sheet.

During my summer tenure, partly in the performance reporting unit, at Permal- I learned that Liquidity risk is difficult to factor into the VAR models. Why? Due to the fact that accounting for potential losses due to liquidation requires a price impact function, which is difficult to estimate.

Also that reported monthly volatility will be less than the true volatility because prices are based on trades during the month, similar to the averaging process.

When talking about the asset size- liquidity risk is a function of the size of the positions as well as of the price impact of a given size trade for the instrument.

In the case of distressed debt/small-cap companies there is intrinsic liquidity risk because the instruments are thinly traded, implying a large price impact for most trades.

RE- with regards to your question if its opportunism or IP- Given the Amaranth incident still fresh in everyone's mind and Citadel's push to secure financing (which maybe irrelevant to the subject at hand) I view this move as a bit of both, opportunism and IP, what say you?

[Roger]

Byrne, clearly you are right. I don't think that is the issue here, however. The issue is more related to the pressures investors can place on fund managers to engage in sub-optimal behaviors due to the (il)liquidy of their assets. And this makes sense.

If the liquidity of your assets is really an issue in your particular fund, i.e., if your fund is principally made up of liquid, exchange-traded assets, then having a tough gate doesn't make much sense. If your performance sucks, investors should be able to leave and generating the cash necessary to pay them out isn't a problem. Conversely, if you have have a pool of illiquid distressed debt of if your position sizes relative to float are huge, then gates can prevent the kind of "run for the exits" perverse behavior that kills funds.

Just my two cents. Thanks for the comment.

[Byrne Hobart]

As Amaranth (and LTCM) demonstrated, the 'liquidity' of some markets is entirely a function of your brokers and your competitors not knowing 1) Your positions and 2) That you're vulnerable to a margin call/forced liquidation.