So, as you may have heard, the top managers of a couple of Bear Stearns (peace be upon it) hedge funds were arrested on Thursday by federal authorities on charges of securities, mail and wire fraud. The crux of the allegations are that while the managers were privately voicing concerns over the hedge funds they managed, which seem to have been deeply invested in securities linked ultimately to residential mortgages, they presented a sunny picture to their investors. There is also evidence that one of the managers simultaneously reduced his own position in one of the funds by about $2M (from $6M). There is also some reason to believe that the $2M was simply moved from one fund to the other, though this remains to be substantiated.
I am not intimately familiar with the structure of these particular hedge funds (and if I were, I wouldn’t be telling you about it—I keep my clients’ confidences, dear readers), but most hedge funds have substantial limitations on liquidity—i.e. the ability of investors to withdraw their money. Unlike a publicly traded stock or futures contract traded on an exchange, an investor cannot simply sell off his or her position in a hedge fund on any given day. Rather, most hedge funds only allow redemptions of fund interests on a quarterly basis with a significant notice period, typically 60 to 90 days. This means that if an investor wants to get out of the fund, he or she must submit a notice to the fund 60 or 90 days in advance of a quarter end (i.e. once every three months). Generally, the fund then has some time to make the payment to the investor—30 days after quarter end is typical. An investor generally also can’t sell his or her position to a third party because the hedge funds rely on very technical and stringent restrictions on sales of interests in the given fund (so that the interests are only ever in the hands of sophisticated investors) to qualify for exemptions from various securities laws.
The hedge funds are set up this way for practical reasons. The investment strategies of the funds are generally complicated, and often involve investments in illiquid assets or complicated (and generally also illiquid) derivative instruments—”over-the-counter” swaps, and the like—on a leveraged basis (meaning that, say, for every $1 an investor puts in, the fund goes out and gets exposure to $10 worth of investments). If an investor wants to redeem some or all of his or her position in the hedge fund, the hedge fund has to go out and liquidate some of these illiquid investments in order to have the cash to pay out to the investor. In addition, the market value of a lot of the hedge funds’ investments are not easily quantifiable, so hedge funds will typically have a “hold back” or “claw back” provision so that, because the fund managers won’t know the exact value of the fund’s portfolio of investments until the completion of a year end audit, final redemptions out of the fund are not complete until the audit is finished. This means that an investor getting out of a fund may not get all of his or her money until six or seven months after the end of the fiscal year in which he or she requested total redemption (or, in the case of a “claw back” structure, he or she may be obliged to give some of his or her initial redemption back to the fund if after the audit it is determined that the fund paid out too much).
All of this is, of course, disclosed to investors in hedge funds before they make the decision to invest. And, what’s more, because the hedge funds are not public offerings of securities and are very complicated and risky investments (all of which also, of course, is disclosed to investors before they invest), only sophisticated investors are permitted to invest in hedge funds, for the most part. This was certainly the case with respect to the two Bear hedge funds currently the subject of all of this fuss and muss. I won’t bore you with the securities law definition of who is a “sophisticated” investor—suffice it to say that the investors in these funds are generally loaded.
The illiquidity of the investments in the hedge funds themselves and the illiquidity of the investments that the funds in turn made with the investors’ money creates a lot of problems for managers when there are problems with the funds. Primarily, if investors get spooked and stampede for the exit, the fund will be forced to liquidate investments that may be hard to value, and may wind up taking huge losses as a result of the difficulty in valuation and illiquidity of the positions of the fund itself. This problem was, of course, compounded in this case by the start of the “credit crisis.”
So, these particular Bear managers were put in a very, very difficult position. The investments of the funds were in trouble, were already pretty illiquid, and became almost impossible to value and liquidate once the troubles in the credit market (or, alternatively, the “sub-prime crisis”) hit. This problem would have been compounded by investors suddenly redeeming en masse, because the fund would then have been obliged to attempt to liquidate most of these messed up assets at the worst possible moment, further driving down their value. If the Bear managers had signaled somehow to the skittish investors that they should be getting out, it is likely that the investors would still have lost every single penny of their investments (which was the ultimate outcome).
Their only reasonable choice, and probably the choice that was totally consistent with their fiduciary duties to their investors, was to urge calm and try to prevent a “run on the fund,” in essence. That’s what the managers did.
Hence, this case, so far as I can tell at the moment, is bullshit.
