Hedge funds' biggest investors might have to sell out regardless of performance. Here's why one investor is 'deeply worried' about the business risks the industry is facing.

Bloomberg News

EJF Capital founder Emanuel Friedman has paused redemptions on his $2.5 Debt Opportunities hedge fund.

• Hedge funds have, on average, weathered the market turmoil caused by novel coronavirus relatively well - with a few types of funds producing some of their best returns in years.
• But liquidity crunches at institutional investors like endowments and pensions may mean redemptions are on the way no matter what.
• Hedge-fund investors sticking with the industry meanwhile must now be cognizant of the business risk facing many managers that might lose big chunks of assets for reasons unrelated to their performance.
• "Capital is king, and it's a precious resource right now," said Jon Aikman, who teaches a course on hedge funds at the University of Toronto's Rothman School of Management and sits on the endowment's investment committee.
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Emanuel Friedman put the gates up before money could come fleeing out.

According to a recent Wall Street Journal report, Friedman, the founder of credit fund EJF Capital, is suspending redemptions from his firm's $2.5 billion Debt Opportunities fund to "protect all of the Fund's investors by not selling assets into a nonfunctioning market."

While Friedman might have been preempting a rush to the door, since his fund was down 15% in March, hedge-fund investors are wary that redemptions are coming from regardless of performance - adding another concern to a long list of them.

The industry's biggest investors - the pensions, endowments, and foundations that helped institutionalize the business - might be forced to redeem to meet obligations.

"This will produce a significant liquidity crunch for a lot of end investors," said Craig Bergstrom, chief investment officer of fund-of-funds Corbin Capital.

Pensions have been struggling to meet their obligations for years, and Mike Moran, a pension strategist at Goldman Sachs Asset Management, said pensions are currently more underfunded than they were at any point in the financial crisis.

Endowments for hospitals meanwhile are going to be pushed to the limit with the additional stress placed on the healthcare system by the novel coronavirus pandemic. University endowments have been floated as a way to provide for students suddenly thrown out of housing and school.

"It could be that both the good and bad [performers in the hedge fund industry] are redeemed," said Jon Aikman, who teaches a course on hedge funds at the University of Toronto's Rothman School of Management and sits on the school's endowment investment committee.

"I'm deeply worried about the operational and business risks hedge funds face now," he said. "So many underfunded pensions are going to be seeking liquidity."

Managers have fared reasonably well, relatively, with some funds, like macro investors and futures speculators, turning in their best performances in years. But shakiness in the structured credit market, where one manager has already sued its lender for making margin calls that it described as aggressive, may be a sign of things to come.

"Many hedge fund strategies have very low correlations to capital markets benchmarks, and some are, or have the potential to become, negatively correlated during a market sell-off. This was seen in 2008 when few hedge fund strategies posted positive returns," wrote hedge-fund consultant Don Steinbrugge.

To protect against a wave of redemptions, funds might begin doing what EJF did and limit redemptions. Others, like Baupost and D.E. Shaw, may open up long-closed funds to raise assets in a time when "capital is king, and it's a precious resource right now," according to Aikman.

Allocators, of course, worry about business risks at hedge funds during non-pandemic times as well, with topics like founder succession on their minds, but those worries are put on the backburner when today's more pressing concerns become more feasible.

"Right now, we're laser-focused on urgent problems like managers' ability to meet margin calls and get waivers for falling NAVs. I look forward to a time when we can worry about longer-term business challenges," Bergstrom said.

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