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September 06, 2008

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a

I thought you want to work in FoF?

Nadav Manham

I do, but I want to work for a FoF with a true long-term outlook, that doesn't hamper its hedge fund managers with such hair-trigger redemption requests.

I believe such FoFs exist. Is that like believing in Santa Claus . . .?


a

"I want to work for a FoF with a true long-term outlook, that doesn't hamper its hedge fund managers with such hair-trigger redemption requests"

The impetus for many/most of these redemptions is the need for liquidity due to redemptions from THEIR underlying investors. To not make these redemptions, while some may be unwanted/inconvenient, would be a direct violation of their fiduciary duty.

Nadav Manham

I'm not suggesting that hedge funds ignore their fiduciary duty to meet the redemption requests of their fund of fund LPs, nor that FoFs ignore their fiduciary duty to meet the redemption requests of their investor LPs.

I'd compare this situation to a bank, a brokerage house, or any other financial institution whose "liabilities" are very liquid--i.e. subject to redemption on short notice.

A FoF in such a situation can either

a) Maintain adequate cash itself to meet redemption requests

b) Ensure that the hedge funds in which it invests maintain adequate liquidity, either in cash or easy-to-sell securities, to meet redemption requests without compromising their portfolio management abilities.

c) Take steps to make its capital more permanent through lockups or filtering out short-term investors.

d) Do none of these things, and hope for the best--i.e. that LPs will only make redemption requests under favorable conditions.

I am not a lawyer, but "hope for the best" does not meet my definition of fiduciary behavior either.

a

A FoF in such a situation can either

a) Maintain adequate cash itself to meet redemption requests

These requests are more than the customary 5% that FoF's hold. And, during "normal" times (like late 2003 through August 2007), FoF's take a lot of flak from their investors for holding this "huge" amount of cash.

b) Ensure that the hedge funds in which it invests maintain adequate liquidity, either in cash or easy-to-sell securities, to meet redemption requests without compromising their portfolio management abilities.

It is the underlying HF's responsibility to set its terms, and then the responsibility of the underlying investor (the FoF in this case) to determine if the asset-liability mismatch is appropriate. However, if a HF previously offering monthly liquidity is either highly levered (as in Equity Market Neutral/Stat. Arb), buying more illiquid securities (many firms across the board), or operating in an environment with limited liquidity (by definition virtually every HF given the current environment), they are subject to permanent loss of capital when forced to sell securities that are below their initial purchase price. Its as simple as that and it is THEIR responsibility to plan for this type of event.

c) Take steps to make its capital more permanent through lockups or filtering out short-term investors.

Yes. Not really sure how you can determine "short-term" investors until after the fact, I understand to not take "hot money" but virtually everyone in this environment has a need for liquidity.

d) Do none of these things, and hope for the best--i.e. that LPs will only make redemption requests under favorable conditions.

Agree. But don't blanket all FoF managers as stupid or short-term investors when many of their investees exhibit similar behavior. I can name you scores of cases in the event you haven't been reading the financial press over the last 14 months.

Nadav Manham

I didn't mean to blanket all FoF managers as stupid or short-term--I hope to work for one who is not. But I do believe that a FoF whose investees behave this way bears some responsibility, either because it helped contribute to it per Redleaf, or because it invested in such a vulnerable fund in the first place. 1 and 10 is a lot to charge on top of 2 and 20, so a FoF's investors deserve a lot to justify it.

I really appreciate your comments on this thread, a. I confess I'm not an expert in how FoF's operate, so I learned a lot. Maybe we could talk more offline?

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