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Following US$700 million (A$895 million) in redemption requests in the final quarter of 2008, US hedge fund Blue Mountain introduced a new fee structure and an optional bidding sys­tem for investors in an attempt to create a nexus between liquidity and hedge fund fees. In October last year, hedge fund-of-funds investing in the multi-strategy credit fund asked for hundreds of millions of invested capital back, an event which threatened the positions of remaining investors and forced Blue Mountain to carve out part of its port­folio and create a redeeming share class to pay the requests. “The liquidating share class bore its own costs for liquidity,” Jay Bryant, managing director of the hedge fund, said.

“It’s one thing to share transaction costs among investors in liquid markets, but it’s another to do so in illiquid markets.” Many of the applicants may have been deploying “game theory”, asking for more capital than they needed in case they were among the last investors in the fund, Bryant said. Ultimately, many applicants either withdrew or scaled down their redemption requests after judging that many other investors would stay the course. But the episode was scary enough.

 

In 2009, after fielding questions from a Texan institution about

Blue Moun­tain’s redemption processes, Andrew Feldstein, the manager’s chief executive and chief investment officer, overhauled the fund’s fee structure and introduced a bidding system to create a market for liquidity among its investor base.  The standard two-and-20 per cent fee with monthly liquidity became 1.75-and-17.5 per cent with quarterly liquidity, while a 1.5-and-15 per cent class was introduced with annual liquid­ity and a one-and-10 per cent class gave investors liquidity every two years. Bryant said the longer lock-up peri­ods reflected the manager’s expectations of future liquidity in its portfolio.

 

“To remove game theory, we wanted to make sure that enough at par liquid­ity was in the book to not be forced to make transactions to pay investors out,” Bryant said. In addition to securing an entitle­ment to future liquidity, investors can bid for further redemptions, or “unlim­ited at-cost liquidity”, at the end of any quarter with 90 days’ notice, through a Dutch auction system that aims to strike a price for the liquidity being demanded to cover transaction costs. Dutch auctions traditionally take just one offer from each bidder and ac­cept the highest.

 

Following this model, investors applying for additional liquid­ity must nominate how much they want to redeem and a maximum discount to the net asset value (NAV) of their investment that they are willing to incur as a premium for liquidity. “People who pay the biggest dis­count get filled first,” Bryant said. If an investor is willing to take a 10 per cent discount to NAV, a representative portfolio accounting for their investment will be sold, and the proceeds and crystallised performance fees – reduced proportionately with the discount to NAV – will be reinvested into the portfolio as “pay for the inves­tors who provide liquidity”. If bidders do not exceed a 10 per cent discount to NAV, redemptions will be met at a discount equalling 1.5 per cent of the percentage of NAV being redeemed. But if this discount exceeds that put forward in an investor’s bid, the redemption request will be cancelled. The new fee structure and bidding system were implemented recently, and Q2 2009 marks the first quarter in which investors can bid for additional liquidity.

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