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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

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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