Study is first to examine the secondary market for stakes in hedge funds

5 May 2008

Several commentators on these pages have wriiten about the hedge fund liquidity premium.  While it makes intuitive sense that investors demand compensation for locking in their money, it can be notoriously difficult to put a price on hedge fund attributes such as this.  When the only decision facing an investor is binary - to invest or not to invest - it is difficult to get a picture of the full demand curve for a particular fund.  Unlike in most other markets, investors don’t bid up or bid down the price of a hedge fund in an open market.

But there is one rough approximation of such a market for hedge funds.  And now one enterprising academic has used data from that market to determine how much investors value things like lock-ups and various other characteristics of hedge funds. That secondary hedge fund market is Bahamas-based “Hedgebay”.   Every month, Hedgebay brings together buyers and sellers of stakes in (mostly closed) hedge funds.  The funds trade at a discount or premium to their net asset value (NAV) depending on various factors.

In a study published in March, Tarun Ramadorai of Oxford University used 10 years of Hedgebay trading data to determine the effect of those factors on the premium or discount for a stake in one of the funds traded on the market.  Over the 10 year period analyzed, buyers have been paying a premium for these stakes in closed hedge funds.  The chart below was crated using data from the study and shows the premia and commissions paid for about 870 hedge fund stakes (excludes about 70 blow-ups that generally sold at around a 50% discount).

The study provides empirical evidence for several intuitive observations about the demand for certain hedge funds:

• The longer the notice period for redemptions, the larger the discount a buyer demands.  (ed: apparently not swayed by the liquidity provided by HedgeBay itself).
• However, hedge fund purchasers don’t seem that fussed about the liquidity of each fund’s underlying investments.
• Hedge fund buyers are willing to pay a premium for higher past performance.
• Buyers are also willing to pay a premium for lower historical volatility.
• Funds with a higher management fee change hands at greater discount.  However, the size of the performance fee does not seem to affect the premium or discount applied to the fund.
• The premium or discount applied to a hedge fund stake seems to predict the out-performance of the fund over the following 24 months (outperformance vs. the fund’s historical returns).   

The last finding is quite interesting since it suggests that, like stock market prices, hedge fund transaction prices contain information about future success.  But the study also concludes that when a fund changes hands at a “high premium”, future returns are likely to be lower than expected (which suggests return-chasing and over-bidding by some hedge fund investors).

Obviously, this kind of horse-trading has been going on for years in the form of secondary markets for closed-end mutual funds.  While the study points out that there are significant structural differences between Hedgebay and markets for closed-end funds, it does find that there is a whopping 59% correlation between the average HedgeBay premium/discount each month and the average premium/discount paid for closed-end mutual funds.  Prompting Ramadorai to conclude:

“The high correlation between the average premium on this OTC market and the celebrated closed-end mutual fund premium suggests that there may be some deeper structure underlying different markets for managed investments, a possibility that warrants further investigation.”

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