Who here has direct experience (on either side of the credit line) with this?
a few ideas started coming together in my head:
- HF industry seems 'priced for perfection', funds proliferating like crazy
- what would you demand in pay as a fund-of-fund quant if you believe that the industry could get their clock cleaned, possibly taking the FoF format down with it
- does the FoF structure change the way HF liquidations get done?
- in particular, does FoF create an opportunity for 3rd-party HF liquidators
- big ($100MM+) debt portfolios now trade regularly as busted CDO casings are peeled away, so there is a similar structure in place elsewhere under the nameplate 'repack'
- how different is this from derivs ctpty risk securitization / insurance?
- would this be fun? (i.e. conditional on being in business, one can count on particularly bad market environment)
ideas, lads?
when HFs fail
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Nonius
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Nonius
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when HFs fail
I am definitely interested in talking more about this, since it crosses an interest of mine with a duty I have to perform.
Chiral is Tyler Durden
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Nonius
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when HFs fail
coupla more comments on this....
your end of the business, which, from my understanding, is on the other side of the Looking Glass, is difficult in HF land. The history isn't there, and the financial statements are not publically available. Plus, credit risk in HFs is not the same as credit risk in widget making companies. HF credit risk is an amalgam of market, credit, model, operational, and liquidity risk.
furthermore, a HF balance sheet is volatile in structure. I do not mean that the assets are volatile, but rather, that the composition of the balance sheet is volatile. Actually, as you surely know, the balance sheet is largely an "off-balance sheet" portfolio.
I want to build a HF credit rating model. However, I am fully aware that with the current default experience in HF, it will simply give rise to "relative" ratings. Over time, it could have value. If I were ambitious on this, I would build a team of people to go out and visit one to three funds every week. there are thousands of funds out there, so, there is enough to review.
Why is there value in a HF rating model? As the alternative investments industry grows, so will the need to have various forms of credit related products. Of course, leverage employed by HF is a function of the credit risk that banks are willing to take. Also, as funds tend towards daily liquidity (which, surely, is the direction it is going), there will be increasing demand for "liquidity facilities" that is, lines of credit, bridge loans, etc etc for allowing for redemptions etc....(also, loans allow for leverage as well)>
your end of the business, which, from my understanding, is on the other side of the Looking Glass, is difficult in HF land. The history isn't there, and the financial statements are not publically available. Plus, credit risk in HFs is not the same as credit risk in widget making companies. HF credit risk is an amalgam of market, credit, model, operational, and liquidity risk.
furthermore, a HF balance sheet is volatile in structure. I do not mean that the assets are volatile, but rather, that the composition of the balance sheet is volatile. Actually, as you surely know, the balance sheet is largely an "off-balance sheet" portfolio.
I want to build a HF credit rating model. However, I am fully aware that with the current default experience in HF, it will simply give rise to "relative" ratings. Over time, it could have value. If I were ambitious on this, I would build a team of people to go out and visit one to three funds every week. there are thousands of funds out there, so, there is enough to review.
Why is there value in a HF rating model? As the alternative investments industry grows, so will the need to have various forms of credit related products. Of course, leverage employed by HF is a function of the credit risk that banks are willing to take. Also, as funds tend towards daily liquidity (which, surely, is the direction it is going), there will be increasing demand for "liquidity facilities" that is, lines of credit, bridge loans, etc etc for allowing for redemptions etc....(also, loans allow for leverage as well)>
Chiral is Tyler Durden
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JabairuStork
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when HFs fail
Question regarding the fund of funds phenomenon:
I personally think that the FoF is a spectcularly bad investment designed to bilk money out of unsophisticated retail investors, but that's just me. Also, even if I am right, that doesn't preclude if from being a very successful industry.
Anyway, here is the question. Most FoF vehicles, as retail products, offer substantially liquidity to their investors. Not the daily liquidity of a mutual fund perhaps, but many have quarterly or even monthly redemptions. Now in a traditional retail fund, you have both a cash buffer and at least some subset of the assets held that are highly liquid (UST's or agencies, etc.)
In the FoF world, you have a severe liquidity mismatch beteween the liabilities and the assets. If the HF returns start tanking, you can bet that retail FoF investors are going to start yanking assets at the very next redemption date. What, exactly, do the FoF managers do about this contingency? (ignore it? Keep a big cash cushion? Liquidate at Rikers Island prices?)
I personally think that the FoF is a spectcularly bad investment designed to bilk money out of unsophisticated retail investors, but that's just me. Also, even if I am right, that doesn't preclude if from being a very successful industry.
Anyway, here is the question. Most FoF vehicles, as retail products, offer substantially liquidity to their investors. Not the daily liquidity of a mutual fund perhaps, but many have quarterly or even monthly redemptions. Now in a traditional retail fund, you have both a cash buffer and at least some subset of the assets held that are highly liquid (UST's or agencies, etc.)
In the FoF world, you have a severe liquidity mismatch beteween the liabilities and the assets. If the HF returns start tanking, you can bet that retail FoF investors are going to start yanking assets at the very next redemption date. What, exactly, do the FoF managers do about this contingency? (ignore it? Keep a big cash cushion? Liquidate at Rikers Island prices?)
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Nonius
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when HFs fail
Most of the places I've seen perform liquidity stress tests to "ensure" that the liquidity mismatch can be met with a variety of workarounds, such as liquidity facilities obtained from banks. banks most likely will not simply loan money for redemptions, but, they would enter into a financial contract with a pledge of something. the FoF won't be able to blow out underlying HF shares as you pointed out, but, if it could pledge shares, it could meet some redemptions. think repo, but dressed up in a sexier way.
on the retail side, I think it is that the little guy wants to get in on the perceived "alpha" coupled with "low vol", coupled with returns that are not worse than the "beta" market. I am pretty sure that FoF investors are still mostly instiutional, other FoF, family offices, and such.
Note that most of us qualify already to directly into a fund, so, the border of retail and "wealthy" even in the U.S. is remarkably low. (1MM net worth OR 250K salary)I understand this border will be raised. In some countries in Europem the standards are even lower! I could be wrong, but I heard that germany essentially doesn't have a 'stanard'. In France, I seem to recall that the condition is simply 10K investment.
on the retail side, I think it is that the little guy wants to get in on the perceived "alpha" coupled with "low vol", coupled with returns that are not worse than the "beta" market. I am pretty sure that FoF investors are still mostly instiutional, other FoF, family offices, and such.
Note that most of us qualify already to directly into a fund, so, the border of retail and "wealthy" even in the U.S. is remarkably low. (1MM net worth OR 250K salary)I understand this border will be raised. In some countries in Europem the standards are even lower! I could be wrong, but I heard that germany essentially doesn't have a 'stanard'. In France, I seem to recall that the condition is simply 10K investment.
Chiral is Tyler Durden
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Nonius
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when HFs fail
anyway, to me the way to do HF lending would be similar to my old Trors R Us idea. You set up an SPV and issue HFCO, that is, Hedge Fund Credit Obligations. Note that HFOs already exist, but, to my knowledge, not on the credit side. The obligations are collateralized by shares in underlying fund shares. You measure the proper overcollateralization via market stress and model (ie correlation shock) techniques. You put in features that forces a wind-down if certain triggers are broken, but the wind-down is put in place as to be orderly. I think you will end up collateralizing at 100% over the loan amount.
Chiral is Tyler Durden
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kr
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when HFs fail
I think this is about right. Honestly, the mechanics isn't all that different from your typical loan credit agreement, and I think in terms of internal marketing that is the sensible way to go. The wind-down 'remedies' is the tricky part, but even beyond that, my guess is that even if you can get all of this in writing, there are some limits in terms of what gets done. Let me outline a small high-yield lending market dynamic:
- in the beginning, there were loans
- but then there were years with phenomenal cash returns on investment
- so the 'asset yield' look really good, and people decided that an increase in leverage is a good idea
- rather than bump off the old debts through refinancing, subordinated debt was piled on top, which was largely undercollateralized when the senior paper was taken into account. This 'cashflow lending' just seemed like such a good idea 'because of the stability and strength of the underlying cashflows' (but watch!)
- then, things started to go bad
- but, you knew the sub debt was undercollateralized already! where's the trigger to pull? well, they didn't put one in - the safety feature was disabled from the very beginning!
- so, nothing was done until the covenants on the senior debt got triggered
- ...at which point they realized that cashflow is in a declining trend, so the asset value they'd counted on at the senior level was overstated, and liquidation-level overcollateralization at the sr debt is also < 1.0x
- fuck, take it through Ch. 11 and take a haircut on your senior debt, sub debt gets zero
Happens all the time and is a reflection of credit cycle psychology. What I didn't say is that if you weren't overly aggressive when everybody else was, then ( a ) everybody would think you're dumb, and ( b ) you'd lose too much market share to be a player. I don't doubt that the HF lending situation is any different - basically you will get your statistical share of pain when the crunch comes. What you can do to innovate, then, is manage your exit strategy. If you just do a blue-light special on these big derivatives portfolios, then you will lose a lot of money. So, the point is to avoid this at all costs, and do something that is uncorrelated with what everybody else is doing. For bankrupt companies, this means you want to keep the company operating, but under a different compensation structure, and if they can't get it done then you need to step into their shoes. That's a tall order in most cases, but even a smart liquidation would be better than what's likely to occur. That's why I think there is room to be ( a ) the beneficiary of bad liquidations and ( b ) the adviser of good liquidations.
I have another idea on this issue but I want to think things through a little more and post a separate thread - this has to do with the problem of charging more-or-less fixed credit spreads on credit exposure where the default rate is concentrated at points in the future instead of being evenly distributed.
- in the beginning, there were loans
- but then there were years with phenomenal cash returns on investment
- so the 'asset yield' look really good, and people decided that an increase in leverage is a good idea
- rather than bump off the old debts through refinancing, subordinated debt was piled on top, which was largely undercollateralized when the senior paper was taken into account. This 'cashflow lending' just seemed like such a good idea 'because of the stability and strength of the underlying cashflows' (but watch!)
- then, things started to go bad
- but, you knew the sub debt was undercollateralized already! where's the trigger to pull? well, they didn't put one in - the safety feature was disabled from the very beginning!
- so, nothing was done until the covenants on the senior debt got triggered
- ...at which point they realized that cashflow is in a declining trend, so the asset value they'd counted on at the senior level was overstated, and liquidation-level overcollateralization at the sr debt is also < 1.0x
- fuck, take it through Ch. 11 and take a haircut on your senior debt, sub debt gets zero
Happens all the time and is a reflection of credit cycle psychology. What I didn't say is that if you weren't overly aggressive when everybody else was, then ( a ) everybody would think you're dumb, and ( b ) you'd lose too much market share to be a player. I don't doubt that the HF lending situation is any different - basically you will get your statistical share of pain when the crunch comes. What you can do to innovate, then, is manage your exit strategy. If you just do a blue-light special on these big derivatives portfolios, then you will lose a lot of money. So, the point is to avoid this at all costs, and do something that is uncorrelated with what everybody else is doing. For bankrupt companies, this means you want to keep the company operating, but under a different compensation structure, and if they can't get it done then you need to step into their shoes. That's a tall order in most cases, but even a smart liquidation would be better than what's likely to occur. That's why I think there is room to be ( a ) the beneficiary of bad liquidations and ( b ) the adviser of good liquidations.
I have another idea on this issue but I want to think things through a little more and post a separate thread - this has to do with the problem of charging more-or-less fixed credit spreads on credit exposure where the default rate is concentrated at points in the future instead of being evenly distributed.
my bank got pwnd