Hedge funds’ survival challenge: Some reflections from last time
By Philip Young, partner, Cooke, Young & Keidan LLP
For years people in the markets have been asking when the sovereign and corporate debt bubbles – fuelled by ultra-low interest rates and quantitative easing – would finally burst.
Many people predicted it would be caused by an extraneous event. With coronavirus we are now seeing that very scenario beginning to occur.
What initially started as a dramatic fall in aggregate demand has since began to show signs of turning into a liquidity crisis. Market confidence fell precipitously and the storm clouds gathered. Now western governments have responded forcefully with very substantial debt and financial support packages.
Last time, in 2007 through 2009, most of the legal sector represented the banks and major financial institutions. Relatively few City litigators were in the midst of it in those tumultuous days advising hedge funds, investors and asset managers – ie the borrower and buy side, especially after the fall of Lehman. I was one of those few and I thought I’d recount some of my experiences of the “survival challenge” for many hedge funds, asset managers and investors, and what it might mean this time.
The shock to hedge funds and asset managers was a pincer movement of liquidity and asset value. On one side were investors who were seeking to redeem investments from hedge funds and asset managers to preserve value, realise cash or respond to margin or collateral calls elsewhere. Funds had to take difficult decisions, often in highly pressurised circumstances, whether to permit potentially disorderly unwinds or whether to gate funds (where possible under their investor agreements) to preserve value but with the risk of wider reputational harm and a run on other managed funds.
This, in turn, often engaged important considerations about treating investors fairly as a whole, and preserving long term value, rather than preferring the interests of particular individual investors.
On the other side were liquidity challenges the funds themselves had to contend with. The banking sector was itself under stress and keen to recover loans – especially from more doubtful debtors. In some cases, hedge funds found their prime brokers either were no longer willing to lend against difficult-to-value illiquid assets or unwilling to lend full stop.
Even where hedge funds had committed facilities that they could, in theory, draw down on, some banks sought to avoid their commitments and tried to dishonour drawing requests. Some banks scoured the representation and warranty language in loan documentation to see if they could trigger an acceleration of loan repayment or at least leverage a negotiation for higher interest rates.
Liquidity providers to asset backed security structures (such as CLO warehouses) became distinctly unwilling to continue their role, and especially unwilling to lend against highly leveraged assets. In the case of hedge funds who had repo’d assets with banks, or who were holding assets in “warehouses”, lenders either looked to seize collateral or, alternatively, valuation disputes began.
In the case of banks who were themselves distressed, this often started with banks putting forward questionable marks, largely in an attempt to get additional liquidity from their counterparts. I recall a whole series of disputes for one client in which the assets in question were illiquid and the contractual valuation machinery in the repo agreements had been defectively drafted – in some cases providing for mark to market valuation (despite there being no available market), or mark to model (but citing a defective model). Indeed, in one case there was a repo agreement where the key valuation machinery was, remarkably, entirely absent.
All of these situations led to protracted argument around how exactly the assets were to be valued. There were examples of banks who went even further and tried via contractual mechanisms to take assets onto their own books to benefit from the delta between hold to maturity values and lower mark to market values.
I doubt I’ll ever forget the week after Lehman went down as I spent pretty much the whole of it on the phone giving clients urgent help in a very rapidly changing market.
Documentary risk also began to rear its head. In most cases, banks’ back office functions were good at generating swap confirmations and the like. Nevertheless I saw a series of examples of substantial swap transactions having not been documented properly, with confirmations either having been defectively worded, or not executed and, in a few stark cases, not issued at all. This led to arguments around the terms of the transaction including whether the terms were solely to be found on the recorded dealing call or whether, for example, the usual additional language banks prefer to include on confirmations was incorporated – such as banks’ template “non-advisory”, “assessment and understanding”, “non-reliance” and “no misrepresentation” language.
There were also issues of interpretation. In the case of CDS structures, there were disputes around whether the credit events, as defined, had in fact occurred at all – and often long arguments around whether a particular event that had befallen an entity fell within the definition.
In some cases the issue was more practical - not only had the credit event occurred but the creditworthiness of the credit sellers themselves became questionable and led to attempts to obtain collateral or other forms of security.
Perhaps most surprisingly of all, there were issues of comprehension. In some cases derivatives had been structured that were so complicated that it wasn’t really obvious that anyone truly understood them or, at least, could fully predict their consequences in periods of extreme market dislocation. In others it was obvious the true risk had not been appreciated from the outset.
I remember sitting in a room full of very clever physics PhDs who were explaining to me, using an Excel spreadsheet, how risk in the sub-prime housing market had been intended to be spread out by one structured derivative but, in fact, had all unexpectedly correlated to one, with disastrous implications.
In the case of many funds, they took the decision to bow gracefully into the night. Others took a more pugnacious view and decided they intended to fight for existence.
In some cases, they choose to amputate the “dead wood” of the failed structured vehicle or fund. In others, they adopted a twin track approach of trying to persuade the bank as to their solvency and offering a higher return on the money borrowed, whilst simultaneously threatening protracted legal disputes.
Others, mindful that a legal case - regardless of its comparative merit - would buy at least months of time and delay and the chance to live for another, hopefully better, day, they picked fights in the view that banks concerned to try to recover money swiftly and cheaply might move on to apparently less prickly targets – often with some success.
For those hedge funds and asset managers that passed the immediate survival challenge, there were longer term challenges associated with a fall in asset values and a corresponding fall in performance related income, and also the challenge of seeking to maximise investor return.
Many funds had asset backed securities on their books, and they looked to realise value from such rights as they possessed. For instance, those who had the equity tranche of RMBS and CMBS structures often possessed valuable rights either against the investment bank who had originally structured the vehicle or in respect of the underlying portfolio of assets.
This often led to claims against the bank where, for example, there were legitimate complaints about whether the quality of assets put into the portfolio matched that originally represented in the prospectus. In other cases, there were disputes because the prospectus had promised certain rights to investors that, upon examination of the contractual documents, were nowhere to be found (apparently due to sloppy drafting). In yet further cases it led to claims against the trustee and/or issuer especially where, for example, it was said that the portfolio of underlying assets was being inadequately managed. In other cases, it led to disputes regarding how exactly the waterfall functioned or how disagreements between different classes of noteholder were to be resolved. Also, as time went on, improper market behaviour, that was being perpetrated prior to or during the crash, began to emerge – being perhaps mostly notably the LIBOR manipulation scandal.
It is said that every economic crisis is different. This time around, it is not a banking originated crisis and some of the historic flaws have been at least partially corrected, i.e. better regulation and improved capital requirements. Nowadays, for example, the synthetic CDS market (that almost sunk AIG in 2008) is much smaller than it was, as is the RMBS market.
However, against all of that, the levers available to policymakers are much more limited. Interest rates cannot realistically drop much lower, productivity has not been strong for years, and we were already in a debt bubble propped up by ultra-low interest rates.
Whilst western governments’ recent substantial steps are very welcome, no government can bail out its economy for long. Also, it remains to be seen how effective those measures are.
Whereas in 2007-08 the contagion risk was banks not lending to each other, now the immediate contagion risk is suddenly imperilled businesses; especially, but not exclusively, those in retail, leisure, hospitality and transportation hoarding cash, not paying each other’s invoices or servicing their debt, and the grave knock-on macroeconomic impacts of that.
Even if substantial government intervention works, as is hoped, a painful recession is inevitable. Already, with the recent dramatic falls in market value, we are seeing a painful unwinding of positions, margin calls, calls on collateral, investors trying to realise cash and banks trying to realise liquidity.
The pincer movement that I saw last time has begun again, and for some hedge funds and asset managers, they will have to decide whether they fight for life or die.
Philip Young is a partner at Cooke, Young & Keidan LLP, a specialist London law firm representing hedge funds, asset managers, borrowers and the buyside.