Gates or discretionary liquidity provision policies enacted by hedge funds in the aftermath of the financial crisis still reverberate today and were decried in the Financial Times on Monday: “Hedge funds close the gate before investors can bolt” (FT Fm). According to the article and data provider Preqin, 46% of investors will not make a new investment in a fund with a gating mechanism.
While gating provisions can generate headlines and create significant pain for investors (especially when gates are enacted unexpectedly and unjustifiably), the criticism of fund gates or side-pockets are not as simple as implied by the FT.
Jerome Lussan, CEO, Laven Partners comments: “Investors must be careful with their initial due diligence – covering gates but also the underlying investments and liquidity issues – and I would think, based on our work, that there are quite a few other pressing issues for investors which are more pertinent than gates, such as corporate governance, independence of directors or risk management, which all affect how gates are or will be utilized. Gating provisions are very commonplace for funds, and in fact if I take a sample of the last 10 funds we carried out due diligence on, 8 of them had gating provisions. I would therefore be surprised, based on this small sample, if 46% of investors were actually really not ready to look at the top funds in the industry based on gates alone. It may be that they do not actually know that gates exist! Therefore, although we look at gates in the course of our work and highlight them to our clients, we do not automatically raise them as a red flag.”
Lussan continues: “Gates are, or at least should be, enacted at the discretion of the directors of the fund, who should act in the best interest of investors as a whole. Investors should therefore focus on Board independence and the management of conflicts of interest. Gates are not there just to protect the fund or to ensure the continuation of fees to the manager, as the FT overstates. Gates are important for more sophisticated products to avoid a complete collapse of the fund in cases of market stress. The key is to appreciate the strategy that is bought. For investors that do not wish to have gates they should remain in liquid long biased equity products and at the same time they should not expect decorrelated returns from their other equity exposure. The view that funds and managers abuse the system is erroneous and the real issue highlighted in this article is whether most investors are simply not able to directly invest in alternative products. If investors carried out a proper analysis, liquidity issues should never come as a surprise and may be used to add alpha.”
