Longer hedge fund lockups seen posing risk

Date: Wednesday, November 15, 2006
Author: Tom Burroughes, Reuters.co.uk

GENEVA (Reuters) - Investors may want to quickly pull out of hedge funds if global economic conditions turn sour, showing the risks of a recent trend of contracts tying clients into funds for long periods, industry executives warned.

The periods over which investors agree to hold money in funds before they can exit -- known in the industry as "lockups" -- are rising to well beyond the previously typical one month, speakers at a hedge fund conference said on Tuesday.

Hedge fund firms should ensure that investors who have not yet liquidated some of their holdings are not forced to book big losses if they are unable to pull out of a fund, Daniel Riediker, partner and chief executive officer of asset manager Alegra Capital, told the Global Alternative Investment Management (GAIM) conference.

"If you run into a more difficult cycle you want to be sure that those remaining in a fund do not get punished," Riediker said.

Among some of the hedge fund strategies such as credit funds, economic conditions have been benign and default rates low, but such portfolios could be hurt if defaults start to rise, he said.

"These strategies do have the potential of rising volatility as default rates go up."

Concerns about a possible cooling of the world economy have been fuelled by weaker U.S. growth, rising interest rates and a fall in the U.S. housing market.

Some hedge fund lockups are now as long as five years, a hedge fund executive said at the conference, though exact data on lockup periods in this traditionally opaque $1.7 trillion industry is difficult to pin down.

DURATION CREEP

The trend of rising lockups, known as "duration creep", is being driven by the ability of top-performing hedge fund managers to persuade investors to commit money to them, particularly in relatively illiquid strategies that could be impossible to conduct if there is a risk of rapid and unexpected client withdrawals.

Longer lockups have also been driven by U.S. regulations. A Securities and Exchange (SEC) registration requirement on hedge funds exempted those that imposed two-year lockups, though a U.S. federal appeals court later ruled the SEC lacked authority to regulate the hedge fund industry, throwing the regulatory picture into uncertainty.

Typically, private client investors and institutions want to have short-term liquidity because they fear what could happen if they cannot pull out money for a long period, Adrian Morger, head of fund and manager selection at Verwaltungs-Und Privat Bank, told the conference.

"Liquidity is a big topic in our bank and a lot of our investors don't accept quarterly redemption liquidity. We have to find a way to solve this problem, otherwise these investors will not invest in our fund-of-funds," Morger said.

One reason why lockups are lengthening is that some top-performing strategies will deliver their results only over the long term, Tom Zucosky, chief investment officer at Discovery Capital Family Office, said.

"I would say that, on the issue of longer lockups, get used to it," he said. "Better returns are made from illiquid investments."

In the United States, investors could face legal obstacles if they want to pull money out of a hedge fund but find it is impossible to do so, Zucosky said.

There is a trade-off between the willingness of people to surrender control of their money for a period of time and the willingness of hedge fund managers to give people rapid access to their funds, he added.