Lock-ups and Redemptions Create Financing Need

Date: Wednesday, December 6, 2006
Author: Chidem Kurdas, New York Bureau Chief, Hedgeworld.com

NEW YORK (HedgeWorld.com)A trend toward longer-term lock-ups of capital by hedge fund managers has led to a demand for bridge loans to facilitate withdrawals by investors. The need arises in particular from a timing discrepancy between funds of funds and the hedge funds they invest in.

Some hedge funds, especially managers that have a strong track record, have imposed lock-ups of two years or longer. This is done in part to take less-liquid market positions that sometimes resemble private equity investments and are potentially more lucrative than short term trading.

But funds of funds have subscription periods that do not match the underlying hedge funds, said Dennis Westley, senior vice president for alternative investment services at PFPC, speaking at a conference. A PFPC paper cited a recent survey that found 77% of funds of funds allow monthly or quarterly redemptions.

As a result of this mismatch, funds of funds can have trouble meeting redemption demands from their own investors. The solution is to arrange credit to tide over a fund of funds until the money comes back from the underlying hedge funds.

Such credit is also used to ease the hedge fund liquidity problem that arises when a number of investors all demand their money back at the same time. Funds would benefit from getting lines of credit in advance of need, Mr. Westley suggested.

He sees bridge loans for hedge funds facing liquidity issues as an opportunity for banks, prime brokers and custodians. Fund administrators like PFPC can act as go-betweens, helping managers get a line of credit to be used in case of heavy withdrawals.

If a fund is suffering losses and many investors want to exit, having ready finance may make the difference between survival and collapse by allowing time for the market to recover. Without a loan, redemptions force a manager to liquidate positions possibly at a bad time.

But there's another issue, namely the hazard that such loans will further entangle banks in hedge fund blowups. New York Federal Reserve President Timothy Geithner has repeatedly warned about the danger to hedge fund counterparties in the event of a market shock Previous HedgeWorld Story

"The challenge for hedge funds, lenders and providers is to ensure that risk in these arrangements is identified and balanced," is how the PFPC report describes the necessary balancing act.