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Blocked exits can be costly at hedge funds-paper

Date: Friday, December 12, 2008
Author: Svea Herbst-Bayliss, Reuters.com

Hedge fund investors may face an expensive tug-of-war with managers, according to a new research paper that suggests they could lose as much as 15 percent of their initial investments should they be unable to exit when they want.
Hedge fund investors have rarely been allowed to pull their cash out immediately, but now they are sometimes being told that they may not be able to pull it out at all as the industry faces its worst-ever returns.
Dozens of prominent hedge funds, including Fortress Investment Group LLC and Tudor Investment Corp, have recently restricted redemptions in some of their portfolios.
This trend is not only aggravating but also extremely pricey, Nicolas Bollen, a professor at Vanderbilt University's Owen Graduate School of Management, said in an interview.
In a paper titled "Locked Up by a Lockup: Valuing Liquidity as a Real Option, Bollen and Columbia Business School's Andrew Ang show that a manager's right to block redemption requests "generates an implied cost of between 5 percent and 15 percent of the initial investment."
Considering that many hedge funds often require investors to commit at least $1 million, losing as much as $150,000 due to suspended redemptions could prompt many investors to select hedge fund portfolios more carefully.
"The main take-away from this paper really is that hedge fund investors need to pay attention to these types of clauses in the partnership agreements," Bollen told Reuters.
In the past, hedge fund managers had rarely restricted their clients' exits, knowing that any whiff of suspended redemptions could be interpreted to mean the fund was dying.
The deepening financial crisis, however, in which the average hedge fund has now lost about 18 percent, has erased any stigma about suspending redemptions, industry lawyers said. They explained that hundreds of managers are using all available methods to hold onto their capital at a time when assets under management shriveled 9 percent to $1.5 trillion in October alone.
"This paper was written for academics, but I think it has practical applications," Bollen said, adding that pension funds and wealthy private investors may become much more careful in selecting hedge funds in the months ahead.
"The legalese that described the vague rights that managers have and that a lot of people may have skimmed over in the past could turn out to be very important," Bollen warned.
"When you take these costs for suspended redemptions into consideration, it could tilt the scales for the hedge funds you want to invest with," he added.
Bollen and Ang began working on their paper more than a year ago, when suspended redemptions were the exception and not the rule in the high-flying hedge fund industry.
"It took us a while to develop the model to capture the data," Bollen said, adding: "Now our timing looks pretty good." (Reporting by Svea Herbst-Bayliss, editing by Gerald E. McCormick)