Withdrawals bedevil hedge funds, and not just the poor performers

Date: Monday, December 15, 2008
Author: Geraldine Fabrikant, International Herald Tribune

For Bernard Madoff, the embattled hedge fund manager, the world came to an end when his funds were unable to meet $7 billion in withdrawals at a time when he was supposedly managing $17 billion.

The number may sound staggering, but in fact it is typical of what has been going on at hedge funds - no matter how successful - when they offer investors the chance to withdraw their money rather that putting up a barrier, which is known as a gate. A gate blocks investors from taking out more than a fixed percentage in any redemption period.

As investors, endowments and funds of funds have needed to raise cash, they have turned to hedge funds that allowed them to pull money out quickly.

"We have become the ATM machines for people that need cash," said George Weiss, who heads a $3 billion multistrategy fund for both U.S. and foreign investors.

Weiss, who has been a hedge fund manager for 20 years, said that his fund was down about 7.5 percent so far this year. Even so it has had 35 percent withdrawals.

While investors have been redeeming actively from hedge funds, some of those that have turned in the best performance - even if it means a decline, albeit a small one - have found investors scrambling for the exits.

"The managers that had the most investor friendly provisions, regardless of performance, but the more flexible you were, got the most redemptions," said Kathryn Hall, whose firm, Hall Capital Partners, acts as an investment adviser for about $20 billion in assets.

She and others point out that the current market has presented enormous problems for investors seeking liquidity whether they are endowments, individuals or funds of funds because many funds do not permit withdrawals unless they receive the request 90 days or more before the planned withdrawal. And some funds only permit investors to take out a percentage of their holdings.

But there can be tension over that rule between managers and investors. "The idea is in theory is that gates protect ongoing investors from too much liquidation," said Robert Rosenkranz, the founder of Acorn Partners, a two-decades-old fund of hedge funds "In theory it is balancing the interests of the redeeming people and the ongoing investors. In some cases it protects ongoing investors."

But, he added, "the manager's decision is not totally disinterested because the gates do allow them to collect fees for longer periods of time."

Weiss and other fund managers say that investors, and particularly funds that use foreign banks to bolster their leverage, have been scrambling to exit from whatever funds they can. There are a rash of explanations, Hall said.

She noted that there had been discussions about withdrawals since autumn. The original focus, she was "market neutral funds." Those are funds that are theoretically not correlated to the stock market's rise or fall, like funds that go long and short equities or other instruments. In other words, that are betting on gains as well as declines.

But she added that those funds did not turn out to be market neutral so that they were not efficient in tumultuous markets as expected. "So investors wanted to reduce their exposure," she said.

In other cases, investors wanted to realign their portfolios. When a fund performs better than other funds in a portfolio, investors will often sell some of the fund that has grown to be too big a percentage of the total in an effort to rebalance. "If a fund did well and was flexible, the more withdrawals it has gotten, regardless of performance," she said.

Leveraged funds of funds have perhaps been under the greatest pressure for withdrawals because the funds often attempted to bolster returns by borrowing against the funds. That was fine when funds were going up in value, but as they started to plummet, the borrowers "blew through margin requirements" as one money manager put it. In order to pay off the debt investors went to the funds that were most liquid.

"The deleveraging has been going on for more than a year," said Charles Gradante, a co-founder of Hennessee Group which advises investors about hedge funds. "Many investors were using leverage and as the market started to drop in price, the leverage they were using went against them. They had to generate cash. Much of the cash came out of their stock portfolios, but some of it came from liquid hedge funds," he said.

And there was also a problem with private equity, particularly among endowments. As private equity funds called on investors to provide cash for new investments, at a time when returns from older investments were minimal, endowments and foundations too sought to raise cash. In some cases that came from hedge funds, experts say.