Hedge Funds Will Be Ruined by Withdrawal Limits

Date: Tuesday, January 6, 2009
Author: Matthew Lynn, Bloomberg.com

Looking for a new definition of a hedge fund? How about an organization that takes 20 percent of the profits on your money in the good times, then refuses to let you have it back when the weather turns rough?

We all know the hedge-fund industry had a terrible 2008. With a few honorable exceptions, its promises of being able to deliver steady, positive returns in either a rising or falling market turned out to be empty.

Yet, in many cases, the industry has taken a bad situation and made it worse. Many funds have placed limits on withdrawals that investors can make. In effect, people are locked into a falling asset.

That is a big mistake. In any investment business, the return of capital is far more important than the return on capital. By forcing investors to keep their money tied up during a bad year, the hedge funds are damaging their own reputation, and it may well never recover.

There are numerous examples of funds limiting withdrawals.

Citadel Investment Group LLC said last month it was stopping year-end withdrawals from its two biggest funds after investors sought to take out $1.2 billion, or 12 percent of assets.

Magnetar Capital LLC took similar action after its largest fund lost 30 percent of its value in the year through November.

Cerberus Capital Management LP last month limited redemptions from a hedge fund that lost 16 percent of its value.

Paulsonís Warning

Shutting the gates on a hedge fund is now commonplace. As of October, 18 percent of the industryís assets, or about $300 billion, was subject to withdrawal restrictions, according to Peter Douglas, principal of Singapore-based hedge-fund consulting firm GFIA Pte. With plenty of announcements since then, the total now is likely to be far higher.

Not everyone is happy with that turn of events. John Paulson, who runs the $36 billion hedge-fund firm Paulson & Co., reckons his colleagues in the industry are making an error.

ďWe think itís a mistake for managers to use gates and other tools to limit investor access to their funds,Ē Paulson wrote in his 2009 outlook to investors. ďWhile we recognize the difficulties of the current environment, we think it is a managerís responsibility to raise liquidity to meet the redemption needs of their investors.Ē

There may well be something self-serving to Paulsonís remarks. As one of the few hedge-fund managers to call the markets right in the past year, he could easily pick up bargains for his own fund if his rivals were forced to liquidate their positions in a hurry. Even so, heís making a valid point.

Two Arguments

There are two main arguments used to lock investors into the funds they have put money into.

First, hedge funds are meant to be long-term investments. They invest in esoteric instruments that can be virtually impossible to sell in a collapsing market. And if there are too many withdrawals, managers wonít be able to take advantage of all the ďopportunitiesĒ suddenly available.

Next, if funds are forced to sell off their holdings, prices will collapse even further. Managers aim to maintain an orderly market and to make sure all their investors are treated equally. The investors who donít sell will be the ones who suffer if half the fund is redeemed at fire-sale prices.

The trouble is, both justifications are nonsense.

Whether a hedge fund is a long-term investment or not is for the investor to decide, not the money manager. Maybe investors want to hold it for a couple of generations, or maybe until Tuesday of next week. Itís their choice.

Empty Claims

A few months ago, hedge funds were claiming that the liquidity they provided in different markets was one of the main justifications for their existence. If the funds havenít created a liquid market in the instruments they invest in, there isnít much point to them.

Even worse is the pretence that they are protecting the remaining investors. Sure, if a fund suddenly sells half its assets, that will drive prices down. Yet investors in hedge funds are sophisticated, wealthy people (or at least they are meant to be). They are well aware that this is a bad time to be selling any asset, whether it is factories, property, crude oil or repackaged bonds with funny-sounding names. Then again, perhaps they really need the money. Or maybe they think that while this is a bad time to sell, tomorrow will be even worse.

Hedge funds canít expect to treat their investors like this and survive. It would be reasonable to say something like this: ďItís a bad time to sell, guys. You will lose what little is left of your shirt, but if you stick with us, we believe we can turn this thing around.Ē Then the fund holders can make their own decisions.

Telling them they canít have their money back will surely leave many investors wondering if hedge funds are an asset class they want to stay in or whether itís better to get out forever -- as soon as that is possible.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.