Hedge funds try new way to avoid big redemptions

Date: Friday, June 11, 2010
Author: Marketwatch

Many hedge funds are adopting a new way to avoid a repeat of the massive redemptions that crushed managers during the 2008 financial crisis. Some investors like the changes, while others don't.

So-called investor-level gates are popping up all over the $2 trillion industry, replacing more traditional fund-level gates, according to investors.

King Street Capital Management, one of the largest credit hedge fund firms with more than $19 billion in assets, introduced an investor-level gate recently.

Philip Falcone's Blue Line distressed debt hedge fund, launched last year, has an investor-level gate. Falcone's main hedge fund suffered big redemptions during the financial crisis.

Ore Hill Partners, another credit hedge fund firm overseeing $2.5 billion, added one after surviving a slew of redemption requests in 2008. Read about Ore Hill.

The new approach limits investors to withdrawing a portion of their money from hedge funds at any one time. A common investor-level gate limits redemptions to 25% of an investor's money each quarter over four quarters.

In contrast, fund-level gates were based on redemptions representing a certain percentage of the overall net asset value of hedge funds. For instance, if redemptions totaled more than 25% of a fund's assets, the manager could put up a gate limiting total withdrawals to 25%. That meant all investors in the fund would only get 25% of their money back.

During the 2008 financial crisis, fund-level gates contributed to redemption mayhem in the hedge fund industry. Many investors put in withdrawal requests just because they were worried other investors would redeem ahead of them and trigger an across-the-board gate.

Pros and cons

"In the past, you could theoretically withdraw all of your money in one go. That's the downside" of new investor-level gates, Jennifer Spiegel, a hedge fund lawyer at Paul Weiss, said. "But the upside is that your liquidity isn't tied to other investors in the same fund."

"Also, over a defined time period, you can get all of your money out," she added in an interview, while declining to talk about specific hedge funds. "This allows the fund manager to anticipate liquidity and cash needs over time. Unwinding a fund can be done more deliberately too."

King Street investors voted for an investor-level gate during the second quarter of 2010. The firm, run by O. Francis Biondi and Brian Higgins, has raised a lot of new money in recent quarters and may have wanted to protect itself from a future rash of redemptions if credit markets get ugly again, investors said on condition of anonymity.

King Street also used to offer some of the most generous liquidity terms among the large credit hedge funds, with monthly redemptions. The firm changed this to quarterly, while switching to an investor-level gate, one of the investors said.

Ore Hill -- run by Ben Nickoll and Fritz Wahl -- adopted a similar gate, so when investors put new money with the credit hedge fund firm, they can withdraw it 25% at a time over four quarters.

Nickoll said one of Ore Hill's investors suggested the firm make the change.

"Some other managers are using it too," he added.

Institutional investors with long-term investment horizons like the new gates because they may protect them from being swept by redemption waves triggered by other investors with more-pressing liquidity needs.

"While investors should not be unduly deprived of their access to liquidity, managers should smooth maximum allowable redemption pressure over a long period of time to ensure that the liquidity risk premium is not subsidized by long-term investors," Utah Retirement Systems wrote in a memo last year summarizing the way it likes to deal with hedge funds.

"Investor-level gates provide an automatic redemption-smoothing mechanism," it added.

Other hedge fund investors aren't so sure. For funds of hedge funds, which allocate client money to a range of underlying managers, investor-level gates can be tricky. That's because they may be offering quarterly or monthly redemptions to their investors, while being limited to withdrawals of 25% a quarter.

Some hedge fund investors said managers shouldn't have investor-level gates if they trade liquid securities.

But that hasn't stopped some hedge funds focused on liquid strategies like equities from trying to adopt investor-level gates, the investors said on condition of anonymity.