Thursday, April 10, 2008

New clouds on horizon for hedge funds

Hedge funds are still reeling after banks unexpectedly pulled credit lines and demanded more security against loans, forcing firesales and heavy losses.
By James Mackintosh, Financial Times

Now they face a new threat: investors are abandoning them, raising the risk that the funds will have to sell assets at any price to raise the cash to meet withdrawals.

So far redemptions are mainly in out-of-favour sectors such as credit funds, small-cap specialists and event-driven funds, which include activists, along with poor performers unexpectedly hurt by the credit squeeze.

But a series of big funds have already been forced to react, restricting withdrawals or restructuring, and more are thought to be considering changes.

“There are two ways you get squeezed running a hedge fund,” says one large investor in the industry. “One is that you can’t get finance from your prime broker. The other is that the clients take their money away and you can’t get enough liquidity [cash] to meet the redemptions.”

Sometimes this is the fault of the fund: big losses tend to prompt panic withdrawals.

But often it is part of a herd mentality that sets in when a strategy falls out of favour, with mass withdrawals from funds that have not been strong performers as investors try to reduce their exposure to that approach.

Recently withdrawals have also come as a result of difficulties at hedge fund investors, who redeem to free up cash to solve problems with other investments.

The growing list of hedge funds hurt by withdrawals lengthened further on Thursday when Tisbury Capital, a $2bn London event fund, received investor approval for a restructuring under which it will return $1.2bn of the $1.4bn of redemption requests. The remaining money, invested in illiquid, hard-to-sell assets, will be held until markets allow them to be sold at non-distressed prices.

New York-based global macro trader Drake Capital is trying to split into a continuing fund and a wind-down operation in order to repay half its investors, who want their money back after big losses from a bad bet on US Treasuries.

Polygon, an $8bn London multi-strategy and event fund, is offering investors new shares which remove a restrictive “gate” that it fears could have prompted a race for the exit by its investors after it received more than $800m of redemptions.

The problem that funds have is a mismatch of the terms they offer investors – typically withdrawals once a quarter or less frequently – and the speed with which they can sell illiquid investments to raise cash.

In the worst case rivals anticipate forced sales, pushing down the price of assets in which troubled funds invest.

Many funds use a gate to avoid forced sales of the underlying assets by imposing a limit on how much can be withdrawn each quarter.

However, investors who do not put in redemption requests can find themselves at the back of the queue for withdrawals, as people who did not get paid in full in the previous quarter get priority with the common “stacked gate” structure. As a result even investors who would otherwise stay put lodge redemption requests to avoid being last to get their money if they later decide to cash out.

“A stacked gate penalises long-term investment thinking,” says Paddy Dear, co-founder of Polygon.

Other funds hit by large-scale withdrawals have also been concocting novel ways to maintain their business while letting investors get at least some of their money back.

Part of the reason to restructure is that investors have traditionally regarded the use of a gate or the full-scale suspension of withdrawals as the death-knell for the fund, and been unwilling to back the manager in future.

But Arnauldt de Torquat, chief executive of London’s Harmony Asset Management, which has $500m invested in hedge funds, says he welcomes moves by troubled funds to restrict withdrawals.

“It is very inconvenient for us not to have liquidity but it makes absolutely no sense to force fund managers to sell illiquid assets in this environment.”

He argues that so many funds are now limiting withdrawals – particularly in the credit sector – that it will not affect their future if their performance recovers.

“Commercially today they are in trouble but this will be very quickly forgotten once markets recover,” he said.

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