The cost of hedge fund restrictions

From the Spring 2009 edition of Vanderbilt Business

Dollar LockHedge funds have long been considered among the most lucrative investment vehicles, employing a variety of often high-risk, high-return strategies for wealthy investors. But the news these days from hedge funds—estimated to represent nearly $2 trillion in assets—is no longer rosy, with funds down more than 17 percent in 2008 alone. The secretive world of hedge funds is facing unprecedented challenges as the global financial market turmoil continues and the industry rapidly heads toward its biggest losses in history.

In the face of such staggering losses, funds are liquidating in record numbers, with 693 funds going bust in the first nine months of 2008, or nearly 7 percent of the entire industry. And the worst may be yet to come, with one prominent hedge fund executive telling a conference recently that about 30 percent of hedge funds may fold completely as a result of the current crisis.

As the perceived risk of failure rises, investors tend to rapidly increase redemption requests to exit from funds. Standing in their way can be all sorts of redemption restrictions that can result in heavy penalties. In October 2008, about 18 percent of the hedge fund industry assets were subject to withdrawal restrictions, according to Singapore-based consulting firm GFIA Pate. And anecdotal evidence suggests that withdrawal restrictions are quickly gaining ground as funds attempt to curtail capital drain.

Although certain restrictions on the ability of investors to redeem their capital from hedge funds—such as lockups and notice periods—are well defined, the ability of managers to suspend withdrawals is often vague in partnership agreements. In some cases individual fund managers retain varying degrees of discretion when it comes to redemptions. “For instance, they may have the authority to process only a portion of a redemption request, known as a gate, retaining the balance of the investor’s capital, and some even have the right to suspend redemptions altogether,” says Nicolas Bollen, E. Bronson Ingram Associate Professor in Finance at the Owen School.

Bollen notes that it typically has been unclear exactly what withdrawal restrictions can mean in terms of cost to investors. Developing a research model that treats the ability of an investor to withdraw capital as a “real option,” Bollen—along with Andrew Ang, Professor of Finance at Columbia Business School—pinpointed the cost of liquidity restrictions by analyzing financial data for more than 8,500 live and defunct funds from the Center for International Securities and Derivatives Markets.

Bollen’s analysis discovered that withdrawal restrictions come with a hefty price tag for fund investors. According to the new study, implied costs to a hedge fund investor from such redemption restrictions can range from 5 to 15 percent at the time of the original investment, with exact amounts highly dependent on fund-specific attributes such as age, expected return and the loss generated by liquidation of fund assets.

Bollen has discovered that investors pay a hefty price for hedge fund withdrawals.

“Given that most hedge funds require significant investment levels to begin with, the resulting costs of liquidity restrictions—whether existing or newly imposed—can potentially be staggering for investors,” Bollen states.

For example, an investor who deposits $1 million in hedge funds—a relatively modest allocation for such financial products—is essentially paying an upfront fee of as much as $150,000 if his or her ability to exit is eliminated through future suspension of redemptions.

Funds whose managers have greater discretion when it comes to withdrawal restrictions should be of the greatest concern to investors, believes Bollen. “These types of discretionary restrictions on withdrawals have the potential to impose much higher costs on investors than standard restrictions such as lockups and notice periods,” he says.

Given his findings, Bollen suggests that hedge fund investors carefully scrutinize redemption rules—and fund manager discretion—before investing. “We are now seeing that, in a serious downturn, investors can face heavy penalties and even be prevented from retrieving their capital should they seek to liquidate their investments, and the implied cost of these restrictions can significantly reduce the return that should be expected from funds,” he says.

Comments are closed.