Hedge Funds Frozen Shut

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To buy time and stave off losses, more funds are blocking withdrawals. Are they just postponing the inevitable?

By Matthew Goldstein
March 5, 2008

There's a chill spreading across the hedge fund industry. With more portfolios falling victim to the credit crunch, managers by the dozen are freezing investor redemptions, preventing a mad rush to the exits that would force funds to sell beaten-down assets to raise cash. But is this unprece­dented move just postponing the day of reckoning for funds and the market?

Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period. Among them: GPS Partners, a $1 billion fund that bets mainly on natural gas pipelines; Pursuit Capital Partners, a $650 million portfolio with troubled debt; and Alcentra European Credit, a $500 million fund that owns slumping loans used to finance private equity buyouts. The new rules affect not only the pension funds, endowments, and well-to-do families that buy the funds directly but also smaller individual investors exposed through diversified portfolios of hedge funds, known as funds of funds. Some hedge funds have broad powers under their contracts with investors to make such changes at their discretion. "It's the largest period of redemption suspensions in the industry's history," says Jonathan Kanterman, a managing director with Stillwater Capital Partners, a money manager.

It's understandable why hedge funds would want to keep investors from pulling out their money en masse. In this market, any sales would almost certainly be at cut-rate prices, guaranteeing big losses in portfolios. And once managers start dumping assets, there's also the danger that big banks, which provided the funds with credit lines to amp up returns through what's known as leverage, will demand their money back as collateral shrinks. Those margin calls would prompt further sales, setting off a vicious cycle that could ensure a fund's demise. "If you are an investor, you are upset," says one well-heeled investor in a fund that has stopped redemptions. "But if every fund has to sell at once, it's terrible."

Mad Scramble

In such fire-sale situations, the results can be ugly. The $2 billion Peloton Partners ran into trouble in February when Wall Street banks began tightening their lending requirements. The fund's managers scrambled to pay back the banks by quickly selling off assets. Peloton is now in the process of liquidating all its investments and closing the fund. Sailfish Capital Partners, a onetime $2 billion fund, got hit by investor withdrawals following a bad bet on mortgages. Instead of navigating the murky market, Sailfish shuttered last month to return as much money as possible to investors.

To prevent such scenarios, managers are trying to buy time until there's a recovery. It's a big gamble since many of the funds blocking withdrawals specialize in asset-backed securities, such as bonds made up of risky mortgages or debt for private equity buyouts. That quadrant has been the hardest hit in the $1.6 trillion hedge fund universe. In some cases, there are simply no buyers for the securities sitting in these funds' portfolios. If the turmoil continues for too long, other types of hedge funds, such as big multi-strategy portfolios that hold billions in stocks and corporate loans, may follow the trend and lock in investors.

The waiting game is dangerous for other reasons, too. By not clearing out problematic securities, uncertainty will continue to hang over the markets, given the suspicions that the real pain simply has been delayed. One fund manager, who didn't want to be identified, says the losses are inevitable since it could be years before many of the illiquid assets bounce back, if they do.

For Your Protection

It's not just troubled funds that are bolting the exit. Pursuit Capital, which invests mainly in debt backed by mortgages, corporate loans, and aircraft leases, earned 12% in 2007 and is up 1% since January. But early this year, nervous investors started asking for their money back. Rather than selling assets into a falling market, the managers decided to block redemptions to prevent a run on the bank. "They are doing it to protect investors," says Michael Burg, a lawyer for Pursuit.

Fund managers are also protecting their paychecks. In a freeze, funds still collect a management fee, which ranges from 1.5% to 2% of assets.

That can be frustrating for investors, especially for those at funds generating huge losses. GPS Partners, a Santa Monica (Calif.) fund run by Brett Messing, the brother of actor Debra Messing, dropped nearly 15% in January, according to two investors. After more than 15% of investors ran for the door, the fund imposed a "gate" in February that limits withdrawals. Citigroup's (C) $500 million Corporate Special Opportunities fund lost 11% last year, prompting nearly a third of the funds' investors to request withdrawals. In February, Citi banned redemptions on the fund. A Citigroup spokesman says CSO's new management team "is taking steps to position the fund as best as possible for future growth."

Of course, funds that ban investor redemptions don't exactly have a good history. They sometimes end up like the two infamous Bear Stearns (BSC) hedge funds that helped touch off the credit crisis. The funds, which owned mainly subprime debt, blocked withdrawals in June. By August they had both filed for bankruptcy.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.