Thursday, October 30, 2008

Closing the Gates of Hedge Hell


Hedge funds are fed up with clients redeeming their money:

Dozens of hedge funds have told investors they cannot get their money back right now as managers try to limit a wave of redemptions to safeguard all their clients' investments -- as well as their own futures.

Only a few months ago, hundreds of the world's estimated 9,000 hedge fund managers made it tough for wealthy investors to put money into their funds by requiring high investment minimums of $1 million or more and charging heavy fees.

Now managers are making it hard for investors to get out.

"Everyone is looking at their gate provisions (mechanisms that limit redemptions) and what rights they have to close their gates," said Timothy Mungovan, a partner who advises hedge funds at law firm Nixon Peabody LLP. "It is a phenomenon that has been occurring for some time and is picking up pace now."

On Thursday, Knight Capital Group's Deephaven Capital Management halted redemptions at two of its hedge funds.

Recently, hedge fund firm Basso Capital told investors it was postponing redemptions. Hedge fund firm Ore Hill Partners imposed a gate in late August.

Before that Drake Capital Management and Pardus Capital Management began restricting clients' departures and Ellington Capital Management stopped allowing investors to exit one of its portfolios last year.

Blocking investors' exits, even if only briefly, was once a highly unusual move that often signaled a hedge fund was on the verge of collapse, managers and investors acknowledged.

That is changing now as ever-more managers and investors engage in a tug of war over who can receive money right now.

"Hedge funds are trying to act as the ultimate fiduciary to their investors and the way they are doing that is by restricting the capital that can leave," said Perrie Weiner, a partner and international co-chair of law firm DLA Piper's securities litigation practice.

Managers argue that, if they had to return investors' money exactly when investors demanded, funds would have to unload securities at fire-sale prices and many clients who were not looking to get out would be hurt by those moves.

Already, hedge funds have been blamed for accelerating the stock market's tumble by dumping shares to get liquidity.

"Restricting redemptions allows the managers to withhold selling into unfavorable markets," said Michael Tannenbaum, a partner at law firm Tannenbaum Helpern Syracuse and Hirschtritt LLP, explaining that panic selling in these markets can be "harmful to both sides: the investor and the redeemer."

But investors are not wholly convinced by this argument. Many are still asking to get their money back now.

Spooked by hedge funds' worst-ever returns at a time the average fund has lost 20 percent this year, pension funds and wealthy individuals alike are leaving hedge funds faster than ever before, lawyers and managers said.

Between July and September, investors pulled out a record $31 billion, which helped shrink the industry 11 percent to $1.7 trillion. And more redemptions are expected to flood in by November 15, the deadline to get money back by year's end, industry lawyers and investors said.

The wave of redemptions is understandable, especially given the poor performance, but I would caution investors not to pull out money right after a steep decline in equities. You are better off waiting for a relief rally to recover some of the losses.

Other hedge funds are offering their clients the option to lock-up their money for a reduced management fee or receive "redemption shares" instead of cash if they decide to quit:

One of Britain’s best-known hedge funds, RAB Capital, has stopped investors cashing out of a second of its flagship funds. Investors in RAB’s Energy fund - which has lost more than 50% of its value this year - have been told they will not be able to liquidate their holdings.

Those who want to quit will be handed “redemption shares” instead of cash - a promise on behalf of the fund to pay back investors as and when it can sell out of enough stocks.

The fund, run by Gavin Wilson and Mark Redway, is entitled to do this under existing agreements with investors.

Those who opt to stay in are being offered the chance to lock up their money for three years in exchange for a reduced management fee. The proposal is based on the deal offered to investors in RAB’s Special Situations fund, run by former chief executive Philip Richards.

Investors have until Friday to tell the firm whether they want to accept the Energy fund’s lockup deal or sign up for the special shares.

The fund, which was worth more than £1 billion at its peak, has been one of the biggest backers of oil and gas-exploration firms on London’s Alternative Investment Market.

It is understood that the fund has held informal discussions with a number of large oil companies interested in buying some of its holdings. The fund mostly holds large stakes in small companies - investments that have become almost impossible to trade in today’s volatile environment.

RAB Capital said: “The fund managers have exercised their right to make redemptions in specie in light of the difficult market conditions.”

Its latest problems come amid mounting expectations that the hedge-fund community will be decimated by the global market meltdown. Banks have been calling in credit lines extended to a number of funds, which has forced them to sell shares to raise cash.

Former US Treasury adviser Nouriel Roubini warned last week that up to 500 hedge funds would collapse within months.

Kenneth Griffin, the founder of hedge fund Citadel with $17 billion (£6.6 billion) in assets, held a 45-minute emergency conference call on Friday to quell fears it was in trouble by going public with information it usually guards militantly.

The call was intended for a small group of bondholders but almost 1,000 investors, analysts and other market players dialled in after a Wall Street blog said Citadel was meeting Federal Reserve officials to manage a pending collapse.

On the call, Griffin and chief operating officer Gerald Beeson confirmed the firm had suffered losses of 35% in its two core funds - Kensington and Wellington - as a result of the global financial crisis.

Beeson stressed the severity of the financial crisis: “To call it a dislocation doesn’t go anywhere near what we’ve seen. We’ve seen the near-collapse of the world’s banking system.”

They said Citadel had not had to sell assets to meet investor demands to return their capital and that the firm had more than 30% of its assets in cash - or close to $6 billion. It has another $8 billion in credit available from commercial banks around the world.

Poor performance has also spurred London-based Centaurus Capital into action. It is proposing to return 30% of cash to investors in its Alpha fund and lock up the rest of the money for two years with reduced fees.

If approved by investors, the plan would take effect on December 1. As an interim measure, Centaurus is restricting the amount of money investors can withdraw to just 10%.

And GLG may decide to suspend redemptions on its $1.4 billion market-neutral fund this Friday – the last day of the month and typically when redemption notices come in.

Wow, things are shaky in Hedge Land. No wonder they are closing the gates, cutting fees and holding emergency conference calls with jittery investors to calm their nerves.

Today, Citadel announced it plans to shut down a $1 billion portfolio that invests in other hedge funds and put the capital it invested in the fund into other businesses. Smart move.

But while some hedge fund managers are licking their wounds, others are raising money in a difficult environment:

Steven Cohen, David Einhorn, Paul Singer and Alan Howard are doing what most hedge-fund managers can't these days -- raising money from investors.

Singer's Elliott Management Corp. added $3 billion in the third quarter and Howard's Brevan Howard Asset Management LLP garnered new cash as they posted investment gains in a year when the average fund has lost 20 percent, people with knowledge of matter said. Cohen's SAC Capital Advisors LLC and Einhorn's Greenlight Capital Inc. have allowed investors into funds that had been closed since 2005, with Einhorn seeking several hundred million dollars this month.

...

Lehigh University's $1.2 billion endowment is seeking to put money into reopened funds, seeing a chance to invest with top-performing managers who previously didn't want new clients, according to a person familiar with the school's plans.

Lehigh currently has about 20 percent of its assets in hedge funds, which are private, largely unregulated pools of capital whose managers can buy or sell any assets and participate substantially in profits from money invested.

Peter Gilbert, chief investment officer at the Bethlehem, Pennsylvania, university, didn't return a call seeking comment.

James Walsh, chief investment officer of Cornell University's $6 billion endowment, said the unprecedented redemptions in the industry have a silver lining for investors with cash.

``You're seeing good hedge funds that have been closed for years finally opening up again,'' he said at a conference in London last week. Cornell, in Ithaca, New York, has a quarter of its endowment invested in hedge funds.

Money-raising has been easiest for firms that have been profitable in 2008.

And so it should be. If you are producing alpha in these markets, it's either because you are short everything or because you know how to deliver consistent alpha no matter what the market presents you (I prefer the second choice because Mr. Shorty can get creamed in a savage rally).

The problem with hedge funds is they forgot the notion of "hedging"and they need a major rethink of how they work:

James McGovern, who's the face of the hedge fund industry in Canada, has predicted it could shrink by a third - and he's an optimist. Others believe it's finished, at least in this country.

But that would be dumb. Rather than obliterating the concept of hedge funds, what's really needed is a major rethink of how they work.

What might they look like? For a start, hedge funds could try, you know, hedging. "In many ways, these weren't hedge funds. They were sector funds," says hedge fund manager Paul O'Neil (or, as my colleague Andrew Willis put it, "leveraged resource plays").

But the real trouble with hedge funds is the unhealthy relationship between those who run them and those who put their money into them. It's not so much that the managers take 20 per cent of the profits; it's that when the profits disappear, as often as not, they'll shut down the fund (as Epic is doing) rather than stick around and "work for free."

It's not so much that the managers are too obsessed with short-term returns; it's that they practically train their clients to be so, too. Many hedge fund websites publish their returns, month by month, and will brag (or did) that they've only had one losing month in the past 12 or whatever it was, as though that's important. Who can invest properly with a 30-day time horizon?

Hedge funds, per se, aren't evil. It's the people who bastardized them, turned them into vehicles for transferring their clients' wealth into their own, didn't really hedge, borrowed too heavily and ignored risk - they're the ones giving their business a bad name. And now some of those same managers complain that their customers are panicking, and withdrawing money at exactly the wrong time. But what else did they expect?

As for investors still worried about their hedge fund investments, they'd better check those redemption clauses and make sure they are still able to get out before the gates of hedge hell close, locking them in for better or for worse.

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