Hedge funds change rules to stem redemptions

ZURICH/LONDON (Reuters) - Hedge funds are trying stem the rising tide of investors taking out their cash but conditions they are imposing may result in a permanent reduction in the high management fees they charge.

In the last two months, more funds have taken steps to staunch outflows as cash-needy investors withdrew assets.

These have included suspending withdrawals, imposing gates -- which limit investor withdrawals in a specific period -- and introducing lock-ups, whereby investors commit their money for an agreed minimum period.

In return for accepting these conditions investors are asking for, and getting, reduced fees. And once the current period of market turmoil subsides, funds may find it difficult to raise them again.

Hedge funds are responding to a sharp acceleration in withdrawals as the end of the year approaches. Recent data from Chicago research company HFR showed that in October outflows exceeded inflows by $40 billion.

This was far beyond the $31 billion in net outflows for the entire third quarter and contrasted sharply with the record $194.5 billion net inflows to hedge funds in 2007.

It wasn't unexpected given the state of the markets and the scarcity of cash. Evidence suggests that several funds have built up a large cash position in anticipation of further withdrawals.

Investors don't object to funds holding cash to manage redemptions, but they don't want to pay for the privilege.

"I'm not paying a hedge fund a 2 percent management fee for holding cash, I'd rather take it back," said Mark Schindler, portfolio manager of alternative investments at Swiss private bank Clariden Leu.

Managers trying to stem redemptions "will recognize that to keep business they need to decrease or waive management fees," said one manager of a fund of hedge funds who asked not to be named. "When there's a continuation or restructuring plan fees are always part of the discussion and they rarely go up."

Even some of the best-known hedge fund firms have introduced protective measures for one or more funds, in return for lower fees. They include BlueBay Asset management (BBAY.L), Henderson Global Investors and RAB Capital.

DOUBLE-EDGED SWORD

When funds have to return investors' money, unless they have sufficient cash they have to liquidate assets to satisfy the requests.

That can be especially tricky for highly leveraged funds who borrow money to invest in securities using their portfolio as collateral. It is an important tool in the hedge fund armory, and its cost is one justification for the high fees many of them charge.

But while leverage can enhance gains when the manager gets it right, in down markets it can accentuate losses at the very moment that investors are clamoring to get their money out.

Managers with insufficient cash to meet redemptions are forced to sell assets into a market where prices are moving against them. If they are selling illiquid securities, they may struggle to find buyers at all.

Adding to this pressure, a leveraged fund's lenders may require it to put up more collateral as the market -- and consequently the value of the fund's collateral -- deteriorates.

Asset sales may thus not be sufficient to improve a fund's liquidity if withdrawals and increased collateral requirements suck out cash faster than assets can be liquidated.

Like the panic that leads to a run on a bank, the belief that a fund is in trouble can turn into a self-fulfilling prophecy as investors rush for the exit.

But funds face a dilemma over restricting investors' access to their cash. While these provide temporary relief for funds struggling to dispose of illiquid assets, they can often erode long-term investor trust if introduced unexpectedly.

"I've seen cases where if you haven't redeemed, you can be moved from 45 days' notice on quarterly dealing to 100 days' on quarterly dealing without consultation," said one fund of funds manager who invests in a variety of hedge fund strategies.

"The long-term winners will be those who keep their funds open according to the original terms," added the manager, who asked not to be named.

But not all investors agree. At the GAIM fund of hedge funds conference held in Geneva in early November, many fund of fund managers, who invest in diversified portfolios of single-manager hedge funds, said the case for managing redemptions had grown.

Some investors say they are happy for managers to change redemption terms if that is the best way to protect investors.

"I don't want my fund's performance damaged because some panicky investor pushes the button and forces the fund to sell at bad prices," said one investor who declined to be identified. "I'd rather have my money locked up for a period, or gated."

A PROBLEM SHIFTED

It's not just funds that have lost money that are coming under pressure. While poor performers saw the first redemptions, some solid performers are now also feeling the heat from investors unable to pull their money from other funds that have limited withdrawals.

Tom Anderson, director of $1 billion hedge fund Yorkville Advisors, told Reuters his fund, which has no gate and which is up 5 percent year-to-date, was set to see around 10 percent redemptions at the end of the year.

"Investors are saying, 'As much as I don't like to do this, I need the money and you guys don't have gates up'," he said.

As a result, even the handful of funds that have done well in 2008 may be forced to restrict investor withdrawals in order to protect their performance. As a result their fees, too, may be on the negotiating table.

(Editing by Chris Wickham)