UPDATE 2-Cerberus to change terms of hedge fund-source

* SPV for those seeking withdrawals -source

* Fees reduced for those that stay - source

* To avoid high profile investments - WSJ (Adds details from letter, background about hedge fund performance in paragraphs 6 through end)

NEW YORK, July 9 (Reuters) - Private equity firm Cerberus is to place investors seeking withdrawals from one of its hedge funds into a special purpose vehicle which would make cash distributions over time, a source familiar with the contents of a recent investor letter said on Thursday.

For investors remaining in the fund, fees will be reduced, the source said.

The Wall Street Journal earlier reported the news. The paper cited a letter sent to clients which said that the vehicle would sell assets over time and make cash distributions.

The letter also referred to Cerberus' high profile investment into Chrysler Group LLC, which emerged from bankruptcy in June.

"In the future, we will seek to avoid transactions that receive the publicity that some of our more recent investments attracted," wrote Cerberus boss Stephen Feinberg in the letter. "We never intended to receive the publicity surrounding those investments."

The Wall Street Journal said the fund, Cerberus Partners LP, lost 24.5 percent in 2008 and declined about 3 percent through the end of May. Feinberg said "significant macro risks" remain and may affect future results, the report said.

"We are embarrassed and disappointed by our 2008 performance, and we feel an obligation to you to turn this around," Feinberg wrote, according to the Wall Street Journal. "But we just don't know when and how much pain we must take before that happens."

Cerberus declined comment.

Hedge funds posted their worst returns ever in 2008 when the average fund lost 19 percent and some, including powerhouse Citadel Investment Group's flagship funds, tumbled 50 percent.

Investors punished managers by pulling out billions of dollars from funds. (Reporting by Megan Davies, additional reporting by Svea Herbst-Bayliss in Boston; Editing by Matt Daily and Tim Dobbyn)