Hedge funds are pooled investments that are open only to accredited investors – investors who meet certain net wealth and income tests. In most hedge funds, investors are called partners and must sign a partnership agreement with the managing partner before they're allowed to invest. Partnership agreements specify the rules under which the hedge fund operates, including fees, minimum investments, earnings allocation and redemption restrictions. In several ways, partnership agreements can restrict partners from freely withdrawing money from the fund.
Reasons for Redemption Restrictions
One or more redemption restrictions are commonly included in partnership agreements. By restricting the withdrawal of money, the hedge fund may be able to hold illiquid --hard to sell -- securities for a long period of time. It also allows the fund to keep less cash on hand, leaving more available for investing. Both of these reasons for restricting redemption become very important during periods in which the fund is losing money. A precipitous drawdown of cash may force the fund to sell illiquid investments at a loss and to raise the amount of cash on hand. These actions are likely to further damage performance.
New hedge fund investors are usually subject to an initial lockup period that may last a year or two. Redemptions are not allowed during a lockup period. By restricting new investors from quickly making withdrawals, hedge funds avoid a certain amount of churning and force new investors to be patient. Many hedge fund strategies require extended periods to turn profitable. Lockup periods give a hedge fund some breathing room to use long-term strategies without being forced into liquidating positions to meet redemption requests.
After the lockup period expires, redemptions may still be limited to certain specified time periods. The frequency and length of these periods varies among different hedge funds. Funds that aggressively deter redemptions may set only one or two redemption periods per year, and may keep each period short – as little as a few days long. During times of severe distress, a hedge fund may have the right to invoke a freeze on redemption periods – the partnership agreement will make this explicit.
Another strategy hedge funds use to suppress redemptions is to demand advance notice of a request to withdraw funds. Aggressive funds may require an advance notification period several months prior to a redemption period. This is effective in denying redemptions to investors who have a sudden need for cash. Also, by requiring the redemption notice well in advance, hedge funds can make appropriate plans for raising the required cash with the least disruption to its trading strategies.
- From Zero to Sixty on Hedge Funds and Private Equity 2.0: What They Do, How They Do It, and Why They Do The Mysterious Things They Do; Jonathan Stanford Yu
- The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True; Simon Lack
- Hedge Funds For Dummies; Ann C. Logue
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.