Polygon, Plexus Partners Llp., Russell Investments—the drumbeat of hedge funds facing significant difficulties grows louder by the day. This week’s crop follow reports last week that Tisbury Capital Management Llp., Cycladic Capital Management Ltd and Knight Capital Group are all facing mass redemptions. The latest hedge fund woes are no respecter of size or strategy or track record—and they will get worse.
These runs on funds--a bit like runs on banks—are a rational response to poor performance, illiquidity, investor risk aversion and a fear of being last out the door. Leaving aside disasters such as Plexus, whose flagship fund is down 35% this year, the average hedge fund was down 2.4% in March. That’s the worst monthly performance since the collapse of Long Term Capital Management in 1998. Funds held through funds of hedge funds—and therefore subject to a second layer of fees—are likely to have performed even worse.
True, hedge funds have performed better than the stock market since the start of the credit crunch. But they haven’t performed as well as cash—and cash is increasingly what investors want to be in. Worse, if investors fear others are heading for the exit, then it makes sense to get out first—as in a bank run. The risk is that hedge funds will sell off their most liquid investments to meet redemptions leaving those last in the queue exposed to the least liquid assets. The credit crunch has already increased exposures to illiquid assets as buyers for certain assets have evaporated.
In this environment, measures designed to protect funds from mass redemptions can turn into double-edged swords. Long lock-ups, three-month redemption notices, or “stacked gate” systems, such as that used by Polygon, which limit the number of redemptions in any one period, can work against funds when investors prize liquidity. If they see other hedge funds taking steps to limit withdrawals, they may decide to make a pre-emptive move to get money out of other funds. And it’s not just investors who can get spooked. Although hedge funds have reduced leverage since the crisis, banks may also withdraw funding from vulnerable funds.
What should distressed funds do? Unlike banks, hedge funds don’t have access to central bank windows to fund their operations. Nor are there many buyers of hedge funds—at least not at a price many funds would sell. Their best options may be to try to trade through this crisis. But that may prove a long slog.