From the May 2008 issue of Wealth Manager Web • Subscribe!

Living with Lockups

In January 2008, Citigroup made a tough decision on CSO Partners--a $500 million fund consisting mainly of leveraged loans, which had lost 11 percent in 2007. This year, when investors tried to withdraw over 30 percent of the assets, Citigroup slammed the door, halting redemptions. In a January 25 letter to investors, fund manager Michael Micko said the fund was acting to avoid forced asset sales "to the detriment of all investors." Since the credit crunch gathered speed last year, some unlucky hedge fund investors have found their assets corralled. Money they once blithely believed to be safely invested and generating healthy returns suddenly was no longer accessible.

When Katie Bars the Door

Typically, hedge fund investors are barred from liquidating during a lockup period and must usually wait during a further 15 to 90 days notice period. Most hedge fund lockups last for less than three years, but even within a fund, various classes of shares may entail different lockups or redemption periods. (Private equity funds, on the other hand, are often designed for more illiquid opportunities, with longer gestations, and typically impose a five-to seven-year horizon.) In addition, many funds apply separate lockup periods to every tranche of an investment made on multiple dates. That means your client's June investment cannot be redeemed when the January investment comes due.

Beyond straightforward lockups, be on the lookout for other provisions that prevent withdrawals. When medieval marauders attacked a castle, the inhabitants lowered a heavy portcullis to keep them out. Fund managers rely on a somewhat similar form of "gating" to keep investors in, and prevent them from exiting en masse at a crisis point. During a market panic, even though a fund may not yet have experienced actual losses, the manager must do everything possible to staunch a potential run on the fund. The standard thresholds for gating range from about 15 percent to 25 percent. "The actual percentage depends on the fund's strategy," explains Ron Geffner, an attorney with Sadis & Goldberg in Manhattan. For example, a manager who focuses on distressed investments or microcap companies might have a lower threshold than one who invests in large caps.

"Once a gate triggers, it means a run has usually already started," says Ann Gill, head of law firm Thelen Reid's private equity group in New York. Investors beware: The provision may carry over to the following year as well, taking a while to work through. The lower the percentage, the sooner the provision triggers, but the less that will have been paid out.

In the most drastic situations, every fund has a contingency plan for suspending all investors' withdrawals. The ultimate goal is to prevent a fire sale of assets at deeply discounted values. "In reality, it is a last resort tactic before an unwinding, because once they institute that type of freeze on assets, few managers can survive it," comments Russ Lundeberg, who is the chief investment officer at Barrett Capital Management, a multifamily office in Richmond, Va. But nothing is written in stone. A fund can always revise its investment documents, although normally, that requires a vote of approval from investors. "Most funds consider it prudent to retain the flexibility to change with the times," Lundeberg says.

A host of other items may sneak in to deplete assets. Various reserves may include indemnifications for the manager, fund expenses, or investments in kind. As Geffner observes of the latter: "Getting paid some shares of an illiquid company isn't very helpful."

Matching Liquidity

A manager ought to be allocating the portfolio with an eagle eye on the best returns, rather than managing redemptions. If redemptions are a concern, a manager might make decisions for reasons of liquidity, which would narrow the potential opportunity set within a strategy.

Since assets and liabilities should be matched, the investment period will depend on the strategy and the nature of the underlying collateral. For instance, multi-strategy or global funds tend to be more liquid--along with managed futures, commodities, convertible or merger arbitrage funds. Other strategies--like distressed debt, credit derivatives or activist investing--are difficult to execute in a hurry,

Activist investing offers a good illustration. The activist strategy uses shareholding to influence a change in a target company, and thus may take some time. Meetings with management, shareholder votes and the entire proxy process can drag on. Moreover, a fund manager who acquires non-public information may be prohibited from trading the company's stock, especially during a takeover.

On the other hand, investors have their own liquidity needs. If they want to keep portions of their holdings liquid, that money should not be allocated to risky strategies. Lundeberg tries to maintain a sound balance in his family office. While the portfolio cannot be liquid at all times, he adjusts for changing environments. "There is room for illiquid investments, as long as compensatory returns offset that. But we might be missing out on another opportunity, or locked into an investment that is not performing well."

In some cases--given extenuating circumstances--a general partner may be able to waive a lockup for a particular investor. Although sometimes the hedge fund can borrow the money to meet such redemptions, banks may not always welcome the collateral. After August 2007, for instance, they became less than enthusiastic about accepting subprime mortgages. "The hedge fund won't borrow money in order to give yours back to you if it is in illiquid investments like SIVs," warns Tom Westle, a New York-based partner at Blank Rome.

Lockups are growing longer, particularly as hedge funds are beginning to operate more like private equity. During their glorious heyday, celebrity fund mangers used their stature to impose extended investment periods, which made their jobs easier and opened opportunities. More recently, in the wake of the credit mayhem, they have lengthened the time frames as a defensive measure. It is becoming less rare to encounter five-year periods, such as that of ESL Investments run by star performer Eddie Lampert, or the six and a half years required by BlueMountain Capital Management, a credit correlation fund.

The trend toward multiyear periods gathered steam between 2004 and 2006 as the SEC tried to impose a registration regime on hedge funds. Many balked at the cost and administrative burdens of the new requirements. Lockups actually provided the loophole. Some managers decided to behave like a wolf in sheep's clothing: They increased their lockups to 25 months in order to look more like private equity. "These hybrids smelled a bit less like hedge funds that way!" says Gill. The exercise is now moot, since in June 2006, Phillip Goldstein of Opportunity Partners successfully sued the SEC and overturned the registration rules, letting the entire hedge fund world off the registration hook.

In any case, the lines between the types of investments hedge funds and private equity undertake are becoming more blurred. In the past, hedge funds concentrated on raising capital and outsourcing functions. Now they are branching out into more illiquid alternative investments to comply with demand. "The more they look and quack like private equity, the more the hedge funds will need to learn to run and operate companies. Or where's the added value?" asks Dory Wiley, president of Commerce Street Capital in Dallas.

The industry has been coming up with several new ways to placate investors. Many funds are becoming more creative in how they implement their lockup rules, such as allowing investors to access their money prematurely, subject to a punitive fee. These so-called "soft lockups" typically incur redemption penalties of about 3 to 5 percent.

Sometimes the carrot works as well as the stick. Another practice to skirt the dilemma is to offer rewards for longer-term commitments of money. For example, the $1.6 billion Laurus family of funds lowers expenses to 1.5 percent for management fees, and to 15 percent for the general partners' profits (versus the more usual "two and twenty") as an incentive for leaving money untouched for three years.

"Sometimes a general partner will negotiate to buy out your share. A subterranean secondary market may also develop in future," suggests Westle. Already, an online exchange--Bahamas-based Hedgebay Trading--has begun to act as an agent for selling hedge fund stakes. Those investors who can find buyers forego from 1 percent to 5 percent of their assets' value in commission charges.

Jumping the Line

When you or your clients discover a promising hedge fund opportunity, one of the first questions to ask is for how long the money must be committed. As always, there is no substitute for due diligence and asking tough questions. You should find out how much of the capital base will be available for redemptions, and whether any other investors are enjoying favorable liquidity treatment.

Above all, use common sense, urges Wiley. What exactly is the collateral? With hindsight, many people acknowledge that some of the more recent esoteric derivative strategies never added up. If you cannot get a handle on what the hedge fund contains, you probably should not be in it at all. You need not know every individual investment, but you should understand the basic classes, strategy and risks involved.

In fact, your clients should not make any such substantial investment without the involvement of an attorney who is immersed in the field. "Most people are not, and they are playing in a game they don't understand," Geffner warns. The devil is in the details, which are laid out in the partnership or operating agreement for a domestic fund. An offshore vehicle uses an investment memorandum and articles of association or bylaws, depending on the jurisdiction. Do not assume the documents are boilerplate. "They are heavily drafted--tailored from one manager to another," Geffner adds.

You can try to negotiate around the edges. "Sophisticated investors look for a 'most favored nation' provision, so at least they won't get treated worse than anyone else," says Gill. Side letters, which are agreements that give certain investors preferential advantages, are the tool for documenting that. You need some leverage to move ahead of the pack, and there are about four ways to parlay your advantages.

First, the pure size of the investment can command respect. If you pony up enough, you can call the tune and do away with lockup restrictions. Second, you may be able to build clout through aggregating with other investors. Here is where an advisor who brings together several high-net-worth clients may be able to play a valuable role.

Another function of negotiating leverage is the stage of the manager's business. If you bring $3 million to a manager who has amassed $20 million, your contribution will be material. Start-ups tend to have shorter lockups, since they are actively seeking capital. Obviously, high flying, big name managers can demand terms that suit them. Finally, cold cash may not be the only attribute investors bring to the table. It could be that they represent potential future investments, or simply glamour. Personal prominence and reputation can add its own value by boosting a fund's stature.

It is a mistake to brand all lockups--especially longer ones--as an evil. From the fund's perspective, "they provide stability for a start-up," says Gill. That guarantees cash flow and allows the fund to recruit and pay higher caliber managers. It also ensures that cash will be available when markets head south and other participants may be panicking, which is a good time to snap up bargains. The corollary is equally valid: If redemptions cascade during market sell-offs, firms may be forced to liquidate at the ugliest moment.

Lockups serve as a protection for investors, too. When the underlying collateral needs economies of scale and a multiyear cycle, they safeguard the investment itself. They may also help to preserve a system of some justice. Nobody wants the first people out of the door to make off with all the money just because they acted quickly. Ideally, you want to receive relatively fair treatment across the investor base, and the assurance that no one is leapfrogging to the front of the line.

Vanessa Drucker, who used to practice law on Wall Street, wrote about volatility in January's Wealth Manager.

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