What Happens to Investors’ Money When a Hedge Fund Fails?

William Ackman and David Berkowitz formed hedge fund Gotham Partners LP in 1993 and established its offices in New York City. The two former classmates from Harvard Business School initially did well and took the fund from its startup value of $30 million to $300 million by making a range of diversified investments. However, the partners then began to pursue a different path and acquired a number of private companies, as well as thinly traded public ones. In 1997, Gotham bought Gotham Golf, a golf course operator that continued to get into more and more debt. To address this issue, Ackman tried to merge the failing company with First Union Real Estate Equity and Mortgage, which had a lot of cash on its balance sheet. After obstacles to the merger arose, and with the fund’s other investments being illiquid, investors in Gotham Partners began asking for their money back. As a result, Ackman and Berkowitz had to close the hedge fund down.

In contrast with mutual fund managers, hedge fund managers typically have freedom to select their funds’ holdings as they wish, and investors receive only limited disclosures concerning those holdings. Illiquid instruments such as mining rights agreements, industrial and real estate contracts often appear in hedge fund portfolios, in addition to more liquid stocks and bonds. Other speculative and frequently illiquid investments like credit default swaps may also be held by hedge funds. The degree of illiquidity in a fund’s portfolio is a significant factor in determining the fund’s risk of ruin.

Requests for Redemptions

The less successful a hedge fund is, the more likely investors are to request redemptions to get their money at risk back. Funds may have to sell some of their asset portfolio to satisfy redemptions. The problem here is that illiquid assets are harder, and usually take more time, to convert to cash. Because the financial viability of a fund may be threatened if too many investors ask for redemptions at one time, hedge funds typically impose restrictions on redemptions, known as gates. An example of a gate is a lock-up period. Normally, investors may request redemptions four times a year on a quarterly basis. Many funds require advance notice of a number of months before a redemption will be made.

Stocks and bonds, generally the most liquid part of a fund’s portfolio, may quickly drop in value in the event of a market downturn. At such times, illiquid and speculative investments fall in value even faster because investors flee from risk. Liquidating assets in a downturn would greatly disadvantage a fund, and therefore funds often retain the prerogative to suspend redemptions in economic down cycles. Investors then cannot access their cash in time of greatest need.

In-Kind Asset Distribution and Dissolution

Many hedge funds offer superior redemption rights to lead investors, allowing them to redeem with less notice than other investors. Under fund partnership agreements, managers may be allowed to segregate some assets from the right to redeem. These agreements typically apply to hard-to-value assets. There may be provisions in such agreements that permit the manager to distribute assets in-kind to investors, especially with regard to illiquid assets.

Despite these considerations and the conditions imposed by fund partnership agreements, it’s important to recognize that there is a tipping point that, when reached through a sufficiently large number of simultaneous redemption requests, renders fund operations impossible. Confronted with a flood of redemption requests, a fund manager may decide upon complete dissolution of the fund and liquidation of all its assets. This is the situation in which Gotham Partners found itself. Investors should then be informed that they will be cashed out over a reasonable time period. When an investor decides that his money has not been returned on a sufficiently timely basis or to an acceptable extent, he may seek recourse through the courts. The terms and conditions of the fund’s partnership agreement and the value of the fund’s remaining assets are critical elements in the resolution of such a legal action.