Hedge-fund redemption shock

LONDON (CNNMoney.com) -- Investors are expected to hit hedge funds with a flood of redemption requests this fall, but those who try to withdraw their money may be in for an unpleasant surprise.

Most hedge funds have "lock-ups," a minimum period of time during which investors agree to tie up their money and not make any withdrawals.

Once that period ends, investors generally can redeem their stakes as long as they give advance notice, usually 45 to 90 days before the quarter end. Although that cut-off has passed for many funds for the current quarter, investors can still put in requests to get their money out by year-end.

But hedge funds also can slow withdrawals, or suspend them altogether. While they're usually loath to do this, since it can signal that a fund is on the verge of collapse, current conditions may result in more funds not letting investors take their money out - at least not immediately.

Hedge funds have been hard hit by the recent turmoil in the market. Two Bear Stearns hedge funds heavily invested in securities backed by subprime mortgages blew up in June. Ensuing volatility claimed funds at Sowood Capital Management and led to big losses at so-called quantitative funds, including some run by Goldman Sachs (Charts, Fortune 500) and others.

The losses sparked panic in the market, as well as worries that more problems will surface at other funds. That's raised expectations that hedge-fund investors, which include institutions like university endowments and pension funds, will try to rush to get their money out before losing more. That, in turn, can unleash a vicious cycle: As hedge funds lose cash, they're left with less money to invest, which can make it difficult for the funds to recover and hasten a downward spiral.

To avoid that scenario, hedge funds can make it tougher for nervous investors to bail out. For example, they can slow redemptions by imposing a "gate," which allows them to cap the amount investors withdraw during a given period - usually at 20 percent of the fund's net asset value, according to David Nissenbaum of law firm Schulte Roth & Zabel, whose hedge-fund practice dominates the industry.

They can also block withdrawals completely, for instance when they can't accurately value the fund's assets or don't have the money to meet requests, legal experts say. Bear Stearns (Charts, Fortune 500) froze withdrawals on a third fund this month, although the reason for the suspension was unclear. Bear Stearns did not return calls seeking comment.

Markets have stabilized recently, which is helping some funds. Leonard Chazen of law firm Covington & Burling said recent signs that merger activity hasn't completely stalled has helped ease redemption pressure among the funds he works with, which invest in buyout deals.

But there's still uncertainty over how long the calm will last. "The trend in the area I work in is positive, but we could have a whole new set of events tomorrow," Chazen said.

And that unease is fueling expectations for investors to keep cashing out. Credit funds and those exposed to subprime mortgages are the most at risk, analysts say, but amid the liquidity squeeze, some investors who need cash are even unwinding positions in funds that are performing well.

Of the more than 9,000 hedge funds that currently exist, at least 2,000 are vulnerable to "runs on the bank" by investors, according to a memo law firm Morrison & Foerster recently issued to its clients.

Pension funds are especially likely to be pressured to pull their money in volatile times, said Evan Flaschen, a bankruptcy specialist at law firm Bracewell & Giuliani who represents many hedge funds.

"There will continue to be redemptions because so much money invested in hedge funds is from pension funds and state trust funds who assumed returns were always going to go up," Flaschen said.

It's unclear how many investors will end up fleeing hedge funds, but pressure is expected to mount as the end of the year nears. The problems at quantitative funds didn't surface until this month, which means nervous investors in funds requiring a 60- or 90-day advance notice weren't able to make withdrawal requests for the third quarter ending in September. They may rush to the exits at the first opportunity in October.

"There is a growing concern that we could be looking at substantial redemptions in the fourth quarter," Nissenbaum said, which could pose a big challenge for the hedge-fund industry.

If funds take the extraordinary actions of using the "gate" or suspending redemptions, "this will be a real test to see whether investors can forgive and forget or if this will remain a black mark on the record of fund managers," he said.