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Hedge-fund redemption shock

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 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 froze withdrawals on a third fund this month, although the reason for the suspension was unclear.