Managing Hedge Fund Risk and Financing: Adapting to a New Era

Conclusion

In conclusion, it is clear that hedge funds can establish many mechanisms in their constitutional documents, trading agreements, and prime brokerage documents to mitigate and manage funding risk arising from both investor redemptions and increased collateral requirements by prime brokers. These rights and mechanisms can ensure the fund's continued solvency and protect all investors from the consequences of a fire sale of fund positions in a distressed market.

While a variety of options to manage the funding risk from a high level of redemptions can be established in the fund's constitutional documents, there are legal and reputational risks involved in exercising those rights. The biggest potential risk is legal. Faced with the inability to immediately monetize their hedge fund shares, investors may seek legal recourse. The case law is still evolving. A court could decide that the fund acted unjustly and inequitably in exercising its rights to control redemptions and that involuntary liquidation of the fund is, in fact, the most equitable course of action for investors.

With respect to prime-brokerage agreements, the biggest potential risk is that the fund fails to meet a margin call and the broker liquidates the fund's assets in order to recover its financing, leaving little or nothing for investors.

While documentation can establish rights and mitigate funding risk, the foremost way to avoid losses from funding risk is for funds to actively manage their liquidity profile ...