Liquidity Risk and Economic Damages
According to "Insider Probe Impact Felt by Pension Funds" by Steve Eder (Wall Street Journal, January 24, 2011), those hedge funds that are being investigated by the FBI may find themselves confronted with even more challenges. If they are forced to sell positions that are deemed "bad" because they resulted from the use of material, non-public information, they could realize an economic loss on top of incurring transaction fees not originally anticipated, including the disgorgement of specified profits. Additionally, if any worried institutional investors want out early, hedge funds being probed may find themselves facing unplanned redemptions. Unless their prime broker (assuming they have one) provides offsetting capital in the form of a cost-effective credit line, a liquidity squeeze could occur.
Although some institutions such as pensions, endowments and foundations invest in hedge funds to diversify their respective portfolios over the long-term, uncertainty about a manager's ability to remain in business can trigger a run which in itself has the potential to hasten its demise. In some cases, a fund manager may offer reduced fees to its investors as a way to buy time and try to get back on the road to recovery.
In the event that a lawsuit is filed, there are numerous liquidity risk factors that must be taken into account. For one thing, it is necessary to know if lockups were accepted by investors. If so, on what terms? If redemption rights existed but a hedge fund chooses not to allow redemptions (which has occurred as an unwelcome surprise to investors), economic damages would have to take into account what (if any) provisions the hedge fund management team had made in order to satisfy withdrawal requests before trouble began. In addition, an analysis would have to take into account whether and on what terms (cost) a hedge fund could sell off part of its holdings to raise cash and whether (and why) credit facilities could be rescinded. The ability to raise cash from new and/or existing investors is another issue, along with whether a hedge fund is overly dependent on just a handful of investors.
The foregoing is not an exhaustive list. Every situation relies on relevant facts and circumstances but one thing is certain. There is no free lunch. There is a cost associated with illiquidity risk.
