Gates are a feature of hedge funds and PE funds that seek to prevent too much money from being withdraw from the fund at once. The mechanism can operate at the investor level, limiting the percentage of invested capital an individual can withraw per quarter, and at the fund level, limiting the percentage of investors who can withdraw money during a certain period. The purpose of such restrictions is to ensure the manager isnt caught in a funding squeeze and forced to liquidate investments at inopportune times to meet withdrawals.
Q. So these are mechanisms that keep investors from pulling the money out of hedge funds, right?
A. Right. There are two kinds: fund level gates, and investor level gates. Fund level gates kick in when, say, 25% of investors are trying to get their money out at the same time. Investor level gates provide that an investor, once past his basic lockup period, can only withdraw, say, 25% of his money per quarter.
Q. Aside from the fact that the hedge fund managers want to keep as much money in the fund as possible, what’s the rationale for these?
A. That if too much money leaves at once, you’ll have to break trades at unfavorable moments. Now, you should recognize that that’s a lot better rationale for some strategies than for others. A true long/short equity fund really should be able to liquidate its positions essentially instantly without undue harm to the book, and to the investors who remain. On the other hand, a distressed credit shop might well need time to work out of positions, and in fact a crisis is probably exactly the wrong moment to sell anything.
Q. So one factor to look in thinking about whether gates are reasonable is the underlying fund strategy. What else should an investor consider?
A. With fund level gates, you have a real “game theory” issue. If everyone knows that only the first 25% get out without waiting, a powerful dynamic is created: at the slightest whiff of trouble, they’ll be a rush for the door. So those can have exactly the opposite effect from what’s intended, creating an exodus instead of preventing one.
Q. And individual level gates don’t have that problem.
A. Right. You can’t get all your money out at once, but you will be able to get it out on a known schedule… much better than being stuck behind a fund level gate for an unspecified time! Also, this kind of gate helps the fund plan its positions better. So for the right kind of fund, ones where you can’t expect the manager to maintain totally liquid positions, this kind of gate does not seem unreasonable.