Hedge Funds and Discretionary Liquidity Restrictions

During the recent financial crisis, more than 30% of hedge fund managers in our sample exercised discretionary authority to restrict investor liquidity using mechanisms such as side pockets and gates. Using a hand-collected dataset of hedge fund investor interests, we examine the determinants of these discretionary liquidity restrictions (DLRs) and their consequences for investors and hedge fund managers. We find that funds restrict liquidity when facing greater funding and asset liquidity risk, consistent with funds using DLRs to prevent potentially damaging runs on the fund's capital. However, we also find DLRs to be more prevalent among funds with greater potential for conflicts of interest with investors. Further, we find that DLR funds underperform both a passive benchmark and a control sample of similar funds subsequent to initiating the DLR. Our evidence suggests DLRs negatively impact fund family reputation, as funds associated with DLR activity had a more difficult time raising capital and were more likely to cut their fees in the post-crisis era