Discretionary liquidity: Hedge funds, side pockets, and gates

During the recent financial crisis, more than 30% of hedge fund managers used their discretion to restrict investor liquidity through the use of “gates” or “side pockets.” Using a database of hedge fund investor interests, this paper is the first to empirically examine the determinants of these discretionary liquidity restrictions (DLRs) and their consequences for hedge fund investors. We find that funds enacted DLRs following poor performance and when their portfolio assets were more illiquid. However, despite claims from managers that DLRs protected investor interests by preventing fire-sales, funds that enacted DLRs continued to underperform comparable funds. Consistent with DLRs reflecting agency problems, we find that restricting investor liquidity during the crisis had a negative impact on fund reputation that spilled over across the hedge fund family. DLR funds and their family affiliates had a more difficult time raising capital and were more likely to cut their fees in the post crisis era.