Prying Open Hedge Funds' Exit Door


Prominent investor Joseph Umbach is suing hedge fund Carrington Investment and its manager for putting a freeze on redemptions

Lately it has become quite common for hedge fund managers to slam shut the exit doors—tying up their investors' money for months on end while hoping for a quick end to the bruising credit crunch that's wreaking havoc with hedge fund performances. For investors it can be a frustrating state of affairs: A wealthy manager gets to keep their money and continue to earn a management fee for sitting on a huge pile of cash.

But at least one prominent hedge fund investor is fighting back by suing a big fund that's barring him from recouping a $1 million investment for at least a year.

Earlier this month, Joseph Umbach, a Florida resident and founder of the Mistic line of beverages, sued Carrington Investment Partners, claiming the $1 billion mortgage-backed securities hedge fund "involuntarily" tied up his investment and improperly "rescinded" a redemption notice that was submitted to the fund's manager, Bruce Rose, in July. The lawsuit filed in federal court in Connecticut seeks a declaration that the action taken by Carrington and Rose was "an illegal or unenforceable ex post facto" action.

Barring Withdrawals

The dispute arises from an action Rose took late last summer to prevent investors from pulling money out of the $1 billion fund, which invests mainly in hard-to-value securities backed by mortgages—most of them from home loans to borrowers with shaky credit histories. In September, Rose persuaded a majority of his investors to amend the fund's partnership agreement to bar any investor redemptions for at least one year. The change also gave Rose the power to rescind any redemption requests submitted before Sept. 30, such as the one submitted by Umbach.

Rose did not a return phone call seeking comment on the litigation. But a copy of the amendment, which is included in Umbach's lawsuit, illustrates why the manager was pushing investors to put a hard freeze on all redemptions. The proposal noted that "given the current market environment," Carrington would incur "significant losses" if the fund were forced to "liquidate assets to meet the withdrawals." The six-page proposal also noted that Rose would likely move to liquidate the hedge fund if investors rejected the redemption freeze.

To his credit, Rose put the matter of freezing redemptions up to an investor vote. In recent months many managers have unilaterally moved to freeze redemptions, citing the broad powers that most hedge fund incorporation documents give them. As of mid-March, at least 24 hedge funds have barred or limited investors from taking their money out, (BusinessWeek.com, 3/5/08) tying up tens of billions of dollars for an indefinite period.

Legal experts say investors who challenge a redemption freeze usually have few options. It's by no means clear that Umbach's litigation will be successful. One way investors can try to get around a redemption freeze is by trying to find a buyer for their investment interest. One place investors can go to sell partnership stakes in a hedge is Hedgebay Trading, a private online trading platform that has created a secondary market in the trading of hedge fund stakes. Sources say several investors in Carrington began soliciting bids for their partnership interests after the redemption freeze took effect. It could not be determined whether any of those stakes were sold, however. Andrew Nevas, the attorney for Umbach, did not return a phone call.

Hard-to-Value Securities

So far, Rose's strategy to freeze redemptions appears to be working. People familiar with the fund say its performance is flat for the year, compared with the negative performance turned in by most hedge-fund managers. These people say Rose is gradually trying to bring down the fund's use of leverage, or borrowed money, to avoid being pushed into a situation in which Carrington must sell mortgage-backed bonds at fire-sale prices. A year ago, Carrington made headlines when it acquired some of the assets from defunct subprime lender New Century Financial.

But critics say Carrington's performance may not be all it seems. They note that last fall Rose began using internal models to price the fund's hard-to-value securities, rather than relying on actual market prices for those bonds. There's nothing wrong with that, but it's predicated on the theory that the current market prices for mortgage-backed securities are inaccurate and will eventually recover.

One thing is clear: Umbach does not want to be around to see whether Rose's predictions about the market for mortgage-backed securities come true.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.

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