Leverage, redemptions, lockups and gates

How does borrowing change a fund’s return?

Borrowing lets a fund hold a position bigger than the capital investors put in. That magnifies gains and losses. Say a fund has its own capital $V_c$ and borrows $V_b$ at the rate $r_b$. The whole position earns the portfolio return $r$, but interest is owed only on the borrowed part. The leveraged return $r_L$ is what is left for the fund’s own capital, as a share of that capital.

$$r_L = \dfrac{r\,(V_c + V_b) - V_b\,r_b}{V_c}$$

Rearranged, it shows the effect of borrowing directly: the unlevered return plus the borrowed share times the spread over the cost of borrowing.

$$r_L = r + \dfrac{V_b}{V_c}\,(r - r_b)$$

The same fund in a bad year shows the other edge. If the portfolio falls 4%, the fund still pays 6% on its borrowing:

Across four portfolio returns, the leveraged return for this fund (V_b ÷ V_c = 0.6, r_b = 6%) is:

Portfolio return r	Spread r − r_b	Leveraged return r_L
11%	+5%	14.0%
6%	0%	6.0%
2%	−4%	−0.4%
−4%	−10%	−10.0%

Leverage helps only when the portfolio earns more than the borrowing rate. At $r = r_b$ the extra term is zero, so the fund is indifferent to borrowing. That break-even borrowing rate equals the portfolio return.

$$r_L = r \iff r_b = r$$

Exam tip Check the sign of (r − r_b) first. Positive: leveraged return is above r. Negative: below r, even if r itself is positive.

How do hedge funds borrow, and what is a margin call?

Sources of leveragea position larger than the capital committed

• Borrowing from prime brokers Memorize margin financing
  • Margin account the fund deposits cash or collateral; it is the fund's net equity in the positions
  • Margin call if equity falls below the minimum, the lender demands more collateral
• Derivatives Know the idea exposure without borrowing cash

A hedge fund usually borrows from a prime broker . In margin financing , the broker lends the fund the securities or cash, and the fund deposits cash or other collateral in a margin account, based on set fractions of its positions. The margin account is the fund’s net equity in its positions. The minimum margin depends on the riskiness of the portfolio and the fund’s creditworthiness. Funds also gain leverage through derivatives.

Leverage is a large part of why some hedge funds earn much more than average and others suffer big losses. If the equity in a position falls below the required level, the lender issues a margin call and demands more collateral. A fund that cannot meet the call may have to close out the losing position. If the order is large enough to move the price, the forced sale deepens the loss. Added leverage means added risk.

Go deeper Leverage through derivatives

A derivative position can give exposure larger than the cash put up without any borrowing, so the effect on returns is similar. The leveraged return formula above is for borrowed funds. Derivatives are covered in their own topic.

How do funds control redemptions?

Investors tend to redeem when a fund is performing poorly. The manager may then have to sell positions at poor prices, with transaction costs, and everyone who stays in the fund bears the damage. Funds therefore set terms that slow or price withdrawals.

Redemption controlsredemptions rise when performance is poor and can force sales at bad prices

• Lockup period Memorize minimum holding period before any withdrawal
• Notice period Memorize advance warning (typically 30 to 90 days) before redeeming
• Redemption fee Memorize charged on withdrawals to offset costs for the remaining investors
• Gate Memorize manager limits or suspends redemptions for a time

A lockup period is the minimum holding period before an investor may withdraw. It gives the manager time to carry out the strategy. A notice period (typically 30 to 90 days) is the advance warning an investor must give, so the manager can sell positions in an orderly way. A redemption fee discourages withdrawals and offsets transaction costs for the investors who remain. A gate lets the manager limit or suspend redemptions for a time, at the manager’s discretion.

Term	What it does	When it bites
Lockup period	blocks all withdrawals for a minimum time	right after you invest
Notice period	delays the payout after you ask	when you request redemption
Redemption fee	reduces what you receive	when you redeem
Gate	caps total redemptions for a period	when many investors redeem at once

A manager with a strong reputation can demand a long lockup and still raise a lot of capital. Redemption terms should match the liquidity of the assets held, but even careful planning can fail when a fund holds illiquid and obscure assets and a sharp loss arrives. Funds of hedge funds may offer easier redemption than direct hedge fund investments, through special arrangements with the underlying managers, added cash reserves, bridge loans or by avoiding less liquid strategies. Investors should know their own liquidity needs before investing in a fund with restrictive terms.

Go deeper Liquidity mismatch

The risk behind all four terms is a mismatch: investors can ask for cash daily or monthly, but the assets may take weeks or months to sell without a price drop. Gates became prominent in market crises for this reason. Such left-tail loss events are hard to model for hedge funds.