Gate provision

Gate provisions are contractual rules that hedge funds use to control liquidity risk. These provisions limit how much capital investors can withdraw during specific redemption periods. Hedge funds are investment partnerships that typically allow investors to withdraw their money only on certain dates, such as quarterly or monthly. Gate provisions help protect both the fund and its remaining investors from the potentially harmful effects of large-scale withdrawal requests.

When many investors try to withdraw money at the same time, the fund manager might be forced to sell investments quickly at poor prices to raise cash. This hurts the investors who stay in the fund because they bear the cost of these forced sales. Gate provisions serve as a critical tool in preventing this problem.

Hedge funds can implement gate provisions in two main ways:

: These protect against excessive withdrawals by setting a cap on the total amount that can be withdrawn from the entire fund on any single redemption date. For example, a fund might limit total redemptions to 20% of the fund's net assets per quarter. If the fund has $100 million in assets, no more than $20 million could be withdrawn in any quarter, regardless of how many investors want to redeem.

Investor-level gates: These limit the percentage of an individual investor's money that can be withdrawn on any given redemption date. This type of gate applies to each investor separately, regardless of what other investors are doing. For instance, an investor-level gate might prevent any single investor from withdrawing more than 25% of their investment on any redemption date.

Gate provisions provide several important benefits:

• They prevent fund managers from being forced to sell investments at unfavorable prices just to meet large withdrawal requests
• They protect remaining investors from bearing the costs of significant changes to the fund's investment portfolio
• They help maintain the fund's investment strategy during periods of market stress when many investors might panic
• They prevent remaining investors from being left with a distorted portfolio that becomes heavily concentrated in hard-to-sell investments

The 2008 financial crisis revealed significant problems with fund-level gates. When markets became stressed, investors began submitting preemptive redemption requests to secure their position in the withdrawal queue. This defensive behavior emerged from legitimate concerns that remaining fund assets would become increasingly illiquid and poorly balanced as liquid holdings were used to satisfy other investors' redemptions.

Additionally, investors began inflating their redemption requests to account for potential scaling back under gate provisions. If they expected their withdrawal request to be cut by half, they would double their actual desired withdrawal amount.

These behaviors created a paradoxical outcome. The very mechanism designed to prevent massive redemption volumes actually contributed to them. The defensive strategies led to exactly what gates were meant to prevent: enormous withdrawal requests that forced managers to liquidate positions and, in some cases, close funds entirely.

Fund managers establish fund-level gates to manage liquidity pressures and protect their investment operations from potential ""—situations where many investors try to withdraw money simultaneously. When a fund faces substantial redemption requests, managers face a difficult choice. They risk being forced to sell holdings prematurely at poor prices, which harms the investors who choose not to withdraw by significantly changing the fund's risk profile. The remaining portfolio often becomes concentrated in less liquid assets that are harder to sell.

Implementing gates allows managers to scale back redemption requests proportionally across all investors who want to withdraw money. This approach helps reduce these harmful effects.

Here's how this works in practice: Consider a fund with quarterly redemption periods that caps withdrawals at 20% of net assets per redemption date. If this fund holds $500 million in net assets and receives redemption requests totaling $125 million for December 31, 2022, the gate provision would allow the fund to reduce these requests to $100 million. This keeps withdrawals within the 20% threshold and protects the fund from excessive outflows.

When gates are triggered, managers typically reduce redemption requests proportionally among investors who want to withdraw money. Fund managers can use two main approaches for this scaling. They can base the scaling on each investor's total value in the fund, or they can base it on the size of each investor's individual redemption request.

Fund legal documents should clearly specify which methodology the fund will use. This transparency helps avoid potential complications during implementation. While neither approach is necessarily more fair than the other, basing the scaling on redemption request size may create perverse incentives. Investors might submit inflated withdrawal requests if they expect the fund to implement gates, knowing their actual withdrawal will be scaled down.

When gate provisions prevent investors from withdrawing their full requested amount, those unfulfilled redemption requests are typically honored at the next redemption date. However, fund documents may require investors to resubmit their requests rather than automatically carrying them forward.

If gates are triggered again at the next redemption date, fund documents vary in how they handle previously unfulfilled requests. Some funds give priority to these older requests over newly submitted ones, though this priority is not always guaranteed.

Fund documents often include "" that limit how many times a redemption request can be scaled back. These provisions prevent indefinite delays in investor withdrawals. Without such provisions, gates could continue applying at each redemption date indefinitely, until all requests are fully satisfied.

Modern hedge funds increasingly adopt investor-level gates rather than fund-level gates. These provisions enable funds to reduce individual investors' withdrawal requests when they exceed specified percentages of that investor's account balance.

Unlike fund-level gates, investor-level gates allow funds to prevent investors from withdrawing their complete investment on any single date while providing greater certainty about withdrawal amounts. Individual investors can better predict how much they will be able to withdraw on any given date because the limitation applies specifically to their own account rather than depending on what all other investors are doing.

This approach also eliminates the strategic behavior problems that emerged with fund-level gates. Investors have no incentive to submit premature or oversized redemption requests because the gate applies only to their own withdrawal percentage, not to the fund's total redemption activity.

Fund managers should carefully evaluate whether fund-level gates are truly necessary. Other liquidity management tools might provide adequate protection against forced liquidations without the potential negative consequences.

Traditional allow managers to temporarily halt all redemptions during exceptional market circumstances. Most hedge fund investors accept suspension provisions as reasonable protective measures when market conditions are genuinely difficult. Investors typically object only when managers appear to use suspensions longer than market conditions justify.

capabilities represent another alternative. These provisions allow funds to distribute actual securities to redeeming investors instead of cash, avoiding the need to sell assets at poor prices.

While gates offer fund managers an additional option when facing substantial redemption pressure, announcing their implementation may actually trigger more redemption requests. In many cases, gates merely delay rather than prevent the need for suspension.