Oct. 31 (Bloomberg) -- Deephaven Capital Management LLC, the hedge-fund unit of stockbroker Knight Capital Group Inc., froze a $1.6 billion fund after investors asked to get back 30 percent of their money.

Withdrawals from the Deephaven Global Multistrategy Fund were suspended so managers wouldn't be forced to sell assets in falling stock and debt markets, the Minnetonka, Minnesota-based firm said yesterday in a letter to investors. Lenders and trading partners also imposed stricter financing requirements, according to the letter.

Deephaven Global, which trades a variety of securities including bonds and commodities, follows RAB Capital Plc, Ore Hill Partners LLC and Highland Capital Management LP in limiting withdrawals amid the worst financial crisis since the Great Depression. The fund lost 15 percent this year through September, and Deephaven estimated it has fallen an additional 10 percent this month. The fund has returned an average of 16 percent annually since opening in 1994.

``This level of redemptions in the current market environment forces the question of whether such redemptions can be processed in the ordinary course without disadvantaging both continuing and later redeeming investors,'' said the letter, signed by Colin Smith, Deephaven's chief executive officer .

Jonathan Gasthalter, a spokesman for Deephaven, declined to comment.

The fund has been hit in part by falling prices on convertible bonds, corporate and distressed debt, and credit derivatives, the letter said.

Prime-Broker Requirements

Convertible bonds have tumbled 30.5 percent since Aug. 31, according to an index published by Merrill Lynch & Co. Bank loans tumbled to a record low of 66 cents on the dollar last week from 88.5 cents at the beginning of September, according to Standard & Poor's LCD. Yesterday, they were at 69.6 cents on the dollar.

Hedge funds have lost an average of 20 percent this year, the most on record, according to the HFRX Global index compiled by Hedge Fund Research Inc. in Chicago.

Smith said prime brokers have increased requirements on borrowing, forcing Deephaven and other hedge funds to sell assets or post more cash to meet margin calls. Deephaven, which manages $2.6 billion, is working on a schedule for when it will let investors remove money from the fund.

Second Fund Frozen

Deephaven also suspended redemptions from its International Volatility Strategies Fund, which tries to profit from turbulence in financial markets, according to a filing yesterday with the U.S. Securities and Exchange Commission. The fund had $70 million in assets as of Oct. 1. Redemption requests through Jan. 31, 2009, were $44 million.

Knight said it had $63.3 million invested in the volatility fund and $32.5 million in the multistrategy fund.

Earlier this year, the firm liquidated a $780 million hedge fund that tried to profit from takeovers after investment returns fell and investors asked for more than two-thirds of their money back.

Knight shares rose 28 cents, or 2 percent, to $14.58 today in Nasdaq Stock Market composite trading. The shares have gained 1.3 percent this year.

To contact the reporter on this story: Katherine Burton in New York at kburton@bloomberg.net

Last Updated: October 31, 2008 00:01 EDT