Jan. 31 (Bloomberg) -- Deephaven Capital Management LLC is liquidating a $780 million hedge fund that tries to profit from takeovers after investment returns fell and investors asked for more than two-thirds of their money back.

The firm froze redemptions from the Deephaven Event Fund after clients requested to withdraw 70 percent of capital, according to a letter sent to investors today by Chief Executive Officer Colin Smith. Minnetonka, Minnesota-based Deephaven, a unit of stockbroker Knight Capital Group Inc., will sell assets and start returning money to investors in February.

Deephaven, which oversees $4 billion, couldn't find enough opportunities to profit from U.S. acquisitions as investors shunned bonds and loans used to finance deals, Smith wrote. The fund, which also bet on companies going through restructurings and other changes, was little changed last year and dropped 6 percent this year through Jan. 25, according to an investor, who asked not to be named because the returns are private.

``Managers' ability to know where to place a bet has been extremely difficult in this market, with all of these announced transactions that appear as if they aren't going to get done,'' said Geoffrey Bobroff, an independent investment consultant in East Greenwich, Rhode Island, who isn't a Deephaven client.

The fund ``is unlikely to produce the type of investment results Deephaven and our investors might expect over the short and intermediate term,'' according to the client letter, a copy of which was obtained by Bloomberg. The firm has seen ``declining investor interest in event-driven strategies generally and increased levels of redemption requests.''

Other Funds Unaffected

Deephaven spokesman Jonathan Gasthalter declined to comment. Knight Capital, based in Jersey City, New Jersey, disclosed the liquidation today in a filing today with the U.S. Securities and Exchange Commission. Directors of the Deephaven Event Fund approved the closure plan, and according to the client letter.

The firm's other hedge funds, including a smaller European event-driven pool and $2.3 billion multistrategy fund, remain open. Investors in the fund that's closing will get back at least half of their money by May, according to the client letter. Deephaven suspended fees on assets in the fund as of tomorrow.

Deephaven's event-driven investments started in 1997 as part of the multistrategy fund. The strategy became a standalone fund in April 2004 and returned an average of 12 percent annually through last year, according to the investor.

Greenberg Leaves

The Event Fund managed $2.1 billion at its peak near the end of 2006, when manager Matthew Halbower left and investors began withdrawing money. Halbower last year started Chicago-based hedge-fund firm Pentwater Capital Management LLC. He was replaced by Andrew Greenberg, a former event-driven manager with Chicago- based Citadel Investment Group LLC.

Greenberg is now departing, according to the letter to clients of Deephaven's event-driven fund and a separate letter to multistrategy fund clients. The firm promoted Tony Chedraoui, who has been managing European event-driven investments and portions of the multistrategy fund, to head of global event-driven investments.

Chedraoui, a former director of mergers and acquisitions at Lehman Brothers Holdings Inc., has generated a 29 percent average annual return on assets he oversees since joining Deephaven in August 2006, according to the letters. He's based in London.

Mixed Returns

Deephaven's multistrategy fund gained 11 percent last year, according to the investor. That compared with the 10.2 percent average gain by hedge funds, according to Chicago-based Hedge Fund Research Inc. The multistrategy fund, which fell 2 percent this year through Jan. 25, bets on global securities including stocks and bonds. Another smaller Deephaven pool, the International Volatility Strategies fund, gained 4 percent during the same period, taking advantage of price fluctuations in securities.

Knight, which makes markets in 17,000 U.S. equities, on Jan. 16 reported higher-than-expected profit on record trading volume during the final three months of last year. Gains from the company's brokerage unit, its biggest revenue source, offset a fourth-quarter loss by Deephaven. The hedge-fund unit posted a pretax loss of $426,000 in the quarter, compared with a profit of $27.4 million a year earlier.

Deephaven executives said in September they will acquire a 49 percent stake in the firm after exercising an option last year to purchase that ownership share from Knight Capital.

Knight shares have gained almost 18 percent this year after losing a quarter of their value in 2007. Knight rose 24 cents, or 1.4 percent, to $16.92 at 12:07 p.m. today in Nasdaq Stock Market trading.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices and participate substantially in profits from money invested. Clients typically pay fees equaling 2 percent of assets and 20 percent of investment profits.

To contact the reporter on this story: Jenny Strasburg in New York at jstrasburg@bloomberg.net

Last Updated: January 31, 2008 13:19 EST