Institutional Investor's Alpha Magazine - October 2008 - (Page 46)

Industry Under Siege assets. Even a year ago that number was closer to 1.5 or 1.6. “There has never been lower reward for taking more risk than there is right now,” says Alex Ehrlich, the New York–based global head of prime services for UBS Investment Bank. “Leverage is going to get more expensive if the frozen credit markets don’t thaw.” This is trouble for plenty of hedge funds that rather dangerously came to rely on abundant cheap money to plump their returns. With market volatility and default rates at historical lows as recently as two years ago, many hedge funds had a hard time ﬁnding true alpha. To generate the high returns they promised their investors — and the commensurately high performance fees — managers turned to leverage. Now they are suffering. Greenwich, Connecticut–based JWM Partners, which specializes in the kind of relative-value trades that founder John Meriwether used at defunct Long-Term Capital Management, was down 26 percent for the year through September. Convertible arbitrage is one of the strategies hit hardest by lending problems. A year ago it would have been possible to borrow from a prime broker at LIBOR plus about 25 basis points using a convertible note as collateral. Today some banks are offering rates in the vicinity of LIBOR plus 200 to 250 basis points. Other investment sectors, such as leveraged loans, have seen similar increases. In the past a hedge fund could ﬁnance its leveraged loan positions for LIBOR plus 50 to 60 basis points; now the rate is closer to LIBOR plus 1,400 basis points. And lending against some assets, such as asset-backed securities, is all but impossible. The hedge fund industry has lived through ﬁnancing crises before, most notably the 1998 collapse of LTCM. The Greenwich-based ﬁrm, which had entered that year with $4.8 billion in assets under management and a 30to-1 leverage ratio, saw the value of its investments tumble — and its leverage soar to more than 100 to 1 — following the Russian debt crisis that August. LTCM’s problem was not that Russia defaulted on its sovereign bonds but that the ﬁrm and its highly leveraged arbitrage strategies were undercapitalized. Just a couple of months earlier, LTCM had returned $2.7 billion in capital to investors because it didn’t want to dilute returns. Once LTCM’s lenders started to pull ﬁnancing, the fate of the ﬁrm was sealed. In September 1998 the Federal Reserve Bank of New York orchestrated a bailout, getting a dozen Wall Street firms to inject a total of $3.5 billion into LTCM in exchange for 90 percent of the firm. Several hedge funds were caught in the wake of LTCM’s collapse, including mortgage specialist Ellington Management Group. The Old Greenwich, Connecticut– based ﬁrm privately auctioned off $900 million in mortgage securities on Columbus Day 1998, while the markets were closed, to prevent borrowers from seizing its assets ﬁrst. This time around, the overall situation is far more dire. It’s not a collapsed hedge fund putting pressure on the sys- FACTORING IN THE UNKNOWN I nvestment banks are supposed to be reliable counterparties for their hedge fund clients, not unpredictable sources of incalculable risk. But Lehman Brothers Holdings’ rapid descent into bankruptcy on September 15 created a black hole in the $1.9 trillion hedge fund industry, and no one knows yet how deep it goes — or which hedge funds will be sucked into the abyss. The problem is as shadowy and complex as it is hard to quantify. Lehman was once a prime broker to a who’s who of hedge fund ﬁrms, including New York–based behemoth D.E. Shaw Group, which has $39 billion in assets under management, and London’s GLG Partners and Lansdowne Partners, which manage $23 billion and $17 billion, respectively. Lehman’s weakened state leading up to its demise prompted many large hedge funds to extract their assets from the bank and diversify their prime broker relationships, reallocating to better-capitalized commercial banks such as Citigroup and JPMorgan Chase & Co. Because large hedge fund ﬁrms tend to have at least two prime brokers providing trading, clearing and settlement services for any given fund — as well as multiple counterparty ﬁ nancing relationships — they’re probably less at risk than smaller ones, notes Stuart Davies, global head of investments for $12 billion fund-of-hedgefunds ﬁrm Ivy Asset Management. Still, Davies expects that a considerable number of managers will get stung by the unsettled trades still on their books. “Some funds are going to ﬁ nd that they have exposure to Lehman, and they are going to struggle to come to terms with what they can recover in the weeks ahead,” says Davies. “I hate to say it, but it probably won’t be very much.” For ﬁrms that worked with Lehman’s North American investment banking and trading unit, which was purchased by Barclays, asset transfers have reportedly been slow but largely successful as the British bank has absorbed the brokerage activities of its U.S. rival. But anyone doing business with London-based Lehman Brothers International (Europe) — which was left out of the Barclays deal and placed in receivership with accounting firm PricewaterhouseCoopers — has not been so lucky. The division’s last-minute transfer of $ 8.2 billion in cash from its British coffers to Lehman’s New York headquarters the Friday before the ﬁ rm declared bankruptcy has hedge fund executives fuming. While Lansdowne and D.E. Shaw have negligible exposure to Lehman International, GLG Partners was still doing business with the bank in the days before its demise. In an effort to protect its right to ﬁ ght for the cash it still held in its trading accounts at the time of Lehman’s implosion, the publicly traded hedge fund ﬁrm, which was 11 percent owned by the investment bank, on September 19 lodged a formal objection in the U.S. Bankruptcy Court for the Southern District of New York to the sale of Lehman’s U.S. broker-dealer assets to Barclays. But GLG has said publicly that its exposure across all its funds is estimated at $95 million, less than 1 percent of its assets under management. Hedge fund ﬁrms that have higher exposure face greater hardship: New York–based Bay Harbor Management, which also used Lehman International as a prime broker, hopes to recover $190 million. Harbinger Capital Partners, part of Birmingham, Alabama–based investment group Harbert Management Corp., 46 • INSTITUTIONAL INVESTOR’S ALPHA • OCTOBER 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2008

Institutional Investor's Alpha Magazine - October 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Process of Evolution The Good Guys: Israel's Champion Interview: Fast Lessons for Hard Times Cover Story: Industry Under Siege The New Hedge Fund Economics Good-Bye, Easy Money Caging the Shorts Strategies: Bottom Fishing Profile: Cult of Personalities Research Center: Alpha Awards: Eye of the Storm Alpha Bytes: Funneling the Chatter Unhedged: Commentary: Attention, Hedge Fund Shoppers

Institutional Investor's Alpha Magazine - October 2008

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