Thursday, September 3, 2009

Hedge Fund Heave-Ho?


A buddy of mine who is a broker typically calls me after the close to ask me my thoughts on the markets. "So what do you think?", he asked, to which I replied "as long as they keep buying the dips, this market is heading higher."

Fellow bloggers, you know I admire you, but sometimes I read stuff that makes my eyes roll back and want to hurl. While part of me agrees that this bear is not for turning, the world is awash with liquidity. I am not a perma bear or a perma bull, I just concede to the fact that the banksters on Wall Street - the very same ones that manufactured this crisis - are printing money and they are flush with liquidity which they are using to trade away in their capital markets operations.

Apart from the banksters, you got their favorite clients, the Masters of the Universe, the elite hedge funds that are also making a killing in these volatile markets. They are buying the dips too, knowing full well there is a lot of performance anxiety out there.

So where did the top hedge funds make money? Where else? According to Reuters, hedge funds bet big on Bank of America:
At least 20 top hedge funds boosted their positions in financial institutions in the latest quarter in a sign that Wall Street is ready to bet on more risky sectors in the hope of longer-term rewards.

The push into financials indicates that fund managers including Steven Cohen and John Paulson, who are watched closely as barometers of risk, have shifted from routine merger arbitrage plays to directional bets that have more potential.

The aggressive switch was given credence by stress tests conducted by U.S. regulators that underscored the underlying health and viability of banks -- if they could raise capital.

Low stock prices also made banks a safer play, even if their profitability was still in question, said James McGlynn, manager of the Calvert Large Cap Value fund.

"It's a fundamental bet that they won't go to zero, and that liquidity will come into the system" over time, said McGlynn, whose fund owns shares in Bank of America(BAC) and JPMorgan (JPM). Big banks have "breathing room," he said.

Positions in big financials such as Bank of America and JPMorgan Chase stood out among the holdings of hedge funds in the second quarter, according to a Thomson Reuters analysis of regulatory filings.

The group of 30 hedge funds in the analysis increased their exposure to the financial sector by 56 percent to $59.5 billion (36.9 billion pounds) in the second quarter compared to the first.

Filings showed at least five of the top funds bought into Bank of America, led by Paulson's purchase of 168 million shares. Shumway Capital Partners, run by Tiger Management alum Chris Shumway, bought 24.1 million shares and Timothy Barakett's Atticus Capital bought 26.9 million.

Notice that these hedge funds did not "hedge" in the second quarter; they took directional bets and bet on financials in a big way. Keep that in mind, because when I tell you most of them are charging alpha fees for beta, that's exactly what they're doing.

The top hedge funds, like Soros Fund Management, are soaring while rival firms shrink:

Soros Fund Management had $24 billion in assets at the start of July, up more than 14% from the end of 2008 and more than 41% from a year earlier. That made the firm the fifth-largest in the hedge fund industry, up from sixth at the end of 2008, AR said.

Soros was one of the few investment managers to foresee the global financial crisis that erupted last year. As markets collapsed, he stepped back into trading, helping the firm's flagship Quantum Endowment fund gain almost 10% in 2008. This year, the fund was up almost 19% through the end of July, AR reported.

Another manager who saw trouble ahead was John Paulson, head of Paulson & Co. After generating huge gains in 2007 from bets against mortgage-related securities, Paulson continued his winning streak in 2008, partly by betting against financial institutions.

This year, Paulson bet big on gold and has taken large stakes in Bank of America and Citigroup . His funds were up as much as 16.38% through the end of July, AR said.

Despite those gains, Paulson's assets under management still dropped more than 6% to $27.2 billion this year as investors redeemed some of their money to rebalance portfolios to avoid being too concentrated in certain funds and strategies, AR said.

Paulson is the third-largest hedge fund firm by assets, maintaining its position from the end of 2008, AR noted.

Bridgewater Associates, run by Ray Dalio, remains the largest hedge fund firm in the world, overseeing $37 billion in assets at the start of July. That was down more than 4% from the end of 2008, AR said.

The asset-management division of J.P. Morgan Chase remains the second-largest hedge fund business, with $36 billion in assets, up 9.4% from the end of 2008, AR said.

D.E. Shaw Group remains in fourth place with $26.7 billion in assets. That was down 6.6% from the end of 2008, AR said.

The asset-management division of Goldman Sachs ranked sixth, up one place from the end of 2008. Assets under management inched up to $20.8 billion, AR said.

Och-Ziff Capital Management was seventh in AR's rankings. The firm, run by Dan Och, lost 6.33% of assets in the first half of 2009, bringing its total to $20.7 billion, AR said.

Baupost Group, run by Seth Klarman, became the eighth-largest hedge fund firm, with assets of $19 billion, up 13% in the first half of 2009, AR said.

Farallon Capital Management, headed by Thomas Steyer, saw assets fall 10% to $18 billion in the first half of this year. That left the San Francisco-based firm ninth in AR's rankings.

Angelo, Gordon & Co., Avenue Capital Group and Renaissance Technologies tied for tenth in AR's rankings, which $17 billion in assets.

Interestingly, Reuters reports that Och-Ziff funds have recouped most of 08' losses:

Hedge fund firm Och-Ziff Capital Management's funds are delivering double-digit returns and have mostly recouped last year's heavy losses, allowing the industry titan to soon begin charging incentive fees again.

The New York-based firm's flagship OZ Master Fund, Ltd gained 17.06 percent in the first eight months of 2009 after having lost 15.9 percent last year when most hedge funds suffered heavy losses during the financial crisis.

But not all large hedge funds are doing well. In fact, last year may have been the worst ever for the global hedge fund industry, and it’s doubly true for the funds of hedge funds who suffered huge outflows:

The redemption crises that struck many single-manager funds were amplified by the run on funds of funds, which in turn filed their own withdrawal requests with their underlying manager. It’s no surprise, then, that 42 of the 50 largest fund of funds firms in the world saw their assets drop, some dramatically so.

Amidst the carnage, UBS’ Alternative and Quantitative Investments remained the largest fund of funds shop with $31.4 billion, according to the Hedge Fund Journal’s Fund of Hedge Funds Global 50. While it holds the top spot, 2008 was not a good year for the UBS group, as its assets under management plummeted 32.6%.

One of the six funds that actually reported an increase in assets—two declined to provide earlier figures—Blackstone Alternative Asset Management was second, adding $5 billion in new assets since Sept. 30 to reach approximately $25 billion.

As for the rest of the top five, it was a bloodbath representative of what the rest of the industry suffered. Union Bancaire Privée shed 27.8% of its assets, leaving it with $23.8 billion. Man Investments dropped 46.3% to $23 billion, while HSBC Alternative Investments dropped 51.9% to $22.27 billion.

(click on image below)


Another well known hedge fund that suffered massive redemptions, Cerberus Capital Management, is looking to start two new funds with a three-year lock-up:

Cerberus Capital Management is making sure it never again suffers a redemption crisis like the one in which it is currently enmeshed. The New York-based alternative investments firm will impose a three-year lockup on two new hedge funds it aims to launch later this year.

Cerberus hopes to raise several billion dollars for its Cerberus Partners II and Cerberus International II, successors to its current hard-luck funds. Investors in the existing funds are pulling more than 70% of their assets after they lost nearly 25% last year on bad bets, including Cerberus’ ill-fated takeover of Chrysler.

The long-term lockups are Cerberus’ way to make sure that never happens again, according to the Financial Times.

But many of the firm’s redeeming investors balked at a lockup, demanding quarterly liquidity to join the new funds, Cerberus said last month. Mark Neporent, the firm’s chief operating officer, said investors holding about 60% of the fund’s total assets were moving their money into a liquidation vehicle that will return capital over the next three years. The rest are moving to the new fund, lockups and all.

Investors are right to balk at any three-year lock-up. In these markets, I wouldn't lock my money up for three months, let alone three years. Cerberus is one of the best distressed debt funds, but if they want a three-year lock-up, they should dicusss this with the private equity managers at the large pension funds, not the external hedge fund managers.

Right now, investors are clear of what they want from hedge funds, and it looks like transparency is surpassing performance as a criterion for choosing a hedge fund:
Despite hedge funds returning to positive performance, we believe investors will be looking at more than just returns in the future. The recent market crisis highlighted four factors of increased importance.

Most rated hedge funds with a 10-plus year history have generally understood that they can succeed or fail by leverage -- borrowings or embedded leverage in instruments that can magnify both gains and losses -- and have accordingly used it sparingly. Some funds have come to shun the use of leverage altogether because of its inherent risk. We have seen funds with historically low leverage [1 to 2 times total assets to risk capital] reduce it even further as a result of the experience of the past 18 months. As we note in our rating criteria, with high leverage comes the high likelihood that cash flow will be insufficient to cover costs and adequately compensate key employees, leading funds potentially to close, if not default.

We evaluate the level of leverage in a fund from an absolute basis -- the debt-to-equity ratio -- but also adjust this ratio based on several factors, including embedded leverage of the instruments and the volatility of the asset values. In general, we believe investors will be more attracted to hedge funds that use low to modest balance-sheet leverage relative to their investment strategy in conjunction with a strong risk management system, which should enable them to respond to market changes more promptly.

Building Investor Goodwill

As with leverage, investors will likely increasingly judge a hedge fund based on the transparency of its dealings with all its business partners. As we note in our criteria, the highest-rated funds are those that provide the greatest transparency and demonstrate the most developed infrastructure and culture of risk controls. At the most basic level, we look for management's willingness to communicate and seek ways for investors or service providers to attain the assurances they need. In some instances, managers have achieved this by engaging agreed-upon procedures with an independent third party such as an audit firm. Where a sensitive matter such as investment strategy is concerned, funds may use dated examples to bring across the relevant points in public statements. In some cases, we've observed funds create investor letters with sufficient detail that investors can adequately judge the merits of performance and risk attribution.

Many funds have realized that the benefits of being transparent outweigh the potential cost from the outset, enhancing investor goodwill. After all, during times of uncertainty, such as the recent financial crisis, investors' focus seems to shift to return of capital from return on capital.

Investors have become wary of hedge funds' use of gating, which can limit the amount of total outflows that can occur at a given time. Historically, gates were used to benefit investors by preventing them from exiting en masse, which could cause the fund either to collapse or to sell assets in a down or illiquid market. Investors understood that management would only gate if it intended to regain its prior years' losses, or a "high water mark." It expected the fund to make the money back or shut down and pay it back to investors. However, some hedge fund managers used gates because in the lead-up to the crisis, what they believed to be liquid investments turned out to be less so, and that caused managers and investors great losses. Funds also used gates to provide a safety net for the fund's own liquidity shortfalls.

Whatever the reason, when hedge funds closed the gates of hedge hell, they lost a lot of good-will. Moreover, the flip-side of transparency is liquidity, which is why 2008 spelled the death of highly leveraged illiquid strategies.And mark my words, the brutal shakeout in the hedge fund industry is not over.

For those investors who were caught out by the lack of liquidity and transparency in their holdings in 2008, managed accounts can address these issues, as well as the more publicized fraud concerns. But I agree with Christopher Rose of Clear Lake Consulting Group, managed accounts for hedge funds are not a panacea.

Some large investors are opting for the traditional fund of funds route. According to Bloomberg, China Investment Corp. (CIC), the country’s sovereign wealth fund, is continuing to shift its investments away from cash and is investing billions in hedge funds and private-equity funds:

China Investment has invested “many times” the $500 million that CIC was reported to have placed in hedge funds and private-equity firms in June, Lou said today in an interview in Beijing. He said China Investment was also investing in fund-of- funds.

Lou said Beijing-based CIC’s performance this year “has not been bad” following last year’s 2.1 percent decline in its global investments. He didn’t elaborate. China Investment Corp. had $297.5 billion in assets and had 87.4 percent of its global portfolio invested in cash and cash equivalents at the end of last year, the fund reported earlier this month.

In December, Lou said he didn’t “dare to invest in financial institutions” after losing money on investments in Blackstone Group LP and Morgan Stanley. CIC raised its stake in Morgan Stanley in June by buying an additional $1.2 billion of shares.

CIC aims to allocate $6 billion to hedge funds by the end of 2009, company adviser Felix Chee said in June. Chee, who is a special adviser to the chief investment officer of CIC, said he will initially run CIC’s hedge fund and proprietary trading effort.

According to Dealscape, In June, CIC put $500 million into a Blackstone hedge fund unit and bought another $1.2 billion of Morgan Stanley's stock. Moreover, according to Reuters, the CIC will increase new overseas investment this year by around 10 times from the previous year on signs the global economy has bottomed out, one of the organization top managers said in an interview with Japan’s Asahi newspaper.

Like I said at the start of this post, the world is awash with liquidity, so keep buying them dips and pay attention to the hedge fund heave-ho. It looks like things are getting bubbly all over again.

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