The Duffman

Every once in awhile, when not busy crafting ridiculous headlines, Bloomberg actually writes fairly decent "exclusives" on interesting finance stories. Today's tasty treat covers Phil Duff, a finance whiz that flamed out in a rather large and embarrassing way in 2008. According to Bloomberg's account, Mr. Duff earned degrees from Harvard and MIT, became CFO of Morgan Stanley at 36, and was recruited as CFO to Tiger Management in 2000. Then, he founded his own hedge fund firm, FrontPoint Partners, which he sold to Morgan Stanley in 2006 for $400 million. So far, so good.

Not satisfied with this impressive winning streak, Mr. Duff decided to try to top himself. With much fanfare in March 2008, Mr. Duff founded Duff Capital Advisers LP, claiming it would be bigger than Tiger. He secured $100 million from Lindsay Goldberg, a $10 billion buyout firm in New York, and then promptly blew through all the money in under a year. Most hedge fund start-ups would consider $100 million in investment capital to be a gift worth investing right away, particularly during some of the most volatile and interesting markets we've seen in decades. But no, the $100 million was just working capital for Mr. Duff, that he used to create some fairly spectacular infrastructure for a massive fund, without really bothering to figure out how he was going to raise any capital. Mr. Duff signed a 15-year lease, costing $5.5 million a year, on 43,400 square feet of office space in Greenwich Connecticut. The new digs had a custom food court, two jumbo flat-screen televisions, showers, a boardroom table for 20 and a skylight with panes that filtered bright light to keep traders from squinting. Did I mention Mr. Duff's $39,000 desk? Mr. Duff hired approximately 104 employees and offered some of them lucrative pay packages, although several actually invested in the fund by purchasing shares.

Right before Lehman's collapse, Linsay Goldberg started asking some questions. Well, actually just one important one: Why are you spending so much money and not earning any? They eventually forced Mr. Duff to fire many of his employees and eventually forced him to hand over control of the firm. The firm was renamed Investment Risk Management Group and changed its focus to developing risk analysis tools. The company was strung along until May 21st, when Lindsay Goldberg finished raising its next private equity fund. Cause really, embarrassing failures like this need to be swept under the rug until new investment capital is raised. The private equity concern was forced to settle with some of the former employees over a pay contract dispute, but everyone signed NDAs, so nobody's talking.

Stories of hubris and excess like this sometimes make me thankful for the great recession of 2008. Anytime people begin to resemble cartoon characters, particularly from the Simpsons, you know we are due for a correction. Mr. Duff should've seen the writing on the wall when he ordered his $39,000 desk.

GDP Finally Up

• After a full year of wrenching declines, US GDP rose by a seasonally adjusted 3.5% annual rate in the third quarter. The gain was driven by consumer spending, which rose by 3.4% in the third quarter compared with a 0.9% drop in the April-June period of 2009. You can thank our federal government for cash for clunkers, the first time home buyer tax credit, and the piles and piles of stimulus cash showered on the economy. But with unemployment at 10%, and consumers continuing to shed debt, it seems unlikely that this sort of momentum can hold for a sustained period of time. Equity markets are not impressed, posting a meek rally this morning.
• Another hedge fund scandal hits the tape, with the founder of K1 (no relation to K10, I promise) Helmut Klener arrested in Germany amid a fraud probe. The hedge fund is entangled in an international criminal investigation after banks including Barclays, JP Morgan, BNP Paribas and Soc Gen were saddled with $400 million in losses. Apparently the fund of funds deceived the banks when borrowing money to boost returns. Unheard of! In any event, details are forthcoming and likely to be juicy.
• The Fed has finished purchasing its $300 billion in Treasuries, having met its quota, and grown tired of playing patty-cake with Treasury. The program has kept long term interest rates artificially low for the past seven-months, allowing lots of folks to refi into much lower interest rates on their mortgages. Lower rates have also led to a massive spurt of bond market issuance by firms, particularly since it's so tough to get a bank loan these days. The low interest rate mortgage boom, however, will continue as the Fed's much larger $1.25 trillion game of patty-cake with Fannie and Freddie goes on through March. Given how much money Wall Street dealers have made being the middle man between the Fed and Treasury and the Fed and Fannie and Freddie, it sort of makes you wonder why the Fed didn't cut them out and trade directly with the other government entities. In any event, rates are likely to head higher so get your refis done while you still can.
• Here's a quick update on the Lembis, my favorite local real estate mogul family that punted generations' worth of real estate wealth in a few short years. Walter Lembi, managing director of the San Francisco based Lembi Group, is wanted for passing around $298,500 worth of bad checks at Caesar's Palace. Mr. Lembi was about as good at gambling away his money at the tables as he was with gambling away the real estate fortune that it took his family decades to build. Apparently, Mr. Lembi is no longer living in his Burlingame home, the address that was listed on court documents so authorities are having trouble tracking him down. Maybe they should check in one of his old apartments? Although judging from all the lawsuits, his tenants hated him so much, they're likely to rat him out.

LTCM Take Three

John Meriwether is back. Remember him? The founder of Long Term Capital Management, the hedge fund that blew itself up in 1998 and almost took down Wall Street with it? Then there was JWM Partners, a vehicle he set up right after Long Term's collapse, a much more conservative fund that only lost 44% in last year's crisis. Mr. Meriwether wound that one down, presumably not thrilled about the prospect of having to work for free to get back to that high water mark again. Not one to rest on his laurels, Mr. Meriwether is launching yet another fund, this one to be called JM Advisors. Has he discovered some new money making scheme? Nah, he's planning to stick to his tried and true strategy of relative value arbitrage, aka "making a little money for a few years before you give it all back in one fell swoop." Anyone willing to invest in this new vehicle deserves exactly what they get. But pensions and endowments should not be allowed in.

Galleon to Liquidate After Redemption Requests

Say you have some money tied up in a hedge fund that has posted nice returns for some time. Then one day you pick up the WSJ and the founder is on the front page in handcuffs claiming he's innocent of the insider trading charges brought against him and the insider trading ring he was allegedly running with some of his good buddies from Wharton. Guess what? It turns out that some of the hedge fund guru's charitable giving was funneled to Sri Lankan rebels too. That's right about the point where you put the paper down, make a phone call, yank your money out and put it into some money market fund currently yielding .002%.

No surprise then that Galleon has been swamped by redemption requests and is liquidating assets in order to unwind. A buyer is even circling around the fund, looking to scoop up any remaining assets. Innocent or not, investors don't care to wait around to find out. Why would you? After all, the market's up, the fund has had good returns so far, and serious legal issues are never something that sharpen a money manager's investing acumen. Mr. Rajaratnam will be preoccupied defending himself for some time to come.

Cerberus to Bar Withdrawals From Two Funds

The FT reports that Cerberus, the three-headed dog-like fund vehicle that loves to buy auto companies right before they go bankrupt, will introduce a three-year lock-up on two new hedge funds that it plans to raise later this year. The funny thing is that the only difference between the new funds and Cerberus' old funds is that this time investors actually know about the lock-up restrictions beforehand. You see, last December investors were denied access to their funds when Cerberus halted redemptions in response to a frenzy of requests for withdrawals from their clients. No doubt investors, who were entitled to withdraw funds based on a previously agreed to redemption schedule, were pissed off when their withdrawal requests were denied so that Cerberus could avoid having to liquidate assets at fire-sale (aka "market") prices. The fund has since relented and will allow investors controlling $4.77 billion, or 60% of the fund's total assets to have their money back, sort of. The funds will be placed in a wind-down vehicle and money will be returned over several years. I believe this is what is called an involuntary lock-up.

According to the FT article, Cerberus abhors the limelight and is really distressed over all the publicity, mostly negative, it has received in the past couple of years and has vowed to avoid high profile deals going forward. COO Mark Neporent states that "We were naive in thinking that buying Chrysler would not have been high profile. But we have always tried to avoid publicity. We are happy making money for our investors and leaving the headlines to others." As if the problem with its investments was that they were high profile, instead of just really dumb money-losing investments. Because piling tons of debt onto both an auto company and an auto finance company with uncompetitive cost structures, in the most cyclical of industries, at the peak of a credit cycle wasn't incredibly stupid? It was just too high profile. Right. If Cerberus manages to raise multiple billions later this year for its new hedge funds, I'll be shocked. Why anyone would give these clowns their money to manage is a mystery.

Another Hedge Fund Bites the Dust Amid Suspicious Activity

The Financial Times reports that Weavering Capital collapsed over a $637 million derivatives position.  If this were just another unfortunate gamble on a derivatives contract that blew up in Weavering's face, the news would've never hit the FT.  Who really cares about another small hedge fund forced to close its door due to bad bets on the market?  This particular derivatives trade, however, was transacted with an offshore entity that was controlled by the fund's founder and chief executive, Magnus Peterson.  Trading with yourself?  Never a good idea, but at least you always come out a winner.  COO Chas Dabhia, one of the few involved in the fund that was not related to Mr. Peterson, discovered the dubious trade a week ago, froze Weavering's flagship fund and called in PwC to investigate.  The fund was put into liquidation yesterday by administrators when it was determined that the claims on the trade could not be paid.  The head of hedge fund restructuring at PwC said that he could not comment on who at Weavering put the trade in place or what it was for.  I'm pretty sure even my toddler can tell you what it was for.

Although this is a small hedge fund, the story of its demise is curiously similar to the Madoff scandal in several ways.  First, the fund had posted "solid returns" of 10-12% a year for the past five years.  Second, the problem was triggered by investor requests to withdraw funds that could not be met.  Finally, on the board of the UK company were a bevy of relatives of Mr. Peterson's including his wife, his brother and stepfather.      

Hedge Fund Outflows Pick Up Pace

Outflows from hedge funds were nearly $150 billion for the month of December, bringing total redemptions for 2008 to $200 billion and total assets under management down to $1 trillion from nearly twice the size.  Despite hedge funds' best efforts to put up gates, set up sidebars, drawbridges, electrified fences, (insert your favorite euphemism for "You can't have your money back.  Try again next month.") some investors still managed to pull out cash from their formerly-favorite, high-flying, status-wielding managers.  They were the lucky ones.  The unlucky ones were those investors who placed their funds with GoldenTree Asset Management.  Although GoldenTree claims to only be down 30% for the year, they have received redemption requests totaling 25-30% of the fund, which apparently they cannot meet with cash.  The managers have opted to repay investors "in kind" (i.e. with whatever they have sitting around the office that may or may not be worth something, CDOs, ABS, CDO cubed, and maybe the office stapler if we can get an appropriate valuation.)  Needless to say, investors who will be receiving these "in kind" securities are none too pleased.  Frankly, if these securities are illiquid and can't be sold at the moment, how are investors to know that the amount of securities is actually worth what GoldenTree claims they are worth?  No doubt, the lawyers will be working overtime on this one.  

Perhaps even more embittered than GoldenTree's clients are those invested with Citigroup's Corporate Special Opportunities hedge fund.  Citi is returning 3 cents on the dollar to investors.  Believe it or not, this is actually a huge windfall for investors, as Citi bailed out the fund which would have had negative equity if it weren't for Citi's capital infusion.  CSO, according to the FT, managed almost $4.2 billion at its peak but wound up with a net asset value of about $58 million and debt of around $880 million in November.  December's results, no doubt, didn't offer any improvement and will likely just show up in the negative column in Citi's earnings results to be reported tomorrow morning.  Special Opportunities indeed! 

  

Former Peloton Co-Founder Convinces Soc Gen To Fork Over Money

Remember Peloton Partners, the $2 billion hedge fund that spectacularly lost all of its capital in early 2008, before the credit crisis really hit its stride?  One would think that the managers of a hedge fund that punted all of its investors' capital would be shut out of any money management opportunities in this difficult environment where even funds with good performance are battling redemptions.  But no.  The Financial Times reports that Geoff Grant, the co-founder  of Peloton has managed to raise approximately $130 million for a global macro fund, most of it from Soc Gen.  It's funny that a guy who missed one of the largest macro events of the last 50 years and was such a bad risk manager that he lost all of his investors' capital in about a month will now be running a global macro fund.   

Blowing up a hedge fund or a Wall Street trading desk and then quickly moving to another fabulous money making opportunity used to be a common theme.  The twisted thinking goes as follows: "he made a bunch of money before he lost it all, so he can make a bunch of money again."  For some reason, however, I thought that John Meriwether had finally put this ridiculous notion to rest.  After blowing up Long Term Capital and nearly taking down the entire financial system in 1998, Mr. Meriwether went on to found JWM Partners.  Everything was going swimmingly, until we hit another credit crisis, similar to 1998, but more severe.  JWM Partners dropped 43% through November 2008 and has halted redemptions.  The thing is, if you're going to suffer catastrophic losses every time the market has its big credit correction every 4-10 years, you have no business managing money.  You have learned nothing from your previous mistakes, and you're just a one trick pony who only makes money in bull markets.  Even a monkey can make money in a bull market.  The secret to being a good investor is making it though the bad times and being around to take advantage of good opportunities when markets get crazy.

So, Mr. Grant, you get a second chance.  Let's hope you learned your lesson the first time around.  As for Soc Gen, well, at least Mr. Grant's fund will be a better bet than the one they made on Jerome Kerviel.

Banks Enabled Leverage in Madoff Scheme

What is worse than the lack of due diligence performed by the fund of funds that invested nearly all of their capital in the Madoff funds?  The banks that allowed the "feeder" funds to leverage their bets on the Madoff.  According to the Financial Times, HSBC, RBS, Nomura and BNP Paribas lent money to the fund of funds so they could lever up their investments in Madoff.  A simple ponzi scheme after all, is really nothing compared to a leveraged ponzi scheme.  These loans were ultra-safe, of course, because they were secured by "assets."  RBS (now mostly government-owned) and HSBC were extremely conservative by only allowing two-times leverage on the imaginary assets in the feeder funds.  Nomura, on the other hand, in an attempt to shirk its image as a conservative Japanese bank, allowed thrice the leverage on the underlying imaginary assets.  One would think that the banks would try to verify that some assets actually existed before going crazy with the lending.  But one would be wrong.  Little, if any due diligence was performed.  Much like the fund of funds, they were not hesitant to collect their fees, just didn't really want to work to justify them. 

Fund of Funds Party is OVER

Contrary to popular opinion, the best job in America for the past ten years or so has not been that of a hedge fund manger.  Sure, rich people threw money at hedge fund managers, their prime broker let them lever up 50 to 1, and they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills.  No, the best job in America was that of a fund of hedge fund manager.  Why?  Because rich people threw money at fund of funds managers, their prime brokers let them lever up, they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills AND they didn't actually have to do any of the hard work entailed in trying to outperform T-bills.  What fund of funds managers were supposedly paid for was evaluating hedge fund managers and protecting their investors from potential fraud and losses in riskier assets due to a lack of diversification.  Fund of funds were supposed to be mutual funds for rich people.  Except with much higher fees.  This way, if you happened to be a grocery store magnate who had significant assets to invest, but didn't really have the time or patience to follow the market or care to hire your own private investigators to follow your hedge fund manager around, you could rest assured that you were paying someone a truckload of money to do it for you.  The fund of funds industry was founded on this principle.  It was a very clever money-making scheme.  Until Friday.

The most curious part of the Madoff Ponzi scheme pertains not to the rich people handing over their life savings to one guy without asking any questions.  Charming con men have always been able to talk the rich into parting with their cash.  What I find most amazing about this particular fraud is the unearthing of gross negligence in the fund of funds community.  So far, a fund of funds outfit called Fairfield Greenwich has announced the largest loss, that of $7.3 billion from its investment in Madoff's fund.  A $7.3 billion investment would be a perfectly reasonable allocation if Fairfield Greenwich managed around $1 trillion in assets.  But, alas, Fairfield Greenwich only managed $14 billion, having allocated more than half of its assets to one fund - a fund that was notoriously secretive, didn't have a legitimate auditor, or a separate custodian.  So I have to ask:  What exactly did the people at Fairfield Greenwich do all day?  I mean, other than calculate the fees they were earning on the phantom 10% returns that the Madoff fund "generated" for its investors?  After they performed all of that difficult and complicated due diligence that led them to believe that putting $7 billion into one fund was a fabulous investment decision, how did they spend their time at work?  They obviously weren't looking at confirms and making sure that all the returns tied out.  Did they even get statements from the firm?  From what I have read in other reports, the Madoff fund sent out statements that resembled this: "beginning balance $1 million, ending balance $1.2 million," without any further detail.  Weren't the crack investigators at Fairfield interested in a little bit more detail about how their returns were generated?  I am not casually throwing the term "investigator" around either, for one of the founders of Fairfield Greenwich was a former enforcement officer with the SEC, which perhaps explains why the SEC didn't unearth the ponzi scheme before Mr. Madoff's sons turned him in.    

Fairfield was not the only fund that perpetrated such negligence in its asset allocation decisions for clients.  Several other funds are on the list of offenders that had inexplicably large allocations to Madoff, with a few allocating ALL of their assets.  Did the managers of these fund of funds really think that their laziness and complacency was worth the multi-million dollars in fees that they collected?  Certainly their investors don't anymore.  Most of these funds will be sued to high heaven as investors go after refunds of fees collected on profits that never existed.  They won't survive and the founders will be tied up in a mass of litigation for years.  Furthermore, the fund of funds redemption game will begin anew.   

      

Madoff Fraud Exposes Regulatory Weakness

How do you perpetrate a $50 billion ponzi scheme?  The details are still hazy, but a few clues that something was amiss at Bernie Madoff's investment fund were enough to keep at least one shrewd advisor from steering clients into the massive fraud.  An advisory firm named Aksia, attempted to replicate the "split-strike conversion" strategy, using a quant analyst who failed to reproduce the returns indicated by Madoff's fund.  Furthermore, since all of the firm's assets were custodied with Madoff Securities, rather than a third-party clearing firm, Aksia investigated the auditor Friehling & Horowitz.  F & H only had three employees, one of which was a 78 year-old living in Florida, one secretary and one active 47 year-old accountant.  The office was in Rockland County, NY and was only 13ft x 18ft large.  Given the scope of Madoff's investment operation, the auditing firm appeared small.  Why other advisory firms and fund of funds firms didn't perform the same due diligence remains a mystery.  After all, what purpose do all of those extra fees on top of fees serve if not to fund extensive due diligence?  It is remarkable how many wealthy and sophisticated investors forked over money to Mr. Madoff given the lack of transparency.  Furthermore, it is even more incredible that some very wealthy investors were so enamored with Mr. Madoff that they handed their entire net worth over to one fund.  The Wall Street Journal has several interesting articles covering many of the issues raised by the Madoff debacle.  The victims of the fraud included many well known wealthy investors and Jewish charities.  Furthermore, an entire enclave in Palm Beach where Mr. Madoff recruited investors has been decimated by losses, with four ultra-luxury condos hitting the market this weekend in one resort, and investors calling the local high-end pawn shop on a Saturday (when it is ordinarily closed) to get loans. 

Where exactly was the SEC?  Asleep at the switch again.  According to the Wall Street Journal, the SEC investigated the firm several times over the years and came up empty-handed.  The agency's enforcement division even investigated a whistle-blower's concerns in 2007, but closed the probe without bringing a case.  Additionally, Mr. Madoff registered his firm as an investment advisor in September 2006 and was not examined within the first year, as is the  requirement for new investment advisors.  The SEC did not sue until December 11, 2008 when Mr. Madoff's sons turned their father in after his confession.  Clearly, there is something very wrong with the regulatory structure of the US securities industry if it cannot unearth a scheme this large without a confession from the guilty party.  The fact that this monumental scam went undetected for so long is mind-boggling and will be a tremendous blow to the hedge fund industry.  Make no mistake, if investors were scrambling to get their money out of hedge funds before the Madoff fraud was unveiled, redemption requests will only increase significantly on the heels of this news.  Analysts who have been calling for the industry to shrink by 30-40%, will have to revise their estimates much higher.  Try 70%.  That's if they can get around the "gates."    

Hedge Funds Overwhelmed by Redemption Requests, Uh Oh

Speculation has mounted in the past month about the number of hedge funds that would be forced to close their doors due to poor performance.  Hedge funds were supposedly bracing themselves for record redemption requests from investors by hoarding cash.  Noted hedge fund managers, such as George Soros, were making dire predictions about the industry shrinking drastically.  Now that the year-end is upon is, it appears as if the shrinkage may have been understated.  The past couple of days have been littered with headlines announcing that large hedge funds had halted redemptions due to an overwhelming amount of requests for capital withdrawals.  What's even more curious is that hedge funds with relatively decent performance have had to act to halt redemptions in order to keep from penalizing the investors that wish to stay in the fund.  Yesterday's announcement by Tudor Investments of its intent to halt redemptions was a bit of a surprise.  Tudor investments was only down 5% so far, a screaming outperformance of just about every single asset class with the exception of John Paulson (Paulson is his own asset class.)  Redemptions in Tudor Investments were halted so that the firm could avoid having to dump all of its liquid assets and leave its loyal investors holding a bunch of illiquid crap.  Perhaps the securities were liquid at some point, but not anymore, which begs the follow-up question: Is the fund really only down 5%?  

Today brought a string of similar headlines from hedge funds.  Fortress halted withdrawals from its global macro fund after it received requests for $3.51 billion, or nearly 50% in withdrawals.  The Fortress Global Macro Fund might ring a bell to my regular readers.  Back in August, I wrote about the manager of that fund receiving a $300 million share grant from Fortress, to keep him from leaving when the fund was already down 12% on the year.  Equity holders in FIG who may have been irritated at being so heavily diluted just to keep someone "motivated" can at least take some comfort in the fact that his $300 million grant is worth a heck of alot less today.

Dealbreaker had post after post today of funds posting lousy performance numbers and announcing halting of redemption requests, names including Farrallon and Highbridge, two of the largest and most well-respected funds in the hedge fund community.  I shudder to think of what we're going to hear in the redemption department from Citadel, which was already down nearly 40% on the year.  

All of this frantic pleading for a return of capital makes me ponder who wants their money back and why?  In particular, why all the redemption requests from funds that have performed reasonably well?  The obvious suspects are the pensions and endowments that have contributed to the hedge fund boom of recent years by increasing allocations towards alternative investments.  Clearly they are getting killed and need to raise cash to meet obligations as the value of all of their investments has fallen across the board.  If that is the case, then really, the hedge fund redemption frenzy will probably be over by year end.  Lots of shops will close, and those that are still standing will be able to buy assets on the cheap.  What concerns me is that the answer is far more ominous.  It's possible that many of the redemption requests are coming from rich people who are blowing out.  One of the things about this downturn that has been somewhat interesting is the number of very wealthy people that have been forced to liquidate stock holdings because of excessive personal leverage (Sumner Redstone and the CEO of Chesapeake to name two that come to mind.)  While it may be the case that wealthy investors are pulling money from hedge funds because they are worried about the market and the economy, it may also be the case that they really need the money.  Perhaps they got a little over extended, they have loans to repay, can't sell any one of their houses, have watched their stocks crater, have contemplated selling the family jewels, and frankly, they just NEED SOME CASH.  I suspect that a nice Fannie Mae conforming loan with a 4.5% interest rate is not even going to begin to solve their problems.          

       

Exotic Illiquid Investments Losing Luster With Pensions, Endowments

According to the Wall Street Journal, The Pennsylvania state employees' pension fund may be forced to make cash payments of $2.5 billion or more to Wall Street trading partners, due to investments in a "complicated" strategy referred to as "portable alpha."  Portable alpha is basically a leveraged bet on hedge fund performance.  An investor buys derivatives to match the market's return (the beta) and then uses the excess cash to invest in hedge funds (the alpha.)  According to the Wall Street Journal, an estimated $75 billion or more has been invested using portable alpha, with pension funds being eager players.  This strategy worked brilliantly from 2003-2006, as did pretty much any investment in anything during the bull market.  Leverage in a bull market is fantabulous.  Those who weren't around during the Long Term Capital kerfuffle in 1998 just recently learned: leverage in a bear market is deadly.  What has contributed to the deadliness of this credit market blow-out is the use of leverage to enhance returns on illiquid investments.  It's one thing to borrow a bunch of money to buy stocks or plain vanilla bonds.  The market goes down, you are forced to sell your stocks and bonds to repay your debt and it's over.  You're out of business but it's a pretty quick hit to the market.  However, stocks and bonds are fairly liquid.  What happens when you are leveraged and invested in illiquid assets, such as private equity funds, hedge funds, land, and oh, I don't know, timber?  Now you have a big problem.  Maybe you thought your hedge fund was liquid, but, um, no, now that it has frozen all redemptions due to the fact that it is down 65% for the year, and it was invested in all kinds of crap you never understood; not so liquid.  Your private equity fund?  Oh yeah, those guys have been in the business for years, everyone is clamoring to get into that fund because it's so prestigious.  I'm sure I can just sell my stake in the fund to someone else who really really believes in the Chrysler, GMAC, Freescale [insert name of highly cyclical company taken private at the peak of the economic cycle and loaded up with debt] turnaround story.  Except that, um, maybe not.  Because, you see, Harvard and a host of other investors who used to have a long investment horizon are now rushing to sell those stakes too at discounts of over 50%.  Also in line to punt private equity stakes are AIG (must repay government loan) and Lehman (must finish liquidating to complete bankruptcy process.)  The problem is; too many people rushing for the exits, and far too few lined up to buy either because they can't or because they believe that even a 70% discount is a crappy deal.

Investors have learned a very hard lesson in the past year.  The common refrain pitched by Wall Street to investors with supposedly long time horizons was that the extra yield offered by less liquid investments was worth the risk of tying up your money in assets that weren't easily redeemable.  Unfortunately, investors didn't demand enough of a premium for liquidity risk.  Now that they need the money, they are paying the price by having to sell their stakes at huge discounts.  What this has created is a yawning divide in the price between liquid and illiquid assets that, frankly, should've always existed.  Sure stocks are down around 40% on the year.  But many hedge funds are down more, and if they've frozen redemptions, good luck ever getting your money back.  Hedge funds have turned out not to be liquid investments.  Private equity funds don't have to mark to market, but given the lack of an exit strategy for most of their investments, they are facing a much longer time horizon than expected to reap any returns.  The time horizons, of course, will be shortened when a host of firms that were recent leveraged buy-outs go bankrupt because they were terrible investments. 

Given the horrible returns that pensions and endowments are certain to post this year, there will be a huge backlash towards the alternative investing that has been the rage for the past several years.  Risk premiums will return to more realistic levels without everyone chasing after the same investment strategies.  Ultimately, extraordinary investment opportunities will abound for those willing to take the risk.  Investors who have patiently sat on the sidelines for years because they didn't believe all the hype, will be in a position to cherry pick from a variety of investment options offering significant returns.  Fees for hedge funds and private equity funds will be reassessed and reduced significantly.  The alternative investment party is finally over.      

Hedge Funds Suffer From Losses, Redemptions, Lack of Humility

US hedge funds suffered $43 billion of withdrawals from investors in September.  Seriously?  Only $43 billion?  I would've guessed much more, given how lousy hedge fund returns have been.  Since investors have to give their hedge funds some notice before they pull their money out, September's redemptions are probably not an accurate reflection of how many investors will be stampeding for the exits before the end of the year.  Some industry insiders are expecting hedge fund assets to shrink by around 50% in the coming months, with some of the decline coming from lousy investments and the balance from redemptions.  No doubt much of the volatility in the markets is due to hedge funds liquidating to meet anticipated investor redemptions, in addition to forced liquidations.

Bloomberg is reporting that Highland Capital Management, a hedge fund with roughly $33 billion under management, will unwind its Crusader and Credit Strategies Funds.  According to the letter sent to investors informing them of the funds' unwinding, the funds suffered from "unprecedented market volatility and disruption."  It's funny that the folks at Highland seem to actually believe that they were somehow the victims of market volatility that they should not have been expected to foresee or manage.  I suggest that Highland's investors were the victims of lousy investment decisions and poor risk management and deserve an apology from their hedge fund managers instead of a letter filled with excuses.  After all, had Highland put on the exact opposite of their trades, the funds would have returned 30% to investors, rather than losing 30%.  I am fairly certain that in that situation Highland would not have issued a letter claiming that their magical outperformance was due to unprecedented market volatility.  No.  They probably would have said it was due to superior investing talent and skill and hiked all of their fees.  I will never understand how fund managers can possibly think that they were not responsible for losses because markets behaved in unpredictable ways.  Why is it so hard for these jokers to just apologize?  Something like this might be nice: "We're so sorry for losing your money.  We had no idea that this credit gravy train was going to come to such a screeching halt.  Due to the enormous losses we have taken this year, my fellow portfolio managers and I will gladly refund any fees we have collected from you on profits from prior years that have now been wiped out until you are made whole."  If you've been getting paid 2 and 20, you owe it to your investors to at least feel bad about losing their money and not send lame letters offering excuses for your poor investing judgement.  If you're a hedge fund manager and you don't know how to apologize, please view the following video for instructions:   

Hedge Funds Struggle to Maintain Prestigious Image Amid a Barrage of Embarrassing Headlines

The reputation of hedge funds as a safe harbor for assets during market downturns has suffered numerous blows in the past year.  Through July, hedge funds were down 3.5% this year, according to data tracker Hedge Fund Research.  Investors may begin to ask themselves if the meager outperformance of the stock market is worth the risk of investing in a typically highly leveraged investment vehicle.  Remember Peloton Partners spectacular blow-out earlier in the year?  What about the seizure of Carlyle Capital by its lenders in March?  The number of internal hedge fund implosions and bailouts at investment banks in the past year (Bear Stearns, Citi, UBS etc.) have made it hard to believe that investment banks are still offered capital to manage.  The current CEO of Citi, Vikram Pandit, became a contender for the top post because Citi paid $800 million for his hedge fund Old Lane Capital despite unspectacular returns.  Since then, the fund has been shuttered due to disappointing performance and Citi has taken yet another writedown related to the restructuring.   

If you open the Wall Street Journal's Money and Investing section today, two highly embarrassing stories related to hedge funds may catch your eye.  First, a piece about how WexTrust Capital bilked a group of Orthodox Jews out of at least $100 million through an alleged ponzi scheme, followed by a story about an ex-UBS trader's hedge fund that has posted losses of 85% since the inception.  There is nothing funny about siphoning money from religious investors, many of whom based their investment decision on an uninformed Rabbi's personal recommendation.  The ex-UBS trader story, on the other hand, is kind of funny, although obviously not for any of the investors who have lost 85% of their money.  First of all, the founder of SRM Global, Jonathan Wood, managed to negotiate a five year lockup out of his investors when the fund was founded in September 2006.  Then he proceeded to invest in nearly every high profile flameout of the past year.  He was a big shareholder in Northern Rock, the U.K. bank that was bailed out by the Government.  Mr. Wood has since accused the U.K. government of using an unreasonable valuation process when it bailed out the bank, and that shareholders were shortchanged.  He also criticized Bank of America's bid for Countrywide as being too low.  The fund owned 8% of Countrywide as of early April.  Mr. Wood seems to have trouble accepting the ramifications of investing in insolvent financial institutions.  One can argue in Mr. Woods' defense that he merely picked the wrong sector to invest in.  However, the fund also owned Cheniere Energy, whose shares are down 86% for the year.  The energy sector has outperformed the overall market this year.  Yet, somehow, Mr. Wood managed to find the one energy stock that has posted a performance equivalent to a bank with subprime exposure.

Only one positive hedge fund headline has hit the papers this week, and it was related to an eye-popping compensation package.  Adam Levinson, the chief investment officer of the $8.8 billion global macro hedge fund was awarded a $300 million share grant by his bosses at Fortress Investment Group.  The fund has a solid performance history, although it is down 2% for the year.  Mr. Levinson reduced his profit-sharing interests in certain Fortress funds in return for the 31- million-share grant.  Mr. Levinson's trade of a huge chunk of equity in return for a reduced profit-sharing arrangement on a fund that is down on the year (i.e. profit = $0) is quite savvy.  Now that is great trade, for Mr. Levinson of course, not necessarily for Fortress' shareholders.  But if he routinely makes trading decisions such as this for his hedge fund investors then he is certainly worth the money.

Without a doubt, the large reputable hedge funds who have generated outsized returns to their investors for many years will continue to thrive.  In particular, the funds that saw the housing bubble from a mile away and managed to architect the right trades to profit from it will have no trouble raising capital.  But the days of raising $1 billion in a month just because you worked at a high profile investment bank are probably over.  Getting leverage of 100-to-1 from your prime broker will more than likely not be an option, making it harder to generate high enough returns to justify your fees.  Hopefully, the days of raising hundreds of millions of dollars on a Rabbi's recommendation are over too.  This is unfortunate for me alone, because I had a great investment strategy I was just about to pitch to my Rabbi this afternoon...

Citigroup in a Pickle, Again

In a desperate attempt to avoid being sued by its retail investors in April, Citigroup chose to bail Smith Barney investors out of Falcon, a hedge fund that lost 75% in three months. Institutional investors are now stepping up to the Citi bailout trough. Wachovia and Fifth Third have disclosed enormous losses from investments in Falcon. According to the Wall Street Journal, Fifth Third is suing the insurer and brokerage firm that arranged the investments. Fifth Third and Wachovia had invested in Falcon through their Bank Owned Life Insurance assets. For those unfamiliar with BOLI, this is life insurance that banks take out on their employees in order to collect money if and when their employees die. If you think it is morbid and creepy that banks hope to collect money when their employees die, rest assured that they have ulterior motives. Apparently, BOLI is some sort of a tax shelter.
Fifth Third and Wachovia had invested over $600 million and $1 billion in Falcon respectively and are now facing combined losses of approximately $1.2 billion. They weighed the embarrassment factor of disclosing the losses against the magnitude of $1.2 billion. Although it was probably a very close call, they chose to suck it up and go after the money. After all, Citigroup has already set a precedent by propping up other hedge funds that were failing and bailing out its retail investors in Falcon. It is true that institutional investors shouldn't be able to sue for refunds based on the "we didn't know what we were doing" defense, since it is their job to know. But it's worth a shot. Citi has already written down $40 billion in losses and raised $44 billion in new capital. What's another $1.2 billion, if investors are willing to continue to throw money at the bank? Note to Wachovia and Fifth Third: If you're looking for a better place to put your BOLI money, give me a call. I'm thinking of starting a hedge fund that comes with a guarantee that it won't lose more than 50% in the first three months.

"Peloton says sorry for $2bn losses..."

but thanks for the fees you paid us last year!  According to the Financial Times, Peloton Partners, the formerly $2 bln, now worthless hedge fund, offered 7 reasons for its spectacularly swift decline.  It could have summed up nicely by telling investors to read "When Genius Failed", the book that gives the hilarious account of how Long Term Capital blew-out in 1998.  It's the same story, with slightly different details.  However, in what was called an emotional conference call, Ron Beller, co-founder, tried to score sympathy by sharing that staff and partners had invested $127 million in the fund and lost it all.  Granted, that is alot of money to lose and I feel sorry for them, but I'd like to point out that most of that money more than likely came from the fees that Peloton collected from its investors when it posted 87% returns last year.  Moral of the story?  Every 4-10 years a leveraged disaster occurs.  It's why Warren Buffett always has $40 billion in cash sitting around.  Because when spreads widen unexpectedly and everyone is dying to invest at amazing levels but can't because they are losing their shirts, my buddy Warren steps up to the plate and knocks it out of the park.  God, I love that man!