Hedge funds show resilience in thorny times
By Henny Sender
Published: January 28 2008 19:37
Thanks to grandpatb of the BV board..
Hank Paulson, US Treasury secretary, was chairing a lunch in New York this month with luminaries from investment banks, private equity firms and hedge funds to discuss regulation of the financial markets when Michael Novogratz interrupted.
The former Goldman Sachs trader who is now president of Fortress Investments, a hedge fund with $40bn (£20bn, €27bn) under management, pointed out that for years the assumption had been that hedge funds would bring financial disaster. Mr Novogratz went on to observe, according to one participant, that instead it was the banks that “blew up the world”.
The point was undeniable. Indeed, Morgan Stanley managed to lose more money on writedowns and a single trade gone wrong than Long Term Capital Management and Amaranth – the two most prominent hedge fund failures of recent years – combined. To be sure, hedge funds were also hard hit by the market upheavals of 2007. But most funds proved far better at risk management than the banks. They cut their losses more swiftly and ended the year with record profits in many cases.
Last year, in other words, hedge funds left Wall Street in the dust. As a result, the most successful of them have become more powerful than ever before. Indeed, a hedge fund – TPG-Axon Capital, which has some $12bn in assets – was among those contributing to the capital infusion for Merrill Lynch.
“If you are handing out report cards for 2007, the hedge funds are looking like some of the smartest kids in the class at the moment,” says John Coyle, head of the group looking after private equity firms at JPMorgan in New York. “There was a common belief that hedge funds would be the most exposed when the capital markets turned. That has not happened to date.”
Whether the Wall Street business model is terminally flawed or merely poorly executed, hedge fund managers say their own template is superior. “Because it is our capital, we move more quickly to reduce risk,” says the head of risk at a big Connecticut-based hedge fund.
At the banks and brokerage firms, many hedge fund managers argue, there is a weak alignment of interests between staff and shareholders. Incentives are skewed toward uncontrolled risk-taking on the theory that heads, the traders win; and tails, the shareholders lose. They are playing with other people’s money but the bonuses when they bet successfully are all theirs.
The experience of Jeff Larson of Sowood Capital Management in Boston illustrates the discipline that hedge fund managers have, even when the market goes against them. Mr Larson pulled the plug on his fund when debt market trades went wrong last summer, costing him and his investors about 55 per cent of their money. But to his peers, he did the smart thing, swiftly cutting his losses.
“Jeff admitted in five seconds that the market had overwhelmed him and took decisive action,” says the head of prime brokerage at one Wall Street firm with knowledge of the situation. “If it had been a Wall Street firm, everyone would have gotten zero back.”
The best hedge funds have strict loss limits, in many cases, written into their offer documents. By contrast, Morgan Stanley’s senior management knew in August about the huge risk being carried by the proprietary trading desk, where bets for the group’s own books are taken. But it was only towards year-end that the bank unwound this – with disastrous results.
Had Morgan Stanley moved more swiftly, say in October when markets rallied, the losses would have been less. Indeed, one senior executive at Morgan Stanley calculates that speedier action could have kept losses below $1bn rather than the $9.4bn it wrote off last month.
Certainly, there are hedge funds whose managers, beguiled by the 20 per cent of the upside that goes into their own pockets, continue to swing for the fences, reasoning that if the losses are too heavy, they can wind up their funds and in some cases start anew. Even the 20 per cent can be an illusion, because the gains are often only on paper rather than the cash hedge fund managers receive after they close out lucrative trades.
The power of hedge funds is evident in the rise of Fortress itself, which went public last year. Fortress’s deep pockets are serving a variety of needs during the current market turmoil. For example, it is the biggest lender to cash-starved Harry Macklowe, whose property empire is trembling. Private equity firms such as TPG are looking to Fortress and others to raise debt for deals at a time when the bank lending market is frozen.
Or consider Citadel Investment Group. In 2006, the Chicago-based hedge fund gained an investment-grade rating for its debt and raised $500m in the bond market as part of a $2bn medium-term note programme. It is in a better position than virtually any other firm to raise capital quickly. That allows it to take advantage of the troubles of its peers – buying assets at a sharp discount, as it did with Amaranth and Sentinel Management, or acquiring stakes, as it did with E*Trade Financial Corp.
Citadel, with $20bn in assets, produced an investment return of about 32 per cent in 2007. After diversifying within the US, it is looking to expand abroad.
Growth among hedge funds is drawing not only capital but also management talent away from the brokerages, with their bureaucracies and inertia. For example, Bear Stearns held tentative talks with Fortress about a merger, in large part because the troubled brokerage needed management expertise, according to a top executive at Bear Stearns.
One reason for the migration from Wall Street to the hedge fund world is the enormous pay packages of the best and the brightest. Lloyd Blankfein, the chief executive of Goldman Sachs, the best managed of the Wall Street firms, took home a bonus of $67.5m last year. But that sum is likely to have been far exceeded by Dinakar Singh, who worked for Goldman until 2005 (and was probably the third highest paid person there), on the back of a 40 per cent gain last year to $12bn in funds he manages at TPG-Axon.
To be sure, many hedge funds have had disastrous experiences. The lean, mean hedge fund model can degenerate into the sort of “eat what you kill” culture that led to the 2006 implosion of Amaranth. Many so-called quant funds, which use computer models to buy and sell securities, posted big losses last year.
Of course, it is possible that the superiority of the hedge fund template may reverse. Some of the funds that boast that theirs is a superior business model are considering following Fortress by going public, which would reduce the differences between them and brokerages.
“It is stupid to go public,” says the head of prime brokerage who, in the case of Sowood, hailed the need for speed. “By going public, they become distracted; they take their eye off the ball. It’s not their own money any more.”
Copyright The Financial Times Limited 2008
