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[ThatHawaiiGuy]

The Next Moment of Truth

http://www.financialarmageddon.com/

The lightly-regulated hedge fund sector is known for its lack of transparency and liberal use of borrowed money. Given that, most people would naturally have assumed that these operators would be at the forefront of the kind of epic financial disaster that has unfolded over the past year or so.

Yet up until recently, that has not been the case. In fact, despite some notable failures and hiccups -- including the meltdown of Amaranth Advisors two years ago and upheavals among the "quant" funds in August 2007 -- hedgies have not really taken center stage in the current crisis (except, perhaps, for those who managed to bet correctly on which banks, brokers and insurers would suffer the most for their prior sins).

Still, given how contagious the crisis has been since since it first began -- you know, back when people like the Fed Chairman were reassuring everyone that problems in the subprime sector would remain "contained" -- there was never really any question about whether many of these Masters of the Universe would eventually get sucked into the vortex of the Great Unraveling and add to the chaos.

Based on the following Financial Week report, "Hedge Funds Wilt in Credit Drought," it looks like that particular moment of truth will soon be upon us.

Investor redemptions could cull herd of hedgies; 700 to 1,000 funds may disappear by year-end

The hedge fund industry is poised for a massive shake-up as investors demand the return of billions of dollars from both struggling and thriving funds.

Hedge fund investors had until Sept. 30 to notify managements that they wanted to recall their money by the end of the year. While it's not yet clear how many investors submitted redemptions, the number could be sizable given the relatively poor performance of the sector lately.

The squeeze on hedge funds from the credit crunch is two-fold: a recent ban on shorting instituted by the Securities and Exchange Commission as a result of the crisis eliminates an important trading tactic, while the crunch itself limits their ability to use credit to add leverage.

The industry as a whole was down 4.85% for the year at the end of August, according to a key index at Hedge Fund Research, which tracks hedge fund strategies. A wave of redemptions could lead to the largest industry culling since 2005, the last time it experienced mass redemptions.

Struggling hedge funds could translate into more bad news for corporate America, which is already reeling from the credit crunch and dismal consumer spending, among other things. As the hedge fund industry has ballooned to $2 trillion in the last several years, it has become a vital source of capital to corporations in the form of debt and equity, said Mitchell E. Nichter, partner in the corporate practice of law firm Paul Hastings.

“Hedge funds are just one possibility on the liquidity menu,” Mr. Nichter said. “If their capital dries up, then that's another source of capital that won't be available to corporate America.”

For instance, a report last year from consulting firm Greenwich Associates found that hedge funds were responsible for nearly 30% of all fixed-income trading in the U.S. That market, and others, could take a hit as hedge funds shrink, said Mr. Nichter.

Some 700 to 1,000 funds are expected to disappear this year, depending on how bad things are through December, estimates Ken Heinz, president of Hedge Fund Research. The industry shrunk by about 10%, or 850 funds, during a rough patch in 2005.

The total scope of redemptions in 2008 won't be known until funds start reporting their assets in the coming weeks, Mr. Heinz said. A look at the first half suggests more pain ahead, though. About 350 funds closed as the industry raised $30 billion in new capital through June, down from $117 billion in new capital during the first half of 2007, according to his data.

“We've seen an increase in the rate of liquidations,” Mr. Heinz said. He expects a flight from low-performing to high-performing funds, as recent research from his firm shows an historic performance disparity between average and top-tier firms. He also expects money to bleed from arbitrage funds, and relative-value funds, among others.

Charles Gradante, managing principal of hedge fund adviser Hennessee Group, is even more pessimistic than Mr. Heinz when it comes to the toll the current economic woes will take on hedge funds. He said the reduction could be as high as 2,000 funds, as restrictions on short-selling and lack of leverage cut into the industry's returns.

Given the recent failures among prime brokers, most notably Lehman Brothers, hedge funds have found it more difficult to borrow more from brokers to cover margin calls. Meanwhile, his firm has found that investors drew down about $80 billion, or 4%, of their money from the hedge fund industry in the latest quarter, the largest redemption in any quarter since his firm started tracking such data in 1987.

Anecdotal evidence that redemptions now are ahead of even that pace started to emerge last week. In announcing an operating loss for the first half of the year, Swiss hedge fund Absolute Capital Management said last week that it expected more of its clients to withdraw their money.

British fund manager RAB Capital last week took steps to stem redemptions from its struggling special situations fund. The firm announced that investors in the fund, which has lost more than 60% of its value since last year, agreed not to withdraw their money for three years in exchange for more favorable rates.

“We're wondering ourselves if the hedge fund model is as viable as it was before,” said Mike Guarasci, chief operating officer at Indus Capital Partners, a hedge fund that primarily uses a long-short equity strategy in the Asia-Pacific and European markets.

In the wake of the shorting ban, hedge funds have been looking to alternative strategies. Among the strategies on the upswing, experts say, are distressed debt (in which a fund buys bonds issued by a company about to file for bankruptcy so it can “call the shots” during the company's liquidation) and global macro (in which a fund takes long or short positions based on the economic or political outlook for particular countries).

These strategies were on the upswing already, but the ban on shorting has added wind to their sails, experts say. Distressed debt had become big in 2000 and 2001, after the tech bubble burst, then fell out of favor until recently. Macro was one of the earliest hedging strategies, but has been seen as too volatile. However, with energy prices spiking, macro strategies are back in vogue.

Yet even some of these alternative strategies may feel the pinch. The Managed Funds Association, which represents hedge funds, has been lobbying hard against the SEC's ban on shorting.

In a letter last month, the MFA said the ban could lead to scenarios in which “some sectors that abruptly rise in value due to temporary restrictions on shorting cause sharp sell-offs in other sectors.” The association pointed to the spike and subsequent drop in energy stocks earlier this summer as an example of “sector rotation.”

Convertible bond arbitrageurs, for instance, have taken an average 4% hit in value recently, according to data from Hedge Fund Research. Convertible bond investors often trade options to convert bonds into shares, but under the current shorting ban they would no longer be able to hedge their risk in financials, which could dry up the convertible bond market, the MFA wrote.

Late last month, many funds were hurt by the ban because they had short positions that were sitting idle and then had to be closed out quickly, with little advance notice from the SEC.

“It's like driving down the highway and then you find out that your brakes don't work,” said David Friedland, a principal at Magnum Funds, which manages a number of hedge funds and funds of hedge funds.