Eric Mindich, worried about the unfolding credit crisis, slashed the leverage in his Eton Park Capital Management multi-strategy hedge fund firm by nearly half, from 2.3 to 1.3 times assets, in 2007. But it wasn’t enough; he is now paring the $11 billion New York–based firm’s leverage still further, to 1.1 to 1.2 times assets. The Eton founder sees plenty of investment opportunities in the market havoc of the past two months, but getting the financing to pounce on them is just too hard.
“Although we have considerable dry powder for future investments,” Mindich wrote in Eton Park’s third-quarter letter to investors, “some portion of this dry powder remains a function of financing availability, an area of uncertainty in the market today.”
Financing is destiny for hedge funds, and its disappearance spells bad news for a struggling industry. Consider that Eton Park is one of the rare funds to have held up well during the credit crisis. It lost just 2.7 percent in the third quarter and is down 3.4 percent on the year through September. Most hedge funds, by contrast, are suffering from grim returns and jittery investors: Assets are melting away; this year will likely see the highest level of redemptions ever.
“The key question right now is: Does the hedge fund industry survive in its current form?” says Daniel Celeghin, a director with Casey, Quirk & Associates, a Darien, Connecticut, consulting firm that advises investment managers. “If it does not survive, it will be because financing has changed drastically.”
For managers with low-levered, highly liquid investment strategies like long-short equity, times have been tough enough. But for funds running arbitrage or macro strategies that require a lot of leverage, things have been far worse. Managers need to be able to borrow money to finance their strategies, but investment banks are facing extinction, and commercial banks are skittish about lending to anyone. Margins and collateral levels have soared, when credit is available at all. Even as funds scramble to reduce their leverage or to find alternative sources of funding, analysts are predicting fund closures and mergers in a sour climate of lower returns.
In recent years, when money was cheap, the sources of capital available to leverage-hungry hedge funds seemed almost endless. Funds could look to their prime brokers or the repo markets. They could issue collateralized debt obligations, manage special-purpose investment vehicles, tap the loan markets for lines of credit or even issue public debt or equity.
That has all changed. Banks, beset by their own host of problems, can’t or won’t provide cheap money — even with the Treasury’s plan to spend up to $250 billion to buy stock in them. And the assets of many hedge funds have plunged in value, so managers have to put up more collateral to get, in many cases, less capital. Alternative options like CDOs and SIVs are simply no longer viable.
“Any strategy that relies on a huge amount of leverage is goint to have a difficult time,” says Mark Astley, CEO of Millennium Global Investments, a $15 billion, London-based currency overlay, hedge fund and fund-of-funds manager.
Prime brokers estimate that today gross leverage in the hedge fund industry is about, or slightly less than, 1 times 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 30-to-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 system but failures, actual as well as threatened, among the banks and investment banks. Tanya Beder, chairman of risk consulting group SBCC Group in New York and former CEO of Tribeca Capital Management, Citigroup’s multistrategy hedge fund firm, points out that the degree of leverage used by most hedge funds is tiny compared with that of the investment banks. Lehman Brothers Holdings, Merrill Lynch & Co. and Morgan Stanley all had leverage ratios in excess of 30 times assets going into the mortgage market collapse. Goldman, Sachs & Co. was levered by 22 times assets. As the investment banks pare their leverage — Morgan Stanley has already reduced it to 18 times assets — the amount of financing that hedge funds can get is also reduced. In the repo market, through which Wall Street dealers and banks provide short-term financing by lending to one another, the size of haircuts — the initial collateral level in repurchase transactions — has increased dramatically for banks where lending is available at all.
Hedge fund financing started drying up 18 months ago. Early casualties were often highly leveraged, credit-focused funds, like Boston-based Sowood Capital Management and London’s Peloton Partners, that borrowed through the repo markets and had exposure to subprime mortgages. Both firms were highly levered in credit-based strategies and had their financing pulled by banks.
Increased borrowing costs have also contributed to negative returns, leading investors to redeem and hedge funds, in some cases, to erect gates to prevent massive redemptions. In August, New York–based Ore Hill Partners put up a gate to limit withdrawals on about half of its $3 billion in assets in response to client redemption requests. Ore Hill invests in leveraged loans, where financing now is virtually nonexistent.
Funds specializing in convertible arbitrage, such as CQS Management in London, have been hit especially hard both by the difficulty of financing their bond positions and by prohibitions on short-selling (see “Caging the Shorts”). CQS’s Convertible and Quantitative Strategies Feeder Fund lost 14.49 percent last month, leaving it down 16.80 percent for the year through September. CQS is among several firms that have assets trapped in the Lehman bankruptcy because of financing positions with the investment bank’s London prime brokerage unit. All have had to scramble to find alternative financing options while they fight to regain their assets (see “Factoring in the Unknown”).
Some firms have chosen to lock in capital more firmly. Last year shareholders in TPG-Axon Capital Management voted to change the terms of its redemption policy so that investors can take out no more than one eighth of their capital in any quarter. “For us, candidly, redemptions are not that relevant,” New York–based TPG-Axon founder Dinaker Sing wrote in his third-quarter investor letter.
A more radical possibility is for managers to start lending to one another. Many hedge funds, such as Fortress Investment Group’s Drawbridge Special Opportunities Fund, run by Peter Briger, already act as direct lenders to corporations. “I can see a group of managers stepping into the role investment banks used to play,” says Casey Quirk’s Celeghin.
Indeed, cross-hedge-fund lending has begun to happen. Fortress considered lending to troubled hedge fund firm SageCrest Finance, a Greenwich-based credit fund operated by Windmill Management that filed for Chapter 11 bankruptcy protection in August. And $2 billion London-based Pentagon Capital Management has been a lender to hedge funds in the past.
Taking the idea one step further is Citadel Investment Group, which already offers hedge fund administration to outside managers through its Citadel Solutions subsidiary. The Chicago-based hedge fund giant, which has $20 billion in assets under management, has been talking about adding prime brokerage for at least six months now. Citadel Solutions president John Buckley, who previously was co-CFO of Europe and Asia for Lehman Brothers Holdings, believes that Citadel can offer a more efficient prime brokerage lending solution. Of course, Citadel right now has its own problems. Its $9.8 billion Kensington Global Strategies Fund fell more than 16 percent in September and is down some 22 percent for the year.
Perhaps the most radical notion comes from Citi’s credit strategies team in London. In a report published last month, they suggested that hedge funds, which are currently sitting on more than $600 billion in cash, should become direct participants in the repo market — not as borrowers but as cash lenders.
The very largest hedge fund firms have long taken steps to diversify their funding sources — among both investors and lenders. Increasingly, these funds look at their balance sheets much as they would at any other large, complex business, raising assets not only through prime brokerage and repo but often also through lines of permanent credit in the form of loans, CDOs and other structured vehicles — and, in the case of Citadel, public bond issuances or, with Fortress, by issuing public equity. Still, UBS’s Ehrlich doubts that hedge fund managers can really fill the void left by banks and brokerage firms.
“There is not enough capital in hedge funds to make a difference,” he says. “It is not a market solution; it is a niche solution. The kind of capital that is needed is going to have to come from massive pools of public capital, such as banks and other financial institutions.”
Tight financing means fewer hedge fund launches, as prime brokers simply have less balance-sheet capacity to go around. “It is going to be tough for smaller funds,” says Michael Rosen, CIO of Los Angeles–based investment consultant Angeles Investment Advisors. “Fewer firms, even in equity, will be able to get financing.”
Firms specializing in investment strategies that require a lot of leverage — or managers that simply need a large capital injection — may end up merging with funds pursuing other strategies. “Those strategies that suck up leverage are most likely to seek refuge in multistrats,” says Jaeson Dubrovay, senior consultant and head of hedge funds for Cambridge, Massachusetts–based investment consulting firm NEPC. A multistrategy manager can borrow against other assets in its firm and, when times are tough, simply get out of businesses that are not working.
Robert Hunkeler, director of investments for International Paper Co., who oversees the Memphis-based paper manufacturer’s $8.5 billion defined benefit pension plan, says he is pleased that the hedge funds in which his company invests have reduced their leverage.
“We entered into the past year with extremely low volatility, which led to excessive leveraging to get higher yields,” Hunkeler says. “We will return to more-normal levels of volatility that will be beneficial to hedge funds as well as to active management in general.”
Hedge funds are already starting to achieve higher yields and wider spreads. In areas where leverage used to be the only way to get adequate returns — like securities loans and convertible bonds — managers have begun to see possibilities that lead the optimistic among them to think they can earn double-digit returns without excessive borrowing. “We believe that the opportunities presented by this dislocation will be long-lasting, meaning that the opportunity set is likely to be robust for years to come,” Eaton Park states in its third-quarter letter. “Therefore our primary objective is to ‘get to the other side’ of the financial crisis in good health and be able to capitalize on those robust opportunities.”
