The collapse of Lehman Brothers in September 2008 stranded billions of dollars in hedge fund assets, but few funds faced as heavy a burden as Amber Capital Investment Management. The New York hedge fund firm had nearly $900 million of its $2.9 billion in assets trapped inside Lehman Brothers International Europe, the London-based affiliate that served as a prime broker for hundreds of U.S. hedge funds.
Unable to continue operating effectively, Amber shut down and began returning its remaining assets to investors. But last year, Amber investors got a pleasant surprise: Lehman assets suddenly thawed and began reappearing in their Amber accounts. When LBIE began sorting through claims from creditors last year, among the first to be reimbursed were those that had clear rights to specific readily identifiable assets. Amber had parked its assets in a separate, unsegregated long-only account and so was able to get to the front of the recovery line.
Amber now expects that when the transfers are complete, it will have retrieved almost all of its stranded $900 million. Bolstered by that recovery, Amber recently reestablished itself with a new fund, drawing on some of the same investors who had participated in the previous Amber fund and whose loyalty was restored by the recovery.
Amber’s nearly 100% recovery rate may be particularly high, but it is indicative of the latest chapter in the long-drawn-out Lehman saga. Assets that were previously frozen have started returning to hedge funds and other creditors from LBIE, and the flow is expected to continue this year. Amber is clearly on the high side in recovery rates, thanks to its especially clear claim. Other estimates of recovery returns have been in the range of 20 cents to 35 cents on the dollar. Meanwhile, the U.S. arm of Lehman is starting to sift through claims through a bankruptcy court case, but payouts are still some time away.
The return of assets from Lehman has provided hedge fund investors a chance to reevaluate how managers handled the crisis when it happened and how astute they were in establishing their prime brokerage relationships. While assets stranded in prime brokerage accounts represented a major source of Lehman exposure, other funds got stuck as a result of swap or other derivative contracts that were left unresolved when Lehman folded.
Managers with Lehman exposure took differing approaches in accounting for their trapped assets, causing different impacts on their funds and their investors. Investors not only in Amber but also in funds of such firms as Millennium Management and Harbinger Capital Partners might be in for a nice surprise, while those in Claren Road Asset Management could be facing fresh losses.
That’s because some managers took a cautious approach to their Lehman exposure, writing those assets down to zero. Others placed minimal values on their Lehman exposure, valuing those assets in the range of 10 cents to 15 cents on the dollar. Those types of zero-to-minimal values reduced fund asset values and thus resulted in marginally lower investor fees, which are based on assets and on performance.
Millennium was among the most cautious. The Millennium International fund, which recorded a loss of 3.07% in 2008, blamed 2.6% of that on assets frozen in LBIE. Millennium wrote those assets down to zero, deciding it was unclear how much, if any, of that amount could be recovered.
Millennium now believes it will get back about $100 million. It is unclear how high a rate of recovery that total represents. But if Millennium ultimately recovers that amount, investors who were in the fund at the time of the Lehman crash should be getting checks representing money they may have thought they would never see again.
Investors in funds where managers took a more aggressive approach to valuing Lehman exposure may be facing a very different situation if the recovery comes in lower than estimated. Some managers placed higher values—50 cents on the dollar, in some cases—on their Lehman exposure. Those higher values, in turn, could be used to boost total assets, which are used to calculate fees. If a Lehman recovery winds up being low enough to change the past performance from positive to negative, investor complaints are sure to follow, since fund managers typically collect performance fees only when funds make money.
“Pricing and valuation are a huge issue here,” says Mike Hennessy, a managing director at Morgan Creek Capital Management, an asset management adviser based in Chapel Hill, N.C. “From a manager standpoint, you must bend over backward to be conservative. If things turn out better, you will get your due.”
One investor says managers who made more aggressive valuations but now expect to recover much less than anticipated will be closely monitored by investors. “Those who made money by not writing stuff off and then took incentive fees on it, the question they will get is, Are you going to pay me back those fees?”
The skirmish over valuation and fees already erupted at one fund last year. The now-$4 billion Claren Road (founded by fixed-income pros from Citigroup) valued its Lehman exposure at more than 50 cents last year, according to one investor, who complained that the higher valuation helped Claren Road post a gain of 8.5% in 2008. Claren gained more than 20% in 2009, according to the investor.
Much of Claren’s Lehman exposure was to LBIE, which held a cache of Claren bonds. According to this investor, Claren has said it will be returning incentive fees based on the Lehman exposure. Claren says it will not be restating returns.
Those who took their hits early on are now in a better position. Amber’s exposure, like that of many hedge funds, came from a prime broker relationship with LBIE. That London arm of Lehman ran a thriving prime brokerage business that counted about 600 hedge funds as customers. The potential impact on funds that used LBIE as a broker could be substantial.
Ramius Capital Group, for example, suffered a 4.9% loss in its multistrategy funds at the time of the Lehman bankruptcy, which it blamed on assets frozen in LBIE. Ramius placed its Lehman exposure in a side pocket and valued it at 20 cents on the dollar. Like other funds, Ramius declined to comment on its current Lehman situation. But the sizable exposure got Ramius a seat on the LBIE creditors committee in London.
Hedge funds were attracted to LBIE for brokerage services because of several financial advantages. LBIE extended greater leverage to hedge funds than U.S.-based prime brokers as a result of more liberal rules in the U.K. In addition, LBIE offered perks like service discounts and interest rate boosts to funds that would use unsegregated, or rehypothecated, accounts for their assets. Funds that elected to keep their accounts segregated typically didn’t get the discounts.
Those who didn’t and engaged in rehypothecation were the hardest hit. Under rehypothecation, Lehman could reuse assets held as collateral. If a client requested its assets back, Lehman could then repurchase similar assets. The system worked as long as Lehman remained a going concern. But if Lehman ran out of capital, as it did in 2008, the entire system collapsed. Funds whose assets had been rehypothecated suddenly discovered their assets were nowhere to be found. Instead, those funds became unsecured creditors of the bankrupt Lehman, hoping to recover some share of whatever was left in Lehman’s accounts after others got paid.
One accountant said most of the hedge funds he has dealt with that had LBIE prime brokerage exposure had taken advantage of the discounts and agreed to keep their assets in unsegregated Lehman accounts that allowed rehypothecation.
Hedge funds are more cautious about their prime brokerage relationships now, willing to pay extra fees as a form of insurance against the type of catastrophe that happened at LBIE. In addition, hedge funds have become more discreet in picking prime brokers and insuring that they maintain several active accounts to keep their assets from being concentrated with one prime broker.
After Lehman collapsed in September 2008, LBIE identified about $32 billion of client assets that it still should have held. In October 2008, a method of returning some of those assets to creditors with trust claims was developed following a hearing in the U.K. High Court. Creditors in this first group could recover their assets relatively quickly. But they had to post additional collateral, agree to repay any amounts later determined to be incorrectly returned, and also pay an additional fee to LBIE. Some funds, like Amber, took that route and got their assets back early, although at additional cost and with strings attached.
Others with claims for money held in prime brokerage accounts became part of the creditors committee that includes Ramius. That group helped negotiate a deal for repaying an additional $11 billion worth of cash and securities still held by LBIE. The plan needed approval by clients representing 90% of the assets, and that threshold was reached in December. The clients in this batch may also have assets in segregated accounts but must still settle other arrangements with LBIE.
Creditors had until March 19 to file claims with LBIE for recovery from this second pot of LBIE assets. LBIE plans to review claims and start paying out this spring.
Steve Pearson, a partner at PricewaterhouseCoopers, the joint administrator of LBIE, says claims are arriving with various levels of supporting documentation. “We have everything from absolutely sensible to completely preposterous. A statistically significant number are not within acceptable parameters.”
Clients with rehypothecated assets are likely to become unsecured creditors in LBIE’s estate and won’t share in this process. Instead, they will try to tap into other assets that LBIE turns up. As of January, LBIE had identified about $10 billion of those assets.
Hedge funds like Millennium that are in line for recovery are now making estimates of how much they expect to get back. The long-drawn-out process of Lehman recovery has presented a challenge for fund managers, who had to figure out how to value those frozen or lost assets, particularly if the assets had been rehypothecated. Michael Patanella, an audit partner with accounting firm Grant Thornton, says funds he follows were valuing their Lehman exposure at 8 cents to 12 cents on the dollar as of December 31. But as LBIE began making payments and moving forward with plans to continue distributing assets, funds have been reviewing and raising those estimates.
One benchmark for the value of Lehman exposure is the secondary market for bankruptcy claims, where holders of Lehman claims unwilling to wait for the recovery process to play out have been selling their interests. LBIE claims have been as high as 36 cents recently on Markit, a financial information service that tracks bankruptcy claim trading.
LBIE represents only one part of Lehman bankruptcy exposure. The U.S. business of Lehman filed bankruptcy separately, and that case has been proceeding at its own, slower pace. The value of claims against the Lehman U.S. entities have also been rising, with some hitting 40 cents.
The rise in value of Lehman claims has fueled some brisk trading in the secondary markets. Some of the most active trading in Lehman claims involves Lehman Brothers Holdings, the U.S. holding company for Lehman operations. Among the most aggressive buyers this year is Taconic Capital Advisors, which has been adding LBHI claims to its Credit Opportunities Fund and its Market Dislocation Fund, both of which have been filing claim transfers in the U.S. bankruptcy case this year. Other buyers of LBHI claims reflected in filings with the bankruptcy court include Silver Point Capital, Serengeti Asset Management, Elliott Management and TPG Credit Opportunities Fund. Among hedge funds that have showed up as sellers of LBHI claims in the U.S. bankruptcy case are Balestra Capital Partners, Arche Master Fund and Element Capital. Longacre Opportunity Fund has been both buying and selling Lehman claims since last year.
The changing value of claims on the secondary market further complicates the task of arriving at correct valuations by hedge funds with Lehman exposure on their books. Patanella says managers have an obligation to attempt a true value of their Lehman exposure and constantly update those values. From an accounting standpoint, being too conservative is no better than being too aggressive, since neither position would represent a true valuation.
Some investors insist that managers have an obligation to protect the interests of their investors. In the view of these investors, managers should err on the side of caution by taking very conservative estimates of their exposure value.
Balyasny Asset Management, for example, wrote down about $1 million trapped in Lehman to zero back in 2008. For Balyasny, the Lehman exposure was small enough to have very minimal impact of less than 1% of overall fund asset value.
Lehman exposure was a bigger issue for Harbinger Capital Management, a New York firm, which initially estimated its Lehman exposure at about 2% of assets. As AR reported earlier, Harbinger wrote the value to zero. Much of its exposure came from swap agreements with Lehman rather than a straight prime brokerage arrangement. One investor lauded Harbinger for writing the exposure to zero, noting that the action insured that performance fees would not be affected by recovery estimates. Harbinger declined to discuss the matter.
The Lehman bankruptcy triggered the use of side pockets, which isolated the issue. But managers still had to value the side pocket and pay fees on it. Some managers opted to forego fees on Lehman exposure estimates, or simply wrote their exposure to zero. When a Lehman recovery arrives at those funds, it is parceled out to investors in the side pocket.
While LBIE is an important link for U.S. hedge funds in the Lehman case, it represents just one part of Lehman’s global empire. Lehman operated as a collection of companies spanning the globe, and its collapse left creditors with varying types of claims in different jurisdictions. In the United States, LBHI is the main party in the bankruptcy case working its way through the courts. One of its related companies, Lehman Brothers Specialty Finance, was the counterparty for derivatives deals with hedge funds and others. Three smaller Lehman entities are also involved in the bankruptcy case: Structured Assets Commercial Corporation, Lehman Commercial Paper and Lehman Commercial Corp.
In the U.S. Chapter 11 case, a total of 64,000 claims have been filed seeking $820 billion. It is unclear how much of that is claimed by hedge funds, but Lawrence Gelber, a partner in New York law firm Schulte Roth & Zabel, who has been tracking the case, says hedge funds are likely one of the largest groups of creditors. The issue in the U.S. for hedge funds revolves around other financial arrangements, particularly derivatives contracts. One of Lehman’s biggest business lines was in derivatives, and hedge funds were among the most active trading partners. (At least one fund—the short-biased Copper River Management—called it quits in 2008 due to losses related to its Lehman derivatives exposure.)
With claims still being filed, Gelber says the total could exceed $1 trillion. When Lehman filed for bankruptcy in the U.S., it listed assets of around $600 billion. Both totals are expected to drop as the case progresses and both claims and asset values become clearer. The first plan for reorganization and settling of claims, which was filed March 15 in U.S. bankruptcy court, will likely be just a starting point for haggling over claims. Much of the jockeying that will take place in the coming months will be among those who fall into the category of unsecured creditors fighting for a share of whatever is left of Lehman’s U.S. assets.
One issue that is yet to be resolved is whether claims and assets will be addressed on a case-by-case basis or combined into a general pool that is doled out proportionately to creditors. Pooled assets could affect different creditors in different ways, potentially lowering recoveries for those with the clearest and largest claims, and helping unsecured creditors who might have done worse pursuing their claims individually.
Hedge funds with Lehman exposure might have been involved with several different Lehman entities, which has kept managers busy trying to follow developments in the various cases. Gelber says hedge funds will be watching closely as the two cases proceed in the coming months. “The biggest questions from hedge funds are, ‘What is the process for getting proceeds distributed out of the U.K. side?’, and ‘what will the reorganization look like on the U.S. side?’” Gelber says. “What am I going to get, and when am I going to get it?”
While the two bankruptcy cases proceed, related events further complicate the amount creditors might be able to collect. In the U.S., the process has become entangled with Barclays, which swept in and bought the core U.S. operations of Lehman a day after the bankruptcy was filed. Barclays paid about $1.5 billion, its takeover aided by Federal Reserve financing. Barclays also got $49.7 billion worth of Lehman collateral in exchange for advancing $45 billion to LBHI.
LBHI administrators subsequently decided that Barclays got more than its fair share in the deal. LBHI sued, saying Barclays received additional collateral and should give back about $5 billion. Barclays has denied any wrongdoing and says it got exactly what it was entitled to through the takeover. The case continues, but in the meantime Barclays has done well with its Lehman purchase. Barclays reported improved profits in its recent earnings statements, partly as a result of solid contributions from the former Lehman operation.
LBIE is watching the Barclays fight closely because it is seeking to recover additional assets from LBHI that it could then distribute to creditors in the U.K. case. LBIE contends that it had nearly $6 billion in client assets held in the U.S. when the company collapsed, much of it as a result of trading in the U.S. managed through LBIE but carried out through LBHI. LBIE wants that returned but so far has had no response from LBHI. If the $6 billion does find its way back to London, it could help boost the amounts owed to creditors in the UK. But at the same time, the shift of assets could reduce recoveries to creditors in the U.S.
The legal wrangling, combined with the task of sorting out claims, is itself a drain on available assets. LBIE has retained more than 450 Lehman employees who now work on evaluating claims and assets. In the U.S., Alvarez & Marsal, the restructuring agent brought in to run LBHI, kept about 150 Lehman employees and subsequently hired another 200 to work on the claims process. Additional lawyers and accountants are working on both sides of the Atlantic. The tab for all that administrative, legal and consulting work is expected to exceed $1 billion.
The bottom line for hedge funds caught in the Lehman bankruptcy is that sorting out the mess and getting a final accounting of it all could still be a year or more away.
All of which makes Amber Capital, which a year ago was the poster fund for Lehman losers, suddenly seem like a savvy winner.
