Which Way Hedge Funds?

Date: Thursday, June 28, 2007
Author: Robert Lenzner, Forbes

The new masters of the universe are the huge hedge fund empires like Cerberus, Citadel, Farallon, Highbridge and Och-Ziff, which are fast becoming modern merchant banks to rival Goldman Sachs and Morgan Stanley, says Harold B. Ehrlich, a financial adviser to wealthy families.

A tidal wave of money--from China ($1.3 trillion), Russia ($300 billion), Singapore ($900 billion), the Netherlands ($360 billion), Norway (almost $300 billion), the Gulf States and huge public pension funds (CalPERS, the California Public Employees' Retirement System, has $243 billion)---is pouring into hedge funds.

But all this cash is also funding the giant private equity houses that place the debt from mega-buyouts with the hedge funds. This symbiotic relationship, rather than the "coming clash" that Ehrlich predicts, is really the defining financial firepower for the $600 billion in takeover debt created last year and the $250 billion high-yield debt that overhangs the bond and loan markets right now. This is one reason interest rates have backed up in the corporate bond market.

Ehrlich put his finger on a trend toward greater leverage on corporate balance sheets. Private equity firms do mega-deals, and their investment banks place the debt with hedge funds. Of course, the investment banks themselves are gobbling up companies as well and are becoming modern merchant banks a lot faster than hedge funds are.

Why should investors be worried about this trend? They've been pocketing the premiums paid for many public companies like Clear Channel Communications (nyse: CCU - news - people ), First Data (nyse: FDC - news - people ) and others. It's because of the mountain of debt being created and the way leverage is building up in the system. I'm not accustomed to poring over credit rating agency reports, but I have to admit that Fitch Ratings' "Hedge Funds: The Credit Market's New Paradigm," published June 5, is must reading for nervous investors.

Roger Merritt and Eileen Fahey have scrutinized one of the most powerful dynamics in the financial markets: the amount of lending that prime brokers (read: major investment banks) offer to their hedge fund clients. They strongly suggest that due to this lending, some $2 trillion in hedge fund assets becomes $4 trillion to $6 trillion in investable assets.

This $4 trillion to $6 trillion, by the way, matches in scale the kind of money central banks have in their reserves. One major advantage: Hedge funds have enormously increased liquidity in relation to the marketplace, as many of them trade their assets every day, making mutual funds and other institutions look stodgy by comparison.

And they raise the No. 1 specter in the markets, exemplified by Bear Stearns' (nyse: BSC - news - people ) subprime paper woes: the amount of leverage upon leverage that exists. Hedge funds borrow tens of billions from the Street. Then they invest in leveraged credit instruments or in pools of credit derivatives that themselves represent leverage.

Fitch claims that the leverage in credit derivative swaps, the fastest-growing part of the markets, is 20 times. Other asset-backed strategies have leverage of six to 10 times, while fixed-income strategies employ leverage of 10 to 20 times. Step aside and consider what this means. In some cases, it means that $5 in equity is bet on $100 in assets, compared with ordinary investors being able to borrow no more than 50% of the purchase of common stock.

"By investing in instruments that are themselves leveraged, hedge funds are able to create a multiplier effect by combining financial leverage with so-called economic leverage," Fitch says. These hedge funds, like the Bear Stearns ones, are using leverage in pursuit of higher returns than normal.

But when the markets turn against you, this leverage destroys the investor on the downside.

How markets behave in the next market downturn may depend heavily on the influx of hedge funds using leverage in their trading strategies. The prime brokers know this and are monitoring the hedge funds very carefully.

Still, as Fitch warns, "the next credit downturn may very well involve more sudden, correlated declines in asset prices as hedge funds and prime brokers seek to unwind their positions in a more risk-averse market."

Indeed, risk aversion may turn into the buzzword of the market's next leg downward.