Banks wary after hedge fund backlash

Investment banks are learning the hard way that fat hedge fund fees are not necessarily a route to instant riches.

Half a dozen hedge funds and similar leveraged vehicles run by banks and private equity have gone badly awry in the past year, leaving lawsuits and reputational damage in their wake.

Not so standalone hedge funds. When a standalone fund fails, the managers often get a second chance, even in extreme cases such as Long Term Capital Management, the hedge fund which came close to bringing down the global financial system in 1998.

When things go wrong for a standalone fund, the individuals running it are not usually worth taking to court personally, in spite of the big fees they charge (although in the case of fraud, regulators are keen to nab high-profile hedgies).

Investment banks, by contrast, have the deepest pockets on Wall Street - and investors know it.

"It is better to have a bank or another obviously financially sound entity than an individual [to sue]," says one New York litigator specialising in hedge fund cases

The dangers facing banks as their hedge funds run into trouble come after years of efforts to attract money to their in-house funds. These can be big earners in good times thanks to annual fees of 2 per cent of assets and 20 per cent of profits.

The banks have been able to use their big distribution networks to sell in-house funds, sucking in tens of billions of dollars from wealthy individuals and institutional investors. One common marketing pitch is that a fund has access to institutional-quality infrastructure thanks to its bank link, an appealing prospect for a pension fund trustee.

But many investors are sceptical of banks' in-house funds. David Smith, who oversees $28bn of hedge fund investments at investment house GAM, says banks find it hard to balance group-wide procedures with top traders' desire for individuality.

Arki Busson, chairman of EIM Group, which has $14bn invested in hedge funds on behalf of clients, says investment banks also run the risk of conflicts between in-house funds, proprietary trading desks and advisory divisions. "If I have an equal choice I prefer to go to a boutique," he said.

However. there is one big benefit of investing with a big bank: when things go wrong at a fund the bank will still be there to rescue it or, increasingly, to be sued.

This year, a group of disgruntled investors in two collapsed Bear Stearns hedge funds seized control of them from liquidators in the Cayman Islands. Earlier this month they used it to launch a lawsuit against the bank and auditor Deloitte & Touche, alleging a "sophisticated fraud" led to $1bn of losses. Bear declined to comment, while Deloitte said the suit was "totally without merit" and it would "defend it vigorously".

Later the same week, an investor began legal action against Citigroup over a "disastrous" investment in the bank's $500m London-based Corporate Special Opportunities fund. A week later, class-action lawyers filed a suit against the bank over its US-based Falcon Strategies funds, claiming the bank pitched them as low volatility but followed high-risk strategies.

Citigroup declined to comment on CSO, where manager John Pickett has left. On Falcon, it said: "As with many other credit-based investment products, Falcon's returns have been hurt by one of the most volatile periods for fixed income in recent memory."

Even when banks are not sued, their hedge funds can cause them big financial headaches. Citigroup rescued both CSO and Falcon, providing a $160m cash injection to CSO when the fund hit problems, and giving Falcon an emergency loan of $500m.

Last summer, Goldman Sachs stepped in with $2bn of its own money and another $1bn from close allies to bail out its Global Equity Opportunities fund. The equity investment helped the highly-geared fund - hammered by the failure of its computer models to predict the market turmoil - avoid forced sales.

Most spectacularly, the closure by UBS of its Dillon Read Capital Management last May - with the loss of $430m for the bank - was the first sign of a flawed strategy that led to DRCM losses of $3bn by the year end.

Lawsuits against banks are likely to make big institutions think twice before creating new hedge funds, says Angelos Metaxa, who oversees $3bn in hedge fund investments at CM Advisors in Geneva.

"Liability issues and name issues are important for the banks so they are going to be treading more carefully in future," he said.