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Beyond the Hedge Fund Shakeout

Date: Monday, June 16, 2008
Author: Mara Der Hovanesian, Businessweek.com

Large hedge funds at prestigious global banks seem to be blowing up routinely. But that doesn't mean the world's largest financial institutions won't be the ultimate beneficiaries of a hedge fund industry in the throes of a shakeout.

So far, some 80 hedge funds have imploded as a result of the credit crunch and subprime crisis—many of which were started by star talent hailing from white-shoe investment banks in the first place. The latest casualty: Citigroup's (C) Old Lane Partners hedge fund, which the bank bought for $800 million last year from the man Citi would later make its chief executive, Vikram Pandit. On June 12 the New York bank said it would fold the ailing multistrategy fund into its alternative investments group. Pandit had personally benefited from the original sale of the fund, pocketing $160 million for a fund that at its peak had some $4 billion in assets. But key management talent had fled after the sale, and it was subsequently hit with big losses. Investors wanted out. Citi took a $202 million writedown related to Old Lane in the first quarter.

And so the decision, which comes atop the rich purchase price Citi paid, the history of the fund, and Pandit's involvement, contributes to raised eyebrows for some observers. "Now that Old Lane is valueless, [Citi] will need to write that off. Add that to Pandit's employment contract (call it $250 million), and you get America's very first billion-dollar CEO," Don Putnam, a former investment banker and founder of the financial-services research group Grail Partners said in an e-mail to BusinessWeek. "He better be damn good."

A Parade of Cave-Ins

Similar hedge fund disasters have hit other Wall Street firms. UBS' (UBS) Dillon Read Capital Management will cost the Swiss bank about $300 million. And, of course, the now infamous hedge fund blowups at Bear Stearns were the seeds of the entire firm's demise. The 75-year-old investment bank was rescued from oblivion by JPMorgan Chase (JPM) in an 11th-hour, Federal Reserve-brokered deal on Mar. 17.

Still, the hedge fund losses (Bear's dramatic downfall aside) are essentially the least of the big banks' problems at this point. Brad Ziff, head of the hedge funds advisory practice at Oliver Wyman, says that in fact there's very little that banks got right before, during, and after the mortgage and credit crisis, and are therefore suffering much larger consequences. "A poor risk umbrella contaminated all their businesses," says Ziff. Despite all that, the big players are still capturing the lion's share of new inflows from institutional investors. "So investors are saying, 'This is a good wake-up call for me.' They know that putting capital with big banks may not necessarily be safe," says Ziff. "But is that where they are still concentrating their assets? From everything we are seeing, the answer is yes."

The biggest, in other words, will continue to get bigger: The world's 10 biggest hedge funds control $324 billion in capital, up 29% since 2001, according to Institutional Investor's annual survey published in December, 2007. Some of the players in the top 10 include Goldman Sachs (GS), Barclays (BCS), Bridgewater Associates, and JPMorgan Asset Management.

Skillful Navigators

Those firms have been particularly adept at navigating through the subprime crisis and have less tarnished reputations. They stand to gain the most in coming years. Case in point: JPMorgan took a majority stake in Highbridge Capital Management in December, 2004, when the company had $7 billion in assets. Highbridge had the money-management talent and teamed up with JPMorgan to gain access to its massive sales force and distribution platform, along with connections to high-net-worth clients and institutions. Last year, Highbridge nearly doubled its capital, to $27.8 billion, from 2006, a fourfold increase in assets from when JPMorgan took its original stake. It is a model that other banks want to replicate. Indeed, Citigroup began to build a similar in-house multimanager platform about 18 months ago with 62 teams of money managers who can invest all over the world in any instrument at a moment's notice.

"Big banks have fabulous penetration of the institutional market, be it large endowments or pension funds," says Christopher Davis, president of the Money Management Institute, the trade association representing the investment advisory industry. "Plus, they may not have the ability to analyze the startups. It's a risky proposition defending why they are allocating money to something that's been operational for less than six months."

Oversight and risk-management demands by institutions investing at the big banks will certainly change. And as the big get bigger, performance will undoubtedly suffer, say some observers. A brand name that has deep pockets often offers security, but that comes at a cost, says Charles Gradante, principal of the Hennessee Group, a hedge fund consulting firm in New York. Big banks will dominate the market and are "more likely to pay out limited partners if there's a blowup, but in most cases very talented people do not want to work for a bureaucracy, unless they are very highly compensated," he says. Still, there may be extra motivation for them to team up with big banks in the short term for survival. Before the recent market rout, many hedge fund founders, such as those at Citadel Investment Group in Chicago and Blackstone Group (BX) in New York, floated public bonds and equity as a way to monetize their firm's assets. That avenue is closed for now. "The IPO is the preferred way to get your money out and still be a player in the industry," says Gradante. Adds Margaret Gilbert, managing director of Greenwich Alternative Investments, a research and advisory firm to institutional investors: "Big isn't always better, but there's no doubt that the name recognition and the power of their own distribution definitely attracts assets. Everyone knows who Goldman is."

Hedge fund investors say as much. They are bracing for more hedge fund consolidation, and their worries about who will succeed will be the big banks' gain. B. Lane Carrick, chairman and CEO of Sovereign Wealth Management in Memphis manages about $500 million for 175 high-net-worth clients. He runs a fund-of-funds that invests in a couple hundred managers, but he tends to allocate more assets in big shops. "It doesn't mean there won't be a blowup," he says. "But by owning large institutional funds we tend to eliminate the business risk."

Der Hovanesian is Banking editor for BusinessWeek in New York .