Hedge funds: sorry seems to be...

For the world’s rich and powerful, the first few days of each month used to bring a little package of joy: an update from their hedge-fund managers telling them how well their investments were doing. For a decade it had been a stream of good news. The markets are up, we are beating them, and you are richer than you have ever been.

For the past couple of months, however, opening the monthly letters has become a painful - and in some cases devastating - experience.

Investors are being told that their money is evaporating and, in some of the worst-performing funds, that they can’t take it out. The one thing the hedge-fund bosses are not saying is sorry.

“September was a devastating month for financial institutions and investors around the world,” was how Ken Griffin, the founder of Citadel, began his most recent letter to investors. The $17 billion (£10.6 billion) fund has suffered losses of 35% in two of its core funds.

Griffin admitted that he did not “fully anticipate” the extraordinary market conditions that led to Citadel’s worst month in its history - but there was no apology.

Blame, on the other hand, is something he and his peers are adept at dishing out. “The decision of regulators around the world to ban the short-selling of equities created material dislocations across many of our portfolios and disrupted our ability to assume and manage risks,” said Griffin.

David Einhorn, the poker-playing founder of Greenlight Capital, which made an estimated $1.7 billion by shorting Lehman Brothers, also took a swing at the regulators in his October letter. It was not, he argued, “his speciality to guess how some erratic actors in Washington will behave”.

“The loud complaints about short-selling are acts of desperation to distract attention from the real problems by business leaders [and now government leaders] that have been caught with their pants down,” he wrote.

With his funds down 16.4%, 15.2% and 14.4% for the year, some might say that Einhorn was the one caught with his pants down.

Why can’t hedge-fund managers just say sorry? “They are never going to be self-flagellating,” said one veteran fund manager, “because if they are, they open themselves up to litigation risks - investors could go after them.”

Sometimes apologies of a sort stray into an investor letter. Consider the October circular from Lee Ainslie III, managing partner of Maverick, where performance across its five funds was down between 14% and 40% in the third quarter.

“Unfortunately, I cannot find words to describe our disappointment, embarrassment and shock over the above results,” Ainslie wrote.

“I find management teams that blame disappointing performance on environmental factors rather than their own poor decisions quite frustrating - and in reviewing the above I recognise that I have just done that, and I apologise.”

Some market players believe hedge funds shouldn’t be apologising. Rob Mirsky, a hedge-fund adviser at the accountancy firm Ernst & Young, said: “I can’t say that I’ve heard many hedge-fund managers say sorry, but I’m not sure they have a lot to apologise for. The market conditions have been exceptional. Did some managers make stupid bets? Sure, but they also made some brilliant returns over the past five years.”

Another hedge-fund analyst painted a less forgiving picture. “If you’re a master of the universe and you apologise for something, then you’re not omniscient and why would investors trust you in future?”

HEDGE FUNDS have attracted huge sums from investors because of their key promise to provide “absolute returns” - or profit - regardless of the market’s direction.

This promise enticed main-stream investors, including institutions and pension funds, into an asset class that was originally the preserve of the rich.

The prospect of all-weather returns also induced investors to accept hefty fees: hedge funds take 2% simply for managing the money and 20% of the profit generated.

Investor appetite, coupled with investment banks’ willingness to provide cheap money for leverage, fuelled the sector’s growth.

In the past eight years, investment in hedge funds soared from $500 billion in 2000 to nearly $2,000 billion today, according to Hedge Fund Research (HFR). The smaller rise in the previous decade - from $38 billion (1990) to $500 billion (2000) - gives a guide to just how rapid the recent expansion has been.

The number of funds also grew exponentially. The last HFR report put the total at 10,000. Some of these traded in stocks and bonds, others were in currencies and arbitrage, but they all shared one common goal: to make money - or at least not lose money - when markets fall.

The biggest winners from the hedge-fund phenomenon were the top-dog fund managers. Philip Falcone, founder of Harbinger Capital, paid himself $1.7 billion in 2007; John Paulson, who made bets predicting the American housing market would crash, took home $3.7 billion and Citadel’s Griffin paid himself $1.5 billion last year.

In many cases their incredible wealth has been tempered by philanthropy. Chris Holn, founder of The Children’s Investment fund, donates 0.5% of TCI’s assets under management to a charitable foundation run by his wife.

Arki Busson, who made his £250m fortune by raising money for hedge-fund veterans Paul Tudor Jones and Louis Bacon, has hosted the annual Ark (Absolute Return for Kids) charity gala for the past six years. This year, despite the effects of the credit crunch, the bash raised £25m, only £2m less than last year.

If any of the hedgies at the dinner knew what lay ahead, though, they might have been less inclined to scribble fat cheques for shooting parties or Louis Vuitton luggage sets.

THREE MONTHS after the Ark ball, Lehman Brothers collapsed with billions of dollars worth of hedge-fund trades tangled up in the carnage. “Trades have not been settled, cash has not been returned,” said one fund manager days after Lehman’s crash. The situation has not improved since then, with the administrator Price Waterhouse Coopers still grappling with the complexity of the situation.

A handful of managers in London and New York were forced to liquidate funds as a direct result of the Lehman failure, including the flagship funds at MKM Longboat and Powe Capital.

After Lehman, life became even more difficult for the hedge funds. Regulators in America and Britain, faced with the imminent collapse of some of their largest financial institutions, banned the shorting of financial stocks.

This was a big shock. Short-selling is the speciality of hedge funds, and overnight one of their main trading strategies was taken away.

Over the next few weeks the bad news kept coming. Many funds that had backed shares in commodity companies found themselves caught out by a sudden slump in prices. Banks, eager to conserve cash, started to withdraw their facilities from the hedge funds they had cosied up to during the good times, pulling the loans that had allowed the funds to maximise their financial firepower.

“The industry is broken,” said one fund manager last week. “Banks are not putting up cash to trade, there is extreme illiquidity, and the disruption in the markets is going to continue.”

Experts last month predicted a 30% mortality rate among hedge funds but as the situation deteriorates the same experts are speculating that that figure could rise to 35%-40%. Everyone is predicting a much-needed shake-out of the industry, which will leave only the best-performing managers.

John Godden, head of the hedge-fund consultant IGS Group, said: “This is fundamentally Darwinian. There are going to be a lot of losers but the surviving players will be a lot stronger.”

Continuing volatility in the market makes it difficult to predict who the winners will be, but the runners include John Paulson’s $35 billion Paulson & Co, which is posting returns of between 5% and 25% this year. Paypal founder Peter Thiel’s Clarium Capital was up 18.9% in September. London’s biggest macro trader, Brevan Howard, is up 14% this year in its main fund.

For most hedge funds and their investors more pain lies ahead. A number of large fund managers are expected to follow RAB Capital, GLG and Polygon in suspending redemptions. Blocking redemptions in “exceptional circumstances” is permitted but some believe this could be the final blow to the industry.

“The reputation of the industry is already in tatters,” said one fund manager. “Moving the goalposts [by suspending redemptions] will not do anyone any favours. People will never go back.”

A lot of these funds are desperate. Greenlight’s letter to investors quotes a line from A League of Their Own - the film about a girls’ baseball league in America during the second world war . The quote - “There’s no crying in baseball” - comes from the scene where the coach, played by Tom Hanks, berates one of the girls for making a costly mistake.

Greenlight used it in the context of the sudden rule change on short-selling. It hit hard, the fund manager said, but it was not worth crying over. Investors, however, may be feeling differently.