We have noted several times in the last few weeks that hedge fund redemptions were likely to produce another ratchet-up of intensity of the financial crisis. Nouriel Roubini has also called it as the next domino to fall.
Hedge fund have had not-so-hot returns so far this year, on average delivering losses despite promises to be able to deliver positive returns in markets good and bac. Short-selling strategies were a lone bright spot , and the powers that be put the keebosh on that.
August was bad, September certain to be worse. And a separate impulse for investors to pull money out is loss aversion. Just as investors are running to cash and gold, they are seeking to exit risky strategies and assets.
Hedge fund redemptions are particularly damaging because, if they rise beyond a modest level, they force manager to sell positions at a time not of their choosing. Worse, at this juncture, they are forced to liquidate in weak markets, depressing prices further, If redemptions go beyond a certain threshold, funds can go into a death spiral. And the price-lowering effects of hedge fund sales force others carrying similar paper to mark them at lower values increasing the likekihood that they in short order will face investor withdrawals. Plus, as a result of falling prices, if a fund used leverage, they may be required, independent of investor action, to sell assets to meet margin calls.
Reader Saboor provided a list of sightings this evening. The fact that so many papers are running pieces on the same topic says conditions are getting acute.
One thing to keep in mind: just like any sort of new business, a lot of new hedge funds fail. But the discussion here focuses on established, larger funds that are hitting the wall.
This is another example of unintended consequences of regulatory intervention. As we have discussed, one of the features of our financial system, per Richard Bookstaber in his book A Demon of Our Own Design, is that the financial system is tightly coupled, that new information or inputs move through the system in a sequence that cannot be interrupted, Tight coupling is actually a sign of bad design. If our bodies were tightly coupled, stubbing your toe would give you, say, a heart attack. The damage would move to seemingly unrelated areas rather than staying localized.
In tightly coupled systems, interventions to dampen risk generally do not work and often make matters worse. In a tightly coupled system, the way to reduce risk is to find a way to interrupt processes. The trading halt that were created in the wake of the 1987 crash were that sort of move. Moving credit default swaps onto exchanges would also be consistent with that goal.
Conversely, as the article demonstrates, the effort to reduce risk by banning short selling is leading (among other things) to more hedge fund failures, which as discussed above, will increase systemic stress.
From the Times Online, “‘We are approached by hedge funds considering fund liquidations on a weekly basis’” (recall the UK is an even bigger hedge fund center than the New York metro area):
Every week at least one British hedge fund is considering winding up its funds as catastrophic investment performance puts the sector under unprecedented pressure, an industry expert said yesterday.
Andrew Shrimpton, the former head of hedge fund regulation at the Financial Services Authority who now runs Kinetic, a consultancy, said: “The credit crisis is definitely kicking in for the hedge fund industry now. We are being approached by hedge funds considering voluntary fund liquidations on a weekly basis.”
His remarks came as CQS, one of London’s best-known hedge funds, wrote to its investors to say that its flagship $4.25billion CQS Fund had fallen 9.42 per cent for the year to date…. The fund, which specialises in convertible arbitrage – or small price differentials between bonds and underlying equities – is down more than 11 per cent for the year.
Mr Shrimpton said that turbulent investment markets and worries that investors are rushing to redeem funds were taking their toll on a sector that had experienced unrivalled growth since the turn of the millennium.
He added that the FSA’s ban on short-selling shares in the financial sector was hitting individual investment strategies, including long-short equity funds and event-driven funds. “There is a shake-out going on. Everyone is being affected,” he said. He also called on the FSA to drop its temporary shorting ban as soon as stability begins to return to the markets: “Short-sellers add liquidity to the markets; there is a clear case for dropping the ban in more stable times.”….
There was no suggestion that the fund [CQS] would be forced to wind up.
It also emerged yesterday that Toscafund, the $6billion London-based hedge fund run by Martin Hughes, was sitting on substantial paper losses on its investments in Washington Mutual and Sovereign Bancorp..
Hedge funds were bracing themselves yesterday for a rush of redemption calls as investors, particularly the super wealthy, try to withdraw their capital by the end of the year.
One manager at a London hedge fund said: “Investors are scared – they want cash. We are not going to be immune from that.”
He said that it was likely that companies that run funds of hedge funds would be hit particularly hard. Hedge funds have recorded their worst investment performance for the year to date.
Worldwide, hedge funds have lost more than 10 per cent, according to Hedge Fund Research (HFR), the Chicago-based research firm.
Almost every hedge fund investment strategy has recorded losses for the year so far, according to HFR data. Only macro investments and merger arbitrage strategies have posted gains.
Now the New York Post, “Hedge Hellfire” (the Post may seem to be an odd source, but is has broken stories on losses at some of the big Connecticut hedgies):
With once-highflying funds seeing their performance worsening, investors are pounding on the door to get their money out,…
“I’d not be surprised if, for some funds, September 2008 is their last month in business,” said Veryan Allen, who advises institutional investors on hedge-fund investments…
The summer’s volatility has already taken down commodity player Ospraie Management, which announced plans to close its flagship fund following a 27 percent drop in August. London’s RAB Capital’s Special Situations fund also has locked up investors’ money following losses of more than 54 percent.
More are expected to follow, although the full extent of the damage could take months to shake out.
That’s because investors who seek to yank out their dough as a result of the most recent turmoil may have to wait until the end of December – the result of strict withdrawal timelines.
Hedge funds often require investors to provide as much as three months’ notice before they can pull their money out. For example, today marks an opening for some redemption requests made in June, when many investors first started rushing for the exits.
To be sure, improving conditions may spur investors to withdraw their most recent redemption requests. But even if things turn around, some of their losses may not be reversible.
A long standing fund manager (Guy Wyser-Pratte was a famous risk arbitrageur in the 1980s) has barred investor withdrawals, which is generally a sign that the end of a fund is nigh. From the Financial Times:
Guy Wyser-Pratte has blocked withdrawals from his hedge fund after the veteran New York arbitrageur and activist warned that the “calamitous” market conditions were the worst since he started trading in the 1960s.
Wyser-Pratte Eurovalue, a $500m fund campaigning for change at mid-sized companies across Europe, suspended withdrawals on Tuesday after some clients asked for their money back…..
Mr Wyser-Pratte said he was blocking withdrawals to protect investors.
“I have come through ’68, ’72, ’86, ’87, ’98 and 2002,” he told the Financial Times. “But this is the worst and one has to act prudently in times like this. It is batten-down-the-hatches time.
Bloomberg discusses a narrower problem, but no less painful for the affected funds, namely, that of having assets frozen in the Lehman bankruptcy:
The list of funds trapped in the Lehman morass keeps growing. London-based MKM Longboat Capital Advisors LLP said last week it will close its $1.5 billion Multi-Strategy fund in part because of assets stuck at Lehman, according to an investor letter.
LibertyView Capital Management Inc. of Hoboken, New Jersey, owned by Lehman’s Neuberger Berman unit, told investors on Sept. 26 it had suspended “until further notice” attempts to calculate the value of its funds. LibertyView wasn’t included in the Sept. 29 sale of Neuberger to Bain Capital LLC and Hellman & Friedman LLC.
Diamondback Capital Management LLC, a Stamford, Connecticut-based hedge fund, told investors that it had assets of $777 million stranded in Lehman. A spokesman declined to comment.
Managers with a smaller percentage of assets in Lehman limbo include Harbinger Capital Partners, Amber Capital LP and Bay Harbour Management LLC, which are each based in New York, and RAB Capital Plc and GLG Partners Inc., both in London. Olivant Ltd., run by former UBS AG President Luqman Arnold, said today it can’t access a 2.78 percent UBS stake, worth about $1.4 billion, it held at Lehman…
PricewaterhouseCoopers, Lehman’s bankruptcy administrator in the U.K., where its European prime brokerage was based, doesn’t know how much money is at stake. PwC said last month it’s trying to recoup about $8 billion in cash that Lehman’s parent company allegedly withdrew from its European unit before the collapse. It will take weeks, if not longer, to sort out the mess, according to PwC.