Over recent months, the list of major hedge funds that have halted investor withdrawals and/or appear to be on the brink of collapse has been growing rapidly. These developments underscore the liquidity problems being experienced by the major hedge funds. This poses a major threat to the financial markets. Hedge funds are typically among the biggest and most active players in the financial markets and further deterioration of these funds could be disastrous. Moreover, many hedge funds are intricately involved in the explosion of derivative investments that have bonded various firms and hedge funds together in ways impossible to predict. Thus, the ramifications of major hedge funds imploding presents far reaching risks to other market participants.
This impending problem was summarized in an article in The Wall Street Journal by Liz Rappaport and Justin Lahart entitled “Debt Reckoning: U.S. Receives a Margin Call.” In pertinent point, the article concludes “The resulting blow to confidence threatens to further weaken lending, borrowing, spending and investment in the U.S. economy. ‘Hedge fund blow-ups have so far been one-off situation. One worry is that we’ll cross some line and there’ll be a systemic wave of fund failures. It’s a reason why the market is so nervous’ says John Tierny, credit derivatives strategist at Deutsche Bank.”
A wave of recent developments has increased the market’s worries. In a March 5, 2008 Business Week article, “Hedge Funds Frozen Shut” written by Matthew Goldstein, Mr. Goldstein points out that “Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period.” Many hedge funds have taken this tact to avoid the forced sale of illiquid assets at fire-sale prices which would almost certainly result in huge losses for their portfolios. This is a major risk for hedge fund managers because many of these funds hold subprime securities and other asset backed securities that are illiquid and at risk of further deteriorating in value. Of course, hedge fund operators also have a vested interest in freezing withdrawals ? their fees are based on assets being managed and fewer assets under management mean lower fees. This inherent conflict of interest presents an array of additional dangers for hedge fund managers ? are they acting for the benefit of investors or for their own benefit?
Other hedge funds have taken a different approach. They have elected to liquidate their funds to maximize investor value or minimize losses rather than gamble on an uncertain future. In essence, they have determined that the fund and its investors are better off liquidating now rather than risking additional losses as time passes. For example, on March 5, Peloton Partners announced that it was liquidating its largest hedge funds as a result of mortgage investment problems. Peloton’s $1.8 billion ABS Fund had invested in various investments tied to subprime and Alt A mortgages. As these investments tumbled in value the funds’ banks, Goldman Sachs, Merrill Lynch and UBS, demanded more collateral forcing the funds to liquidate. Investors were unlikely to receive any funds in connection with the liquidation.
Similarly, on March 12, Drake Management announced that it may shut down its largest hedge fund (Drake Global Opportunities Fund) and was evaluating closure of two others (the Drake Low Volatility Fund and the Drake Absolute Return Fund). The New York money manager notified investors about these developments after sustaining significant losses last year. Redemptions had been frozen on the Global Opportunities Fund had been frozen for several months.
The liquidity problems being experienced by major hedge funds are likely to continue. Lenders, including Wall Street banks, are demanding that hedge funds pledge more money to secure their loans. According to Bloomberg.com, “Since February 15, at least six hedge funds, totally more than $5.4 billion, have been forced to liquidate or sell holdings, because their lenders … raised borrowing rates by as much as 10-fold with new claims for extra collateral.” These “margin calls” are likely to further reduce hedge fund liquidity and force additional liquidations.
The continuing deterioration of major hedge funds could throw the financial markets into further turmoil. The interrelationships and dealing between banks and hedge funds is so complex that it is difficult to predict where the losses would fall.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in representing individual and institutional investors regarding their subprime problems. For further information, please contact us.