PRT 2 - COVER STORY: HEDGE FUND SPECIAL REPORT
June 2002 Issue
By the late 1990s the business of servicing hedge funds would be
dominated by five brokerage firms: Bear Stearns, Goldman Sachs, ING
Baring Furman Selz, Morgan Stanley Dean Witter and NationsBanc
Montgomery Securities.
Some of the more active prime brokerages helped new hedge funds get
off the ground, even renting them space in warrens of offices -
dubbed "hedge fund hotels" - in New York buildings. But hedge funds
generally remained a curiosity and didn't get much backing from
investment banks. "Prime brokerage was nothing but a transaction
business," recalls James Hedges, CEO of LJH Global Investments.
"Furman Selz and Bear Stearns had their hedge fund hotels on Park
Avenue. Bear Stearns published a directory. That was it."
Fundraising for hedge funds was typically dominated by third-party
marketers, which often took a cut of future fees for the assets they
raised.
There were exceptions. Merrill Lynch raised a then-staggering $1.25
billion for Long-Term Capital Management in 1993, but that
fundraising was for former Salomon Brothers fixed-income arbitrage
chief John Meriwether, the most fabled bond trader on Wall Street.
And Donaldson, Lufkin & Jenrette helped gather about $1 billion in
1998 for a hedge fund called Ocelot, but it was being run by Julian
Robertson, already the manager of the second-largest hedge fund in
the world.
Both LTCM and Ocelot turned out to be unhappy experiences for the
investment banks and some of their senior executives. Merrill, a
major counterparty to LTCM, was one of the banks forced to step in
and prop up the failing hedge fund five years later. And DLJ
executives dropped millions of their own money when Ocelot suffered
losses in 1998 and 1999.
To be sure, hedge funds were becoming important Wall Street trading
and financing customers throughout the 1990s. Too good, on the
fixed-income side, as it turned out.
In their rush to accommodate a new group of profitable and
fashionable fixed-income arbitrage hedge funds, such as LTCM, Wall
Street investment banks provided them with vast amounts of leverage
through their repurchase desks. In the summer of 1998, a plunging
bond market and the Russian government bond default triggered a
chain reaction of margin calls and hedge fund portfolio write-downs
that nearly sank LTCM.
Wall Street soon discovered just how overboard it had gone. Two of
LTCM's biggest creditors, Merrill and Salomon, put their exposure to
hedge funds during that period at about $2 billion apiece. Sources
at the time said that Salomon's notional swaps position with LTCM
was a staggering $118 billion.
The fallout in the fixed-income world roiled many firms. Angry over
losses that they still insist were triggered by needless margin
calls, major hedge funds, including MKP and Ellington Capital
Management, filed lawsuits against the brokerages that pulled their
credit lines. The suits continue to wind through the courts to this
day, with the investment banks disputing the claims.
Brokerages cut way back on the leverage they extended to
fixed-income arbs. But they didn't sour on hedge funds. Quite the
contrary. Says LJH's Hedges, "It was in 1998 that investment banks
began seeing what a major business hedge funds could be." So a
50-year-old financial product that had just caused one of the
greatest debacles in financial history surged in popularity.
A confluence of events appears to have set off the explosive growth.
A major selling point of hedge funds is that they purport to produce
investment returns uncorrelated with those of the stock market. Such
returns are certainly a lot more attractive when the market is
plunging, as it has been in recent years. Last year the CSFB/Tremont
Hedge Fund index rose 4.4 percent while the Standard & Poor's 500
index dropped 13 percent and the Wilshire 5000 fell 10.96 percent.
Although the average hedge fund manager, like the average
traditional money manager, doesn't appear to be able to beat an
index, there have been some exceptional performances, net of fees,
by individual managers. These include David Tepper of Appaloosa
Management, who has averaged 30 percent in his Palomino Fund since
1995 (page 35); James Simons of Renaissance Technologies Corp., who
has racked up average annual returns of 37 percent over the past 12
years (page 35); and Lee Ainslie III of Maverick Capital, who has
posted net annual returns averaging 23.5 percent since 1995 in his
Hedge Equity Strategy fund (page 40).
Returns like these attract attention. And the decision in 2001 by
the California Public Employees' Retirement System, the country's
largest pension fund, to invest $1 billion of its $150 billion
portfolio in hedge funds has been an important endorsement for the
hedge fund market. "Five years ago you had hedge funds starting with
$5 million," says Robert Sherry, head of prime brokerage at ABN
Amro. "Now they're starting with $100 million."
All of this is splendid news for Wall Street, where the spoils of
the hedge fund business are spread widely among major investment
banks. The big hedge funds do business with dozens of brokerage
firms, but they concentrate their business and fees with their prime
brokers. The term is a misnomer, however, because
multibillion-dollar hedge funds almost all have multiple prime
broker relationships.
When Pequot Capital Management partner Daniel Benton split off to
form $7.5 billion hedge fund Andor Capital Management, he selected
five prime brokerages: ABN Amro, Bear Stearns, Goldman Sachs, Morgan
Stanley and UBS Warburg. He later added Lehman.
But adding up the prime brokerage mandates as a way of keeping score
can be deceiving. Just as universal banks are wielding their
enormous size and credit expertise to win underwriting business,
institutions such as Deutsche Bank and UBS Warburg are using their
balance sheets and derivatives know-how to win hedge fund accounts.
"People don't realize it, but Deutsche is huge in the hedge fund
business," says one hedge fund investor. "If you look at where the
giant convert hedgers actually keep their balances, it's at the
banks. Investment banks can't compete on cost of funding."
Banks are also involved in hedge fund activities not tied to prime
brokerage. J.P. Morgan Chase, for example, has been working on new
types of offerings that turn hedge funds into structured products.
"As the hedge fund business grows, you have to start creating
products that are more recognizable to a broader group of
investors," contends Dana Pitts, the bank's head of hedge fund
services.
But as any Wall Street marketer knows, peddling image is every bit
as important as selling substance. Morgan Stanley's annual do at the
Breakers is arguably the hedge fund world's answer to Mrs. Astor's
ball. The firm even enlisted chairman Philip Purcell as a
glad-hander. Morgan Stanley, say hedge fund executives, was
inundated this year with hedge fund investors pulling strings to get
an invitation to the exclusive event.
Goldman, however, also knows how to throw a party and whip up a
little excitement at its hedge fund soirées.
At Goldman's April 2001 European hedge fund dinner - at the aquarium
in Monte Carlo - Karel Van Miert, former European Union competition
commissioner, gave a long-winded but prescient talk. He explained in
some detail to attentive arbitrageurs in the audience why the
then-pending General Electric Co.-Honeywell International merger
might violate EU antitrust rules. The deal was killed soon after by
Van Miert's successor as competition commissioner, Mario Monte.
Competitors are determined to one-up Morgan Stanley and Goldman. At
its major hedge fund conference in December, Deutsche turned the
Ritz-Carlton Hotel in Amelia Island, Florida, into a kind of hedge
fund bazaar: Usually aloof hedge fund managers were persuaded to sit
in rooms so that investors could cruise the halls checking them out.
Deutsche even pulled the beds out of 40 hotel rooms to create
private meeting space for individual managers.
To its credit, Wall Street has brought some measure of
sophistication and rationality to the inbred,
fly-by-the-seat-of-the-pants hedge fund world. Secretive and far
from pristine, the industry has long been notorious for providing
scant information (if any at all) and for suspect fundraising
practices. A persistent rumor has been that consultants take
payments from hedge funds to recommend them to investors.
But in focusing on hedge funds, investment banks have forced
changes, making it easier for qualified investors to get reliable
performance information. Wall Street firms have also developed
useful investor tools and services, such as real-time reporting and
risk management systems.
"Capital introduction has grown in importance because it tapped into
a legitimate need of both parties," says Morgan Stanley's Barrett.
"The introductions are a positive step in addressing the hedge fund
informational void."
Wall Streeters make good cheerleaders. But will hedge fund investors
be cheering Wall Streeters a year from now?
Guaranteed trouble?
It's an appealing proposition. Investors attracted to hedge funds
because of their often spectacular returns and resilience in down
markets, but wary of their inherent risks, can protect themselves by
purchasing "guaranteed" hedge fund notes. These securities, also
known as principal-guaranteed notes, assure investors that they will
get back their original principal regardless of how much a fund
loses because of trading reverses.
Veteran traders and other market experts, however, worry that as the
popular notes proliferate, they could themselves pose risks for the
hedge fund market. "These bank-guaranteed products could become a
ticking time bomb for the hedge fund business," says
structured-product specialist Robert Gordon of New York-based
Twenty-First Securities Corp.
Developed and sold mainly by hedge fund specialists and private
banks, guaranteed notes are structured almost entirely for
funds-of-hedge-funds. In return for guaranteeing investors'
principal, the sellers charge steep fees and require that investors
give up a significant share of the upside of the underlying hedge
fund.
Hedge fund specialists say many of these notes are a dubious
investment because the guarantees come at too high a price. But
that's not what alarms them. Their real fear is that the global
banks that provide the credit guarantees that ensure the principal
of the notes, including ABN Amro, BNP Paribas and J.P. Morgan Chase
& Co., will exercise their right to sell out of the hedge funds
they're guaranteeing when the funds' value plunges below certain
levels to avoid incurring losses themselves.
That could set off a cascade of forced sales and redemptions of
hedge funds, these professionals warn, triggering a wider market
panic. The amounts involved are not negligible. One Wall Street
structured-finance expert estimates that about $25 billion in
notional value of the guaranteed notes have been sold to date. And
the danger is greatest for certain leading hedge fund strategies,
such as convertible bond arbitrage, in which hedge funds dominate
trading activity and often hold similar positions, creating the
conditions for herdlike selling behavior.
Some see ominous similarities between guaranteed notes and portfolio
insurance, the discredited 1980s hedging vehicle that promised to
protect institutional portfolios against steep market drops. Trading
experts charged that portfolio insurance exacerbated the 1987 stock
market crash by compelling institutions to sell - or dynamically
hedge, as it was termed - into the market plunge. "One bank can
dynamically hedge, but not every bank can dynamically hedge," points
out the head of a multibillion-dollar hedge fund. Portfolio
insurance fell out of favor after the crash.
Guaranteed hedge fund products come in several varieties, but the
structure causing the greatest concern is one in which banks hedge
their exposure to a fund as it falls in value. Twenty-First's Gordon
notes that one common form of these products has set defeasance
triggers to allow a bank to sell a portion of its positions in a
hedge fund if the fund declines by a certain percentage.
"Let's say the convertible market falls and you hit the trigger,"
says Gordon. "Well, a lot of convertible hedge funds hold the same
positions, so a lot of other funds get their positions marked down.
The fear is that you end up triggering and triggering and triggering
redemptions. A cascade effect is definitely possible."
Bank officials insist that such a scenario is extremely unlikely.
They point out that they guarantee widely diversified baskets of
funds, so that troubles in one or a few wouldn't have that much of
an impact on any hedge fund sector. "I can only speak for J.P.
Morgan products, and we take a very conservative approach," says
Gary Krivo, head of hedge fund corporate finance activities at J.P.
Morgan Chase. "The products we've worked on have extreme
diversification. Guaranteed products that are based upon
funds-of-funds as the asset class are not ones I really worry
about." Adds Victoria Owen, head of structured products for
alternative-investment shop Man Investment Products: "The banks have
been very risk-averse. It would take extreme conditions for these
products to start to have that effect. When I say extreme, I mean at
least twice what you had in [the hedge fund collapses of] 1998."
Assessing the potential risk is further complicated by the lack of
concrete information about the size of the market and the mix of
hedge funds that are being guaranteed. But a number of hedge fund
executives and investors, who asked not to be quoted, say that they
are indeed concerned that if guaranteed hedge fund products continue
to spread, the result could be systemic risk during a market
upheaval.
"The real fear is that it becomes a retail product," says a senior
official at one prominent hedge fund organization. "There's probably
not enough of this product to create systemic risk now. But if this
becomes how the retail market accesses the hedge fund market, then
you're going to have systemic risk." It would be ironic - though not
unprecedented - for a product designed to reduce risk to add to it
instead. |
