Saturday, February 27, 2010

When Hedge Funds Blow (Reprised)


Note: Two years ago, I wrote this piece for the first time, and many of you have suggested that given events since it needed updating. (Also, many of you never saw it to begin with as the distribution list was much smaller then).


The biggest single impediment for investors contemplating an investment into hedge funds is “blow up” risk. This skittishness is understandable given all the publicity that attends the self-immolation of any hedge fund. Heck, the media eats it up - Rich guys get theirs! Blow-ups score a 10 on the CNBC schadenfreude scale. On the other hand, the mere thought causes dyspepsia among investors, particularly those of an institutional variety. For them, blow up risk translates into “headline risk,” which translates into “pink slip” risk.


How common are hedge fund blow-ups? How often do they happen? What do they do to returns? These are questions I wanted to get to the bottom of.


Fishing around, I found surprisingly little research on the subject, so I thought it might be useful to conduct a survey of my own. Specifically, we will look at hedge fund blow-ups through the years to see what kind of conclusions can be drawn. For many of you, this will be a stroll down memory lane.


Note: I define blow-up as an NAV loss of 50% or more, and in some cases the numbers are estimates. If I’ve missed any, please let me know, as I will post and update this on my blog. Perhaps we can become the “official repository” of blow-up data.


Hedge Fund Blow-Ups – A Brief Historical Survey


1994


Askin Capital Management

David Askin, a star mortgage trader of the day, can lay claim to being the father of the modern hedge fund blow up. Interestingly, the industry had gone from its inception in 1948 to 1994 without a notable hair ball. Of course, the industry was tiny back then. Askin ran a mortgage fund that specialized in some of the complex mortgage instruments that had recently come into existence. If this doesn’t sound familiar, perhaps you’ve just returned from a long vacation. The Fed raised rates unexpectedly, crushing the risky “principal only” tranches on which Askin had loaded up, with leverage.


Losses: $600 million

Cause of death: Excessive leverage, concentration


1997


Niederhoffer Investments


Author, squash champion and philodox Victor Niederhoffer gets squashed by a leveraged bet on Thai stocks.


Losses: $130 million

Cause of Death: Excessive leverage, concentration


1998


Long Term Capital Management


The ne plus ultra of hedge fund blow-ups. John Merriwether’s LTCM cratered when third world credit problems led to a sudden repricing of risk. Their book, seemingly diversified, was basically long risk and short safety. 40-1 leverage (accounts vary) led to margin calls they couldn’t meet and, subsequently, a Fed-engineered bailout by Wall Street. “When Genius Failed,” an account of the collapse, is recommended reading.


Losses: $4.6 billion

Cause of death: Excessive leverage


2000


Manhattan Fund


Run by Michael Berger, a native Austrian, this fund shorted technology stocks from 1996-1999. Oops, a tad little early on that trade. Losses prompted Berger to falsify his track record, which caught up with him by 2000. Arrested, he skipped bail and remained on the lam for a few years until he was caught in Austria.


Losses: $400 million

Cause of Death: Fraud


Laser Advisors


Run by former Goldman partner Michael Smirlock, Laser concealed a series of bad bets on options by falsifying position prices on exotic securities. Smirlock spent three years in the Big House and now does charity work.


Losses: $70 million

Cause of Death: Fraud


Ashbury Capital Partners


This one, at $8 million, is a rounding error but it’s too good to leave out. Manager Mark Yagalla told investors he had averaged 80% in his personal account for nine years. He was 23 years old. Hmm. He blew most of the money on his girlfriend, a Playboy centerfold by the name of Sandy Bentley. Among other thing he bought her furs and, yes, a Bentley, which she promptly sold for cash. Yagalla bought himself a helicopter. When his assets were seized the centerfold dumped him, news of which was promptly reported to Ripley’s Believe it or Not.


Losses: $8 million

Cause of Death: Fraud


Marque Partners


Rob Littel, a pal of JFK junior’s, had a magic black box that promised to churn out 20% returns regardless of market direction, only he wouldn’t explain it to anyone. Which makes sense, since all his box did, apparently, was eat money. Shortly thereafter he started lying about returns. Pleading poverty, he paid a paltry fine to the SEC. Immediately after this, he signed a book deal for a nice advance to write about JFK’s secrets, a book called “The Men We Became.” From ripping off investors to selling out a dead friend, Littel is currently not considered a candidate for the Integrity Hall of Fame.


Losses: $120 million

Cause of Death: Fraud


2001


Integral Investment Management


The Chicago Art Institute suffered most of the loss here when this relatively unknown fund turned out to be a low-level scam. The term “headline risk” became widely used after this case, as the Institute had egg all over its face. The fund-of-funds industry, with its implicit protection from embarrassment, took off in the aftermath.


Losses: $70 million

Cause of Death: Fraud


Lancer Group


Lead manager Michael Lauer manipulated the prices of penny stocks to inflate investment performance. Morgan Stanley got taken in by this one, as did former Sotheby’s Chairman Al Taubman.


Losses: $200 million

Cause of Death: Fraud


2002


Lipper Convertible Fund


Ken Lipper was a former Deputy Mayor of New York City. He was a former Salomon Brothers partner and Columbia professor. He even wrote the book “Wall Street” that later became the Oliver Stone movie. (Greed is good!) None of this meant, apparently, that he wasn’t a scam artist. His fund got killed in the convertibles market so he started falsifying returns. Julia Roberts got taken in by this one which, I know, is hard to believe.


Losses: $350 million

Cause of Death: Fraud


Beacon Hill Asset Management


These guys got tripped up by the mortgage market (I sense a developing theme…) and started falsifying returns. Does that ever work out? Lots of institutional names got caught up in this one, and it ranks as one of the bigger frauds.


Losses: $800 million

Cause of Death: Fraud


Eifuku Master Fund


This was a Japanese fund, the name of which, if only slightly mispronounced, must have phonetically captured the sentiments of its founders. (Do not try to figure this out in front of your children, at least not out loud.)


Losses: $300 million

Cause of Death: Concentration, excessive leverage


2004


Sterling Watters


Angelo Haligiannis, a college drop-out from Queens, raised $27 million, mostly from friends and family, by lying about his returns. Haligiannis skipped on his bail and was arrested two years later in Greece.


Losses: $27 million

Cause of Death: Fraud



Angelo Haligiannis, a college drop-out from Queens, raised $27 million, mostly from friends and family, by lying about his returns. Haligiannis skipped on his bail and was arrested two years later in Greece.


Losses: $27 million

Cause of Death: Fraud


2005


Portus Group


Set up as a Canadian hedge fund for the little guy, Portus accepted investments for as little as $5000. Money allegedly used to buy stocks was diverted to pay expenses.


Losses: $150 million

Cause of Death: Fraud


Bayou Group


Your basic Ponzi scheme with returns fabricated to cover losses. Only these guys took it a step further: they actually started their own accounting firm – complete with the waspy, fiduciary-sounding name of “Richmond Fairfield” – to sign off on fraudulent audits. Founder Sam Israel tried to fake his own suicide by parking a car on a bridge and leaving a suicide note. Nobody was buying. Israel was caught a few days later and sentenced to 20 years.


Losses: $450 million

Cause of Death: Fraud


Wood River


How’s this for a hedge fund strategy: put 80% of your money in one high tech stock. That’s exactly what Wood River did, investing in a stock called Endwave, which promptly fell from $54 to $10 a share. One problem was that the fund’s marketing materials spoke much about benefits of diversification. Another was that Wood River never bothered to tell the SEC they owned 45% of Endwave.


Losses: $200 million

Cause of Death: Concentration, fraud


KL Group


This one was fraud from the outset. Perhaps recognizing their own limitations, they never even tried to make money. The proprietors, three Koreans, skimmed $150 million from the Palm Beach society crowd, all the while claiming 125% returns. Money was used to live large, however briefly. (Note to future scammers: don’t overreach, 20% is far more credible, and the scheme will last longer. For more on this, see my blog post, “Creating the Perfect Ponzi,” posted in February ’09.)


Losses: $130 million

Cause of Death: Fraud


2006


Matador Fund


Author, squash player…wait, this guy again? Victor Niederhoffer becomes the first hedge fund operator to blow up twice, qualifying immediately for the Blow Up Hall of Fame.


Blow-up Artist Niederhoffer


Losses: $190 million

Cause of Death: Excessive leverage


MotherRock L.P.


Big bet on natural gas futures goes the wrong way.


Losses: $230 million

Cause of Death: Concentration, excessive leverage


Amaranth Advisors


A sophisticated, $9 billion hedge fund in Greenwich gives most of their capital to a 29 year-old energy trader in Canada, who then makes a gigantic spread bet on natural gas futures with 8-1 leverage. Ka-Boom.


Losses: $6.4 billion

Cause of Death Concentration, excessive leverage


2007


Sowood

Caught off guard by a sudden widening in credit spreads (see Long Term Capital), Sowood announced a 57% loss. Founded by ex-Harvard endowment wiz Jeff Larson, the fund counted Harvard as one of their core investors. Harvard took a $350 million hit, which amounted to a 1% hit to their endowment.


Losses: $1.5 billion

Cause of Death: Excessive leverage


Bear Stearns High Grade Structured Credit Strategies Fund


This mouthful of a fund was the canary in the coal mine of the credit crisis. A big bet on subprime mortgages goes horribly wrong.


Losses: $1.6 billion

Cause of Death Concentration, excessive leverage, and maybe a really bad name


2008


Carlyle Capital Group


This $230 million fund was founded in 2006 by the eminence grises of the private equity arena, the Carlyle Group. The purpose was to buy mortgages using tons of leverage. Oops.


Losses: $220 million

Cause of Death: Excessive leverage


Blue River Asset Management


Munis are safe, right? Maybe not. Denver-based Blue River has the distinction of being the first muni hedge fund blow up. Lots ‘o leverage.


Losses: $500 million

Cause of Death: Excessive leverage


Focus Capital


Here’s an odd one: a New York-based long-short fund that specialized in small cap Swiss equities. They lost 80% when they had to liquidate on margin calls. Perhaps an office in Geneva next time?


Losses: $800 million

Cause of Death: Concentration, excessive leverage


Lancelot Investment Management


How’s this for a bad idea: take all the money in your hedge fund and give it to one guy with one strategy. In this case the “guy” was Tom Petters who had a phony asset-backed lending scheme. The biggest hedge fund fraud to date.


Losses: $1 billion

Cause of Death Fraud


Peloton Master Fund


After making 80% in 2007, these guys lost huge in 2008 and closed shop. Mortgages on leverage. It would be tempting to say “same old,” except the London-based principal behind Peloton was this guy…

named Ron Beller who had a personal assistant…

named Joyti De-Laurey who previously gained notoriety in England because she managed to lighten Beller’s bank account by a few million before he noticed. De-Laurey and Beller were later depicted in a BBC film starring these two…

Public opinion in England was decidedly on De-Laurey’s side.


Losses: $1 billion

Cause of Death: Excessive leverage


Tontine Partners


These guys were highly successful, until they weren’t. “Weren’t” is an understatement when you’re down 80%. Tontine was a Tiger cub, no less, with $10 billion of AUM. Biggest blow-up loss ever, although not highly publicized.


Losses: $8 billion

Cause of Death Concentration, excessive leverage

______________________________________________________________________________

2009


Weavering Capital


Here’s a clever idea – trade with yourself! It was discovered that Weavering’s assets were invested entirely in swaps where the counterparty was an offshore entity owned entirely by a man named Magnus Peterson, who also just happened to be Weavering’s managing partner.


Losses: $500 million

Cause of Death Likely fraud (the whole thing hasn't been sorted out yet)


You should be seeing a theme here: hedge fund blow-ups are almost always caused by fraud or excessive leverage (concentration is also listed, but almost all these examples would have survived with less leverage). Also notice that of the non-frauds, almost all blow-ups are in a fixed income related fund, especially in the mortgage area.


A critical point here, though, is that the money lost in the non-fraud cases was not actually lost by the industry as a whole. Invariably, these losses were in derivative instruments like futures (from whence the leverage), where every loser has a winner on the other side of the trade. So Amaranth’s pain was someone else’s gain, and that someone else was more than likely another hedge fund. When Bear’s hedge fund was blowing up because of sub-prime, John Paulson’s fund was on its way to the biggest payday in hedge fund history for exactly the same reason. So you see, most blow-up risk is really fund-specific. It is not an industry risk.


Ergo, when thinking about this from an industry-wide perspective, blow-up risk is really only about fraud.


Hunt Taylor was a well-respected hedge industry veteran, known as a real free thinker. I was fortunate enough to have met him casually before his tragic death in a motorcycle crash last year. Hunt was perhaps the first person to put fraud blow-ups in context. Specifically, he added up all the blow-ups to assess the overall impact on the industry. I have taken the liberty to add to his work here:


Fraud Losses as a Percentage of Hedge Fund Industry Assets


Source: Hennessee Group, IFSL


No doubt I missed a few, but I think I have all the major ones. (Let me know if I don't.) The point here is that fraud-related blow-ups have been 0.04% annual drag on industry performance since 1994. That’s 4 basis points. If you add up all the losses it comes to $4.4 billion. That’s a big number, right? No, it’s not. It's equivalent to an 84 cent drop in Exxon. Exxon dropped about three and a half points in a single day not long ago.


This is worth restating: all the hedge fund fraud losses since the dawn of the industry add up to about 1/4 of what Exxon cost investors in a single day.


And yet institutional investors galore own Exxon but won’t touch hedge funds because they are terrified of fraud, which to them translates into “headline risk.”


Yeah, But What about Bernie?


I thought about this one, and I just don’t think you can call Madoff a hedge fund. He didn’t call it one, nor was he charging hedge fund-like fees (one of the few things that makes a hedge fund a hedge fund). In fact, he had no stated fees at all. It was an investment fraud, of course, but I don’t know what makes it a hedge fund fraud.


A better argument could be made that the feeder funds could be categorized as hedge funds. It's kind of a stretch to call a fund that just hands money over to someone else a hedge fund, but they did at least have fee structures that looked hedge fund-like. Let's say those losses were about $15 billion. That would increase the "fraud drag" to 37 basis point per year, on average. Meaningful, but far from scary.


A smirking Charles Ponzi


Not every Ponzi scheme is “hedge fund fraud,” and not every hedge fund fraud is a Ponzi scheme. The original Ponzi scheme used postage stamp coupons.

1 comment:

  1. Although Madoff did not fit the structure of the typical hedge fund, Madoff was characterized like a hedge fund by the press. This meant the same headline risk was associated with Madoff that hedge funds receive – and even more so in his case because of his notoriety. There is a fund of funds that avoids head line risk by avoiding hedge funds that have well known management teams or something notable about them that would bring excess attention by the press in the case of a blow up.

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