Hedge Fund Redemptions: Let the Bloodbath Begin

September 30 was the final day (end of the quarter) that investors in most hedge funds could request to redeem their money in December. If you've been following my posts on this matter, you know we're in for a rough ride. There have already been reports of massive redemption requests by investors. As of right now, redemption estimates are in the hundreds of billions. Nouriel Roubini, respected Professor of Economics at NYU, recently predicted this and said the run on hedge funds could last up to two years.

Why are investors running to redeem their money you might ask? Well, maybe it’s because hedge funds have had a rough year just like everyone else. While there are some standout performers, the majority of funds have been on the losing side of things. Overall, the performance of hedge funds and fund of funds this year has been the most widely dispersed in six years. And, such dispersion is bound to cause redemptions. These redemptions cause hedge funds to sell out of their positions and raise cash. Increased selling in the markets can create increased volatility, in a time when we are coming close to testing historical levels of volatility. Citigroup analysts already estimate that hedge funds have around $600 billion in cash reserves in anticipation of redemptions.

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FT Alphaville captures the possible severity of the situation:

The bottom line, according to industry outfit hedge fund research, is that up to 2000 hedge funds can be expected to be liquidated in the coming months. Given the complexity of the market - the way hedge funds and their holdings so interlace the financial system, this is a potential massive shock. It almost makes the failure of Lehman pale into insignificance. The Lehman collapse will be worked out over years. Hedge fund redemptions and liquidations will take days or weeks.

Simply put, hedge funds are deleveraging. Not to mention, you have the added threat of hedge funds straight up liquidating and closing up shop. We've already seen evidence of this with the closing of Dwight Anderson's Ospraie Fund. In addition, rumors started swirling as to who was next. Then, on top of all that, numerous funds are close to shutting down simply because all their assets are tied up in the prime brokerage operations of the now defunct Lehman Brothers. Hedge funds who used Lehman's prime brokerage services have seen their accounts frozen as Lehman filed for bankruptcy protection a few weeks back. Here are some excerpts from Bloomberg illustrating how many funds are affected by this:

Lehman Brothers Holdings Inc.'s (LEHMQ.PK) bankruptcy probably means the end of hedge-fund manager Oak Group Inc. after 22 years in business.

Diamondback Capital Management LLC, a Stamford, Connecticut-based hedge fund, told investors that it had assets of $777 million stranded in Lehman.

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.

Darden Capital Management, an investment club run by students of the University of Virginia's business school, has about $6 million in four funds that are stranded.

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.

As you can see, investors aren't the only ones threatening hedge funds' livelihood. Counterparty risk is very much a problem as well. The collapse of numerous Wall Street institutions has sent a shock wave through the entire investment community.

As I recently wrote, this has been the worst year for hedge funds in a long time. Heck, Boone Pickens' funds are down $1 billion. The market volatility has affected everyone, and it could get even worse.

Sources:

• FT Alphaville
• Bloomberg

Comments

[mangum:]

Interesting that there is no mention here of naked short selling's demise (at least in theory) as a reality that will adversely affect hedge funds' assets to a degree that most are still in denial about. Most, if not all, the hedge funds mentioned here have used illegal, abusive short selling as additional leverage in making their ill-gotten gains.

2008 Oct 03 10:35 AM

[wpdragon:]

I'm a strong supporter of free and open markets, even if the SEC, Fed and Treasury are not. Hence, I am a big proponent of LEGAL short selling, for the liquidity, price discovery and other benefits it provides to the markets.

I'm also a big non-supporter of the egregious and despicable practice of naked short selling which has decimated so many investors, particularly small ones, and which is the exclusive domain of the hedge funds who operate in the shadows and share their profits with the brokers and trading desks who do their trades and provide their funding for them.

I'm not sad to see the demise of so many hedge funds, even if it means more volatility and short term pain for all investors. Their meltdown is part of the process by which Darwinian capitalism cleanses the markets and ultimately restores confidence, and liquidity, to them.

So, as far as the hedge funds go, my thought is burn baby, burn.

2008 Oct 03 10:37 AM

[wpdragon:]

heh heh, great minds think alike mangum

2008 Oct 03 10:38 AM

[carey_jim:]

It's ironic that intellectuals (the professors of finance and economics in major American universities) are responsible for the business models such as hedge funds, derivatives, naked short selling and other models that have led to the present crisis but no one blames them for the present crisis.

We blame politicians and traders instead.

Whatever your economic philosophy is, the choices of economic models range from Marxism to anarchism with many variations in between, but American graduate schools teach only one thing and its variations: Laissez-faire.

Who is to blame for this dismal state of economic knowledge and discourse in the United States? (Television, no doubt.)

2008 Oct 03 12:27 PM

[DizzySailor:]

It is a cycle, profit = greed. Larger profit-(risk-CDS)=Larg... greed
When the risk has been taken out of a market and the profit allowed to grow unchecked EVERYONE runs to that plan. When everyone runs to one side of the boat, what happens?? Now comes the sharks.

2008 Oct 04 02:55 AM