Hedge flops share ties

Hedge-fund blowups come in all shapes and sizes, but many high-profile failures share a couple of common traits: high leverage and bets on debt, technology stocks, or both.

Thousands of hedge funds suffer losses each year and close quietly. So why do the problems at these few – roughly a dozen in the past nine years – stand out?

Michael F. Griffin, an attorney with Dorsey & Whitney LLP in New York who specializes in hedge funds, says failures fall into four broad categories: outright fraud; unusually high use of leverage; mispricing of securities, intentional or otherwise; and strategy failure.

“It’s a business where people are constantly looking for innovative approaches to investment management, and testing them,” Mr. Griffin says.

Long-Term Capital Management LP, he says, would fit into the excessive-leverage category

And although they were less highly leveraged, so would Askin Capital Management, Convergence Asset Management and, most recently, Eifuku.

Strategy failures brought down Soros Fund Management, Tiger Management, Niederhoffer Investments and Everest Capital.

Securities mispricing helped claim Beacon Hill Asset Management and Lipper & Co.

There are also examples of outright fraud in Cambridge Partners and Manhattan Investment.

And even within these categories there are interrelationships, combinations of strategies that failed and then increased leverage to try to make up for that failure, as with Long-Term Capital.

There are mispricings bordering on fraud, as in the case of Beacon Hill and Lipper. A federal grand jury is said to be looking into possible fraud at Beacon Hill.

Still another common thread is the personalities of the fund managers themselves, says Jonathan S. Bean, managing director of Mellon HBV Alternative Strategies LLC in New York.

Some funds implode because of the way the managers approach their business.

“What are the commonalities? Hubris, lack of risk control, lack of an efficiently running back office,” Mr. Bean says.

“Hedge fund guys consider themselves to be iconoclasts. They get up in the morning and do great things; they don’t make doughnuts. There’s a certain amount of infallibility about their decisions. There’s luck and there’s skill. But it’s sometimes hard to tell the difference between the two.”

Long-Term Capital, considered to be one of the largest and highest-profile hedge fund failures ever, leveraged thousands of tiny trades designed to capture pricing inefficiencies in various securities – mostly foreign government debt – by an overall ratio of 25 to 1.

Some individual trades were leveraged much higher.

Overall, that meant the fund had $25 of market exposure for every $1 in actual invested capital. With equity capital of $5 billion, its market exposure was roughly $125 billion.

Its failure in late 1998 was largely the result of not having enough actual capital to cover margin calls on the securities it had borrowed to leverage its bets.

Leverage became a problem, however, only after the fund started moving into equity volatility and equity risk arbitrage, strategies less familiar to the firm than relative-value fixed income.

The same problem of abandoning a successful strategy also led to large losses at hedge funds run by George Soros and Julian Robertson, says Thomas A. Hickey III, an attorney with Kirkpatrick & Lockhart LLP in Boston. Mr. Hickey advises pension funds on hedge funds and other financial matters.

“With [Mr. Soros and Mr. Robertson], they primarily abandoned their core expertise,” Mr. Hickey says. “When they went into value and tech stocks, betting and hedging, shifting their strategies, that’s when they had problems.”

Mr. Hickey says managers have to identify their strategy, give notice when they shift strategies, and allow investors to pull their money out if they aren’t comfortable with the shift.

“I want to make sure my client knows exactly what he’s getting into, and I want to build in as many ways as I can to get out,” he says.

Long-Term Capital is the standard by which spectacular hedge fund failures are now measured.

But it doesn’t take a loss of that magnitude to qualify as a blowup; all it takes to trigger concern is losing 25% or more of the portfolio in a year, says Chris Sugrue, chairman of hedge fund advisory and monitoring firm PlusFunds Ltd. in New York.

“Lots of hedge funds lose money, even 25%,” Mr. Sugrue says. “It’s when you get to 25%, 30%, 35% and up which brands you a disaster.”

And even those losses might not be so bad, but some hedge fund managers can’t handle losing money or telling investors they lost money. So they try to make it up by ratcheting up the leverage and taking bigger directional bets, Mr. Sugrue says.

If those don’t work out, the manager gets deeper in a hole, and it becomes easier to start doctoring financial statements to mislead investors.

“They’re already in trouble with the loss,” Mr. Sugrue says. “They’ll be in more trouble if they have to disclose the loss.”

“More often than not, they have an innate belief they can make it back. They’re not always right,” he says.