Hedge fund failures rising sharply By Phil Davis Financial Times: August 14 2006
Evidence is growing that hedge fund liquidations are rising as the weight of money going into the industry forces many to invest in high-risk assets to meet customers' expectations. Record growth in hedge fund assets in the first half of this year is coinciding with a sharply rising failure rate, according to Walkers, the Cayman Islands law firm. More than 1,000 new hedge fund firms were registered in the Caymans alone in the first six months of the year, approaching the local regulator's estimate for a 1,100 net increase over the whole year. About 80 per cent of the 10,000 hedge funds worldwide are registered in the Caymans. But Walkers, which was legal counsel to Long Term Capital Management, the hedge fund that collapsed in 1998, and which sets up about a third of all the hedge funds domiciled in the Caymans, said it was also seeing large amounts of wind-ups. Although 1,893 funds were set up over the past 12 months, 575 had been liquidated over the same period. Guy Locke, head of insolvency and restructuring at Walkers, said: "In the last six months there has been a pick-up in failures. There seems to be too much cash chasing too few opportunities and the resulting poor performance has led to a rash of redemptions. "Over the past couple of years the big blow-ups were mainly due to fraud but there is now a clear trend of fund failures due to poor performance." An increasing amount of these failures were related to hedge funds buying distressed securities, once the preserve of private equity funds. As inflation and interest rates rise around the world and defaults start to increase, firms that have bought the lowest grade securities are likely to suffer a fallout. "Some of the newer hedge funds, in particular, are getting themselves into trouble by investing in very risky instruments," said Mr Locke. He said any "credit event" could create a much higher failure rate, particularly as most of the large hedge funds invest in distressed securities even if that is not their main strategy. "There is the expectation that they will be able to sell their positions at a higher price," said Mr Locke. "But all it would take is one very significant bond default to rock markets. Once confidence is rocked there could be a significant market correction. This could well take place in the next 12-18 months." He said many established distressed debt firms were "sitting on their hands", believing there were few good opportunities in credit at current prices. Harsha Patel, co-head of credit at Investec Asset Management, said it was "taking risk off the table selectively", company by company. "We are more cautious than our peer group and are slowly moving up the credit curve. We are also looking at using credit derivatives as a cheaper way to hedge portfolios, but have not implemented that strategy yet. "Our base case for credit is that spreads remain range-bound." Collateralised debt obligations (CDOs), pools of bonds with varying levels of risk, could well prove unstable if a "credit event" hit the markets. "CDOs can sustain one or two big names going under but more than that is a problem," said Ms Patel. "The whole structure of CDOs would look less compelling and we could see some unwinding of deals." Jerome Booth, head of strategy at Ashmore Investment Management, which specialises in emerging market debt, said developing countries were probably least at risk in the case of a severe credit contraction. "The risks are more than fully priced into emerging markets," said Mr Booth. "The prejudice has recently moved from 80 per cent to 70 per cent in terms of emerging market debt versus developed market debt."
