Sunday, January 11, 2009

The hedge fund after Christmas sale---30-60% off!!

It looks like the sellers of their positions actually understand the value of hedge funds "side pocket" assets or hard to value securities that they mark up to engage in their own ponzi scheme. Look at the discounts they are now getting:

Some battered hedge fund investors are so desperate to get out of their positions that they don't mind selling them - for 75 percent off.

Some hedge funds lost 50 percent to 60 percent of their value in a brutal 2008 - and many have put up gates to keep investors from withdrawing their funds. That hasn't stopped the beaten down individuals or funds of funds from turning to brokers to peddle their stakes.

At the Liberty View Credit Opportunities Fund, one investor was willing to give up three-quarters of his watered-down position just to get out, according to a letter sent to prospective buyers of the stake by one broker, Bahamas-based Hedgebay Trading Corp.

A $1.4 million investment in the Amber Fund Ltd. was on the block for 50 percent of its value while an opportunistic investor with $6 million could snap up a $10 million position in the Highland Credit Strategies Fund Ltd. - at a cool 40 percent discount, according to the Nov. 13 letter, which was viewed by The Post.

"While some might ask why an investor would want to get into a beaten down hedge fund at this point in time, you have to remember that some fund managers just had a bad year in 2008 after years of success - and that the fund is probably so far under its high water mark that the new investor isn't likely to have to pay the 20 percent of profits incentive fees for quite a while," said one investment researcher.

That is true. In a letter from Hedgebay Trading last week to prospective investors, the broker wrote that it had buyers waiting to get into Perry Partner International, Kairos Focus, Wexford Offshore and Oaktree EPOF funds. No prices were listed.

Most sellers were listing their stakes at a discount between 10 percent and 30 percent. It is believed that the sellers would have the approval of the fund manager to sell their investments. In some cases, it is in the interest of the fund to have the investment sold by an existing investor than have the money withdrawn.

"The fund gets to continue to collect a management fee and does not have to liquidate positions," said the researcher, in describing why fund managers would let investments be sold. Since hedge funds started putting up gates, the selling of investment positions in hedge funds and private equity firms have become a cottage industry.

Now it may be inflammatory (or pulling a Lennar) to some to call these hedge fund's Ponzi schemes, but I'm just repeating what had said in a previous article. So to spare yourself the googling, here that is: (And then you'll understand why people are parting with their stakes at such a discount!)

The Ponzi Scheme in Every Hedge Fund

At the heart of the difference is the distinction between realized and unrealized gains. Gains are realized when assets are liquidated to cash. For instance, if you buy a stock for $100 and it is currently trading at $200, you have made $100 in unrealized gains. If you sell it at $200, you have made $100 in realized gains. Most hedge funds do not regularly liquidate their entire portfolio, so they report unrealized gains to their investors and to the public. (See the top 10 scandals of 2008.)

Now comes the murkier part: Many assets — particularly those that unregulated hedge funds can trade — are not as liquid as stocks, so they do not always have a definite price on the market. Since a fund reports unrealized gains, it could easily get away with inflating profits. More specifically, the fund could use the most optimistic models to price its illiquid assets, which include mortgage-backed securities and other swaps. After all, economists disagree about how to value these assets, so the fund is not necessarily being dishonest in its assessment.

Madoff never even came close to realizing the gains he reported and paid out to some investors. Yet even funds with fairly accurate estimates of unrealized gains are guilty of engaging in similar Ponzi practices in the short term. Here's why:

Suppose some investors decide to withdraw their money from a hedge fund. The fund must liquidate the appropriate amount of its assets to pay these investors. Say the fund holds large positions in illiquid assets. The fund cannot immediately sell these assets, except at a fatal loss, so it would sell its more liquid assets. Given that the fund is more likely to inflate its estimation of the illiquid assets, it would seem that investors who withdraw early get the better returns over that time period. Sounds a bit like a Ponzi scheme, right?

Even in the most vanilla of trades, liquidation can impact the market price. With lightly traded securities, this can be magnified. For example, a fund might corner some asset by buying and buying and buying and then reporting a huge unrealized gain. But the moment the fund tries to sell and realize the gain (perhaps to pay off its last few investors), demand disappears, and the asset crashes. Again, investors withdrawing early got better returns over that time period than those who waited until later. (See the top 10 financial collapses of 2008.)

Every year hedge funds do have to liquidate part of their profits in order to pay their managers, traders and other support staff. Fund managers typically keep 20% of (unrealized) trading profits. But first they must realize that 20% by selling the liquid assets. If a fund is overestimating the value of the illiquid assets, then its manager's profit is grossly overestimated. In most cases, the profit is at least slightly overestimated because of slippage in the liquid assets. In other words, if a fund liquidated all profits, the supposed 20% taken out first would actually be larger than 20% of the total realized profit.

If hedge funds had to regularly liquidate assets, we would not see the spectacular returns reported in the past. One factor of the supposed success of hedge funds is their ability to report unrealized gains and to be flexible in liquidation, since investors who believe they are getting high returns are unlikely to withdraw their money. That was how Madoff was able to maintain his charade for so long.

Wonder why Chicago-based hedge fund Citadel is not allowing investors to withdraw their money until at least March? Citadel has already reported about 50% losses for its two largest funds. Remember: these are unrealized losses. If Citadel liquidated assets to pay out to investors, losses would be even greater. Barring a miracle, the first investors out would lose less than those going out later. But even in good times, the withdrawal of money from a hedge fund impinges its performance.

Hedge funds are designed to take in more and more investors' money. Then inefficiencies and performance distortions of withdrawing money for investors and profit-taking for managers are smoothed out. The recent failures in hedge funds, while rooted in the financial meltdown, have been further fueled by the lack of new investment as well as pressure from current investors to take their money and run. Regardless of a fund's investment strategy, liquidation tends to make unrealized gains smaller — and unrealized losses larger — when they are finally realized.

By design, hedge funds benefit managers more than investors. Since the liquidation of assets always results in slippage — the more that is sold, the worse the price — managers for every hedge fund always get the "best" 20% of the profit.

So you see, there could be a little Ponzi scheme in every hedge fund. It is inherent to the model of the modern hedge fund. The only way to avoid these schemes is to regularly liquidate all assets and allow all investors to decide what to do with their cash returns. In the past, this would have meant seemingly diminished returns. With returns seemingly high, investors did not complain about the status quo. Now, given that regular liquidation would mean more transparency and diminished losses, in recent days investors' opinions would likely differ.,8599,1869196,00.html

And why would hedge funds have these "murky" assets in their funds in the first place? Because then they can mark them up! Unless of course, they get a redemption request where they have to sell the asset. Then they close the gate!

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