Hedge Funds Suffer

While hedge funds have performed better than the market-at-large, losing only about half what the markets have lost, they have been embroiled in the crisis themselves and, indeed, have been decimated by it.

A sector that was worth $US1.9 trillion at the start of last year is now expected to be worth $US1 trillion, at best, by the end of this year.

The hedge funds .. are .. victims of their own miscalculations and of the general environment.

During the credit boom, the funds chased growth, with the cheap credit and mis-pricing of risk enabling them to pursue transactions that would have been unachievable in more normal times.

As with all other financial players, credit is no longer cheap and, for leveraged players, virtually unattainable. The economics of existing deals are imploding as borrowings mature and asset values fall and there is no funding, debt or equity, for new deals.

Their plight is, however, worse than a simple return of financial gravity to unsustainable deals entered into at the top of a credit bubble.

Some of the bigger and more experienced funds went into the crisis with significant levels of uninvested funds or other sources liquidity. They should have been very well placed to take opportunistic advantage of the general distress in the financial system and the leveraged impact that has had on asset values.

Instead, they have experienced their own liquidity issues as anxious investors and lenders have retreated to the sidelines, sucking as much available liquidity from any available source that they can. The stronger hedge funds and private equity firms have been hit by a flood of redemptions from instantly risk-averse investors preferring to sit on their own cash.

Many of the funds have had to freeze withdrawals to control the outflows, adding to the general uncertainty about the future of the leveraged funds’ sector. Even those with significant residual cash and liquidity, however, can’t leverage those funds – they can’t get the credit to do sizeable deals.

That’s why the funds haven’t played a role in blunting the impacts of the crisis – they don’t have the free liquidity of their own to supply it to distressed markets and companies.

The leveraged investment sector, when the dust finally settles and the majority of them, by number, have exited the scene, will be a fraction of the size it was at the peak.

Comment by Stephen Bartholomeusz.