Stanley Druckenmiller Recently Left Soros Fund Management

The Wall Street Journal Europe

Page 24

Hedge Funds Expect Troubles to Exact a Toll

By staff reporters Mitchell Pacelle and Matt Murray in New York and Michael R. Sesit in London

Hedge funds are bracing to pay the price for the near-collapse of Long-Term Capital Management LP, as their investors and lenders grow skittish about risk levels and U.S. federal regulators review their oversight responsibilities.

"There's a great deal of fear," acknowledged Stanley Druckenmiller, chief investment strategist at Soros Fund Management, which has about $20 billion under management, in an interview. "Many of our investors who haven't met us probably think, `If this can happen to Nobel Prize winners, it can happen to us.' I would assume that regulatory and Congressional hearings are coming. That's almost a given." (Long-Term Capital's partners include two Nobel laureates in economics, Myron Scholes and Robert Merton.)

For now, however, pressure from Washington may be least among the worries of managers of hedge funds, which are largely unregulated investment partnerships restricted mainly to millionaires.

For starters, many of their wealthy investors are in a panic. Most hedge funds allow only monthly or quarterly withdrawals, so it is too early to gauge the level of capital flight that will result. But because shares of the various Soros funds are bought and sold daily through a London market maker, Mr. Druckenmiller has an early sense.

Quantum Fund NV, the marquee Soros fund, is up a solid 9.6% so far this year. "That's not an alarming number, and yet we're seeing a lot of redemptions," noted Mr. Druckenmiller. "And I guarantee that it's at least partly because of the fear" sparked by Long-Term Capital's failure, he said. A recent sell-off in Quantum Fund shares by investors bailing out caused the fund's share price to drop 11% from Aug. 14 to Thursday. On Aug. 17, the Russian government's bond default sparked a global flight from risk and word spread that there were losses at many funds, including Long-Term Capital.

The value of Soros's Quasar International Fund NV's assets is up 4% in 1998, but its share price fell 31% between Aug. 14 and Thursday. And Soros's Quota Fund NV, whose net asset value is up 1% year to date, saw its share price tumble 32% during the same Aug. 24-Sept. 24 period.

"Hedge-fund managers are spending all their time on the phone trying to keep clients," said Michael Belkin, president of Belkin Ltd., an investment adviser to hedge funds and mutual funds. To prepare to meet redemptions, funds are "reducing the exposure of their portfolios, raising cash or imposing clauses that inhibit redemptions," said an official with a Swiss bank that allocates funds to hedge funds. They also are scrambling to convince investors that their bets aren't as risky as those made by Long-Term Capital.

Last month, Julian Robertson's Tiger Management, with about $20 billion under management, began imposing a 5% exit fee on investors who wanted to cash out of its huge Tiger and Jaguar funds earlier than 12 months after investing. A spokesman for the firm, whose fund assets have risen 17% so far this year, said the new requirement was "not in response to recent events, but to discourage short-term money."

In the future, it will be difficult for funds to be as secretive about investments and strategies as Long-Term Capital was. "These rich investors will never put money anymore into some fund that says, `I'm not going to tell what we do,'" said E. Lee Hennessee, of Hennessee Hedge Fund Advisory Group in New York.

Bankers said that also applies to them. Lenders to Long-Term Capital, which at times -- through massive borrowing -- held more than $30 of assets for every dollar investors put into the fund, said they were themselves unaware of the full extent of the fund's exposure.

To be sure, that kind of leverage is highly unusual. "Long-short" hedge funds that aim to profit by buying stocks, while selling borrowed shares of other stocks they believe will fall in value, are often unleveraged, or carry very little debt. Large "macro" funds that make large directional bets on stocks, interest rates and currencies generally carry more. Leverage at Soros's Quantum rarely exceeds 3-to-1 or 4-to-1, said Mr. Druckenmiller, and Tiger Management's portfolio is leveraged less than 10-to-1, said a person familiar with its finances. Bond-arbitrage funds like Long-Term Capital, which try to profit from minute changes in interest rates, carry far more leverage, as have some other Soros funds.

Nonetheless, lenders "are all going to pull back," predicted lawyer R. Todd Lang of New York's Weil, Gotshal & Manges, which has been hired by a number of banks for advice on the issue. "They aren't going to distinguish" between types of hedge funds. "Credit is going to get tighter."

Executives at commercial and investment banks said they are reviewing policies, making some calls for more collateral from hedge funds perceived as risky, and asking for more data from many. "Everyone's double-checking their books," said a commercial banker with risk-control oversight. Bankers said they are now far more reluctant to be lenient on initial margin calls, which are calls for more capital when a fund's assets decline in value.

Additional margin calls are going out to some hedge funds, bankers said, though none provided names. Going forward, bankers said, they would demand more collateral from some clients and that, as others unwind risky positions, they may refuse to renew lines of credit. "I'm going to limit my new business either to deals that will reduce my risk, or where the margin (clients) put up is more significant," said the bank risk-control specialist.

"In the lead-up to this, arguably, credit was too easy and terms were too loose," he said. "The wake-up call here is the speed with which this occurred and how much money they lost in a short period of time."

The Long-Term Capital debacle also is causing bankers to scrutinize the potential conflicts of interest arising from simultaneously financing hedge funds, investing in them, and making money executing trades for them, as many investment banks did with Long-Term Capital.

"Some big banks clearly are both investors and lenders," said Philipp Hildebrand, global strategist for the U.K. affiliate of Moore Capital Management , a New York hedge fund with more than $8 billion under management. "This has distinct features of what's often labeled crony capitalism. You have a huge conflict of interest."

One commercial-bank chief executive involved in the Long-Term Capital bailout admitted as much, and vowed changes. "The industry as a whole has not tended to have a creditor-type relationship with hedge funds," he said. "The relationship was driven by transactions. Now there will tend to be more of a creditor-type relationship, which will mean dealing with fewer people and more transparency in positions and exposures." In the future, he said, that will mean less flexibility for hedge funds to set terms, and higher capital requirements.

But will it really? Several bankers conceded that once the current crisis passes, it will take only one bank offering special breaks to hedge funds to begin the cycle all over again -- that is, unless stricter regulation is imposed.

Rating agencies warned on Friday they were reviewing the credit quality of all major U.S. and European banks, and would probably lower the ratings of several. Standard & Poor's Ratings Services made the first move by cutting its rating on some Bankers Trust Corp. senior debt.

Because many hedge funds are set up outside of the U.S., and thus largely elude regulation, some in the industry are betting that regulators will focus on lenders to hedge funds, tightening current loose limitations on financing bond purchases.

"The knee-jerk reaction whenever you have a market break or a big default is to call for more regulation," said lawyer Paul Roth, of New York's Schulte Roth & Zabel, whose department represents some 200 hedge funds.

Another possibility is requiring lenders to disclose their hedge-fund positions. "If you can come up with a way of disclosure where competitors won't be able to look over your shoulder and effectively front-run your positions, we wouldn't necessarily object," Mr. Hildebrand said.

Copyright (c) 1998, Dow Jones & Company, Inc.

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