While the conventional way of looking at hedge fund assets has traditionally been to simply add up the assets under management to estimate gross exposure, as so often happens conventional wisdom is wrong. Because what the "traditional" approach simplistically looks at is merely a fund's equity and ignores all leverage through assorted generic and "shadow" conduits such as repo, loans, rehypothecation, "hedging" and others. Luckily, as a result of Dodd-Frank, hedge funds were required to present their full market exposure when netting leverage as per an annual SEC form known as Form PF. It is here that we learn that SAC's market exposure, something very relevant now that the firm is facing an imminent or eventual winddown, is likely orders of magnitude above what the market believes.
First, select extracts from the full prestory from Bloomberg's April 2012 report on just this issue [8].
Under the Dodd-Frank Act, signed by U.S. President Barack Obama in July 2010, Congress required hedge and buyout funds with assets of $150 million or more to register with the SEC by March 30. It was one of several provisions designed to help regulators control risks to the financial system, which became evident when the 2008 failure of Lehman Brothers Holdings Inc. (LEHMQ) caused banks to stop lending to each other because they were worried counterparties owned too many toxic assets.
In seeking to adopt a uniform method for determining who met the threshold, regulators instructed firms to count assets that most were excluding from tallies on size, including holdings obtained through loans, short sales and hedging. Traditionally, hedge-fund advisers have quoted a net number, comprising investor capital plus investment gains and losses, when disclosing their assets under management.
While some fund managers only gave information on their gross assets, 31 of the 50 largest also disclosed their net assets in a separate section known as the client brochure. For these advisers, gross assets of $949 billion were more than double their net assets of $422 billion.
That indicates hedge funds may be using as much leverage as they did prior to the 2008 financial crisis. On average, hedge funds held total assets that were double their net capital as recently as 2007, said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, a Darien, Connecticut, adviser to asset managers.
In practical terms, the SEC rule meant that fund managers had to measure all assets on their balance sheets rather than the industry equivalent of net equity, according to John Tavss, a partner in the investment-management group at the law firm Seward & Kissel LLP in New York. Because the use of borrowed money, or leverage, boosts both potential profits and losses, investors may conclude that firms with a big gap between their regulatory and net assets are taking on more risk.
The amount of leverage that an adviser uses, and thus its ratio of regulatory to net assets, is often tied to the firm’s primary trading strategies. Prime brokers are often willing to lend more money to firms that make bets that aren’t tied to market swings, said Leonard Zacks, a Chicago-based money manager who oversees about $2 billion.
And the bottom line for the firm's exposure as of YE 2011: high to quite higher than just its net assets.
[9]
We can only hope the unwind of all these levered assets, and not just equity, will be as smooth and seamless as the market expects.