In the aftermath of the stunning liquidation and gating of first Third Avenue's junk bond mutual fund, and shortly thereafter several other fixed income hedge funds, investors have been following with great interest capital (out)flows from the fixed income space. However, while the junk bond space is certainly ripe for fireworks, even more dramatic events are taking place in the far more familiar equity space, where with redemption submission deadlines looming or having just passed, LPs and all other hedge fund investors have decided that after seven years of underperforming the market, it is time to get out, and do so with a bang.
Case in point: Carlyle's Claren Road.
We first profiled the deeply troubled hedge fund four months ago [17], when we reported that investors had redeemed nearly half, or $2 billion, of the firm's total $4.1 billion in AUM.
By way of background, Claren Road was founded in 2005 by former Citigroup Inc. credit traders Brian Riano, John Eckerson, Sean Fahey and Marino. Carlyle bought a 55 percent stake in Claren Road five years ago as part of a push into hedge funds. At its peak less than a year ago, in September of 2014, Claren Road managed $8.5 billion.
As we further said in August, "Claren Road is facing redemptions that will pull 48% of the funds investments, forcing across the board liquidations, mass layoffs, and what will ultimately almost certainly be the fund's liquidation."
Four months later we are halfway there: according to an update by the WSJ [18], in a rush to beat last week's fourth quarter redemption deadline, investors submitted withdrawal requests for another $950 million from Claren Road, in the process slashing the fund's AUM by half for the second consecutive quarter. According to the WSJ, The firm is expected to have $1.25 billion under management as of Jan. 1, down from $8.5 billion as recently as September 2014.
Worse, the fund has now seen its AUM cut by half for two quarters in a row, in the process forcing liquidations of whatever securities it may have left, and putting downward pressure on the asset prices of securities it once invested in.
And while we did forecast the inevitable liquidation of the once reputable hedge fund, a new twist has emerged: it appears gates are not only a "debt thing", where highly illiquid securities may if not justify then explain why a hedge fund is forced to gate. According to the WSJ, in an attempt to avoid forced liquidation Carlyle's hedge fund also had no choice but to gate redemption requests:
Claren Road previously told clients that it would delay full payment of withdrawals requested in the fourth quarter, as it had with their third-quarter requests. The $1.25 billion under management as of January doesn’t include funds that are to be paid back.
Investors, hoping to get quick access to their depleted funds, are not happy:
The delayed-repayment schedule, unusual since the financial crisis ended, has rankled some investors. The firm’s executives have said they believe the extended payout is the best way to protect both remaining and redeeming investors. The firm has told clients it won’t immediately pay back about two-thirds of the nearly $2 billion in withdrawals requested in the third quarter. It wasn’t clear when fourth-quarter redemption requests will be paid in full.
Claren Road's reaction is understandable: the last thing it wants is for competing hedge funds to heavily short its longs and vice versa, in the process forcing it to liquidate at even more disadantageous prices. Even so, it has merely delayed the day of reckoning.
Worse, since it is unclear when the hedge fund and its peers will ultimately pull the plug on liquidating existing positions from the "side book", there will now be a constant lid on stock prices, as any and every ramp will be promptly taken advantage of by Claren Road to sell into.
And not only Claren Road but its peers. As the WSJ also notes, "investors have been defecting from funds large and small in the face of losses, say hedge-fund executives and investors, who predict redemption requests will continue to hit funds into early next year as clients reassess their holdings. Hedge funds that have turned in consecutive years of poor performance are being hit particularly hard, they say."
Here are some other biggest losers and the names most likely to impose gates:
Mason Capital Management LLC, an event-driven hedge-fund firm out of New York, has seen its assets under management shrink from $8.3 billion at the start of the year to $4.9 billion, according to a person familiar with the firm. Mason is down about 9% for the year through November, following a 12% loss last year.
Luxor Capital Group, which is down about 13% for the year through November in its event-driven hedge funds, has received year-end redemption requests that total about 8% of the $4.5 billion in assets under management in the funds, according to people familiar with the firm. The strategy lost 10% last year. One of the people said the size of the redemption requests was in line with those of prior years and that investors would be paid out as usual.
Red Mountain Capital Partners, a Los Angeles-based firm started by Goldman Sachs Group Inc. veteran Willem Mesdag to take activist positions in small-cap companies, converted to a $500 million closed-end vehicle in September after experiencing losses in the low teens. The change, which was approved by the firm’s investors, means that investors looking to get out of the fund this year can instead expect to receive the last of their funds back within roughly five years, Mr. Mesdag said.
LionEye founders Stephen Raneri and Arthur Rosen, formerly executives at hedge fund Ramius LLC, decided to shutter the firm after most of its largest investors submitted redemption requests, according to people familiar with the matter. LionEye had lost 27% in the five-month period ending in November, bringing its performance for the year through November to a 19% loss, said one of the people. It was the firm’s first losing year.
Stone Lion Capital Partners LP recently said it suspended redemptions in its credit hedge funds after many investors asked for their money back.
As a reminder, we profiled Stone Lion's management team a week ago [19]when we revealed that its two "debt expert" principals were also co-heads of distressed and high yield trading at none other than the bank that started it all: Bear Stearns. How ironic.
Needless to say, these names are just the beginning: once the redemptions - and gating - genie is out of the bottle, there is no putting it back.
Not helping is that not only will the broad hedge fund universe underperform for the 7th consecutive year, but 2015 will be the worst year for hedge fund returns since 2011, which in turn was the worst since the financial crisis. Worse, as we reported over the weekend, hedge funds have now tipped their hand and are actively lowering their fees in a scramble to retain clients [20]; the problem is that clients do not want to be "retained" - they want to go where their money is not desperately needed.
Which means that in addition to outright capital flight, hedge funds will be forced to mark to far lower markets, in the process launching a margin call cascade because while the value of the assets is declining, the value of the margin debt remains consistently unchanged, forcing even more selling to satisfy the initial margin request, and so on until the inevitable death spiral kicks in.
What is most surprising is that such gates and redemptions are traditionally a harbinger of, or contemporaneous with the end of the business cycle, the start of the default cycle, a tumble in asset prices or a massive exogenous shock to the system [21]: think the failure of the GSEs, Lehman and the AIG near-death experience. This time, none of those are readily apparent which makes one wonder just how bad is the real picture behind the "rose-colored glasses" facade.
And since we live in a centrally-planned world, the Fed and central banks will do everything in their power to continue both the exhausted and fading business cycle for at least a few more quarters, knowing that 25-50bps of rate hikes will not be nearly enough to easy from once the NBER finally admits the recession has arrived. As a result, expect even more gates, even more liquidations, and even more sharp price drops once hedge funds are no longer able to delay the day of liquidation reckoning and are forced to sell into a painfully illiquid market, leading to cross-contagion and other hedge fund gates, liquidations and so on until some central bank, somewhere, is forced to step in.
