Hedge Funds: Failures and Mergers
Hedge Funds: Failures and Mergers
In this study, we focus on hedge fund failures. Since hedge funds have no obligation to report their performances to database, sometimes they do report and do inform them of their liquidation when it is the case but sometimes they don’t. From the moment these hedge funds do not report their performances to databases they are considered as dead. A recent study of Liang & Park shade the lights on these funds considered as dead but in reality are not really dead. Funds can stop reporting to databases when they want to hide their negative performances, when don’t want to attract any other investors… In the hedge fund universe, some strategies seem to be more affected by hedge funds failures than others. Indeed, Long/Short equity, CTA/Managed futures and arbitrage are the strategies that record the highest level of failures. The main reasons behind a hedge fund death are: liquidation, mergers, strategic restructuring, closed because of macroeconomic conditions or management issues. These failures can be linked to various macroeconomic conditions: European crisis, Asian crisis, some famous failures: LTCM or Amaranth for instance, IT bubble and the financial crisis. Lately, we have noticed that mergers of hedge funds have been increasing. Here again, this phenomenon seems to affect some strategies more than others: Long/Short equity, CTA/Managed futures and arbitrage. The reasons behind this can be linked to the nature of the strategy but also to macroeconomic conditions.
Part 1: Literature review & theoretical framework
In less than a decade, media have shade the light on hedge funds. They have become the object of many research papers, publications, books, movies and so on. As a consequence, most items in our literature review are recent publications that have been released along with major events.
In 1949, Alfred Winslow Jones defined hedge funds as “a limited partnership, which can take long, and short positions, use leverage and pay to the manager 20% of their profit. The manager has usually invested his own money”. Georges Soros focused on other characteristics of hedge funds while giving a definition, he defined them as “a mutual fund that employs leverage and uses various techniques of hedging”. The TASS database focuses exclusively on the returns provided by these funds, for them hedge funds are “all investment funds with an absolute return goal”. Finally, Money Central Investor comes with a risk oriented definition; it defines hedge funds as “a risky investment pool, generally open only to well-heeled investors, that seeks very high returns by taking very great risks.” Since the birth of the first hedge funds and until today it has been very difficult to formulate a precise definition of what exactly a hedge fund is. In her article published on the CPA Journal in 2002, Laura Carpenter, senior analyst at Innovest Portfolio Solutions said “Almost everyone has an opinion about them but almost no one understands what they are or how they function”.
When it comes to defining the death of hedge funds, the mission is not easier; practitioners can’t agree on a commonly agreed definition. “Defining hedge fund failure is a challenge because it is difficult to obtain detailed information on defunct hedge funds” (Liang & Park).
Hedge funds databases commonly agree on a definition : to consider that hedge funds are dead when they stop reporting to the hedge fund database whereas they were listed in it and used to regularly report their performances. In their paper, Fung and Hsieh (2000) have noticed that lot of studies and databases have aggregated all dead hedge funds into a single group but many “dead” funds are alive and well. Researchers such as Baquero and Al (2005) also focused on the fact that the word “graveyard” could be a misnomer because it may contains funds that are not really dead; because “funds that performed well have less incentive to report to data vendors…”. At the end of their analysis, they claim that only liquidated hedge funds should be considered as dead and failed ones. Following the previous articles, it is now clear that hedge fund failure is as complicated to define as it is the case for their definition.
To have an accurate overview on really dead hedge funds, researchers have to make a classification to understand these failures and define criteria to prevent them. But here again, practitioners seems to have different points of views. Early studies on hedge funds (Malkiel and Saha 2005), reveals that hedge funds stop reporting performances to databases because they don’t want to publish their poor performances. But this explication is incomplete looking that even “successful hedge funds with good records are frequently closed because managers have understood that size may have a negative impact on performance.” (Gregoriou (2002)) Feffer and Kundro (2003) agree with Baquero and Al on the classification based on the drop reasons and shades the light on the fact that discretionary fund liquidation is very frequent and driven by the market expectations and must be distinguished from a normal hedge fund failure. They define a hedge fund failure as the ceasment of investment operations for reasons outside management control.
In a paper published in 2009 in collaboration with Antonio Diez de los Rios, René Garcia provides a statistical methodology to deal with the nonlinear structure of hedge funds returns. When assessing all the biases and risks that might affect a hedge fund through the construction of an index he selects five factors that he estimates represent in a significant way a reasonable set of risks exposure that can be generalized to any hedge fund. They include the returns on (i) the CRSP value-weighted NYSE, AMEX, and NASDAQ combined index as a stock market measure; (ii) an equally weighted portfolio of British, German and Japanese 1-month euro currency deposits to capture any exposure to an exchange rate (FX) factor; (iii) the Lehman US Corporate AA Intermediate Bond Index to capture bond market risk; (iv) the Lehman US 16 Corporate BAA Intermediate Bond Index in excess of the return on the Lehman US Treasury index to capture a credit risk factor; (v) the Goldman Sachs commodity index. Summary statistics for these factors are reported in panel (a) of Table I. With this methodology used, they can correct the two major biases: backfilling and liquidation and also gives relatively more weight to small hedge funds. The created indexes are then more reliable in determining which funds can be considered as failing.
In 2000, Liang started examining survivorship bias in hedge fund returns by comparing funds in two databases: TASS and HFR. Basing on a sample of 1627 funds and the modelisation of a probit model with the probability of hedge fund failure as the explained variable, the author comes to the conclusion that an old fund with good performances, significant asset under management, high incentive fees and even low leverage are likely to survive. In a recent study published in the journal of financial and quantitative analysis, Bing Liang and Hyuna Park (2010) focused again on hedge fund failures. One of the major contributions of their paper is to distinguish ‘real failure rate’ from the attrition rate of hedge funds. They first started by clarifying the definition of hedge fund death. To this end, they set up an accurate definition of “real failure”. They noticed that since successful hedge funds can be liquidated voluntarily; not all the funds put in the graveyard by hedge fund databases were necessarily real failures. Indeed, the “real failure” of a hedge fund corresponds to the convergence of three criteria:
1/ Once listed in a database but stopped reporting.
2/Negative average rate of return for the last 6 months
3/ Decreased AUM for the last 12 months.
Their study was based on the TASS live fund and defunct fund database which is composed of 2590 live funds and 1726 defunct funds. As they included live funds and defunct funds in their analysis, it helped them reduce the survivorship bias. Based on this new criterion they have defined, they calculated the real failure rate of hedge funds in order to compare it with the conventional attrition rate. They came up with the conclusion that downside risk measures are superior to standard deviation in predicting both the attrition and the real failure of hedge funds.
The first part of our analysis is to confront Liang & Park definition of failure to the commonly admitted one.
After analyzing the various reasons behind these hedge funds failures, we will focus more on mergers.
Indeed, in 1959, Ralph L. Nelson was one of the first to identify the existence of waves in the business of mergers and acquisitions. He was the first to have the intuition that a link exists between the business of mergers and business cycles. It is by combining databases of all mergers in the U.S. economy between 1895 and 1920 that he will establish the theory that the number of mergers and acquisitions increased during periods of acceleration of the economy.
Ralph Nelson goes beyond these conclusions, and identifies the key role of financial markets: he revealed indeed a strong correlation between the price of the stock index and the number of operations. His methodology will be applied to hedge funds in order to analyze the aspects of mergers of hedge funds.
Part 2: Descriptive analysis & Methodology used
Hedge fund database and biases
In this study, we first conduct a statistical analysis to evaluate the number of “real failures”.
This study utilizes the Eurekahedge database to analyze the real reasons behind hedge funds failure.
Launched in 2001 by several professionals, Eurekahedge is today considered as a huge reference and an independent data provider for hedge funds. The database is well known for its complete databases that are continuously enlarging. Indeed, it provides a complete set of information: statistical information, managers’ details, fee and redemption structures, service providers, profile and strategy description. The databases used in this study are a good representative for the hedge fund universe and allow having significant conclusions.
Eurekahedge database, as it is the case for many other databases, is subject to many biases. Some of them can be eliminated through very complex calculations but it is impossible to do so for all of them. The major biases that remain and are to be analyzed are: self-selection bias, backfilling bias, survivorship bias and illiquidity bias.
a) Self-selection bias
One of the major characteristic of hedge funds is that they are not obliged to disclose their performance data to the public. Especially in the US, hedge funds are not allowed to market investors. As a consequence, databases constitute a strategic way to release information. Every information that is published on Eurekahedge is the object of a strategic and voluntary decision from the management. As some hedge funds will be willing to release information to databases when performing well or needing investors, some others will not report to them if having a bad track record or not needing investors. To this end, the idea of having a perfect representativeness for the hedge fund population is questionable. Fung and Hsieh (2000) consider that this bias is not significant but some other practitioners like Lhabitant (2006) have focused on how to measure the impact of this bias and came up with the conclusion that it is very hard to be estimated as long as the number of non reporting funds remains unknown.
b) Backfilling bias
Through an exchange emails with some interlocutors at Eurekahedge, it has been said that the database gives the option to new hedge fund manager willing to join it, to include all or part of its historical returns. This represents a strategic decision to the fund, it allows him select the information that is to be public and hide others if he wants. New hedge funds for instance, will have less interest to report initial performances that are generally under the average. But if those are above the average performances, managers will have strong interest to have them published. The main consequence is that past performances will have an upward bias. Lhabitant (2006) have been very interested by hedge fund databases methodology, suggested a good estimate to this bias by comparing average returns since inception to the average returns since the fund joined the database.
c) Survivorship bias
Survivorship bias corresponds to the bias that is introduced on the database when a hedge fund fails and is removed from it along with its performance history. Its elimination has a significant impact on the quality of the information provided by the database: from the moment the failing fund is not listed anymore, the database tracks only successful funds and leads to returns that are artificially high. This is why it is more realistic to calculate historical returns from a pool that includes both living and dead funds. These biases send the hedge fund investors some misleading signals because the universe appear to better than the reality.
d) Illiquidity bias
Hedge funds generally hold illiquid assets that are very difficult to price because there are no daily pricing for them or very small volumes of trading. As a consequence, the objectivity and accuracy of the net asset value (NAV) that is reported to databases is very questionable. Generally, hedge funds communicate the last figure available which is not always the exact one, generating through this the bias.
Data and Descriptive Statistics
This study relies on monthly hedge funds return data from Eurekahedge database from January 1987 to January 2007. The European database was constituted of 2486 funds and the North American of 2313 funds combining living funds and dead funds. We first combined the European and North American databases in order to have a complete one that will be the basis of our work with 4799 funds. With these funds, we constructed subsamples for each one of the fifteen hedge funds strategies. The main strategies that are represented are : arbitrage, bottom up, CTA/ managed futures, distressed debts, diversified debts, dual approach , event driven, fixed income, long/short equity, global macro, multistrategy, relative value, top down, value and others. The following step of our study was to determine, according to the common definition “a hedge fund is considered dead when it is no longer reporting to the database”, the number of failures and new births for the considered period. To this end, we have set up a macro that records on a monthly basis and for each hedge fund strategy the results. We also implemented another macro according to Liang and park’s definition: the “real failure” of a hedge fund corresponds to the convergence of three criteria:
1/ Once listed in a database but stopped reporting.
2/Negative average rate of return for the last 6 months
3/ Decreased AUM for the last 12 months.
The aim of this work was to go beyond the basic definition of hedge fund failure.
First, we can notice that from January 1987 to January 2008, the hedge funds universe has knew very significant changes that have been materialized mainly in the birth of new strategies. Indeed, Arbitrage, Long/Short equities and Multistrategy were the predominant strategies in 1987. In 2008, twelve strategies were added to the scope of hedge funds with a significant predominance of long/short equities: this strategy represents 40, 55% of total AUM in January 2008, which is consistent with the figures published in the Eurekahedge report for April 2008 (41%). [Appendix C].
This strategy retains its place as the most popular in Europe thanks to its great liquidity and capacity but also in the USA where it offers various opportunities. Also, we can notice that there is a geographical organization for these assets under management; it seems that European hedge funds have the largest part of AUM. This is generally due to the fact that most of European funds invest in North America and Asia in addition to the European market which is not the case for north-American funds. But this won’t be an issue in our analysis, because our database is compounded Also, we can notice a significant correlation between the total number of funds by strategy and the split of asset under management by strategy. This notification allows us to conclude that funds have generally the same sizes but also small ones; there is no concentration of asset under management in one hedge fun. For CTA/ Managed futures, we can notice the opposite; the number of funds is higher than the portion of AUM that it represents.
When applying the first criteria to define hedge funds failures [hedge fund that is no longer listed in the database is considered as dead.], we can notice that some strategies were more affected by hedge funds failures than others. Indeed, while considering births of hedge funds, the top three strategies are Long/Short Equities, CTA/Managed futures and multistrategy. (Refer to the chart of births/ deaths by strategy Appendix B) but while considering deaths of hedge funds, the top three differs a little bit and became: Long/Short Equities, CTA/Managed futures and Arbitrage. Since we are analyzing causes of hedge funds we are going to focus more on these three strategies among others.
For all hedge funds strategies, we can say that from January 1987 to the beginning of 2007, they have all experienced a phase of development and significant growth. This is linked to various factors (technological, psychological, financial…) that combined together explain this upward trends. First, since their creation, hedge funds have benefit from an increasing attraction from institutional investors. Indeed, improved governance, accurate accountability, enhanced yields and increased returns have been such factors to expand the scope of potential investors. With mentioning that institutional investors have the perfect profile that hedge funds are seeking for: motivation and resources. From a behavioral finance point of view, this general attraction have had a huge argument in favor of hedge funds, since more and more investors are investing in hedge funds, it became an obligation to stay in the race and perform at least as well as others that are competitors and have already invested in them. Technology has also been in favor of hedge funds growth, the huge improvements in computing power have done a lot to encourage this type of investment strategies. Very performing tools have been set up to help manager’s trade in an instantaneous basis, follow all positions, notice any pricing anomalies but also are able to measure their risk exposures. This technology has helped setting a climate based on transparency and accuracy. Another explaining factor has been the multiplication of investment styles. Whereas originally the hedge funds universe was limited to the basic strategy of going long assets estimated underpriced and going short assets estimated overvalued. Over the years, more and more funds are being specialized in the exploitation of market anomalies and getting specialized in very accurate segments they deal in. They have various strategies: they can seek mispricing between relative and historical norms and then take positions based on a reversion of price relationships to more normal patterns; they can take positions on potential future mergers; they can take positions on potential futures events that they judge are not correctly reflected in existing prices and so on. Strategies are driven by sector specificities, events, prices and knowledge of specific industries.
While dealing with due diligences, governance structures and risk measure has become a threat to hedge funds, the birth of funds of funds has brought new life to hedge funds. Indeed, though this new structure, investing in hedge funds has become easier: no need to undertake a due diligence, to identify risks but also had the great advantage to offer an access to variety of investments styles, sectors and strategies without making many investments. In our analysis, we didn’t represent the part of funds of hedge funds because it complicates the analysis of our scope.
This hedge fund age of glory was surrounded by an increased power: power of hedge funds toward their counterparties characteristics and prime brokers; but also the power of many hedge funds managers whose portfolio managers are considered as “stars” and in another way a guarantee of good revenues.
The persuasion that hedge funds will constitute a source of stability in the market place vanished through years. Indeed, the various crisis that the industry went through had shade the light on various weaknesses that had deep consequences. Moreover, from 2007, it has been noticed that returns were compressed as the industry was getting more and more mature: financial engineering had hard time creating new opportunities especially while other asset classes were demonstrating their resistance to fluctuations and crisis: commodities for instance. The hedge fund promise of alpha generation seems to be a very difficult task to accomplish looking to all the surrounding regulations in the industry.
Since 1987, the number of hedge funds has grown steadily as the volume of asset under management has.
We are going to discuss positive and negative effects of financial crises on hedge funds strategies.
a) European currencies crisis
In the early 1990s, George Soros through his global macro fund: The Quantum Fund speculated against fixed European exchange rates, which was a contrarian analysis and didn’t correspond to the macroeconomic situation in the country concerned in 1992, the fund sold very large amounts of the British pound and the Swedish krona and took short positions on the US dollar forward rate. In the same time, central banks couldn’t support their fixed exchange rates and were forced to abandon them. This situation directly led to the decline of these currencies and generated huge profits to The Quantum Fund: one billion pounds on its shorts positions in the British pound alone. The Bank of England abandoned its defense of the pound on 16 September; the Quantum Fund had a return of 25% and continued on a positive trend for the following months.
The following graph shows the evolution of the two currencies and the cumulative earnings for a global macro index and the Quantum fund over the period from August to November 1992.
Soros was subject of many criticisms for this action and his gain, he just answered that currencies were obviously mispriced and adjustments would have occurred sooner or later.
b) Asian crisis
Number of countries in South East Asia suffered in mid 1990s of large deficits in their current accounts. As a consequence, they fixed their exchange rates against the US dollar: it helped the promotion of domestic borrowings in foreign currencies and at the same time, increasing exposure to currency risk. Inflow of international capital encouraged the development of the financial bubble and let to a difficult situation when this inflow reversed and became an outflow. The fixed exchange rate became untenable and let to the devaluation of many currencies in Thailand (1997) but also Malaysia and South Korea. Hedge funds was pointed at as responsible of pressuring countries to devaluated their currencies because the financial bubble led to some major asset prices adjustments and hedge funds were mainly holding short positions on Asian currencies. On the other side, hedge funds that were specialized in emerging markets lost about twenty percent of their value during this period. The financial bubble led to various fundamental and structural imbalances in the financial system. The difference between this crisis and the previous one (1992) was the absence of individual investors or group of investors as responsible of this crisis. Fung and Hsieh (2000) showed by means of regression analysis that any negative correlation between hedge funds returns and changes in the value of Asian currencies were applicable. We can notice in the CTA/Managed futures graph that end of 1998 has seen a huge number of births of new funds for this strategy: 18 and 33 new funds (with 13 in December 1998) respectively in 1997 and 1998 comparing to the creation of 7 funds in 1992. Indeed, since the few specialized funds were reporting huge performances during these periods of economical instabilities, it encourages lot of practitioners create their own funds to benefit from this trend. In December 1998, half of the funds in this strategy were already present.
It is important to underline the fact that some strategies: managed futures have high probabilities of failure. Managed futures for instance can see high probabilities of deaths of hedge funds given the risky nature of their business operations.
The Long Term Capital Management (LTCM) was one of the major interruptions of hedge funds growth, because it was closely combined with the Asian financial crisis. LTCM collapsed in August 1998. His strategy was to look for mispricing particularly on the bond market: it invested large amounts with the judgment that interest rates of bonds issued at different times but with the same maturity would converge. But their analysis didn’t lead to the expected effect because of the Russian financial collapse that led to a sudden change in market situation and instead of converging, interest rates diverged. The fund suffered from major losses because it high leverage and positions in derivatives. This collapse was a real threat on the entire financial system: the fund had equity of 5 billion USD but had borrowed up to 125 billion USD, which means a degree of leverage of about 25 times.
This huge collapse shade the lights on the risks linked to high degree of leverage but also on how powerful hedge funds can be in generating a systematic crisis. Indeed, fund’s investor and counterparties are directly affected but so does other leveraged investors because if values of assets of the same type fall, they will be oblige to sell off their assets if the value of the collateral falls below the borrowed sum. This concatenation leads to financial instability.
LTCM debacle opened the debate about the best degree of leverage. In their paper published in 2002, Eichengreen and Park came up with the conclusion that in 1998, 74% of hedge funds had a degree of leverage less than two times their equity. This conclusion is consistent with our results obtained in our graphs, indeed, since majority of hedge funds had reasonable levels of leverage, it helped them resist to this crisis. In a general way, we can notice for mainly all the strategies that the total number of funds is very stable but not decreasing. Hedge funds did not fail but they became more prudent in dealing with risks and leverage.
d) IT Bubble
In 1999, IT-related shares knew a special evolution: their value increased in a dramatic way but these values proved to be very artificial and in March 2000, the trend reversed and their price fell dramatically. The stock market is a relatively liquid market and in order to lead to this big crisis, large volumes were traded. The role that was played by hedge funds during this episode was subject to many controversies: when some claim that hedge funds have played the role of arbitragers and that they should have take short positions on IT shares, others, Brunnermeier’s and Nagel’s (2004) for instance defend the opinion that hedge funds were aware that there was a bubble and the optimal strategy was to ride the wave rather than correct the prices. Indeed, they also confirm this hypothesis by saying that hedge funds did not have sufficient influence on the financial markets to be able to burst the bubble themselves. The fact that hedge funds have not suffer or lost many assets under management during this crisis explain that there is any hedge fund failure in this period , but instead, the development of many strategies like Arbitrage which have seen the creation of 21 new funds during the period from March 2000 to December 2000.
This IT bubble was also the cause of failure of few funds: Tiger funds for instance. After raising 6 billion USD, the fund manager misjudged its opportunities. Indeed, he took important expositions on stocks through a strategy that involved buying some stocks he picked considering they are good bets and short selling what he considered as the worst stocks. The strategy failed completely during the bull market in technology. He shorted overpriced technology stocks that didn’t perform. “Tiger management suffered massive losses and a man once viewed as hedge fund royalty was unceremoniously dethroned”.
e) Series of collapses in the hedge funds universe:
Considering the nature of hedge funds, failure is an accepted part of the process that founders keep in mind while launching a speculative investment, but when large , there is obviously a lesson to be learn somewhere during the collapse.
On September 18th, 2006, the hedge fund universe is facing a huge collapse: Amaranth Advisors, a multistrategy hedge fund founded in 2000 lost around 6,6 billion USD making this collapse the largest one in the hedge fund universe. Amaranth was funded in 2000 by Nicholas Maounis with an initial capital of 600 million USD. The fund’s initial strategy was convertible arbitrage, merger and utilities. But in 2002, they changed a little their orientation with the creation of an energy arbitrage desk. The strategy was also based on the assumption that prices of natural gas are going to all. Indeed, since gas consumption in the US market is cyclical, the strategy followed the following pattern: to be short natural gas contract during summer and fall and to be long natural gas contracts during winter. Through years, this strategy showed some weaknesses in 2005 but rapidly the fund managed to achieve some very high returns (from 15% to 20%) through the purchase of cheap out of the money call options (hurricanes Katrina and Rita). There was a very high correlation between the purchases of Amaranth of natural gas contracts for January 2007 and price movements on the spread. This successful decision was performing and very successful in 2006. But in May 2006, the fund noticed 974 million USD of losses and in September of the same year, the energy portfolio was sold to two investors: J.P. Morgan and Citadel; ending Amaranth’s story. Indeed, in September 2006, natural gas futures market behaved entirely differently than it had historically. Dramatic negative returns of natural gas futures have occurred in September which was up to 27% for front-month contracts and the negative returns were less for non-winter months. The changes in natural gas futures in September would have led Amaranth to lose around 3 billion USD. Margin calls on the large losses led Amaranth to search for buyers of their portfolios and the liquidation of the fund.
Amaranth’s failure created an atmosphere of doubts for all investors even if the Commodity Futures Trading Commission (CFTC) focused on monitoring the energy market. It also created fear for investors that didn’t know which value to trust because Amaranth was charged with the attempted manipulation of natural gas futures prices.
Bailey Coates Cromwell Fund
In 2004, Eurohedge was rewarding the event-driven, multistrategy fund as Best New equity Fund. One year later, the fund’s performances were going down: bad judgments on the evolution of U.S. socks, poor strategic decisions and highly leveraged trades generated a loss of 1,3billion USD inb few months. The fund was dissolved in June 2005.
On June 16, 2005, Marin Capital’s management sends a letter to shareholders informing them that the fund will be stopping its activities because of “lack of suitable investment opportunities”. Few years before, the fund was successful at attracting 1,7 billion UD in capital. It was mainly focused on Credit arbitrage and Convertible arbitrage to make very large bets on General Motors. Their strategy mainly consists on being long convertible bonds which can be redeemed for shares of common stock and shorting the underlying stock in order to make profit on the price difference between the securities. This strategy is often characterized as a low risk strategy because the two assets are normally traded at similar prices. But the exception happened: General Motors’ bonds were downgraded and this led the fund directly to the collapse.
f) Current crisis
The crisis that started at end 2006 is quite different from the Asian crisis in the way that the negative development of hedge funds can’t be related to a particular strategy or particular event. Indeed, all hedge funds strategies could report negative returns. According to our database, 47% of the Eurekahedge database hedge funds had reported negative returns in August 2007. When can tell that after this period, hedge fund index and share index both declined after.
This table helps us understand why we cannot apply the definition brought by Liang & Park. As we can see few strategies present negative return in a period of six consecutive months.
The chart shows the market return over a period of thirteen months, for all our strategies. In May 2007 all of the strategies had a positive return. The beginning of the crisis can be defined between May and July 2007 with the collapse of several hedge funds that specialize in credit derivatives: UBS Dillon Reed Capital Management, Bear Strearns High Grade Structured Credit fund. During the second half of 2007 and early 2008, mostly invested in subprime ABS have experienced difficulties leading them to suspend payments to investors or to go bankrupt. Factors common to all these episodes of crisis are exaggerated use of the leverage, naturally in structured products, an underestimation of the underlying risk, and difficulties in refinancing loans leading to a situation of illiquidity. There after the negative trend began and accelerated in August 2007.The strategies that clearly performed the best during this period are CTA and diversified debts. The one that performed the worst are arbitrage and long short equities. The poor returns of the Long/Short strategy reveals that this strategy had a predominance of long positions in a stock market that was down. What factors can explain this strong vague of hedge fund failures? Rumors about a change in the hedge fund regulation in early 2008 are responsible of a major negative impact. Indeed, the ban of short selling affected more hedge funds than mutual funds because short selling is a major characteristic of hedge funds. It affected all strategies but in different degrees. In a market going down, this interdiction was difficult for strategies that are based on economical trends. Long/ Short equities and arbitrage were very concerned by this change: indeed, it was difficult to back up long positions with short positions and it was also difficult to use arbitrage strategies.
Another significant reason is the decline in asset values. Indeed, during their age of glory, hedge funds reported very good performances through the diversification of their portfolios. But in time of crisis, they have mainly reduced their borrowings by selling assets in order to reduce their risks. This general situation of asset selling (commodities and property), led to the decrease of asset prices which has decreased the good effects of diversification. Hedge funds were expecting a global price adjustment that didn’t take place; leading many of them to failure. Shares also suffered from very high volatility, which made it difficult to forecast future market movements: many hedge funds that have invested in negative stock market trend went through many difficulties. Moreover, during this crisis, banks went trough very hard times which have direct effect on hedge funds: increasing borrowing costs, more restrictive lending policies. In a MIF study, analyst consider that 22,8% of losses linked to subprimes have been experienced by hedge funds versus 53,3% for banks. The direct impact was the selling of assets in a falling market, which can explain the negative returns that are in the chart.
Also, it is normal for hedge funds to receive premiums for taking huge risks: credit risk, duration risk and liquidity risks, these premiums constitute a large portion in hedge funds profits. But with this crisis, things have not been the same, high risks taken have not been rewarded by premiums but led to massive losses.
LEVERAGE hedge funds:
We have previously noted that hedge funds are permanent users leverage, especially arbitrage strategies where managers seek toamplify gains on porting spreads initially limited. This lever is provided by their prime brokers, via lines of credit or securities lending. However, it is major international banks that provide prime brokerage function, even those that have been taken in the turmoil of the crisis derivatives subprime, who found themselves in search of cash, made a last
spring by central banks. They are required now to clean up their balance sheets. It is in this environment that relations are highly strained between banks and hedge funds which were, however, until then, their best customers because of the importance of commissions paid, up to 25% income investment banks [A. Dubois, J.-P. Mustier, 2007]. But this situation has precipitated several hedge funds into bankruptcy. The month of August 2007 were a first illustration of what could be call a prime brokerage risk, with a negative performance of more than 2% for hedge funds, the largest decline since early 2000, even though the equity markets, meanwhile, had advanced across the months (Table 3). The banks, in fact, have been responsible for many failures when panic-stricken before the turnaround in equity markets, the initial concerns over U.S. mortgages and the unwinding of carry trade exchange, mid-month, they then demanded a massive deleverage among hedge funds, including increased haircuts, margins on credits. This has led investors to sell at lower and to undergo significant losses. The event was first seen as an isolated phenomenon, for the months that followed were generally carriers for hedge funds (Table3), besides reinforcing the impression of a limited impact of the financial crisis on their performance, while banks competed announcements always write downs more impressive. The trouble, however, would soon return for hedge funds, by combination of two mechanisms. On the one hand, the prospect of a recession over increasingly likely the United States precipitated the entire equity markets world in a real crash in the first quarter of 2008, causing heavy losses for almost all hedge fund strategies (except global macro / CTA and Short Seller, of course). For about half of them, hedge funds can things get tricky because they display a positive beta (for Long-Short Equity) or because the M & A deals are being questioned (Merger Arbitrage strategies). But it is the new restrictions imposed by the liquidity that prime brokers will result in the second half of March 2008, huge waterfall difficulties for many funds, the most important: Carlyle, Focus, Drake, Blue River, DB Zwirn, Pardus, Sailfish, Tisbury, JMW Partners, Platinum Grove4, several funds of Citigroup. Some hedge funds have also abandoned their prime brokers, the first of which included Bear Stearns, precipitating bankruptcy of the latter.
A significant and meaningful indicator that was calculated is the attrition rate. This rate corresponds to the ratio of the number of failed funds to the number of existing funds at the beginning of the year. It has been calculated for each strategy.
PART 2: MERGERS OF HEDGE FUNDS
In an annual report dedicated to asset managers, the consulting company Ernst & Young highlighted lessons that need to be learned from the crisis in order to restore confidence in asset management. The financial crisis has ended the euphoria that characterized hedge fund universe for many years. Indeed, majority of asset under management had lost around 40% of their values; portfolio, returns and index have reached their worst level in few months. However, this activity has yet powerful potential and structural drivers such as savings in Western countries or emerging countries. In order to remain in the competition, “survivors” must go through a transitional period of reorganization and restructuration in a universe that has been transformed itself. This new period is mainly marked by five main priorities:
1. Ensuring short term liquidity: One of the key lessons of the crisis was the importance of the liquidation. The majority of financial institutions did not fail just because of their bad investment but also because withdrawals and divestment of their customers forced them to liquidate their assets and close out positions at inopportune times.
2. Improving the practice of risk management: Given the speed at which even investments rated AAA ratings suffered from as a rapid degradation, risk management has been a sore point during the crisis. Some contracts considered previously safe and some reliable diversifications proved to be potential sources of debt whose magnitude was difficult to estimate. In fact, the risk of the investment becomes a spiral with a multitude of factors and risks specific.
3. Reducing fixed costs: since markets have a downward trend, the cost structure became a central element. In fact, numerous asset managers have been in danger when revenues plunged. This experience has taught for survivors of the importance of conserving cash and making cost base flexible. More fund managers have considered the merger of hedge funds, it was one way for dealing with this cost reductions.
4. Finding new balance in the remuneration: even if the asset managers are hoping that business will resume as before, customers are increasingly reluctant to award significant compensation to managers. In consequence, the money will be won by showing more flexibility compared to the situation.
5. Restoring consumer confidence: public and institutional investors are now skeptical of the hedge fund universe. Fund managers now have no more choice but to work hard to regain the confidence lost in the debacle, regardless of the time required.
From all these important issues, one has been put in practice by hedge funds. Since regulatory institutions have shade the lights on short term liquidity and the issue of risk management, hedge funds wanted to focus to reduce fixed costs through one major way: mergers. Combining knowledge and strategic issues of two hedge funds will be indirectly a way of restoring consumer confidence. Indeed, when considering the various reasons behind death of hedge funds, we can notice that mergers represent about 5% of these reasons which is quite significant since many hedge funds do not communicate the reasons. As discussed in previous part, for many funds we can’t have access to the real reasons since hedge funds are not obliged to report performances, it is then better not to communicate anything rather than communicating very bad performances.
We can synthesize the various reasons in eight major ones:
1. The reasons are unavailable
2. Funds have been liquidated
3. Funds have merged
4. Funds have gone through strategic restructuring
5. Funds have noticed full redemptions
6. Funds suffer from macroeconomic conditions
7. Funds have been closed
8. Funds suffer from management issues.
In 2006, 67% of all assets under management were controlled by the elite group of the top 100 fund, compared with 49% in 2003. Giles Conway-Gordon, managing partner in Cogo Wolf Asset Management is even saying “we think there’s going to be a Darwinian process, a sorting out of those who are actually producing a respectable performance and those who are not”. Indeed, since 2006, one sector is shining: marriages between hedge funds. Recent statistic of Dealogic is very relevant: global mergers have reached 2.46 trillion USD in 2010; it was already 2.3 trillion in 2009. Regarding hedge funds the volume of mergers have totaled 7.75 billion USD in 2010 meaning 44,4% more than last year.
Even if this area represents a very modest part in the scope of mergers, these deals represent strategic investments because they have been growing and are expected to expand as was saying the global head of asset management investment banking at Credit Suisse. The entrepreneurial verve that was once characteristic of hedge funds is not on the agenda any more.
Since 2006, various hedge funds have led the hedge fund landscape to consolidation. First, it has become a necessity for hedge funds to have a well-developed legal and compliance department in order to be as competitive as other hedge funds.
Mergers have also been driven by assets, indeed, 2007 crisis have led all assets to the biggest hedge funds because they were considered by investors as more reliable in the current context.
Some hedge funds are profiting from this trend of hedge fund failures to increase and establish their business. The well know example is Fortress Investment Group that acted as a buyer to build businesses through acquisitions of Logan Circle Partners, a long only fixed income manager with 12 billion USD in assets under management. The fund has been seeking to expand its global platform of products.
Many of these deals are negotiated by the principals and bankers after long negotiations.
From our analysis, we can come up with two majors trends: mergers for hedge funds have affected three main strategies: Long/Short equities, CTA/Managed futures and Arbitrage. We are going to focus our analysis on these three strategies.
a) Long/Short equities
After being one of the most profitable strategies in the hedge funds universe, this strategy seems to be also one of the most affected by the crisis, by failures and also by mergers. We are going to have a macroeconomic analysis to understand why these funds tend to merge a lot, and what the issues behind this strategic decision are.
First, we can notice that the Long/Short equities universe is the largest one of our entire hedge fund universe. (figure for LSEQ/ correlation S&P & returns). It is then legitimate to say that this area is too crowded. Lot of hedge funds are implementing the same strategies and taking very similar positions. The correlation between the funds is very high. This strong concentration reduces the diversification and potential alpha that can be generated. Some others will defend the theory that this strategy is subject to cyclical market conditions. Indeed, during the period from 2003 to 2007, we noticed the birth of many long/short equity funds that weren’t much experimented. This new trend reduced the opportunities area as much as the profit that could be generated. This is the main reason why we noticed decline in Long/Short equities returns especially from 2006 (XXX). In 2008, this downward trend will continue with the dramatic reduction of asset under management, hedge funds will continue to suffer from negative returns, leading them to wide failures. The changes in regulations in the market mainly the decision to ban shortselling affected the strategy, especially since this fundamental feature is widely used. This ban affected short positions but also long ones indirectly. In this complex macroeconomic context, only large long/short equity hedge funds can keep up. Indeed, with their size, they can afford a great selection of products, class research; they can also select funds from other geographical areas. They can provide the means to achieve better diversification and sources of alpha generation. They can hire very talented managers that can lock market inefficiencies and come up with a real added value, source of differentiation. The only way for smaller funds with specific knowledge, to compete with larger hedge funds remains concentration. It is important to note that, these concentration period benefits to the whole Long/Short equity universe. Indeed, it presents many advantages: it eliminates not experimented funds and it also lowers competition in this very challenging area. The surviving hedge funds benefits from more interesting opportunities: they are more able to protect their capital and increase their returns.
b) CTA/Managed futures
Since its beginning, this strategy was the most profitable and the less correlated to the stock market. Especially during the crisis where all the strategy recorded negative performances, managed futures performed their best and recorder their best results. Indeed, when the S&P 500 decreased of 40%, managed futures returns were reaching about 14%. The flexibility of this strategy allows it to take advantage of all type of trend. But one of the main reasons behind these performances is the wide diversification that this strategy offers: there is various types of CTAs as there are futures markets: many products, investment styles and exposure to different markets. These features are significant in term of diversification that is lacking in the Long/Short equity strategy; and indirectly significant in term of alpha generation.” It is a crisis alpha strategy” as was saying Jay Feuerstein, CEO at 2100 Xenon. Managed futures have been profitable since their creation, ensuring very good returns. It’s important to note that during years of crisis (2007/2008), this strategy didn’t perform it best but the losses were always not significant comparing to what the S&P 500 was going through. Managed futures have always created excess returns and manage to reduce volatility as well. Whereas majority of hedge funds strategies are seeking for securities underevaluation and betting on prices moving from their intrinsic values; managed futures seems to be a divergent strategy. It is mainly based on trend following or momentum based strategies. Trend following consists on forecasting trends before they happens through the analysis of historical price models and consider investors’ alternatives in different situations. “While every crisis is different, the way people react to them is often very similar. The responses fit into a handful of categories: greed, hope, fear and despair. If you can recognize the reaction, then you have a good chance of predicting the direction of the market” as was saying Troy Buckner, managing principal at an Investment Manager. This is very noticeable in our analysis; indeed, over the thirteen months analyzed from January 2007 to January 2008, the strategy shows only four negative returns in different months than the majority of strategies (it is not a trend follower) but also positive returns are very high comparing to other strategies.
This strategy is performing well during the crisis but not all of them. If prices move quickly in a high volatility scenario, it is not possible for trends follower to take position if they are not large. Indeed, to fully benefit from the move, hedge funds need to take a large position which is not possible for all hedge funds. In our analysis we can notice that managed futures is the second strategy in term of number of funds, there is a significant concentration which lead us to say that not all of them are large funds. In order to protect their capital and their great performances and be able to take appropriate positions, managed futures hedge funds started to merge. (Figures, & correlations to S&P).
As seen in the previous part, the nature of the strategy oblige hedge funds to close and new other to be create in order to be able to deal with the risky nature of their business operations but also dispose of high leverage when market moves.
III - CASE STUDIES
1) EMC International Fund Ltd
In February 2007, five managed futures funds: EMC International Fund class A, EMC International Fund class B, EMC International Fund class C, EMC 2XL New Program and EMC New Program merge into a global fund EMC Classic Program.
EMC Capital Management has been founded by Elizabeth A.Cheval. Elizabeth started her career on the exchange floor of the Chicago Board of Trade. After that, she joined a unique group selected to participate in a unique investment management training program offered by C&D Commodities. Elizabeth became close to the founder of C&D Commodities, Richard DENNIS, she traded for him and his family until the end of this program.
In 1988, EMC was created and Ms. Cheval directed all investment activity of the firm and was credited with the development of EMC’s investment programs: Classic, New and New2XL. The three programs offer a systematic, technical trend following investment strategy and incorporate various independents and non correlated systems specifically designed to accommodate their respective risk profiles.
The founder has over 23 years experience in futures industry and 17 years as CEO of EMC.
Let’s analyze funds strategy for the merged hedge funds:
• EMC New Program #
The New Program is a lower risk alternative in the managed futures investment sector with significantly less downside and volatility. The goal of the Program is to produce a return profile with smaller upside profit spikes, smaller drawdowns and lower standard deviation. The Program is a systematic, technical investment strategy, which employs a blend of several independent trading systems and proprietary money management principles designed to control risk within the portfolio. The New relies on historical analysis of price patterns to interpret current market behavior and to evaluate technical indicators for trade initiations and liquidations. It is a broadly diversified portfolio investing in over 45 global markets through the following sectors: stocks, currencies, financial instruments, metals, agriculturals, softs and energies. Although primarily trend-following, the Program also contains significant counter-trend components. While the counter-trend component reduces profitability, this loss is made up for on a risk-adjusted basis by reducing drawdowns and smoothing out volatility. This preference for sacrificing some upside to reduce the downside and volatility is the signature of the New Program’s risk profile. The Program’s approach also aims to reduce risk exposure much more quickly during losing periods.
• EMC 2XL Program:
The 2XL New Program, is a straightforward double-leveraged version of the EMC’s New Program. The Program is a systematic, technical investment strategy, which employs a blend of several independent trading systems and proprietary money management principles designed to control risk within the portfolio. 2XL New relies on historical analysis of price patterns to interpret current market behavior and to evaluate technical indicators for trade initiations and liquidations. It is also a broadly diversified portfolio investing in over 45 global markets. This preference for sacrificing some upside to reduce the downside and volatility is the signature of the New and 2XL New Programs’ risk profiles. The 2XL New Program’s approach also aims to reduce risk exposure much more quickly during losing periods.
• EMC International Fund Ltd – Class A #
This strategy is a lower risk alternative in the managed futures investment sector. It was designed in to offer investors an attractive return profile, but with significantly less downside and volatility. The aim of the program is to produce a return profile with smaller upside profit spikes, smaller drawdown and lower standard deviation.
• EMC International Fund – Class B #
This class utilizes the investment strategy of the EMC Classic program. It was designed as an aggressive program seeking high returns during favorable market periods both relative to other advisors and in absolute terms. It is a systematic, technical investment strategy which employs some independent trend-following trading systems and proprietary money management principles designed to control risk within the portfolio.
• EMC International Fund Ltd – Class C #
Class C uses the investment strategy of the 2XL New Program. It consists on straightforward double-leveraged version of the EMC’s New Program. The level of leverage is increased to provide approximately double the returns.
The last fund that has not been merged with others is the Currency Program.
• EMC Currency Program #
The CURRENCY PROGRAM utilizes a diversified, systematic investment strategy across global currency markets. It employs both trend-following and counter-trend components and applies proprietary money management principles designed to control risk within the portfolio. The strategy employed in the Currency Program evolved from strategies in the currency sector in the Classic Program. The strategies have been modified to accommodate the less diversified portfolio. The Currency Program invests exclusively in Cash Forward Currencies, which carry counterparty risk.
During the three years before the merger, we will analyze the results and trends of the EMC funds concerned by the merger. In 2004, EMC’s investment were driven negatively by three major themes: rise of interest rates, surge in oil prices and the collapse of the U.S. Dollar.
• The Federal Reserve has raised interest rates five times since late June, bringing short-term
rates to their highest level in more than three years. Despite the number of increases, the
most in ten years, short-term interest rates remain remarkably low at just 2.25%, still below
the current rate of consumer price inflation that has been running at more than 3%. This
contradiction was evident in the volatility of the financial markets.
• Energy markets mounted a spectacular rally to historic highs in response to the Iraq war and
global supply concerns.
• The U.S. Dollar, affected by a large and growing current account deficit and a relaxed dollar
policy stance, collapsed to contract lows against the Euro and many other major currencies.
In 2005, the funds presented slightly negative results but ended at the positive end of the range. Attractive returns to our diversified portfolio strategy that includes a 35% allocation to physical commodities. Softs and stock indices were the best performing sectors in December and throughout the year. In addition to making significant profits in physical commodities, EMC benefited from its proprietary volatility filters which reduced our exposure in difficult sectors, such as currencies and long-term financials. The most prominent events that affected markets in 2005 were Hurricanes Katrina and Rita, which impacted the energy sector and US economy, and the Federal Reserve’s continued tightening to the point of inversion in the yield curve.
EMC produced strong returns for the year 2006. Sustained rallies in stock indices and exceptional
opportunities in physical commodities drove portfolio performance. Copper, Nickel, Silver, Hang Seng, DAX and Sugar produced the largest profits in the portfolio.
the success in 2006 is attributed to specific factors: the significant allocation to commodities, ,and their comprehensive risk management. These factors enabled EMC to participate in strong trends and capture a significant portion of the gains, while avoiding initiations in excessively volatile markets.
EMC’s performance was positive in January 2007. Financials, energies, and base metals were the most profitable sectors. Small losses in the grains and currencies offset a portion of the gains. EMC experienced several losses in February2007. Large reversals in stock indices and financial interest rate products, combined with excessive volatility, led to liquidations in those sectors during the final two days of the month. Long positions in metals and grains mitigated a portion of the losses in the portfolio. EMC sustained losses in March. The largest losses occurred in early March following the stock market sell off in late February. The sell off in global stocks triggered liquidations across the portfolio. The largest losses were in precious metals, grains, stock indices, and financials. A portion of the losses were absorbed by gains in base metals and energies. EMC’s performance for the month and the year is the direct result of our significant allocation to commodities. Although financials and currencies also had positive returns, energies, grains and metals contributed more than two thirds of EMC’s profits for the month and the year.
In March 2007, EMC anounced the merger of the five funds. The fund manager didn’t give any explanation. The analysis of financial indicators ( ANNEX) show that fund managers anticipated the coming crisis and wanted to protect their assets to this end the merger aimed first to the creation of synergies between the funds : lowering cost of trading and various costs linked to each fund alone: analysts, traders, cost of trades… It also allows also the principal fund to gather all the assets under management in one only fund which allow having more leverage for the deals, better selection of investments and better risk management.
We can say that this strategic decision was very profitable to the fund. Indeed, one month after, they were recording positive returns. The ended the year 2007 with very positive returns that confirm the good effect of the merger.
We should underline the fact that we couldn’t obtain the returns for the fund EMC international class B.
2/ CTA Mergers: ANTENOR VS Beaumont fund.
Antenor is one of the three funds of Prospero Capital. Benjamin J. Bornstein has been president and portfolio manager at Prospero Capital since its inception in November 1992. His professional experiences have centered on professional investment management services, with a particular expertise in analyzing healthcare, financial and consumer equities. He has a strong background in evaluating management teams, financials and strategies for developing products. Prior to Prospero Capital, he worked for Goldman Sachs and Oppenheimer & Company in New York; he also covered the US portfolio for the global fund products of Orbis Investment Management in London and Bermuda from 1997-99. Bornstein graduated from Harvard Business School with high distinction as a Baker Scholar (top 5% of class), Harvard Law School as part of the JD/MBA program and magna cum laude from Princeton majoring in economics. He received the John Loeb Award (awarded to the top four students in finance) and Sheridan Logan Fellowship (awarded to one Baker Scholar) at Harvard Business School. Bornstein maintains close contact with his key academic affiliations, representing a substantial consulting resource to Prospero Capital.
Prospero's objective is to provide our investors with high annual rates of returns, primarily in the form of long-term capital gains, over an extended number of years. Prospero follows a highly differentiated investment strategy focused on growing companies with (i) strong customer loyalty, (ii) recurring revenue business models, (iii) sustainable competitive advantages, (iv) potentially high cash returns on invested capital, and (v) excellent management teams. They believe that most companies do not meet these demanding criteria, but the few that do have the potential for superior growth and value creation over many years. Prospero invests in such companies, but only when we believe the shares are trading at a discount to intrinsic value and that this intrinsic value is likely to increase significantly over the next four years.
Antenor's investment objective is to provide investors with a high net compounded annual return, utilizing a multi-cap, relative value approach. It invests in 20 to 30 stocks, focusing on companies trading at significant discounts to intrinsic value that was estimated to increase significantly over the next four years.
In 2002, while the markets gave back a significant portion of their 4th quarter gains in December, Prospero outperformed the S&P by 4.8% and the NASDAQ by 8.6% for the month in its full-market-exposure fund: Antenor. Prospero Capital's substantial outperformance in December contributed to a strong year for the funds, the core-equity strategy Antenor was 15.7% per annum ahead of the S&P 500 during the last three years. The hedge fund has produced gains for its investors during the last three years, consistent with our target of delivering positive returns in both rising and falling markets.
In 2003, the fund appreciated 38.0% net of all fees and expenses and has produced double-digit annual returns for its investors during the last five years, while the S&P 500 and NASDAQ indexes declined during the same time period.
In 2004, the fund continued to produce positive net returns, consistent with it respective level of underlying market exposure and risk. Antenor finished the year strongly, with monthly net returns of 3.0. Furthermore, Prospero's long-term record continues to shine, as for the 5-year net results for Antenor are now 11.4% per annum ahead of the S&P 500 Index for the period ending 12/31/04.
2005 was the year of the "hedge" at Prospero Capital. Net of all fees and expenses, year-end returns for Antenor were 6.8 respectively, versus only 4.9% for the S&P 500 Index. Antenor has now outperformed the market by 8% per year (47% cumulatively) net of all fees and expenses during the last five years. Furthermore, the S&P 500 Index remains 10% below its August 2000 peak levels, while Antenor is up 45% during the same period.
For nearly ten years, the fund has performed with an active risk management program, coupled with superior equity selection, to produce net performance significantly in excess of the S&P 500 Index with low volatility. The long-term success of Prospero's long-only Antenor Fund led to the formation of our hedged products (Beaumont and Curan) in 2002, which utilize risk management strategies to produce more stable returns. By combining short positions with Antenor's long-term holdings, Prospero has been able to produce positive net returns, as illustrated above, while exposing our investors to reduced levels of market risk.
In 2005, the success resulted from winners on both the long and short sides of the portfolio balance sheet. As for sector exposures, Prospero maintained overweight positions in Consumer Staples (particularly tobacco), Financials, and select Transports (railroads), while remaining underweight in Capital Goods and Consumer Cyclicals. We maintained in-line weightings in Healthcare, Technology, and Utilities, and small net exposures to the lower-weighted sectors of the S&P 500 Index (Basic Materials, Communications, and Energy). Recent additions to natural gas, India, and major pharmaceuticals also boosted returns for the year.
Analysts considered that real estate as an overall asset class no longer represents good value. Regarding foreign equities, while less expensive than their US counterparts in many cases, they carry with them sovereign risk, currency risk, and operational risk and must be monitored carefully.
In 2006, in this difficult context, the company started strategic organizational changes that aim to increase access to company management teams, idea flow, research products, and industry conferences. Over the last years, we can notice that Antenor’s returns have been decreasing. As it is usually the case for many cta/managed futures funds, funds are born and other close on a regular basis. In January 2007, Prospero formed a new long/short hedge fund, Beaumont Fund, LP, which will be the exclusive investment vehicle going forward as the merger of Antenor (long only), Beaumont (Long/short) and Curan (market neutral). The major reason for this merger and reorganization is a tax-free restructuring of the three existing funds to optimize net market exposures. In this context, the hedge fund implemented a strategy of cost-cutting by establishing its offices in New York and beginning an affiliation with Omega Advisors, a $5.2 billion hedge fund managed by Leon Cooperman. Omega has provided Prospero with a line of capital to manage in concert with long/short Beaumont Fund. Through this affiliation, Prospero will be able to obtain more leverage and capitalize on superior access to Wall Street investment research, conferences, company management teams, and idea flow, increasing the likelihood of producing superior returns for our investors.
As it is the case in the CTA/managed futures universe, hedge funds appear and disappear regularly; it doesn’t mean that they have failed. In this case, the merger doesn’t happened because the funds were performing badly ( CF Statistical returns ) but it has happened in a context of financial crisis, hedge fund managers were expecting the worse this is why they implemented strategic changes while their returns were still good. These strategic changes had several goals: to implement cost reduction on all the levels, to get close to an advisor that will provide leverage and better access to products and investments.
Case Study 3: Long/Short Equity unsuccessful merger:
Libre Group Trust:
Libre Group is a Long/short equity hedge fund in North America. Its universe consists of the top two deciles of stocks ranked by market capitalization, or about 1,600 companies. The hedge fund does not invest in private placements, IPOs, small cap stocks, foreign stocks, or derivatives and select only long and short positions through intensive bottom-up quantitative analysis of fundamental data, using proprietary research and techniques developed over 30 years at Towneley Capital Management Inc.
For long positions, analysts seek undervalued stocks with improving fundamental characteristics. For short positions, they look for overpriced companies with deteriorating fundamentals and unsustainable growth rates. The resulting long and short portfolios are concentrated in specific industries but well-diversified across many different companies.
The fund experimented two phases during its life: From inception to June 2002, the fund managed to have fair returns, but from this date, the fund was not performing very well in comparison to his peers. The worst drawdown was experimented in August 2003 with an amount of -27,14. It was the worst the fund ever noticed. In February 2006 – one month before the merger-, the fund knew another negative drawdown this event can be linked to the financial crisis. Over the last year before the merger, the fund didn’t record positive returns: the best monthly return that could be noticed was 1,64% in comparison to -1,82% as the worst monthly return. While analyzing, the skewness and kurtosis of this fund, we can notice that over the last year, the last six months and also the last three months, these indicators presented all negative values, which is not a very good sign. A negative skweness indicates that the tail on the left side of the probability density function is longer than the right side: it is more probable to have negative returns than positive ones. Over the last year, the skewness was decreasing more and more from -0,83 to -1,71, which means increasing probability of having negative returns. The kurtosis indicates that the distribution is flatter than the normal distribution and fatter tails, which means less probability of having peaks and more probability of having positive or negative returns. But in this context of crisis (2006), the context was not favorable and led the fund to one of its worst historical returns in February 2006: -1,86%. Funds manager didn’t expect the fund to perform well in this crisis context, this is why, instead of liquidation, they decided to merge it with Libre Partners.
Libre Partners is a hedge fund that seeks high absolute returns with controlled risk through investing long and short in liquid, mid/large cap, publicly traded US stocks. The investment universe and the methodology used are not different from those used for Libre Group Trust. The difference is that this fund was launched first (February 1992) and since December 2002, the fund has maintained a net exposure of approximately 30% at a low correlation with the US stock market.
Even if the strategies were about the same, Libre Partners didn’t manage to perform well and benefit from this merger. The returns were very low. In August 2006, the mean return was – 0, 02.The same scenario that we could notice for Libre Group Trust, was noticeable here again: a negative and increasing skewness and very low kurtosis. Seven months after the merger, the fund was liquidated. The Long/short equity universe is very competitive as developed in previous part, it is the strategy that records the maximum number of hedge funds, as a consequence, it is a challenge to find exclusive opportunities and not all the funds can be in the race.
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Appendix A : VBA CODE
Dim numcol As Integer
Dim numrow As Integer
Dim fundinfo As fund
Dim k As Integer
Dim allfunds As Collection
Dim i As Integer
Dim j As Integer
Dim previousK As Integer
Dim AFM As Integer
Dim bor As Integer
Dim previousAFM As Integer
Dim m As Integer
Dim Over As Integer
Application.ScreenUpdating = False
numcol = Sheets("data").Cells(1, 2).End(xlToRight).Column
numrow = Sheets("data").Cells(1, 2).End(xlDown).Row
k = 4
Set allfunds = New Collection
For i = 2 To numrow
Set fundinfo = New fund
fundinfo.fundID = Sheets("data").Cells(i, 2)
If Sheets("data").Cells(i, 4).Value = "" Then
fundinfo.edate = Sheets("data").Cells(1, Sheets("data").Cells(i, 4).End(xlToRight).Column).Value
fundinfo.sdate = Sheets("data").Cells(1, Sheets("data").Cells(i, Sheets("data").Cells(i, 4).End(xlToRight).Column).End(xlToRight).Column).Value
fundinfo.edate = Sheets("data").Cells(1, 4).Value
fundinfo.sdate = Sheets("data").Cells(1, Sheets("data").Cells(i, 4).End(xlToRight).Column).Value
k = 1
For Each fundinfo In allfunds
Range("fundid").Offset(k, 0).Value = fundinfo.fundID
Range("sdate").Offset(k, 0).Value = fundinfo.sdate
Range("edate").Offset(k, 0).Value = fundinfo.edate
k = k + 1
AFM = 0
k = 12
For j = 2 To 254
previousK = k
previousAFM = AFM
AFM = 0
k = 12
bor = 0
For Each fundinfo In allfunds
If Sheets("output").Cells(j, 1).Value <= fundinfo.edate And Sheets("output").Cells(j, 1).Value >= fundinfo.sdate Then
AFM = AFM + 1
Sheets("output").Cells(j, k).Value = fundinfo.fundID
bor = bor + 1
For m = 12 To previousK
If Sheets("output").Cells(j - 1, m).Value = fundinfo.fundID Then
bor = bor - 1
k = k + 1
Sheets("output").Cells(j, 2).Value = AFM
If bor = 0 Then
Sheets("output").Cells(j, 3).Value = ""
Sheets("output").Cells(j, 3).Value = bor
Over = AFM - previousAFM - bor
If Over = 0 Then
Sheets("output").Cells(j, 4).Value = ""
Sheets("output").Cells(j, 4).Value = Over
Appendix B: Results of the Macro: Births & deaths by strategy
APPENDIX 6 : Strategic mandates by AuM.
In his “Walk through the graveyard”, Ross Barry generally noticed that many hedge funds are closing when their net asset value falls below their previous high-water marks for incentive fees. When analyzing deeply the probable causes of death for a hedge fund, he came up with the impacts of return and volatility, the impact of incentive fees and self closure, the importance of investment strategy and hedge fund style but also the significant impact of leverage. Indeed, he ended his paper claiming that high leverage is almost always a factor where very extreme losses occur. Study of 2200 hedge funds in the Tass database from 1994 to 2001 936 hedge funds are considered dead.
Analysis of returns is a sensitive area:
a) 2 majors bias in hedge funds returns: survivorship and selective backfilling.
As stated earlier, not everything in the graveyard is truly dead. Not surprisingly, these funds have, on average, fairly chronic negative returns and much higher levels of volatility than average.
Other defunct funds in the TASS database have stopped reporting returns because they are closed to new investors, have been merged with other funds, or have stopped reporting for other reasons.
b) 3 factors are making things more complicated: A/ Not all databases retain historical data about defunct funds. B/ Marketing issues for US investors: when funds need investors they cover the major databases and when they raise enough capital they become closed to new investors (TASS directly transferred to the graveyard). C/ Discretion in reporting: funds will e willing to hide returns if these were too weak “self-selection bias”: unsuccessful in some days don’t report.
Probable cause of death:
Primary cause of death: poor returns, excessive volatility and skewed returns
For them, the death of a fund caused the mean, standard deviation and skew to deteriorate sharply in the final six to twelve months of a fund’s life.
It reveals that A/ Investors focus more heavily on short term performance when evaluating hf, B/ Highlights the market impact of liquidating funds.
Closer look to liquidated funds they think that many funds that are listed liquidated are in reality closed but want to protect their reputation.
The information available to investors is not always conclusive and does not necessarily tell the whole story. Therefore, there is a good reason for investors to stick with hedge fund managers who invest in their own funds and have much at stake in the event of liquidation.