Hedge fund managers 'funereal' in midst of crisis
More pain expected, but some look for opportunities in 'rubble'
By Alistair Barr, MarketWatch
Last Update: 8:32 PM ET Nov 7, 2008
SAN FRANCISCO (MarketWatch) -- In the midst of the worst financial crisis since the Great Depression, several top hedge fund managers sent a grim message to their investors in October: it isn't over.
One said he was sickened by the crisis, while another admitted shock and embarrassment at the severity of the market slump and the losses his firm suffered. A third warned clients to be careful about buying anything and said it will be years before investors should buy stocks.
Such pessimism is often taken as a sign that markets may have hit a bottom and most of the managers realized this. Indeed, some said they'd already begun buying securities that they think are cheap enough to discount all the gloom.
The Standard & Poor's 500 index slumped more than 16% in October, while credit markets collapsed.
Spreads on investment-grade corporate debt jumped by 151 basis points, while junk bond spreads surged by 521 basis points to a record 1,617, according to CreditSights.
Losses in these markets so far this year reached 19% and 31% respectively, prompting the fixed-income research firm to ask "Can it get any worse?"
Hedge funds have been hit particularly hard by this market collapse. The average manager lost 5.43% in October, leaving them down more than 15% so far this year, according to preliminary estimates on Friday from Hedge Fund Research.
That puts the 1.7 trillion industry on course for its worst year since at least 1990, when HFR began tracking performance. Before 2008, hedge funds had only one down year in that time: in 2002 they lost 1.45% on average.
Steve Galbraith, a partner at Lee Ainslie's Maverick Capital, read about 25 letters other hedge funds sent to their investors in October.
"The tone of the discourse was funereal," he wrote in Maverick's own Oct. 9 letter to clients. "The global economy has already entered a grim recessionary period akin to those of the '90s and '80s rather than the shallow post tech bubble recession of 2001-2002."
The Maverick Fund, Ltd. was down more than 7% last month through Oct. 17, leaving it off roughly 26% so far this year, according to a hedge fund performance report compiled by HSBC's private bank.
In Maverick's Oct. 9 letter to investors, the firm reported that its funds lost between 14.4% and 40.6% during the third quarter.
"I cannot find words to describe our disappointment, embarrassment and shock over the above results," Ainslie wrote.
Oct. 1 marked the 15th anniversary of Maverick Capital, during which time Ainslie has outperformed the S&P 500 handily.
But Maverick couldn't shelter from what Ainslie called a "perfect storm" of hedge fund de-leveraging and failure, short selling bans, slumping equity markets, faltering prime brokers and a spike in volatility.
"Be careful buying ANYTHING today," Kyle Bass, managing partner of Hayman Advisors, warned in an Oct. 17 letter to investors.
"There will be a time to buy stocks," he added. "That time is a few years into the future when the strong have separated themselves from the week ... a time when unemployment has hit 10% and U.S. GDP has dropped 4-5% (maybe more)."
He criticized Berkshire Hathaway BRKABRKB Chairman Warren Buffett who advised investors to buy U.S. stocks in a New York Times column last month.
"Mr. Buffett has enough money to be able to have his holdings drop 50% and still fly in his jets and live the way in which he has become accustomed," Bass wrote. "Do you have enough capital to take what you have left, cut it in half, and continue to live the way you have for the past few years? I don't."
Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be "vicious and protracted."
"The financial market collapse and bailout makes us sick," he wrote. "There is likely more carnage to come."
The U.S. dollar will likely weaken and its reign as the world's reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.
The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.
Baupost has built a "sizable position" in low-cost inflation protection for the next three to five years, he noted.
Howard Marks, chairman of Oaktree, a giant LA-based fixed-income hedge fund firm, said some "great" investors he knows were "genuinely depressed" when the credit crisis reached a peak in October.
Pessimism fed on itself as managers exchanged increasingly gloomy emails about the coming meltdown, he explained in an Oct. 16 letter to investors.
"People's only concern was bullet-proofing their portfolios to get through the coming collapse, or raising enough cash to meet redemptions," Marks wrote. "The one thing they weren't doing last week was making aggressive bids for securities. So prices fell and fell -- the old expression is 'gapped down' -- several points at a time."
Like Klarman, Marks worried about the impact of government bailouts and interest rate cuts on future prices, recalling the hyper-inflation in Weimar Germany in the 1920's.
It may be time to re-think holding long-term U.S. Treasury bonds, which currently yield little because investors have bought them as havens from riskier assets, Marks said. (Inflation eats into the future fixed payments of bonds, undermining their value).
Thomas Barrack, founder of distressed debt and real estate investment firm Colony Capital, said the crisis has exposed how complicated the financial system has become -- and how difficult it will be to get it working properly again.
"I have absolutely no idea how the intricacies of the global financial system function. I had previously taken solace in believing that 'the other guys' did understand," said Barrack, a former Reagan administration official. "What we all now realize is that nobody understands and nobody ever understood."
"The current turmoil is larger, more complicated, more volatile, more interconnected and more global than anyone had anticipated," he added in an Oct. 14 letter to investors.
Barrack has experience with troubled banks during previous financial crises, having worked with TPG's David Bonderman and Cerberus Capital Management's Stephen Feinberg restructuring Korea First Bank and Aozora Bank respectively.
He was gloomy about the Treasury's efforts to buy toxic assets from troubled U.S. banks, arguing 750 billion won't be enough. The amount needed to acquire these assets, even at true market value, could be in the trillions, he said.
Bank stocks probably haven't bottomed yet and the stock market "will no doubt have further and dramatic dips," he predicted.
Still, almost all these managers said the carnage will create great investing opportunities. The key is surviving to take advantage.
Perry Capital LLC, run by former Goldman Sachs GS trader Richard Perry, has been buying first-lien bank debt that yields more than 15%. It's also bought a portfolio of securities backed by near-prime and so-called Alt-A mortgages.
"We will continue to pick through the carnage," Perry said in an Oct. 8 letter to investors.
Baupost's Klarman has been buying corporate debt offering yields of as much as 30%. The firm is also seeing some opportunities to invest in real estate, through the debt of distressed companies, he added.
"The seeds of recovery and eventually of substantial profit are sown amidst the carnage," he wrote. "The world is not ending."
Oaktree's Marks expects boutique investment banks including Evercore EVR and Greenhill GHL to benefit as larger banks become more regulated, bureaucratic and risk-averse.
"In the third stage of a bear market ... everyone agrees things can only get worse," Marks wrote on Oct. 16. "There's no doubt in my mind that the bear market reached the third stage last week."
"That doesn't mean it can't decline further, or that a bull market's about to start," he added. "But certainly it's a good time to pick among the rubble."
Maverick's Ainslie said on Oct. 9 that he'd never seen as many extremely over-valued and under-valued stocks at the same time. That presents great opportunities for hedge funds that both short equities and go long.
"The most important objective at this point is simply to endure this unique turbulence to be positions to take advantage of the far more productive environment that will exist on the other side of this nightmare," he wrote.