Don Sussman and When Market-Neutral Isn't - TheStreet

Don Sussman and When Market-Neutral Isn't

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Editor's note: This story, originally posted Oct. 22, has been reposted to remove an erroneous characterization of the relationship between Paloma Partners and Shadwell Partners LP. For details please see a letter from a Shadwell representative and our corrections and clarifications page.

Paloma Partners

, the private investment firm run by reclusive

S. Donald Sussman

, revealed Oct. 22 that its hedge funds lost "between 2% and 25%" of their value this year through Sept. 30.

The hedge fund, whose assets under management are said to be around $4 billion, sent out a statement disputing rumors it was hit by even bigger losses, and dismissed as "utterly ridiculous" rumors it was a big seller amid the Oct. 20 stock-market selloff.

More importantly, Paloma's losses may have forced a move by Sussman away from his famously aggressive "relative value" investment strategy, a high-risk path that calls for heavy leverage and has allowed his firm to go for years without a down quarter.

Despite the losses in his various funds, Sussman tried to comfort investors by saying his firm is now carrying "more than $300 million in cash and excess liquidity." Paloma Partners is "in the final stage of altering our portfolio compositions with significantly less leverage. ... We are actively seeking new investment opportunities that we expect will begin to reverse losses experienced over the past few months."

As many on Wall Street know, Sussman, 52, is not just the multimillionaire head of Paloma. He's a successful trader and Wall Street personage in his own right who married into New York's

Tisch

family and managed part of the family's fortune. Sussman founded Paloma in 1981, the same year he married Laurie Tisch, and named his firm after

Paloma Picasso

, the

Tiffany

(TIF) - Get Report

jewelry designer whose work Sussman and his wife admired.

Over the years, Paloma has acted as investment adviser to such Hollywood luminaries as blockbuster producers

Jerry Bruckheimer

and the late

Don Simpson

. More recently it counted endowments as its chief clients, including those of

Brown University

and the

Mellon

family. Sussman personally has emerged as an unabashed supporter of

President Clinton's

, donating $10,000 to the president's legal defense fund this year after a hefty $100,000 gift to the Democrats in support of legislation making it harder for shareholders to sue their companies in state courts, according to newspaper reports.

However, Sussman himself is legendarily tight-lipped. He rarely gives interviews, although in a 1993

Forbes

article he revealed himself as a pioneer of the market-neutral strategy that has allowed so many hedge funds to hang out a shingle in recent years. Sussman was an early adopter of statistical arbitrage, and a master of diversification.

In more recent years, he has become more of a manager of managers, at one point spreading more than a billion dollars in capital with about 70 different outside money managers.

But in the post-

Long Term Capital

era of hedge funds, the meaning of "market-neutral" is up for debate. Many hedge funds shop themselves as such in an effort to assure investors that the firm is using strategies designed to make money no matter what happens to the markets. That works just fine until the markets take a series of turns that surprise the managers. That's what undid Long Term Capital, the Greenwich, Conn., firm forced into a $3.5 billion bailout by its Wall Street lenders last month, resulting in a massive credit crunch in U.S. markets. A spokesman for Paloma said the firm was in no way as leveraged as Long Term Capital.

Chatter about Paloma Partners bubbled up earlier in the week after

BankAmerica

(BAC) - Get Report

disclosed in its third-quarter earnings report that it lost $372 million on a $1.4 billion loan to

D.E. Shaw

, a New York-based hedge fund. Paloma Partners had been one of the original investors in D.E. Shaw, a computer-powered quant house investing in exotic bond instruments.

A professor by avocation, chief David Shaw had for years produced market-beating returns with secret mathematical algorithms. So secret, it turned out, that Wall Street forgot just how staggering a loss statistical arbitrage could produce. Shaw's losses prompted talk that Paloma Partners would be dragged down with it. There was even talk that Paloma would suspend redemptions by investors in its hedge funds, according to a rival hedge fund manager.

Not only that, but Paloma had lost big once before on Shaw's black-box strategy. In 1992, after the

European Exchange Rate Mechanism

came undone, Shaw thought he'd worked out a profitable hedging strategy taking advantage of disparities between expected and actual discount rates on secondary European currencies. But the model failed miserably in the ensuing currency turmoil.

In his statement, Sussman called rumors circulating about Paloma's exposure to D.E. Shaw "inaccurate. Paloma has no relationship, whatsoever, to D.E. Shaw Securities Trading -- the entity that caused recent losses at BankAmerica."

Sussman said some Paloma funds "do have exposure to D.E. Shaw Investment Group, a separate portfolio which has a lower risk profile than that of D.E. Shaw Securities Trading." Paloma's total exposure to D.E. Shaw Investment Group is relatively small in relation to Paloma's overall assets, he said. He didn't give a figure for Paloma's total assets under management.

A spokesman for Paloma Partners tried to clarify in a telephone call: "We believe they're different exposures, though they have similar portfolios in many respects."

Even if Shaw's misfortunes didn't spill over into Don Sussman's yard again, it's undeniable that Paloma Partners, a diversified firm, was involved in lots of markets that tanked this year: mortgage-backed and global fixed-income arbitrage, junk bonds and emerging markets. Paloma has been a heavy seller in the convertible bond market this week, and "it sounds like they want to take their lumps now, mark their portfolios and get into cash in anticipation of redemptions," said the rival hedge fund manager.

The word on Paloma Partners may be that, compared to many other veteran hedge funds, some down 50% or more this year, Paloma Partners may not have fared too badly. "Two percent to 25%? That's very acceptable, given this market," said another rival manager.

On the other hand, the average market-neutral arbitrage fund was up 5.3% year to date, and down just 1.9% for the quarter, according to George Van, chairman of

Van Hedge Fund Advisors

. If so, that could mean more red faces in Greenwich.

As originally posted this story contained an error. For details please see our

corrections and clarifications page.