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Hedge Funds' World of Hurt

Will conservative investors such as pension funds flee the turmoil?

Remember when Wall Street would obsess over the next leveraged buyout candidate, and hedge fund masters of the universe could raise ungodly war chests with just a handful of phone calls?

What a difference a few months make.

Lately, hedge fund implosions have replaced the LBO parade as the market's signature event. Investors have seen huge setbacks at funds run by

Bear Stearns

(BSC)

,

UBS

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and

Goldman Sachs

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, among others, as the credit environment has grown fraught with uncertainty and lurking turmoil.

Now investors find themselves wondering how institutional investors will respond as the wheels come off the once-fast-moving credit wagon. Will pension funds and other conservative types of investors, who had just begun pouring money into these so-called alternative investment vehicles in earnest, back away from hedge funds in their hour of need?

For now, the answer seems to be no, as the damage from this summer's credit crunch has been limited. Still, there are worries that we've seen only the beginning of the problems in alternative-investment land.

"Hedge funds and

private-equity firms today are like the dot-coms in 2000: Ask for money and you'll get it," fund manager Ray Dalio of Bridgewater Associates said in

Barron's

back on May 26. "They bid up the prices of everything. The amount of money flowing is almost out of control, and it's making everything overvalued."

In the past, hedge fund collapses were a one-off affair. The 1998 unraveling of Long Term Capital Management's Nobel-Prize brainiacs on bad currency bets and the implosion of Amaranth Capital under infamous gas trader Brian Hunter's wrong-way derivatives trades underscored this point.

The collapse of Dillon Read Capital Management early in the year was a portent of what was to come, though bank officials insisted the subprime crisis was contained. What followed was unprecedented: No fewer than 13 hedge funds have met their tragic demise since the beginning of the year, according to Web site

hf-implode.com.

That number includes Sowood Capital, run by former Harvard University money manager Jeff Larson, and United Capital, headed by John Devaney.

Along with the leveraged-buyout titans, hedge fund managers had experienced a golden age of capital raising and fat-cat prosperity. But with investors becoming hip to what appears to be the use by many hedge funds of marginal trading strategies underpinned primarily by the heady use of leverage, fat returns and easy fund-raises from investors, who have plowed billions into alternative investment vehicles, may be a thing of the past.

"This crisis is a little bit more about the marginal investor," says one Connecticut-based fund of funds manager who declined to be identified. "Leverage doesn't make the strategy," he adds. "How good are they? If you're applying leverage to an inconsistent strategy, that's quite dangerous," the fund manager comments.

Indeed, a marginal trading strategy that generates 5% returns can be ratcheted up to 30% applying six times leverage -- but, on the flip side, the risk of steep losses rises, too. This is what many investors faced in Bear Stearns' highly leveraged (and now bankrupt) hedge funds, which used leverage of more than 10 times in some cases.

Such was the case with Goldman Sachs' so-called quantitative Global Equity Opportunities Fund, which saw about $1.4 billion of its value wiped out, according to

Bloomberg

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. Goldman since has injected $3 billion to prop up the failing fund, alongside billionaire investor Eli Broad and former

AIG

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Chairman Maurice "Hank" Greenberg, among others.

Although Goldman has repeatedly rejected references to the cash injection as a bailout, the white shoe investment firm has taken the added step of cutting the 2% management fee as well as any performance fees that might be associated with running the vehicle.

Goldman's fee-cutting maneuver likely is one that will be mimicked by other hedge funds trying to retain investors and draw in new cash.

"You're moving into an environment where you have to try and retain capital to ensure confidence," says Steven Weddle, director of alternative investments at ING Investment Management, whose firm was not invested in Goldman's Global Equity vehicle.

"It takes 12 to 18 months to bring in new capital, so if you can figure out a way to keep the capital on board, you're better off retaining investors if you can do so," Weddle adds.

To be sure, quant funds similar to Goldman's, which employ computers to identify inefficiencies in the market, all have been suffering. The tumult that has resulted from the credit squeeze has roiled many fund managers strapped for cash due to margin calls.

What the future holds for hedge funds is uncertain. Certainly the best-of-breed firms such as Goldman and others will continue to garner investor dollars, but smaller names and start-ups likely will face challenges.

Geoffrey Tudisco, CEO of small prime brokerage firm VanthedgePoint Group, says anecdotally he has seen some slowdown in new funds, but he declined to speculate as to whether there'd be a lasting effect on the hedge fund industry.

"Summer is usually slow, but this summer is slower," he comments. "Most investors are doing damage assessment."

Institutional investors, who have only recently begun to pour more money into alternative investment vehicles, may be the first to become gun-shy after the smoke clears -- though for now, many investors say that they have emerged largely unscathed.

The $50 billion defined-benefit Massachusetts Pension Reserves Investment Management Board, which reportedly lost about $30 million through its indirect investment in Sowood, says it is well diversified and has seen a good year so far despite the Sowood blip.

The $8 billion pension fund for

International Paper

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, run by Robert Hunkeler in Stamford, Conn., has managed to avoid the pitfalls of investing with badly performing hedge funds, according to Hunkeler. He says he is happy with the pension's year-to-date performance, adding that through July, the fund's performance was greater than his expectations for the full year.

"We do run a very well diversified portfolio with a deep pension," Hunkeler adds. "If I made my first investment in hedge funds in the month of June, I wouldn't be very happy right now," he adds.

"Our first reaction

to the hedge fund collapses was to try and get our arms around the situation," the IP fund manager says. "And at this point we think that it's more technical than fundamental."

The really scary prospect for many hedge funds, having sold off their most valuable and attractive assets, is holding onto the hard-to-sell junk that has been significantly devalued amid the market swoon. That has many investors envisioning more pain and waiting for more fallout from the financials, even as Capitol Hill and the

Federal Reserve

attempt belatedly to salve the market's wounds.

According to the hf-implode Web site, 13 other funds including Australian fund Basis Capital Fund Management and U.K.-based Queenswalk Investment are facing significant declines in value.

Still, this environment may prove ideal for some hedge fund players. Hedge fund Citadel Investment, which acquired Sowood's assets, has been one of the beneficiaries of the credit swoon and one of a handful of vultures in the wings ready to scoop up assets on the cheap.

After all, things have been worse.

"In the 10 years I've been with IP, we've seen worse periods," Hunkeler comments. "It's been a sharp correction so far but it hasn't been a deep one."