Using a penny stock to hedge long positions in a bankrupt company's bonds sounds like a recipe for disaster, and for some hedge funds trading Delphi ( DPHIQ) last week, it was.

As reported here last week, many event-driven funds were caught leaning that wrong way after Delphi sought Chapter 11 protection on Oct. 8, although some appeared to have traded out of the bonds the day before the filing.

The stock, a study in volatility throughout the auto-parts suppliers' ordeal, continued to trade erratically in the filing's aftermath. After plunging the day before and the day after the news broke, the shares caught a midweek bid after David Tepper's Appaloosa Partners announced a 9.3% position.

The trade reminded some managers of the punishment meted out by Kirk Kerkorian to funds that were short shares of Delphi's biggest customer, General Motors ( GM), after GM's credit rating fell to junk last summer.

Delphi's shares remain absurdly volatile but are tenuously correlated to GM because both companies are locked in negotiations with the United Auto Workers. Given GM's reported progress on that front Monday, it is possible Delphi CEO Steve Miller could win enough wage and benefit concessions to keep his own stock alive in some form for the duration of the company's reorganization.

Hennesseein' Ain't Believin'

The Bayou Management scandal continues to resonate weeks after the hedge fund's managers pleaded guilty to fraud. Greencastle, Ind.-based DePauw University, one of the fund's direct investors, sued its advisory firm, the Hennessey Group, whose advice, it says, led it to allocate 0.94% of its assets into the now-infamous hedge fund run by Samuel Israel.

The $4.03 billion endowment, which allocates 15% of its assets to hedge funds, had $3.25 million invested in the Bayou fund that it now considers lost.

In a lawsuit filed in U.S. District Court in the Southern District of Indiana, the institutional investor accuses Hennessee of making misleading or untrue statements and failing to conduct thorough due diligence. The lawsuit claims Hennessee didn't mention early trading losses in the fund and should have picked up on the falsification of Israel's resume.

"That which was promised was not delivered," said Ken Owen, a DePauw spokesman. "The filing of the lawsuit represents our disappointment."

Charles Gradante, a principal at Hennessee, did not return a call for comment.

River Battle

In London, as in New York, big demand for alternative-asset managers has powerhouses consolidating or poaching talent from their competitors. Thames River, one such titan, with $7.2 billion under management, has entered the fray, nabbing Glyn Jones as its CEO. Jones is CEO of a big rival, Gartmore Investment Management, an alternative-investment franchise with $8 billion under management.

A lot of times, these powerhouses want to build large multistrategy boutiques. They need the expertise of talented generalists capable of understanding both hedge funds and funds of funds, which are apples and oranges. Jones fits that generalist profile. At Gartmore, he was overseeing a portfolio of not just hedge fund assets but also private equity.

While the bulk of Thames River's business is in hedge funds, the firm also runs a $500 million fund of funds.

Heavy Lifting

Pardus Capital Management, a hedge fund that owns 14.4% of Bally Total Fitness ( BFT), is pushing hard for changes.

In a recent 13D filing, the activist manager says that it wants to increase its position to more than 15% of the gym-operator's shares. It also wants to participate in "strategic alternatives" including a sale or all or part of the business or new issuance of stocks or bonds.

Unfortunately for the fund, Section 203 of the Delaware General Corporation Law is in the way. The law blocks any shareholder owning more than 15% of the shares from engaging in these strategic changes without obtaining first the permission of the board. Pardus, as a result, wants management to waive the application of Section 203. Good luck!

Nagging Concerns

Elliott Associates continues to file proxies against the closed-end Salomon Brothers Fund ( SBF) managed by Citigroup Asset Management. On Tuesday, it sent a letter to the closed-end fund's board criticizing Citigroup and SBF for calling its proxy fight a "side show."

The battle isn't a sideshow. Elliott wants the elimination of the fund's discount to net asset value. And in order to get it, the activist fund has invited shareholders to say no to the transfer of the management agreement from Citigroup to Legg Mason ( LM).

Elliott faces the opposition of two of the nation's leading proxy firms, Institutional Shareholder Services, and Glass, Lewis, which last week advised shareholders to approve the transaction. Shareholders will cast their ballots on Oct 24.

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