Hedge funds that practice convertible arbitrage continue to bleed assets and remain one of the poorest performers of any category this year. But here's a secret, according to a hedge fund manager: Convertible issuance is back.

Convertible financings have rebounded because interest rates are up and it costs less for companies to issue these stock-and-bond hybrids than traditional corporate paper. Also, while companies may be sitting on a lot of cash, they've still found uses for borrowed money in the area of share buybacks, acquisitions, and to fund research and development.

With that in mind, says the manager, investors should be wary of certain names that have shown a propensity for convertible offerings in the past. He mentioned First Data ( FDC), Radian ( RDN) and Weatherford International ( WFT). If a company sets a convertible sale, arbitragers are sure to short the underlying stock.

Tough Legacy

Life is full of surprises when you're Biovail ( BVF). Uncertainty around the Ontario pharmaceutical firm has created a feeding ground for hedge funds that see the stock as a pure "event" play. Biovail got a boost earlier this month when it announced a marketing partnership with Johnson & Johnson ( JNJ) for the sale of Tramadol ER, a pain reliever.

"The partnering is fantastic news. They found the best partner," says David Maris, a Banc of America Securities analyst who is neutral on the stock. New York-based Deerfield Management, a specialized life science hedge fund, is long the stock and held 3.77 million shares, according to its most recent 13H filing.

On the downside, Biovail, which manufactures Wellbutrin XL, is facing generic competition. OrbiMed Advisors, a hedge fund specializing in life science products, sold its 2.1 million-share position based on the generic risk, according to a source familiar with the sale. York Capital Management also sold almost a million shares, according to regulatory filings. Both trades looked prescient Thursday when Biovail tanked 13% to $22.30 after Anchen Pharmaceuticals obtained tentative approval for its generic version of Wellbutrin XL.

The vulnerability to generic competition was part of the reason the company announced Tuesday that it would spin off its off-patent drugs ("legacy assets") next year. That news sent the stock down 6% Wednesday. "This is one of the few cases where a spinoff takes away value," says Maris, explaining that Biovail, in creating a distinct company, is giving up some of its earnings while concentrating the risk on Wellbutrin. "You should do a spinoff to extract value, not to extract cash from the business," he says. That's an interesting distinction, especially when hedge fund activists preach spinoffs as a panacea to unlock shareholders' value.

Rough Patch

Everybody agrees that October was an ugly month for hedge funds, but the devil is in the details.

Among various categories, so-called special situation strategies were hit hard by the bankruptcies of Refco ( RFXCQ) and Delphi ( DPHIQ). The problem wasn't necessarily investments in those specific situations (indeed, the Refco scandal was mined for profits by certain vulture funds ), but rather the bankruptcies' impact on the ability of other troubled companies to raise money. The uncertainty produced negative returns for the strategy in October, says Justin Dew, a hedge fund analyst at Standard & Poor's.

Convertibles had been in recovery mode since last summer, but that ended last month, according to a convertible arbitrager. Apparently, some so-called outright-convertible investors, (long the bond without shorting the underlying stock) took profits last month, while redemptions continued to hit the convertible hedge fund sector, he says. The redemptions led to forced selling, the departure of portfolio managers, and, in some cases, funds shutting down. Outright investors are typically institutional investors and multistrategy hedge funds that play the convertible bond market without hedging. They were a major contributor to the summer rally.

On the positive side, global macro, a strategy in which participants take leveraged directional bets in all global securities, including stocks, bonds and currency, based on macroeconomic views, was the big winner, according to S&P. Perceiving a recession, those managers were short the U.S. equity market and long Asia, and this was a rare occasion in which they got it right on both sides of the trade, says Dew.

More on Funds of Funds

Scott Johnston, a hedge fund manager at Peconic Management who also teaches finance at Yale, recently penned a missive to investors titled, "Biting the Hand that Feeds Me." In the letter, Johnston predicted that if fees go down for funds of funds, incentive fees, which are paid to the manager as a percentage of the profits and can run as high as 25%, are likely to be hit. Management fees, which are typically 1%-2% of assets, are a more logical way of paying for the service. That is because funds of funds are "franchise builders." They are valued at 10 times management fees and only two or three times incentive fees, which shows that they extract more value from managing than from performing.

Hedge fund fees, on the other hand, are unlikely to come down anytime soon, says Johnston. "No matter how you cut it, it's harder to manage money than to allocate to those that do." In fact, hedge funds are only as good as their team. Often, the departure of a well-known portfolio manager will precipitate redemptions. When a hedge fund manager walks out the door, his shop's value drops to zero, says Johnston. For hedge funds, incentive fees are not a luxury.

J.P. Morgan ( JPM) has a $16 billion group in its private banking department that does nothing but invest in alternative investments for its high net-worth clients. Called Alternative Investments Group, this private banking group invests in hedge funds, private equity and real estate, and has grown steadily in 10 years. As a result, J.P. Morgan just split the leadership into two functions and created a new CEO role to be filled by Doug Wurth, a bank senior executive. Andrew Craighead, who led the group before, will be its chief investment officer.

Pequot Capital Management, the $7 billion multistrategy hedge fund, is raiding rival Citadel, poaching three of its portfolio managers. Peter Labon will handle the technology and media-telecom portfolio; Carson Levit will work on a growth equity long/short portfolio. Both Labon and Levit left Citadel earlier this year. Steve Pigott will be an analyst and portfolio manager responsible for the North American merger arbitrage investments. All three positions are new ones and all three men held similar role at Citadel. Bottom line: Pequot is expanding in these sectors.

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