Party's Over

Investment banks are supposed to be reliable counterparties for their hedge fund clients, not unpredictable sources of risk. But Lehman Brothers Holdings’ rapid descent into bankruptcy on September 15 created a black hole in the $1.93 trillion hedge fund industry, and no one knows yet how deep it goes — or which hedge funds will be sucked into the abyss.

The problem is as shadowy and complex as it is hard to quantify. Lehman was once a prime broker to a who’s who of high-profile hedge fund firms, including London-based GLG Partners, which has more than $23 billion in assets under management and is listed on the New York Stock Exchange, and $17 billion-in-assets Lansdowne Partners, which is also based in London.

Leading up to its demise, Lehman’s weakened state prompted many large hedge funds to reduce their risk by diversifying their prime broker relationships, pulling assets from the firm and shifting them to such commercial banks as Citigroup and JPMorgan Chase & Co. Because large hedge fund operations tend to have at least two prime brokers providing trading, clearing and settlement services for any given fund — as well as multiple counterparty financing relationships — they are probably less at risk than are small hedge funds, says Stuart Davies, global head of investments for $12 billion fund-of-hedge-funds firm Ivy Asset Management. Still, Davies expects a few managers will get stung by the unsettled trades they still have on their books. "Some funds are going to find that they have exposure to Lehman, and they are going to struggle to come to terms with what they can recover in the weeks ahead," he says. "I hate to say it, but it probably won’t be very much."

For firms that worked with Lehman’s North American investment banking unit, which was purchased by Barclays, asset transfers have reportedly been slow but successful as the British bank has absorbed the brokerage activities of its former U.S. rival. But anyone doing business with London-based Lehman Brothers International (Europe) — which was left out of the Barclays deal and placed in receivership with accounting firm PricewaterhouseCoopers — has not been so lucky. The division’s last-minute transfer of $8.2 billion in cash from its British coffers to Lehman’s New York headquarters on the Friday before the firm declared bankruptcy has hedge fund executives fuming, and the legal objections are coming thick and fast.

On September 19, GLG Partners, which did business with Lehman International, lodged a formal objection to the sale of Lehman’s U.S. broker-dealer assets to Barclays in the U.S. Bankruptcy Court for the Southern District of New York, seeking to protect its right to fight for the cash it held in its trading accounts at the time of the firm’s implosion. GLG, which is 11 percent owned by Lehman, estimates its exposure across all of its funds is $95 mil-lion, or less than 1 percent of its assets. Others may have had more at stake. Harbinger Capital Partners, part of Birmingham, Alabama–based investment group Harbert Management Corp., filed its own objection on September 26, seeking to recoup $250 million from Lehman; London-based MKM Longboat Capital Advisors told investors at the end of last month that it will have to close its $1.5 billion flagship MKM Multi-Strategy Fund because of poor performance and its prime brokering relationship with Lehman. (Two other MKM Longboat funds will remain active.)

The most unnerving aspect of Lehman’s failure is the bank’s role as an aggressive counterparty to a wide range of over-the-counter derivatives — from plain-vanilla interest rate and equity swap contracts to more-exotic credit default swaps, which alone constitute a massive $54.6 trillion global market, according to midyear statistics from the International Swaps and Derivatives Association.

In practical terms, institutional asset managers and hedge fund firms that believed they had purchased protection through Lehman against a specific company’s default risk, for example, no longer have any safeguard. Those hedges have simply disappeared. So have the many millions in cash and securities that individual hedge fund firms put up as margin, or collateral, with Lehman.

"I don’t think people understand how big a problem this is," says one hedge fund manager who declines to be named. "It is absolutely enormous. If your assets were secured and ring-fenced within Lehman, you should be fine, in theory — but that is just a theory. If your assets weren’t secured, I think you’re out of business, because you’ve just lost whatever was in there, including any profits. You’re now just another unsecured creditor."

Complicating matters is the timing of Lehman’s demise. Every manager of a hedge fund was working feverishly to determine its profits, losses and total portfolio net asset value by September 30 — which was the close of the third quarter and the last window of opportunity for many investors to give notification of redemption requests before year-end. How individual firms were going to assess their funds’ exposure to Lehman was still uncertain at the end of the month.

"The problem is that many managers have no clarity right now about what their OTC-traded swaps and derivatives are worth or what the likely settlement is going to be," says John Godden, co-founder and CEO of London-based IGS Group, a hedge fund advisory firm that assists managers with risk management and portfolio modeling. "This is what PricewaterhouseCoopers is going to have to work through — and fast — but it will probably take some time."

"Right now Pricewaterhouse-Coopers is the biggest global trader of OTC derivatives, which is ironic," notes Robert Sloan, the former head of prime brokerage services at Credit Suisse and founder of S3 Partners, a hedge fund advisory firm in New York. "You think we’ve got chaos now? PWC is already unwinding convertible bond swaps, and it’s having a cascading effect in the markets."

At the easy end of the scale of net-asset reconciliation, says Godden, managers may be able to specify a certain percentage of their portfolio’s value and hold it back to reflect the unknown valuation of any outstanding swaps. At the tougher end, he adds, some hedge funds — many of which are already facing redemptions irrespective of their relative performance — may get into trouble if their exposure to Lehman instruments turns out to be more than a few percentage points, or if their redemption requests are greater than the free liquidity in their funds. If that happens, redemptions will be suspended, he says, which may ultimately sound the death knell for some funds.