The collapse of Peloton Partners is another timely reminder of the peculiar dynamics of the hedge fund business. 

---

Out of what seemed like a blue sky, Peloton Partners’ flagship ABS hedge fund had an extraordinarily good year in 2007, returning 87% to its investors. Assets under management grew to some $3.5 billion. Then, within a matter of a few short weeks, the flagship fund goes bust and its second fund, 40% invested in the first, is in liquidation. Peloton Partners is now going out of business.

Ron Beller, a former trader at Goldman Sachs, one of the founders, called his investors last week to say that he was genuinely sorry about what had happened. Well he might be, given that he had only weeks before re-invested all the fees the fund had earned him last year back into the fund. He is facing a personal loss, some reports suggest, of more than $100m. Whatever this hedge fund suffered from, at the death it was not lack of identity of interest between manager and investor.

The demise of the fund echoes that of Long Term Capital Management 10 years ago, where the principals were so confident of their investment prowess that they voluntarily returned cash to their investors a few months before their creation also went down in flames. The cushion of equity that the principals surrendered in this way, presumably to enhance their own returns, might well have kept them afloat when their terminal crisis hit a few months later.

Add in the examples of Amaranth, Bear Stearns and Sowood last year, and yet again therefore we have the curious spectacle of a successful hedge fund, led by a team of apparently smart professional investors, all with fame, fortune and reputation on the line, presiding over a total wipe out of their main funds, in the process imposing 100% or near 100% losses on their investors.

Even at Lloyd’s of London, in the bad old days of unlimited liability, it often took blatant fraud to deprive gullible investors of all their money. Yet in these more recent blow up cases nobody has suggested that the failure of the fund was down to anything but the knowing investment decisions of the managers. Their fatal bet appears to have been a big position in synthetic asset-backed securities (surely an oxymoron, incidentally?) that had to be forcibly liquidated when some banks tightened their credit terms.

In hindsight it is always much easier to see where failed funds were taking unnecessary risk. In all these cases certain themes recur – high degrees of leverage, concentration in a relatively narrow asset class, and liquidity problems brought on by a unforeseen deterioration in market conditions. The standard defence of those caught out in this way is to talk about a “perfect storm” or for those more probability-minded, “multi-sigma” events. In the case of Peloton, it simply seems to have made some very poor decisions, whether through hubris or some other cause, we do not yet know.

As defenders of the hedge fund concept say, these spectacular blow-ups are isolated occurrences, which can be dismissed as small blips in a fast growing and fast maturing industry. What is genuinely puzzling however is the apparent lack of awareness amongst those responsible of their impending fate. From the limited amount of information that emerged last week, Mr Beller appears to have been in this camp. It does not seem to have occurred to him or his partners that their strategy could conceivably go sour to the extent that, in the event, it did.

Although leverage has always been there at the death of all hedge funds, it is difficult to argue plausibly that it alone was the contributory factor in these cases. Given the background and experience of Mr Beller and his partner Geoff Grant, it stretches credulity to think that they did not understand the concept of leverage. Where better than Goldman Sachs, you would have thought, to gain a decent grounding in the mechanics of proprietary trading?

Equally it is difficult to find a behavioural model that adequately explains how such individuals can put themselves at risk of losing so much money personally. Of course few hedge fund managers start out poor. Few loss-making hedge funds give investors the right to claw back fees and profits from earlier successful years. The lopsided nature of the incentives in hedge funds is a continuing structural flaw.

But while there have been individual cases of hedge fund managers who fulfil the role of out and out gamblers, addicted to risk, that does not seem to be the case in many of the spectacular blowups we have seen.  The eggheads behind LTCM famously believed that what they were doing was riskless arbitrage. The only thing missing in their complex models was experience of what happens in the real world during a liquidity crisis. The worry now is that more hedge funds are going to disappear this year as the fallout from the credit crisis continues.




Jonathan Davis
Email Jonathan Davis