Hedge Summer: Who Built Their Dollars

Many Winners, Losers;
Reduced-Risk Appetite
Favors Some Like Titan

By GREGORY ZUCKERMAN
September 4, 2007; Page C1

Summer vacation is over, and hedge-fund investors are getting down to business: In with distressed-debt specialists, hedge funds sitting on cash and those betting on volatility. Out with some brand-name funds and activists. And don't count out those quants just yet.

On the heels of a bumpy summer marked by dramatic losses at several high-profile firms, hedge funds and their investors are adjusting to a new environment featuring a reduced appetite for risk taking.

While markets have calmed, some worry that if investors withdraw money later this month, or if infrequently traded debt securities see downgrades by ratings agencies, hedge funds will be forced to dump certain investments, putting renewed pressure on a slew of funds. The possible beneficiaries could be rival funds sitting on cash hoards.

"We do expect to see fairly significant redemptions over the next three months, which will put pressure on the funds to liquidate positions," says Tim Mungovan, a partner at the law firm of Nixon Peabody LLP.

Another reason things could stay bumpy: Hedgies who focus on strategies that tend to damp market moves are scaling back, reducing their impact on the market. For example, large quantitative funds, or those that use computer models to govern their trading, have been slashing their portfolios. In recent years, they have often been the buyers of unloved stocks and sellers of fast-climbing ones -- in other words, a force for stability that may be less visible going forward.

At the same time, investor infatuation with the largest funds finally may ebb. That is because some of the hallowed names in the business are hurting lately. So-called activist funds, which have profited by pressuring companies to sell out, pay juicy dividends and buy back shares, also could be left in the dust as debt costs rise and dealmaking slows.

Here's a list of the likely winners and losers in the emerging shakeout for the hedge-fund business.

Volatility = Profitability

The placid markets of recent years benefited hedge funds that made aggressive moves, such as piling on borrowed money to amplify their returns. Others sold out-of-the-money options, or options conveying the right to buy or sell shares at levels that weren't near the price of the underlying stock.

They pocketed profits for many months because the stocks didn't have big enough moves, so the options expired worthless.

That all could help firms like Titan Capital Group, an $800 million New York hedge fund that specializes in bets on rising volatility. Titan, which is up 10% in the past three months, is seeing a surge of interest from investors, according to someone close to the firm.

Bargain Hunters

Other winners could be firms like Eric Mindich's Eton Park Capital Management and Ken Griffin's Citadel Investment Group that act as quasibanks. They can step in to make big investments at potentially bargain-basement prices in times of distress. As banks try to get out of buyout loans, fellow hedge-fund managers sell subprime mortgages and structured-finance positions, and companies feel pressure from heavier borrowing costs, these hedge funds could make attractive deals. They are already eyeing the opportunities, traders say.

Eton Park is up more than 20% so far this year, according to investors, while Citadel is up about 16%.

Distressed-debt specialists, or those that bet on beaten-down bonds and loans, later this year could see the best opportunities in years, though some are dealing with losses on current holdings. Junk-bond traders say the market isn't yet at bargain levels.

Foreign Focus

Hedge-fund managers say U.S. and European markets could be disappointing for the foreseeable future, even if the Federal Reserve cuts interest rates. So they are scrambling to boost their focus on Asia and emerging markets. They could clean up if growth, and related mergers and restructurings activity, continues in those markets. The $2.6 billion GLG Emerging Markets Fund, for example, rose 9% in July and was up 24% for the year, according to investors.

Quant Comeback

Quantitative hedge funds endured their most brutal period on record in early August, shocking investors who have been plowing money in, hoping for impressive returns in all markets. Some still are smarting. But like a baseball team making a furious comeback in the ninth inning, a number of the highest-profile of these funds engineered dramatic turnarounds in the tail end of the month.

Two funds run by Renaissance Technologies Corp., Jim Simons's giant quant firm, made so much money in the past two weeks that they gained ground in August, after losing 9% in the first nine days of the month. Other heavyweights like AQR and Highbridge also engineered impressive turnarounds, according to investors.

But many quants have depended on dollops of borrowed money to generate big gains in recent years, and some are still trying to dig out of deep holes. Because the quants and their lenders have turned more cautious, future profits may be steady, but not as impressive as investors have become accustomed to.

Brand-Name Busts

Some were surprised that the $10.5 billion Caxton Global Investments Ltd., the flagship hedge fund of star investor Bruce Kovner, dropped 4.5 % in August, on top of a 3% or so drop in July, and was down 1.1% for the year, as of Aug. 28, according to investors. James Pallotta's $8.5 billion Raptor fund also has suffered lately, as have funds run by Tim Barakett's Atticus Capital LP. Mr. Barakett is still up sharply this year.

When even the big names find it harder to navigate markets, investors may begin to search for successful, smaller hedge funds. The biggest "fund of funds," or firms that invest in other hedge funds, also could feel pressure. August wasn't kind to some of them, and with the best-performing hedge funds offering an array of strategies for investors, it could cut the need for the diversification that funds of funds provide.

Activist Angst

Activists with turnaround expertise may be the only ones who thrive in the new hedge-fund world. Overall, these investors already are feeling some pressure.

A large hedge fund run by activist Daniel Loeb dropped 8.4% in the first 22 days of August, according to investors, though it remained up almost 7% for 2007.

The losses aren't causing them to turn quiescent, however. Activists like Mr. Loeb continue to take on underperforming companies; his firm, Third Point LLC, last week called on PDL Biopharma Inc. Chairman Patrick Gage to resign and for PDL's board to focus on the "prompt" sale of the Fremont, Calif., firm.

But it isn't clear whether buyers will line up for the company, which saw its shares tumble 20% when it reduced earnings guidance. Mr. Loeb didn't respond to requests for comment.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com