Toomre Capital Markets LLC

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Dresdner Research: "The Great Unwind is Coming"

Today, on February 9th 2007, Fortress Investment Group became the first publicly traded hedge fund in the United States. Aside from providing a readily tradable currency for attracting additional personnel and capital to further expand their investment activities, the IPO proceeds will give the firm more flexibility in its financing activities. The investment banks in the equity syndicate meanwhile have made millions in underwriting fees.

Back in November 2006, Citadel Investment Group, another large alternative investment manager headquartered in Chicago, issued the first publicly-traded debt secured by a hedge fund. That debt was issued to protect Citadel from the vagaries of the prime-broker market, which tends to tighten lending terms in times of financial market stress. The prime broker sector is dominated by the large investment banking organizations like Goldman Sachs, Morgan Stanley and Bear Stearns.

Now two equity analysts, Stefan-Michael Staimann and Susanne Knips at Dresdner Kleinwort, have issued a detailed research report on how important hedge funds are to the investment banking industry. Their conclusion is that one should head for the hills because "The Great Unwind is Coming!" -- and it is going to hurt!!! The Financial Times Alphaville blog has a summary of their thesis:

* Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.

* A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies - removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM.

* While hedge fund strategies across the industry may look diversified, there is actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia will force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.

Staimann and Knips declare: “We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).”

“The virtuous cycle on the slow way up (the supply and demand from building spread bets leads to tightening spreads, which in turn raises confidence to build new positions) turns into a vicious cycle on the fast way down.”

So how vicious is this great unwind going to be? Well, the Dresdner pair estimate that investment banks sucked roughly $40-50bn in revenue out of hedge funds last year, mainly through sales/trading and services other than prime brokerage. That is about 15-20% of all industry revenues in investment banking.

Toomre Capital Markets LLC has not yet seen a copy of this sobering research. Perhaps a kind reader might forward a copy to TCM? We are most curious to read the appendix comparing Citadel Investment Group with the investment banking division of Deutsche Bank.

We have been concerned for several months that the financial markets are approaching one of their periodic periods of stress. Investment risk premiums are close to their lows while the U.S. equity markets are at recent highs. There is a rush on alternative investments, both hedge funds and private equity deals. Are people paying enough attention to risk? Are we really on the verge of the Great Unwind? Thoughts and comments are welcome.

[Update: More on this hedge fund topic posted in TCM entry Hedge Funds, Investment Banks and Value of Liquidity?.]