Investment banks and their in-house hedge funds were once thought capable of building a compatible, mutually beneficial relationship. It is now clear that they are unhappy bedfellows.
UBS had its reputation marred after its in-house hedge fund unit, Dillon Read Capital Management, was forced to wind down last year just 11 months after starting to trade, having incurred losses of $124 million.
Lehman Brothers has been forced to move $1 billion of assets from three troubled internal hedge funds onto its balance sheet. A better example still is Bear Stearns, which was brought down by its two in-house hedge funds.
Citi does not seem to learn, however. First, Tribeca, its initial multi-strategy fund, was pulled when it purchased Old Lane, run by Vikram Pandit himself. Now Old Lane has shut down as a multi-strategy fund as three of the six senior managers left their positions, Pandit included. Falcon, Asta and MAT, Citi’s fixed-income hedge funds, have lost as much as 75%, forcing Citi to put up hundreds of millions of dollars to help investors recoup losses. But still, Pandit in his role as chief executive of Citi, is considering spinning some of the teams within the multi-strat Old Lane into in-house single-strategy funds.
There are several reasons why it is not worthwhile for investment banks to have internal hedge funds. One is simply risk. Bear Stearns, by all accounts, was a conservative house. It had been doing its bread-and-butter business well for years. Enter the decision to have in-house hedge funds and, bang, it’s game over.
Why? Simply, according to insiders, because Jimmy Cayne did not understand the strategies of the two funds that blew up. Nor did many other senior managers. Without top management understanding the underlying strategies as much as they understand their investment banking business, the risk of in-house hedge funds is simply too great.
Vikram Pandit, wth his background, is arguably in a good position to have this oversight of the hedge funds, but he has too many other business lines to oversee to make that a priority.
A second reason is that investors don’t want to be in a hedge fund that is run inside an investment bank. They question why a manager with talent would run a fund in house. When it is difficult to attract investment, the easiest route is to market product to brokerage and private clients. But brokers and private bankers do not understand the risk levels of hedge funds, so it is no surprise that several of Citi’s hedge funds have allegedly been sold to clients as low-risk investments instead of high-risk ones. Investors in Bear Stearns’ funds made similar claims.
It is understandable that investment banks want to offer hedge funds to asset management or brokerage clients but they should stick to owning stakes in them. Neither Morgan Stanley nor Lehman Brothers have accrued any damage from their minority stakes. That is easier said than done in this environment, as capital to buy stakes is hard to come by.
Perhaps the new private equity type funds set up by Goldman Sachs and Lehman Brothers are the key. Goldman Sachs is backing Petershill, a fund that has already purchased five minority stakes in funds, and Lehman Brothers is thought to be launching Omega, a fund that might buy up to as many as 12 stakes.
Pandit might want to take heed and switch from Old Lane to a new path.