L.A.’s Hedges Get Clipped

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Shortly after the Sept. 11 terrorist attacks, Curtis Macnguyen decided it was time for a change.

The hedge fund manager, who in 1998 left a $600 million fund to start his own firm in Manhattan, had grown tired of the constant stress of Wall Street. So he took a bold step: Macnguyen packed up his fund and headed 3,000 miles west to Los Angeles. Even among the hedge fund set, it can be hard to resist the lure of sunny Southern California.

“In New York, you basically work and sleep and breathe hedge funds,” Macnguyen said. “We just wanted to have an environment where you can be more balanced and don’t have to feel the daily stresses of New York. There’s a certain lifestyle in L.A. that’s very different from New York.”

As founder of Ivory Investment Management LP, one of Southern California’s largest hedge fund firms, Macnguyen now manages $3.5 billion through the firm’s three fundamental-value funds, which invests in stocks that he believes are undervalued.


When he first came to California, Los Angeles was a hedge fund desert. A handful of firms dotted the Southland, but the area had no real hedge fund community.

Since then, however, the area has quietly blossomed into one of the top hedge fund centers in the country, with clusters in Century City, Pasadena, Santa Monica and other Westside locales. At least five hedge funds reside in one building on Santa Monica Boulevard in L.A.’s Westside.

The county, with its estimated 140 hedge funds, now outpaces the likes of Dallas and Denver, and it is neck and neck with Chicago; Boston; and Greenwich, Conn.; according to data provided by Channel Capital Group Inc., a New York-based hedge fund database provider.

Los Angeles still trails San Francisco, which has seen a vibrant industry crop up around the city’s Pacific Exchange trading floor and Silicon Valley’s technology sector. But all U.S. cities lag far behind the country’s hedge fund mecca of New York, which has 1,500 funds.

A traditional hedge fund attempts to offset potential losses through the long- and short-selling of stocks. But the term has grown to encompass a wide variety of sometimes-arcane investment strategies that may not necessarily involve true hedging of positions. Locally, the region has its fair share of traditional equity-focused funds, while others have a distinctly L.A. vibe, investing in niche areas such as film financing and distressed mortgages.

“There’s a lot of money out here; there’s a lot of very, very interesting things going on,” said Kurtis Kupiec, senior principal of Shoreline Trading Group LLC, a Los Angeles-based prime brokerage that clears trades for hedge funds. “There is a vibrant hedge fund community within Los Angeles, but it’s largely unseen.”

However, just as the L.A. industry is reaching a critical mass, it is facing tremendous turbulence as a result of the nation’s financial turmoil. Funds nationwide are down significantly as losses pile up and investors ask to redeem their money for safer havens, such as Plain Jane T-bills.

As many as half of the estimated 10,000 hedge funds across the globe are expected to shutter as a result of the current economic upheaval, and certain niche funds, like those investing in feature films, are rapidly disappearing.

“I think the wings are going to get clipped a little bit,” Kupiec said.


Hedge funds rising

But that’s not how it’s been for better part of two decades.

The vast pools of wealth, which have an estimated value of $2 trillion globally, have come to symbolize Wall Street’s excess and exclusivity.

Hedge fund managers such as George Soros, John Paulson and T. Boone Pickens have taken home billion-dollar paydays, and the funds are only open to institutional investors and accredited investors, who must have either a net worth of $1 million or an annual income of at least $200,000.

Unlike mutual funds, which must register with the Securities and Exchange Commission, hedge funds operate mostly free of regulation and out of the public eye. As Los Angeles Democratic Rep. Henry Waxman said at a hearing in November on Capitol Hill during which greater regulation was discussed, “Regulators aren’t even certain how many hedge funds exist and how much money they control.” (See article opposite page.)

Los Angeles-area funds are no different.

There is no comprehensive list of local hedge funds. Channel Capital Group estimates that there are roughly 95 firms in the county operating anywhere from 130 to 150 hedge funds. Other research firms and data providers have other numbers. In this issue, the Business Journal publishes a list of 41 firms operating 66 funds, but that is drawn from data voluntarily provided to the investment research firm Morningstar Inc., which provides the data to institutions and accredited investors. Among the notable names not on the list is Oaktree Capital Management, a reclusive investment firm reputedly operating one of the largest local hedge funds.

Perhaps not surprisingly, many of the hedge funds contacted for this article declined to comment, or did not even bother to answer repeated telephone calls. Still, industry experts and a few hedge fund managers were willing to talk and provide some perspective on the local industry.

With the exception of a handful of firms such as Los Angeles-based Canyon Capital Advisors LLC, which was founded in 1990 and now operates several hedge funds including the $2.7 billion Canyon Value Realization Fund, there were few funds in Los Angeles just a decade ago. It was not until the markets recovered after the recession of the early 2000s that hedge funds really began to proliferate.

“Starting in the mid- to late ’90s, hedge funds started to become more popular and then after the recession, it kind of exploded in 2002, 2003,” said Richard Wilson, a hedge fund consultant and author of HedgeFundBlogger.com. “The hedge fund industry is now big enough in California that somebody could move there and search around and have a decent chance of actually landing a position within a hedge fund.”

While there are pockets of niche funds throughout Southern California as well as those targeting Asia and other global markets, Los Angeles is dominated by domestic fixed-income and equity funds standard fare for the industry. But unlike the many Northeast funds, L.A.’s are generally younger and smaller; the average local one has less than $300 million under management.

“In L.A., there’s only a handful of sizable hedge funds,” said Macnguyen of Ivory Investment Management. “It’s more nascent. There will probably be spinoffs as hedge funds get bigger over time that’s what happened in New York, that’s how I grew very quickly. As people become more senior within a particular hedge fund, they then branch off to start their own hedge funds. I do think there’s been some of that in L.A.”


Lifestyle choice

To date, however, many L.A. fund managers are New York transplants.

“A lot of people who run hedge funds in Los Angeles have prior experience in New York and leverage those relationships,” said Zack Cohen, a hedge fund manager in Century City. “Most people would come out here because of the lifestyle. There is a benefit to being in Los Angeles. In New York, there are a lot of hedge funds and when you walk down the street, you hear people talking about mergers and acquisitions and stocks and whatnot. Whereas in Los Angeles, there are not as many funds. I think that allows some managers to have a more independent perspective and not get caught up in group-thought.”

Cohen, who previously worked at a New York hedge fund, moved to Los Angeles and started Palisair Capital Partners in September 2007. The sub-$100 million fund, which targets undervalued stocks, made a splash when Cohen launched a failed proxy battle with the board of Century City-based 1st Century Bancshares Inc.

Cohen acquired 6 percent of 1st Century’s shares and demanded in February that the bank holding company look into buying troubled mortgage lenders, which he argued were drastically underpriced. Though Cohen failed to land a spot on 1st Century’s board, he has maintained his holdings in the company.

And much as Cohen was looking at distressed lenders, other hedge funds cashed in as the mortgage industry began its decline. Andrew Lahde, founder of hedge fund Lahde Capital Management LLC in Santa Monica, earned a whopping 870 percent return last year by betting on the eventual collapse of the subprime house of cards. (See profile page 26.)

But as the economy has plunged headfirst into a recession, the belief that hedge funds can thrive even in the worst conditions has been put to the test.

Hedge funds have lost anywhere from 7 percent to 16 percent this year, depending on which research firms are doing the reporting. And while that’s far better than the 30 percent decline in the Standard & Poor’s 500 stock index, some individual hedge funds have suffered major losses. Perhaps more importantly, investors have learned fund managers can’t necessarily be counted on to make money in bad times.


Painful redemptions

As a result, many hedge fund investors are pulling their money out. Roughly $40 billion was pulled from hedge funds in October. A recent report by Citigroup Inc. said redemption requests could reduce the value of hedge fund holdings by as much as 50 percent by the middle of 2009.

“They’re caught between a rock and a hard place,” said Sol Waksman, founder of Barclay Hedge Ltd., a database provider tracking more than 5,600 hedge funds. “As investors are looking to liquidate their holdings, hedge funds are faced with two difficult choices. Either they can try to liquidate what are basically illiquid holdings into a market where the prices for the holdings are very, very distressed, at best. Or the other painful way out is to limit redemptions.”

L.A. funds, with their high exposure to the U.S. equities market, haven’t escaped the carnage by any means. The average L.A. fund has fallen about 17 percent, more than twice the national average, according to data provided by Absolute Return.

“It’s a very challenging market for hedge funds,” said Cohen of Palisair. “Investors are very nervous right now and they’re hoarding cash. They’re selling liquid assets and trying to pay off debt. Even hedge funds that have terrific performance are getting redemptions.”

Gerbino Gold Group LLC, a $3.8 million fund run by Kenneth Gerbino & Co. in Beverly Hills, is off 60 percent this year. Los Angeles-based Dalton Investments LLC’s $20 million Dalton Greater China Fund is down 62 percent and its $5 million Edgebrook Partners LP fund has fallen 79 percent.

Steve Persky, chief executive of Dalton Investments, said the funds, which focus on Asian equity markets, have seen an increase in the number of redemption requests, but he has no plans to shut them down.

“We have a lot of money in Asian equities and Asia has done very poorly this year,” he said. “It’s always rough when you have a fund that’s negative. We’re evaluating the China fund, but so far we’re keeping it open, and we’re keeping Edgebrook open as well.”

Though the two funds are down dramatically, Persky said Dalton Investments, which has about $800 million under management, is still doing relatively well because it operates a handful of funds and several of them are doing better than the industry average.

In July, the firm started a distressed mortgage fund. “We’ve had positive returns steadily,” he said.

But with returns dropping in virtually every other industry, experts predict a number of hedge funds will likely close up shop in the coming months.

Most funds use what is known as a “high water mark” system in which the fund must earn back all losses before the manager can earn a fee, which encourages managers to close down poorly performing hedge funds and start a new fund rather than forge ahead with the same one.

“There’s going to be a shakeout in the hedge fund industry for sure,” said Macnguyen of Ivory Investment Management. “A lot of smaller funds will go out of business or will voluntarily shut down because they basically don’t want to work for free.”


Uncertain future

Hedge fund activity in the entertainment industry is dwindling in particular.

Hedge funds have put more than $10 billion into slates of feature films with titles as varied as big-budget blockbuster “Poseidon” and small comedy “The Holiday.” Canyon Capital Advisors is among the local funds active in Hollywood, which also has drawn investments from funds outside Los Angeles.

But the bright lights of Hollywood have dimmed for the hedge fund crowd amid concerns the deals were unfairly structured, insulating studios from risk while pawning much of it off on the funds. It hasn’t helped that some slate films, such as “Poseidon,” have been huge flops.

Qualia Capital LLC, a Los Angeles-based media investment firm that manages a fund on behalf of Canyon Capital, has found success purchasing libraries of completed films. The firm had arranged earlier this year to help finance a slate of 30 films for Paramount Pictures, but the deal fell through when too few investors stepped up.

Stephen Prough, founder of Salem Partners, an L.A. investment bank that advises on entertainment deals, said there is no doubt hedge fund investors are now wary of Hollywood but the issue goes far beyond that.

“I don’t think there are a lot of hedge funds out there making new investments, especially illiquid investments, in any industry,” Prough said.

Indeed, until the economy steadies and the country emerges from one of the worst financial crises in generations, times will be tough for the hedge fund industry.

It also will have to deal with heightened scrutiny by Congress, which was stunned by the collapse on Wall Street. As recently as last month, Congress summoned five top hedge fund managers to Capitol Hill to talk about the possible need to closely regulate the funds.

Edward Wedbush, president of Wedbush Morgan Securities Inc., a Los Angeles-based investment bank, has seen the carnage first hand. His firm’s trading desk has handled big blocks of stock made available as hedge funds look to liquidate their holdings.

However, despite his ground-floor view, Wedbush believes that hedge funds in general, and those in Los Angeles in particular, still have a bright future. With more millionaires than any other county in the United States, Los Angeles could be primed for a strong comeback.

“California, particularly Southern California as a reasonably wealthy community will have the resources to promulgate the further development of hedge funds,” he said.


INVESTMENT STRATEGIES

Hedge funds use a variety of strategies in different markets to maximize returns. Here are some of the most common.

– Long/Short Equity: Invests in the stock market through long equity positions hedged with short sales

– Arbitrage: Exploits the difference in price between related assets or markets. For example, buying convertible bonds while simultaneously short-selling the stock of the bond issuer

– Emerging Markets: Invests in equity or debt in emerging global markets

– Distressed Securities: Invests in companies trading below market value due to impending bankruptcy or reorganization

– Macro: Exploits shifts in global economies often using derivatives, such as currency or commodity futures contracts

– Fund of Funds: Invests in a variety of other hedge funds


Source: Magnum Global Investments Ltd.



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