Buyout, Hedge Funds Will Be Next Dominos to Drop: Matthew Lynn

Commentary by Matthew Lynn

Oct. 21 (Bloomberg) -- If Sherlock Holmes were analyzing the credit crunch, he would be drawing our attention to the dog that didn't bark, just as he did in ``The Hound of the Baskervilles.''

The dog, of course, would be hedge and private-equity funds.

Anyone tracking markets in recent years will remember the prediction that the unregulated, feverish trading of hedge funds, and the massive debts and complex financial engineering of buyout firms, would cause the next crash.

The crash happened, but it was started by what appeared to be safer institutions. It was the relatively dull mortgage lenders, and the investment banks that supplied their funding through the wholesale money markets, that sparked the collapse.

The dog didn't bark. That doesn't mean it won't. The hedge and private-equity funds will be the next dominos to fall. The process may already have started. And just as the last few months have been dominated by the bailout of banks, we will soon hear more about the sinking of alternative asset managers.

``We are going to see a lot of consolidation, and a lot of funds are going to close down,'' says Jacob Schmidt, chief executive officer of London-based hedge-fund advisory firm Schmidt Research Partners. ``We are going to see a real reduction in the number of offerings out there -- and some of the good guys are going to suffer along with the me-toos and copycats.''

The funds have so far avoided the worst of the crunch. There is a simple reason: They were more conservatively managed than many people gave them credit for. They took fewer risks than the investment banks, largely because they have their own money tied up in the businesses they are running. They weren't just making big bets in pursuit of this year's bonus.

Job Losses

Now the pain is starting to spread.

The hedge-fund industry lost $79 billion through asset-price declines and investor withdrawals during September, according to the Singapore-based research and publishing company Eurekahedge Pte. The executive search firm Options Group estimates that there may be as many as 10,000 job losses in the industry this year.

The share prices also suggest a bleak future. Man Group Plc, the world's largest publicly traded hedge fund, has dropped to 352 pence from 600 pence in July. RAB Capital Plc, another star of the industry, has slumped to 13 pence from 126 pence last year. It's hard to see anything positive in that.

At the same time, the outlook for buyout funds is turning scary. Candover Investments Plc, a U.K. private-equity firm, said last week the looming economic slowdown was likely to hurt the value of its investments. Meanwhile, the debt that buyout funds use for financing is dropping in price as investors shun any kind of asset that looks risky.

No Credit

Hedge funds will suffer because they won't be able to leverage investments anymore. The credit won't be available.

They will face more restrictions as part of the regulatory backlash that will be the inevitable consequence of the market turmoil over the last month. That is going to limit returns and room for maneuver, making the funds less attractive to investors.

And central banks will be so chastened by the last few months, they are unlikely to allow any bubbles to build up for a long time -- and hedge funds were good at chasing asset bubbles.

Buyout funds, likewise, relied on debt markets to finance acquisitions. Investors' appetite for the intricate financial engineering employed has vanished. Without leverage, it will be hard to make the business work. The debt markets were what buyout funds used to make their investments and then to sell them a few years later. They were the entry and exit strategies. With those doors closed, there won't be much left to do.

Sour Deals

Worse, as Candover has pointed out, a world economic decline will damage the industries that buyout funds bought into, such as retailing and food manufacturing. They won't be able to make new deals, and the old ones are about to turn sour. It isn't a happy combination.

Both types of funds boomed in an era of turbocharged innovation. They were satellites to the investment-banking economy that has now collapsed. We are entering a period during which financial markets will be very restrained. There won't be much space for financial buccaneers, precisely what the hedge and private-equity funds had become.

They will struggle, and the dog is barking.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.