Convertible liquidations moderate in wake of Lipper scandal, which is seen as leveling the playing field

By Ronda Fears

Nashville, Aug. 11 - The convertible market has been abuzz for months about liquidations, often in the context of impending doom in the wake of the Lipper Convertible funds' $400 million liquidation amid a scandal in March 2002 and with the $4 billion collapse of Long Term Capital Management in 1998 as a backdrop.

But market sources, including the manager of a fund that closes its books Thursday, say there is no big cause for alarm and the liquidations haven't been as dreadful as sentiment suggests.

"We had heard that one or maybe two small-medium sized convert arb funds closed up and liquidated their holdings although if memory serves, those took place about a year ago. Aside from one or two funds that seem to be doing an inordinate amount of selling lately, I haven't heard about anything else along the lines of liquidations. Thus, adding up all the liquidations of which I'm aware would not be enough to impact the convert market to any significant degree," said Stuart Novick, convertible analyst at Citigroup Global Markets Inc.

"I suppose that it is somewhat surprising given how mediocre the convert market has fared both in terms of new issuance and performance, which may not be two entirely different matters, actually. In fact, Dow Jones just released its latest arb performance numbers which shows the year-to-date return for convert hedge funds to be 0.1% Overall, the relative lack of withdrawals is probably a testament to the 'stickiness' of hedge fund investments."

Professionals on both the buyside and sellside also assert that increased regulatory scrutiny is a financial burden, but many also feel it was necessary and levels the playing field among the players.

Without question, the volume of research from the sellside, particularly the bulge bracket firms that regulators have targeted, has dwindled dramatically. But that also has made research a premium and provided jobs for analysts on the buyside.

Lipper exec faces 10 years

Edward Strafaci, the former executive vice president of Lipper Holdings LLC, pleaded guilty Wednesday in New York to federal securities fraud charges and admitted overstating the value of the Lipper Convertibles and Lipper Convertibles Series II funds by more than $300 million.

Lipper Convertibles had $392 million when it was liquidated in March 2002, after reporting $722 million in assets before the scandal erupted, prosecutors said, and the other fund had $21.1 million when it was liquidated, down from the $29.5 million it had claimed beforehand.

Bloomberg News reported that Strafaci told the federal government just that some securities would be marked higher according to his estimate of what they would be worth in the future.

Strafaci faces up to 10 years in prison.

Lipper fallout levels the field

"The Lipper thing was so serious that it's almost separate from the general increase in hedge fund scrutiny," said the head of research at a hedge fund in New York.

"The one positive from the fiasco though is that high-profile cases like this make every hedge fund manager pay much better attention to what is going on throughout their firm. It also forces customers and regulators to ask much more detailed questions.

"Over the long run, this makes it a much more level playing field for all managers, which we welcome."

It is good for the hedge fund industry, he said, since the survivors gain much more credibility. It also benefits hedge fund investors, he added, as they receive better safeguards and stronger managers.

Regulations costly on buyside

Regulations are becoming more burdensome for hedge funds now, however, as they have not previously been required to have the necessary infrastructure and personnel to satisfy Securities and Exchange Commission oversight.

Some blame the extra cost on the doors getting closed at some buyside shops.

"With regards to the high number of smaller firms going out this year, the bottom line is that increased regulations makes it harder and more expensive to start a firm today than years ago, since larger fund-of-fund players and institutions are reluctant to put money with smaller firms today unless they do make these added investments," said a convertible hedge fund source in New York.

Additional costs only exacerbate the frequent problem for new hedge fund managers in a flat or lower-return environment as currently exists, he said.

"Specifically, if one has a small asset base and no performance, the management firm itself then has to survive on the 1% to 1.5% typical management fee alone, since there is no 20% performance fee revenue if there is no performance," he said.

"Therefore, unless the firm is a start-up with very good connections and growth prospects, it gets stuck in a place where it can't generate enough revenues from management fees alone to survive. Adding another layer of compliance and reporting on top of a small firm at a low revenue time like this only makes it worse."

Liquidations come, go anyway

When Lipper liquidated its $400 million or so of convertibles in March 2002 it caused a great deal of anxiety, but in hindsight many onlookers say it was a ripple that was barely felt in the market.

"The Lipper liquidation seemed big at the time, yet it had no visible impact on the convertible market at the time," said a convertible fund manager in New York, who is involved in both outright and hedged strategies. "There's plenty of demand for convertibles."

There is a "weeding out process that happens naturally every year," said another manager, although he believes the number of firms going out recently is more a function of higher costs in a lackluster return environment.

"Hedge fund liquidations are inevitable because there are so many new funds run by managers without prior hedge fund experience. And many of the new funds are both small and below their high-water-marks, so the fees that the managers anticipated will not be forthcoming," said the New York manager.

"Moreover, the hedge fund fad will pass as more hedge funds turn out to be something other than hedged. How often has the word 'hedge' been associated with losing money? Anyone with any experience knows that the answer is many times. My guess is that the liquidations are too small to matter."

About 3,500 new hedge funds have opened over the past five years, and there are about 6,000 funds worldwide, according to Tremont Advisers Inc. The Securities and Exchange Commission filed civil suits involving 12 hedge funds in 2002, compared with two in 1999, six in 2000 and seven in 2001.

Money tougher to raise

Despite the seemingly endless list of new hedge funds each week, it appears that money is getting tougher to come by. That's not exclusive to convertibles as an asset class, however.

One convertible hedge fund manager spoke to Prospect News on Wednesday about the firm shutting down its convertible portfolio, as of Thursday, after a 21/2-year stint. The manager said part of the problem was management at the bank that seeded it in addition to it being a tough environment in which to raise money.

"It had nothing really to do with the asset class, convertibles," the portfolio manger said.

"Our demise came because this firm could not raise money since day one. We were running about $60 million and one-third was the firm's, another third was managed accounts that someone at the firm had an existing relationship with. The sales force here was only able to raise about $20 million in two and a half years.

"That is a stinky sales force. Management changed here at the end of March. The CEO, head of accounting and head of legal were here one day, gone the next. I bet there is some story there; they won't tell anyone what really happened."

Research a big premium now

The convertible fund manager in New York involved in both outright and hedged strategies said that new regulations have made research more of a premium than ever before and gives funds that were prepared with a research staff a leg up.

"One thing I like about new regulations: Street research has been cut back, which gives advantage to those of us who have in-house research," the manager said.

On the sellside, indeed, there is little research to be had.

"As for us here on the sellside, in research, specifically, I'm sure that you're aware of the overall dearth of published convert research. Without getting into the gory details, I can tell you that practically every firm on the Street has decided that it is no longer worth giving anyone - investors, the media, etc. - the idea that anything improper is going on and has therefore pretty much stopped publishing proprietary research off their respective sales and trading desks," said Citigroup's Novick. "To my knowledge, the only firms still publishing idea-based convert research are those in which the analysts are physically located somewhere other than their desks - another building, within equity research, etc."

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