Analysis: Raided U.S. hedge funds face a long struggle

BOSTON Tue Nov 30, 2010 2:24pm EST

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BOSTON (Reuters) - If history is any guide, three hedge funds raided by U.S. federal agents a week ago face a daunting task to return to business as usual, and may be left with only one good option: return money to their wealthy clients.

So far no one has been charged with wrongdoing, but legal experts and investors say lasting damage may have been done.

For investors, the risk lies in whether the managers of these once well-regarded funds will be able to focus on selecting stocks and raising new capital at the same time they are busy calming nerves and working to clear their own names.

"The longer you have this kind of back-and-forth between the government and a hedge fund, the more difficult it can become for a fund to survive," said Brad Balter, chief investment officer at Balter Capital Management.

"No allocator wants to simply sit there in the face of this potential risk, and so people start putting in their redemption notices," said Balter, whose firm invests in hedge funds.

William Brandt, who advises troubled hedge funds at Development Specialists Inc, expressed a similar view and said investors were right to worry about whether a fund that had been raided by authorities can continue to thrive.

"It is not a death knell, but it is pretty close," Brandt said. "In the financial world, you are often guilty until proven innocent, not the other way around."

FBI raids are rare on Wall Street. It's a technique usually reserved for busting up the likes of "pump and dump" brokerages that are selling worthless stock to the public. The normal way for authorities to gather information from hedge funds and other financial firms is through a subpoena.

So the $1.7 trillion hedge fund community was shocked when the FBI came calling at Level Global Investors, Diamondback Capital Management and Loch Capital Management last Monday and hauled away dozens of boxes of documents.

ON LEAVE

Even before the raids, Loch Capital had suffered heavy redemptions in recent months as investors expressed concern about the close personal ties between the firm's founders and a witness in another insider trading case, the Galleon probe.

On Monday, Diamondback Capital Management told investors it had put one of its portfolio managers on leave. In a letter to investors, Diamondback's managers said the fund itself was "not a target of the government's investigation."

Level Global, the third fund that was raided, also told its investors that it had been advised that it was not a target of the government's insider trading investigation.

Still, the funds are scrambling to contain the damage.

David Ganek, manager of the $4 billion Level Global fund, backed out of a scheduled appearance on Tuesday with Securities and Exchange Commission Chairman Mary Schapiro at an event sponsored by his alumni association at Franklin and Marshall College in Pennsylvania.

A spokesman for Level Global declined to comment on Ganek's decision to cancel the appearance.

People familiar with Level Global said employees were "blindsided" by the FBI visit.

Executives at Diamondback, where FBI agents had ordered employees to put their hands in the air as they entered the premises, also were said to have been caught off guard -- especially so because Peter Derby, a former top SEC official, is an employee of the fund.

A lawyer for Diamondback declined to comment.

REPUTATIONAL DAMAGE

Some institutional investors and their advocates suggested that the managers of the three funds could best serve their clients by liquidating and returning money to investors.

"Any time a fund is under siege it is hard to conduct business," said Scott Berman, a partner with Friedman Kaplan Seiler & Adelman in New York.

"It is a rare occasion that you can find a fund facing this kind of duress and continue to operate a business."

Indeed, there is precedent in the industry for shutting down before regulators swing the ax. Arthur Samberg liquidated his Pequot Capital fund months before settling another insider trading case.

Other analysts, though, said that shutting down the funds now, before charges have even been made, would be akin to acknowledging that the fund managers had done something wrong.

Still, investors said it would be tough for the managers of Level Global and Diamondback to continue operating their businesses while simultaneously trying to defend their reputations and keep key traders and analysts from bolting.

Diamondback and Level Global may face higher operating costs because top managers and traders who are looking at other jobs might require more money to stay. And the funds' prime brokers might be more cautious about lending money.

"The longer this goes on, the more there will be an asset bleed," said Balter said. "These things just don't age well," he said, referring to lingering probes.

For now, Diamondback and Level Global may have some breathing room, since the deadline for investors to submit year-end redemption requests has passed. The next major withdrawal period for the two funds is in March.

Rival fund firm FrontPoint Partners, embroiled in another insider trading probe earlier in the month, was not so lucky.

Its news hit earlier, and investors have asked for the return of $3 billion. The scandal already is forcing FrontPoint to liquidate a health-care portfolio that was implicated in that earlier and unrelated insider trading case.

(With additional reporting by Jonathan Stempel and Matthew Goldstein in New York; Editing by Ted Kerr)

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