* Assets dwindled to $1.45 bln from $5 bln two years ago
* Former Diamondback trader on trial on insider charges
* Redemption notices swamped firm's expectations
* Diamondback was up 7 percent in mid November
By Svea Herbst-Bayliss
BOSTON, Dec 6 (Reuters) - Hedge fund Diamondback Capital Management, one of a handful of firms embroiled in a government insider trading investigation, told investors it would close down after nervous clients demanded the return of more than a quarter of its assets.
Richard Schimel and Larry Sapanski, the firm's co-heads, broke the news to clients in a letter Thursday just three weeks after investors asked Diamondback to return $520 million, five times the amount top executives had expected.
As assets dwindled to $1.45 billion from about $5 billion two years ago, the firm's business model was in jeopardy and executives had to decide between closing the firm down or trying to engineer a second big restructuring within 18 months.
"Rather than continue to manage investor capital while undertaking to restructure the firm to manage this reduced level of assets, we have decided that the most prudent course is to wind down and terminate the funds and return investor capital," the two men wrote in the letter, a copy of which was obtained by Reuters.
Diamondback expects to lay off nearly all 133 employees. A small number will stay to manage the final liquidation, the people familiar with the matter said.
Founded by Schimel, Sapanski and a third partner, Chad Loweth, in 2005, Diamondback had been an industry darling.
Its three founders had all worked at Steven A. Cohen's successful SAC Capital Advisors, giving them the kind of pedigree that attracted some $6 billion of assets from marquee clients like the New Mexico's pension fund and Blackstone Group's powerful fund-of-funds unit.
The fund's returns were strong with an average annual return of 9 percent since 2005, boasting gains even during the financial crisis when many hedge funds were in the red. There was only one down year - 2011.
But two years ago, the firm's fortunes plunged when federal agents raided its Stamford, Connecticut-based headquarters, shepherding employees into a conference room, taking their cell phones, and spending hours boxing up documents.
With Diamondback swept up in the government's fast-moving insider trading probe into how managers might be using illegally obtained tips to make million-dollar trades, many investors got cold feet and ran for the exits.
The probe had already led to the arrest of Galleon Group founder, Raj Rajaratnam, in 2009 and would later lead agents to Cohen's SAC, where seven former SAC Capital employees have now been implicated or charged. Last week, SAC told its clients it would likely face civil securities fraud charges.
Diamondback's founders and the firm were never accused of any wrongdoing, but many clients left, and the company gradually shrank.
In January, when Todd Newman, a former Diamondback portfolio manager, was arrested in Boston, the news turned worse for the firm. Although executives promptly fired him after he came under a cloud and cooperated with the government investigation, the fact that Newman's trial coincided with investor redemption notices that were due hurt the firm, a person familiar with the matter said.
So managers began selling assets and moving into cash in order to return the bulk of client money by mid-January.
Yahoo! Inc, Capital One Financial Corp and American International Group Inc were among the firm's biggest holdings at the end of the third quarter, according to securities filings.
Diamondback's liquidation now closes the last chapter of four firms that were surprised by FBI raids in November 2010, when the government's probe picked up speed.
The other firms - Level Global Investors, Loch Capital Management and Barai Capital - unraveled quickly. Diamondback, however, vowed to stay in business, helped by powerful investors like Blackstone Group's ongoing support.
But by Nov. 15, the date for investors to decide whether they would stay or go, there was a tough decision to be made.
While Diamondback was delivering respectable returns of 7 percent after having returned an average of 9 percent a year since its founding in 2005, Newman's trial was playing out in a Manhattan court room.
Even though Diamondback's founders would not be prosecuted in the matter, there was a lot of headline risk. The firm had agreed to pay $9 million to settle civil charges that Newman, who made technology investments from Boston, and Jesse Tortora, a former Diamondback analyst, were making illegal trades.
Diamondback joins a large number of funds that have recently decided to get out of the business for a variety of reasons. John Kleinheinz is shutting Kleinheinz Capital because, he said, he wasn't having fun running the fund anymore, and Pierre-Henri Flamand, who set up Edoma Partners after leaving Goldman Sachs, said he could not make money in the current tough market environment.
At the same time, tougher regulations have also put a crimp in some traders' operations, industry experts said. And the government's insider trading case is expected to continue for some time at least.