Sowood founder apologizes for hedge fund losses

SAN FRANCISCO (MarketWatch) — Sowood Capital Management Founder Jeff Larson apologized to investors during a conference call on Friday after hedge funds run by the firm lost more than half their value at the end of July.

The estimated net asset value of the funds is $1.4 billion, Larson said. That’s down from a $1.5 billion estimate earlier this week and about $3 billion in assets earlier this year.

Sowood sold most of its portfolio to Citadel Investment Group, a $14 billion hedge fund firm run by Kenneth Griffin, because that was the best option. Without that deal, Sowood investors would probably have been left with a total loss, Larson said. Citadel got a “substantial discount” for taking on the positions, he noted.

“You entrusted us with the management of your money, and we lost a lot of it, to say the least,” Larson said during the call. “There is no way to express how sorry I am about what has happened. This experience has harmed not just our clients but our friends.”

Sowood told investors on Monday that it lost more than half of its roughly $3 billion in assets this month amid margin calls in turbulent credit markets. See full story.

Harvard University’s $29 billion endowment and hedge-fund investment firm Aetos Capital LLC are among those that could be hit by losses from Sowood’s demise. See full story.

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Sowood has been contacted by regulators who want to know what happened and the firm is cooperating, Larson explained on Friday.

The firm is putting roughly $90 million in incentive fees that it earned in 2006 back into the hedge funds, he also said. Sowood will now unwind its few remaining positions and return capital to investors as quickly as possible, Larson said.

‘No fundamental reason’

Sowood’s troubles mounted swiftly, taking the firm by surprise and confounding a hedging strategy that had generated 16% returns in the 12 months ending June 30.

Sowood had built positions in the senior debt and bank loans of companies. Those stakes were cushioned because these companies had other debt that ranked lower in their capital structure, Larson explained.

In many cases, Sowood shorted, or bet against, the subordinated debt and the equity of these companies. The firm was hoping that if the market declined and credit spreads widened on the senior debt, that widening would be much more pronounced for the lower-quality debt and would be accompanied by a drop in the companies’ shares, Larson said.

“We saw relatively strong balance sheets, little to no chance of loss even in default, no near-term liquidity pressures, and no fundamental reason to expect extraordinary widening in those corporate credit spreads,” he explained.

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However, in June spreads widened sharply on senior corporate debt, but the accompanying moves in subordinated credit and equities that were expected by Sowood didn’t happen. The firm’s hedge funds lost 5% that month.

‘Radically worse’

At the time, Larson said Sowood didn’t see this as the beginning of something much worse. The firm also thought it had enough liquidity — cash and easily tradable securities – to weather another month like June, he noted.

“Unfortunately, we were wrong,” Larson said. “July was not just a repeat of June, it was radically worse.”

In the first three weeks of July, Sowood lost another 8% as senior corporate credit continued to perform worse than less sturdy credit and the stock market remained benign, he explained.

Larson didn’t say why he thought markets acted in this way. However, several other hedge funds have been under pressure to raise cash in recent weeks. In weak markets, managers sometimes sell their highest-quality assets first because they can get better prices. If lots of people do that at the same time, that can knock the prices of high-quality assets more than lower-quality securities.

Sowood cut positions, but during the week of July 23 corporate credit markets deteriorated even more. Dealers began to put much lower values on the firm’s collateral and buyers deserted the firm’s positions or bid very low prices for the assets, Larson said.

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Over the weekend of July 28, Sowood explored alternatives with several financial institutions that it thought had the resources to take on the firm’s positions before the markets re-opened on Monday.

Those talks didn’t go very far, so Sowood turned to Citadel as its best option, Larson said. That resulted in losses of more than 50% in July.

Without Citadel, Sowood was worried that its counterparties were going to seize its assets and sell them off in the market.

“In such an uncontrolled process, we believe there was a high likelihood that little to no net asset value would remain for our investors,” Larson explained.

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