Monday, October 13, 2008

That MoFo saw it coming

Morrison Foerster (affectionately known as, MoFo, if affection is the right word) is one of America's big law firms. Guambat remembers it as the pinnacle of the summer law clerk positions on the West Coast (or among those at the pinnacle) eons ago. Certainly no where near Guambat's league.

So they know their soup, and they saw the current soup beginning to boil over way back in August 2007 with this prescient bit of client guidance and, perhaps, a bit of rain-making:

Hedge Fund Failure Predictions and Strategies: How to Catch a Falling Knife and Not Get Cut

Nine thousand hedge funds exist today, holding roughly $2 trillion in assets. At least 2,000 of such funds are perceived to be vulnerable to “run on the bank” investor redemption pressures. Such redemptions result from fears that the last to exit will suffer greater losses. The concern about financial reporting credibility is particularly focused on the exposed funds’ assets that are difficult to value. Suspicions about such valuations are increasing, especially in a falling market with decreased liquidity and that is vulnerable to successive forced sales as a result of margin calls, bankruptcies, excessive redemptions, limited refinancing at far lower valuations, and other factors. Such at-risk hedge fund assets include credit default swaps (“CDS’s”), collateralized debt obligations (“CDO’s”), collateralized loan obligations (“CLO’s”), leveraged buyouts (“LBO’s”), and other distressed debt and exotic categories.

The reason this problem is focused on vulnerable hedge funds, as opposed to private equity funds or other investment vehicles, is that hedge funds have both shorter lock-up agreements with investors ranging from 30 days to a year or more and more aggressive valuations on difficult-to-value assets. Lawyers who are regularly involved in these disputes divide the world of private equity funds and hedge funds based on the length of the investors’ lock-up commitment of their funds. Funds with lock-up periods of a year or less are generally viewed as “hedge funds,” and those with longer lock-up periods are viewed as “private equity.”

Bankruptcy/restructuring lawyers also divide hedge funds into “vulnerable funds” versus all other funds, based on a variety of factors, one of which is the length of the investors’ lock-up, with those able to redeem on 90 days or less being most vulnerable. While most funds also have other contractual protections against excessive redemptions compared to liquid assets, those protections only delay and cannot overcome the angry investors’ litigation strategies described below.

While our analysis of at-risk funds contains many other factors, other vulnerabilities include a strong focus on the types of asset classes held by the fund. Some asset categories are often presumed to be booked far higher than the prices at which they will sell in a falling market or, in the case of the liability side of the balance sheet, to establish a net value payout on the credit default derivatives that insure distressed debt, for which the fund reported what may prove to be inadequate reserves. For example, if a hedge fund “insures” $100 million in bonds (whether owned or not by the “insured” hedge fund buyers of the credit default derivatives), that insurer fund may book both a $5 million token reserve and a $15 million theoretical profit. The insurer fund cites both rating opinions and GAAP reporting rules about not recognizing contingent liabilities that are too remote or inestimable.

But (like the rating agencies themselves) the funds ignore the predictable market dynamics that will arise once the debt insurers no longer can refinance at par their massive first- and second-lien debt in a falling market. All that the beneficiaries of such credit default derivatives must do in order to profit generously is to cause the debt issuer’s bankruptcy. Often, only more than 25% of any strategic tier of bond debt is required to force a secured debt default that, in turn, forces a defensive bankruptcy in order to stay the lien enforcement.

Unfortunately, the hedge fund selling the credit default derivatives then will need to explain to investors how it lost $80 million and now also must reverse the $15 million theoretical profit on which the fund managers paid themselves a generous fee.

Since credit ratings focus on holding-to-maturity risk, without regard to the effect of the interim “games” and market “corrections,” the ratings do not reassure those who are concerned about the effect on market declines from massive margin calls, CDS-insurance-inspired bankruptcies, and other forced sales for accommodating redemptions by fund investors. Absent reliable asset values, what emboldens the fiduciary money in these funds (e.g., pension funds, university endowments, foundations, etc.) to continue to bet against the risk of a massive exit?

Those of us who were involved in the prior hedge fund collapses in this cycle know well what will surprise the public, when “war stories” are exposed in litigation. Some hedge practices are not going to sound sympathetic to juries, or even to some judges, who believe that predictable rules should be enforced in these “games.” “Side pockets,” “side letters,” and many other special hedge fund accommodations in this cycle for favored investors eventually will filter into public discourse, much like the terms “Fat Boy,” “Get Shorty,” “Death Star,” and the rest of the lexicon of the strategies of Enron energy traders that eventually came to light.

The fact is that litigators will feast on certain practices of failed hedge funds, notwithstanding justifications in the fund partnership agreements and their documents and disclosures. Why? Because at the core of this impending crisis—underneath all the other many things that intelligent people will dispute—is this inescapable truth: from hindsight, failed hedge fund books often will appear to overstate asset values and to understate the value of the liabilities, particularly with respect to credit default derivatives.

Representing “foreign representative” liquidators and investor/creditor committees early in U.S. Chapter 15 bankruptcy cases, following the first round of failed funds’ filing of offshore insolvency cases, has helped us appreciate the “game” to come. We are now also helping prime brokers and bank creditors prepare their defensive and recovery strategies for what is coming next, as we enter this serious, crash-risk period. As failed funds begin to liquidate their portfolios, whether in the courts or outside of court and “below the radar,” our Team is also there to support the buyers. The cross-border and multi-disciplinary nature of these issues requires a unified Team of lawyers with relevant experience acquired from cross-border bankruptcy/restructuring, M&A, and litigation in prior down-cycles. Also relevant are practices for international tax and hedge fund formation and advisory practices, for distressed M&A, and for other specialties applicable to certain asset categories, such as credit default derivatives.

You'll kick yourself for not having read that letter last year. And kick yourself again if you fail to read or re-read it now.

Now, considering, as Guambat does, that the lawyers are always the last to know anything, who else saw or should have seen this coming, when, and what did they do about it?



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