Hedge Funds: Leveraging the Numbers

Date: Monday, November 26, 2007
Author: Alistair MacDonald and Margot Patrick, The Wall Street Journal

Size Can Be Deceiving When Borrowed Money Is Added to Calculation

Hedge funds have become famous for using borrowed money to boost their returns. But the upheaval in credit markets is shedding light on another way they use it: to make themselves look bigger than they really are.

When reporting their assets under management, hedge funds typically refer to the amount of money they have attracted from investors -- a practice long established by mutual funds and other investment firms. Many hedge funds also borrow money to increase their "leverage," which amplifies their potential returns (and potential losses).

In recent months, as the market turmoil has forced many funds to cut back on their borrowing, it has become evident that some were adding in the borrowed money when reporting their size.

For example, bond fund Y2K said it had assets under management of $2 billion as recently as July. But after a tough summer, London-based parent Wharton Asset Management UK Ltd. said the fund actually had less than $100 million in investor capital, and that most of the rest had been borrowed.

A spokesman for Wharton declined to comment.

"It's a pretty common practice that should be stopped," says Bradley Alford, founder of Alpha Capital Management, an Atlanta-based investment advisory firm that caters to wealthy families.

Though not illegal, the practice is significant because size matters in the hedge-fund industry. Investors tend to flock toward funds that have already attracted a lot of money from other investors. Also, for management companies that make their money on fees, assets under management offer an important indicator of earning power -- something akin to sales numbers at a retailer, or reserves for an oil company.

The practice also raises questions about the true size of the global hedge-fund industry at a time when it is trying to get away from its image as a bevy of secretive mavericks.

In an effort to head off calls for greater regulation, a group of Europe's largest hedge-fund managers last month drafted a proposed code of behavior that would give investors and banks more information about the risks hedge funds take and how they value their assets. The U.S. Treasury has also commissioned a group to look at a code of voluntary standards.

"It's all to do with confidence," says Andrew Large, chairman of the European group, known as the Hedge Fund Working Group, and a former Bank of England governor. "If people feel that the facts they are given they can't understand and rely on, it doesn't give them confidence in the underlying" fund or in the industry.

Take, for example, New York-based Fairfield Greenwich Group, which describes itself in a prospectus sent to investors as "one of the largest" alternative asset managers, with over $15 billion under management as of October. Actually, that number includes borrowed assets totaling around $2 billion, according to people familiar with the fund. Nevertheless, the $15 billion number is often reported to data gatherers, according to these people. Fairfield declined to comment on the appropriateness of the firm's reporting.

To be sure, most hedge-fund managers report their numbers according to the market custom, according to fund brokers and investors. Those that don't tend to be either in the credit market, where large amounts of borrowing are often used to invest in complex securities, or are smaller funds looking to inflate their size.

The lack of consistency in reporting helps explain why the size and performance of the global hedge-fund industry has been so notoriously difficult to pin down. As of the end of June, Chicago-based Hedge Fund Research Inc. put the total assets managed by hedge funds at $1.74 trillion, while London-based HedgeFund Intelligence put it at $2.48 trillion. Credit Suisse Tremont, which also tracks the industry, puts it at $1.25 trillion.

"While every index provider will do their best to present data as accurately as possible, it is difficult to capture every fund accurately," says Philippe Schenk of Credit Suisse Tremont. Mr. Schenk says the nearly 1,000 funds run by the world's largest hedge-fund firms, which have about $650 billion under management, are required to show audited financial statements. The rest, though, are self-reported.

Borrowed money isn't the only factor skewing hedge funds' reported size. Managers of funds that invest in other hedge funds, for example, sometimes double-count when their investments include other funds they manage. London-listed RAB Capital PLC, for example, has a fund of funds called RAB Multi Strategy, which invests about $500 million across the group's other funds. This money is added into RAB's total reported assets under management of $7.1 billion, despite being counted twice.

RAB Capital says it does so because it collects a separate management fee on the fund.

"We are reporting on all the assets on which we earn fees," says Philip Richards, RAB chief executive. Otherwise, "we would have a gap where there were incremental fees coming in out of thin air," he says.

Write to Alistair MacDonald at alistair.macdonald@wsj.com and Margot Patrick at margot.patrick@dowjones.com