July 31 (Bloomberg) -- Sowood Capital Management LP lost 50 percent in July, or about $1.5 billion, the biggest hedge-fund manager to collapse after declines in the corporate bond and loan markets.

Sowood sold most of its assets to Citadel Investment Group LLC and will unwind its two funds, Jeff Larson, founder of the Boston-based firm, told investors in a letter yesterday. Sowood sought a buyer when it couldn't meet lenders' demands for more collateral. Terms of the sale to Chicago-based Citadel weren't disclosed.

``The transaction enabled us to avoid anticipated forced sales at extreme prices,'' Larson, a former Harvard University endowment manager, said in the letter. ``The weakness in corporate credit, particularly focused on loans and loan credit- default swaps, accelerated sharply during the week of July 23.''

The firm's credit holdings plummeted in value as investors shunned riskier debt such as subprime mortgages and bonds used to fund leveraged buyouts. Bond prices have dropped even as the global corporate default rate hovers at the lowest in 12 years.

Sowood's Alpha Fund Ltd. lost 57 percent in the month and Alpha Fund LP dropped 53 percent. The funds plunged 56 percent and 51 percent for the year, according to the letter.

Sowood spokesman Shawn Pattison declined to comment, as did Bryan Locke, a spokesman for Citadel.

`Mind-Boggling'

``It's mind-boggling,'' said Bradley Alford, a former investment manager at the Duke University endowment who runs Atlanta-based money-management firm Alpha Capital Management LLC. ``This last week, the velocity of losses has picked up dramatically. The models work when they look at history, but not when history is all new.''

The extra yield investors demand to own corporate bonds has risen to the highest relative to U.S. Treasuries since 2003. As prices declined, losses forced New York-based Bear Stearns Cos. to close two hedge funds and Basis Capital Fund Management Ltd. and Absolute Capital Group Ltd., both of Sydney, to freeze investor accounts.

Sowood used a variety of strategies, including trading in convertible bonds, commodities, bonds and stocks. It amplified its bets using borrowed money.

The firm will start returning money to investors ``as soon as it can,'' the letter said. Clients agreed when signing up not to withdraw money until late 2008. Sowood said it will hold meetings with clients next week and ``seek to retain key staff to manage the distribution.''

Collateral Calls

Sowood's losses were ``exacerbated by a marked decline in liquidity'' and no offsetting decrease in equity prices, according to the firm's letter.

``Until the end of last week these developments, while reducing the value of our portfolio, were manageable,'' Larson wrote. ``However, towards the end of last week, given the extreme market volatility, our counterparties began to severely mark down the value of the collateral that had been posted by the funds.''

The firm didn't own subprime loans made to borrowers with poor credit histories or mortgage-backed securities, Megan Kelleher, Sowood's general counsel and a managing partner, said in a July 27 interview. Sowood owned about $6.4 billion in stocks as of March 31, according to a U.S. Securities and Exchange Commission document.

The premium investors demand to own investment-grade corporate bonds instead of Treasuries rose 20 basis points last week to 128 basis points, according to data compiled by Merrill Lynch & Co. Spreads on high-yield bonds widened 91 basis points to 428 basis points, the highest since May 2005, Merrill indexes show. A basis point is 0.01 percentage point.

To The Rescue

Citadel has stepped in to take over assets of failed hedge funds before. In September, it and New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, assumed the energy trades of Amaranth Advisors LLC when the Greenwich, Connecticut-based hedge fund collapsed under the weight of more than $6.6 billion in losses on natural gas. Citadel, which manages $14 billion, later bought the positions held by New York-based JPMorgan.

Hedge funds are largely unregistered pools of capital that cater to wealthy individuals and institutions and allow managers to participate substantially in profits from investments. They control about $1.74 trillion, more than double the amount five ago.

Larson, 49, opened Sowood in 2004 and early investors included Harvard, which put in $500 million. He joined the university's investment unit, Harvard Management Co. of Boston, in 1991 from the finance division of Cargill Inc., the largest U.S. agricultural company. He started at Cargill in 1979 as an economic analyst.

Harvard Pay

At Harvard, Larson managed foreign stocks and a commodities portfolio and ran about $3 billion of the endowment of the Cambridge, Massachusetts, university. He earned $17.3 million in 2003, a year when Harvard paid more than $100 million to internal money managers, raising the ire of alumni.

Larson lived in River Falls, Wisconsin, as a child and later attended St. Paul, Minnesota-based Macalester College, earning a bachelor's degree in economics in 1979, according to the school's Web site. He was elected chairman of Macalester's trustee board and 2006 after four years as a trustee.

Harvard's $30 billion endowment, the largest for a university, was to increase its allocation to Sowood's hedge fund and a separate private-equity fund this year, according to a December statement from Sowood. The commodities-focused private- equity fund was spun off this month as Boston-based Denham Capital Management LP.

Denham `Unaffected'

Denham Capital said in a statement today all financial and legal links between it and Sowood were severed, and that its holdings were unaffected by Sowood's failure. ``We will continue to execute on both our short- and long-term objectives without regard to this or any unrelated events,'' Stuart Porter, Denham's managing partner, said in the statement.

Porter, 41, previously ran Sowood's private-equity business. Before that he was a vice president and portfolio manager for commodities at the Harvard endowment, where he started in 1996.

John Longbrake, a Harvard spokesman, declined to comment. Mohamed El-Erian, CEO of Harvard Management, didn't return phone calls.

El-Erian said in the December statement that splitting the hedge-fund and private-equity businesses would boost returns for both. The Harvard fund was the sole initial investor in the Sowood private-equity fund, whose assets increased 10-fold in two years to $2.3 billion as of December.

Sowood's name came from ``South Woodside Avenue,'' the street in Wellesley, a suburb of Boston, where Larson lived when he started at Harvard Management. The fund raised $2 billion before closing to new investors.

``We are very sorry this has happened,'' Larson told clients in the letter. ``A loss of this magnitude in such a short period is as devastating to us as it is to you.''

To contact the reporters on this story: Jenny Strasburg in New York at jstrasburg@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net.

Last Updated: July 31, 2007 16:43 EDT