Citadel Advisors LLC and Millennium Management LLC said their assets soared ninefold when tallied under a new rule that requires hedge funds to disclose investments financed through borrowings.
Citadel, run by Ken Griffin out of Chicago, reported $115.2 billion of regulatory assets in a March 30 filing with the U.S. Securities and Exchange Commission, compared with $12.6 billion of net assets. Millennium, founded by Israel Englander, disclosed comparable figures of $119 billion and $13.5 billion as of year-end.
The two firms are among more than 1,200 private fund advisers that have registered this year with the SEC and begun providing a more comprehensive count on the assets they manage, including those acquired through the use of borrowed money, under rules aimed at curbing systemic financial market risks. The filings, which regulators may use to identify firms they want to monitor more closely, suggest the largest funds have returned to the level of leverage used before the financial crisis.
“People are worried about whether the larger numbers will make them more of a regulatory target,” said Michael Sherman, a partner in the financial-services practice of the law firm Dechert LLP in Washington. “The systemic regulators will use this,” along with data that firms must file confidentially with the SEC, “to try to stop the next great market blowup.”
April Emspak, a spokeswoman for New York-based Millennium, and Devon Spurgeon, a spokeswoman for Citadel, both declined to comment.
Loans, Short Sales
Under the Dodd-Frank Act, signed by U.S. President Barack Obama in July 2010, Congress required hedge and buyout funds with assets of $150 million or more to register with the SEC by March 30. It was one of several provisions designed to help regulators control risks to the financial system, which became evident when the 2008 failure of Lehman Brothers Holdings Inc. caused banks to stop lending to each other because they were worried counterparties owned too many toxic assets.
In seeking to adopt a uniform method for determining who met the threshold, regulators instructed firms to count assets that most were excluding from tallies on size, including holdings obtained through loans, short sales and hedging. Traditionally, hedge-fund advisers have quoted a net number, comprising investor capital plus investment gains and losses, when disclosing their assets under management.
More Than Double
In short sales, investors borrow assets to sell them in anticipation that they can be repurchased at a lower price later and they can pocket the difference. Hedging includes the purchase of offsetting positions to limit risk in a trade.
While some fund managers only gave information on their gross assets, 31 of the 50 largest also disclosed their net assets in a separate section known as the client brochure. For these advisers, gross assets of $949 billion were more than double their net assets of $422 billion.
That indicates hedge funds may be using as much leverage as they did prior to the 2008 financial crisis. On average, hedge funds held total assets that were double their net capital as recently as 2007, said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, a Darien, Connecticut, adviser to asset managers.
Not all of the difference between net and gross assets may be explained by leverage, because the SEC’s gross number also includes proprietary stakes that money managers hold in their own funds as well as assets that don’t get charged a management fee. The SEC’s calculating method can lead to double counting of assets at funds, such as Citadel, that include multiple entities.
Even so, the higher asset calculation could lead to more regulation for some firms. Investment advisers with at least $150 million of private fund assets under management will have to make an annual filing to the SEC known as Form PF that provides information on their performance, assets and leverage. Those with $1.5 billion in hedge-fund assets under management will have to make a more detailed filing and do so at the end of each quarter rather than once a year.
Moreover, the U.S. Financial Stability Oversight Council approved a final rule on April 3 that said non-bank financial institutions would be evaluated for possible oversight by the Federal Reserve if they have more than $50 billion of consolidated assets and meet any one of five other thresholds.
Robert Plaze, a deputy director in the SEC’s division of investment management, said money managers with other types of clients, such as wealthy individuals or institutions with separate accounts, have always included assets purchased with margin loans in the totals reported through their annual Form ADV. In extending the practice to managers of private funds, the SEC also wanted to ensure that managers didn’t use leverage as a way of avoiding reporting requirements.
“If we used net assets, the more risk you have and the more systemically relevant you are, the less likely it would be that you have to report” information required under Dodd-Frank, Plaze said in a telephone interview.
Before the new rule was put in place, the 50 largest advisers to hedge funds that had voluntarily registered with the SEC, including Ray Dalio’s Bridgewater Associates LP and Seth Klarman’s Baupost Group LLC, reported combined assets of $613 billion for 2010, according to SEC data.
The 50 largest hedge-fund advisers registered under the new rules reported regulatory assets of $1.35 trillion at the end of 2011, the SEC data show. The two groups aren’t directly comparable because they include some different firms.
The rankings include firms that have at least 50 percent of their assets under management in private funds, while excluding those that oversee a variety of vehicles, such as mutual funds and separate investor accounts. Banks with large asset-management divisions, such as Goldman Sachs Group Inc., aren’t included in the tally, nor are firms such as Blackstone Group LP and KKR & Co. that oversee both buyout and hedge funds.
“This is one of the largest changes to the way assets under management are calculated historically,” said Sidney Wigfall, co-managing partner at SC Advisors-Barge Consulting Group, a Chicago-based firm that advises money managers on regulatory compliance. “The SEC wanted to be able to see firms’ asset exposure to both short side trades as well as trades that involve using leverage, regardless of the amount.”
The financial stability council, a panel headed by Treasury Secretary Timothy F. Geithner that was created to monitor systemic risk, said the its five other thresholds for possible oversight include a leverage ratio in which a firm has $15 of assets for each $1 of equity. Other thresholds include $3.5 billion of derivative liabilities or $20 billion of total debt outstanding.
“All of a sudden, not only is the SEC going to regulate me, but the Fed is going to be at my door,” said Dechert’s Sherman. “That is pretty daunting.”
In practical terms, the SEC rule meant that fund managers had to measure all assets on their balance sheets rather than the industry equivalent of net equity, according to John Tavss, a partner in the investment-management group at the law firm Seward & Kissel LLP in New York. Because the use of borrowed money, or leverage, boosts both potential profits and losses, investors may conclude that firms with a big gap between their regulatory and net assets are taking on more risk.
“If you are heavily levered, obviously that will result in you having a larger gross asset number,” said Gary Kaminsky, a principal in the business advisory services group at Rothstein Kass, a Roseland, New Jersey, accounting firm that audits hedge funds. That’s because, under the SEC approach, “all that matters is what’s on the asset side of the balance sheet,” Kaminsky said.
Hedge funds are relying less on margin loans from prime brokers, the securities firms that provide credit and facilitate trading, and more on repurchase agreements, leveraged exchange-traded funds, and derivatives such as total return swaps, according to Josh Galper, the managing principal at Finadium LLC, a Concord, Massachusetts, investment research and consulting firm.
“Leverage is down across the board from the perspective of borrowing from a prime broker,” Galper said in a telephone interview. “It’s tough to measure how much embedded leverage funds are using.”
The amount of leverage that an adviser uses, and thus its ratio of regulatory to net assets, is often tied to the firm’s primary trading strategies. Prime brokers are often willing to lend more money to firms that make bets that aren’t tied to market swings, said Leonard Zacks, a Chicago-based money manager who oversees about $2 billion.
Citadel, for instance, generally seeks to follow strategies that have a low correlation to stock and credit markets. An example would be an index arbitrage trade in which a fund manager bets that futures on the Standard & Poor’s 500 Index are cheap relative to the price of the individual stocks that comprise the benchmark.
“From the prime broker’s point of view, they have an almost zero risk portfolio,” said Zacks, who has been running a market-neutral strategy for 15 years. He said most market-neutral strategies use leverage of three to four times capital.
Citadel’s gross assets were also nine times its net figure back in May 2008, when the company was bulking up on convertible bonds as part of a relative-value strategy designed to profit from small price differences in related securities. The firm had gross assets of $145 billion at the time before the bets went awry, leaving clients with a 55 percent loss for the year.
AQR Capital Management LLC, the money-management firm headed by Cliff Asness, reported in an April filing that it had regulatory assets of $75.6 billion and net assets of $43.5 billion at the end of 2011. D.E. Shaw & Co., founded by David Shaw, reported regulatory assets of $49.3 billion and net assets of $16.5 billion. James Simons’ Renaissance Technologies LLC disclosed $49 billion in regulatory assets and $20 billion in net assets. SAC Capital Advisors LP, run by Steven Cohen, had $43.8 billion of regulatory assets at Dec. 31 compared with $13 billion of net assets as of Nov. 30, its filing shows.
“Almost everyone will understand the difference as leverage,” Celeghin at Casey Quirk said. Some hedge funds “are concerned that this might scare some of their LPs because the difference in assets under management is going to be so big,” he said.
Spokesmen for all of the firms declined to comment.
Trade Group Opposition
The SEC’s switch to gross assets was opposed by the Managed Funds Association, which has a presentation on its website stating that the concept isn’t an accurate indicator of investor capital at risk, leverage or the riskiness of a particular fund. The trade group, which has offices in Washington and New York, says the traditional net number better reflects client assets at risk, and many funds continue to report both the larger and smaller figures in their Form ADVs, albeit in separate sections of the filing.
“It may be confusing to some investors,” said Tavss, the lawyer at Seward & Kissel. “Investors could look at some of these regulatory filings which will be publicly available and managers will report regulatory assets that are potentially significantly higher than the net assets investors thought the manager had.”
================================================================ Fund Regulatory Assets Net Assets ================================================================ Bridgewater Associates $121,007,400,554 $121,000,000,000* Millennium Mgmt $119,000,070,000 $13,512,188,000 Citadel Advisors $115,208,973,792 $12,610,000,000 AQR Capital Mgmt $75,642,756,187 $43,500,000,000 D.E. Shaw & Co. $49,315,000,000 $16,500,000,000 Renaissance Technologies $48,980,049,045 $20,000,000,000 Pine River Capital Mgmt $44,733,152,526 $7,150,000,000** S.A.C. Capital Advisors $43,827,960,417 $13,039,600,000 Cerberus Capital Mgmt $40,180,435,963 $19,500,000,000 OZ Mgmt $35,234,349,244 $29,500,000,000** Paulson & Co. $30,545,850,000 $30,500,000,000* Elliott Mgmt Corp. $29,762,032,247 $29,762,032,247* Moore Capital Mgmt $29,739,680,486 $14,723,337,831 Farallon Capital Mgmt $28,911,501,446 $19,276,900,000 Angelo, Gordon & Co. $26,631,184,168 $26,600,000,000* Lone Pine Capital $24,827,697,900 $19,100,000,000 Adage Capital Mgmt $24,492,584,514 $15,931,400,000 Baupost Group $23,752,781,342 $23,752,781,342* Viking Global Investors $22,538,977,341 $16,203,894,475** Highbridge Capital $22,211,343,072 $19,618,599,502 Convexity Capital $21,969,300,000 $14,003,600,000 Capula Investment US $21,000,000,000 $1,600,000,000 Tudor Investment Corp. $19,450,190,442 $19,450,190,442* Eton Park Capital Mgmt $19,401,291,008 $11,846,524,268 Tiger Global Mgmt $16,992,700,000 $13,765,800,000 Oak Hill Advisors $16,212,171,543 $12,861,000,000 Invesco Senior Secured $15,959,470,247 $16,000,000,000 Maverick Capital $15,205,053,349 $15,000,000,000* Appaloosa Mgmt $14,605,972,000 $12,012,276,000 Canyon Capital $14,521,413,000 $14,500,000,000* Carlson Capital $13,688,515,417 $13,700,000,000* QVT Financial $13,452,851,221 $5,448,756,389 Taconic Capital $13,204,408,395 $8,240,000,000 HBK Capital Mgmt $12,978,682,000 $12,978,682,000* Third Point $11,980,000,000 $9,100,000,000 Caxton Associates $11,888,260,131 $11,888,260,131* Black Diamond Capital $11,291,710,478 $11,291,710,478* Brigade Capital Mgmt $10,822,180,170 $10,822,180,170* Magnetar Financial $10,723,994,744 $10,723,994,744* ESL Investments $10,575,000,000 $6,700,000,000 Pershing Square Capital $10,479,603,293 $11,287,035,042** Perry Capital $10,476,889,323 $7,346,600,000 Diamondback Capital Mgmt $10,245,843,754 $2,533,131,216** K2/D&S Mgmt $10,071,923,907 $10,071,000,000* Paulson Mgmt $9,526,813,000 $9,500,000,000* Balyasny Asset Mgmt $9,120,737,128 $4,020,000,000 Aladdin Capital Mgmt $9,100,500,000 $9,100,500,000* Vinik Asset Mgmt $8,892,796,850 $8,900,000,000* Greenlight Capital $8,836,997,393 $8,836,997,393* Saba Capital Mgmt $8,222,238,107 $5,508,700,000** Total: $1,347,441,287,144 $820,818,595,577 ================================================================ *Firm did not report separate figure for net assets **Assets as of Jan. 31 for Diamondback; Feb. 29 for Pershing and Viking; and March 1 for Saba, Pine River and OZ.