Beyond the Hedge Fund Shakeout

The recent stream of implosions is the least of the big banks' worries. Money still seems to be pouring into such investment channels

Large hedge funds at prestigious global banks seem to be blowing up routinely. But that doesn't mean the world's largest financial institutions won't be the ultimate beneficiaries of a hedge fund industry in the throes of a shakeout.

So far, some 80 hedge funds have imploded as a result of the credit crunch and subprime crisis—many of which were started by star talent hailing from white-shoe investment banks in the first place. The latest casualty: Citigroup's (C) Old Lane Partners hedge fund, which the bank bought for $800 million last year from the man Citi would later make its chief executive, Vikram Pandit. On June 12 the New York bank said it would fold the ailing multistrategy fund into its alternative investments group. Pandit had personally benefited from the original sale of the fund, pocketing $160 million for a fund that at its peak had some $4 billion in assets. But key management talent had fled after the sale, and it was subsequently hit with big losses. Investors wanted out. Citi took a $202 million writedown related to Old Lane in the first quarter.

And so the decision, which comes atop the rich purchase price Citi paid, the history of the fund, and Pandit's involvement, contributes to raised eyebrows for some observers. "Now that Old Lane is valueless, [Citi] will need to write that off. Add that to Pandit's employment contract (call it $250 million), and you get America's very first billion-dollar CEO," Don Putnam, a former investment banker and founder of the financial-services research group Grail Partners said in an e-mail to BusinessWeek. "He better be damn good."

A Parade of Cave-Ins

Similar hedge fund disasters have hit other Wall Street firms. UBS' (UBS) Dillon Read Capital Management will cost the Swiss bank about $300 million. And, of course, the now infamous hedge fund blowups at Bear Stearns were the seeds of the entire firm's demise. The 75-year-old investment bank was rescued from oblivion by JPMorgan Chase (JPM) in an 11th-hour, Federal Reserve-brokered deal on Mar. 17.

Still, the hedge fund losses (Bear's dramatic downfall aside) are essentially the least of the big banks' problems at this point. Brad Ziff, head of the hedge funds advisory practice at Oliver Wyman, says that in fact there's very little that banks got right before, during, and after the mortgage and credit crisis, and are therefore suffering much larger consequences. "A poor risk umbrella contaminated all their businesses," says Ziff. Despite all that, the big players are still capturing the lion's share of new inflows from institutional investors. "So investors are saying, 'This is a good wake-up call for me.' They know that putting capital with big banks may not necessarily be safe," says Ziff. "But is that where they are still concentrating their assets? From everything we are seeing, the answer is yes."

The biggest, in other words, will continue to get bigger: The world's 10 biggest hedge funds control $324 billion in capital, up 29% since 2001, according to Institutional Investor's annual survey published in December, 2007. Some of the players in the top 10 include Goldman Sachs (GS), Barclays (BCS), 2 Next Page