BOSTON (Reuters) - Pictures of hedge fund managers in handcuffs being led away to face fraud charges on Thursday have sent a chilling message to the $2 trillion (1 trillion pound) industry.
The warning was clear: mind what you say in your e-mails if you are a manager and do a lot of due diligence if you are an investor.
While this is not the first time hedge fund managers have been arrested — police are searching for a convicted manager who recently faked his suicide to avoid prison — the two former Bear Stearns managers who were surrounded by a swarm of federal agents on Thursday were in a different league.
Ralph Cioffi and Matthew Tannin were called savvy managers who understood the complicated credit markets and worked for a bulge bracket investment bank that promised investors strong risk controls. Bear Stearns also had deep pockets in case something went wrong, analysts thought.
Much of the case against the two was based on e-mail traffic between Tannin and Cioffi, including one that included the prophetic line: “... the entire subprime market is toast.”
The two men stand accused of having known their portfolios were in trouble, but lying to investors about it.
“You can’t say one thing to investors and another thing to your colleagues and think that is OK. It is not,” said Dick Del Bello, a senior partner at Conifer Securities, who used to run the U.S. prime brokerage business for UBS.
The men’s arrests are the first criminal charges related to the sub-prime mortgage crisis that has impacted the loosely regulated hedge fund industry through heavy losses and a wave of redemptions.
“Unless you write it on a post-it note and put it on top of a book of matches, everything stays around and it can bite you,” said a hedge fund manager who asked not to be named.
Still, endowments and pension funds need hedge funds to help boost sagging investment portfolios as the economy slows and stock markets wobble. To protect themselves, they will ask more consultants to help with due diligence.
“Investors will rely more on third parties to check statistics about how much leverage a fund is using and to demand more transparency from fund managers,” said Stewart Massey, a founding partner of Massey, Quick & Co, an investment consultant with money with about 30 hedge funds.
And people may stop believing a single manager’s explanation for how safe the money is, several investors said.
“We never rely exclusively on what one manager tells us,” said Michael Travaglini, executive director of the $53 billion Massachusetts state pension fund, an early and big investor in hedge funds.
“We already spend all of our time monitoring our portfolios, so for us this case doesn’t mean very much. But in general, it really underscores the need for investors to understand exactly what they are buying.”
At the same time, investors’ appetite for very risky hedge funds — the kind that use a lot of leverage, or borrowed money, to boost returns — may also taper off, industry experts said, adding that now more than ever people want to play it safe.
One of the collapsed Bear Stearns funds was said to have borrowed $20 for every $1 it invested.
“Hedge funds can be used as offensive weapons and as defensive weapons and this will probably prompt more people to use them as defensive tools, marking a return to the basics of unleveraged funds that reduce volatility,” Massey said.
The trend is illustrated in quarterly flow data that show hedge funds attracted only $2.6 billion in the first quarter, an 81 percent drop from what they pulled in during the previous quarter. Long/short equity hedge funds experienced the biggest redemptions, losing $7 billion in net new money during the quarter, data from Lipper TASS, a unit of Thomson Reuters show.
Also the arrest of the Bear Stearns managers might finally drive home a message to everyone using e-mail — everything they put in writing can stay around forever.
Chief compliance officers at larger hedge funds have long warned portfolio managers to be candid but careful. This case should reinforce the message.
“One would hope that after all the previous scandals involving e-mails that hedge fund managers will realize they have to make sure the things they say internally match what they are telling their clients,” said Randy Shain a private investigator who specializes in the hedge fund industry.