Another 100 year storm coming?

Ron Lake, of Lake Partners in the global hedge fund capital of Greenwich, Connecticut recently told an opalesque Round Table that   “There were three key lessons from 2008. Lesson 1: keep things in historical perspective. Lesson 2: avoid panic. And Lesson 3: Take the long view.

Regarding Lesson 1, the Credit Crisis of 2008 truly was the proverbial "100-year storm". There were some very scary moments. But we all know that so-called "100-year storms" seem to happen every three or four years.

If you look back over how the hedge fund industry has evolved, there have been several cycles of opportunity, growth, crisis and retrenchment, followed by renewed opportunity and growth. Too many of us have forgotten (or never knew) our industry's financial history.

The first "Golden Era" of hedge funds occurred during the "Go Go" years of the 1960s. The first hedge fund bust occurred when the "Go Go" years went "bye bye" in the run up to the 1973-74 bear market.

The second "Golden Era", when funds such as Tiger, Tudor and Odyssey were launched, coincided with the bull market of the 1980’s. This was followed by Black Monday in 1987, the collapse of the UAL Deal in 1989 and the Savings and Loan Crisis. A number of hedge funds did perform well in this period, but others found themselves on the wrong side of these events and there was a shakeout in parts of the industry.

The third cycle got under way with the 1991-92 market recovery and then accelerated as the "Masters of the Universe" capitalized on the European convergence trade, culminating with Soros' famously "breaking" the Bank of England. But all of this led to yet another shakeout in 1994 when rising interest rates pulled the rug out from under the carry trade and Mexico suffered its currency crisis. At that stage many of the "Masters of the Universe" looked more like mere mortals after all. Ironically 1994 was when Long Term Capital Management was launched, taking advantage of many of the lingering dislocations in the markets.

The 1995-97 bull market saw the hedge fund industry rise again. But of course this was followed by the Asian Currency Crisis and the Russian Default in 1998, a year that was capped by the collapse of LTCM and a wave of margin calls throughout the industry that led to yet another shakeout. In retrospect, LTCM seems almost quaint in comparison to Lehman's collapse, but at the time it seemed like the financial system as we knew it was teetering on the brink of collapse.

In short order though, the next bull market got under way and hedge funds thrived again. It didn't take long for the next crisis, which of course was the "dot com Bubble" bursting in 2000. These first few years of the Millennium were interesting because the ensuing bear market really separated the wheat from the chaff. Some hedge funds imploded while others proved their mettle by preserving capital and making money, this touched off the quantum leap in interest from institutions who were finally convinced that hedge funds could play a constructive role in their asset allocation plans.

As a result, industry AUM doubled from 2004 to 2007. But this coincided with a period in which market volatility virtually vanished, prompting many hedge funds to boost their use of leverage in order to maintain returns. We now know that this helped set the stage for the Credit Crisis of 2008, which became the Year of the Gate.

Note that throughout each and every one of these cycles, many hedge funds started out with relatively well controlled risk profiles and were well positioned to take advantage of opportunities. But as performance improved, too many managers - not all, but too many succumbed to the temptation to get over-leveraged, over-concentrated, or over-exposed.

In this historical context, the latest crisis was no different. Does that mean we all should have seen it coming? Hindsight is twenty-twenty, but this brings us to Lesson 2. As a friend of mine told me during the dot com bubble, "If you are going to panic, panic early." In other words, try to anticipate problems as best you can, and be wary of getting carried away with the crowd.

I believe that too many hedge fund managers and investors last year were scrambling for liquidity when it was already too late, either because they were over leveraged in the first place or because their assumptions about access to markets proved to be faulty. There were plenty of hints well before Lehman went under that it was probably prudent to reduce leverage and dial back risk.

Regarding Lesson 3: Invariably, crises create some very interesting opportunities for investors who are able to be contrarians. But you have to keep your wits about you and have some cash available to take advantage of them. All of which is easier said than done. We purposefully put off increasing allocations to credit strategies until the end of 2008, but it was really hard to actually pull the trigger when the world still looked so scary. ”