In 2006, Goldman Sachs’ Geoff Grant and Ron Beller took an oracular gamble on the collapse of the subprime mortgage bond market which generated last year a staggering 87% return for one of their hedge funds.
However, Grant and Beller, who together run London-based Peloton Partners, aren’t looking quite so canny today. They’ve been forced to liquidate their once florid ABS fund, after betting big on a mortgage bond rebound that failed to take place.
The $1.8 billion fund’s collapse comes after a series of recent trades dropped sharply in value, leading to margin calls from creditors that the firm was unable to meet.
The ABS fund’s implosion, coming just three years after Peloton Partners was formed, highlights the steep challenges that hedge funds face amid the credit crisis gripping Wall Street. Last week D.B. Zwirn & Co shut down its two biggest hedge funds amid investor defections. Citigroup, earlier this month, halted withdrawals from one of its hedge funds.
Grant and Beller also told investors that they were suspending redemptions in a second Peloton portfolio, a $1.6 billion multi-strategy fund that finished 2007 up 27%. According to a letter sent to clients, the multi-strategy fund had a very large position in the ABS fund, whose failure led to a substantial knock-on impact on the multi-strategy fund.
Grant and Beller said in the letter that they were weighing up their options. But depending on the assets left in the ABS fund, the multi-strategy fund’s investment could be almost worthless.
The story of the ABS fund’s demise began last year when Peloton took short positions on investments backed by pools of subprime mortgages, meaning it bet that their values would fall. While other hedge funds like Paulson & Co. also bet short on mortgage bonds, Peloton did something more complex: It wagered that slices of the same bond portfolio with different ratings would diverge sharply in price – a strategy known as capital structure arbitrage.
The fund was long on AAA-rated mortgage bonds and gambled that BBB-rated subprime bonds would fall in value. That calculation paid off big when, according to ABS investors who spoke to Fortune.com on the condition of anonymity, the fund’s short position fell 75%, from an average of nearly $100 to $25. Meanwhile, the price of the fund’s AAA-rated long position declined much less. The price differential between the short and long positions led to the 87% return.
The fund apparently had around $16 billion in long positions versus $3.2 billion in shorts. The short positions – which were so profitable in 2007 – declined modestly in value, while the credit crisis drove the value of the massive long positions down an average of between $15 and $25 per bond in about a month. The fund suffered massive losses as a result.
In addition, the fund’s investment bank creditors – whose balance sheets were pummelled in the credit crisis – did not have the resources to absorb the hit on behalf of the fund and demanded additional collateral. Peloton was unable to meet those demands.
In turn, a consortium of Peloton’s lenders declined to buy the portfolio. Grant and Beller are now trying to sell pieces of Peloton’s portfolio, according to US-based mortgage hedge fund managers who have been approached.
Founded in 2005, Peloton’s collapse has caught the hedge fund community off-guard. Does this mark the beginning of the spread of the credit crunch from the banking sector into the hedge fund sector?