Sowood: Long Debt, Short Equity

Marc Andreessen made a lot of money last week, when he sold his company for $1.6 billion. But has he been losing a lot of money, too? His blog was the first place I know of which had the letter Bear Stearns sent to investors in its failed hedge funds. And today he reprints the letter that Sowood sent to its investors. Now I'm sure that Andreessen is best buddies with lots of finance types, but still – he does seem to be very good at getting those letters sent only to the investors in failed hedge funds.

One thing I learned from the Sowood letter is that it looks as though the fund was hedging its bond positions in the stock market.

Our actions over the weekend followed severe declines in the value of our credit positions and non-performance of offsetting hedges...
During the month of June, our portfolio experienced losses mostly as a result of sharply wider corporate credit spreads unaccompanied by any concomitant move in equities...

The long-debt, short-equity strategy is a venerable one in the hedge fund world: some of the world's firs hedge funds started out in the business of convertible arbitrage, which is essentially a variant on that theme.

But the strategy is also extremely dangerous. The classic risk, of course, is that a company becomes the victim/beneficiary of an LBO. The stock skyrockets to the acquisition price, while the debt gaps out in anticipation of huge new issuance.

In this case, however, it wasn't some LBO event which caused losses. Credit in general deteriorated sharply, while stocks were (until recently, relatively) unaffected. That doesn't make a lot of sense from a commonsense view of capital structures, where equity is the most junior asset class, and should suffer the most volatility and the first loss.

But try telling that to your prime broker.