The heightened financial crisis is taking its toll on a number of large US hedge funds and asset managers, prompting them to take both defensive and opportunistic positions. TPG-Axon, with $6bn in assets under management, has taken measures to reduce portfolio volatility from 18% to the low teens, according to a letter sent to clients October 1. VaR, which had jumped as high as 1.9% has moved back to a 1-1.3% range of assets under management. While such a level is above the .8-1% expected range when the fund was launched, TPG-Axon has moved VaR to a higher level to better reflect current market conditions.

In the ensuing two weeks since the letter was sent, markets have largely been in a free-fall, with the Dow Jones Industrial Average falling below 9000 for the first time since 2003. Sounding caution, the fund has also identified a number of opportunities. “We are focused on high quality financials with compelling valuations and whose earnings power is not leverage sensitive and impaired,” says Dinakar Singh, founding partner of TPG-Axon. “In the carnage of financial stocks, one can find high quality companies who are actually winners, and whose franchise value and earnings power have arguably improved because of the credit crisis.”

While no specific names are given, TPG Capital, an affiliate of TPG-Axon, invested in financials before the recent market rout. In less than six months, the fund’s $2bn investment in Washington Mutual (WaMu) has steadily dwindled. WaMu has been placed under federal receivership and is being sold to JP Morgan. In its letter, TPG-Axon also identifies distressed mortgages as an asset class, where extreme price dislocations, have created attractive risk/return dynamics. In the past year, the fund seeded and built Roosevelt Management, dedicated to delinquent mortgage assets.  Conversely, the fund has avoided small-capitalisation stocks owned largely by other hedge funds. “Our portfolio has always been weighted towards larger capitalisation, liquid stocks, and that is even truer today than ever.”

Greenlight adds to shorts

Greenlight Capital, which uses short-selling strategies, has sent an equally sobering letter to clients. The $6bn hedge fund run by David Einhorn lost 11.5% in September, leaving it down 12.9% for the year as the credit crisis deepened and regulators banned short-selling of more than 900 financial services stocks. Greenlight had generated positive returns in the first half of 2008, partly helped by short positions, including a famous one against Lehman Brothers.

The fund ended September 74% long and 65% short, representing its lowest net exposure ever (an indication of its high short position), according to a letter sent to partners. “On several of the government bail-out days or, more aptly the days of changes in short-selling rules, the shorts recovered dramatically more than the longs, especially the financial shorts abundant in our portfolio. We don’t believe this sort of government-driven manipulation alters the issues that companies in our short portfolio face, so our plan is to wait out this period in our highest conviction short ideas. While we did have another contribution from the Lehman short, most of those gains were ended in prior quarters.”

 The US Securities and Exchange Commission’s restriction on short-selling of financial stocks was imposed on September 19, following the collapse of Lehman Brothers, though the ban expired October 9. Most European countries still have a ban in place in one form or another. Italy instituted a short ban for all stocks October 10.

Similar to TPG, Stephen Feinberg’s Cerberus Partners has set its sights beyond the October rout and is looking three to four years ahead for opportunities in the mortgage market. “We are looking at whole loans, synthetic and derivative instruments where there has been significant dislocation. This is a historic opportunity in the US residential and commercial real estate markets,” Feinberg wrote to clients.

“Based on the sheer size of the markets, with over $7.9tr of cash securities outstanding, plus additional whole loans, synthetic and derivative instruments, we believe there will be a three- to-four year window of distressed opportunity in the asset class. With a steep yield curve, spreads near historic wides, volatility high, and the presence of increased illiquidity premiums, current market conditions are aligned for the opportunity to execute transactions with extremely attractive risk/return dynamics.”

VB