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


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


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.

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