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If you're a hedge fund manager, you've got lots of explaining to do

awillis@globeandmail.com

Hedge fund owners are opening letters these days that explain why their savings are down 40 or 50 or, gasp, 60 per cent this year, and what portfolio managers intend to do about it.

Most of these performance reports contain a frank admission. Fund managers acknowledge that what worked in the past doesn't work any more.

They ask for patience, and continued support. Don't redeem, plead the fund managers. Stick with us, hunker down, and we'll figure out how to make money again when everyone calms down.

There's a degree of honesty to these letters. Any fund manager who claims the worst is over, and that they've figured out how to trade this market is delusional, at best. But investors have every right to wonder if they should continue to pay 20-per-cent performance fees for hedge fund approaches that no longer work.

Most hedge funds have one of two goals: There is a large camp that chases absolute returns, and a smaller camp that swings for the fences to post market-beating performances.

Fund managers in that absolute-return world, folks who delivered on their promise of making money in good times and bad during recent months, are candidates for sainthood. Sadly, there's not many of these heroes around.

Funds in that second camp, that tried to turbocharge performance with leverage and big bets, have lost serious amounts of money. They face a crisis of confidence.

In the domestic market, the downturn has driven home a sobering reality: A great many Canadian hedge funds were leveraged commodity plays. Many of these funds don't have a second act to roll out when the resource story is no longer a crowd pleaser.

The pension fund crowd routinely fires money managers if they break discipline on style - if a value fund manager starts chasing growth plays, that manager gets dumped.

Hedge fund investors should be equally intolerant if a fund that's traditionally focused on long and short positions in energy stocks suddenly dives into, say, distressed debt.

With performance rotten, and unlikely to get better any time soon, expect a number of fund managers to call it a day, as Epic Capital Management did yesterday.

What started the year as a $300-million, value-focused hedge fund was down 37.9 per cent through the end of September, and Epic founder David Fawcett and his team decided that with redemptions picking up steam, the fairest way to treat all investors was to wind the fund down.

A number of Epic's peers face the same issues, and will likely be forced to make the same retreat. No less an expert than billionaire George Soros yesterday predicted that the global financial crisis will reduce the hedge fund industry to as little as one-third of its current size.

Q9'S LESSON

Investors might just want to look back at trading in Q9 Networks when trying to decipher what the market is saying about the BCE buyout.

Q9 announced a friendly, $17.05-a-share sale to private equity fund ABRY Partners back in August. That deal was always expected to close by mid-November.

In normal markets, arbitrage-obsessed hedge funds would have been all over Q9. Their buying would have narrowed the gap between ABRY's offer and the price of the tech stock to less than 5 per cent of the bid, or about 85 cents.

But these are not normal markets. Hedge funds have been routed, and are in full retreat. To fund redemptions and pay back margin loans, arb funds are selling positions, or changing their approach.

Against this backdrop, Q9's share price dropped steadily. When the TSX closed Friday, Q9 was a $12.94 stock. Late Friday, ABRY announced that the buyout had closed, ahead of schedule, at $17.05. Fortunate investors who bought Q9 on Friday made a one-day, 24-per-cent return.

That striking gap where Q9 traded and what ABRY paid illustrates the new economics of merger arbitrage.

In the past, hedge funds targeting 20-per-cent returns would buy a stock at a 5-per-cent discount to a takeover offer, and leverage their holding fourfold with margin loans, courtesy of prime brokers such as Lehman Brothers. Those margin loans are no longer available. As a result, hedge funds will only engage in merger arbitrage if they see much larger spreads.

Which brings us to BCE and the $42.75-a-share bid from a private equity consortium led by the Ontario Teachers' Pension Plan.

There are well-founded doubts this buyout will close, as expected, by Dec. 11. Those concerns help explain why BCE closed yesterday $34.97 on the TSX.

But the fact that BCE is changing hands at a 20-per-cent discount to the bid also reflects the new dynamics of merger arbitrage. And Q9 showed on Friday that the market's perception of a deal doesn't always match reality.

See Andrew Willis's Streetwise Blog at ReportonBusiness.com

© 2007 The Globe and Mail. All rights reserved.

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