From Long Term Capital Management to Amaranth, dramatic collapses of large hedge funds have occurred throughout the history of hedge funds. In general, hedge fund blow ups result from a similar series of events and financial elements.

1. Improbable Market Events
First, there is normally an improbable market event that effects the specific central investment or trading strategy of the hedge fund. For example, the 1997 Asian Financial Crisis contributed to the failure of Long Term Capital as widening spreads caused relative value trades to fail. Hedge funds frequently engage in this type of relative value trade or other forms of arbitrage, such as capital structure arbitrage, that center on profiting as spreads return to theoretically normal levels. The failure of these types of relative value trades also contributed to the blow up of Sowood Capital Management.

2. Leverage
The second factor that causes hedge fund failures is leverage. To enhance returns, hedge funds frequently employ leverage. Hedge funds acquire leverage by borrowing money from counterparties, frequently investment bank prime brokers. Hedge funds post a small amount of margin to purchase securities, using the investment as collateral.

During a hedge fund blow up this use of leverage has two negative effects. First, if margin terms between the broker and hedge fund are not locked, brokers can modify the hedge fund’s margin requirements. This is problematic, because during a hedge fund implosion and chaotic market, brokers may reevaluate the riskiness of the hedge fund’s assets and thus demand a higher margin haircut. Second, as the hedge fund’s portfolio falls quickly in value, margin calls occur. The broker demands additional collateral to reduce the broker’s risk to the falling asset value.

When a hedge fund’s portfolio quickly falls in value the results of the negative impact of leverage cripple the hedge fund. To meet margin calls and higher collateral requirements, hedge funds normally first burn through excess cash. As the investments fall further, the hedge fund normally sells the most liquid investments. However, by selling liquid investments, the portfolio becomes more illiquid, and thus more risky from the broker’s viewpoint. This causes the broker to demand even more collateral, and the downward spiral to the ultimate collapse continues.

3. Investor Redemptions
Investor redemptions  contribute to hedge fund blow ups. If investors withdraw money from a hedge fund that has little cash, the hedge fund is forced to liquidate positions, causing a downward spiral similar to events resulting from margin calls. However, many hedge funds have long lock ups that prohibit investors from withdrawing money. Also hedge funds normally have significant early redemption penalties.

4. Forced Liquidation or Portfolio Sale
Ultimately, a failing hedge fund normally faces one of two options. First, the portfolio may be liquidated by brokers to cover margin requirements. Second, hedge funds frequently sell the entire portfolio to other large hedge funds or investment firms. For example, Sowood sold the portfolio to Citadel to avoid a forced liquidation by brokers. Citadel, a large liquid hedge fund, was able to absorb the risk of Sowood’s portfolio and ultimately profit as spreads on relative value trades and capital structure arbitrage began to return to equilibrium.

Hedge fund collapses begin when an unusual market event causes the portfolio to quickly fall in value. As margin calls and investor redemptions increase, the hedge fund is forced to either liquidate the portfolio or be acquired by another firm.

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