Friday, January 4, 2008

The Leverage Game

As a relatively new Hedge Fund manager, I tend to get calls from vendors and assorted financial types trying to sell me services or systems. I got a call the other day from an organization whose name I will withhold that offered to lever up my assets under management (AUM) by ten times.

So here is how the deal works. They lend you ten times your AUM and in return the payoff is split as follows:

First 10% return - they get 90%, you get 10%.
Second 10% return - they get 50%, you get 50%.
Third 10% return - they get 10%, you get 90%.

Sound too good to be true. Well it is. Here is how the downside is split:

First (-10%) return - you lose 100%, they lose nothing.

The payoff is asymmetrical, as you probably figured out. So in effect, after a ten percent decline, your capital is wiped out. What happens if you go down more than 10%? Well you can't because they monitor the portfolio daily and will pull their money out once you hit a negative 10%.

Also, if you assume that you achieve a 10% return for the year on the borrowed money, you are no better off than if you hadn't borrowed. Let's say that you started with a million and borrowed $9 million (just to keep the numbers even).

After a year, your have a ten percent return, or $1 million. You have to hand over $900 K of that and you keep $100 K. That's the same $100 K return you would have earned if you had just invested your $ 1 million by itself and earned 10%.

I keep wondering how many of my fellow managers are levered up like this. I read about a Warburg fund that was levered up 20 to 1.

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