Vultures To The Rescue

Two years ago, Bayou Group, a hedge fund based in Stamford, Conn., collapsed amid charges of phony bookkeeping by its founder, Samuel Israel III. Since then, investors in the once-$300 million fund have been biding their time, waiting for the bankruptcy court to divvy up what's left, potentially around $100 million. But there's no guarantee they'll get any money back. So in mid-March, Argo Partners, a New York firm that specializes in buying distressed assets, offered to buy their stakes for 10 cents on the dollar--giving Bayou investors an easy escape from the litigation logjam.

Argo isn't alone in trolling among the hedge fund wreckage. Liquidity Solutions Inc., a Hackensack (N.J.) company, last summer made a similar offer to Bayou investors but was rebuffed. Distressed-debt traders at Deutsche Bank (DB

) have reached out to limited partners in now-defunct funds like Bayou, Wood River Capital Management, Lancer Management Group, and Beacon Hill Asset Management.

So far, Bayou investors aren't selling out, calling Argo's initial offer "too cheap." But such flameouts have proven to be tempting fare for vultures. Hedgebay Trading Corp., an online exchange that matches up buyers and sellers in a secondary market for hedge funds, estimates distressed stakes now account for 25% of its business, up from 8% four years ago. "We have gotten a lot of calls of late from both buyers and sellers [of troubled investments]," says Barry E. Silbert, chief executive officer of Restricted Stock Partners, another middleman who's considering getting into the hedge fund game.

Like Bayou, many scandal-plagued funds are tied up in bankruptcy litigation with investors trying to recover what money they can from managers who allegedly bilked them. Scavengers are betting that once the courts have their say they will be able to collect a tidy sum. Consider Beacon Hill, a hedge fund that largely bought mortgage-backed securities. The former managers of the Summit (N.J.)-based fund paid $4.4 million in penalties to settle charges they manipulated the returns of its bond funds, and a court-appointed receiver is now dividing up Beacon's assets. A Morgan Stanley (MS

) fund that invests in hedge funds estimates its original $18.7 million investment will be worth $8.8 million once the litigation plays out. Sure, that's a 53% loss for Morgan Stanley. But for scavengers like Argo that jump in after a fund's demise and buy at cut rates, such moves can reap a pretty sweet gain.UP FROM UNDERGROUNDBefore, investors in damaged funds had little choice but to hold on and wait out the bankruptcy proceedings. Now, says Scott Berman, an attorney with Friedman Kaplan Seiler & Adelman in New York who often represents investors caught in hedge fund meltdowns, that's changing. Vulture players are creating a necessary secondary market for investors who prefer to cash out their losses sooner rather than hope for a recovery down the road. The fledgling market began six years ago as a way for pensions, Wall Street banks, funds of funds, and other large institutional investors to buy shares in hot funds that had stopped accepting new money. There's a similar underground exchange for swapping shares in private equity funds, which has taken off largely because those buyout firms maintain long lockup periods that prevent investors from pulling out their money for as long as two years.

Today, distressed stakes, either in underperforming funds or those that have imploded from scandal, are the fastest-growing segment of hedge fund trading. When Amaranth Advisors collapsed in September after losing $6 billion on natural gas bets, a number of investors put their partnership interests up for sale on Hedgebay for as little as 35 cents on the dollar. Laurence Allen, CEO of NYPPEX, a firm best known for its online private equity trading platform, is optimistic about opportunities in the hedge funds, especially as funds adopt longer lockup periods. But he cautions investors against latching on to the first deal that comes their way. "Don't hit these bids that are pennies on the dollars," says Allen. "Sometimes the assets aren't as bad as they appear." By Matthew Goldstein

The Epic Hack

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