Sowood founder apologizes
Larson says fund's strategy for hedging against risk failed
A contrite Jeff Larson, founder of Boston hedge fund Sowood Capital Management, spoke to his clients for the first time yesterday and tried to explain how events of recent weeks wiped out more than half of their $3 billion investment.
"You entrusted us with the management of your money, and we lost a lot of it, to say the least," Larson said. "No apology is sufficient."
He spoke on a conference call with investors for about 10 minutes but did not take questions.
Larson said Sowood was unwinding remaining positions and expected to return about $1.4 billion to investors, slightly less than the $1.5 billion estimated earlier. Sowood agreed this week to sell most of its debt securities, which had caused the fund's problems, to Citadel Investment Group of Chicago at a deep but undisclosed discount.
It has been an abrupt end for Sowood, launched three years ago by Larson when he left his job at Harvard Management Co. investing part of the world's largest university endowment. Harvard Management, which lost about $350 million in Sowood's demise, had been Larson's principal investor when he opened the hedge fund's doors.
State pension officials in Massachusetts say they lost about $30 million in their Sowood investment. The nonprofit Boston Foundation estimates it will recover only about $10 million from its $28.6 million direct investment in the hedge fund.
Sowood wrote to clients Monday explaining broadly how the fund's investment strategy had gone disastrously wrong in a matter of weeks. Larson yesterday described in greater detail events inside Sowood that pushed the firm's portfolio into a financial crisis.
He said Sowood borrowed heavily to make investments the firm believed were low risk and backed them up with a hedging strategy intended to act as insurance in case anything went wrong. But markets reacted much differently than Sowood expected, driving down the price of its securities and rendering its hedges ineffective.
Sowood tried to get out of trouble by selling some of the securities, but demand dried up and Sowood found few buyers for sinking assets purchased with mostly borrowed money. That led to a kind of financial death spiral. Finally, Larson said he spent last weekend negotiating a big deal to avert a complete financial disaster he feared could have occurred this week.
"We did this in order to avoid what we believed was the very real possibility of counterparties seizing our collateral and liquidating or auctioning our positions," Larson told investors yesterday. "In such an uncontrolled process, we believe there was a high likelihood that little to no net asset value would remain for our investors."
Larson said Sowood began building up investments in senior debt securities of high-quality companies with strong collateral this year. He said Sowood took concentrated positions in some cases, but did not identify them.
One obvious risk to that strategy was the way corporate debt markets were behaving earlier this year. Investors normally demand higher interest rates on corporate debt compared with nearly risk-free alternatives like US Treasury notes. But they had been unusually accommodating to companies borrowing money, and the rate gap between risk-free debt and corporate securities was squeezed hard. When the market inevitably reverted to more normal rates, corporate debt could lose value.
Sowood tried to protect itself against that threat and the possibility of default at individual companies with a strategy betting against more junior debt issued by the same companies. If anything went wrong, the less-secure junior debt should suffer at least as much in price as the better-protected senior borrowing. Sometimes Sowood bought "put" options in the stocks of the same companies, intended to accomplish the same thing by profiting in a decline.
Larson said Sowood lost 5 percent when its corporate debt portfolios began to sag in June but no one at the firm considered it a serious threat. "Unfortunately, we were wrong," he said. "July was not just a repeat of June, it was radically worse."
Potential risk in the corporate bond market became a gale-force reality. As the price of Sowood's senior-debt securities sunk, the more junior borrowings did not respond as expected. Stocks generally went up, not down. Sowood's strategy wasn't working, and it couldn't find enough buyers for its senior securities.
The problem began a crisis by the week of July 23. "Each day brought greater and greater losses," Larson said. Sowood's securities that acted as collateral for its loan were being marked down drastically in value by brokers. Soon, Sowood's situation became hopeless.
"A loss of this magnitude is as devastating to us as it is to you," Larson said.
Steven Syre can be reached at syre@globe.com. 