The Private Market Meltdown

Redemptions, gates, and the ghost of Madoff….It all sounds so familiar

FOLLOWING THE BANKRUPTCY of Lehman Brothers on Sept. 15, 2008, financial markets went into a tailspin, and many of the hedge funds that had been printing money for years suddenly found their very existence threatened.

Hedge funds had been around for decades, but in the years leading up to the market crash many critics thought they had become a bubble—derisively referred to as a compensation scheme disguised as an asset class. But that perception did not matter to investors. After the collapse of the dot-com bubble in 2000 and the failure of Enron two years later, savvy investors including university endowments, public pensions and sovereign funds looking for ways to make money in down markets had jumped into these funds, which claimed to be uniquely positioned to do just that.

Like virtually every financial innovation of the past 50 years, hedge funds were the product of loopholes in the regulatory framework designed to protect investors, in this case the Investment Company Act of 1940 that regulates mutual funds, closed end funds and ETFs. As a result, only the very rich were allowed to participate—so-called sophisticated investors.

It was in this environment that Absolute Return, a small magazine devoted to hedge funds where I had been the editor since 2005, held its annual conference in midtown Manhattan in early December of 2008. The mood was tense, as some of the most prestigious hedge funds in the world were facing huge losses. Ken Griffin’s Citadel—now the most profitable hedge fund in the world—would end the year down more than 50 percent, and there were rumors (denied by the firm) that the Fed was on its trading floor, monitoring it closely.

The conference was standing room only, with anxious investors and dour hedge fund billionaires mixing nervously as they pondered the future. (At the time, things looked so bleak that one hedge fund executive told me that she was considering becoming a high school math teacher.)

In the green room, where a number of investors were getting ready to go on stage for a panel discussion, one woman who ran a well-known fund of funds—an entity that collects yet another layer of fees by investing in several hedge funds for its well-heeled clients—blurted out to everyone within earshot: “Thank God for Bernie Madoff. Without him, we’d be out of business.” She wasn’t the only one voicing that sentiment. One of Absolute Return’s reporters later told me that en route to the conference he had shared a taxi with a hedge fund investor who confided that Madoff’s fund was his only investment that was in the black.

Days later, Madoff would be arrested for running the world’s largest Ponzi scheme—which somewhat ironically came to light when investors burned by the fallout from Lehman demanded their money back. But until exposed, Madoff offered investors—on paper at least—exactly what they craved: double-digit returns every year, all without the ups and downs of the stock market, which in market speak is “low volatility.”

We later learned that as the scheme drew in more dollars, some early investors had cashed out. That is the very definition of a Ponzi scheme: paying off existing investors in a fund with money collected from new investors.

I thought of this moment recently after hearing the name of Madoff invoked (twice!) while I was working on an article about the troubled state of private credit, an asset class that was virtually created out of the ashes of the 2008 financial crisis, or what people in the markets call the GFC (great financial crisis) as if saying the words out loud is too dangerous to repeat.

Investors jumped into private credit because, not unlike Madoff, it has offered lofty returns with low volatility. (To be clear, Madoff didn’t actually invest in anything. Private credit funds do.) Last year people suddenly began wondering if private credit—which had started to take off when regulators clamped down on the regulated banking system following the crash of 2008—was also a bubble that was just about to burst.

When I reached out to institutional investors recently, many told me that the problem is just too much money chasing the business. It’s a classic tale. A clever investment strategy that makes a ton of money (typically by using a ton of leverage) draws in more people, standards are lowered, rules are skirted, bad investment decisions are made, some fraud is suspected, returns suffer, and people start to lose faith.

And while quick to point out that there’s nothing inherently illegal about how private credit or its sister strategy, private equity, work, some people have even uttered the words “Madoff” and “Ponzi” to explain how new money is required to keep the system from collapsing.