Hedge Funds Shake in the Teeth of Financial Storm

Thousands of hedge funds are expected to go bust in the next few months, amid fears that the secretive sector of the financial industry will be the next to buckle under the pressure of global market turmoil.

Tumbling stock markets and a reluctance among banks to do business with hedge funds has further worked against an industry known as much in recent years for multimillion pound bonuses and jet-set lifestyles as the increasing reliance of pension funds and other investors on its investment returns.

Two major funds in the US revealed today they were under pressure. It is estimated that 20-50% of the 10,000 hedge funds worldwide are vulnerable to a squeeze on their funds.

Highland Capital Management, a US fund that has seen its assets fall in value since March by almost a quarter, to $33bn (?19bn), is expected to close its flagship Highland Crusader Fund and one smaller fund after suffering losses on high-risk loans. It was the world's largest non-bank buyer of leveraged loans last year, according to Bloomberg.

Citadel Investment Group, one of the world's largest hedge funds, told investors that returns for one its major funds would swing wildly as it was battered by the markets. Its $18bn worth of funds have fallen by 30% in value this year, despite putting a third of the funds into cash.

Recent figures from Hedge Fund Research revealed a 15% rise in the number of hedge fund liquidations.

The prospect of a sharp downturn in the industry's fortunes follows 10 years of rapid growth, as wealthy investors and then institutions such as pension funds reaped supercharged returns. In 1990, there were 610 hedge funds worldwide; this year there were 10,233. Average gains in the late 1990s topped 20% a year.

Short selling became a particular favorite as traders saw an opportunity to borrow shares in a firm and sell them in the expectation that the price would fall.

Philip Falcone, who earned ?1.7bn last year from his Mayfair-based firm Harbinger Capital, is believed to have made ?280m from shorting HBOS prior to its rescue by Lloyds TSB.

To cope with the crisis, several hedge funds are expected to follow the example of RAB Capital, the beleaguered fund that lost millions of pounds in Northern Rock. Last month, it persuaded investors in its troubled Special Situations Fund to maintain their investments for three years, by threatening to liquidate the fund.

Many of the industry's leading players have expanded rapidly in recent years, based on borrowed funds which they have used to multiply their gains. However, banks have become increasingly reluctant to lend for hedge funds to make bets, except at prohibitive interest rates.

The collapse of Lehman Brothers has also hit hedge funds, many of which relied on the investment bank as a counter-party in complex trades with clients. Several funds are believed to be in financial trouble after being told they must wait to access funds locked up in the US bank.

PricewaterhouseCoopers, the administrators for Lehman Brothers, who are demanding that ?8bn of funds be repatriated from New York as part of a rescue plan for the bank's London operations, have denied the hedge funds have access to accounts holding hundreds of millions of pounds.