Operational Risks for Hedge Funds Evaluating Capital Structure Arbitrage - Carbon360 Research Note

New York/July 27, 2005/: As more hedge funds are attracted to capital arbitrage strategies within the structured credit markets, Carbon360 sounds a cautionary note for managers with already existing operations seeking to enter this high-performing, unrestricted-capital capacity business.

Through extensive research, Carbon360 found operations for capital structure arbitrage - a relatively recent strategy that seeks to exploit pricing inefficiencies within the capital structure of the same company - is extremely labor intensive, and often error prone. Entering this business can be a culture shock, especially for long/short equity or statistical arbitrage firms used to clean settlements and low fail rates. Furthermore, the barriers to entry are numerous and costly in terms of personnel, services, and systems.

"There are many complex issues to be aware of when contemplating entering the business," said Brian Shapiro, President of Carbon360. "For example, many contracts are traded physically, rather than electronically, and the lack of automation in clearance and settlement as well as payment processing, puts tremendous pressure on middle-office staff," he added

Operationally, difficult issues to resolve include collateral management, non-violation of ERISA requirements[1], and exacerbated settlement risk. In fact, nine out of ten managers who have entered the capital structure arbitrage business have done so before building adequate infrastructure, according to Carbon360’s soon-to-be published research. This has typically resulted in several quarters worth of undue operational pain.

While the near-term potential for profits remains attractive, the hurdles and issues to starting and running this business strategy are numerous and costly. "Managers should fully comprehend the issues at hand, and be ready to commit sufficient resources to cope with them, before initiating a capital structure arbitrage business," said Shapiro.

The development of the credit risk market is major reason for rapid increase in the popularity of capital structure arbitrage. A recent Fitch survey[2] showed the credit derivatives market expanded to $2.8 trillion of gross sold outstanding, or $3 trillion, including cash collateralized debt obligations (CDOs), an increase of 71% from $1.7 trillion ($1.8 trillion including cash CDOs) last year. Hedge fund activity grew substantially year-over-year and now comprises a sizable percentage of credit derivatives volume (20%-30%).

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