Smell disaster? Citadel is near

My colleague Peter Cohan covered the Sowood Capital debacle on BloggingStocks a few weeks ago. Interestingly, we're seeing much of the same in a recent hedge fund blow-up, most importantly Citadel's involvement.

Basically, after hedge funds lose investor interest due to poor performance they suffer from redemptions (or withdrawals) of investor capital. When this happens, its a downward spiral because many funds hold positions in rather illiquid securities. As a result, rapidly 'dumping' these positions to the market wouldn't make sense. Therefore, they need a buyer who can come in and purchase these positions at a lesser discount than they would've received if they were forced to quickly liquidate in the open market.

Citadel Investment Group has a growing role in this business. According to a Chicago Tribune piece on the Sentinel sell-out, Citadel bought $500 million in assets for "85 to 90 cents" on the dollar. This means that Citadel paid $425-$450 million for $500 million of 'stuff.' Not so good it may seem. However, I'd bet that Citadel believes many of the positions they acquired are undervalued as other hedge funds sold off the positions on fears that Sentinel would flood the market with supply.

It's becoming painfully clear that hedge fund blow-ups are simply a reality of today's market environment, primarily due to the growing size of hedge funds and their complicated strategies in sometimes-illiquid markets. However, not everyone is suffering. While investors and fund managers at blow-ups are simply 'screwed' by the process, Citadel is able to take advantage of the madness and purchase quality assets at a discount. Although this might seem flawed, Citadel is actually performing a valuable service to both the markets and the blow-up. The markets benefit because they aren't loaded with supply while the blow-up benefits because 85-90 cents on the dollar is likely much better than a figure it would've received in a fire sale.