Japan Trading Companies Trawling Hedge Fund Eco-System

"It really gets my adrenalin flowing to hear the ping of the cash registers."

Stanley Kalms, b. 1931

One of Japan's largest trading companies, Mitsubishi Corporation, recently paid US$40 million for a 19.4% stake in the fixed income arbitrage hedge fund Aladdin Capital Management LLC.

Aladdin has approx. US$17 billion in assets under management many of them wrapped up in funds and a bevy of structured products, some of them that turned toxic towards the end of 2007 in the midst of the credit-crunch and the subprime meltdown.

A number of Aladdin's clients (mostly in Japan, and probably including Mitsubishi) were on the sore end of that trade. So what happened recently may indeed be the decision taken from one of these firms to "get closer" to the product manufacturer in the hope that once the dust settles they may be able to return to the fore attracting sizeable institutional allocations.

Unfortunatley, we live in times when labels themselves have become toxic. Institutional investors, including those in Japan, will not go near anything called fixed income arbitrage, relative value or even structured product or note. The fact is that association with these strategies has led to losses, and we are talking about big losses over the last 6-12 months.

Investors are not going to allocate to them for the time being. It is time for "wait and see".

Another trading company, Itochu, has a slightly different approach. They, too, started out as distributors in the early 2000s, initially using exclusive distribution contracts to share in the fees generated from selling these products to Japanese investors through their domestic broker-dealer network.

Itochu is famous for an initiative launched by Saito-san in the U.S. to expand into the seeding business. According to urban legend, Itochu gave CEO George Hall of the Clinton Group US$1 million in return for equity in his business model. This is how he started. Once this fixed income arbitrage operation had grown to US$5 billion, George bought out his Japanese seeder for around US$250 million. Saito-san was hailed as a genius and reported back to Tokyo in a senior management position.

Since then, Itochu is believed to have followed up its seeding initative with about 4-5 managers (mostly in the U.S.) with the model being to offer a slug of investment and working capital (US$10-25 million) in return for equity and exclusive distribution rights throughout the world - all this in the hope of finding the next George Soros or George Hall-manager.

They also bought out a hedge fund of fund operation in New York back in 2002 called Acam Advisors. All told, Itochu probably has exposure to hedge fund assets (single managers and fund of hedge funds) of approximately US$2.5 to US$3.0 billion.

Yet another trading company, Sojitz has also been active in the hedge fund business. It was originally a hedge fund of fund operation jointly owned by Nissho Iwai and Nichimen. Unfortunately, it started out with a focus on Japan and Asian fund of hedge fund product - an area that has been producing poor returns over the last few years. It probably has exposure to hedge fund of fund product to the tune of US$400 million (and falling).

Other major Japanese trading companies including Sumitomo, Marubeni and Mitsubishi, have all been active in the hedge fund business either as principal investors or as product manufacturers and distributors. It is believed that taken toegther this group may have a combined exposure of up to US$8-10 billion.

Given that Credit Suisse/Tremont broad hedge fund index has produced negative 2.01% over 1Q2008 one can expect internal pressure to mount within these trading companies to trim their portfolios, reduce exposure to volatile strategies and even to re-structure units if losses are steep enough.

Ultimately, some firms may be soon be forced to pull out of the business altogether, especially if end-buyers in Japan decide that now if not the right time to buy hedge fund product. A bumpy road lies ahead for many of these players. Mahalo.