By Michael Lewitt, Editor, The HCM Market Letter

The hierarchy of global finance has been turned on its head. Human nature being as stubborn and inertial as it tends to be, the doyens of finance were not going to be dragged from the casino without first trying to scrape every chip off the table. The financial disaster that will color the rest of the 21st century originated in the canyons and computers of Wall Street and the City of London, and those epicenters of wealth and power will deservedly bear the brunt of the damage. But the pain will extend far beyond those centers of ego and folly to the Main Streets of America and the rest of the world. That is the dark side of the current version of the globalization project that mankind has rerun over and over again over the centuries.

It is difficult to provide a complete damage assessment in the middle of a battle, but we will attempt to provide readers with the best casualty count we have been able to assemble from sources and observations.

Hedge Funds:

The hedge fund community has been decimated by the discovery that its business model doesn't work when markets shift suddenly into reverse. Over the past few years, these investment vehicles grew increasingly dependent on a combination of derivative-based strategies (involving credit default swaps), leverage, and the ability to avoid accurately marking their books to promulgate the illusion of success. Many funds are stuffed with securities that are completely illiquid and almost impossible to value because they do not trade on any exchange known to man. As a result, the work-out period for these securities, which are now severely distressed and unsellable, will be counted in years.

Several months ago, Jeremy Grantham predicted that half of existing hedge funds would go out of business; that prediction is now looking very conservative. We expect the number of functioning hedge fund to fall by at least 75 percent by the time the smoke clears. Investors who once clamored for entry into this exclusive club are now coming to realize that they never should have wanted to become a member of a club that would accept them as a member.

Hedge funds were never more than a compensation scheme (emphasis on the word "scheme") that favored managers at the expense of investors. As one of our favorite market commentators recently wrote in The New Republic ("Make It Work," November 5, 2008, p. 15), "[a]n illusion had developed on Wall Street that this generation of investment managers possessed a new kind of genius, but, in truth, the only thing these managers did differently was to apply more leverage to the same old investment strategies in a bull market. When the laws of investment gravity brought the markets back to Earth, their spaceships crashed on the rest of us." Not to put too fine a point on it, but years of returns and bull have just gone up in smoke.

Private Equity and Credit Funds:

Every week brings a media report (or two) about the demise of one of the large credit managers or the credit affiliates of one of the large private equity firms. These organizations used to exert enormous influence in the world of corporate finance, dictating the terms on which Corporate America could raise debt capital. Now these firms are almost uniformly reporting losses on the order of 40 to 50 percent and trying to explain themselves to their shell-shocked investors.

At first it seemed that firms that rushed to purchase discounted bank loans and junk bonds in late 2007 and early 2008 were just a little early. This rationalization of early losses misread the fact that something much larger than a run-of-the-mill market correction was taking place. Instead, the great weight of decades of sustaining the economy on a mirage of debt was starting to collapse. Many of these firms continued to increase their exposure to these asset classes as they ostensibly became "cheaper" throughout the first half of 2008, again ignoring what was really going on, a complete unraveling of a financial illusion. Now, despite the assurances they are desperately trying to provide their investors, these firms are unlikely to be able to recoup these losses or be in a position to return capital to investors for many, many years (if ever). The reasons for this will be clear after we discuss the fate of the equity that has been lost over-leveraged private equity deals done over the last few years.

Private equity firms have yet to fess up to the fact that virtually every penny of the $85-$100 billion of equity that was invested in their transactions since 2005 is worthless today. Nor are they hastening to inform their investors that it is highly unlikely that these investments will ever recover in value under any reasonable scenario due to the irresponsibly high multiples paid to play in the late innings of the credit bubble. This story has not yet hit the media but is starting to be whispered about by investors in these funds. These investors are now facing the decision whether to fulfill earlier capital commitments to these private equity firms that were not fully funded (many firms have extended draw-down arrangements). This situation in the private equity business will be extremely important to watch in the coming months.

One can speculate on the reasons why private equity firms are making capital calls at the worst time in history to do so. Some may need the money immediately (or in the near future) to prop up failing deals (many deals are likely to run out of cash by the end of 2009 or early 2010 under current forecasts). Other firms may want to build a war chest now to take advantage of future opportunities and are justifiably afraid that their investors will refuse to give them money in the future once they learn the truth about their existing investments. One thing is for certain - they can't use the money right now or in the foreseeable future to invest in new leveraged buyouts because the outlook for leveraged buyouts has never been worse.

We have long believed that private equity is grossly overrated as an investment and primarily rewards the private equity manager at the expense of return-hungry investors. On a risk-adjusted basis, the vast majority of private equity returns are mediocre at best. Crashes like the current ones, which were preceded by periods of gross excess, erase many years of returns that were artificially inflated by a bull market and opaque accounting conventions. Investors should think long and hard before giving these firms additional capital. Private equity firms will argue that the market will recover and the equity in their existing underwater deals will rebound in value. In making this argument, they will cite what occurred in earlier market crashes such as 1990-91 or 2000-2001. Their arguments, unfortunately, do not hold water.

(Reprinted with permission from The HCM Market Letter)