Deephaven to sell its assets

Deephaven Capital Management, the local hedge fund whose assets were cut in half last year by poor performance and investor redemptions, plans to sell its roughly $2 billion in remaining assets for up to $44.6 million to Milwaukee-based Stark Investments.

The deal requires investor approval.

Stark will pay $7.3 million at closing for the assets. The remaining amount, up to $37.3 million, will be based on performance and asset retention, according to a federal filing Tuesday by Knight Capital, majority owner of Deephaven and whose management recently expressed dissatisfaction with Deephaven's performance.

"The up-front payment of $7.3 million is paltry, but acceptable," Kenneth Worthington, an analyst at J.P. Morgan Chase who covers Knight, wrote in a note to investors. "We view the exit from the hedge fund business as a positive despite selling out at what could be the bottom of the market. Deephaven is a non-core unit and has been a drag on earnings as well as a public relations headache."

Knight said in a statement that the deal was struck "with the goal of protecting the interests of Deephaven investors in the current environment."

Ty Schlobohm, a hedge fund analyst at Cherry Tree Investments, said "It's basically an option for Deephaven investors on whether to go with Stark. It appears at first glance that Stark will pay up to a certain figure at each date assuming that investors don't vote instead to redeem [their shares for cash]."

Deephaven is 49 percent owned by its three top executives. The Deephaven principals won't get anything for their 49 percent of Deephaven, according to a person familiar with the terms of the deal.

The filing underscored troubles at once high-flying Deephaven, one of dozens of unregulated U.S. hedge funds that were losing huge sums and trying to stave off panic among well-heeled investors and institutions who had been treated to double-digit returns in earlier years.

Leverage exacerbated losses

Hedge funds often bet big by "leveraging" investments with up to $3 in debt for every $1 in investor equity. Amid last year's reversals, big gains turned into big losses at Deephaven, at Minneapolis-based White Box Advisors and elsewhere. The losses were exacerbated by debt and investment bank trading partners and lenders who demanded more collateral on their loans.

Last week, Knight CEO Tom Joyce told analysts that Deephaven's blended-fund performance was -28.9 percent for 2008. Deephaven had asset management fees of $7.5 million and recorded a pretax loss of $5.7 million in the fourth quarter of 2008 compared to asset management fees of $28 million and a pretax loss of $426,000 in the fourth quarter of 2007, reflecting investment results, redemptions and stricter margin and finance requirements by lenders.

Hedge funds are tremendously lucrative for their operators in good times because, besides a 2 percent management fee, hedge fund owners typically keep 20 percent of gains.

Deephaven, with offices in Minnetonka, London and Hong Kong, was launched in 1994 with $5 million in assets and grew to six funds and $4.4 billion in assets under management before it started losing money and investors last year. Stark Investments is a larger firm that invests globally across a wide spectrum of assets.