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Market chaos batters hedge-fund star

A month that should have been a bonanza for David Einhorn turned into a bust.

By Roddy Boyd, writer
Last Updated: October 3, 2008: 4:15 PM ET

NEW YORK (Fortune) -- David Einhorn should be celebrating one of the best months of his career. Two companies whose stock he bet big against - Lehman Brothers and Allied Capital - suffered grave blows, with Lehman filing for bankruptcy and Allied shares plunging 60%.

But Einhorn and his management team at Greenlight Capital, with $5 billion in assets, aren't trading high-fives these days. Instead, they're reeling from the most brutal month in hedge-fund history.

Greenlight's $2.2 billion offshore fund lost 11.5% in September, according to HSBC's hedge-fund database. Another Greenlight fund dropped 12%, Bloomberg reports.

Einhorn isn't alone in feeling the pain of the market's volatility. Kleinwort Benson lost 24.2% on its $220 million Greater Europe fund. Closer to home, Tiger Management alum Stephen Mandel's Lone Cypress fund was down 14.7%, a marked turnaround for a fund used to double-digit gains in the other direction. Hundreds of other European, multi-strategy and convertible arbitrage funds were decimated, with losses often above 20%, according to fund databases.

The market beating is unusual for the 39-year old Einhorn, who has often posted double-digit gains at Greenlight.

Two of Einhorn's biggest targets - and the subjects of his scathing public criticism - in recent months were Lehman and Allied Capital (ALD). Einhorn first publicly brawled with Lehman earlier this year. By August, Greenlight Capital had put options, or bets that a stock price would fall, on more than 580,000 Lehman shares, according to a regulatory filing. That gamble paid off big when Lehman collapsed Sept. 15 after its ratings were cut and trading partners pulled their business over concerns about its portfolio of troubled mortgage-related assets.

As for Allied Capital, Einhorn first shorted the Washington, D.C.-based business development company in 2002, leading to one of the most colorful disputes between a company and a short-seller in the past decade. In September, Allied Capital shares fell nearly 60% as it shut a business loan unit whose brokerage of Small Business Administration loans had come under regulatory scrutiny.

Einhorn did not respond to an e-mail seeking comment.

At first glance, it doesn't stand to reason that in a month when both Lehman Brothers collapsed and Allied Capital suffered a sharp decline, Greenlight should suffer too. So what went wrong?

Greenlight, contrary to news report, does not predominantly short company shares. Instead, it more often invests in bonds and bets long on stocks.

Lehman's collapse was good for Greenlight's short bets, but it further stressed already troubled credit and equity markets; when American International Group (AIG, Fortune 500) came within hours of filing for bankruptcy a week later, many sectors of the bond market ceased operating.

Liquidity from brokers - the ones that were not collapsing, that is - literally evaporated as trading desks stopped putting up capital to get trades done, and the market's gyrations forced pension and mutual funds to the sidelines. Hedge funds like Greenlight couldn't sell big blocks of stocks as they used to.

Making matters worse for Greenlight, the SEC's temporary ban on short sales of hundreds of companies means hedge funds couldn't minimize losses in their long-side investments, or make money with short-sales across the battered financial sector. To top of page

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