Oct. 16 (Bloomberg) -- Highland Capital Management LP will close its flagship Highland Crusader Fund and another hedge fund after losses on high-yield, high-risk loans and other types of debt, according to a person with knowledge of the decision.

Highland, whose total assets under management has shrunk to about $35 billion from $40 billion in March, will wind down the Crusader fund and the Highland Credit Strategies Fund over the next three years, said the person, who declined to be named because the decision isn't public. The hedge funds had combined assets of more than $1.5 billion.

The Highland Credit Strategies fund suffered from ``unprecedented market volatility and disruption,'' according to a letter to investors that was obtained by Bloomberg News. Barclays Capital Inc. seized $642 million of leveraged loans from Highland yesterday and is offering the debt for sale in an auction today, according to a person with knowledge of the situation.

Highland, founded by James Dondero and Mark Okada in Dallas in 1993, follows firms including Sailfish Capital Partners LLC and Peloton Partners LLP in closing funds after the seizure in financial markets choked off credit and sent asset values plummeting. The average price of actively traded high-yield, or leveraged, loans has dropped to 71.2 cents on the dollar from 100 cents in June last year, according to Standard & Poor's.

CLOs

Highland, the world's largest non-bank buyer of leveraged loans last year, also manages collateralized loan obligations and in March raised $1 billion to buy distressed loans. CLOs are created by bundling together loans and repackaging them into new securities. Leveraged loans are rated below Baa3 by Moody's Investors Service and BBB- by S&P and are used to fund private- equity acquisitions.

The Markit LCDX, a benchmark credit-default swap index used to hedge against losses on leveraged loans, dropped 1.5 percentage point to a mid-price of 82.5 percent of face value today, according to Goldman Sachs Group Inc. The index falls as credit risk increases. The index series fell to a record low of 81 on Oct. 10.

Bids for the Barclays auction were due by 2 p.m. today in New York, according to documents obtained by Bloomberg News. The sale will close at 4:30 p.m.

Barclays spokesman Brandon Ashcraft declined to comment.

`Highly Constrained'

The firm plans to sell 20 percent of the Highland Credit Strategies Fund's assets in the next six months and a further 20 percent in the following six months, the letter said. Closing the fund will avoid forced sales that would result in lower prices, the person said.

``The environment is one where the fundamental tools to manage the Credit Strategies funds' trading, hedging, shorting and financing are highly constrained, and in some cases unavailable,'' the letter said.

Highland has a separate closed-end retail fund that is also called the Highland Credit Strategies Fund, which isn't being shut down, the person said. The investment firm manages about $7 billion in mutual funds, including the Highland Distressed Opportunities fund.

The Crusader fund is down more than 30 percent this year, the person said. The fund slumped 14 percent in January after reporting 40 percent gains in 2006 and a 4.5 percent loss in 2007.

Hedge Funds Fall

Hedge funds fell 4.7 percent in September, the worst month for the $1.9 trillion industry since the collapse of Long-Term Capital Management LP in 1998, according to Hedge Fund Research Inc. The drop has dragged the Chicago-based research firm's Weighted Composite Index down 9.4 percent so far this year, on pace for the biggest annual loss since HFR started keeping records in 1990.

Citadel Investment Group Inc.'s biggest hedge fund fell as much as 30 percent this year because of losses on convertible bonds, stocks and corporate debt, two people familiar with the Chicago-based firm said yesterday. Kenneth Griffin, who founded Citadel in 1990, said in a letter to investors this week that returns for the $10 billion Kensington Global Strategies Fund may swing wildly as markets are battered by the global credit crunch.

To contact the reporter on this story: Pierre Paulden in New York at ppaulden@bloomberg.net

Last Updated: October 16, 2008 14:39 EDT