RAB Capital, the hedge fund that is Northern Rock’s second-largest shareholder, issued a surprise profit warning yesterday as a slump in the value of its equity investments looked set to wipe out growth in performance fees.

The London-listed hedge fund, which holds a 6.7 per cent stake in the stricken mortgage bank, said that growth in profits would almost certainly be wiped out this year, because of a slide last month in small-capitalisation equities.

Michael Alen-Buckley, the executive chairman of RAB, said that the British small-cap sector had fallen by 14 per cent in November. He noted that the sliding equity values had hit RAB’s $2.3 billion (£1.1 billion) special situations fund and its $1.5 billion energy fund, large chunks of which are invested in small-cap mining and development companies.

This would translate into an inevitable reduction in performance fees, he said, and, given how close the firm was to the end of its financial year, it would be unreasonable to imagine that the investments would recover in time.

“If you look at the history of the fund, there have been three previous occasions where it has suffered a setback,” Mr Alen-Buckley said. “As it happens, in previous periods these setbacks have taken place earlier [in the year]. Given where we are in the financial year — our end is on December 31 — the chances of us clawing back the lost performances this time are not good.”

Shares in RAB, one of the few listed hedge funds, fell by as much as 5 per cent to 77p before closing ½p, as analysts rushed to downgrade their forecasts. They had pencilled in pre-tax profits of as much as £70 million.

At one point, as much as £20 million was wiped off RAB’s market value, as investors digested that profits this year would come in at about £50 million. Market observers also highlighted how exposed RAB was to performance fees in general. In keeping with other hedge funds, RAB typically charges a management fee of 5 per cent plus a 20 per cent share in the performance of the assets being managed.

Fintan West, a Cazenove analyst, said: “Clearly, the volatility of performance fees will continue to be an issue, but we would highlight that gross performance fees in the current year, on our estimates, will still be almost £59 million on revenues of £110 million, and so the problem is one of a shortfall against high expectations rather than one of an unwinding of the business model.”

Mr West downgraded his full-year profit forecast on RAB to £48.6 million last week, halving his expectations for performance fees.

The profit warning yesterday was the latest setback for the special situations fund, which was set up and is run by Philip Richards, the chief executive of RAB. The fund also holds shares in Northern Rock, the embattled Tyneside-based lender that is the focus of at least three serious rescue plans. Mr Richards has voiced his support for a proposal put forward by Olivant, an investment firm run by Luqman Arnold, the former chief executive of Abbey National.

As a Northern Rock investor, RAB is second in its stake’s size to SRM Global, a hedge fund that is run by Jon Wood, a former trader at UBS, who has also thrown his weight behind the Olivant plan.

Having paid an estimated £2 a share for its Rock holding, RAB is estimated to be sitting on a paper loss of about £35 million on its investment in the bank.

A continued slump in the value of RAB’s investments could jeopardise bonuses for the hedge fund’s portfolio managers, who will be paid based on their performance. Salaries for RAB staff are capped at £100,000.

Mr Richards was among the City’s highest-paid executives last year, collecting a salary, bonus and long-term performance package worth £19 million. He is also one of the Square Mile’s biggest charitable donors.

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