London’s embattled hedge fund community is bracing for a spate of blow-ups in the wake of yesterday’s $16 billion (£7.9 billion) debt default by Carlyle Capital Corporation, the Dutch-listed affiliate of the American private equity group.

Numerous small start-up credit hedge funds, managing between $10 million and $200 million of assets, are facing a funding squeeze, according to sources. The prime brokers that provide credit liquidity to these funds are beginning to withdraw financial support or heavily increase their margin calls, they said.

Several bigger credit funds with as much as $2 billion under management are also looking vulnerable, particularly if they are highly leveraged, according to other sources.

“It’s basically any single-strategy hedge fund that is leveraged and invested in mortgage securities; it doesn’t matter whether it is AAA or sub-prime paper; these guys are at risk,” one London hedge fund manager said.

“The smaller players with $10 million or so of funds, guys who jumped out of the investment banks to set up on their own, are under the greatest pressure. They don’t have enough assets to generate proper alpha [sic] for their investors. They barely generate enough management fees to pay their wife’s shopping bill,” the source said.

“They are not in a position to add assets because the banks don’t want to lend, so suddenly they don’t have a reason to exist any more.”

The default by Carlyle Capital Corporation, which was invested in AAA securities, represented the second shock wave in as many weeks to rip through the UK hedge fund market. It had already been reeling from the crisis at Peloton, which was forced to liquidate its $2 billion bond fund after failing to meet margin calls.

Like CCC, Peloton was invested in high-quality assets, whose credit quality had not been expected to fall in the wake of the collapse in values of sub-prime mortgage securities – loans extended to borrowers with patchy repayment histories.

The CCC fund faced a similar double whammy. As well as the value of its assets sliding, it was hit by increased margin calls by its financing banks. Hedge fund experts said the problems at CCC underscored how prime brokers – the providers of liquidity to hedge funds – have been tightening their terms.

The most successful prime brokers tend to be investment banks, many of which are short of capital after writing down billions of dollars from the credit crunch.

George Cadbury, president of PCE Investors, an asset manager that provides services to start-up hedge funds, said: “Some credit funds have compounded their problems by seeking relationships with multiple prime brokers.

“In reality, they might have been able to negotiate better terms with just a single prime broker and avoid the risk of numerous banks calling for capital at the same time.”

Taco Sieburgh, director of research at Liability Solutions, a consultancy, said: “Carlyle is just an example of what is happening in the industry. Banks are capital-constrained and the financing terms they have been providing have been tightened to hedge funds and other products.

“Another factor causing the current credit market declines is that, as the assets held by structured investment vehicles and hedge funds decline in value, their leverage ratios rise further.

“They are then forced to sell assets to satisfy their financing agreements. Although it looks like a very vicious circle, we expect opportunistic funds to start stepping into the market to benefit from these depressed prices.”

A mini shake-up in London’s busy hedge fund community might be overdue and improve the quality of the remaining funds, according to some observers.

“Some of the smaller funds seem to be lacking in operational controls, independent risk management and valuation procedures,” Mr Cadbury said.

Yannis Procopis, deputy chief investment officer at CM Advisors, which manages the London-listed fund CMA Global Hedge, said: “The key is leverage. Funds with little or no leverage are less likely to have a problem. It is funds with a lot of leverage that will have trouble if they have to liquidate their book. Being big can also be a negative in that a big sale of assets will depress prices in the market.”

Invariably, there will also be some hedge funds that benefit from the credit crisis. One source said his firm had already identified cheap opportunities and would be investing shortly.

Funds that operate macro strategies that focus on long-term global trends have also outperformed in recent weeks, according to managers.

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