A Classic Post on Public Hedge Funds

I wish I would have listened to myself more closely. This is from more than a year ago.

Hedge Fund IPOs – Individual Investors should be careful

Today’s boom stocks are hedge funds that are going public. Fortress could be the netscape of the boom with Blackstone and many others to follow. Would I buy ? No. I personally would never buy stock in a public hedge/private equity fund. Ever. My position is based on basic common sense and a rudimentary understanding of the hedge fund business. Here is the logic:

When you are an investor directly into a hedge fund you have 1 single element of leverage on the hedge fund , and that is the ability, often with very stringent limitations, to pull your money from the hedge fund. That is it.

That leverage is mighty however, particularly for the bigger investors in the hedge fund. Why ? Because when an investor pulls a significant amount of money from the fund, it creates a cascading series of problems.

It may cause the fund to have to sell securities in order to pay back the investor while still retaining their required or chosen cash levels.

The more leverage the fund uses, the more the cash problem is leveraged as well.

A fund’s “scoreboard” is their return and their amount of assets. Its also their marketing pitch. If they perform, they can draw more money into the fund if its open, or to their next fund if its closed. If they don’t outperform, they can usually forget about growing or their next fund. Its unfortunate, but you rarely if ever hear about the hedge funds that closed unless they were absolutely huge.

Hedge funds obviously don’t want their big investors to withdraw, so they work incredibly hard to make sure they outperform their peers. As the number of funds has grown, so has the difficulty to outperform. There are so many funds chasing the same deals in every area of specialty that the funds keep on investing in riskier and riskier deals. All in hopes of keeping their “money happy”

Bottomline is that hedge funds scramble hard each and every day to make their big investors, some of which can leave on the drop of the hat, happy.

Appeasing hedge fund investors is a very, very different business than making shareholders happy.

If a shareholder sells their share of stock, the hedge fund wont really care. Sure, they want the stock price to go up. They own shares of stock in the fund, and as the stock price goes, so goes some percentage of their networth. That should be enough for them to do whatever it takes to increase the stock price, right ? Maybe

Increasing the price of a share of stock is as much marketing to create demand for the stock as it is earnings of the fund.We also call this increasing the P/E of a stock. There are dozens of ways to increase the PE of a stock that is showing a profit. Hedge fund investors care about 1 thing. Cash. Money that is returned to them. Shareholders care about the price of the stock. One is capital returns, the other is capital appreciation.

That difference is just common sense, but its significant.

Which makes me wonder why those who put money into these hedge funds are letting them take the fund public. It will certainly change how the fund invests and manages its assets, even if the fund says it wont.

They can’t be responsive to shareholders and investors with the same story

Hedge funds are known for laying it all out on the line and doing the big deals. Often ones considered to be crazy by outsiders, but smart by insiders. They are the ones buying the lousy or stagnant public companies and taking them private, remastering them, only to reissue them to the stock buying public investor a couple years later at multiples of their investment.

How many public companies do you know that are known for their risktaking ? That gladly take outsized risks that some consider crazy,and do they do it on an ongoing basis ? How many public companies do you know that aren’t focused on hitting “the number” to keep shareholders happy ?

The hedge funds that are staying private have to be licking their chops. Competing against public hedge funds that have to deal with reporting and disclosure requirements is a lot easier than competing with a company that is stealth in their actions. They also know that despite proclamations to the contrary, the public funds will certainly change how they approach investing to make the market happy. The earnings of public funds impact the brand of the fund. If earnings are good, its business as usual. If earnings are bad, and / or the stock underperforms, then the public fund’s brand , and their ability to raise money is diminished.

Finally, the IPO also seems to put public shareholders on the opposite side of the ledger of those that have invested in the fund directly. Shareholders participate with management in the earnings of the fund, while those who put cash into the fund participate in the returns of the investments of the fund. Of course, the higher the return on investments, the greater the income of the fund itself and the numbers allocated to public shareholders. But fund investors returns are also a function of how much or how little management takes off the top. This isnt a problem when things are going great, but its always a problem when things aren’t going great.

This post isn’t expert commentary. Its just a friendly heads up based on what I see.

If you are looking at investing in any hedge fund stock, take a long, hard look at the business,IN PARTICULAR, the tax consequences of the investment and your place as a shareholder before you buy. If you are looking at just getting in and hoping it goes up because its the hot company in a hot industry… Welcome to 1999

7 thoughts on “A Classic Post on Public Hedge Funds

  1. the website is alistradio.net we have 150,000 views a week. and we just started 1month ago.
    What do you think I should do?

    Comment by michael broadway -

  2. Hi. Thanks for taking your time to read. I have #1 internet radio statin in new york with the biggest
    dj names. i had a offer to sell but I don’t know if I should sell or put in the stocks.

    Comment by michael broadway -

  3. I think any Investment is always a risk,
    and it shouldn’t matter weither it’s considered high risk or lower risk.

    It shouldn’t make you take your guard down on exactly where your putting your money.
    I mean if you aren’t doing the same level of research or
    checking over the numbers it leads to over confidence, which is always
    bad for any investment.

    Just my 2pennies anyway

    Comment by Chris Bourton - IPS -

  4. Mr. Cuban:

    You should launch a e-hedge fund site. You can have a 5 year look-up and allow members to make deposits via paypal. It’s just a thought. I bet you could raise a lot of money and invest in undervalued companies. I wonder how much money you could raise?

    I would be willing to contribute $x,xxx a month. I wonder who else would be willing to follow your proven track record?

    Comment by NoToACentury -

  5. Would you agree that with the massive stock sales resulting from large-scale redemptions of hedge funds, that the funds are bailing out of stocks that they fundamentally believe should outperform? The fact that investors are bailing shouldn’t affect whether or not the investments are worthwhile. If the hedgies are the smartest guys in the room, and are being forced to blow out of positions they believe in, doesn’t it stand to reason that (for once) the opportunity is there for non-hedge fund investors to go long the same stocks at cut rate prices? The hedgies are having a liquidity crisis that’s forcing sales. I think if we find those stocks that the squeezed hedgies are bailing on, there should be some w/ huge upside.

    Comment by Iggy Bop -

  6. Does this mean that you suffered a significant loss because of a ‘public’ hedge fund investment? I would have thought that your shorting strategy would have made you a bundle on these stocks. Adding a ‘Categories’ section under the ‘Recent Comments’ section in your sidebar would help us readers who look for finance-related posts. The search box pulls up posts that are too general in context.

    From MC>
    No it means I should have shorted them all. Unfortunately, I didnt

    m

    Comment by econ365 -

  7. Enron aside, Publicly held utilities are a safe bet.

    Take our Sierra Pacific or NV Energy… They raised rates to cover rising energy costs. And then made $0.90 per share last qtr.

    They litterally have the best of both worlds. Zero competition, serfdom customer base a 3 person panel of regulators that have ALWAYS sided with the shareholders and not the consumer.

    Plus 2 laws garunteeing profits. 1. They are allowed a 19MMillion proft by law and 2. Their rates have to be approved if they cover costs. It’s a no lose situation as long as they aren’t performing creative accounting.

    Comment by PSC -

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