I posted a warning almost 2 years about Hedge Fund IPOs and the risk of leveraging. With the market skyrocketing back up and never seemingly going down, I wanted to re post some reminders of just how I believe the market works. Agree or disagree, its up to you. This post is from June of 2007
I’m far from a sophisticated investor, although I guess I am an accredited investor because of my networth. As I have written before, I’m a big believer that whenever you do a business deal with people you don’t know, particularly buying and selling stocks, you always look for the sucker. If you don’t see the sucker, then you are the sucker.
I have found myself on both sides of trades. I’ve been the sucker, buying stock in companies that turned out to be far from what they said they were, or even who the principles said they were. I’ve watched in amazement as the internet bubble went to the moon with the entire world ignoring the history of technology stocks. Anyone who tells you they have never made a mistake in the market is either lying to you or never traded in the market.
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
Good advice, though it was one that was echoed by other commenters of the day. David Swensen argued explicitly that publicly traded investment companies had a specific disadvantage in generating superior investment returns.
Fund fees tend to be structured in two ways. A management fee of a 1% and a performance fee (in hedge funds 20%). As the fund becomes larger and larger, the management fee becomes a more and more substantial part of the revenue stream which gradually disincents the fund manager from seeking superior performance (As an example, if you make 50K a year in salary, that next 50K in bonus is a huge incentive. If you make $50M a year in salary, you certainly won’t work as hard for the next $50M.)
The problem becomes more acute when the fund is publicly traded. Performance fees are by their nature, unstable and unable to be predicted. MAnagement fees are annuity-like, highly predictable and reliable. As a shareholder, the clear prefererence is for management fees. However, as a investor in the fund, your preference is for performance fees, as higher performance fees means that your gains have grown. Publicly traded fund management have conflicting fiduciary responsibilities and, given that the shareholders ultimately elect the board of directors who in turn dtermines their own compensation, will likely reward shareholders more than investors.
As a side note, A more elegant explanation of this conflict can be found in Swensen’s citation of Miles Morland of Blakeney Management.
http://books.google.com/books?id=SbIz2gRbrF4C&pg=PT282&lpg=PT282&dq=%22blakeney+management%22+guerrilla&source=bl&ots=qoaQLeGNRz&sig=70cgVk8meIkOpdnkJAsY9crd7Fc&hl=en&ei=dZ4BSsGGDdqgmAfZlbCYCA&sa=X&oi=book_result&ct=result&resnum=1
Comment by JY -
Funny thing is I read somewhere that fund managers rarely beat the S&P500. I don’t know if this is true for hedge-funds, too.
Comment by Ward Roberts -
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Comment by sohbet -
One more thing, why is it b/c of my age which is 28, these funding sources tell me Im green and need to be much older in order to actually lead my project? Is it my fault that im following whats in my heart? Or that I feel that why not impact at least as much as I can as soon as I can? Does anyone actually care anymore about seeing other people rebound and do well? Im not sure why there is more of an effort to allow anyone with a viable initative “Takeoff” as long as they have the plan and mechanisms, of course we all need assistance and some guidance from others, AHHHHH Just frustrating, I will stop babbling…
Comment by Eric -
I remember reading the original shortly after I started reading your blog. Been reading ever since.
Comment by joryan44 -
Sorry, I meant to say “stay private”.
Comment by geewhiz -
One thing I think you missed. Why in the world would a hedge fund want to sell their equity if they believe strongly in their strategy? If they are going to do well then they should build value, stay public and sell out when the time is right.
Comment by geewhiz -
“I’ve watched in amazement as the internet bubble went to the moon with the entire world ignoring the history of technology stocks.”
Yes, Mark, but I’m sure you can give us 6 billion reasons why this worked out well for you.
GO MAVS!
Comment by Jeff -
Great info, thanks for the blog!
Comment by Christina Viering -
And I don’t want to get brained washed again by countless articles telling me to Buy and Hold and DCA. You can’t time the market but you can guess which stage it is in right? Damn those buggers!
Comment by as -
Great Post !
Since reading your posts on dividends and how you “played” stocks, I have always read in anticipation of your new post on the stock market.
Please do more of those. I don’t want to lose more than I have in the market. Dividends-paying blue-chips are my source of income now. No more Penny Stocks!
Comment by as -
Hedge funds are divided in two parts – a management company and one or more fund partnerships. All hedge fund investors are limited partners in the fund partnerships. The management company’s official clients are the fund partnerships. It draws fees from the funds and invests their assets.
The point is that when hedge funds like Fortress go public, it’s only the management company that goes public, not the fund partnerships. Fund partnerships couldn’t go on the stock market, because their shares are priced based on asset value, while stock market shares are implicitly priced on supply and demand.
As an investor in the management company, the only thing you could pressure the management company to do is increase the returns of the fund, which would increase performance fees, and therefore increase the earnings of the management company. The management company has that interest anyways, because most performance fees end up as bonuses. So, floating a management company does not go against the interests of the hedge fund investors, or partners.
Comment by essentialfix -
Great write up. Its become clear to me that these steep downturns happen about every 8 years and are accelerating in frequency as more people come online and trade online (personal betting basically). http://tawk1.com/28
Comment by Scott -
This article from 2001 about derivatives and leverage written by an accountant is also interesting given the current problems with credit default swaps and collateralized debt obligations.
http://www.gold-eagle.com/gold_digest_01/hamilton091001.html
“We believe that JPM’s management is taking a mammoth gamble with the wealth of its shareholders by supporting derivatives with a notional value of over $26 TRILLION dollars with a relatively trifling $42 billion of shareholder equity.
Adam Hamilton, CPA, MCSE
7 September 2001”
http://suddendebt.blogspot.com/ has some interesting articles on the subject as well.
Comment by Rene -
Why couldn’t the funds themselves see it coming? Blind greed and fear to move when things feel good. http://tawk1.com/28
Comment by Scott -