Why are Profitable Hedge Fund and Private Equity Management Companies being sold off to the public now?

Why are Profitable Hedge Fund and Private Equity Management Companies being sold off to the public now?

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Equity interests in several hugely profitable big name hedge fund (HF) and private equity (PE) management companies have recently been offered to the general public through IPOs. More management companies are considering sales to the public as well. The question is why … and why now?

Self styled, New Age Management Guru, Dr. A S Johan offers several possible reasons, discusses if such offerings are a good long term investment for the average investor and, more importantly, developing a practical philosophy to profit from the phenomenal growth in Hedge Funds and Private Equity Funds.

Just what are HF or PE Management Companies?

HF or PE Management Companies are registered entities (usually limited partnerships) that have traditionally been tightly owned by their founders who are, in the main, individuals who have worked and gained a level of experience (sometimes referred to as pedigree), at some of the big banks like Morgan Stanley, Goldman Sachs, CitiGroup etc.

Believing they have reached as high as they could go in their jobs or that they can earn more money going out on their own, they start up a HF or PE Management company with some financial support from friends and former clients. In order to differentiate themselves from other managers, in their marketing for Assets Under Management (basically money to manage. Usually abbreviated to AUM), they emphasize their intent or ability to produce profits from one or more investment strategies or styles over other styles or strategies. Terms such as Global Multi Strategy, Equity Long – Short, Leveraged Buy-out, Management Buy-out, Market Neutral, Risk Arbitrage etc. are commonly used to describe the preferred strategies.

At the end of the day however, all these so called styles are merely a marketing strategy and the ultimate focus of any management company is really to make as much money for the partners as possible - from management fees (usually around 2% p.a. of AUM) and additionally from performance fees ( a form of sharing in the profits of the AUM usually set at around 20%, but in some cases could be higher).

So, in a word, a management company is simply a business entity that’s set up to earn money for it’s founders from managing assets (belonging to others - institutional and other high net worth families or individuals). No doubt, the management company provides a service that its investors consider worth paying for. If and when investors change their minds, they can withdraw their funds from a manager (with or without some sort of financial penalty) and give it to another. When this happens, a management company (that typically has to carry most of it’s own costs), loses revenues and, unless it can quickly replace any lost AUM, will have to cut costs by shedding staff, reducing overheads, drinking less martinis over lunch, selling that bright red Ferrari etc.

So why are these profitable and up-to-now tightly owned Management Companies being sold to the public …. now?

People who have founded and built successful HF or PE Management Companies are nobody’s fools. As a group, they are a pretty sharp lot. Three possible reasons for their current interest to sell a part of their companies could be as follows : -

(a). They think that it’s a good time to take profits on the back of past profitable performance records set by their management companies;

(b). that HF or PE management company profitability has reached their natural limits and may soon start declining because of additional competition, even from their own trade execution brokers who have begun lunching competitive funds and worse still emulating (polite word for copying) their profitable ideas and thereby diminishing the effectiveness of previously profitable strategies;

(c). that given the stock market’s current bullish mood for hedge funds and private equity funds generally, it may be a good time to raise additional funds through the stock markets so as to reduce reliance on client’s funds. This could however mean that these management companies cease to be management companies and instead become proprietary investment companies relying more and more on higher risk proprietary trading and investment profits;

So would buying shares in a HF or PE Management Company be a good long term investment for the average investor?

In my opinion the answer is a definite NO. Over the last few years there has been phenomenal growth in Hedge Funds and Private Equity Funds, resulting in record profits for Management Companies. While I do believe that more money will continue flowing to such funds, I am not entirely convinced that management companies will be the single beneficiaries as they have in the past.

The key word to understand here is management. Generally speaking, a HF or PE management company’s success in attracting vast amounts of AUM (leading to more management and performance fees) tends to be very closely identified with one or two key personalities within the company. In a situation where the management company’s shares have become publicly traded, such key management personalities who had in the past driven the company and relied on generating fee income can now easily find ways to cash out of their shares in the company. After all, who in their right minds may not be tempted to sell out if he could receive five or ten years potential income upfront today.

Without this “management” component, a management company really has nothing much by way of tangible future revenue generating assets. This is a particularly disturbing thought as clients can easily switch managers and move huge amounts of AUM away from a manager. So called lock-ups generally don’t strictly apply to larger clients.

Recently, some larger clients have even begun recruiting pedigreed persons and setting up and running their own private label Hedge Funds, sighting the savings from management and performance fees for just so-so performance as ample justification. This experiment could easily become a dangerous trend resulting in management companies losing AUM and having to rely on less stable but much more risky proprietary trading activities which of course requires considerable amounts of their own capital (one earlier mentioned possible reason for raising money by selling shares to the public).

So, unless you as an investor in the shares of a HF or PE management company are going to be directly involved in the senior management of the company and reap some serious insider privileges (perhaps that red Ferrari), I believe that you, as a long term investor in the stocks are better off investing in the shares of other regular (asset or technology based) companies or better still low transaction cost based Exchange Traded Funds (ETFs).

So is there a neat way to profit from the phenomenal growth in Hedge Funds and Private Equity Funds?

I believe that there is a way to profit from the current and predicted growth in Hedge and Private Equity funds without having to invest directly in HF or PE Management Companies. First off, let’s put some numbers to the current and forecast size of these funds.

Hedge Funds : As at end of March 2007, Global Hedge Fund assets (all types) are estimated to have soared to over $2 trillion (that’s a 2 with twelve big zeros after it). There is no sign of any slowdown in the dramatic rate of growth of hedge fund’s AUM. Most experts estimate the growth to continue or even accelerate as more and more countries consider allowing their less affluent investors to participate in Hedge Funds to earn absolute returns (as opposed to returns relative to some arbitrary benchmark).

American Express

A key question here is will high (or higher) returns be sustainable as AUM grows bigger and bigger? Like many informed independent analysts, I have serious doubts. Most pure hedge funds (with no involvement in Private Equity), rely on their unique management skills (so called Alpha) to extract returns from the equity, debt or commodity markets. As these funds, because of the sheer size, effectively become the market, only very average market returns can be expected going forward. Add to this, the proliferation of duplication (i.e. copying of successful strategies) by former employees, execution brokers and counterparties and what we’ll have is a lot of similar strategies trying to squeeze returns from the same markets.

Market dependant trading strategies in any specific given time frame is a zero sum game. What this means in plain language, is that in any fixed time frame (one minute, one hour, one week, one month etc.) the total profits of all profitable market participants, in that time frame, will be equal to the total losses of all the unprofitable market participants.

This is a mathematical truism whether we are talking about the regulated Exchange operated markets or the bigger institutional over-the-counter markets. Therefore, if everyone (using a particularly profitable strategy) is profitable by a certain amount of dollars in a particular time frame, there must be an equal amount of loss suffered by others (presumably not using the particularly profitable strategy) in the same time frame.

Given that everyone wants to use profitable strategies and be profitable in all time frames, it’s no wonder that secret profitable strategies will not remain secrets for very long (notwithstanding claims of Chinese walls etc.). A good case in point was a claim by LTCM that some of its more profitable arbitrage strategies became much less profitable and even a loser when it was borrowed by others.

The above described problems will surely surface as ever larger amounts managed by HF Management companies seek alpha based returns from the same markets. More and more hedge funds will have to be satisfied with some portion of market beta based returns or seek their returns from other less market-specific investment activities. The most immediate and obvious route to adopt will be to commit more funds to private equity style investment strategies that have a longer time frame to succeed or fail. Increases in time generally adds greater variability of returns – also known as more risk with a greater potential for profit in plain English. It also provides the ability to continue earning the 2% in management fees for a longer time.

From recently announced mega sized leveraged-buyout deals initiated by Private Equity firms, we can already see this phenomenon being played out. You can expect this trend to continue as Hedge Funds start to supplement or even out-bid and replace banks directly or indirectly as lenders to leveraged-buyout deals.

Under this scenario, investors could ignore hedge funds altogether and instead concentrate their investments indirectly through PE Management companies or directly by investing in the shares of target buy-out companies and be the first and possibly largest beneficiaries of any upside on buy-out deals.

This would support my view that investing directly in the shares of regular companies (preferably those that could potentially become buy-out candidates) is a far superior long term investment strategy to investing in the shares of HF or even PE Management companies or for that matter in HF or PE Funds managed by either these of the management companies.

Private Equity : As at end of March 2007, Global Private Equity Fund assets (all types) are estimated to have soared to over $7 trillion (that’s a 7 with twelve big zeros after it). It is believed that the actual figure could be much more if it included funds held in the war chests of global corporations seeking to acquire other companies. So far few are predicting growth numbers lest they get it wrong. To a large extent growth in the largest part of the PE Funds universe i.e. buy-outs depends on the availability of credit. Not so much the cost but just the availability. History has shown that even in the relatively high interest rate era of Mike, the Junk Bond Milken, buyouts were thriving till they blew off.

Promoters of PE strategies, especially those involved in the leveraged buy-out side of the business, often sight the huge advantage they bring to the target company’s shareholders in the form of more efficient, leaner and usually meaner management, to enhance shareholder value (meaning higher stock prices). Our task here is not to argue the merits or otherwise of these incoming management attributes, but instead to see if and how we can profit from the actions of PE firms.

Basically PE Management Companies (fondly referred to as firms) are similar to HF Management Companies - structure wise. To justify earning fees from investing other people’s money through one or more dedicated funds, their founders too claim expertise gained in deals at their employers cost (the pedigree factor).

Unlike hedge fund managers, PE mangers areas of expertise is not so much related to trading securities in the stock, debt or commodities markets, but in being able to successfully manage a turnaround in a sick company with some future perceived potential or strip an under managed company of its assets and sell it off for more than the purchase price or some combination of the two strategies. Principals at most PE Management companies are generally credited (by their admirers) of possessing almost superhuman management capabilities across all industries and of enjoying the patronage of top World Leaders and Royalty (similarities with the promoters of the South Sea Company somehow comes to mind).

Anyway, whatever superior management skills are attributed to the senior partners at PE Management Companies, the following qualities and requirements usually seem to dominate the process : -

(a). that in selecting a target company, minimal involvement in messing around with the company’s real business i.e. getting ones hands dirty) should be required;

(b). that one of the most important criteria about a target company should be its hidden assets that have not been properly priced by its existing management and the markets i.e. corporate assets that can easily and quickly be liberated post buy-out;

(c). that more important than any real world input from the company’s management team (both technical and others) or other qualified industry experts, is information provided by one or more big name (again the concept of pedigree) due diligence experts who have never actually started or managed any business even remotely similar to the one being contemplated for the buy-out;

(d). that another important factor is the availability of corporate assets that can easily be pledged as security (collateral) for raising at least 120% of the purchase price (so as to provide for fees and expenses over and above the purchase price);

(e). the availability of one or more disgruntled ex-employees who are prepared to provide confidential and usually negative information about the target company’s CEO, other key management personnel and if possible major shareholders and influential board members as well.

(f). Will the deal make headlines and push the PE firm further up the deal league?

(g). Can the deal be done with little or no effort excepting for writing cheques to outsourced consultants?

Reading through (a) to (g) one may be inclined to think that in making a buy-out decision PE Manages are least concerned with profitability of the deal. This is not true of course. Profits are important. However, as mentioned earlier, PE deals tend to have a much longer time frame than HF deals to prove themselves. Typical HF transactions particularly those that can easily be marked-to-market show an instant profit or loss in real time. Profits or losses from PE deals can be (and usually are) differed to a more accommodating time frame. However, given the huge amounts being made available for PE deals, it’s really not that difficult (having assiduously followed steps (a) to (g)) to sell the bought-out company to another deal hungry PE fund (even one managed by the same manager) for a profit after a couple of years.

So, how can an ordinary investor, without access to World Leaders and Royalty, make a buck out of these huge HF and PE trends (pronounced opportunities)? One way is to simply try and figure out which companies will become the next buy-out targets and buy a bucket load of their shares and wait for the PE magic to unfold.

AH! you say, but what about the real risk of losing my principal if the deal does not happen (as it often can) and / or the target company tanks? Should I not be better off just buying into a Hedge Fund that specializes in taking positions in potential buy-out candidates?

Well! Maybe that’s an answer. But do remember that 100% of your principal is still at risk from deals that fail and / or companies that tank. Your capital invested in the hedge fund is still not in any way Guaranteed against loss by any credible third party. Further, you’re still going to have to pay the 2% or so annual management fee on you capital plus any undistributed paper gains, while your HF manager drives around in his or her red Ferrari (the Ferrari’s back) waiting for the next big juicy buy-out deal to fall into her lap.

So, what’s the real solution you ask again? Well, here it comes. I have developed a strategy (more of a philosophy really), which I believe to be a realistic, workable, 100% capital protected, pro-active solution that completely eliminates the need to risk any portion of capital and doesn’t require waiting around for buy-out deals to happen.

It can succeed because it leverages off and takes advantage of some of the most serious weaknesses that PE managers are all prone to. However, the methodology does require effort and commitment. But then seriously, what safe and profitable investment strategy that is set to take away profits from smart private equity managers is going to be easy or require no effort and commitment? None that I know of.

I will be writing more on the subject in future articles but you’re welcome to contact me by email at contactjohan@gmail.com Maybe, we can cooperate to create a business that will provide an opportunity for regular folks to profit from the laziness of the pedigreed elite.

Hate the word pedigree myself. Sounds like my neighbor’s Poodle. Can’t imagine why the industry chose this word to describe it’s best talent. Or maybeI can.

By A.S. Johan

About : A S Johan provides highly creative, and original strategic management consulting solutions to institutional, corporate and family office investors seeking to profit from the huge growth in Hedge Funds and Private Equity Funds. His professional services are provided under his personal service mark of A S JOHAN GMS.

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