Thursday, August 10, 2006

Private Equity, Hedge Funds and the Struggle to Spend Cash

Uncorrelated returns, perhaps two of the more dangerous words that you may hear. What this boils down to is essentially performance that has a low correlation (statistically measured) versus a benchmark index.

Low correlation means enhanced diversification, something that traditional hedge funds were designed to provide.But uncorrelated return does not equate to good returns. The Japanese equity market was beautifully uncorrelated with the S&P 500 through the 1990's. But the returns were not all that beautiful.

Affluent investors certainly gravitate toward hedge funds that access private equity and I must admit that I have utilized such funds myself. But do such deals always provide value? According to hedge-fund research firm, Greenwich-Van Advisors, hedge fund assets have grown to over $1.1 trillion from $480 billion back in 1999, a 15% CAGR versus an S&P market that provided -1% over that period!

Ultimately, this is not rocket science despite the brilliant minds that gravitate toward the area. Hedge funds do not necessarily represent a vehicle that is entirely separate from capital market returns, at least not the way many of them practise their craft. Capital markets' returns reflect the underlying wealth build or fall in the entire economy over time. In a 2001 study "Do Hedge Funds Hedge" by Krail, Asness, and Liew of AQR Capital Management,one of the conclusions was: "hedge funds seem to do a lot less hedging than simple estimates might suggest." Hedge funds as a group, at least according to this study, exhibited a beta of 0.85, that is 84% of the price movement could be explained by the S&P 500. For entry into this mystical rite, an investor pays 2% plus 20% incentive my view, a ridiculous toll. Nice work if you can find it, but is this sustainable?

At the last Berkshire Hathaway annual meeting, this was a topic that incited Charlie Munger to be much more vocal than usual: " Half the business school graduates at the elite Eastern schools say that they want to go into private equity or hedge funds. Their goal seems to be to keep up with their age cohort at Goldman Sachs. This can’t possibly end well."

Which brings me to private equity. According to the Financial Times, "Private equity is struggling to spend cash as fast as it is raising it."
There is an astonishing amount of capital that has come into the private equity arena. According to the artilce, about $300 billion in uncommitted, "un-called" capital is available to buy-out funds, representing core equity. Given the ability to finance at 4:1 debt, this represents about $1,500 billion in purchasing power, which equates to over 10% of the total market capitalization of the S&P.

This can be a very attractive proposition to the management of a company:

  1. Increased ability to make significant long term capital project investments with less shareholder quibbling and criticism.
  2. Set aside Sarbanes-Oxley compliance public investors, no SOX.
  3. Less scrutiny and criticism of executive compensation arrangements.
  4. Private ownership equates to overall privacy as to corporate strategy.
  5. No public owners equates to no SEC regulatory and legal risks.
In short, going private means less transparency, less visibility. Unfortunately, as a limited partner in a hedge fund per se, transparency is always an issue. This reminds me of John McMullen's quote regarding being a limited partner in the Yankees with George Steinbrenner, "Nothing is more limited than being George Steinbrenner's limited partner."

Transparency and disclosure is almost always a problem with hedge funds. Toss in a mix of private equity deals selected from a group of managers who crave privacy, and you have a rather uncertain fate. Oh yes, you also may be locked in for periods of five to ten years (or longer) waiting for the "Liquidity Event."

The public markets do not always recognize intrinsic value immediately, or in the short term. In the last seven days, my clients and I have benefitted from going private transactions in Aramark (RMK) (at too cheap a price) and Reynolds and Reynolds (REY) at a fair price. But private equity investors are lurking and their coffers are full of cash. Intrinsic value has a higher probability of being recognized more quickly, in my view with these characters around.

As FT points out, buy-outs are becoming less selective. Having too much un-utilized money makes a private equity manager appear slovenly and out of tune with the times. These guys are not incentivized to hold cash. "If less discriminating buy-outs are the future, it is best to be on their receiving end."

The smartest way to be involved in private equity investing at this point may well be as a seller.

Disclaimer: I,my family, and clients have a current position in Berkshire Hathaway, Aramark, and Reynolds and Reynolds.


At 1:21 PM, Blogger Jack Doueck said...

At Stillwater Capital we believe that all hedge fund managers with more than $25 million under management or more than 14 clients should register with the SEC. We have been registered with the SEC and went through a thorough but appropriate audit last summer. The SEC Auditors checked all our books and records, and reviewed our checks and balances, trying to discover any conflicts of interest, any inconsistencies between what we promise our clients and what we actually deliver. They checked the books and records of our funds and our management company. When I saw the level of detail that they paid attention to, I was very excited about the possibility that EVERY hedge fund that we invest in would be subject to these periodic audits without a lot of notice. That is a good check for the industry in general. Our Stillwater Asset Backed Lending business invests money with other asset backed hedge funds which are complex and difficult to do the due diligence work on. If every one of these funds were audited by the SEC, we would feel much safer and more certain that these managers would be operating in accordance not only with GAAP, but with
the rules of the SEC, that they are delivering what they are promising and that there is less of a chance of foul play.
That being said, the best way to regulate the Hedge Fund Industry is for SEC to require that every manager publish or make public their assets (in general, without specifics) via independent administrators and brokers on a monthly basis. That would further deter greedy and reckless managers from fraud. Our decision to register with the SEC was a good one and we hope managers follow our lead.

Jack Doueck
Stillwater Asset Backed Strategies


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