Fortress windfall warms managers to benefits of transparency
Hedge funds have become Wall Street darlings following the spectacular initial public offering last month of Fortress Investment Group, a New York hedge fund and private equity manager with USD29.9 under management. The float of 8.5 per cent of the company's equity was off to the races with an 89 per cent price ump on the first day of trading. After being priced at USD18.50 apiece, shares opened at USD35 and traded as high as USD37, making it the best showing for a US IPO since November last year, when commodities exchange operator Nymex Holding doubled its stock price on the first day of trading. The share offering put a USD7.4bn market capitalisation on Fortress, which manages a third of its assets in hedge funds and the remaining two-thirds primarily in private equity.
Fortress's windfall is being viewed as a goldmine for its competitors as well as the vendors and the underwriters of the IPO. Armed with this example, investment bankers and brokers are trying to woo others onboard; market talk has it that tens of other firms are exploring public offerings. 'This reflects a natural maturation of the hedge fund business,' says Patrick Keane, who heads the US practice of London-based hedge fund marketing firm Liability Solutions.
He compares the IPO trend among alternative asset managers with the shift of the reinsurance industry in the early 1980s as firms went from exclusively private funding to becoming publicly listed companies. 'You are going to see a lot of interest from hedge funds,' he says. 'The current multiples are phenomenal.' Still, top-performing managers aren't expected to follow suit in a hurry. Why, ask industry insiders, would they want to deal with issues such as regulatory
compliance, quarterly earnings disclosures and Sarbanes- Oxley requirements, just to name a few of the burdens borne by public companies? 'There's a reason why the likes of Steve Cohen and Paul Tudor Jones never let the world know about what they do,' says a New York fund of funds manager who requested anonymity. Moreover, he adds, once the frenzy triggered by Fortress's IPO fizzles out, questions will arise as to whether a share offering compromises the interests of investors in the company's funds. Managers of public companies may tend to make safer bets and disclose more.
But the higher level of transparency implicit in IPOs supports Keane's viewpoint that the industry is evolving. 'Transparency in itself won't necessarily be a bad thing,' he says. 'It would depend a lot on the manager and the type of strategy.' But the overall trend could lead to a 'slight shrinkage' of margins, he believes.
Managers can use the capital raised by public offerings to tap into new areas and lure star talent with stock options. But the jury is still out whether the high valuation put on Fortress's shares will extend much beyond the initial enthusiasm. Barely a month after the IPO, retail investors who bought in at USD37 apiece were already nearly USD10 out of pocket.
Still, Fortress's underwriters - Goldman Sachs, Lehman Brothers, Deutsche Bank, Citigroup and Bank of America - and its five key executives have plenty to celebrate. Peter Briger, Wesley Edens, Robert Kauffman, Randal Nardone and Michael Novogratz raised USD634 million in captive capital while retaining 78 per cent of voting power in the company.
Meanwhile, managers are continuing to tap the traditional hedge fund investors, high net worth private individuals and families, for continued inflows, but also pension funds and financial institutions such as insurers. Pension plan sponsors are banking upon hedge funds to juice up returns, which is especially critical for those still recovering from losses incurred during the 2000-03 equity market slump.
And with the major stock indices still not far off record territory following the run-up since last summer, despite the correction at the end of February, they need such investments to ride out any further decline in traditional US markets due to their generally uncorrelated nature.
Institutions, for their part, need a home for the vast amounts of money now being saved by Americans, prompted by higher earnings, a still healthy economy and rising interest rates. The beneficiaries of higher oil prices are chasing big returns as well. As a result, hundreds of millions of dollars are being invested into hedge funds each month. In 2006, asset inflows stood at USD35.6 billion while returns totalled 11.3 per cent, according to MSCI Barra's latest data.
'Given that returns were sufficient last year, it would be hard to come up with a reason for inflows not to continue at the same pace as last year,' notes Hilary Till, founder of Chicago-based Premia Capital. Pension funds conduct lengthy and extensive due diligence prior to allocating but once five years. Moreover, it takes the larger pension plans long periods of time to complete their target allocation.
Other than strategy, size will have a tremendous bearing on returns going forward. Markets viewed a USD500 million fund as big five years ago; now the threshold is probably USD5 billion. But as capital grows, returns are stagnating, investors claim. That's because mega funds have to take big positions for them to be meaningful, detracting from the nimbleness that enables them to get in and out of investments profitably. Further, they tend not to bet on smaller companies, which hold out the promise of generating higher returns but are riskier.
Managers are expecting specialty strategies to fare best in 2007, with credit and emerging markets the likely frontrunners, according to industry insiders. Global macro, which experienced a relatively lean year in 2006, could see a comeback, while multi-strategy and commodities are seen as fallen heroes. Could last year's sudden demise of highflying Amaranth Advisors deter pension funds? Not in the long run, says Till, provided funds continue to produce steady low-double digit returns. 'Even in the worst case scenario, a 5 per cent allocation could have left them with a 3 to 4 per cent loss, which isn't good by any means, but isn't catastrophic either.'
Despite the requirement on most US hedge fund managers to register with the country's financial regulator, the Securities and Exchange Commission, being overturned in the courts last year, the industry still has a number of regulatory clouds on the horizon. As pension funds increasingly allocate to hedge funds, the House of Representatives Labor Committee could call for more scrutiny, says Randall Dodd of the Washington, DCbased Financial Policy Forum.
Registration and daily net asset value reporting should be made a requirement if pension funds are investors, adds Dodd, whose non-profit organisation focuses on regulation of financial markets. Meanwhile the SEC, which has already proposed tougher new rules on hedge fund fraud and a sharp raising of the minimum net worth for individual investors, is looking into so-called side-pocket arrangements used by hedge funds to park illiquid investments and transactions linked to private investment in public equities, or PIPEs.
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