The Multiple Personalities of Hedge Funds

Is it a Bank, a Private Equity Firm, an Insurance Firm or a REIT?

Introduction

With nearly 8500 funds of every conceivable hue, the hedge fund industry has had a turbocharged run from $38 billion of assets under management in 1990 to over $1 trillion at the end of 2005. However, of late, the hedge fund race is getting increasingly crowded with decreasing returns in the stock and bond markets. These issues are causing the industry to take a pit stop and look at other avenues where high returns of the past can be maintained.

This stratospheric growth has been fueled by the increasing appetite of institutional investors, wealthy individuals and family offices, for higher risk in lieu of returns of 40%-plus promised by hedge funds, despite the fact that investors have to fork out high annual fees of typically 2% and performance-linked fees of 20% of new profits every year. For a while, the rising tide in global capital markets lifted all the hedge fund boats and every one appreciated it.

Hedge Fund Industry – The Present Reality

Many “stars” from arbitrage desks at investment banks as well as portfolio managers at buyside firms struck out on their own. Those who did not have the big-money backing started fledgling hedge funds, hoping to become the next George Soros of Quantum, Paul Tudor Jones of Tudor Investments or Steven Cohen of SAC. Alas, the hedge fund industry is very unforgiving – the industry landscape is strewn with the remains of scores of firms which had to down their shutters when investors pulled money out, because these funds could not deliver the high returns they had promised. With the SEC now mandating that certain types of hedge funds register with the regulator, there is a greater push for transparency in the way these funds operate – this alone will enable investors to compare hedge funds before committing their capital, leading to a more involved due diligence process. It is very much a harbinger of a potential slowdown in liquidity flows into hedge funds and points to a slugfest among funds to show better returns and increase assets. A key indicator of this coming trend is found in a recent report by Reuters stating that hedge fund managers are starting to worry about relative, peer performance rather than focusing on absolute returns.

According to Hedge Fund Research, in 2005 alone, a record number of fund closures occurred. While 2073 funds were launched in 2005, 848 went out of business, compared to the 1,435 funds launched in 2004 with only 296 closures. Another report by Morgan Stanley estimates that the top 50 hedge funds now control 40% of all assets under management, with the top 200 managing 90%. What about the rest of the 8,300 funds? They have become so-called “bottom feeders” and unless they find their sweet spot, are in danger of either closing or becoming zombies. The same report by Morgan Stanley says that average returns generated by traditional hedge funds are starting to decline because more money is chasing the same investment ideas. The report goes on to say that based on a survey of 40 US institutional investors, starting a hedge fund now has never been more difficult. While in 2003 and 2004, most launches exceeded their one-day target for fund-raising by at least 25%, most funds less than $100 million could only garner 50% of their one-day targets in 2005. Funds greater than $100 million did not fare better either, barely managing to achieve their one-day targets.

Therefore, assets are increasingly being deployed towards illiquid and non-traditional strategies that promise higher returns. We are experiencing a subtle but dramatic shift in the character of the hedge fund industry as it seeks to reinvent itself in search of higher returns and in a sense, for its own survival.

Morphing of the Hedge Fund

In this scenario, the average hedge fund is morphing into multiple personalities as it strives to achieve better returns and asset growth. In this quest, it is encroaching on the turfs of many other types of capital market intermediaries including banks, insurance firms, private equity firms, etc. This ruthless invader has given a warning call to traditional players, who are now frantically plotting strategies to answer the challenge.

The New (obliging) Bankers

It wasn’t so long ago that Krispy Kreme Doughnuts was the darling of Wall Street, which developed an insatiable appetite for the sugary glazed pastries – symbolic of the excesses of the dot-com revolution. For a while, nothing could go wrong for the company, whose stock rose more than 200% post it’s IPO in 2000. However, the stock soon left a sour taste in investors’ mouths when in 2004 the company announced disappointing profits, and said that the SEC was looking into irregularities in its accounting practices, including the way it treated franchise buybacks. It currently trades at nearly $10 – 80% down from its high of $50 in 2003. From 2000 to 2004, debt rose nearly six times – $22 million to $135 million.

Krispy Kreme became an instant pariah in the world of financing, when its bankers cut off access to its credit lines. Into this vacuum stepped Silver Point Capital, via an affiliate. The $2.2 billion hedge fund, along with Credit Suisse, lent $150 million in the form of second-lien financing, at 5.88 percentage points above LIBOR. At a time when companies such as Krispy Kreme are desperate for money, and traditional banks are loath to lend, any lifeline is welcome. These hedge funds are increasingly willing to lend to cash-strapped companies because of the high rates of interest they can demand.

This type of a loan, called a second-lien loan, gives lenders second highest importance in the event of a bankruptcy, after the first-lien lenders are paid. Therefore, while hedge funds can get in cheap, they end up ahead of the other types of investors such as high-yield investors, and shareholders. Banks are increasingly focusing on the credit-worthiness of companies they are lending to – this is forcing many smaller companies to turn to hedge funds in order to stave off liquidity crises.

In February of 2005, Tower Automotive, a supplier of truck frames, saw its fortunes sink in response to the slump in the big three auto firms’ revenues. In addition, rising costs of raw materials and debts of $1.3 billion drove the company to seek bankruptcy protection. Its creditors included, Silver Point Capital, the CT-based hedge fund. Silver Point had bought some of Tower’s second-lien loans while simultaneously shorting its stock. This way, it was protected on either side. When Tower filed for chapter 11, the value of the stock went to zero, giving the hedge fund a very nice upside on the short position.
Some traditional bankers believe that hedge funds only care about making money and are agnostic about the fate of companies whose loans they hold. Such views may have merit, but one would find it hard to argue against hedge funds who say that they help companies with much needed cash when no one else is willing.

They defend their ruthless tactics by saying they force companies to “do the right thing” in achieving quick turnaround.

Other examples of companies that turned to hedge funds rather than banks include SLS International, Aloha Airlines, textile manufacturer Dan River, and Salton, the maker of George Foreman grills. According to Reuters, while banks still make loans to large corporations, the second-lien loans market is increasingly becoming a fertile ground for hedge funds, which now control almost 50% of the $500 billion market for such risky, high-interest loans..

Private Equity and Hedge Funds – The Clash of the Titans

In their bid to capitalize on the lucrative private equity market, hedge funds have been taking part in more and more p
rivate equity deals. From short-term trading-centric outfits, today’s hedge funds are becoming increasingly prominent players in the private equity space. This has ruffled feathers in the normally staid and conservative buyout community.

Eric Lampert’s hedge fund, ESL Investment’s, recent buyout of Sears is a case in point. A radical transformation from a trader to a business-owner of Kmart, and subsequently Sears, is but one indication of the crossover of hedge funds into the private equity space. Private equity players scoff at the idea that hedge funds can effectively compete against them, saying that their long-term, relationship-driven strategies of investing in and rebuilding corporations is anathema to the rapid-fire trading-driven activities of hedge funds. The entry of hedge funds, however, has shaken up the private equity industry, even to the extent that many buyout firms have themselves started hedge funds to cash in on any missed opportunities.

When Toys ‘R’ Us put itself up for sale, it witnessed a classic battle between two industry titans – hedge fund Cerberus Management and the venerable buyout firm KKR. While Cerberus lost out in the deal, it was successful in the $2.3 billion buyout of MeadWestvaco. With hedge funds now starting to require longer lockups from investors, the stage is set for them to seek out longer-term investments typically required in a private equity deal. On the other hand, pursuing a strategy that offense is the best form of defense, the private equity firm Texas Pacific Group has spawned or funded hedge funds including Dinkar Singh’s Axom Capital. Another interesting situation is the merger of hedge fund manager AETEOS Capital with the private equity firm AEA Investors.

The blurring of the distinction between a hedge fund and a private equity firm points to a dilemma in the minds of pension plans and wealthy investors, who might want to invest in only one type of firm. There is also the matter that valuations suffer when both hedge funds and private equity firms go after the same prey – something that points to a bubble.

Hedge Funds and the Re-insurance business

Driven by the constant need to seek out inefficiencies in the financial system, hedge funds are forever on the look out for opportunities where they can get in and exploit the arbitrage opportunity. This appetite for untapped investment opportunities has driven them to either invest in or start private reinsurance companies, which in essence, provide insurance to insurance companies. When a “loss-event” occurs, insurance companies pay their policyholders out of their own reserves; when the extent of the loss is severe, insurance firms turn to reinsurance to pay for some of the losses, in essence, diversifying some of the risk away.
One way for hedge funds to get into the insurance market is to make equity investments in publicly traded reinsurance companies. The latter are viewed as a separate asset class, different from stocks or bonds. Hedge funds have also set up their own specialty reinsurance companies.

The most notable example is Citadel Investments, the mammoth $12 billion hedge fund out of Chicago, which invested nearly $450 million in CIG Re, a Bermuda-based reinsurance company that specializes in catastrophe insurance against earthquakes and hurricanes. Another reinsurer, Glacier Re, got startup funding from George Soros’ hedge fund as well as from another fund called HBK Investments based in Dallas. Because of their sponsors’ deep pockets stuffed with cash, these reinsurance companies are able to insure against catastrophes and yet get solid ratings from agencies including A.M.Bestand S&P. Though the hedge fund entry into the reinsurance industry is for now only a trickle, it is enough that the big boys have taken notice. In response, Montpelier Reinsurance Holdings, the traditional reinsurer with $1.3 billion in shareholder equity, has now teamed up with West End Capital Management, a Bermuda based hedge fund, to form Rockridge Reinsurance, a new reinsurer based in the Cayman Islands.

Conclusion

The jury is out as to whether the slowdown in the Hedge Fund industry has commenced. Notwithstanding the question, hedge funds are on a fast track and are flush with funds. Now the dilemma is: where to invest and yet make the returns that investors would want to have? It looks like the answer to this question lies in breaking all traditional boundaries of asset classes, geographies and time zones. Hedge funds are invading territories previously thought of as strengths of buyout firms, insurance companies and other financial intermediaries. It remains to be seen if taking on multiple personalities actually help the hedge fund industry in its objective of delivering sustained increasing returns and asset growth.

About the Author

Kris Sakotai is Vice President and SBU Head of Knowledge Process Outsourcing at KARVY Global Services, Hyderabad, India. He has 15 years experience in the US investment industry, and has worked at leading firms such as Putnam Investments, Wellington Management and Standish Mellon Asset Management.

KARVY Global Services is the global business process outsourcing arm of the KARVY group, India’s largest integrated financial services company. For over 23 years, KARVY has been the most trusted name in providing critical outsourcing services to India’s capital market industry. We help hedge funds and funds-of-funds with offshore support services in the areas of research, risk management, modeling, performance reporting etc. In addition, we offer support in hedge fund accounting, including reconciliation of positions, trades and cash.

KARVY Global Services is a market leader in providing world class BPO services to clients in Financial Services, Retail, Healthcare, Transportation and High Tech industries. These services include Knowledge Process Outsourcing, Transaction Processing, Finance and Accounting Outsourcing, Human Resources Outsourcing and Voice Services.




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