Q&A: Opening the Hedges – What Will a Hedge-Fund IPO Mean
December 15, 2006
By ANNELENA LOBB
Fortress Investment Group LLC is the first alternative-investment manager to announce an IPO in the U.S. But will it be the last?
The planned stock listing by Fortress, a New York manager of hedge and private-equity funds, has analysts wondering whether other hedge-fund managers will follow in Fortress’s footsteps, and what the move means for the $1.3 trillion hedge-fund industry.
A flood of hedge-fund IPOs could also give individual investors another way to tap into hedge funds at a time when the Securities and Exchange Commission will likely make it tougher to invest in these lightly regulated, secretive investment vehicles for the wealthy. The SEC has proposed raising the bar for hedge-fund investment, adding a requirement of $2.5 million in investment assets to the current requirement of $1 million in net worth or income of $200,000 a year or $300,000 with a spouse, in part to protect less-sophisticated investors. Is giving those same investors another way to invest in hedge funds a good idea?
The Wall Street Journal Online spoke with four hedge-fund experts about these issues and compiled their answers.
Does Fortress’s IPO mean other hedge-fund managers will soon be going public?
It remains to be seen, but other alternative-investment companies will be watching Fortress carefully; if it succeeds, many analysts believe others will follow suit.
It’s important to note that Fortress’s IPO is actually a public offering of interest in a hedge-fund manager, not an offering of shares in the fund itself. Fortress’s management company will go public, acting as a sort of holding company, while the funds it manages will presumably continue with business as usual, limiting access to wealthy investors. Fortress says it will use the IPO money to pay managers, make acquisitions and pay “general operating” expenses — not pour extra money into its funds. Most analysts say future IPOs will most likely take a similar tack. “If Fortress is the model, and I believe it would be, it’s the management company that is going public,” says Aaron Kase, a partner and head of the securities service group at Levenfeld Pearlstein LLP in Chicago.
Is investing in shares of a public hedge fund a good idea for individuals?
It depends. The idea behind SEC constraints on hedge funds is to protect less-wealthy investors from taking risks they don’t understand, says Stephen Brown, finance professor at New York University’s Stern School of Business. But he thinks some individual investors may be savvy enough to invest in these types of products, regardless of their net worth. “Wealth doesn’t necessarily imply ability,” he says.
But a hedge-fund manager’s income depends heavily on performance fees, meaning earnings — and the company’s stock price — depend heavily on the success of the underlying hedge fund. In a good year, hedge-fund management fees can be massive. But a bad year could wipe out those performance fees and possibly wipe out the stock price as well. Good luck predicting when a bad year will hit. “A billion-dollar hedge fund, generally, is dependent on the performance of a few key individuals, and you wouldn’t give a lot of money betting on its returns many years into the future,” says Marc Freed, an investment advisor specializing in alternative investments. “The uncertainty surrounding expected future cash flows is so great it isn’t reasonable to think of [hedge funds] as potential issuers of equity.” On the other hand, if a hedge fund promises consistently smooth performance, it may not be taking enough risk to grow earnings very quickly, he adds.
Could a public hedge-fund manager have an Amaranth-style meltdown?
It’s always possible. “If that fund is taking concentrated positions, using large amounts of leverage and isn’t in strong control of risks, there will still be that remaining risk of a meltdown,” says Joel Schwab, managing director at Channel Capital Group, Inc., which owns HedgeFund.net, a hedge-fund industry research Web site.
On the other hand, a public hedge-fund will likely draw greater scrutiny from investors and analysts, says Mr. Freed, possibly alerting investors to the risk. Had Amaranth been public, he says, “Maybe someone would have said, ‘it looks good from a distance, but it’s all concentrated in [natural gas bets].’ But my guess is that many smarter investors knew [that], and they were okay with it.”
What would a public hedge-fund manager have to disclose about its investments?
An investor in Fortress may not get much transparency about investment strategies, says Mr. Kase, because the IPO is simply an offering of equity interests in the management company that runs the hedge funds, not in the funds themselves. “People are jumping to the conclusion that by virtue of an affiliate of a hedge fund going public, it means there will be an opening of the books on the underlying investments,” he says. “That’s not necessarily the case.”
The SEC already requires hedge funds with more than $100 million invested in public companies to reveal their equity holdings every quarter. They are not required to reveal how much they have in alternative investments, and that would not change for a public company. Like any public company, public hedge-fund managers would have to reveal top executives’ compensation, quarterly revenue and income and other such financial information — just as, say, Goldman Sachs, which has a massive hedge-fund operation, already does — but the nuts and bolts of their investments would still be hidden.
“While the amount of transparency that’s going to be required for Fortress will be light-years beyond what other hedge funds are required to do, there will still be a certain amount of opaqueness with respect to investments,” Mr. Kase says.
But won’t even a little disclosure cause some fund managers to shy away from going public?
Probably. But other fund managers might consider the transparency a good thing, as it might help convince potential investors the fund is not going to implode. “Most well-managed hedge funds understand that maximum transparency can only help them attract customers,” says Mr. Brown.
Following an IPO, would fund managers’ salaries shrink?
Having to disclose salaries to the public could have some dampening effect, but it would probably be limited. Though a public company must disclose the compensation of its top executives, those may not be the people managing the funds, Mr. Kase points out, so fund managers could still rake in management fees without public disclosure. In general, compensation for every employee would not be public information, and that makes it easier for undisclosed salaries to stay very high. “Being a shareholder in a hedge-fund firm, you’d have to keep a very close eye on to how much is being used for compensation, and how much is left for shareholders,” says Mr. Schwab.
Many funds have shut their doors to new investors. Now one is going after public money. Is that a sign that private interest in hedge funds is waning?
Probably not. IPOs may just represent the next step in industry maturity; well-established funds such as Fortress may want to add the aura of permanence a publicly traded stock provides. Plus, private interest in hedge funds is cyclical, says Mr. Schwab, and often has to do with the direction of equities markets. When stocks pull back or move sideways, there’s additional demand for hedge funds — but in a strong upward equity market, it’s unusual for a hedge fund to outperform. For example, this year, many hedge funds are struggling, even as the Dow Jones Industrial Average and Standard & Poor’s 500-stock index post double-digit percentage gains.