- January 11, 2017
- Posted by: Vincent Sarullo
- Category: Fund Administration, Hedge Funds, Marketing, New Funds, Private Equity / Venture Capital
In searching through the archives of Wall Street, I’ve found a number of conflicting assertions as to what was the first hedge fund. It’s possible to trace what we would consider the rise of the hedge fund industry back to the early 1920s. The Roaring Twenties provided the perfect environment to give rise to these private funds that catered to the wealthy. If I were to point to the very first fund, I could say it was the Graham-Newman Partnership, founded by Benjamin Graham and Jerry Newman. I’m taking this view since it was cited by Warren Buffet in 2006 as being the first, and far be it for me to contradict the Great Oracle. The sociologist Alfred W. Jones is credited with creating the term “hedge fund,” and some maintain that he created the first hedge fund in 1949.
The reason these funds are cast as hedge funds is because they are meant to be run in a fashion that mitigates risk in a down market through short positions and other techniques that mutual funds could not use and which were historically long positions only and could fluctuate wildly with market swings.
The following charts were compiled from the Securities and Exchange Commission’s Division of Investment Management Risk and Examination Office report on Private Funds Statistics – Fourth Quarter 2014 (issued on October 16, 2015). The report was compiled from the statistics the SEC received through data collected through Form PF and Form ADV filings. Keep in mind, the information only includes fund managers large enough to be an SEC Registered Investment Advisor, which most emerging managers do not qualify for. There should be a correlation to the emerging manager sector, since they follow the same trends as the larger fund managers in terms of coverage of the market.
Hedge Fund Versus Private Equity
From a legal structure perspective, hedge funds and private equity or venture capital funds are basically the same. They are all typically limited partnership structures that afford investors the same protections. The investment strategies can overlap, too. It is very common for hedge funds to be involved with private company investments or other illiquid types of investments, and private equity funds have invested in market-traded investments for short-term cash positions and also for stock that they received in an IPO of a portfolio company they were investing in.
The primary differences between the two lie in the liquidity for investors. In hedge funds, investors subscribe to the fund for a certain amount and send that capital into the fund for immediate participation in the fund’s portfolio. Investors can add or remove capital from the fund on a periodic basis, according to the fund’s terms. Private equity and venture capital funds, on the other hand, assemble a group of investors that commits a specific amount of capital to the fund but does not send that amount to the fund at the time of subscription. Depending on the fund’s strategy as far as the number of investments they expect to make and the size of those investments, the fund manager will raise a certain amount of commitments from investors at a point in time and start their search for target acquisitions. As the fund manager finds the acquisition opportunities, they will “call” the funds needed from the investors. We will delve into the private equity fund life cycle a little later on.
Long/short equities is the most common type of strategy new hedge fund managers fall into. (Although, from my experience, the “short” side of the title tends to be limited at best.) Since most investors come from a background where they spend most, if not all, of their time focusing on finding quality investments, shorting tends to be counterintuitive and an area that managers just don’t feel comfortable executing on.
A quick explanation for the non-investment professional: “shorting” is the process through which you sell a security that you don’t have. You might well ask, how can you sell something you don’t have, and why? To explain, let’s first ask the obvious question, “Why do you buy a stock?” Answer: because you think it is a good company and you expect the stock price to go up. Shorting a stock is taking the opposite view; you expect the stock to go down. How does that physically work, since usually when you sell something to someone, they expect you to give it to them when they give you the money. The same holds true with shorting. The brokerage firms have stocks that they will lend to you so you can give the buyer of the stock (which you don’t own) their shares. Depending on the ease of getting a specific stock, the brokerage firm charges you interest on the stock you borrow from them. Eventually you will have to buy the stock to give it back to the brokerage firm. With the expectation that the stock price will go down, you will be able to buy that stock at a lower price than what you sold it for and make a profit.
Here’s as an example: suppose you sell short one share of ABC Company stock at $100 per share. The buyer of your stock gives you $100. The buyer deposits the $100 in your brokerage account and your broker sends the buyer his share of ABC Company. After a month, the price of ABC Company stock goes down to $80 per share. You buy the share of ABC Company, give the brokerage firm their stock back, and you have a $20 profit still sitting in your account (less the interest cost on your borrowed stock).
If you buy (or are “long”) a share of stock for $100, the most you can lose is $100 if the stock goes totally bust. But with shorting, you can theoretically have an infinite loss exposure. If the stock you were betting on to go down went, for some crazy reason, from the $100 you shorted it for to $1,000 or $1 million per share and the brokerage firm demanded that you give them their stock back, you would have to pay out of pocket to buy the stock at that higher price to satisfy the short position with the brokerage firm. With this knowledge in hand, long/short managers focus on finding specific investments they view as undervalued for their long positions and investments (for short positions) they think are overvalued or will be subject to an industry event that will push prices down. The managers in this category may differentiate themselves by focusing their strategy on a specific sector or investing style. Most managers will use shorts to limit the drawdown risk if the market were to drag their entire long portfolio down.
Managers looking to make a foray into the global markets can take two approaches to their investment strategy, company-specific trades or country-directional trades. These managers either have specific knowledge of the local markets in various countries or take a macro-economic study approach. You would be hardpressed to find companies large enough to be on an exchange that were not participating in the global markets, at least from a sales perspective. Managers look for companies that either have their primary production or supply chain in specific countries or regions, or their consumers concentrated in a limited region. In order to make trades in the foreign markets, managers can either purchase American Depository Receipts (ADRs) which are traded on the US stock exchanges or open brokerage accounts in the foreign markets where they wish to trade.
An ADR is a negotiable certificate issued by a US bank representing a specified number of shares (or one share) in a foreign stock traded on a US exchange. ADRs are denominated in US dollars, with the underlying security held by a US financial institution overseas. ADRs help to reduce the administration and duty costs that would otherwise be levied on each transaction.
This is an excellent way to buy shares in a foreign company while realizing any dividends and capital gains in US dollars. However, ADRs do not eliminate the currency and economic risks for the underlying shares in another country. For example, dividend payments in euros would be converted to US dollars, net of conversion expenses and foreign taxes and in accordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX or Nasdaq, as well as OTC.
Emerging market fund managers take a similar approach to investing as the global equity managers, but focus on countries that do not have the long-established business or market infrastructure, legal history, or regulations as the US, European and some Asian markets. These emerging market countries are on the move to be in the developed market category. In recent years, we have come up with various acronyms such as BRICs (Brazil, Russia, India, China) and SPICs to use as shorthand descriptions of the emerging markets.
For the very bold who want to step one level down from the emerging markets, we have the frontier markets. Welcome to the Alternative Investments: Wild, Wild West, young fund manager! These markets usually sit in a region where government stability, economic standards, and social standards are shaky at best. The overall stability of the region can turn on a dime. There is very little consistency or view of stability in the market and there is no “business as usual” mindset. Certain areas of the Middle East, Asia and Africa (including such countries as Iraq, Pakistan, Kenya and Croatia) are considered frontier markets. These markets are greatly lagging behind the rest of the world but have great upside potential, as these areas are expected to grow tenfold over the next couple of decades.
In addition to the regional risks involved with investing in frontier market companies, investors will also be subjected to less corporate transparency, few or no short-term liquidity options, limited or non-existent stock exchanges (which may result in an invest/trade by invitation situation), and high transaction costs.
Working with fund managers who focused on frontier markets, I have dealt with situations that I never thought I would see. For instance, one of my clients was investing in Iraq infrastructure focused companies and needed to get the purchase documents and stock certificates from the CEO of a company. In addition to the normal document fee that he had to pay to the local government in Bagdad, he had to spend several thousand dollars for an armed security detail to escort him across the city to pick up the documents.
Market-neutral funds are supposed to balance their “net” market exposure by having positions on both sides of the market to compensate for market swings. They are quantitatively driven and chip away at the market changes to keep returns at a level close to market return.
Managed futures funds typically cover markets across the globe by trading in a trend-following pattern across various equity indexes, commodities, currencies, and bond futures. They move with the market trends, so they buy when the market is moving up and sell short when the market is in a general downward trend.
To make a parallel comparison to a “fund of funds,” structure multi-strategy managers employ several teams of sub-managers who specialize in specific market areas and strategies. Unlike a fund of funds where you are making investments into other hedge funds with fees and expenses, multi-strategy managers have these sub-managers in their firm or hire the sub-managers to manage separate accounts that are in the multi-strategy fund’s name. The sub-managers are paid through the fees the multistrategy manager collects for his fund.
Private Equity Funds
What makes a fund a private equity (PE) fund – investment size, target company maturity, etc.?
Private equity funds invest primarily in the equity position of private companies and, on a limited basis, the debt structure of these companies. Many times, PE funds take a significant equity position in the company, if not a majority interest. The investments made by PE funds tend to be larger in comparison than those made by PE cousin funds run by venture capitalists and angel investors. In most cases, the PE fund manager will seek to have a board of director’s seat at a minimum if the fund does not have a controlling interest in the target company. The involvement of the private equity firm in the target company ranges from a laissez-fare approach if they feel the company’s current leadership is solid to a very hands-on approach that might see them replace management with people they work with directly to build the company in the manner they feel will maximize their value.
Since the target companies are usually private companies and there is no quoted stock price from an exchange to determine the company’s value, purchase prices of these companies are negotiated based on a multiple of their net annual cash flow or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).
Multiples used for the acquisition valuation are based on the target company’s industry and the relative size of the company in its industry, among other considerations, and can vary greatly among companies and industries. For instance, a company that has an average EBITDA of $1 million and the multiple for its industry and size is 4x, the company would have a total purchase price of $4 million placed on it.
The PE funds usually make an investment in a target company in conjunction with getting debt financing from banks or other groups, which has given rise to the term leveraged buyout (LBO). In the previous example, the $4 million purchase price that the seller of the company would receive would come from a combination of equity from the PE fund and debt from a bank, in a probable ratio of $1.5 million equity and $2.5 million debt. Over time, the expectation of the PE fund would be that cash from company operations would pay off the debt, thus increasing the equity valuation.
During the holding period of the portfolio company, the PE fund hopes that a combination of things may occur to increase the valuation of their investments. First, acquisition debt is paid down. Second, company earnings or profits increase, giving the company a greater base for when a sales multiple is applied.
Third, the company could grow or the view of the industry it operates in could change so that the multiple by which they can value the company increases. One or more of these occurrences would provide for a greater sales price.
The ultimate goal of the PE fund is to have a company in which it has an investment be realized. The realization, or liquidity event, can take a number of routes. For larger companies, the goal is to take the company public with an initial public offering (IPO). If an IPO is not in the cards, a number of other things can occur.
Many PE transactions start with a company’s management team looking to take an interest in their company from an owner who is ready to retire or who has no family succession plan in place. Management will take a small equity stake in the company, with the remaining capital coming from the PE fund. These incented management team members tend to grow the company to a point that their personal wealth builds up enough to enable them to buy out the PE fund in whole or in part.
Sometimes the realization takes the form of a merger with or an acquisition by another company. This can result in either a full cash realization event or a combination of cash and equity in the merged company. What has become more prevalent in recent years is the sale of portfolio companies from one PE firm to another. Since the PE funds do have a limited time horizon on buying, holding, and selling their portfolio companies so their investors can make profits, many portfolio companies have tremendous growth possibilities towards the tail end of a PE fund’s life, and these companies are much sought-after by other PE firms.
Line of Credit
Use a line of credit with your bank to fund expenses and small capital infusions into a company mid-quarter to reduce the need for multiple small capital calls from your investors. Many private equity investors are larger groups that have internal processes for approving movements of funds. Most prefer making one larger capital commitment payment during a quarter than making multiple small ones. Having fewer transactions also reduces the accounting burden.
PE managers live in direct opposition to TLC’s 1994 hit song lyrics, “don’t go chasing waterfalls.” For PE fund managers, the waterfall is the means by which they receive their profit share or carried interest in the profits of the fund. As the name implies, the profits from an investment will flow down from one level to the next based on an agreed method. The profits on an investment will be first shared among the fund’s investors, and if those profits go over a certain threshold, the excess profits flow down to the fund’s general partner for its share. The terms dictating how the profits are allocated to the general partner are detailed in the fund’s offering documents and may include various preferred rates for investors, with multiple levels of carried interest percentages at different hurdle rates. For an example of how this works, see below:
Every PE fund tries to tailor the waterfall to reflect how they expect to generate returns for their investors, and how to match the performance they generate for their investors with how they get paid. The bigger the hit, the bigger the share of the profits for the general partner. The specifics of the calculations can range widely between funds, but there are two general methodologies or schools of thought followed by waterfalls, the European and the American waterfalls.
The European waterfall performs the carried interest calculation at a fund level. It takes into consideration the fund’s overall performance, including current and past investment transactions, to see if the thresholds have been exceeded before carried interest is earned.
The American waterfall is a deal-by-deal calculation. In this method, a poorly performing investment would not have an impact on the profit share a general partner will receive for a successful investment. To accommodate this situation, funds may have a “clawback” provision that requires a general partner to return previously paid carried interest amounts to compensate for poorly performing investments.
Capital Commitments, Calls, Remaining Commitments
PE funds operate by investors making commitments for certain amounts that the fund manager can call upon to make investments and pay the fund’s expenses. For example, the fund manager will get several investors to commit funds that they can call upon at any time. Each investor will send into the fund their proportionate share of the funds “called” by the fund manager, based on the percentage of their committed capital amount compared to the rest of the investors’ commitments.
The fund manager needs to track by investor the amounts called and any remaining uncalled commitments for each investor. The amount available to call from each investor may change during the lifecycle of the fund.
There are three stages in the life of a PE fund, the investment period, the holding period, and the liquidation period. These periods are usually defined in the fund’s offering documents with specific time frames. It would be very typical to see a fund have a predetermined life span of 10 years, with the investment period and liquidation period each having three-year terms, one at the beginning and one at the end of the time frame. The fund manager is given a mandate to find target companies during the investment period, and the investors plan on having a significant portion of their commitment available to fund these acquisitions.
Knowing that it takes several years for a portfolio company to go through its maturation phase and ultimate exit, investors give the manager a “use it or lose it” checkbook for the start of the fund. After the investment period, investors can expect smaller capital requirements to cover fund expenses and possibly small add-on acquisitions for existing portfolio companies.
During the three stages of the fund, the management fee arrangement can change. During the investment period, fund managers usually receive their management fee based on the fund’s total committed capital, at a rate of 1% to 2% of the committed capital. The underlying philosophy is that the manager is getting paid to find acquisitions that could potentially use up all the committed capital and maximize the potential returns for investors. The manager must do a lot of work to find and close these investments.
Either at the end of the investment period or soon after, the management fee earned by the manager often changes, going from being based on what the total commitments were to being based on the fund’s total invested capital. Given the chance to deploy the investors; capital, the fund managers now earn their management fee based on what is in the portfolio and their responsibility to work with and sell those companies.
Do not feel too bad for the fund manager who has not deployed all of the available capital in the fund and who potentially faces a significant reduction in management fees. The timing of this change in fee typically coincides with when the first portfolio company is getting ready for sale and the fund manager will be earning their carried interest on the profits of that sale. The manager can expect the trade-off of the management fee (at 2%) in exchange for the carried interest on profits (around 20%).
There will be future posts that discuss Venture Capital, Real Estate Funds, Tax Lien Funds, and more.
By Vincent M. Sarullo