An exclusive interview with Hedge Funds and Private Equity Guru Dr. A. S. Johan By Jayke UmarezzCategory: Social Issues
Article added by: A S Johan
Note : If of any reason you can’t see the full text of the following isocially important interview, please contact me Jake Umarezz at jaykeumarezz@yahoo.com for a free copy or just Google for it.
Dr. A S Johan is a New Age Management Guru and the founder of GAiiN, The Global Alliance of Intelligent Investors. His recent articles on the IPO of Hedge Fund and Private Equity Management Companies has created quite a stir among stock market investors and the tightly-knit Hedge Fund and Private Equity community. Widely followed, Life-Style Trends Commentator, Jayke Umarezz, interviewed Dr. A S Johan and asked some hard hitting questions about his articles.
Jayke : Dr. Johan. How should I address you? Would you like me to stay with the full enchilada of Dr. A S Johan or may I just call you ASJ?
ASJ : Oh! Ah! ASJ is fine. Anyway, all my friends call me ASJ. I assume you are a friend too. So why not?
Jayke : That’s great thanks. A lot easier on the tongue as well. ASJ you’ve created quite a stir with your articles. Was that intended?
ASJ : No. Certainly not. I had been inundated with press reports and stories about recent successful public offerings of shares in Hedge Fund and Private Equity Management companies. I thought it may be useful for the industry and general public, particularly the average investor in the stock markets, to read an unbiased opinion of the phenomenon.
Jayke : I see. What, may I ask, qualifies you to analyze and comment on the ‘phenomenon’ as you call it?
ASJ : Ha! Ha!. Well, Jayke, you’ll agree that I too am a member of the general public and was a recipient of all the news about these IPOs. As such, I believe I am entitled and in a way qualified to comment on them. I don’t expect everyone to agree one hundred percent with my analysis but my conscience is free that my comments are sound and unbiased.
Jayke : Oh ASJ, you are far too modest. From what I have learnt, you’re more than qualified to comment. I understand that you provide strategic consulting services on Hedge Funds, Private Equity and Venture Capital to some very influential people in Asia and the Middle East. In fact, you help establish Hedge Funds and Private Equity Funds for them and even provide advise on their effective management. Am I right or am I right?
ASJ : Well Jayke, yes I do, but you know what they say about consultants. All unemployed knowledge workers eventually become consultants.
Jayke : No. I’m afraid I haven’t heard that one before. But it’s interesting. I wonder if it applies to us Journalists as well.
ASJ : Not really. Journalists have a pretty accepted position in our society. They’re the people who don’t’ need to be experts in any field but have the power to write authoritative reports about them. Power without accountability. Isn’t that what they say? Freedom of the press I guess.
Jayke : Point taken. But freedom of the press is, I would assert, a very necessary facet of a truly free society. Not all of us abuse the so called power we’re supposed to have. In fact, considering the large number of us around, surprisingly few have actually abused it. But hey! This is not about journalists or me. It’s about you and your article.
ASJ : You’re right Jayke. I’m sorry to take you off the subject. What would you like to know about my articles?
Jayke : Well, for starters, why are you so against hedge funds and private equity funds and the management companies offering their shares to the general public through IPOs?
ASJ : Jayke, I’m not at all against them. I fully support their existence. In an economy that has embraced a capitalistic, free market system, I believe any business has the right to raise capital or sell its shares through any legal means available. So, in that sense, hedge fund or private equity management companies, like any other business, have every right to raise capital from the capital markets so long as it’s done within the legal constraints in place so that investors can make informed decisions. I am sure that the recent HF and PE management company share offering have indeed done that.
Jake : OK. I’ll refer to one of your recent articles, entitled Why are Profitable Hedge Fund and Private Equity Management Companies being sold off to the public now? The title is framed as a question and seems to me to suggest that there may have somehow been a hidden agenda to the IPOs. Would you care to comment?
ASJ : Well Jayke, you as a Journalist of all people should know better than to judge an entire article just by its rather long title. The mission of the article was essentially to (a) offer several possible reasons for the IPO, at this point in time, by the very persons, who have in the past been heard to vehemently declare that being a public company was not for them and that disclosure requirements would adversely affect the very strengths that earn them large amounts of money (b) to analyze if the offerings would be a good long term investment for the average investor, on a comparative basis and (c) much more importantly, to explore as to whether it would be possible to develop a practical investment strategy to profit from the phenomenal growth in Hedge Funds and Private Equity Funds.
Jayke : Yes. The article did indeed do all that. As to possible reasons for these HF and PE Management company’s IPOs now, you suggested the following three reasons : -
(a).Current insiders (owners) of Hedge Fund (HF) and Private Equity (PE) Management companies think that now is a good time to take profits on their shares on the back of their firm’s past performance records;
(b).that insiders think their HF or PE management company’s profitability has reached their natural upper limits and may soon start declining because of unwanted additional competition, even from their own trade execution brokers (who have begun launching competitive funds) resulting in the copying of profitable trading strategies effectively diminishing the effectiveness of previously profitable strategies;
(c).that the stock market’s current bullish mood for hedge funds and private equity funds generally, allows HF and PE management company insiders to think it’s a good time to raise additional permanent investment funds through the stock markets rather than relying only on so called limited partner’s funds.
Would you care to give some further insight on these three reasons you have sighted as the possible motivation for HF and PE management company insiders to offer their company’s shares to the public at this point in time?
ASJ : Sure. I’ll certainly try. The whole issue of motivation can be rather complex and at the same time quite obvious. Individual insider’s (as you have called them) motives can be different and highly personal. My comments were made taking insiders as a group and on the basis of economic rather than other less quantifiable personal reasons for the IPOs of their management companies at this point in time. I believe that insiders may have opted for a public listing and IPO now for a combination of the three reasons I have sighted.
As you may well know, HF and PE management company’s Assets Under Management (AUM) are currently at record highs, particularly at the largest of these companies (i.e. the ones that have had headline IPOs). Large amounts of AUM translates into very significant revenues from the 1% or 2% in management fees on AUM. It’s a simple formula really, the larger the AUM, the more the absolute amount of dollars earned in management fees, whether or not the AUM performs. Management fees are charged for the purposes of covering a management company’s administrative and operating costs to service the AUM.
These costs are typically not at all as high at HF or PE management companies as they are in say a bank, a stock brokerage, a manufacturing company or a technology company. HF or PE management companies generally outsource most operations that require large manpower or expensive equipment. Further, administrative and operations costs at HF or PE management companies do not as a rule rise at the same rate as the increase in AUM.
Therefore, once a certain fixed administrative and operations cost threshold is covered, management fees earned from a larger AUM base gets into surplus territory and management company shareholders can distribute the fees to themselves as earned profit.
Then there is the 20% or more in annual performance fees that HF and PE management companies charge on any period-on-period increase in the market value of their AUM. These are performance based and are generally charged on annual increases in AUM valuation over the previous highest watermark. What this means is that a manager’s performance fees is earned only on and when the current year’s increase in AUM value, adjusted for new inflows of money, is above it’s previous highest valuation level. While this may sound a very strict measure for managers to achieve, the fact has been that the US and Global stock and commodity markets have been extremely bullish over the last few years. This fact has allowed even the most useless of managers to be able to achieve remarkable increases in annual AUM valuations and allowed them to charge and earn huge amounts as performance fees.
Savvy managers of course realize that markets of the future may not perform quite as well and as such their management company’s performance fees earnings may start to dwindle as a result. So if an IPO was done now, on the basis of past performance, most HF or PE management companies would look like super cash cows and attract a favorable response in a public offering of their shares.
As it happens this has in fact been the case and these management companies are now quoted at humongous market capitalization levels. However, if as anticipated by the savvy insiders, markets of the future do not perform as well as they have over the recent years, performance will be affected and so will the inflow of performance fees. If performance is not up to expectations, AUM too will flee and the usually stable management fees will be severely reduced as well. By becoming a publicly listed company now, insiders will be able to sell off their shares to cash in.
At the same time if enough new money was raised from the public the possible future reduction of AUM from major institutional and qualified investors could be replaced with proprietary funds raised from the IPO and subsequent share placements. Such a change from being offered to the public as a management company to becoming a proprietary investment company could however have significant ramifications on the sources of profits as they will then depend not on stable fees but instead on less stable and more risky proprietary trading activities.
Jayke : Wow! That’s a very eye-opening analysis. It almost sounds illegal or if not, ought to be. Don’t you think so?
ASJ : No. I don’t think it’s illegal or that it ought to be. It’s what an open, equal opportunities based free market capitalist system is all about. Why shouldn’t money management firms enjoy the same access to the capital markets as any other business do? Nobody would accuse, say a high tech business like Microsoft or Google placing shares on the back of a record breaking profitable year as being in any way underhanded.
In fact, it’s done all the time. It’s really up to the buyer of shares to carefully evaluate the merits and as to whether or not the price being paid for the shares is acceptable on the basis of sustainability of profits in the future. If investors over rely on past performance, they would generally pay the price for not properly considering the future. Usually this luxury will be the suffering of losses on their purchases.
Jayke : Valid point. But gauging the future is so subjective and really difficult. It’s so much easier to look at the past because it can be seen as a fact. What do you think?
ASJ : Sure Jayke. That’s probably why it’s said that there are more losers in the markets than winners. To win, it’s necessary to do what others don’t want to or cannot do. If investment decisions could be made on the known (e.g. past profits) then everyone can do it and profit. Who then would lose? Where would market gains come from if not from the losses of others? No my friend. Investment success can only come for taking calculated and educated risks. This is why I founded GAiiN. To offer a platform for investors to evaluate the not so obvious factors affecting an investment situation. In any investment, there is the element of luck of course and it’s true that we all need a big dollop of it. But as the saying goes, Luck seems to favor the prepared.
Jayke : Well put ASJ. Thanks. I want to now deal with the second part of your article where you say that you don’t think purchasing the shares of HF and PE management companies is a sound long term investment for the average investor. Why? Do you think the shares will not perform well?
ASJ : In my opinion, I don’t think that shares in HF and PE management companies are a particularly good or suitable investment for the average investor. That does not however mean that the shares are going to tank right now. I just happen to believe that there are better alternatives for the average investor to cash in on the HF and PE boom. Mind you, shares in HF or PE management companies may well be suitable for certain types of institutional investors particularly those that have not as yet but do want to enter the magical world of offering and managing alternative investments. But then that’s another story for another day.
As you are well aware, over the last few years there has been phenomenal growth in Alternative Investments in particular Hedge Funds and Private Equity Funds, resulting in record profits for Management Companies. While I do believe that more money will continue flowing into such funds, I am not entirely convinced that management companies will be the single beneficiaries as they have been in the past.
The key word to understand here is management. Generally speaking, a HF or PE management company’s success in attracting vast amounts of AUM (leading to more management and performance fees), tends to be very closely identified with one or two key personalities within the company. In a situation where the management company’s shares have become publicly traded, such key management personalities, who had in the past driven the company to generate ever increasing amounts of fee income with a big chunk of it flowing back to them personally, can now easily find ways to cash out of their shares in the company at maybe 10 times forecasted income. After all, who in their right minds may not be tempted to sell out if he could receive five or ten years potential income upfront today.
Without this “management” component, a management company really has nothing much by way of tangible future revenue generating assets. The so called Brand is just so much wishful thinking. We are not talking about a Coco – Cola here. The loss of key management to a management company is a particularly disturbing thought as clients can easily switch managers and move huge amounts of AUM away from a manager-less manager. So called AUM lock-ups generally don’t strictly apply to larger clients in the real world. Just to some hapless private investor (usually foreign) with a few million dollars invested.
Another danger on the horizon is where larger clients have begun recruiting pedigreed persons directly and setting up and running their own private label Hedge and Private Equity Funds. Often sighting the huge savings in management and performance fees they had been paying for performance generated by a bull market rather then a manager’s skill, as ample justification. This experiment could easily become a dangerous trend resulting in management companies losing considerable AUM and having to rely on less stable but much more risky proprietary trading activities which of course requires considerable amounts of their own capital (one earlier mentioned possible reason for raising money by selling shares to the public).
So, unless you, as an investor in the shares of a HF or PE management company, are going to be directly involved in the senior management of the company and reap some serious insider privileges (perhaps a comfortable salary package, a red Ferrari) etc., I believe that you, as a long term investor in the stock markets, would be much better off investing in the shares of other regular (asset or technology based) companies or better still in low transaction-cost based Exchange Traded Funds (ETFs).
Jayke : That makes sense. I now understand a bit more of the reason why you don’t think purchasing the shares of HF and PE management companies is a sound long term investment for the average investor. Now, I want to move on to the third part of your article where you offer some suggestions as to how an average investor could still, through their investments, benefit from the growth in HF and PE AUM. Could you explain?
ASJ : Yes. I do think it’s possible for the average investor to not invest in the shares of HF and PE management companies and still position themselves to benefit from the growth in HF and PE AUM. However, it’s going to take a lot of hard work.
To really understand the key issues at hand, we have to look at the future management of Hedge Funds and Private Equity Funds separately and figure out which is going to be the dog and which the tail.
Hedge Funds : As at end of March 2007, Global Hedge Fund assets (all types) are estimated to have soared to over $2 trillion (that’s a 2 with twelve big zeros after it). There is no sign of any slowdown in the dramatic rate of growth of hedge fund’s AUM. Most experts estimate the growth to continue or even accelerate as more and more countries consider allowing their less affluent investors to participate in Hedge Funds to earn absolute returns (as opposed to returns relative to some arbitrary benchmark).
A key question here is, will high (or higher) returns be sustainable as AUM grows bigger and bigger? Like many informed independent analysts, I have serious doubts. Most pure hedge funds (with no involvement in Private Equity), rely on their unique management skills (the so called Alpha component) to extract returns from the equity, debt or commodity markets. As these funds, because of their sheer AUM size, effectively become the market, only very average market returns, if at all, can be expected going forward. Add to this, we have the proliferation of duplication (i.e. copying of successful strategies) by former employees, execution brokers and counterparties. As a result, we’ll have a lot of similar strategies trying desperately to squeeze returns from the same markets.
Market dependant trading strategies in any specific given time frame is of course a zero sum game. What this means in plain language, is that in any fixed time frame (one minute, one hour, one week, one month etc.) the total profits of all profitable market participants, in that time frame, will be equal to the total losses of all the unprofitable market participants (ignoring direct trading costs).
Unfortunately this is a mathematical truism whether we are talking about the regulated Exchange operated markets or the bigger institutional over-the-counter markets. Therefore, if everyone (using a particularly profitable strategy) is profitable by a certain amount of dollars in a particular time frame, there must be an equal amount of loss suffered by others (presumably not using the particularly profitable strategy) in the same time frame.
Given that everyone wants to use profitable strategies and be profitable in all time frames, it’s no wonder that secret profitable strategies will not remain secrets for very long (notwithstanding claims of Chinese walls etc.). A good case in point was a claim by LTCM that some of its more profitable arbitrage strategies became much less profitable and even became a loser when it was borrowed by others.
The above problems will surely surface as ever larger amounts managed by HF Management companies seek alpha based returns from the same markets (and there are just so many tradable markets). More and more hedge funds will have to be satisfied with some portion of market beta based returns or seek their returns from other less market-specific investment activities. The most immediate and obvious not-so-market-specific route to adopt will be to commit more funds to private equity type investment strategies that have a longer time frame to succeed or fail. Increases in time generally adds greater variability of returns – also known in plain English as more risk (hopefully with a greater potential for profit). Such strategies may also provide the ability to continue earning the 2% in management fees for a longer time.
From recently announced mega sized leveraged-buyout deals initiated by Private Equity firms, we can already see this phenomenon being played out. You can expect this trend to continue as Hedge Funds start to supplement or even out-bid and replace banks directly or indirectly as lenders or co-investors to leveraged-buyout deals.
Under this scenario, investors could well ignore hedge funds altogether and instead concentrate their investments indirectly through PE Management companies or directly by investing in the shares of target buy-out companies, and be the first and possibly largest beneficiaries of any upside on buy-out deals.
This would support my view that investing directly in the shares of regular companies (preferably those that could potentially become buy-out candidates) is a far superior long term investment strategy to investing in the shares of HF or even PE Management companies or for that matter in HF or PE Funds managed by either of these management companies.
Private Equity : As at end of March 2007, Global Private Equity Fund assets (all types) are estimated to have soared to over $7 trillion (that’s a 7 with twelve big zeros after it). It’s believed that the actual figures could be much more if it included funds held in the war chests of global corporations seeking to acquire other companies. So far few are predicting absolute numbers lest they get it wrong. To a large extent growth in the largest part of the PE Funds universe i.e. buy-outs depends on the availability of credit. Not so much the cost of credit, as many believe, but just the availability of credit. History has shown that even in the relatively high interest rate era of Mike, the Junk Bond Milken, buyouts thrived till they finally blew off.
Promoters of PE strategies, especially those involved in the leveraged buy-out side of the business, often sight the huge advantage they bring to target company shareholders in the form of more efficient, leaner and usually meaner management, that will enhance shareholder value (meaning higher stock prices eventually). Our task here is not to argue the merits or otherwise of these incoming management attributes, but instead to see if and how we can profit from the actions of PE firms.
Basically PE Management Companies (fondly referred to as firms) are similar to HF Management Companies - structure wise. To justify earning fees from investing other people’s money through one or more dedicated funds, their founders too claim expertise gained in past deals at their employers cost (the pedigree factor).
Unlike hedge fund managers however, PE manger’s areas of expertise is not so much related to trading securities in the stock, debt or commodities markets, but in being able to successfully manage a turnaround in a sick company with some future perceived potential or to strip an under managed company of its assets and sell it off for more than the purchase price or some combination of the two strategies. Principals at most PE Management companies are generally credited (by their admirers) of possessing almost superhuman management capabilities across all industries and of enjoying the patronage of top World Leaders and Royalty (similarities with the promoters of the South Sea Company should come to mind).
Anyway, whatever superior management skills are attributed to the senior partners of PE Management Companies, the following qualities and requirements usually seem to dominate the evaluation process : -
(a).that in selecting a target company, minimal involvement in messing around with the company’s real business (i.e. getting one’s hands dirty) should be available;
(b).that one of the most important criteria about a target company should be its hidden assets that have not been properly priced by its existing management and the markets i.e. corporate assets that can easily and quickly be liberated post buy-out;
(c).that more important than any real world input from the company’s management team (both technical and others) or other qualified industry experts, is information provided by one or more big name (again the concept of pedigree) experts who have never actually started or managed any business even remotely similar to the one being contemplated for the buy-out;
(d).that another important factor is the availability of corporate assets that can easily be appreciated by potential lenders and pledged as security (collateral) for raising at least 120% of the purchase price (so as to provide for fees and expenses over and above the purchase price);
(e).the availability of one or more disgruntled ex-employees of the target company, who are prepared to provide confidential and usually negative information about the target company’s CEO, CFO, COO and other key management personnel and if possible major shareholders and influential board members as well.
(f).Will the deal make global headlines and push the PE firm further up the deal league resulting in even more AUM flowing into its next fund?
(g).Can the deal be done with little or no capital from the management company so that when it’s eventually sold off, the returns on investment can be expressed in astronomical and almost unbelievable percentage terms?
Jayke, in going through (a) to (g) you may be inclined to think that in making a buy-out decision, PE Manages are least concerned with profitability of the deal. This is not true of course. Profits are important. However, as mentioned earlier, PE deals tend to have a much longer time frame than HF deals to prove themselves. Typical HF transactions particularly those that can easily be marked-to-market show an instant profit or loss in real time. Profits or losses from PE deals can be (and usually are) differed to a more accommodating time frame.
However, given the huge amounts being made available for PE deals, and the fact that considerable leverage is used (by pledging the target company’s assets), it’s really not that difficult (having assiduously followed steps (a) to (g)), to sell the bought-out company to another deal hungry PE Fund (even one managed by the same manager) for an enormous return-on-investment (in percentage terms) after a couple of years.
So, how can an ordinary investor, without access to World Leaders and Royalty, make a buck out of these huge HF and PE trends (pronounced opportunities)? One obvious way is to simply try and figure out which companies will become the next buy-out target and then to buy a bucket load of their shares and wait for the PE magic to unfold.
AH! you say, but what about the real risk of losing my principal if the deal does not happen (as it often can) and / or the target company’s shares tanks? Should I not be better off just buying into a Hedge Fund that specializes in taking positions in potential buy-out candidates?
Well! Maybe that’s an answer if you have a few million to lock-up for a couple of years. But remember that 100% of your principal is still at risk from deals that fail and / or companies that tank. Your capital invested in the hedge fund is still not in any way Guaranteed against loss by any credible third party. Further, you’re still going to have to pay the 2% or so annual management fees on you capital plus any undistributed paper gains, while your HF manager drives around in his or her red Ferrari (the Ferrari you’re now partly paying for) waiting for the next big juicy buy-out deal to fall into her lap.
Jayke : Umm! You’re probably right about Hedge Funds getting more involved in PE deals as lenders or buyers of junk debt as trading profits from market operations get more and more competitive. Makes perfect sense to me. It’s really obvious too. So you think that the average investor who wants in on HF and PE activities is really better of just buying the shares of potential buy-out candidates. But it’s going to involve some hard work and there is still the issue of principal at risk. Right?
ASJ : Right you are. I am currently working on a project that will transfer the ‘work’ component to managers of a special purpose vehicle and at the same time eliminate 100% of the risk on investors’ principal.
However, there is no free lunch as they say. Investors will have to sacrifice some part of the realized profits in exchange for not having to work and for having 100% of their principal Guaranteed by the most credible entity in this world. Considering that they will only be sharing actually realized and distributable profits as opposed to just valuation (or paper gains), I think it will be a pretty decent deal.
Jayke : Sounds good. I wish you all the best of luck. Do let me know details of the deal when you can.
Posted By: A S Johan
Contact: e-mail
| About the Author: |
| Jayke Umarezz is a widely followed Commentator on New Age Life-Style Trends and may be contacted by email at jaykeumarez@yahoo.com |
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