Size, strategy and swagger

27Sep06

One of the ongoing debates in alternative investment circles is the question of capacity. The question is how much capital can be employed in vehicles like hedge funds and private equity before that “excess” capital begins to drag down average returns for the entire industry.

In the hedge fund realm it has been hypothesized that there is only a limited amount of “alpha” that can be captured by hedge funds. Logically if the hedge fund industry continues to grow that alpha will be spread ever more thinly. The question is the same for private equity as well. As more private equity firms raise ever larger funds it begs the question whether the pickings will become slim?

One almost needs to argue that there remains a public market-private market “arbitrage” (a word we feel is grossly overused). Where private equity firms can continue to “take private” public firms, apply leverage and some managerial skill, and exit in a quick and orderly manner. As an aside, one obvious and nagging threat to the private equity industry is not surprisingly a good old fashioned economic recession.

The fact of the matter is we will only know the answers to these questions in hindsight. At the moment the pressure to perform is affecting the way many managers in the alternative investment world behave.

The erudite Going Private has a timely post up on the delicate interplay between “first mover” activist hedge fund managers, “follow-on” hedge funds and private equity firms. If you have gotten this far in the post we would recommend you read their entire post. However it should not come as a surprise that, “…the dynamics between activists are complex and often require a lot of tip-toeing.”

That tip-toeing extends to the relationship between hedge fund activists and the private equity firms who continue to hold substantial stakes in their newly public holdings. Going Private demonstrates that the challenge then becomes one of trying to maximize the share price of the firm against the time (and effort) required to bring about additional price leverage.

Coincidentally the Wall Street Journal has two articles up today on the challenges facing two prominent activist managers. Susan Pulliam reports on the issues facing Pirate Capital which include regulatory issues and below market performance, that have at least for now put a damper on the firm’s “swagger.”

Pirate’s stumble reflects a growing problem faced by hedge funds these days. Many of these funds — private pools of money catering to wealthy investors and institutions — are jam-packed into stocks with other hedge funds pursuing similar investment strategies. When the strategy falters, fast-money traders rush for the exits, dragging the stocks down further and faster than they would have had hedge funds not plowed in.

On the hand another activist investor, Nelson Peltz, is dealing with another aspect of activist investing. What happens when you actually get what you are agitating for, that is a “seat at the table”? Nik Degoun reports on how the challenges facing an activist investor change when they go from rebellious outsider to board member.

The capital markets, including those for alternative investment managers, is constantly changing. The fallout from the Amaranth Advisors is a lesson in the need for managers of all stripes to remain flexible (and liquid) in the face of adversity. John Carney at DealBreaker.com relates how “flexibility” keeps one prominent firm stays out of firm-risking trades:

…Flexibility. When Goldman Sachs talks about what it does well it usually emphasizes that it’s not in the business of predicting the future. It’s in the business of being more flexible and reacting quicker to changes in the market.

Forecasting the future is both difficult and perilous way to manage other people’s money. The challenge for investors is to seek out managers that are not dependent on “being right.” In that sense activist managers are forging a different path. Their approach is not dependent on forecasts of the future, but rather on net asset values (and on convincing managments and the market that what values they see are real.)  As more money pours into the world of alternative investments it will become more important that managers of all stripes have a way of adding value that they will never find back in the pack of me-too investors.

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