Public pressure to perform

11Nov06

One of the long-standing themes here at Abnormal Returns is that the rising assets (and profile) of alternative investments, i.e. hedge funds and private, will inevitably lead to publicly traded vehicles. This process is already well underway in Europe with a raft of publicly traded hedge funds and a high-profile private equity offering from KKR.

While the hedge fund wave continues apace, the KKR deal seems to have put a brake on the once seemingly inevitable wave of private equity offerings. Heather Timmons in the New York Times looks at how the structure and performance of the KKR deal has made it difficult for other firms to follow in their footsteps. High fees aside, the biggest complaint seems to be the somewhat muddled investment strategy for the fund. In contrast, Timmons notes that publicly traded hedge funds have, in a sense, a more transparent investment strategy.

As noted previously, the hedge fund listing wave has now reached the shores of America. The rumored initial public offering of hedge fund operator Fortress Investment Group is now a reality. The IPO filing has opened up a window onto the finances and operations of a large, high profile alternatives manager. Jenny Anderson in the New York Times notes the extraordinary profitability that a successful hedge fund can generate, and the obvious fact that Fortress’ founders will make out quite well in the deal.

The logic behind the deal backs up our contention that there is an institutional impulse behind these deals.

Fortress wants to offer shares to the public, the filing says, to have capital, currency, people and permanence. In other words, it wants money from the offering to invest in the business, a stock to use to make future acquisitions, stock to use as incentive compensation and a ticker symbol on the New York Stock Exchange — FIG — that elevates it from yet another big hedge fund to a permanent institution.

If the Fortress deal goes according to plan, one can expect to see other large hedge fund organizations take advantage of this window in the capital markets and raise capital to cement their legacy. However, just because hedge fund operators are going public, does not necessarily mean they are a good investment.

John Christy at breakingviews (via WSJ.com) takes a look at money management comparables and how one should value a firm dependent on incentive fees for much of its profitability. The point being that to avoid the issues surrounding the controversial KKR deal, Christy believes Fortress would do well to not “push the envelope” on valuation.

That raises a note of caution: Investors should distinguish between the two components of an alternative fund managers’ income. Management fees get a traditional fund manager a rating of about 20 times earnings; riskier performance fees fetch about 10 times earnings — in line with, say, Goldman Sachs. Assume 70% of Fortress’s net income comes from performance fees and only 30% from management fees and that implies a blended multiple of 13 times 2007 earnings.

Assuming Fortress prices their deal correctly and absent a capital markets hiccup there is realistically only one other potential roadblock for further hedge fund legitimacy, political interference. The change in control of Congress has raised the possibility that there might be legislation or further pressure put on the SEC to curtail hedge funds. Daisy Maxey in the Wall Street Journal looks at the potential fallout from the Democratic takeover.

One likely change seems to already be in the works. Bloomberg reports that the SEC will propose changes to the minimum eligibility requirements to invest in hedge funds, prompted in part by the Amaranth blow-up. Given that these standards have been unchanged for some time, this should not come as a surprise to many.

The democratization of alternative investments appears to be on track. This is a welcome development to individual investors who have not the means to invest directly with these managers, but who still crave the potential diversification benefits. As noted, absent a capital markets upheaval we should expect to see a steady stream of these deals. However, investors should take a good, hard look before investing. Just because you can invest in publicly traded alternatives doesn’t mean you necessarily should.

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