Killing it like a hooker in Hong Kong

Misnomers: Hedge Fund and Private Equity

The terms hedge fund and private equity are probably the most mistakenly used in the finance vocabulary today. The industry has grown much faster than the public’s capacity to understand it, and not a day goes by without a newspaper columnist, layperson or well-meaning friend makes remarks that make me cringe at the generalizations made of an enormously complex industry.

Private Equity: Traditional private equity was precisely that, all it meant was investing in the shares of non-publicly traded companies. It relied on fundamental equity analysis to identify companies which were not large enough to be listed, but had great prospects. However, over time, a number of strategies began to emerge as the market outperformers during some cycles. These included

LBOs: Where a minimal amount of equity is used to take an inefficient public company private, using a large amount of debt. The idea is really that the public company has a baseline of cash flow even when it is inefficient, and this can support the debt. Any improvement in the company’s prospects is upside to the equity, the PE sponsor.

VC: Venture capital, another mangled term, means one of two things. The first, which is commonly associated with the VC term is really funding of early and middle stage technology companies. Exits are usually based on strategic sales or IPOs and these firms take on very little debt, as the tech companies usually do not have cash flows to support it. The lesser known use of VC, is really traditional seed funding of businesses, such starting up a hotel, a small manufacturing company, etc. But most people tend to ignore this aspect of VC, even though it is the far larger market for funding.

Hedge Funds: The traditional use of the hedge fund term would probably apply to strategies which have been around as long as a stock market existed. The initial, essential idea was that a money manager could short one security, while being long another, and this would help him make money regardless of where the market ended up going. In contrast a long only manager is a slave to the vagaries of the market. Even if you made a good bet, a market downturn would put you in the red. Over time of course, many strategies sprang up around this concept of long/short:

Risk Arbitrage: Legalized insider trading. Wait till a merger is announced. The price of the target moves close to offer price, the price of the buyer moves lower due to dilution concerns. The HF will start calling up his buddies in banking, accounting, law firms, brokerage desks to see whether the merger has a good chance of happening. After getting all the market rumors, from whether the shareholders of both firms are keen to whether the bankers are able to fund the deal, the HF decided whether or not the acquisition will go through. If so buy target, short buyer. If not, the converse.

Convertible Arbitrage: One of the most successful strategies, and has produced some of the big names of our times including Och-Ziff, Fortress and Citadel. A convertible is essentially a bond which can be converted to equity at a certain stock price. You’re protected on the down side by the bond like features, and get the equity upside if things go well. There are a number of mathematical trading strategies to realize profits over short periods of time due to the volatility of the stock. Plus margin leverage at up to 10:1 with some brokers.

Distressed Debt: Buy up the debt of a company in distress or unable to pay its loans. Pay40 cents on the dollar. Short the stock at the same time if you think company is heading into bankruptcy. Used the legalized insider trading and market rumor system to make short term profits over the bankruptcy process. Alternatively, propose a restructuring plan which rewards you with 80,90,100 cents on the dollar while the shareholders get wiped out. This strategy has been inconsistent over time. Similar to risk arbitrage. Just as you need a bull market for mergers to occur, you need a bear market for distressed.

Credit Trading:  Perhaps the most technical off all the HF strategies. It’s all about exploiting different values of fixed income instruments based on risk perceptions, maturity, spread, duration and currency. Complicated, and usually depends on leverage from prime brokers to amplify small price differences. Think Long Term Capital Management.

Quantitative Trading: Engineer builds computers. Puts in all the data in the world. Computer crunches historical numbers, tell Engineer what to buy and sell. Essentially  something like “Buy gold when Japan yen bonds yield x”. Requires liquid markets, lots of fast computerized trading. This strategy ran into trouble recently because all the Engineers read the same books and went to the same schools.

Commodity Trading: What started out as a system for mid western farmers to lock in profits by agreeing to sell their crop three months in advance is now a multi billion dollar HF industry. Guys trade options and forwards as well as physicals (I will ship 100m barrels of oil to you in Hamburg by next week). Names like Glencore, Ospraie, Olam, Philipps Brothers, Red Kite Metals

Welcome to a new world

And that’s just the beginning. What most laypeople fail to understand when they lump hedge funds together is the world of difference between what the various strategies do and who these people are.

An Australian Glencore trader who goes to a coal mine in Newcastle, buys 1m tonnes of coal, and then ships it to China where a power plant in Shenzhen would be forced to shutdown and create a blackout if it didn’t get coal on time.

is very different from

An equity long/short guy who sits at a Bloomberg terminal in a dingy building in Hong Kong, listening to endless company calls for these small mainland Chinese companies, buying stock in them while being short the market.

The skill sets, the risk-return, the value to society, the actual people, personalities, are all completely different.  The difficulties of the job, the people they communicate with, whether they build a business or just do some trades.

So hedge funds as a whole are never going to go away, and are never going to implode. Individual funds, certain strategies, at certain times, will perform badly. Like in any other industry, there will be some instances of fraud. But the only consistent thing about the industry is allowing a small number of people to play with large amounts of money and get paid like stars.

April 3, 2008 Posted by | Hedge Fund, Private Equity | , , , , , , , , , , , , | 1 Comment