Direct Distribution (“Country Club deals”)
I have heard it said that New Yorkers trade stock, while in Dallas people “do deals.” Several years ago, I was invited to a breakfast hosted by a wealthy businessman to introduce his friends and acquaintances to a hedge fund manager on the West Coast. The two men had attended an Ivy League college together, and the Dallas businessman had invested successfully with the hedge fund manager for a couple of years. A little over a year later, the hedge fund blew up, losing most of its clients’ money.
That’s an example of what I call “country club deals,” where personal referrals drive investors’ decision-making process.
Most investors don’t have the tools, the knowledge or in some cases the time, to conduct adequate due diligence. Investors often confuse knowing someone personally versus knowing someone professionally. An investor with a longstanding personal relationship may find it difficult to ask the tough questions needed about an investment opportunity, and to obtain complete background checks, etc. At some point in the investment consideration process, the investor should either obtain or perform a professional background check that will look at four key areas: credit; criminal and civil records, education, and employment history. To gain access to such information, you will probably need proper authorization from the person you are checking.
Outside private investigation firms are the best ways to accomplish these checks; however, they are expensive. Also, while such firms can verify information such as employment dates, they probably will not be able to determine how well someone performed in those positions. Validating someone’s past job performance is often one of the toughest parts of the due diligence process. If the manager has a performance track-record from previous deals or funds, chatting with former investors is the best way to obtain some understanding of past performance. However, trying to gain access to the performance record of a manager when they were part of a substantially larger institution is significantly more difficult.
Typically, smaller deals or funds are marketed directly by the principals of the fund, whereas larger funds/firms will have an internal investor relations team responsible for marketing. It is also typical for private equity managers to hire outside placement agents to market their funds.
As we previously discussed, size does matter when managing capital or managing a fund. Small funds (or direct investment deals) may not have the proper level of resources to employ adequate analytical and support teams to run the business. Conversely, firms with a large infrastructure to support (dollars) may not have the option of raising a smaller fund during periods when market conditions warrant such moves. This situation may cause fund managements to overreach and raise funds at times when opportunities to effectively deploy capital are uncertain. This type of situation is most likely to occur in private equity and real estate funds. This situation developed during the early part of 2000 when many venture funds had trouble downsizing their newer funds while still supporting the bloated infrastructure created in the late 1990s.
One of the main components of good investment research is performing comparative analysis. For certain types of investments, such as mutual funds and individual stocks, this can be easy. However for alternative investments, it is usually much more complicated.
Hedge funds are different animals than most mutual funds. Whereas mutual funds usually have a precise mandate, hedge fund documents usually allow the manager a greater degree of investment flexibility. It’s also harder to get detailed transparency on hedge funds. Given the potential for hedging transactions to affect returns, it can be extremely difficult to get your arms around what is actually driving the results. With private equity funds, it is all about judging track records. Since you are investing on a prospective basis, all you have to analyze is the track record of previous funds and compare that to the current investment environment for the relevant sector.
In the area of hedge fund or fund of hedge funds comparative analysis, investors must have access to comprehensive databases that can provide performance data on similar types of funds and the appropriate indexes. That comparative analysis will set the stage for further analysis.
In the case of hedge funds, if a fund has meaningfully outperformed similar strategy funds during a difficult period, you should investigate what actually caused the results. A lot of things can drive traditional long/short hedge fund results: the amount of leverage, the ability to successfully hedge positions, long stock selection, short stock selection, just to name a few. When analyzing long/short equity hedge funds, it is important to understand the short position attribution to determine if the fund is really a long equity fund with hedges that may drag down overall returns or whether the short positions actually contribute to the long-term performance.
An area that most high net-worth investors significantly underestimate or miss altogether is the interrelationship of the capital markets.
There are many participants in today’s capital markets; financial dealers, hedge funds, program traders, traditional institutional investors, retail investors and regulators.
While investors, both institutional and retail, often expect markets to move in a predictable fashion, a change in any one of the capital market participants can alter normal relationships. For instance, markets may not perform as expected if dealers decide to increase or decrease their internal levels of risk. Altering traditional inter-market relationships can impact hedges, causing investments to experience increased volatility.
While interest rates can have a direct impact on the capital markets, they can also affect returns in an indirect way. For instance, when a hedge fund sells short a stock, that transaction creates a cash balance at the fund’s prime brokerage account, which earns interest for the fund. In a normalized rate environment, that short interest rebate may earn 4 or 5 per cent annualized. If a fund typically has a 30 percent net short position, the interest earned on corresponding cash balances might contribute 1.2 percent to 1.5 percent in annualized returns. In a 1 percent interest rate environment, the fund would earn substantially less. One needs to adjust expectations when comparing a fund’s results during a period of higher interest rates versus lower interest rates. Also in areas like convertible arbitrage, it is important to relate previous performance to the equity capital market cycle for that period.
One thing that is often hard for part-time investors to adequately judge is the appropriate level of fees and expenses. In areas such as private equity and real estate, it is often customary for the fund manager to charge the underlying portfolio investment a management fee or transaction fee. The fees may be a necessary but evil part of the structure, or they may create incentives for the managers to focus more on executing transactions than the actual returns to the investors.
Fees may also be driven by market conditions. Also, in new funds, it is very difficult to understand the impact that the manager’s former firm had on their success during their previous employment. We see the headlines all the time about a team from a big investment bank leaving to start a new hedge fund. You need to ask yourself: Was this a good team in a great place or just a great team?
In some areas, such as private equity funds or direct private placements, commitment deadlines can make the decision process hard. The time limitations may prevent investors from performing a high level of due diligence and research on the investment before committing. Investors would be better to pass on the opportunity instead of jumping in without doing their homework.
Returning to my original story of club investing, the fund presented by the Dallas businessman had higher returns than other funds in the sector. However, the fund had used various techniques to boost results. These include purchasing so-called Pipe deals (private investments in public equity) and entering into levered total return swaps. In this particular case, comparing funds that had lower returns (and lower volatility) to the higher returning fund produced some stark findings.
The higher returning fund had significantly less infrastructure; support staff, office setup, etc. Because of its rapid growth, it had staffed up rather quickly and management was not as well-defined. The more established funds (with lower total return) had significantly more seasoned management teams and better operating methods, including risk control. Understanding the sector can make the difference between investing in a good investment or a financial disaster. If an individual invested solely on the personal referral and the shorter term track record, they would have been extremely disappointed when the fund had to be liquidated.