Overview
Any HF or FoHF manager who enters the insurance, reinsurance, or banking industries usually does so in order to:
(1) raise a significant amount of permanent capital;
(2) take advantage of systemic inefficiencies available in reinsurance or banking;
(3) significantly improve returns without a proportionate increase in risk; and/or
(4) provide superior liquidity, income tax, UBTI, and ERISA solutions to investors
In doing so, the HF or FoHF manager should also gain a very valuable option with respect to monetizing some or all of his or her HF or FoHF management firm.
The hedge fund industry has experienced a combination of growth and profitability unprecedented in the history of business. If a widget industry had the same growth and profitability metrics that the hedge fund industry enjoys, 99% of the profitable ones could easily monetize some of their business by selling out and monetize all of their business by selling out or going public.
On the other hand, we believe that fewer than 5% of all HF and FoHF managers will ever get one penny for any part of their business, because the hedge fund industry does not lend itself to being bought out or to be a public company, which are the two primary means of monetization.
The IPO of a HF or FoHF Manager
For most companies, an IPO not only monetizes the business, it also raises capital that can be deployed to increase profits. In addition, it provides currency to make acquisitions, decouples its shareholders from the lock step timing of their individual monetization, and provides a more meaningful equity incentive for up and coming talent in the firm.
HF and FoHF managers do not require very much capital and, even if the proceeds were deployed in the investment strategy of the manager, it is unlikely that their portion of the balance sheet would command a premium to book value and might even cause the company to trade at a discount to book (although book value could rise significantly as returns and fees compound).
As such, the proceeds of most IPOs in the space have gone to selling shareholders rather than the company and the firms intend to pay out most, if not all, of their earnings (because they cannot put them to work effectively as well as for tax reasons in the U.S.).
Another negative aspect of an IPO for a HF or FoHF manager is the level of disclosure required. In an IPO, the company must bare its innermost secrets, even though the IPO may not be successful. Even if the success of the IPO were guaranteed, baring the innermost secrets of a HF or FoHF manager is antithetical to the hedge fund culture. After the IPO, Sarbanes-Oxley would likely be a cultural nightmare for any publicly traded HF or FoHF manager that chose to list in the U.S. and flotation in other markets might not make as much sense if there is no natural connection to that market.
Investors in publicly traded companies like to see smooth upward growth in earnings. This is a problem for a publicly traded HF or FoHF manager, because EBITBA (Earnings before interest, taxes, bonuses, and amortization) will be somewhat dependent on performance and earnings could fluctuate violently unless assets grow at a tremendous rate. The problem of accelerating AuMs is the law of diminishing returns. In the hedge fund business, size kills and absolute size kills absolutely. If returns fall, and redemptions accelerate, it could have a disastrous effect on the stock price.
Lastly, the above negatives apply in today’s tax environment but would be magnified and/or pale by comparison if proposed legislation altered the current U.S. tax laws. At this time, U.S. based hedge fund managers doubly benefit from tax treatments of their domestic funds and their deferred compensation plans for offshore funds. These benefits have been preserved to some degree by using REIT-like tax rules for the publicly traded HF or FoHF manager.
However, legislation has been proposed to close these down for publicly traded HF or FoHF managers (it may ultimately fail to pass, grandfather those already public, or could ultimately extend to privately held hedge fund managers as well). If the ultimate scenario applies only to publicly traded firms, there will be even less reason go public than there is now.
A Total or Partial Sale of a HF or FoHF Manager
The history of acquiring all of a HF or FoHF management firm has not been great. The assets go down the elevator every night. HF and FoHF managers are a very entrepreneurial class by definition, while almost all potential acquirers are large financial institutions, run by bureaucrats and technocrats (Sarbanes-Oxley anyone?) and cultural clashes are inevitable. In almost all cases, the principals in the HF or FoHF management firm that has been totally acquired leave at the first opportunity.
Partial sales seem to work better, although the lesser the amount acquired, the more likely that both parties will be satisfied. When a majority stake or large minority stake is acquired, the two parties end up in a deadly embrace, particularly if the acquirer has provided institutional credibility that has allowed the HF or FoHF manager to grow rapidly. For the buyer, acquiring the balance could be very costly and could ultimately drive the principals (who have stayed to protect their remaining stake) away. For the principals, purchasing the institutional piece could put them in debt for the rest of their lives.
Anecdotally, we know of a situation where the institution acquired a majority stake, but the hedge fund manager has consistently posted better results than the institution’s proprietary trading desk. He has repeatedly asked for the opportunity to run the prop desk, only to be rebuffed by the politics of the institution. The founder of this firm is the most unhappy, seriously rich, person that we know.
Smaller minority stakes (10% to 20%) seem to work far better, particularly if the acquirer has distribution capabilities that could help the HF or FoHF manager grow by a percentage greater than that acquired. If a manager sold 15%, but the acquirer helped it grow by 15% or more than it would have otherwise grown, then the seller has a smaller piece of a much bigger pie (and has not lost anything) and has pocketed the sales price in the process. Assuming the buyer has not paid too much, there are often synergies that result from the new relationship that further enhance the buyer’s ROI beyond cash on cash returns.
These transactions can occur in many forms from a purchase of percentage of equity to a purchase of a percentage of revenues. They can also target management fees only, performance fees only, domestic fees, only, offshore fees only, or any combination of these in equal or differing proportions. Depending upon the jurisdictions of the buyers and sellers, the tax and regulatory regimes can make all the difference as to whether or not a transaction can or should consummate and in which form.
Reverse Mergers
A variation of both selling out and an IPO is the reverse merger, whereby some or all of the HF or FoHF manager merges into a company that is already publicly traded. In 2007, GLG, a British hedge fund manager merged into Freedom Acquisition Corp, a Special Purpose Acquisition Company (or “SPAC”) and began to trade on the New York Stock Exchange. Also in 2007, Carl Icahn merged his investment management company into an REIT that he already controlled.
Relative to selling out, the manager may take advantage of a reverse merger without losing control. Relative to an IPO, proxy disclosure is less onerous than IPO disclosure and success is far more likely at the time of disclosure than in an IPO. A reverse merger can have significant positive or negative tax ramifications that are too complicated to cover in this piece and if merged into a SPAC, there can be a substantial frictional cost (estimated at $500 million in the case of GLG) for the HF or FoHF manager.
Should a HF or FoHF manager sponsor a startup insurer, reinsurer, or bank, that entity could ultimately acquire some or all of the manager (as in the Icahn case). The manager could then enjoy the benefits of monetization on a basis that is advantageous to both the manager and the acquiring institution in ways that would be unlikely for a less connected combination and the manager can further consolidate his control of the public company. Under this scenario, the HF or FoHF manager begins to look a lot more like Buffett.
One of the benefits of monetization through a reverse merger into an insurer, reinsurer, or a bank that was sponsored by the HF or FoHF manager (as opposed to an IPO or a reverse merger into a SPAC or another public shell) is that the earnings of the far larger institution are less dependent on the earnings of the HF or FoHF management business to meet growth targets. Thus, the HF or FoHF manager can get full value for his or her business without the long term risk imposed by the pressures to grow AuMs. In addition, the HF or FoHF manager controls something that has far more gravitas or clout, while after market liquidity and attractiveness for institutional investors becomes far more likely.