Background
The HF or FoHF structure is inherently unstable and many HF or FoHF funds have “blown up” when they suffer losses, which trigger redemptions, requiring untimely liquidations and a spiral of additional losses, further redemptions, and more liquidations may repeat itself (often more than once). Leverage further exacerbates this spiral because its availability is often tied to asset values and thus, it may either be pulled or it can require multiple liquidations (per dollar of redemption) into falling markets, which further depresses prices and may kick start another round of redemptions, liquidations, and losses.
Because of the “high water mark”, many HF and FoHF employees leave during these cycles of loss, redemption, and liquidation, since they are unlikely to see any incentive fees for several years no matter how well they perform if they stay, but, if they join another firm, even a startup, they can immediately be rewarded for performance. By the same token, no one is likely to join a firm undergoing one of these cycles, since performance and compensation are disconnected until the high water mark is achieved.
“Blowing up” rarely means that investors lose all of their investment, unless fraud is involved. However, investors often realize additional if not meaningful losses when a fund “blows up”, and a “blow up” usually means that significant redemptions have reduced the organization and/or the fund to a level that it is no longer able to realize the returns envisioned or the fund manager is unable or unwilling to continue to operate it.
This is what happened in 2000, when XL Capital funded Front Point for two of the most senior members of Tiger Management. A number of the Tiger staff followed them out the door, and no one was available to replace them. As such, the largest hedge fund in the world went out of business, not because its investors lost everything, but because there were too few people left to service the remaining assets and investors continued to redeem until Tiger finally decided to return all remaining funds.
When Tiger disbanded, it had $6 billion in AuM, which would still have made it one of the largest hedge funds at that time and more than viable in terms of size (even today) . It just couldn’t service those assets. Nobody was home.
Ironically, while Tiger investors endured losses relative to the high water mark, many of them were long time investors who had actually prospered mightily from the time of their original investment in Tiger until their funds were returned. This is analogous to finding a stock early, riding it upwards, and then watching it back off 20%. At any time, investors can choose to take a healthy profit or stick with the stock. In Tiger’s case, the early investors had still done exceedingly well; they just never had the opportunity to stick with it.
Lock Ups and Closed End Funds
In the hedge fund industry, the traditional remedies for this problem are lock-ups ( including variations, such as longer redemption and notice periods and gating) or closed end funds. Lock-ups and their variations usually meet resistance from investors. Part of this stems from the fact that they sometimes exceed the real amount of time that a manager needs for an orderly liquidation. Even when successfully negotiated, lock ups are often too short to take advantage of some of the opportunities for superior performance that require the longer term view.
Closed end funds are also difficult to raise, because history argues that they are likely to trade at a discount to net asset value. Thus, knowledgeable investors usually avoid them on the offering, preferring to take advantage of the sure discount in the aftermarket and purchase later on, if at all. If no one buys the offering, will there be an after-market discount to take advantage of? To a large extent, closed end funds often depend on “dumb money”.
There have been a modest number of closed end hedge funds and closed end funds of hedge funds launched in the UK because two types of investors were willing to suffer a discount to NAV, provided that it was not too great: (1) taxable investors in the UK used to get far better tax treatment in closed end funds (in comparison to open ended funds), although new UK tax rules are expected to eliminate some of this benefit; and (2) certain regulated entities can only access the returns of hedge funds and funds of hedge funds through closed end funds.
However, in order to succeed, most of these closed end funds have to promise to buy back shares in the open market if the discount becomes too steep, so it is questionable whether or not this is really permanent capital or more like semi-permanent capital (which is nonetheless far better than the normal HF or FoHF structure).
Furthermore, in one case, a large FoHF manager, FRM, was replaced as the manager of a closed end fund by Permal. Because the discounts have tended to be greater than tolerable (they should become even less tolerable if new tax rates are instituted in the UK) and because the universe demanding these benefits is somewhat limited in the first place, we feel that closed end HFs and FoHFs will likely become nearly impossible to launch in the future.
The Buffett Model
To the extent that a hedge fund is defined as a non-traditional investment strategy that actively buys and sells publicly traded securities (as opposed to private equity or real estate), seeks to generate alpha, absolute returns, and asymmetric returns, and primarily rewards its manager with a percentage of the profits, then it is arguable that the best known and most successful person to have ever run a hedge fund for more than 10 years is Warren Buffett. He solved the problem of permanent capital by ceasing to be a hedge fund manager and going into the insurance, reinsurance, and banking industries instead.
Warren Buffett started the Buffett Partnership in 1956 (long before the term “hedge fund” was as ubiquitous as it is today) with $100 of his own money and less than $100,000 from friends and family and began working from his bedroom in his parents’ house. He always beat the bench marks (alpha), never had a down year (absolute returns), and always emphasized taking risks only when potential rewards more than justified them (asymmetric returns). He charged no management fee and a performance fee of 25% of profits in excess of 6%. God forbid, he even took short positions. Contrary to his current “Gotrocks” polemics, he sure sounded like a hedge fund manager to us.
13 years later, Buffett’s fund had produced returns of approximately 30% since inception (net of fees), was roughly $100 million in size, and Buffett’s share was $25 million. However, by 1969, he had accumulated a 70% stake in a publicly traded textile company called Berkshire Hathaway. If today’s hedge fund manager accumulated a 70% stake in any publicly traded company, he would be marked for life.
If Buffett had stumbled prior to 1969, he would have likely had redemptions, would have been unable to liquidate Berkshire in an orderly fashion, causing more losses and further redemptions, and might have suffered the same fate as Tiger. Instead of becoming the “world’s greatest investor”, he might have become a candidate for Greg Newton’s Hall of Shame.
As pointed out earlier, Mr. Buffett cleverly solved this potential redemption and liquidity problem: he simply quit managing his “hedge fund” - cold turkey. To do this, he liquidated the Buffett Partnership and made a distribution in kind (which is tax free). Through horse trading and the liquidation of other positions, he increased his indirect stake in Berkshire from 17.5% at the time the partnership was dissolved to a direct stake of 41%.
Prior to the dissolution of the Buffett Partnership, Berkshire had acquired insurance, reinsurance, and banking businesses. Because of the interests in the insurer, reinsurer, and bank and because his 41% stake (and the other 29% held by his former partners) gave Buffett control of Berkshire, he was able to continue to invest in publicly traded securities without being deemed to be a closed end fund and running afoul of the Investment Company Act of 1940 (11 years later, regulators made him give up either (re)insurance or banking and he sold off Illinois National Bank).
Furthermore, Buffett could continue to deliver superior returns, because: (1) permanent capital allowed him to pursue less liquid opportunities (he has acquired 72 whole companies); (2) he had access to leverage through the “float” (insurance and reinsurance premiums and bank deposits until 1980 – currently $50 billion), which was not only cheaper than borrowing, it was not tied to asset values or their liquidity; and (3) he could defer taxes and invest the deferred taxes (currently $20 billion). In essence, instead of being a 0% plus 25% over a 6% hurdle manager (compared to the 1% and 20% manager of today), Buffett became a $100,000 (his famous salary) and 41% (with no hurdle) manager.
Even today, if a hedge fund is defined as a non-traditional investment strategy that actively buys and sells publicly traded securities (as opposed to private equity or real estate), seeks to generate alpha, absolute returns, and asymmetric returns, and primarily rewards its manager with a percentage of the profits, it is arguable that there is still a lot of hedge fund manager in Warren Buffett.
Non-traditional investment? Currency trading? Sounds like global macro to us. See’s Candies, NetJets, Nebraska Furniture Mart? Don’t you just love the smell of synergies in the morning? Insurance and reinsurance risks? For the first 41 years, Berkshire had never had a cumulative underwriting profit. However, as Buffett has often pointed out, his “cost of float” was generally less than 1% per year and was not correlated to asset values as normal leverage is (meaning it cannot be pulled if asset values are down as margin loans often are). 2006 was one of the greatest underwriting years in the history of the insurance and reinsurance industries (no major disasters or shocks in the tort system) and Berkshire’s cumulative underwriting results turned profitable for the first time (finally giving him a negative cost of “float” over the history of the company).
Marketable securities? A $70 billion portfolio with $50 billion of unrealized gains in it (BRK’s total net worth is roughly $100 billion). Yet, in the best of all underwriting years, Berkshire’s unrealized gains were still 7 times greater than the underwriting profits. No wonder the “world’s greatest investor” is never referred to as the “world’s greatest insurance guy”.
Alpha? The first page of Buffett’s annual letter shows each year’s performance against the S&P 500 (which he has beaten 32 out of 42 years) and the relative compounded values since inception (by which he has soundly trounced the index).
Absolute Returns? Buffett’s first rule is to never lose money. His second rule is to see Rule #1. In fact, Berkshire Hathaway has only had one year where its book value per share decreased (when the dot.com bubble burst, it took everything down, even the old economy fuddy duddies like Buffett and Tiger).
Asymmetric Returns? Buffett says, “When Charlie (Munger) and I do not see anything we like, our default position is Treasuries. We hate taking risks and only do so when the rewards are compelling and relatively sure. Our idea of real risk is eating cottage cheese one day past its expiration date”.
Performance fees? 41% is pretty good. He certainly never got rich on the $100,000 per year.
Reverting to the year 2000, it is useful to compare Berkshire Hathaway and Tiger Management at that time. Both were value investors. Buffett and Julian Robertson were derided and criticized by pundits and investors alike for failing to “get” the new economy and for failing to jump on the technology band wagon. They were both heavily invested in U.S. Air.
Even though they never went over to technology’s dark side, they both suffered significant portfolio losses when the dotcom bubble burst. However, in contrast to Tiger, unhappy Berkshire investors could not redeem, but could only sell their shares. And while Berkshire’s price suffered, Buffett did not have to pour gasoline on the fire by having to liquidate assets as Tiger did. Buffett could continue to invest as he had historically.
Those investors who stayed with Buffett were rewarded for their patience. Those who would have wanted to stay with Robertson were not only unable to do so, but were trampled in the stampede if they tried to.
As a pure hedge fund manager, Buffett was successful by any standard. However, because he quit the hedge fund business as we know it, he has been able to achieve a legendary level of success that is unlikely to be attained by any of today’s HF or FoHF managers who exclusively use the traditional hedge fund structure.
Replicating the Buffett Model
A HF or FoHF manager does not need to take such a drastic step as quitting the HF or FoHF management business cold turkey as Buffett once did. Instead, the HF or FoHF manager can simply sponsor a startup in the insurance, reinsurance, or banking industries (whereby he or she would manage all of the investable assets of the startup) and treat the foray as he would another new product launch.
In order to do this, it is more than helpful if the new business becomes publicly traded as a startup, because the HF or FoHF manager’s clients and (unaffiliated) Strategic Investors will be willing to make larger commitments if their commitments are conditioned on the success of an IPO and the greater their commitments, the more the public is likely to invest in the IPO.
The best way for the HF or FoHF manager to convince investors of these benefits is to make the largest possible personal financial commitment to the new company (because the HF or FoHF manager believes he or she will achieve better returns than investing the same amount in his own funds).
Based on the HF or FoHF manager’s level of personal commitment (also conditioned on the success of the IPO), many of the HF or FoHF manager’s clients should also commit conditioned on a successful IPO because they will get several significant benefits (relative to directly investing in the same HF or FoHF strategy): (1) higher returns, without taking a proportionate increase in risk; (2) daily liquidity instead of lockups, periodic liquidity, notice periods, and gating; and (3) tax deferral on annual returns for U.S. taxable investors and lower rates on sale of the shares for U.S. and UK taxable investors. The merits of these will be covered in the next section “Superior Returns”.
Financing a startup with an IPO runs counter to conventional wisdom, but in insurance, reinsurance, and banking, there is significant precedent. In the insurance and reinsurance business, we have had direct involvement with three companies that raised their initial capital in an IPO: PartnerRe ($980 million in 1994); Annuity and Life Re ($360 million in 1998); and Scottish Annuity ($250 million in 1998). In 2005, Merrill Lynch raised $1 billion for Lancashire Holdings on AIM in London.
Virtually every bank in the U.S. was initially financed through an IPO. In fact, U.S. banks are exempt from registration under the Securities Act of 1933, because public policy was against concentrated power in banking and the government could diffuse it by making it easier for anyone to become a shareholder in any new bank (hence the exemption).
There are several reasons that a startup in insurance, reinsurance, and banking can finance itself through an IPO. Most new businesses only try to raise enough capital to get to cash flow breakeven, without diluting the founders more than is necessary. Because overheads in new insurers, reinsurers, and banks are relatively low as a percentage of equity capital, they are usually cash flow positive from the beginning.
Furthermore, founders of new insurers, reinsurers, or banks rarely get cheap stock (they usually participate in the upside through options and warrants, which have notional values proportionate to the size of the financing – that is an incentive for them to make the start up as large as possible), so dilution is rarely an issue for the founders.
Another reason that a startup insurer, reinsurer, or bank can raise its initial capital through an IPO (and allocate all of its investable assets to a HF or FoHF strategy) is that there are no diseconomies of scale. Most businesses raise an amount of capital to target a specific return on that new capital.
However, raising twice as much capital is unlikely to double the magnitude of the return, because the second increment of capital cannot be deployed as profitably as the original amount and the extra capital dilutes the founders. If an insurer, reinsurer, or bank invests the IPO proceeds in a HF or FoHF strategy, then twice as much capital should generate at least twice the returns and four times should generate four times etc. and size is an advantage in the insurance, reinsurance, and banking businesses.
First of all, size improves ratings so each entity can charge more for the same product or get the flight to quality nod when pricing is the same. Furthermore, they can attract better talent. Lastly, after-market liquidity is better and more institutions will be able to own the stock.
If an investment bank likes the story enough, it can sell air conditioning in the Arctic and hangar heaters in the Amazon. Investment bankers are paid on the number of zeros separated by commas, so size matters for them. Since most startups limit the size of their initial financings due to diseconomies of scale and dilution issues, and because they have significant downside risk, they are not attractive enough to get the attention of major investment banks. However, IPOs of startup insurers, reinsurers, or banks raising hundreds of millions, if not billions of dollars, with significant commitments from the manager, his or her existing clients, and/or Strategic Investors has limited downside risk and is a story that an investment bank can sell and the payday is very attractive.
Based upon the HF or FoHF manager’s demonstrated preference for investing in the startup (motivated by the prospect of significantly better returns than he would get in his funds not to mention the prospect of fees on permanent and semi-permanent capital equal 60 to 260 times his personal investment), he can craft a business plan and forecasts for the insurer, reinsurer, or bank and try to convince as many of his existing investors to follow him as is possible, but strictly subject to an IPO (no IPO, no obligation to invest).
Every investor who follows the manager converts his investment from something that can be redeemed to permanent capital. Furthermore, since a U.S. based manager can defer fees and reinvestment of fees on offshore income, an offshore investor is worth two to sixteen times future after-tax fee income to the U.S. manager than an identical onshore investor.
Thus, the manager could be far better off if each domestic investor converts to the insurer, reinsurer, or bank and the startup should significantly increase the U.S. manager’s future wealth (even if AuM did not grow), provided that current tax laws do not change.
Based upon the HF or FoHF manager’s personal commitment and the commitments made by investors who know him or her well, he or she can recruit management and a board, and try to convince Strategic Investors with recognized expertise in alternative assets and/or insurance, reinsurance, or banking to invest as part of the IPO (again, no IPO, no obligation to invest).
If the commitment from the manager and his clients is less than $50 million, it is unlikely that any Strategic Investor of note will join. However, at $50 million in personal and client commitments, it is still likely that that investment banks can raise another $50 million in an IPO, which should still create a total of $250 million to $1.25 billion in new AuM.
If the HF or FoHF manager and his investors are willing to commit $150 million or more, then Strategic Investors might invest $100 million or more. Because Strategic Investors validate the business strategy, the investment strategy, or both, investment banks may raise a far greater proportion of capital from the public (maybe as much as three times the committed capital, if the committed capital exceeds $250 million).
It is not beyond the realm of possibility that a $50 million commitment by the HF or FoHF manager could result in $100 from his or her clients, $100 million from Strategic investors and $750 million form the public, resulting in $1 billion of permanent capital. Even greater levels of commitment by some combination of the manager, his or her investors, and Strategic Investors, could magnify those amounts even more.
To place these greater amounts in perspective, a larger fund manager could arguably commit significantly more than $50 million, convince a larger number of its clients and Strategic Investors to commit billions, and a $5 billion, or even $10 billion IPO is not out of the question.
If an HF or FoHF manager could pull off a $10 billion IPO, the equity capital would be virtually equal to the 10th largest (re)insurer or 10th largest bank in the U.S. With $5 billion, the company would be equal to the 15th largest (re)insurer and 25th largest bank. With only $1 billion, it would be virtually equal in size to the 35th largest (re)insurer or 50th largest bank.
Semi-Permanent Capital
Equity capital, raised in an IPO, is only part of the permanent capital story. The equity should always be managed by the HF or FoHF manager and can never go away unless the company fires him (for complicated reasons, this is almost impossible to do, whereas in a closed end fund it is far easier).
However, insurers and reinsurers generate semi-permanent capital in addition to their equity by issuing policies and contracts for premiums and investing those premiums (net of operating expenses) until claims are paid. Banks can also generate semi-permanent capital in addition to their equity by taking deposits and using them to either make loans to or finance structured products for the HF or FoHF manager’s investors or directly invest in the hedge fund strategy.
While premiums and deposits are not as permanent as the equity capital, they are more permanent than most lock ups and far more permanent than margin financing, without having their availability being correlated to asset values.
Most hedge fund managers gather assets the old fashioned way. They take out their knee pads and tin cup and go begging on hand and knee – one investor at a time. This is a tough road. It generally requires an appearance by the founder and/or portfolio manager and disrupts their ability to maximize returns. Premiums (for insurers and reinsurers) and deposits (for banks) are wonderful alternatives that do not take anywhere near the same effort to generate and do not tie up the founder or portfolio manager’s time.
When a policyholder buys insurance, the insurer gets to hold the assets (less operating expenses) until a claim has to be paid. When an insurer buys reinsurance, the reinsurer gets to hold the assets (less the operating expenses) until the claims are paid. When an HF or FoHF manager sponsors an IPO for an insurer or reinsurer, he or she gets to manage the assets created by the premiums, without having to make a typical sales call. Underwriters generate the assets and do so without requiring the founder or portfolio manager to make an appearance (which frees them up to concentrate on maximizing returns)
In some forms of insurance or reinsurance, the interval of time between collecting premiums and paying claims is very short (property insurance). In other forms, the interval of time between collecting premiums and paying claims is much longer or very long (life, medical malpractice, warranties). Some forms of insurance and reinsurance can be quite volatile (hurricanes in the Southeastern U.S.), while others are less volatile (highly structured reinsurance contracts – even if the underlying risks are volatile).
In order to avoid one of Taleb’s Black Swans, the competitive advantage of the investment strategy allows the hedge fund sponsored reinsurer to contractually limit the magnitude of the worst possible scenario in exchange for leaving more of the underwriting profit with the ceding insurer (this is very attractive to very profitable insurers with capital constrained capacity limits).
Insurers and reinsurers can usually support premiums that create reserves of one dollar for each dollar of equity to three dollars for each dollar of equity, although higher and lower numbers might exist for differing lines of business. This means that insurers and reinsurers generate additional semi-permanent capital of 1 to 3 dollars for each 1 dollar of equity.
We generally use 2 to 1 (Berkshire’s level of leverage) for forecasting purposes. Even if policyholders quit buying coverage, these funds remain for a long time and if policyholders continue to buy, new premiums usually replace claims that are paid, so the level of semi-permanent capital is maintained (or continues to grow), arguably forever, which, in effect, makes it more or less permanent.
Banks can provide semi-permanent capital for the manager in two ways: (1) by lending to and providing HF and FoHF linked structured products (rated and unrated principal protected notes, rated and unrated fund linked notes, total return swaps, barrier options, letters of credit for captive insurers and reinsurers) to investors in the manager’s HF or FoHF strategies; and (2) by directly investing some of the deposits in the strategy itself (some credit strategies might be able to utilize most, if not all of the deposits this way).
For most hedge fund and funds of hedge fund strategies, the bank can take in 12 dollars of deposits for each 1 dollar of equity and use 10 dollars of the 12 dollars for lending purposes and 2 dollars of the 12 dollars as a “prop book”.
If the HF or FoHF strategy is conducive to margin lending or hedge fund linked structured products, then the deposit generated permanent capital could be any where from 2 dollars per dollar of equity (the “prop book”) to the full 12 dollars (also the “prop book” for certain credit strategies).
How permanent is capital from the structured products business? In 2004-2005, Man Group plc had four flagship funds. AHL and Man Global lost 5.4% and 2.7% respectively, Glenwood was only up 0.6%, and RMF was only up 3%. Any other manager would have hemorrhaged assets. At the time, Man had more than $40 billion in AuM, 68% of which were locked up in structured products with a weighted average life to maturity of nine years. The terrible performance barely made a ripple, because structured products are a form of relatively permanent capital.
A word of caution - unlike insurance or reinsurance liabilities, which can last for years, if not decades, deposits can leave rather quickly and as a source of “semi-permanent capital” might not be so permanent if the bank is not careful, although we have some developed methods to significantly mitigate this for most banks.
Summary
At the end of the day, the successful launch of an insurer, reinsurer, or bank can reasonably result in permanent and semi-permanent capital of anywhere from 60 to 260 times the investment that a HF or FoHF manager can personally make. Aside from the 7 to 14 times the return (10 to 20 times, if taxable) that the HF or FoHF manager can make as an investor over 10 years (as opposed to investing in his own funds), he or she also stands to earn incremental management and incentive fees each and every year that may be far in excess of the amount of his personal investment.
Because of their permanent and semi-permanent capital, insurers, reinsurers, and banks with large amounts of capital have gravitas. With their transitory capital, hedge fund managers risk becoming dinosaurs (Tiger showed that even the largest hedge fund manager can go out of business) and those that survive are unlikely to ever gain the kind of respect or clout that an insurer, reinsurer, or bank can have.