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Friday, August 11, 2006

Private Equity, Hedge Funds and the Struggle to Spend Cash

From Value Discipline

Uncorrelated returns, perhaps two of the more dangerous words that you may hear. What this boils down to is essentially performance that has a low correlation (statistically measured) versus a benchmark index.Low correlation means enhanced diversification, something that traditional hedge funds were designed to provide.But uncorrelated return does not equate to good returns. The Japanese equity market was beautifully uncorrelated with the S&P 500 through the 1990's. But the returns were not all that beautiful.

Affluent investors certainly gravitate toward hedge funds that access private equity and I must admit that I have utilized such funds myself. But do such deals always provide value? According to hedge-fund research firm, Greenwich-Van Advisors, hedge fund assets have grown to over $1.1 trillion from $480 billion back in 1999, a 15% CAGR versus an S&P market that provided -1% over that period!

Ultimately, this is not rocket science despite the brilliant minds that gravitate toward the area. Hedge funds do not necessarily represent a vehicle that is entirely separate from capital market returns, at least not the way many of them practise their craft. Capital markets' returns reflect the underlying wealth build or fall in the entire economy over time. In a 2001 study "Do Hedge Funds Hedge" by Krail, Asness, and Liew of AQR Capital Management,one of the conclusions was: "hedge funds seem to do a lot less hedging than simple estimates might suggest." Hedge funds as a group, at least according to this study, exhibited a beta of 0.85, that is 84% of the price movement could be explained by the S&P 500. For entry into this mystical rite, an investor pays 2% plus 20% incentive my view, a ridiculous toll. Nice work if you can find it, but is this sustainable?

At the last Berkshire Hathaway annual meeting, this was a topic that incited Charlie Munger to be much more vocal than usual: " Half the business school graduates at the elite Eastern schools say that they want to go into private equity or hedge funds. Their goal seems to be to keep up with their age cohort at Goldman Sachs. This can’t possibly end well."Which brings me to private equity. According to the Financial Times, "Private equity is struggling to spend cash as fast as it is raising it."There is an astonishing amount of capital that has come into the private equity arena. According to the artilce, about $300 billion in uncommitted, "un-called" capital is available to buy-out funds, representing core equity. Given the ability to finance at 4:1 debt, this represents about $1,500 billion in purchasing power, which equates to over 10% of the total market capitalization of the S&P.

This can be a very attractive proposition to the management of a company:

Increased ability to make significant long term capital project investments with less shareholder quibbling and criticism.

Set aside Sarbanes-Oxley compliance public investors, no SOX.

Less scrutiny and criticism of executive compensation arrangements.

Private ownership equates to overall privacy as to corporate strategy.

No public owners equates to no SEC regulatory and legal risks.In short, going private means less transparency, less visibility. Unfortunately, as a limited partner in a hedge fund per se, transparency is always an issue. This reminds me of John McMullen's quote regarding being a limited partner in the Yankees with George Steinbrenner, "Nothing is more limited than being George Steinbrenner's limited partner."

Transparency and disclosure is almost always a problem with hedge funds. Toss in a mix of private equity deals selected from a group of managers who crave privacy, and you have a rather uncertain fate. Oh yes, you also may be locked in for periods of five to ten years (or longer) waiting for the "Liquidity Event."

The public markets do not always recognize intrinsic value immediately, or in the short term. In the last seven days, my clients and I have benefitted from going private transactions in Aramark (RMK) (at too cheap a price) and Reynolds and Reynolds (REY) at a fair price. But private equity investors are lurking and their coffers are full of cash. Intrinsic value has a higher probability of being recognized more quickly, in my view with these characters around.As FT points out, buy-outs are becoming less selective. Having too much un-utilized money makes a private equity manager appear slovenly and out of tune with the times. These guys are not incentivized to hold cash. "If less discriminating buy-outs are the future, it is best to be on their receiving end."

The smartest way to be involved in private equity investing at this point may well be as a seller.

Disclaimer: I,my family, and clients have a current position in Berkshire Hathaway, Aramark, and Reynolds and Reynolds.

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