Thursday, November 1, 2001

Using Hedge Funds as Alternative Investment Vehicles

STANFORD GRADUATE SCHOOL OF BUSINESS—Dominic DeMarco, MBA '96, bets on companies that most large investors don't think are worth their time. He is a principal of Stadium Capital Partners, a hedge fund that focuses exclusively on small-cap firms —the 75 percent of US public companies with market capitalizations of under $500 million.

DeMarco was a guest speaker in finance professor Darrell Duffie's recent seminar for second-year MBAs, and provided an insider's view of the secretive world of hedge funds.

Stadium Capital, he says, has produced annualized returns of 30 percent since its launch four years ago, by focusing on undervalued stocks in the chronically ignored market segment of small-cap public companies. Such returns seemed low in the NASDAQ bubble years, but now look relatively healthy. "The bad news in a good market was that nobody cared about our stocks. The good news in a bad market is that nobody cares about our stocks," he said.

The low correlation between hedge funds' performance and the market's ups and downs is the main reason why such funds are valued as alternate investment vehicles. They essentially exploit market inefficiencies, using long or short positions to offset market risks.

By one estimate, the number of hedge funds grew 10-fold in the 1990s, exceeding 3,000 last year. The most famous is probably George Soros' Quantum Fund, which reportedly made $1 billion by betting on the British Pound's devaluation in 1992. Such a fund, focusing on global, macro-economic trends, represents just one possible strategy. Others include event-driven funds that focus on mergers and bankruptcies, for example.

Hedge funds are private investment vehicles, set up as partnerships. As such, they have more freedom and flexibility than mutual funds, which represent the more common form of pooled investment. By dealing with wealthy individuals through word-of-mouth, instead of soliciting business from the public, hedge funds are exempt from various registration and disclosure requirements in U.S. securities laws. Investment advisers warn that this greater freedom also amounts to a greater risk of fraud, especially as the number of funds multiplies. They are probably best left to sophisticated investors who are able to exercise their own oversight.

Hedge fund managers have strong incentives to perform. They receive an annual management fee of 1-2 percent, plus an incentive fee of 15-20 percent of profits. The latter is subject to a "high-water mark": it is earned only when the fund recovers past losses. As the industry matures, investors are also demanding hurdle rates: the fund is expected to surpass some minimum rate of return. Managers also tend to invest heavily in their own fund, and many are general partners with liability for losses.

A study by Carl Ackermann, Richard McEnally and David Ravenscraft notes that hedge funds' organizational features help align the interests of their managers and their investors, whereas most mutual fund managers do not receive incentive-based rewards.

The latter also enjoy less latitude, because they are more regulated and attract less sophisticated investors. "This combination of incentive alignment and investment flexibility gives hedge funds a clear performance advantage over mutual funds," they write.

Stanford Professor of Law and Business Joseph Grundfest, another guest speaker, highlighted the impact of the highwater mark on managers' psyche. "Say the highwater mark is 100 and you lose one-third of its value, to 67. You must then work for free to increase its value by 50 percent to get your head above water."

This means that hedge funds manager must control risk, contrary to their popular image as "wild, swing-for-the-fences types," he noted.

For Stadium Capital, the way to control risk has been to conduct in-depth research. Its principals believe that 6 to 10 positions are sufficient to eliminate 80-90 percent of portfolio volatility risk.

Indeed, a much larger portfolio would be too difficult to keep tabs on. So, it targets just 10 to 15 positions at any one time. It takes at least one or two months to study a company, including long meetings with its management and conversations with its customers and vendors, before making a core investment.

With one investment, it even meant standing in front of a K-Mart store to ask 300 consumers what they thought of the target company's brand. "In this market segment, hard work yields real, proprietary information," explained DeMarco.

For most hedge funds, however, private information is virtually impossible to get, argues Grundfest. "You have to play a level up," he says. "If venture capital is like playing poker, hedge funds are like chess. You're all looking at the same board. If the other player sees mate in four, can you see mate in three?"

Related Information

The Performance of Hedge Funds: Risks, Return, and Incentives, Carl Ackermann, Richard McEnally and David Ravenscraft, 1999, The Journal of Finance, LIV, No. 3 (June), 833-74

A Primer on Hedge Funds, William Fung and David A. Hsieh, 1999, Journal of Empirical Finance, 6, 309-33, Research Paper, PDF version

Research

Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans, Sandeep Dahiya; Manju Puri; Anthony Saunders, GSB Research Paper #1688, 2002

Bank Entry, Competition and the Market for Corporate Securities Underwriting, Manju Puri; Amar Gande; Anthony Saunders, GSB Research Paper #1525, 1998

Conflicts of Interest, Intermediation, and the Pricing of Underwritten Securities, by Manju Puri, GSB Research Paper #1383, March 1996

Bank Underwriting of Debt Securities: Modern Evidence, by Manju Puri, Amar Gande, Anthony Saunders, and Ingo Walter, GSB Research Paper #1384, March 1996

Manju Puri, Argument for Freeing Banks

J. Darrell Duffie, Short Selling May Affect Stock and Bond Prices

J. Darrell Duffie, Tax Shield May Make Convertible Bonds Attractive