Investment Firms Open to the Masses, But Should You Buy?
NEW YORK — In February, Fortress Investment Group, a manager of hedge funds and private equity, enjoyed a successful initial public offering. Now, Blackstone Group, a premier private-equity shop, is preparing to go public as well. And Wall Street is abuzz with promise of more to come.
But are shares in these alternative investment firms a good deal for small investors?
Some money managers say they wouldn’t touch these offerings with a 10-foot pole. Why should they buy, they ask, when the best and the brightest who run these firms are cashing out?
“If I were smart enough to start one of these, I certainly would want to find an exit strategy,” said David Dreman of Dreman Capital Management.
But others say the alternative investment market has not reached its peak. Many U.S. companies with strong balance sheets are still attractive acquisition targets for private-equity firms, analysts say, and institutional players on a continuous hunt for
above-market returns are more than willing to supply the money.
“Fund flow from the pension funds are providing alternative investment groups with sustained revenue sources,” said Doug Couden, portfolio manager for SCM Advisors. “That’s good for the firms, which should be good for the stock.”
Analysts say the main thing investors should remember is that buying Blackstone or Fortress shares does not grant them access to the funds those firms run or a stake in the companies they buy. Rather, investors get a small piece of the underlying management company, whose earnings are largely derived from fees charged on the funds.
“You just have to realize that you are very much a minority investor,” said Charles White, chief investment officer of ThomasLloyd Funds, which specializes in blending traditional and alternative investing techniques. “You’re not buying their venture capital investments. You’re not buying the same thing the private-equity partners are buying into.”
Helped by low interest rates and easy access to capital, private-equity firms have led multibillion-dollar leveraged buyouts of some of the most established names in corporate America in recent years. Private-equity firms combine their clients’ money with loads of borrowed cash to take publicly traded companies private. They typ- ically hold a company for several years, making management and business changes, before selling its shares back to the public.
Hedge funds are lightly regulated, aggressively managed investment pools that use complicated — and risky — strategies to generate big returns. There are more than 9,000 hedge funds managing an estimated $1.4 trillion in assets.
The best-known of these alternative investment firms have delivered annual gains of 20 percent or more to investors in their funds, but those gains come at a price. Private-equity firms and hedge funds charge their clients steep fees, typically about 1.5 percent of assets under management and 20 percent of the profits. (Traditional funds typically charge about 1 percent of assets under management.)
In its prospectus filed last month with the Securities and Exchange Commission, Blackstone said its 2006 earnings were $2.3 billion, including $1.55 billion in fees from the funds it operates. Fortress reported $255 million in management and performance fees during the first nine months of last year.
The companies say they are going public to access new sources of capital, to expand, to attract and compensate employees, as well as to pay down debt. Blackstone says it intends to raise $4 billion with its offering. Fortress’s raised $634 million, and its shares soared 68 percent on the first day of trading to close at $31. (It closed Thursday at $28.25 a share.)
Until now, most investors have been excluded from the alternative investment game by federal securities law, which limits access to sophisticated investors such as pension funds, university endowments and wealthy individuals.
While the door has opened slightly for small investors, anyone thinking about buying shares in alternative investment companies should be aware of the potential risks, analysts say. As with any investment, a company’s past performance should not be seen as an indication of its future returns.
For one thing, because most alternative asset managers are privately held, there isn’t a peer group of publicly traded companies against which investors can easily measure a prospective investment, at least for now.
“I think they’re a bit hard to value because of that,” said Couden, who nonetheless sees opportunities within the category and does not rule out buying such stocks in the future.
Furthermore, these companies have been structured for tax purposes as limited partnerships. That means people who buy units in the partnership don’t have the right to elect directors. The companies say investors should not expect much disclosure about operations, including investment strategies.
And when it comes to strategy, investors should remember that while hedge fund trading methods have generated stellar returns, they can also backfire. Last year, a big bet on the direction of natural gas prices by a trader at Amaranth imploded, producing a $6 billion loss and forcing the hedge fund’s closure.
Interest rates are another factor to consider, analysts say. The returns generated by these companies’ funds may suffer if the currently cheap cost of corporate debt rises. That could shrink the fees charged by fund managers and, in turn, the profits passed along to shareholders.
Analysts also say the stocks may face downward pressure if performance falls off and alternative investment managers have to justify the fees they take from the funds.
In 2006, the broader market measures had exceptionally strong returns, making it tough for alternative players to beat them, particularly once those fees are factored in. Hedge funds returned an average of 12.9 percent for 2006, according to Hedge Fund Research, slightly less than the 13.6 gain by the Standard & Poor’s 500stock index.
Robert Lutts, chief investment officer at Cabot Money Management, said Fortress shares were performing well so far, but he likes to let new stocks get a little bit more established before buying.
“There are so many more opportunities than there were before,” he said. “There is also more room to make mistakes — great opportunity means more risk."