Hedge Funds May Be Worth Less Than You Think
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Oct. 13 (Bloomberg) -- There is no quicker way to make lots of money than starting a hedge fund, right?
Wrong. Hedge funds may not be worth as much as you think.
The evidence from the two listed hedge fund operators in London -- including Man Group Plc and Rab Capital Plc -- is that even though such investments are good ways to boost income, they aren't generating great returns for the managers. You might be better off going into, say, plumbing supplies, or Internet poker, both of which may have better growth prospects.
In effect, the market is saying the hedge fund industry has little growth left in it.
``The market doesn't put much of a premium on hedge fund profits,'' said Tim Price, senior investment strategist at Ansbacher & Co. in London, in a telephone interview. ``The quality- of-earnings issue is paramount.''
The hedge fund industry has exploded in recent years. It had an estimated $1.03 trillion in funds under management in the second quarter, according to Chicago-based Hedge Fund Research Inc. Big names are still drifting across from mainstream investment banking into hedge funds. Only last month, for example, Pequot Capital Management Inc., a U.S. hedge fund, said Byron Wien, Morgan Stanley's senior stock market strategist, would join as chief investment strategist.
$1 Billion
No one would doubt that the founders of those companies are making a lot of money, mainly through paying themselves huge dividends and salaries. Edward Lampert, chairman of Greenwich, Connecticut-based ESL Investments Inc., earned $1 billion last year, more than any other hedge fund manager, while the average earnings for the top 25 executives in his industry rose 21 percent to $251 million, according to Institutional Investor's Alpha magazine. That sounds like more than enough to get you out of bed on a Monday morning.
The mystery is why companies that are making enough money to pay $250 million-plus salaries don't want to list their shares.
It is clearly not because they don't have the cash flow. Nor can it be because their owners aren't interested in making money - - why else would you start a hedge fund?
The hedge fund frenzy is often compared to the dot-com boom of the late 1990s, and with good reason: Both have attracted lots of clever young entrepreneurs, intent on getting rich fast. There is a key difference, however. While the dot-com managers created lots of quoted companies that had little revenue, the hedge fund industry has done the opposite. It has come up with companies that have plenty of revenue, yet very few of them are quoted. Whereas the Internet entrepreneurs created capital, not income, the hedge funds create income, yet very little capital.
P/E Ratios
Why's that? There is a clue in London. Its two quoted hedge funds have been denied market endorsement. Two companies may be a small sample, but since they are the only two quoted hedge fund companies, there isn't anything else to go on.
Man Group trades at a historic price-earnings ratio of 14, according to Bloomberg data, and a prospective ratio of 11. By comparison, Amvescap Plc, a large U.K. money manager, trades at a prospective P/E ratio of 17 and Aberdeen Asset Management Plc is at 21. So the market is telling us that each pound or dollar Man Group earns is less valuable in relative terms.
Rather surprisingly, plumbing supplies may be a better business to be in than hedge funds. Wolseley Plc, a U.K. plumbing distributor, trades on a prospective P/E ratio of 12, slightly more than Man Group.
Likewise, RAB Capital, whose current P/E ratio is 16 and whose forward ratio is 13. The company more than doubled its profit in the first half and increased management fees by 41 percent. Yet it is still valued as if it were an average business. For example, the FTSE 100 index had an average P/E ratio of 20 in the week through Oct. 7.
20 Percent Fees
There is a straightforward explanation for that. The relatively low price put on the hedge fund companies says two things. First, the rapid growth rates of the industry probably won't last. Next, the 20 percent performance fee that hedge funds typically charge can't last, either. In effect, the business model the hedge funds have created won't work much longer.
``In times past we have argued that Man Group's hedge fund business deserves to trade in the midst of the trading range for traditional asset managers of 15 times earnings per share to 20 times earnings per share,'' Credit Suisse First Boston said in a recent note on Man Group. ``Increasingly we believe that the market is unlikely to ascribe such a valuation to Man Group, given high fee structures and the concerns over their longer-term sustainability.''
`Drop in the Ocean'
There are plenty of worries about hedge funds. The performance fees may eventually have to come down. And most of the firms are dependent on a handful of talented individuals.
Were they to walk out the door, the companies they work for would be less valuable. Maybe that is why the market doesn't trust them. A company such as ESL wouldn't be worth much without Lampert.
That may not mean there isn't some growth left in the industry. ``The market is assuming that the flood of money into hedge funds is going to slow down,'' Price said. ``I'm not sure that is the case. It is still just a drop in the ocean of the total asset management industry.''
Right now, that isn't what the market is telling us.
That explains why very few hedge funds have gone public, even though they've generated huge profits. If there is one thing hedge fund managers are good at, it is spotting undervalued assets, all the more so when the asset in question is their own company.
And until the market changes its mind about hedge funds, none of the companies will follow the lead of Man Group and Rab Capital and list their shares. If the market won't put a fair price on them, why should they go public?
