Grotesque rewards and mediocre returns of hedgies
First published in the Sunday Times on 8th March 2015.
I have always been an active investor. The epithet is often conflated with activists, who are the modern-day equivalents of corporate raiders. These were notorious figures on Wall Street in the 1980s. Typically they would buy stakes in sleepy public companies, then threaten to call an extraordinary meeting and replace the management, or sell the entire corporation. Often the frightened board would pay off the raider. Saul Steinberg, for example, was the antihero of Storming the Magic Kingdom, a terrific book from that era about the attack on the Walt Disney Company.
The principal criticism of so-called activist investors is that they are short-term. Academics have argued that pressure from wolf packs of speculators leads to companies cutting capital expenditure, destroying jobs and even breaking themselves up — all to deliver a quick turn to transient money.
Of course, sometimes agitation can lead to the removal of weak chief executives and better long-term performance too. The best-known American activists are hedge fund managers such as Carl Icahn, Bill Ackman and Daniel Loeb. Some have excellent investment records. But the wider effects of their campaigns on the economy are harder to judge. There are few British equivalents: the best known is Sherborne Investors, run by Edward Bramson. It is currently targeting Electra.
I call myself an active/activist investor because I get involved with the companies I back, and make concentrated bets. But essentially I undertake only agreed, long-term transactions. I want to partner with management (very often founders) to grow their companies.
From time to time I will take a minority stake — thus owning less than the entrepreneur running the business. Classic activists target complacent quoted companies where institutional investors have been too busy or lazy to challenge the incumbent board.
To me the very phrase “passive investor” conjures up images of allowing life to happen to you, rather than taking charge of your own destiny. However, an increasing proportion of savings do flow towards fund managers who pursue such a policy by tracking one index or another. Such investors are the opposite of stock pickers; computer programs should be able to do the job.
Firms such as Vanguard, Fidelity and BlackRock have huge businesses running low-cost trackers or exchange traded funds. I approve of such vehicles because they offer balanced equity exposure with very low fees. For most conservative savers I would recommend that they use such low-cost channels to access stock markets and achieve diversification at a sensible price.
By contrast I am a confirmed sceptic of the merits of many hedge funds. For those who want a comprehensive analysis of their flaws, I strongly recommend a short but expert text called The Hedge Fund Mirage, by Simon Lack. He has spent over 25 years in that world, and demonstrates empirically how overall results for clients have been poor, while fees for the industry have been disproportionate. That explains why his book’s subtitle is The Illusion of Big Money and Why It’s Too Good To Be True.
I recently saw the machinations of hedge funds at work. A charity with which I’m involved has invested a fair chunk of its endowment over the past five years in a portfolio of such funds — a decision taken before I arrived. While the returns have been mediocre (at least in my opinion), the various layers of investment managers have done gloriously — raking in almost a quarter of the total income and gains received during the period as fees. This level of reward is simply grotesque, especially considering hedge funds are relatively illiquid assets.
The old remuneration structure of a 2% management fee and 20% carry must surely be disappearing given an era of low interest rates and very mixed returns from lots of hedge funds.
Observers might argue that private equity fees are similarly rich. Generally I would say that private equity managers have to do much more work for their backers. They must identify unquoted companies to back, often arranging debt; go on boards to help steward the business; and typically commit five years or more to every project. But I admit that the economics of a large private equity fund can be spectacularly profitable for the partners — even when a fund delivers feeble returns.
At Risk Capital Partners we have decided not to raise another fund because we don’t need external capital, and we want to focus entirely on making capital gains — rather than getting sucked into the game of running a fund for the management fees.
Active investing takes much more energy but is fundamentally more satisfying than staying entirely hands-off. Indeed, playing a genuine role in building a successful business, working constructively with management over the long term, is actually as fulfilling as receiving the profits that should stem from such endeavours.