...a company is worth as much as someone else is willing to pay for it.
-Louis Winthorpe III
Billy Ray Valentine once said that the best way to hurt rich people is by turning them into poor people. In one fell swoop, Fortress Investment Group made a lot of wealthy folks wanting for more.
I, like so many others, watched with bated breath as FIG opened for trading last week. As a former hedge fund manager, my career path has morphed from trader, to a trader that writes to a writer that trades. I left the stress of big money management a few years ago, conscious that I was likely leaving some meaty pay days on the table.
Not even I could imagine the opportunity cost.
By now, we all know the numbers. On the first day of trading, the Fortress IPO posted an eye-popping 68% gain, valuing the hedge fund at over 30 times last year's earnings. Lofty numbers to be sure, particularly when juxtaposed against Wall Street pace-setter Goldman Sachs, which currently commands an eleven multiple.
Granted, the management team at Fortress is a sharp collection of proven producers. To prove that point, or perhaps because of it, the top five managers spent the weekend worth an estimated $10 billion dollars. In the uber-competitive world of hedge funds, you can bet that many of the 9,000 players in the space spent some time with a calculator before thumbing through the Robb Report or perusing timeshares at Marquis Jet.
I've learned through the years that the basis of valuation on Wall Street is a matter of psychology. That, no matter the metrics assigned or assumed, a company is worth as much as someone else is willing to pay for it. Just ask Mark Cuban. Or the lucky ducks at YouTube. Or the sorry lads from Enron. At the end of the day, supply and demand validates a vision or a venture. Capitalism in its purest form.
In a recent interview, I was asked my take on the current state of hedge funds. My response was that I want to be "long the quality and short the quantity." That would seemingly support a bullish stance on Fortress but there's a subtle yet important difference between investing in a hedge fund and buying the stock of one.
As an accredited investor, you're bound by uniform lock-up restrictions. As an equity holder, the exit doors are left unlocked and odds are that the public doesn't fully understand the inherent risks.
A stock is essentially a call option on earnings. That "option" is valuable when a company has a source of growth and a reasonable risk of attaining it.
How does a hedge fund retain and grow earnings? Two sources: management fees (typically 1% of assets) and performance fees (industry standard is 20%). The only way to grow management fees is to constantly grow assets. But as a hedge fund grows assets, it becomes harder to make money, sort of like a cruise ship trying to navigate a turn in a narrowing canal.
That leaves performance. But performance is risky: a hedge fund can lose money as well as make it. Additionally, the primary expense at a hedge fund is compensation. To retain intellectual capital, the fund must pay them a large percentage of what is made. That creates a law of diminishing return, either for the fund or for the talent. Neither are positive for shareholders.
This isn't a knock on Fortress. The people there are undeniably intelligent and have a track record to prove it. And it's not to say that the fund is the second coming of the Long Term Capital Management or Amaranth. Those were bad eggs and from what I can gather, the FIG Newtons are running a tight ship. They very well may be best in breed but, at the current multiple, there is precious little margin for error.
Paradoxically, while all eyes fixate on the battle for a Wall Street pecking order, the implications for the broader market war is vast.
If Fortress is the first of many hedge funds to tap the public appetite for risk--and more follow suit--the capital raised by these funds can then be leveraged, creating even more liquidity in the global marketplace. It could build to the point of exhaustion, but not before befuddling the bears who can't fathom the price action.
Somewhere in the back of my mind, nestled between unspoken jealousy and worn wisdom, I can't help but sense that we've all seen this movie before.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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