HEDGE FUNDS - Making It Public

Hedge fund IPOs are the latest European export, bringing both capital and pressure to perform.

In August 2005, under a blue alpine sky, the 29 senior executives of Partners Group were navigating the steep climb from Lake Lucerne to the tiny village of Isenthal, Switzerland, perched some 8,000 feet up the mountainside. Co-founder and executive chairman Alfred Gantner was less anxious about the grueling hike than about the likelihood that the meeting he was headed for would reshape his company and the lives of everyone in it.

On the surface it was just one of five annual senior-executive meetings for Partners Group, a Swiss-based private equity and hedge fund company with Sf17.3 billion ($14.1 billion) in assets under management. Its principals convene twice by video conference, twice in their boardroom in picturesque Zug, a wealthy Swiss town of about 25,000 people, and once at a two-day strategy meeting deep in the Alps, always at a different location.

That summer’s 48-hour brainstorming session was to take place in a basic cabin, where the Partners Group top brass would bunk eight to a room while cows and sheep roamed outside the pinewood walls. The spartan setting was meant to free everyone’s minds from daily business life -- and free their minds it did.

“We had been in business for nearly ten years, and we wanted to know how we could be successful for another ten years,” Gantner says. “We asked questions like, ‘How do we attract and retain top investment people?’ and ‘Do we want to be in the arms of a big bank?’”

Gantner divided the party into four groups and sent them to separate rooms to debate four options: keep the status quo, sell to a bank, tender all of the firm’s shares in an initial public offering or list a minority of the shares. A few hours later, the groups returned with a unanimous vote for a minority listing. Partners Group went public on Zurich’s SWX Swiss Exchange in March 2006, valuing the IPO at Sf1.7 billion and turning more than 50 of the firm’s 140-odd employees into paper millionaires.

DURING THE NEXT YEAR, TWO OTHER FIRMS -- London-based BlueBay Asset Management and Charlemagne Capital -- took the same plunge, making it six European hedge funds that have gone public. With last month’s IPO of New Yorkbased Fortress Investment Group, the first U.S. hedge fund to go public, managers from Bermuda to Tokyo are weighing their options.

“Everybody of any size in the hedge fund world is thinking about listing,” says Jeremy Sillem, senior partner at Spencer House Partners, a London-based boutique investment bank that advised BlueBay on its November 2006 IPO. But as Partners Group and others have discovered, the benefits of taking a hedge fund public don’t necessarily outweigh the possible drawbacks.

Judged on shareholder returns alone, however, hedge fund IPOs have almost all been a success. After a slow start, Partners Group shares have more than doubled, climbing from Sf63 to Sf133 as of early March. Shares of London-based RAB Capital -- which went public in 2004 and now has $5.2 billion in assets under management and a market capitalization of $1 billion -- have nearly tripled. BlueBay and Mallorca, Spainbased Absolute Capital Management have also seen above-market increases in their stock prices.

But the biggest splash was made by Fortress, which went public on the New York Stock Exchange on February 9. The alternative investment company’s IPO was 20 times oversubscribed; its shares opened at $35, or 89 percent above their offering price (see box). Only Charlemagne Capital, which specializes in emerging markets funds, has traded down, off 25 percent from its March 2006 offering price.

For hedge fund firms, going public can satisfy many needs: raising capital, improving credibility and creating a currency in the form of shares that managers can use to make acquisitions. For Partners Group, the main reason was people: Being public would enable its management to lock in key staff and attract talented investment managers from other firms by issuing them shares.

Of course, for this plan to work, the stock has to perform well. Gantner says his employees gave him blank looks when the company issued options valuing it at Sf1.2 billion. “They said, ‘Thank you, I’m flattered, but are they in the money?’” he recounts. “Now that the company is valued at Sf3.7 billion, the question no longer applies.” Partners Group, which has grown to 200 people since the IPO, instituted seven-year lockup contracts with noncompete clauses for the firm’s partners and to date has had no defections.

For investors in a hedge fund firm’s products, however, the notion of instant wealth creation is a concern; they don’t want the investment team to become distracted or complacent. According to RAB Capital co-founder and executive chairman Michael Alen-Buckley, a handful of his clients pulled their money before the firm listed. Partners Group clients also resisted: One Swiss institutional investor said it would withdraw all its assets if the company went public. After Gantner explained that the flotation was about staying independent and keeping a stable staff base, the investor was pacified, going so far as to buy shares in the IPO.

To avoid similar charges of a cash grab, at least one firm has reconsidered going public. In late 2005, London-based Thames River Capital, which manages $10.2 billion in hedge funds and long-only strategies, began mulling an IPO. It even hired Glyn Jones, an industry veteran who had previously run London-based Gartmore Investment Management, an independent fund manager with more than $44.5 billion in assets, as CEO to oversee the possible listing. But by the following spring, Thames River decided it would be stronger as a private firm, and Jones stepped down.

Thames River co-founder and managing director Jonathan Hughes-Morgan says that some clients had expressed doubts about how motivated the company’s fund managers would be after the lockup period ended and they could sell their shares. “When we eventually announced we weren’t floating, most of our clients were more than happy with the decision,” Hughes-Morgan says. Instead, Thames River rewards its fund managers by giving them a share of profits and performance fees.

THE BENEFITS OF GOING PUBLIC rise and fall with the stock market -- and shares of alternative asset managers tend not to move in a straight line. Hedge fund firms don’t have long histories as publicly traded companies; any sign of market turbulence can send their shares spiraling downward, regardless of whether they’re actually losing money in those markets.

After three years of being public, RAB is still getting used to the wild ride. Executive chairman Alen-Buckley says the gyrations in his company’s share price have been unexpected and unwelcome, given RAB’s wide array of funds and their consistent performance. “Because the sector is so small, we have come to believe our shares reflect the market’s view on hedge funds rather than on us as a company,” he explains.

Still, Alen-Buckley doesn’t think the volatility has hurt RAB’s ability to lure new staff and clients. In fact, issuing stock options has allowed the firm to recruit heavily while expanding its funds from three in 2004 to 12 today. Opening new funds is important to RAB. With 600 clients -- double the number from a year ago -- capacity gets used up quickly, and the company closes funds to protect existing investors from any falloff in performance.

Going public has also given RAB the balance-sheet muscle it needs to make acquisitions. Last September it bought London-based Northwest Investment Management for £20.55 million ($39.6 million) in cash and shares. The Northwest deal added $500 million in sought-after Asian market funds and was RAB’s second big acquisition since joining the London Stock Exchange’s Alternative Investment Market. In June 2005, RAB paid £9.5 million in cash and shares for London’s Cross Asset Management, which runs $330 million in event-driven strategies.

Unlike RAB, Partners Group did not go public hoping to raise capital for acquisitions. It was looking to secure staff, retain major clients and increase its visibility. About 100 of its clients -- mainly direct investors and distributors, including global and private banks -- subscribed to the IPO, receiving 40 percent of the total shares. Every institutional client still holds its allocation, Gantner says. “The great thing is, we kept our clients and aligned their interests to ours,” he adds.

For hedge fund firms like Partners Group, a public listing can raise their profile outside their home market. “Before the IPO we were just a private Swiss firm,” Gantner says. “Now we have a Sf3.7 billion market cap, and anyone looking at our accounts can see we make money and have no debt.” Bruce Hamilton, a financial services analyst at Morgan Stanley in London, says Partners Group has gone from relative obscurity to an obvious choice for institutional investors scouting potential investment firms. “Anyone asking around for a big player in funds of private equity funds would be guided to Partners these days,” he asserts, “even though some of its rivals may have been around longer.”

Of course, most hedge fund and private equity firms have traditionally avoided having a high profile. The last thing they want is regulation that forces them to reveal their underlying positions to other market players. Partners Group didn’t pay that price for going public: Its funds are separate entities whose holding company has to show only aggregate figures on disposals of marketable securities and gains and losses on investments. According to Gantner, the only other disclosure requirement was the senior executives’ salaries.

More burdensome for listed hedge fund firms is the pressure to increase profits year after year. RAB’s pretax profits have grown 75 percent annually since the firm went public in 2004. “As you get bigger it becomes harder to compound growth at such a rate,” says Hamilton, who warns that the easy growth is over for RAB.

FOR THE PARTNERS OF Partners Group, the 111 percent rise in share price since the March 2006 IPO belies the tough time they had getting to market as a little-known outfit in a little-understood sector. The main problem: explaining their business model to potential investors, including other hedge fund managers. Partners Group is highly diversified, managing Sf12.6 billion in private equity, Sf2.7 billion in hedge funds and Sf2 billion in private accounts and mutual funds.

Gantner, at 38 the youngest of Partners’ three founders, says the prefloat period was trying. “The analysts in the syndicate said it was the most educating they had needed to do for ages,” he recalls. “The road show slots were scheduled for 30 minutes, but most were over an hour. We spent several hours with some hedge funds.”

In the end several single-strategy hedge funds subscribed to the offering. After doubting that the hedge funds would honor a pledge to hold on to the stock for at least a year, Partners Group has been pleasantly surprised. “We thought many would flip us, but they have kept their promises,” Gantner says.

That loyalty probably has something to do with the founders’ credentials. All three are alumni of Goldman Sachs, where they worked together in the Zurich office before launching Partners Group in 1996. Co-chairman and chief markets officer Urs Wietlisbach, 45, was Gantner’s boss, while executive vice chairman and chief investment officer Marcel Erni, 41, was Goldman’s CIO for Swiss equities. Gantner and Erni were close colleagues, having been in the same induction program at Goldman back in 1988.

The trio formed Partners Group because they thought the Swiss institutional market was poorly served by foreign banks that didn’t understand its culture and by local banks that wouldn’t embrace modern financial concepts. Wietlisbach says that in the mid-1990s, no competitor had the foresight to realize that every bank would be offering capital-protected structured products a decade later. “We now have a team of 14 doing this from start to finish in-house,” he says. “They work out the leverage, calculate the monthly NAVs and create any customization clients are looking for.”

Wietlisbach says the founders’ skills are complementary, pointing to his own sales experience, Erni’s investment savvy and Gantner’s motivational techniques. “Fredi is the world’s best cheerleader,” he says. On Mondays, Gantner, who invites employees to drop by his office anytime to discuss strategy, likes to make a presentation on company developments live to his staff in Switzerland and by video to the other Partners Group offices in Guernsey, London, New York, San Francisco and Singapore.

Early last year, however, workplace conviviality took a backseat to the technical difficulties of going public. Partners Group had to find financial advisers who were prepared to learn about a new type of company. After sitting through a lot of pitches, the firm tapped Credit Suisse, Merrill Lynch & Co. and Sal. Oppenheim Jr. & Cie.; they had the advantage of being existing distributors of the firm’s investment products.

Choosing where to go public, a crucial decision that affects how well a stock is covered by analysts and received by the market, proved a headache too. The Partners principals thought it unwise to head for the U.S., where Gantner and Erni had both gotten their MBAs, sensing that a small-cap Swiss stock would receive little or no attention there. Although they coveted the global profile that a London or Frankfurt listing would generate, they decided on Zurich so as not to alienate local clients. “Swiss groups that list elsewhere are sometimes accused of believing they are too beautiful for little Switzerland,” Gantner says. “We didn’t want to risk that.”

The Swiss firm needn’t have worried. Partners Group’s listing was 17 times oversubscribed, a level of interest since exceeded only by Fortress. “This is all about scarcity value,” says Martin Cross, an analyst at London-based investment bank Altium Capital. “But I don’t believe this kind of interest will be sustained if there is a rash of hedge fund firms coming to the market.”

Investors seem to like Partners Group and Fortress in part because their broad product bases don’t rely too heavily on a single asset class. Fortress’s asset mix is similar to that of Partners Group: $17.5 billion in private equity, $9.4 billion in hedge funds and $3 billion in listed investment vehicles. The Fortress private equity funds have lockups of eight to ten years; Partners Group’s funds of private equity funds typically commit investors for 12 years.

Morgan Stanley’s Hamilton thinks Partners Group’s earnings are more stable than those of pure hedge fund firms, whose customers can redeem their money in some cases with just one month’s notice. “But the risk to private equity returns and fundraising will rise if the macro environment worsens,” he says. In other words, falling markets make private equity exits difficult, and cheap funding dries up if banks stop lending. The same risks apply to hedge funds, but Partners Group trades at a premium because private equity funds have more-consistent revenue streams.

Performance has been compelling. Partners Group’s funds-of-private-equity-funds business has returned 16 percent a year since 1996, outperforming its peers by 8 percentage points, according to New Yorkbased private equity data provider Thomson Venture Economics. Partners’ direct leveraged buyout funds have had a 26 percent internal rate of return since launching in 1997, compared with an industry average of 9 percent. The firm’s secondary funds -- which buy private equity portfolios from other institutions, either because the portfolio is underperforming or because the institution no longer regards it as core -- have an IRR of 31 percent, compared with a 12 percent industry average. Partners Group charges a modest management fee of 0.9 percent of assets but tacks on a 10 percent performance fee on returns above 8 percent. Still, it’s Partners’ hedge funds, not its private equity vehicles, that are most likely to sustain the firm’s annual growth rate of 50 percent and stoke shareholder enthusiasm.

Partners Group’s hedge fund business is growing faster than most of its other businesses, mainly because of its development of hedge fund replication strategies. These hedge fund clones inexpensively reproduce the returns of hedge fund indexes by using derivatives to simulate the volatility of a given index as well as the correlation between stocks and bonds in that index. They’ve been a hit with investors since Partners Group began offering them last summer; assets have since swelled to Sf1.1 billion. The funds returned 11.5 percent in 2006, earning a 15 percent performance fee on top of their 1 percent management fee.

The other Sf1.6 billion in hedge fund assets are in managed accounts. These give investors daily liquidity in most cases and more transparency than do most funds of hedge funds, for a flat fee of about 1.5 percent. Investors can select any combination of the 30 hedge funds on the Partners Group platform. The flagship managed account, which combines all 30 strategies, was up 8 percent in dollar terms last year, trailing the HFRI fund of funds index, which was up 10 percent. Gantner defends its performance. “Our clients are not looking for high, double-digit returns,” he says. “They want an alternative for their bond allocation.”

An 8 percent return would have RAB shareholders running for cover. RAB Special Situations fund and RAB Energy fund, the company’s two best-known funds, were up 43 percent and 40 percent, respectively, in 2006. The RAB MultiStrategy fund, which equal-weights the 12 RAB investment strategies, returned 14 percent last year.

Three years after the RAB listing, these are the figures that matter most for executive chairman Alen-Buckley. The 48-year-old was previously head of institutional sales at Merrill Lynch’s London office, where he worked alongside RAB co-founder and CIO Philip Richards, who was executive director of that firm’s European equity division. Alen-Buckley’s challenge is to keep investors interested and avoid any hiccups that might hit market sentiment. “Every time we increase our assets by $1 billion, our annual fees rise by $45 million,” he says. That projection is based on a “conservative” 12.5 percent investment return, and on RAB’s standard 2 percent annual management charge combined with a 20 percent performance fee.

Altium analyst Cross says RAB’s unusual performance-fee model can hardly fail, noting that the company has no hurdle rates, so it earns performance fees on any returns above zero. “If it makes only 5 percent for clients, it takes a performance fee. It’s a mystery why people sign up, but they do.”

Despite RAB’s strong earnings growth, some shareholders may be concerned about the potentially dangerous overreliance on Richards, who runs about a third of the firm’s total assets in the $1.6 billion RAB Special Situations fund. They may also flinch at having nearly 40 percent of RAB’s profits come from investments in energy and natural resources companies. But Alen-Buckley is unapologetic. The firm, he says, will not diverge from what it sees as a sustainable long-term play in those sectors. He also believes the IPO has given RAB enough working capital to survive a market downturn.

Alen-Buckley admits that RAB has been slow to tackle distribution of its hedge fund products, choosing to put performance first. But he says that will change with the hiring of more direct-sales staff in Europe, Asia and the U.S. “We do need better distribution, but Rome wasn’t built in a day,” he adds.

It turns out that methodically building the brand is just as important for a publicly quoted hedge fund firm as it is for retailers and carmakers. According to Gantner, the employees of Partners Group must keep a sense of perspective, even with revenues and stock options rising almost daily. The company’s reaction to its successful IPO is instructive. “We wanted no fuss,” Gantner says. “We listed on a Friday, held a little cocktail party afterward and went back to work on Monday as usual.”

Scaling Fortress: European Analysts Weigh In

On February 9, Fortress Investment Group became the first U.S. hedge fund firm to go public when it listed on the New York Stock Exchange. Shares in the New Yorkbased company, which runs $17.5 billion in private equity, $9.4 billion in hedge funds and $3 billion in listed investment vehicles, opened at $35 -- 89 percent above the offering price. As the dust settles on Fortress’s explosive IPO -- by early March, shares were trading at $26 -- European analysts are divided on the firm’s prospects.

Unlike their U.S. counterparts, who have no historical data to build into valuation models, the Europeans can draw on more than a decade of experience in the public hedge fund sector. They have been watching it since 1994, when London-based Man Group went public. Some of them believe that because Fortress includes performance fees in its earnings, the firm’s price-earnings ratio of nearly 40 is optimistic.

“Performance fees by their nature are more volatile than annual management fees,” says Martin Cross, an analyst at Altium Capital, a London-based investment bank. “In some companies these fees depend upon certain thresholds, high-water marks and hurdle rates. It’s a risky calculation.”

In contrast to that of Fortress, the price-earnings ratio of Man Group, the world’s largest hedge fund company, with $57 billion in assets under management, is only 18. That’s partly because Man is older than Fortress, but the main reason is that analysts don’t factor performance fees, the key driver of Man profits, into their calculations. In the 12 months ended June 2006, Man’s revenue from performance fees nearly tripled, climbing from $119 million to

$450 million. Yet the company’s share price rose by only 50 percent during the same period. Meanwhile, the market has awarded a P/E of just 11 to RAB Capital, another London-based public hedge fund company.

Still, some European analysts think the demand for Fortress shares -- they were 20 times oversubscribed -- and the jump in stock price on the firm’s first day of trading were reasonable market responses. “This is the world’s most profitable and fastest-growing industry,” says Jeremy Sillem, senior partner at Spencer House Partners, a London boutique investment bank. “Everyone wants a bit of it, but there is still little available.”

Yet even Sillem admits that fast-growing companies such as Fortress, which has doubled its assets every year since it was founded in 1998, are hard to value. “The trick is to know how far forward you are projecting earnings,” he says.

The problem of valuation also comes down to a lack of understanding by analysts and investors. Alternative asset management firms like Fortress have many streams of embedded profits, but unearthing them is challenging. And some business lines, such as Man Group’s $17 billion AHL quant fund, defy any attempt at accurate evaluation. Despite the uncertainties, though, Cross expects more IPOs from alternative asset managers. “Those that do list are more likely to be in the U.S.,” he says, “for the simple reason that’s where most of the managers are."-- P.D.