Two scholars affiliated with Singapore Management University have published a study of “the pitfalls of going public,” that is, of what can happen when the management of a hedge fund becomes a publicly owned company.
They conclude that the going-public process itself breaks the alignment of incentives between managers and investors that otherwise exists in the hedge fund GP/LP structure, and thus leads to underperformance.
The scholars begin with their estimate that as of 2013 about 16.68% of the assets of the hedge fund industry were managed by listed firms. As of 1994, the corresponding figure had been just 4.02%. In terms of the total number of listed firms involved, there were 12 listed hedge fund managers in 1994, 113 in 2013.
Certain of the IPOs that have marked this shift have been very high-profile: Fortress; Och-Ziff; and Blackstone each went public in 2007, the year otherwise remembered as the moment when the housing derivatives market hit the proverbial fan.
Fund managers who make this move often argue that the sale of their stock on an exchange will allow them to boost performance, for example by using stock options to motivate employees, or by investing the IPO proceeds in attractive ways. Some have also made the case that the move is in the public interest since public companies must of necessity be a good deal more transparent than their privately owned analogs.
Then There’s the Agency Problem
The usual counter-argument is that an IPO brings in new investors who do not typically “eat the cooking” of the managers. They don’t invest alongside the limited partners. Thus, by definition, they have different interests and, to the extent they make their interests felt with management, they create an agency problem that didn’t exist for the private entity.
The SMU authors side with the latter, skeptical, view of these IPOs. Their tabulation shows that hedge funds managed by listed firms underperform their private peers by 2.89% per year.
Intriguingly, relative to the control group, newly listed firms continued to grow their AUM. Indeed, there was a surge in AUM post-IPO, which arose according to these authors less from organic growth than from the launch of new funds. “[B]eing listed increases the chance that a firm will launch a new fund by 30.65 percent,” they write.
This eagerness to launch new funds confirms the agency problem. The shareholders will be rewarded on the basis of the fees the managers can charge the limited partners, and that depends in large part on the amount of assets under management, and that is what the newly public firms are moving to boost, arguably in excess of what the scalability of their strategies can justify.
The Investment Styles
These authors classify the hedge fund industry as consisting of four distinct investment styles: security selection; multi-process; directional trader; relative value. The defining characteristics of those styles are evident enough from the names, although perhaps it’s worthwhile to say that the multi-process funds include what are sometimes called “event driven” or “special situations” funds.
Where would shareholder activist funds fit in this fourfold rubric? Funny you should ask. These authors kept shareholder activist funds out of their database altogether out of fear that their performance after the IPO would be stunted by an irrelevant consideration – the unwillingness of people who live in glass houses to throw stones; that is, their inability to challenge the managements of portfolio companies in ways analogous to those in which they as newly public companies, could themselves be challenged.
At any rate, the fourfold classification didn’t really matter to their analysis. They seem to have introduced it only by way of explaining their use of a dummy variable in their tables. The upshot is that their results are robust notwithstanding strategy.
Authors and Other Work
The authors, Lin Sun and Melvyn Teo, are both affiliated with SUM’s Lee Kong Chian School of Business. Twelve years ago, Teo was one of three authors of a fascinating “Bayesian and bootstrap analysis” of whether hedge funds deliver alpha, arguing that hedge funds do in fact deliver alpha, and that this finding is “neither confined to small funds, nor driven by incubation bias, backfill bias or serial correlation.”