The Fortress IPO

The IPO of Fortress (NYSE: FIG) on Friday closed at $31 or 70% above the IPO price on the first day of trading. It was the largest first day jump in a while. The fact that the forward P/E is now at 40x speaks to the frothiness of anything associated with hedge funds and private equity. But another interesting question that needs to be asked is – should a hedge fund be a public company?

First, something that needs to be understood, but outside of the capital markets is not well understood – FIG, the company that went public is not the hedge fund itself but the management company that manages the hedge fund. Also, FIG manages not just hedge funds but also private equity funds and a few alternative asset funds that are themselves listed. You’ll find a lot of information in their S-1.

There are two reasons why I take a dim view of a hedge fund going public. The first one is the lack of Residual Value. The second is the conflict of interest that arises in compensating senior managers.

A professional services startup, with anything from a consulting to a BPO business model, were to go to a VC for funding, many VCs would not even entertain a pitch. Their reason is well explained by a bit of jargon that they use – Residual Value – or rather the absence of it. What that means is that the value of the business is all tied up in the people. There is no technology, product, website or anything that has value independent of the people of the company. This makes VCs nervous. What if a couple of key people leave? What if the management team can’t work together? In most startups this will impact the business, but in a professional services startup it could take the company down.

What is risky in startups is risky in public companies as well. Most public professional services companies mitigate these risks to a large extent through sheer scale. Infosys has nearly 50,000 staff. But FIG has only 250 investment professionals.

The private equity and hedge fund businesses are entirely people-driven businesses. To generate alpha, you have to outcompete the market. Only better people can do that (though many will say that you can’t consistently beat the market anyway). A better investment process, which belongs to the firm independent of the people, could be called Residual Value, but is not a huge determinant of success. Brand matters but savvy investors care more about performance. Further, better performance creates a virtuous cycle. Better performance attracts better people who reinforce better performance. Better performance also attracts more investors generating more commissions. If there is any business where the departure of a few people could impact the business greatly, FIG’s is that kind of a business. Their S-1 talks about five year contracts with the five principals, but investors in public companies must consider risks that extend beyond five years and below the five principals in the org chart.

The second reason is tied to compensation for senior managers. A knowledge-based company will typically have payroll costs as the largest head of expenses. However, in the case of a hedge fund or a private equity firm, payroll and in particular compensation for the investment professionals will be the predominant expense of the company.

The 250 investment professionals in FIG will be quite well compensated, in line with their professions. Changes to their compensation can materially impact the profits of the company. It puts the investment professionals and investors in the company at opposite ends of a conflict of interest situation. Even if the investment professionals have their interests aligned with shareholders through ownership of equity, the fact remains that investment professionals can make money in two ways – straight cash and stock appreciation, while shareholders can make it only one way.

This misalignment of interests exists in general between employees (who’d like to be paid more) and shareholders (who’d like them to be paid less, other things being equal, so the profits are higher). However, in most companies, the conflict is not as clear. The decision-making is sharply concentrated at the top and those top executives are very well aligned with shareholder interests. There many classes of employees and a large number of them. Pay, generally and in larger part, is aligned to market rather than the performance of the company.

In FIG, on the other hand, the conditions are very conducive to bringing out this conflict – a few, senior managers, in one or two classes of employees, account for the lion’s share of the payroll.

Management Consulting firms have similar characteristics. Partners take a large share of the value of the company in either cash or equity. Which is one of the reasons why most of them, like McKinsey, choose to remain private partnerships.

Here’s a true story. An IT Consulting firm, that shall remain nameless, soon after it went public, encountered a situation that taught them an important lesson in being public. In a certain quarter which turned out to be better than they had foreseen, their earnings were beating guidance by a handsome margin. The company did what it thought was the fair thing to do. It bumped up the partner bonuses and let the earnings drop to just a little over guidance. In their minds they had given the investors what they wanted, the rest was richly deserved by the partners. Unfortunately, that’s not how a shareholder sees things. He doesn’t expect to have ‘second dibs’ on the earnings of the company after the Partners have had their fill. The company was lambasted by investors that quarter, in spite of a good quarter. Shortly after, they put a structured bonus plan in place for their partners.

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6 Responses to The Fortress IPO

  1. Siddharth says:

    Basab, Some of your posts have no clear ending. What is the message that you are trying to convey? Is the first day of trading not significant? or FIG should not have gone public? or laws should govern compensation?

    I am sure you type on the fly as thoughts come to your mind, but for the sake of your blog readers, please scope out your viewpoint clearly. Okay?

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  2. Surya says:

    Hi Basab, Out of the 30 billion dollars, if 17 billion dollars are in private equity, should we not consider the book value of the PE investments as residual value? Even if there are the best educated and experienced professionals managing funds like Amaranth and Redkite, the macro-economic factors or Random events will strongly influence the outcome, hence investors might be trying to hedge inflation risk using a multi factor model.
    A single factor model where-in software company performs,as a result the stock outperforms market, so better Beta Ri-Rf/Rm-Rf. However might not work where a falling dollar reduces the software companies Rupee earnings, hitting its offshore business model and thus BSE investor’s returns fall. Here we turn a full cycle as IBM also starts building offshore capabilities.

    NYSE is reasonably efficient, so either the FIG will come down or the book building process was inefficient or there is some helpful statistical secret! This article did help me relate market efficiency theory to practise :).

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  3. Basab says:

    @Siddharth, I am often guilty of what you are accusing me of, but this time I thought I wasn’t random. The third para of the post given below is the conclusion of the post. The rest of the post elaborates upon the reasons.

    “There are two reasons why I take a dim view of a hedge fund going public. The first one is the lack of Residual Value. The second is the conflict of interest that arises in compensating senior managers.”

    @Surya, FIG is NOT the fund itself, it is the fund management company. Nor is it like a fund-of-funds. Investing in FIG is like investing in the mutual fund management company (like say Legg Mason, which is public) rather than in their Value Trust or myriad other mutual funds.

    And actually from a risk standpoint, a downmarket can impact FIG pretty seriously. According to their S-1, their sources of income are 1)management fee on all assets managed, 2)carry, or incentive income on gains with clients’ capital and 3)gains in FIG’s own investments in the funds.

    #2 and 3 are both likely to be hurt in a down-market. The hedge fund and private equity businesses are different but are definitely correlated. A good post on this can be found here http://www.informationarbitrage.com/2007/02/my_review_of_fo.html

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  4. krish says:

    Interesting. Asset Management Company of a hedge fund going public –

    Could be part of FIG’s marketing strategy to expand its Assets Under Management (AUM) size by flaunting its Public status. A public company offers better transparency ( in comparison with a lowly regulated hedge fund) and large pension / University funds would flock to it for this very reason.

    By going public, I think FIG lends an element of credibility and permanence to its business model so that it holds out to other hedge funds ( facing exodus of its star fund managers ) to turn in their investments for FIG to manage. Thus remaining unaffected by star attritions.

    There are downsides, of course.

    The quality of investment decisions would vary from that of (the exiting) fund manager and may be FIG assumes that investors are Manager agnostic ( not always) and would stick with the FIG.

    It could also go against the wishes of the investors in the fund. Normally accredited investors ( including individuals with a min networth, Funds with some min. no. of qualified investors etc., alone are eligible to invest in hedge funds ) prefer a hedge fund, owing to its low regulatory oversight enabled by its in-built and permitted opacity. This brings down compliance costs ( SOX Compliance cost for a mid-sized company is about $ 2 mm ) of the fund manager. By going public, it is deprived of this immunity and relative obscurity that comes with it.

    By submitting itself and its investment processes ( and the hedge fund itself ) to higher level of probity by SEC and other regulatory peek-ins, its investment strategies are no longer confidential. Everything is laid bare for others to emulate and the arbitrage opportunity vanishes quickly. FIG will have to spin innovative strategies all the time since the viginity of the strategy lasts only till its next periodic filings with the regulators.

    Demand for anonymity prefered by qualified investors in a hedge fund will no longer be available if the Fund Manager is a Public Company. It would also neutralize the relative obscurity / low compliance cost advantage conferred by the hedge funds to its qualified investors who are locking themselves into this asset class for this very reason.

    But I am sure FIG must have its own reasons outweighing the downsides which occur to me and chances are that I may have missed a whole lot of things here.

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  5. Spence says:

    Basab-

    The the on the underlying investments cannot be completly attibuted to the skill of the managers. Because many of the fees, and corresponding cash flow, are based on the return of the underlying investments there is at lease some basis for calculating residual value.

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  6. Gurvinder says:

    Basab – Nice post. My two cents.
    The intent of FIG in going public is to make more money given strong market sentiment. The market is more likely than ever before (or after!) to reward hedge fund / PE business model. The other side is the market / shareholders – who are certain that there is money to be made in the PE / Hedge fund model and are playing on strong returns.

    In between all this, who cares (really!) about issues like lack of residual value or conflict of interest! Everyone is happy right now.

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