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.