Some of the world's most exclusive hedge funds and private equity shops are starting to offer publicly traded shares to ordinary investors. Should you buy to get a piece of the action, or are these IPOs a sign that the alternative investment craze has topped out?
The appeal, of course, can be intense. Blue-chip private equity firm the Blackstone Group, which sold 12% of itself to the public on June 22, has returned an annualized 30% over the past 20 years to the pension funds, endowments and high net-worth individuals invested in its flagship private equity portfolio. On the first day of trading, Blackstone's public shares surged 13%.
Since then they have fallen below their IPO price, while public shares in Fortress Investment Group, a firm that specializes in hedge funds, are down 28% since the close of trading on their February 9 debut. Granted, that's a short-term, backward-looking viewnever the best way to size up a potential investment. Yet as other shops like Kohlberg Kravis Roberts, Carlyle Group, Apollo Group, and British hedge fund manager GLG Partners toy with listing public shares, it's worth taking a critical look at the broader, ongoing forces impacting these stocks.
The biggest cause for concern is that the economic conditions that produced outsized returns for alternative investments might be over. In the past few weeks, there have been indications that there aren't as many people as there used to be who are willing to buy the bonds private equity shops need to sell to finance big buyouts; a number of deals have been put off. Credit runs in cycles and this, it seems, might be the top. You might consider it exhibit A that the people most in tune with that cycle, those running firms like Blackstone, are deciding to sell some of their stake to the public. Companies usually go public to raise capital, but Blackstone hardly needs to float shares to find investors. Instead, the move is a way for executives to cash out.
"Typically, when the individual investor has access to what was a terrific returning investment, it's too late," says Anton Schutz, portfolio manager of the Burnham Financial Services and Burnham Financial Industries mutual funds. "Blackstone takes companies private, but they're going public — that's a message."
The recent stumbles in Blackstone and Fortress shares might also point to another looming risk — that Congress will change the way such firms are taxed. Legislation introduced in the Senate on June 14 would tax financial-services partnerships as corporations, raising their rate from 15% to as much as 35%. The next day, Fortress shares dropped nearly 7% on heavy trading.
There are other reasons to steer clear. In its IPO filing, Blackstone was very blunt about how erratic profit can be. That may be the nature of the private equity business model — buying existing companies and then spending years fixing them up before reselling and realizing gains — but it also makes it next to impossible to model future earnings and thus come up with a fair stock price, says Brian Hamilton, CEO of Sageworks, a financial analysis firm that specializes in private companies going public.
On top of that, the IPO filing revealed a Byzantine operating structure, over which investors holding public shares — technically "units" of the Blackstone partnership — will hold little sway. "When you buy 10 shares of IBM, you don't have much of a voice, but at least there's a democratization of how the organization is structured," says Hamilton. "You're not getting that with Blackstone. What you're getting is, Trust us, we have a good track record." And keep in mind that that track record is from a time when the company didn't have to deal with the constant and short-term-minded scrutiny of the stock market.
Despite all that downside, there is some reason to think you're not necessarily a fool for jumping in. Holders of Blackstone "units" include the Chinese government and insurance giant AIG. At least two Blackstone directors have bought shares in the open market, though insiders are, by far, net sellers. Still, plenty of on-lookers have warned that if the super-savvy billionaires who run Blackstone are selling some of their stake in the company, you don't want to be on the buying end of that transaction. But if that logic really held up, you'd never want to buy around the time of an IPOmanagers always have better insight into their company when it has just been listed. Yet folks who got in early at, say, Google, are probably pretty happy.
Perhaps the best way to think about investing in public shares of alternative investment companies is to consider what else might get you similar exposure. Often the answer is a more traditional investment bank such as Goldman Sachs, which runs the nation's largest hedge fund. Plus it trades at 10 times earnings, less than half of Blackstone, and doesn't have its tax bracket being debated by Congress. In fact, many Wall Street firms have significant divisions devoted to alternative investments. Among them, fund manager Schutz most likes Morgan Stanley for its lower valuation.
Just don't forget that any stock comes with risks. On June 22, the day of Blackstone's IPO, the Wall Street outfit Bear Stearns, which has been publicly traded for two decades, announced that it would spend up to $3.2 billion bailing out an internally run hedge fund that was flailing from bad bets in the declining sub-prime mortgage market. The stock dropped more than 4% for the week.