The Racket: Finance Bros Edition

A couple of funny memes re-making the rounds on LinkedIn this morning...

Private Equity:

Hedge Funds:

DPI is the New IRR? Caveat Emptor...

For the past year, private equity managers have sought to prioritize returning cash to investors after higher interest rates stifled deal activity and exits. The drop in distributions has left many financial institutions that invest in private equity with less money to allocate to future funds. As a consequence, DPI, or distributions to paid-in capital, has replaced IRR, or the internal rate of return as the most important measure of private equity performance—at least for the time being. 

IRR has long been favored by the private equity industry to demonstrate its superiority over public markets. And justify the hefty management and performance fees (?). IRR is a cash-weighted measure of return that takes into account the time value of money, which ROI, or return on investment, does not; which is helpful when committed capital is called over different points of time. However, there are also some unrealistic assumptions underpinning the mechanics of IRR calculations that can make returns appear more attractive than they really are. That effect is compounded by how private equity funds mark their assets. 

The value of an asset is whatever someone is willing to pay for it. But in the absence of an active market for said asset, its value is whatever the fund manager says it is. Now, to be fair, fund managers do consult third-party valuation experts and their valuation processes are usually audited by well-credentialed firms at least annually. Still, as owners and experts on said asset, the fund managers' views carry a lot of weight. And it's not really in their economic interest to aggressively mark things down. So, even when public markets gyrate wildly, private equity valuations tend to remain relatively stable, as fund managers hold out hope for better times. In fact, this is actually an attractive feature of private markets for many investors, to chagrin of others. 

But what if you have to sell? Recently, amidst funding cuts by the Trump administration, the liquidity needs of major university endowments have increased. For example, Yale is reportedly exploring the sale of up to a third of its private equity portfolio. And Harvard tapped the bond market raise $750 million to meet short-term needs. Heck, if multi-billion dollar endowments (like Harvard and Yale with $50.7B and $40.7B of assets, respectively) start selling their massive private equity portfolios to generate liquidity, fund managers are not going to be able avoid price discovery for very long. And investors, long shielded by IRRs, may find actual realized returns, or DPI, are a lot skinnier than they imagined.

Did GameStop Just Change the "Hedge" Fund Business Model?

Like the rest of America, we've been riveted by the GameStop standoff between Redditors and hedge funds. While new short interest data suggests we may be at beginning of the end of this saga, there could be lasting damage to the hedge fund business model itself. Nir Kaissar at Bloomberg ponders the options for equity long/ short funds who may fear being targeted in the future by the Redditor crowd:

"...that leaves long/ short hedge funds with some unappealing options. If they abandon their shorts, then they lose their hedge. Who want to pay sky-high hedge fund fees-- traditionally a 2% management fee and 20% of profits-- for a long-only stock portfolio that can be had for a fraction of the cost through a mutual or exchnge-traded fund? And if try to protect their shorts using options and other derivatives, the cost will drag down returns, possibly as much as 3% to 5% per year. After more than a decade of dissapointing performance, they can ill afford to squander precious percentage points."

To be clear, hedge fund fees have been shrinking for a while now as promised returns never materialized and very few hedge funds ever consistently generated positive returns from their short book. Investors had long started to question the merits of such higher fees for an activity that never generates alpha, but now they will have to contend with the business risks (and not just investment risks) of doing so.

And regulators are loathe to be seen helping hedge funds. In any case, from what we know, there does not seem to be much they can do. The Redditors have not broken any rules and any actions taken to "help stablize markets, blah, blah, blah" will only add to the widespread perception that the game is rigged in Wall Street's favor...just look at the anger Robinhood's restriction on GME trading stoked. So hedge funds are in a bind...many will need to adopt or wither.

PS: This sober post from Naked Capitalism takes the opposite view that Redditors' actions will change hedge fund and market behavior for the worse...hurting everyone.