The American Spectator

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The Coming Hedge Fund Earthquake

By Barron Thomas on 8.17.07 @ 12:07AM

CNN last week was reporting that seismologists are warning about the next "big one," a disturbance greater than the severe San Francisco or Northridge 'quakes of the 1990s. It will start in the Coachella Valley (Palm Springs) and spread to Los Angeles along I-10, and will probably be felt all the way south to Mexicali, Mexico.

I think the big one is indeed coming, but it will actually start in Manhattan, spread to Connecticut and Chicago, and be felt in Lubbock and Joplin. This earthquake won't topple buildings and freeways, but it will do a lot of damage to retirement accounts, overly aggressive investors and money managers. It won't involve geological plates shifting below the earth's surface, it will involve a lot of over-hyped and marginal hedge fund deals that come unraveled.

Investors today are watching the wrong ballgame, and totally completely over-reacting to that game.

The subprime situation is indeed a mess, but hardly a surprise. Smart money guys like Ben Stein have correctly dissected the whole mess, and called it for what it is. After estimated recoveries on the actual foreclosed properties, it may portend a 2 or 3% loss, which, in historic loan loss terms, is about the proper amount that should have been reserved anyway for good loans, not to mention loans that everyone knew upfront had "issues."

The ballgame that investors need to closely monitor, and act upon accordingly, are some hedge funds that have literally been throwing money at about anything, hoping some will stick.

The whole hedge fund scenario brings to mind the classic 1955 book by Fred Schwed, Where Are the Customers' Yachts?

The main problem with some go-go hedge funds, and some that were run by "experts" who were in dorm rooms during the last market melt-down, is that the hedge fundsters get paid fabulously well no matter what the outcome is for the person that actually takes the risk.

The incentive is to book the deals, any deals, because everything is on a fee basis. Buy the asset and earn a fee, package the assets into a fund and earn a fee, and sell shares in the fund and earn a fee.

In the global scramble for assets to package and re-package, the truly under-valued gems get picked up pretty early.

What's left are the cats and dogs, but they too can be "packaged" and resold. After all, if the cat or dog doesn't make the numbers, that really doesn't affect the 26-year-old Deal Manager or his $6 million log home in Montana. Some overly aggressive hedge funds, in a rush to generate fees, are picking up companies that are labor-intensive, or worse, highly specialized-labor-intensive in very competitive markets. The founders of these specialized endeavors many times get the check and head off for a well-deserved vacation and much needed rest, leaving the company in the hands of managers directly or indirectly under the direction of a "Deal Manager" at Hedge Fund headquarters.

Rarely does this work.

Worse, to make the numbers look attractive, the Deal Manager starts leaning on whatever management is left to make their numbers work. You can always in the short-term make your numbers if you don't care about the future. Layoff people now, cut quality, cheapen everything and your immediate numbers will look great, and the problem numbers don't show up for 2-3 quarters in the future when customers start canceling orders and going to the competition. By then, the company should squarely be in the hands of investors and it's "their problem."

What is the lesson here?

Don't be the last person standing when the music stops on some of the fee-driven, overly-leveraged deals with questionable fundamentals in highly competitive, labor-intensive industries with very recent, or worse, new "expert" management. Sell these now and move into reasonable growth and stability for the near-term.

Can money still be made in the coming cycle?

Letter to the Editor

topics:
Trade, Business, Oil