Permanent capital: Perpetual cash machines
William "Bill" Ackman, founder and chief executive officer of Pershing Square Capital Management LP, speaks during an event in New York, U.S., on Tuesday, July 22, 2014. Herbalife Ltd. shares fell the most in three months yesterday after billionaire Ackman vowed to show Enron Corp.-like fraud at the seller of supplements and weight-loss shakes. Photographer: Jin Lee/Bloomberg *** Local Caption *** Bill Ackman©Bloomberg
Bill Ackman, founder and CEO of Pershing Square hedge fund
In 2009, Bill Ackman surveyed the wreckage of the US property market and spotted a golden opportunity. General Growth Properties, owner of shopping malls in 40 American states, was teetering on the verge of bankruptcy — and Mr Ackman, founder of the Pershing Square hedge fund, sensed it was time to buy.
There was just one problem: his own investors. Spooked by the financial and economic crisis spreading around them, many Pershing clients were asking for their money back. To cope with the flood of redemption requests, Mr Ackman had to keep almost half his fund in cash — money that he wanted to put to work in companies like General Growth.
Today, General Growth is worth 140 times its value in 2009. Pershing Square is thought to have made about $3.5bn from its investment in General Growth, but Mr Ackman still rues not being able to invest more in the company.
“I had one hand tied behind my back,” Mr Ackman recalls. “In 2009, we wanted to go on the offensive. But even though we were up a lot that year I still felt like we missed out. Because of the possibility of massive redemptions we had to hold too much cash.”
Hedge fund and private equity managers have always been subject to the whims of their investors or the rules of their funds. After all, the money belongs to their clients. But, for the managers, few things are more galling than having to pass on a “sure thing” because they have to give the money back, as Mr Ackman was forced to do.
Now many of the world’s savviest hedge fund and private equity managers think they have found a way round the problem. Instead of traditional funds that allow investors regular opportunities to redeem their money, or buyout funds that wind up after 10 years, they are looking to raise money for vehicles that bring cash in that can be invested in perpetuity. In the industry parlance, this is known as “permanent capital” and is seen as a new holy grail.
Whether these are stock market listed funds or acquisition vehicles that raise money in public share offerings, or reinsurance companies that bring in premiums to invest, they have a few things in common: fat fees and an end to the need to plead with potential investors to write cheques every few years.
Private equity bosses, complaining about a shortage of cheap companies to buy, are staring at years of lower returns. And with hedge funds having had their fourth consecutive year of sub-10 per cent growth, pension funds such as Calpers are reconsidering their investments. Pressure on fees is intensifying and permanent capital raised now could lock in arrangements that may in the future look quite generous.
While it is too early to say how many of these vehicles will justify the fees they pay to their managers, the quest for permanent capital is already changing the alternative investment management industry. Hedge fund managers and private equity firms are getting larger, more diverse and more institutional, becoming more like traditional fund management groups where gathering assets may be prized ahead of generating stellar returns.
The inspiration for many alternative managers is Berkshire Hathaway, the listed investment vehicle of Warren Buffett, who for 50 years has been able to invest the profits from his businesses and the premiums from his insurance operations without investors pressuring him to return cash to them. The result is that Berkshire is the fourth largest company on the US stock market.
“Everyone is suffering from Warren Buffett envy,” says the head of a private equity firm in New York. Berkshire had the money for rescue loans to Goldman Sachs in 2008 and Bank of America in 2011, moments of great fear in the markets when everyone except the US government seemed to be fleeing. Berkshire has made profits of more than $12bn to date on those deals.
Mr Ackman has been mulling the need for permanent capital since the crisis and, by giving discounts on fees and other incentives, has lured $6.7bn into a closed-end fund called Pershing Square Holdings. The vehicle was listed on the Euronext stock market in October, in what was the largest initial public offering in Europe in 2014. About one-third of the $18.5bn Mr Ackman manages sits in this listed unit.
Unlike investors in Mr Ackman’s hedge fund, Pershing Square Holdings shareholders who want to cash out must do so by selling their shares on Euronext, rather than withdrawing from the fund. “Permanent capital is the best protection,” he says. “I wanted to make it both compelling and material.”
Listed funds have also been raised by Third Point, the US hedge fund manager founded by Daniel Loeb, and (twice) by London-based Brevan Howard. Mr Loeb and David Einhorn’s Greenlight Capital are also among the hedge funds to have set up reinsurance companies in recent years. These bring in billions of dollars in additional money to invest, thanks to the companies’ capital reserves and insurance premiums, and have favourable tax treatment. Apollo, the private equity group founded by Leon Black, has nurtured an insurance group that has added tens of billions of dollars in permanent capital.
Other stock market listed vehicles could include special purpose acquisition companies — also known as shell companies — which raise capital for a future deal, real estate investment trusts, business development corporations and holding companies.
Advocates in the industry believe permanent capital vehicles hold the answer to another long-running frustration of alternative asset managers: the stock market’s refusal to value their businesses as highly as traditional fund management companies.
Public market investors dislike the volatility of alternative asset managers’ fee income, which is vulnerable to client redemptions and heavily reliant on unpredictable performance fees. Since permanent capital vehicles pay their managers’ fees in perpetuity, running them should be more valuable, according to the theory.
“These vehicles are likely to be a meaningful alternative,” says Marco Masotti, a lawyer with Paul, Weiss, Rifkind, Wharton & Garrison in New York, who helps many of the biggest firms to structure them. “There is no ticking clock of a finite life and there is always a readily available pool of capital.”
Mike Vranos, founder of mortgage specialist hedge fund Ellington Management, says the ability to pick from a variety of capital-raising structures increases a firm’s flexibility and there is a “game theoretical aspect” to picking the right framework.
Since the crisis, Ellington has created and listed two permanent capital vehicles, a Reit and a $670m specialty finance company called Ellington Financial, which buys mortgage-backed securities and also owns part of a mortgage lender. “Permanent capital allows you to go into less liquid assets and even operating businesses, which require patient money,” Mr Vranos said.
Permanent capital vehicles typically must be listed on a stock market to allow investors the option of getting out — and that comes with disclosure requirements that would be anathema to hedge fund managers a decade ago. “It is a higher bar because there is a lot of scrutiny on the manager, a lot of issues around infrastructure and compliance, so you have to be up for it,” he says.
Those hurdles seem smaller, however, now that many, such as Blackstone and KKR in the private equity industry and Och-Ziff from the hedge fund world, have floated their own management companies on the stock market. Since the Dodd-Frank reforms of 2010, US hedge funds have been required to register with the Securities and Exchange Commission, and hedge fund managers now get most of their money from pension funds, which have high due diligence requirements.
Blackstone and Apollo have been among the private equity pioneers which have transformed their businesses into diversified investment management companies spanning private equity, hedge funds, asset allocation strategies and numerous other products for clients, including permanent capital vehicles. The expansion of their model comes amid concern that competition has cut the potential returns from the traditional 10-year private equity fund.
Some large firms, including Blackstone and Carlyle, are trying to lure their investors into funds with a lifetime of up to 20 years as a halfway house between the traditional 10-year fund and permanent capital. Investors are divided about the virtues of such a long lock-up.
Hanging on to lucrative investments longer is one of the more powerful arguments of proponents of permanent capital models.
Just ask Wes Edens about mobile phone towers. His New York-based private equity and hedge funds firm, Fortress, assembled a national portfolio of towers after the dotcom bust but had to sell the business in 2008. “Had we owned that in a permanent capital vehicle we would still own it today,” he says.
Fortress has been expanding its range of businesses since the credit crisis, and now has a diverse set of six listed or soon-to-be-listed vehicles that specialise in areas including healthcare, mortgage services and US newspapers.
As well as Mr Buffett’s, the business models Mr Edens uses for comparison are those of Teekay, a Canadian energy investor, and Carl Icahn, the controversial corporate raider. Mr Icahn runs a family-only hedge fund but also has an $11.4bn listed vehicle called Icahn Enterprises, whose businesses span railcars, metal recycling and textiles.
Mr Edens said: “Comparing yourself to Warren Buffett, good. Comparing yourself to Carl Icahn, not bad exactly, but Carl is Carl. However, if you look at what he has done in the permanent capital vehicle, it has been really productive.”
Not all the experiments in permanent capital have been a success. KKR listed a vehicle on the Euronext exchange, but it was absorbed into KKR’s New York-listed stock after trading at a discount.
And even Mr Ackman, whose investments were up more than 40 per cent in 2014, has not received the stock market welcome he hoped for. Despite his prediction that Pershing Square Holdings will one day trade at a Berkshire Hathaway-like premium, it has traded stubbornly at a discount, suggesting investors want to build in a margin of error in case performance slips.
The early evidence suggests potential shareholders will be cautious about these options for tapping the expertise of hedge fund and private equity managers. The capital may be permanent, but history suggests that investing success may not be.
Exit strategy: After making a profit, time to ‘harvest’ Alibaba?
Three years before Alibaba set a record with its $25bn IPO, Silver Lake Partners began building a stake in the Chinese ecommerce giant.
Silver Lake, a private equity firm, invested $450m at a blended cost of $14 a share. It was a good price: Alibaba went public in September at $68 a share, after which Silver Lake sold 7 per cent of its holdings and distributed the proceeds to investors, according to confidential letters to them.
Alibaba reached $88 by the end of the third quarter, giving Silver Lake’s remaining stake a value of $2.8bn. Those spectacular results have given its Silver Lake Partners III fund — which made its first investment in 2007 — a huge boost.
But when should Silver Lake cash out?
The life cycle of a private equity fund is generally 10 years. Investors expect managers to put their money to work in the first five years and then start to cash out.
The lock-up period for the listed shares for Alibaba’s private equity holders ends in March. One investor says he would like Silver Lake to either distribute the shares to investors or return cash to them sooner rather than later.
This investor was told that Silver Lake has not decided on when it will sell its shares. A general partner such as Silver Lake has total discretion over the timing of an exit. Still, the Silver Lake fund is already in the period in which it would be normal to wind down its holdings. A spokesman declined to comment.
By contrast, General Atlantic, another private equity firm with a stake in Alibaba, has taken a different approach. It has what it calls an evergreen structure, meaning it is not bound to invest over five years and then “harvest” its investments over the following five. It also has much more freedom in timing its exits.
Investors who think Alibaba shares are a good long-term bet might be happy to give their fund managers a little extra freedom.