High Water Marks Bring Yet Another Bias To Hedge Fund Returns

Survivorship and backfill bias in hedge fund returns have been written about extensively. A recent article in Hedge Fund Alert drew out attention to yet another problem with the reporting of hedge fund returns. It turns out that last year’s carnage has left so many hedge funds underwater that the returns posted for this year are not actually what you will earn if you are a new investor.

Hedge funds have high water marks so that managers do not receive the 20% performance fee until the fund has reached its prior high. That is one of the reasons why so many managers simply shut down their funds and launch new ones not subject to that constraint. But it also leads to difficulties with the reporting of returns. Performance fees are assessed not at the fund level but on each investor’s capital account. In other words, if you invest on December 30 you do not have to pay the performance fee for the whole year.

And that’s where the bias in return reporting comes in. Returns are shown for an investor who has been in the fund since its beginning. After last year’s carnage most hedge funds are still underwater and therefore do not charge performance fees this year to their investors who have been with them for some time. A new investor, however, who entered this year will have to pay performance fees for this year.

This now leads to the absurd situation that hedge funds generate two different after-fee returns this year, a higher one for longer investors and a lower performance for newer investors. The number reported to the major databases is, of course, the better one.

The problem is not just theoretical. Hedge Fund Alert reports that 77% of all hedge funds tracked by hedgefund.net were underwater at the end of August. As a result most hedge fund indices report inflated return numbers for this year.

Startup hedge funds are likely to suffer as a result of the bias. Typically they are above water and report their performance for this year net of performance fees. Therefore, they appear to do worse than more established managers even though the discrepancy has nothing to do with actual performance but is only due to the skew in reporting. Many investors, including supposedly sophisticated institutions, do not understand this subtlety and are likely to make decisions based on data that compares apples to oranges.

To make matters worse, the performance skew that results from the high watermark and performance fees is not the only issue. The good old survivorship and backfill biases also contribute to an overstatement of returns this year. Through August, HedgeFund.net reports an average performance of 13.7% for hedge funds, whereas funds of hedge funds returned only 6.7%. The difference can not be explained by fee layering but is an indication that many poorly performing hedge funds have simply stopped reporting their numbers to the databases. Fund of funds are still invested in them and therefore provide a better guide to the real performance of hedge funds as an asset class than the indices.

All this proves what we have been thinking for some time: data is nice to have, but its usefulness is often limited and even simple figures can have so much devil in the details that they are a clear and present danger in most investors’ hands.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which does not charge performance fees. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).

:: :: :: :: :: :: :: :: :: ::

Harold Hamm’s Hiland Buyout Has Upside

It is doubtful that the buyout of the Hiland MLP (HLND and HPGP) by billionaire Harold Hamm will get sufficient votes at Tuesday’s shareholder meeting. This is already the second meeting after the Otober 20 meeting was adjourned when only 43% of the publicly held shares voted in favor. Both Hiland companies have significant upside if the deal falls through.

In our recent Hiland posting we speculated that oil magnate Harold Hamm, the acquirer, would not obtain sufficient votes at the October 20 shareholder meeting to close the transaction. We think the only way to get shareholder to buy into the deal is to follow the recent example of Black Stone Minerals bid for Eagle Rock Energy’s (EROC) minerals business and increase the price.

Hamm should look closely at the bidding war that is unfolding at Eagle Rock (EROC) over its minerals business. It began on September 18 when Natural Gas Partners (NGP), which controls the general partner of Eagle Rock, proposed to acquire the minerals business for $135 million. While EROC was evaluating the proposal, NGP raised its bid to $145 million on October 13. Less than a week later Black Stone Minerals Company joined the bidding with a $157.5 million bid. Both proposals include support for an equity raise.

As we pointed out in our last post about Hiland, natural gas trades higher now than when the original buyouts at $9.50 (for HLND) and $3.20 (for HPGP) were announced. Nevertheless, Hamm sticks to prices that value the firm at a level when natural gas was some 30% lower. We believe that the strong performance of natural gas is the principal driver of the pending bidding war at Eagle Rock, and we do not see why Hiland should be stuck at a gas price from a different economic environment.

Performance of the Hiland Companies and Natural Gas

The trick is the interaction between the shareholder meetings at HLND and HPGP. Both buyouts must be approved by the public shareholders (other than Harold Hamm) before the transaction can close. At the last meeting only 43% of the public shareholders supported the transaction. Since the adjournment of the meeting to allow Hamm to solicit more votes HLND has moved above the $7.75 acquisition price. This indicates clearly that the market believes that the deal will not get done at $7.75. HPGP still trades at a small discount to the $2.40 acquisition price.

Two outcomes are possible if Hamm can not get enough votes:

1. Hamm will increase the price of the merger. We think that a price that is closer to the initial January 15 bid of $9.50 for HLND and $3.20 for HPGP could sway sufficient shareholders to vote in favor. In our opinion this is the most likely scenario.
2. If the deal collapses then HLND and HPGP would probably trade above the acquisition price in light of the dramatic improvement of the gas price over the last two months. Gas has more than doubled from its September lows, trades about 40% higher than when Hamm lowered his acquisition price to the current levels, and is 10% higher than it was when Hamm lowered the price. As a result, HLND and HPGP should restore their profitability. One concern that triggered the acquisition was Hamm’s support of the company in light of its covenant violations. We believe that Hamm, as a 50% shareholder, has more to lose than anyone else if Hiland suffers as a result of covenant violations. He should be willing to provide support even if he were to withdraw his acquisition proposal.

We think the first scenario is the most likely one. Hiland’s shares are held widely by retail investors who typically do not vote. They are even less likely to vote if they get a bad deal such as this buyout, which is priced at roughly two years worth of dividend payments (prior to their suspension).

Some shareholders who initially voted for the deal might try to change their vote to a “no” when they see the shares trading above the deal level. Such changes in votes would offset any additional “yes” votes that the proxy solicitors collect. Changing the vote is not easy, though: most shareholders hold their shares through a brokerage account and vote at proxyvote.com or via telephone at the 800 number that comes with the voting materials. However, when we did a test the other day the control number no longer worked, so that shareholders can not change their vote in the normal way. The trick to work around this issue may not be known to many shareholders: rather than using the materials the company sent out, the shareholders must call the proxy solicitor D. F. King (1-800-967-4612). However, this also means that the only “yes” votes that can come in at this point are those that are collected by the proxy solicitor. On balance, the chances for a “yes” vote on Tuesday are not high.

Whether or not the transaction goes through, we believe the risk/return profile of the two Hiland companies is attractive. The market prices the probability of an upside into HLND at Friday’s 5 cent premium to Hamm’s acquisition price. We think that probability is much higher than that premium suggests.

Disclosure: Thomas Kirchner manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which owns shares of HLND and HPGP. He is the author of the book Merger Arbitrage: How to Profit from Event-Driven Arbitrage (Wiley Finance, 2009).
:: :: :: :: :: :: :: :: :: ::

Clarium’s Peter Thiel Is Bearish On Innovation

At Thurday’s 2009 Investor Leadership Forum hosted by the Argyle Executive Forum and Capital IQ Peter a speech by Thiel of Paypal and Clarium fame linked future economic growth to innovation and technology rather than government stimulus.

Peter started by noting the difference in the type of question asked today of emerging markets and the developed world.

Hiland: The Worst Deal Among MLP Consolidations

Among the many consolidations of MLPs (recall the mergers of Magellan Midstream MMP, Atlas ATLS or the pending Enterprise/Teppco EPD/TPP) one deal stands out as a particularly bad deal: the opportunistic squeeze-out of minority shareholders of Hiland Partners (HLND) and Hiland Holdings GP (HPGP) at record low prices by oil magnate Harold Hamm. Management of the two firms seems to be getting increasingly worried about obtaining sufficient votes for the buyout at the October 20 shareholder meeting, judging by the flurry of proxy solicitations that we have received. With the recent recovery in gas prices the acquisition looks priced too cheaply, and it is no wonder that shareholders are reluctant to support this bad deal.

Billionaire Harold Hamm controls

American Community Properties Trust May Attract A Higher Bid

Surprise, surprise! American Community Properties Trust (APO) is selling itself. And you won’t even get market value for your shares: while ACPT trades between $8.35 and $8.50 the buyout will happen at $7.75.

The sudden sale at a discount to the market price comes out of the blue for shareholders who still remember the failed attempt by the Wilson family, the 50.68% owners, to take the company private in 2007. The Wilsons had engaged a financial adviser

The End Is Near For Wilshire Enterprises

Wilshire Enterprises (WOC) finally launched its $2 tender offer for 4 million shares, roughly half of the outstanding shares. It is a bad deal for shareholders and we anticipate that worse is to come because public shareholders will be minority holders in a firm whose management has a record of poor decisions, such as the refusal to sell at $8.50 to Mercury Real Estate Partners a few years ago.

Cash Shells: SPACs, MathStar, PetroSearch and Cadus

It has been a while since we first reported on SPAC liquidation arbitrage in January. The battles over MathStar (MATH) and PetroSearch (PTSG) has prompted us to follow up, as did our annoyance with the slow progress at Cadus (KDUS).

SPACs represented a great liquidation arbitrage late last and early this year when they traded well below their cash value at double-digit annualized yields. Other companies trade occasionally below cash, usually when

Bidding War Looming At Entrust If Shareholders Oppose Thoma Bravo Buyout

In a surprise move, private equity firm Thoma Bravo increased the price it is willing to pay for Entrust (ENTU) from $1.85 to $2.00 on Friday. We had forecast that shareholders would vote down the transaction in this post last week, and we suspect that a rejection of the $2 buyout will lead eventually to a bidding war over Entrust. Three other bidders expressed interest in Entrust during the go-shop period at prices higher than Thoma Bravo’s, but the board decided that these proposals were not “superior”. Therefore, we think that there is enough interest in Entrust to make it a candidate for a bidding war if shareholders vote down the current deal.

Will Shareholders Vote Down Entrust’s Private Equity Buyout?

In another illustration of the pointlessness of “Go Shop” periods the board of Entrust (ENTU) ignored three buyout offers received in the 30-day go shop period that were higher than that of the group that includes the CEO. Moreover, the Entrust management buyout shows all that is wrong with buyouts by private equity funds where management remains with the firm and has an incentive to lowball the buyout price. Shareholders expected an increase of the $1.85 merger consideration, and shares traded as high as $2.10 during the go-shop period. We believe that due to the high level of dissent from shareholders and even a board member it will be difficult for management to achieve the required approval by 2/3 of the shareholders.

Pershing Square Misleads About General Growth’s Equity Value

Pershing Square Bill Ackman’s presentation about General Growth Properties (GGWPQ) at the Ira Sohn Investment Research conference has us wondering what he is up to. The tone of the presentation clearly targets an audience that is not familiar with bankruptcy investing. At the same time, his financial projections for GGP are overly optimistic and do not square (no pun intended) with current results. We believe that some of his analysis is very misleading.

Looking For Outperformance? Invest With An Emerging Manager!

An ill-advised, persistent and costly error among institutional investors and their consultants is their reliance on large brand name money management firms to look after their assets. We had the privilege of attending and speaking at the recent Emerging Manager 2009 conference, from where we return with some very persuasive statistics that show the outperformance of small money managers over the large mainstream firms.

Porsche At Risk Of Bankruptcy Over VW Option Trades

Porsche CEO Wendelin Wiedeking with CFO Holger Härter

These days, liquidity is in short supply for all hedge funds, and it comes as no surprise the hedge fund wannabe Porsche (POAHF) suffers from the same liquidity squeeze symptoms as many of its hedge fund brethren. The liquidity situation for Porsche will be critical over the next three weeks.

Recall that Porsche engineered a massive short squeeze of Volkswagen common stock (VLKAF) just a few months ago. Volkswagen’s common had been shorted by arbitrageurs who went long the undervalued preferred (VLKPF) at the same time. When Porsche announced that it had acquired 75% of Volkswagen through options and intended to take over the firm, the common stock soared while the preferred didn’t budge. This led to large losses for the hedge funds when they had to cover their short positions in the common.

The flipside of Porsche’s large position in VW option is