July 30, 2014

Investing

Chasing Alpha

Behind a mushrooming number of hedge funds is a crop of young entrepreneurs attracted by the prospect of big earnings and less regulation.

Mike Vogel | 11/1/2005
HEDGE MONEY: "There's definitely opportunity in Florida," says Medon Michaelides, director of U.S. institutional sales at Miami's PRS Group, which has $830 million in assets.

New York native Neil A. Levy started his career as a CPA and then, in his words, changed careers a "bunch of times." "Bunch" is an exaggeration, but after graduate school, Levy went into stock research and then moved to Florida in 2001 to join a Palm Beach-based hedge fund firm. This summer, pleased with his investment track record, he opened the doors of his own firm, High Point Capital Advisors, in Coral Springs. He's all of 34. "I kind of caught the hedge fund bug," Levy says.

Among Levy's generation of business school grads, the bug seems pandemic. Indeed, for young financial whizzes, hedge funds now seem to have displaced management consulting, investment banking and mutual funds as the career path of choice. "This is a very young industry," says Boca Raton lawyer Stephen Mendelsohn of Greenberg Traurig, who has hedge fund clients. "The participants are quite young."

Behind the trend is a surge in hedge fund formation since 2000, when hedge funds as a group performed well during the market meltdown. Investors have poured money into the unregulated funds, and investment managers have hurried to meet the demand. Nationally, there are now some 8,500 funds operating, managing some $1.3 trillion.

In Florida, there are approximately 150 funds and a host of businesses and professionals to serve them -- even a business founded by two young entrepreneurs that tracks hedge funds. HedgeCo.net, a 5-year-old West Palm Beach firm founded by New Yorkers Evan Rapoport, 32, a University of Florida grad, and Andrew Schneider, 31, gathers information on hedge funds and disseminates it to investors who meet the SEC's $1.5-million minimum net worth definition of qualified investors. HedgeCo also consults for startup funds such as Levy's.

'1 and 20' incentive
Hedge funds date to 1949, when Alfred Winslow Jones, an Australian writing for Fortune magazine, got the idea of forming a private partnership -- and hence escaping SEC regulation -- to buy stock. Traditionally, hedge fund managers specialized in leverage and selling some shares short -- betting the stock's value would fall. Today, however, hedge funds encompass a breadth of investing from traditional long/short stock investment to arbitrage, investing in distressed companies and betting on macroeconomic movements.

Some funds, like John W. Henry & Co., the $3-billion, Boca Raton-based hedge fund firm owned by Boston Red Sox owner John Henry, trade commodities futures. In addition, there are funds of hedge funds, popular with the clients of financial planners, in which a manager pools client assets and then invests in several hedge funds.

GLOSSARY

Fund of hedge funds
A fund registered with the SEC that invests in hedge funds. It can have a lower minimum investment and a larger number of investors than the underlying hedge funds.

Convertible arbitrage
Profiting on the difference between a company's stock price and securities the company has issued that can be converted into stock.

Managed futures
Investing in government securities, futures contracts and options on futures to lower volatility and profit in any economic environment. The people who run them are called commodity trading advisers.

INVESTING TRENDS

More Attention
Endowments, foundations, pension funds and other institutions are investing more in hedge funds, prompting more regulation as the institutions demand more information about the performance and methods of funds in which they invest.

Florida Targets
Florida companies have attracted their share of hedge fund interest. Tampa-based Anchor Glass Container Corp. and Reptron Electronics and Naples-based Beasley Broadcast Group are partly owned by hedge funds. ESL Investments, the Greenwich, Conn.-based firm of Edward S. Lampert that begat the merger of
Kmart and Sears, is the largest shareholder in Fort Lauderdale-based car retailer AutoNation. Some of the funds have taken an activist role with company management. In May, for example, two funds that together owned 21% of Walter Industries told the company's board that it should spin off some of its units. One investor group threatened a fight for control of the board.

Pension Funds
Pension funds are the fastest-growing source of institutional money flowing into hedge funds, reports Casey, Quirk & Associates, a Darien, Conn., investment advisory firm. Just 15% of pension plans invest in hedge funds. Florida's most prominent pension plan, the state retirement system, has no hedge fund investments.

Most fund managers say they don't make huge one-way bets. Instead, they concern themselves with preserving capital and "alpha," the gain the manager produces compared to the overall market.

One factor attracting young financial managers into hedge funds is the prospect of a big payday. Managers typically earn a 1% fee to manage a portfolio and 20% (and sometimes higher) of performance gains. "You can't argue with a 1 and 20 management incentive fee," Levy says. "It could be lucrative, right?"

Right. In 2002, as the S&P 500 fell 23% and the Nasdaq composite fell 32%, two funds managed by Jacksonville's Water Street Capital were up 24% and 37%, net of fees, earning its chief, Gilchrist Berg, $95 million for ninth place on Institutional Investor's compensation list that year. Meanwhile, Henry, two of whose funds were up 45% and 31%, took home $40 million for 20th place. (Neither made the 2003 list published by Institutional Investor's Alpha magazine.)

In addition to financial compensation, hedge fund entrepreneurs like Levy are attracted by the prospect of investment flexibility their mutual fund counterparts can only envy. Levy, for instance, like a lot of mutual fund managers, hunts for undervalued stocks as long-term plays. Unlike mutual fund managers, he shorts overvalued companies. His aim: Use the combination to produce strong returns with a risk profile akin to a bond fund.

The small investor
Levy is stepping out on his own at a time when regulation and government scrutiny are increasing. The SEC was content to let hedge funds look after themselves when they served a small club of wealthy investors with high net worths. But the market for hedge funds is growing. Institutions and endowments are crowding in. Also, less well-heeled investors can put as little as $25,000 or $100,000 into a feeder fund that pools small investor cash to get past funds' minimum investment hurdle.

The SEC has taken notice. Scandals haven't helped. The SEC sued KL Group of West Palm Beach in March to halt what the commission called a "massive hedge fund fraud" whose principals told investors they had earned annualized returns of 125% and 150% on aggressive growth stock trading ["Promises, Promises," October, FloridaTrend.com]. In fact, KL lost nearly all of the $81 million it had collected from more than 300 investors. Some published reports have put the losses at as high as $300 million.

In May, a hedge fund operator named Howard K. Waxenberg, who had raised more than $70 million from 200 investors over 15 years and claimed 20% annualized returns on day-trading options and futures, killed himself in his Bradenton condominium as his scam unraveled.

In response to the changing landscape, William Donaldson, while SEC chairman, pushed through a rule requiring all funds with more than $30 million in assets to register by next February. Some Florida companies, such as PRS Group in Miami, have been registered for years. Florida's Office of Financial Regulation, meanwhile, is working on a new rule requiring fund managers with more than 15 investors to register as investment advisers, which would enable the state to step in to problems more readily and to make rules on maintaining books, records and sales practices, says Don Saxon, commissioner of the state's Office of Financial Regulation.

At present, the law and fund managers look at a hedge fund as a single client, no matter how many investors have put money into it. Saxon is concerned about smaller investors. "We feel we have to take some proactive stance on this," Saxon says.

Margin pressure
While the number of Florida-based hedge funds has grown, the state is still only an outpost in an industry centered around Greenwich, Conn., New York and other financial capitals. Florida is, however, prominent as a matchmaking place where brokerage houses, which want hedge fund trading business, host their "capital introduction" conferences, bringing hedge fund managers and prospective investors together.

It's not clear whether the industry can continue to enjoy the same returns it has historically. Some data indicate that as more dollars chase the same market inefficiencies and strategies, margins and returns must fall. "The industry 10 years ago was a lot easier," observes David Friedland, president of Magnum U.S. Investments, an Aventura-based fund of funds.

For investors, the influx of money into hedge funds puts a premium on finding successful managers, many of whom close their funds to new capital before growing so big that size hampers performance. "It's becoming increasingly difficult to find managers who can generate alpha on a consistent basis," says Medon Michaelides, director of U.S. institutional sales for PRS.

Levy and his young cohorts are willing to play on that field. To start, he relied on managing an account for another hedge fund. He spent part of the summer traveling to meet prospective investors and raise capital for his own fund. He says friends from business school and "a lot" of analysts he knew are making the switch to hedge funds as he did. The hours compared to the compensation can be better in hedge funds than brokerage house research, he says, and he likes his returns determining his pay.

Says Levy, "Performance is much more the name of the game."

Who's Who in Florida Hedge Funds

Reporter's Note: Some hedge fund managers are a bit forthcoming, but others are loath to talk for the record to media (though plenty will talk off-the-record to pan a company they have shorted). Many fund managers don't even have websites, saying any whiff of publicity can be construed by the SEC as an illegal attempt to publicly solicit investors.

While the number of hedge funds in the state is growing, Florida's role in the industry is small as a player. Only about 150 Florida-based funds, many of which are run by the same managers, show up on HedgeCo.net's list. Of the top 100 fund managers by asset size on Alpha magazine's list this year, only John Henry's firm, at 87th, is Florida-based.

Hedge Funds and Commodity Traders

John W. Henry & Co., Boca Raton, $3 billion in assets. The one-time farm boy and current owner of the Boston Red Sox made his fortune in commodity trading/managed futures. His contribution to the industry has been in advocating ways for it to be more hospitable to institutional investors.

Everest Capital, Bermuda, $1.4 billion in assets. Though based offshore, Everest has a significant operation in Miami. The Miami office looks for investment opportunities in the Americas, Europe and Africa.

Sage Capital, Sarasota, $250 million in assets. The three-partner convertible arbitrage and convertible securities fund manager relocated to Sarasota from New York via Sun Valley, Idaho, as the partners' children reached school age.

Water Street Capital, Jacksonville, $1.65 billion in assets (unconfirmed). Water Street founder Gilchrist Berg tried to short his first stock at age 14, according to a brief 2003 profile in Institutional Investor. "Arguably the best short-seller" in the hedge fund business, the magazine said, Berg shorts "questionable business models run by questionable people." He's gone long on Berkshire Hathaway among others.

Epsilon Investment Management, Boca Raton, $223 million in assets (unconfirmed).

Otter Creek Management, Palm Beach, $200 million in assets. Keith Long founded Otter Creek in 1991 after retiring from Wall Street. "Fairly typical hedge fund story," he says. "This is just something I wanted to do for 20-odd years." Long has two long/short funds, one domestic, one offshore, and has on occasion been activist, though not with any Florida companies.

Imperium Advisors, Tampa, $190 million in assets. Founded in 2001, it specializes in energy and utilities. The 10-person company has a long/short fund. Managing director Stephen Goldfield is an electrical engineer and Wharton MBA.

Matador Capital Management, St. Petersburg, $632 million in assets. Matador caused a bit of a stir last year in Baltimore when it lured key portfolio manager Lisa Rapuano from Legg Mason to share chief investment officer duties with founder Jeff Berg.

Ronin Capital Management, Miami, $132 million in assets (unconfirmed; too high, according to Ronin). Principals Magnus Eriksson and Chris Sawtell worked together at Sofaer Global Research in Hong Kong and New York before founding Ronin in 2000.

Fund of Funds Firms

PRS Group, Miami, $1.7 billion in hedge fund assets, including fund-of-funds, single strategy funds such as convertible bond arbitrage, structured products and separate advisory accounts. PRS investors are primarily European. The group also has a "substantial investor base" in Latin America, says Medon Michaelides, who was brought in in January as director of U.S. institutional sales. Founded in 1981 by two Harvard MBAs, Spaniard Gonzalo Rodriguez-Fraile and John Sullivan, to provide advisory services, PRS has been in hedge funds since 1986.

Collins Capital, Coral Gables, $350 million in assets. Life insurance executive Michael Collins got into hedge funds in Dallas as a sideline -- until racking up a 68% annualized return for four years prompted him to go into it full time. Collins says less than half of 1% of his investors are from south Florida.

Magnum U.S. Investments, Aventura, $250 million in assets. Magnum's clients predominantly are high net worth individuals, most of them offshore. The 15-employee company was started in 1994. Magnum President David Friedland also is a director of the Hedge Fund Association industry group.

Lighthouse Partners, Palm Beach Gardens, $3.8 billion in assets. Henry A. "Hap" Perry founded the company after a career in cable TV, real estate and autos. Research analysts are based in Chicago and New York. Lighthouse is a unit of AMA Holdings, which is 80% owned by SunTrust.

Worldmark, North Palm Beach, $539 million (unconfirmed). D. Dean Rhoads, an inventor, manufacturer and investor who made Fortune's list of the richest Americans in 1991, runs the Worldmark funds.

Hirst Investment Management, Lake Mary, $1.5 billion in assets (unconfirmed). Founded by Gary Hirst in 1991. A University of Miami grad, Hirst authored the global macro funds section of John Wiley & Sons' "Hedge Funds: Definitive Strategies and Techniques."

Tags: Around Florida, Banking & Finance

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