The Best Way to Buy Hedge Funds?

Hedge funds and private equity investments have long had an allure beyond ordinary investments. Yet even as many investors have scurried over the years to try to overcome regulatory obstacles that limit participation in these alternative investments, others have concluded that if they can't invest in a hedge fund, they should do the next best thing: Invest in the companies that manage hedge funds.

Given the way that private equity and hedge fund managers get compensated, there's a certain amount of logic to that reasoning. But does investing in shares of alternative asset managers actually give shareholders returns similar to those that hedge-fund investors enjoy?

Another horse in the race
From the way investors gravitate to anything related to hedge funds, you'd certainly think the answer would be yes. Despite (or perhaps because of) the ups and downs in the financial markets in recent years, interest in the industry has continued to run strong. According to Financial Times, Oaktree Capital is planning to make an initial public offering of shares in the near future. With about $85 billion under management, Oaktree, which is well-known for making money on distressed debt in the fixed-income securities market, could be worth as much as $9 billion if it comes public. Right now, the company has shares on a private market exclusively open to institutional investors that value it at about $6.2 billion.

But when you actually look at the performance of other alternative asset manager stocks, you'll find mixed results at best. Here's a summary:

Source: Yahoo! Finance. Returns compared with dividend-adjusted closing price on first day of trading.

Certainly, the 2007 entries have all performed horribly, although Kohlberg Kravis Roberts has seen a nice run that corresponds to its far-better timing (for shareholders) in coming public with its main business than it showed with its real-estate offering of KKR Financial in 2005. What caused the carnage?

From one perspective, you could argue that the IPOs themselves were the best sign of trouble ahead. For companies whose primary mission is to time the exit from privately held investments in order to reap as much profit as possible, the natural inclination would have been for them to try to sell shares of their own businesses at the time they'd be most likely to be near a top. After the stock market started heading downward in late 2007, the credit crunch of the financial crisis made it almost impossible for private equity firms to get out of their investments on their hoped-for timeframe.

In addition, the very structure of alternative asset managers made their IPOs fundamentally different from those of most other business. Often, a company comes public in order to raise capital for new investment or to improve its balance sheet. But with hedge funds and private equity facing extremely high costs to retain top talent, much of the money that didn't represent firm owners cashing out went toward labor costs. Blackstone's own prospectus for its IPO said that the company would use most of the proceeds to pay employees.

Be careful
Over the years, many have believed that the best way to profit from investing is to own the shares of the companies that reap the rewards from their investor customers every day. Certainly, that strategy has worked well for mutual-fund managers such as T. Rowe Price (Nasdaq: TROW), whose shares have risen at better than a 22% clip over the past 20 years.

But with alternative asset managers, that common sense hasn't held true. So as appealing as it may seem to get into a company like Oaktree if it comes to market, think twice -- especially if you believe the current bull market may be coming to a close.

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