I teach an entrepreneurship course in the MBA program at SMU, essentially a survey of starting a business, getting it financed, and growing it to an IPO or sale. In addition to teaching business principles, I try to show my students how to increase their odds of achieving personal financial independence, which I define as whatever you need to give you the freedom to choose how you want to spend your day. Whether it’s to continue working at a job you actually love, to travel the world in first-class accommodations, or to lie on the couch in a ratty bathrobe and leaf through celebrity tabloids (my preference), you have enough dough to tell The Man you aren’t coming into work, ever again. Or words to that effect.
Then I go on to demonstrate that A) you really need a minimum of $5 million in investable assets to be financially independent; and B) unless you had the foresight to be born to wealthy parents or are a professional athlete, rock star, movie star, best-selling author, or Powerball lottery winner, you really can’t get there from here. With an Excel spreadsheet on the overhead projector, using wildly optimistic earning assumptions, savings assumptions, and stock market appreciation assumptions, I show that it’s impossible to save your way to financial independence at any time before you’re in diapers again, drooling into your strained prunes. The Millionaire Next Door is a book, not anyone’s life I know. The “American dream” is just that.
This would be my lead-in to why they should be trying to find a wealthy spouse. Okay, seriously. It’s the basis for entrepreneurship. If financial independence is important to them, they should be starting their own businesses (Bill Gates, Mark Cuban, etc.) or working for startup companies with generous stock options (Austin “Dellionaires,” Google employees, etc.).
Except that I’ve changed my tune. Now I recommend that they pack up their books, drop my class, and start a hedge fund.
A “hedge fund” is a barely regulated investment fund consisting of “accredited investors” (people with a net worth of at least $1 million or who have earned more than $200,000 per year for the past two years) run by a “hedge fund manager” who put the fund together and who reaps the lion’s share of the rewards. Correction: the whole pride’s share. The compensation to the hedge fund manager used to be “1 and 20,” but now the norm is “2 and 20”—meaning that the hedge fund manager gets 2 percent of the assets under management each year, plus 20 percent of the “ups.”
In a relatively small $100 million fund, the hedge fund manager would get $2 million per year before he got out of bed in the morning (2 percent of the assets under management) plus 20 percent of the fund’s performance. Therefore, if the fund had a decent year and earned, say, 15 percent, the hedge fund manager’s performance fee (over and above his 2 percent management fee) would be $3 million. Five million dollars total for the year. A couple of years of that kind of pay, and you’re a sand wedge away from financial independence, under anyone’s definition.
Now let’s dial that up to what Steven Cohen of SAC Capital Advisors in Connecticut earns. Cohen has a “3 and 50” deal. And he has $10 billion under management. Three percent of $10 billion is $300 million. Each year. And let’s say his stock-picking yields a 15 percent return, or $1.5 billion. That means his 50 percent performance fee earns him $750 million. Total of $1,050,000,000. In. One. Year. The Wall Street Journal puts his net worth at $3 billion. People in the know think that’s low. But $3 billion, a fortune put together from scratch in less than 15 years, puts him at No. 85 on this year’s Forbes 400 list. Not bad for sitting in front of a computer screen yelling buy and sell orders all day.
HBK Investments in Dallas is even bigger, with $11 billion under management. But they don’t have a 3 and 50 deal. And they split profits among 11 partners. But if financial independence means owning your own private jet while in your 40s, they’re doing okay.
Aside from the astronomical dough, the hedge fund world has its own fun language, starting with the types of hedge funds themselves: long-short, merger arb (merger arbitrage), PIPEs (private investments in public equity), converts or convert arb (arbitraging convertible preferred stock). The name describes the strategy, and each involves “shorting,” which is what entitles the fund to wear the “hedge” moniker. In contrast to normal funds (like mutual funds), the hedge fund manager is able to hedge his investment in the stocks he buys (his “long positions”) by shorting other stocks or whole sectors of stock. 1
One “shorts” a stock by selling stock that one doesn’t own. How? Simple. You call up your broker and tell him to short, say, 1,000 shares of IBM. With IBM trading at $96 per share, the transaction will yield $96,000 in proceeds into your account. Nifty, huh? Now, of course, because you didn’t own IBM, you’ll have to fix things at some point. So you wait until IBM drops to, say, $89 per share, and you buy 1,000 shares of stock, “closing out” your position, for a $7,000 gain. Nice!
But like stunts on Jackass, shorting is something you shouldn’t try at home, because bad stocks don’t always go down. And the broker who sold your shares short will want you to close out your position. (Otherwise the brokerage firm is on the hook.) And if IBM shoots up to, say, $125 per share on a takeover rumor, you’ll need to spend $125,000 to cover, for a $29,000 loss. Not nice.
A hedge fund, theoretically, should never lose money. In a bull market, it would presumably be long “biased” and should make more money on its longs than it loses on its shorts. In a bear market, it should make more money on its shorts than it loses on its longs. The hedge fund run by Jim Cramer of TV’s Mad Money made an average return to its investors (after Cramer’s management and performance fees) of 24 percent per year for 15 years, ending with a 29 percent return in 2000, the year he shut down his fund, when the S&P was down 10 percent and the NASDAQ was down 39 percent. (In 2000, I would have happily paid his 2 and 20 fee, plus waxed his back, for that kind of return.)
|So You Want to Invest in a Hedge Fund?|
Outside of the New York area and California, Dallas has the highest concentration of hedge funds in the country. By one estimate, there are about 140 firms operating here, with combined assets of about $40 billion. Some of the largest are Maverick Capital, HBK Investments, Carlson Capital, and BP Capital Management. The last is an energy-focused fund run by T. Boone Pickens, who was the second-highest paid hedge fund manager in the country in 2005. He made an estimated $1.4 billion.
So your next investment might only be a local phone call away. But if you’re only a little bit rich, you’d better hurry. Right now, individuals can invest in hedge funds if they have a net worth of $1 million or an annual income of $200,000 in the previous two years. The Securities and Exchange Commission is considering adopting a rule requiring investors to have $2.5 million in investment assets (excluding primary residences).
That’s how it’s supposed to work. But when theory fails, you sometimes get what’s called a “blow-up”: when a hedge fund loses a shockingly large amount of money in a shockingly short period of time. We’re not talking about a few bad picks here. We’re talking about major carnage to the fund itself. A recent example is Amaranth Advisors, based out of Greenwich, Connecticut, which lost more than $6 billion—70 percent of its fund’s value. In two weeks. As my Swedish mother would say, “Oofdah!”
Hedge fund managers talk about “leverage” or “levering up” their funds. Those are fancy word for going into hock. Just like you might buy more house than you can afford, the hedge fund manager is financially motivated to make bigger bets than he can afford. Leverage magnifies returns. The house example illustrates it perfectly. Say that you buy a house for $500,000 and put 5 percent down, or $25,000. Your mortgage would be $475,000. Say that the house itself appreciates only 5 percent. You’ve doubled your money. (You sell the house for $525,000, pay off the $475,000 mortgage, and put $50,000 in your pocket.) Hedge fund managers can get leverage in two ways: by shorting stocks (which, as we saw, causes the brokerage house to pour money into your account) and by borrowing against the stock they own long. Except that while your gains can be magnified by relatively small movements in the assets, so can your losses.
So your natural response to news that your fund is down 70 percent is: get me the heck out of here! But unlike a bad bet on a stock tip you heard in the sauna after 36 holes of golf, you can’t just call up your hedge fund manager and demand to be sold out of your position (or in fancy words, get a “redemption”). Well, you can call up the manager, but the redemption will have to wait. Go back and read your investment documents. The paragraph under “Lock-up.” Most hedge funds don’t permit a redemption within one year (sometimes two) from your initial investment.
Moreover, the hedge fund manager will hold back 10 percent of your capital (trust me, it’s all there in the fine print) until after the fund’s accountants do their annual audit, usually sometime in April of the following year. So, assuming that you have $25 million in a hedge fund, and you request a redemption at an inopportune time, the hedge fund manager will hold back $2.5 million for up to 13 months. That’s a long time to have that much money not earning interest.
Can you mitigate the changes of being “blown up” by keeping careful tabs on your fund’s investments? No. A hedge fund rarely discloses its positions to anyone, including its investors—and if you read the fine print of the hedge fund documents under which you invested, you’ll know that, notwithstanding the announced strategy, the hedge fund manager is generally permitted to buy any type of debt or equity security, public or private, under any kind of strategy. With your money. That you can’t seem to get back.
That’s not necessarily the last indignity. If your hedge fund manager had a blow-up, it’s also likely he didn’t run the fund “tax efficiently.” Nearly all hedge funds are set up as limited partnerships for tax reasons. The fund itself is not taxed for federal income tax purposes, and in Texas it’s not taxed on the state level. Instead, the fund’s performance is passed through directly to its investors. The fund files an information return with the IRS and distributes K-1s to its investors, showing their allocable share of the fund’s gains or losses.
Assume that you have $1 million invested in a hedge fund, and assume that the fund has a bang-up year and earns 45 percent net of fees for the year. Therefore, your capital account would show your investment being valued at $1.45 million at year-end, and theoretically you would get a K-1 in April of the following year showing $450,000 of gain that would need to be included in your tax return. With that kind of income, you’ll be in the 35 percent tax bracket, so your tax on that $450,000 investment gain would be $157,500. Except that all of your money is still in the fund. You’ll just need to scrounge up that $158K from other sources.
So you might ask, where’s the indignity and what did you mean by “theoretically”? Going back to your $1 million investment, let’s say that instead of a bang-up year, your fund had a blow-up, and your capital account goes down to $550,000, for a 45 percent loss. So, naturally, you demand a redemption. And then you get your K-1 in April and think, “Hey, at least I can take my loss—while I wait for the fund to return the rest of my money.” Except that your K-1 shows that you had taxable gains of $100,000. What?!
In the midst of the blow-up, the hedge fund manager panicked and sold all of the stocks that he had big gains in and held onto the losers hoping that they would recover their prices. So the fund’s performance—for tax purposes—showed a 10 percent taxable gain for the year, even though the fund lost 45 percent of its value. As a going-away gift, your hedge fund manager blessed you with experiencing the exquisite agony of paying $35,000 in taxes in a year that your capital shrank by $450,000. Thank you. Thank you.
Sorry. We’re talking about financial independence, building wealth, not sour grapes. I’m thinking like a lawyer again and not like a private jet-traveling, 25,000-square-foot-house-in -Greenwich-living, Damien Hirst-shark-in-formaldehyde-owning hedge fund manager. To amass a real fortune in a few short years, you need to be sitting at the helm of a $10 billion, 3 and 50, two-year lock-up hedge fund, avoiding a blow-up. How hard can it be?
So assume you can raise $10 billion …
Attorney Ray Balestri teaches in the MBA program at SMU.