Bridge over ocean
2 May 2019 CFA Institute Journal Review

Public Hedge Funds (Digest summary)

  1. Priyank Singhvi, CFA

Performance analysis of hedge funds before and after a listing suggests that performance deteriorates. This deterioration is attributed to increased conflicts of interests among the shareholders, investment managers, and investors. Conversely, these conflicts have also benefited these same groups through growth in assets under management, higher fee income (and earnings), increased breadth of product offerings, and improved fund transparency and liquidity in the medium term.

What Is the Investment Issue?

Asset management companies (AMCs) going public argue that better employee incentives—listed stock, greater financial performance transparency, and investments in technology and marketing—after listing are the key advantages. However, public listings are not necessarily advantageous in terms of fund returns. The authors examine pre- and post-listing data of hedge funds to determine the effects of going public on hedge fund performance.

How Did the Authors Conduct This Research?

The authors analyze net-of-fee monthly returns and assets under management data of 30,509 hedge funds reported during 1994–2013 in TASS, Hedge Fund Research, and BarclaysHedge. Screening to eliminate funds with multiple shares classes leaves a total of 16,592 hedge funds, of which 5,947 are live funds and 10,645 are dead funds representing a variety of strategies managed by a spectrum of AMCs.

Portfolio risk-adjusted performance is calculated using the seven-factor model of Fung and Hsieh (Financial Analysts Journal 2004). The authors use ordinary least-squares regression and its variations to further test the findings. They carry out an event study around 60-month windows before and after the IPO as well as an array of robustness tests to ensure that the baseline findings are consistent across various scenarios and peculiarities of hedge fund industry.

What Are the Findings and Implications for Investors and Investment Professionals?

The authors find that five-year average risk-adjusted performance after going public deteriorates by an annualized 8.4%. The average five-year firm alpha wanes by 7.2% post listing. Even after accounting for risk factors known to have considerable explanatory power over hedge fund returns, performance still turns out to be lower by 2.9% a year, even after adjusting for such factors as illiquidity and share restrictions, incentives, fund age, fund size, return smoothing behavior, backfill and incubation bias, and manager manipulation of fund returns. These baseline findings are consistent across years, fund types, and asset management company types.

Inherent agency conflicts of interest among the fund managers, the fund investors, and the shareholders of asset management companies are only exacerbated after listing publicly and are the key reason for the post-listing performance drop.

Each of these agency conflicts is affected by different factors, which in turn give rise to varying impacts on the alpha spread between public and private firms. Overall, listed management firms with greater separation of ownership, control, and investment capital exhibit more acute underperformance. With respect to the conflict between control and investment capital, the alpha spread is smaller when manager deltas, governance scores, co-investment by fund managers, and manager ownership of AMCs are higher. With respect to the conflict between ownership and investment capital, short-term stock price pressures further contribute to this conflict, as evidenced by the increased underperformance of firms with a greater earning response coefficient of AMC stock prices.

Despite this underperformance, listed firms seem to be able to grow their fee revenues (55% higher than the unlisted control group) and assets under management (78% higher) in the post-IPO period studied. This asset gathering happens both through the existing funds and through the launch of new funds. These new demands divert fund management companies’ attentions away from managing the funds and toward the short-term pressures of revenue and earnings growth faced by public companies.

Abstractor’s Viewpoint

These findings should lead to a greater realization that striving to monitor and reduce these conflicts as well as proactively and creatively constructing a greater alignment of interests among managers, investors, and owners/shareholders—in both public and private contexts—can prevent deterioration in performance, which would eventually work well for all stakeholders and for asset management industry as a whole.

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