Thursday, August 15, 2013

A Hedge Fund Steps into Private Equity: Steinway

A Hedge Fund Steps into Private Equity: Steinway

At the eleventh hour, Paulson & Company stepped into the bidding for Steinway Musical Instruments (NYSE: LVB) with a $512 million offer ($40 per share) topping KKR’s previous offer of  $35 per share.  While Steinway’s board has accepted the offer, the company’s stock closed at $41.29, which suggests that the market thinks someone will emerge to pay an even higher price.  Steinway is a great company with a strong balance sheet.  However, I’m not really interested in the bidding war or valuation of the venerable musical instrument company.  What interests and concerns me is that a hedge fund is wandering into an area where they don’t belong.

Client Off-Site (2010)

Paulson & Company is the hedge fund run by John Paulson, who made vast amounts of money for his investors by betting against the mortgage markets in 2008.  He is also the manager who lost a big wager on gold in recent years.  Paulson has $18 billion under management, so the Steinway acquisition would not be too big for the hedge fund to swallow. 

The SEC regulatory filings do not reveal precisely which of Paulson’s investment funds will be acquiring Steinway, but I’m pretty sure its hedge fund investors will be funding the Steinway acquisition if the bid succeeds.  If I were an investor with Paulson, I’d have some significant concerns about this potential investment.  While the legal documents probably permit Paulson to acquire illiquid assets, that’s not what his investors expected when they committed to his funds. 

Many hedge funds leave room for exotic forays in something called a “side pocket.”  Frankly I’ve never understood why hedge fund investors tolerate this sort of investment, as it usually involves esoteric and illiquid investments that aren’t central to the hedge fund manager’s expertise.    Many hedge fund managers like to include side pockets in their legal documents because it allows them to dabble in far -flung areas with their investors money.  Nonetheless side pockets are a bad idea. 

As an investor, I’d view the Steinway deal as potential distraction to Mr. Paulson and his team.   Overseeing a private company involves a different set of skills from buying and selling securities.  Steinway may be a great acquisition, but a hedge fund is the wrong acquirer.

Investors develop an asset allocation so that their capital is properly diversified between stocks, bonds, real estate, private equity, and other assets.  By acquiring Steinway, Paulson is muddying up its investors asset allocation process.  They’d be better served if a private equity firm did the Steinway deal.

Mr. Paulson’s bid for Steinway illustrates the hubris found in all too many money managers.  Because they are fabulously rich and successful, they think they can do anything.   Eventually, they make an investment that is far beyond their expertise.  It’s those types of investments that tend to have unhappy endings.

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