Friday, February 14, 2014

A Hidden Expense of Hedge Fund Investing: Opportunity Cost

A Hidden Expense of Hedge Fund Investing: Opportunity Cost

Scout Capital, an equity long-short hedge fund, is shutting down and returning capital to its investors.  At first I was going to write about the demand by Scout’s investors to waive its 1.5% management fee because 80% of the portfolio is already sitting in cash.  Scout manages about $6.4 billion in a series of funds.  According to the firm’s SEC Form-ADV[1], the principals have about $220 million of their own money in the fund. In addition, the data indicates that they earn more than $20 million per quarter in management fees on the money managed for outside investors.  Before starting to wind down, the firm only had 15 investment professionals, including the two founders, Matthew Weiss and James Crichton, who own 100% of the firm.  In other words, Scout Capital has been wildly profitable to its principals without even accounting for carried interest.  I’d hope that they would waive the management fee since they are no longer actively managing the money.
Sketchbook #10 (2001)
There’s a more important lesson for investors, especially for the public funds piling into hedge funds.  According to Pension & Investment Age, Florida State Board of Administration and Colorado Fire & Police Pension Association invested $200 million and $30 million respectively with Scout about a year ago.  They earned roughly 21% in 2013 net of expenses.  It’s hard to say if this is a good return or not, since we don’t how much net exposure or leverage Scout employed.  After only having their capital invested with Scout for a year, 95%of their invested capital will now sit in cash for the remainder of this quarter, and another 5% will be held back for a substantially longer period of time as Scout’s auditors and lawyers wind up the funds. 

Having capital sit in cash is an expensive proposition for a pension plan.  For example, if the market were to rise 2% during the quarter, Florida and Colorado would lose that performance while its money is idle.  They’d lose about 2.4% if the fee isn’t waived. Moreover, Florida and Colorado might incur even larger opportunity costs if they aren’t able to immediately redeploy the capital when it is finally wired into their accounts.

When institutional investors contemplate allocating capital to hedge funds, they probably don’t factor in the significant opportunity costs associated with the investment.  Whether the manager decides to shutdown or the investor decides to redeem, there will almost always be a three to six month period when an investor’s capital is idle.  For institutions trying to fund long-term pension liabilities, that’s not a good outcome.


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