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PureVC

A blog about venture capital, private equity, technology, and the markets...

The HurdleYesterday

It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.

Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.

I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my mone

It's been a tough year for private equityDecember 27 2008

It's been a while since the Madoff news broke and it does sadden me to hear the news how a single person pulled off the largest Ponzi scheme known to mankind. I am tempted to say once again that it is all about trust - a money manager must trust his partners and partners must trust their money manager. However, the Madoff scheme appeared to have all the makings of lots of relationships built on solid trust. Perhaps too much trust.

Most of the investors that had money with Madoff had a personal connection to Mr. Madoff or someone who had this connection to allow access. Additionally, statements were produced backing up transactions and asset values. And people who wanted to get their money out were able to because there were so many other investors coming in. It is easy in hindsight to say that any vigilant investor should have seen the signs. However, all of these factors enabled the kind of trust that only a money manager could dream of - blind trust from investors.

Part of me is very distraught over Madoff because it paints a bad picture of the hedge fund industry. A picture of dishonesty and scandal. Another part of me is not distraught because the people that lost money with Madoff were either of the wealth that they can afford to lose money or they were stupid enough to put 100% of their net worth with a person that they did not know very well. With any financial investment there is risk and an investor must be willing to lose his entire investment. There

Deleveraging, Recapitalizations, & Margin CallsDecember 3 2008

People still don't seem to believe or comprehend the depths and extent of the financial crisis. Here is my brief explanation. We have been in an economy built on leverage and that leverage is coming down like a house of cards. Banks and financial companies were levered 40:1 loaning monies out that far exceeded the capacity for defaults. It started with residential mortgages and sent the financial world reeling as banks packaged these loans and sold them to others. Due to recent changes in accounting rules, banks were forced to value these assets "marked to market". Thus when the market froze and there was no liquidity to trade debt, valuations declined. We saw the collapse of some venerable investment banks such as Bear Stearns and Lehman Brothers as well as thrifts such as Washington Mutual and Indy Mac and mortgage titans Freddie Mac & Fannie Mae and Countrywide - the list goes on and on. We also saw the swallowing of Merrill Lynch and Wachovia, and the near crumbling of Citigroup. Even Goldman Sachs and Morgan Stanley have not been spared.

For those of you who believe that the financial companies will be coming back anytime soon, please think again. The market no longer values any business model that relies on leverage. In order to deleverage, companies must sell assets both good and bad. This compounds the problem as these assets are worth less and less. To make matters worse, the entire industry is in trouble and there are no buyers to take on leverage (the

Hedge Fund Managers Come Out to the FedsNovember 15 2008

It was interesting to listen to the testimony provided by several hedge fund managers on Capitol Hill this week. Although I do not agree with all of the support toward more regulation, it was nice to see and hear from some of the more secretive hedge fund managers who do not typically show their faces in public. One thing is clear, the government does not really know anything about the hedge fund industry - there was no rhyme or reason why they chose those managers instead of others. And it was even more clear by the varying testimony that the managers themselves did not know exactly why they were testifying.

Do hedge funds need more regulation and disclosure? Definitely not. A hedge fund is nothing more than a pool of money that is used to make money by any means necessary through a hedged strategy. It really does not make any difference if it is a hedge fund or an individual person that has billions to throw around. I certainly do not want to have to report all of my transactions to the government on a daily, weekly, or monthly basis. And I certainly do not need to tell anybody how much margin I am using and what I am buying or selling.

Regulation is necessary to keep a fair marketplace intact and to ensure that rules are followed. Regulation cannot control greed or risk. You cannot regulate speculation. You cannot regulate irrational exuberance. And you definitely cannot regulate bearishness or short selling. If I want to bet the farm that a company is

If You Are A Hedge Fund You Should Be Making Money NowOctober 18 2008

As I've mentioned before, there is a lot of pain in this market right now. All broad market indices are down signficantly for the year. Most mutual funds are showing big losses. And now many hedge funds are being forced to liquidate positions and "unwind" as investors redeem capital.

If you are a hedge fund, you should be thriving in this environment. If you are mutual fund disguised as a hedge fund then you are not thriving. If you are a value fund and are buying shares while they are cheap only to see them go lower then you are not a hedge fund. You are an investment fund that does not hedge. The whole point of a hedge fund is to "hedge" or curb your bets so that you control risk. If you are suffering big losses then you are not hedged and you really are not a hedge fund. This is the type of market in which the real hedge funds show their attributes.

There are plenty of rumors going on in the HF world about turtle traders being let go by SAC and other firms because they cannot produce. While I do not like to see people lose their jobs, the one thing that I like about the HF industry and in particular the turtle model is that if you do not produce you are let go. If you do not produce it means that you are losing big. If you are losing big it means that you are not adequately hedged and so you should not be in the hedge fund business.