Peeping through the hedge

A once opaque industry has started to open up

Hedge funds - once characterized as secretive, private and lacking in transparency - have changed. In 1990 there were as few as 300 funds in the US. Now, they number over 7,000 and constitute a $650 bn industry. In the next five to ten years, hedge fund assets are predicted to exceed $1 tn. Like any great secret, it seems they're too good to be kept quiet.

Sticking its head above the parapet, however, has meant that this mainly unregulated industry has become the subject of calls for greater oversight. In September the SEC published the findings of its study of hedge funds - research which was spurred by a lack of information about them, coupled with their recent growth.

But the SEC says any changes in regulation would not affect the fundamentals of how hedge funds operate. No restrictions would be put on a manager's ability to use investment instruments; no disclosure of trading strategies or portfolio positions would be required; and there would be no call to identify hedge fund investors. Instead, it seems the aim is to increase general transparency and accessibility - making hedge funds more company- and investor-friendly. It might also help the funds throw off their shark-like image.

Murky reputation

Malaysia's former prime minister, Mahathir Mohamad, once famously called hedge fund managers the 'highwaymen of the economy'. For many investor relations officers this image persists. 'Hedge funds are certainly not something we try to target,' admits Dwight Grimestad, vice president of IR at Archer Daniels Midland (ADM). 'By definition they're going to be very short-term holders, so we don't proactively see hedge fund managers.'

Grimestad says he would be very reluctant to bring hedge fund managers together with ADM's senior management. 'My CEO is expecting to see people who will take the time to understand the stock and the story,' he explains. 'If I brought a hedge fund manager by his office, he'd ask why I'd done so. A hedge fund will be in big or out big, and it's not the CEO's priority to spend time with people like that.'

For Grimestad, a big problem is the secretive nature of hedge fund managers. 'With the positions they take, they're intentionally trying not to tell you what they're doing, as they don't want people to get in front of them,' he says, adding that while he does respond to hedge fund managers, he keeps their strategy in mind. 'I think it's important that everybody understands what they're trying to do; that's the nature of the game,' he concludes.

John Chironna, US-based vice president of investor relations at ABB, concedes that many IROs share Grimestad's opinion. 'When you mention the term 'hedge fund' to IROs, many shy away and say, I'm not going to waste my time,' he notes. 'They have very negative views of hedge funds and think they're all short-sellers.' Chironna, however, does not agree. 'I will talk to any investor with an interest in my company - that's how I view my job,' he says. 'I meet with hedge funds fairly regularly and not all are short-sellers. In fact, a number of them have long positions in us.'

Chironna admits that his relationship with hedge funds isn't entirely smooth, though. 'At the risk of generalizing, hedge fund managers tend to be more aggressive and less polite,' he says. 'They push really hard on certain issues and ask much stronger questions. They look for something that's going to move the share price more quickly, rather than sitting back and looking at the long-term growth of the company.'

Washing away sins

But as Chironna points out, not all hedge funds are short-sellers. In fact, one of the key features of the hedge fund industry is its diversity, with the variety of strategies far exceeding those available in the mutual fund industry. And while some have highly aggressive investment strategies, others value protection of investors' capital.

'Some companies perfectly understand that there are different investment styles,' comments Daniele Serruya, a fund manager at Olympus Capital Management. 'But hedge fund managers are demonized, particularly in continental Europe - and it's without reason. We are professional investors like any other professional investor and it's an IRO's business to treat all his or her investors in the same way.'

Don DeLaria, vice president of IR at Regal Entertainment Group, says he does treat all his investors the same, he doesn't view hedge fund managers negatively, and has 'no reservations whatsoever' about bringing them in front of senior management. But he says Regal Entertainment makes every attempt to appeal to investors with a long-term focus, and discourage those who might be looking to short-sell.

'With week-to-week box office results, we're one of the more visible industries,' he explains. 'But by not talking about our weekly box office results on a regular basis, we try to encourage long-term trading based on our overall financial performance.'

What is important to DeLaria is recognizing that hedge funds come in a variety of styles, so they shouldn't be written off. 'We try to attract the best shareholders for the company, and increasingly that can mean hedge funds,' he explains.

This attitude is indicative of a new wave of thought towards the hedge fund industry. Now, rather than being seen as the 'highwaymen of the economy', it is recognized that hedge funds can have a positive impact on a company's stock, even if they are short-selling. The UK's Financial Services Authority even approves. 'Our view is that short-selling in many ways enhances the functioning of the markets,' confirms FSA spokesman David Eacott.

Theodore Economou, assistant treasurer at ITT, agrees. 'Hedge funds provide liquidity in the market, and liquidity is a key driver of stability in the share price,' he says. 'One of the functions of IR is to ensure there's enough liquidity in the stock, so it's important for IROs to engage hedge fund managers.'

As hedge funds move from the fringes of the investment world to become key players - with a large amount of money under their control - it has become increasingly important for IROs to notice them. But many still prefer to proceed with caution.

'The onus is on IROs to do their homework prior to talking to hedge funds,' explains Economou. 'With traditional investors, you might not have to do a lot of research because you know pretty much what they're rooting for. But it's important to have discussions with stock-watch firms, sell-side analysts and equity sales in order to have a good understanding of hedge fund managers' styles, before you actually talk to them.'

According to Economou, this approach has paid off for ITT. 'We've been selective in the hedge funds we have chosen to cultivate, and generally the impact has been beneficial,' he notes. 'It has increased liquidity in the stock, and has opened up a new clientele for the shares.'

Moving closer

This idea that IROs need to do their homework about hedge funds is something that Serruya agrees with. In her opinion, the image problem that hedge funds suffer from 'is largely linked to a lack of information.' DeLaria, too, feels there's a general lack of knowledge about the hedge fund industry. 'The more detail we can get about funds the better,' he says. 'But some funds just aren't willing to provide that information.'

In considering new regulations, the SEC is most likely hoping that hedge funds come to be better understood. But Benjamin Chui, managing director of American Pegasus, believes that even with changed regulations, the mysterious image of hedge funds will persist. 'Transparency is always in comparison with what's available to the general public from other investment vehicles,' he explains. 'Even with the SEC regulations, hedge funds would still be considered a very opaque bunch of investment managers.'

While this opacity might be a bad thing for companies, it's not necessarily something the hedge funds resist. As Mark Latham, director of investment at Odey Asset Management, says, 'Hedge funds to a certain extent revel in their own image - we like being the bad guys.'

So despite government bodies keeping a closer eye on them, IROs learning more about them, and companies recognizing that they can sometimes have a positive impact, hedge funds may not entirely lose their 'villainous' reputation.

But that's all the more reason for IROs to cozy up to the hedge fund managers who come knocking at the door.

Take heed, all you courageous IROs out there: keep your friends close and your enemies closer.

A hedge too far

A hedge fund trader, who prefers to remain anonymous, offers his view of IR

My experience with IROs has been less than satisfying. After years of working on the buy side, one might say I'm used to being coddled. Because of my company's formidable investing power, I usually receive excessive attention from the sell-side professionals I deal with every day.

While I realize IROs are busy, I want to be given more time and a more sophisticated response to my questions. Without exaggeration, the following summarizes the type of conversation I have with most IROs.

ME: I'm a trader for XYZ hedge fund, and would like to know how you feel about the increased competition in the industry and the weak consumer numbers we've had in recent weeks.

IRO: We feel we'll maintain our market share - the consumer numbers are cyclical and will rise again when shopping season comes.

ME: I am looking into taking a sizeable position in your company's stock. Do you have a view on the company's performance in the near term?

IRO: We should continue to do well. We have a superior product and there's plenty of market share to go around, so we're not unduly concerned about the increased competition.

ME: Is there anything else about the company on a more microscopic level that you think I should consider before taking a long-term position?

IRO: Tell you what, give me your e-mail address and I'll send you some literature.

In fairness, I did get an answer to all my questions. But what I sought was a little more candor. Pacifying me didn't necessarily deter me from investing in the company, but it certainly didn't make me more excited about the prospect of doing so. I would have benefited more if the IRO had said the following: 'Well, competitor A's new line has taken some of our market share, and that's why our first-quarter numbers were a bit below expectations. But two years ago, when we had a similar fall in numbers due to a new product from competitor B, although there was a short-term drop in the price of the stock, it did rebound. This was down to our ability to adjust to increased competition.

'We have been around for 60 years, and competitors come and go. What allows us to maintain our strength and consistency is a flexible business model that gives us room to react to changing conditions. Our second-quarter numbers are out in a week - why don't you wait to see how these come out, and if they're good you'll see we have steadied the ship. If the stock price drops after the numbers, you can view it as an opportunity to buy a great company at a lower price.

'If you want to discuss the specifics of the results after the numbers are released, please call back and we'll chat. Of course, keep in mind that, like all companies, we are subject to general market conditions. But we're a low beta stock and one that's worth owning if fitted appropriately into your portfolio.'

The IRO alludes to potential weaknesses in the company but also addresses them and tells me why they're not insurmountable issues. This gives me the feeling he has been frank with me, and I have received information beyond what's in the company's monthly statement.

When I call an IRO, I'm looking for color I can't find anywhere else. When I'm given generic answers, I have wasted my time. But when I'm offered true candor and attention from an IRO, the results can benefit both the company and me.

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