WHEN NORWEGIAN DIRECTORY company Findexa was planning its innovative high-yield IPO in May 2004, it expected as much as 50% of demand to come from high-net-worth individuals, private clients and retail investors. But when this demand failed to materialize it wasn't long-only investors that filled the gap but hedge funds. Half of the IPO went to hedge funds and just 30% to long-only accounts.
Hedge funds are now rivalling if not eclipsing traditional fund managers as the main buyers of new equity issues. Hedge funds have long been the main buyers of new equity-linked and accelerated deals: it now looks as if their presence as substantial investors in IPOs is here to stay. Their rise is changing the equity new-issue dynamic.
Investment bank underwriters had little choice but to turn to hedge funds to complete what few primary equity capital market deals there were between the collapse of the dotcom bubble and the return of the IPO market in the third quarter of 2003. Long-only investors stayed well clear of the primary market. Although they have since returned, hedge fund allocations in IPOs have settled at an average of anywhere between 20% and 50% according to syndicate bankers – substantially higher than in times of comparable IPO activity.
As more and more money flows into hedge funds and they become bigger players in all financial markets, it is hardly surprising that their demand for ECM deals has increased. What is surprising, however, is the extent to which their allocations have increased.
Is the growing power of hedge funds in new issues bad news for companies selling equity? And what lies behind their growing importance in the primary equity market?
Many issuers, such as Google, which last month moved to limit hedge fund participation in its controversial IPO, remain wary of hedge funds because of the common perception that they are short-term investors with high portfolio turnover rates and that they habitually short outstanding shares or comparables.
Syndicate bankers, however, increasingly take their side. They argue that many hedge funds are no longer the second-, third-, or even fourth-tier accounts they were once considered. In fact, a large number of ECM and syndicate bankers now suggest not only that hedge funds are quality accounts that deserve high allocations but that they are actually better accounts than many traditional fund managers. The received wisdom is being turned on its head.
Hedge funds, say syndicate bankers, are smarter, faster, and harder-working investors than traditional accounts. They are more likely to take time to study a deal, meet management and provide useful feedback than are many of the largest traditional fund managers.
Some bankers even argue, in contrast to the popular perception, that hedge funds are also more trustworthy. They are less likely, they say, to try to influence the price of deals by clubbing together or by talking to the press about the level at which specific deals ought to be valued, as institutions did with Google and in the run-up to Deutsche Postbank's IPO in June 2004.
Hedge funds are also more likely to put their orders in early instead of waiting until the last minute, a habit of long-only fund managers trying to unnerve issuers into lowering the price. It's a game that syndicate bankers find intensely frustrating. The comparatively early involvement of hedge funds in IPOs makes them the leading source of momentum in deals, which can be crucial in attracting other investors.
Some vendors are coming around to this more favourable view. "Hedge funds are more willing to do the work and understand difficult deals," says the European managing partner of a US private-equity fund that was involved in a recent IPO. "The typical UK institutional investor uses more gut feel and common wisdom."
Syndicate bankers also say that many hedge funds are long-term fundamental investors and so are desirable accounts with which to place stock.
But how much of investment bankers' hedge fund cheerleading is motivated by their desire to do more business with the hedge fund community that butters their bread?
Aftermarket effects
Large-scale hedge fund participation might be crucial to whether an equity capital market transaction succeeds at all. But it brings near-term and longer-term worries.
In the longer term, hedge fund managers promising absolute returns have a greater incentive than traditional fund managers to secure returns from an IPO by selling parts of a performing stake regularly. This kind of regular drip-feeding into the market can help to depress the aftermarket performance of IPOs for many months.
If hedge funds sell, it is the long-only funds that eventually pick up the pieces. Hedge funds focused on absolute returns are also more fixated on short-term performance than long-only accounts and, bankers concede, also tend to be the first investors to dump a company's shares at the first sign of trouble to cut their losses.
The suggestion that long-only fund managers are somehow less desirable accounts with which to place stock than hedge fund managers is highly questionable given the greater variety of games that hedge fund managers can play in the run-up to a new issue.
One strategy they play is to short comparable companies against which an IPO is being priced. By shorting the comparables, often using leverage, hedge funds might be able to drive down the valuation that a company receives. It does, however, also mean that hedge funds are likely to bid higher to ensure that they get enough stock to cover themselves. But such behaviour can lead to a hedge fund-only book at the top of the range, pricing out long-term investors that need more price protection in order to take a longer-term view and because they can't short the comparables.
It is a risky game but one that hedge funds – as they get larger allocations – are growing more confident of playing. "The problem is that if everyone were to play by the same rules then you wouldn't have to give them the stock," says a global head of ECM at a European investment bank. "But they are now such big players that they will short comparables and fully expect that someone will look after them and get them the allocation they want because they're so important on the trading side."