What's a Hedge Fund Worth? Insight From Morgan Stanley's Buyout Binge

by: Greg Newton

Morgan Stanley’s (NYSE:MS) three-day hedge fund acquisition spree this week, during which it cut wires for $1 billion more or less, added some datapoints for the always fascinating game of ‘What’s a hedge fund worth?’

While the official proclamations were silent on key terms, the usual “people familiar with the situation who declined to be identified” blabbed to Bloomberg (among others), allowing me to calculate a definitive number:

It depends.

Monday’s deal, for New York-based Avenue Capital Management, valued the distressed strategies specialist at roughly 12.3 percent of assets, a slight discount to the 13.2 percent valuation paid on Wednesday for London-based Lansdowne Partners. In both cases, Morgan Stanley acquired minority stakes, said to be slightly less than 20 percent; the $12 billion Avenue’s principals collected a reported $280 million, while Morgan’s piece of Lansdowne, and its $12.5 billion in assets, reportedly cost $300 million.

FrontPoint’s owners, many Morgan Stanley alums headed for top jobs in Morgan Stanley Investment Management, collected the largest check – a reported $400 million – but they sold the whole company, getting just 7.25 percent of its $5.5 billion under management. Several things:

  • Speaking of blabbermouths: While it’s hardly a valuation point, the FrontPoint deal was widely anticipated, and had been for as much as a year; word of the pending Avenue transaction began spreading at least two weeks ago. By contrast, Lansdowne’s name hadn’t come up, and the proclamation was nearly as much as a surprise as that yesterday (Thursday, Nov. 2) passed without Morgan buying into yet another hedge fund.
  • It's going back in the pot: In a move probably intended to quell investor concerns about on-going commitment to showing up in the morning, both the Avenue and FrontPoint partners said a significant proportion of the proceeds would be reinvested in their respective funds. Which may give Lansdowne investors pause; if its serangs made a similar commitment, it didn’t make the press release. Valuation point: If their proceeds aren’t committed to the pot, that widens Lansdowne’s premium, even if only by a little.
  • Growth costs: All three firms are well-regarded, but Avenue and Lansdowne are growing faster; Bloomberg, citing Institutional Investor’s Alpha magazine, said that Lansdowne’s assets had almost doubled since 2005, while Avenue had added $5 billion, or 70 percent, to its asset base in the last 18 months. Both firms also represent traditional large hedge fund structures, each offering a range of strategies focused on core competencies; distressed-related, with a credit concentration, in Avenue’s case, and equity-related in Lansdowne’s.
  • A little off the top: Some of the FrontPoint haircut can be attributed to the business model. While often billed as a multistrategy fund, it is more precisely a central infrastructure support platform for what the Morgan Stanley press release said is “11 experienced teams pursuing 21 different investment strategies” under the FrontPoint banner. The risks of that approach were clearly exposed in Feb. 2006, when California-based Ivory Investment Management LLP, which then accounted for about 30% of FrontPoint’s assets, decided that it had outgrown the structure.

    In 30 months with FrontPoint, starting in Aug. 2003, Ivory’s assets had grown from $300 million to around $2 billion. That and its net cumulative return of 35 percent accounted for a significant proportion of FrontPoint’s asset growth and performance.

    The company has moved rapidly to overcome that loss, adding China and consumer and industrial equity teams, and as recently as last month announcing a “strategic partnership” with Menachem Sternberg’s Eagle Trading Systems to offer a quant-based macro strategy product. But its total assets remain below their peak.

  • And some off the sides: But at least some of the discount was likely self-inflicted. Morgan Stanley was close to acquiring FrontPoint when the Ivory issue flared; in Jun., founding partner Philip Duff stepped down as chief executive, retaining his chairman’s title. The change was officially intended to “flatten out the company’s organizational structure,” or somesuch similar nonsense.

    A more likely, and never denied, scenario was painted by Hedge Fund Alert in its Jun. 21 issue, which broke the story of Duff’s sidelining. “Outsiders familiar with the company,” said the move resulted from a clash between FrontPoint’s portfolio managers and Duff, who not only rebuffed demands for more favorable terms but may have alienated some by asking them to invest some of their profits in FrontPoint.

Once the transaction closes – it’s the only one subject to regulatory approval and other consents – Duff will become a consultant on firm strategy to Morgan Stanley chairman and chief executive John Mack. His fellow founders? Gil Caffray, who assumed the title of managing partner after Duff stepped aside, will become vice chairman of Morgan Stanley Investment Mgt, and continue managing the FrontPoint Multistrategy Fund, while Paul Ghaffari will establish an independent investment firm.

Other FrontPoint notables taking MSIM roles include Mike Kelly, Arthur Lev, Joanne Pace and Daniel Waters.

Noted with interest: If the going rate for high-profile hedge funds is 13 percent of assets, Amaranth was worth around $1.2 billion, on or about Sep. 1. Gulp. As John Lennon had it, Imagine...

Noted with interest II: Closing three deals of this size, and doubtless complexity, on three consecutive days is something more than a mere triumph of scheduling. Is that Purcell guy still cornered in Tora Borah...or do I have that wrong again?

Bloomberg coverage
Morgan Stanley Buys Minority Stake in Avenue Capital
By Jenny Strasburg and Christine Harper
Bloomberg Oct. 30 2006

Morgan Stanley to Buy FrontPoint Hedge-Fund Firm
By Jenny Strasburg and Christine Harper
Bloomberg Oct. 31 2006

Morgan Stanley Buys Stake in Lansdowne Hedge Fund
By Andrei Postelnicu
Bloomberg Nov. 1 2006

Press releases
MSIM Forms Strategic Alliance with Avenue Capital Group
Oct. 30 2006

Morgan Stanley to Acquire FrontPoint Partners
Oct. 31 2006

MSIM Acquires Stake in Lansdowne Partners
Nov. 1 2006