Is Trouble Brewing at GLG Partners?

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Includes: GLG-OLD, JAH, LEH
by: Eric Wolff

Alternative investments have, over the past 3 years, attracted record attention from investors, the public markets, and business students eager to cash in on the boom. Over the past several months, as the financial markets have been rocked by credit issues and declining valuations, the fairy tale, in many cases, has begun to turn dark.

GLG Partners (GLG-OLD) is one of the leading hedge funds in Europe, with a strong investment track record, diversified assets across strategies, and a solid investor base. At the same time, the company's unsustainable FY07 results (driven largely by gains in emerging markets), and its uncertain use of leverage, provide substantial catalysts for a sharp decline in revenue and earnings in FY08. If past performance is any indication, it is possible that a large chunk of GLG's performance revenue will dry up in 2008, resulting in a strong drop in revenue, margins, and profit.

GLG Incentive fees at risk

GLG is structured like a typical hedge fund, in that it earns revenue primarily based on a combination of management and incentive fees. Annual management fees equate to an average of about 1.9% of AUM. Incentive fees vary across funds, but typically average between 20 and 30% of all performance gains across most single manager products. Incentive fees accounted for 50% of revenue last year, but also tend to be higher margin, and so have a disproportionate impact on earnings.

As of the year end 2007, GLG managed approximately $24B in assets spread across over 40 funds. Though funds are widely spread, there are some concentration issues, particularly in regards to revenue:

GLG's top three funds account for only 37% of AUM, but last year accounted for 64% of revenue. Most importantly, I think it's fair to say that the emerging markets performance is nowhere close to sustainable. This implies gross returns (returns before fees) of annualized 90% since inception in November of 2005, compared to ~35% for the emerging markets ETF. Given the tougher emerging market conditions (down about 13% YTD as of this write-up) and the high growth in AUM (which makes high performance more difficult), the huge associated incentive fees should come down substantially.

Also, note that this one fund may have accounted for over 50% of GLG's management fees in the 2nd half of the year. Many of GLG's funds were actually down in the 2nd half, so this fund in particular helped artificially keep the firm's profits afloat.

The Leverage Risk

The other two funds noted above (European L/S and Market Neutral) have components of hedging, making them less prone to market fluctuations. At the same time, these sorts of hedged funds are the most likely to use leverage. Leverage allows funds to amp up their performance and was a particularly common practice over the last couple years, as low risk premiums and eager prime brokers would often loan funds capital at only 4-5%.

Over the last few months, and in particular over the last few weeks, prime brokers have begun reigning in this excess. The result varies from crippling to disastrous (see the Caryle Capital collapse). GLG is very hush hush on the extent of leverage it uses. I doubt it took on the sort of ratios that Caryle took, but analysts reports indicate that it has, in some documented cases, used leverage in excess of 4x.

Also, anecdotally, there are two points worth mentioning:

1) GLG is part owned by Lehman Brothers (LEH), which itself was an aggressive prime broker. You've got to think that at the height of the boom, there was a chance that LEH encouraged GLG to gorge itself with leverage to boost its prime brokerage business.

2) Freedom Acquisition, the SPAC that took GLG public, is run by the infamous CEOs of Jarden (NYSE:JAH), who I have written about previously. If their own appetite for leverage and risk is any indication, the leverage in GLG's funds could be scary.

If the leverage at GLG is extreme, the downside is clear: funds could blow up, leading to mass redemptions, lawsuits, loss of key talent, and potential collapse. While possible, I have no reason to believe this outcome is likely.

Painful de-leveraging

The alternative and more likely scenario, while not as bleak, is still damaging to GLG's earnings prospects. Let's assume that GLG's Market Neutral fund conservatively used 4x leverage in 2007 and earned 13.7% net fees (according to Morningstar), and charges typical hedge fund fees. Using those assumptions, you'd get an un-leveraged gross performance of only 8.2%, vs. the estimated 18.5% leveraged gross performance that was implied to get to a net performance of 10%. By borrowing 4x its money at 5% and earning 8.2%, GLG was able to return more than double on a net basis what it would have been able to do if no leverage was available.

If it does continue to use leverage and rates go up and/or gross returns go down, leverage could magnify the losses. Also, due to the nature of leverage (typically short term lending), these agreements must be negotiated often. Depending on GLG's terms, it's possible that de-leveraging could force a liquidity crisis and force GLG to liquidate positions and rapidly reduce its leverage, resulting in a sharp decline. This is somewhat unlikely given LEH's economic interest in GLG, but given LEH's own liquidity position I'm not sure they'd be able to step in to help.

The high watermark and hurdle risk

Relationships between performance and incentive fees are not linear. It's impossible to know without reviewing the incentive structure of each fund, but we do know that some of GLG's funds are subject to high watermarks, which means a fund that declines in one period must reach its prior highs before incentive fees can be charged again. Some funds are also subject to hurdle rates, meaning a certain performance benchmark must be exceeded before incentive fees can be charged. These measures should hurt GLG in tougher stock market times.

2008 Update

The bulk of GLG's funds had an abysmal January. The flagship European L/S fund was down over 4% in January and the Market Neutral fund was down 3%. The Emerging Markets fund was flat, which is impressive on a relative basis, but will not be particularly helpful in repeating GLG's outstanding emerging markets performance last year. If GLG's performance in a tough January is any indication of its ability to weather a tough 2008, flat YoY performance (and, consequentially, little/no performance fees) is not out of the question.

What does this all mean financially?

Barring stellar out-performance by GLG in these tough economic markets, GLG should experience somewhere between a rough and devastating 2008, cases that are not currently reflected in the stock price. If GLG does not keep up its rabid performance, and, worse, if performance turns flat or even negative, much of GLG's revenue and profitability will dry up. Performance turning flat or negative is not out of the question, and has occurred before. Let's take a look at GLG's historic performance:

The image quality isn't great (blogger is giving me trouble), but you can see that performance in 2000-mid 2002 remained relatively flat. Also, before the incredible launch of GLG's Emerging Market fund in late 2005, GLG's overall performance was not very impressive. GLG returned 10.4% and 8.2% net fees in 2005 and 2004, well below its most recent performance, driven primarily by its emerging market returns.

Best Case Scenario

In my best case scenario, GLG sees half of its AUM rise an average of 20% gross, and the other half of its funds experience losses. This could be possible if Emerging Market and a few other big funds do exceptionally well, despite losses in most other funds. In this scenario, GLG earns about $1/share, at the high end of estimates.

Base Case Scenario

A more likely outcome given the market turmoil is a scenario under which 65% of assets perform negatively or otherwise do not hit the rate required to charge performance fees. The other 35% of assets return 15% gross of fees. In this case, GLG earns $.65, well below estimates.

Bear Case Scenario

In another likely outcome, if January is indicative of how the year will turn out, it's entirely possible that about 75% of assets end up negative or below the rate at which performance fees can be charged. The other 25% return 12% gross returns, meaning earnings around $.40.

Conclusion

I believe the best case scenario for GLG is that they meet or slightly exceed expectations, while the likely scenario leaves them under performing by a wide margin. Slap a 10-15x P/E on the base and bear case scenarios and we can see downside between 33 and 66% to the stock price, or 66 and 90% to the warrants.

Disclosure: Author is short GLG common and warrants.