The cascading effects and the hedge funds’ dilemma

A topic seldomly been brought about but it is also indispensable in decision making is the cascading effects of different investor sets. It is important to notice that because of the large spread of the expected returns of different investor sets the different investors can view the same opportunity totally differently.

The idea behind it is so well-known in ordinary asset classes that money market, bond and equity market are suitable for different investors sets. What is commonly missing is that there are also quite big gap between hedge funds and mutual funds, ETFs and other low cost equity investment apparatus. Because of the much higher cost stuctural (normally 2% management fee & 20% carry) and much lower flexibility (normally more than half year lock up period and fixed redemption periods), it is reasonable for the hedge funds LPs to have a higher expectation of at least 10% after fee annual return, which translates into an at least 12.5% before fee annual return. And for the smaller and less pretigious hedge funds that requirement can go up as high as 15% or even 20%. To acchieve a return much higher than everybody else, HF managers have to be more risk taker and willing to go against trend, as a result. Understandably, there is no easy money to be made for those high price tag services.

Here is one example of a truly great growth opportunity. Let’s assume a company can grow at 30% annual rate in next 5 years and can be assigned at 25 PE at the fifth year. What is the propriate price for this growing opportunity?

As mentioned above, for most of the hedge funds, especially those smaller and less prestigious, they are aiming at a compounding return of 15-20% or even higher to justify their much expensive charging fees, no matter what the certainty of the opportunity is. In this case, sticking with the compouding discipline would mean an early exit of this great growth story. Even if you are aiming to achieve only 15% compounding return, you should exit this opportunity at 46 PE and lose more than half of its future upside potential.

Likewise, when we look at opportunities in a more bulging and consistent business, as internet, software, cloud, etc, which aims at a 10 year 25% compounding growth rate, a truly exceptional and salesforce, google, facebook, alike opportunities.

We will see, assigning different discount rate we can arrive at widely varied PS valuation, depending on what expected returns the investors and market are looking for. For a 15-20% return HF, a much earlier exit under strict discipline would mean missing most of the upside potential. Which can be so disappointing. However there has to be some price to be paid for the higher expected returns.

The difficulty for hedge fund managers are their much higher expected returns can push them out of some great opportunities much earlier than their mutual fund and other institutional peers who have much lower expected returns. And the missing part can be huge sometimes, if the HF is stick to their discipline.

It is notable that the market discount rate can vary greatly within hedge funds and can move both downwards and upwards:

The market discount rate move downwards when:

1, The risk-free rate decreases; especially when today, many of the major treasury rates are moving to negative territory.

2, The market risk premium decreases; maybe because the expected returns of other asset categories also drops;

3, The stock specific risk premium decreases, due to certainty and confidence increase.

Likewise, the market discount rate can also move upwards when:

1, The risk-free rate increases;

2, The market overall risk premium increases;

3, The risk premium increases, due to certainty and confidence reduce.

Therefore, an investor can earn a profit by setting a discount rate at first and stand by the discipline or anticipate where the market discound rate will be in the future, as the current price is mainly driven by the market concensus discount rate. Anticipating the market can be much more difficult than analizing the foundamentals as the market can be quite whimsy and capricious. So far, BEDROCK had not found a perfect way of doing so. Thus, we mostly stayed in our boundaries and chose to let go a big chunk of profits when targeted compounding return drops below our 15% minimum rate. We have full awareness that we can never grasp every opportunity and every bit of profit. Luckly enough, with global horizon, there are still many opportunies out there which can provide more than 15% or even 20%+ compounding returns under nowdays valuation and growth projection.