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What Exactly Is It that a Hedge Fund Hedges?

October 15th, 2006 by David Kronemyer · No Comments

There has been a spate of recent developments in the esoteric world of what the financial community calls “hedge funds.” While I’m sure they’re piggish in their own right, hedge funds have nothing to do with hedgehogs, or topiary, for that matter. Rather, the hedge fund is a form of investment vehicle that has sprung up to cater to the needs and requirements of institutional investors, high net-worth individual investors, and the like.

In classic market theory, a “hedge” is a way of avoiding, or at least mitigating, risk. One of my favorite examples is what happened to Western Electric Corp. in the mid-70s. At the time, one of Western Electric’s businesses was building nuclear power plants. As a price inducement to lure potential customers (which were large utilities) into ordering reactors, Western Electric guaranteed to deliver uranium at a favorable price (the uranium being necessary to operate the reactor). At the time, uranium was cheap, and Western Electric’s accountants (financial geniuses all) thought there was “no way” it would climb.

Of course, this is exactly what happened. The price of uranium rose five-fold, and Western Electric found itself obligated to deliver uranium to its customers for a price that was far less than the price it would cost Western Electric, to buy the uranium. As a result, Western Electric would sustain a loss on each transaction, and a huge loss overall.

So, Western Electric declared it would not perform its contractual obligations, characterizing the price rise (rather ineffectually, I think) as an “act of God.” Naturally, the utilities sued, for about $2 billion dollars – i.e., the difference between the contract price, and what it now would cost the utilities to “cover” and obtain substitute uranium, on the open or “spot” market. At one point, legal claims against Westinghouse on account of these lawsuits totaled nearly 70% of its assets! Stuart, R., “Utility to Buy Uranium At a Quadrupled Price,” New York Times (Dec. 9, 1975); Martin, D., “Suit Ended on Supplies of Uranium,” New York Times (Jan. 30, 1981).

All of this could have been avoided had Western Electric simply hedged its exposure, by buying futures contracts in the uranium market. Such a contract would obligate the seller of the contract to deliver the uranium, on the date the contract became due; or, to pay to Western Electric the difference between the contract price, and the then-current market price.

This is just one example of hedging; there are many others. Hedges are commonly used, for example, in foreign currency transactions (to lock in a particular exchange rate); in the commodities market (so a farmer knows exactly what his grain will sell for, when it comes time to reap what he has sown); and in the stock market (to narrow the range against which the price of a stock either will appreciate, or depreciate).

The problem is that I don’t see any of today’s hedge funds engaging in this type of strategy. Rather, it appears that what they’re doing, simply is going out and buying a lot of assets – that is, holding a “long” position in those assets, without a counterpart hedge. As a result, the hedge fund is exposed to all of the market risk that the investment presents. While it is possible the investment will appreciate in value, the converse also is true. If the former is the case, then the investors will make money, and the managers of the hedge fund will look like they’re financial geniuses. If the latter is the case, then the investors will lose money, and the managers will look like idiots. Either way, whatever; the problem is that it isn’t a hedge.

This issue came to the fore recently When Amaranth Advisors, a $9.2 billion hedge fund, shut down after losing $6.5 billion in less than a month, Anderson, J., “Hedge Fund With Big Loss Says It Will Close,” New York Times (Sep’t 30, 2006); Sender, H. & Zuckerman, G., “Amaranth Halts Withdrawals; Talks With Citigroup Falter,” Wall St. Journal (Sep’t 30, 2006). Another hedge fund, once “one of the world’s largest,” has lost more than a quarter of its value, Patrick, M. & Macdonald, A., “Vega’s Funds Are All Losing Money,” Wall St. Journal (Oct. 6, 2006).

Another interesting case is Relativity Media. In a short period of time, Relativity has achieved spectacular success in assembling credit facilities for major studios. It put together a $528 million package for Warner Bros. Pictures, McClintock, P., “WB, Relativity order up a six-pack,” Daily Variety (Oct. 5, 2005); McNary, D., “Warner banks virtual coin,” Daily Variety (Dec. 6, 2005). Then, a few weeks later, it launched another package worth more than $600 million to finance films at Sony and Universal, Synder, G. & LaPorte, N., “Funds pop for pix,” Daily Variety (Jan. 19, 2006); Munoz, L., “2 Studios Acquire Financial Partner – Columbia and Universal will share profits with an equity group to cut risk of losses from flops,” Los Angeles Times (Jan. 20, 2006). Yet a third fund raised an additional $700 million for the two studios, LaPorte, N. & Snyder, G., “Relativity factor – Fund raises more cash for Sony, U pix,” Daily Variety (May 11, 2006).

These transactions, among others, have lead to speculation in the movie industry that hedge funds have created a new template for financing film production, in much the same way that tax shelters were in the 1980s, and the German Neuermarket in the 1990s, Snyder, G., “Other people’s money – Studios look to outside investors for financing,” Daily Variety (Jan. 22, 2006); Goldsmith, J., “H’w’d open-book policy,” Daily Variety (Jan. 22, 2006). In fact, many foresee a decreased role for the major studios, as talent contracts directly with the hedge fund for financing, and then simply “rents” the studio’s marketing and distribution system,” “Your own private equity – Indie bizzers debate the opportunities and implications of the latest wave of financing that’s hit Hollywood,” Daily Variety (Sep’t 10, 2006); Holson, L., “Wall Street Woos Film Producers, Skirting Studios,” Wall St. Journal (Oct. 14, 2006).

Ryan Kavanaugh, Relativity’s co-Chief Executive, has said that, in principle, all of the Relativity transactions are 50-50 splits of production costs, with a corresponding 50-50 split in net proceeds, “Studios, Relativity Media Raise Funds for 19 Films,” Los Angeles Times (May 12, 2006). The facilities aren’t just for one movie, but rather, have adopted more of a “mutual fund”-type of approach. “Financing one movie is risky,” says Kavanaugh, “But financing a lot of movies is not risky. If done right, this industry is not more risky than any other,” Munoz, L., “2 Studios Acquire Financial Partner,” op. cit. And: “The investors we work with understand the film-slate methodology,” he said. “That’s why we are in the business of diversification. No one’s going to bat a thousand, and there are going to be some films that lose money and some that lose significant money. But all in all, money will be made,” LaPorte, N. & Snyder, G., “Relativity Factor,” op. cit.

But look carefully at what’s happening here. The hedge fund in effect is hedging the studio’s risk, by absorbing half of the production budget. Recoupment isn’t strictly pari passu, because the studio gets to recoup prints and advertising costs (“P&A”), collect interest, and also earn a distribution fee, probably in the range of 12.5%. Furthermore, all of the “gross” profit participants – such as the lead stars, and the director – come “off the top.” The result is that the revenue base from which the hedge fund recoups, becomes considerably smaller, with correspondingly greater risk. Significantly, the hedge fund itself has no “internal hedge,” such as separate recoupment corridors, laying off risk on something like residual value insurance (“RVI”), or any other kind of device or mechanism that would provide a hedge, properly understood. Rather, the hedge fund simply is holding a “long” position in an asset – which is half of the net proceeds potentially derivable from the commercial exploitation of the film property. I’m not sure I would be giddily happy about this, if I was the hedge fund investor, i.e., the person who has put money into the hedge fund, thinking it would in fact be hedged.

“With all the x-factors facing the business right now, with studios having no way to predict what is going to happen, they’re hedging their risks,” says one dealmaker. “That way, they won’t lose as much if they guess wrong and audience patterns worsen or the DVD marketplace starts to shrink.” Snyder, G., “Other people’s money,” op. cit. Of course this makes sense, especially when, like any other form of commodities speculation, there are chumps on the other side of the deal to absorb the loss. “I’m always leery when I see huge piles of money flowing into anything, whether it’s the movie business or chemical companies,” says Vic Hawley, a fund manager at Reed, Conner & Birdwell, adding, “I’m not nervous for Hollywood – I’m nervous for the investors,” Goldsmith, J., “H’w’d open-book policy,” op. cit.

And losses there will be. For example, the Warner Bros. picture “Poseidon” cost some $160 million to produce, plus let’s say another $25 – $30 million to market – yet only was able to achieve a domestic theatrical box office gross of $61 million. “With ‘Poseidon’ capsizing at the U.S. box office, the honeymoon cruise is over for Virtual Studios, the private equity fund that split the pricey production budget 50-50 with Warner Bros. Pictures. * * * Disappointing performance of Warners’ first summer tentpole could serve as a bellwether for the parade of private equity firms coming to Hollywood in recent months and inking co-financing deals with all the majors. ‘Poseidon’ is the first of these films to underperform to such a degree – causing plenty of buzz on Wall Street on Monday,” McClintock, P. & Goldsmith, J., “Sea change at H’wood newbie,” Daily Variety (May 15, 2006); see also Horn, J., “Investors hope to cruise but sometimes sink,” Los Angeles Times (May 16, 2006).

Another example is the yet-to-be-released movie, “Evan Almighty,” which, with a budget of $175 million, holds “the dubious honor of being the most expensive comedy ever,” Munoz, L. “Budget Overruns of Biblical Proportions – Universal tries to tame spending that may make ‘Evan Almighty’ the costliest comedy ever,” Los Angeles Times (Oct. 9, 2006). This has lead to what has been described as considerable “nervousness,” Snyder, G., “The pressure cooker – After D’Works exit, new U team hammers out a slate,” Daily Variety (Oct. 8, 2006). If “Evan” under-performs – and it surely will, given the inflated expectations accompanying it – this undoubtedly will result in another “reality check” for the hedge fund schematic.

UPDATE: Mr. Kavanaugh was the subject of two articles that, on balance, have to be characterized as less-than-flattering: Kelly, K., “Defying the Odds, Hedge Funds Bet Billions on Movies,” Wall St. Journal (Apr. 29, 2006); and, Christensen, K., “PR Guru’s Public Spat Over a Debt,” Los Angeles Times (Oct. 21, 2006). We wish him luck!

UPDATE: “Private-equity firms have broken the fund-raising record they set in 2000, with almost two months left in the year. As of yesterday, 278 private-equity funds — which invest in corporate buyouts and start-up companies — had raised $177.89 billion, according to Private Equity Analyst, a trade magazine published by Dow Jones & Co. * * * That bests the record set in 2000, when 630 funds raised a total of $177.75 billion.” Tracy, T., “Private-Equity Funds Set Record,” Wall St. Journal (Nov. 3, 2006). In fact, “Hedge funds have invested in wine, whiskey and movies in pursuit of returns that outpace stocks and bonds. Now they’re taking on an even riskier bet — the search for soccer’s next Wayne Rooney. Investors willing to pay 250,000 pounds ($470,000) will have the chance to buy a piece of the next potential superstar. Two British-registered funds, Hero Investments and Sports Asset Capital, plan to buy stakes in the contracts of younger athletes, then grab a slice of the transfer fees clubs pay to obtain players,” “Two Hedge Funds to Bet on Soccer,” Los Angeles Times (Oct. 31, 2006).