Fortress Investment Group LLC issued stock at $18.50. Shares opened at $35. On the first day of trading, they closed at $31 – 68% higher than the IPO price, Zuckerman, G., Sender, H. & Patterson, S., “Hedge-Fund Crowd Sees More Green As Fortress Hits Jackpot with IPO,” Wall St. Journal (Feb. 10, 2007). Now this is what I call innovation – take an investment vehicle, known for the opacity of its activities and operations, and then issue shares in it to the public. Which shares then are bid up to a rather lofty price, mainly on variations of the following two themes: (a) these guys are smart, and they probably know more than I do, so I’ll follow their direction; and/or (b) the train’s leaving the station, and if I don’t get on board now, the opportunity will be lost. In the meantime, what the fund managers actually are doing with all of this money, remains as obscure as ever.
One thing is crystal clear about the current hedge-fund private-equity cycle. Which is, it will take a lot of effort to wring further economies out of the already beleaguered, privatized companies owned by the hedge fund, in order to make this business model work. If there is any investment “lesson” of the late 1990s – early 2000s, it is, most industrial firms benefit from careful overhead value assessment. When properly evaluated, and with costs reduced, such firms emerge as more formidable competitors. However, there comes a time when cost reduction begins to impinge upon business fundamentals. Put differently, some notional level of cost, or overhead, is necessary, in order for the company to function practically, in its chosen area of commerce, to begin with. Exactly what this “minimum” overhead level is, necessarily will vary by sector.
My particular area of expertise is film – music – internet. I now have seen several cycles of brutal cost reduction, followed by gradual re-growth over time, followed by brutal cost reduction. Kinda like what Joseph said to Pharaoh, there will be seven fat years, then seven lean years. In a way, I pity the people who now work for the Warner Music Group, or for EMI Music, because those companies have been pruned down to the bone, so as to extract maximum value for the benefit of their current proprietors. As a result, it becomes more difficult for a new artist to get signed, and to market and promote existing artists. Triage is fast and furious, and it’s important for that new artist to distinguish itself quickly. If that first single isn’t a hit, then you’re outta here. This acceleration in turn leads to formulaic pop pabulum, as artists and their managers attempt to envision imaginary criteria, of what the marketplace, as interpreted by record company overseers, conceivably might want. In the meanwhile, any corporate initiatives lacking the prospect immediate return on investment, simply are abandoned.
It seems inevitable this same phenomenon will visit itself on most companies acquired by hedge funds and private equity firms. If the employees of those companies think they’ve seen the worst of it, the fact of the matter is, pain and turmoil just are beginning to commence. While some people become extremely wealthy during this process, the vast majority of workers don’t, or, find themselves unemployed. The company’s products or services suffer, due to retrenchment. That in turn dramatically affects its name, image, reputation, and positioning in the competitive marketplace.
I am not saying all cost reduction is a bad thing. In today’s economy, businesses need to be alert and vigilant about their cost structure. What I am saying is, given developments like publicly-traded hedge funds, I think it’s inevitable this will be carried too far, in order to demonstrate return to shareholders. The hedge fund’s primary business interest isn’t running the company, and making it work. Rather, it’s fattening it up for later sale or disposition, for example, in its own IPO. This process will leave the companies acquired, through the miracle of smoke-and-mirror financing, in even worse shape than they were, prior to the commencement of the exercise.