Hedge Funds, Private Equity as Risky as S&P 500

There is a day of reckoning in financial markets every day.

Take the boom in deals, one of the most remarkable features of this market. We have never seen so many deals...or such rich ones. On Tuesday, KKR announced that it would try to get US$1.25 billion out of the public's pockets. Och-Ziff Capital Management, a hedge fund group, earlier said it was looking for US$2 billion.

Meanwhile, the Carlyle Group is taking Manor Care (NYSE:HCR) private for US$6.3 billion and Hilton Hotels (NYSE:HLT) is being bought by Blackstone (ASX:BX) for US$20 billion. And the biggest private equity takeover ever is underway in Canada, where Bell Canada Enterprises is going for US$32.6 billion in cash, plus US$15.9 billion in debt.

The hedge funds and private equity firms are not only doing deals...they're BECOMING deals themselves. "Hedge funds continue public path," says the NY TIMES. They're moving into the public markets for a simple reason - there's money to be had there. But what kind of system is it where the public investor thinks he can profit from funds that make their money by outsmarting him? 'Never give a sucker an even break' is like the Lord's Prayer at KKR, Blackstone and Och-Ziff. They repeat it in unison at board meetings. They put it on their business cards. They have it printed on their securities and I.O.Us.

Of course, when these companies file to go public they are forced to open their doors so we can see what they've been up to. In the case of Och-Ziff, we find that their performance for several years has been about the same as the S&P. Why would an investor pay '2 and 20' (2% of capital and 20% of performance is standard hedge fund pricing) to get the same thing he could get by throwing darts at the S&P listings? Because it is less "risky". Och-Ziff got the same numbers as the S&P but with substantially less volatility.

Wall Street cannot really measure risk. It doesn't know any better than we do when the "black swan" is going to appear. Our friend Nicholas Taleb has made the black swan famous - pointing out that just because every swan you've ever seen has been white, it doesn't mean the next one won't be black. Wall Street looks back and counts swans. If it counts 20 white ones and one black one, it puts the 'risk' of a black swan appearing at 5%.

Counting the swans in the S&P performance and comparing them to Och-Ziff's record may or may not be meaningful. Maybe it is worth paying a premium to get the whiz-kids' lower-volatility performance. But our guess is that when a real black swan comes along both the S&P will go down...and Och-Ziff along with it.

Bill Bonner
The Daily Reckoning Australia

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