Hedge funds represent a substantial pool of potential capital to biotech management teams, but engaging with them can offer many challenges due to their varying structures and motivations. Understanding the drivers of the decisions within this class of investors should aid in increasing management teams’ comfort level in dealing with them. Two of the more common frustrations regarding hedge funds are that they tend to be overly focused on short-term events and that they may be short a stock.
Mutual funds vs. hedge funds: Risk tolerance and the difference between absolute and relative performance.
The first distinction one must make amongst investors is between mutual funds and hedge funds. Mutual funds are highly regulated pooled assets that must be sold to investors under a prospectus. The prospectus sets forth stringent guidelines regarding investments that may be included. The mutual fund was designed to reduce the risk for unsophisticated investors and allow broader participation in markets.
The second most common identifying feature of a mutual fund is that its performance is generally measured relative to both a peer group of similar funds and a benchmark index. The S&P 500, the Nasdaq composite and the Russell 2000 are three of the most common. Mutual fund managers express their performance in terms of their percentile performance relative to their peer group and whether they out or underperformed their benchmark, e.g. “over the past 3 years our fund outperformed the S&P 500 by 6%, placing it in the 86% percentile of our peer group.” Though greatly enhancing market participation, mutual funds, by their very design and regulation, have shortcomings. Most notable is the fact that mutual funds offer little defense when markets are weak.
Hedge funds first sprang to popularity in the 1970s as investors saw very few opportunities to profit from owning stocks during this period and were searching for alternatives. Far less regulated than mutual funds, hedge funds were only to be sold to “qualified investors” under Regulation D of the Securities Act of 1934. Hedge funds were designed to give more affluent, sophisticated investors who could tolerate more significant potential losses, the opportunity to pursue higher returns that could come about in more varied market conditions. For more on hedge funds, see our introductory piece here.
Portfolio concentration and leverage: why hedge funds managers always seem to be more focused on the short term.
In order to offer higher rates of return and to manage market volatility, hedge funds, by necessity, must run more concentrated portfolios and sell stocks short. Short selling necessitates the use of leverage as one must borrow shares to sell them into the marketplace with the hope of buying, and covering the short position, at a lower price level. In addition, managers often use leverage to amplify their returns on the long side as well, feeling that their shorts will protect them from any sudden downturns. Concentrated portfolios and leverage conspire to rob the hedge fund manager of the luxury of time and patience as each position contributes far more to overall portfolio performance than in a mutual fund. Leverage only amplifies this risk. These attributes increase the nervousness of the managers driving far more portfolio turnover as it is far worse for a fund to incur losses from bad trades than miss out on the profits from successful trades as the losses are much harder to make up. For example, a $1 million position that loses 50% must then rise by 100% to recoup the loss. As a result, hedge funds are far more likely to “shoot first and ask questions later.” This explains why interactions with hedge fund managers are dominated by intense discussions of near-term milestones, often to the consternation of management teams and the mutual fund investors who may be sharing the same meeting.
Short sellers: It’s not personal. Don’t shut them out.
Having a dialogue with hedge funds will require management to have discussions with individuals who may have sold shares short. It is possible to have productive interactions with an information flow that can be beneficial to both sides. Frequently, management will attempt to reduce their interactions with people who may be short their stock, assuming that restricting access and information will dissuade short sellers. Unfortunately, the opposite tends to be true. Management truculence only serves to encourage and attract shorts as their conviction grows that “management is hiding something.” As discussed above, understanding the motivations of short sellers can increase managements’ confidence in dealing with them.
A hedge fund can short a stock for a myriad of reasons. Their reasons can be central to the future of the company, “the drug isn’t likely to work,” or they can be utterly irrelevant in the long term, “I think the stock is too expensive,” or “I am short a basket of stocks because I think the market is due to pull back.” Understanding the underlying motivation of the short is very important and can only come about through dialogue. Finally, management should also be aware of any credible short thesis that has emerged from information sources outside of their control — for example, doctors or patients who are making negative comments. A short seller is very unlikely to reveal their sources, but the tone of their questions may help to uncover their thesis.
Ultimately the job of a biotech management team is to develop a drug and not to understand why any given investor is making a particular decision. Therefore, too much focus on the activities of investors is likely counterproductive to the central corporate mission. Regardless, it is beneficial for management to have access to a broad pool of investors as the back and forth of the marketplace can reveal useful pieces of information. Within that context, a basic understanding of the hedge fund should allow management the ability to create far more productive interactions with them.
Matt Lane, Managing Director