9 ways hedges make their millions

Written by: Chris Menon Posted: 04/12/2017

BL53_hedgiesIn the world of money managers, having the smarts to make more dough is what makes you the king of the jungle. Hedge funds have turned an atavistic human desire for domination into an art form, and the strategies they employ sometimes border on the surreal and ethically dubious. Here are a few that caught BL’s eye…

1. Life settlements 
Several funds invest in the secondary market for life insurance policies, known as life settlements. When a consumer wishes to stop a life insurance policy, for example, the hedge fund will pay a surrender value that’s higher than that offered by the insurance company. However, it’s still buying at a discount to the face value. Once the fund has bought the policy, it will continue to pay future premiums and the future payout is received by the fund upon the death of the original policyholder.

Longevity is the key risk in investing in life settlements. If the hedge fund’s life expectancy assumptions are too short, the fund will pay more premiums and its return will decrease. Perversely, these funds would lose money if there was a cure for cancer or heart disease, or for any medical breakthrough that extends life. 

2. Distressed debt 
Hedge funds make money by buying distressed debt on the cheap – be it mortgages or the sovereign debt of a whole country – and then force the debtor to make full payment or suffer the consequences. In Ireland, this has led to the eviction of families in mortgage arrears. Most notoriously, a group of US hedge funds that included NML Capital (a subsidiary of Elliott Management Corp) bought Argentine defaulted bonds on the cheap after that country defaulted on its debt in 2001.

After much lobbying, a US judge ruled in favour of these hedge funds in 2012, and said Argentina had to pay them back at full value. Eventually, NML Capital received an estimated US$2.28bn for its initial investment of $177 million. Such actions don’t appear to cause Paul Singer, the billionaire head of the Elliott Management hedge fund, any guilt. As he famously said: “Resentment is not morally superior to earning money.”

3. Natural disasters
Some hedge funds specialise in reinsuring natural disasters, charging high premiums to assume the risk of such a catastrophe from an insurer. Ironically, they tend to make more money following a natural disaster such as Hurricane Irma, as fearful insurers and state governments seek counterparties that will assume the risks that they bear. The most successful hedge funds exploit such ex-ante disaster concerns better than others, while being less exposed to the ex-post realisation of disaster shocks.

One such fund is Nephila Capital. In one interview, Greg Hagood, its co-founder and Managing Partner, explained the best time to invest in insurance-linked securities. “The perfect environment would likely be after a series of large catastrophes, where the market is quite dislocated and there is a shortage of capital in the broader market,” he says. Delightful...

4. Prisons
Profiting from the incarceration of fellow humans is a popular trade for some hedgies. UK hedge fund Winton Group is an investor in Florida-based private prison operator GEO Group, which has been accused of poor treatment of inmates and immigrant detainees. GEO’s website states that in the US it ‘oversees the operation and management of approximately 77,000 beds in 72 correctional and detention facilities’, making them sound more like hotels than prisons.

GEO UK also manages the much criticised 249-bed Dungavel House Immigration Removal Centre in South Lanarkshire, Scotland, which until this year even detained the children of immigrants.

5. Litigation finance
Although class-action lawsuits can settle in the billions of dollars, successful cases often entail mountainous legal fees and take years to settle. That’s where litigation finance comes in, funding the legal costs in order to take a cut of the expected settlements.

One hedge fund that specialises in this area is Emanuel Friedman’s $7bn EJF Capital. EJF has provided funding for lawsuits over products such as Risperdal, a schizophrenia drug that allegedly causes men to grow breasts, and a medical treatment known as transvaginal mesh implants, which has caused damaging side-effects.

6. Tax inversions 
Companies spend a lot of time trying to figure out how to avoid paying taxes and it can make a huge difference to their profit and losses. Sometimes, one company can acquire another company domiciled abroad in a lower-taxed jurisdiction, then reincorporate in that foreign country in order to enjoy a much lower tax rate.

Hedge funds have also got into this game by looking for companies in the US and abroad which may be good fits for each other. After that, it’s a simple matter of investing in the company, talking to management, and creating a catalyst.

John Paulson’s hedge fund was making money from such moves, but a $51bn takeover of Jersey-registered biotech company Shire by US pharma specialist AbbVie was scuppered by US government rule changes under President Obama in April 2016. 

7. Appraisal rights
In a merger, acquisition or management buyout, a shareholder has the right to sue in court if he thinks the takeout price is too low, and can request the court to re-appraise the value of the company. This measure makes sense because it protects the shareholders against a ridiculously low takeout price. Hedge funds buy stock in a target company shortly before, or even after, a merger is announced, then file lawsuits right before the merger consummates, with a view to forcing a higher price for their shares.

Hedge fund Magnetar Capital did this when it invested in Dell and opposed its takeover by Silver Lake Partners in 2013. Three years after the deal went through, Magnetar received £25 million more, as a judge ruled the takeout price should have been $17.62 per share, not $13.75. 

8. Commodity speculation
Numerous hedge funds speculate on commodities, such as crude oil, wheat, cocoa and so on, pushing the price up in the futures markets with long-only contracts. For example, following leaks by Wikileaks, it became clear that the reason the price of oil shot up to $147 in the summer of 2008 wasn’t down to oversupply by the Saudis but because of speculation.

Such activity increases price volatility and leads to price shocks that often harm the poor. “What we’re experiencing is a demand shock coming from a new category of participant in the commodities futures markets,” Michael Masters, head of Masters Capital Management testified before Congress in the midst of the 2008 food crisis caused by the rising price of food staples for the world’s poor.

9. Madoff claims
In 2010, a Partner at Baupost Group, the Boston hedge fund run by investment legend Seth Klarman, bought a claim against the disgraced hedge fund manager Bernie Madoff, who had run a Ponzi scheme.

It paid $74 million for a $230 million Bernard L Madoff Investment Securities claim from Kenneth Krys, a co-liquidator of the biggest Madoff feeder fund, Fairfield Sentry. Very soon, the Madoff trustee responsible for disposing of the fund’s assets to pay claimants found that it had more money to pay claimants. In one move, the value of Baupost’s investment increased substantially and was worth approximately $150 million. 

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