Hedge Funds
In the last one decade, hedge funds have become a buzzword in the global financial markets. Hedge funds are privately-owned, highly leveraged and unregulated investment vehicles whose managers buy and sell securities and assets, and profit substantially from the process. The managers of hedge funds also charge whopping management fees.
It has been estimated that there are over 5000 hedge funds in the world, with US$ 2 trillion under management. However, only a handful of hedge funds dominate the global business. The majority of hedge funds are registered in tax havens to save taxes and to avoid regulatory scrutiny.
Unlike mutual funds, hedge funds seek positive absolute returns, regardless of the performance of an index or market conditions. The hedge funds are engaged in more aggressive strategies and positions, such as short selling, trading in derivative instruments (such as options and futures) and using leverage (borrowing) to enhance their risk/reward profile of investment bets. As a result, one finds that hedge funds are very active in both bull and bear markets.
Typically hedge funds buy and sell securities and assets at a breathtaking speed. They largely invest in liquid assets in financial markets — stocks, bonds, currencies and commodities. Unlike investors in a private equity fund who are “locked in” for the entire term of the fund, investors in hedge funds can pull out their money quickly if performance of fund deteriorates.
The main investors in hedge funds are high-net individuals, pension funds, university endowments and sovereign wealth funds. In recent years, a number of investment banks have set up their own hedge funds or acquired them. For instance, Old Lane Partners Fund was acquired by Citigroup in 2007.
Globally hedge funds have been in existence for more than 2 decades, but it is only recently that their role and impact in the resource industry, particularly mining, has come under public notice.
The role and influence of hedge funds in global extractive industry could be gauged at two levels.
First, hedge funds are direct investors in commodities, in terms of physical holdings as well as derivative positions. Why commodities? For the simple reason that the commodity markets provide the perfect opportunity for making short-term gains.
According to UK-based New Finance Capital LLP, the commodity-trading based hedge funds returned between 13 percent and 23 percent in 2006, much above other market indices.
The large-scale direct exposure of hedge funds in the commodity markets has led to significant price swings and volatility. In particular, hedge funds have significantly impacted transactions and prices in the metals trading. And therefore the rise in price volatility has become a matter of serious concern as the metals prices are no longer driven solely by supply, demand and inventory factors.
The volatility in the commodity markets has helped some hedge funds to book huge profits (and suffer significant losses too) within a short-span. Two hedge funds were closed down in 2006 because of wrong-way speculative bets in energy markets. The US-based Amaranth Advisers lost $6.6 billion on gas trades while MotherRock LP, a $400 million hedge fund was shut down after bad bets on energy prices.
The Red Kite Metals, a $1 billion US-based hedge fund, is a shining example of risks and rewards inherent in the speculative trading in the global metal markets. The Fund was co-founded by Michael Farmer, who was previously joint chief executive of MG Plc, the world's largest copper-trading company which was subsequently bought by Enron Corporation, a year before it went bankrupt.
The Red Kite Metals was one of the best-performing commodity funds as prices for copper, zinc and related metals surged in 2006. The market analysts estimate that returns generated by the fund topped 188 percent in 2006. However, as global inventories of copper increased in January 2007, the prices tumbled and consequently the Red Kite Metals was forced to sell copper contracts in order raise cash which further led to collapse in prices. It has been estimated that the fund lost 50 per cent. Subsequently, the prices of nickel and zinc also declined on account of increased supply. In January 2007, the markets witnessed a one day decline of 9 per cent in the price of zinc, the largest single day decline since 1999. This incident clearly reveals how a fund loss can seriously destabilize the operations of entire market.
The loss at Red Kite Metals came at a worst time for the global hedge fund industry which suffered huge losses in the wake of credit crunch which started in August 2007. There are hardly any hedge funds in the world which remain unaffected by the contagion effects of credit crunch. As a result, many hedge funds have constricted their exposure to metals trading. But what is important to note is that hedge funds have moved to oil and energy markets.
The second level of hedge funds involvement and impact in the mining industry pertains to their active role as shareholders in publicly-traded companies. For years, hedge funds have been active in the equity markets. But it is only recently that hedge funds have taken up the role of shareholder activism. More and more hedge funds are nowadays taking up the task of disciplining management of companies.
In the past, shareholder activism has been widely used by activists, NGOs, social and political movements to influence corporate behavior. Therefore many are surprised over the recent levels of shareholder activism by the hedge fund industry.
Hedge funds, often in tandem with other shareholders, have attempted to influence decisions pertaining to acquisitions and restructuring of companies in which they own stake.
A shining example of this trend was witnessed during the long takeover battle for Falconbridge and Inco where it was estimated that over 50 per cent of these companies’ shares were held by hedge funds. In June 2006, Phelps Dodge Corporation announced a US$56 billion three-way merger under which Toronto-based Inco will acquire Falconbridge and subsequently Phelps Dodge Corporation will acquire the Inco-Falconbridge combination. The resultant company, Phelps Dodge Inco, would have ranked number one worldwide in nickel production and number two in copper and molybdenum production. The industry analysts claim that such a friendly merger could have created synergies with positive outcomes. But hedge funds did not favor the proposed transaction due to lack of cash component. As a result, both friendly deals collapsed.
Meanwhile, a hostile bid for Inco by Teck Cominco also failed as this company was unable to raise sufficient cash as sought by hedge funds. Subsequently, Falconbridge and Inco were acquired with the cash bids from Xstrata (Switzerland) and CVRD (Brazil) respectively. The preference for cash takeovers by hedge funds reveals their short-term investment horizons and undermining of medium –and long-term synergies and value creation.
Apart from such mega takeover deals, the involvement of hedge funds in the day-to-day running of middle-sized mining companies has also become visible. For instance, the chairman of African Platinum was ousted at an extraordinary general meeting called by its largest shareholder, North Sound Capital, a hedge fund. The hedge fund also voiced its opposition to a proposed capital raising transaction by African Platinum.
The above discussion poses two pertinent policy issues: Does the short-term outlook of hedge funds serve the long-term interests of the mining companies? Do hedge funds create long-term value?
To conclude, it will not be incorrect to state that hedge funds have played a significant influence on the global mining and resource industry in recent years. Given the fact that the metal and natural resource markets are prone to cyclical changes, the impact of hedge funds have been more significant as compared to other markets. As a result, one finds greater price volatility in the metal and commodity markets. Besides, the hedge funds have also emerged influential players in corporate management and takeover transactions.
A recent paper by Stephanie Fried looks into "Alternative Investments and Secrecy Jurisdictions" (pdf) and looks into how hedge funds and private equity works.
See also the following article:
- Ospraie to Close Flagship Commodity Hedge Fund, September 2008
