In the world of small-cap healthcare, we have observed that the class of asset managers who are collectively referred to as “hedge funds” are often viewed negatively by executive management teams, particularly those that are new to the public markets.
This tendency is understandable in light of the fact that hedge funds, as a whole, most often attract media attention when they’ve disclosed a sizable position in a company with activist intentions (“corporate raiders”), or when they’ve come under the scrutiny of regulators. These high-profile examples distort the public perception of hedge funds overall.
But the reality is that there is a great deal of diversity in investment strategies across the more than approximately 5,000 hedge funds worldwide.
We think management teams should be thoughtful, not draconian, when considering potential interactions with hedge fund analysts and portfolio managers. Some hedge funds can, in fact, be strong, long-term, shareholders in your company.
But don’t take our word for it. We recently interviewed a portfolio manager of a healthcare-focused hedge fund with almost 20 years of healthcare investing experience. We asked for his thoughts on how management teams should think about potential interactions with hedge fund analysts and portfolio managers.
Here are a few key takeaways from our discussion:
First, the term “hedge fund” really describes the investment vehicle, not the specific investment strategy. For example, despite the traditional association of hedge funds with short-selling and other hedging strategies, it is increasingly common to see firms with the “hedge fund” moniker that utilize a long-only or predominantly long approach to investing. (For more information on this trend, take a look at the Wall Street Journal article, “‘Long-Only’ Funds Lose Their Hedge.”).
Second, when evaluating potential interactions with hedge fund analysts and portfolio managers, there are three important characteristics of a hedge fund’s investment strategy to consider:
- Does the hedge fund employ short-selling strategies?
- Some hedge funds do not routinely take short positions, and many fund charters indicate whether short-selling is integral to the investment strategy.
- If the fund employs short-selling, do they short individual securities or indices/sector ETFs? This is an important distinction: Are we unnecessarily ‘afraid’ of the potential impact on your company’s stock?
- Does the overall investment strategy target alpha-generation or risk-mitigation from short positions? Many hedge funds utilize short-selling primarily to mitigate risk. For these firms, short-selling takes a back seat to long-only investing and other investment strategies when it comes to generating alpha.
- What is the hedge fund’s investment horizon?
- Not all hedge funds are focused on short-term performance. Some require their investors to commit to asset lock-ups, often of the multi-year variety. Lock-up provisions allow hedge funds to invest with a longer time-horizon, allowing them to make investments in companies with characteristics (e.g., low trading liquidity, uncertain near-term business outlooks, undergoing management changes or restructurings, etc.) that would otherwise make them unattractive to investors focused on short-term stock returns.
- Unlike large mutual funds, which are often reticent to take sizable positions in micro/small-cap companies with low average daily trading volume, hedge funds with asset lock-ups can take meaningful positions in companies with the aforementioned characteristics, because they are less concerned with daily pricing and liquidity (risk) considerations.
- Does the hedge fund have a history of shareholder activism?
- It is hard to make a case for embracing interactions with hedge funds that have a demonstrated history of activism. That said, only a fraction of hedge funds utilize activist strategies as part of their investment approach.
By focusing on the key characteristics of a hedge fund’s investment strategy, management teams can better identify and prioritize the accounts that are most likely to be high-quality, long-term shareholders.
Westwicke can be a valuable resource to this process. Contact us to see how we can help.