Monday, October 20, 2008

Equine Hedge Funds

Even as the world financial system came crashing down over the last few weeks, it appears that promises of returns that are too good to be true aren’t limited to Wall Street.

For those who, luckily, aren’t in the stock market, here’s a quick definition.  A hedge is an unregulated, rich guys’ version of a mutual fund.  It collects money only from “qualified investors” (i.e., rich people) and invests in, well, anything, from credit default swaps with Lehman Brothers to thoroughbreds with blazing speed and bad feet.

For the promoters of hedge funds, the big lure is the compensation.  The industry standard – don’t ask me how it got to be the standard, because it represents an unbelievable level of greed – is that the fund manager’s annual compensation is 2% of the value of the assets, plus 20% of the profits.  So, if you can attract enough money into the fund, you’re guaranteed to do well even if your returns are no better than what one would get putting the money into the S&P 500. Or a mattress.  It appears that hedge funds as a whole are losing something like 25% this year. But the managers will still get that 2%. So if you have a $100 million hedge fund, there’s $2 million in compensation just for turning on the lights.

It was only a matter of time until this get-rich-quick model made it into horse racing. Michael Iavarone of IEAH, whose name in most newspapers is preceded by the label “Wall Street investment banker”  (and who, actually, should be labeled “former Long Island penny-stock broker,” but, hey, a little puffery never hurts, right?) is setting up a $100 million fund, with a minimum investment of $500,000. Reportedly, the IEAH fund does NOT include an interest in Big Brown.

Not to be outdone by those sharp New Yorkers, the Kentucky establishment has countered with the Thoroughbred Legends Racing Fund, the brainchild of Kentuckians Olin Gentry and Thomas Gaines, along with New York investment banker Tripp Hardy of Gallatin Capital.   The model is similar – a goal of around $100 million, with a minimum investor commitment of $1 million a year for three years.  The major come-on is that the horses will be divided evenly among the “legendary” trainers D. Wayne Lukas, Bob Baffert and Nick Zito.  Like IEAH, the Legends Fund will operate on Wall Street’s “2 and 20” model. Thoroughbred Legends was among the leading buyers at the Keeneland September sale, spending $12 million for 29 yearlings, an average of just over $400,000.

Now, if you spend enough money at the sales, you’re going to get some good horses, so I’m sure the investors in IEAH and Thoroughbred Legends will get to be in the winners circle for some big races.  If that’s all they’re looking for, then maybe they’ll be happy. But if they’re looking to make money – which is usually why people invest in hedge funds -- the odds are surely against them

Here’s why. Purses are going down, while the costs of maintaining horses are going up.  The current nationwide purse level of some $1.2 billion doesn’t even cover the current costs of keeping horses in training, and that’s not counting  the original capital costs of buying or breeding those horses, and maintaining them until they are old enough to race.  And, once they are at the races, perhaps one of every ten horses is modestly profitable in a given year, and perhaps one in 100 is a serious money-maker.  But everyone (except, I’m sure, the marks who are going to be attracted to these hedge funds) knows that you don’t go into racing to make money

In the past few decades, the real money has been in stallion stud fees. And the only wildly successful business model has been Coolmore’s. The Irish powerhouse spends perhaps $40 million a year, mostly on well-bred yearling colts.  It probably buys 50 or more yearlings every year, but if even one or two of those colts turn into multiple Grade I winners or champions, then Coolmore is in a position to recoup the whole $40 million through stud fees, breeding their stars 200-300 times a year, in both Northern and Southern hemispheres. One wonders if an equine Viagra is part of their vet bills.  If Either IEAH or Thoroughbred Legends can convert some of their pricey colts into high-priced stallions, then maybe the investors can make some money.  But the timing is against them, as all the presure right now is for stud fees to go down, and for fewer mares to be bred.

For most stables, if they can’t afford the top-of-the-market prices for yearlings with blue-blood pedigrees that have the potential to be important commercial stallions, the economics are strongly against serious profitability. And the hedge fund model of putting all the assets in a single fund makes it even more likely that the fund as a whole won’t break even.  There’s a strong tendency in these aggregations for results to return to the mean – and the mean, or average, result in racing is that an owner loses money.  That’s why most partnership operations, including my own, have moved toward single-horse partnerships.  That way, if you happen to get a really special horse, its earnings aren’t eaten up by the losses on the others. Still no guarantee for making money in the long run, but, I think, more psychologically satisfying.

So, if anyone out there has a spare $3 million, or even a spare $500,000, have fun with these equine hedge funds.  But remember, the people making the money will be the managers, not you.

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