Private Equity Squeezes the Shorts

Short-sellers once profited off troubled companies, but private equity's expansion is crimping investment opportunities and boosting risks

It has never been more popular to bet against stocks. Once the realm of a few specialists, the financial alchemy of turning a garbage stock into gold by shorting it has moved into the mainstream: The strategy is now employed routinely by thousands of individual traders, hedge funds, mutual funds, and others.

Short interest on the New York Stock Exchange hit 3.1% of all listed shares in May, the highest level since 1931, according to research firm Bespoke Investment Group.

A Short Primer

Just what is a "short" anyway? Liken it to borrowing a pound of sugar from a neighbor, selling it to someone else at full price, and then replacing your neighbor's sugar with a cheaper bag you snagged at a two-for-one sale the following day. You have just turned a short profit on the sugar. If a trader thinks a company is going to perform poorly, he can borrow the stock in question and sell it. If the price dips as expected, the trader buys the stock back at a discount when it's time to return the borrowed shares to their owner.

It's a simple concept, but relatively complex to execute in the real world—and an influx of competition is making the short-seller's life even more difficult. The number of short-sellers has multiplied dramatically during the last year, thanks to the rise of so-called 130-30 funds. These funds borrow against the money they have raised, enabling them to invest 130% of their capital in stocks. They borrow additional money so that they can invest the equivalent of 30% of their original capital by going short.

There were just a handful of 130-30 funds a few years ago. The 130-30 funds, and similar products such as 120-20 funds, are now abundant. Nearly every asset manager, from mutual fund companies to banks, has developed such funds as customers seek out cheaper alternatives to hedge funds (see, 5/22/07, "Hedge Funds Inc."). All engage in short-selling.

Enter the Spoilers

But as short-selling has proliferated, it has become increasingly difficult to make money at the game. Whereas a profit-challenged enterprise may once have floundered until shutting down or filing for bankruptcy, many such companies are now targets for private equity firms that style themselves as turnaround artists (see, 10/8/06, "Private Equity Keeps Booming"). What's more, such firms are often willing to pay a rich premium to the market price for troubled outfits in which they see promise.

As a result, fewer companies work as successful short plays, and the strategy has soured for many. The sector is down 7.56% for the year, according to Ken Heinz, president of Chicago-based Hedge Fund Research. "We are hearing from hedge fund managers that it's getting harder and harder to make money on the short side," says Robert Discolo, head of hedge fund strategies at AIG Global Investment Group.

The pressure on short-selling has grown dramatically, according to one money manager with experience in both private equity and hedge fund investing. Steven Chang, 34, was never a big short-seller, although he had some experience with the practice earlier in his career. Chang hasn't bothered with short-selling at all since co-founding Clearlake Capital Group with several partners and Reservoir Capital Group, a hybrid hedge and private equity fund with up to $1 billion to invest.

Case in Point: Jones Apparel

The recent history of Jones Apparel Group (JNY) helps illustrate the difficulties. Many hedge funds took short positions in the New York company last year but got squeezed as the market began betting that private equity firms would pay a robust premium for its Jones New York, Nine West, Anne Klein, and other fashion and accessory brands. The company cut its 2007 earnings forecast after it missed expectations for the first quarter. But private equity spies a solid turnaround play in Jones because of those established brands and cash flow of $500 million over the last 12 months.

Takeover talk pushed the stock from the high 20s during the winter of 2006 to the mid-30s in the spring. Shares then settled back into the upper 20s last summer as the talk died down. Then on June 12, the New York Post (NWS) reported that a private equity firm owned by the Dubai government was nearing a deal to buy Jones' Barneys unit for $950 million. That report led analysts at UBS (UBS) to boost their target price on the stock to $41. The shares finished the week at $29.01 on the NYSE (NYX).

Costs Headed Higher

With so many players in the market, it's more and more difficult to find companies to short. What's more, the costs associated with executing such a trade are rising, according to Josh Galper, managing principal of hedge fund consultant Vodia Group. Pricing of borrowed stock depends on many factors, including the size of the hedge fund, and Galper says it can be very costly to borrow oft-shorted stocks such as Internet retailer (OSTK). "As more 130-30 managers raise assets, and hedge funds continue to raise money, I think demand for borrowed stocks will outstrip supply during the next few years," Galper says.

Cleveland Rueckert, an analyst with fund manager and researcher Birinyi Associates, adds: "Costs associated with short-selling will go up and risks will go up, although you have to count on the fact that people managing this money have very sophisticated risk-management models at work as well."

Longer Term for Buyout Firms

Today, many troubled companies are less likely to go out of business, because shareholder activists or private equity firms are willing to expend time and energy to salvage them, investment managers say. That makes shorting a riskier, more complex bet. A few years ago, short players were concerned mostly with whether a stock was a buy or a sell. Now they need to consider how the company is viewed by private equity firms, which have a completely different approach to investing.

Buyout firms often acquire the very companies that equity traders are most likely to sell. And while traders think in terms of quarterly gains, private equity firms typically spend two years or more turning a company around. Hedge fund investors can redeem their money on short notice if they don't like a hedge fund's results—putting immense pressure on fund managers to post good quarterly results. But private equity firms "lock up" their investors' capital for years at a time. A pension fund can't simply pull money out of a private equity fund whenever it wants, and that gives the buyout firm time to focus on troubled investments (see, 11/7/06, "The Money Behind the Private Equity Boom").

Short-sellers should not abandon all hope, though. Turning a short play into profit may be trickier, but "shorts can still make money," says Phil Phan, professor of management at the Lally School of Management & Technology at the Rensselaer Polytechnic Institute in Troy, N.Y. "They just have to move faster, take bigger bets, and jump a lot sooner." The lesson: There's always a place in the financial world for those who profit from others' woes.