One of my favorite strategies is the Endangered Species / Darwin’s Darlings strategy I discussed in some detail earlier this year (see Hunting endangered species and Endangered Species 2001). The strategy is based on a Spring 1999 Piper Jaffray research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.
The NYTimes.com has an article, Accretive Uses “Take Private” Tactic In Equities, discussing hedge fund Accretive Capital Partners, which uses a strategy described thus:
Accretive Capital’s strategy is to buy long-only stakes in small- and micro-cap stocks that [founder Rick] Fearon believes would be attractive “take private” companies. The benefits of being public just don’t add up for such companies, he said.
Years ago when Fearon was a principal at private equity firm Allied Capital, he was struck by the wide gap in value the public and private equity markets assigned companies.
In private equity, companies were valued at six to seven times their cash flow, while public companies, especially the smallest businesses, were valued at almost half that, he said.
Fearon believes that market inefficiency, where prices often fail to reflect a company’s intrinsic value, and the $400 billion or so that pension funds and endowments currently have committed to private equity, will help spur returns.
Fearon is fishing in waters where, because the market capitalization of the smallest companies is less than $100 million, Wall Street research fails to adequately cover their operations. In addition to helping create an inefficient market, it has eroded the benefits of being a public company.
With an undervalued stock, stock options are never in the money, erasing the use of stock as a motivator for management and employees; cash becomes preferable to stock for acquisitions, and management holds on to undervalued shares.
“Management teams that have a strategy of A, B, C and D for creating shareholder value may in the back of their minds be thinking, ‘Well, maybe strategy E is the take private transaction, or we sell the company to a strategic buyer, because we’re not recognizing any of the benefits of being public,'” Fearon said.
In essence, the strategy is Endangered Species / Darwin’s Darlings. How has Accretive Capital performed?
Accretive Capital has been involved in 19 take-private transactions, or about one-third of the positions it has closed over the past decade.
Fearon has managed to take the $2 million in capital he started with from mostly high-net worth friends and family to about $20 million on his own. His fund plunged in 2008, but returned 132 percent last year and is up about 20 percent as of July.
Assuming no additional outside capital, turning $2M into $20M in ten years is a compound return of around 25%, which is impressive. [Update: As Charles points out in the comments, the article clearly says he’s returned 4x, not 10x, which is a compound return of around 15%, which is still impressive in a flat market, but not as amazing as 25%.]
Says Fearon of the investment landscape right now:
“We’re not lacking investment ideas or opportunities, our primary restraint is capital right now.”
I think the Times chose their words poorly in stating that Fearon has managed to “boost returns almost fourfold” since 2000. This could mean that the return in 2000 was 5% and the return in 2010 was 19%. I don’t imagine that this is the case but since the breakdown of inflows versus capital gains is not specified, it’s impossible to say. I think the Greenbackd post was meant to highlight the Darwin’s Darlings angle, rather than the scale challenges faced by micro-cap fund managers. Personally I think the real story is asking why someone who previously enjoyed a seven figure income bothers managing two million anyway. Presumably because he believes capital allocation is a “noble business”. If he is sincere, and micro-cap is his thing, then why not?
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I’d be very interested in your Endangered Species report/list that you were considering. Are you still pursuing creating a pay service for the list?
Thanks
Brad
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Nice puff piece.
The article says the returns are 4x, not the 10x you put at the end of your note. That’s a 15% gross return or a 10.5% net return on 2&20 fees. That’s OK, not impressive, given the volatility he has put up.
I love how when the return in 2008 is awful the number isn’t disclosed but in the bounce back in 2009 and 2010 the numbers are precise. How are we supposed to know if he earned the money back?
You ignored it, but the entire article was about how hard it is to make a living pursuing a micro cap strategy. I think this stuff is great for the PA but pursuing it as a career is very different.
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