How Hedge Funds Generate Enormous Returns Without Taking Any Significant Risks

Hedge fund managers occasionally complain about the detrimental effect of portfolio size on their returns, yet they rarely mention the benefits of managing large sums of money. Last year Third Point’s Daniel Loeb filed a 13-D with the SEC regarding a tiny company compared to the funds Third Point manages: Emmis Communications (EMMS). According to the 13Fs filed by Third Point, Loeb developed a $7 million position in Emmis’ preferred stocks. Emmis’ common stock closed at $2.27 on July 13th, 2010, the day Loeb filed the 13D.

THIRD POINT

Months earlier Emmis’ CEO and large shareholder Jeffrey H. Smulyan offered $2.40 to take the company private. The shares were trading at around $1.15 before the announcement and shot up above $2.30 after the announcement. The buyout was almost a sure thing… sort of. Here is how Loeb explained why he initiated this position in his 13-D:

The Reporting Persons are aware that on May 25, 2010, the Issuer executed an agreement and plan of merger (the “Merger Agreement”), that if consummated would result in the Issuer being taken private by Jeffrey H. Smulyan, the Issuer’s Chairman, Chief Executive Officer and President. The Merger Agreement provides for a series of transactions, including (a) a cash tender offer for the Issuer’s Class A Common Stock, (b) an offer to exchange (the “Exchange Offer”) all outstanding shares of Preferred Stock for new 12% PIK Senior Subordinated Notes due 2017, and (c) a solicitation of proxies to amend certain terms of the Preferred Stock (such amendments or any other amendment or amendments that adversely affect the rights or preferences of the holders of Preferred Stock, whether or not proposed in connection with the Merger Agreement, are referred to herein as the “Proposed Amendments”). Adoption of the Proposed Amendments described in the Merger Agreement requires the affirmative vote of holders of at least two-thirds of the outstanding Preferred Stock, voting as a separate class.

On July 9, 2010, Double Diamond Partners LLC, Zazove Aggressive Growth Fund, L.P., R2 Investments, LDC, DJD Group LLC, Third Point LLC, the Radoff Family Foundation, Bradley L. Radoff, and LKCM Private Discipline Master Fund, SPC (collectively, the “Locked-Up Holders”) entered into a written lock-up agreement (the “Lock-Up Agreement”) pursuant to which, among other things, each of them agreed, subject to certain exceptions, to: (1) vote or cause to be voted any and all of its Preferred Stock against the Proposed Amendments; (2) restrict dispositions of Preferred Stock; (3) not enter into any agreement,

 

The 13-Fs don’t show all of a hedge fund’s positions. You can see their long positions in companies that are traded in U.S. exchanges, but you can’t see their short positions. Daniel Loeb stopped talking about his short positions but we can still speculate about his short positions. Insider Monkey, your source for free insider trading data, believes Dan Loeb was shorting the Emmis common stock while he was accumulating his preferred shares.

Here’s why:

Dan Loeb and other holders of preferred shares were planning to force Jeffrey H. Smulyan to sweeten the deal significantly for them while keeping the deal unchanged for common stockholders. If they prevailed, then their shorts in Emmis common stock would appreciate only a few percentage points but their preferred shares (ticker:EMMSP) would gain at least 30% or so. So, they would come out ahead. If their offer is turned down by Smulyan, then they would proceed to block the buyout. In this case, Emmis’ common stock would probably fall at least 50%, going back to pre-announcement levels. Preferred shares would also go back to their pre-announcement levels, declining by about 30%. This means Dan Loeb would again come out ahead. Whatever the outcome, Daniel Loeb would stand to make at least 20% from this deal.

So what happened? The negotiations with Smulyan went on for a few months but they couldn’t reach a deal, so the buyout was cancelled. Emmis’ common stock declined to $0.78 by the end of September, a loss of around 65%. The preferred shares declined to $16 by the end of September, a loss of 27%. Daniel Loeb probably made about 40 percent from this riskless undertaking. A small investor couldn’t do this. Dan Loeb’s size enabled him to exploit the weakness in Smulyan’s buyout proposal.

Even though a small investor couldn’t do what Loeb did, they could still have imitated Loeb’s transactions. These opportunities don’t come every day, but when they do investors should take advantage of them. We will be covering hedge funds’ 13D and 13G filings more frequently, so that small investors can educate themselves about investing like a hedge fund pro. We also started sharing hedge funds’ 13F portfolios for free on our website. This is still a work-in-progress, so we will be adding more functionality in the next few weeks to make the filings more useful for you.

blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

The 10 Most Overrated Movies Of All Time by Out-of-Touch Critics

Top 6 Least Expensive Cruise Destinations For 2015 that Will Take You to Paradise

10 States with Lowest Substance Abuse Rates in America

The 14 Most Watched TV Finales Ever

The 10 Best Selling Role Playing Games of All Time for PC

10 Most Influential Papers In Economics

Top 8 Biggest Charities in the US

10 Worst Celebrity Career Moves Ever

Top 10 Best Paid Tennis Stars in the World

10 Cities with High Demand for Nurses

6 of the Worst Greeting Card Messages Ever Crafted

6 Ways to Make Money in ArcheAge and Build Your Empire

10 Foods To Eat To Lower Cholesterol Levels

The 10 Most Hated Television Characters of All Time

The 30 Worst Halloween Costume Ideas Ever Brought to Horrible Life

10 Vocational Skills in Demand Today with Jobs Waiting to be Filled

10 Best Places to Visit in Central and South America

The 10 Greatest Empires in History Which Nearly Conquered the World

The 6 Cheapest Boarding Schools In America 2015

5 Clear Reasons LoL is Better than DotA, Continues to Rule MOBAs

The Only 9 Teams with a Chance to Win the Super Bowl

The 15 Most Common Phobias in America that Induce Fits of Panic

Top 6 Least Expensive Tourist Destinations in 2014

Jim Goetz, Peter Fenton, Jim Breyer: Top 6 Venture Investors for 2014

Top 15 Billionaires in 2014

5 Pitfalls To Avoid When Buying a Franchise

Top 20 Medical Schools in the US – 2014 Rankings

4 Business Strategies that Turned Jamie Oliver into the World’s Richest Chef

6 Qualities That Make You A Good Team Player

10 High Paying Seasonal Jobs in America this Holiday Season

The 10 Busiest Shipping Lanes in the World

5 Most Valuable Brands in China

The 10 States with Highest Substance Abuse Rates Crippling Their Populace

The Top 10 Things to Do Before You Die That Will Echo for Eternity

The 10 Best Selling Items on Etsy

Top 10 Things to Do in Tokyo, the Greatest City in the World

10 Mistakes on Social Media that Can Harm You and Will Probably Get You Canned

The 10 Best Cities to Find Jobs in 2014

The 10 Most Controversial Songs Of All Time to Hit (and get Banned from) the Airwaves

The 20 Biggest IPOs in US History

The 10 Best Places to Visit in Mexico that Are Beautiful and Safe

7 Bad Habits that Age You Beyond Your Years

The 40 Best Fortune Cookie Sayings That Will Leave You Bemused, Befuddled, or Beguiled

10 Foods to Eat Before a Workout to Make Every Drop of Sweat Count

The 5 Best Documentaries On Netflix You Must See

The Most Heartwarming and Inspirational Story Of This Halloween Season, It Will Make You Cry and Jump For Joy

10 Best Party Songs of All Time to Bring the House Down With

5 New World Order Conspiracy Theories that Will Strangle the World

The 10 Highest Rated Movies of 2014

The 10 Largest Container Shipping Companies in the World

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!