Tim du Toit is a value investor based out of Hamburg, Germany. Tim is the editor and founder of Euro Share Lab. On his website he reveals what more than 20 years of equity investment have taught him Euro Share Lab

 

Ever met a hedge fund manager that gives back fees if future years are bad?

Me neither, until I met this manager.

I first heard of this manager in a September 2005 interview she had with the excellent investment newsletter called Value Investor Insight.

She gave the interview shortly after leaving Legg Mason where she worked with the legendary Bill Miller for more than 10 years.

The interview was full of valuable insights that made me a better investor.

For example:

“Perfect investments have three layers of return. The first layer is the short-term return to what I’d call static intrinsic value.

The second one is when the business, strategy and management turn out to be what you think them are and there’s real value creation.

The third layer, if you’re really lucky, is when the market gets so excited that it discounts more and more of the future into the present. The big homeruns are usually there.

I always try to find at least two layers of potential, but it’s also important to recognize when you put something in your portfolio whether it’s a one-layer or a two-layer name.  You’re going to make a two-layer name a bigger position.”
and

“I’ve learned that you have to have a lot of different risk-reward profiles in your portfolio.

You’ll have some things you  think  can  go  up  25%  but  you  don’t think can go down very much.

You’ll have things that can go up 50%, but might go down 30%.

“Others can go up ten times, but may go down 75%.

I try to manage to the proper mix of all those.

You  just  can’t  have  a  portfolio  where you say everything is priced to have 20% upside  with  little  downside.

What’s  going to happen is that you’re going to be wrong about two of them and they go down 50% and  you’re  screwed  because  nothing  else has enough upside to make it up.

Our portfolios are managed to be reasonably loss averse, but that doesn’t mean every position in the portfolio has to be that way.”

After a short detour at Matador Capital Management she in November 2006 started her own hedge fund called Lane Five Capital Management.

I am of course talking about Lisa Rapuano.

At Lane Five she really made headlines in the hedge fund world when, instead of the normal 20% yearly performance fee she structured her fund so that she receives a 40% performance fee but only calculated after three years (triennial).

With this fee structure Lisa addressed the most common criticism of hedge funds that they only participate in the upside in good years but not on the downside. In other words there are no negative performance fees.

Since reading that interview I’ve been following Lisa’s investment and learning from her.

About a year ago I asked her if she would be willing to do an interview and share some investment insights with you.

It took more than a year to get done but finally Lisa scraped together enough time for the interview below.

I hope you find it as valuable as I did (emphasis mine)

Apart from the November 2006 fee structure for your new fund of 20% performance fee that is calculated triennially instead of once a year and the November 2007 Value Investors Congress presentation you have been very quiet.

What have you been up to?

Lisa Rapuano First let me give you an update on that experiment in fees.

As you mention, I launched my fund with an innovative fee structure – wait three years and then charge only on the positive returns over the market.  I also was lucky enough to have a set of long-term Limited Partners who were willing to commit to a three-year lock up.

The lock-up and delayed fees worked together.

We finished our first triennial period at the end of 2009. We were not good enough to earn any performance fee at all, since it has to be both positive and ahead of the market.

Additionally, given the changes in the marketplace we simply did not think a three-year lock-up was a tenable proposition under any circumstances.  So, in changing to a one-year lockup, we had to abandon our three-year fee structure as well.

Our new terms remain incredibly client-friendly, fair and well matched to our process:  20% of positive returns over the S&P 1500 on an annual basis with a traditional high water mark.

I think, however, that it was an experiment worth trying.  It communicated a “money where our mouth is” commitment to long-term investments.

What I was extraordinarily surprised by however, was how little this matters to many potential investors.  There is an institutional imperative that has evolved in hedge funds that is very similar to that which has evolved in long-only funds.

Being different, no matter how right it may be, doesn’t help.

Having had to change the terms, we remain true long-term investors.  We will not get a performance fee unless we truly earn it and clients will not pay for the beta inherent in a long-biased, non-volatility constrained portfolio.

I am convinced more than ever that managing for the short-term increases errors, increases risks and promote poor analytical judgment.  Since we manage a portfolio of all public, relatively liquid stocks, we think we can stay true to concentrated, long term value investing while providing clients more reasonable liquidity terms.

Outside of the fee changes, Lane Five and I have simply pursuing our passion for uncovering value in good long-term businesses.

I’ve not been intentionally quiet; I’ve just been working on building my portfolio and business with single-minded focus.

Can you talk about your investment approach and how it has developed over the past few years?

Lisa Rapuano Our philosophy remains static but we pride ourselves on being adaptive in process and tactics.

So, our approach in some ways hasn’t changed in many, many years:  find deeply undervalued companies, investigate and analyse them with great rigor to understand long-term business value, and create a portfolio that balances risk and reward appropriately to outperform long-term.

The core of the process is to understand the nature of a business in order to assess its ability to generate free cash flow over its life span.  This involves a great deal of good old-fashioned securities analysis in order to understand the key variables of the business, how margins progress, how pricing works, how much capital has historically been required to grow, things like that.

We’re then at a point where we simply understand the business and the company’s past and can start the much more difficult process of looking ahead.  We focus on what the company might look like in three to five years, since we believe the shorter term outlook is nearly always reasonably discounted into the stock price.

When you’re looking at a three to five year time horizon, you ask different questions. You think more about strategy, pricing, competitive position, capital decisions, incremental profitability and business models than you do about what

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