Private Equity Squeezes the Shorts

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

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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 BusinessWeek.com, 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 BusinessWeek.com, 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.