Private Equity Squeezes the Shorts

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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 Overstock.com (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 BusinessWeek.com, 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.

Rosenbush is a senior writer for BusinessWeek.com in New York.