Hedge funds’ love affair with exchanges

Several prominent US and European hedge funds have been aggressivebuyers of the publicly traded shares of the world’s stock exchanges. These investors, such as Atticus Capital and Lone Pine in the US and The Children’s Investment Fund in London, have been among the prime beneficiaries because the relatively young category has ranked as one of the best-performing sectors of the past half decade. Archipelago Holdings has more than quadrupled in the past year, while Deutsche Börse has tripled in the past 18 months and Euronext and the London Stock Exchange have more than doubled.

The marriage of the New York Stock Exchange and Archipelago Holdings, (set for completion on Tuesday March 7) which will result in the NYSE Group, marks an appropriate time to ask the question: why do hedge funds love stock exchanges so much?

First, it is a fixed-cost business. Once an exchange has earned enough revenue from tariffs on trading, the additional cost to it of handling ever-larger volumes is marginal. The additional revenues are therefore almost pure profit.

Second, the companies are huge generators of cash. Third, the explosion in derivatives trading is driving growth across the board, not just for exchanges that specialise in derivatives products but also exchanges focused on stocks, bonds and cash equities that are often used in hedging against derivative bets. Even the LSE, which is essentially a single-product exchange, has benefited from the derivatives explosion as a residual benefit from investors buying underlying equities as a hedge.

While multi-security exchanges such as Deutsche Börse have benefited most from the growth in the derivatives business, an analysis of margins on separate business segments shows that the margins on cash equities come up trumps. Margins have exceeded 40 per cent in this area

Fourth, the industry is rife for consolidation, which has buoyed many of the exchanges’ stocks.

Last, there is some confusion in the marketplace about how to properly value exchanges – and hedge funds exploit uncertainty for potential upside.

One US hedge fund manager sums up this philosophy in describing his fondness for Deutsche, in which he has a stake. “To own Deutsche Börse is to harness the most powerful innovation in human history, the capital markets.” This manager also likes Deutsche as a broad-based play on a recovering Germany.

The exchanges’ ability to generate cash has proved especially compelling to hedge funds, since cash generative activities have made them ideal candidates for the use of gearing to enable even greater returns of capital to shareholders.

The LSE, fighting off a hostile bid led by Macquarie Bank, announced plans to double its return of capital to shareholders to £510m and said it would finance that through £350m of additional debt. Macquarie’s own plans for the company implied gearing of 10 times the company’s earnings before interest, tax, depreciation and amortisation (ebitda).

Mamoun Tazi, analyst at Man Securities, calculated the gearing at two times the company’s forecast 2007 ebitda, and notes that the LSE is the first exchange to begin to use leverage in any significant way.

Indeed, several hedge fund investors in Deutsche Börse were urging precisely that approach last year as the exchange piled cash on its balance sheet. One, Atticus Capital, calculated that Deutsche Börse could return as much as €2bn to shareholders using both the cash it was piling on its balance sheet and funds raised through borrowing.

Moreover, it is likely to remain under pressure to borrow in order to speed the return of capital to investors, a prospect which analysts say has increased the appetite for its shares.

In a recent report on Deutsche Börse, analysts at Morgan Stanley pointed out that even after the company’s recent return of capital to shareholders, about €715m of cash remained on its balance sheet.