Have I Got A Hot Deal For You

You can always trust Wall Street to do the right thing--the right thing for Wall Street, that is, not necessarily the right thing for you. The latest example of this eternal verity is a hot new product taking the Street by storm: investment pools that give us average folk a chance to have our money managed by legendary firms like Leon Black's Apollo Management or the Kohlberg Kravis Roberts leveraged-buyout house or by other "private equity" firms. Normally, these outfits restrict their clientele to the likes of pension funds, college endowments or people with pockets deep enough to hold a giant squid. But now, Average Investor, you're getting a rare chance to run with the big dogs. Woof, woof, woof.

Here's what you need to know if your broker calls peddling this stuff. First, you'll be paying a premium for a fund that will almost surely sell at a discount shortly after you buy it. Second, the fund managers get such heavy fees that they will make out OK even if you don't.

Our tale begins about three weeks ago, when investors scarfed up $930 million of shares in Apollo Investment Corp., Apollo Management's entry in this sweepstakes. Investment bankers from UBS had concocted a clever way to mate private firms with public investors, but no one got excited until Apollo raised that huge pool of cash. Rivals then decided they had to get their share of public money before it dried up. The prospect of fees--at least $18 million a year for Apollo, far more if the fund does reasonably well--didn't hurt, either. Since Apollo's big score, KKR and at least seven other firms have filed with the Securities and Exchange Commission to sell billions more of these securities. More filings will doubtless appear. Think of it as prospectors registering their claims before competitors can grab all the good sites.

Now, to details. The securities the Street is peddling are shares in closed-end mutual funds. Unlike the familiar open-end funds--in which you buy shares directly from the fund company and sell them back to the company at net asset value--closed-end fund shares trade like stocks. Investors buy and sell them on the open market. For a variety of reasons, shares of closed-end funds typically trade at less than their net asset value. But when you're buying in the initial public offering, you're paying much more than net asset value because you're absorbing Wall Street's sale charges and the fund's other initial expenses.

Take Apollo Investment, the only one of these securities that has been sold, and hence the only one where we can see specific numbers rather than my having to make estimates. Public investors paid $15 a share, of which 6.25 percent (just under 94 cents) went to the brokers. Throw in the other expenses, and investors paid $15 for a security that had a net asset value of $14. So it had to sell at 7 percent above net asset value for investors to break even. The stock sold above $15 briefly, and has since drifted into the 14s. It wouldn't surprise me to see it in the 13s, or lower. You could have bought the stock at its closing price of $14.24 on Friday, forked over a brokerage commission, and still paid less than the $15 offering price. "You never want to buy closed-end funds at their original issue, because you're paying all those costs," says Tom Herzfeld of Thomas J. Herzfeld Advisors, who has been dealing in these securities since 1968. What's more, says Herzfeld, when Wall Street begins trotting out lots of closed-end funds in a particular category, be it municipal bonds or real-estate investment trusts, it often marks a market top. "Investment bankers and brokers sell what's easiest to sell, not necessarily what people should be buying," Herzfeld says. If you're looking for a high-yielding fund, Herzfeld adds, you might consider buying a junk- bond fund trading at a nice discount to asset value rather than paying a premium to buy a new fund. The time to buy these private-equity funds, Herzfeld says, will be when they've established a track record and are selling well below their net asset value.

Tempting as it is to flog Wall Street, I'm not even going to get into the problem of the ongoing fees on these things: typically a whopping 2 percent of assets a year, plus 20 percent of the profits (and interest) after you get 7 percent or so. And I'll just mention in passing that many of the offering firms--including Apollo and KKR--don't have a track record in the kind of investment they're peddling, known as "mezzanine funds." Mezz mavens buy securities that are in between the ground floor (lenders, who take the lowest risk for the lowest reward) and the top floor (stock investors, highest risk, highest reward). They aim for an interest yield and a slice of stock action, and expect to have some losses. It's a specialist's game.

The bottom line: it's ego-gratifying to invest with the big dogs. But don't pay steak prices for dog food. Buy these things when they get cheap, and you can make out. With luck, your pockets may even get deep enough for squid.

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