Mother of all side pockets

Harbinger Capital’s massive investment in LightSquared could end up one of the greatest private investments ever. Or it could be the single worst private equity deal to date. The flow of dollars from LightSquared’s fund would indicate that limited partners think the latter scenario is more likely.

Harbinger is a New York-based hedge fund run by Philip Falcone. The firm’s goal is to “invest in alpha-generating ideas”, according to its website.

Right now about half of Harbinger’s ideas are centred on a single company: LightSquared, a greenfield wireless venture that is seeking to build out a next-generation network based on the Long Term Evolution (LTE) standard. The investment is in a private equity side pocket that is part of the main hedge fund. LightSquared’s business plan is to sell spectrum on a wholesale basis to major US telecom companies like Verizon and AT&T. If all goes according to plan, Harbinger and its investors will end up the Vanderbilts of our wireless future.

Harbinger is now encountering a confluence of unenviable problems, one of them specific to its hedge-fund origins – redemptions. Having once controlled $26 billion at its peak in 2008, the hedge fund is now down to $6 billion, and of that, roughly $2.9 billion is invested in Reston, Virginia-based LightSquared. Already, major investors like The Blackstone Group’s hedge fund-of-funds unit and Goldman Sachs, have pulled their capital from Harbinger. According to the Wall Street Journal, there has been an additional $1 billion-worth of redemption requests recently.

At least in front of his investors, Falcone is hugely confident in his LightSquared investment. His conviction is no doubt enhanced by Harbinger’s having been exactly right in its earlier bet on the collapse of the US housing market. If the fund was able to see around that corner, why doubt its ability to back the right play in 4G wireless technology?

But there are indeed doubters and they want their money back. Unfortunately, Harbinger will not be honoring these redemption requests in cash alone. According to an investor memo, a portion of the redemptions will be provided “in-kind” – in other words, in private shares of LightSquared.

If you want to hear salty language, ask your LP friends how much they appreciate in-kind distributions.

When half of your fund is concentrated in a single, illiquid position, redemption requests force you to sell all your liquid securities while the private “side-pocket” position begins to bulge. In an investor memo, Falcone states his concern that liquidating the LightSquared shares would jeopardise the firm’s controlling share in the business. A sceptic would also surmise that the value at which LightSquared shares would now change hands would fail to reflect Falcone’s bullish forecast.

LightSquared has reportedly held serious talks with strategic partners about spectrum sharing. If these deals come through they could transform the company’s prospects. But there is a pesky concern about its technology – at least one government test indicates that LightSquared’s current network might make airplanes crash. The National Executive Committee for Space-Based Positioning, Navigation, and Timing (PNT) has found that “LightSquared’s broadband wireless transmitters jam GPS receivers crucial to aircraft navigation systems”, according to a report.

Setting aside concerns over the commercial viability of the network, Falcone left a bad taste in many of his investors’ mouths when they discovered that he took a $113 million personal loan from the fund in 2009 to pay his taxes. This was during a period when the fund’s investors were themselves barred from taking redemptions.

Regulators are reviewing the facts surrounding this loan, Harbinger has disclosed.

The Harbinger/LightSquared situation is not exactly a ringing endorsement for the use of side-pockets, the fund-accounting technique that allows hedge funds to place private-equity style illiquid investments in the same vehicle as liquid, traded assets. When valuations fall, liquid and illiquid assets live together about as well as dogs and cats. When investors want out, it gets even messier.

Side pockets also present a risk to investors that most regular-way private equity funds take great pains to avoid – over-concentration. That Harbinger now has half of its assets tied up in a private bet on a next-generation wireless venture is very troubling. 

The most money ever lost in a private equity deal was $2.8 billion (Terra Firma Capital Partners; EMI). Harbinger, with its $2.9 billion and counting in LightSquared, has gone from diversified hedge fund to what could be the biggest and scariest concentrated bet in private investment history.