Fund Focus: Mutual Series Keeps a Private Equity-Like Window Open

Michael Shari, pictured here, writes about the difference between mutual funds and private equity funds in this week's fund focus.
Michael Shari, pictured here, writes about the difference between mutual funds and private equity funds in this week's fund focus.

It has been said that when the capital markets are on the way up, there's not much work for a mutual fund manager to do except turn the lights on when he arrives at the office and turn them off at the end of the day. This is because the vast majority of mutual funds don't use the most adventurous or ambitious methods to invest your money. They simply buy stocks or bonds on the public market from traders, the fees for which get passed on to the investor.

That's the main difference between mutual funds and the private equity funds, which are only for "sophisticated" investors who invest hundreds of thousands of dollars at a time. Very few mutual fund managers would ever contemplate taking the time or the risk of scouting out a company that needs to raise capital in a hurry and then offering to buy a chunk of its equity or one of its bank loans. This is cheaper than buying stocks or bonds on the market, particularly if the company in question is desperate to sell. But it also requires a much deeper level of research than most mutual funds can muster.

Franklin Mutual Series Funds

But there's one mutual fund family that acts like a private equity fund when it wants to, and you don't have to be rich to use it. It's the Franklin Mutual Series Funds, which is run by Peter Langerman and a team of portfolio managers and analysts in Short Hills, N.J. Part of the Franklin Resources (BEN) complex, Mutual Series is a value shop that focuses on "distressed situations" that make companies desperate, which is not an unusual strategy per se. But a prospectus filed with the Securities and Exchange Commission certainly makes an uncommon claim -- that Mutual Series funds can and will make "direct purchases" of equity or debt from the companies it invests in.

The Mutual Series funds also act like hedge funds when they want to. The prospectus says they can invest in derivatives.

I caught up with Langerman between meetings in Midtown Manhattan with financial advisers, broker dealers and other gatekeepers who are in the business of picking your mutual funds for you. (You may not actually be aware that you employ these people, particularly if you have entrusted your retirement savings to a large financial institution.) He was quick to point out that private-equity-like investments are "just one piece of the arsenal" at Mutual Series and that its "core investments" are the publicly traded stocks and bonds that fill those gray tables on the back pages of the Wall Street Journal.

Buying Direct Equity Stakes

But then Langerman referred me to one of his analysts, Luis Hernandez, whose job is to seek out and recommend direct purchases. Hernandez told me he was working on several complex investments that were at various levels of completion. He declined to discuss most of them, but he went into detail on one that had closed last October, when Mutual Series joined several other investors in a consortium that bought an equity stake worth about $150 million directly from West Coast Bancorp (WCBO), a publicly listed regional bank based in Lake Oswego, Ore.

The investment was made by Mutual Financial Services (TEFAX), a mutual fund with $449 million in assets, when the bank's stock sold for about $1.30 a share more than six months ago. It closed at $3.28 on May 5, more than double the purchase price.

Before closing the deal, Hernandez spent months trying to figure out why West Coast was so desperate to raise cash and deciding whether it was a safe investment. Shortly before the real estate market fell apart in 2007, the bank had started issuing loans that were used for a double purpose -- buying land and building buildings on said land -- which gave the bank a double whammy. Hernandez concluded that West Coast was well managed and had a sound consumer banking franchise, but needed money to shore up its capital base. Then the bank issued new shares, which Mutual Series and the other investors snapped up. (He declined to disclose the value of Mutual Series's portion.)

Talking Like a Private Equity Manager

Now, I've covered institutional and retail investing for longer than I care to admit. But I had never heard an analyst at a retail mutual fund talk like a private equity manager until I spoke with Hernandez. Mutual Series is certainly treading in institutional territory, but the intended investor is not a state pension fund in California or a university endowment in Cambridge, Mass. It's Joe Schmoes like you and me. The fees are small, and so are the minimum required deposits. Mutual Financial charges only 1.24% of your investment, and the minimum deposit is just $1,000.

It would be nice if all of Mutual Series's investments had performed as well as the West Coast deal since the financial crisis. In fact, Mutual Financial has performed worse than the Standard & Poor's 500 Index every calendar year since 2007, and it's still trailing the index year-to-date.

What gives? "It's not a secret that we are conservative investors," explains Hernandez. "The investments we make are for the long term."

Only for InvestorsWith Patience

And so it goes for private equity investors, too. If you stray away from the public market, you have to be patient enough to wait years for an acceptable return -- regardless of how that market is performing. Mutual Financial beat the S&P 500 by 7.7 percentage points a year on average for 10 years through May 5, according to Morningstar (MORN), which tracks mutual funds in Chicago.

Few mutual funds can make that claim. Then again, very few of them claim to make direct purchases.