Sudden Success Proved Perilous for the Internet Fund

Usually when a manager leaves a mutual fund, it's a result of bleeding assets and lagging returns. But for the (WWWFX)Internet fund, the opposite was true.

Success was so sudden and so smashing that it apparently torpedoed a proposed sale of the fund to a new advisor, leading to the departure of its star portfolio manger.

An examination of the fund's asset flows, coupled with Securities and Exchange Commission filings, tells the story of a burgeoning fund that made far less money for its adviser in 1998 than it did for its investors, then exploded in assets after a deal to sell it was already inked.

This sequence of events illustrate the dramatic opportunity -- and perils -- that Internet funds pose not only to their investors but to the companies that run them as well.

The Internet fund remains in the hands of its founders at Kinetics Asset Management, which has brought in a new portfolio manager and is hiring a team of analysts to help run the fund.

But the fund is now without Ryan Jacob, the manager who piloted it to a 271% return over the last year. Wednesday, TheStreet.com broke the story that Jacob had quit to start his own company.

Jacob said Thursday he chose to leave after Kinetics' deal to sell the fund to Lepercq, de Neuflize, a money management firm in New York, fell through.

"I submitted my resignation on Friday and Kinetics obviously tried very hard to get me to reconsider and stay, but I told them, given the circumstances, I did not feel comfortable staying," Jacob says.

He would not elaborate except to say there were "extraneous" circumstances.

Jacob says he'll now start Jacob Asset Management, which will specialize in Internet investments. Jacob is taking his lone analyst from the Internet fund, Michael Dubrow, with him.

"We're planning more of a broad-based firm," Jacob says. "We're going to offer retail, institutional, onshore and offshore products. We've already had enough interest in all of those areas to make them viable."

Jacob leaves behind in the Internet fund some $660 million in assets, a substantial portion of which poured into the fund during a surge of investment in the Internet sector during April.

The magnitude of that surge could hardly have been anticipated on March 12, when Lepercq agreed to purchase "substantially all of the assets of Kinetics for cash," according to an SEC filing. On March 31, the filing says, Kinetics' directors unanimously approved the deal.

Before Kinetics elected to sell the fund, it toiled to make it profitable. At the end of 1998, Kinetics, which launched the fund in 1996 and ran it out of a suburban home near New York City, calculated the 1.25% management fee it got from running the Internet fund for the year. The grand total from the year's best-performing mutual fund? An unimpressive $26,884, according to the filing.

Why so little? The fee, paid in monthly installments, was based on the fund's average daily net assets throughout the year. And while the fund had grown to $22 million by December 1998, it started the year with just $200,000, according to Financial Research Corp. of Boston.

Though its assets were growing, so was demand for its shares. That meant Kinetics had to quickly build out its infrastructure -- installing telephones and outsourcing back-office tasks -- to meet that demand. So even though the management fee was relatively small, other costs had swollen the fund's expense ratio to a whopping 3.08% of assets by the end of 1998. That was 50% higher than the previous year's expense ratio and far above the average of 1.75% for other technology funds, according to Morningstar.

By the time the deal was signed at the beginning of March, the fund's assets were around $150 million. When the fund's board approved the sale a few weeks later, assets had doubled to $321 million. A month after that, at the end of April, the total had more than doubled again to a mind-boggling $748 million.

Sources familiar with the situation say the deal soured over money, specifically the March price at which Kinetics had agreed to sell the fund. By June, Kinetics found itself about to walk away from a fund that had more than quadrupled in assets in three months, and Lepercq was ready to swoop in on a money-making machine at a bargain price.

Neither Lepercq nor Kinetics would comment on why the deal fell through.

But Jeff Lovell, a managing director at investment banker Putnam, Lovell, de Guardiola & Thornton, says the exploding assets of the fund would have complicated the deal dramatically.

"I suspect with the magnitude of asset movement that took place here, it basically went outside of any general parameters they had on how to reprice the deal at closing," Lovell says.

To sell a mutual fund, bankers usually use a multiple of about five times the cash generated by its annual management fee. If a $100 million mutual fund had a management fee of 1%, it would be priced at $5 million, Lovell says.

Before a mutual fund deal can go through, shareholders must give their approval through a proxy vote. So a "collar" of plus or minus 15% to 20% of assets is routinely included in any sale agreement to account for a fund's change in value by the time the deal is closed, says Lovell.

But the Internet fund's change in assets probably blew the doors off any agreement the parties could have had in place.

At $150 million in assets with a 1.25% management fee, the Internet fund was worth about $9.4 million. But at $750 million in assets, five times its annual management fee would be $46.9 million.

"Somewhere along the way the people said, 'OK, this is a change of a sufficient magnitude that we're not willing to do this deal,'" Lovell says.

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