Hunting season on "vulture" funds

The new issue of Conde Nast Portfolio writes about Elliott Management and other "vulture" funds. The story illustrates how Elliott buys foreign debt at deep discounts and then uses the courts to win payments from governments like Congo and Zambia. The practice has drawn the ire of activists who want to advance debt forgiveness as part of economic development in the Third World.

Note: A posting onPortfolio.com makes important clarifications to the print story and sets the record straight about "vulture" funds.

TCI's activist Web site

CSX shareholders vote today on a slate of directors nominated by The Children's Investment Fund and 3G Capital Partners. The CSX-TCI battle is a marathon, not a sprint, though, and CSX says that it could take weeks to certify the election. Despite everything that CSX has thrown at it, the TCI freight train cannot be slowed. First, CSX sued TCI over disclosure requirements and the use of swaps to amass its position. That case resulted in a draw. Next, CSX played the jingoist card and enlisted Lou Dobbs to say that an asset crtitical to national security was in danger of falling into foreign hands. TCI is based in London. The red coats are coming!

That's the old media stuff. The new media stuff and what catches this blog's attention is TCI's activist Web site, "Moving Toward a Stronger CSX." The site explains TCI's view of the value of CSX and offers several documents related to its engagement with CSX. A white paper on the site details governance and perfomance issues at CSX that TCI wants to see improved. It also gives investors instructions on how to vote their shares and gives them the ability to vote by phone, mail, and Internet.

The site is a great resource for investors, institutional managers, other hedge funds and the media. Activist Web sites will become another arrow in activists' quiver as the industry catches on.

People are buying into TCI's argument. Hedge funds hold at least a third of CSX shares and the stock is up 42% this year, outperforming the Dow Jones Wilshire Rail Index, which is up 24%. Imagine, if TCI did a YouTube video? Just kidding...kind of.

Defending the shorts

Even when they are right short-sellers get no respect. Lehman Brothers just reported a $2.8 billion loss, announced a plan to raise $6 billion in new capital, and replaced its CFO amid a long-standing and very public "dialog" with famous (or is it infamous) short-seller David Einhorn of Greenlight Capital.

Trouble is that people and many in the media still don't know quite what to make of him and his breed. Even other hedge fund managers won't endorse his practices.

It's never been popular to say that the emperor has no clothes. Fortunately some, like Einhorn, say it anyway.

That even Einhorn, who is renowned for forensic dissection of balance sheets and earnings reports to uncover hidden truths or at least very tough questions for management, faces criticism of his strategy illustrates how much work he and the hedge fund industry needs to do to educate the media and everyday investors about the facts of short selling.

A starting point is stressing that shorts have more skin in the game than long investors. First, they must keep collateral and pay fees to borrow stock. Then they must return shares bought on the open market to the lender. Profit arises when they are able to repay the lender with shares worth less than the ones borrowed. Thus, shorts are as on the hook and economically vested as long investors. This fact gives them equal moral authority to advocate their position and engage in public debate about the merits of a company.

Second, as noted by UConn law professor Steven Davidoff in the New York Times' DealBook blog, it is not illegal to "talk your book."

The opinions of equity analysts are considered part of the way the game is played on Wall Street. But doesn't a downgrade send the same message to the market as a short position? Just today, analysts at Goldman Sachs urged investors to "underweight" U.S. financials. It should be realized that short-sellers signal the market in similar ways, except they put their money where their mouth is.

As we witness the depth of the credit crisis and await action from the Fed and the SEC on the future of financial services regulation, what we need is more debate in the market, particulalry when it comes to accounting, reporting and governance issues, not less.

The industry is catching on. Today, the Financial Times reported that Bill Hwang, founder of Tiger Asia Asset Management noted that companies with major corporate governance issues are "a big red flag for short-selling for us."

New York magazine recently profiled Einhorn and his stance on Lehman.

Fortune reviewed Einhorn's new book, Fooling Some of the People All of the Time, which recounts his battle with Allied Capital.

Carl Icahn launches blog

Carl Icahn today launched his blog, The Icahn Report. His first posts highlight "absurdities" in corporate governance and include "The Absurdity of Corporate Board Elections," "The Absurdity of the Staggered Board," and "The Absurdity of the Poison Pill."

Former CFO speaks on IR

Here's rare communications insight from a company that has a serious communications problem -- Lehman Bros. Floyd Norris of the New York Times interviewed Erin Callan (coincidentally, right before she was replaced as CFO at Lehman) and she was unusually candid about the challenge a CFO faces in communicating with investors and media. “Trying to strike the right tone, to tell what really happened, what are the facts, and trying to give some confidence to your stakeholders, is a difficult process,” she said. “You don’t always get it right.”...“People are telling us they want to know more. They are not comfortable with what they know,” Ms. Callan said. “It’s a hard thing to figure out what that line is. How can we give a requisite amount of information that is satisfactory?”

That last question is hard to answer for any bank, right now. However, Lehman is in an extraordinarily difficult position, reputationally, as a result of its refusal to take the writedowns its peers have, become more transparent about the quality of its balance sheet, and become more proactive in its investor relations. Maybe the CFO and COO won't be the only members of the c-suite to pay the price.

Reputation management = risk management

The Financial Times today reports that in the rarified air of private banking reputation management has become as important as risk management. It's a valid point, particularly at a time when the world and well-heeled clients are focused on risk. The story goes on to point out that the biggest problems come when clients incur losses on products that they do not understand. "The problem is more losses or products that have been sold to private clients that, actually, the clients have not understood." While I don't think we are going to see product suitability issues on a grand scale (like subprime mortgages) at the high end of the market, banks need to carefully review their sales and risk disclosure practices.

Crises of confidence are difficult to contain in the banking industry. Even typically "sticky" money, like retail deposits and assets at private banks can quickly become unglued. Banks need to re-audit their products and practices to safeguard against operational issues that escalate into reputation damaging events. A lot can be learned from the experience of E*Trade, which lost $2bn in assets in just one day. Fortune chronicles the de facto run on the bank and it is interesting to look back and see the interrelation between risk management, operations and reputation management.

She said, he said

It shows you how rough things are in the banking sector when even good news hurts your stock price. Meredith Whitney, analyst at Oppenheimer, wrote this morning that Bank of America would not cut its dividend in the near future. The bank then denied making that claim and, in effect, reserved the right cut its dividend (BAC has a dividend yield over 8%). BofA might now be joining the list of banks grumbling about Ms. Whitney's calls. Well, she got it right on Citi and being bold and being right earns you credibility.

But this is not about an analyst's opinion. This is about Bank of America's failure to communicate effectively to the market on a number of important business issues. It's about not giving sufficient guidance on how its retail bank is going to perform as the health of the consumer fails (the retail bank delivers about 50% of BofA's profits). It's about Bank of America making deep cuts in its investment banking business and selling its prime brokerage. It's about Bank of America's inability to convince anyone that buying Countrywide was a good idea, much less that Countrywide has long-term strategic value, despite its short-term liability. It's about BofA's credibility and that's why BAC was down 1.4% today.

Post script: A Reuters story from a long interview with BofA CEO Ken Lewis is here.

Playing the don't pass line

The New York Times' Deal Professor blog features an examination of the legal issues related to vocalism (I won't call it activism) by short sellers. Of course, the case study is Einhorn v. Lehman Bros. The writer, a law professor at UConn, draws the important distinction between "talking your book" and manipulating the market and doesn't suggest that Einhorn is engaged in the latter. Comparing the strategy of Einhorn to playing the don't pass line is a pretty good analogy. He may not be popular, but he is playing with the best odds.

This blog will compare the "moral authority" of activism by long- and short investors in the next week.

Buffet bets against hedge fund industry

Fortune reports that Warren Buffet has bet Protege Partners, a New York-based fund of funds that five funds selected by Protege will not outperform the S&P 500 over the next 10 years. The $1 million bet is looking at performance net of all fees, costs, and expenses. Buffet, to quote the article, feels that it is the high cost structure of most hedge funds that makes them "onerous and to be avoided."

In making this bet, Buffet appears to agree with the findings of a Merrill Lynch research report dated February 22, 2008, that makes the case that hedge funds' returns are becoming more correlated with the broader market. Quoting the report: "Our analysis continues to show that 2000’s non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced, if not completely eliminated."

High fees and the perception that risk and return for fund managers is uncoupled, because managers don't share losses equally with investors when the fund loses money, drove media scrutiny and animosity when the industry expanded so rapidly from 2004-2006. Going forward, the fee structure could continue to raise media, not to mention investors' eyebrows, particularly, if funds find it difficult to match historical returns in the current market.

The bet itself is overseen by the Long Now Foundation of San Francisco, which exists to encourage long-term thinking. The organization operates a betting mechanism for long-term bets and wagers include whether commercial air travel will be pilotless by 2030.

It's pretty hard to bet against Buffet, but Protege has shown keen foresight in the past. For example, they invested in Paulson & Co.'s funds, which were among the few to reap rewards from the subprime and real estate crises.

When the going gets tough, the tough might have to get more active

Jeffrey Sachs, in the current issue of Fortune, writes that he sees many disturbing parallels between today's U.S. and global economic picture and the economic downturn of the 1970s. Indeed, striking similarities exist: rapid increase in the price of oil and other commodities, the U.S. fighting a costly and unpopular war, a weak dollar, among others. The result, back then, was 15 years of slower global growth. Should the scenario recur, it certainly will hurt retail investors looking (nervously) at retirement, but it also will make things harder for hedge funds and mutual funds seeking growth in a stagnant, albeit probably volatile, market.

In low-growth or stagflation the business-as-usual mindset of corporations, clearly, won't cut it. Hedge funds might have to increasingly turn to activist tactics to convince companies to unlock value and pursue unconventional growth strategies.

Lehman Bumps Up Earnings Call

Lehman Brothers might release earnings this week -- earlier than its regular schedule -- in an attempt to stem the tide of speculation about the quality of its balance sheet. Lehman officials spent much of last week publicly quantifying its cash and liquid reserves in hopes of calming investors and trading partners. Even if investors aren't going to like the news about earnings and the need to raise capital, it's about time Lehman gave the market more insight into the scope of writedowns and its plan to catch up to other banks in writing down assets. The decision to release early leads me to believe that Lehman realizes that Bear Stearns was prepared to announce strong earnings two days after it was bailed out by JP Morgan.

Rumors, Fact and Fiction in Bear Stearns Collapse Show Limits of Traditional Media

A recent three-part series of articles in the Wall Street Journal chronicled the collapse of Bear Stearns. As part of the company's effort, CEO Alan Schwartz, appeared on CNBC to dispel rumors about Bear's eroding solvency. In the old days, this might have worked, or at least have helped the bank buy time. Unfortunately, there was no real way for Bear Stearns to contain what was happening. No matter what the company said to CNBC and other major media was enough to convince traders around the world who were refusing to do business with Bear Stearns. The degree to which informal information networks among traders showed how banks, hedge funds and other financial institutions are all at risk of public crises of confidence, especially in this jittery market.

Time Warner Cable CEO Unabashed about $10 bn Debt Load

The Wall Street Journal recently interviewed Time Warner Cable CEO Glenn Britt about the long-awaited spinoff from Time Warner. Surprising to analysts and deal watchers was the proviso that TWC would assume $10 billion in debt to pay a one time dividend, mostly to its parent company. In the interview, Mr. Britt claims that TWC's debt load is lower than the industry average and levering up was part of the effort to bring its capital structure in line with competitors. Sure TWC generates a lot of cash, but developing and delivering the next-generation services that customers want is not cheap. Why take a company that is at a competitive advantage (more free cash flow) and constrain it by borrowing to feed not its own growth, but the needs of the parent company?