The two faces of hedge funds

An interesting dichotomy arose at the Walkers Fundamentals of Hedge Funds Seminar in New York today. Seeing the beauty in the hedge funds industry, not surprisingly, was Joel Press, managing director in the prime brokerage division at Morgan Stanley. Seeing the beast, also not surprisingly, was Gregory Zuckerman, hedge funds reporter at the Wall Street Journal and author of the recently-released The Greatest Trade Ever, an account of Paulson & Co.'s bet against the mortgage and financial services market in 2007-2008.

Here's a quick summary of both points of view:

Joel Press -- The beauty is back in hedge funds

• Press predicted that AUM by hedge funds will be "well north of $3 trillion" in four years.
• "There is no need for [hedge fund] fees to go down," because the the performance of the asset class is better than anything else an investor can find. He also says FOF fees should not go down.
• He says that in the run-up to the credit crisis hedge fund investors "didn't know what they were signing," referring to the LP documents, but the "documents were clear." "Managers never thought they would need to gate" investors claims Press.
• When it comes to liquidity, Press said "you can't fight what investors want, but we are not a mutual fund industry...We need to reestablish what we are about." Investors, according to Press, mismanaged their asset liability and were forced to redeem underwater hedge fund investments.
• Press predicts that hedge funds of funds will continue to control 40-45% of the industry, due in large part, he says because FOFs will "maintain the standards of due diligence"
• Press sees institutions and endowments returning en masse to hedge funds -- particularly for the equity strategies in their portfolios. Furthermore, Press predicts that funds dedicated solely to pension fund assets (because of regulatory requirements) will be a growth area for the industry.

Greg Zuckerman -- The beast is still loose in the hedge fund industry

• Gates continue to"bother" investors, says Zuckerman. He says that it is "remarkable" that certain funds have maintained their gates, despite the return of liquidity to most markets and called it an act of "hubris" for a manager to launch a new fund while the gate was down on other funds he manages.
• Returns touted by the hedge fund industry are inflated by the "survivorship bias" (if a fund closed in 2008, for example, its losses are not tallied in the final calculations for the industry for the year).
• Hedge fund industry players knew Madoff was a fraud, but "played along," says Zuckerman.
• "We are in an age of bubbles," said Zuckerman. He says there in an incentive for the industry to "pile on trades" and follow the herd."
• Zuckerman sees gold as the "hot trade" of the day. He pointed out that the downside is much greater with gold than it was with mortgages, when Paulson placed his prescient trade, or earlier this year with financials, when Citi was at $0.97. He characterizes the run up in gold as a "crowded" trade that "follows conventional wisdom," hinting that it is a bubble. Yet, Zuckerman notes that Paulson & Co. has $30 billion invested in gold and will launch a gold-focused fund in January.
• Zuckerman appears to doubt the wisdom of the industry itself. He notes that "funds are fully invested" and thinking about "adding leverage," but managers don't have conviction about the rally we are seeing in the market. "Will they all get out in time?" wonders Zuckerman.

Who is right? Maybe they both are, but Zuckerman raises interesting questions about correlation, contagion, and diversification that hedge fund investors need to carefully think about. Press of Morgan Stanley himself admits that reputation is a leading factor for investors allocating to hedge funds. Zuckerman as a journalist is, perhaps, more skeptical than most, but his opinion, in part, shapes the reputation of the industry.

It was a shame that the program went long and Zuckerman, as the last speaker, had to rush his presentation. Outside perspective in healthy doses is what the hedge fund industry needs.

Getting some respect for hedge funds

Israel A. Englander, the founder of Millennium Partners shared his views on the state of the hedge fund industry in a keynote address at the Absolute Return Symposium in New York. Millennium, like all hedge funds, said Englander, is feeling the pressure to increase “investor friendliness.” He outlines four areas of investor concern that need new focus by the hedge fund industry: transparency, risk management, liquidity and duration of capital, and focus on core competencies.

A few highlights from his remarks follow and the the entire document is linked below:

On valuation and transparency: Englander says it's hard for hedge funds to get respect these days. “When Goldman Sachs puts a value on a position, everybody accepts it. When Citigroup puts a value on a position, everybody just accepts it... When a hedge fund puts a value on a position, first we have to get some highly regarded independent verification that we really do hold that position somewhere, then we have to get independent verification of the value of that position. Why do I feel like Rodney Dangerfield?”

On risk managment: Englander says, "Our risk management practice aren't changing. But the way we communicate these practices to our investors and the level of transparency we provide with regard to our risk management is increasing."

On liquidity: Englander says the industry needs to focus on "better matching the duration of the investors' capital with the fund's investment horizon." At the same time, he says, hedge funds should do "due dilligence" on investors because "it helps in making sure the interests of the manager of a fund are well aligned with the interests investors..."

On investment "style drift": Englander says a lesson for his fund was "to work on keeping the grass green on our side of the fence, and to forget about looking over the fence at somebody else's grass. The grass may look pretty green on the other side of the fence, but the fertilizer can be very expensive."

On hedge fund regulation: Mr. Englander says that oversigh “isn’t something to be too afraid of” because, whether it is a smart response or not, it may result in investors feeling more comfortable about the industry in general.

These investor-friendly trends in the hedge fund industry will combine to deliver superior risk-adjusted returns for investors in the asset class, says fund-of-funds manager Nexar Capital in a new report to investors. Nexar cites new transparency initiatives, lower fees, less leverage and better liquidity terms as factors that should attract investors back to hedge funds.

The kinder, friendlier hedge fund might not be the way forward for some managers, though. According to The Wall Street Journal, Ken Griffin, head of Citadel Investment Group "expressed exasperation at investors' desire to keep dissecting last year's disaster, comparing their fascination with people's inability to look away from a car crash. "I've told the story of 2008 many times," he said."

Israel Englander Keynote Address at the Absolute Return Symposium

Shamrock whips Texas Industries board

In a column in Sunday's New York Times entitled "When Shareholders Crack the Whip," Gretchen Morgenson writes about three directors failing to win reelection at Texas Industries. Shamrock Holdings, the firm that helped oust Michael Eisner from Disney, nominated the alternate slate of directors. The election results, according to the column, "are an example of what happens when shareholders act appropriately -- like the company owners they are."

The story appears to be good news for activists and governance advocates, but the novelty of such shareholder success is in itself a cautionary tale and those seeking to shake up corporate boards still have an uphill battle. Before launching its proxy contest, Shamrock received no response to its suggestions on how to improve governance and perforance issues at Texas Industries. "We had a read tough time getting management to sit down and talk to us...They just stonewalled us," said Shamrock. Shamrock estimates that its campaign cost $1 million and attributes its success to growing interest among mutual funds to support the activist route.

Morgenson notes that "no single election proves that investor attitutes are a-changing everywhere," but that is a major understatement. Pershing Square spent $10 million and failed to get a single board seat at Target. The Children's Investment Fund threw in the towel in its effort to get CSX to switch tracks.

Research by The Corporate Library shows that the more troubled the company, the more tone deaf the directors. A study of financial firms that required government assistance showed that boards ignored withhold votes by shareholders. Another study showed that nearly two-thirds of directors who received majority withhold votes retain their seats.

Fact is that it takes much more than a whip to take on an entrenched board of directors. Activist hedge funds and governance advocates need to get media and the SEC to shine a brighter light into the lack of responsiveness of boards. When it comes to proxy fights, sadly, there is a bigger lesson to be learned from the efforts that fail than the ones that succeed.

Update: SEC Chairman Mary Shapiro has called for changes in proxy access to make it easier and cheaper for shareholders to nominate corporate directors.

The risk of talking about risk

In a recent article in The New Yorker entitled "Rational Irrationality" John Cassidy seeks to explain how bubbles occur. In deconstructing the tech bubble and the housing bubble, the article basically argues that there is no such thing as the "irrational exuberance," so famously described by Alan Greenspan. According to Cassidy, it is precisely rational behavior that leads to bubbles and that fact pretty much guarantees the occurence of bubbles in the future. "In a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a fist," writes Cassidy.

Wall Street is particularly succeptible because of the pressure to generate earnings forces banks into riskier and riskier businesses. As Cassidy writes, "In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them."

As early as July 2007, Charles Prince, CEO of Citigroup acknowledged that a collapse in the credit markets could result in huge losses for Citi. He also understood the Catch-22 he was in. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance," he said.

The game of musical chairs appears to have started up again and is playing in real time. Morgan Stanley had a serious brush with insolvency last fall. The bank retrenched and posted losses while gutsier firms like Goldman Sachs scored huge profits from trading.

Now Morgan Stanley is playing catch up. Value-at-risk reached $123 million, the highest level since 2007 and its strong earnings of $2.1 billion are still more than $1 billion lower than Goldman's. VaR at Goldman hit $208 million last quarter. Morgan Stanley plans to hire 400 people to bolster its trading businesses and its VaR is bound to rise, whether they like it or not.

What is a bank CEO to do? Clearly there are massively complex business decisions to be made. But CEOs also need to begin speaking clearly and publicly about risk and it's not the big risk-takers that need to start that dialog. Rather, the imperative falls on those firms (banks, insurance companies, hedge funds, etc.) that do not want to get trapped in a game of financial musical chairs.

The conversation centers on articulating how an enterprise is prepared to balance reasonable growth with reasonable risk and the limits the firm is willing to accept to protect its strategy and growth plan. It takes vision and it takes courage and it will take perseverence because firms will see their earnings lag other, potentially riskier, firms.

Why can't a bank, for example, make a case for controlled growth? Don't firms like investment banks that tend to have volatility in their earnings have lower PE ratios than slower growing, but more predictable institutions?

CEOs with something to lose should be ready to begin the risky discussion about risk. If someone doesn't stop the game of musical chairs, we will know that the cynics are right and that on Wall Street the game really is heads I win, tails you lose.

Update: Warren Buffet in a new interview touches on Wall Street compensation. He says, "in addition to carrots, there need to be sticks...We need to create a downside to people who mess up large institutions...too many people have walked away from the troubles they've created for scoiety...and they've walked away rich." Creating this downside will bring risk management and communicating about risk to the forefront of the financial industry.

Update: Here is commentary advocating that investment banks need to return to being private partnerships in order to effectively manage risk.

The sinking feeling about Galleon

The Wall Street Journal's editorial page jumped to the defense of Galleon yesterday. "When Wall Street and business are as politically unpopular as they are now, the media temptation is to chalk up every indictment to "greed" and assume prosecutors are always right. In this case they may be right, but when political calls for scalps are in the air is precisely when the rest of us should reserve judgment until they prove it in court."

It is a curious move for the Journal's editorial board, which has been pretty muted about hedge funds, despite ample opportunities to address issues like short selling, risk management, compensation, etc. Yes, the accused are innocent until proven guilty, but there seems to be a lot of smoke in this case. The market seems to sense this too and Galleon is facing $1.3 bn in redemptions -- more than one-third of its assets under management -- and counterparties like Merrill Lynch and Barclays are cutting Galleon off from trading.

The New York Times explains that insider trading is difficult to prove, but author Dan Strachman suggests on CNBC (see clip below) that trading on insider information could be an issue for the entire money management industry, not just hedge funds. Indeed, Reuters reports that the SEC is poised to announce more cases involving insider trading and people in the financial industry.

How big a black eye the Galleon episode is for the hedge fund industry is unclear. Certainly it is not a good thing. However, for the first time in a year, the industry is net positive for asset inflows and many funds are posting solid performance amid the broad recovery in the markets since March.

We can expect that cases like Galleon, so close on the heels to the Madoff fraud, will rightly make investors even more cautious. Hedge funds need to embrace a higher bar for transparency and they must be prepared to communicate better with investors about their strategy and the specific drivers of performance. Funds which cannot explain their performance to proactive investors are going to be told to walk the plank.

Update: Galleon is winding down the fund. In a letter dated October 21, founder Raj Rajaratnam wrote to clients, "I have decided that it is now in the best interest of our investors and employees to conduct an orderly wind down of Galleon’s funds while we explore various alternatives for our business."

Update: See the Reuters column about potential defense strategy for Rajaratnam.

Hedge fund conspiracy theory about to go mainstream?

Everyone has heard about the 9-11 conspiracy theory. Millions have seen the slickly produced video which argues that a plane did not hit the Pentagon. It's easy to dismiss as the work of a small group of whatever you want to call them. However, one cannot deny the pervasiveness of that particular conspiracy nor the effectiveness of the Web in propagating the allegations.

Here's a conspiracy theory that the financial industry needs to watch: that short selling and the outsize power of firms like Goldman Sachs were at the root of the financial crisis. At the center of that theory is a blog site called Deep Capture which rails against short selling and in particular the destructive nature of naked short selling. A video on the site that attributes the fall of Bear Stearns and Lehman Bros. to massive spikes in naked short selling is eerily similar in tone and style to the 9-11 video. The name of that video: "Hedge funds and the global economic meltdown."

Deep Capture is founded and probably funded by Patrick Byrne, CEO of Overstock.com. Mr. Byrne is infamous for consistently alleging that the shares in Overstock.com are unfairly and illegally targeted by short-sellers. In the About section of the site, it writes:

"...short-sellers and affiliated investors use a variety of other tactics to drive down stock prices and destroy public companies. They hire thugs to stalk and threaten corporate executives and their families. They pay small armies of “bashers” to flood the Internet with scurrilous rumors and lies. They engage in extortion and blackmail. And they collude with crooked law firms to saddle corporations with bogus class-action lawsuits. They also conspire to cut off companies’ access to credit. They finance dubious market indexes and credit rating agencies that spread false information about the prospects of companies and the economy. They pay shady financial research shops to publish false, negative information, disguised as “independent” analysis. And they manipulate credit default swaps and derivatives, the prices of which are considered indicators of corporate health."

You get the picture.

Matt Taibbi, a writer for Rolling Stone, who gained notoriety for a conspiracy-esque article about Goldman Sachs, now writes on his blog about Golman's lobbying efforts to head off curbs on short selling. The blog entry alleges, but by no means proves, that Goldman is also trying to defend the practice naked short selling. According to the New York Times, in public filings Goldman has argued that new short-selling rules adopted last year have worked to curb abuses and “fails to deliver” — the term for problems associated with naked shorting — and that further restrictions are not needed.

Here's my own conspiracy theory about the conspiracy theory: the people behind Deep Capture are working to influence journalists like Taibbi to do their bidding and get their ideas into the "mainstream" media.

I myself have no idea about whether new curbs on short selling are sufficient nor about the true market impact of naked short selling. I do know that questions about short selling, transparency and efficient market function are immensely complex, that that the causes behind the collapse of Bear and Lehman are widely misunderstood, and that neither the government nor the banking industry has been clear about what went wrong and how to prevent future shocks to the financial system.

The confluence of these unknows is the condition that gives rise to conspiracy theories and hedge funds, which already have the stigma of being opaque, private and secretive, now more than ever need to avoid being the subject of conspiracy theories.

Mr. hedge fund goes to Washington

BusinessWeek observes that hedge funds are increasingly turning to think tanks, political analysts and lobbying firms to gauge how political forces and legislation might affect the private sector. Particularly for sectors like insurance, health care, and energy, what transpires in Washington will affect those companies' financial fortunes.

While this is not "big news," it does demonstrate the extent to which politics have become entwined with the economy. Bringing expert political analysis into the investment decision-making process seems only sensible. It is part of developing a mature outside-in perspective that any enterprise needs to thrive.

With new perspective on political risk, hedge funds might be able to develop keen insight into the winners and losers in regulated sectors. Taking that assumption a step further, hedge funds might become more vocal on policy issues.

For hedge funds that see business value in shaping the debate in Washington, media will become an important tool and they will find that the media will listen. Independent voices in the private sector are too few and far between these days and the media will welcome institutional investors' view on policy matters.

If it quacks...

In virtually every meeting I have had with communications and marketing people in the financial industry this year, they each say that their institutions are different from their peers. It makes sense, because from hedge funds, to banks, to insurance, companies are trying to distance themselves from their troubled industry segments. I am not sure that it is working, though.

Here are some examples:

"Our investment process is different from that of other quantitative hedge fund." - Hedge fund marketing executive.

"Media don't understand that mutual insurance companies are more financially sound than traded firms." -- Insurance industry communications officer.

"We don't consider ourselves to be in the same tier as those other firms." - Communications director at a leading independent advisory firm.

"Our business model is different from other private equity firms." - Communications VP at a major PE firm.

Here's the catch, the natural tendency media, client prospects and the general public is to group businesses into tiers and categories. Each of those groupings has its own identity -- for better or for worse. It is extremely difficult to differentiate a firm within its group, much less shed the group identity.

So, a quant fund is a quant fund. A private equity firm is a PE firm and even the most storied independent M&A firm is just that -- not Goldman Sachs, not a specialized boutique, but one of the handful of firms in between. If it quacks like a duck, for most of the world, it is a duck. The only question is is it a big, medium or small duck.

So, how does a firm change it spots (sorry for mixing metaphors)? Not easy. In practice, it's less about standing out in the traditional category than creating a new category all together. It requires aggressively walking the walk and talking the talk. From business model to corporate culture, to marketing, everything needs to be rebranded and reinvented.

It doesn't stop there. CEOs committed to changing the paradigm of how they are perceived need to speak out about controversial industry practices and take the lead in embracing sensible regulation among other initiatives designed to set the company apart from firms that would otherwise be considered peers.

The process can take years and it involves risk. However, if there ever was a time to "think different" as Apple (one of the few companies that defy categorization) used to say, it is now. For hedge funds, banks, and private equity firms facing regulation and government officials hopped up on populist backlash, the stakes could not be higher.

No time to waste. Get quacking!

Goldman's evil reputation

A new study shows that Goldman Sachs' reputation is something less than golden. The survey shows that while the reputations of most banks have deteriorated in the last year, Goldman's has fallen the farthest.

During the best of times Goldman was criticized for working "both sides of the deal." People grumbled, but still did business with the bank, sometimes out of necessity. These days, things are more sinister. Goldman is accused of owning the allegiance of top government officials, manipulating bank bailouts to favor itself, paying executives lavish bonuses at the expense of taxpayers, profiting from high-frequency trading, and reverting to its high-risk, high-leverage ways to generating revenue (aka multi-million dollar bonuses).

Much of this is sour grapes. Fact is Goldman weathered the financial crisis better than other banks, was forced by the government to accept TARP funding (recently refunded with interest) and just reported record quarterly earnings. People, especially during hard times, like to hate supremely-successful organizations. In that regard, Goldman Sachs is like the New England Patriots or New York Yankees of commerce. Goldman is not tone-deaf to what is going on and CEO Lloyd Blankfein is reported to have cautioned employees to keep a low profile and avoid conspicuous consumption.

Does that mean that Goldman has nothing to worry about? Not really. Pulling strings with Paulson, Geithner, Summers, et al is one thing, fending off congressmen hopped up on populist rage is another. Not many in Congress are willing to have an thoughtful discussion about the role of risk-taking and risk management in modern capital markets, but the nature of public concensus on those complex issues is the primary risk facing Goldman and why reputation matters to the firm.

Fueling negative sentiment about Goldman is an column from an unlikely source: Rolling Stone. Matt Taibbi's now famous column argues that Goldman manipulated the governement into doing its bidding during the height of the financial crisis. Even New York magazine has attempted to shed light on Goldman's dealings and its article suggests that Goldman itself was close to failure back in September.

The influence of Taibbi's article, in particular, demonstrates an important fact about media today. Because it is so easy to share news and opinion via email and the Web, where an article is published is less relevant today than in prior years. What influences people is who circulates the article to whom. In other words, while I might not think Rolling Stone is an authority on capital markets, if I am referred to Taibbi's article by someone I know and trust, I am likely to ascribe greater credibility to the piece (and, in turn, circulate the piece, furthering its influence).

This is both an opportunity and a threat to institutions large and small. On one hand, companies don't necessarily need the Wall Street Journal to get ideas into the marketplace. On the other hand, it is much more difficult to contain negative publicity because of the degree to which reputation-damaging opinion can be syndicated by individuals.

Regulation, driven by excesses on Wall Street, is coming, but I don't expect Goldman to be particularly affected. Goldman will jettison its bank charter and get back to the real work of printing money.

What do you think? Submit a comment via the link below and I'll update the blog with your views. If you'd like to remain anonymous, just indicate so.

Getting serious about hedge fund marketing

Hedge funds are marketing harder than ever and fewer investors are listening. Investors report fielding more phone calls and receiving more marketing literature from fund managers and are taking steps to limit the deluge. At the recently concluded GAIM conference, for example, in order to avoid being badgered by funds on the hunt for new cash, one family trust manager had cards printed without phone or email information.

What do hedge funds have to do to be effective at fundraising in this environment? Hedge Lines recently spoke about the challenge with two asset management professionals. Not surprisingly, many of the keys fundraising hinge on effective communication with investors and other influential parties. Here is some insight:

It's the strategy, stupid. Hedge funds need to understand that smart investors buy into strategy, not simply performance. "The key is for the manager to show conviction in his or her ability to manage money," said author Daniel Strachman. "They need to be able to communicate how they actual put a trade on and why. Performance is important but conviction in one's strategy is more important and ability to communicate why the strategy works is most important. If it was me, this is what I would be talking about all day and all night."

Don't hide losses, explain losses. "Funds need to communicate in the big picture what happened, not just the number," advises investment professional Andrew Tilzer. He says that funds need to be clear about the time horizon they use and their peer group to put performance in context for investors. "If I was down 10%, 20% or more or less, the story would not be the returns it would be the strategy and why it failed," said Strachman. Document strategy with proof of your real-time thinking, like investor letters, to show consistency and conviction, adds Tilzer.

Invest in relationships. "Too many hedge funds don't truly know why their existing clients came to them and how they appeal to different classes of investors," said Tilzer. "To raise new assets, it is important for funds to have the patience to learn what existing LPs like about them and what prospective clients need." This outside-in perspective helps define what makes a fund unique and gives the fund insight about the niche they fill in the market that they can use to further differentiate themselves.

Leave marketing to marketing people. The Reuters story cited above noted that more managers attended this year's conference in person, as opposed to sending marketing staff. This is a worrisome trend and PMs need to resist the urge to be personally responsible for marketing. "There is a difference between being a portfolio manager and a business manager," explains Tilzer. "To be efficient, the manager has to respect the back office."

Don't hang up on the media. "The idea that hedge funds don't want to talk to the press is lunacy. It is also lunacy to think that talking to the press will help raise money - directly. Indirectly, however, talking to the press is a good thing because it provides third party credibility," notes Strachman. Too many funds are disengaging from the media process and the industry needs to resist that instinct. Quantitative and activist strategies are among those currently out of favor. Managers in those sectors, for example, need to use the media to promote the investment case for their specialties.

Ackman to media: Screw you guys, I am going home!

Seven months after announcing that he was going to become more visible via the media, William Ackman is going home. In November, Ackman told investors that he decided to engage with the media, in part, because "it is important for the hedge fund industry to come out of the shadows and defend the importance of our work." Now, in his most recent letter to investors, he writes, "you should expect that we will do our best to fade into the sunset as far as the media is concerned until such time as an investment opportunity requires us to work more closely with the press. We hope such time is many moons from now."

In Cartman's words, screw you guys, I'm going home.

What happened? Ackman waged a very public and expensive proxy fight against Target and lost. A media program designed to build support for electing new directors to the Target's board included appearances on CNBC and an open town hall meeting. It didn't work. At the Target shareholder meeting last month, neither Ackman nor any of his other nominees were elected.

What's worse is that Ackman took some lumps in the media. Most notably, a column in the New York Times, questioned Pershing Square's motivation and tactics.

Here's some friendly advice for Mr. Ackman and other shareholder activists:

You need a thick skin. Publicity invites criticism and the motivation of hedge funds are always going to be questioned. That said, if the straw that broke the camel's back was indeed the critical column in the New York Times, it would be a shame. The column appeared after the shareholder vote and the writer had the benefit of hindsight to dissect Pershing Square's argument. As such, it is not as much of an indictment of the fund's approach as it might have been had the column appeared before the vote. Mr. Ackman did not see it that way and felt compelled to issue a long rebuttal. This was a mistake. Activists need a thick skin and be prepared for criticism. When the record needs correcting, it has to be done in a more selective and efficient way.

Understand the risks. Pershing Square needed to understand that most shareholders did not feel that Target was a company in trouble and in need of a shakeup (Target was trading at about $40 per share in early November and is still at that level). Moreover, the core of Pershing Square's campaign hinged on non-operating fixes for Target (selling off its real estate and its credit card operation). It was too easy for the company to paint these strategies as "financial engineering" that had nothing to do with the retail business. Pershing appears to have underestimated the difficulty in changing the prevailing sentiment among Target shareholders:"if it ain't broke, don't fix it."

Nice guys finish last. In Ackman's own words, when it comes to activism "thoughtful and constructive engagement based on careful and detailed analysis focused on shareholder value creation will always, in our opinion, be an effective means to maximize value in the public markets." Maybe not. Throughout its campaign, Pershing Square took pains to be non-adversarial. It praised management and even Target's board. It encouraged "exploration" of options like selling the real estate assets. Curiously, more tangible strategies, like getting Target into the grocery business, as Wal Mart has done, were never at the forefront of the campaign. Overall, this fight needed a much sharper edge to compell shareholders to vote with Pershing Square.

I encourage Mr. Ackman to rethink his decision to withdraw from the public debate about hedge funds, activism and even the business prospects for Target. His next activist situation will require engaging with the media and the steps he takes between now and then can affect the how his argument will be perceived by the market.

He had it right in November when he wrote "if we and others (that includes hedge fund investors in addition to the managers) don’t do so [engage in the public debate via the media], the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry."

Reputation risk sinks Pequot

The resurfacing of an investigation that began in 2006 has led to the shuttering of Pequot Capital Management. The fund, which managed $15 billion at its height in 2001, still managed more than $6 billion in March 2008 and now has $3 billion that will be unwound.

The inquiry focuses on Pequot's trading in Microsoft stock in 2001. While both the SEC and the Justice have reopened the investigation, there is no indication that the regulators will pursue enforcement actions.

Pequot lost money last year, but was up so far this year. Nonetheless, fund manager Arthur Samburg wrote to investors, "With the situation increasingly untenable for the firm and for me, I have concluded that Pequot can no longer stay in business.”

Historically hedge funds and other asset managers have been able to weather inquiries and settle with regulators without jeapoardizing their business. These are not normal times, though, and this case shows how management of reputation risk is at least as imporant as the management of market risk to the survival of hedge funds.

Go to the New York Times account of the Pequot closing.
Go to Reuters' story.
See Arthur Samberg's letter to investors.

Ackman goes to town on Target

On Monday, William Ackman, president of hedge fund Pershing Square, held a "town meeting" in Manhattan and broadcast on the Internet to present his case to shareholders of Target and encourage them to elect new directors that he called more experienced and more independent than current members of Target's board who are up for reelection.

In his hour-long presentation, Ackman says that Target does not have the proper structure for its credit card operation and that the company should offload the credit risk to a bank or other financial institution. He also notes that among retailers, Target owns the most real estate and claims that the company has several options to monetize its real estate assets. Third, he points out that Target missed the boat on grocery sales and, as a result, cannot challenge Wal Mart in that category. The directors endorsed by Ackman has extensive operating experience in those three key disciplines.

What's innovative here is Ackman's use of the town hall format. The meeting was open to anyone interested and during Q&A questions were fielded from the audience and from those viewing the webcast. This degree of transparency is fairly unique in the realm of proxy fights and marks a continuation of Ackman's earlier pledge to be more public about issues facing his business and the hedge fund industry.

From a communications perspective, Ackman dedicated part of his presentation to systematically countering recent claims Target has made against him. He also took pains to praise Target's management and positioning his beef with the board as one focused on independence and receptivity to new ideas intended to enhance shareholder value. Most noteworthy, he was clear that shareholders have a choice among directors and that voting for one or more of those endorsed by Pershing Square does not require them to vote for Ackman himself, who is also on the alternative slate.

In all, it was an effective presentation of a business argument and the event went a long way to refuting Target's claim that this proxy fight is all about Ackman and his fund's short term interests.

Update: In a move that The New York Times calls "unusual tactic in proxy fights, but one the company feels it must make in order to win over shareholders," Target is fighting back by issueing its own presentation that tries to discredit the nominees supported by Pershing Square.

Hedge funds need a community organizer

"Hedge funds really need a community organizer," quips Clifford Asness, managing partner at AQR Capital Managment, in a strongly-worded letter rebuking the administration's comments about secured investors opposing the reorganization plan for Chrysler. When asked about the 16 or so bondholders who were not willing to accept the government's terms President Obama said, “I don’t stand with those who held out when everyone else is making sacrifices.” Mr. Asness, rightly, tries to set the record straight.

Certainly there are plenty of targets for bondholder ire in the Chrysler case -- even for funds, like AQR, that are not invested. The sanctity of contracts, the government intrusion in the economy, the package offered to the UAW, the merits of bankruptcy court are all at issue here. However, the size of the auto companies and their historical importance to the econmy make it easy to tar as un-American those who would see Chrysler in bankruptcy.

In the economic crisis, there is a broad perception that, as the President suggests, we are all in this together and we need solutions that require cooperation from all parts of society and business. This puts Chrysler's dissident bondholders in the same uneviable position as those investors who oppose restructuring mortgages because of ripple effects into the bond market. The complexity involved in both of these situations and Main Street's lack of understanding of the rules of bankruptcy and the financial system in general contribute to the reputational risks associated with taking a principled but massively unpopular stand on hot-button issues like automakers and mortgages.

Of the Chrysler holdouts, The New York Times writes, "this bit of brinkmanship — which many characterized as a game of chicken with Washington — has become yet another public relations disaster for Wall Street...What is striking to many in financial circles is how much Chrysler’s reluctant creditors gambled for what is, in the scheme of this bankruptcy, a relatively small amount of money."

Yes hedge funds need a community organizer. Job one would be to unify the industry and develop a sense of, well, community based on shared business interests. Job two would be to become more effective at advocating common sense on critical issues facing hedge funds' ability to operate freely in the marketplace. Job three would be to know which fights, like Chrysler, cannot be won.

TCI switches tracks on CSX campaign

London-based hedge fund The Children's Investment Fund has sold its position in railroad operator CSX and will resign the board seat it gained after a long court battle last year. This "defeat" for TCI demonstrates the difficulty investors of all stripes, even the most sophisticated and deep-pocketed, have in advocating change at traded companies.

BreakingViews writes, "the top brass at CSX demonstrated an unwillingness to take criticism or suggestions from a substantial shareholder — the kind of parochial response that other investors should find worrying." Agreed.

However, BreakingViews goes on to say "if hedge fund activism is indeed on the wane, then shareholders looking for a more enduring advocate for their interests may need to do the job themselves. Come to think of it, that wouldn’t be such a bad outcome after all." Disagreed.

If hedge funds cannot be effective activists, how in the world can anyone on Main Street be an effective voice for change? What are individuals supposed to do? Show up at annual meetings and grab the microphone? Yeah, right.

View the story from BreakingViews.
View the story from The Journal of Commerce.
View the story from DealBook at the New York Times.

Springing forth: Op-eds by hedge fund managers

April showers have brought a bloom of recent op-ed articles by prominent hedge fund managers. Mark-to-market accounting, regulation of financial services, executive compensation and corporate governance are the subject of articles written by the likes of James Chanos, Carl Icahn and Paul Singer in the Wall Street Journal and New York Times.

These are high-profile and important pieces because they demonstrate how the interests and opinions of the hedge fund industry are aligned (in these cases) with the best interests of the country. Icahn argues that shareholders should have more influence and that it should be easier to replace corporate boards. Who would disagree? Chanos writes that while mark-to-market accounting isn't perfect, it is an important contributor to integrity of financial statements. Seems logical. Paul Singer, head of Elliott Management, writes that "private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity throughout the world." Sounds reasonable.

Articles like these, appearances on CNBC, and meeting with lawmakers are important steps in publicly aligning the interests of the hedge fund industry with the economic recovery and the creation of a well-functioning marketplace that this blog calls the New Financial World Order.

See also Andy Kessler's op-ed on bear raids that provides good perspective on the shorting of financial companies.

Media misses demand side of hedge fund equation

Think about what you read about hedge funds. What makes "news?" It's the AUM for the industry -- way up and now way down. It's the activists, the larger-than-life manager, the lavish hedge fund affairs. It's the flame outs, the frauds, the gates and the side pockets. It's the compensation. It's shorting and "black boxes."

All of this is the supply side of the industry. Nobody is writing about the demand side of the industry -- the source of those trillions in AUM and those willing to pay the notorious two and twenty for performance.  This lack of focus on the demand side is central to the the poor state of the reputation of the industry.  

The result is a situation in which the media criticize hedge funds without asking the simple question, "why do hedge funds exist?"  

They exist to serve the needs of their investors. Plain and simple. If they fail in what Dan Strachman in his new book calls the "hedge fund promise" (the ability to use all the arrows in Wall Street's quiver without taking on significantly more risk than the market as a whole to deliver alpha), hedge funds cease to exist. Everything about hedge funds is completely elastic. No performance, no assets. No assets, no hefty fees.

The people stretching (or not) that elastic are the investors, mostly large institutions. But hedge funds reporters are not talking to those people and, as a result, don't understand the demand for hedge funds and the ways good investors work with hedge funds on the key management issues like risk management, governance and reporting.

If I were advising a major fund or the MFA, I would work to have the fund's investors do much of the talking (to the media) for the fund. A company's customers are always the best evangelists and it is no different in the hedge fund industry. In fact, it's even more important in the hedge funds business because the demand side has received so little attention. Think about it. What's more credible to a reporter's ears? Having a hedge fund say that they allow investors free access to their books or having an investor tell the reporter that his auditors spend several days a year poring over the books with the hedge fund CFO and COO.

A recent profile of megafund Bridgewater Associates in Fortune takes steps in that direction. Here's an excerpt: "I view them [Bridgewater] more as a partner than a vendor," says John Lane, the director of Eastman Kodak's $7.5 billion pension portfolio, which has had money with the firm since the late 1980s. "We don't make a major change here in strategy without calling Bridgewater to get their view...Of all the investment firms we work with," he says, "they're the most trusted."

That is powerful. Any manager worth his or her salt, though, should be able to get similar endorsements from their clients.

The media and the public need to better understand why hedge funds exist. The answer comes from the demand side and the industry needs to figure out how to get those voices out there.

The rocky shoals of regulation and reputation

It's time to set the record straight about short selling. The media doesn't get it. Congress, certainly, doesn't get it. And the hedge fund industry is at risk of getting it right where it hurts, if short-sighted regulation is the result of misplaced concern about short selling. A recent column on Bloomberg blames naked short selling for the collapse of Lehman Brothers. The column begins with this shrill statement, "the biggest bankruptcy in history might have been avoided if Wall Street had been prevented from practicing one of its darkest arts." Fraud, dark arts, and collusion are among the charges levied against hedge funds in the piece.

An effective counter-argument can be found on Portfolio.com, but just because a debate on short selling exists, doesn't mean that people are hearing both sides.  The critics are much more vocal and their claims play on the concerns people have about everything Wall Street.  Experts say that people need to hear something between three and five times before they believe it.  Believe me, people have heard that short selling is bad, dangerous, even un-American lots of times.  They are writing their congressmen. Congressmen (and there are not many bankers and securities lawyers in the House), in turn, are turning up the populist rhetoric against the industry.  

What's at stake here is license to operate.  When I worked for Texaco, license to operate was the primary PR concern of the company.  The energy industry understands that reputation is central to winning contracts with foreign governments, executing acquisitions and preventing over-regulation.

Ensuring that short selling does not come under unreasonable regulation should be taken as seriously as the energy sector takes regulation on offshore drilling ,CO2 emissions, double-hulled tankers and other aspects central to its operation and profit.  

Right now, the hedge fund industry is running a proverbial oil tanker onto a reef and they don't even know it.

What can be done?  Here are some tactics:

Get independent third party experts, like academics or former regulators, to set the record straight. 

Sponsor and promote independent research that documents the effects of short selling on the market.

Get involved in the debate online.  The blogs listed (see right hand column) on this site all feature intelligent comment and debate among readers.

Become more vocal in the media.

Educate key lawmakers.

The blog on Portfolio.com listed above suggest creating an official panel (like the 9-11 Commission) to investigate (and hopefully vindicate) short selling.

Jon Stewart swings and misses in showdown with Cramer

Jon Stewart flopped Thursday night in the final battle of his much-hyped "war" with CNBC and Jim Cramer.  Stewart was neither funny nor insightful in his attempted grilling of Cramer.  The only comedy was watching two non-journalists talking about the presumed guilt shared by real financial journalists in not foreseeing the financial crisis (see March 4 post).  In his attempt to be serious, Stewart lost the art of what makes him so effective -- the ability use humor to point out the serious, even insidious hypocrisy in politics, business and society.   

Stewart has interviewed people with whom he has more philosophical differences than Cramer.   John Sununu, Mike Huckabee, Dana Perino, Bill O'Reilly, Bill Kristol, Ari Fleisher, to name a few.  But he reserves the long knives for Cramer and despite his domination of the conversation (Cramer doesn't get too many words in edgewise), completely whiffs.  The result is an interview that is just as superficial and farcical as the CNBC body of work Stewart was lampooning in the first place.

I don't blame Cramer for agreeing to the interview, but he was unprepared and let Stewart set and dominate the agenda.  Poor media training.  Maybe he was blindsided, expecting Stewart to be more like his playful real self.  Maybe he didn't know what he wanted to achieve in agreeing to the interview.  Bottom line is that Cramer hasn't learned his lesson from his longer-running, much more serious feud with Barron's.  The bad blood there began to be spilled in 2007.  Barron's won't let go of this "story" and recently revisited its critique of Cramer's stock picks.  

Cramer's problem is that he doesn't know what his show is really about and has not found an effective way to put his stock "picks" into perspective.  He needs to admit to himself that his picks and pans are NOT what the show is about.  His show is about speaking to (mostly) young investors about how the market works and how to do research on investments.  It's not a stock picking show, stupid!  On The Daily Show, Cramer should have said, "Jon, I don't think you understand my show" and taken control over the interview from there.  

Cramer needs to understand that what he does is not very serious and very serious at the same time.  Not serious because he cannot have an informed micro-level opinion about all of the equities covered in the Lightening Round and very serious because he is communicating with an audience ignored by the financial community in a way they understand and connect with (could Suze Orman fill the basketball arena at any university like Cramer routinely does?)  

In response to the most recent salvo from Barron's, I wrote as much to the editors of Barron's.  Scroll half way down the page.

Oh, in my ranting, I almost forgot:  Bank of America (one of the institutions supposedly coddled by CNBC and Cramer) advertises on The Daily Show.com. How's that for irony?  

Hedge funds silent on "golden coffins" and other governance issues

Apparently its not enough for some CEOs to get massive compensation packages, lavish corporate perks and a golden parachute when they get fired for mismanaging their enterprise.  Now there are "golden coffins" too.  According to the Wall Street Journal, golden coffins are generous posthumous payouts to senior management and dozens of corporations offer generous death-benefit packages that might include allowing heirs to collect unvested equity, posthumous severance payouts, supercharged pensions and/or years of postmortem salaries.

With executive pay coming under intense scrutiny in the wake of the banking crisis, corporate governance issues are moving to the forefront.  Hedge funds -- except Carl Ichan -- are surprisingly silent on the matter.  This is a mistake.  Corporate governance is a non-controversial issue, but one of great importance.  Fighting the good fight right now are a couple of pension funds, academics and proxy advisors.  These are mostly passive players, however, and corporations are not under meaningful pressure.  

That could change if hedge funds enter the fray.  Aligning with other governance activists would demonstrate that hedge funds are a responsible part of the modern capital equation.  It would also show that hedge funds can be watchdogs and enforcers of fair play in the markets in what this blog calls the "new financial world order."  Lastly, it would advance their business interests as shareholders in corporations that are less wasteful, have better boards, and are less protected by poison pills and other anti-shareholder defense mechanisms.

Organizations that hedge funds should cooperate with on the issue of corporate governance include:

The Corporate Library

RiskMetrics Group (ISS)

The Weinberg Center for Corporate Governance (U Delaware)

GovernanceMetrics International

CalPERS

Hear no evil, see no evil, speak no evil.

"How could 9,000 business reporters blow it?" asks Dean Starkman, a former Wall Street Journal reporter and current writer for the Columbia Journalism Review, in a recent essay that examines how the media missed the warning signs in the run up to the credit crisis.  According to Starkman there are several factors to consider:

- Shrinking newsrooms and increasing financial pressure on media as factors that have reduced investigative reporting.  

- The rise of M&A reporting, in effect, made media Wall Street "insiders" dependent on Wall Street for information and potentially coopting independence

- An editorial focus on outsized CEOs was a distraction from the real business stories underfoot

Starkman makes good points but sensibly does not entirely indict media for missing the boat.  Indeed, many in the media were asking the right questions and reporting about smoke in the real estate market.  As early as 2005, Ruth Simon and Bob Hagerty of the Wall Street Journal were asking my clients hard questions about subprime lending practices and default rates.  It is clear to me that they knew something dangerous was happening, but they never could get their suspicions confirmed by the right people.  The complexity of mortgage securitizations and CDS and CDO markets made it almost impossible for journalists to identify what was going on, much less "expose" anything with confidence.  (See a more complete defense of financial media at The Deal.)

The big question is how can the media (or regulator or other whistle blower) focus on bad news when the market is going up and up?  Not easy.  Ask Harry Markopolos.  Indeed, there were examples of stories that identified exactly what the risks were.  In September 2005, the Wall Street Journal wrote an in depth piece on the limitations of the Gaussian coupola, the formula at the heart of the models evaluating mortgage securities and derivatives.  The piece explains how the formula was being applied to gauge risk of CDOs and synthetic CDOs.  Read today, the article is truly scary.  Back then no few paid attention.  The Gaussian coupola is the subject of the cover story in Wired this month.

Of course, there were many who figured out at least some of what was happening.  Steve Eisman of Front Point Partners (see the December cover story of Portfolio) and John Paulson made fortunes shorting financial firms.  It's just that their voices were not heard over the din inflating the bubble.  Why be a sourpuss when everyone is getting rich?

Someone, though, always seems to know the truth.  Even in the Bernie Madoff scandal, certain private banks refused to allow their clients to invest in the Madoff funds.

It appears that, especially during bubbles, it takes more than one voice to show that the emperor has no clothes.  It can't be media alone, or short selllers alone, or a noble minded whistle blower, like Markopolos, alone.  

In the wake of the banking crisis, hedge funds should choose to be more vocal, utlizing the media and other means to expose unsound unsound business practices, accounting sleight of hand and fraud.  Speaking up and getting people to listen, even when they don't want to hear the truth, is good for hedge fund business, the economy and our society.

Short sellers: "The real financial detectives"

James Chanos, president of Kynikos Associates, recently did an eleven-minute interview with PBS' Nightly Business Report.  Similar to William Ackman's recent appearance on Charlie Rose (see previous post), this was a thoughtful exchange about key issues facing capital markets. Veteran reporter Darren Gersh did not pull any punches in the interview, querying Chanos on short-selling, vetting of qualified investors, and transparency issues.  So, this was no puff piece.

The important fact though, as Chanos demonstrates, is that there are credible, logical answers to just about any question a responsible hedge fund might face from the media.  Moreover, reasonable people watching at home are likely to agree with those answers.  If hedge fund managers did more of these interviews there would be far less confusion about the roles hedge funds play in the market, the institutional investment needs they seek to fill and how they make money.

Some notable quotes by James Chanos during the interview:

Short selling "should be encouraged, not discouraged."

Short sellers are "the real financial detectives.  Regulators are the financial archaeologists."  

Regarding accusations by bank CEOs that short sellers imperiled their banks: "It's easier to point fingers at others, when you've screwed up."

On Bernie Madoff and whether there is such a thing as a "sophisticated" investor: "people will always do stupid things with their money, when greed takes over."

On the effectiveness of regulation, the largest "financial disasters happened among regulated firms."

Click on the image below to view the interview in a new window.

I trust you. NOT!

Edelman's annual trust barometer study suggests that the financial industry has a long road to travel before it can rebuild the trust it requires to operate. It also suggests that intelligent media relations might provide much of the solution that will once again win the industry the support of the public and regulators.

First a few grim statistics from the study:

- While trust in all industries in the U.S. declined last year, banking suffered the most, with a 35% decline in the trust metric. Banks and insurance companies are among the three least trusted industries in the U.S.

- Only 49% of Americans think the free market function is sufficient to prevent future financial crises

- 61% of Americans think that government should impose stricter regulations on business and people were evenly split on whether the government or business should be most responsible for ending the credit crisis

- CEOs were the least trusted of all expert spokespeople and people cited excessive compensation as the number one reason they had less trust in corporations (When President Obama spoke about demanding new accountability from CEOs, the MSNBC audience reaction meter went into the stratosphere of approval ratings... even higher than it did than when he outlined a new commitment to cure cancer!)

What's a bank or hedge fund or private equity firm to do? Ramp up the public relations. The study shows that using media to win back third party validation of a company's mission and merit is the best way to rebuild trust. Importantly, old media remains a key component of influencing opinion and creating trust. According to the study, traditional media (analyst reports, articles in business magazines, newspaper articles, and radio and TV news) are the most credible information sources, even for young people (age 25 - 34). In fact 55% of those age 25 - 34 and 43% of those age 35 - 64 find business magazines the most credible of all media. After media, people find conversations with company employees highly credible, meaning that employee communications need to also be a priority.

Ok, no problem, right? Not so fast. Part of the challenge is that people need to get information from multiple sources, multiple times to believe it. The study says that 60% of people need to hear or see something (positive or negative) about a company between three and five times before they believe it to be true.

This means that there are no shortcuts on the long road back to trust. The journey is worth it, though, as trusted corporations have greater license to operate and receive the benefit of the doubt when things inevitably do go wrong in the future. Heidi Moore, DealJournal columnist at the Wall Street Journal says, "You can call on trust when you need it."

Where are the good apples?

Portfolio.com argues that the private equity industry doesn't produce real returns for investors. According to the article, "private equity firms generally don’t make their money by choosing good investments. They make it on an amazing Technicolor array of fees: management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the bubble years."

The entire spectrum of alternative asset management is under attack. Much of it is deserved and we are in the early phase of a shakeout. In the meantime, the good apples are tainted by the bad and they are not doing much about it.

Are there hedge funds that are delivering for investors even now as so many funds are making excuses instead of money? Yes. Are there private equity firms that are truly creating value instead of paying themselves out by further saddling their portfolio companies with unnecessary debt? Yes.

The problem is that no one is talking about the good apples in the alternatives arena. No one is making the case that hedge funds and private equity are valuable, even important, vehicles for institutions, like pension funds, that should reasonably expect to make money even when the market is down. This should be an easy argument to make, but no one is actively taking it on.

No one ever got fired for buying IBM, for making the safe choice. The question at hand is will the alternative arena become perceived as the patently unsafe choice for institutional managers? And if so, will it go down without a whimper?

Hedge funds aim at bird in the hand

With raising assets becoming more difficult, hedge funds need to focus on retention. Funds need to realize that institutions of all sizes have suffered losses and are scrutinizing all of their managers. The spectrum of communications, including investor letters, meeting with investors, and media relations need to be stepped up as part of a broader effort to compete for allocations.

Investors need more detail of how funds are managing in the current environment, which opportunities they are targeting and why. Some funds are choosing to share more information about specific investments. See previous post. 

A few funds with significant losses are thinking creatively about management and incentive fees. This is a good strategy because it recognizes the fact that investors have been hurt across the board, not just in one fund. For example a single stock fund run by William Ackman's Pershing Square Capital Management is down 90%. Pershing Square is helping investors recoup losses by suspending incentive fees on their investments in other Pershing funds until they are whole. It might not satisfy all investors, but demonstrates the degree to which Pershing will go to retain investors. See shareholder letter from Pershing below.

Hedge funds have always competed aggressively for assets. The battle now is to keep assets from walking out the door.

Pershing Square IV Letter to Investors

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