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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Reactionary forces continue to oppose hedge funds

Martin Lipton, founder of the venerable law firm Wachtell, Lipton, Rosen & Katz slammed hedge funds at a recent New York Bar Association conference.  In his keynote address, Lipton accused activist hedge funds as being motivated by short-term gains instead of long-term value.  Ironic, since Lipton is credited with the creation of the poison pill -- a strategy used by corporations to prevent takeovers, even takeovers that offer premiums to shareholders.

Hedge funds need to plow through this reactionary bluster and step up their activist strategies, not curtail them.  In the new financial world order (see previous post), activists and short sellers are an important part of the marketplace of ideas that enforces good corporate governance and compels CEOs to explore all alternatives to create value for shareholders -- even at the expense of their own jobs.  

Poison pills and break-up fees are nothing more than anti-shareholder defense mechanisms designed to preserve the status quo and the lucrative relationships law firms maintain with corporations.  

Clearly Wachtell, Lipton, Rosen & Katz is part of the problem, not the solution, and hedge funds need to identify the forward looking law firms, PR firms and other service providers to help them with constructive activism.