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.