Media pendulum swinging toward short sellers?

I was shocked, shocked, when I found two stories today outlining the constructive roles short sellers play in the market.

At BusinessWeek.com, Susan Antilla, a Wall Street columnist for Bloomberg excoriates regulators and calls short sellers "important contributor(s) to keeping markets honest." Here are a couple of the many zingers in the article:

• "With regulators taking a refreshing two-decade snooze, it’s now up to judges, plaintiffs’ attorneys, short sellers, bloggers and detectives to fill in for the somnolent stock cops."


• "...regulators and whiny corporate executives often think the wise way to deal with shorts is to investigate them -- not the public companies they target for incompetence or cheating."

The New York Observer has a Q&A with Jim Chanos of Kynikos Associates. He touches on Lehman, health care, politics, Goldman Sachs, among other topics. Some highlights:

• "People thought [Lehman Bros.] were tough, no-nonsense guys. But we were saying, actually, they’re incredibly aggressive risk takers with a wide berth for what they consider the truth."


• "Putting more and more money into housing and keeping us healthy in our golden years doesn’t necessarily make us a more productive society. We should be devoting more of that money to technology and education."

Is the media pendulum really swinging toward understanding how short sellers work? Not yet, but people are beginning to realize that there is an important function for contrarians in the market.

Walking the talk on transparency

Why is a guy like Steven A. Cohen, who didn't used to even play golf with investors, sitting for a cover story in Bloomberg Markets magazine? Why is he inviting reporters into his firm right after SAC Capital 's name was linked to insider trading and the collapse of Galleon? Because he's smart. That's why. He understands that the rules have changed and that transparency, not performance, is now the name of the game. (And he's getting good counsel from his PR firm.)

SEI's The Era of the Investor: New Rules of Institutional Hedge Fund Investing study found that institutional investors said "transparency" was the most important challenge they faced in hedge fund investing. "Performance" was third. Similarly, according to Prequin's Global Hedge Fund Investor Review, "understandable/transparent strategy" was the most important consideration for institutions when choosing a hedge fund manager.

These days, according to an exec at a family office quoted in the Bloomberg Magazine story, "nobody will invest in an operation that is very clandestine...Even the most crass and abrasive managers are more investor-friendly now."

Engaging with media is an important part of walking the talk on transparency and savvy managers understand this. Furthermore, after the average hedge fund lost nearly 30% in 2008 and the Madoff fraud, most hedge funds need to do more than just ramp up the investor relations and provide more detail in their marketing materials.

Working properly with media can provide third party validation of how a fund thinks, works and generates returns. When this information reinforces what the fund is telling investors and prospects, it makes a difference when they decide to whom and how much to allocate.

In the Bloomberg Markets Magazine story, for example, we get insight into the following important aspects of SAC:

• SAC's investment process (and how the fund has ended all non-equities trading)
• The fund's risk-mitigating strategies at work during the credit crash
• SAC's compliance department
• How the firm is structured and how the firm runs itself as a collection of 100 small funds
• How individual managers are held accountable for performance

The story also airs some dirty laundry, like Mr. Cohen's ongoing legal battle with his former wife, but that is anecdotal, in context of what we learn about the inner workings of SAC.

My criticism of the story -- and this extends to the decisions made by the reporters as well as to how SAC managed the boundaries of the story -- is that it details Mr. Cohen's art collection and has a photo of his mansion in Connecticut. It would better serve the interests of the firm had the focus of the story been all business (lose the list of Cohen's charitable contributions while you're at it) and included more commentary from other SAC investors (the story only quotes one).

To get an idea of what hedge funds should aspire to, when it comes to media, read the excellent profile of Bridgewater Associates in Fortune last year. It is noteworthy for two reasons. First, it avoids wasting ink on the fluff that too often permeates reporting about the hedge fund industry. More important, it articulates why investors choose to do business with Bridgewater.

This explanation of the "demand side of the hedge fund equation" is precisely what is lacking in media coverage of the industry and the opportunity for hedge funds to use media to demonstrate the value they provide clients, in their own words, is priceless.

It's not the hedge funds, stupid!

Ready, fire, aim. That's what the Justice Department appears to be doing in opening an investigation on whether hedge funds colluded to bet against the Euro. SAC Capital, Greenlight Capital, Soros Fund Management and Paulson & Co. are among the funds who have received inquiries from Justice.

The inquiry partly stems from the fact that several hedge fund managers were in attendance at an "idea dinner" hosted by advisory firm Monness, Crespi , Hardt & Co. where investing ideas were discussed.

This "investigation" shows us, as if we needed convincing, two things. First, hedge funds continue to draw unwarranted scrutiny from regulators and media. Second, and more important, it is more proof that the deeply-rooted long-bias in our system of financial oversight is not changing.

This systemic bias that extends from Main Street to Pennsylvania Avenue is becoming the single largest threat to hedge fund reputation and operations.

Was it a mystery that Greece was overleveraged? No. It seems that months ago we saw reporting that currency and sovereign debt traders coined the word PIGS as a pejorative for the European economies bound for trouble (Portugal, Italy, Greece, Spain). Why wouldn't hedge funds or any other investment manager realize the same thing and try to profit from that assumption?

Where is the accountability? It's like Greece, Bear Stearns, Fannie Mae, Enron (the list goes on) were not to blame. We are led to believe that it was the "speculators," "short sellers," or "profiteers" who caused the problem.

Every trade has a buyer and a seller. Someone wins and someone "loses." Shorting is the same buying and, technically, has more risk (because the security can appreciate to infinity, while it can only depreciate to zero).

There are too few voices trying to set the record straight. Here are a couple:

Jim Chanos, quoted in the Wall Street Journal, today explains that going long the dollar is "exactly the same trade as going short the euro...It gets to a certain point of demonizing traders and hedge funds for mistakes elsewhere."

Peter Eavis, financial columnist for The Wall Street Journal acknowledges media and government overreaction to trading activity related to Greece's crisis and the fall in the Euro. He writes, "it appears that hedge funds are seen as more suspicious than other market participants....any evenhanded probe woul have to involve [banks] too. And how about the companies that sell Euros as a hedge for their business operations? Perhaps the more prosaic truth is that there are good reasons for the Euro to fall."

Goldman adds bad press to list of business risks

Goldman Sachs, in its most recent 10-K filed with the SEC, acknowledges risks to its business associated with bad publicity and hits to its repuation.

Goldman writes, "The financial crisis and the current political and public sentiment regarding financial institutions has resulted in a significant amount of adverse press coverage, as well as adverse statements or charges by regulators or elected officials. Press coverage and other public statements that assert some form of wrongdoing, regardless of the factual basis for the assertions being made, often results in some type of investigation by regulators, legislators and law enforcement officials or in lawsuits. Responding to these investigations and lawsuits, regardless of the ultimate outcome of the proceeding, is time consuming and expensive and can divert the time and effort of our senior management from our business."

See the section entitled, "We may be adversely affected by increased governmental and regulatory scrutiny or negative publicity" in the 10-K at the bottom of page 34. The section on reputation risk is number 17 of 24 material risks identified by Goldman.

Goldman is correct to draw a clear link between what is reported in the media and what happens on Capitol Hill. The risk that incomplete or erroneous media coverage results in unnecessary or harmful legislation is real. Just think about all the fuss about short selling.

Goldman Sachs' PR problems have been getting a lot of attention recently. Goldman Sachs recently hired a lobbying and PR firm founded by Dan Bartlett and Mark McKinnon, former message masters from the George W. Bush White House. Even Goldman's PR chief has become the object of media coverage.

I suspect that much of the criticism of Goldman will fade into the background with time, especially if the banking industry recovers relatively quickly (and that's a big if). Fundamentally, financial institutions need to pick their battles and fight to win when they choose to engage with media. For example, executive compensation is not a good battle to fight in the press. I don't think that banks can win.

However, ongoing misinformation in the media about market mechanics and trading activity, like negative press about hedge funds shorting Greek sovereign debt, is another matter. That the media don't acknowledge that there are two sides to every trade continues to boggle my mind.

Goldman is not the first financial firm to acknowledge reputation risk in the fine print. In late 2008, Pershing Square Capital Management cited reputation risk as a concern for the fund and the industry in its letter to LPs.

If anyone knows of any other public companies or banks citing reputation risk in SEC filings, please let me know.

UPDATE: On March 8, Goldman was sued by a pension fund for its its pay practices, which, according to the suit, "vastly overcompensate management and constitute corporate waste."

John Bogle to institutional investors: Stop being part of the problem

In a recent op-ed in The Wall Street Journal, investing legend John C. Bogle argues that institutional investors need to change the way they do business and begin to assert their fiduciary responsibilities as dominant shareholders. The ability for institutional investors to exert activist pressure on corporations to ensure the creation and preservation of value for investors is among the remedies Bogle seeks.

Bogle indicts institutional investors, who control 70% of shares of U.S. corporations, on several levels and writes, the "failure of money managers to observe the principles of fiduciary duty played a major role in allowing our corporate managers to place their own interests ahead of the interests of their shareholders."

He says that the apathy of instituional investors is partly to blame for a range of ills including the rise of speculation over long-term value investing, the ready acceptance of financial engineering and "innovation," and excessive corporate compensation systems.

At the same time, Bogle sees institutional investors as having the potential to be agents for positive change and as having the potential to act as important corrective forces in better functioning financial markets. This blog calls that kind of dynamic the new financial world order. The role of institutional investors, including, ostensibly, hedge funds is important, Bogle says, because government is ill-equiped to effectively police the markets. "There are few regulations that smart, motivated, targets cannot evade," he writes.

A recent example of an institutional investor trying to use its weight to enforce fair play is AllianceBernstein's opposition to the terms of Novartis' takeover of Alcon. The deal would pay Nestle, the majority shareholder in Alcon $180 per share, while minority shareholders in Alcon will receive $147.

The New York Times piece linked above notes that it is rare for AllianceBernstein to take such a public stand that challenges corporate interests. That's because the bar is too low for mutual- and pension- fund managers. They don't have enough incentive to put the time and effort into correcting corporate abuses and they simply shift their assets elsewhere. Bogle believes that has to change.

Clearly, though, hedge funds are incentivized to take on corporate boards and constructively use activist strategies to enhance the value of their investment. In the Alcon situation, getting $180 per share for the minority holders represents at 22% increase in value. What hedge fund wouldn't pursue that?

Hedge funds need to take the lead in ensuring corporations deliver value and need to, when appropriate, get other money managers to support activist campaigns. There is no lack of targets. Morgan Stanley reported that compensation at the firm last year represented 62% of net revenue. TIAA-Cref, Oppenheimer, and Calvert Asset Management are among the institutions publicly decrying the situation.

With massive failures of leadership at America's largest (and at one time most respected) companies, like GM, Citigroup, AIG, TimeWarner, etc, it has become easier to effectively criticise boards and the media is more receptive than ever to views that challenge management. Hedge funds and other asset managers can capitalize on that to exert pressure on boards and corporations.

The failures of corporate boards are detailed in Money for Nothing: How the Failure of Corporate Boards is Ruining American Business and Costing Us Trillions. An interview with the author can be heard at Slate.com.

UPDATE: Calpers' portfolio of funds that challenge underperforming companies exceeded the return of the S&P 500 by 8.2% since 1999. "The long-run returns for experienced activists should again beat the broader market. Slumbering boards beware," writes a column by BreakingViews on the market prospects for activist hedge funds.

A video discussion with William D. Cohan and John Guillespie about corporate boards is at Bloggingheads.tv.

New Citi Web site takes positive message straight to Main Street

At the beginning of February, Citigroup launched a new Web site to speak directly to clients, employees, shareholders and other stakeholders. Called The New Citi Blog, the site is part blog, part social media and all extension of Citi's PR and internal communications departments.

Featuring video testamonials from a range of Citi employees and already two posts by CEO Vikram Pandit, the site tries to send multiple messages to multiple audiences. Citi is a good place to work, Citi values its clients, Citi is serious about risk management, the Citi organization is getting better at working together.

Citi might or might not be a viable institution in its current form, but this new Web site is a good tool to communicate management's vision and put a human face on the much maligned bank. Citi is taking advantage of the Web to go around media to get its message direct to stakeholders. Sure, media is still important and the third party validation is more valuable than the obvious corporate spinning going on at New.Citi.com, but this could be an important tool to reach the people Citi needs to reach. Besides, it is unlikely that the media are buying whatever Citi is selling, so the bank needed a new channel.

Companies need to realize that the Web and social media provide conduits to go direct to the stakeholders that matter the most. Before these technologies it simply was not possible to effectively present a company's view of complex situations or defend itself from criticism, much less engage people -- in large numbers -- in a dialog. Companies now can inject their own voice into the debate and have new tools to actively take charge of their reputation.

For this reason, I routinely disagree with PR people who say that the Internet has killed the news release. If anything, news releases are more valuable now than they ever have been, because of the reasons above and the fact that a news release on the Internet now has a more diverse audience than just the media.

The media still matter. It's just that now the media don't necessarily have to have the last word.

A bulge of media opportunities for non-bulge-bracket banks

It is "morning in America" if you happen to be a non-bulge bracket bank. Think about it: your larger, previously-unassailable competitors have either dissolved or are consumed with their own issues (TARP, compensation, regulation, risk management, etc) and now, finally, second- and third-tier institutions have a historic chance at grabbing market share.

From a media relations perspective the opportunity is simply amazing. Again, think about the landscape: Bear Stearns - gone; Lehman - gone; Merrill Lynch - gone(ish); Citigroup - utterly consumed with their own operating issues; Morgan Stanley - retrenching, then expanding, probably only to retrench again; Bank of America - too big to succeed. These firms were the go-to providers of analysis in media coverage of capital markets, equity research, corporate earnings, M&A, industry trends, currency markets, economic trends, etc. They simply dominated the Wall Street Journal, Reuters, Bloomberg, BusinessWeek, The New York Times, and other major financial media. Not any more.

Not only have firms disappeared or retrenched, but the reputations of the survivors are seriously compromised. First came the questions of culpability of major banks in the mortgage/financial crisis. Then came the restrictions accompanying TARP bailouts. Now, the big banks are up against the wall over the issue of compensation. This will be the hardest bullet to dodge and look for compensation issues to persist througout 2010.

Moroever, the media understand now that they have almost a fiduciary duty to broaden their sources away from the large banks and trading firms. This, combined with heightened skepticism by reporters and deeply seeded resentment (in my opinion) about compensation practices, opens the door like never before for smaller firms in virtually every financial sector to enhance their brands and market themselves through the media.

Since September, my firm has been representing a small fixed-income broker-dealer that had no previous experience in working with media. Our hypothesis at the start of the engagement was that the media would welcome a new voice for analysis of credit market trends. We were right and even underestimated media demand for the client's perspective. More than 80 stories in major financial media cited the firm's credit market expertise.

I mention this to underscore the size of the opportunity for firms that previously may have been at competitive disadvantage when it came to media relations. Even compensation comes into positive focus in a story about a mid-tier broker-dealer like Jefferies.

Already, non-bulge-bracket firms are scrambling to fill the vaccuum created in markets ranging from credit trading to M&A advisory. Firms like Cantor Fitzgerald are hiring like crazy. Citadel's foray into investment banking has been well chronicled. Now, Blackstone is said to be interested in entering the banking market in the U.K.

[Update: The February 8 issue of Barron's profiles Jefferies, Broadpoint and other firms hoping to capitalize on the troubles at big banks.]

It's not all downhill sledding, though. Last summer the head of marketing of a leading broker-dealer told me that despite all the carnage at the top of the market, his firm's research showed lingering client preference for doing business with the old guard firms.

Asserting themselves more through the media can help mid-size firms overcome client inertia to expanding their list of preferred banking and trading partners.

To illustrate how much the compensation issue can derail the large banks, here is a sampling of recent stories:

Goldman caps London bankers' comp (Bloomberg)

Morgan Stanley chief to receive up to $13 million bonus (New York Times)

Investment bankers on bonuses: "less show, no tell" (New York Times)

Reputation risks associated with bank bonuses (Hedge Lines, January 2009)

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.