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.

Hedge funds must be part of the new financial world order

Could hedge funds be part of the solution? Could short-selling hedge funds be doing the market and regulators a valuable service? Surely you jest. However, that's exactly what ex-Wall Street Journal columnist Jesse Eisinger hints at in his story about restructuring the financial system in the current issue of Conde Nast Portfolio.  

"We need more dissidents.  We need to make the world a safer place for short-sellers to criticize companies.  Regulators should publicly praise short-sellers, rather than periodically ban their activities.  Critics and whistle-blowers, no matter how self-motivated, should be regularly consulted about suspicious companies, not dismissed as cranks once they expose wrongdoing."  Really.  Page 47.  

For hedge funds to be a respected part of a new financial world order, two things need to happen.  Regulators, analysts and shareholders need to aggressively seek the opinion of independent parties and be much more skeptical of corporate claims and the CEO bully pulpit.  That shouldn't be too hard.

Second, short-sellers and hedge funds of all stripes need to admit they are part of the system and behave like they have an interest in stability in the market, preventing fraud and encouraging financial fair play.  Once they take their positions, they must go public in cases where systemic risk, fraud, or deceptive accounting is afoot.  Profits will still be made, but full-blown crises might be averted.

What hedge funds cannot do is sit on the sidelines grinning like the Cheshire cat.  In a new financial world order, it is not sufficient to be the smartest guy in the room.  You also need to be responsible.  

In the same issue of Portfolio, John Paulson, whose funds made $15 billion in 2007 by betting against homeowners, banks and mortgage companies in 2007, is scrutinized along these lines.  "Left unexamined is the uncomfortable moral dimension of Paulson's achievement.  If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down?  Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?" 

Financial firms risking more than reputation by continuing lavish spending and bonuses

Wall Street bonuses have always drawn the attention of journalists. In the best of times, the topic of bonues at investment banks has been covered much like auctions at Christie's -- phenomena to behold, but not quite believe. These are not those times and the issue of bonuses at Merrill Lynch was toxic enough to send John Thain into retirement. How can Citigroup buy a new corporate jet on the heels of more financial support from the government? How can AIG pay $450 million to workers at the unit that brought down the firm? It is hard to fathom that the culture of compensation and the perception that it requires bags and bags of money to retain talent in the financial sector is so pervasive that the same hand that is begging for taxpayer-funded relief is signing whopping bonus checks.

Bankers need to look at the case of Detroit for a reality check. Automakers were denied a government bailout partly because public sentiment was against them. Financial firms will lose political support in hurry if they continue to enrich their own at public expense.

By comparison, the 2/20 compensation system for hedge fund managers, long criticized by media, seems aligned with the interests of investors. Not that you are going to read that anywhere soon!

Maureen Dowd turns her wit on John Thain and Wall Street bonuses in today's New York Times.

Bloomberg outlines $450 million in payments at AIG's financial products unit.

A former Merrill banker writes about the bonus culture on Wall Street in an op-ed in the New York Times.

Wall Street paid $18.4 billion in bonuses last year, the sixth biggest bonus year on record, according to the New York Times.

John Thain's$1.22 million office renovation is detailed on the DailyBeast.com.

Of course the antique commode purchased by Thain for his office at Merrill is too tempting for the Daily Show to pass up.  The first three minutes of last nights intro segment lampoon John Thain.

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Classic IR tactic not working for banks

Insider buying by CEOs and other top executives is a classic tactic to signal that the market has the wrong perception about a company.  The problem is that it is simply not working for banking CEOs these days.  Confidence is just too low in the financial sector and would-be investors simply don't trust banking CEOs.  Trust in CEOs overall might be at an all time low and companies need to understand that and adapt to a new communications environment where new efforts are required to earn trust. 

Earlier this week Ken Lewis and other chiefs at Bank of America purchased more than 513,000 shares.  It won't make a difference.  The Wall Street Journal writes "credibility is a series of small, successful gestures [and] bank executives must see that their gestures are being read by the market as empty ones."  In fact, research by InsiderScore.com and other analysts suggest that buying by insiders should be a strong sell signal for everyone else.  Turns out that execs, of late, have been wrong more often than they have been right.

BreakingViews.com writes, "given how erroneous the public statements on Wall Street's top banking executives have proven to be, it would be hard to take their prognostications seriously."

Unfortunately for bank CEOs, the market is not doing as they say nor, when it comes to insider buying, is it doing as they do.  The herd is going the other way.

Communicating with current investors is job one

The New York Times' DealBook blog profiles JHL Capital Group, a Chicago-based hedge fund run by James Litinsky.  While JHL returned up to 18 percent to investors last year certainly bucks the current trend, it is not the only thing notable about the fund.  From his quarterly letter to investors, Mr. Litinsky clearly realizes that resting on the laurels of exemplary performance is not sufficient in today's environment.  Good returns alone might not prevent newly risk-conscious investors or investors who have suffered losses elsewhere from cashing in their chips.  Managers must give investors compelling reasons to stay in the fund or risk redemptions.  

In the case of JHL, Mr. Litinsky uses his quarterly letter to reinforce his investment philosophy and detail the business case for two primary investments, the bonds of The New York Times Company and Lamar Advertising.  For each, the fund explains its view of why the debt was undervalued, but secured.  It also explains why neither company is likely to default in the near term and goes on to give worst-case scenarios for both investments.

Mr. Litinsky writes: "In both the NYT and LAMR situations, we modeled out the path to paydown.  We not only had asset coverage well in excess of our basis but also had a priority interest on family heirlooms.  If conditions deteriorated further, the management teams would likely be most focused on maintaining long-term control of the assets rather than extracting an extra dividend or attempting something more overtly hostile.  Those are the kinds of borrowers we like."

This level of transparency is one way to give investors the confidence to maintain or even increase their commitment to a hedge fund.  Right now, getting the right information to current investors is job one, superseding any new marketing and fundraising.

 

Hedge fund "convergence" is good for embattled industry

All About Alpha.com writes about "convergence" in the asset management industry.  Citing recent examples of Putnam launching an "absolute return" mutual fund and quant fund manager AQR starting its Diversified Arbitrage mutual fund, the story discusses how hedge funds are morphing into diversified financial institutions that are providing traditional asset management and investment banking services among other offerings not typically associated with the hedge fund business.

While this trend is good for hedge fund business, it is also good for the reputation of the industry.  The media don't appreciate the extent of the role hedge funds play in the global capital equation, particularly now, as commercial banks are severely constrained and the investment banking options reduced.  Why can't hedge funds and private equity firms be a driving force behind recapitalization of the banking industry and the broader economic recovery?  By stepping into the breach created by troubled banks, new institutions can be part of the solution -- and maybe, just maybe get credit for it.

See a previous post about hedge funds and their importance to the broader market.

As early as 2005, the New York Times was writing about hedge funds getting into corporate lending.

Read the Wall Street Journal's account of the new AQR fund.

Read the FT's story on hedge funds morphing into investment banks.

Transparency at issue in bank system fix

The New York Times writes about the Obama administration's options in dealing with the ongoing banking crisis.  The story notes that one of the main differences among options being discussed is the level of transparency about the ultimate cost to taxpayers and the degree to which banks would be required to disclose the true magnitude of likely losses.  

According new analysis by the Congressional Budget Office, costs to taxpayers are highest when bailouts involve opaque transactions that are difficult to understand.  TARP is the poster child for a program with limited transparency.  The CBO estimates that taxpayers will end up absorbing 26% of $247 billion in disbursements to financial institutions through December.  The AIG bailout, another complex program, is estimated to cost taxpayers more than $20 billion.  November's decision to guarantee $306 billion of toxic assets on Citgroup's books is estimated to cost the public $5 billion.  

The new administration must do a better job in disclosing the real costs and real value behind its plans for the banking system.  More transparency and better communication with voters and the media are needed to both ensure the best solution is reached and help stabilize reeling bank stocks.  In addition, more transparency will increase the likelihood that hedge funds and other private investors buy some of the assets in question and invest in the banks themselves.

The Times notes, however, that "banks may not want that kind of openness, because accurately valuing the toxic assets could force many to book big losses, admit their insolvency and shut down."

MFA's Baker Interviewed

Fortune interviews Richard Baker, head of the Managed Funds Association.  The short Q&A covers the Madoff affair, the ban on short-selling, and prospects for increased regulation of hedge funds.  This blog has commented that the MFA and similar bodies in the U.S. have struggled to defend the reputation and interests of the hedge fund industry, but the article notes that the lobbying restrictions on Baker, a former Congressman, lift next month.

PR advice for Goldman Sachs

The "Jack Flack" column at the New York Times Dealbook blog dispenses reputation management advice for Lloyd Blankfein, CEO of Goldman Sachs. The column notes that, while Goldman has avoided the massive writedowns taken by its i-banking bretheren, it is still guilty by association from the perspective of reputation. The very act of registering as a bank holding company raises the question of what is going on at Goldman and is the jig up.

All the counsel offered by Jack Flack to Goldman is directly applicable to hedge fund managers: tell 'em what you've learned, be careful about compensation, tell people what the future of your institution is, have honest discussions about risk and risk management.

Speaking of risk, the issue of risk for hedge funds and risk for investment banks (or whatever we're calling them now) is not the same thing. Everyone knows hedge funds are risky and their core business is taking and managing risk. What the media and the public don't fully appreciate or admit is that the level of risk, how risk is managed and investing strategy of hedge funds is shared (in non Madoff funds, at least) with investors and investors can meet with managers to have detailed discussions on risk.

Not so for the banks. In fact, the banks, like Goldman, upon becoming publicly owned, offloaded the risk to investors (who don't have the ability to discuss risk management with the instition). Goldman execs retain the lions share of the upside when the bank does well (see the bonuses for the last few years) and bear virtually none of the downside during bad years. Bonsuses, temporarily, go by the wayside, but salaries are paid. Goldman partners may frown in public, but at home they gotta be smiling for the years they spent laughing all the way to the bank. Jack Flack doesn't speak about this fact and risk to reputation. Probably because there is no way around it.

I wonder if the CDO/CDS crisis would be this large if Bear Stearns, Lehman, and the other investment banks were privately held and the risk been owned directly by the partners, instead of shareholders.

Justin Fox, writing in the January 19 issue of Time, examines the link between outsized risk taking and public ownership of investment banks.

Massive Madoff fraud nails hedge fund reputation

Thank you sir, may I have another. That's what hedge fund managers must have thought when the news of the massive fraud perpetrated by Bernard Madoff was uncovered. The Wall Street Journal writes that the scandal is the nail in the coffin for the fund of funds business. One of the key advantages promoted by FOFs is that they do the due-diligence on hedge funds. Oops. The Journal notes that "in an industry that depends on trust and confidence, the fact that so many respected names fell short is likely to lead to yet more redemptions across the sector.

Of course the Madoff affair has set off new calls for regulation of the hedge fund industry and a former SEC official was on the Newshour last night. The official called hedge funds "unregulated" and predicted that regulation is on the way, due in part because the SEC's "international reputation is now taking a major hit." View the segment on PBS.org.

The New York Times writes that certain banks spotted "obvious" red flags when doing due diligence on Madoffs funds, but other banks weren't so lucky.

Billions in losses, mammoth fraud, Palm Beach society and non-profits left high and dry. Thank you sir, may I have another.

Activist model seen as having staying power

Several recent articles note that activist hedge funds are well positioned to weather the credit and market crisis. Opportunities in the distressed sector and the fact that activist funds tend to have longer lock ups are cited among the factors favoring activist funds. Check out the following:

Hedge fund industry outlook from Investment Dealers' Digest.

Carl Icahn is interviewed by Financial Week.

Reuters writes about changing activist strategies.

Media is a part of Kynikos' short strategy

A long profile in New York of Jim Chanos, president Kynikos Associates, a short-selling specialist illustrates the role media plays in his investment strategy. The article notes how Kynikos shares information and investment hypotheses with journalists and other asset managers. The fund will even walk reporters through the financial statements of companies it sees as overvalued.

According to the article, "In this information culture, Chanos has built valuable relationships with journalists who take his ideas seriously, promote his point of view, and ultimately help make him rich. Like Washington, Wall Street is a game that is fueled by the selective leak. The right tip can mean the difference between winning or losing millions."

Critics of short-selling call this manipulation, but they are wrong on this count, too.

The stock market is a marketplace of ideas and information. These ideas compete, and in a perfect world, the best/right ideas win out and drive stock prices up or down. The more ideas that compete the better. Shorts have just as much a right to advocate their positions as longs. Moreover, the ultimate longs are the companies themselves and they have big advantages when it comes to influencing media.

Still skeptical? Consider this: Chanos is credited with pointing Fortune to the misdeads at Enron and we all know how that turned out.

How to say we're sorry

Financial Times columnist Lucy Kellway deconstructs investor letters from hedge funds. In her sights are the recent investor letters issued by Greenlight Capital and TPG-Axon. The story brings into harsh relief a very important question: what do you say to investors when you are down 20, 30 or 40%? Using these two funds as templates, Kellway notes 8 "rules" of the investor letter, ranging from being too long to sounding upbeat about the future.

What she doesn't appreciate or mention in the article is that, in these circumstances, the letter is a formality. The more important communications with investors are happening in person and over the phone.

Click here for the Greenlight letter.

Click here for the TPG-Axon letter.

Greenwich Financial Services sues Countrywide and opens Pandora's Box of media scrutiny

Greenwich Financial Services has raised the hackles of Lou Dobbs and Congresswoman Maxine Waters, among others, over its decision to sue Countrywide after the bank decided to modify the terms of 400,000 troubled mortgages. Greenwich says that modifying the loans damages the financial interests of the bondholders.

William Frey who heads GFS and his attorney both appeared on a CNN interview. They deserve a lot of credit for taking a very unpopular position in a very public manner. Hopefully, their investors will appreciate the effort.

The explosiveness of the situation and risk undertaken by GFS is clear in the CNN interview when Rep. Maxine Waters refers to GFS as "greedy hedge fund operatives...looking for fast money."




The New York Times writes about the lawsuit and includes more details about the complaint.

Check out the Deal Professor's analysis of Countrywide's pooling and servicing agreements and the merits of Greenwich's claim.

Survey: 98% of hedge fund managers expect new regulation of industry

A survey by accounting firm Rothstein Kass finds that virtually all hedge fund managers expect increased regulation. Areas where new regulation is expected include: asset valuation, counterparty risk management, capital raising and transparency. 77 percent of the respondents said that the overall impact of the new administration on the hedge fund industry "will not be positive."

Hedge fund cowboys "fell off their horses"

The infighting has begun. In a story on Reuters, Veritas Asset Management manager Ezra Sun blames his fellow fund managers for the "tremendous" reputational damage he sees the industry having sustained. Sun accuses hedge fund "cowboys" of not properly hedging, boosting returns through unwise borrowing, charging high fees, and locking up investors once the losses started piling up.

While accurate, Sun's critique further damages the industry. Rather than finger pointing at the very visible bad apples, we should reading about seasoned managers who are weathering the storm and earning their keep for preserving, if not enhancing, their clients' assets. Investors need to hear that the good managers are surviving and that the industry will emerge from the current crisis stronger and smarter.