Hedge Fund Kingpins Testify - Highlights

Here are some of the highlights from the prepared statements today in front of the House Committee on Oversight and Government Reform by the five famed Hedge Fund managers.

Phillip Falcone of Harbinger Capital Partners

"I would like to take just a moment to tell you a bit about myself. I currently reside in New York City with my wife of 11 years and two children. By way of background, I was born in Chisholm, Minnesota, population 5,000, on the Iron Range in Northern Minnesota. I was the youngest of nine kids who grew up in a three-bedroom home in a working class neighborhood. My father was a utility superintendent and never made more than $14,000 per year, while my mother worked in the local shirt factory. I take great pride in my upbringing, and it is important for the Committee and the public to know that not everyone who runs a hedge fund was born on 5th Avenue - that is the beauty of America."

More later.

The Leverage Game

As a relatively new Hedge Fund manager, I tend to get calls from vendors and assorted financial types trying to sell me services or systems. I got a call the other day from an organization whose name I will withhold that offered to lever up my assets under management (AUM) by ten times.

So here is how the deal works. They lend you ten times your AUM and in return the payoff is split as follows:

First 10% return - they get 90%, you get 10%.
Second 10% return - they get 50%, you get 50%.
Third 10% return - they get 10%, you get 90%.

Sound too good to be true. Well it is. Here is how the downside is split:

First (-10%) return - you lose 100%, they lose nothing.

The payoff is asymmetrical, as you probably figured out. So in effect, after a ten percent decline, your capital is wiped out. What happens if you go down more than 10%? Well you can't because they monitor the portfolio daily and will pull their money out once you hit a negative 10%.

Also, if you assume that you achieve a 10% return for the year on the borrowed money, you are no better off than if you hadn't borrowed. Let's say that you started with a million and borrowed $9 million (just to keep the numbers even).

After a year, your have a ten percent return, or $1 million. You have to hand over $900 K of that and you keep $100 K. That's the same $100 K return you would have earned if you had just invested your $ 1 million by itself and earned 10%.

I keep wondering how many of my fellow managers are levered up like this. I read about a Warburg fund that was levered up 20 to 1.

Wilbur Ross Speaks and You Damn Well Better Listen

I just listened to a great interview with Wilbur Ross on Bloomberg which was brought to my attention by the people at Vinvesting


Wilbur Ross Bloomberg Interview

The interview is 25 minutes long and goes into good detail on the issues of the day, including the sub prime lending fall out, brokerage earnings, the growth of the hedge fund industry and the inherent weakness of quantitative "black box" investing.

What is Value Investing? – Part II

I think that it is safe to say that when William Ackman, the renowned Hedge Fund Manager that runs Pershing Square Capital, says that Target is “undervalued,” and when Warren Buffett, the equally renowned value investor says that Burlington Northern is “undervalued,” they mean two very different things. And yet both are very successful at what they do and very rich. So who is right?

Ackman is not your typical stereotyped “value investor,” and Target is not your typical stereotyped value stock. Target’s enterprise value is 9.5 times its trailing 12 month EBITDA. Its forward price to earnings is 15.5 times, while it trades at 3.5 times tangible book value. It is not cash rich, holding $550 million in cash, or about $ 0.55 per share according to Yahoo Finance. The performance has been great as well. Target is up 12.3% year to date and has beaten the S & P 500 by 700 basis points.

So what’s going on here? Why is the stock “undervalued?” according to Ackman. Well, in a sense there is the effect of what is known as “cult investing.” When a well-known and successful investor announces that he is buying a stock, the herd moves onto it en masse pushing up the price. Ackman enjoyed that effect as rumors hit the market a week before his filing was done on 7/16/2007.

Buffet and other traditional value investors look for a “great business selling at a great price” in his words. He doesn’t seek to change anything at the company he buys. In fact he wants nothing to change, that’s the entire point. Management usually stays in place.

Ackman wants the company to change, to restructure in some way. Not because it will help the company long term, but because the market will pay more for your company if it looks the way I tell you it should look. For Target, that means sell or spin off your credit card division and try to unlock the value of your real estate somehow. For other companies that are being targeted it might mean something else - sell the entire company, split in two, issue debt and use the money to buy back stock. He doesn’t really care if 2 or 3 years down the road Target is a weaker or stronger company because he probably won’t be a shareholder by then.

I hesitate to say that Ackman is price indifferent to what he pays, because everyone cares about what they pay for something but in a sense he is price indifferent. He creates value at the companies he owns not by making its business stronger or better, but by shuffling parts of the puzzle around. Call it financial engineering if you like. If earnings grow faster than they did before he got there, its not because he helped them become better at retailing, its probably because its share count will decline due to some huge buyback that the company announces. When Ackman sits down with Target management is he going to say that they should work on their merchandising or that they should cut back on the number of SKU’s at their stores?

The Ackman strategy then is this simply put –

1. Find a large cap stock where the market is valuing the stock exactly at what it should be valued at based on the company’s profile.

2. Quietly accumulate a large stake in the company over a period of several months.

3. Leak word on the street that you are building a stake in the company and receive the cult effect.

4. Make your public filing of ownership and send letter to management.

5. Meet with and pressure management to do what you tell them to do to get the stock price up.

6. Wait for management to cave in and see the stock rise even more.

7. Sell quietly in a few months after the general public piles into the stock.

8. Give part of profit to charity but only in years when Hedge Fund manager wealth is getting really bad press.

Now I am not criticizing Ackman for what he does. Everyone has to create value for their investors and if it can be done this way then so be it. I was only trying to demonstrate how two investors who are very different can utter the same word and do it with a straight face.

The Panic of 2007

Is it possible that we are on the verge of a full blown financial panic? I remember studying about the periodic financial panics that would hit the United States economy every generation or so. They seemed quaint and remote and not something that could happen in the age of deposit insurance, the Federal Reserve and the heavy hand of government intervention.

There have been so many financial panics in our history that they had to name them after the years they occurred. The panics of 1893, 1907, etc. Most of these panics involved banks, but the concept is the same. They are characterized by lack of confidence in our financial system, with a sudden shock to that system being the accelerant that sparks the conflagration or panic. And then a rush for the door, as everyone tries to get their money out first.

Let's look at what is occurring in our financial system:

1) Credit for purchasing residential real estate is drying up. It's no secret that sub prime and Alt A lending is essentially unavailable, but now it is spreading to prime lending and jumbo mortgages. If you think that jumbo mortgages is an issue only for rich people then you should take a look at the average home price in California, where you need a jumbo mortgage to buy a shack. This credit contraction will accelerate and prolong the housing downturn even further. This, of course, will have repercussions in the economy.

2) A money market fund just "broke the buck" or would have, if it let investors redeem their money. This is the first time that I can remember that this happened since Merrill Lynch, Pierce, Fenner and Smith pioneered these in the early 1980's.(Yes, I purposely used the former name to show how old I am.) Most non-professional investors assume that money market funds are "cash," and they are not.

3) We may be on the precipice of major redemptions in hedge funds, which will trigger another leg down in the equity financial markets. Think of all the money that has flowed into hedge funds the last decade, and then consider what would happen if that river reversed. Now if you think this is about a bunch of spoiled hedge fund managers whining because they have to sell their third vacation home, you are wrong. If I remember my numbers correctly, around 40% of Americans are invested in stocks.

4) We have a hyperactive media where every bit of information is available instantly, and then magnified tabloid style. Don't underestimate the effect that the media can have in creating panics. They are at the center of all of them if you look back at your high school history book.

The last recorded financial panic was in 1910, but of course we have had them since then but they stopped calling them "panics" and started using other terms for them. I hope that this doesn't happen in my lifetime, but I wonder sometime what really can be done to stop these events. After all, by definition, they are "panics," implying uncontrollable events.

Another Leg Falls

How many legs do we have propping up the Stock Market? I've lost count. We all know that the Private Equity buyout "leg" is history. The latest one to collapse is the buyback stock craze, which has reduced the supply of stock the last few years. Once again a chart from The Wall Street Journal says it all:



Public companies have been levering up to buy back stock, most of them due to pressure from idiotic hedge fund managers who have apparently never lived through a business cycle. I have this picture in my head of the typical company in a meeting with its bankers to renegotiate its covenants during the next business cycle contraction. The CEO says something like this: "We don't know what happened, our largest shareholder told us this was the ideal capital structure." The bankers just stare back at them, their mouths open, unable to formulate a response to this stupidity.

This is now coming to an end as lenders tighten standards and credit rating agencies actually start doing their jobs. Now many legs does a table need to stay standing?

Schadenfreude

I confess that I am one of those people who sometimes take a perverse pleasure in the misfortune of others.

Schadenfreude

The latest bunch of smart guys to have their asses handed to them are the people at Sowood Capital Management, a hedge fund started a couple of years ago by alumni of the Harvard Endowment. It was reported today that funds they run have lost 50% of its value in a month. This is getting to be a commonplace event lately but the news with Sowood is that they didn't invest in sub prime paper but in regular corporate debt.

How does such a thing happen? Major hedge funds have entire departments dedicated to risk management.

Was it a fatal combination of leverage, lack of liquidity and hubris? Was it a reliance on impenetrable mathematical black boxes that tell you the pricing relationship between different securities but that never seems to work in times of market crisis?

We'll never know. The principals at Sowood will no doubt move on and start another hedge fund with an equally impressive sounding name and raise another billion from people who are supposed to know better.

High-Grade Bonds ?

Definition - A bond with a rating of AAA or AA, the two highest ratings.

Bear Stearns dropped the bombshell today on investors in its two sub prime hedge funds. The company stated in a letter to investors that "the preliminary estimates show there is effectively no value left for the investors in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and very little value left for the investors in High-Grade Structured Credit Strategies Fund as of June 30, 2007."

The real stunner, at least for me, was this line in the letter, where they gave the cause of the loss in the value of the fund,

“Unprecedented declines in the valuations of a number of highly-rated (AA and AAA) securities.”

Well, I’m sorry but AA and AAA securities don’t go from par to effectively nothing in a couple of weeks. Well maybe if you lever up 5 to 1 they do but someone at the ratings agency or Bear didn’t do their job.

So just imagine the meeting where Bear salesmen were pushing this fund on its clients.

“Well isn’t this a little risky?” said the client.

“Oh no, don’t worry, we only buy AA and AAA rated bonds,” said the smiling salesman.

“Oh, OK,” said the client

“We even put the words – High Grade – in the name of the fund to make you feel safe,” said the smiling salesman.

“Yes, but what about the word – leverage – that’s in there also?” said the client.
“Oh, don’t worry about it, we know what we are doing here. We are experts at this type of thing,” said the smiling salesman.

I even had to sit my wife down this morning and explain to her why this would never happen to the Hedge Fund where we have all of our life savings invested.

"I don't buy crap like this," I said.

"Well make sure you don't. I don't want to be working for a living when I am 70 years old," she said.

No Margin of Safety

Everyone knows the concept of the Margin of Safety in Value Investing. This is what happens when you ignore those words:

“United Capital Asset Management has temporarily suspended payments from four of its Horizon funds following losses from its investment in sub prime mortgage bonds. In the past ten days, the firm received an unusually high number of redemption requests, including one from its largest investor, which accounts for one-quarter of the firm's assets under management.”

Full Story

A similar situation occurred in the CMO market back in 1994, when a firm called Askin Capital Management lost hundreds of millions of dollars as the market disappeared for the products that they owned and the so called "proprietary models" to price these things no longer worked. The lesson? If the person who manages your money can't explain the investment to you - then don't go near it.

What is a Hedge Fund?

So what is a Hedge Fund and why does everyone hate them? A Hedge Fund, in its simplest form, is just a limited partnership. A legal document drafted by an attorney sets up the legal structure into which accredited investors invest money. The media and the non investment world loves to use various terms to describe Hedge Funds. The definition in the American Heritage Dictionary is this:

"An investment company that uses high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains."

Well, actually no. In theory if you sell short along with going long equities, then you have less risk and there is no law that says you have to borrow money when you run a hedge fund.

So here is my definition of a "hedge fund." I will give the characteristics of a Hedge Fund and then an explanation of why I am including it. A Hedge Fund is a:

Lightly Regulated - Most Hedge Funds offerings are exempt from registration under the appropriate U.S. Securities Laws. I use the word "lightly" because some Hedge Funds do register as investment advisers

Private Pool of Capital - An obvious one that is simply descriptive. It is private because it is only available to accredited investors and not the general public.

Focused on Absolute Returns - I don't care who you are or what your strategy is, but you damn well better be up every year. I don't give a rats ass what "the market" does. If I want a closet indexer I'll go to a mutual fund company and invest in a fund with an R squared of .99 that holds 400 positions.

Performance Based Compensation - Hedge Fund Managers earn most of their compensation from a percentage of the excess gains above a hurdle rate, and subject to a high water mark. This percentage is usually 20% but can go as high as 50%.

So there it is then - a Hedge Fund is a lightly regulated, private pool of capital that is focused on achieving absolute positive returns in any market where the manager is compensated mostly on performance.