While I tend to bristle when pressed into involuntary service as a professor, teaching first year investment theory or financial instruments to people who, though they love to belittle MBAs, never bothered to learn these concepts- believe it or not, my role simply is not to correct the many misconceptions exhibited by, or to fill the gaps in financial education possessed by, certain financial journalists who find themselves the subject of my musings- the connection between debt, debt markets and activism as an investment strategy bears some additional scrutiny. Lest I be accused of failing to substantiate my accusations of intellectual sloth, a somewhat in-depth discussion is probably warranted. In this vein, the role of debt generally as it is tied to returns (alpha, if I may be so crude) realized by active (not just activist) strategies likely could benefit from some discussion.
To complete the professorial metaphor, some classroom background may be helpful.
It amazes me how many market actors profess to be adherents to "perfectly efficient markets" theory (all information is perfectly reflected in prices all the time) and still engage in active investment strategies. Below this threshold there are any number of more limited versions of efficient market theory- but unless one finds oneself on the far opposite side of the spectrum (no information is reflected in prices- they are a perfect source of entropy- and this would be beyond fascinating for reasons only interesting to those investors, like me, who also have a deep lust for theoretical physics and information theory) you should agree that information asymmetry, while not the only source of alpha, is probably the most influential.
My own disposition is towards limited market efficiency- prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital. This implies two major sources of pricing error:
1. Insufficient distribution of material information.
2. Insufficient capital applied by those in possession of material information.
This further suggests that active management can exploit asymmetric information (learn something the market doesn't yet fully understand) or asymmetric capital (apply capital where the market hasn't yet bothered to) in the pursuit of "true" alpha. Although, technically asymmetric capital is just a derivative of asymmetric information.
There is hope for those of us who believe that information grows more and more "imperfect" every day, at least if you listen to the likes of Moody's (though the wisdom of that decision could occupy several posts by itself). Abnormal Returns points us to Alea which, quoting Moody's, suggests that:
One of the key reasons for the lack of information on the extent of risk and its location has been financial innovation, leading to greater complexity.
The combination of financial innovation, opacity and leverage is generally explosive.
Financial innovation often leads to an uneven distribution of the information available to the different parties at risk.
The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards.
Overall, the financial system suffered from flawed incentives that encouraged excessive risk-taking.
In no small measure, information asymmetry as a pricing force has all the elegance of a unified theory and (ironically) a certain symmetry (even super symmetry) in application. I have referred to this phenomenon before in the context of CDO/CLO structures and the incentive structures that encouraged the (potentially reckless) growth of these instruments, as well as in the context of "debt attitude arbitrage." The take-away message is that information asymmetry is a thread that runs through what are essentially pricing models. To the extent one, as an investor, does not examine the incentive structures of the market, one risks being on the wrong side of the information asymmetry balance. As an aside, this has what can only be termed "very serious" ramifications for an analysis of investment banking markets.
Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.
For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compensation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.
True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha.
This is important enough that it bears repetition. Particularly this bit below. Really. Read it again. It's that important:
If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage.
The important thread to follow into the rest of the discussion is that these questions should have set off alarm bells loud enough to deafen, if only market actors bothered to listen. Of course, the social rub is that this analysis shifts the burden of loss to the market actors who incurred the losses (an effect that tends to inspire rejection of the premise of information asymmetry, or prompt the invocation of the magic regulatory conjuring spell "That's unfair!" which is often laid across a rotting floral bed of "the losers were snookered by sophisticated financial insiders," where "sophisticated financial insiders" usually translates to "educated investors" and "losers" usually parses to "armchair investors who feel entitled to abnormal returns.") Let's face it, losers make sympathetic victims, and, as I quoted recently:
...[the somewhat spoiled sense of American entitlement] can spawn vices. One is impatience. Another is a culture of chronic complaint. A third is the belief that every problem has a solution, that trial is possible without error, that risks must always be zero, that every inconvenience is an outrage, every setback a disaster and every mishap a plausible basis for a lawsuit.
One can see the change over the last few decades in the comments of one astute reader's response to the Alea entry.
Nearly 3 decades ago, at a large commercial bank, the risk management effort was based on not ‘what-if’ analysis (the statistical analysis relied on by firms like Moody’s) but ‘if-what’ analysis. That is, first determine all the conditions under which an transaction could lose money. Then assign probabilities to those conditions. If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.
There is no entitlement to abnormal returns. And, to quote our favorite tag line (from Abnormal Returns), "investing is hard." This, I think, is the point where certain financial journalists and other pundits fall off the moving train and start looking for explanations that permit them to reject this basic (and very undemocratic) inequality. Information asymmetry looks awfully unfair. This is because it is. The mistake is not in the label "unfair," but the assertion that "unfair" is, somehow, intrinsically evil.
Investing is hard. But it is not impossible. I will make no claims whatsoever to having "called" the credit crunch, but the incentives issues in these markets were a frequent topic on these pages early on. Part of this approach flows from my personal view of the human condition:
Confucius: Man basically good. (Significant evidence during the brutal warlord infighting of the Chou Dynasty to the contrary notwithstanding).
Rousseau: Man basically good ("Noble Savage"). Society makes man evil. Widespread peasantry is the ideal state.
Scientologists: Man basically good, but the machinations of certain evil aliens long ago complicate matters.
Kierkegaard: Man is impossible to classify.
Puritans: Man is basically evil. Fire purifies. (Though this is hard to compute given how deeply carbon stains).
Baptists: Man is plagued by total, hereditary depravity.
Equity Private: Man is basically lazy. Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior). Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.
It is ironic that those with more optimistic views of behavioral sciences ("give sanctions a chance!") end up defending these notions to the death in the face of all evidence to the contrary. And so, myths and misconceptions not only appear about the world of finance, but are latched onto by those desperate to defend the rosy refractions that color their world view. When so colored, these misconceptions tend to show themselves rather glaringly to anyone who cares to subject the assertions and predictions of these human optimists, (dare I say, populists?) to scrutiny.
This brings us to certain attitudes about activist investors, and the most prevalent in my field of view today happen to be those of Mr. Sorkin. (In my defense, this is entirely the fault of Mr. Sorkin).
Misconception number one is a common one among Maxwell Smarts, that is that financial investors (as opposed to "strategic investors," and there is much fudging among Smarts as to where the line here actually lies) are short-term profiteers. The corollary to this misconception is the conviction that short-term investment is intrinsically evil, but we will leave that for another day. Taking just activism,
we find that average holding periods range from 1 to 3 years (depending on the study and whether the investment holding period is measured from the filing of the first 13D, or from the first appearance on a 13F). In the case of activists this misconception stems from a basic misunderstanding of what activist investing is, and in particular that activist investors are generally value investors first.
Misconception number two is that activists are just reformed corporate raiders. It is true that former raiders make up a large portion of the list of who we might call "activists" today, but anyone convinced that the game is the same (or that greenmail takes place with any frequency anymore) has simply seen Wall Street too many times (and forgotten that it was released in 1987). It is probably prudent to point out that back in their day, raiders did not have available to them the plethora of tools for injecting accountability to corporate management that they do today. The only tool was the threat of a loss of control and liquidation (which begs the question if liquidation is also intrinsically evil). Regardless, activists today have a much broader set of tools to inject accountability.
Misconception number three is that activists depend on cheap debt for their returns. The corollary to this misconception is that debt today isn't cheap anymore. Even the most cursory study of historical debt rates and relative debt prices today (72kB .pdf from Clearbook Financial as cited by Infectious Greed) would disabuse the most research averse financial journalist of this misconception. (Only five countries have rates lower than the United States today). But "work is for suckas," in the world of the average financial journalist- and unnecessary as the narrative fallacy is alive and well in the psyche of the news consuming public. Maxwell Smarts wouldn't bother to notice that in mid-2000 LIBOR rates were nearly 7.5%. Chapman Capital was busily squeezing change out of the American Communities Property Trust back then. And in 1988, 1989 and 1990, when the same rates were in or nearly in double digits for a period of over 18 months? Ralph Whitworth (who would later found Relational Investors in 1995 when rates were again peaking around 7-8%) was running insurgent campaigns via the United Shareholders Association (T. Boone Pickens was a major investor). Today LIBOR rates sit around 4.3% or so.
So it is not surprising that Mr. Sorkin might be possessed of the mistaken belief that the last six months of activist performance (which he documents poorly in any event) could somehow be explained by debt prices. (Even if there were a connection as direct at Mr. Sorkin claims, it is his lack of understanding with respect to activist holding periods that compounds his error- since a six month debt pricing spike will hardly show dramatic results on returns if investor holding periods average at least twice if not six times that duration).
All of this is a rather extended way of saying that astute Going Private readers will regard with skepticism any pundit or financial journalist (or indeed, anyone) claiming that leverage is intrinsically evil, that returns for a given strategy are dependent on cheap debt (amazing the profits the early buyout kings made when they had to borrow at 12%) or that "losers" in a given marketplace have de facto been the subject of fraud and deception.
Indeed, Going Private regulars will smirk at such suggestions, and recognize the attempts of lesser students of financial markets to disguise their ignorance, and that of their populist peers, by calling investment strategies "black magic," and mistaking the role of leverage in legitimate strategies as often as they are fooled by its complexity creating effects for merely beta-based returns.
Debt can either magnify returns generated by true alpha, or disguise (that is increase information asymmetry in) returns that may or may not have anything to do with alpha. The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest. Or, to emphasize the commenter of earlier fame:
If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.
Follow that? If you don't understand what you are buying, don't buy. Quite simple. Or so you would think.
Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.
Activism is, along with value investing strategies and in my view, one of the few pure sources of alpha.
Activism is not hard to understand. If you bother to educate yourself.