Going Private

Reader Oxidation

The SarOx costs discussions that have been penned here on Going Private have generated almost as much reader mail as my musings on the impending death of private equity.  Interestingly, Going Private readers have been almost exclusively anti-SarOx.  Many had personal examples of the slow, vampiric suck SarOx had on their firms.  Noted one valued reader:

I have been following your discussion and various articles on the true costs of SarOx with interest.  I head up sales and marketing for a mid-sized, publicly traded professional services firm that is struggling with the costs of being public.

I cannot give you hard figures but some "circimstantial" evidence to back up your thoughts.

- We know have two outside auditors that essentially sit in our offices looking over the shoulder of the finance and accounting team.  They are supposed to be there working on "other things" but it ends up they are involved in ongoing day to day accounting decisions and of course we are paying for all that time they are there.  We have complained continiously about it but have gotten nowhere.

- As head of sales I am deeply involved in revenue recognition activities on a monthly/quarterly basis and I can tell you that in the last year, the time I spend on these discussions has more than tripled. 

- At 2:00 PM on the last day of Q2, the auditors informed us that we would have to use a brand new method for revenue recognition for all fixed fee software development projects that were over $1,000,000 in value. This required a team of people across 5 different offices (US, Asia and Europe) to work practically non-stop for 4 days to re-calculate the revenue to be recognized.  Further in the 2 months since then, the auditors have continued to "tweak" the model so by this point, the assumptions used to recognize revenue for Q2 are invalid so we have been doing write ups and write downs this quarter to deal with it anyway.

- The guys that I work with in legal and accounting are burned out and tired of it and turnover has increased.  In addition the the added expense for the audit firm itself, we have added staff to help deal with the  increased work load and it is still not enough. 

- The best people we have in finance who I used to work closely with to help craft creative deals for our clients are no too busy to spend much time on that.  The external auditors have priority over our clients and prospects (not all the time but most of the time).

All this has us seriously looking at the business going forward to determine if we can continue to be viable as a public company.

Another reader opines:

...its not just monetary concerns that turn people away from US listings.  The just released CEO Survey in the NYSE magazine (don't ask me why I have a copy) has another stat.  It does corroborate that financially, US listings are a bitch: 70% of the CEO's of NYSE listed companies have said compliance costs have increased over three years ago. But additionally, 89% of the same group say they are spending more TIME on regulatory and compliance manners.

I'm not aware of any study that looks at "soft costs," i.e. time, opportunity cost, additional payroll expense required to deal with SarOx, but I should like to find one.  I have to wonder what the additional hours and CEO grief alone cost a large firm.

Voodoo Economics

You remember Ben Stein, don't you?  The host of "Win Ben Stein's Money?"  No?  He's the monotonic economics teacher in "Ferris Bueler's Day Off," you know, "Bueler...?  Bueler...?  Bueler...?"  Ah yes, now you remember.  Few things amuse me more than old episodes of "Win Ben Stein's Money."  You have to give credit to a game show host who challenges the lead contestant for the final prize (and usually wins).  It is not easy to win Ben Stein's money either.  Not when you are a contestant on "Win Ben Stein's Money," and not if he's a shareholder of the firm you are trying to take over via a management buyout (as the management of Narragansett Capital apparently discovered when Stein filed objections with the SEC and caused the commission to ask for a full review and kill the deal). I was pleased, therefore, to be pointed by an email from Abnormal Returns to a piece that Ben Stein, intriguingly penned (free but annoying NYT registration avoidable via bugmenot) for this Sunday's New York Times titled "On Buyouts, There Ought to Be a Law."  Information Arbitrage and Financial Rounds get in on the game too.

What surprised me is that therein Ben Stein, usually the champion of reason, calls for more regulation, in fact an outright ban, to correct some kind of market imbalance he sees in MBOs.  I say "surprised" because his usually deft command of logic and quick wit seems absent here.  It also seems out of character for Stein.  He was a speech writer for Richard Nixon and appears on Fox News, after all.  I even ventured to wonder, at one moment, if someone hadn't pulled a bit of a hoax on the New York Times.  (Then again, Stein is a celebrity judge for "Star Search," suggesting at least the early signs of mental defect).

Mr. Stein's main objection to MBOs seems to be a "fairness" one.  I've discussed the pitfalls of the "fairness" trap before, I fear this encounter with the concept is no different.  Stein quips:

The deals were happening because the market swooned in the mid- and late 1980’s, but asset values remained high, and so there was a major arbitrage to be realized between asset value and stock price. To me, it seems that this arbitrage belonged to us stockholders and not in any way to our trustees, the managers. But the managers wanted that money, and if they wanted it, they usually got it. There was not much of anyone to stop them.

Then the market rallied and stocks came to be worth more than their underlying assets, so the leveraged buyouts came less often. That gap between the value of the assets that managers sold after the buyout and the stock’s value before the buyout had vanished.

Now, the markets have corrected— they have been lackluster for a long time now, in fact— but inflation and immense gains in the price of oil, as well as gas and other commodities, have spawned opportunities for looting us stockholders, and management buyouts are running riot.

Stein's complaint, it seems to me, stems not from "opportunities for looting us stockholders," but rather the "arbitrage to be realized between asset value and stock price."  This, his argument implies, is unfair.  The fact that the stock price at any particular moment is below asset value is, he seems to suggest, unfair.  For a third party to take advantage of this arbitrage is unfair.  It is "looting."  This argument is just silly.

The arbitrage opportunity, i.e. the difference between the stock price and the asset price, is the result of one of two things:

1.  The public market for the securities in question is somehow inefficient.  That is, it is "mispricing" the asset (shares of the company) because of liquidity problems, incomplete information, or pure irrationality.

2.  The public market for the securities in question is efficient, and is pricing other factors (probably risk) into the stock price.  The market's appetite for risk is low, so a small premium and "cash now" sounds much better than patience and maybe cash later.

In either case, Stein's issue is with the markets, not management.  One might even suggest that by paying a premium over the current stock price (which they almost certainly will), management is doing the shareholders a favor.  Let's also remember, that a management buyout will require board and potentially shareholder approval.  If Stein, as a shareholder, wants to involve the SEC, sue, rally shareholder dissent for the deal, or force a proxy fight, he is welcome, as every shareholder is, to do that (as he did with Narragansett Capital).  If he cannot convince the rest of the market or the board that the offer is too low, then perhaps it is Stein's pricing of the risk that is off, not the market's.  Even this relies on this very flimsy concept that there is some "correct price" for an asset outside of what buyers and sellers will actually agree to pay for it.

Consider this:  Two shipwreck victims on a desert island.  4 cans of beats.  If the first shipwreck victim offers to sell her 3.5 caret flawless, colorless diamond wedding ring for a can of beats and the second shipwreck victim refuses, what is the diamond "worth?"  And this is just the point.  Just because it might be worth $80,000 in New York, it is worth less than the salt in her tears on a desert island.  They aren't standing in New York.  (The fact that the time horizon of the market participants here is measurable in weeks contributes to the low betas, will anyone actually live to actually sell/enjoy the diamond?)  Mr. Stein's stock might well be worth more than it is now in an ideal environment.  But using that as a price point is about as legitimate as using a parallel universe where the company has a parent for cold-fusion as a price point.  It is fantasy.  Pricing it accordingly is also fantasy.

Take my scenario and add some mass drama to it, like, say, an oil crisis, and we actually look at market actors who raise prices in the face of dire shortages as criminals.  This we call "price gouging."  It is illegal because it is unfair.  It is unfair that because supplies are low people should have to pay more for a scare product in high demand.  (Follow that?  Me neither.  Seems to depend on the idea that there is some intrinsic right to low prices [or high prices if you are a seller] regardless of market forces.  You will see this theme again, I promise).

Calling in the SEC to determine a "fair price" seems absurd to me as well.  A "fair price" is what you can get for it.  I am constantly suspicious of a small central group (i.e. the SEC) dictating price, particularly when the much larger and more fluid market disagrees and the centralized price is dressed up with the word "fairness."  To that point, though Stein seems to imply that Narragansett's management pulled the deal because it was a "looting," I imagine the cost of enduring a full SEC review had more to do with management's decline to pursue the deal than any fear of it being disclosed as some kind of theft or fraud.

Let's also look at Stein's position as a shareholder and the "fairness" of this "arbitrage."

Stein either bought the stock when it was higher (and therefore is underwater on the stock) or he bought it when it was lower, but thinks it should be even higher.  If the former, well, it seems to me that Stein timed the market poorly and if he isn't ready to cash out at a premium to the current price then his beta is just different from the majority of the other shareholders.  Tough cookies.

If the later, then Stein's return expectation is just higher than the majority of the other shareholders.  Tough cookies.

Either way he is swimming against the tide of the market.  What really irks Stein, it seems to me, is not that there is an arbitrage opportunity, but that he's on the wrong side of it.  The subtle implication here is that Ben Stein is smarter than the rest of the market and if only he could make them act rationally (or his in line with his view of rationality) then he could make the money he expects, nay that he deserves.

Be afraid, be very afraid, I say, of anyone who wants to pass laws to make the market "fair" because they aren't getting the returns they would like.  And that's what Stein wants.  To wit:

To my mind, these deals should be illegal on their face. That is, they should simply not be allowed at all as a matter of law. Here’s why:

The managers do these deals only to make money. It’s business, after all. They do them to make money off the assets of the stockholders. They could, if they wished, sell off the assets or otherwise manage them for the good of the stockholders. (Again, the assets of public companies do belong to the stockholders as basic law.) Instead, they buy the assets on the cheap and sell them off for their own management benefit, or they manage the company differently for the benefit of themselves and their buyout partners.

But as a matter of basic fiduciary duty law, managers are bound to put the interests of stockholders ahead of their own, in each and every situation. By buying the assets on the cheap and then reaping the benefits, management is breaching that fiduciary duty, or so it seems to me. Likewise, if the managers can run the company more profitably, they owe it to the stockholders to do that for them.

So what is Stein complaining about, exactly?  It is not a question of "if the managers can run the company more profitably," it is more a question of whether the shareholders believe management can run the company more profitably, and even if they do, if they are willing to wait that long (and thereby increase their risk to any number of external factors) to cash out rather than take a 20% premium right now.  Management gets massive returns because they adopt the risk that the public shareholders willingly sell to them.  This is what Stein seems to ignore.  As if it is a slam dunk that if we just stay the course he will pocket millions.  As if there is no general market risk to running a large public firm.

Stein's timing for this argument stinks as well.  If the firm ends up in a management buyout bid this week, it has just put itself in a very liquid and very fluid environment with a ton of competition and a tidal wave of cash floating around, not the least from hedge funds that are spending in a fashion that approximates financial retardation.  Hardly a situation where you expect shareholders to get screwed.  In fact, you only have to look at the multiples buyouts are paying these days to realize that being a shareholder in the midst of a buyout today is like getting mana from heaven.  The Financial Times and the Economist have both quipped in the last quarter that, given the prices of assets, the only beneficiaries of buyouts right now are the shareholders lucky enough to be exited by one.  Stein should really look at historical multiples rather than gripe about one or two examples back in the 1980s where no one else wanted to bid on the company he was foolish enough to invest in.  In this environment, if you can't even get two bidders then be lucky you have a way to get out of the stock at all.

As for the structural issues, there are ex ante mechanisms in the United States both to guard the shareholder in the form of fiduciary duties of the board and of management, and there are ex post mechanisms for redress if a shareholder feels an executed buyout is unfair despite these protections.  Are these somehow ineffective?  Is Stein really talking about a corporate governance issue?  Let's examine that.

Stein believes there is a conflict of interest here.  Classically, there is.  What he is pointing out is the classic so-called "agency problem."  And what is the conventional solution for the protection of shareholder interests?  Anyone...?  Anyone...?  Anyone...? B...O...A... something...?  The board of directors.  On paper the board of directors is supposed to safeguard shareholders from management.  In buyouts, their role is to review the transaction (often by appointing a special committee) and assess fairness.  In many proposed management buyouts, the board will actually fire management, or those of management proposing the buyout, or at least put the parties involved on leave and appoint an interim CEO to deal with the conflict.  One public board member I spoke with indicated that if ever approached with an MBO proposal by a CEO he quips back "well if you are serious, give us your letter of resignation and let's get the process moving."  Not many take him up on the offer, he says.  (Consider the fate of RJR Nabisco's F. Ross Johnson when he tried to mount an MBO).

If these protections are insufficient, and lawsuits challenging the board's objectivity are not sufficient the Stein's problem is with the corporate governance system in the United States, not buyouts.  And let's not forget, as a shareholder, Stein had an opportunity to make changes at the board level if he wished.  That's what shareholder voting is for.  If shareholders believe the board is not objective enough, why did they wait until after a buyout to sue rather than remove them before the problem arose?  It doesn't take a genius to see that we are in an era of very powerful shareholders right now.  The days of the Imperial CEO are over, for now.  Accordingly, I am unsympathetic to these oppression pleas.

Stein goes on to point out:

But in a management buyout, management is seeking to pay the least it can get away with for the assets of the public holders, while the public holders want the most they can get.

How exactly this differs from any buyer-seller transaction in the history of free markets is a mystery to me.

Stein does, however, in a brief flash of the superiority complex I speculated about, finally give us a hint of what drives his call for a new law:

"I want to make sure you know that I am somewhat ahead of the curve. No court has yet put all of this together and banned management buyouts. But it took a long time for courts to bar segregation or for Congress to bar residential housing discrimination."

Ah yes, the great injustices of the world.  Segregation.  Discrimination.  Management buyouts.  What WOULD we do without "ahead of the curve" Ben Stein to right these tragic wrongs?

Win Ben Stein's Ire

As a rule, I usually don't spend a lot of time on reader mail, or on the analysis of it here in these pages.  It always feels self-serving to wax poetic at audience response to one's writing.  For the same reason I don't turn comments on for the entries here.  (A few readers have asked me to, and sometimes I actually consider it).  Recently, however, reader mail has been interesting and insightful enough to warrant more comment.  The three recent posts that have gotten me the most reader interest (as measured by influx of mail) here at Going Private include:

1.  Imminent Death of Private Equity Predicted,
2.  Nicole Kidman Should Run a Hedge Fund, and;
3.  Voodoo Economics.

The majority of replies to "Voodoo Economics," my critique of the piece in last Sunday's New York Times on the evils of management buyouts by econ guru, general figure of shareholder menace and sometime economics teacher actor, Ben Stein, began with some version of:

"Ben Stein is off his rocker, but..."

...and continued to suggest that MBOs really ARE evil, though not for the reasons Mr. (Professor?) Stein would indicate.  My favorite in this vein is, by far, the opening penned by a fellow practitioner.  Specifically:

"While I agree that Ben Stein's butter seems to have slipped off his pancakes..."

I have to say I admire the structural consistency many of Going Private's valued readers display in writing comments to the editor.  The next phase of almost every Ben Stein letter was triggered by prose generally resembling:

"I think you're misinterpreting Stein's [noun]", or;
"Your critique fails to account for [shopping list of items]."

Here are some of the arguments Going Private readers made in defense of Professor Stein:

1.  My critique relies on the existence of "efficient markets" in the philosophical sense.  In other words, my argument falls apart if markets are not perfectly efficient in the economic theory sense.

I'm not sure where this criticism comes from as I thought I pretty clearly explained how one's theory of market efficiency was not operative on the question of MBOs except as to define if "inside information" could actually benefit an insider.  (Proponents of "perfectly efficient" market theory would be hard pressed to show how inside information could be helpful to an insider).  The question is not "are markets fair" it is "are shareholders oppressed by MBOs" compared to other transactions.  A lot can be gleaned from simple resort to comparison between LBOs (to which Stein seems to have less objection) and MBOs.

2.  There is some fundamental unfairness intrinsic to MBOs with respect to shareholders.

I was struck by the similarity of some commentators objections to the attitudes that caused me to pen "Beware Dark Figures Bearing Fairness."  We should all know that in markets, as in life, fairness is a relative, subjective and therefore dangerous term.  Oddly, the trend in the United States seems to be in the other direction, towards an entitlement to returns.

I suspect that the creeping entitlement to "market returns" that has begun to rear its ugly head is, to no small degree, fostered by the increasing linkage of high market returns to defined benefit (as opposed to defined contribution) retirement plans.  The issue is framed nicely in a recent Wall Street Journal opinion piece by McMahon, a senior fellow at the Manhattan Institute:

Public funds, however, are allowed to discount their long-term liabilities based on the assumed annual rate of return on their assets-- which, for most public funds, is pegged at an optimistic 8% or more. In other words, the risk premium in the investment target is compounded in the liability estimate. (This accounting twist also explains how politicians can claim, with straight faces, that pension obligation bonds are a nifty arbitrage play.)

If the liabilities of public pension funds were valued on the same basis as private funds -- using, for example, the 30-year municipal bond rate as the discount rate -- funding requirements would be dramatically higher. Estimates of the nation's real public pension funding shortfall range from an added $500 billion for state retirement systems to at least $1 trillion for all public systems.

The 8% rate of return assumption, while shared by some major corporate plans, is certainly open to question. But public pension fund managers are in a pickle: If assumed returns were reduced, even "fully funded" systems like New York's would find themselves tens of billions in the hole -- as shown by alternative calculations buried in financial reports for Gotham's retirement systems. And so, in the name of protecting taxpayers from having to pay higher contributions in the short term, funds expose them to more volatility and risk over the long term.

Public pension funds used to be run on more of an insurance model, heavily reliant on fixed-income securities. But over the past 40 years, the vast expansion of government at every level has vastly expanded the pool of public pension liabilities. This leads to a vicious cycle: As the employee head count rises and unions lobby for bigger pension entitlements, funds feel pressure to pursue riskier investments with higher returns -- which explains their increasing reliance on stocks, as shown in the nearby chart. But when returns exceed expectations, as in the boom market of the 1990s, politicians and fund trustees feel irresistible pressure to raise benefits again.

Not surprising then, the news that pulling an 8.5% return on a $10+ billion portfolio gets you fired in this day and age.  High returns have become an inalienable right.

I have also wondered to myself what a 1920s era Lloyd's broker would think if teleported to the year 2006 where auto insurance is mandatory in some U.S. states and somehow health care insurance has become a "right."  Same issue.  A "right" to a financial return.  Something for nothing.

We should all know better than to believe that regulation can "level the playing field."  I would love to be able to run as fast as Carl Lewis.  Too bad for me.  There ought to be a law!

I was surprised, therefore, then to find most of the pro-Stein arguments bearing some version of this "fairness" argument.  That the poor shareholders were being fleeced somehow by clever management.  That they were being deprived of returns that were rightfully theirs.  Returns that they "already owned" somehow, even though these returns have yet to materialize.  Arbitrage opportunities that were "rightfully theirs" in the words of one email contributor.

It is this attitude that permits market actors to indulge themselves with fantasies that returns that they themselves are in no position to create or realize, or returns that are not possible without substantial changes in the financial environment, perhaps even returns that they had expected when they bought the stock in the first place, are theirs to capture (even before they have been earned).  This attitude, I believe, is what prompts writers like Stein to decry managers in a position to create returns when taking private a firm that the very shareholders now complaining made impossible to realize in the public capital markets in the first place though behaviors as varied as the fixation on short-term (quarterly) earnings prospects, poison pill arrangements, and pricing the company's stock below book value because of an aversion to risk.

"But you are ignoring the vast information disparity between managers and shareholders," worried one commentator.  (The same commentator that only two paragraphs earlier had insisted that markets were perfectly efficient.  My question as to how the managers could capitalize on "superior information" in a perfectly efficient market went unanswered).

Even in an inefficient market (and I don't believe U.S. capital markets are perfectly efficient) superior information only gets you so far.  And in the United States there are any number of safeguards to prevent abuses here.  Ex ante there is the shareholder vote and board approval requirements.  Ex post there is a long and studied history of shareholder litigation over items like price and deal terms.

"They are sharing non-public information with potential buyers and showing favoritism in picking which buyers to share that information with."

Let's pretend for a moment that this is true.  The redress for this is in Rule 10(b)(5), not in the outright ban of MBO transactions as Stein suggests.  The disclosure of material non-public information to a potential buyer to the exclusion of others falls into the insider trading realm.  Woe to the buyer who continues to bid in such a circumstance.

Shareholders are hypocritical here quite often.  Insisting on full disclosure when "good news" might give them an upside, but quite happy for information to be secret and markets mispriced upwards when they are selling.  In reality, shareholders like Stein don't care if markets are mispriced, they just don't want to be on the wrong side of the mispricing.

"But poor shareholders can be victimized by the tyranny of the majority, even if they didn't want to sell," said one writer.

I am unsympathetic.  Shareholders knew or should have known when they bought the stock that they were subject to the possibility of a MBO (or any M&A transaction) where they would be on the losing side of a Board of Directors decision or proxy fight.  That is "the deal."  One wouldn't expect to be taken seriously if one's political candidate lost an election and one was moved to complain "I should have two votes!  It is not fair that I lost and the voting rules I knew about before the election should be modified retroactively to permit my victory!"  Strange then that this argument is constantly being forwarded in the context of shareholder actions.

Another reader points out something insidiously clever.  Stein, he quips, is outraged at exactly the behavior he, himself, is exhibiting.  Stein bought the stock in the first place convinced that he knew better than other shareholders how to extract value from the stock or that a price disparity would benefit him.  Superior knowledge, therefore, is what Stein wants to profit from.  How then can he, with a straight face, complain when management does the same via an MBO and most shareholders willingly sell?  Stein is entirely free to start an activist fund to do the same, if he can garner the capital.  Should we ban all transactions where homework, good sense and a lot of research give one participant an advantage?  This same reader points out that Stein's argument is "so eerily similar to an argument recently put forth in the 8/28 New Yorker."

Another reader wondered if how these transactions could be fair given that management had all upside risk and no downside risk.  I can't speak for that reader's experience, but I haven't seen an MBO where management didn't have substantial personal net worth at risk.  Sub Rosa has done 4 MBOs since I arrived. All of them contain provisions (like co-investment) that would put the senior managers in the poor house if the deal blows up.  This is not an accident.  We do it, as do other private equity firms, for precisely these incentive reasons.  While not my favorite example of excellence in financial journalism, a recent article in Fortune on the decision of former GE Vice Chairman Dave Calhoon to head up VNU when opportunities in much larger, public firms were available demonstrates this point nicely.  Says Fortune:

Press reports valued his pay package at around $100 million, but its real value is uncertain because Calhoun is also making a substantial investment in VNU (no one is saying exactly how much).

[...]

The most interesting question arising from this situation is: Why couldn't a huge publicly traded company make Dave Calhoun an offer he'd accept, but a small privately held firm could? Again, the answer seems obvious. In today's climate of deep shareholder distrust, no public company would dare to offer a prospective boss such munificent terms.

[...]

Any public company that now offered a new CEO $100 million would be scourged without mercy by shareholder activists and TV talking heads nationwide.

And as to the question of "skin in the game," and sweetheart deals to management?

Calhoun is as sharp as anyone, and he was negotiating against people representing the Blackstone Group, the Carlyle Group, Kohlberg Kravis Roberts, and the other private-equity firms that bought VNU - collectively the smartest, toughest SOBs in business. Whatever deal they reached is the correct deal because it represents the market at its most efficient, ruthless best. Calhoun stands to make $100 million or more because cold-eyed investors with their own money at stake believe he's worth it.

Increasingly, public capital markets are beginning to look like the laws of thermodynamics (You can't win; you can't break even; you can't get out of the game) with Vegetable Capital actors playing the part of the universe and getting the free lunch.  Managers increasingly are faced with reduced compensation for more risk.  When they do profit it is called "windfall."  Responding totally rationally to this perverse set of incentives, they choose to leave the public markets and, in doing so, find themselves under attack from the likes of Ben Stein, who feels he has been cheated because they didn't sit around and "do what they were supposed to do in the first place," i.e. make money for shareholders while taking less and less pay and adopting more and more personal legal and financial risks and incurring increasing opportunity costs.

Why does this increasingly feel to me like the plot for an Ayn Rand novel?

Manufactured in Switzerland

Like clockwork, The Economist touches this week (subscription required) on the issue of the day here at Going Private.  One might be tempted to think that yours truly has an inside track with one of The Economist editors, so regular and aligned are the weekly topics between that publication and your humble author's print here.  (Your author actually prefers the egotistical, and rather unlikely, intrepretation that Economist writers regularly read Going Private to get the pulse of the financial world).

"The efficient market hypothesis can land you in jail," is The Economist's latest stroll across the Going Private commons.  Quoth The Economist:

[The efficient market hypothesis] also has the rare distinction, for an economic theory, of the approval of America's Supreme Court. In 1988, in Basic Inc. v. Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them.

That ruling has proved a goldmine for America's trial lawyers, who have won fortunes by suing firms for damages when news (often, in practice, a restatement of their accounts) is followed by a sharp fall in their share prices. The fall is treated as proof of overvaluation due to the initial, wrong statement.

Increasingly, a similar logic has been used in criminal cases, as Mr James Olis, [the tax accountant, found guilty of committing fraud while working for Dynegy] discovered. His 24-year sentence stemmed from a calculation of the financial loss caused to investors in Dynegy by Project Alpha, an accounting fraud in which he took part. That financial loss was estimated using the fall in Dynegy's share price on the news that Project Alpha was fraudulent. According to Judge Lake, it was so big that, under sentencing guidelines then in place, Mr Olis had to go to jail for a long time.

This would be all fine and good, perhaps, if the efficient market hypothesis were understood to be fact.  It is, of course, not.

None of [the defense's objections] challenges the use of the efficient markets hypothesis. Yet for years the hypothesis has been under increasingly fierce attack in academia, unnoticed by the legal system. In a recent paper, Bradford Cornell, of California Institute of Technology, and James Rutten, of Munger, Tolles and Olson, a Los Angeles law firm, argue that even highly developed financial markets such as the New York Stock Exchange are not efficient enough to allow courts to use declines in share prices to calculate the financial damage caused by a fraud. In particular, markets often react disproportionately to news, especially bad news. They therefore conclude that estimates of damages based on the hypothesis and on share-price movements will be overstated. If Judge Lake has been spending the summer getting up to date on economics, perhaps Mr Olis will be out of prison much sooner than he must once have feared.

Time

Beginning 8:46:30 a.m. on Going Private, 2,997 minutes of silence.
Remember....

Finality

We miss you, Paul.  We will never forget.

Rule #1: You Do Not Talk About SarOx in London

In keeping with the increasing convergance of private equity and hedge funds, I find myself dreaming up hedge fund strategies in any number of strange situtations.  Most recently, literally, I dreamed it.  I am pretty sure the seed was planted elsewhere, but it has recently been bolstered by an article in The Guardian (which a fond reader, reading my mind, also recommended and quoted in an email today).  That reader also points to a Bloomberg piece wherein British authorities related with chill voices, the prospect of a purchase of the London Stock Exchange by U.S. interests exporting SarOx to their shores.  Quoth The Guardian:

Sarbanes-Oxley, the US rules introduced in 2002 after the collapse of Enron, are at the root of the latest worries and were yesterday cited by the pharmaceutical company, Acambis, for its decision to withdraw its listing from Nasdaq.  London has also been attracting new stock market listings because of Sarbanes-Oxley - a matter now being studied by the US treasury secretary, Hank Paulson.

Mr Balls's efforts were welcomed. John Pierce, chief executive of the Quoted Companies Alliance, said: "We're very anxious that the London boat isn't rocked, and the bogey is Sarbanes-Oxley." The investor lobby group, ABI, said it hoped that "the powers proposed to be given to the FSA will prove an effective safeguard for the exchange to remain UK-regulated".

Sez Bloomberg:

The U.K. plans to prevent any buyer of London Stock Exchange Plc from importing rules to the British market amid concern that a fresh takeover bid by Nasdaq Stock Market Inc. may spur changes to regulation.                

"The Sarbanes-Oxley regime in the U.S. is not a regime that some companies find easy to deal with,'' Ed Balls, U.K. treasury economic secretary, told reporters in Hong Kong today. "Were there to be an exchange of ownership, this could have the effect over time of rules from other countries being imported into the U.K.''

Since the increasing flight of U.S. firms from Sarbanes seems likely to spur some change in the U.S., (WSJ subscription required) wouldn't it be the time to buy U.S. listed firms, making loud noises each time about the crushing weight of SarOx as the root cause, wait for the regulatory easing (servicing debt meanwhile) and then go IPO in a spectacular blitz of prospective future spin?  Regulatory arbitrage at its finest.

Ode To Dr. Mark Klein, M.D.

Persistance being a virtue
I cannot let pass
The many eager laments to markets capital
You pen with such quick ease
Without comment or recognition.

Few DealBook entries on hedge funds or private equity pass without your lightening quick response.  I know it is you long before I reach your familiar multi-lettered monogram, complete with the finance credibility building "M.D." suffix.  I know so very many financially astute M.D.'s, after all.  How could your unique and distinctive tone- a tinge of paranoia, suggesting perhaps recreational reading preferences that, no doubt, include cautious publications exploring the shadowy actors behind the scenes of life, a soft but palpable bitterness the source of which I often wonder after- fail to delivery the delight of a rueful shake of my head and a soft, sad smile?

And what of this Mattheauesque crankiness?  Where is its root?  Perhaps the prominent "M.D." in your monogram hides a subtle clue?  For you are far too quick to the comment draw to be in practice now.  A lost patient?  Screaming horror as anesthesia inadvertently wears off mid-procedure?  Too many fat cats with warm and sticky heart disease?  Too much blood, fatty tissue, blackened lungs?  Or perhaps the vapid triteness of plastic surgery, a decade of enduring the legions of kept women desperately fighting the doomed battle against time, but spending tens of thousands doing it.  Bedside manner never was your thing, maybe.  Or did the futility of it all, surgery in pursuit of vanity, caused you to snap?

These are but uneducated guesses, I admit, but I can hear the omnious ticking if I inadvertantly venture too close.  The relentless marching towards an episode of postal proportions.  At first, I back away, frightened, but am hauntingly drawn back to look.  That familiar sinister and black curiosity: Did anyone die in the highway accident?  What's under that crimson stained white sheet in the road?  Is there a good horror flick on cable tonight?  Why doesn't the search feature on DealBook include the comments?  Scary.  But safely distant.  But then I wonder: What if you live in my neighborhood?  Last desperate act to leave the gas main open and take half the block away rather than give the beloved townhouse- years of medical school and 10 years of practice to finally acquire it- to your soon to be ex-wife?  And if the inclusion of the occasional medical related term in context ("No better example of my belief NBC is total poison for GE shares," for example) is perhaps cause for alarm, then full-blown diagnosis without the benefit of a patient exam ("There’s a good chance, unless he was initially diagnosed with biliary obstruction by an advanced cancer of the head of the pancreas, he survived for years fighting it.") certainly pegs the threat board straight to red. 

Whatever the source of your dark tone, your omnipresence within DealBook is precious.  The entry with but one comment is almost universally yours.  In the sphere of multiple comments, yours is almost always first.  Your message is consistent.  The deck stacked against the powerless citizens of the impotent kingdom which you ineffectively rule from behind the glowing LCD display: The ranks of the disaffected and disillusioned lower-upper class.  You have just enough to realize how little you have.  Defined wonderfully and contemptuously as "...some $400,000-a-year Wall Street stiff... flying first class and being comfortable" by your fictional nemesis, Gordon Gekko.

Your laments are unified by a pervasive and willing helplessness.  What purpose would you have if your enemies, the titans of corporate management and capital markets, were not omnipotent and universally dedicated to your personal ruin?  No, you must not win.  Your audience would shrink away to nothing.  Your fame, what of it there is, would fade quietly.

I salute your unwinable fight, Dr. Mark Klein, M.D., but I fear I must wish you no luck.

Fading Amaranth

I was fortunate enough to know several professionals at Amaranth.  I say "fortunate" because they were quite pleasent to work with and knew their stuff.  I say "was" because they don't answer my calls now.  It would be a simple task to join the hoards crowing over the quasi-fall of the fund, but there is a deeper lesson here, and I don't want to neglect it.  Abnormal Returns touches on it today by referencing, in true Abnormal fashion, an entirely different and entirely similar discipline.  Cooking.  Says Abnormal Returns, citing Bill Buford in the New Yorker:

Tim Zagat, the publisher of Zagat Guides, points out that for more than two decades the cost of going to restaurants or getting takeout has risen less than the annual rate of inflation—that it’s much less expensive today than at any other moment in our history to pay other people to prepare our dinner. Never in our history as a species have we been so ignorant about our food.

Abnormal Returns then comments:

Let’s take a minute and think about the world of investing today. At no time in history has it been easier or cheaper to assemble a low cost, indexed, globally diversified portfolio. (This is one of the great accomplishments of the ETF revolution.) The vast majority of investors would be well-served in this approach. However the majority of the media reaching investors serves to tell an entirely different story.

From CNBC, to infomercials to brokerage ads we are constantly bombarded with the notion that investment success is simply a click away.  Any one who has read this blog for any period of time knows that we are in the camp that active investing is far from easy, indeed active investing is, in fact, hard.  That should not deter an individual from pursuing investment expertise, but they should do so with their eyes wide open.

This analogy is a deft one, I think.  Short of the not yet revealed revelation that Amaranth deviated from its investment strategy as defined in its placement memorandum, or that it timed the disclosure of its massive losses to avoid a run on the September 18th deadline for October 31st redemption requests, I find it difficult to point fingers at Amaranth.

I have commented before in these pages on the slow, but sure, creep towards an entitlement to returns in the United States.  As if everyone were somehow possessed of the right to above market returns (or even market returns) and anyone who interfered must be arrested, sued, imprisoned or sent into exile.  An ignorance about the trade off between risk and return is, I suspect, at the heart of these sorts of delusions.  The kind of world view, one that believes that we can apply the laws of thermodynamics to market actors (can't win, can't break even, can't get out of the game) and thereby extract better than market returns from them at no risk to ourselves, seems increasingly acceptable.  (Ignoring for the moment that it is the market actor we box in that is expected to pay).

This is the formula that prompts legislators and other demagogues to propose "windfall profit taxes," "poison pills," restrictions on LBOs and causes people to expect that a fund like Amaranth can return 20%+ returns year in and year out without taking the kinds of risks that may, surprise, surprise, blow it up.

It is interesting to me the sort of double standard we apply to these kinds of melt-downs.  Take such risks and lose and the Wall Street Journal might cite industry experts with: "To have a relative newcomer… receive so much discretion is just shocking to me."  But at the same time we all worship the general who fights against impossible odds and wins.  We cheer for the quarterback to completes the impossible pass.  We love risk, when we win.  We condemn it, when we lose.  Half a dozen traders happily piped in with an "I told you they were reckless!" but no one, least of all investors, seems to remember actually being told that until now.

Despite this, it does surprise me that Amaranth bet "half the farm" on one man's game, and it is quite illustrative that Abnormal Returns would run down a New York Times piece (avoid irritating registration via bugmenot) pointing out that there doesn't seem to be a single big winner (or three) on "the other side of the trade," or another firm that took a career-ending injury loss.  Amaranth was truly out in the cold on this bet.

Be that as it may I think we need to start to remember what risk/reward is.  Particularly as we begin to grapple with the entirely unreasonable expectations that have been heaped on, among other areas, the world of retirement finance by the many blind Barons of Short Termernia.  Ignorance in this area, after all, can be lethal.

The Lost Wisdom of Polonius

Laertes:
O, fear me not.
I stay too long:--
but here my father comes.
[Enter Polonius.]

A double blessing is a double grace;
Occasion smiles upon a second leave.

Polonius:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There,--my blessing with thee!

[Laying his hand on Laertes's head.]

And these few precepts in thy memory
Look thou character. Give thy thoughts no tongue,
Nor any unproportion'd thought his act.
Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them unto thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledg'd comrade. Beware
Of entrance to a quarrel; but, being in,
Bear't that the opposed may beware of thee.
Give every man thine ear, but few thy voice:
Take each man's censure, but reserve thy judgment.
Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy:
For the apparel oft proclaims the man;
And they in France of the best rank and station
Are most select and generous chief in that.
Neither a borrower nor a lender be:
For loan oft loses both itself and friend;
And borrowing dulls the edge of husbandry.
This above all,--to thine own self be true;
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

Laertes:
Most humbly do I take my leave, my lord.

Polonius:
The time invites you; go, your servants tend.

I was once told that the brilliance in Hamlet is, Hamlet.  I think this view trite and shallow.  I've always understood the brilliance in Shakespeare, as a whole, to be the many layers in which he writes.  Every tier of the audience can draw something from his best work.  Hamlet, while a tragedy, is sprinkled nicely with humor.  Some dark, some light, some subtle, some slapstick, some all four.  And Hamlet, while perhaps one of the deepest and certainly the most existential of the Bard's works, (The Life and Death of Richard the Third is it's only rival for complexity and depth of exploration in my opinion) still holds enough lighter fare for the young to pleasantly sit through a good production thereof.

One of the down sides of such flexibility is that people see what they want in Shakespeare, and they tend to do so by missing subtleties.  Dick the Butcher's famous "...kill all the lawyers," quip in Henry VI is perhaps the most notorious example.  It pays, therefore, to pay attention to the details and the deeper meanings in his works.

The humor in Polonius, I have always found, is his begging insistence to be a part of the play in a role much larger than he warrants.  His contradicting advice (rambling wisdom to those willing to ignore those details I speak of) amuses both because it sounds contradictory and mostly useless (though deeper reflection shows it actually to be quite wise) and seemingly endless (at least to the characters unfortunate enough to be on stage with the ill-fated advisor).

His interests work entirely against the world that the audience associates itself with, and to which Shakespeare deftly distracts their attention.  The trials and travails of Hamlet.  Hamlet's plight is so terrible to contemplate that without some relief the play would doubtless would lack the potency it enjoys.

Consider, however, if the play were titled "The Tragedy of Polonius," (his demise is awfully tragic after all).  Hamlet's existential whining and endless moping might well grate our nerves in this new play as we anxiously await the next development in Polonius' struggles to preserve his place in the King's court, to prevent his daughter's flirtations from Hamlet from marring his reputation with the King, to see his son off to University well, and so forth.  There is a whole nuance there, a play within a play, (at least the second in Hamlet) keenly ignored- or at least overlooked.

Polonius plays against the audience expectation that a minor character, would prattle on so, and outlive his welcome in every instance of his appearance, so much so, in fact, that it eventually kills him when he finally wanders for the last time into a scene that should have much earlier carried the stage instruction "[exit Polonius]" or perhaps even "[exeunt all but Polonius]."

Indeed, at least for Polonius, timing was everything.  I want to explore this conflict- but let's use something more "Going Private" for the theme today.  Let's use finance.

My Polonical fascination with timing stems from an ongoing conversation with the head of activism for a hedge-fund on the neglected topic (as if it were Shakespearean detail) of what has in recent years, and against the backdrop of private equity and hedge fund convergence, become an increasingly common occurrence, namely, cooperation and, occasionally, conflict between private equity and hedge funds as common shareholders.  I believe that the fluid transformation of these dynamics has changed the landscape of shareholder activism and, in turn, unveiled a new interplay in corporate governance.  This, I believe, is worth no small amount of attention.

Sub Rosa has had occasion to work with some of the more active and prominent hedge funds (including, by the way, the likes of the luckless Amaranth, with which I have, in particular, done quite a bit of work).  While it had been mostly rare for us to encounter activist shareholders given the smaller size of deals we tend to pursue, we have begun to find ourselves in cahoots with such shareholders more often in the last several months as the fluidity of the market place causes them to reach for smaller deals and for us (and smaller private equity firms like us) to reach higher.

I have been lumping hedge fund activists into two categories.  First movers and follow-on activists.  First movers tend to seek out, target and attack publicly held firms as a primary strategy.  Follow-on activists jump on the bandwagon after someone else has started the fight.  I am less responsible for this categorization than Morgan Jospeh, the mid-market investment bank, and they have probably lifted it from common usage themselves.  (Their white paper on the subject is highly recommended).

The dynamics of the cooperation between these two classes of hedge funds are themselves very complex and driven (or restrained, as the case may be) by disclosure requirements.  13Gs are filed before the intent to exert an active role through the shares.  However, within 10 days of acquiring 5% or more of the voting interests (or having options to do so) of a listed firm Schedule 13D must be filed disclosing, among other things, the intent of the investor (acquisition, management replacement, etc.).  Complicating matters, if any group acting in concert together owns 5% or more of the voting interests, or has options to acquire them, they must together file Schedule 13D within 10 days of the acquisition of the shares or options.

This lower bound is complicated by the upper bound of 10%, after which the firm or group must file a Form 3 within 10 days.  A Form 4 must be filed within 2 days of any purchase or sale of shares thereafter.  The 10% number is sticky not for the reporting requirement, but because the 10% ceiling imposes an "insider" status to the investor and this triggers some ugly matching and profit disgorging rules that most activists will badly want to avoid.  For this reason firms with under 10% are wary of appearing to act in concert with other shareholders as they may be branded as a "group" holding in excess of 10% and, therefore, subject to disgorgement, etc.

Even more burdensome, the Hart-Scott-Rodino threshold, surprisingly named for the "Hart-Scott-Rodino Antitrust Improvements Act."  This obscure restriction requires notices and prior governmental clearance after a 30 day waiting period as the government looks for anti-trust issues if more than $56.7 million in shares are owned by an entity.  That's a time consuming and expensive process.  Says the Head of Activism: only the likes of Carl Icahn, who expect to be in for a long haul, bother.

All this is a long way of pointing out that the dynamics between activists are complex and often require a lot of tip-toeing.

According to my Head of Activism friend, the former class of activism seems to take very heavy lifting.  There are few first mover activist funds and fewer "pure" activist funds (who concentrate primarily on activism as a strategy).  First movers require quite a bit of work and high adept legal teams, as the threat of litigation, and eventually proxy fights, is the primary "stick" activists wield.  They are expensive to run, have long-term horizons and, accordingly, are the rarer variety.

Targeting firms is probably the "highest art" in the tasks undertaken by first mover activists.  Morgan Joseph outlines a set of criteria for "activism vulnerable" firms that Going Private readers will likely have anticipated:

...high cash balances, M&A activity with questionable rationale, under-exploited asset values, depressed valuation multiples, earnings underperformance or the presence of disparate businesses with limited strategic underpinning wrapped within a single entity.

Follow-on activists tend to join first movers once a firm is in "play" and join, either formally or informally, in the agitation.  This strategy is often less lucrative (as the news of a well known activist's attack often itself drives stock price up in anticipation of positive change) but also doesn't hold the up-front and ongoing costs that first movers might.

This effect can look "wolf-packish" or, in an analogy brought to my attention by the yummy Abnormal Returns citing Jeff Matthews, "…when the market smells blood in the water, it goes after whatever is bleeding and doesn’t let go."

Clearly, publicly held firms present the cleanest targets for activism as the liquidity in shares makes it easier to both gain a significant stake in the firm, and also exit quickly once return targets or other goals have been achieved.  (Despite this, some jurisdictions with significant- even misplaced- concern for the oppression of minority shareholders in closely held firms make good hunting grounds for activism in closely held firms.  Often these efforts tend more to the sinister and sleazy).

Quick reflection will cause the Going Private reader to realize that activist firms would do well to target public firms with highly concentrated blocks of major institutional shareholders likely to have similar goals to the activist, rather than fragmented equity structures that will make it difficult to generate a credible threat of a victory for the activist(s) in a proxy fight.  Depressed share prices in combination with a number a large (and theoretically cranky) institutional shareholders are, therefore, likely a beacon for activist interest.  Retail shareholders are generally considered a "minus" and high insider or employee ownership (where it tends to vote with management) is equally annoying.

Interestingly, this dovetails nicely with recently IPOd (and I now wonder after LIPOd, *ahem, Burger King*) firms with significant "leave behind" investments by private equity firms.  Almost by definition, if a public firm has a private equity fund as a significant investor, that investment is near the end of its term for a private equity investor.  Even assuming a 1-2 year time frame between initial investment by a private equity investor and an IPO (and this would be wonderfully quick) it is doubtful that the private equity fund has more than a 2 year lockup, and perhaps not even that.  More likely, the IPO was after 3-4 or even 5-6 years and the private equity fund is itching to get out.  Perhaps the life of the fund is drawing to a close.  Certainly, distributions to the fund's investors are a strong pressure for a quick private equity exit.  Not only that, but given the importance of IRR to the fund, and that the fund is already probably sitting on 35%+ of it, the private equity fund has sharply different motivations with respect to timing than an activist.  A quick example might be illustrative.  I draw this from a highly sanitized real-world Sub Rosa example:

Let's assume for a moment that Sub Rosa invested $10,000,000 in Loser Management, Inc. back in 1/1/02 for a leveraged buyout.  Sub Rosa acquired 100% of Loser Management in the transaction, did all the things private equity firms do for the next four years and then, with great fanfare, IPOd Loser Management, Inc. on New Year's Day 2005.  (Since Sub Rosa is so influential, and the IPO so hot, the market was opened specially for the IPO).  Let's give Sub Rosa paper gains of 300% on the investment and assume, for argument's sake, that it held its entire position in Loser Management, Inc. pursuant to a 1 year lock-up agreement that forbid the selling of any shares by Sub Rosa (even in the IPO) until 1/1/2006.  This isn't particularly realistic, as Sub Rosa would certainly have insisted on exiting a good portion of the investment and probably given itself a fat dividend in the meantime before the IPO, but the Debt Bitch was asleep at the wheel after a hard night of martinis with the folks at Pershing Square and bungled the pre-IPO loans.  (This simplifies things and the outcome isn't particularly different for the purpose of the analysis- don't tell Laura about this hypothetical, thanks).

Unfortunately, on 12/31/06 (right before the corks pop) Activism, L.P., calls up Sub Rosa and introduces itself as the next largest shareholder of Loser Management and indicates that it intends to agitate for change and anticipates a sharp increase in share price as a result.  Would Sub Rosa like to participate?

Sub Rosa is torn.  Big boost in the stock price sounds good, but Sub Rosa has ties to the management of Loser Management (we probably actually installed them, actually, but the private equity firm could well have slipped out of the power circles intentionally as the IPO approached) and really isn't sure it wants to alienate them.  So the senior people at Sub Rosa ask some poor, young, Vice President to do a quick analysis.  What kind of returns can Sub Rosa expect from an activism campaign?

In this particular case I used Bally Total Fitness, a long and protracted campaign involving litigation, but generally considered a success.  (The campaign yielded a 58.1% ROI to Liberation Investment Group after almost 2 years).  Should Sub Rosa jump on board?  The math looks about like this:

As you can see, the impact to the IRR of Sub Rosa is not good.  This late in the game Sub Rosa, like most private equity firms, is highly time sensitive when it comes to exit.  In this case a 25.74% IRR (tasty for the hedge-fund) is just not enough to keep Sub Rosa in the game.  This is in addition to the additional risk of a failure of the campaign, and it becomes easy to see why private equity firms might choose to pass on the opportunity to participate and, in fact, might find themselves on the other side of activists angling for a better price on a sale when it looks likely to be a 6-12 month fight.  At this point, Sub Rosa would just love to hook Polonius right off the stage.

Later this week:  Ophilia was a private equity Vice President.

(Special thanks to a certain Head of Activism for some local color and a certain SVP in a private equity firm for war stories, three hours of discussion and as many hours of martinis).

Amaranth? *yawn*

Increasingly surprising is the non-story of Amaranth.  I say non-story because, media hand wringing aside, the impact of a "spectacular" (New York Times) "breathtaking" (Wall Street Journal) and "devastating" fall of a $8 billion dollar fund has, in fact, hardly made a splash in the financial system.

So minor was the impact that the Wall Street Journal struggled early on to find any collateral damage at all.  So much so, that the best Margot Patrick could drum up was the fund of funds "Man Group, PLC."  And even there, the Journal only managed to solidly identify a (gasp) $10 million investment in Amaranth.  I am sure more lurks under the opaque surface of firms like Man Group, but what seems clear is that where risk management "failed" at Amaranth (and I'm not so sure it really did, more on this later) the major holders seem to have diversified very well and, at least so far, no major collateral damage seems apparent.

The Journal eventually dug more victims out.  The San Diego pension fund, for example, (not exactly the poster child for excellent management lately) had $175 million at stake with Amaranth, but that's out of $7.7 billion in assets.  Could it be that the financial system is just better able to handle catastrophic failures within single firms like Amaranth today?  And if so, isn't this how financial systems are supposed to be designed?  Doesn't this show us the system is working?  The rational allocation of risk and reward is proceeding apace?

We desire, nay, we demand that firms like Amaranth exist.  We encourage it.  Insist on it.  There is always an appetite for risk, a huge one, even on the level Amaranth was taking it.  I haven't heard it put better than by Barry Ritholtz at The Big Picture (who Abnormal Returns pointed me to) when he describes what talking to potential investors on a hedge fund road show is like for a GP:

Now comes THE QUESTION. This is the one that gets people into trouble:

"We are looking for a number. What should we expect from you in the first 2 years?"

What they want to hear is "I am going to do 30-40% annually, fully hedged."

I don't say that, because it isn't true. (God bless Jim Simons, who actually can honestly say that). That's what too many investors are looking for; its nothing more than the greed factor at work.  They don't say it explicitly, but its true: We want you to outperform the long term S&P500 benchmark by 300-400% annually (and we don't care about mean reversion). We really don't care how you do it. We want outsized profits. WE WANT THE LATE 1990S AGAIN.

Money raisers and some GPs have long ago figured this out. You have a few choices: you can answer the investors' questions honestly -- or to quote Ray Davies, you can give the people what they want (or think they want):

"We expect gains of 35-45%, with minimal risk or leverage. Our black box algorithms  have been backtested, and generate better numbers than that, but we would rather under-promise and outperform."

So what are we really worried about?  That Amaranth took on a lot of risk?  That was their job.  That's what we wanted Amaranth to do.  Required of them.  What surprises me is the ease with which Amaranth swallowed their downside.  So far as I am aware Amaranth didn't even fail to meet a margin call on the way down, which is quite a tall order given the size of the position that blew them up and the extraordinary leverage (up to 8:1) on it.

Within less than 10 days most of the offending business has been wound up and pawned off.  So orderly, in fact, was the disposal that there is at least an "even money" case to be made that Amaranth might still be able to carry on (as some former shadow of itself) with operations.  In short, it sounds a little to me like Amaranth's risk management was working not too badly.  They imploded, rather than exploded.

There is nothing wrong with pure risk plays as long as we don't pretend that the returns therefrom are anything but risky, and we don't bet more than we can afford to lose.  At least today it looks like Amaranth calculated that amount quite exactly.  I wonder if their huge bets on natural gas were, actually, a calculated risk from the start.