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Wednesday, January 02, 2008

Reaction is the New Action

louderTom, an analyst from some or another financial institution that you will have heard of, but only barely, is trying to convince me that a perfect storm of sub-prime and corporate debt woes is actually a reason to invest heavily in financial institutions with sub-prime and corporate debt exposure. This makes me immediately suspicious what kind of analyst Tom actually is, if his title is attached to the investor relations department of his own firm, and what webinar he's been repeatedly viewing to pick up the absurdly pop-finance vocabulary he seems so fond of using in every sentence that manages to avoid the filter of his super-ego and escape him (and many accomplish this trivial bit of evasion).

I'm only even listening to Tom because the Debt Bitch isn't bothering to answer her phone. It's Laura who constantly plots "dates" with these randoms, so far as I can tell merely as a bit of sadistic and carefully authored finance theater with her as the chief protagonist. I only agree to attend because it is both the cheapest and the most entertaining finance-speak that can be had. But now that she is late, and I am not, and seeing as how I was stupid enough to introduce myself to her not-date before she arrived, well, I might as well be the demonstration model for a waterboarding seminar.

We are sitting at a upscale (and accordingly very dull) bar with the sort of organic New York finance look that you would expect people who have little to do with the large transactions that flurry about this city to talk about the large transactions that flurry about this city. I want to drain the martini in my hand in a single draw, but I am afraid that the quick surge in systemic anesthetic would somehow dull my annoyance and prevent me from escaping Tom's formidable verbal event horizon at some point later. Instead, I practice wordsmithing the offering memorandum Tom's hedge fund, if ever investors were foolish enough to fund such a venture, might issue. This tactic, one I employ often of late, permits me to appear interested and involved in the discussion without enduring the emotional damage actually concentrating would inflict. I suppose it is telling that the process of mentally penning fictitious offering memorandums completely suppresses the urge to recognize the content as unadulterated bullshit.

It reaches a crescendo when Tom insists that "post 9/11," consumer spending has become fatalistic. In the same fashion that, back in the day, people sold all their worldly possessions on hearing H. G. Wells' War of the Worlds broadcast, the lack of any hope would spur reckless spending in proportion to the fear in the air. A sort of emotional "tilt," would result. The sub-prime mess was so bad, and the corporate debt market would eventually be so decimated, this effect was sure to kick in and the markets would give back their losses like so many slot machines. Just look at Black Friday this year, he insisted. I wondered if he meant this to be the shock that would induce panic buying, or the result of it, as I remembered the reports to be rather mixed this year, but I wisely held my tongue.

I just don't have the killer instinct of the Debt Bitch. I waited longingly for her arrival, eager to have a proxy to throw Tom and his theories that, as their novelty wore off, lost their improbable and novel appeal to the weight of his droning, under the Holiday Express bus.

I managed to slip off with the pretense of a ladies room visit, hug the wall around to the entrance, or in my case exit, unseen. My route required me to navigate behind Tom, and some other banker to whom he seemed now acquainted, by about two meters. Just before I gingerly deposited my martini on the first convenient flat surface and slipped into the sweet New York air, soaking up harsh, chilly smell of freedom, I caught a snippet of their conversation.

"She's way into you," Tom's new friend intoned.
"It is what it is, my friend," he replied smiling. "It is what it is."

(Taken from actual events, performed by an actual "Tom," filtered through the polarized lens of an actual Paul Kedrosky prose contest).

Tuesday, January 08, 2008

The Patron Saint of Mediocrity

i will block you I have had many an occasion to contemplate the depth of meaning contained in the phrase "Perfect is the enemy of 'good enough.'"  This particular turn of phrase has often awakened in me a twinge of guilt, because in the final analysis, I am quite the perfectionist.  This, I think, is one of the great qualities required of a change agent- and I count myself a member of this seemingly rarefied population- and in particular the change agent who would actually have herself affect change.  There is, I sense, a deep conflict in the heart of every reformed (or recovering) perfectionist.  It manifests in the form of a clash between the urge, even the compelling need, to improve things- a deep disdain, if you will, for mediocrity in all its forms- and the limitations of time and sanity that forces a surrender to imperfection.

Naturally, any discussion of compromise, of surrendering battles to the overwhelming forces of mediocrity, would have to involve a mention of the new Wall Street Journal.  I must admit to a deep and painful mistrust and, dare I say, even occasional hatred of the Jorunal's op-ed pages.  Be this as it may, I couldn't help but catch this snippet today on why Obama makes the United States look "naive."

There is great virtue in the American way, which expects CEOs to perform on a quarterly basis, presidents and Congresses to reinvent politics in 100 days, generals to wipe out opponents in 100 hours without taking significant casualties, doctors to save life and limb every time, search engines to yield a million results in less than a second, and so on. There is also great virtue in the belief that what is bad can be made good, and that what is good can be made great, and that what is fractionally less than great is downright awful.

But these virtues 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.

The drive to excel is cultural, I think sometimes.  But, then, so is the drive to coast, foot off the gas, downhill, at a leisurely pace.  Swimming through the molasses of those drives makes it awfully hard to muster the energy to press on.

"I'll speak for you.  I speak for all mediocrities in the world.  I am their champion.  I am their patron saint."

                           - Antonio Salieri (as interpreted by Peter Shaffer)

Wednesday, January 09, 2008

Activists are Sort of Hot

activists You know what I mean.  In that sort of squirmy-can't-hold-still restless-leg-syndrome we-can't-afford-a-dividend and I can't-not-get-the-wife-jewelry this year sort of way.  Well, and they are just hot in general too, frankly.  Forgetting even that they fear no CEO, and love causing discomfort to others at cocktail parties.  What's not to love?

(muffiehbs05 has joined the chat)
3:17:54 PM ohhoneyitstess: look what the pussy dragged in
3:18:45 PM muffiehbs05: Hey tessy!
3:19:06 PM muffiehbs05: What's doing?  Did you meet that guy over the weekend?
3:19:46 PM ohhoneyitstess: which one
3:19:57 PM muffiehbs05: You had more than one date?
3:22:01 PM ohhoneyitstess: no, just one date, but i thought you meant the guys we were talking to saturday
3:22:06 PM ohhoneyitstess: w/ EP?
3:22:28 PM muffiehbs05: Gawd! No!  Ew!
3:22:51 PM muffiehbs05: That one guy worked for Morgan Stanley, for crying out loud.  Where the hell IS ep?
3:25:29 PM ohhoneyitstess: i don't know, working? that harpy bitch.
(equityprivate has joined the chat)
3:25:56 PM ohhoneyitstess: it's almost close, maybe she'll be done soon
3:26:02 PM ohhoneyitstess: by close i mean the close of the market, muffie
3:26:20 PM muffiehbs05: What?  It closes at 5, doesn't it?
3:26:51 PM equityprivate: muffie, you are so mercifully free of the ravages of intelligence.
3:27:19 PM muffiehbs05: That's absurd.

3:28:53 PM ohhoneyitstess: muffie, tell us what you did today
3:29:05 PM ohhoneyitstess: you didn't go into the office, i'm assuming, yes?
3:29:52 PM muffiehbs05: I was too tired.  And I'm kinda sore after last night.
3:29:59 PM equityprivate: hi tess
3:30:29 PM equityprivate: do I even want to know how you managed to get sore on a monday night?  clearly not from the treadmill.
3:31:25 PM ohhoneyitstess: you didn't go in b/c you were sore?
3:31:29 PM ohhoneyitstess: how'd the md take to that excuse?
3:31:49 PM muffiehbs05: I don't really do excuses anymore.
3:31:55 PM ohhoneyitstess: oh, that's nice for you
3:32:03 PM muffiehbs05: Well it really just saves everyone time.
3:32:24 PM muffiehbs05: Plus, the guy I was working for, I don't think he's working anymore.  I guess the fund he worked for didn't do very well.
3:32:39 PM equityprivate: wait, your boss worked for the flagship fund?
3:32:52 PM muffiehbs05: Not my boss, my patron.  You know, my sponsor.
3:33:08 PM equityprivate: from the orientation class or what?
3:33:34 PM muffiehbs05: No, you know, like he looks out for me and we go out when his wife isn't in town?
3:33:57 PM ohhoneyitstess: wait
3:34:05 PM ohhoneyitstess: you mean the guy who looks like our activist crush?
3:34:11 PM muffiehbs05: Who?
3:34:21 PM ohhoneyitstess: dl!loeb
3:34:30 PM equityprivate: he looks like Dan Loeb!?!
3:34:42 PM muffiehbs05: What?  Who is Dan Loeb?
3:34:54 PM equityprivate: my god, he is so hot!
3:35:06 PM equityprivate: and so married.  its such a shame.
3:36:51 PM ohhoneyitstess: yeah it is a shame, although it's not as though marriage has ever stopped big muff before
3:37:34 PM muffiehbs05: Hold on, let me google Dan Lobe.
3:37:42 PM equityprivate: muffie, it's Loeb.
3:37:46 PM muffiehbs05: Oh.
3:37:56 PM equityprivate: Activists in general are just... hot.
3:38:44 PM ohhoneyitstess: yeah they are
3:38:47 PM ohhoneyitstess: they get so riled  up
3:38:53 PM ohhoneyitstess: u still have a thing for tom?
3:39:08 PM equityprivate: Loeb wrote me an email once.  he was the namesake of one of my worst management prizes on the Going Private blog.
3:39:20 PM equityprivate: oh, tom hudson DOES make me weak in the knees.hudson
3:39:32 PM ohhoneyitstess: even though his fund has shit the bed?
3:39:44 PM muffiehbs05: Activists?  Like protestors?
3:40:01 PM equityprivate: just getting back to his roots, tessy.
3:40:30 PM ohhoneyitstess: hehe
3:40:36 PM equityprivate: no, muffie, shareholder activists
3:40:39 PM equityprivate: you know, they buy up 5% of a publicly held...
3:40:42 PM equityprivate: ...that triggers a SC 13D filing requirement...
3:40:45 PM equityprivate: ...then they proceed to alpha-male-investor away at the current management *swoon*
3:40:56 PM muffiehbs05: They are not hot.  What about Carl Icahn?
3:52:19 PM ohhoneyitstess: carl icahn is hot, objectively, but i'm not attracted to him
3:52:22 PM ohhoneyitstess: something about his...icahn
3:52:23 PM ohhoneyitstess: age
3:52:35 PM equityprivate: oh, that's the part I love!
3:52:51 PM muffiehbs05: EP just wants her daddy to spank her, that's all.
3:53:08 PM equityprivate: carl icahn does NOT look like my father.
3:53:16 PM muffiehbs05: Ok, EP wants her uncle to spank her.
3:53:42 PM ohhoneyitstess: eww
3:53:45 PM ohhoneyitstess: to the uncle
3:53:48 PM ohhoneyitstess: the spanking?
3:53:49 PM ohhoneyitstess: maybe
3:54:40 PM equityprivate: whatever, I still think icahn is kinda hot.
3:57:51 PM muffiehbs05: Yeah, if you want to be spanked by your uncle.
3:58:23 PM equityprivate: muffie, you should be so lucky that Carl Icahn would want to put you over his knee and smack your little, lilly white ass.
3:59:45 PM muffiehbs05: I've been spanked by better.
3:59:55 PM equityprivate: better *what* exactly?
3:59:55 PM ohhoneyitstess: oh, yeah?
3:59:57 PM ohhoneyitstess: who
4:00:02 PM ohhoneyitstess: spanks
4:00:05 PM ohhoneyitstess: who
4:00:06 PM ohhoneyitstess: names
4:00:06 PM muffiehbs05: Just never you mind.
4:00:09 PM ohhoneyitstess: where/when/what appartus
4:00:11 PM ohhoneyitstess: shut up muffie
4:00:13 PM ohhoneyitstess: you love to talk
4:00:16 PM muffiehbs05: Hairbrush.
4:00:20 PM muffiehbs05: If you must know!
4:01:03 PM equityprivate: the newly promoted MD down the hall from your office doesn't count, muffie.
4:01:19 PM muffiehbs05: Why not!?  That's bullshit!
4:01:25 PM equityprivate: see, i knew it.
4:01:49 PM ohhoneyitstess: why doesn't it count, ep?
4:01:52 PM ohhoneyitstess: just out of curiosity
4:02:00 PM ohhoneyitstess: does it have to be a fund manager?
4:02:05 PM ohhoneyitstess: cause they take no prisoners?
4:02:10 PM equityprivate: because she didn't do anything but walk by his office once (since she's only been there once)
4:02:31 PM equityprivate: well at the very least he cant be from the same office.
4:02:50 PM equityprivate: its not some kind of HR thing, its just keeping the crush pure.
4:03:10 PM muffiehbs05: Well how am I supposed to compete then?
4:03:40 PM equityprivate: muffie, we weren't talking about guys you slept with, it was crushes.  you don't have to bang everyone you have a crush on.
4:03:49 PM muffiehbs05: Wait, I don't understand...
4:03:53 PM equityprivate: nevermind
4:04:14 PM ohhoneyitstess: sorry, dozed off there for a sec
4:04:17 PM ohhoneyitstess: but wait
4:04:18 PM ohhoneyitstess: muff
4:04:21 PM ohhoneyitstess: re: how can i compete
4:04:27 PM ohhoneyitstess: showing up to the office would be a start
4:04:36 PM ohhoneyitstess: it's all smooth sailing/spanking from there
4:04:49 PM equityprivate: you working or something tess?  I notice most of the articles are from you nowadays.
4:05:00 PM muffiehbs05: Ok, just shut up.
4:05:35 PM ohhoneyitstess: ep, tell us who the latest hf crushes are
4:05:57 PM equityprivate: well, I kind of have a thing for Bob Chapman.chapman
4:06:06 PM equityprivate: he reminds me of the alien bounty hunter guy on x-files.
4:06:30 PM ohhoneyitstess: i don't know him
4:06:39 PM ohhoneyitstess: hey, if you like ichan, what about james simons?
4:06:43 PM ohhoneyitstess: he's a dinosaur
4:06:52 PM equityprivate: that sort of deep, penetrating look that says, "just try to avoid completing a stock buyback program."
4:07:46 PM equityprivate: well, he's not really an activist, tessy.
4:08:10 PM muffiehbs05: That guy looks like Camilla Soprano's father.
4:08:12 PM ohhoneyitstess: bob chapman does?
4:08:22 PM muffiehbs05: No, no no.  Simons does.
4:08:26 PM equityprivate: you know Simons muffie?
4:08:38 PM muffiehbs05: Sure, I was at a party somewhere and he broke it up.
4:09:01 PM equityprivate: I don't want to know.  really.

Activism is Hot

dangerous fool? Long-time Going Private readers will express little surprise when confronted with hints that I dislike Andrew Ross Sorkin's style.  (Or that I just plain dislike Andrew Ross Sorkin).  My disdain tends to be connected to the phrase "a little knowledge is a dangerous thing," and, unfortunately, that tends to be magnified by the fact that Sorkin has the resources of the New York Times at his disposal to spread his pet theories.  Like all good practitioners of the narrative fallacy, Sorkin's explanations sound reasonable at first blush.  They do not, however, stand scrutiny well- but then I don't think the typical New York Times reader regards skeptical inquiry as a virtue.  This would not disturb me so much were most of his spoutings not of the populist variety.

This sort of demagoguery previously prompted me to describe Sorkin as...

...a dangerous fool who is prone to do some serious damage wandering around carrying a Louisville slugger with nails driven through it while wearing a red bandanna fashioned into a blindfold and swinging wildly at dangling financial issues in the middle of a seven year old's birthday party.

So back in August, Sorkin speculated aloud that "...the credit crisis may have just claimed its latest casualty: the so-called activist shareholder."  He went on to spout off that:

"...activism, for the most part, is a one-trick pony. For all of activists’ hemming and hawing about strategic change, their real mission boils down to four things: have the company sold, break the company up or push it to take on debt so it can buy back stock or issue a big dividend."

Let's examine that closely.  Activism is a "one-trick-pony."  What if we were to outline the activist strategy as a "one-trick" approach?

1.  Activist Goal:

1(A).  Sell company
1(B).  Break company up
1(C).  Assume debt to:

1(C)(1).  Mount stock buy-back program
1(C)(2).  Issue dividend

So that's how Sorkin defines "one-trick" I suppose.  Of course, Sorkin has neglected some activist "tricks" in his analysis, including:

1(D).  Acquire company in tender offer, and:

1(D)(1).  Improve operations before:

1(D)(1)(a).  Selling company to private buyer
1(D)(1)(b).  Going public

1(D)(2).  Hold indefinitely for cash flow

1(E).  Agitate for corporate governance improvement and:

1(E)(1).  Sell stake for gain, or
1(E)(2).  Push for sale of improved company, or
1(E)(3).  Mount proxy fight, and:

1(E)(3)(a).  Sell stake for gain
1(E)(3)(b).  Push for sale of improved company

I am, of course, only scratching the surface.  Still, that's a pretty big "one-trick" for a pony to have.  Sorkin continued:

All of those strategies rely on cheap capital, but because of the current credit squeeze, that financing is vanishing. The big buyout firms have already been stopped cold in their tracks. That may mean the activist bravado of yore — and the typically unspoken symbiotic relationship between buyout firms and activist hedge funds — may disappear along with easy credit.

Reading this, I suppose Sorkin couldn't have been much of a Going Private reader, since that "unspoken symbotic realtionship" was the subject of much discussion on my part several months earlier.  Indeed, almost a year before Sorkin's great revelation about the one-dimensional nature of activism, Going Private already had an entire category dedicated to the topic.  I was hardly the first person to cite these kinds of relationships either.

Equally unsurprising, given the shaky ground his assumptions stood on, is the fact that Sorkin was dead wrong.  The only surprise is that DealBook (a.k.a. Sorkin) bothered to cite Sorkin's wrongness.  But Sorkin seems to like citing Sorkin, so perhaps that was actually more predictable than we might have thought.  Funny, I wouldn't have even noticed had it not been for (the always yummy) Abnormal Returns.

We can hardly blame Sorkin, however.  Like many (most?) of his peers in financial journalism, familiarity with the basic tenants of investor strategy is, apparently, not a compelling prerequisite to writing pieces on the investors who employ them.  It is difficult to hold Sorkin to any kind of higher standard.  Really, his awareness that there is such a thing as an "activist investor" probably gives him a B- on the curve of the financial journalism knowledge test.  Being unaware that activists do more than just employ leverage is par for the course when it comes to the universe of anti-capitalist journalists.

Still, one gets a lot of negative points from me for badmouthing activist hotties.

Thursday, January 10, 2008

Deep Debt Impact

deep debt? 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.

The passage from the Financial Times' Raghuram Rajan that follows may well be the most important thing reproduced in these pages in 2008, as brought to my attention (again) by Alea.  To wit:

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.

Monday, January 14, 2008

Wealth and Fame

you have no idea At least in contemporary finance culture (is there such a thing?) the interplay between money and fame is most glaringly apparent in the world of hedge funds.  Be this as it may, some recent incidents have caused me to wonder to myself if this dynamic, like many in contemporary finance culture (if there is such a thing), isn't more complex than it first appears. Incentive fees (and management fees) being what they are, there are strong incentives for hedge funds to grow assets at (nearly) any expense.  There are some noted exceptions to these rules (I can think of an activist or two who have returned rather large sums to investors when they have been unable to, in good faith, place the funds in sufficiently worthy investments) but these are few and far between.  Getting the word out, and pushing the hype is, as with any financial product, part of the fundraising game.

Of course, technically hedge funds aren't supposed to be engaged in "general solicitation."  That is covered by Rule 502(c) which provides in part:

Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

Hedge fund managers who are prone to quoting returns and figures in publications, or chatting too liberally with members of the press are likely to get something of a spanking from the SEC.  We must, after all, protect non-accredited investors from themselves (though I suspect this bit of nanny-statism is preferable to a legislative unwinding transactions between consenting parties because they are judged "unfair" after the fact and in the context of a shift in markets to something other than permabull dynamics).

Fame, then, would seem a shortcut, even a loophole, to such restrictions.  Many managers court such publicity actively.  This is, to the extent this term has any meaning whatsoever, "marketing."

It amuses me then when such managers are described as "secretive," "publicity shy," "reclusive," or "intensely private."  It is hard to take, for instance, Bloomberg very seriously when they "speculate" on the "ever secretive Renaissance."  Apparently, Renaissance wasn't so secretive that its founder the "reclusive" James Simons couldn't be persuaded to give Bloomberg an exclusive interview (or three), pan his life story and sit for an extensive Bloomberg photo shoot.  Of course, Bloomberg tries to maintain the illusion of hard hitting investigative financial journalism with lines sprinkled with breezy comments like "...according to Bloomberg calculations," and "...though Simons dislikes talking about it...."  Ah, yes.  Of course he does.  But not so much that he won't talk about it.  Guess the hard hitting investigative reported had a nice pair.  ("Of what," is the question- but then I think Simons' smile in the picture might be a clue there).

Any number of hedge fund mangers or private equity firms have found themselves in warmer-than-comfortable water with the SEC after a puff-piece appeared on Bloomberg under the "Bloomberg.com: Exclusive" banner.  And Bloomberg, by the way, is particularly guilty of such sins.  This should be enough to land them in Going Private's Maxwell Smart category by itself, but their ethical lapses are not limited to managers cast from the publicity hound mold.

Rare are the managers who are, in fact, "secretive," whatever Bloomberg may try to sell you- but they do exist here and there.  Not that Bloomberg has much regard for such privacy in the rare instance that they encounter it among the rolls of professional managers.

Recently, a good friend of Going Private pointed me to a Bloomberg profile on a number of hedge fund managers, including his boss, the head of a rather successful family of funds which have made him quite wealthy by almost any standards one would care to articulate.  In the course of reading the article I managed effortlessly to determine:

1.  His street address
2.  The price of his house
3.  His daily exercise habits and, thereby, his daily whereabouts
4.  The school his two minor children attend
5.  His performance and management fees for the year
6.  His wife's habits

I could go on, but time forbids me.

Ah well, I thought, another ego-driven hedgie who's publicist managed to score a puff on Bloomberg.  *yawn*  Yeah, except not.

Turns out that the subject of the article had nothing to do with it, refused to comment and asked Bloomberg not to print it.  Forgive me my cynicism, but I wonder if the classic journalistic threat (Want a favorable piece?  Give us access.) wasn't at work here.  If so, and this is just my speculation, it borders on criminal in my opinion.

Suffice it to say, if I was running an international kidnapping cartel, my arrival in New York would be followed immediately by a visit to the most anonymous internet cafe I could find (or some wireless wardriving perhaps) and several Bloomberg searches.  (Law and Order had a totally cool episode about a hedge fund manager kidnapped by his employees recently, so you just know that I'm current).

Still, some hedgies, and other professional "money runners," do get some use out of publicity.  For some, this is merely an ego gratification.  (You people know who you are).  Indeed, publicity hounds in this category are, at least in my view, violating at least the spirit of Rule 502(c), and the hedgies I respect avoid rather than court publicity.  Still, it can be useful in some circumstances.  For instance:

Your investment vehicle is going public.  I don't know that anyone would make the argument that Steve Schwartzman's stock suffered when the over-the-topness of his birthday parts became (and by this I mean, was encouraged to become) public.  Sure, Congress might be pissed off, but a few dollars in share price buys a metric ass-ton of lobbyists.

You are an activist.  Before you ever get to the point where you are soliciting shareholders for your proxy fight, the pure intimidation factor your name lends to the initial discussion with management can keep campaigns simple, quick and effective because you are a "credible threat," (Dan Loeb filed a 13D?  Go to threat level RED: severe risk of activist campaign!)  This helps even more if management decides to fight and you need to go to street for support.  So here, well, I'm more sympathetic.

As for the rest?  Really, let your performance do the talking.  Or my hedge fund friend would say:

"Just because you have $10.00 and everyone knows about it doesn't make it $11.00."

But then, he gets mad when investors leak their (outstanding) performance figures to the press- so he's a rare bird.  Think, dear hedgies, about the company you keep:

In America, I find, it's fame, rather than money.  Now, after all this unpleasantness, I always get the best table.

- Klaus von Bulow

Wednesday, January 23, 2008

Adventures in Diligence

oh yeah!

When Barbara introduces me to the team she includes the phrase: "She is on our side.  She is one of the good guys- er, girls.  I want you gals to treat her as family and give her whatever she needs."  Don't get me wrong, I'm not fooled by these kinds of public pronouncements, because you never know what was said before them (when you were not in the room) or what will be said after them in your absence or one-on-one with the individuals now standing around smiling at you.  I am standing in the offices of "Challenge, Inc.," a $300 million dollar company, doing due diligence on-site.

Sub Rosa lives in small and mid-sized buyouts, and so occasionally we come across these firms that just don't have a strong grasp of the acquisition process, the right way to run it or, for instance, that you really don't want potential buyers roaming the halls of your facility just because it seems like the "right thing to do, giving open access so you can really see what our family here is like."  Dear readers, allow me for a moment to just offer you a little piece of advice if ever you want to sell your business or know anyone who does:

Don't ever, ever, do that.

So I was introduced to the team putting together records for us to review.  Normally, there would be a sell-side banker organizing all this, a data room set up in some lawyer's office somewhere (or, indeed, online) and quiet whisperings in conference rooms late at night in order to avoid tipping off the employees that the place might be for sale and they might all be out of a job.  Not so with Project Challenge.

Instead, a "small" team of upper-middle management was let in on the "secret," and asked to help Sub Rosa "learn the business."  I suspect senior management felt this would increase the valuation of Challenge, once we saw what a wonderful place it was.  It helped that it was a no-auction deal.  There was only one group of us to show around, after all.  Of course, what a management team like this fails to realize is that potential buyers haven't been drinking the Kool-Aid for years.

I suppose I should feel guilty for taking advantage of the situation, but that's sort of my job, isn't it?  Armin actually had Laura the Debt Bitch at Challenge's office for awhile until someone, totally unaware that a diligence team was roaming the halls, asked "Who's that girl who says 'fuck' all the time, is she a new employee?"

I asked Armin what, exactly, I was supposed to be looking for.  He looked at me like I was wearing a tie.  "Whatever you can."  And so, I wandered around.  Listening.  Smiling.  Hanging around the little kitchen and taking note of the gossip.

Barbara had been so kind (and stupid) as to provide me a cover story.  I would, it seemed, be joining the firm soon, and giving me a big Challenge welcome would be the best way to show me how wonderful things here were.  Astute Going Private readers will by this point have guessed that Challenge, Inc. was in California.

At some point in my wanderings- and really, let me pause to say that the Challenge people, particularly the girls, were really very nice, I was invited to something like 4 dinner parties and twice to after-work drinks after only 48 hours- I heard hushed tones emerging from a little set of three connected offices.  Having long ago in my youth learned to listen very carefully when anything was spoken in hushed tones (that's where you hear the interesting bits) I keened my ears and caught as much as I could of the conversation.

"But it isn't, like, a few of the files, it is, like, almost all of the files," this from what I could only assume would be a ditsy, 20something blond once I walked around the corner.

"Well, it could be a clerical error," this from what I guessed had to be her less excitable brunette friend.

"You don't understand, it is like it was a clerical error if one of the agreements was signed.  That's how many aren't signed," I couldn't hover around much longer without obviously eavesdropping, so instead I just walked right in to the offices, like I had just turned the corner in a hurry, and then stopped short suddenly and threw a mask of confusion on my face.

"Oh.  This isn't...."  Here I trailed off as if to name the name of someone's office I was looking for.  Since I didn't really know a name of anyone on that particular floor I hoped the girls now looking at me- mouths agape like they had just been caught in a state of near undress with their boyfriends on their parent's couch- would just fill something in for me.

"Uh, hi," said the nervous blond.  (I was right).

"Hello," said a much more composed blond.  (I was wrong).  "Oh," a look of recognition pulls down over the composed blond's expression.  "You are the new girl Barbara introduced."

"Yes!" I beamed.  "I am!"  This worked like a charm.  The nervous blond fell right into formation, as if she had just found a herd of familiar grazing animals and now she would be less vulnerable to predators roaming the great, gray commercial pile carpeted expanse of the office.  Safety in numbers, you know.  I could almost hear the inner monologue over the B-flat hum of the fluorescent lights:

"Oh, one of us, ok, I guess that's alright then.  Phew!  Ok, where's the watering hole?"

"What are you guys doing?"  I asked innocently.

"Well..." And again, I could almost hear the inner monologue:

"It is supposed to be a secret, but, like, Barbara, like, introduced her and everything."

"...we are supposed to put together all the employment files and pull the actual employment agreement and the NDA everyone signed so it can be copied for someone, you know?"  Yes, actually I did know.  That someone it was being copied for was Sub Rosa.  "But there's this, like, problem."

"What kind of problem," I asked.

"Well, Donna and Ted, you know," and, interestingly, I actually did know this too, since "Donna" and "Ted "are the founders, "they kind of didn't ever sign any of them."

A long pause.

Here it suddenly became a challenge to maintain my composure against the many competing urges that ran riot in my head.  At once I had to bite my tongue to avoid laughing, spitting up and adopting a sly, sardonic smile.  Nervous blond handed me the folder in her hand, opened to the employment agreement and pointed to the signature line.  More composed blond looked like she thought this was a bad idea, sharing with me, but her concern never rose to the level where it could override her desire not to have a spat with nervous blond about it right there in front of me.  Sure enough, right at the bottom, a signature line with both names neatly typed, Donna and Ted- and why the founders would be personally signing employment agreements (outside of some hokey family corporate values crap) was beyond me- with two glaringly empty lines above them.  Why two signatures would be required was also beyond me.

"Wow, how many did they forget to sign?"

"Like, uh, all of them," the nervous blond blurted out.

"No, not all of them," now her timid friend managed to correct her, and the reason why she hadn't before came into a very sharp focus.

"Ok, like, look," nervous blond puffed herself up, her voice growing, not so much louder, as more shrill and something like rapid-fire. "Something like three quarters of them are unsigned and anyhow it doesn't matter because there are a lot that are unsigned so really the exact percentage doesn't make a difference."  An uneasy silence followed this.  Apparently it bothered nervous blond more than anyone else, since she, herself, was the one to break it.  "The employee NDAs aren't signed either."

This was probably not good.  Just off the top of my head I wondered how Challenge would even begin to correct this.  Was a counter-signature required to make the agreement effective in California?  If not, certainly an employee's attorney could make quite a stink about the matter.

"Well, they are just going to have to come in here and sign them all."  Never fear, Challenge, Inc., nervous blond has the matter completely under control.  But this made me think.  There was also a date line under both signature lines.  How would they date the new signature?  With today's date?  With the date the employee had signed?  Well, the later seemed to me quite a bit like forgery.  The former seemed to suggest that employees hadn't been bound for a long period of time either by non-compete clauses, non-disclosure clauses or, indeed, any other provision these contracts purported to cover.  And had employees been given copies of their executed agreements?  I found it hard to imagine that not a single one of these hundreds of employees hadn't asked for a copy of their signed employment agreement.  So if all these were then signed with today's date, or even the date of the employee's signature, you'd have documents that either didn't agree on what looked like a fundamental term, or that looked like they might be forgeries.  And what if they did sign them, but never disclose the gap to Sub Rosa.  I wondered if these sorts of liabilities were substantial (I had to guess they might be) and if they were and Challenge didn't disclose, would they rise to the level of securities fraud if Sub Rosa bought the company?

"We need to get Thomas down here and ask him what to do."

"Yeah," and, you know, it occurs to me that it doesn't really matter which blond said what anymore.  Thomas, I guessed, was probably the head of Human Resources.  "This ought to be good," I thought to myself.  I was right.

Friday, January 25, 2008

Adventures in Diligence II: The Paper Cut

the floating fat man Thomas reminds me of a certain long-winded CEO from a deal long since past who I used to call "The Dirigible."  This owing to the way he floated around, his massive inertia rendering him unable to operate without dozens of men hanging from ropes guiding him in and out of his hangar, at the mercy of the prevailing winds, filled with hot air, or at least some lighter than air gas, the fact that he occupied an unduly amount of space, was prone to sudden, fiery explosions and was highly annoying to the other, faster air traffic trying to navigate in the airspace in order to actually get somewhere.

True, it also just tickles me to picture a certain movie scene with Ken McMillan ("Bring in that floating fat man, the Baron.") when I remember the inflated CEO, but really my analogy lends a bit too much importance to Thomas' description.  News announcers would ignore, I think, his spontaneous combustion.  Or, at least, none of them would be compelled to cry, "Oh, the humanity!"  Come to think of it, they would have ignored the CEO's spontaneous combustion too, well, aside, perhaps, from firing up "Bang the Drum All Day," by Todd Rundgren on the PA speakers throughout the office.

Thomas turns out not, in fact, to be the head of Human Resources.  He is the Chief Operating Officer and CFO.  I take this to mean that he manages the company's employment issues and payroll.  The Debt Bitch later explains it to me when I tell her his title:  "Yeah, he's the head of Human Resources."

The Blond calls Thomas and starts to explain the situation.  She gets about as far as, "...and so, like, we found that none of them," and here she is interrupted in the background by The Other Blond ("Not none of them!") before correcting herself with "...practically none of them are, like, signed.  And so we have been trying to..."  At this point even I, standing halfway across the room, can hear the "Fuck!" and the click of Thomas hanging up on The Blond.  Somehow, though, she keeps talking.  And keeps talking.  And keeps talking.  In fact, from the initial click to the point where I can hear approaching the loud, heavy footfalls of what must be a very corpulent man in shoes with bad heels, is about 18 seconds.  They grow in intensity, like a scene out of a bad horror film, until, finally, right as The Blond is starting in with "Hello?  Hello?  Are you there?" around the corner rounds Thomas "Many of our clients find pants confining so we offer a range of alternatives for the ample gentleman" Falder, CFO and COO of Challenge, Inc.  All 380 pounds of him.

And then, the moment that will always remain with me, The Blond starts in with inane chatter and Thomas, with surprising agility for a man of his gravity well, presents her with an open palm in the best, "talk to the hand because the face ain't listening" execution I have ever seen performed live.  He doesn't even add a vocalization.  It occurs to me, just then, that Thomas' mastery of The Blonds could be a clue that it is not just his mass that is substantive.  They sit up and shut right up.

As if he weren't already an imposing figure, the floating fat man then produces a green laser pointer and wordlessly directs it at the file in The Blond's hand.  In stark contrast to the frantic and nervous tenor of her previous drivel, she now recites things in a methodical, fact-based litany that any auditor would appreciate.  "Well, Mr. Falder," no "Thomas" anymore apparently, "there are 600 employee files with employee contracts in each folder.  There are non-disclosure agreements separate on all of the files before last year, when we re-wrote non-disclosures into the employment agreement itself.  At least 530 of these and the employment agreements have never been countersigned by the company."  The word "like" is never uttered.

I blink.

I blink again.

The dirigible is a fucking hypnotist.  Or maybe more accurately, a dog trainer.  I have to get a green laser pointer.  I just have to.  He is silent for a moment, the laser temporarily extinguished.  He turns, scratches his chin, furrows his brow and then turns back.  The laser pointer shifts to the file cabinets.  The Blond jumps to respond.  "All the files are here, Mr. Falder.  These are the only copies."  How the hell did she know the question?

Finally, he speaks.  "Besides the people in this room, who knows about this?"

Now, dear readers, whenever you hear this phrase, be exceptionally careful.  Do not, under any circumstances, make the mistake I proceed immediately, by sheer force of habit, to commit.  "Just the people in this room," I reply.

Falder turns to look at me, someone he never noticed in the room before now.  I realize my mistake.  I failed to use either the hypnotized monotone, or the frantic "Blond Panic" (tm) voice.  The "Blond Panic" voice would also have been a mistake, but Falder would probably have just pointed the green laser pointer at my mouth and I would have fallen into a trance-like silence and he would have, after furrowing his brow and looking curiously at his laser pointer- had the batteries weakened?- been comforted enough to forget the incident.  From the look on his face it is deadly obvious that I am no Blond (literally or figuratively).  He has detected something like intelligence in me, and that this is both unexpected, and threatening.

I am suddenly in the glare of the Gorgon.

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