Category Archives: hedge funds

why do so many insider trading investigations involve hedge funds?

March 7, 2012 By in hedge funds, Industry Analysis, Investment firms, Trading Tags: , , , , , Leave a comment

where the money is

The diminutive Depression-era bank robber, Willie Sutton, was reportedly once asked why he chose banks to hold up.  His alleged reply:  “because that’s where the money is.”

Whether Mr. Sutton actually said that or not, the answer contains the essence of this post.  Hedge funds have more money to spend.  Until recently, they’ve been very far from the focus of regulatory and client attention to how investors spend client money;  even now, it seems to me they’re subject to far fewer restrictions on their trading activity than traditional long-only investors.

Finally–and this may just be my personal axe to grind–many hedge funds are the creations of professional traders, not researchers.  To me, this means they don’t have the experience or mindset to develop useful research conclusions by themselves.  Yet their own marketing claims put them under great pressure to produce superior results.  And they don’t have the compliance awareness that’s repeatedly pounded into every US-trained analyst’s head to make it clear what’s legally permissible and what isn’t.

Details:

“soft dollars”

Clients compensate money managers in two ways.  One is clear–they pay management fees.  The second is less obvious–they give their managers the power and influence with brokers that comes from controlling large trading commissions.  In my last job, for instance, in round numbers the firm spent $100 million a year in trading fees.

Managers who manage pension plans (subject to ERISA regulations) or or vehicles like mutual funds catering to ordinary individuals (subject to SEC oversight) have a fiduciary obligation to minimize the commissions and fees they pay for trading.

One exception:  they can pay extra-high amounts as compensation for research services brokers provide.  These services can come from the brokerage house itself.  Or, like Bloomberg terminals or copies of the Wall Street Journal, they can be paid for by the broker but provided to clients.  The commissions (or bid-asked spreads for OTC stocks) that pay for research services are called “research commissions” or “soft dollar” commissions.

clients’ money

The key benefit to the money manager is, of course, that the “extra” amount involved in a research commission comes out of the client’s pocket.  One might argue that the manager should pay for his own Bloomberg.  But that’s not industry practice.

Research commissions are a potential area (and, in the past, an actual area) of abuse.  So they are under increasing scrutiny.  A common rule when I was managing institutional and mutual fund money was that the percentage of research commissions for the overall asset management effort should be no higher than the average of all major money managers.  Five years ago, that was about 15%.

Trading frequency is also monitored carefully.  Managers who have above-average turnover rates risk losing their customers–and their jobs.

restrictions on use by traditional money managers…

Anyway, today’s traditional money managers have severe restrictions on the way they can use commissions to buy information.

…but not for hedge funds

On the other hand, to the degree that hedge funds manage money for wealthy individuals or non-pension institutions, they’re subject to neither asset turnover nor research commission limitations.

Hedge funds are Fort Knox to the traditional money managers’ kids’ piggy banks.

management fees

Yes, the famous ” two and twenty,” that is, a management fee of 2% of the assets per year + 20% of any investment gains, that hedge funds charge may well be fading out.  Nowadays, some may “only” collect 1.5% and 15%.  Compare that with the long-only manager charging, say, .75% of the assets annually with no profit participation.  I’m not saying we should feel sorry for traditional money managers.  But the comparison is Fort Knox vs. maybe a small-town savings and loan.

Two implications:  there’s much more at stake for hedge funds if they generate outsized returns, and here’s much more money potentially sloshing around inside the partnerships and in the partners’ pockets.

separation of research and trading

In the US, there’s a strict separation between the research and planning a portfolio manager does, and the execution of that plan through the trading room.

Typically, the PM designates the brokers he wants to receive research commissions over, say, a three-month period of time. He submits his trading orders to the trading room.  But he cannot direct a given order to a specific broker.

The idea is to prevent the PM from directing business to his friends or from taking a bribe to buy some dud stock a broker is trying to unload from his inventory.  This isn’t a cure-all.  The rules don’t end wrongdoing.  They shift the locus of possible wrongdoing to the traders, where there’s arguably less room for monkey business.  But, for good or ill, that’s the way the system works in the US.

In contrast, hedge funds haven’t typically had these safeguards.  In fact, it may well be that the chief PM is also the head trader–or sits on the trading desk right next to the head trader.  So there’s the opportunity for all sorts of under-the-table activity that would be impossible in a traditional money management firm.

PM as researcher

Scratch a successful equity portfolio manager in the US and you’ll uncover an exceptionally good securities analyst, who may have spent a decade or more polishing his craft.

In my view, the last thing a good analyst wants is inside information.  If you’re in a meeting where a company executive accidentally blurts out some piece of confidential information that you’ve already figured out for yourself, you’re stuck.  The information is suddenly transformed from the product of your creative mind to a company secret revealed.  It’s now forbidden fruit; you trade on it at your regulatory peril.

Though some hedge funds are headed by experienced analysts, others are run by professional traders or marketers.  The latter have their own strengths, but in my experience they don’t have the nerdy turn of mind a true analyst needs.  Yet they’re under tremendous pressure to come up with novel ideas to justify their high fees.  I’d imagine that this creates a big temptation to either accept–or even solicit–inside information.

compliance

Over the past twenty years or so, traditional money managers have all built sophisticated departments to supervise regulatory compliance.  Compliance rules visible every day.  Periodic training sessions are mandatory.  In my experience, emphasis is on avoiding any action that could possibly be (mis)interpreted as being intended to violate the laws.  Better safe than the subject of an SEC inquiry.

Pluck a couple of proprietary traders or a sell-side analyst out of their brokerage firms and set them up as hedge funds, and there isn’t the same awareness.  They may not know what the laws are.  They may not even see the necessity of setting up safeguards.  So the whole corporate culture may evolve into one where principals are encouraged to push the legal envelope in seeking proprietary information from third-parties about potential investments, rather than to safeguard the firm against the negative consequences of using inside information.

dealing with hedge funds: institutional salespeople and industry analysts

March 5, 2012 By in hedge funds, Industry Analysis, institutional salesperson, Investment firms Tags: , , , , Leave a comment

a new SEC move

A little less than two weeks ago, the media heralded the opening of another in a long line of investigations by the SEC of insider trading involving hedge funds.  This time, those reportedly targeted include an institutional salesman from Goldman Sachs and the former head of GS’s research in Taiwan, as well as hedge funds who allegedly traded on inside information passed by the GS pair.

what do these people do for a living?

The press reports made me start to think that I should write on three associated topics:

–what does an institutional salesman do?

–what does a sell-side securities analyst do?

–why the focus on hedge funds?

three posts, starting today

I’ll answer these questions–from my perspective as a former client, never myself having been a hedge fund principal, an institutional salesperson or a sell-side analyst–over the next three days.

Before I start, though, I should say that the brokerage landscape has been changing, with increasing speed, over the past decade, and to the detriment of many institutional salesmen and industry analysts.

Two reasons:

–pension fund clients and mutual fund boards of directors are paying increasing attention to the amounts paid by traditional long-only investment managers to brokers.  This is only natural, since this money comes out of the pockets of the clients, not the managers (more about research commissions in Wednesday’s post), and

–increasingly, successful traders (think: Jon Corzine) have become the heads of major brokerage firms.  They’ve been reshaping the firms in their own image, and shifting emphasis away from areas like research and institutional sales.

what does an institutional salesperson do?

An institutional salesperson is a marketer.   He’s is in charge of the overall relationship between the broker and a specific set of money manager clients.  The job is to ensure that the broker makes a profit on each client relationship.

The institutional salesperson is a gatekeeper, in two senses:

–he regulates access to brokerage services, depending on the level of client payments.  “Access” includes things like: phone calls or private visits from industry analysts; private meetings with companies on road shows hosted by the broker; one-on-one company meetings at broker-hosted industry conferences; favorable allocations of initial public offerings (the salesman is only one of several parties in this discussion, though).

–he also regulates the timing of access.  Does a requested analyst drop everything he’s doing and rush to the client’s offices?  …or does he make a phone call the following day?  Is a company meeting for an hour at 10:00am?  …or twenty minutes at 5:30pm?  …or a conference call, instead of face to face?  …or a canned presentation at a group lunch?  If the salesman makes personal calls to relay information from the broker’s morning meeting (in addition to internet dissemination) about companies he knows the client is interested in, who is the first call and who is the tenth?

relationship:  commercial to emotional…

As is the case with any effort to sell recurring services, part of the job is to try to turn a commercial relationship with the client into a personal one.  To that end, institutional salespeople study and cultivate their clients very carefully.

In my experience, salespeople know much more about the client and what makes him tick than he would ever dream.  If the client likes to be taken to lunch or to sporting events, fine.  If the client likes to gossip about rivals, okay.  If he likes flattery, so be it.  If the client responds better to salespeople who are tall/short, young/old, male/female, slim/portly, sports nut/nerd–even if the client is unaware he does so–assignments will be altered to suit. (I’ve even seen one brokerage house–long since merged away–that wanted to establish a certain image.  It had only salespeople who were young, slim, good-looking and very tall.)

…or maybe not

An intelligent salesperson (and that’s just about every one I’ve come into contact with) also makes judgments about the client’s overall business.  Is it on the rise, or has a former hot hand turned permanently cold?  Adjustments are made, accordingly.  One of my friends used to classify clients explicitly in terms of the BCS matrix.  I never asked where I stood.

information collection

The salesperson also has an information gathering function.  Particularly in the US, money managers take pains to separate research decisions made by portfolio managers and their implementation through the trading desk.  One reason is to disguise their investment strategy from their trading partners (another is to guard against bribery).  However, experienced institutional salespeople can often ferret out information by reading between the lines in their conversations with clients–data which is immediately relayed to the broker’s trading desk.  Salespeople also usually know their clients’ analytic strengths and weaknesses very well.  If they believe a key client is buying a stock in an area where he’s an expert, the salesperson may give other clients an extra nudge–after alerting the trading desk, of course.

In a good year, an experienced institutional salesperson in the US can make millions of dollars.  And a strong working relationship with a client who becomes a super-star manager can make an institutional salesperson’s career.  On the other hand, high compensation also makes someone like this an obvious target for downsizing during a period of brokerage retrenchment like the one we’ve been going through over the past few years.

Back to the media reports on the SEC investigation:  can an institutional salesperson develop inside information on his own?  Maybe, but that would be very unusual, in my view.  I think a more likely accusation would be that a salesman either traded on inside information himself or passed it on to a client who did.

Tomorrow:  the sell-side securities analyst.

 

 

layoffs on Wall Street: where do people go?

February 20, 2012 By in economics, employment, hedge funds, Industry Analysis, Investment firms Tags: , , , , , 1 Comment

The weekend Financial Times has an interesting article about the decline in financial markets employment during the Great Recession.  It says that the industry lost over 200,000 workers, of whom more than 40,000 were relatively highly paid professionals.  The article relates a number of stories of transition to other kinds of work.

That’s basically what happens in investment-related businesses during downturns–people find other, unrelated industries to work in.

Looking at the situation a little more systematically,

finance has two main branches–three if you count the often bizarre area of financial “theory” that prospective finance teachers must master.

–commercial finance, commercial banking and corporate finance.  It deals with areas like lending, capital structure, budgeting, financial management controls, investing/raising cash for corporations, communicating with investors and regulators.  It’s generally insulated from the violent ups and downs of securities markets.

–investments, which deals with the structure and practices of securities markets.  People who focus on this branch of finance are generally much higher paid and much more highly specialized.

While it’s common for a commercial finance professional to move among different areas during a career, however, there’s virtually no carryover in skills, other than at the most basic level, from the investment specialty to the broader world of commercial finance.  In fact, other than early in one’s career, there’s very little movement possible among various areas–like stocks, bonds, trading, investment banking–within investments.  Career paths are that highly specialized.

This is a recipe for big career trouble for investment people if your sub-specialty suddenly has too many workers.

buy side vs sell side; professional investors vs. investment professionals

The industry commonly splits jobs into buy-side (investment management) and sell side (investment banking and brokerage).  There’s also typically very little movement between these two.  You can also distinguish between professional investors (the people who actually make investment decisions) and investment professionals (trading, sales/marketing and recordkeeping functions that provide services to portfolio managers).

professional investor issues.  The main industry problem over the past several years has been the decline in the value of assets under management.  This is the key problem for profits, since professional investors typically charge a percentage of assets under management as a fee.  Investment firms are also highly operationally leveraged–meaning they have roughly the same costs, no matter what the level of assets is–so the loss of assets under management results in a disproportionately large fall in operating income before compensation of portfolio managers.

The moves to index products and from equity to fixed income, both of which generate lower fees, haven’t helped, either.

What do investment management firms do?  They prune the least profitable products, eliminate staff and lower the level of compensation for almost everyone who survives.  There isn’t much else they can do.  Laid-off money managers either go into business for themselves (massive layoffs of value-oriented PMs in the late 1990s formed the basis for much of today’s hedge fund industry) or find smaller, often regional or local, firms to work at.

investment professional issues.  On the buy side, firms trim their trading and marketing staffs and lower compensation for those who remain.  The investment industry is mature, however, meaning there are few new customers.  So firms gain business mostly by taking it away from other firms.  So marketing is a vital function–more important than the investment management itself.

On the sell side, it’s important to distinguish between high-value employees, who are masters of their trading or investment banking trades, and low-value workers, whose main function is to act in a sense as “overflow” capacity.  That is, they answer the phone and process orders, or visit clients and make presentations, during cyclical peaks in business.  They may not add much value, but the firm avoids losing potential profits by being unable to respond, even badly, customers’ requests.

Such second-tier workers are paid a lot, both in absolute terms and relative to the value they add.  But when business slows down, they’re the first to be laid off.

First-tier investment professionals typically earn (much) less in lean times.  They also risk being laid off, as well.  Like their portfolio manager counterparts, they may end up at regional or local firms.  Boom times give second-tier workers an inflated sense of their own abilities.  Typically, though, they’re unable to remain employed in the investment industry during downturns and eventually end up working in other professions.

where are we now?

My sense is that the investment industry is at a cyclical bottom for employment.  But the industry still has enormous idle capacity available with the staff it now has.  We won’t see the boom times of 2004-2007 again soon.

why do pension plans choose hedge fund and private equity managers?

January 27, 2012 By in Getting financial advice, hedge funds, Private equity Tags: , , , , , , Leave a comment

private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?

correlation

The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

what is a carried interest?

January 20, 2012 By in carried interest, hedge funds, Investment firms, Securities regulation Tags: , , , , , , , , Leave a comment

Mitt Romney’s taxes

Mitt Romney’s partial disclosure of his tax situation has reopened debate on the issue of how private equity managers and some hedge funds use carried interest as a device to shelter their earnings from tax.

Since Mr. Romney left the private equity business a decade ago, it seems to me that he isn’t currently using carried interest as a tax shelter.  In all likelihood, it’s some combination of itemized deductions, like charitable contributions or state and local taxes paid, and the favorable treatment of long-term gains on investments that’s producing his low tax rate.  But he was a prominent figure in the private equity community, so the press–and his political opponents–have made the connection anyway.

Powerful lobbying efforts by the private equity industry have defeated repeated attempts to close the tax loophole it uses to lower its executives’ tax burden.

I wrote about this topic in mid-2010.  But I haven’t read anything, wither in the current discussion or in the past, that explains exactly what a carried interest is.  Hence this post.

carried interest

A carried interest is a participation in an investment venture where the holder gets a share of the cash generated by the project (profits or cash flow) without having to contribute anything to the venture’s costs.  The holder of such an interest is “carried” in the sense that the other venture participants pick up the burden of his share of project expenses.

Carried interests aren’t just a private equity phenomenon.  They’re very common in the mining industry, which is where I first encountered them thirty years ago.  But they also occur in lots of other industries, particularly those where highly specialized experience or skills, or possession of crucial physical resources are key to a project’s success.  In the extractive industries, holders of mineral rights may be carried.  The fund raisers or organizers of any sort of projects may be carried, as well.  So, too, famous actors or holders of key intellectual property.

variations on the theme

As with everything in practical economic life, there are myriad variations on this basic idea.  For example,

–a party may not be carried for the entire life of the project, but only up to a certain point–say, when cash flow turns positive.

–the other parties may be entitled to recover the “extra” costs they’ve paid to subsidize the carried interest before the carried interest receives a dime (there are also lots of variations on the cost recovery theme), or

–the carried interest may only be paid if the project exceeds specified return criteria.

In plain-vanilla projects, the carried interest receives a portion of the recurring revenue that the venture generates.  This is ordinary income and taxed as such.  The private equity case is different.

private equity and carried interest

Private equity raises equity money from institutions or wealthy individuals, arranges financing of, say, 3x -5x that amount, and uses the assembled war chest to make acquisitions.  It targets mostly badly run companies.  It spruces them up and resells them a few years later.  There’s no conclusive evidence that this process adds any economic value, although it certainly sets the process of “creative destruction” in motion in the affected company–but that’s another issue.

Private equity companies appear to me to act as a blend of business consultants and managers of a highly concentrated (and extremely highly leveraged) equity portfolio.  What’s really unique about them is their pay structure.

Private equity charges its clients a recurring management fee of, say, 2% of the assets under management plus a large performance bonus if the turnaround projects they select are successful.  This bonus is structured as a carried interest (an equity holding) in each individual project.  Because the projects last several years and result in an equity sale, the bonus payments are capital gains, not ordinary income.  This means the private equity executives’ tax bill is much less than half what it would be if the payments were income.

my thoughts

You’ve got to admit that turning investment management income into capital gains is a clever trick.  Should the loophole be closed?  When I first wrote about this I thought so.  I still do.  But I’d prefer to see more comprehensive tax reform that achieves this result rather than specific legislation that targets the private equity industry.  I also find it somewhat disturbing that private equity political contributions and lobbying allow them to “own” this issue in Congress, despite the fact that private equity’s taxation is clearly different from other investment managers’, from management consultants’ and from corporate executives’ for basically the same activities.