Category Archives: hedge funds

the SEC is looking at hedge fund performance claims

December 27, 2011 By in hedge funds, Industry Analysis, Investment firms, Private equity Tags: , , , , , , Leave a comment

the new approach

Today’s Wall Street Journal tells about current SEC efforts to scan the hedge fund universe in search of  potential civil fraud.  The idea is to use computer analysis to identify hedge funds whose results are too good to be true–where the operators rarely, if ever, have a down month, or where aggregate results are sensationally good.  This new direction apparently comes as a result of the agency’s failure to detect the gigantic Ponzi scheme that Bernie Madoff ran for many years–despite being supplied continuous evidence of the fraud by investigator Harry Markopolos.

Markopolos, a financial analyst, was asked by his employers to “reverse engineer” Madoff’s returns and create a duplicate it could market to clients.  A quick look at the numbers was enough for Markopolos to suspect fraud.  It took him less than a day to develop conclusive proof, which he then tried in vain to present to the SEC for close to a decade.

The new SEC interest in hedge funds appears to mimic the Markopolos methods.  The agency is also extending its scrutiny to mutual funds and private equity.

it’s about time

For years, academic studies have concluded that the returns hedge funds report to the public are at best implausible, and most likely false.

My favorite is one led by NYU professor Stephen Brown.  He analyzed investigations done by a hedge fund due diligence firm, HedgeFundDueDiligence.com,  which was hired by potential institutional customers to check out new managers.  It turns out that about a fifth of the hedge funds misled HFDD.com, despite the fact they knew their assertions would be checked.  It also turns out that customers generally hired the dishonest hedge fund managers, despite the due diligence warnings.  Go figure.

The biggest reasons for falsifying returns, in my view, is that reporting is voluntary and that the databases which collect the numbers make no attempt to check the figures.

an example

The WSJ article cites the case of the now-defunct ThinkStrategy Capital Management.  TSCM reported a return of +4.6% for 2008 in its Capital Fund-A, a year in which the fund actually lost 90%.  Chetan Kapur, who ran TSCM, also reportedly inflated his assets under management in reports to shareholders and wrote about non-existent team of analysts supporting him.  Kapur also continued to manufacture and report performance numbers for Capital Fund-A, even after the fund was shut down.

The article says there are lots more where TSCM came from.

I believe it.

 

 

what is a roll-up?

September 27, 2011 By in economics, hedge funds, Private equity Tags: , , , , , , Leave a comment

definition

Roll-up is the name commonly used to describe the process of buying up and merging small participants in a highly fragmented industry.

characteristics

The acquirer is most often a financial buyer, typically a private equity firm, rather than the operating management of a company in the industry in question.

The companies acquired are typically relatively small–and of sub-optimal size, in economic terms.

They are most often privately held, and owned by individuals who don’t have a sophisticated awareness of the value of their firms–either as stand-alone entities or as part of a larger combination.  As a result, purchase prices can be small single-digit multiples of yearly sales.

examples

Industries in the US that have been rolled-up include:  radio stations, auto dealerships, funeral homes, independent radio and TV stations, billboards, taxi walkie-talkie radio systems (i.e., Nextel).

why do this?

The two basic aims of a roll-up are to achieve large size relative to other competitors in the industry, and to grow to economically optimal size in absolute terms.  Doing so allows the roll-up to:

–lower administrative overheads,

–cut capital spending by sharing plant and equipment,

–negotiate lower prices and/or better payment terms with suppliers,

–offer a wider array of services to customers,

–create and market a brand name–with the increase in unit profits that this will bring,

–have units mutually support each others’ sales efforts,

–focus competitive activity at firms outside the roll-up.

profit sources

I’ve already mentioned that:

–the target companies can usually be bought very cheaply, and

–economies of scale and simple improvements in general management can boost profitability a lot.

In addition:

–better access to credit can reduce borrowing costs,

–the target firms can be more highly leveraged financially (= more debt) as part of a larger unit, and

–the rolled-up company will likely be IPOed, allowing the private equity company to cash out at least several times its purchase price.

why an IPO?

Two reasons, other than extra profits  …one good reason, one bad:

–the private equity company is likely funding the roll-up with money from institutions or high net worth individuals.  These investors will expect their capital + profits to be returned after, say, five years.

—firms that carry out roll-ups typically have little hands-on experience running businesses, and not much detailed knowledge of the rolled-up industry.  They’re good at basic general management and at creating a capital structure with a lot of debt in it to boost returns on equity.  I think they realize they’re better off exiting the roll-up before some crucial issue arises that requires industry knowledge to solve.

 

US stocks are moving in unusual lockstep: what’s going on?

September 11, 2011 By in Current Market Thoughts, Derivative instruments, hedge funds, Portfolio management, Recent Market Action, Strategy, Trading Tags: , , , , , , , 2 Comments

strong correlation

Recently, the 250 largest stocks in the S&P 500 have been marching up and down in formation with one another 80% of the time.  This compares with 30% of the time in normal circumstances, according to a Financial Times report of a study by JP Morgan.

That correlation is higher than during last year’s “flash crash,” when a hapless midwestern portfolio manager ordered his trading room to sell massive amounts of stock index futures without regard to price.   It’s also higher than at the market bottoms in 2003 and 2009.  In fact, the lockstep movement of the biggest S&P names is at its highest since Black Monday in October 1987, a time of immense panic as an unprepared investing world witnessed for the first time the power of stock index futures to move equity prices.

What’s going on?

As the 30% number above indicates, most of the time investors in the American stock markets trade to rearrange their holdings as new information about individual companies emerges.  We sell stocks we think are overvalued and reinvest the proceeds in stocks we think are undervalued.  We also respond to changes in the overall economic environment by buying economically sensitive issues and selling defensive ones, or vice versa.  We typically don’t try to time the market by raising cash.

The movements analyzed by JP Morgan are different.  They represent asset allocation shifts into stocks (and away from cash and bonds) or away from them (and into fixed income)–rather than rearranging the “cards” in the hand the portfolio manager is playing.

Two–maybe three–points:

1.  US stock portfolio managers don’t act this way.  Yes, almost everyone is able to sell stock index futures against stock positions earmarked for sale, in order to raise cash more quickly.  But the few people who actually do this are too small to create the effect we’re seeing.

2.  The selling we’re seeing is more characteristic of EU-based managers, who tend to manage balanced portfolios (i.e., portfolios that contain both stocks and bonds) and to use top-down asset allocation techniques to decide what they hold.

In addition, if there’s going to be a recession any time soon it’s going to be in the EU, so EU manager selling would make some sense.  Trading-oriented hedge funds may be taking the other side of the transactions.

3.  More important, this behavior is typically a sign of very strong emotion–mostly fear.  In my experience,  a high level of panic is so psychologically exhausting that it can’t be sustained for a long time.  Also, it typically only occurs at significant turning points in the market.  Normally at least a “relief” rally follows.

I don’t expect a big rally this time, however.  To the degree that the current sellers are reallocating assets they own, rather than speculating on the future course of markets, they’ll eventually run out of stuff to sell (or recover their equilibrium) and their influence on the S&P will gradually fade away.  I think a sideways market, where stock pickers rule, will emerge.

I’m often too early, but I’m starting to see hints in the past few days that this is already starting to happen.

 

 

the LA Dodgers’ bankruptcy: strange stuff

June 30, 2011 By in baseball, hedge funds, Industry Analysis Tags: , , , , , , , , Leave a comment

the occupational disease

The occupational disease of securities analysts is that they analyze everything.  For instance, I have a friend that I worked with over twenty years ago.  One day, she came to me at work and said she’d been counting the steps on the flights of stairs in the subway station near our office and found that each flight was 13 steps.  Wasn’t that a strange number, she said, and what did I make of it.

The notable thing about this exchange is that we both thought of it as perfectly normal.  I was flattered that she had asked me.

the Dodgers

It’s in this same vein of below-the-surface interest that I’m viewing the recent entry of the Los Angeles Dodgers into Chapter 11 bankruptcy.  I don’t see any way for me to make money–other than perhaps bar bets–from finding out what’s going on.   But I can’t help myself.

how a Chapter 11 filing usually works

The company in question has a lot of long-term debt outstanding, which is not being fully serviced.  Trade creditors are not being paid, either.  Trade creditors threaten to start bankruptcy proceedings in court as a way to force long-term creditors to pay them off.  At some point, the long-term creditors get fed up at being nickeled and dimed to death and allow the bankruptcy to occur.

Management stays in place.  Long-term debt holders trade some portion (maybe all) of their debt for 100% of the equity in the firm that emerges from the proceeding.  Equity holders are wiped out; they receive nothing.  Trade creditors may or may not get paid, depending on the circumstances.

the Dodgers’ court case

I’ve glanced through the court papers. They don’t say a lot.

–They indicate that five interlinked companies are filing for bankruptcy together.  The names suggest that the overall ownership structure is complex and involves both corporations and partnerships.

–They also indicate that the Dodgers have a working capital problem and aren’t able to meet the June 30th payroll, either through the club’s cash flow or through borrowing.

–Secured creditors are not listed in the filing, only unsecured ones, like former ballplayers who agreed to deferred compensation (Manny Ramirez, at $20 million, is owed the most).

–The only thing the McCourt camp says about the overall debt situation is that it believes the filers have more than enough assets to satisfy secured creditors; total assets are $500 million-$1 billion; total liabilities are under $500 million.

What else do we know?

1.  According to the Los Angeles Times, Fox Sports has offered the Dodgers $1.6 billion for the right to broadcast Dodgers games for thirteen years after the current contract (also with Fox) expires in 2013.  A reasonable first approximation (read: good guess) is that the present value of the proposed contract is $800 million.  That’s just about the entire asset value of the baseball franchise.

Fox reportedly was willing to advance about half that amount (the numbers being reported vary) to McCourt/Dodgers.  Major League Baseball, whose approval was needed, rejected the deal as not being in the best interests of baseball.  Reportedly, this was because about half the advance would have been paid directly to Mr. McCourt to settle personal debts, leaving the Dodgers in a deeper hole than before.

2.  The Dodgers were unable to get a working capital loan from a bank.  The club was quickly able to line up $150 million in financing from a JP Morgan hedge fund once it was in Chapter 11, however.

The issue here is that in Chapter 11 unsecured creditors go the bottom of the list of entities to be repaid–and therefore may not get back a penny of what they’ve lent.  This suggests to me that the Dodgers had no unencumbered assets to use as collateral for a loan and that potential lenders who saw the club’s financials suspected that a Chapter 11 filing was imminent.

One possible explanation is being offered by Dodger Divorce, a blog written by Josh Fisher, an ESPN correspondent.  In his June 21st post, titled Mechanics, Mr. Fisher says basically that the revenue from parking at the stadium and from non-premium ticket sales go to other parts of the McCourt empire and not to the Dodgers.  Fisher estimates this cash flow to be about $80 million a year.

One other thing:  the interest rate the Dodgers negotiated for the financing is staggeringly high.    The simplified version:  $15 million in interest yearly, plus the Dodgers must pay back $150 million, even though they’ll only get about $143 million.

3.  Bankruptcy–in which equity holders virtually always lose everything–was Mr. McCourt’s best option.  That says something, doesn’t it?

One thing Chapter 11 accomplishes is to freeze litigation between McCourt and his wife over who owns the club.  And it may make that whole question moot, since Chapter 11 may well disenfranchise both.

At the same time, the bankruptcy allows McCourt to reopen the possibility of sale of Dodgers’ broadcasting rights.  It’s hard to imagine that the court would allow any money to be diverted for anyone’s personal use, though.  But who knows.

Stay tuned.  The court proceedings should be very entertaining.

one odd figure catches my eye

The obvious point of comparison is with another woefully managed franchise, the Mets.  In contrast to the Dodgers, the Mets have agreed to turn over the running of the franchise to professional baseball people and are negotiating to sell part of the team to replace what they lost by using Bernie Madoff to manage their money.

If I recall correctly, the Mets baseball team receives $60 million a year for broadcasting rights from SNY, the cable venture that the Wilpons own a share in.  But Fox is apparently offering the Dodgers more than double that for broadcasting rights to Dodgers games.  Hmm.

 

 

“LinkedIn Scammed”–what were you thinking, Joe?

May 24, 2011 By in Current Market Thoughts, hedge funds, Industry Analysis, internet, Investment firms Tags: , , , , , Leave a comment

“Was LinkedIn Scammed?”

A friend who’s a regular reader asked for my comments on the LinkedIn article that reporter Joe Nocera wrote for the op-ed page of the New York Times last Friday. (See my post describing the offering.)

Nocera’s comments about LinkedIn

The article makes two assertions:

–underwriters Merrill Lynch and Morgan Stanley (I don’t know why JP Morgan, listed as a first-rank underwriter on the prospectus, isn’t included)  “scammed” LKND–which is an NYSE stock, by the way, despite the four-letter ticker symbol.  They deliberately priced the IPO too low, he says, in order to shift tens, maybe hundreds, of millions of dollars out of the pockets of LKND and into those of favored clients.

–this damaged LKND, for whom the money left on the table may one day be the difference between success and Chapter 11.

Wow!!  Strong stuff.  What’s the evidence?  I can’t see much.

my thoughts

general

Of course, anything’s possible.  And I think it’s clear that the sell side’s primary loyalty is to its largest brokerage customers, not to one-time investment banking clients.  But the acknowledgement of status involved in dispensing and receiving a large allocation of a “hot” IPO is, to my mind, far more important to the broker-client relationship than whether the price is $45 a share or $65.  For large clients, the money difference is a rounding error in their performance calculations.

In addition, I don’t see why an industry so deeply distrusted by most Americans and under continuing scrutiny from Washington would take the chance of deliberately mispricing an offering–especially when campaigning for the next election has already begun.  Also, why jeopardize your chances of being in the running to manage the really big social networking IPOs, like Facebook or Groupon?

the example of Renren (RENN, also a NYSE stock)

LKND followed close on the heels of RENN, a Chinese social networking stock that came public on May 4th.  RENN was priced at $14.  It opened at $19.50, quickly reached a high of $24 and closed that day at $18.01.  But by the time LKND was being priced, RENN had fallen below its IPO price–the last thing any party to a public offering wants to see.

RENN had to be an argument for more cautious pricing of LNKD.   It suggests, as well, the jury is still out on whether LNKD should have been priced more aggressively than it was.

the LNKD valuation

LKND earned $.17 a share last year.  At the initial suggestion of a $32 offering price, that would have been a PE of 188x.  At $45, the actual IPO price, the multiple is 265x.  Is Mr. Nocera actually saying the stock should have been priced at 350x earnings?

is LNKD hurt financially by an IPO price of $45, instead of, say, $60?

an opportunity loss of $90 million?

In one sense, yes, because at $60 a share, LNKD would have taken in $340 million or so instead of $250 million.  But at $60 the risk of a failed IPO would have been higher.  Remember, too, that LNKD wasn’t exactly a babe in the woods.  It had a list of professional investors who were already shareholders that it could call on for advice.  Goldman was the only one to take the money and run, but still…

Use of Proceeds

There’s a section of any prospectus called “Use of Proceeds.”  When I looked at this section of the LNKD document, I almost started to laugh.  I’ve never seen a company struggle so much to explain what they’re going to do with the money.  Here’s a sample:

“The principal purposes of this offering are to increase our capitalization and financial flexibility, increase our visibility in the marketplace and create a public market for our Class A common stock. As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to us of this offering. However, we currently intend to use the net proceeds to us from this offering primarily for general corporate purposes…”

In other words, LNKD can’t imagine how it will spend the money.  By the way, the company already had over $100 million on the balance sheet on March 31st and had just started to generate enough cash flow to cover all its expenses.

employee stock options gain $1 billion+ in value

What LNKD really needed was a way for its 990 employees to cash in the tons of stock options LNKD has issued to them (page F-24 of the prospectus tells us that there are 16+ million of them, with a weighted-average exercise price of $5.86).  That works out to over $1 million apiece–a billion dollars in compensation that LNKD doesn’t have to come up with itself.

lapses in logic

Mr. Nocera asserts that the investment bankers “with their fingers on the pulse of the market, absolutely must have known” that LNKD would double on the first day.  He forgets to mention that the only investment bank among the insiders, Goldman, cashed out completely at $45.

He starts out the article by saying that during the past decade investment banks routinely tricked their institutional clients into buying dud securities at wildly high prices.  He then uses this as support for the assertion that Morgan Stanley and Merrill are now doing the opposite.  Huh?

Mr. Nocera cites two “authorities” in support of his contentions.  Both are web postings.

One is by an employee of social games maker Zynga.

The other is by Henry Blodget, the former Merrill internet analyst who is barred from the investment industry for having lied, in glowingly positive reports, about his negative investment opinion for companies under his coverage.     Maybe Bernie Madoff was unavailable.

All in all, not your best day, Joe.