The Big Hedge Fund Stories from 2011

Although individual news items can have can have historical significance (such as story 1 below) the effort here is more to point to the themes and trends at work in the hedge fund industry last year. Here are my top stories for 2011:

Bruce Kovner

1.  Big Name Retirements – two of the best known names in the business stopped running other people’s money in 2011. George Soros turned Soros Fund Management into a family office in the middle of the year, allowing him to have some involvement, even if he is not the CIO at 81 years of age. 

Bruce Kovner has handed over the investment reins at Caxton Associates to Andrew Law, and the macro maven is retiring. The extent of his future involvement in the $9.4bn firm is not clear at this point.

2. Regulatory Body Success in Prosecutions – after much effort over the years, regulators in the United States got some hedge fund scalps of significance in 2011. After the SEC was criticised for its handling of allegations against Pequot Capital Management, the Securities and Exchange Commission need the conspicuous success it achieved in the convictions against the employees and owners of Galleon Group. Galleon founder Raj  Rajaratnam was convicted of insider trading and sentenced to 11 years in jail in October. Galleon trader Zvi Goffer, who controlled two insider dealing rings, was sentenced to 10 years in prison and ordered to pay more than $10 million in forfeitures. 

The other conspicuous success was the case brought against Chip Skowron, portfolio manager at FrontPoint Partners.  The healthcare stock specialist was convicted of insider trading in August and sentenced to 5 years in prison.  

3. A Hedge Fund Winner From The Euro Crisis – that classic global macro management can still be effective was demonstrated by Kyle Bass (and Hugh Hendry) last year.  Kyle Bass, the principal of Hayman Capital Partners, made capital (both monetary and reputational) out of the sub-prime mortgage imbroglio of 2007-8. It required patience and the ability to structure the trade right. Having demonstrated that trait and that ability in making great returns then, in 2008, Kyle Bass went on to talk about the potential for the indebtedness of some European countries to become an issue of significance.  He also identified that the long-dated credit default swaps were a great way to give low cost of carry and a big pay-off.  Bass’ patience and insight were rewarded in returns when the structural flaws of the European project became clear to everyone in 2011.

The classic global macro set-up of a structural imbalance and an option like pay-off was also successfully used by another contrarian, Hugh Hendry.  Hendry shares with Kyle Bass a wariness of  fiat currencies, but his pay off in 2011 came from sharing the trait of patience. The manager of the Eclectica Fund had pointed out some problems with the phenomena of Chinese growth in 2008, and in 2010 he began last year to short highly-cyclical Japanese corporate credits with high exposure to Chinese demand. The Eclectica Fund was up over 12% for the year by early December of last year.

4. King Quants Come Back – several of the hedge fund industry leaders made money for their investors applying quantitative techniques to markets, but the crowns of these kings of the algorithms have been tarnished by the aftermath of the quant shock of August 2007.  The archetype has been the Goldman Sachs Global Alpha fund. The two founders of the research process behind the product, Mark Carhart and Raymond Iwanowski, left Goldmans in 2009, and the fund itself was closed in the fourth quarter of 2011.

But not every quant outfit has followed a route of inexorable decline.  It was commented here last year (see this article) that Renaissance Technologies, founded by Jim Simons, was back on form, and the Renaissance flowering was sustained into 2011. The Renaissance Institutional Equities Fund International Series B was up 32.47% through the end of November 2011. 

The quant turnaround of 2011 was D.E. Shaw & Company. The firm had had a rough time post credit crunch – for a longer exposition of the decline in assets see this article.  Asset growth is a function of returns, and returns for 2011 were excellent at D.E. Shaw:  the firm’s multi-strategy Oculus fund was up 18.3% for 2011 (through the end of November), and the flagship Composite Fund was up 3.8% over the same period. AUM at D.E. Shaw went from $14bn at the end of 2010 to $16.5bn in the 4Q of 2011.

5. Closing to New Capital Reflecting Industry Concentration - the big have continued to get bigger in 2011, just as they have previously. But in 2011 the long-term trend was reflected in a phenomenon that was welcomed back like discovering an old friend who was out of contact for a long while – closing to new capital.

An early indicator in the year came when Cevian Capital announced that they were capping Cevian Capital II. That produced a wry smile of recognition for the return of the phenomenon, but it came to feel like it was contagious when indications came in May from SAC Capital Advisors that it was considering closing to new money (the actual cut-off point was August 2011), and in the same month Daniel Loeb closed Third Point Partners to new money with AUM of over $7bn. Good examples of the way flows were directed came in Europe at CQS and in the States at Sandler Capital Management. 

   

In June 2011 CQS announced it was closing the CQS ABS Fund to new money. But what was more indicative was that the firm's total assets had almost doubled over the previous year-and-a-half ( to around $11 billion). Inflows at the aggregate level stopped half way through the year, amid the turmoil in Europe, but at the micro level the announcements kept on coming. In October New York-based Sandler Capital Management announced a six moratorium on new capital to its long/short hedge funds while it digested a tripling of assets over the previous 18 months.

Newer and smaller firms were also closing to new money (Edoma Partners, JAT Capital Management and Taylor Woods, for example), but the increasing concentration in the industry was reflected more by the announcements by the brand name managers. The news flow on major manager closings continued to the end of the year as Viking Global Investors announced it was closing Andreas Halvorsen’s flagship fund, Viking Global Equities, to additional capital.

6. The Volcker Rule Leads To Big Trader-Led Launches – the Volker Rule separating prop trading from the rest of investment banking came into law in July 2010, and put real juice into the launch calendar in 2011. Given the lead times to set up businesses, it was inevitable that the impact on the hedge fund industry would come in 2011, and many in prime brokerages have stated that they have seen the best quality pipeline in years as a result. Here are some of the more notable ones.

The epitome of launches from former prop traders was Hong Kong-based Azentus Capital, set up by Morgan Sze, who had headed Goldman Sachs Principal Strategies Group there.  The fund launched with a billion dollars in April, an unusually large day-one size, but very unusual in Asia.  And in an echo of the glory days of the hedge fund world, the Azentus fund doubled in size in four months and closed to new money.

A notable launch by a prop trader in 2011 was by Tony Hall – a trader with a good reputation. In his last year at Credit Suisse he had generated one of the most profitable books ever seen at the bank.  Working with the Duet Group he launched a commodities focused hedge fund in early 2011 which was up over 27% after 10 months.  Avantium Investment Management was founded by a team of executives from Deutsche Bank headed by Kay Haigh. Having traded emerging markets for the bank, they launched their Avantium Liquid EM Macro Master Fund onto the world in October.   

Another fund launched to invest in commodity markets came from Taylor Woods, a management company set up by a 7-strong team of former traders at Credit Suisse led by Beau Taylor. With launch capital of $150m from Blackstone the Taylor Woods Master Fund made positive returns in 2011 by engaging in commodity arbitrage, particularly in energy markets. 

A fund launch from ex-prop traders which reflected another trend for start-ups in the industry was Benros Capital Partners in London.  The principals of the firm, Daniele Benatoff and Ariel Roskis, are   alumni of Goldman Sachs who launched their European event-driven fund in the 2Q of 2011 with backing from a firm seasoned in the hedge fund industry. Stockholm’s Brummer and Partners were the first hedge fund company in Northern Europe, and have helped into business a string of hedge fund companies through part ownership of the management companies. In the case of Benros, Brummer own a chunk of the equity in return for seed capital of $300m.  

7. Two Sides Of The Performance Race -Bridgewater outperforms (again), and some big name equity managers falter. After producing a return of up 27.4% in 2010 in its Pure Alpha Fund, Bridgewater Associates’ Ray Dalio described that outcome as a one-in-twenty year event. Given that in 2011 over the year to end November HFRI Fund Weighted Composite Index was down 4.6%, that probably makes the sequence of +27.4% for 2010 followed by +15.92% for 2011 (to end Nov) for Bridgewater’s flagship fund a once in a century series of events.  While statisticians will claim that given 9,000-plus hedge funds there is bound to be a fund with these good-but-unlikely results – an argument used to negate Warren Buffett’s achievements – realistically one must congratulate Bridgewater Associates for taking advantage of some great market background for their big picture style of investing.  

The same cannot be said for equity long/short managers in general.  The HFRI Equity Hedge Index was down 7.39% for the first 11 months of 2011. Against this benchmark and over the same period the underperformers amongst the larger managers were Kingdon Capital Management (-18.15%) and Lansdowne Partners’ UK Equity Fund (-19.8%). It may not be taken into account fully by investors in equity hedge funds, but in contrast to the opportunity set for Bridgewater, the equity markets were down on the year in 2011 and the see-saw pattern they traced in the second half of the year – no direction but with high volatility – is an adverse market background for most equity long/short managers as they tend to be structurally long biased, and the larger ones have to be biased towards investing rather than trading.

The most noteworthy underperformer of the year amongst the mega managers, the range of funds run by Paulson & Company, has been well covered elsewhere.

The stories that didn’t quite make the list above were on the Shumway Capital Partners restructuring and the rise of seeding capital and seeders in 2011. If you would like to suggest other stories and themes that were characteristic of 2011 please use the comments input field below.

Consulting Two - No Explicit Cost v Negative Carry Option Strategies

In my consultancy work I have been surprised by the frequency with which I have come across zero-cost strategies in options. Traders and portfolio managers find them more alluring than they should. It is as if these strategies intrinsically have more merit and deserve more attention. They don't.

To take on an options strategy, in say an equity index, the trader or PM must have a view on the underlying. To have an informed view the trader must follow the instrument closely – this allows them to attach probabilities to the possible broad scenarios behind taking a view via options. So the thinking may be that the index has had a good run and is beginning to act tired; that is there is limited upside from the current level. Or it could be that a particular share has formed a double bottom, there is good value in them and selling might begin to dry up. The first scenario is one that might suit an over-writing of call options. The second might fit an underwriting near current levels by selling put options.

To simplify market activity there are three broad outcomes possible – a trading range, a further significant rise, or a significant fall. Lesser directional movements are captured in the trading range scenario. The money manager or trader will have views on the likelihood of each of these, or to put it another way, if pressed most money managers could attach probabilities to the three broad outcomes. The money manager might have a view that the odds of a significant decline are small, say 10%, but having had a good run the odds of a trading range to consolidate the rise is quite high, say 60%. And the chances of further significant upside are greater than the chances of a significant fall, given the evidence of new buyers – so the odds of a significant rise are 30%. Whatever the exact percentages, the trader will have his own take on what the probabilities are of the three possible outcomes. It is his own probabilities which need to be fed into the construction of an option strategy to make it a fit of his view.

Of course the further significant rise might follow an intermediate pause for refreshment in the price of the shares or index. The extent of time taken to consolidate or pause is a key point. This is the time frame factor, and all managers have a time frame in which they add most value. This is the period over which they generate alpha. If they are a scalper, they shouldn't be taking a view over the next quarter, and a fundamentally-driven stock selector should not be looking to implement a view over the next couple of days. If a manager has a variant perception on earnings, for example, that would normally emerge over several quarters rather than over a week. All option strategies have a time frame, fixed around the months of the option maturities. To be a good fit for the trader the option strategy has to take place over the right forecasting horizon for them.

In a commodity market traders will know the price level at which industrial users will be highly likely to come in to buy. They may know the price zone when commercial hedgers have historically increased their open interest. In the world of equities a manager will have a clear idea of where value is emerging in a particular stock, and where companies buy-in their own stock. In fixed income traders will know at what interest rate funding becomes attractive to a particular category of market participant. So the portfolio manager or trader will have his own mental map of the significant levels of the markets they follow as they see them. In contrast, traded options are bought and sold for strike prices set at intervals by the rules of the exchange on which they trade.

The currency of option trading is volatility. So it might be said that the vol on a class of options is at least a couple of points rich compared to its recent history. Or that the smile of the volatility curve is particularly skewed because of a recent freefall in prices, meaning that out-the-money puts are expensive relative to those with strike prices near-the-money. The 3-D volatility surface is what the options market maker takes his view on.

The users of options may or may not have a view on volatility per se. The users may have opinions on levels and how long it might take for moves to develop and mature, and what probabilities they attach to scenarios for their markets. Professional traders will have a view on vol. Portfolio managers who read a lot of fundamental research and meet company managements are unlikely to have a strong or well-informed view on option volatility by class, never mind by strike. So having done option training, PMs will know what implied and realised volatility are, but it is not the element on which they are typically able to take a well informed view. It is not their currency.

So it is that option strategies are often expressed in the language of levels – strike prices plus or minus net premium. For simplicity pay-off graphs tend to illustrate possible outcomes at maturity. This makes the marketing of strategies more straight forward, and expresses strategies in terms closer to those most readily understood by the widest number of portfolio managers. It does little for suitability or fitting with a manager's market view. And so we come to "zero cost" option strategies.

Zero-Cost Strategies

 

Zero-cost strategies would not matter much were it not for the frequency with which they are implemented. After all the PMs are all grown-ups and they can always say no to an options strategy proposal. But the allure of the cachet of no explicit cost seems to be very strong with the buy side. So a disproportionate number of strategies are created, sold and implemented based on the appeal of no up-front premium outlay.

The typical circumstances are that, for a give maturity, the premium attached to a near-the-money strike option happens to be twice the premium for an out-the-money strike option. This means that, taking account of one side being on the bid and the other on the offer, an investor can receive as much premium for selling two lots of options O-T-M as they pay for buying one lot of A-T-M options. The payoff profile is rising profit through to the OTM strike, and from that level out a declining profit.

Sometimes the ratio between the strikes dealt in is not 2:1, but say 5:2, but overwhelmingly in reality the zero cost collar or put protection is sold and implemented using a ratio of 2:1. The outcomes are then much more intuitive to comprehend (and pitch).

In the process of putting the strategy together the strike levels and maturity of options are selected to fit the template that the purchased premium outlay should be offset by the premium received from the options sold. Occasionally, when the term sheet is put together by a less experienced sell-sider, the O-T-M option is struck further out in time than the near the money option. This diagonal call spread/put spread is less elegant to sell and understand, and utilises two time horizons.

Now going back to the portfolio manager's use of options, he or she should use traded options when they efficiently implement their views on markets, and within their style of investing/trading. Their views come in several aspects: their own take on what the probabilities are of the (three) possible outcomes in the specific market; their own mental map of the significant levels of the markets;  and they should take views via option positions over a time-frame that has a resonance with their own horizon for adding value.

Explicitly stating the elements going into the views on markets makes plain how specific they are to the trader or portfolio manager. It may well be possible to express the market view of a portfolio manager using options – so the time frame, probabilities and significant levels match what can be achieved and structured in the options market. That can be guaranteed to happen using over the counter options; that is, using bespoke instruments. To a degree using pre-existing strikes, dates and a given volatility surface of traded options will always be a compromise versus that ideal fit.

Lay on top of that that zero-cost strategies are put together when there is a conjunction of option maturities, skewness and strikes that just happens to give a ratio of 2:1 in premiums, and the impartial observe can see that zero cost strategies are a very artificial construct. Further it is plain that in order to put them on portfolio managers or traders are quite conceivably having to compromise their own market view in some dimension to accommodate the implied view of the zero-cost option strategy. So the real cost of the zero-cost strategy is not the premium expended, which by definition is nil, but the potential for a significant compromise with the actual market view of the risk taker. This mis-match is too often the cost of the zero-cost option strategy.

Using Negative Carry Strategies

 

Parenthetically, the inverse of the driver of the zero-cost options strategy, has produced great returns in some hedge funds. Rather than be a net seller of gamma (through being short one unit of O-T-M delta) some of the most successful trades of all time have been long long-dated optionality. Being net long of option premium comes at a cost – there is time-value erosion to cope with. But for some patient investors there is a big attraction in having a negative carry trade which gives well defined upside/downside parameters.

The "greatest trade of all time" is the definitive example of the successful negative carry trade. Mortgage backed securities have embedded optionality in pre-payment risk, but through derivatives on MBS specific tranches and indices it was possible to construct trades that would benefit from no payment risk – when mortgagees hand back the keys on their houses. So it is that the likes of John Paulson and Kyle Bass made billions on the subprime meltdown. There was an explicit cost to the trade, but the downside was known from the outset, and at least in the mind of the originator of the trade the real risks were in rolling over the positions – the collapse was going to happen at some point, though its exact timing was not foreseeable.

A similar set up was seen by Mark Hart of Corriente Capital of Fort Worth Texas. Like Paulson he created a dedicated vehicle to run a long long-dated option strategy to play one specific investment idea for the medium term. In the case of Hart, the fund he created in 2007 with the founders of GavKal, the European Divergence Fund LP, owned credit default swaps on European sovereign risk. Hugh Hendry of Eclectica is hoping for a similar payoff (7:1 and better) from using CDSs for taking negative views on China-related plays.

Another successful manager that uses negative carry options is Jerry Haworth of 36 South Investment Managers of London. 36 South has a diversified fund, the Kohinoor Fund, that only uses long-dated options and which has a 10 year track record. Haworth has also set up funds to benefit from specific tail risk events that use the same approach – for example the Black Sawn Fund that made 234% in 2008.

For each of these managers the use of negative carry option strategies gives a very useful attribute - the left side of the distribution of returns is truncated. That is the range of possible outcomes is limited on one side, which is the classic desirable skewed distribution of hedge funds.

Finally, some successful managers will not engage in negative carry trades with optionality on a structural basis in their fund. Rather for some long established and successful managers they see themselves as earning the right to start to use these strategies once they have passed a return threshold for the year. So once they have earned 8 or 10% (and therefore have every chance of producing a double digit year as a minimum) they will invest some of their profits to give a shot at making a banner year.

When I was Head of Derivatives at Clerical Medical I used to tell the investment professionals there that derivatives should be used to implement their views on markets when the instruments allowed that to be done economically. So in specific circumstances, for a particular money manager, a zero-cost collar may exactly fit their market/stock view. But the investment concept invested in, and the fit of the option tactic with the view is more important than the explicit cost, as the successful examples of the use of negative carry option strategies show. 




The first article in this series on consulting in the hedge fund business can be found at Consulting One

The Top Ten Hedge Fund Stories of 2010

The hedge fund industry is still dominated by America in terms of where the majority of assets are directed and invested. So I have given due weighting to U.S. focused stories in the top ten for the year – they are the first five stories, published by trade press in the States. My own viewpoint and concerns put global and regional stories into the top ten for the year – they are the second five stories here.

Expert Network Insider Trading

Hedge funds' use of so-called expert networks was called into question in late November when more than a dozen money managers were issued subpoenas for information related to a vast government investigation of insider trading.

Among those asked for information—but not accused of wrongdoing—were SAC Capital Advisors, Diamondback Capital Management, Level Global Investors and Loch Capital Management. All stressed they were subjects, not targets of the investigation (the latter, which means the government is likely to bring charges, would likely cause massive redemptions). Loch, which did not respond to a request for comment, is laying off most of its staff by year end, according to Hedge Fund Alert. Firms like Loch and Balyasny Asset Management, which was also subpoenaed, suspended their use of third party research firms as a result.

Drunkenmiller Quits but Team Lives On	"I have had to recognize that competing in the markets over such a long time frame imposes heavy personal costs," Druckenmiller wrote in a one-page letter announcing his plans to retire and close the firm, also citing the challenges of running a large fund.

Duquesne was reportedly down 5% at the time, which would have been the fund's first losing year in 30 if it did not snap back by year end, having returned an average 30% annually since 1986. As of November, fund returns had indeed turned positive, according to Bloomberg.

A group of former Duquesne Capital Management managers prepared to start a new global macro fund, Point State Capital, which will oversee roughly $5 billion, one of the largest launches ever, Bloomberg reported in November. The funds come entirely from Druckenmiller ($1 billion) and former Duquesne investors. In addition Wojtek Uzdelewicz, a Duquesne managing director who ran a roughly $500 million technology focused fund at the firm, plans to launch a fund, Espalier Global Management in New York City.

The Goldman-Paulson CDO Scandal Goldman settled with the SEC in July for $550 million, the largest ever penalty from Wall Street. John Paulson, for his part, was never dragged into the legal mess despite initial concerns that led him to let investors know that he was prepared for a possible legal battle and would personally cover any legal fees. One of those key facts, the SEC said, was failing to disclose the role that Paulson & Co. played in the portfolio selection process and the fact that the hedge fund had taken a short position against the product (Paulson made about $1 billion on the bet). In April, the Securities and Exchange Commission charged Goldman Sachs with defrauding investors by "misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter." FrontPoint's Annus Horribilis FrontPoint Partners, the once highly successful hedge fund firm, had a difficult year. In October, FrontPoint announced it was spinning out from Morgan Stanley, which had acquired the firm in 2006 when it managed $5.5 billion but was concerned about new hedge fund investment restrictions under the Dodd-Frank Act. But as FrontPoint restructured, an insider trading scandal hit its healthcare hedge fund, causing the suspension of portfolio manager Chip Skowron and the liquidation of the fund. FrontPoint faced large redemptions—reportedly as much as $3 billion of $7.5 billion, according to the Wall Street Journal—from skittish investors as the insider trading probe spread to more than a dozen hedge funds and put unwanted attention on the use of expert information networks. Buffett's Hedgie Successor Until late October, Todd Combs was a successful but largely unknown manager of a small Greenwich, Connecticut hedge fund. But Combs was thrust into the spotlight with the announcement that Warren Buffett has chosen him to manage a large chunk of Berkshire Hathaway's roughly $100 billion investment portfolio, one of the most high-profile money management positions in the world. Combs, 39, ran Castle Point Capital Management, a financials-focused long/short equity fund launched in November 2005 that managed $405 million as of September. The fund was down 3.93% through September, with a net annualized performance since inception of 5.93%, unspectacular performance compared with its peers. Hedge Fund UCITS Mushroom Whilst service providers and some of the managers were over-excited about the prospects of UCITS versions of hedge funds last year, in 2010 there have been some strong growth trends. There are now around 350 UCITS hedge funds, most of which have mildly amended mandates of the mother (offshore) fund. There have been some UCITS only fund launches, but not many. Early evidence is that UCITS provide a solution to the major drawback of hedge funds that was revealed in the Credit Crunch – the ability to deal in the funds at will. 76% of UCITS hedge funds offer daily liquidity, 21% offer weekly liquidity. The buyers of UCITS hedge funds are client types that put a premium on this positive feature – HNWIs that were much aggrieved at being locked into offshore hedge funds and are buying through wealth management networks; and insurance companies that have problems of admissability of assets when putting capital into offshore funds. UCITS hedge funds manage €27bn of capital. JP Morgan takes a BRIC Hedge Fund Bias JP Morgan's 2004 partial takeover of Highbridge Capital for $1.3bn was the deal which said that institutional flows into hedge funds were believed to be for real and for some time. Eventually Morgan bought all of Highbridge. In October this year JPMorgan Chase & Co. agreed to acquire a majority stake in Brazil's Gavea Investimentos Ltda., the fund manager founded by former Brazilian central banker Arminio Fraga. Gávea Investimentos has $5.1bn AUM invested in hedge funds and illiquid investments, and has a staff of 103 people. The hedge fund industry in Brazil is dominated by bank-run domestic retail flows, but JP Morgan likes the international appeal of Brazilian hedge funds. There are many international investors who use Brazil as a proxy for the best of the BRICs – high employment and industrial production growth, an appreciating currency, a relatively sound fiscal position and a commodity play to boot. One of the lessons of the post-Crunch period has been that the appeal of emerging markets to investors in developed markets has recovered as well as the prices of iron ore and coffee. Has the JP Morgan deal for Gavea confirmed that emerging market flows are for real and for some time? Renaissance is Back In 2006-7 there was a feeling abroad that Renaissance Technologies was going to eat the lunch of a lot of hedge funds by soaking up the flows into the industry as it looked to take in as much as $100bn into the Renaissance Institutional Equities Fund (RIEF). However the large capital inflows turned into outflows when RIEF was down 16% in 2008 and down 7% in 2009. The Renaissance Institutional Futures Fund (RIFF) fared no better in 2008 - it was down 12% when most CTAs were up on the year. The reverse happened last year – RIFF was up 5% and most CTAs were down. Overall firm assets were down 25% last year, and to cap it all founder James Simons retired as CEO at the end of 2009. After successor co-CEOs Peter Brown and Robert Mercer considered closing the two institutional products, it as well they didn't. This year RIEF International - Series B is up 17.00% YTD, and the Renaissance Institutional Futures Fund is up 17.14%. The latter fund did well enough on a 12-month risk adjusted return basis to win the Best Managed Futures Fund at the AR Awards in November. Renaissance is back. The Eurocrats Take a Grip In America the intense interest of politicians, regulators and the media was such that Anthony Scaramucci, founder of fund of funds Skybridge Capital, said "We have felt like a piñata - We certainly felt like we've been whacked with a stick." But it is the European end of the industry that will suffer more from actual interference. The politicians and Eurocrats have wilfully failed to understand the significance of their proposals, despite lobbying and submissions from the industry. The hedge fund industry gives employment, tax revenues and invisible export earnings – in return the industry got proposals treating all management companies as publicly quoted, regulations on how private companies should pay their employees, damaging increased disclosure of short positions, and little-island-thinking that would have created a fence around the European hedge fund industry. On top of that the UK, home to most of the European industry, increased tax rates to an extent that it has pushed some hedge fund companies and leaders into other tax jurisdictions. The country, continent and industry are not the lands of opportunity they were. Recovery by Madoff Receiver The story which has come back with new developments through the year is the efforts of receiver in the case of the Madoff ponzi scheme, Irving Picard, to recover cash from the 2,000 or so net beneficiaries of the scheme. These are the investors who withdrew more money than they invested with the fraudster, and around a thousand of them have been in the sights of the receiver. The list of banks, intermediaries, investors, friends of Madoff and counterparties to receive suits form Picard is long. Some have been obvious targets, like the 34 affiliates with ties to Madoff feeder fund Fairfield Greenwich Group. But he has been very thorough and looked through to where the "profits" have been deployed. For example, in July the court-appointed trustee took aim at three Madoff family entities, a family fund, an oil and gas properties business and a trading business, seeking $30 million that the family had invested in them. As the deadline approached for the receiver – he had until the 11th December, the two-year-anniversary of Madoff's arrest, to file the suits – activity accelerated. Picard reached a $625m settlement with Boston billionaire and philanthropist Carl Shapiro this month, and on the last day for possible filings, the receiver filed a suit against Austrian banker Sonja Kohn and dozens of firms linked to her for $19.6 billion—all of the principal he estimates was lost by Madoff's investors and more than twice as much as he has sought in any of the thousands of other lawsuits he has filed since Madoff's arrest two years ago. The single biggest settlement to date was $7.2 billion from the estate of Madoff investor Jeffry Picower.

 

John Paulson on the Benefits of Activism

John  Paulson

John Paulson may have made been the subject of the book "The Greatest Trade Ever" about his shorting of (residential) mortgage-backed securities, but that trade was as typical for him as Michael Steinhardt going long U.S. Treasuries in 1981. Steinhardt was an analytical equity investor betting his reputation on an unfamiliar asset class in government bonds. Paulson's deep experience was in something else too*.

John Paulson's professional background is in mergers and acquisitions, and so it was natural that the investment strategy in which he came to specialise was risk arbitrage, first with Bear Stearns and then Gruss Partners, before he opened his eponymous firm. As with many practitioners who go on to play other stages of the event cycle, risk arbitrage led to exposure to distressed bonds, and eventually to the full panoply of event investing of divestitures, recapitalizations and other company reorganizations and financings.

So it is the associated specialism of activist investing that is covered here with John Paulson. This is a written form of a presentation he made a few years ago on the topic . Whilst the principles of what John Paulson describes are still valid, the aftermath of the Credit Crunch makes comments on real estate and banking anachronistic in today's market conditions.

Simon Kerr, December 2010





Paulson & Company is an event arbitrage firm, and we have been in business 15 years and activist investing is not our only activity but is in an important part of our investment strategies. I'm going to talk today about the benefits of activism.

Activism is good for the stock market. It is good for investors and is also good for business and is good for corporate governance.



The Benefits of Activism

One: The first benefit, and primary benefit, of activism is to increase shareholder value. We get involved when a stock is trading at a discount to its true value. Through activist strategies we seek to realise that value.

Two: The second goal, and as important as realising shareholder value, is to improve corporate governance. Unfortunately there are situations where corporate Boards or managements don't always act in the best interests of the stockholders. Activists make sure that all shareholders are treated fairly and properly.

Three: Another benefit is that activist investing carries out a role on behalf of other investors. We might have to act alone, and we might own only 5 or 10% of a company, but when he share price goes up all investors in the company benefit. That helps individual investors who don't have the time or resources to act in this way. It also benefits pension funds and other institutional investors that can't get involved for political reasons or because it is outside their mandate. But I would say that in many if not most of the situations in which we get involved we are clearly getting the support of institutional investors. Even if they are somewhat constrained in coming out and saying so publicly, they are supportive of the goals we are trying to achieve.

Four: Activism keeps management and boards focussed on shareholders' interests. Prior to activist investing Boards acted in their own interests. It used to be that the only thing shareholders could do when they didn't agree with what was going was to sell the stock. Activism gives shareholders a voice, and makes management listen.

I believe it also creates companies stronger. Many times what leads to an activist situation is where a company management is pursuing a strategy that that they are reluctant to let go of. Shedding loss-making operations and merging with other companies to get to global scale, in the end, does result in stronger, more competitive and more profitable companies.

Five: Activist investing also removes inertia. You can't just accept the status quo. If management have been doing something for a long time and are happy with it, that is not good enough. Management have to be accountable and activist investors showing up forces management to be accountable.



Why is There a Need for Activism?

The primary reason for activism is that in public companies there can be divergent interests between owners of the business and management. In many public companies, particularly in cases of very old, established companies, the board members and management frequently own de minimis amounts of stock. So their decision-making criteria for running the company are other than those which are best for company shareholders. Frequently they are focussed on the perks of running a large public corporation. Many times they like their cushy jobs, they like all their perks and the prestige that go along with the positions they hold. Ideally the Boards want to be left to run the company - they view shareholders as bothersome.

In some of the old companies the Boards can become very insular. Many times the Boards don't have any stock at all. They are reluctant to incorporate change. Then there is a need for an activist to get involved.



The Criteria We Look for in an Activist Situation

1. The company is trading at a deep discount to fair value
   
   If the company is doing the right thing, the shares are trading at a full value and the shares are trading at a high P/E, then there is no need for an activist to get involved. However if it is trading at 50% discount to fair value, if it is pursuing strategies that have failed, if it is under-performing and the sum-of-the-parts is at premium to current traded values then that attracts the activist investor.
   
   
    
2. Strategic Initiatives Available
   
   There have to be readily implementable strategic alternatives to unlock that value (some examples will follow). So we look for a discount and a situation where if management took action that discount could be quickly eliminated. Typically the management has been reluctant to act, simply because they don't want to change things. The activist investor comes in and acts as a positive catalyst for positive change.
   

Why Would the Company be Under-valued?

Why would a company be undervalued to the extent that an activist could get involved? The most common reason is that the company is in disparate businesses. Some of the businesses are weaker than the others. The sum of parts is greater than the value of the whole, and the remedial strategies are not always seen as readily implementable.

Examples:

The sum of the parts was greater than the whole. Take as an example Cadbury Schweppes. In the U.S. beverage business it was an also-ran in market share, but it had an attractive confectionary business. Combined as a public company they traded at a discount to the fair value.

Sainsbury's had very valuable real estate and the management was reluctant to separate that real estate element from the retail operations. It traded at a big discount to the asset value of the business. (Property investor) Robert Tchenguiz showed up on the share register and highlighted that differential, and the stock appreciated significantly.

In (Dutch company) Stork – another situation where they were in many disparate businesses - people that wanted the individual businesses didn't want the whole rag-bag of businesses, and as a consequence the shares traded at a very significant discount.

Then there are situations where the track-record of the management is poor. Though there are pieces of the company that are valuable, investors lose confidence in the management, and as a result don't attach a high multiple to the stock. Two situations come to mind – Ahold from Holland and ABN AMRO, the Dutch bank. Both companies, for different reasons, had underperformed in stock market. There were actions that could be taken to highlight the value, but the managements needed some pressure from shareholders to do something about it.

We also see situations where managements are not focussed on shareholder value. It could be through no fault of management, but that the private market value is very different from the public market value. A ready example is the real estate sector. Real estate can be capitalised at very high multiples of cash-flow, but generally the public market looks at multiples of earnings. You can't get full value for real estate assets in the public market.

So for example, Ahold had a fair amount of real estate and the shares traded at approximately 7 ½ x EBITDA. Yet real estate transactions are being done at over 20x EBITDA. So put the real estate in a public company and the market gives it 7 ½; separate the real estate, sell it to someone privately, and you can get 20x. Some deals were done recently at approaching 24x EBITDA. The latter deals had cap rates as low as three and a half percent. That is the incentive - the difference between public and private valuations. For the retailers it is not necessarily a problem of management, but a difference in value can be realised through re-structuring, tax treatments and other considerations.



Activism Need Not be Confrontational

Many people see that activism has to be confrontational. That is not the case - some of our best investments have been where we have been working together with management, outside of the public eye, to enhance value. For example, a fund was written up in the newspaper yesterday: Blue Harbour is an activist investor that only does friendly transactions. They buy a stake in situations which are under-valued, and where they believe strategic re-structuring will add value, and then they work with management collaboratively to achieve that goal.

We have worked with managements at Ahold and The Mirant Corporation constructively. Actions the management have taken have added value in both cases.

In Cadbury and Laidlaw we have worked in a non-confrontational manner. Generally it is important for management to listen to shareholder concerns: when investors make a point that is valid, it is up to management to respond to those concerns and help to realise that value.



But Management Can Defend Aggressively

In the ideal situation, you take a stake and management greet you with open arms, and you agree to enhance shareholder value, but sometimes management is very confrontational. Sometimes the Board and management don't like being told what to do, and the management take action which harms shareholder value. I will refer to two recent examples.

After ABN AMRO granted exclusive negotiating rights with Barclays, RBS indicated an interest to pursue an acquisition. ABN AMRO management said they couldn't negotiate with RBS because of the exclusivity agreement with Barclays. That exclusivity period expired, and even knowing the RBS interest, ABN AMRO management then extended that exclusivity period. They used that second period to negotiate what was effectively a poison pill: they arrange to sell the prize asset which RBS was after (LaSalle Bank) to Bank of America. This made it almost impossible for RBS to pursue the deal they wanted with ABN AMRO.

ABN AMRO was refusing a deal at a higher price so they could choose the buyer that they wanted to sell to. This was done though many shareholders in ABN AMRO did not want this to happen. This is thankfully rare, where management use scorched-earth tactics to destroy value in order to serve their own interests.

Thankfully ABN AMRO were taken to court by Dutch shareholder group, VEB, and the shareholder group won. In order to sell even some of the the assets ABN AMRO management needed shareholder approval. Without that activism on the part of the Dutch shareholders association the incremental value in the asset sale would not have been realized.


Another hostile situation where were involved was Stork – this was a deeply undervalued businesses on a sum-of-the-parts basis. It traded at a 50% discount to fair value of the component parts on a peer group public company basis. It was in chicken processing, aerospace, oil services, and believe it or not scores of other businesses at well. So there could no corporate buyers of the whole company, because buyers of oil services did not want a chicken business. We believed the best and most promising business in the group was aerospace. We suggested either splitting into three businesses or building the group around the core aerospace business.

The Board refused to listen to us, even though we owned up to 35% of the shares, and the Board owned no stock. We said that that was unfair, and let's put it to a shareholder vote. At the shareholder meeting 89% of the votes at that meeting were for the change in strategy. The Board refused to listen to the voice of the meeting and said the Board make strategy not shareholders. So we called another meeting to replace the Board. To deny our rights the Board then initiated a poison pill – issuing super voting preferred stock to themselves. The preferred would represent the majority of votes if the issue was allowed. We had to take the company court. We argued that the poison pill was originally put in place to stop an unwarranted takeover, not to prevent shareholders from voting. The court agreed with us and threw out the pill. We are now in the process of trying to negotiate something with Stork. Our preference is always to do something collaboratively rather than confrontationally, but unfortunately it doesn't always work out that way. And we have to act to protect our interests on those occasions.



Examples of Activist Positions of Paulson & Company

Cadbury – a great company. In two businesses: it is a world leader in confectionary, but also had a substantial but sub-scale drinks business. Everyone knew that it was in the interests of shareholders that the businesses split – the best strategy was thought to be to sell the drinks businesses and concentrate on confectionary. Once Nelson Peltz declared his stake management realized the logic and immediately announced they would consider separation of the businesses. The stock jumped almost 40% in a few months of the announcement of the split of the businesses. Incidentally Nelson Peltz had good knowledge of the situation as he had sold Snapple Beverages to Cadbury five years previously.

ABN AMRO – over the five years prior to the involvement of the The Childrens' Investment Fund the stock had moved sideways whilst the banking sector was up substantially. ABN AMRO share appreciated 40% in a few months after the TCI stake became public knowledge. This shows the benefit of an activist stirring the pot. Shareholders had been disgruntled with ABN AMRO management for some time. It was a big bank, but it had pursued a strategy of being a small player in a lot of different markets. It was one of the largest banks in the world, but it had a tiny operation in the U.S., it had small operations in Italy, in Brazil, and the Middle East. That situation does not create operational strength, or allow for synergies, or allow for expanded margins. Contrast that with those banks that had large shares of deposits in its markets. Large shares of deposits in a banking market leads to profitability, so although ABN AMRO had grown it had not created value.

Ahold – the re-structuring activity in Ahold took the shares up 50% at the same time that the retail index was up 5%. The company does well operationally in Holland and Sweden but poorly in the US. As a consequence the shares traded at a discount to the sum of the parts. We proposed selling off or spinning-out the under-performing US operations, to focus on the successful European operations. We believed that that would create shareholder value. They were responsive. They sold off the US food service operations, and received much more than anyone expected – some $7bn. They bought back stock with the proceeds. The story doesn't end there because management are considering other initiatives which came from the activist shareholders. We have met with management and they have listened.

The Mirant Corporation - a very successful situation as the shares are up over 100% in a year, and Paulson & Company was the largest shareholder. Mirant, an Atlanta-based power company, itself had come out of bankruptcy and had a new CEO. They announced that they wanted to buy another utility with stock, but their own shares were trading at a discount to the sum-of the-parts, and they were proposing to acquire the target company at a premium. It was a very dilutive acquisition proposal.

The proposal drew very sharp criticism from nearly all the existing Mirant shareholders. Ed Muller, the CEO, was surprised, but he listened to shareholders, and dropped the proposal within a week. He then reached out to shareholders, and met with us and other large shareholders individually. We explained that we thought they should do is sell off their non-core assets and concentrate on the Mid-Atlantic utility business. Rather like ABN AMRO they had bits of businesses all over the place. It had utilities in the Philippines, Jamaica, Trinidad and Tobago, and the Bahamas and in the U.S. in Texas, in California and in other states.

After meeting with us he realized that the best thing to do was to hire bankers and sell off the widespread operations, and concentrate on the core utility business. He sold the Philippines assets to Tokyo Electric; he sold the Caribbean assets to Marubeni; he sold the non-core US assets to a private equity group. It was our most successful activist position, and it was done with a collaborative approach to management.



Summary: Benefits of Activism

• Activism Improves Valuation for Everyone
  
• It Frequently Results in Better Governance
  
• Activism Creates More Efficient Companies
  
• It Removes Inertia
  
• Activist Investing Holds Management Accountable
  

*Before he began his investment career, John Paulson accumulated academic distinctions. He was Valedictorian of his class at New York University's College of Business and Public Administration and received his MBA from Harvard Business School as a Baker Scholar, the school's distinction for the class' top students. After a stint as a management consultant with the Boston Consulting Group, he joined Odyssey Partners as an Associate and moved on to Bear Stearns in 1984 where he became a Managing Director in mergers and acquisitions. In 1988, he became a general partner of Gruss Partners. In 1994, he started Paulson Partners L.P., and in 1996, Paulson International Ltd., a companion offshore fund. In 2001, the firm launched a leveraged version of its funds. Based in New York, Paulson & Co. currently manages $33.6bn, up from $700 million in July 2003.

For a European take on activism read about Cevian Capital on this blog or at The Hedge Fund Journal