The Dangers of Mixing the Functions in a Hedge Fund Management Company

In an in-depth due diligence questionnaire of a hedge fund manager there is often a question about the outside business interests of the principals. For an organisation with a broad team of decision makers managing investments this is less of a concern. To the extent that there is a single presiding talent who sets the tone and manages the largest allocation of capital, it is an issue if an individual has executive duties in other companies, or has too many non-executive directorships or Board positions. Think of SAC - if Steve Cohen more actively pursued his art interests at the expense of time at the firm would that that impact the returns produced by the whole firm? Undoubtedly, yes. But there are other ways in which hedge fund investment managers can be distracted from their main event.

I was reading about companies' management structure (link here, with thanks to author Daniel Dupree), perhaps a hangover from my Business Studies degree, and  was reflecting on how the construct applied to the hedge fund business. The article was about levels of management:

Management levels within an organization exist to demarcate different roles within the organization or company, and to help establish a chain of command. Broadly, there are three main levels of management. You can think of the levels as a triangle, or pyramid. At the top level, there are fewer people, but they have more say in the overall direction of the company — they have more authority. This level is often called the administrative level. At the second level of management, you have those who have some authority over certain departments or projects. This is called the executory level, since those who populate it are involved in executing so that the aims of the organization are met. Finally, at the bottom of the pyramid, is the supervisory level. These are managers that have more direct contact with workers, and are mainly involved in encouraging performance, and monitoring employees. 

The article then goes on to describe the scope of work in each level. Here are the descriptions of the top two levels:

Top Level: Administrative

The top level of management in most organizations is the ultimate authority. Administrative level managers can give authority to other managers in the organization, delegating to, or directly promoting, other managers. The top level of management consists of board of directors, top officers in the company, and directors in the company. Some of the functions of those at the top level of management include:

• Setting out the goals, benchmarks and big picture for the organization.
• Prepares policies for the organization, and sets forth consequences for their violation.
• Promotes and appoints others to fulfill various roles in the company.
• Coordinates activities for the whole organization, making sure that different departments are working in tandem to reach the organization’s goals.
• Usually in charge of making public statements on behalf of the organization, as well as making appearances so that the community is aware of what the company is doing.
• Directs broad changes in company direction.
• Shows accountability to shareholders and other stakeholders in the company.
• Ultimately responsible for the success or failure of the organization and its enterprises.

Those in the top level of management are often well-compensated for their efforts, due to the fact that, in theory, they have great responsibilities. It can be difficult to make it to the top level of management, since those positions are often scarce, and the competition for them is fierce. However, with hard work, good ideas, competence, and an ability to network, it is possible to reach the top level of management.

 

Middle Level: Executory

Depending on the size of the company or organization, middle management can be bigger or smaller. In some of the smaller organizations, the functions of the middle level and lower level of management are combined. However, in larger organizations, middle level management often requires additional divisions into senior and junior levels.

At this level, managers are in charge of branches or departments. Their job is to come up with sub-plans that contribute to the success of the company when meeting its goals. Middle managers are often involved in making sure that the steps to achieving the larger aims of the company are carried out. Some of the other duties that those at the executory level of management might be required to carry out include:

• Training lower management, and training employees.
• Coming up with incentives for employees and lower level managers.
• Coordinating projects within the departments and branches.
• Evaluating employee and lower manager performance.
• At more senior positions in middle management, sometimes it is necessary to interact with the public, or issue statements.
• Report to members of the top level of management. This might include in-person reports, or written reports and memos.
• Enforce policies handed down from top management, and sometimes discipline lower level managers, or employees.

The owners of hedge fund businesses carry out all the tasks of Top Level Management as given above. However, it is quite usual for the largest shareholders of a hedge fund business to be carrying out the main activity of the company, that of carrying out research and making investment decisions. That is, the principals of a hedge fund management company carry out the Executory Level activity as well as fulfill the roles of those in the Administrative Level. Even where there is a separate CEO in a hedge fund, the CIO whose name is over the door is highly likely to be involved in decision-making related to how the business is run as well as how the investments are run.

Switching Modes

For many senior figures running portfolios this involves looking at a trading screen and taking company and investor meetings until the end of the trading day, and then switching modes to take Executive Committee meetings and Board Meetings into the early evening. If there are not those formal meetings there will be job interviews and looking through (management information system) reports on the business after the Bloomberg screen has gone dark.

I had a reminder of the duality of the lives of the senior executives running hedge fund companies when I bumped into one of them off Davies Street in Mayfair yesterday. In the course of  our exchange he disclosed that the meetings and reading of documents associated with the expansion of his business was taking up some of his normal trading screen time. He said "I've cut back on the number of markets I'm actively tracking, and, to be honest, even in those I'm relying on what I researched earlier this year for the core of my views."

This chimed with what I had read about events at Touradji Capital Management this year. Paul Touradji is the former head of commodities trading at Tiger Management who set up his own firm in 2005. Just over two years later Touradji Capital was running $3.5bn in commodity related funds. But the progress of the firm has not been smooth since the Credit Crunch.

Returns from the funds were disappointing in the last two calendar years - up 4.5% in 2009 and then up 2% in 2010 against a background of bull market conditions in commodities. Investor redemptions took capital down to below $2bn this year. The senior management team has not been stable. Gil Caffrey came on board from FrontPoint Partners to be CEO at Touradji Capital Management, only to decide last year to walk across the hall back to Tiger Management. Julian Robertson's Tiger Management shares office space with Touradji Capital on Park Avenue, New York. Sang Lee was brought in as President of Touradji Capital in October 2010 as part of a handover of day-to-day management of the firm from Caffrey. But that transition was not successful.

It was announced last month that President and Chief Operating Officer Sang Lee and CFO Tom Dwan will leave the firm, and a search is on for high calibre replacements. In a letter to his investors Paul Touradji wrote "Simply put, the daily operation of the firm must go from being a major time and energy drain on me to an integral support function for our entire team, allowing us to concentrate our full attention on investment performance." The flagship fund of Touradji Capital Management was down 17% in the first 8 months of the year.

Touradji Capital Management is not a start up or a very small hedge fund management company. But events there illustrate that non-investment issues can be a drain on the capabilities of professional investment staff at the very top level of hedge fund companies. Even very capable people have to be careful about how they allocated their time and intellectual bandwidth. To consume the creative thinking time of a well-paid investment professional at the top of his game with the banalities of failed trades and who is doing the cash reconciliations this week is a failure of management resource and structure.

Potential investors in hedge funds sometimes go to great lengths in due diligence to fully appreciate the state of play at a hedge fund management company. I heard a comment this week that there is something of an arms race in due diligence processes amongst funds of hedge fund companies, as they try to differentiate themselves on something other than results. But there is a risk in a small company that the scarce resource of management time can move from the mission critical (investing) to the necessary (operations and company oversight) and that is something of which a prudent investor should be aware.

Major New York Hedge Funds Join Lawsuit v Porsche

Eighteen investment funds today joined the lawsuit against Porsche Automobil Holding SE asserting fraud and securities manipulation in relation to Porsche SE’s failed 2008 attempt to take over Volkswagen AG. With the addition of the new plaintiffs, the now 35 funds seek to recover more than $2 billion dollars in losses. The 18 funds that joined the lawsuit are part of 6 fund families: Canyon Capital, D.E. Shaw, Greenlight Capital, Ironbound Partners, Royal Capital, and Tiger Global.


The Amended Complaint, filed this morning in Manhattan federal court, explains in greater detail how Porsche SE manipulated the price of VW stock as it secretly cornered the market in VW shares. According to the Amended Complaint, Porsche SE hid that it was cornering the market in VW’s freely traded shares by repeatedly issuing misleading statements about its activities and by spreading purchases of call options around to several counterparties to avoid detection of its increasing control. The scheme induced the plaintiff funds to establish short positions on VW stock. When Porsche SE suddenly revealed the extent of its true control of VW shares on October 26, 2008, a massive short squeeze ensued. The price of VW shares skyrocketed several hundred percent, briefly topping 1,000 Euros. Investors who had shorted VW lost billions covering their positions in the squeeze. Porsche SE collected outrageous profits at the expense of plaintiffs and others by releasing some of its shares into the market at artificial prices.

  

Today’s filing reveals previously unknown details of Porsche SE’s plan. The new allegations include that:

• Less than a week before Porsche SE revealed the truth—that it had amassed control of more than 74 percent of VW’s shares— it conducted phone calls with investment advisors in New York during which Porsche SE sought to reassure the New York-based investment advisors that it was nowhere near 75 percent control. Among the false statements Porsche SE made was that although it would acquire a simple majority of VW shares, "going to 75% is not on the agenda." Porsche SE told another fund that it would stop acquiring shares after achieving 50–55% control.  
• Porsche SE admitted to at least one plaintiff that it was spreading its options trades around to multiple counterparties to avoid detection.
• Porsche SE’s fraudulent strategy deliberately targeted short sellers. In order to secretly obtain 75 percent ownership in VW, Porsche needed short sellers to borrow stock from owners who would not or could not sell the stock themselves and then to sell it to Porsche or Porsche's call-option counterparties. Without the additional supply created by short sellers, Porsche could never have gained control of 75 percent.  
• Porsche SE financed its call-option strategy in part through selling put options. As the price of VW declined in the third week of October 2008, Porsche SE’s liability on the puts it had sold threatened to force the company into bankruptcy. It avoided this threat by forcing the price of VW up, which it accomplished by announcing its call-option position on October 26, triggering the squeeze.

The case is pending in the Southern District of New York, where it is captioned as Elliott Associates, L.P., et al, v. Porsche Automobil Holding SE, et al, No. 10-civ-532 (HB)(THK).

The funds are represented by Bartlit Beck Herman Palenchar & Scott LLP (see www.bartlit-beck.com) and Kleinberg, Kaplan, Wolf & Cohen, P.C. (www.kkwc.com).