PureVC

Taking Advantage of the Pain - Citadel Expands Into I-Banking

For those of you who haven't heard, Citadel is expanding into the investment banking arena by hiring some ex-Merrill guys. I've said this before - when times get tough and there is pain it is a great time to take advantage. The financial turmoil and destruction of almost every investment banking unit on Wall Street has created a huge opportunity for those looking to expand. Almost every boutique bank I know of has been hiring non-stop all of the bulge bracket refugees, looking to become the next big player.

Expansion and diversification into financial infrastructure plays is not new to Ken Griffin and Citadel. A lot of people don't know but Citadel makes a ton of money in its market-making business. It essentially has so much market flow that it IS part of the financial exchanges as we know it. Additionally, it has a turn-key hedge fund infrastructure program that caters to the hedge fund industry.

So not only it is a hedge fund, it is knee deep into the infrastructure of the US financial markets. Expansion into I-banking is a natural step and a very smart one. A lot of big players such as Blackstone do advisory work that practically equates to banking but most have not officially crossed the line. It will be interesting to see how it all plays out and whether someday Citadel's hedge fund will only be a tiny part of its overall business.

It's Time to Lean In

I can't believe that I haven't posted in nearly 3 months! What has happened in the interim? Well, I last posted about the Ponzi scheme that the State of California planned on perpetrating against its citizens. Since then a lot of other Ponzi schemes have come to light of various managers who had been living on borrowed time. Financial firms continue to deleverage and as I predicted, the words "mark-to-market" is now known to every man. Interestingly, there seems to be a glimmer of hope in the economic data that the worst is over.

For those who invest and make a living off of investing, this is the time to lean in. Things could get worse, but there are so many powerful forces at work trying to make things better. In my opinion it is a tough time to bet against the capitalistic spirit. This is the time to push forward and invest, create, and prepare to ride the next wave. It will come and when it does it will be violent.

The smart money has been busy picking up gems from the dead. There are plenty of people hurting in every industry right now and if the past is any predictor of the future, the cycle will refresh and lots of folks will be kicking themselves that they didn't take advantage of the unique investing climate we are in. Good luck.

The Biggest Ponzi Scheme You've Never Heard Of

By now we have all heard of Bernard Madoff. It is reported that his Ponzi scheme of $50+ billion dollars is the largest of all time. I've found one that may top Madoff's Ponzi scheme that may occur under the everyone's radar.

As you may know, several states in this country continue to have budget shortfalls. In a typical year, many of these local governments run a bit in the red and borrow money until tax revenues come in. Given the current state of world financial affairs, the projected tax revenue shortfall will likely bankrupt these governments. New York is facing a big shortfall, so is California.

CNBC reported today that in response to California's budget shortfall the state may be taking desperate measures to make sure it keeps running. Among those under consideration is the state simply writing I Owe You's to vendors. However, the state finance guy indicates that he is not likely to do that because it would affect the state's ability to borrow in the future. Thus, his solution is to simply delay the payments of people's tax refunds.

Does this sound a little bit like robbing Peter to pay Paul? Does this sound a little bit like the big hedge funds that have lowered the gates on redemptions? Perhaps this is so Bernard Madoff that people do not realize it. I am amazed that the world wants to send Madoff to jail, wants to demonize hedge funds for not allowing withdrawals, and wants to crucify anybody who runs a Ponzi scheme - yet when California wants to do something as preposterous as "delaying" tax refunds because of a budget shortfall, this goes unnoticed.

I am not an attorney, but this situation is akin to a clearing company utilizing clients' account assets for operating expenses. It is illegal and gets you a fine from the SEC and possibly shut down.

Thus in our great country, not only do you have to prepay your taxes and essentially pay for something ahead of time before your bill is due, you actually may have to pay for something that you don't actually owe. You pay your taxes ahead of time and then when there is no tax due, you don't get it back until it is convenient for the government. It is the taxpayers that should charge interest to the government who does this, not the other way around. It is once again the taxpayer who is bailing out the government.

Is it any wonder why people in this country try and hide their assets offshore?

The Hurdle

It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.

Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.

I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my money in a mutual fund or buy a piece of commercial real estate and get a good cap rate. When I invest, I want the manager to make big returns and be rewarded on the back end for the great return.

It is sort of analogous to investing in public equity for dividends. I am not a dividend investor and would never invest in a stock for its dividends but more for its appreciation. Additionally, in a private venture type investment, taking a dividend in a startup does not make sense to me because you want the cash to stay in the company to add value to the equity. An LBO is a different scenario because the company is cash flow rich and taking a dividend should not weaken the company materially.

Thus to me the hurdle rate should be a non-issue and in a private deal where I am looking for a good return, I do not want the manager to focus on the hurdle. I would rather that it be clean and simple. I want to be able to calculate the return and fees that I paid to the manager in my head or on the back of a napkin, not through a complicated spreadsheet.

If I am investing in a fund, I am looking to build a relationship is someone who can earn good returns over any cycle. I may negotiate some terms or fees, but the hurdle certainly is not one of them. I would rather go with a talented manager with a low hurdle than a first-timer with a high preferred return.

It's been a tough year for private equity

It's been a while since the Madoff news broke and it does sadden me to hear the news how a single person pulled off the largest Ponzi scheme known to mankind. I am tempted to say once again that it is all about trust - a money manager must trust his partners and partners must trust their money manager. However, the Madoff scheme appeared to have all the makings of lots of relationships built on solid trust. Perhaps too much trust.

Most of the investors that had money with Madoff had a personal connection to Mr. Madoff or someone who had this connection to allow access. Additionally, statements were produced backing up transactions and asset values. And people who wanted to get their money out were able to because there were so many other investors coming in. It is easy in hindsight to say that any vigilant investor should have seen the signs. However, all of these factors enabled the kind of trust that only a money manager could dream of - blind trust from investors.

Part of me is very distraught over Madoff because it paints a bad picture of the hedge fund industry. A picture of dishonesty and scandal. Another part of me is not distraught because the people that lost money with Madoff were either of the wealth that they can afford to lose money or they were stupid enough to put 100% of their net worth with a person that they did not know very well. With any financial investment there is risk and an investor must be willing to lose his entire investment. There was greed involved and this greed came in the form of investors willing to do anything for returns including trusting someone that they did not know well.

The silver lining to the Madoff scandal is that where there is carnage there is opportunity. When it is harder to start a hedge fund that means it is a better time to start one and to be in the business. There is less competition and only the very strong survive. These past few years have been a trying one for almost all of private equity - buyout funds getting bad press, venture capitalists with few exit opportunities, real estate values decreasing with tight credit, and hedge funds facing massive redemptions and loss of trust from investors.

But all things come in a cycle. These are the times when managers must dig deep and lean in and set things up for the next wave to come. And there is no doubt that another wave is coming - it may take a while. But, the economic policies being set forth to get us out of trouble will undoubtedly stoke a huge blaze in the other direction. Money flows to the best returns and right now the government is decreasing the rates of return on everything and driving money toward real estate and equity.

The recapitalization has taken place in the economy and the Madoff scandal just triggered the reset button for the hedge fund industry.

Deleveraging, Recapitalizations, & Margin Calls

People still don't seem to believe or comprehend the depths and extent of the financial crisis. Here is my brief explanation. We have been in an economy built on leverage and that leverage is coming down like a house of cards. Banks and financial companies were levered 40:1 loaning monies out that far exceeded the capacity for defaults. It started with residential mortgages and sent the financial world reeling as banks packaged these loans and sold them to others. Due to recent changes in accounting rules, banks were forced to value these assets "marked to market". Thus when the market froze and there was no liquidity to trade debt, valuations declined. We saw the collapse of some venerable investment banks such as Bear Stearns and Lehman Brothers as well as thrifts such as Washington Mutual and Indy Mac and mortgage titans Freddie Mac & Fannie Mae and Countrywide - the list goes on and on. We also saw the swallowing of Merrill Lynch and Wachovia, and the near crumbling of Citigroup. Even Goldman Sachs and Morgan Stanley have not been spared.

For those of you who believe that the financial companies will be coming back anytime soon, please think again. The market no longer values any business model that relies on leverage. In order to deleverage, companies must sell assets both good and bad. This compounds the problem as these assets are worth less and less. To make matters worse, the entire industry is in trouble and there are no buyers to take on leverage (the only buyer is the Federal Government). Anybody that acquires or merges with another insitution is simply asking for trouble. How can an overleveraged bank imagine that it can purchase another weaker overleveraged bank without weakening its position? It can't. Thus, it must go back and raise funds such as Bank of America did after its Merrill acquisition. Dividends will be cut completely. Massive amounts of equity will need to be raised. And when the federal money runs out we will be in trouble.

Thus the economy is in a massive recession and is shrinking because of deleveraging. If we were levered 40:1 and we are going back to 10:1 leverage then you can imagine our economy will shrink that same amount. If you don't understand what I am talking about, think about the size of the economy as measured by credit card transactions. Imagine if your bank suddenly froze your credit cards and you could not buy anything on credit and you had to use cash. Transactional volume would come to a halt because most people use credit to pay for just about everything. Unfortunately, a freezing and cutting of credit extended to consumers may actually happen. You can imagine what this will do to retailers. It looks like we are going back to the age where cold cash is king.

Essentially, we have had a recapitalization of the entire economy. The stock market has lost trillions of dollars as reflected by the haircuts of stock prices. Open up your 401k statement and you will see what I am talking about. 99% of the population does not understand what "recapitalization" means. In the private equity world, recapitalizations are the re-valuing and re-valuation of a company's worth. When you hear "recap" it typically refers to loss of valuation to the downside - think "massive shrinkage of company's value". Sometimes a recap is to the upside but that is what we would call a "dividend recap" meaning that we are taking out money from the company at the time of recapitalization. Anyways, the key theme in a recap is this - previous investors typically get washed out unless they "pay to play."

One final thought - the entire world has been put on a "margin call". How? Well, the market has told us that any business model using leverage is no longer desirable. Thus anybody with leverage is forced to close out its leverage down to either zero or something more reasonable. This is why it is a treacherous downward spiral - the only assets to sell are those that are devalued and those companies that are publicly traded are thus in a bad position. They have margin calls on them and must sell devalued assets that are losing more value everyday.

Do you still think that the next shoe to drop is not the commercial real estate industry? Or the consumer credit industry? The market thinks leverage is evil - any business models with leverage must adapt or become the next victim of market evoluion.

Hedge Fund Managers Come Out to the Feds

It was interesting to listen to the testimony provided by several hedge fund managers on Capitol Hill this week. Although I do not agree with all of the support toward more regulation, it was nice to see and hear from some of the more secretive hedge fund managers who do not typically show their faces in public. One thing is clear, the government does not really know anything about the hedge fund industry - there was no rhyme or reason why they chose those managers instead of others. And it was even more clear by the varying testimony that the managers themselves did not know exactly why they were testifying.

Do hedge funds need more regulation and disclosure? Definitely not. A hedge fund is nothing more than a pool of money that is used to make money by any means necessary through a hedged strategy. It really does not make any difference if it is a hedge fund or an individual person that has billions to throw around. I certainly do not want to have to report all of my transactions to the government on a daily, weekly, or monthly basis. And I certainly do not need to tell anybody how much margin I am using and what I am buying or selling.

Regulation is necessary to keep a fair marketplace intact and to ensure that rules are followed. Regulation cannot control greed or risk. You cannot regulate speculation. You cannot regulate irrational exuberance. And you definitely cannot regulate bearishness or short selling. If I want to bet the farm that a company is going down or going up, I am allowed to do so by the rules of the SEC and by the margin limits of my brokerage. Any additional regulation would amount to nothing more than a Sarbanes-Oxley type of thing for the hedge fund industry. And you know what SarOx did for the new issues market.

All regulation will do is make people leave. And this is not the time to get dollars flowing out of the USA. Financiers are smart enough to figure out a legal way around the rules.

If hedge funds had anything to do with the bringing down of the market then perhaps it is good they were around. They did all Americans a favor by exposing the overleveraging of the financial system and have helped weed out the companies who should not survive. In every cycle there must be a boom and a bust. We are definitely in the bust but it is all a set up for the next wave. If the government sets up too many rules, then there will not be another booming wave. Or perhaps it will occur somewhere else.

If You Are A Hedge Fund You Should Be Making Money Now

As I've mentioned before, there is a lot of pain in this market right now. All broad market indices are down signficantly for the year. Most mutual funds are showing big losses. And now many hedge funds are being forced to liquidate positions and "unwind" as investors redeem capital.

If you are a hedge fund, you should be thriving in this environment. If you are mutual fund disguised as a hedge fund then you are not thriving. If you are a value fund and are buying shares while they are cheap only to see them go lower then you are not a hedge fund. You are an investment fund that does not hedge. The whole point of a hedge fund is to "hedge" or curb your bets so that you control risk. If you are suffering big losses then you are not hedged and you really are not a hedge fund. This is the type of market in which the real hedge funds show their attributes.

There are plenty of rumors going on in the HF world about turtle traders being let go by SAC and other firms because they cannot produce. While I do not like to see people lose their jobs, the one thing that I like about the HF industry and in particular the turtle model is that if you do not produce you are let go. If you do not produce it means that you are losing big. If you are losing big it means that you are not adequately hedged and so you should not be in the hedge fund business.

Full Disclosure - I am a Capitalist

I've always thought it was kind of silly the way people disclose their financial interests. People usually write "Full Disclosure - ..." then goes on to say that they own an interest in the company they are talking about or they own a position in the stock they are touting. I think it is a pretty silly thing to say that because in this world it is obvious that people look out for themselves and their own interests. If they don't then they don't survive.

In the blogosphere, you will often read that someone does or does not have an interest in what they are writing about. Maybe they are writing on their blog about some subject that they find interesting but do not have a financial interest in, but the fact that they have their own blog and are promoting it essentially means that they have an interest in the success of the work. Thus self-promotion essentially runs counter to the full disclosure that a person has no interests in the products or things they are writing about. We live in a world of shameless self-promotion and we are all guilty of it.

 

Thus I have developed a full disclosure that any capitalist should consider adopting.

FULL DISCLOSURE:

I am a capitalist. What that means is that everything I do I do for my interest or any of these entities that are in my sphere of influence - my family, colleagues, portfolio companies, my community, or my profession. Given that I am a capitalist, a lot of what I do during the day is geared toward stimulating profits or the progress of the free markets. In short, I make money and help other people make money. Most of what I say or do works toward that effect.

Fear Factor - Is a CDO worthless?

I've been having a great debate with one of my closest colleagues about what is going on with the financials and the housing market. We differ on many points, the largest being that he believes that a mark-to-market system is essential and that if you can't sell something or there is no market for something that it is worthless. I completely disagree.

My analogy is that of a large piece of land you own. The land is so large that very few buyers can buy it. If the asset can't be sold does that mean it is worthless? Certainly not. But what if there are rumors that your piece of land is toxic and there are environmental issues with it? Does that mean it is worthless? Maybe. But what if there is no evidence to prove that? Most people in that situation would just sit on the land and not really care what it was valued at. But let's say that one day you get into some financial trouble and your bank is forcing you to value your land in order to loan you money. Rumors continue to swirl that your land is tainted. Eventually you give in and value it close to zero.

This is essentially the situation we are in. However, the reason that CDOs are being forced to be valued so low is that the companies that hold them are public companies and investors are demanding that those assets be valued. There is no market in the CDOs because no one wants to touch them. But the truth is that no one knows what they are worth and no one knows how to value them. And the reason they are difficult to value is because they are debt obligations and the only way to know their true value is for them to play out and see which debts get paid back and which don't. Even the most scientific method of valuing debt obligations will not come close to what they truly will be worth when all is said and done.

Is anybody who is reading this wondering one key question - IF WE DO NOT KNOW HOW TO VALUE CDOs AND WHAT THEY ARE COMPOSED OF, WHY ARE FINANCIAL COMPANIES IN SUCH DIRE STRAITS? Well that question points to how messed up the entire situation is. It really is a combination of fear factor, overdramatization by the media, and those two factors forcing the value of CDOs be marked to market. In plain English it means that CDOs are difficult to value and investors got worried and labeled them as tainted. The public markets demanded to know their value and since no one was willing to buy them, they booked their value at close to zero.

If you look on TV in the days and weeks forthcoming you will undoubtedly hear people saying that CDOs will turn out to be good investments and that buyers of CDOs will make out like bandits. If that is true, why the hell did we force them to be valued at zero?

And if the government bailout occurs, what will happen is that a floor for the value of those CDOs will be set and then private equity and other buyers will come in and start buying them. And to make matters worse I suspect that even banks and investment banks will get back into the trading of those very CDOs that brought them to their knees!