DE Shaw: Going Institutional, Going For the Gold

I have long thought that DE Shaw is an amazing firm. Institutional Investor recently had one of the better articles I've read on David's business, where it has been and where it is going. It just reminded me that they are at the forefront of much of what's going on with the largest hedge funds, and have an impressive array of assets with which to build a leading institutional asset management firm:

• An attractive 18-year track record;
• The experience of getting rocked - hard - surviving, and emerging smarter and stronger than before;
• A "best athlete" orientation and a commitment to recruiting excellence, hiring the best from a wide variety of domains to create a team of superior intellect and breadth;
• Consistency in firm vision and leadership; and
• The creation and development of a broad-based management team that takes the risk out of single-manager governance.

And so, exactly, how are these strengths being brought to bear on growing the already-massive $29 billion DE Shaw business?

• Using its long/short quantitative excellence to drive a mega-capacity, long-only institutional product (DESIM);
• Using this same experience base to bring out a large capacity long/short "lite" product - the 130/30 structure so popular with institutions today; and
• Leveraging its risk management expertise to expand into other hedge fund strategies, i.e., currency, commodities, real estate, distressed and private equity.

All of these items, taken together, point to a single fact: David is building the business for the long run, taking advantage of demographic and market trends to apply his team's skills in a much comprehensive way than in the past. This means developing into a true institutional asset management complex, with the ability to take the management company public, individual funds public, or to remain private and maintain the status quo. None of these are bad outcomes. It's just that by building the business the right way - which largely means hiring, incentivizing and retaining the best people and giving them input into long-term strategy - the market will come to DE Shaw. And it has. And it will.

Hedge Funds and Managed Accounts: A Discussion

My friend and fellow blogger Yaser asked me the following question: "I would love to hear your opinion on Managed Accounts and whether they improve transparency and other pros/cons of HF investing." While I find it flattering and humorous that anyone would "love" to hear my opinion on anything, I think the question is deserving of a response, for what it is worth. Yaser also forwarded me the results of an August 2006 survey from Terrapinn Ltd. concerning managed accounts, and suggested I take a look at it as well. The results of this survey are predictable: many Institutional Investors don't invest in hedge funds due to lack of transparency; many would be more inclined to do so if there was greater transparency; and a significant number are considering investing in hedge funds via managed accounts in the future. Yeah, whatever. So what is the straight dope on managed accounts? Here it is.

So what is a managed account, exactly? A classic hedge fund managed account has the following characteristics:

• The investor owns actual assets via the managed account, not simply LP interests in a pool of assets;
• The hedge fund manager is an advisor to the managed account;
• The investor has full transparency into the assets being managed;
• The investor generally has liquidity superior to the LPs in the main fund;
• Running a managed account is an operational and logistical hassle for a hedge fund manager; and
• Most hedge fund managers will require a sizable capital commitment in order to accept a managed account.

This presumes, however, that a hedge fund manager is willing to run a managed account under any circumstance. Many top managers simply won't, or only run managed accounts for legacy investors for whom they do it as a courtesy (as they may have originally helped them get their start, etc.). Why are managed accounts viewed with such disdain by managers, while they are clearly desired by Institutional Investors? Principally, because:

• They are an operational pain, requiring discrete resources for their proper management which reduces returns;
• They often provide a window (read: transparency) into a portfolio and trading strategies that managers find undesirable;
• They often come along with preferential liquidity rights for their owners which managers don't want to give;
• They often create asymmetry with the main fund, as managed account holders may want portfolios run pursuant to their unique portfolio objectives and/or risk parameters; and
• They create unnecessary and unwanted complexity in to manager's operations when they simply are not needed.

There is a supply and demand imbalance for top hedge fund managers, where the demand for their product far outstrips supply. Therefore, there is absolutely no incentive for these managers to take on managed accounts. And they won't. So which managers are offering managed accounts? Not the top managers. Frequently emerging managers or those for whom asset gathering has been a problem. Remember the S&P investable hedge fund index? It failed. Managed account platforms run by big banks are challenging by their nature, because frequently the only funds willing to accept the rigid parameters of the program are, quite simply, not the best. Therefore, there is, to a degree, structural adverse selection when it comes to managed accounts. Those who are willing to run them are simply not the best, because they need to accept them to raise assets. Top managers don't, and want all their investors to be fund investors with homogeneous (and painfully rich) terms. This makes life easy.

So ultimately it is up to the Institutional Investor to vote with their feet:

1. Is gaining transparency worth the possibility of giving up returns? or
2. Is it best to simply avoid hedge funds altogether and accept that the asset class won't be available to me? or
3. Should I sacrifice my transparency guidelines on a small portion of my portfolio in order to gain exposure to top hedge fund managers in the hope of generating true alpha?

While 1 is clearly stupid, either 2 or 3 are perfectly reasonable and valid choices,  IMHO. But the punch line remains:

Those who think the flood of Institutional assets into the hedge fund space wanting greater transparency will force the use of managed accounts on top managers are on crack. It just won't happen.

I think transparency can be a beautiful thing - depending on the context. But for most high quality hedge fund managers (and for many investors as well), transparency is NOT considered a good thing, and it will be those most in need of assets (read: novices or B-type managers) who capitulate to such demands. Now is this any way to invest? Maybe if you are seeding new funds. Otherwise, choose another asset class.

Search and Personal Privacy: It's What You Don't Know That Matters

Overview

As one who uses the Internet - a lot - I find myself using the concepts of security and privacy interchangeably. I intuitively know this to be wrong, and I actually know this to be wrong after having attended Open Data 2007. The issue of privacy permeated the discussion, and was driven home by the comments I blogged about last week. The ramifications of violating personal privacy were highlighted by Abdur Chowdhury, former Chief Architect at AOL Search, in his recounting the AOL release of search queries that led to the specific identification of people and their searches (and the subsequent firestorm that engulfed AOL). Three key questions concerning privacy and data that emerged from his harrowing experience:

• Why open up data? If you give up control, you hope/expect to make things better. If not, don't do it.
• What are you going to do once you open up the data? If 50 people ping you in a week to discuss the data, but you can speak to maybe 2-3 per week, how do you handle this?
• What are you going to do if something bad happens? Because companies fundamentally can't handle when stuff like this happens.

The New York Times ran a story last week about Google strengthening their privacy measures. After having read it, however, I think they would have been skewered by most of the Open Data attendees. Why?

Because the issue isn't simply the ability to protect your privacy, but the knowledge and awareness of how to protect your privacy. Is it Google's (and Microsoft's and Yahoo!'s and Ask's) responsibility to inform and educate, or to merely provide the tools to exercise personal privacy?

This is the $64,000 question.

Who's Really in Control?

My sense is that market forces will dictate what people will accept and that education concerning privacy and the ways of exercising it will eventually be free-flowing and available, but that there will be a significant lag between now and when this degree of awareness takes hold. Some excerpts from the NYT article are provided below.

The company (Google) keeps logs of all searches, along with digital identifiers linking them to specific computers and Internet browsers. It said on Wednesday that it would start to make those logs anonymous after 18 to 24 months, making it much harder to connect search records to a person. Under current practices, the company keeps the logs intact indefinitely.

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But it is unclear whether the change will have its intended effect. Privacy advocates reacted with a mix of praise and dismay to it.

“This is really the first time we have seen them make a decision to try and work out the conflict between wanting to be pro-privacy and collecting all the world’s information,” said Ari Schwartz, deputy director of the Center for Democracy and Technology, an advocacy group. “They are not going to keep a profile on you indefinitely.”

Others were less enthusiastic.

“I think it is an absolute disaster for online privacy,” said Marc Rotenberg, executive director of the Electronic Privacy Information Center. Mr. Rotenberg said his organization has been trying to combat efforts by law enforcement officials to require online services to retain search records for long periods of time.

He said that 18 to 24 months was too long, and added that because of Google’s dominant position, it would most likely set a de facto standard for data retention.

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Just how personally revealing such data can be became evident last year, when AOL released records of the searches conducted by 657,000 Americans for the benefit of researchers. While AOL did not identify the people behind the searches, reporters from The New York Times  were able to track down some of them quickly through their search requests.

The ensuing flap caused AOL to tighten its privacy policies. The company now keeps search histories for only 13 months and does not link them to Internet protocol addresses — digital tags that can identify a specific computer.

For its part, Yahoo keeps search data for “as long as it is useful,” said a spokeswoman, Nissa Anklesaria. And Microsoft said that while it does not keep search histories alongside I.P. addresses, it can connect the two if law enforcement requests it.

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Google may be tightening its privacy policy around search logs, but the company recently relaxed its privacy practices in another area. Earlier this year, Google users who signed up for services like Gmail that require them to sign in started to be automatically enrolled in a service called personalized search. The service tracks a user’s search history and tailors search results accordingly. Previously, users had to specifically choose to enroll in personalized search.

Users can opt out of the personalized search service and delete their search history. Still, some analysts believe Google should give users more notice.

“I don’t know that a lot of people have realized that that kind of change has happened,” said Danny Sullivan, who edits the blog SearchEngineLand.com. “You can delete your search history at any time —  if you remember.”

The Punch Line

Google's own policies and those of the other search giants reveal a very squishy and amorphous series of practices relating to privacy. Of course this is all about money - what else? Behavioral targeting. Getting more bang for your advertising buck. And sure, as consumers, don't you want ads that better target you and your interests? Well, some do and some don't. But the fundamental question remains - is it the consumers' responsibility to be aware of these privacy issues or the search engine providers' responsibility to inform? Does this, in fact, represent a kind of externality, where the search engine provider receives the lion's share of the benefit (ad revenues) off the backs of the consumer (loss of privacy)? Good question.

One thing is for sure: there are more PR firestorms to come. And given Google's current flap over YouTube, they might want to get out in front of this one and proactively create a set of "best practices" relating to privacy with which to lead the industry. Because it is the right thing to do and they can use all the good PR they can get.

Me in the FT

Today I was honored to have the Financial Times publish an editorial I penned concerning the pending Blackstone IPO and its implications for private equity and the overall market. I am especially proud because their interest in my thoughts emanated from my blog, where I have written quite a bit on the topic of hedge funds and private equity firms going public.

This reflects a true crossing of the mainstream media/alternative media chasm, another transformation about which I've written and which I am confident will change the face of media forever. And it is exciting to be even a small part of this tectonic shift that is taking place before our eyes. Thanks for joining me in this historic adventure.

AppleTV: MSM vs. the Blogosphere, and the Winner Is...

The blogosphere, duh. I read an article in the 3/19 Wall Street Journal titled "AppleTV Could Be Big Opportunity For Apple And Its Stock," re-read my post dated 3/2 titled "IPTV and Asynchrony in the Consumer Era of Computing? The Apple/Microsoft/Sony War Kicks Off," and said to myself, "The blogosphere kicks MSM's butt on issues of speed as well as the breadth of valuable perspectives on new, bleeding edge technologies." Now, the WSJ is a fine publication and there is much I find of value in its pages, but come on, folks. You can't compare their little missive versus the insights I was able to glean by extracting intelligent, reputable, high-value data and commentary from the Internet. Check it out. The analysis is pretty black-and-white. The blogosphere wins, hands down.

This isn't me, folks: it's you. My single stock and thematic posts (basically where I'm not waxing philosophic about either Wall Street or hedge funds) are my simply connecting-the-dots of what's out there. Now as you know I don't trade single stocks, but the trends and issues identified in my posts have by and large been pretty spot on (and I will write a post with some data in the next few weeks). It's kind of like a real-time, dynamic Wikipedia. What's up, what's news, what's deep, RIGHT NOW. This is where my Monitor110 thing comes in handy.

Anyway, congratulations to Apple with the arrival of AppleTV. But I'm not going to tell you about the ramifications of its release. And whom it might effect. And which industries could be disrupted. And how certain companies could get flamed. And why it represents a huge opportunity but is not a slam-dunk. Because I already have.

Gone Fishing

Fellow Internet denizens, I will be away on vacation with the family for the next week or so, and for the first time in 15 years attempting to be "off the grid." Those who know me well have little confidence in my ability to actually do this, but f*ck them. I'm gonna try.

In any event, I have a little backlog of posts which will be dripped in between now and when I return, but I will not be commenting during my hiatus. So please don't get pissed off if you write a flaming comment and it is met with resounding silence. I will reply upon my return.

Thanks, as always, for being part of my community. This blogger just needs a little rest. C ya, Rog.

Private Equity and Biotech: Yet Another Data Point for Convergence

So I write about KKR booking less risk, and now I read about private equity going high-risk by wading into the quagmire of biotech? I have written extensively about convergence in the past, but what gives?

Here is the punch line from my perspective:

• PE, to use the baseball analogy, is trying to "hit 'em where they ain't," e.g., identify the areas that are under-invested from a risk/reward perspective and deploy capital before others do;

• Biotech investing, just like the PIPE deal KKR did with Sun, is well-suited to PE. Why? Long time-horizon; illiquid; potentially volatile mark-to-market over its life; layers on well to PE's existing porfolio of very different risks;


• Smart investing in any domain tries to identify cheap optionality, i.e., in the KKR PIPE deal (via the embedded call) or in PE investment in biotech (building a portfolio of inexpensive call options via investment in the common stock of efficient, research-oriented biotechs. Investment in the common stock of these companies is nothing more than buying a call option on its being sold or becoming profitable);

• PE principals tend to have strong relationships with corporate chieftains, for example, of the large pharma companies, who represent the logical strategic partners, licensors of compounds/technologies or acquirors of these nascent biotechs;

• PE investors are attractive to biotechs in need of capital, as they are principally interested in financial return and less interested in meddling with the science and approach of the scientist-driven biotechs.

To be clear, while this might be revolutionary for PE is certainly isn't for hedge funds. Hedge funds have invested in several biotechs to date, and already understand the concept of cheap optionality very, very well. But, in fact, PE should have an advantage over hedge funds in these types of investments given their compensation model, i.e., volatile biotech investments can profoundly and adversely impact short-term incentive fee compensation for hedge funds, while PEs longer-term oriented performance-fee-upon-liquidation approach should structurally make it less sensitive to such short-term variations in mark-to-market value. That said, this is dependent upon a fair mark-to-market framework for illiquid hedge fund investments, which may or not be the case (remember autocorrelation?).

This type of investing is already in the sweet spot of the venture capital community, particularly those larger funds that are looking to deploy large amounts of capital. That said, PE firms can potentially offer friendlier terms and possibly better relationships with the corporations who are most strategically important to these biotech firms. Who wouldn't want a KKR, a Carlyle, a Blackstone or a Bain as an investor? I would.

But do you see what is going on here - this type of investing, which was not that long ago only the provenance of strategic corporate (read: big pharma) and venture capital investors, is now being done by hedge funds and even PE firms. Alternative asset managers are allocating capital in a free-flowing, opportunistic manner, aggressively seeking cheap optionality and identifying areas that are under-invested from a risk/reward perspective. So where does VC end and hedge funds/PE begin? You've got me. There is only one guiding mantra these days: make money. Any way you can.

Apple and the Enterprise: In 20 Years, "Who Would Have Thought...?"

Tomorrow WILL NOT Be Like Today - Guaranteed

Pet peeve: people who insist that tomorrow will look like today. Wall Street analysts often fall into this camp. Unfortunately, I frequently find myself peeved because this type of myopic thinking is everywhere, and always has been. Why? Probably due to the social psychology concept called framing, e.g., we are systematically given the messages that dominant companies, technologies, social and political mores, etc. will persist indefinitely, and therefore find it hard to move away from these beliefs. It could also be just plain idiocy, but I'll opt for the more textured and academically-appropriate answer for now. We clearly know this to be the case yet we keep on making the same stupid, short-sighted judgments again and again and again.

• GM? Unbeatable. Yeah, right. Toyota and others have systematically kicked their butt - design, engineering, production - across every conceivable dimension.

• Eastman Kodak? Invincible. They used to make film, right? Can you say late to the digital photography game?

• IBM? Who can touch them? Alive and kicking but not the force of nature they once were. Who would have thought that a couple of long-haired brainiacs offered them the keys to the OS kingdom, only to turn them down?

• Microsoft? The $600 billion Evil Empire. Well, they've been chastened a bit, haven't they (if you call being chastened losing over $300 billion in market cap)? Being shackled to the legacy desktop-centric, software-laden culture has weighed heavily on their growth prospects.

• Google? The movie still has 90 minutes left. Come back later. But they will invariably come up against their own demons before long. They always do. Creative destruction and the challenges of scale ensures that this is and will likely always be the case.

The Punch Line

Given the investment community's poor track record of long-term prognostication, why should we believe them when we hear "Microsoft owns the enterprise. Apple is and will continue to be a non-player in the enterprise space." Answer: we shouldn't. Because they are consistently wrong and are likely to be wrong in this case as well. And besides my somewhat irreverent tone, there are actually really good reasons why investors should wake up to the possibility that XP/Vista/etc. won't be the dominant desktop platform forever, and that Apple could represent a new paradigm in enterprise computing.

The Case for Apple

The Wall Street Journal ran an interesting article a few days ago concerning the impact of a Mac's ability to run Windows, and how this has opened doors to small businesses, educational and professional users who previously wouldn't have considered buying from Apple. That said, there is more than a little cynicism from, yes, Wall Street.

Helping Macs gain a bit of ground within the workplace are a growing array of programs that let the machines run Windows or Windows applications on Macs with little loss of performance.

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No one believes Microsoft's dominance of the professional market, which includes businesses, education and other non-consumer fields, is in any imminent jeopardy. Analysts say such organizations, especially big companies, have far too much invested in Windows for Apple to ever win a big share of the market. Apple, tacitly conceding as much, puts more focus on the consumer market, with products like the iPod and forthcoming iPhone.

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"I would say the opportunity there is very limited," Charlie Wolf, an analyst at Needham & Co., says of the professional market.

Apple is making small inroads in the professional market with its critically acclaimed line of Mac desktop and laptop computers, and even slight market-share gains can bring meaningful new business to the company... Apple's share of total new PC shipments in the U.S. jumped to 5.4% last year from 4.5% the prior year, Gartner says. Nearly all of the rest of the market is Windows.

Over the holiday quarter, Apple sold 1.6 million Macs, 28% more than in the same period a year earlier and nearly five times the growth in global PC shipments overall in the period. Apple Chief Executive Steve Jobs this year said the company's research showed more than half of all people buying Macs were new to Apple computers.

Apple's move to Intel microprocessors -- which act as the brains of PCs -- has helped the Mac business by giving the machines a performance boost. Macs may also have benefited because they have been largely free of viruses and other security woes that plague Windows PCs.

Uh, I'm not really sure I agree with the assessments of "Analysts say..." or Mr. Wolf. They sound so sure of themselves, even in the face of the frequently-occurring yet statistically unexpected 3 standard deviation events and the examples of empires being toppled every generation. Companies are "too heavily invested" in Windows to ever switch to Apple? The opportunity for Apple in the enterprise is "very limited?" You've gotta be kidding me. I wish I could be that sure of myself - but I know it would be false security, anyway.

I've written a little bit about Apple and its leadership in the rise of the Consumer Era of Computing. This does not mean that Macs are only for the consumer, but that Apple as a company is laser-focused on delivering the best user experience, be it in the home or at the office. Check out a little of what I had written around the time of Microsoft's release of Vista, and how the market was handicapping its adoption rate:

I guess the question is whether or not those 73 million households are a gimme. A lot has happened in the consumer market since the release of XP: the rise of the Mac Book,  the popularity of iTunes, the ubiquity of the Apple consumer experience. Analysts frequently love to base projections on previous product adoption cycles. Is Mr. Schadler correct in assuming that Vista will enjoy the same uptake as XP did when it went live? Today's world is clearly different, my friend, and woe be those who are bounded by yesterday's thinking in projecting tomorrow's reality. Even a small dent in Microsoft's OS market share would have a huge impact on its P&L (with the benefit going straight to Apple).

And let's not forget: James Allchin, Microsoft's Head of Vista, said he covets a Mac; Pat Gelsinger, General Manager of Intel's Digital Enterprise Group, bought two Macs.

So, when you've got your own executives (Microsoft) as well as those of one of the most powerful suppliers (Intel) in the tech sector singing the praises of your competitors' (Apple's) products, all cannot be good. It also raises the interesting question that if Vista requires so much memory and processing power that current XP users would actually need to upgrade machines to properly use the new software, then why not try a Mac? Allchin likes it. Gelsinger likes it. Millions of people love it. And Steve Jobs loves it.

In my earlier post I reconciled the issues of being user-focused while tapping into the enterprise opportunity in the following manner:

Bottom line for Apple: it's not about the enterprise, it's about the user. If the user wants a platform that melds their personal and professional lives, Apple will deliver this reality. If the enterprise follows from the users, that will be their way in. But make no mistake: Apple is focused on what matters - their users. Markets, per se, are secondary. Their users will take them where they need to go.

Conclusion

And this is the point. I know from my own experience in my company how this transformation takes place. We started out being a Dell/Intel/Windows XP Professional-based shop. Then our developers needed better machines, several of whom had Macs at home, and requested hi-test Mac machines for development. They loved them. Told everyone. Then anybody doing graphics/visualization wanted a Mac. Then anybody in a client-facing role who did presentations, online demos, etc. wanted one. Now pretty much everybody has one. It has become "the" supported platform in my company. And it happened in a stealthy, inside-out way, where a core of passionate Mac users got the ball rolling, showed others how awesome it was after which people were beating a path to my desk asking for one.

So change can happen quickly within SMEs. Yeah, we're not talking about Deutsche Bank going Mac tomorrow, but as the PC user experience degrades and/or requires new hardware, and as more and more grass-roots Mac users begin speaking up, some change - material change -  will invariably take place. First in small, semi-autonomous groups. Then in larger groups. And then it becomes viral. I saw this movie with the Blackberry phone. Early adopters were supported by IT in a one-off, kluge way, told others how awesome the device was, a wall of demand was created, and finally the Wall Street firms caved and properly supported the device on an enterprise-wide basis. The same thing can happen with the Mac. And don't tell me that change can't happen and that Apple is out of the enterprise game. Because it can. And because it's not. Really.   

Listen to the Leaders of the PE World: They See the Big Picture

In my earlier posts on Blackstone and KKR, I made it pretty clear that their steps - going public and creating lower risk, lower return investments - are a foreshadowing of what's to come: namely, a much tougher environment for private equity. These difficulties will emanate from several sources, principally:

• Less friendly debt markets (both higher rates and tougher terms);
• Fewer attractive buy-out candidates;
• Too much liquidity across the alternative investment landscape (PE, HF and large VCs); and
• Greater regulatory scrutiny.

No sooner did I write this that I read about Apollo's pushing the limits on issuer-friendly debt terms. Based upon what I've seen, it is starting to feel like the late 1980's in the leveraged debt markets. Now remember, I was around back then, and it was crazy, man. This from the WSJ:

Strong demand for bonds, particularly those offering extra yield, has created the right environment for such offerings (those exclusively used to fund dividends), with investors more concerned with return than a company's cash flow. After all, financing a dividend payment does little to improve a company's operations, yet the added debt leaves bondholders more vulnerable to potential losses.

Apollo financed that dividend with a high-yielding pay-in-kind "toggle" debt, a new twist on the PIK notes popularized in the 1980s that allows a company to pay interest in either cash or additional debt. These notes began popping up with greater frequency in the fall, starting as a way to finance giant leveraged buyouts and later championed by Apollo as a way to pay dividends.

This is a bad, bad thing. Too much liquidity can cause perverse decision-making, and the brash and brainy private equity financiers are only too willing to take advantage of this market anomaly (that is, the inadequately-priced risk that is willingly underwritten by sheep-like investors awash in cash). Leon "Pizza the Hut" Black knows this. Stephen Schwartzman knows this. David Rubenstein knows this. Henry Kravis knows this. They all know this. They are making hay while the sun is shining, especially when they see mounting clouds on the horizon. So Henry is buying PIPEs. Steve is going pubic. What is next?

This from William Conway, Co-founder of Carlyle, as reported in Dailyii.com and taken from a note that was supposedly sent from Bill to his peers at Carlyle. Please note my comments in bold capitals:

Conway warned that the cheap debt private equity firms have been thriving on is likely to be history in the not-too-distant future, saying, "The longer it lasts, the worse it will be when it ends." Conway, directing his memo to his p.e. peers at Carlyle, stated, "Frankly, there is so much liquidity in the world financial system, that lenders are making very risky credit decisions. This debt has enabled us to do transactions that were previously unimaginable, and has resulted in generally higher exist multiples than entry multiples." When Conway says "us," he literally means deals involving his own firm, including the $15 billion buyout of Hertz and the $18 billion Freescale deal. In preparation for the eventual fall, Conway offered three recommendations:

--"If the excess liquidity ended tomorrow, I would want as much flexibility as possible – are our covenants loose enough? Have we hedged against a share upward move in rates? Can we draw down on our revolving credit loan facilities?" he asked. SEE LEON BLACK, APOLLO

--"Second, liquidity has led to a significant reduction in risk premiums – most investors in most asset classes are not being paid for the risk being taken. Our strategy should evolve to take lower risk deals and earn lower returns." SEE HENRY KRAVIS, KKR

-"Third, we should redouble our focus on deals with downside protection – asset coverage, multiple and early exit paths, strategic partners, government protection, consumer needs, controllable capital expenditures and defensible market positions," he said. SEE PRIVATE EQUITY, ORIGINAL BUSINESS MODEL

If I've said it once I've said it a thousand times - watch these guys. Because unlike many of us, they are seeing the big picture. The institutional debt investor is myopically focused on deploying their cash and spreading risk around different credits (even when, say, it is best to keep some money in cash because it offers the best risk/return trade-off?), while the IPO investor is also interested in participating in the New New Thing and finding another name in which to deploy capital (notwithstanding trifling considerations like, say, valuation?). These are all signs of things to come, friends. Eyes wide open, ok?

KKR and PIPEs? What Are They Smoking?

Overview

So I'm glancing at an old issue of Business Week and came upon an article talking about KKR's purchase of a private convertible note from Sun Microsystems (also see Sun's Press Release and Jonathan Schwartz's blog post on the subject). I had heard about this but filed it away in the back of my mind until it was jogged loose. Now that I am looking at this I am asking myself: Why?

I am all about buying cheap optionality and managing risk (which KKR has done by investment via a structured debt instrument versus straight common equity), but is this really what I want from my hot-rod private equity shop? Can't I get exposure to this same type of security by investing in a convertible bond mutual fund, and without all those fees? Something just doesn't add up. Ah, protecting their fees! Now I get it.

Where's the Beef?

Let's consider a few facts (with some opinions sprinkled in, namely mine):

• KKR is making this investment from its publicly-traded, Euronext-listed vehicle, ticker KPE;


• KKR has a "carve-out" in its KPE document: "Up to 25% of KPE's assets may be committed to opportunistic and other investments identified by KKR that are outside the scope of KKR's traditional private equity investments;"

• Competition for deals has heated up across the global private equity landscape, as hundreds of billions in purchasing power has been raised over the past twelve months;

• KPE's trading performance has pretty much stunk, down about 5% from its IPO price;

• KKR is likely stinging from the poor performance of its listed vehicle, and would like solid if unspectacular deals to point to in order to say "Hey, we should be trading better than this;"

• The deal carries coupons of between 1.25% and 1.50%, certainly not the key source of return (at least it chips away at the KPE management fee, however);

• KKR likely wants to get a bunch of KPE deals under its belt so it can show it is not simply a "blank check" SPAC but an active and vibrant investment vehicle worthy of its premium fees;

• As full publc-to-private deals get harder to source and the pressure on private equity returns builds, KKR is going to want to be seen as a friendly, value-added investor to people like the Jonathan Schwartzes of the world so more of these PIPEs can be booked;

• KKR is banking on its relationships and reputation as a smart investor to help propel the stock; it is clearly not trading volatility around the embedded call option so is a classic buy-and-hold investor through the convertible; and

• KKR, by taking a Board seat, will be deemed an "affiliate" for regulatory purposes. Those who have said that this gives them an "insider view" or the "inside track" to a possible buyout are smoking crack, as they will come under brutal (and hostile) regulatory scrutiny if this scenario comes to pass.

So, the key take-aways from my perspective:

• KKR knows that deal sourcing is going to get increasingly difficult. They are seeking to build a track record in the PIPEs space and to gain experience with the management of these types of investments. This is very, very different than the stuff they're used to. And they are acutely aware of this. The hope is that by being successful and by working well with Managements and Boards of Directors, that they'll ensure a steady source of deal flow tomorrow and beyond.

• KKR knows that deal return risk is increasing. You know those Blackstone guys? They see the same thing. KKR's approach (though an IPO is possible) is to put less risky assets into their portfolios to prepare for rainy days ahead. From a portfolio management perspective, this is smart.

• KKR, besides putting on an implicit portfolio hedge by booking a convertible debt structure versus straight common equity, is putting on a management and performance fee hedge. If KKR is moving down the risk/return continuum by shooting for lower risk, 10-12% total returns versus higher risk, 30-40% total returns, they are betting that shellshocked investors won't be offended by paying premium fees for stable, low double-digit returns. And they're probably right.

• KKR knows that private equity is coming under increasingly regulatory and PR scrutiny, and wants to be the firm wearing the white hat. By supporting company management's in PIPE deals, they burnish their image as a concerned corporate citizen that is a supporter and not a raider of industry. No asset stripping. No debt-funded dividends 3 months after taking a company private. Only good, wholesome, long-term investment. This isn't your father's KKR, my friends.

I could go on, but I think this is quite enough.

And in Conclusion...

Is this investment approach a one-off or a trend for KKR? Inquiring minds want to know. My guess is that they'll do more of this - patient, less risky, strategic capital - versus the Coniston Partners-type toehold investment-then-agitate model of the late 1980s (which failed miserably). They are smart, just like the Blackstoners, and I would posit will likely use PIPEs more frequently as a vehicle to hedge both portfolio returns and GP returns (fees, get it?).This is a great deal for Sun - which I didn't talk about. They get cash, a supportive, high-profile, smart investor willing to help, and a security that just gives them a little more runway to invest in their business. Btw, the structure is actually pretty cool, because Sun is synthetically rolling up the strike to around 60% over spot at the time of issuance versus the 25% embedded in the convertible sold to KKR. Anyway... sorry I had to derivatives geek-out on you for a minute there. Bottom line - good for KKR, good for Sun. But good for KKR investors? I'm not so sure.

ADDENDUM

My friend Paul Kedrosky pointed out to me that he had blogged about this earlier (he was quick and efficient about it, as always). After reading his post(s) I wanted to highlight a few key issues. I find his deterrence argument interesting but not quite spot on. Firstly, the $7.21 strike really isn't the strike from Sun's perspective: they invested a portion of the $700 million offering proceeds in a derivatives deal. They effectively "rolled up" the conversion price, by repurchasing the $7.21 strike call options embedded in the convertible(s) (actually there are two separate tranches with 2012 and 2014 maturities), and selling higher strike call options with strikes of approximately $9.23 and $10.09, 60% and 75% premiums to spot, a far cry from the 25% premium in the actual convertible notes. This shows that Sun's price targets are far above those implied by the convertibles (or Paul's analysis), meaning that Jonathan and the Board don't see $7.21 as meaningful but only prices at least $2-$3 above that. Investing some of the proceeds in this manner is an undeniably bullish signal from Sun, and should be interpreted as such. In any event, thanks to Paul for shining a light on this issue. Hopefully this is helpful in the context of the overall dialogue.