Financial Engineering Run Amok: Macro Hedging Your Career?

Remember where I came from, people: I used to run financial engineering teams. So it may seem a bit weird that I am throwing stones at an approach that purports to offer risk management benefits for the layperson - namely, the use of oil hedging strategies to manage your life/work financial exposures. This strategy is put forth by none other than Mr. Irrational Exuberance himself, Robert J. Shiller, in a recent article in Forbes (June 4th issue). Given digital rights issues (!) I am not able to provide a link but I'll attempt to accurately reflect the big picture here. Before diving in, I am proud to note that Robert and I share an undergraduate alma mater - the University of Michigan. I'm not sure if Robert's love for risk management was seeded at U of M or not - I can tell you that mine most assuredly was not. Other seeds were planted - but that is a post for another time...

Shiller's basic hypothesis is straight out of Finance 101 - if you are going to be consuming something (like oil), and you are subject to its price fluctuations over time (in oil prices), you'd benefit from having some of this in your portfolio (through some financial instrument). Further, some people might be at greater risk to price increases and price volatility of the item in question (like the impact of oil prices on those who work in or around the auto industry and its environs), and should consider having an even greater exposure to this thing in your portfolio. And in the article Robert reviews a variety of different ways of hedging oil price exposure, providing the pros and cons of each. All in all, an interesting academic review. And I'd expect nothing less from a man of Shiller's background and intellect.

On paper, it is hard for me to argue with Robert's theory. It is factually correct on its face. The problem with his approach, however, is that it doesn't take into account the most powerful and insidious of risks - irrational human behavior. This is something that I've written about a lot and witnessed on more than a few occasions. Like individuals buying single stocks because they are so smart and the market is so dumb. Like gamblers making larger bets as they are losing as opposed to shrinking bet size as their assets drop. And these are just two examples of what extensive academic literature has shown is, unfortunately, human behavior. When it comes to economic decisions, we frequently do absolutely stupid things. We just do. And we can't help it. So when Mr. Shiller proposes what is, in effect, an elegantly straight-forward risk management strategy for laypeople I shudder. BECAUSE I KNOW FOR A FACT THAT PEOPLE, IN GENERAL, WON'T BE ABLE TO IMPLEMENT SUCH A STRATEGY IN A LONG-TERM, RATIONAL MANNER. And this doesn't take into account the inevitable basis risk that will occur between oil prices - the hedged asset - and people's wealth. Unless hedging is brutally simple and startlingly straight-forward (like swapping a fixed-rate bond into floating for its term), basis risk and peverse motives (like the desire to unwind a "winning trade" - all of a sudden the risk management rationale goes right out the window) take over. I've seen it with retail investors. I've seen it with ultra high-net worth individuals. I've seen it with Fortune 50 corporations. I've seen it everywhere.

So, bottom line: I believe Mr. Shiller's heart is in the right place. I just think he is somewhat detached from the human condition, something about which he really should know. But my advice to those non-professionals considering his recommendations: think long and hard before jumping in. Because doing the right thing over long periods of time - even if it makes sense at the outset - is awfully hard. In fact, almost impossible.

EA: Backing the Leaders, Feeling the Pain

Catching up on my feeds this weekend saw me stumble over a story that brought back some memories: from the San Jose Mercury News, "EA's fumble: Game maker may have misjudged popularity of Nintendo Wii." This story is, in essence, at least six months old. Even this blogger penned a post over six months ago titled "EA: Why Didn't Wii Focus on Nintendo?" The interesting thing is that I was going out on a limb back in November when I was calling EA to the mat, back when it's stock price was $58 and it was trading at 43x earnings. Fast-forward to today: the stock is trading at $48, having dropped 17% from my original post. One of the principal reasons: stagnant revenue growth, skyrocketing development costs. Why? Having to ramp up development for yet another platform, but one that will be absolutely vital to its growth prospects in the near and medium-term: the Wii.

So this is what the Mercury News had to say about EA today:

Some analysts and investors are beginning to question this upbeat outlook. The biggest problem: the surprising early dominance of Nintendo's Wii in the latest round of the console wars. It's no coincidence, they say, that EA emerged as the top game maker at a time when Sony's PlayStations dominated the game console market. The threat that  the Wii now poses to Sony's dominance is bound to affect EA as well, they say.

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EA officials blame the company's recent problems on the complexity of the transition. Not only has the company been developing games for about 11 different platforms during the transition, but there also are multiple emerging opportunities in the industry, from the growing market for games in Asia to in-game advertising to games for mobile phones, said company spokesman Jeff Brown.

While EA was late to recognize the potential of the Wii and Nintendo's DS handheld, it's been ramping up its development efforts for both, Brown said. Meanwhile, the company has also been investing in many of those new areas of the game business, he said.

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In some ways, EA's troubles aren't unexpected. The transition to new generations of game hardware usually are troublesome for software vendors. That's because they typically invest in developing games for the new consoles long before sales of the machines take off.

But this time, analysts and game makers expected an easier time. Companies such as EA promised to continue to develop games for outgoing platforms longer than they had in the previous industry cycle. Sales from those games as well as for two new handheld systems, Nintendo's DS and Sony's PlayStation Portable, were supposed to help bridge the gap during the shift from older to newer generations of game consoles.

But things didn't work out as expected. Sony's PSP saw limited demand. Although games for Sony's older PlayStation 2 continued to sell, development costs for the new consoles skyrocketed, eating into company profits. And when the new consoles arrived, fewer than expected made their way into consumers' hands because of supply problems, demand problems or both.

For the industry, the result has been a longer than expected transition. For EA, it's meant that sales have grown at an annualized rate of just 1.5 percent over the last three years, its research and development costs have more than doubled during that time period, and its profit has fallen by more than half.

Now compare this to what I had written on November 21, 2006. DId these risks of backing the legacy leaders ever come home to roost, or what?!

However, when a platform technology shift happens (roughly every five years), game developers encounter a rough patch and need to increase diversification by making fewer titles across more platforms. They then wait for the fall-out and watch for the winners to emerge, after which point they revert back to the original operating model. While this is a business that has the capacity to mint cash, it also has the capacity to result in a lot of dry wells. Clearly not a business for the meek.

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So if EA continues its emphasis on Sony it is clearly exposed to the degree of adoption (and supply) of new PS3 consoles. If PS3 flops then what? EA will need to identify and milk another future cash cow. They could look to Microsoft’s Xbox 360, with a current installed base approaching 10 million by Dec 31. Not exactly the 100 million installed user base of PS2, but not too shabby nonetheless. However, if the situation evolves such that the Nintendo Wii becomes the rising star, EA may be in trouble. FYI, the French company Ubisoft has lined up nine titles for Nintendo including that exculsive to the Wii: Red Steel.

Ninendo has forecasted up to 4 million units shipped worldwide and with sharply lower development costs than Xbox and PS3: $5-$8 million per title for the Wii vs. the $15-$20 million for Xbox 360/PS3 platforms. This makes the Wii far more attractive (and less risky) for both developers and publishers. If EA sticks to their PS3/Xbox 360 strategy, they may miss the boat on Nintendo, spending too much in development costs while missing what looks to be a home run console in the Wii. This could dent the next several quarters of EA’s earnings, painting a pretty ugly picture for the stock price going forward.

Ok, ok, so I called this one (or, rather, the internet did). But what about Ubisoft, that company that was well ahead of the pack in putting its chips in with Nintendo and the Wii? They just reported blow-out earnings today. Among the big winners in their current product portfolio? Red Steel, exclusively for the Wii, as mentioned in my post above. As I have noted before, game development is akin to trading, where bet distribution and bet sizing are key to winning. And in the case of EA, while they are working dutifully at playing catch-up, they find themselves deep, deep in the hole with a declining pile of chips in front of them. EA has won before and I am sure they'll win again, but theirs is a tough row to hoe. And it takes time. A. Long. Time.

 

Hedge Fund Asset Pricing Revisited: First; Communicate the Process. Then; Follow the Process. It's That Easy.

People who know me know that I am way into process and control. Define the process. Test the process. Refine the process. Document the process. Communicate the process. Follow the process with rigor and collect data along the way to ensure that the process continues to be both accurate and stable. This is the way it's done. Sounds easy, right? Easier said than done in practice (though why, I'm not too sure). Today's Financial Times carried an article on one of my favorite subjects - valuation of complex hedge fund assets - which is really all about creating an effective, clearly communicated process and adhering to it with religious fervor. While reading the article I had this familiar feeling of deja vu. Where have I read about this illiquid asset valuation stuff before? Hmmm. Oh, that's right. My blog, that's where!

This is not a new issue by any stretch, but FT piece does provide a helpful reminder of how important this topic has become given the proliferation of complicated, over-the-counter derivatives such as CDOs, CDSs, TRSs, and other three-letter acronyms. It is only with clear and effective processes and policies that the continued, healthy institutionalization of the hedge fund business can continue apace. Otherwise, issues of trust and transparency will rear their ugly heads and the inevitable blow-ups will occur, ruining what represents a historic opportunity for the hedge fund industry to grow in a prudent, risk-controlled manner and to take its rightful place in the architecture of institutional portfolios as a core asset class. From the FT:

The valuation of hedge fund assets has risen from nowhere to become a hot-button issue. How to value illiquid instruments is occupying minds inside and outside the industry. On the inside, the Alternative Investment Management Association in March published its Guide to Sound Practices for Hedge Fund Valuation. This followed the International Organisation of Securities Commissions releasing its Principles for the Valuation of Hedge Fund Portfolios. The issue was even on the agenda of a meeting in April of the G7 advanced industrial nations where representatives of leading hedge funds met deputy finance ministers.

This sudden focus is recognition that valuation of the increasingly complex assets used by hedge funds is a big issue for investors. Incorrect valuations can mean investors pay too much for units in a fund, lose out when they sell, or pay too much to managers in performance fees.

Pricing and valuation is only a minor issue in equity long-short funds, where standard mark-to-market techniques are sufficient. But there has been a proliferation of sophisticated strategies in recent years that have required advanced valuation techniques. These techniques are required primarily for over-the-counter derivatives, which are illiquid and therefore not easily priced. Instruments include collateralised debt obligations, credit default swaps, total return swaps and mortgage derivatives, all of which have grown enormously in popularity.

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Complex and illiquid issues are typically hand-priced, involving an evaluator calling the desk of a broker-dealer that makes a market in the security (ideally the primary dealer). Mortgage-related products are often priced using models with analytical data and dealer quotes as inputs. Vendors will often incorporate actual trade data into the models and adjust the model prices in line with any visible trades in the market. This process is clearly far from straightforward.

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Meanwhile, an Iosco committee including US, UK, French, German, Hong Kong and Spanish regulators, as well as hedge funds and investors, proposed nine principles of valuation. The main suggestions were that hedge funds should draw up policies for valuing investments, ensure they are used properly and applied as independently as possible. Valuation methods should also be made clear to investors.

While there are no precise answers to the questions of complex derivative pricing, there can be a precise, clearly communicated process that is followed for valuing such instruments. And this is what will set hedge fund managers free. It is hard to get angry - much less get litigious - if someone tells you the process they are going to follow for handling a complicated problem that is carefully adhered to and logical on its face. No funny business. No single-data point valuation on which NAV and, therefore, compensation is based. Engage several dealers, maybe even rotate among a larger number to ensure fairness and independence, toss out the high and low, document all responses, repeat. To get a sense of how important I believe this issue to be, here are some thoughts I had written last July when discussing how poor illiquid asset valuation can skew NAV and cause a big, big problem for the industry:

But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

For those who care, here are some posts I had written previously that also discuss the illiquid asset valuation issue:

• 07/21/2006: Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Firms begin?
• 08/04/2006: Side Pockets - Use or Abuse
• 12/26/2006: Hedge Fund Convergence: Strategy Versus Structure
• 04/30/2007: DE Shaw and Convergence: Putting the Issues on the Table

Sometimes getting the right answer is easy. And notwithstanding the complexity of the instruments at hand, the right answer to the valuation question is simple: clearly communicate and follow the process. End of story.

 

Wallstrip: The Magic is in the Process

I have been cracking up reading the various theories as to why CBS supposedly bought Wallstrip. Explanations abound: it's Lindsay, right? It's all about the talent. Hey, it's hard to create a popular web video show, right? The writing, acting and production needs to really resonate with the audience. Or gee, is CBS really be behind the eight-ball in their creative process if they need to go out and pay a bunch of money for a seven-month old vlog site? The best way to break down the problem: analyze the value stack.

Where exactly are the pressure points in bring a show from idea to release? The answer: it is the vehicle for stringing together the creative writing, the acting and the filming in a seamless, time-sensitive and cost-efficient process. IMHO, it is this process that represents the real IP of Wallstrip. Lindsay, Jeff, Adam and Howard are all key to making this process happen, but it is their collective know-how that creates the value. Believe me, it is not as simple as it seems. This is why CBS made this purchase, to get this know-how and to expand it beyond Wallstrip into a provider of leading-edge web video content. They've got the talent pool. They've got the distribution. They've got the ability to do edgy deals in the contex of a large, old-line organization. This is smart.

The only story I've read in the mainstream media that begins to get at this point was in today's New York Times. The idea for this was, of course, picked up from the web on the VC Ratings blog, which was, in turn, extracted its essence from Fred Wilson's authoritative post on the topic. So there you have it. To the NYT's credit, they got it. And the real answer was on the Web. It's good to be open minded. Get the best content from wherever it resides. And this is the result of the value engine that is Wallstrip.

Taking the Long View: Honda Has it Right

One of the things that really irritates me about the U.S. public markets - and the mind-set of many U.S.-based institutional investors - is an emphasis on short-term results. There are inherent, structural, perverse incentives for corporate executives to do things that maximize short-term results to the detriment of long-term shareholder value. And this is a shame, for investors, executives and the economy alike. And every so often I read a story that flies in the face of this approach, providing an example of a company or companies that eschew short-term thinking and instead choose to take the long view. And I know, I KNOW, this is the right thing to do. I just read one of these stories, and surprise, surprise, the company mentioned is not a U.S.-based enterprise - Honda Motor Company.

In general, Japanese corporations have done a better job focusing on long-term benefits than their U.S. counterparts, particularly in the capital-intensive industries like autos and steel, and the results have been  predictable. But in this case, Honda is bringing their long-term thinking onto U.S. shores, insisting that cars sold into a foreign market are largely made of parts produced in that market. And if this means working with local suppliers in order to up their game to achieve Honda's high standards, then so be it. And if it costs a pile of money in the short-term but stands to create a strong, financially stable partner in the long-term, that is the price of playing the game the right way. I respect this so much, it is hard to put into words. Anyway, here are some interesting elements of the story.

Two years ago the walls were closing in on Anthony Chopp and the other employee-owners of Northwest Tool & Die. The tiny Walker, Mich. manufacturer had just racked up a $1 million loss on $10 million in revenues. It had $5 million in bank debt and owed $1 million more to vendors. Its customers, auto parts suppliers, were ailing. They were turning to low-cost tool shops in Japan, Korea and China for the dies they use to stamp sheet metal into sculptured steel parts for automobiles. "It was a pretty bleak picture," recalls 42-year-old Chopp, who was thrust into the chief executive's job in the midst of the crisis.

Today Northwest is thriving, even as much of the tool-and-die industry continues to deteriorate. Northwest's savior was of a most unlikely sort: Honda Motor. The Japanese automaker took Northwest under its wing, teaching it to more efficiently design and manufacture while steering millions of dollars in new business to it--even though its prices were 50% higher than any of a number of Asian suppliers. Today the new manufacturing techniques have brought Northwest's tool prices to within 15% of the low-cost Asian competitors.

"We took the long view that by working together we could make them competitive," says Timothy Myers, a purchasing executive for Honda of America.

Crazy like a fox, Honda has always been a quirky company driven as much by principle as by economics. It believes in building cars in the markets where they are sold--half of its global sales are in North America--and using locally produced tools, as well. So it made sense to rescue an ailing U.S. company, says Myers. When the tool supplier is situated nearby, he says, communication between engineers is better and cheaper, leading to improved manufacturing and fewer quality problems. "If everything is sourced overseas and shows up in a crate, we haven't really learned anything," says Myers. He has not forgotten that in 2002 a port strike on the West Coast delayed the shipment of important tools needed at a factory in Ohio for the launch of the Honda Element.

One point I plainly disagree with is the author's statement that Honda has been "driven as much by principle as by economics," somehow weakening the economic rationale of their actions. While that may be the case in some decisions made by the Company, that certainly isn't the case here. I believe the decision to prop up a local supplier, teach them how to become competitive, and have them effectively integrated into Honda's production process is manifestly rational from an economic perspective. Honda is creating a stable, local, high quality supply of parts. It is investing in the U.S., something that will endear it to labor unions, local, state and federal governments. It is greater vertical control over its production process without taking on the fixed costs. This is startlingly smart and something that flies in the face of what the U.S. automakers have been doing with their suppliers, namely, squeezing them as hard as possible in order to reduce their cost structures. Yes, lower costs are better, but not if it creates a financially unstable supplier. It can cause labor unrest. It can sour relations with government entities at all levels. In short, it is taking the short view. And it stinks.

Honda is so pleased with its progress that it is adding two North American tool shops to its comanagement program. American companies account for 41% of the tool-and-die business on Honda parts, up from a third before.

Northwest exited bankruptcy court in July 2006. It reported $12.5 million in revenues and a 6% pretax profit margin for the year. Honda accounts for 40% of that business, up from 20% before the bankruptcy. Chopp is aiming for sales of $25 million and a 10% margin within two years. He has won business from new customers, including big Ford and Chrysler suppliers. Its workforce has gone from 46 to 74.

And Chopp is sharing what he learned from Honda with other toolmakers in Michigan, who have formed a coalition in an effort to stop the industry's decline. "If you're not changing, you're headed for extinction," said Chopp. "We started to change too late, and it almost killed us."

So, you can see how Honda's actions have a salutary effect on several constituencies:

• Honda, for the reasons mentioned above;
• Northwestern, the tool-and-die maker assisted by Honda, because they have a new chance at life;
• U.S. auto makers, who have a financially healthy, high quality supplier of parts that they are sharing with Honda;
• The U.S. tool-and-die industry, to whom Northwestern's lessons are being disseminated through a trade coalition;
• Consumers, who will get a steady supply of the cars they demand;
• Employees in the U.S. tool-and-die industry, who won't lose their jobs; and
• U.S. taxpayers, as employed people generally pay more taxes than unemployed people.

The losers in this story? None. Except that it just shines a bright light on the innovative, long-range thinking of Honda versus the U.S. automakers. And that, as a U.S. business professional, is hard to stomach.

Goldman Sachs' TrUE is Truly Golden

So it happened. Oaktree's unique public-while-staying-private offering is now complete. And the results were nothing short of terrific - for Oaktree, for Goldman Sachs, and for the institutional investors that now have another way to access top-shelf product that might not have become available in the absence of such an innovative structure. A few details from today's story in the LA Times are provided below. It is interesting to note that both the tone of the story and the comments of the Oaktree principals are very much in line with my earlier analysis of the strategy:

Los Angeles-based Oaktree and its principals took in more than $800 million selling a stake of about 14% to fewer than 50 other large investors.

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Oaktree, which manages about $40 billion in assets, specifically decided not to offer shares to the public at large. Instead, its stock offering is the first on an exclusive market created by brokerage Goldman Sachs Group Inc.

The idea behind the market is to allow private firms to raise money — and create a way for their executives and employees to cash out some of their wealth in the business — without taking the cumbersome route of going public.

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They said Oaktree's shares, or units, were priced at $44 apiece late Monday and began trading at $50 on Tuesday. Only institutional investors can trade the shares; the general public isn't allowed in.

"In time, we expect to see this [market] employed by a number of premier companies in other industries that wish to access liquidity and outside capital but also to remain private," Marks and Karsh said in the memo. "It makes sense that there be a way for leading companies to accomplish these dual goals."

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If Goldman's market becomes popular, it could present more competition for the New York Stock Exchange and the Nasdaq market as they seek to entice public stock offerings.

"I think it's quite appealing," said David Brophy, a finance professor at the University of Michigan. The greater federal regulatory burdens imposed on public companies since the corporate scandals of a few years ago have raised the cost and hassle of being publicly traded, he said.

"A lot of companies now say, 'What's the point of being public?' " Brophy said.

Although some analysts said Oaktree could have raised more money selling a minority stake in the public market, Marks and Karsh said in their memo to clients that that issue "meant little to us in comparison to the advantages" of staying private.

RIght. So, the issue raised more than expected, as is normal for sought-after newly-issued shares. It traded up on the open like most solid IPOs. The entire issue was soaked up by only 50 institutional investors, resulting in an average of over $15 million in shares per buyer. This is not your your father's retail-driven IPO of yesteryear. And oh, by the way, all of those nasty and annoying  legal, regulatory and compliance issues associated with being public are simply not present. And finally, the clear perception that any economic give-up by the principals by doing a private versus a public deal is well worth it. In sum, what does this indicate? Exactly what I spelled out two weeks ago, that the new issuance market in the U.S. is going to come under pressure - and fast. I have received a few comments from readers who believe that regulations like Sarbox, while a pain, are not a true deterrent to companies going public in the U.S. I have to roundly disagree. And time will tell. But if I were a betting man, I'd wager that the TrUE structure and the inevitable variants will become an increasingly attractive alternative for top new-issue prospects, especially now that Oaktree has broken the ice. The offering was a success and congratulations to all. Except my friends at the NYSE and Nasdaq, whom I assume are shaking in their boots.

AND NOW A LITTLE ON SARBOX

I was pleased to read about the SEC approving guidance to ease Sarbox rules. From today's Wall Street Journal:

The 2002 Sarbanes-Oxley law requires company executives to assess at the end of each year the adequacy of internal controls over financial reporting -- the policies, procedures or activities designed to minimize the chances of inaccuracies in financial reports. The internal-controls assessments, combined with a separate evaluation by outside auditors, have spawned complaints that rules mandated after the Enron Corp. and WorldCom Inc. scandals are too costly and cumbersome.

Under the SEC's guidance, company executives may be able to conduct fewer tests and assemble a smaller amount of documentation to back up their evaluations of internal controls over financial reporting. The guidance gives managers leeway to use their own judgment to identify the areas of their business most at risk of creating financial errors, determine whether controls are in place to address those risks, and then evaluate the operating efficacy of the controls.

This is big, from both cost-saving and time-management perspectives for large companies and from a compliance perspective for small companies. For the first time it seems that Sarbox guidelines might actually be appropriate and achievable for smaller companies, which has certainly not been the case up to this point. Hopefully this will have a salutory effect upon the perception of the U.S. public markets. Because as noted above, we can use all the help we can get.

Ah, Wallstrip, I Knew You When...

So it's a done deal. Wallstrip has been sold to CBS Interactive. Howard has blogged about it. Om has blogged about it (notwithstanding the lousy prognostication of GigaOm readers). Fred has blogged it as well. So what more is there to say, really? Well, I've got a few thoughts of my own to share.

Howard, thanks for asking me to both invest in and sit on the Board of Wallstrip. You built a great team, surrounded yourself with great investors and advisors (Fred, Brad, Mike - the list goes on and on) and really made a go of it in a short amount of time.  You truly know how to leverage networks like none other, and have that perfect mix of humility, arrogance and confidence that makes for a rocking entrepreneur. I love you, man.

Andy Monfried was terrific to work with on the Board. A brilliant marketing guy and just a hell of a nice guy. I look forward to doing more deals with you in the future.

Jeff and Adam, what can I say, our Bright Red boys are now making the Green. Congrats! You taught me a lot about the business; I hope my prattling on about strategy, value stacks, competitive advantage and all that b-school crap didn't put you to sleep too much! Anyway, you are both rock stars and I know you'll create massive value for your new friends at CBS Interactive.

Lindsay, oh Lindsay, what can I say? The way you managed the action in that referees' shirt during the Blackberry Shoot-Out. The way you laughed at me when I tried to explain that the name of my company, Monitor110, was derived from the binary for "6." Ah, those magical moments. Sorry about flicking that rubberband in your eye just before the Shoot-Out. I guess now I understand who had greased my Blackberry just prior to the thumb-off, rendering my performance less than stellar. It was you, sister! Good luck anyway - I know you'll rock the house.

Anyway, it was all a ton of fun and I wouldn't have traded those crazy seven months for anything. Onward and upward - I'll be rooting for you!

An "A Ha" Moment for the BIS: Hedge Funds Really ARE Regulated

Shortly after Germany's call for a voluntary hedge fund "code of conduct" was roundly defeated, the BIS released the results of a year-long study indicating that lending practices geared towards hedge funds have slackened. This then prompted the BIS's call for more intensive monitoring of investment banks' portfolio exposures and more stringent risk management practices. From today's Financial Times:

Evidence that action is needed comes in a report from the Basel-based BIS, saying investment banks’ declining financial discipline is making them more vulnerable to future turbulence. It says the underlying problem is that banks are competing fiercely to win business from the hedge fund sector, which has expanded greatly this decade.

Consequently, the BIS warns that regulators may need to press hedge funds and investment banks to reveal more data about their market activities, and relationships. And it urges banks and hedge funds to step up their level of stress-testing, to cope with the accelerating pace of financial innovation in areas such as derivatives.

“There has been some erosion of counter-party discipline [among banks] recently,” warns the report, which was drawn up by the Financial Stability Forum, a committee of international regulators organised by the BIS, and released over the weekend.

It adds: “This complements other signs of complacency about risks in markets . . . such as the weakness of covenants in credit contracts that could impose significant challenges for market participants”.

Hey now, BIS. You are on the right track. Banks lend to hedge funds. Banks are regulated institutions. Banks should be able to provide data indicating their risk management practices and a granular review of their portfolio exposures. In fact, I know that banks are asked to produce this information as I've sat through many of these meetings over the years with various regulators. This is what regulators are supposed to do. Regulate. But in order to do so effectively, they need to ask the right questions. Which means really understanding the industry you are regulating. As I've noted previously, the SEC has been doing a much better job of understanding hedge fund risks over the past five years. Whether banking regulators have been keeping up with the rapid changes in the alternative investment landscape I'm not so sure. But in any event, the opportunity exists to proactively manage systemic risks through the effective monitoring of regulated institutions (read: prime brokers), namely, those which are providing the lion's share of credit for hedge funds.

The other piece of the puzzle is really being on the leading-edge of hedge fund investment practices and strategies. And likely the best way to stay in the information flow is to do what the FSA does, which is to develop dialogues with the largest and most influential hedge funds in their jurisdiction. Rather than providing incentives to be evasive and withholding by virtue of heavy-handed and illogical regulation, the FSA approach encourages the kind of voluntary transparency that the German regulators would like to hit you over the head with. Between having an insider's view of the market through light-touch regulation of hedge funds and the sheer power to impact lending practices through the oversight of banks and prime brokers, the BIS, FSA, SEC et al should be in pretty good shape. And now if they'd just put their heads down and focus on doing this in the best way possible we could get on with it and stop the never-ending tug-of-war across borders and regulatory bodies. This is what would really protect those whom they purport to be protecting - and not simply politicians' jobs.

Me on Reuters TV Discussing Halo 3: Financially Successful? Likely Yes. Transformational? Definitely Not.

I was recently interviewed on Reuters TV concerning a topic I love: gaming, and specifically the new release of the Xbox 360 game Halo 3. What about the game? Is this just the ticket to help the Xbox 360 cross over into the mass market? And what about the Xbox 360 media center strategy anyway? Does it have legs? These were some of the questions posed to me by Jeanne Yurman of Reuters. Though I have provided a link to the clip, the two key points I made during the interview are:

1. Halo 3, while likely a very successful game that will be sold into the existing installed base of mature, hard-core Xbox 360 gamers, is not going to help Microsoft cross the chasm into the mass market. First of all, the game is an M game. A mature game, a violent game. This is most decidely not a game for the whole family. Contrast this with Nintendo, where most of the games are rated either E or T and with much broader appeal. Further, unlike its predecessor Halo 2, the Halo 3 game is not backward-compatible, only being able to be played on the Xbox 360 console. This limits its initial target audience to around 10 million Xbox 360 console owners, versus the 30 million that are available to Halo 2. Neither of these are helpful facts if "mass market" is truly the objective. And I certainly don't buy the argument that the Halo 3 game itself will drive new console sales. The game has gotten OK reviews and I am confident it will sell well to existing Xbox 360 loyalists, but beyond that, I am neither a dreamer nor a believer.

2. The Xbox 360 media center strategy has been discussed ad nauseum on this blog and others. And there are certainly differences of opinion on the likely success of this strategy. My position remains: the mass market will not be willing to pay for an all-in-one home entertainment solution, and certainly not one which is first and foremost a gaming console. They will buy consoles to play games at home, play games with others and maybe a little game-related social networking on the side. Might I be wrong? Of course. But this is one hell of an expensive bet to make, and one that has some ugly historical precedence in the form of the Sony PSX.

Anyway, that's it. I hope you find the clip interesting. I have so much more to say and so little time... More later.

IA To Barron's on Dividends: Let the Market Decide

Dividend strategy, among the most contentious of capital structure policy issues and one about which I've written before, graced the cover of Barron's this weekend. The thrust of the story: that dividend payouts are too low and that buybacks are overused. The story, penned by Andrew Bary, is both well-written and well argued yet misses an important point: that the market - namely, institutional investors - appears to be pretty comfortable with corporate financial policies, at least on an aggregate basis. Sure, there are isolated circumstances where institutional shareholders may clamor for higher regular payouts, but in general, the market is trading pretty well given current corporate behavior. And I don't really buy the argument put forth by Henry McVey of Morgan Stanley concerning the impact of retail demand for dividends:

"A lot of corporations are missing the seismic shift in retail demand for yield," says Henry McVey, chief investment strategist at Morgan Stanley. As tens of millions of baby boomers start retirement, the demand for yield-oriented investments will climb. McVey notes that Americans over 65 have equity portfolios with an average yield of 2.6%, versus 0.8% for those under 65.

Much of this money is going to be run by institutions, not by retail, so I'm not really sure if this "seismic shift" really matters. I think not. And while I'm at it, I also don't really buy the following argument governing the motivation of corporate-sponsored buybacks:

Corporations are wedded to big buybacks because executives believe that repurchases are the best way to lift share prices. And higher prices enrich corporate managers who have lush stock-option packages. Individuals, meanwhile, can benefit from buybacks to the extent that they defer paying capital gains.

Corporations like buybacks because they are flexible, can be used to soak up short-term excess cash as well as to facilite a more optimal capital structure, and because of the signaling effect they can have on management's view of business prospects. I don't think corporate managements really believe that institutional investors are as dumb as Mr. Bary would have you think. Given my knowledge of corporate finance departments and their decision-making processes, I am pretty confident that the reasons I raised for why buybacks are used are more on point, IMHO.

So while we can prattle on about what should and should not be, the market is saying something: that the current dividend vs. buyback policy is just fine, thank you. And while we can debate the point on a theoretical basis, the fact that the two strategies are tax-neutral and that institutions seem to like the discretionary and signaling aspects of buybacks means that things are unlikely to change. Until institutions begin stand up and begin voting with the pocketbooks, that is. Which means a change in the market. Which is the way things should be, not the way some people think things should be in the financial media eco-chamber. Let us always remember: Mr. Market rules, now and forever.