Sowood, So Long. And Not Short Enough.

Sowood, simply the next in the parade of likely credit hedge fund blow-ups. Exactly how many funds will be laid low by the current credit markets ugliness? I'd hazard a guess that the final count will be in the low hundreds. I keep asking myself why, WHY this is happening, and it always comes back to THE common thread separating the truly successful hedge funds with long track records from road-kill: strong risk management practices. This seems like straight-forward common sense, right? Well, apparently not. I know as much as all of you do, but what I can infer from Sowood's situation is the following:

• They were long lower-rated credit instruments, either pure credit or credit spreads;
• The likely hedged the long positions by shorting equities and/or high-grade credit instruments;
• They likely employed leverage to amplify the bet; and
• Their book wasn't very well diversified by strategy, even if it was across a range of credits.

The net result: lower grade credits eroded, higher grade credits eroded as well, and the drop in equities didn't begin to offset the decline in credit values. And leverage only increased the adverse result of the trade. Now, consider that Sowood was a Day 1 $2 billion launch by Harvard Management rock-star Jeff Larsen. This is not some greenhorn tossing around huge institutional dollars without having any inkling of what they should be doing. This was JEFF LARSEN. Of the super-successful Harvard Endowment? Right - you know the one. Don't you think Mr. Larsen knew better than to place so many concentrated and statistically-related bets such that, if all hell broke loose, he'd drop 50% of his NAV in a month? I'd think so. But then, I'd be wrong.

I guess if it can happen to LTCM and its brain trust it can happen to anyone. But didn't Mr. Larsen learn from LTCM? Or, more recently, Amaranth? What is driving these types of behaviors? Unhappy with a few years of mediocre returns and trying to shoot the lights out? I'd bet a lot of money that Sowood's true NAV didn't drop 50% in a month - it actually dropped a lot less. Why? Because it really began dropping well before last month, it is simply that positions weren't marked to true liquidation value but marked-to-model. I will almost guarantee you that this high-profile blow-up will cause many to revisit this issue - and fast. This kind of practice causes artificial stability in both position values and fund NAV, and generally provides a false picture of risk as well as possibly resulting in excess manager compensation. Autocorrelation - the smoothing of returns - is a big no-no, and if there is some basis in fact that banks aren't causing gradual mark-downs in counterparty collateral because it would hurt their own proprietary positions, we've got a big, big problem. And this is what I'm afraid we may have.

Anyway, at times like these I hear the refrain from Queen "Ba da ba, ba, ba, another one bites the dust." And I'm sure I'll be hearing it a lot more in the coming months.

Tougher Lending Terms for Hedge Funds? Free Market Regulation in Action

The Financial Times had a front page story today titled Tougher terms for hedge funds, discussing the impact of credit market uncertainty on the willingness of investment banks to provide leverage:

Investment banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.

Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil.

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The move could raise pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of market swings. The average hedge fund, across all strategies, returned 0.8 per cent in June, down from 2.3 per cent in May, according to Credit Suisse Tremont.

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The stricter approach to lending to hedge funds by investment banks comes as markets continue to suffer as a result of concerns about the state of the US credit markets.

There are several messages one can extract from this story:

1. The Bear Stearns debacle has put prime brokers behind the 8-ball;
2. Credit-driven strategies are hurting, and are dragging down the returns of composite indexes;
3. Hedge fund leverage will be harder to come by for the foreseeable future;
4. Prime brokers are able to manage their policies, practices and exposures based upon market conditions; and
5. Regulation via the free market is effective.

I'd say 2-5 are right and 1 is wrong. Prime brokers aren't behind the 8-ball, they're on the ball. Most of the people I know at the leading prime brokers have lived through ugliness before, and are pretty experienced as it relates to non-normal market risks. And while competitive market forces may drive down pricing and hurt the risk/reward balance for prime brokers in hot markets, my sense is that sufficiently conservative controls exist around the risk side of the equation such that they will do just fine in most market dislocations. They've taken their lumps in the past and have learned from their mistakes. In fact, almost all leading investment bank risk management infrastructures, policies and controls have been strengthened dramatically over the past decade. So I am pretty sure that 1 is untrue.

2-5 are factually correct. Credit-driven strategies (at least most long strategies) are hurting, and it appears that their is more blood to be shed on the Street. Prime brokers are reining in lending practices, so portfolios for both credit and non-credit strategies alike may well be more difficult to finance. Clearly prime brokers have the flexibility to deliver bad news to their clients and make lending more restrictive, as this is happening all across the globe. And this is the very essence of market regulation, provided courtesy of the free markets, no government involvement required.

Prime brokers are in business to make money, not make friends, and if this means pissing off some friends by tightening lending standards to protect current and prospective P&L, so be it. And this is highly rational. And it's not as if they needed the SEC, Congress, the OCC or anyone else to tell them how to do it. They know just what to do as rational market actors. I hope Commissioner Cox and those in Congress are tracking this story. Because this is the way it should work. Mr. Market driving decision-making. And, as is almost always the case, leading to the right answer.

EA: Building Up by Being Broken Down

My friend Chris Kohler at Wired Game/Life wrote a little blurb in the wake of EA's recent investor meeting:

In another statement that reconfirms his commitment to getting Electronic Arts back on the right track, new CEO John Riccitiello says to an investors' meeting that they messed up at the beginning of this console cycle:

“Our stock hasn’t moved as much as we’d like,” Riccitello told one investor during a Q&A. He admitted that EA was on the “wrong horse” by concentrating mainly on the PS3 and Xbox 360 while throwing less resources towards the Wii during the console transition.

Yyyyep. To be fair, they've got their bets spread around a little more evenly now.

You said it, John, and right on, Chris. The only point of clarification I'd make is that EA's stock has moved plenty since I first critiqued their strategy in mid-November of last year. Problem is, it has been a great investment for the shorts, having fallen around 14% over the past eight months. Come on, 20%+ annualized, that is a pretty good return! But seriously, Mr. Riccitiello has done a very good job acknowledging EA's problems and taking concrete steps to remedy them. Their strategy which is, as Chris notes, far more diversified, is also less reliant on the core gamer and the legacy platforms that are having serious user-adoption issues. This is most definitely NOT the same EA I wrote about last fall, when their shares were riding high but a reading of the Internet tea leaves indicated trouble on the horizon:

Make no mistake: EA is a game-creating machine. A techno-behemoth making big-headline games for the Big Three: Microsoft, Sony and Nintendo. But at $58 per share and 43x earnings I would be afraid - very afraid. What was once a company able to focus on harvesting its category-leading franchise is now under siege: high development costs, uncertain platform plays and lofty equity valuation. While EA has deftly navigated the vagaries of the fickle gaming marketplace, it is now facing a competitive landscape unlike any other it has seen in the recent past. Ergo, this is one complex business encountering an array of complex market and business risks. This is not a scenario that makes me terribly comfortable as an equity investor.

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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.

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EA has some real problems. Historic market dominance, rising development costs, backing high-end platforms with limited user bases - none of these factors point to an explosion in valuation in the near term. And these issues are compounded by EA’s gold rush resulting from the run-away success of PS2, which does not look to be replicated by PS3 in light of both production delays and fierce competition from the lower-priced and highly innovative Wii. As noted by the ‘Net, all ain’t well. In short, all I can say is: Buyer Beware.

Now that EA has their strategy right it boils down to execution. And executing in this increasingly complex marketplace is no easy task, but I think John has the goods and has built depth in EA's senior management ranks that gives it a fighting chance to come out on top.

Goldman Sachs: Taking a Page from the DB Advisors Playbook

Yesterday in Dailyii.com and today in greater detail in the New York Times, it was reported that a chunk of Goldman Sachs' Principal Strategies Group is moving from the securities business to the asset management business to build a hedge fund operation. This means that traders and teams that were previously running only the firm's capital will be part of fund structures that will trade both firm and client capital. Interesting. Very, very interesting. This something I know a little bit about, having run a group called DB Advisors which was, in essence, exactly the same business. We ran about $4 billion of prop risk and $2 billion of client capital as part of a Registered Investment Advisor that was wholly-owned by Deutsche Bank. This structure can be great or it can fail miserably, and few have gotten it right. Based upon my reading of how Goldman is doing it, they are getting the big things right (no surprise). That said, running a successful operation of this type involves walking a very fine line, the reasons for which I'll share with you. But first, for background I'll pull a few extracts from the NYT article to give you context for my comments.

Now Raanan A. Agus, 39, head of that (Principal Strategies) desk, is starting a hedge fund, but with a twist. His fund will be inside Goldman Sachs itself.

In a first for Goldman, Mr. Agus will move part of his principal strategies team — the formal name for the equity proprietary desk, which had been known as the risk arbitrage desk — to the bank’s asset management division to start a hedge fund that some insiders speculate could reach $10 billion.

The fund, which does not have a name yet, will receive money from Goldman and raise money from its private clients and outside investors, according to people with knowledge of the fund.

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The decision to move Mr. Agus highlights the importance of hedge funds for investment banks because of the potential revenue they can generate and as an option the banks can market to their wealthy clients. Inside the securities division of Goldman Sachs, Mr. Agus puts up the firm’s own capital.

With Mr. Agus’s shift into the asset management division, he and his team can gather money from Goldman Sachs, its clients and outside investors, offering Goldman three benefits: a fund for its clients to invest in, a stream of fees from the funds and the ability for Goldman to put more money at risk — through the hedge fund, and in principal strategies.

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This will allow Goldman to try and make money in both places: the securities division with the remaining principal strategies group and in asset management with the new hedge fund (two of the bank’s internal hedge funds, Goldman Sachs principal strategies and its special situations group, account 12 to 15 percent of the firm’s revenues, according to one person briefed on the firm’s results).

So, the punch line: Goldman is taking one of the prizes of its securities division (and, in fact, the entire firm), Principal Strategies, and handing it over to the asset management division. This could only happen in a place where politics take a back seat to business rationale, and, quite frankly, I am not aware of too many shops like this. This "playing well together" concept might be the single greatest asset Goldman has over other firms, and it is grossly undervalued by the market. Goldman's people are great, sure. But there are lots of great people at other firms as well. In my opinion what distinguishes the firm from its peers are two key things: (1) a culture of teamwork, and; (2) excellence in risk management. Goldman is, at its core, a hedge fund with an advisory, underwriting and asset management fee component, and the only way this works is because the firm is so good at taking and managing prudent risks and leveraging relationships and insights across its business lines. Anyway, it is this distinguishing feature that gives it a shot to make this new venture work.

This all sounds really good. So what's the issue? Well, these platforms have some inherent issues that need to be considered when building them out. If Mr. Agus and his pals took their team outside, they'd get 2/20 and plenty of Day 1 assets to manage. They'd also get to build a brand just like Mr. Singh, Mr. Mindich and Mr. Steyer have, which has value in and of itself if, say, you want to go public someday. So, why accept an internal deal where, by definition, they will not be getting the full 2/20 and will not be readily thought of as an independent, branded entity? Three key reasons:

1. Reduced management and administrative headaches. Setting up a robust, multi-billion hedge fund platform takes time, effort and money. But more importantly, it is a major distraction to what a top trader/investor wants to be doing - making money. And then there is the ongoing management, compliance, record keeping, vendor management, etc. It is no walk in the park, let me tell you. So by setting up this business within Goldman, much of this burden will be offloaded to its prime brokerage unit and other internal teams. While setting up a platform like this even in a well-oiled machine like Goldman isn't easy, it is far easier than doing it de novo as a new independent hedge fund.
2. Enhanced asset gathering power. A person with a reputation and a track record like Mr. Agus would certainly be able to raise $1-$2 billion+ upon launch. But again, this takes time and effort. By staying in-house and having the full Goldman asset gathering operation at your disposal, not only is the process easier but the sheer amount of assets raised will likely be far greater. It is a pretty compelling pitch to say "Top trader performance with world-class controls and infrastructure from Goldman." Don't you think this message would resonate with institutional investors? I know it will. We used the same rap at DB Advisors and it is both true and represents a powerful selling point.
3. Flexibility and portabiity. Though I am not privvy to Mr. Agus' deal, I'd be willing to be A LOT of money that his contract contemplates things such as taking his audited track record should he want to set up an independent fund outside of Goldman; taking his brand; and taking his team. In exchange, I am virtually certain that Goldman is getting guaranteed fund capacity; possibly preferential fees; either an implicit or guaranteed share of their prime brokerage business; serving as the asset gathering conduit for the independent fund; and maybe an option on a share of the GP. And you know what, this makes sense and is fair. We did some of these things at DB Advisors because they were fair and worked for both the manager and for the bank.

One key to making these structures work is to for there to be seamless communication and team play between the securities and asset management divisions, since the securities division's core competencies (risk-taking and risk management) and the asset management division's core competencies (fiduciary management, distribution and client management) are both complementary and absolutely necessary for the venture to succeed. Competing interests, politics and BS only hurt what could be a supremely profitable, value-added business.

The other big key is for the manager contracts to be sufficiently flexible to provide for hedge-fund like compensation as well as portability should the manager wish to move their team outside the firm. If the manager wishes to move outside, however, the firm gets a package of benefits that reflects the value they've helped create during the manager's tenure. And this feature is critical because without it, you won't be able to attract and retain the best managers - period. What you'll end up with is an assemblage of traders that emerge from a structure that promotes adverse selection, as no star manager will allow themselves to be trapped without a clear path to taking what they've built outside the firm. And this is very, very hard for a lot of firms to cope with, viewing traders leaving as a failure. But it is only a failure if you don't get value in return.

Ah, this brings me back to 2003-04 when I was dealing with these exact issues at DB Advisors. Goldman has the right culture and the right human capital to make this work. It is a smart move this is good for both shareholders and clients alike.

The Best Argument for De-regulation: Removing the Safety Net

I have long been a champion of light-touch regulation for hedge funds, focusing on the burden of investors to do their homework with the proviso that information provided needs to be truthful, straight-forward and timely. I have also been a proponent of letting funds fail, as I scarcely hiccuped in the wake of the $9 billion Amaranth implosion. That said, no argument I've seen for light-touch regulation is any more compelling than that I read in this weekend's Wall Street Journal penned by Allan Meltzer of Carnegie Mellon. His punch line:

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. The answer to excessive risk-taking is "let 'em fail."

All I can say is: Amen, brother. You've got it. Think back to all the perverse behaviors that were prompted by ill-conceived market regulation. The S&L crisis. The Great Depression. The hyper-inflation of the 1970s. And now the quasi-Federally guaranteed home loan entities. And this list goes on and on. But the S&L crisis  along with Fannie Mae are probably the best analogies for the hedge fund industry. There was an implicit "safety net" that protected investors in these sectors and companies, leading to perverse risk-taking by both the entities and the financing sources backing those entities. After all, if the Federal Government is implicitly backstopping any crisis, the they are effectively underwriting a free put option, the premium of which is used to gamble on the upside. It is the same thing as hedge fund managers themselves exhibiting negatively-skewed returns with high kurtosis, which is akin to writing options and hoping they don't pay off. The net result: a steady stream of out-performance followed by a colossal bust. And at that point the managers can simply move on and try again. Just look at Brian Hunter. Who would have thought that he was employable after his little fiasco? Anyway, Mr. Meltzer goes on to say some other pretty interesting stuff that warrants mention:

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

This is clearly what happened during the S&L crisis, where so many S&Ls held long-dated mortgage assets funded by short-term money market instruments. And when the yield curve inverted, they were toast. Or, rather, the U.S. taxpayer was toast. And Fannie Mae? Declining credit standards, but again due to the put option issued by Uncle Sam. Mr. Market is very, very smart. It will consistently go to the place that maximizes the expected value of those in power. And what about the appropriate role of financial regulators?

The responsibility of financial market regulators is to the market, not to financial firms. Sometimes risk-takers have to be allowed to fail. At the same time, announcement of policy -- and acting in accordance -- has great advantages. Financial firms can understand the rule: no bailouts, period. That will induce firms to hold more relatively safe assets and to take fewer risks. Incentives achieve what regulation cannot. They focus a manager's attention on the firm's self-interest. The Fed is responsible for aligning self-interest with the public interest.

I absolutely, positively guarantee that Mr. Meltzer is right. Financial firms will adapt. Because they will to maximize their own self-interest. And this is adaptation for the right reason, not because of some ill-conceived regulation arising from political posturing or a tussle for headlines. And, finally, the punch line:

A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

I wish I had written this Op-Ed because it is so right. Arguing with its conclusions is hard to debate. Turning the market on itself, giving it clear parameters within which to operate and letting it run will both spur innovation and foster prudent risk-taking. And isn't this what we really want from our financial institutions, be they banks, investment banks, asset managers or hedge funds? I'd say so.

The Dumbing Down of American Culture

As a parent and as a citizen, I have long been concerned over what I perceive to be a decay in American culture. And the crux of the problem is life as experienced by our children. A life that is increasingly filled with advertisements, video games, computers, lousy movies and sedentary activity, and a seemingly incessant need for stimulation. Now I know that I am neither a sociologist nor a cultural anthropologist, so my views might not possess the legitimacy of my discussions concerning Wall Street or technology. That said, I did spend my childhood in a different era and am experiencing first-hand the environment in which my children are growing up today, so I am not completely without valid reference points or data. But mine is not a call for the abolition of the things that my children are experiencing today, but a better balance among them and activities that promote creativity, social interaction and physical and spiritual health such as reading, imaginative play, listening and playing music, creative writing and outdoor group activities. And I am deeply concerned that American culture has lost its way, and in the process has created a bifurcated society that further divides us along class lines. This is not my vision of America.

The catalyst for this post came from an abridged version of a commencement speech carried in the July 19th Wall Street Journal, delivered a week ago at Stanford University by none other than the Chairman of the National Endowment for the Arts, Dana Gioia. While I generally consider myself to be a pretty good writer and reasonably capable of getting my point across, Mr. Gioia's speech is so beautifully written and well-considered that I feel anything I could say would pale in comparison to its brilliance. A few of the more memorable points mentioned include:

The loss of recognition for artists, thinkers and scientists has impoverished our culture in innumerable ways, but let me mention one. When virtually all of a culture's celebrated figures are in sports or entertainment, how few possible role models we offer the young. There are so many other ways to lead a successful and meaningful life that are not denominated by money or fame. Adult life begins in a child's imagination, and we've relinquished that imagination to the marketplace.

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But we must remember that the marketplace does only one thing -- it puts a price on everything. The role of culture, however, must go beyond economics. It is not focused on the price of things, but on their value. And, above all, culture should tell us what is beyond price, including what does not belong in the marketplace. A culture should also provide some cogent view of the good life beyond mass accumulation. In this respect, our culture is failing us.

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In a time of social progress and economic prosperity, why have we experienced this colossal cultural decline? There are several reasons, but I must risk offending many friends and colleagues by saying that surely artists and intellectuals are partly to blame. Most American artists, intellectuals and academics have lost their ability to converse with the rest of society. We have become wonderfully expert in talking to one another, but we have become almost invisible and inaudible in the general culture.

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We need to create a new national consensus. The purpose of arts education is not to produce more artists, though that is a byproduct. The real purpose of arts education is to create complete human beings capable of leading successful and productive lives in a free society.

This is not happening now in American schools. What are we to make of a public education system whose highest goal seems to be producing minimally competent entry-level workers? The situation is a cultural and educational disaster, but it also has huge and alarming economic consequences. If the U.S. is to compete effectively with the rest of the world in the new global marketplace, it is not going to succeed through cheap labor or cheap raw materials, nor even the free flow of capital or a streamlined industrial base. To compete successfully, this country needs creativity, ingenuity and innovation.

It is hard to see those qualities thriving in a nation whose educational system ranks at the bottom of the developed world and has mostly eliminated the arts from the curriculum. Marcus Aurelius believed that the course of wisdom consisted of learning to trade easy pleasures for more complex and challenging ones. I worry about a culture that trades off the challenging pleasures of art for the easy comforts of entertainment. And that is exactly what is happening -- not just in the media, but in our schools and civic life.

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If you don't believe me, you should read the studies that are now coming out about American civic participation. Our country is dividing into two distinct behavioral groups. One group spends most of its free time sitting at home as passive consumers of electronic entertainment. Even family communication is breaking down as members increasingly spend their time alone, staring at their individual screens.

The other group also uses and enjoys the new technology, but these individuals balance it with a broader range of activities. They go out -- to exercise, play sports, volunteer and do charity work at about three times the level of the first group. By every measure they are vastly more active and socially engaged than the first group.

What is the defining difference between passive and active citizens? Curiously, it isn't income, geography or even education. It depends on whether or not they read for pleasure and participate in the arts. These cultural activities seem to awaken a heightened sense of individual awareness and social responsibility.

Art is an irreplaceable way of understanding and expressing the world -- equal to but distinct from scientific and conceptual methods. Art addresses us in the fullness of our being -- simultaneously speaking to our intellect, emotions, intuition, imagination, memory and physical senses. There are some truths about life that can be expressed only as stories or songs or images.

Art delights, instructs, consoles. It educates our emotions. And it remembers. As Robert Frost once said about poetry, "It is a way of remembering that which it would impoverish us to forget." Art awakens, enlarges, refines and restores our humanity.

I find this incredibly alarming, mainly because I have a hard time envisioning the way back. Sure, my kids have video games (DS Lites, to be exact), occasionally watch Boomerang and see the once-in-a-while crappy movie (which still annoys me). But my wife and I find ourselves aggressively managing their consumption of video games, computer games and video content in an effort to maintain balance in their lives. I can't tell you the feeling of watching my children experience art and literature first-hand; it is almost magical.

When we were in Paris last month we took our boys to the Musee Rodin, which has an amazing sculpture garden just perfect for viewing with children. My little one was extremely excited by the sculpture, making observations about how certain statues appeared to be related to one another (which, in fact, they were) and providing his theories concerning the artists' motivation. Though he is only six there was a purity of thought and a clarity of expression that brings tears to my eyes, completely unfettered by preconception or bias. And when I was at the luggage return at JFK one day later, a fellow traveler said to me "You were at the Rodin yesterday, weren't you? I recognize your boys; they had such interesting and insightful things to say about the sculpture." I felt like hugging him. I couldn't have been any more proud.

The problem is, we are not representative of the general populous. We live in New York City, one of the world's great cultural hubs. We are blessed by having parents with artistic and musical skills and interests which were instilled in us as children. And we have the resources to travel and expose our children to different peoples and cultures. And it is even hard for us to fight society's pressure for our children to conform, which means playing lots of video games, spending lots of time on the computer, viewing a bevy of low brain-food movies and other intellectually bankrupt activities. This is not a hopeful sign. I only hope that our subsequent Federal administration can take Mr. Gioia's assessment into account, because he is right. And this isn't simply a call for re-emphasizing the arts for art's sake, but a call to protect the spirit of creativity and intellectual challenge that is ingrained into what it means to be an American. At least the America that I know.

 

Actively Traded Private Issuances: Wall Street Hops on the Bandwagon

Well, well, well. It took a little longer then expected but it finally happened: some Wall Street firms stepped up with an answer to GSTrUE. As discussed in today's Financial Times:

Merrill Lynch , Lehman Brothers, Morgan Stanley and Citigroup are among a group of investment banks developing an electronic trading platform for unregistered securities to compete with existing systems such as the one created by Goldman Sachs.

The move comes after Goldman signed up Oaktree Capital, the hedge fund group, and Apollo Management, the private equity firm, to sell unregistered shares through its GSTrUE private trading system. Apollo shares will also trade on a platform created by JPMorgan Chase.

The system being developed by the group of banks is intended to ensure that Goldman, JPMorgan or others do not come to dominate the electronic market for unregistered shares, people close to the matter said.

Not for nothing, but yours truly was all over this over two months ago. From my post titled More Evidence of the Ravages of Sarbox: U.S. Private Placements Overtake IPOs 5/19/2007:

This final point, a point which I raised in my earlier post, is absoutely critical when assessing the magnitude of the threat posed by these alternative exchanges. The retail investor is not the driving force in the equity markets here or abroad, and given the structure of U.S. regulatory doctrine once one crosses into the realm of the "accredited investor" there is much one can do on a private basis. Like start a private exchange. Or many private exchanges. If GSTrUE is successful, as I expect it will be, is there any doubt that Morgan Stanley and the like are close behind? And with the great leap forward in low latency trading technology, what is stopping a flow aggregator like Nasdaq or any ECN from pooling the deals originated on these private exchanges and enabling them to be traded more broadly? In fact, I am almost certain that this is how it will play out. So, to recap, if:

• You have a massive pool of institutional liqudity in need of high-quality product; AND

• You have a sea of high-quality companies that would like liquidity but are put off by the regulatory demands of going public in the U.S.; AND

• You have innovative investment banks structuring these early deals between high-quality issuers and high-quality, leading-edge investors willing to buy a new and untested product; AND

• You have ECNs with capacity that can pool flow across these private exchanges and centralize trading, clearing and settlement in order to broadly and efficiently distribute product; THEN

• You get a withering U.S. new issues market that will slowly and inexorably die on the vine.

We are in the early innings of an extra-inning game, but you can see where things are going. Either Commissioner Cox and his friends in Congress are going to get busy streamlining our public company regulatory environment or else...

 

Microsoft's Identity Crisis Rages On - Take a Page from Nintendo, Guys

So, I've been mentally out to lunch for a few days but I'm back. And during my mental hiatus Microsoft reported earnings, some more stuff came out on Nintendo, and, in general, my views on these two companies and their strategies have been validated. Nothing like a little validation to help get you up and running again.

So, first, my friends at Microsoft. Earnings were good. Congratulations! But these nice earnings were in spite of the continued poor performance of its Home & Entertainment (H&E) Division. My thesis, spread out over many, many posts, can be summarized as follows:

Microsoft's enterprise software business is like a portfolio of oil wells. It kicks off a highly profitable yet declining annuity that it seeks to bolster through the drilling of new wells (i.e., Vista, exactly how much of a gusher this will be remains to be seen). This can be a risky and costly proposition. However, it knows how to drill for oil and has done so successfully in the past. But Microsoft has sought to tap into other, less proven forms of energy (i.e., fuel cells), that it is seeking to bolster through investments in non-core activities (like, say, those in its Home & Entertainment division?). As a result, it is using the oil wells to subsidize its foray into fuel cells which, if successful, could put the Company back on a real growth ramp. But, alas, it is not that good at leveraging fuel cell technology, causing its core oil business to subsidize continued operating losses and adding volatility to its business. Both of which should, over time, damage its business and hurt its stock price.

Ok, ok, you say. Microsoft is in H&E for the long run. After all, they're in it for 20 yards ($20 billion in FX-speak), and there is the whole "window to the living room" strategy thing that will take years to play out. But they can afford it. My response: so what? So they can absorb $5 billion in operating losses and they just took another $1.1 billion hit. Is this better then, say, paying a big dividend back to shareholders? Or making a strategic acquisition that can augment a business they actually understand and that leverages their core competencies? Theirs appears to be a strategy of conglomeration which, by the way, generally is not rewarded in the stock market (see Electric, General). This isn't the 1960s, Microsoft is not ITT and Steve Ballmer is not Harold Geneen. So, I've never bought this diversification argument and I never will. And their numbers continue to bear out my thesis: success in their core, failure in their non-core. They can stop the bleeding if they want. But they won't.

But wait, there's more. A 7/20/2007 article in PC World indicates that Microsoft sees 2008 XP sales doing better than anticipated and representing a higher proportion of the XP/Vista operating system mix.

During a conference call with analysts following the earnings results release Thursday afternoon, Chief Financial Officer Chris Liddell said the company has changed its fiscal year 2008 forecast from an 85/15 split in sales between Vista and XP to a 78/22 split. Windows XP sales will, in other words, be nearly 50 percent higher in the next 12 months than Microsoft had estimated earlier.

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His remarks caught the attention of Michael Cherry, analyst at Directions on Microsoft, a Kirkland, Wash.-based research company. "What that seems to say is that XP has stronger legs than you would expect after the release of a new operating system."

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"Most of the machines I see pitched in catalogs are in the $700 range, certainly under $1,000," said Cherry. "Computers with that amount of hardware are a better fit for XP. With Vista's requirements, people may be thinking about sticking with XP, and putting less money into the hardware."

Now this can't be good. Vista costs more. Vista is much more complex. Vista often requires hardware upgrades. And the market says - we don't want as much of it as you thought, Microsoft. I had hypothesized about these kinds of problems back in December. And now they're here. Here is an extract from my post dated 12/12/2006 titled Microsoft vs. Apple: Is Vista the Answer in the Era of Consumer Computing:

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). I'm just saying it's a possibility, but apparently not to Mr. Schadler.

Um, no. Not the same uptake. And now consider some new skinny on the Zune. From Apple Tech News 7/19/2007:

A new survey conducted by the eagle research group says Zune owners may not be all that satisfied with their purchase.The survey shows that 70% of those questioned did not have a firm loyalty to Zune and intended to switch to an iPod or iPhone when their current phone contract expires.

The survey went on to say that the most compelling features of the iPhone was the ability to swipe through music play lists easily and of course making phone calls.

Of the 30% of people unwilling to switch brands to iPhone the most common reason given was a lack of music storage, 43% and the dislike of all things Apple, 22%.

Apparently Zune buyers are no different than any other consumers when it comes to buyers remorse with 36% saying they would not have purchased Zune if they knew Apple would produce such a ground breaking product as the iPhone.

Now, I knew the Zune wasn't doing so hot, but this is abysmal. More than 2/3 of those who went out and purchased a device want to pitch it when their contract expires? This is worse than the mobile industry! This can't be what Steve et al had in mind when they poured the hundreds of millions into developing an answer to the iPod. I think the conclusion I wrote to my 12/12/2006 post is as valid today as it was back then, and maybe even more so given the hard data coming out of Microsoft in terms of financials, unit sales and market perception:

Microsoft has to decide what it wants to be. "Bet the ranch" projects like Vista are not the future. While the Company can say it beta tested Vista to death, if it takes 5 years, billions of dollars and millions of man-hours to kick out a commercial product you've got a problem. What top young pro wants to be part of that? The problem is deeper than business model and who your customer really is (though these are, without question, two of the most critical issues to Microsoft's future), but how you attract, retain, excite, challenge and incentivize the best people. Without this, the battle is lost. And right now, Microsoft needs to focus on those dimensions if it wants to maintain its role in shaping the technology of tomorrow. Because we have firmly entered the Era of Consumer Computing, an era with which Microsoft has little experience and even less success. And based upon what I am hearing from the corners of the Internet, they've got a seriously uphill battle.

So as far as I'm concerned the Microsoft identity crisis rages on. And, unfortunately, with little relief in sight for Microsoft's shareholders.

Nintendo, conversely, is simply continuing its laser-focused, highly successful march toward console game ubiquity. Whether it is in actual numbers or symbolism, Nintendo is making it happen. Most recently, a powerful cultural indicator of the rising power of the Wii/DS franchise was highlighted in Kotaku 7/20/2007:

For something like ten years, the first floor of Akihabara retailer Sofmap was PlayStation territory. Not anymore. PS goods, games and hardware have moved to the third floor. What's in its place? You guessed it, Nintendo. Shoppers looking for Wii/DS consoles and games can easily find them on the ground floor. Retailers are a good source of info from the trenches, and this is very telling. That, or the move's to make things more convenient for elderly Nintendo customers. How thoughtful!

Little wins. Better store positioning. A changing of the guard. This I plucked from a post I had written in February titled Microsoft Revisited: Vista, Apple and the Sony/Nintendo Phenomenon:

We may be witnessing an historic changing of the guard, which takes place in every generation. Remember IBM? They were invincible. How could they be beat? By a couple of geeks in a dorm room, that's how. Microsoft rises. And then another snot-nosed kid with a great idea and a dorm room made it happen in the box business, enter Dell. Then others got wise and squeezed their efficiency-based margins to nothing. Apple rose like a phoenix, crashed and rose once again, by virtue of innovation and a customer-centric ethos. Sony was like IBM. Now they've been bloodied by the customer-centric and community-oriented Nintendo. And now there's Google, the poster-child for the democratization of the Internet and the ever-flattening, increasingly frictionless world. When put in this context Microsoft just seems so big and slow and old, hidebound by 30 years of culture and organizational silos that seem impregnable. And it appears that Vista - the product, the PR, the marketing approach - is the result of such an organization. At times brilliant, very heavy, complicated and expensive. This is not a product for today. This is a product for an era when the desktop ruled. And that era is long gone.   

This changing of the guard is happening all over the technology landscape. And its effects are just beginning to be felt. Keep an eye on shifting corporate strategies designed to create more flexible, more entrepreneurial teams designed to leverage core competencies. The issues for companies like Microsoft and Sony is exactly where their core competencies lie. Because their self-perception and the perception of those who really matter - their customers - seem painfully out of sync.

Marketing Analyst Wanted: Global Bay Mobile Technologies

My friends at Global Bay Mobile Technologies are hot on the trail of a Marketing Analyst to augment their high-performance team. A link to the job spec and instructions for applying can be found here.

Company Description
Global Bay Mobile Technologies, Inc is a leader in providing mobile applications, through our AccessPoint Mobile Information Management System software. Since 2002, we have delivered enterprise class mobile solutions to hundreds of customers across the globe, ranging from government agencies and multinational corporations to small and medium sized enterprises across a number of sectors.

Job Description
Development, maintenance and updating of marketing resources and materials (print and website) Assist in key message development for all communications Conduct ongoing competitive intelligence gathering and analysis: evaluate competitors capabilities: identify new players, products and services launched into the marketplace. Support and assist outside PR firm in their efforts Lead coordination of trade show attendance Competitive product and strategy research to support the needs of sales and product development. Work with product managers to identify, monitor and analyze market issues and trends that represent opportunities or risks for inclusion in the environmental assessment and competitive analysis. Assume other marketing, research and analysis duties and special projects as assigned.

Job Qualifications
Some business experience and/or prior experience in a marketing environment Strong strategic focus, including the ability to think, writes and present in terms of management perspective. Working knowledge of competitive analysis, industry research techniques and a solid understanding of relevant business issues. Strong business writing skills-ability to take complex issues and transform them into clear, concise communications. Strong analytical skills with the ability to think strategically Interest or experience in technology especially PDA mobile and wireless technologies.

So if you've got the goods and the interest, check it out. Sandeep Bhanote and his team are a group of cool, super-smart guys.

Alternative Asset Managers: Does Going Public Skew the Risk-Reward Continuum?

I think of the financial markets and its components as a mish-mash of overlapping, yet compressed Kondratiev waves (instead of long cycles of 50-60 years, say, 20 years), with boom/bust cycles characterized by overshooting in both directions (assets become too dear at market tops and too cheap at market bottoms). And I view both returns and assets under management (AUM) in the alternative asset space in the same way. When returns are relatively attractive assets flow in, after which point it becomes harder and harder to maintain relative out-performance. During this phase risk goes up as market participants reach for return, increasing volatility near market tops. Predictably, both fewer good investment opportunities and heightened risk leads to decaying returns, causing assets to flow out. Once enough assets have left, fear and uncertainty prevails and relatively attractive investment opportunities again become available. Returns can once again begin their ascent.

There exists an efficient frontier of investment, with returns on the y-axis and risk on the x-axis, which slopes upward and to the right. At the far left you have instruments like T-Bills and short-dated, AAA-rated agency paper. These instruments are characterized by high liquidity, low repayment risk and relatively low returns. Basically, near-cash assets. At the far right you have private equity, venture capital and other long-dated, illiquid investments. These investments are characterized by poor liquidity, high repayment risk an relatively high returns. If one sought to liquidate these investment before they fully matured, there would be a large haircut suffered by the investor. Now, it is possible (in my opinion) to generate alpha all across this continuum, though alpha needs to be normalized relative to the risk being taken to extract this excess return.

Through economic and market cycles this efficient frontier will shift, and will generally flatten in boom times and steepen in bust times (as the premium required to hold risky assets rises in adverse market circumstances). This is the way things have generally worked, with motivations around performance pretty well-aligned, particularly in the less liquid, alternative asset space where the concept of carried interest prevails.

But what happens if this carried interest model is broken and some other motivation begins to effect manager decision-making? Say, if someone was willing to pay you more money not for performance fees, but for management fees. Seems kind of perverse, right? Well, think about the motivations inherent in alternative asset management firms that go public:

Equity investors like annuities, cash flows that exhibit relatively low volatility, high persistence and, therefore, good predictability. What is a cash flow like this called in an alternative asset management firm? A management fee.

Jenny Anderson had an interesting piece in today's New York Times  on this very issue today.

The crucial factor in that argument (for alternative assets) is, of course, those stellar returns. So it is not altogether surprising that some pension funds and endowments are a bit flummoxed over the current stampede of private equity funds and hedge funds lining up to go public.

As large investors, or limited partners, in the funds, the endowments and pension funds are concerned that the short-term interests of public shareholders might make it harder to deliver the same kind of returns. A public company takes time and attention that were formerly focused on investing.

“All things being equal, we would rather they stay private,” said Christopher Ailman, chief investment officer of the $170 billion California State Teachers’ Retirement System. “But we understand why they are doing it.”

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Then there is the alignment of interests and compensation. Private equity and hedge fund managers argue that the genius of their compensation is not just the size of it, but the fact that their interests are aligned with investors. They take 20 percent of the profits and investors get 80 percent.

But managers also earn a management fee, usually 2 percent of assets managed, which was originally intended to cover the cost of running the business. In public companies, management fees are awarded a higher multiple of earnings than incentive fees, which means that bigger management fees translate to a better share price. The best way to raise the management fee is to manage more money, which inevitably makes bigger returns harder (size, it is said frequently in money management circles, is the enemy of performance).

So to help shareholders, the public firms need to pump up management fees (gather more assets) and manage buying and exiting more carefully (to make the earnings stable) and further diversify the revenue streams. None of those things are necessarily good for limited partners.

So, in theory, the rational play for these newly-public alternative asset managers is to create massive, diversified asset gathering machines, maximizing management fees while being more risk-averse as it relates to their core investing activities. Why kill the golden goose by overreaching for return? The risks to AUM and brand value posed by a big investments with large but highly volatile payoffs just aren't worth it. If the true economic motivation is to grow assets and, therefore, management fees, then you can understand an increase in risk aversion among the principals of newly-public alternative asset managers.

Now consider with this behavior does to the efficient frontier discussed above:

I'd posit that public alternative asset managers almost become a new asset class in and of themselves, shifting to the left along the risk/return continuum. Lower risk, lower return, due to the emphasis away from maximizing carry and towards maximizing the more highly-valued management fees in a public format. Private managers, however, will remain where they are, naturally buffeted by the ups and downs of economic and market cycles that directly impact their returns and, therefore, their carry. Their public brethren, however, will be far more insulated against the vagaries of the market due to their scale and the relatively high ratio of management fees to overall fees.

So you can see why legacy LPs are squawking - they want this IPO trend to go away. But they are powerless to do anything about it.