Internal Hedge Fund Platforms: Get the Model Right or GET OUT!

Trashing in-house hedge fund platforms is currently all the rage. And why not? They had a bad year, no? This from today's Institutional Investor's emii.com:

Poor performance by in-house hedge funds launched by investment banks and the like may lead some big Wall Street names to exit the field, Dow Jones reports. While many a top hedge fund enjoyed returns that outperformed the standard indices, a number of in-house HF offerings by the likes of Goldman Sachs, Bear Stearns and Barclays have not.

And there were several pieces in the past week that were in this same vein. Bottom line - this is not new news. Most banks have gotten this business wrong for quite some time, in pursuit of its promise of great riches. And last year's weak performance does not begin to illustrate the core problems of most internal hedge fund platforms. Recently stories are trying to sell longer-term business model issues as near-term news. Sorry to disappoint, but these writers don't really get what's going on. Fortunately, I do.

Most pure quants and trend followers had a bad year in 2007. They got whipsawed, statistically durable relationships broke down and they generally got hurt. Luminaries as bright as Jim Simons, Cliff Asness and the Goldman and BGI quant groups got hurt, and they were by no means alone. Whether the teams in this area were internal or external, the markets brought harsh reality to the lot. And let's talk about hedge funds investing in structured mortgage paper. Unless you were shorting like a Paulsen you were getting murdered. Again, it didn't matter whether your were internal or external. Someone ripped your face off, pushed you in front of the mirror and you screamed for the last five months of the year. This is just the way it was.

So Goldman (quant), Bear (mortgages and mis-management) and Barclay's (quant) suffered the same as off-platform funds, so this this whole line of argument is a bunch of garbage (pronounced gar-baaaaage). It makes for a good story, but this isn't the real story. The REAL story is why most on-platform funds suffer from adverse selection, where the best of the best either start their own hedge funds or get a sizable book at an established hedge fund, while the remainder trade in-house. Here are some of the issues:

• Compensation
• Autonomy
• Stability of investment capital
• Compounding of capital
• Branding
• Ego

Compensation is an easy one. Most in-house operations don't pay nearly as well as hedge funds do. Because it is just not the bank culture to pay like hedge funds. If you want to be successful running an in-house platform you need to pay a much more competitive wage. And if you have truly great traders, it is worth it. And the more liquid the portfolios they run (and therefore attract a lower amount of regulatory capital), the better the deal for all parties involved. I could talk about this for days but this is the gig. Pay fair, create a separate culture for the in-house group versus the traders in the broker/dealer and get on with it. Or don't even try.

Autonomy is what it is. Some top traders just want their own show. And they have to go; because if you contort yourself to keep them they will kill the culture and damage the platform. However, if what they really want is to do their thing and be left alone then agree to clear parameters for book size, portfolio construction and risk parameters. And stay on it. But a little light mentoring and strong risk oversight can give the bank the security and comfort it needs while giving the trading team the perceived autonomy it wants. Again, a culturally challenging thing to do but absolutely necessary for building and running a successful in-house operation.

The biggest fear traders have is getting their capital yanked away from them and precisely the wrong time (or at any time, for that matter). If you run and hedge fund with some locked-up capital, you don't deal with this risk. This is a tricky point, because as head of an in-house platform you want to balance favorable capital treatment (which generally connotes the ability to liquidate positions at a moments notice) with giving the trader a measure of comfort (that you won't arbitrarily make them cut the book). Given these opposing needs, a pretty big measure of trust needs to exist between the trader and trading management, because the manager can't get the security they really want without killing the capital treatment (which the bank won't accept). It is what it is. The answer to this one isn't perfect.

Compounding of capital is an interesting point. When you run a hedge fund that starts the year at 100 and you generate 20% gains, you begin the next year at 120. In a bank where you are trading prop capital outside of a fund structure (i.e., in a managed account with the assets held on the bank's balance sheet), that 20 gets swept out and the trader begins year 2 at 100. Over time, the loss of the value of compounding can be stunning. Once an on-platform team begins trading client capital, this issue is ameliorated through a melding of manager and client capital which both benefit from compounding. But when a trader is running purely prop funds, they generally lose the benefit of compounding. Just something to be aware of when negotiating a deal.

Branding means more to some than to others, especially once client capital is being managed. The trader generally wants to own their brand and to have portability, which I think they need to have if you want to attract and retain (for a period) the true rock stars. Inevitably the rock stars are going to want to set up their own fund, and the strong in-house platform should be supportive of that move subject to terms in the agreement that provide a package of benefits to the bank, i.e., capacity guarantees, fee discounts, distribution agreements, etc. If a bank tries to hard to keep the intangible assets (the brand, the track record, the models) all to itself, it will lose out on the best teams out there. Because the best will want to be in-house at the right time and for the right reasons, and if they feel like they are being held up they simply won't do it, or will be resentful and cost the bank in other ways down the road.

Ego really relates to branding as well as portability. Many platforms don't anticipate teams being able to leave in a pre-agreed manner, and end up fighting bitterly with the team when the time comes for them to externalize. This just dumb. Put it all on the table upfront, let the team keep the brand, track record, and models should they leave, with the proviso that the bank gets the benefits mentioned above. it become a win-win, where only the best teams are able to spin-out because of strong performance and investor demand, which creates enormous value for the bank through their capacity option, discounted fees and distribution rights. This is the natural evolution of things. Don't fight it.

In sum, the in-house platform isn't dead. It has been dead for most for a long, long time. It is precious few firms that have ever done it well, but those that have created tremendous value for shareholders, traders and fund investors.

Market Mania: Why it Makes Sense to Stand Back - Way, Way Back

Here are some assorted headlines from my current Bloomberg screen:

• "Stocks in U.S. Rally After MBIA Says It Expects to Keep AAA Credit Rating"

• "U.S. Personal Spending Slows, Jobless Claims Rise, Boosting Rate-Cut Bets"

• "MBIA Says Capital is Adequate, Rejects Bankruptcy Speculation; Shares Rise"

• "Bristol-Myers Posts Loss as Subprime Investments Overshadow Palvix Gains"

• "Google Succeeds in Effort to Open Airwaves After Bids Exceed $4.6 Billion"

Oh, and by the way, the Dow is up about 1.5%. Now do most of these headlines have any basis in reality and, if so, what are they really telling us? What it's telling me is that messing around with the stock market with a short-term time horizon is a very, very dangerous proposition. The words "caveat emptor" should be on investors' minds right at this very moment.

Stocks rally based upon MBIA's statement that it expects to stay AAA? If that is true then whatever smidgen of rationality I thought might exist in the U.S. stock market is simply an illusion. Does MBIA management have any credibility? And on a day when Bill Ackman, who has been tracking this firm and business model for over five years, places his financial model on the Internet for all to see and urges others to contribute data and insights in order to deepen understanding of the bond insurance business? And the conclusion he has come to is that the two biggest players in the space, AMBAC and MBIA, are likely to incur losses exceeding $11 billion - each. Yeah, this is the basis for a market rally. If we are living in some parallel universe where up is down, right is wrong and bond insurers make money. I think not.

Spending slows and jobless claims rise, getting investors excited about future rate cuts. This has always been a puzzler for me. I am acutely aware of the impact on lower rates on discounted cash flow models, and on the hoped stimulus effect on spending arising from more accomodative Fed policy. But such policy moves also indicate deep fear about economic fundamentals, and a falling US dollar together with rising budget deficits aren't really helped by lower short-term rates. And if the yield curve steepens, that may be good news for banks trying to rebuild balance sheets but potentially less good for non-financial businesses trying to fund long-term capital projects. Anyway, I wouldn't be dancing in the aisles after hearing about a drop in spending and rising unemployment claims. But hey, that's just me.

MBIA says? Stock rises? Are these investors kidding? Unless someone believes that they are going to be bailed out - and in size - by state and federal agencies, what is the basis for a rising stock price given what we know? How much more right does Bill Ackman have to be before his thesis and supporting analysis is taken seriously? Inquiring minds want to know.

A drug company getting whacked by subprime. This is not good. I believe it was Mr. Stein who was tossing around a number like $100 billion in losses this weekend; didn't S&P (another firm with questionable credibility at the moment) just come out with a figure like $265 billion - or more? Let's just cut to the chase - the bottom line is that nobody really knows. Bristol-Myers is one of the largest companies on the planet that got nicked in their investment portfolio on a small amount of their holdings. Sure, it sucks, but who cares as it relates to their core business, the R&D, manufacturing and distribution of pharmaceuticals? Apparently the market does. And this type of fearful and irrational behavior will dominate trading until we can see a bottom to the subprime losses. But when we might see this is still very, very uncertain.

And amidst the sea of crap there is Google, forcing the winner(s) of the C-block wireless auction to open their networks to any and all mobile devices. This is good for consumers. This is good for device makers. This is pretty much good news all around, as open access sparks innovation and freedom of choice. So even when things are looking pretty bad, Google is a catalyst for something really good. Thanks Sergey, Larry and Eric.

I don't know, maybe I'm just getting old and cynical. It's just that so many headlines I read these days are so irritating, either because they make no sense or because they reflect some sort of a twisted reality illustrative of investor stupidity or awful market conditions. What it really says to me is that being a voyeur at this time is just about right. And that's where you'll see me. On the sidelines. Watching.

 

The AMA, the FDA and Ratings Agencies: Conflicts, Conflicts Everywhere

Money is a very powerful motivator. And this can inure to the benefit of the individual and to all of society. Unless it doesn't. Like when there are clear conflicts of interest, where a financial payoff is received based upon performance that could be compromised due to self-interest, and where the conflicted party's actions can hurt those whom they are purportedly supposed to be helping. Such as when a rating agency slaps premium ratings on instruments that it doesn't really understand, garnering huge fees in the process while setting up those who bought the bonds for a sharp fall down the road. Or when a medical researcher has a financial interest in a certain product getting FDA approval, encouraging them to skew test data to get the approval but where the actual patients might get inappropriate treatment and suffer great harm. Here are two real-life situations where money, in the face of stark conflicts of interest, can and has been a dangerous tool that visited unnecessary suffering upon many, many innocent people.

Regulation should exist to protect those who cannot protect themselves, and who depend upon the truthfulness and ethics of parties in a position of authority to make informed, intelligent decisions. Like rating agencies and doctors sanctioned by the AMA. But we have seen two horrific breakdowns in recent months, breakdowns that must be addressed by the relevant governing bodies. The rating agency conflict problem has been extensively discussed on this blog and I won't belabor the point. But the medical researcher conflict has not. Because while M.D.s supposedly learn the precept primum non nocere (first, do no harm) in medical school, some have clearly forgotten important message as they've evolved into high profile, highly compensated researchers and practitioners. And if only half of the information contained within today's New York Times story is true, describing conflicts of interest around FDA approval of the Prodisc spinal implant, this may even exceed the gross self-dealings between rating agencies and their issuer brethren. Difficult to fathom.

Here are a few key excerpts from the story:

“As a surgeon, it is gratifying to see patients recover function more quickly than after fusion and return to their normal activities more easily,” Dr. Jack E. Zigler, a well-known spine specialist and one of the study’s lead researchers, said in a 2006 news release announcing the latest results of the Prodisc clinical trial.

As it turns out, Dr. Zigler had more than a medical interest in the outcome. So did doctors at about half of the 17 research centers involved in the study. They stood to profit financially if the Prodisc succeeded, according to confidential information from a patient’s lawsuit settled last year.

********************

The way the Prodisc was tested and approved provides a stark example of conflicts of interest among clinical researchers — conflicts that are seldom evident to doctors and patients trying to weigh the value of a new device or drug. Instead of serving as objective gatekeepers who can screen out potentially harmful or ineffective new devices or drugs, some medical experts say, clinical researchers with conflicts may have incentives to overstate the value of a new product for patients.

********************

“The surgeons themselves are guilty of being insufficiently critical of products and techniques they are developing,” said Dr. Richard A. Deyo, a medical professor at Oregon Health and Science University. “More people are interested in getting on the gravy train than on stopping the gravy train.”

********************

“Industry’s goal is to make a profit for its shareholders, not to advance medicine,” said Dr. Rosen, who in 2006 saw a need to start a group called the Association for Ethics in Spine Surgery. It now includes 85 specialists who say one of their aims is to warn the public about industry influence on medical practice.

********************

Close relationships between surgeons and device companies can affect more than the potential quality of an individual clinical trial, said Dr. Drummond Rennie, a professor of medicine at the University of California, San Francisco who has studied conflicts of interest among physicians. Because the entanglements are so common, Dr. Rennie said, it is unlikely another surgeon will speak out about any potential misgivings they have about any device.

“The absolute ideal from a drug or device company is everyone is covered,” he said. “And what they have it covered with is money.”

This does not appear to be a situation where self-regulation can work. Doctors won't rat each other out. And if a doctor with a big reputation and a big position sees a chance for a nice payoff to implicitly (or explicitly) endorse a device, who's going to say "don't do it?" FDA rules permit a researcher to receive payola, provided it is disclosed. This does not appear to have been what happened in the Prodisc case, however. But I'm not sure disclosure is even the issue here. When is it appropriate for a researcher to have a financial incentive for the outcome of a study to be one way or the other? I can't think of when. Because without a financially disinterested party doing the study, where are the checks-and-balances in the system? Who is protecting the patient? Who is their advocate? This breach of ethics in a profession so seemingly bound by ethics is incomprehensible.

And while rating agency analysts don't take anything remotely resembling the Hippocratic Oath or learning about primum non nocere, they are, without question, in a position of responsibility akin to that of a fiduciary as literally millions of people depend upon the quality of their work and the veracity of their ratings. With these two examples of conflicts run amok it appears that the ethics woven into the fabric of our society are becoming increasingly frayed. And this may well be more important that the financial market crisis itself.

Lessening the Reliance on VaR: It's About Time

Taking a new approach to quantifying risk: it isn't just for Taleb zealots any more. And when such a move hits mainstream, you know something big is afoot. Bloomberg ran a pretty informative article today on the shift in risk management practices among investment banks, and how a firm's stated VaR (Value at Risk) did not necessarily relate to how badly they were hit in the recent credit crunch:

Goldman Sachs Group Inc., the firm with the highest nominal VaR, was the sole investment bank to report record earnings in the fourth quarter, while New York-based Merrill, which had the second-lowest nominal VaR of the five biggest U.S. securities firms, posted a $9.8 billion loss for the last three months of 2007, the biggest in its 94-year history.

I find this statistical artifact fairly humorous. It's not that VaR is worthless; it just needs to be seen for what it is. A quick snapshot of book-wide risk assuming normal markets. This is a number risk managers and business heads should have. But if, and only if, it is augmented by far more detailed analyses that take into account non-normally distributed market movements, skyrocketing correlations in gapping markets and shocks that are far beyond those witnessed in even the past 30 years. Taleb has a quote in the article that makes the point quite poignantly:

``Finance is an area that's dominated by rare events,'' said Nassim Taleb, a research professor at London Business School and former options trader. ``The tools we have in quantitative finance do not work in what I call the `Black Swan' domain.''

While I'm sure we've all had our fill of Taleb, the Black Swan, Fooled by Randomness, etc., his points are well-taken and have certainly been borne out over the past decade. I remember a week in Q2 2004 while I was running DB Advisors when we had three days - in a row - where our portfolio moved beyond the 95% confidence interval. Three days in a row of moves exceeding two standard deviations from the mean - talk about a black swan! But it happened. And it happened after one of the greatest quarters in my lifetime, when almost every trading strategy worked beautifully. And then - plop. But these things happen. Far more frequently then ordinary quantitative finance techniques would indicate.

And even when using stress tests and breaking away from the limitations of normally distributed outcomes, one needs to be very, very careful. Here are a few great quips from the Bloomberg article that drive the point home:

The other risk tool commonly used by securities firms, known as stress testing or scenario analysis, also failed to prepare the industry for the plummeting value of AAA-rated securities that had previously been deemed the most creditworthy, he said.          

``Stress tests are only as good or as predictive as the scenarios used and in many cases the scenarios that played out were much more severe than people anticipated,'' (Ed) Hida said. ``One lesson learned is that these stress tests should be broader, should consider more scenarios.''                  

(Colm) Kelleher, who became Morgan Stanley's CFO in October, explained the flaw in the firm's stress testing in a Dec. 19 interview, the day the company reported its first unprofitable quarter.           

``Our assumptions included what at the time was deemed to be a worst-case scenario,'' he said. ``History has proven that the worst-case scenario was not the worst case.''

So the banks are moving in the right direction. It's about time. And not just for their own risk management purposes, but for investor disclosure. Because don't you want to know the true level and types of risks embedded in the books of the firms whose stocks you own? I sure do. And it looks like we are getting closer to that day. Thankfully.
           

"How to Lie With Statistics" a/k/a Ben Stein's Modus Operandi

This is the title of a legendary book written in 1954 by Daniel Huff. In short, it explains to the layperson how they can be misled by the way information is presented, how those serving up the figures can be economical with the truth and to generally be on guard when consuming numbers, charts and graphs. Well, my bells were going off as if I were in the midst of a five-alarm blaze as I read Ben Stein's piece in yesterday's New York Times. It is articles like these for which Mr. Huff's book was written: reader beware. Because if you take Mr. Stein's figures on their face, you might actually believe his thesis. However if you dig down a few layers and think a little bit, it doesn't take long for you to realize that what he is saying is the same weak-minded analytical drivel that he has been dishing out with such frequency of late. Why I do not know, but what I do know is that articles like these are dangerous because they contribute to a perception - no, a mania - that Wall Street is rotten to the core. And this is simply not true. Do problems exist? Of course, they do everywhere. But the extent of Mr. Stein's indictment is both factually inaccurate and actually destructive of the conversations we should be having on how things should be fixed (like, say, the post I wrote yesterday concerning lessons we can learn from the recent crisis). In any event, the article was truly a drivel-fest and worthy of much scorn and derision.

In short, Mr. Stein's thesis is that traders push the market around, plant stories with the press, get the hype machine going, and make a ton of money on the backs of dumb retail investors like you and me. Sure Ben, I'm sure every trader out there wishes it were only that easy. Unfortunately it isn't. Your deep-seated conspiracy theories are coming to the surface again, Ben. There are the little issues of the depth of liquid markets (in terms of being effective in pushing it around except around small moments in time, i.e., the close) and the shallowness of illiquid markets (in terms of how do I get out without giving up all my ill-gotten gains?). The world has gotten very flat when it comes to the liquid markets, and if certain traders are trying to push the market in irrational ways there are always those who are willing to take the other side and push back just as hard. Eventually the market settles where it should based upon fundamentals, but for short periods of time it can deviate for any number of reasons. But to say that a trader's core strategy is to establish a position, devote massive energy to hype it and then have the ability to profitably exit is a pure flight of fancy. It's just not that simple. Sorry.

Now here is one of those number "facts" you've got to view with a jaded eye.

Note that the losses in United States markets alone are on the order of about $2.5 trillion in recent weeks. How can a loss of roughly $100 billion on subprime — with some recoveries sure to come as property is seized and sold — translate into a stock-market loss 25 times that size? The answer is trader realism.

Ok, now maybe it's just me, but I've come to believe that the subprime issue has moved well beyond subprime portfolios themselves, no? In fact, I've written about this, and others have written about this extensively. Falling housing prices. Less purchasing power. An over-leveraged and distressed consumer. Locked credit markets. Falling corporate profits. Broken bank balance sheets. Diminished earnings expectations. Might this, when you capitalize the impact of these adverse events, equal 25x the subprime losses? I'd say so. And this doesn't even take into account the possibility of subprime losses far exceeding the $100 billion mark. This isn't called trader realism, Ben. It's called reality.

Here is yet another example of twisted math:

The losses in the stock market since the highs of October 2007 are about 14 percent. This predicts — very roughly — a fall in corporate profits of roughly 14 percent. Yet there has never been a decline of quite that size for even one year in the postwar United States, and never more than two years of declining profits before they regained their previous peak.

Here we've got the issue of a "stock" versus a "flow," namely, the difference in accounting parlance between those things that are measured at a point in time (i.e., a balance sheet) versus those that occur over time (i.e., financial projections).  How does one equate a present value decline with an annual measure of a like amount? I'm not sure how Ben found economics so easy in school as his powers of numerical reasoning are sorely challenged.  A 14% drop in the value of the stock market (a stock) equates to a fraction of the present value of an expected 14% decline in corporate profits into the future (a flow). Why he attempts to link these two disparate concepts is a mystery to me. I'm still scratching my head over this one.

And his grand conclusion in the wake of such analytical and logical rigor:

In other words, traders are sending stocks down by a fantastically larger amount than is warranted by a recession or the losses in subprime. How and why does it happen? As someone said in the movie: “Forget it, Jake. It’s Chinatown.” It’s just Chinatown in trader-land, where money is made and there is no perspective.

So when you see the market gyrating wildly downward and hear some pundit saying it’s because of this or that data or this paradigm or that ratio, remember trader realism. The traders move the market any way they want, any way they think they can make money, and then they whisper a reason to journalists later in the day. Then the journalists print it or say it on television, and the amateurs believe it. And the traders snicker.

I think maybe he and Charlie Gasparino have been hanging out and sharing conspiracy theories while bowling or something. They both purport to "know" Wall Street and to "understand" the trading community, but little in what they say or write comports with any experience I've ever had in my 20+ years in the financial markets. I am much more concerned with compensation regimes, risk-taking and risk measurement on Wall Street, the real factors which drive trader behavior. With increased market liquidity, "dark pools" and the rise of offshore exchanges, it is harder than ever to game the system (smacking the close, trying to skew VWAP, stuff like that). And the thought that each trader has their little hotline to their journalist of choice is sheer fantasy. They are trying to manage their book and not get slammed while taking a piss. Because in today's hyper-volatile, super-flat world, you'd better get your positions straight or you could meet with an unhappy fate. But Ben would have you believe that all these traders are just having a grand old time and laughing at us all the way to the bank. Yeah, right.

The Pier 40 Rally: You, the Community, Made it Happen

So today was the rally. At least 1,500 people made it out on a winters day to celebrate the Pier, its place in our community and the amazing people and institutions that make up Downtown NYC. We had incredible, supportive politicians representing our district - Assemblywoman Deborah Glick and State Senator Marty Connor. We had Mario Batali, a downtown fixture, a world-famous chef and restauranteur but, most importantly, a super-active and engaged father and a person devoted to preserving and enhancing the quality of community life. And we had 1,500 of you out there with us today showing the Hudson River Park Trust, the elected and appointed officials, and the Related Companies that we mean business. United as one our community cannot be stopped. Because we know for what we stand. And we have right on our side. Check out today's events on this well-done video. We will win together. A park forever. Pier 40.

And here are some pics from the event:

Molto Mario doing his thing.

Assemblywoman Deborah Glick saying it like it is. Pier 40 should be about low-impact, community-driven uses.

State Senator Marty Connor sharing his love and vision for a community-centric Pier 40, not Disneyworld on the Hudson.

One of Pier 40 Partnership's own, Chris McGinnis, getting the crowd energized around the vision of a "third way forward" - the roadmap outlined in the feasibility study presented to the HPRT board by the Pier 40 Partnership.

Me and my boys cheering on the speakers at today's magical event.

What has the Credit Crisis Taught Us?

I have read a lot of different views concerning the credit crisis, the market dislocations in its wake, and the lack of confidence in the Fed's ability to materially cushion the blow of the inevitable unwinding that will ensue. None has really brought it all together for me, however, in a way that looks at both the strengths and weaknesses of current market structure and regulatory regimes and charts a better way forward. I will share a few thoughts that hopefully sheds a little light on what I consider to be a key part of the dialog that remains under-addressed.

A story in yesterday's Financial Times asked a key question, and perhaps THE question, that remains to be answered:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope? On that diagnosis rests the future of our highly liberalised financial markets.

As is usually the case with answers to very complex questions concerning very complex contexts, the answer is neither black nor white. Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global  financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:

1. Increase transparency among regulated institutions
2. Homogenize global accounting standards
3. Homogenize global regulatory frameworks
4. Aggressively strip conflicts of interest out of the system
5. Clarify the roles and responsibilities of fiduciaries
6. Develop common sense compensation policies and practices

Greater transparency. Let's be honest, is anything more important than getting good, full and accurate information about assets, liabilities, cash flows, contingencies and accounting practices of institutions responsible for providing such information? I'd say not. And if there is one thing we've seen time and time again. banks, insurance companies and other regulated entities were not clear about their asset portfolios and the contingencies associated with off-balance sheet transactions. Further, they themselves did not have an accurate grip on how certain multi-billion dollar pools of exposures should be valued and reflected on their financial statements. Now as investors, regulators and counterparties to those institutions, isn't this information that you'd like to have in order to make an accurate assessment of their financial position and appeal as both an investment candidate or a commercial partner? I'd say so. Regulators across all the major financial markets need to get together and agree on standards for transparency and disclosure that provide market participants with all the data they need to make informed decisions. Because in a world lacking transparency one can imagine a perpetual boom-bust-boom-bust cycle with amplified volatility, because the markets will not be accurately pricing in all the relevant information - just all the information that they are getting, which is materially imperfect. Heightened and consistent transparency is an essential element of helping address one of the precursors of the latest market crisis.

Common accounting standards. Even with IAS, financial statement presentation is not yet consistent across markets and geographies. This issue is closely related to that of transparency. Accounting rule-makers across the globe should use the current crisis as an opportunity to effect change, by once and for all creating a level playing field for issuers and investors everywhere. Let companies compete on their own merits - the merits of their operating business - without regard to financial gamesmanship. The US and Europe have been groping towards common standards for probably 20 years, ever since I first became a financial markets denizen. Let's get to it and salvage some good from the bad we've witnessed over the past six months. The heightened level of investor confidence should be reason enough to build a global agreement in the accounting realm.

Common regulatory frameworks. Principles-based? Rules-based? The SEC model, the FSA model, the BaFIN model or something different?  Hard question. Really, really hard question. But one thing is for sure, there is still immense friction operating regulated businesses across markets due to different rules and standards. It truly makes no sense and can contribute to the types of problems we've witnessed in the current crisis. Divergent valuation policies. Varying risk management standards. Alternative views of what constitutes a transaction of true economic substance versus financial statement window-dressing (as with SIVs that suddenly found themselves back on bank balance sheets)? As capital flows become increasingly fluid and institutions everywhere are attracting global investor bases, comparability in both financial statement presentation and regulatory oversight is critical to creating a global market based on fairness, common data and common sense.

Address systemic conflicts of interest. The crisis of confidence in rating agencies has sharp parallels with another crisis of confidence we saw in an institution fraught with conflict - sell-side research.  Write a nice report, get an M&A assignment, an equity underwriting, a bond deal? The system was broken, those of us in it saw it was broken and eventually this unstable and utterly-conflicted system was laid bare for all to see. Fast forward to 2007 - is the situation with the rating agencies any different? Whenever the seller pays for someone's imprimatur, be they an II-ranked research analyst or a rating agency's seal of approval, the mere appearance of conflict should send alarm bells ringing. Did the rating agencies issue ratings on instruments they didn't fully understand, and whose behavior they couldn't have imagined upon issuing their rating? Apparently so. Should they have allowed the market to evolve, albeit with smaller deals and at much lower levels, by refusing to rate instruments that they've never seen behave across even a single market cycle? Probably. But they didn't. Because the market was there and they wanted the money. They're no dummies. Investors and regulators are, because they bought these ratings hook, line and sinker and allowed this flawed practice to continue unchecked. Why should anyone place value on a rating with such an apparent conflict? Beats me. This is simply one conflict that needs to be stripped out of the system, but such an essential one given the role of the rating agency in the institutional investment process.

Firm up the roles and responsibilities of fiduciaries. If you are the steward of someone's money, and it is your responsibility to make intelligent, informed decisions, is this a responsibility you can abrogate by passing on to another? And, if the responsibility is passed along and accepted by another, are they then held to the same fiduciary standard to which you are being held? For instance, if a pension fund hires a fund-of-funds manager because they themselves do not have the due diligence expertise in-house, is the fund-of-funds manager responsible for discharging their fiduciary responsibility? Or if they buy a CDO because S&P rates it AAA, do they then pass their fiduciary responsibility on to S&P? These are hard, hard questions. All I know is that the buck needs to stop somewhere, and right now it seems that the buck gets broken into change as fiduciaries retain consultants, asset managers and buy instruments with certain ratings that conform to their charter, and that when things go wrong the party harmed - the people whose  money is being administered by the fiduciary - has nowhere to turn. This needs to change. Roles and responsibilities need to be clarified and everyone needs to know where the buck stops. Because it seems that abrogation of responsibility is rampant and it is the little guy who is getting screwed.

Develop common sense compensation policies. I come from Wall Street and I like money and pay-for-performance. But there is a problem between the asymmetric risk/reward so common on Wall Street where the incentive is to swing for the fences and to even game the system, because compensation is partly based on unrealized P&L. Heads I win, tails you lose. Frequently not a problem in up-markets, often catastrophic in down markets. This also gets to the issue of transparency. Like I've written before, compensation should largely follow the path of realized gains, with some measure of compensation paid on unrealized gains in liquid securities. In less-liquid or hard-to-value instruments, compensation should follow a private equity-type model - pay out cash when cash is realized. Otherwise, management is going to be wish they had a claw-back when such a model, we all know, is fanciful on Wall Street. The issue needs to be dealt with head-on, up front, not years down the road. Investors should pay more for the shares of a firm that pays its people well but pays them for value they've really created, not highly uncertain value that may or may not be realized down the road.

Conclusion

Free, flat and liquid markets hold the promise that has been discussed for years: optimal capital allocation, proper risk distribution, leveling of the playing field between large and small investors and cheap and efficient capital formation. The issue is that several factors need to hold in order for this promise to be realized. Markets really need to be free. They need to be flat. And they need to be liquid. And the current crisis shows us that none of these things are really true. But I do believe that my suggestions can go a long way towards helping us build a fair, integrated and global financial marketplace. Hopefully regulators and rule-makers everywhere will rise to the challenge.

Saving Pier 40: The Power of Community Activism

Almost nine months ago, over 1500 people of all ages came to PS 41 in Greenwich Village to hear about plans for repairing and rebuilding Pier 40. And tomorrow, hundreds of people are going to show up on a winter day to celebrate Pier 40 and rally around a cause that has served to further bond an already tightly-knit community, keeping Pier 40 as a park - forever.

The Event

This rally will be held at the Pier 40 courtyard fields from 12-12:45pm, with speakers ranging from Assembly Member Deborah Glick and State Senator Marty Connor to the master chef and all-around cool dude Mario Batali (a fellow downtown denizen whose kids go to the same school as my children). Hot chocolate, bagels and other surprises are in store for all attendees. If you are in town I urge you to stop by.

The Background

Pier 40 is a 15-acre jewel on the Hudson River that currently serves as a place for affordable parking and, more importantly, a place where children and adults can play and relax safely. It is used by both child and adult sports leagues, schools, boaters and others who simply want to be close to the water and chill out. Park space is rapidly being eroded in Manhattan as real estate prices skyrocket, and the West Village, in particular, has been plagued by this phenomenon. It ranks 47th out of 51 districts in New York using the metric of park space per person, and without Pier 40 this already awful ranking would drop further. As some of you know, more and more families are joining the downtown community, attracted by the high-quality public and independent schools, the low-key atmosphere, less population density and shorter buildings that let you see the sky from wherever you are. In short, we could use another Pier 40 - not lose the one we've got to yet more commercial development.

The Problem

But the fact is that Pier 40 has fallen into disrepair after years of neglect. It needs help - big help - to the tune of around $125 million. And this is just to fix it. Toss in another $150 million or so to make it ready for additional uses that fit with the mission and guidelines established by the Hudson River Park Trust (HRPT) and you've got one big bill that needs to be paid - yes, around $275 million. Now where is this money going to come from? The HRPT Act of 1998 clearly established the ways in which Pier 40 could and should be used, and to this end ran an RFP (request for proposal) to get ideas for fixing and developing the space. The RFP yielded overly-commercial uses that caused huge backlash in the community, and the RFP was terminated and the proposals tossed out. Fast forward to today - a second RFP was initiated with two formal proposals submitted, one of which was essentially discredited (pretty unfairly, I might add) at the beginning of the process and the second from one of the titans of commercial development, The Related Companies.

The Wrong Answer

The Related Proposal would turn Pier 40 into an entertainment complex. A permanent installation of Cirque du Soleil. A giant movie complex. A banquet hall. A music hall. A Disneyland-esque extension of Houston Street onto Pier 40, with big and small retail shops, restaurants and the like. Oh, and their will be fields, too. On the roof. So, rather than Pier 40 being a park with some alternative uses, it would become an entertainment center with a park on the roof. Now, for those who know and use Pier 40, it is a safe, relaxing place to go. It needs to be fixed and it would benefit from additional uses that support the community, but can you imagine sending your children into a crowded entertainment complex slated to attract 2.7 million visitors to play ball? Oh, and what about the increase in traffic volume in an area that is already choked with cars? And what about the joggers, cyclists, bladers, and walkers who stroll along the water? Can you imagine cars cutting across this in order to park in the complex? Clearly this construct would turn Pier 40 into a destination location and not a park. Yet another mall, not really what we need. The Related folks aren't bad people, they are just trying to apply a private market solution that requires private returns on capital to a situation that is better suited to a not-for-profit construct. And this is just what a group of which I am a member has suggested to the HRPT and the entire community.

The Right Answer

And now we get to the punch line of my story. After the outpouring of community support following the May gathering, a group of us got together to figure out how to channel this energy, passion and enthusiasm in a way that could help alter the dialog around the Pier 40 issue. Since the RFP was formally closed, and therefore no new proposals were being accepted, our group, the Pier 40 Partnership (Partnership), needed to figure out another way to influence the process and to ensure that the community's voice was being heard. So we started with the grass-roots approach of setting meetings with every elected official, every appointed official, every community board, block association and community constituency that wanted to figure out a community-centric plan of use that was bankable. Remember, we need $275 million, remember? But we didn't have that data point at the time. We just knew that we wanted to get involved, get smart and figure out how to effect the outcome of the RFP process.

At the end of the day the Partnership's solution was to hire a top consulting firm, HR&A (the group that worked on the High Line project), to conduct a feasibility that took into account our community-driven uses and establish a "third way" forward. And the HRPT only gave us five weeks to do this. And we did it. And we came up with a conservancy-based approach that eliminates the friction of returns on private capital and creates a bankable entity for which to raise financing against the cash flows of parking revenues. The plan also includes private donations, and only asks the state and city for a measure of tax capacity to issue tax-exempt bonds. Ours in an innovative solution that has garnered the support of entire community - community boards, block associations, public and independent schools, buildings, and myriad downtown affinity groups. Our study was basically like the Doug Flutie-to-Gerald Phelan "Hail Mary" pass at the end of the BC/Miami game, coming up with a viable solution that arose from the energy and creativity of the community as catalyzed by the Partnership. It is a model for community involvement and how enormous, seemingly intractable problems can be solved.

The Reality

But even with all of this work and near-unanimous support for our plan, politics and short-sightedness might work to quash the voice of the community. And this is why we are having the rally on Sunday, a mere four days before the HPRT is likely to vote on the Pier 40 issue. Click here for more information. I hope to see you there on Sunday. The future of our park depends on it.

Read Fred Wilson's recent post on Pier 40.

Why Investment Banking Mergers Stink

This morning, DealBook linked to a Breakingviews piece on rumors of Credit Suisse possibly buying Bear Stearns. I immediately broke into a cold sweat even considering the possibility. Why?  Because investment banking mergers are quite simply one of the most efficient ways of destroying the buyer's shareholder value, especially when one considers the probabilities of a deal actually being successful. I can't think of another type of M&A transaction that is fraught with more risks than the investment banking merger or acquisition. Examples of failed investment banking deals are too numerous to mention, with the 2000 acquisition of DLJ by CSFB and the 1998 ingestion of Citicorp by Travelers as shining examples of deals gone bad, both financially and culturally.

In fact, I'd argue that the best buyers of and/or investors in these businesses are strategic partners, either the sovereign wealth funds (SWFs) that can open doors in new and valuable markets not currently penetrated by the investment bank, or firms that operate in other markets and can bring many of the same business-building benefits of the SWFs. In each case, the culture of the firm isn't changing and cost savings through integration is not a key component of making transaction economics work. Time and time again buyers get this wrong, either due to hubris, stupidity or both.

Here are some of the reasons why investment banking M&A deals are doomed to fail from the outset:

• The franchise is the people, not the brand. While most investment banks will tell you that the power of the brand is what helps them secure business, the brand isn't worth much without the people supporting that reputation through real-life actions. DLJ is a great name, but what is the DLJ franchise really worth without D, L, J, their lieutenants and the transactors actually getting deals done? Not much. Clients deal with people, not with brands, so the branding argument only goes so far. And generally when these investment banking M&A deals happen some group of people get disenfranchised, fear and uncertainty prevails, and those who stay are staying for their guarantees and not for the relationships and camaraderie they've felt by being part of the firm. Because that firm is gone and will never exist again. The real value of the deal goes up and down the elevator every day, and it is very, very hard to secure their loyalty (and, therefore, their value and the value of the purchased business) in the wake of the chaos that ensues during the integration phase.

• A changed culture threatens the buyer, the seller and merged firm. In each and every one of these deals there are winners and losers; the whole notion of a "merger of equals" (which is how the Citicorp/Travelers deal was billed) is a bunch of malarkey. In that deal Traveler's Salomon unit won, and in the DLJ deal it was a non-issue as they were simply bought. Well, what about those who have lived and worked in a culture and are now being asked to shift gears and operate in another? From first-hand experience I can tell you that it sucks, especially when you think the culture of the buyer sucks and you are simply being absorbed by it. This point relates to the first, as cultural unhappiness can lead the real driver of the deal - the people - to simply leave for greener pastures. Why not? Every high-quality person in the losing firm is getting barraged by calls from headhunters and friends asking them to jump ship for a fresh start and a big payout. Why deal with the headaches and the sadness of seeing your firm changed in ways you dislike when there are loads of others willing to give you a big hug, both culturally and financially? And believe it or not, the same applies to highly-sought after professionals on the winner's side. It is no fun for them, either, as concessions made to the losers can also wreak havoc on the culture and hierarchy among the winners. So many of them frequently bug out and further depress the likelihood of the deal succeeding.

• Clients are frequently confused during the firm integration process, damaging relationships. A banker's relationships are their own personal assets, assets they monetize for the benefit of their firm and themselves. And when an M&A deal stands in the way of realizing the value of these assets, bankers get very protective. They work hard to maintain legacy relationships, even if this results in duplicate coverage from the combined entity. Is this what the client wants? Of course not. But they generally aren't asked to choose. A power struggle ensues between the bankers from the two firms, sometime resolving itself fairly quickly but often times dragging on for years. Over time, this has a corrosive effect on relationships and on the firm's brand, depressing the value of the assumed "synergies" that were so certain to appear once the deal was consummated. Ha!

• Bankers are perpetually free agents, and an investment banking M&A deal is akin to imposing a collective bargaining agreement. It simply doesn't work. The individual attention that would be required to get each and every key person - of both buyer and seller - on the same page with respect to strategy, reporting lines, client ownership and compensation would take a millennium, maybe more. But this is what it would take to give one of these M&A deals a chance of succeeding. To be clear, I am not talking about a merger of two commercial banks, where one is looking at a map like a game of Risk and filling in gaps in branch networks, deposit bases, credit card portfolios, etc. These are deals of efficiencies and of scale, and while I don't mean to understate the importance of cultural and human resources issues in these transactions they are much, much more straightforward than where the lion's share of the assets - namely, goodwill housed within each and every employee - can disappear within months. This is not a smart bettor's risk/reward profile - it more akin to a drunken gambler sitting with $2k in their pocket playing blackjack at a $500 table where they expect to win. Is winning possible? Yes. Is the probability distribution negatively skewed with a mean return well below zero? Yes.

In sum, If CS wants to bulk up its prime brokerage or mortgage trading businesses, simply hire the people you want from Bear, BofA, whomever. Be surgical. Be strategic. Give each hire the attention they deserve to make sure both they and the firm are successful. There is no reason to try and buy the entire asset. The problems that will emerge will consume valuable management time, be a major distraction in particularly challenging markets and invariably cause share price to fall. Believe me, both you and your investors will thank me in the morning.

 

Alternative Asset Managers and Down Market Cycles: What to Expect

The equity market has been a roller coaster, characterized by bone-jarring volatility and single-stock blow-ups that are enough to make even the most steely-eyed hedge fund manager cringe. And private equity firms have seen arbitrage spreads explode, fueled by the knock-on effects of broken credit markets and concerns over whether the PE firms or the banks will walk away from agreed-to transactions. But these are merely observations. The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

• The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.

• The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today. Today, just about anyone who wants higher fees based on total return calls themselves a hedge fund, even if they are just a buyer of assets. And the fat cash flow yields in global stocks have also attracted a number of hedge funds into net long equity positions. As a result, hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

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Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.

Let's see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you've got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both.

I happened to be at the Greenlight Limited Partners Annual Dinner last night, and David Einhorn did his usual impressive presentation of 2007 results with an overview of trends, risks and opportunities today and in the future. The great thing about David is that he is very honest, very humble and very, very focused on sticking to his long-term value mission. In quest of high IRR value-based ideas, wherever they be found, even if they take a long time to play out. He gave examples of positions that have been in the book for five years, making lots of money for investors on an IRR basis but only after the market finally bought into the Greenlight thesis. Several other funds I respect a great deal roll this way, including Rob Medway and Yale Fergang's Royal Capital and Seth Klarman's Baupost Group. It is funds like these that can withstand the pain, and which also have the skills and experience to manage an active short book as part of a true "hedge" fund portfolio.

Bridgewater also had some cautionary words for the private equity industry:

Private equity also looks vulnerable... One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.

I heartily agree. This is an area I've written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR's investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we've witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we've become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.

So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won't be pretty but we'll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.

Tuesday's Investment (and Life) Advice: Stop, Breathe, THINK.

People are freaked. Asia's been smashed. Europe is in the toilet. And the US recovered from an early morning swan dive thanks to the Fed's 75 bp easing, yet the credit markets aren't exactly buying it (I mean, has anything really changed in the wake of more accomodative Fed policy except to telegraph their deep concern over the state of the economy?). In short, the "deep crap" scenario I've written about many times is now clearly playing out (notwithstanding my friend Mr. Kedrosky's missive about the excessive bearishness of financial stock bloggers), and it is at times like these when some clear and powerful messages need to be repeated to keep those among us from doing colossally stupid things (like selling low and buying high, which is part and parcel of the human condition).

And if there is one message I'd like to suggest, three particularly sage words that are sufficient to guide our actions during the most difficult of times, I'd like to share the following wisdom uttered by Steve from that fine kids show, Blue's Clues:

Stop. Breathe. THINK.

Seriously, is anything more complicated needed for most of us right now? I don't think so. So let the elephants stomp and the angels cry and celestial bodies spin backwards on their axes for a while. It's just not worth getting all in a froth about things. If you are diversified, that is. If you have all your money in a high vol stock which is exhibiting tremendous downside volatility at the moment, well, you haven't been reading this blog and I can't help you. But if you do have a modicum of diversification, some stocks, some bonds, some cash, some real estate, a little gold and energy ETFs here and there, and if your time horizon is more than a month or two, you'll be ok. And by all means lay off the CNBC and Fox News for a bit - it will give you an ulcer. Even give the business page a rest for a few weeks. Or maybe a few months. Or more.

Pull out the New York Times crossword, sharpen your skills, read a good book and hold on. Because the financial markets won't be in turmoil forever. And your portfolio will benefit from listening to that prophet Steve that has been telling your kids the exact same thing. Whether you are trying to cope with anger and frustration towards a friend, a parent, a sibling or the financial markets it is all essentially the same. Staying cool and resisting your negative impulses will set you free.

Who REALLY Benefits from Volatility

Most articles on volatility, its genesis and characteristics, are quite scholarly yet fail to drive home a simple yet essential point: the key beneficiaries of volatility are those with liquidity and an understanding of value, plain and simple. I'm not talking about flow traders who want volatility so they can capture more bid/offer spreads, or position traders who swing for the fences in volatile markets so they can create a winning bet. I'm talking about investors who have discipline, protect their capital against crowded trades and think independently from the rest of Wall Street. It is these people for whom the sun is shining when for others it is raining cats and dogs (and bears), who quietly sit back until the fear across the market is so palpable you could hear a pin drop and then swoop in and deploy capital at precisely the time it is most counter-intuitive yet profitable to do so.

A prime example of this might be Berkshire Hathaway's recent establishment of a municipal bond insurance unit, at precisely the time when the rest of the industry is melting down. By starting a new vehicle without a legacy of ill-conceived expansion into new (and unprofitable) business lines, it has the ability to garner a Triple A rating and to rapidly secure high-quality (read: profitable) business that the market leaders simply cannot. In fact, it is questionable as to whether the MBIAs and the Ambacs should even be raising capital to defend their Triple A ratings, which essentially results in current shareholders bailing out current management at the cost of stunning dilution to their equity interests. In fact, some have even argued that it might be best for the established firms to shift into run-off mode, paying off risks as they come due and delivering the remainder to shareholders. I think the arguments are pretty compelling, but that's not the point. The point is that insurers are panicking, issuers are panicking, stockholders are panicking, and Berkshire Hathaway sees gold amidst the detritus that is now so obvious but was so hidden until they said "we're in business." And the reason they could do this is because of liquidity and a deep understanding of value.

Is there a reason why most asset managers, hedge funds and Wall Street firms have established pools to buy up busted mortgage paper and other distressed assets stemming from the subprime debacle? Yes, exactly for the reasons I stated above. The fact is, however, that the opportunity will be a lot less compelling for these folks, as there is already a huge amount of capital chasing these assets. The beauty of the Berkshire Hathaway example is that it combines liquidity, a sense of value AND specific business knowledge. Professionals with cash that understand mortgage paper and distressed debt are not that rare - they don't grow on trees but some reside within virtually every major financial institution of every stripe. The same cannot be said for those within the bond insurance business (at least those who know how to do it well). These situations are also examples of information arbitrage, where distinct knowledge together with liquidity and market opportunity creates maximum value. And it is these people that thrive on volatility and fear.

There is going to be a lot of money made in the next 12-18 months by a precious few, at precisely the time when most are getting brutally hammered. Long live volatility! If you can take advantage of it...

(Economic) Reality Bites

I generally write about the economy and the markets from my little ivory tower, throwing stones, feeling frustrated and getting critical even though I am largely immune from the day-to-day impacts. Gas at $3.50 a gallon? It sucks, but I can handle it. A carton of orange juice that costs me $5 bucks? Irritating, but it's not going to change my life. Even a domestic stock market that is down more than 10% from its high isn't going to materially impact my existence. I am very lucky and I am acutely aware of my good fortune. Sadly, my stagflation hypothesis appears to be playing out, and this is likely to have a material impact upon many in my community and beyond.

This really hit home today when discussing financial forecasting in the context of my children's school. I have sat on the Finance Committee for around four years and have largely lived through the good times; I am only now seeing the bad times. Those high gas prices, those rising food prices, the increases in daily living costs even in the face of a weakening stock market, lower short-term interest rates and crimped access to liquidity? These economic realities hurt people, honest, hard-working people, who want the best for their children and their families. And in the context of planning for the next fiscal year, we are coming to grips with several adverse circumstances: the likely spike in bad debt expense (tuition payable that simply can't be paid on time), as job losses and tighter credit markets make it harder to make ends meet, which causes us to think about increasing tuition assistance; skyrocketing insurance costs, which means that staff benefits cost more to both the insured and the school; financing for school construction projects, and on and on. In sum, this simply isn't a pretty picture.

It is easy to get hyper-intellectual about economic circumstances when I read about it in the Wall Street Journal, The Economist, Barron's and online sources. But sitting in a meeting and talking about real people with real children living in my community and anticipating the struggles they're likely to endure in 2008 and for some years in the future, it feels bad. Really, really bad. To those who happen to be fortunate like me, all I can say is be charitable, be prudent and be mindful of exactly how lucky you are. Because you, my friend, are in the minority.

Clear Asset's New ETF Contest: School Support Brings Opportunity

The first Clear Asset Management ETF contest was a huge success. Over 100 entries. Dozens of great ideas. One big winner with ten other winners. It was so successful that Clear Asset is going to do another contest starting February 25th, but wants to broaden the schools from which to draw ideas. The first contest involved Columbia, Lehigh and NYU. Three great schools. Clear Asset would like other schools to submit their interest in participating, particularly those committed to getting professors as well as students involved. The contest provides tremendous real-world experience, something around which a project might be designed or where mentoring could be an invaluable teaching tool. In any event, if you are a student and interested in entering you should speak to your professors, your investment club and your administration about getting behind the contest and securing your school's participation. Then you're off to the races. It should be a fun ride.

Monitor110 has a New CEO

So it's official: Monitor110, the company I have helped build and lead over the past three years, has announced the hiring of a true world-class financial technology leader, Brennan Carley. His hiring is the result of a thorough search process that yielded several impressive candidates, but none possessing his unusual and powerful balance of technology expertise, strategic thinking, Wall Street experience and leadership. As a Wall Street deal-maker and trading manager, I could only take the company so far, and together with our strong Board recruited Brennan out of NYFIX. Prior to that Brennan had been an Entrepreneur-in-Residence at Warburg Pincus, and spent most of his career at the likes of Radianz (where he was a co-founder), Reuters, Instinet and IBM. So now Monitor110 has the technology and business leadership it needs to fully take advantage of the massive market opportunity at the intersection of online data and computational finance, and I couldn't be more happy for both Brennan, the Monitor110 organization and its hedge fund and Wall Street clients. They are all winners in this trade; congratulations to all.

So what about me? I am moving into the role of Chairman, helping Brennan transition and then to be available to him and the entire Board as a trusted advisor. As was the case when I co-founded and joined the company, I am deeply passionate about its mission, its clients and its ability to help change the face of financial intelligence:  helping institutional investors gather, analyze and make money from unstructured data. I also have a pretty healthy rolodex that I will continue to leverage for the benefit of the company and potential clients. I have had a great experience helping to build a world-class early stage company, raising money from and working with leading institutional investors like Draper Fisher Jurvetson and DFJ Gotham Ventures, recruiting top-notch professionals in the fields of computational finance, technology, strategy and research, and, finally, bringing Brennan on board. Throughout my career I have always sought to surround myself with people better than me, with the goal of making myself replaceable at a certain point. And I have finally reached this point at Monitor110.

What will I do with my time? In the near-term I will continue to be an active early-stage investor through IA Capital Partners, having made 10 investments and achieved three exits during 2007. I also have three new deals closing in the next two weeks, and find myself squarely in the middle of high-quality deal flow from both coasts. I enjoy working with strong management teams with big ideas and sound business models, and will continue to do deals as long as I continue to see great young companies to back. I am also doing some work with a group that is taking a public company out of bankruptcy and using the public vehicle in almost a SPAC-type fashion, working to do small and medium-sized buyouts of companies in a select group of verticals in need of consolidation and scale efficiencies. Needless to say, I will continue to write my blog and use the Monitor110 product suite for finding interesting and investable data when I write stock-specific posts. I am also deeply involved in non-profit work associated with my kids' school, Little Red School House/Elisabeth Irwin High School, as well as the Pier 40 Partnership. All this stuff is keeping me pretty busy right now.

In the intermediate term I am considering opportunities to either take a leadership role in the Alternatives business on Wall Street, helping to build and expand a hedge fund platform or to do larger transactions in the private equity world. In each case I want to keep my hand in the investing realm. I miss the markets and big deals; and after three years focusing on emerging growth companies I feel the need to re-visit my roots. I am meeting with business leaders and mentors in each of these areas and will figure out what is the best fit given my background, skills and interests. The ticket to play is having fun and having a big impact. We'll see where it goes. Exciting times, to be sure.

If you want to talk early stage deals, buyouts or making money from alternative data, give me a shout. You know where to find me.

Compensation and Retention: Wall Street and Technology Ain't That Different

Attracting and retaining the best. This is the lifeblood of fast-moving, innovative fields like Wall Street and technology. And equity participation is a key vehicle for both aligning employee and shareholder motives as well as creating "golden handcuffs" though vesting provisions. The problem is when the music stops: this could be due to the cooling of a rapid-growth phase and maturity of the business (read: Microsoft) or an adverse business cycle together with poor managerial decisions (read: Merrill Lynch). In both cases the results are the same: brain drain. When the value of equity-based compensation either begins to stagnate  or is simply perceived as worthless pieces of paper, a key lever of attraction and retention is gone. And in talent-intensive business like Wall Street and technology, this can mean permanent damage to a franchise and a brand that has been built up over decades. But what to do?

The New York Times carried a story outlining Merrill's plan for accelerating the vesting of certain equity-based compensation plans. This is invariably being used as a tool for retention in the face of an abysmal bonus year:

Merrill Lynch & Co Inc's move to accelerate vesting on previously awarded stock-based pay to employees could add to the huge fourth-quarter loss already expected by analysts.

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Last month, the company told employees they would get ownership of some stock-based compensation awarded in previous years earlier than planned, according to people who read the letter. The payout for some is expected at the end of the month.

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For employees, they'll receive money sooner than expected after huge mortgage-related losses hammered the company in 2007. Analysts expect Merrill's fourth-quarter mortgage losses to top $10 billion. As a result, bonuses for 2007 performance have been disappointing, some employees told Reuters.

This is not a dissimilar fact-set faced by Merrill back in the late 1980's, when a very smart and creative guy named Herbert Allison turned Wall Street comp on its head by structuring payouts based on ROE targets for both individual business unit and company-wide achievement. Not based on individual performance? What? While employees puked at first, as unit and firm performance picked up they ended up with bonus compensation far in excess of what it would have been under a conventional bonus plan.

Would such a plan work in today's market? Good question. I think it depends upon the job alternatives available to the middle 50% of the work force (the "soldiers"), the folks who are solid performers that generate value but not those on whose backs the franchise is built and potentially reliant (the "stars"). If the middle 50% has lots of options, then it likely wouldn't work. They would vote with their feet and grab the guaranteed hard dollars. However, given that the market for the middle 50% looks pretty poor right now, a "Herbie"-type plan might well be an effective vehicle for both managing cash and motivating employees.

The way most firms handled the weak 2007 bonus pool numbers is to further widen the chasm between the stars and the soldiers, making sure the stars were well-paid and not likely to move firms while the soldiers, who inherently have fewer options, got royally screwed. While some of this screwing is deserved much of it isn't, and this degree of pay-for-performance stratification can have horrible effects on both morale and motivation for those who received pay that was completely unrelated to performance. It remains to be seen how creative Wall Street gets during this cycle, as I have spoken to friends across the pay spectrum and one thing is clear; the status quo is not stable, and becomes increasingly unstable as the length of time to recovery gets longer and longer.

In the technology realm, Microsoft was the bell of the ball through the 1990s. Mr. Softee's employee stock options were gold. They were an amazingly powerful tool for attracting top talent and created thousands of Microsoft Millionaires in the process. It's fun to work in places like that, no? And then the company turned 25. The market crashed. Their core products were getting long in the tooth. Attempts at diversification were disastrous. By 2002 the stock price dropped by around 60% from its 2000 high. This resulted in both a lot of unhappy employees (with deeply underwater stock options), as well as elimination of a powerful lever for bring the best and brightest into its fold. And around this time you also had the rise of some pretty cool early-stage companies, like Google. The fact is that the chance to flex one's brain muscles and get rich at the mighty Microsoft was being eclipsed by hot, Ph.D-laden pre-public companies like Google. Maturity bites. Sure, they dropped some strike prices in exchange for shrinking the amount of options held and stuff like that, but that is only putting a Band-Aid on a deep gash. Fundamental change is required to get employees re-energized and to get recruiting back on track.

Google had the innovative idea of letting employees monetize a portion of their stock option holdings through their TSO program. This was a forward-looking HR maneuver to help employees diversify their holdings and to gain some liquidity, as living on pizza and beer and sleeping under your desk is only cool for so long. Further, Google's stock price had been a moon shot since it went public, and along with it anxiety about its ability to rise as it had in the past. This is the natural outgrowth of success. Just like Herbies and Google's TSO program, continued innovation in compensation practices are what's required to deal with the problems of maturity, market cycles and mistakes. And the need for innovation hasn't been any bigger in the recent past than it is right now.