Hedge Fund Fees and Liquidity - Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets. Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out. I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

The Inevitable Growth of Derivatives Exchanges

The World Of Derivatives Has Changed

Derivatives exchanges for the trading, clearing and settlement of options and futures is nothing new; they've pretty much been a fact for over 30 years. And volume growth at these exchanges is exploding, regardless of the venue - ICE, ISE, NYMEX, CME, etc. They are all flourishing amidst rising market volatility and rising transaction volumes in general. That said, exchanges continue to miss an enormous part of the derivatives trading and hedging activity that happens in the over-the-counter (OTC) market. Back when I was a derivatives structurer and marketer, the OTC market was THE place for derivatives transactions, particularly in the fixed income, foreign exchange, credit and commodities markets. But today things have changed. The meteoric rise of the OTC credit derivatives market has caused many market watchers to question both the degree and extent of this largely unregulated activity, and recent crises that have involved credit default swaps (CDS) and the like are raising questions about issues of transparency, counterparty credit risk, broker/dealer market exposure and documentation.

Why OTC Markets are Still Enormous

Even in light of the clear benefits of exchanges - transparency, standardized documentation, centralized credit, clearing and settlement functions - the OTC markets have continued to thrive. But why?

• Customization: Whether for risk management or for speculation, the standardized (or lightly customizable) contracts offered by the listed markets simply don't meet the needs of many market participants. Whether for a corporation issuing a bond that wants to precisely hedge a recent issuance (e.g., by swapping a bond with a fixed coupon to floating rate), a project financing vehicle that needs to protect a series of highly variable and choppy cash flows or a speculator that wants to express a particular view through a basket of credit swaps and equity positions, the OTC market is able to address and and all requirements on a highly customized basis.

• Lack of transparency: Let's face it, banks want as little price discovery as possible because it leads to more generous pricing opportunities. Especially if a hedger or speculator wants to put on a non-standard position, banks stand to make the lion's share of their profits relative to facilitating large numbers of exchange-traded instruments with razor-thin margins. This is just reality.

• Potentially better terms: This transcends pricing, as bank counterparties may be easier on collateral requirements and credit terms than exchanges. It is in a bank's interest for derivative counterparties to honor their agreements over their life, and have been known to do unnatural things to keep a derivative counterparty alive for the duration of the agreement.

Rising Volumes Make All The Difference

When I marketed and structured derivative solutions customization was the key driver, as tailored solutions that better met a client's needs also provided the opportunity to make more money. It was effectively the synthesis of an investment banker and a Sales & Trading professional, offering strategies and counsel in order to deliver the right OTC or public capital markets solution. This was pretty cool. The transactions got papered right, the appropriate credit was approved and the necessary ISDA Master documentation was in place. But maybe I did 50 transactions a year. This is a very different situation than we have today where tens of thousands of credit derviative transactions and trillions of dollars of notional value get done annually.

Risks Of The OTC Documentation Blizzard

Further, prime brokers and their broker/dealers were nearly in crisis around undocumented trades, particulary in the 2004-06 time frame, so much so that the SEC had to step in to force banks operations areas to clean up their act - or else. Imagine a situation where a major institution fails with tens of billions of outstanding CDS' written on its bonds, and thousands of unconfirmed trades spinning a tangled web of relationships among investors, speculators and hedgers all over the world. It would be a bonanza for litigators but a nightmare for financial market participants and those for whom they manage money. Not a scenario I want to imagine.

Exchanges Are Designed To Help

So what is the answer? Getting the leading derivatives originators to agree on a standardized template for CDS trades, interest rate swaps and the other building blocks of the OTC market, and creating enough degrees of freedom in the contracts such that there is some ability to customize without losing the liquidity of the instruments. The central exchange function is simply so valuable in an a world of exploding volumes and numbers of counterparties, and can serve as a mechanism to ensure best practices with respect to transparency, credit provision and documentation. I am not one to bang the drum for excessive regulation, but by pushing as much trading volume onto exchanges as possible I believe the likelihood of market dislocations will be minimized and "unexpected" crises in the wake of credit and performance defaults will be substantially reduced.

The Inexorable Shift Towards Exchanges

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota's success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.

On Spiritual Holiday

For whatever reason I'm just not in a writing mood these days. Very intense. Working on projects. Lots of deals. Helping portfolio companies. Busy with my family. L-A-S-E-R-F-O-C-U-S-E-D. For the first time in nearly two years my well is dry, my inspiration lost. Having not experienced this since becoming a blogger, it is kind of freaking me out. Am I letting down my readers? Do I really have nothing more to say? Am I brain dead? None of these are pleasant prospects. It used to be that every day I had 2-3 ideas I wanted to write about and just couldn't wait to sit down at the computer and type away. But that feeling is lost right now. And I am feeling somewhat guilty. And pretty sad about it.

That said, I am doing what I need to be doing, which is letting it flow - or not. I'm sure I'll get over my hump, but for now I am taking care of business. My business. And right now my business does not seem to include writing. I am sure my feelings are not unusual and that many of my blogging friends and colleagues have experienced something similar, but right now it seems like I am the only regular blogger in the world who isn't blogging regularly. And it feels like crap. Fred Wilson? Paul Kedrosky? Barry Ritholtz? Felix Salmon? Those guys are super-human. I am a mere mortal.

But not to worry, I'll be back. Oh, you betcha. I'll be back.

Does SPAC Really Spell SCAM?

To be clear, I don't see the SPAC industry itself as bad. Well, not too bad. What I do see, however, is an industry that might be moving towards a role that is neither good for SPAC investors nor consistent with an alignment of interests among private equity firms, SPAC sponsors and their investors. A good friend of mine got my thoughts flowing after forwarding me a recent article from Bloomberg:

May 16 (Bloomberg) -- Kohlberg & Co., Madison Dearborn Partners LLC and Kirtland Capital Partners have resorted to selling holdings to so-called blank-check companies, a path more private-equity firms may follow as other buyers remain scarce.

Leveraged buyout firms stepped up the pace of takeovers in the past five years, aiming to cut costs at businesses ranging from newsprint makers to crane purveyors and then sell them to the public. Now they're turning to special-purpose acquisition companies as demand for IPOs sinks to a three-year low and tight credit markets make it harder to borrow money to finance LBOs.

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

While SPACs are flush with cash, the other buyers private- equity firms have traditionally relied on are unable or unwilling to invest, according to Steven Kaplan, a finance professor at the University of Chicago's business school.

``Buyout firms are selling into these situations where they can't go public by the normal route and there's no one to sell it to,'' Kaplan said.

So have SPACs become the buyer of last resort for those private equity-backed companies in need of liquidity? Probably not exactly what SPAC investors had in mind, unless the prices paid by the SPACs are cheap. The words "private equity" and "selling cheap" generally don't go hand-in-hand, so this recent phenomenon has caused my BS detector to emerge from its week-long slumber.

It kind of seems like a case of adverse selection; since institutional investors aren't eager to fund a current IPO calendar, perhaps retail investors can be tapped indirectly by selling these companies to SPACs? Maybe I'm just being cynical. But wait a minute, these deals are pretty good for those SPAC sponsors, right? They get a big chunk of equity for simply putting together the SPAC and are long a call option on, say, 20% of the business if a deal goes through. And these sponsors are under time pressure, because they've been sitting on a pile of cash and in need of a deal, or their money will be returned (less fees) to investors. So it is just this kind of a dynamic (a ready-to-deal private equity industry, closed IPO markets and SPAC sponsors in need of deploying cash - now) that makes me wonder: is something rotten going on here?

Consider the key constituencies and what they have to gain by the current PE portfolio company-to-SPAC deal cycle:

Private equity firms: They want liquidity and can't do so via an IPO. Sales to possible strategics are often harder to accomplish and result in lower sales proceeds, and sometimes come under regulatory scrutiny. SPACS offer ready pools of public markets liquidity, the incentive to get deals done, less price sensitivity and complexity than selling to a strategic buyer. Not bad. It's pretty clear why the private equity industry is heading in this direction given today's less-than-friendly market environment.

SPAC sponsors: They are all about getting a deal done, since the clock is always ticking on deploying their funds before they have to be returned to investors. Buying public companies is hard, because dealing with multiple shareholders, regulatory approvals and SEC red tape is a major hassle. Further, the risk of the deal not getting done is far higher than dealing with a single entity, e.g., a private equity firm. One could imagine a scenario where SPAC management might not sharpen its pencil to get a deal done at the right price, since the motivation to get a deal done is so great. And while the proposed acquisition has to be approved by 60% of SPAC shareholders, unless the deal is a dog on its face it is easy to imagine it getting through.

SPAC investors: The original investors, under the SPAC structure, pay a boatload of fees for the privilege of participating in the SPAC. And these fees don't get returned, even if the SPAC never does a deal. So there is a lot of motivation for investors to support the SPAC sponsor's proposed deal, since flushing 7% down the toilet is a hard thing to stomach. So even if the sponsors appear to be overpaying for a deal, unless the deal smells very, very bad it is pretty likely to get through.

So my word to SPAC investors is: be careful out there. First, does buying into a SPAC make sense in the first place? Second, are you better off voting down a deal, even if it means giving up the fees, in order to avoid an even worse outcome? Best advice: if you must invest in a SPAC, wait until after it has traded for a while and begins to trade at a discount to NAV. Then you won't have to shoulder the full weight of the upfront costs and are simply long a call option on the sponsor's ability to get a good deal done. And if they don't, you don't get burned. Today is a time for prudence; this is my Rx.

ADDENDUM - 5/18/2008

One of my readers sent me some additional information concerning SPACs that I wanted to share. As one who is not currently active in the SPAC marketplace, my perspective might be applicable to the industry of yesteryear (like buyers of convertible bonds, which is now dominated by vol arb players and less by long-term, fundamental investors). I appreciate the insight and knowledge shared by this individual. Thanks, Mark.

When the SPAC is originally funded, almost all the investors are hedge funds with absolutely zero intention of voting for the (eventual) acquisition. Instead, they buy the shares using leverage, then immediately strip off and sell their warrants and continue to collect interest on the (refundable) balance. By doing this, they guarantee themselves a very high (10%+) risk-free return. Once the target is identified, the SPAC management team then has to do a SECOND roadshow, in order to find "long-term" investors to buy the shares from the original SPAC investors. (Those original investors are generally highly cooperative in this process, because it greatly reduces the time it will take for them to get their money back, vs. waiting three years for the SPAC to dissolve, and then another four months for the escrow money to be returned to them.) So, anyone who buys into a SPAC up front really has nothing to worry about if they don't like the original acquisition, and anyone who does so later is doing it with his or her eyes "wide open."

The real problem with SPACs is that it can become a massive (and ultimately unsuccessful) time drain for their management teams, as it's so hard to get approval for whatever deal they line up. More and more frequently, those teams are now giving up big chunks of their equity to investors willing to come in (on the secondary market) and vote "yes"; at some point, it won't be worth the effort for a team to put one of these things together... In which case, they may have to go out and get real jobs!

Long PM Health/Short Tums

What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:

1. Becoming "institutional," substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
2. Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.

I've spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire's stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.

So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn't be judged on short-term results, then they shouldn't get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.

I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.