The Quants Must be Crazy

As a number of historically top-ranked long/short managers have decided get out of the LP game, there is another pocket - a quieter, more stealthy pocket - of the hedge fund universe that is heating up to bubble-like proportions: high frequency statistical arbitrage trading. Where long/short managers were once the kings of the hill, the AUM titans that could move markets with the mere awareness of their interest in a particular security, the secretive, underground, geeky uber-quant crowd is now being feted by top shops looking for talent. Hedge fund strategies rise and fall in favor in a cyclical manner, as "hot" strategies become over-crowded and returns get compressed, while those out-of-favor are fertile ground for some truly differentiated alpha generation. Then those shunned strategies attract new assets while the previously desirable lose assets. And so it goes...

Generally, such strategy shifts are a function of alpha opportunity: investors will generally tilt towards strategies that can generate the most alpha in the current environment, and since investment conditions oscillate strategy allocations oscillate as well. But there is a new factor weighing on investors' minds (and pocketbooks) that is having a pronounced effect on strategy allocation: liquidity. Among the universe of hedge fund strategies, which is the one that has the best liquidity profile? High frequency stat arb.

With signal horizons measured in sub-seconds, minutes or sometimes hours, these strategies trade highly liquid instruments long and short and generally will end the trading day at or near flat. Money is made through rebate capture strategies, rapid-fire pairs trading and the like. They good high frequency books tend to have Sharpe Ratios that are multiples of those of long/short and relative value strategies, specifically because the volatility of these strategies is muted due to the microscopic holding period. But this gives rise to the big drawback of high frequency stat arb - massive capacity constraints. In general, these strategies don't scale well, and as the frequency goes up (with "ultra high frequency" being the moniker for the most silicon-intensive, millisecond holding period strategies) the capacity tends to go down. Books of $10-$20 million are not uncommon, and it is hard to build an ultra high frequency book north of $100 million. This compares to the multiple billions that can be profitably run via a value-oriented long/short strategy, where much more concentrated positions and much longer holding periods rule the day. But in today's environment, this is not what investors want. Long lockups and high volatility? Out. Short redemption periods and low volatility? In.

And investors are willing to grant much higher payout to such strategies, and for good reason. Gains are losses are realized daily, not weekly, monthly or yearly. The mismatch between strategy holding period and the payout of incentive compensation is the driver of the backlash by LPs towards many of the premier long/short funds, and it makes sense. If your strategy has a holding period that is 18-24 months, should incentive comp really be paid quarterly? There is no rational argument for why the industry has grown up this way, and my guess is that this feature will, over time, come to an end. Both the timing and level of incentive comp needs to be calibrated to holding period - when these finally come into line, there will be a true alignment of motives between GPs and LPs.

But back to the high frequency frenzy. Of course, there is no free lunch. The influx of capital into what is a fundamentally capacity constrained strategy will compress returns and strip the alpha out in short order. And unless these funds amp up leverage as they did in 2007/08 to try and keep returns constant while spreads were compressing (which is what contributed to the quant fund blow-up), capital will necessarily flow out and into strategies previously tossed to the side where alpha once again exists, e.g., long/short. This is simply the nature of things. But for the hedge fund industry to rebuild its asset base and develop a healthy relationship between managers and investors, the timing and level of fees has to match the strategy. A "one size fits all" approach is neither appropriate nor desirable. It's high time the LPs asserted their power and the GPs grew a conscience to do the right thing for the industry.

Private Equity Markets: Not Today, Perhaps Tomorrow

Claire Cain Miller penned a story in last Wednesday's New York Times concerning the development of private markets for venture-backed equity investments. The article raised several important issues, but I'd like to provide further color beyond my quotes in the story. Private markets, their opportunities and risks are very complex: my belief is that while it would be great for a "third exit" to emerge, its realization remains far, far away, except for the most popular, "branded" private companies. Think Facebook, Twitter and the like. Legal and regulatory issues are a problem. Scaling is a problem. And the demand side is a problem. For these and other reasons, I believe it will take years for a true alternative means of liquidity to emerge.

Not a Technology Problem

First off, let's be clear: this is not a problem that subjects itself well to a technology solution, at least not now. The hardest issues with these types of transactions are operational: compliance with transaction documents, e.g., Right of First Refusal provisions, etc.; transfer and custody of physical stock certificates; receipt of stock powers; alterations to books and records; collection of sufficient information about the company to make an educated investment decision, etc. Due to investor demand and regulatory limitations, technology as a vehicle for price discovery hasn't really been necessary. So those that consider this a technology problem to be solved are far off the mark. Think of one of the single most successful financial start-up of the past decade: Gerson Lehrman Group. The company is worth over a billion dollars. The vast majority of this market value is not attributable to technology, but to making a match between information seeker and information provider. The technology that has been built in recent years is nice but certainly not a key driver of firm value. The largest and arguably most successful company in the private/illiquid asset space, SecondMarket, has painstakingly built an back-office environment to rival that of a small broker/dealer. Companies that are at all successful in this space will have significant infrastructures to handle the operational requirements of trade execution and settlement. Everyone else is simply pretending.

Not a New Idea

Making a match between a large seller of restricted/private stock and a buyer. Hmm, that sounds familiar. Who else does this? Right, Mergers & Acquisition bankers and block desks. Depending upon whether the sale is to a strategic buyer or a financial buyer, Wall Street has long dealt with exactly the problems these private exchanges are purporting to solve. If it's employees with small holdings ok, not the same, but if it is a venture firm like Union Square Ventures, Kleiner Perkins, or DFJ looking to find an alternative path to liquidity, they can always call up their friendly investment banker and place the stock through them. Bankers can do the job of price discovery just like a listed market, and the prices will be much more reflective of the kind of size the sellers want to move than a shallow indicative level that doesn't do the venture firms much good. It will take years to cultivate a truly new investor base, e.g., high net worth retail, to take up the stock. Moving large size in private companies tends to be an institutional phenomenon, those same institutions that are currently no bid in the largely dead IPO market.

Depth in Demand Does Not Exist

The investors that generally drive the IPO market - not high net worth individuals but mutual funds, hedge funds and other institutional investors - are largely on the sidelines. There is a massive emphasis towards liquidity in today's environment, and private company stock is not high on most institutional investors' shopping lists. So in the absence of these key players, are accredited investors (in Securities Act of 1933 terms) really sufficient to pick up the slack? It's not as if angel investors have been deploying large amounts of capital, and those "super angels" that have been bridging the gap between founders and institutional rounds are primarily "first-money-in" investors; they are not looking for Facebook stock at $4 billion or Twitter stock at $350 million. So the fact that there isn't a vibrant IPO market says to me that there isn't a deep private company stock market, either. In the absence of real demand, all the recent buzz in this space appears to be a solution looking for a problem.

The Regulatory Environment is Hostile, and the Trend is Not Your Friend

All of these private markets are predicated upon either the Accredited Investor or Qualified Institutional Buyer (QIB) rules; these provide safe harbors from a host of SEC reporting and disclosure requirements, on the assumption that investors in these buckets are sufficiently sophisticated to make investments in risky, unregistered securities. These restrictions, coupled with the 500 investor limitation pursuant to the Securities Exchange Act of 1934, sharply limit the potential parties that can underpin the demand for these private markets. In effect, for the volume of these markets to scale, the same institutional investors mentioned above need to participate. And if they won't buy shares of more profitable, less risky IPO companies that will provide detailed SEC-compliant disclosures, then why would they be motivated to invest in less profitable, riskier private markets companies with limited disclosure requirements? Answer: they wouldn't. Further, in order for these markets to truly flourish, rules such as the 500 investor limitation would need to be relaxed. But with today's environment awash in scandals, trillions of losses due to illiquid and non-transparent asset portfolios and the taxpayer and Congressional backlash arising from the bailout, is anyone really in a position to ask for relaxation of rules that are designed to protect investors? Good luck. The timing could not be worse.

Private Markets Could Work - Someday

The key needed for these markets - any private market - to succeed is real and durable demand. When that will emerge I do not know, but I am pretty confident it won't be for another 18-24 months, at best. Another factor are the public company listing, filing and compliance requirements. Sarbanes-Oxley (Sarbox) has certainly raised the bar for companies going public, and represented one of the key motivations for markets such as GSTrUE and Opus-5 to emerge. But if Sarbox were rolled back or recast in such a way that compliance was less complex and cheaper to implement, then the need for private markets might go away. I don't buy the argument that a "long tail" of demand exists for non-brand name private companies, except insofar as these companies are raising capital, not for investors who are looking to sell out. Just as with GSTrUE, the companies that were able to be placed were top-shelf names with big brands and significant pent-up demand. This kind of dynamic does not exist in the long tail. It seems to me that Internet investors are seeking to apply web logic to a Wall Street phenomenon. Sometimes characteristics of the online world don't necessarily apply to the offline world. I could be wrong here, but I doubt it.

The Bottom Line

I appreciate the desire for a third path to liquidity, and acknowledge its importance, but you can't manufacture demand where none exists. Demand will pick up at some point and these markets will be viable, but their growth will be sharply capped due to both the "brand name" and "head of the tail" phenomena and the regulatory environment. So this is one to keep an eye on, but my sense is that this third path simply won't become viable for a long, long time.

Note to the Administration: The AIG Flap is Because of YOU

The AIG bonus kerfuffle is beyond absurd, but what else would you expect from a flawed bailout program with conflicted motives littering the landscape? Congress and the Treasury should be ashamed of themselves: they've committed hundreds of billions of taxpayer dollars yet work to undermine its value and efficacy, in real time. A casual observer from another planet looking at the recent flap would invariably say: short the US - or at least its legislators.

Consider a few observations:

• They (Congress, Treasury and the Administration(s)) entered into a bailout program with the stated (and reiterated) idea that sick institutions must be kept alive, e.g., preserving value for common stock and debt holders;
• They initially worked to minimize the Government ownership associated with bailout funds, hurting the US taxpayer's return on investment while ostensibly allowing the recipients free rein over how to deploy the funds;
• When it became clear that the capital injections were insufficient for the largest and most troubled institutions, more funds were committed on the same unstructured basis as before;
• When even these amounts were deemed inadequate, either more money was put in (AIG) or senior claims were converted to subordinate claims (Citigroup's investors' conversion of preferred shares into common stock);
• As ownership in bailed out instituions crept up, notwithstanding the earlier desire not to have the Government involved in the management of bailed out firms, Congress decided it was time to pass judgment on how the businesses were being run; and
• Now we have a Congress smelling blood (and a PR opportunity), passing odd and abusive legislation to convey their moral outrage (hypocracy, anyone?), while simultaneously damaging the US taxpayers' massive investment in the bailed out firms (and any firm either forced or desperate enough to take Government money).

President Obama, Congress and our friends at Treasury, you can't have it both ways. Either you are making investments and letting the private sector decide what to do with it or you are taking control and restructuring troubled businesses. By choosing a middle-of-the-road strategy, you have guaranteed failure. Troubled institutions are not getting fixed, and you have wasted US taxpayer money and damaged investor sentiment. All of this could have been avoided by supporting a Good Bank/Bad Bank initiative from the outset (one Government-controlled Bad Bank; many Good Banks). This would have enabled you to:

• Clearly segregate illiquid bad assets from the sound operating businesses, focusing US taxpayer dollars on bridging the liquidity gap for the Bad Bank while raising private capital for the Good Banks;
• Replace legacy managements and Boards of Directors to avoid the PR damage and ongoing concerns about the stewardship of restructured institutions;
• Hire a team to work out the Bad Bank over months and years, paying a small management fee and carry on the assets sold while staying out of the management and compensation policies of the privately-funded Good Banks;
• Avoid micro-managing private institutions with massive public ownership and driving the value of the public stakes into the ground.

I'm hoping it is abundantly clear that the Government's plan for handing sick institutions has been an unmitigated disaster. The primary argument against Good Bank/Bad Bank - the difficulty valuing the illiquid, bad assets - almost looks like a joke today. Yes, it would have been difficult. But yes, it could have been done. The collateral damage associated with the Administration's handling of AIG and Citigroup is only just beginning to be felt. What is now a public relations circus which makes for entertaining reading is anything but funny: it threatens the value of the bailout funds already deployed and has boxed the Government into a corner. Congratulations on showering your moral outrage on AIG; the fact that this issue could have arisen is simply indicative of your ongoing failure.

Regulatory Litmus Test: Can the "Four Horsemen" Ride Again?

As noted in my recent post with Matt Harris, the venture industry has massive problems of scale. Large investments from even larger funds are weighted down by a dark feature of the past decade: limited opportunity for exits. Venture-backed companies, if they go public at all, do so at much greater scale than they used to, necessitating many rounds of venture investment. It used to be that companies could go public on the NASDAQ much earlier, often brought by a host of middle-market investment banks like the "Four Horsemen" (Alex.Brown, Hambrecht & Quist, Robertson Stephens and Montgomery). Young growth companies could raise $20, $30, $50 million, at valuations in the $100 million range. It set the stage for subsequent share offerings as growth opportunities warranted, and the investment banks provided research on the young companies to keep investors informed of their progress. While many parts of Wall Street and our financial markets are broken, this was one area that functioned quite well and fueled the engine of innovation that led to the technology revolution. Yet in a classic case of unintended consequences, onerous regulations such as Sarbanes-Oxley have served to squelch the fires of creativity and capital formation to the detriment of our economy, our environment and our society.

Our regulators, Congress and yes, President Obama, need to take a big step back and ask the following question: what re we trying to accomplish with our regulatory framework? As with most things, regulations involve a trade-off: impose too many, stifle growth and innovation; impose too few, provide the basis for fraud and mismanagement. My fear is that our regulations have gotten both more strict and less effective, causing the venture business itself to be on life-support. Is this what regulators set out to do? I'm sure not. But here we are. Even a $250 million venture fund has a hard time returning carry - remember, you need $250 million in exits just to break even on a nominal basis, $500 million if you want a decent track record and return for your investors. Tallying up a cool half-billion in exits is no mean feat. Think about the $500 million fund that needs to return $1 billion: where is that coming from without an IPO market or corporate acquirers with huge financial capacity? This is why we need a vibrant middle-market investment banking function to help bridge the gap between A/B round investment and later-stage investment. 

The only other way around the problem: later-stage venture funds becoming a proxy for the IPO process, providing outside investors with an exit, letting the founders take a little off the table and re-incentivizing them to take the business to the next level. This way, the original outside investors don't have a massive layer of preferences on top of them, the founders are happy for partial liquidity, greater financial stability and a nice incentive package, and the later-stage fund gets to put big dollars to work efficiently. While this is fine, it is not a substitute for financial markets and structures that support the kind of growth needed to prepare this country, and the world, for the challenges of the 21st century.

Let's accept the fact that it is impossible to eradicate fraud. Some degree of fraud has to be acceptable, because the costs of 100% regulatory effectiveness would be to stop commerce altogether. The question is, how much bad behavior can we live with to support flexible and inclusive capital markets?And what kinds of policies do we need to support an active growth-company financing environment? Here are a few observations:

• Sarbox doesn't work. It is a tax on all companies, but is massively regressive (as smaller companies have far higher percentage compliance costs than larger companies). Therefore, it is the worst kind of legislation for a country built on small businesses and innovation. It needs to be scrapped and re-conceived.

• Accounting rules need to be simplified with an emphasis on transparency. We should move away from rules-based and towards principles-based standards. Enforce bad behaviors through regulators and the courts, and have companies submit grey-area issues for interpretation as they arise. The regulatory apparatus needs to be set up to handle these policy clarifications in a timely manner.

• Tax policy must be simplified, with incentives provided for start-up investment and R&D spending. Corporate taxes should be kept low and easy to compute. Tax shelters should be wiped away except for explicit policies geared towards investment. Forget about Sarbox: the cost of tax compliance (and tax "optimization") for public companies is a massive and rising expense due to increasingly labyrinthine tax rules. This is wasteful and has to stop.    

• The theory behind separation of banking and research needs to be revisited. In middle-market growth company underwriting, it is very hard to get third-parties to publish research on nascent companies. It is generally the role of the underwriter to keep investors current on the company's business and prospects. While conflicts of interest can certainly exist, and principles-based regulations should be applied (e.g., if you are "talking your book," you can get fined, censured, etc.), this is a model that can and does work for financing and supporting trading of growth company stocks.    

These are four of perhaps ten or more steps that need to be taken to address this issue. Bottom line: without the ability to take younger companies public as was done for decades, the large-scale venture business is not a viable business model. Too few exits. Not returning carry. Disenchanted LPs. Period. 

Advice for Transitioning from Wall Street to Start-ups

In my last post, I talked about some the challenges and barriers to success facing Wall Streeters interested in the start-up world. Difficult doesn't mean impossible - it just means that you are going to need the same passion, intensity, steely resolve and thirst for learning for transitioning from Wall Street as you'll need for either founding or working in a start-up. So it is actually a pretty healthy and necessary self-selection process, in my opinion. Over the last 4+ years I've done stuff that I couldn't have imagined that made all the difference in my acclimation to the start-up/technology world. The thing that will be difficult for most Wall Street refugees to understand is that being at a technology start-up, whatever your capacity, isn't a job: it's a way of life. Because success is partly dependent upon being an active learner, opening both your mind and your heart to new and non-intuitive things on a daily basis.

While I am only one data point, I will share some of the steps I took to make the transition from Wall Street to Silicon Alley, and continue to make every day.

• Reach out to friends who either work in or are investors in start-ups. Duh, obvious, right? One of the guiding principles on Wall Street is using data to make decisions, and it should be no different when making this transition. You need to speak to lots and lots of people who have either gone through what you are contemplating, or who have experience with those who have attempted the same. I was lucky to have guys like Fred Wilson and Jeff Stewart as early resources, both as data points and as connectors to others who gave me even more data. While your experience, personality and skill sets are unique, those of others can be very, very instructive.

• Immerse yourself in the start-up ecosystem. This means going to relevant Meetups, presentations offered by law and accounting firms, select conferences, etc. Subscribe to Gary'sGuide.org and other meeting notification services in order to keep your finger on the pulse of the technology and start-up scene. See, be seen, collect business cards from both investors and entrepreneurs, and hand out zillions yourself. Eventually you will become a fixture in the community. And this is a good thing.

• Become a "Let's go out for breakfast" and a "Let's grab a coffee" madman. Network, network, network. Entrepreneurs. Venture capitalists. Angels. Potential clients. Potential partners. Smart people in your domain of interest. These meetings exhibit exponential - not linear - benefits upon your networking and data collection process, as people in this realm tend to be incredibly helpful and introduce you to lots of other people who become nodes - offering new connections - themselves. Once you get this ramped up your learning absolutely skyrockets, and the contacts you make can help land a job, locate a business partner or de-risk a new venture through an advisory or commercial relationship.

• Read lots of good blogs. There is so much great content out there, stuff that seems like it is written JUST for you given your areas of interest. Take advantage of this. It is also a great way to meet people with common interests with whom you can start a dialogue, out of which might come - who knows? I've commented on people's blogs, sent them emails and built dialogues that evolved into great relationships. Becoming an avid consumer of the medium is very important from both knowledge and networking perspectives but also for getting your head around being a start-up guy.

• Start a blog yourself. I know, it's not for everyone. But if you fancy yourself a start-uppy kind of person, then you must have the ideas necessary to populate a blog. The value, however, is well beyond that. It is a place you can refer people for greater insight into you both as a person and as a professional. It is a platform for igniting conversations around topics of interest to you. And it brings with it a certain aura of engagement, of caring enough to set it up and maintain it. This is pretty important cred when interacting with technology types, many of whom have blogs and use them to great effect. While it takes a meaningful amount of time to do a blog and do it well, it is a valuable mechanism for getting fully ingrained into the technology ecosystem.

• Join and use Twitter, Facebook and LinkedIn. While I've been on LinkedIn a long time, I find myself spending the most time on Twitter, followed by Facebook. LinkedIn is a distant third. While I think it is important to have a presence on all three, Twitter is clearly the most dynamic, fastest moving, and most powerful vehicle for getting a grip on the conversations happening in your areas of interest. Twitter and blogs. Choose the Twitterers and bloggers you follow well and it will pay off in spades. You will be extremely well-informed, on the cutting edge of information, and have a circle of influencers with whom to interact. It's all good.

• Separate - really separate - from Wall Street. It is really, really hard to sever the spiritual umbilical cord. The political machinations that were irritating while you were on the inside are a compelling soap opera once you go outside. Resist the Siren's Song. Also, it can make the fear even greater when you stay close to people still on the (albeit smaller) gravy train while you've made the break. Don't hang out with them. Spend the time getting acclimated to your new world. This doesn't mean saying goodbye to friends; it just means having a clear delineation between personal and professional boundaries, and refusing to allow yourself to live in the past. Making the break is hard. Once you've done it, DO IT. Don't let yourself get sucked back in. Because you will end up depressed and frustrated, and further way from your goal of being a different kind of person, a different kind of professional. You deserve better. Move on.

• If you can, do a little angel investing and/or advising start-ups. I am strongly against "dabbling" in the angel investing domain, but I view this as a little pocket money akin to going to Vegas or AC to play poker. Becoming an angel, getting to see how others start companies, pitch ideas, interact with investors and staff their firms is invaluable education, well worth the price of admission. I'm not suggesting spending a material amount of your net worth doing this, but enough so you are able to see some deal flow and perhaps use a more experienced friend to help select a few small-ticket investments. Also, putting yourself out there as a potential adviser to start-ups is a great way to learn about how they work. With your domain expertise from Wall Street, you could add a lot of value to a nascent company. Get engaged. Help out. And learn, learn, learn.

• Acknowledge the challenges but don't be daunted. If you come into this transition with humility, excitement, intensity and focus, you can make it happen. Invariably the road will contain some potholes (if my own experience is any guide), but persistence is what makes great entrepreneurs and great partners, and what makes victory at the end of the day just so sweet.

Don't worry, be happy? Not at all. There is plenty to worry about. But there is a lot that you, former Wall Streeter, can do to make your move into the world of start-ups a much more satisfying and successful experience. Best of luck and get on with it.

Will Ex-Wall Streeters Fuel an Entrepreneurial Boom? Well...

Much has been written about the unleashing of entrepreneurial potential in the wake of lost jobs, frustrations with being a "depressed survivor" and general dissatisfaction with life on Wall Street 2.0. For those of us who spent time at the big firms during Wall Street 1.0 and have a sense of 2.0 life, it makes sense that many of the smartest, most capable people would either head for established boutiques or leave to create their own ventures. But it is important to distinguish between different kinds of ventures, in particular those that reallocate the value pie versus those that expand the value pie.

At one end of the continuum, populated by guys like Ken Moelis, Frank Quattrone and their banker buddies, you've got the value reallocaters. What these people are doing isn't rocket science; in fact, it's not materially different than what they had been doing previously. Sure, they might be providing higher-touch service, deeper advice and more senior partner attention, but all they're doing is taking share away from Goldman Sachs, Morgan Stanley and JP Morgan. Is this entrepreneurship? Sure. Is this the kind of entrepreneurship, however, that's going to fuel an economic resurgence? Not a chance.

Then you've got all those IT professionals, middle- and back-office pros, and less senior bankers trying to figure out what to do with their lives. These are the potential value expanders. Some would like to apply their skills to the ideas of others, get out of the big corporation and go and work for a start-up. Others want to be their own boss and pursue their own dreams as entrepreneurs. Bravo! Assuming the idea makes sense, taking big company skills and applying them to new and exciting problems is fantastic. However, here are a few issues to consider:

• The physical environment and resources of a start-up are light years away from that of Wall Street - at any level. I went from a corner office with an assistant, an IT staff, oodles of resources and most anything within my grasp to a sixth floor walk-up (the building had an elevator, but I wouldn't be caught dead in it - or maybe I would), a bathroom with a washer/dryer that blew lint in your face and a sink that was falling off the wall such that a permanent cesspool existed at the bottom. Oh, and up to eight of us were crammed in an office that was smaller than my corner beauty on Park Avenue. Shocking, yes. But I was ready for it. No assistant. No IT support. Nobody to order my lunch. I went straight back to college, after nearly two decades of being a coddled Wall Street denizen. For whatever reason I was psychologically ready for the shift, but I've seen others for whom the transition was somewhat more challenging.

• The culture of a start-up is night and day from that of Wall Street. Fiefs and political barriers exist all over the place on Wall Street, and "playing the system" requires a defined skill set: toughness, cynicism and mistrust. Fact is, these attributes that helped you succeed on Wall Street are more than simply unhelpful in a start-up environment; they are toxic. Start-ups are truly collaborative, roll-up-the-sleeves, we're-all-in-this-together kinds of places. If you are withholding information, managing politics or constantly positioning, you'll both damage the company and your chances for success. I can personally say that it took me a while, particularly in negotiations with financing sources, to lay down my arms and to stop being the aggressive and tough Wall Street animal I had become. It doesn't mean being a pansy; it means not always thinking people are trying to screw you and to alter the tone of communications. It's not that easy.

• The risk of a start-up is worlds apart from Wall Street. Salaries are sharply lower. Bonuses by Wall Street standards don't exist. Upside is in the form of highly illiquid, massively volatile call options. It is a completely different payoff profile. This is hard to swallow for someone who has been on the gravy train for a long time. And even if that gravy train no longer exists, it doesn't mean the adjustment isn't very challenging. It takes time to adopt the start-up mind-set, and it isn't easy for people who come from such a radically different world.

Without a doubt, there will be some Wall Streeters who migrate towards the "value expanders" bucket and do great things. But the challenges of making the switch should not be underestimated. A lot of mentoring, a lot of patience and some hard-core retraining is necessary to help these talented professionals successfully make the transition into the start-up world. This is a place where some stimulus dollars would be well-spent. Let's unleash the entrepreneurial spirit, but do so in a way that both expands the value pie and prepares these nascent entrepreneurs for success.

Buy the Rumor, Sell the ...

The equity market certainly bought the rumor of the bailout plan (hereafter referred to as the "Geithner Plan"), rallying like crazy over the past week on nothing but bad news across the globe. But on the day when the big news was finally expected to hit, Treasury Secretary Geithner's release of his "comprehensive plan," he said absolutely nothing. Weeks of planning. A day's delay in making sure he was ready, really ready for his coming out party. Only problem was, those that came to the party left. Immediately and rapidly. Today's market news was no better or worse than any other over the past week, but somehow equity traders proceeded to lop almost 5% off its value. Do you think investors, like the Treasury, might be just a little jittery, placing a little too much hope on the impact of a plan that few thinking rationally consider a panacea?

My friend Paul Kedrosky posted an excerpt from President Obama's discussion on ABC Nightline tonight. The punch line: while being creative with statistics, the President dismissed Sweden's (successful) approach to restructuring its banking sector on both economic and ideological grounds. His stance that Sweden "only" nationalized five banks, while the US would need to nationalize thousands to achieve the same effect, is both specious and absurd. No discussion of relative GDPs. No comparison of the size of the banks that were nationalized relative to, say, the top 10 banks in the US. It was one of those typical "a politician says it on TV so it must be true" moments, only I'm really disappointed that President Obama is resorting to such tactics to sell the Geithner Plan not a month into his Administration.

His discussion of different cultures is slightly more valid but no less meaningful as the problems at hand require sharp and decisive actions, like those specifically avoided by Geithner and his advisors thus far. President Obama had this to say:

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.

And so, what we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets and ultimately that's going to be the key to getting credit flowing again.

The approach of Good Bank/Bad Bank, with an immediate requirement for mark-to-market accounting across all portfolios not supported by term financing embraces private capital and, in fact, requires it. A principal difference between this approach and the Geithner Plan is that it places the costs where they belong - on lousy managements and moral hazard-hoping shareholders and bondholders - instead of where they do not (the US taxpayer). Further, it forces swift accountability and dealing with the depths of the problems upfront, instead of deferring the pain and hoping for a market recovery to bail us out. Plans built on hope invariably fail, and do not establish a solid foundation on which to re-build broken balance sheets, businesses and industries. Messrs. Geithner and Obama would have you believe otherwise, and hide behind ideology as a principal motivator of their actions.

I had hoped for so much more coming out of a stirring victory, broad-based enthusiasm and words filled with promise and action. Instead, we've gotten a plan and an ideology that appears frighteningly similar to that which preceeded it, which failed miserably by any accounting. No real accountability. No real acknowledgement of the magnitude of the problem. Deeply concerned with stock market reaction today instead of where it might be in three years, five years, ten years. This is why I'm scared out of my mind.

A "New" Bailout Plan? Hardly.

I watched our President's brief address on prime time this evening. His delivery was passionate. His message, strong and partisan. His intentions were clear. Rally support for his stimulus program. In the wake of a few really bad days of press, his honeymoon period clearly over, I thought he did a strong and ballsy thing. Problem is, the plans being bandied about concerning the financial sector are still off the mark. How is it, after the mistakes made by Paulson and the prior Administration that we are still unclear as to what the plan should be? As I've said before, I just don't get it.

But now it's even worse. It seems as if the discussion among those in power has gone back to what we had during Bush II, injecting capital into sick institutions, yet on "tougher" terms than we had previously. Simply doing more of something that was flawed from the beginning isn't going to help solve the problem any better. Why the brainy President Obama or the equally brainy Larry Summers don't seem to get this is beyond me. From tonight's WSJ Online:

WASHINGTON -- The Obama administration's financial-rescue plan is shaping up to include capital injections with tougher terms than the first round and an expansion of an existing Federal Reserve lending facility that could potentially buy up toxic assets clogging the system, according to people familiar with the plans.

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Instead of buying preferred shares, as it did before, the government is discussing taking convertible preferred stakes that automatically convert into common shares in seven years. Such a move could help banks as they look for ways to bolster common equity. When a bank takes a loss, it has to subtract that amount from the value of its common equity. As losses mount, investors increasingly believe banks need to find ways to shore up this first line of defense on their balance sheets.

To get money, banks would likely have to pay a higher dividend to the government than the 5% rate the government charged in the first round of infusions and agree to a host of new restrictions, such as lending above a baseline level, reporting frequently on their use of the money and curbing executive salaries. While Treasury wouldn't preclude healthy banks from participating, the stricter terms would likely attract primarily weaker banks in need of capital.

Does anyone else see how dumb this is? Let's see:

1. The sickest banks with the lousiest managements get access to Government (read: taxpayer) capital.
2. The Government is looking to play accounting/ratings games by making the instruments convertible into common after seven years, by which time any self-respecting and solvent bank will have paid off the preferred well before its conversion date.
3. The curbs on salaries will likely cause many firms to reject Government capital even if they are very sick, preferring to hang onto their compensation "call option" and hope that things turn around in order that their firm avoids bankruptcy. By this time they will have scooped out far more compensation than what is permitted under the new Government guidelines.

And let's not forget these not-so-trifling issues:

1. Banks with toxic asset-laden balance sheets will still be reluctant to lend, even with Government capital injections. And forcing them to lend will only put us right back in to the world of the GSEs (Fannie Mae, Freddie Mac), which may well cost taxpayers several trillion dollars.
2. Bad managements will still be running the show, even after losing billions or even tens of billions of dollars.
3. Common equity holders and debt holders are still being bailed out, perpetuating a moral hazard that should have ended months ago for many (Citi, BofA, etc.).

Have we learned nothing over the past six months? The ideas being proposed simply won't work, and I don't care which Harvard Ph.Ds are saying so. It is a matter of transparency. It is a matter of good governance. It is a matter of creating healthy institutions that are in a position to fund the renewal and growth of this country. Current plans do not contemplate any of these things. Why not? That is a mystery. President Obama has his chance to take a stand, the right stand, and I'm afraid his first big step forward will in fact be two steps backwards. And the country will suffer for it.

Citigroup - Somebody Please Say "Game Over"

From the Wall Street Journal Online:

Until recently, Citigroup Chief Executive Vikram Pandit had repeatedly backed the company's "universal bank" model. But with directors and executives now bracing for a fourth-quarter operating loss of at least $10 billion and federal officials worried about previous turnaround efforts, Citigroup has decided that more dramatic action is needed, according to people familiar with the matter.

Shrinking Citigroup won't be quick or easy. The company is assigning management teams to handle the gradual disposal of units and other assets, but a person familiar with the matter emphasized that Citigroup doesn't plan to engage in a "fire sale." Efforts to find buyers also will be complicated by rocky market conditions and the recession.

Citigroup already has pursued some pieces of its downsizing push. For example, executives have been trying for months to reduce its exposure to Japan, where rising defaults are hurting profits. Citigroup also has been searching for about a year to find a buyer for Primerica, which sells mutual funds, insurance and other financial products.

That auction hasn't resulted in a sale because of a scarcity of buyers willing to pay what Citigroup regards as a reasonable price, according to people familiar with the matter. 

As part of the new plan, Citigroup executives are considering the possibility of creating what is known as a "good bank-bad bank" structure, these people said. Under that structure, Citigroup would create a new corporate entity to house what it regards as its core businesses.

The "bad bank" would hold around $700 billion in assets, with the remaining $1.1 trillion considered core. The entity would face accounting-related complications, and Citigroup hasn't settled on the approach, people familiar with the discussions said.

It is hard to articulate the contempt I have for the Treasury surrounding their handling of the Citigroup situation. Is it any surprise we (the US Taxpayer, that is) now find ourselves in this position? You can't blame Vikram, Win and the stellar board for sitting back and letting the Government throw money at them in a panic without addressing the core issues at hand: namely, erosion of both on- and off-balance sheet asset values together with difficulty in funding these assets.

What if, just what if, Treasury (together with the SEC) had said four months ago - game over, guys. Employ FAS 157 across your asset portfolios, show us exactly how broke you are, hand us the keys, we'll settle accounts with those who are owed money and say too bad to those who aren't (common stockholders and unsecured debtholders), sell of the good assets and warehouse the bad at marked-down levels. The Government could have worked out illiquid derivatives positions over time without causing a market cataclysm. Oh, and Management and the Board, don't let the doorknob hit you in the butt on your way out. You'll be hearing from a few lawyers any day now. These decisive actions would have saved taxpayers tens if not hundreds of billions of dollars, yet we still have the good ol' Citi management at the helm steering the ship. It's almost like the Madoff situation; he's dead, yet somehow he's still sending millions jewelry to his friends and family. He should be in the clink. And Citigroup Management should be on the street.

Why is legacy Management getting to decide how and when to dispose of assets on our dime? The firm is bankruput save for Treasury's largesse. Someone needs to say game over - now - that has the best interests of the US Taxpayers and the financial markets in mind. Because up to this point, it is not clear that anyone has been looking out for these two key constituencies.

The Citi Never Sleeps - Only its Board, Risk Managers and Regulators

The Citigroup of the past decade is THE shining example of an array of costly failures: accounting policies; business strategies; management compensation schemes; risk management practices; and Government policies. And now we see that Citigroup is doing badly; more badly, in fact, than many thought likely. Rubin is out. Smith Barney is being jettisoned for a little cash and some accounting profits. Desperation is taking hold. Will more bailout funds be required, notwithstanding the egregious deal the second-time around? You can bet on it. We are now seeing the sequel to the original Citigroup drama, As the Stomach Turns.

Accounting Policies

First, there was the Sandy Weill empire-building phase. In short, accounting standards gone awry. Because of the "pooling method" of accounting for mergers, Sandy was able to bolt on enterprise after enterprise by doing stock deals that met the necessary criteria. This resulted in effectively slapping together two sets of historical financial statements without showing the "goodwill" (premium paid over tangible book value) paid for in the deal. And because there were no charges to earnings for the amortization of goodwill, Citigroup could defer the time when it needed to come clean that it had paid too much for acquisitions and that the goodwill didn't really exist. Happy for Sandy, his largest deals (Primerica/Travelers and Travelers/Citicorp) were done prior to the end of the pooling method pursuant to FAS 141 and 142. Surprise, common shareholders! We paid tens of billions too much for the businesses we bought. But the joke is on you. To even greater effect, Citigroup availed itself of a juicy 21st century accounting fiction, Special Purpose Vehicle (SPV) accounting, that laid the foundation for its cataclysmic collapse over the past 18 months.

Business Strategies

Sandy figured out something truly brilliant: by growing so large he created a firm that was "too big to fail," but just big enough to get paid outsized sums for facilitating its growth-by-acquisition strategy. Get paid on the upside and bailed out on the downside. Whether it was simple greed or an amalgam of greed and market prescience, his strategy worked beautifully. He got paid princely sums while the firm was in rapid growth mode and got out near the top, his minions - and the US taxpayer - were left to deal with the detritus after-the-fact. This may have been his most brilliant business deal of all; working with his Board to get paid for high-risk, ultimtely transient earnings and bailing out at just the right time. Has anybody showed such skill at market timing? Nice work, Sandy. Further, his approach was also deeply flawed from a corporate finance perspective. With few realizable synergies among his portfolio of businesses, it would have been more efficient and created greater shareholder value by having these businesses as stand-alone entities. They would be been more focused, properly financed, received the necessary managerial oversight and attracted the best investors for their particular business activity. Asset allocation is always done best at the investor level; corporate managers only have an incentive to get big, and the friction and distraction associated with managing a disparate array of businesses is costly for both shareholders and the businesses alike.

Compensation Practices

Grow the numerator (revenues), avoid charges to the denominator (goodwill), take more risk and back up the compensation truck at year-end. It really wasn't that complicated. Conglomerators for decades have played a similar game and made away with monstrous rewards for their era. It is only that so much had been written about pooling and its being an accounting fiction that Boards and HR departments should have been hip to the game by the late 1990s. This, together for paying for short-term results, particularly in its trading businesses, contributed to a compensation culture that was skewed towards all the wrong things - top line growth without an approriate discount for risk and persistence. Not smart, guys.

Risk Management Practices

When the intellectual purity of Jamie Dimon was still at hand, he sharply reduced Citigroup's exposure to Russia - and fast. He closed down the Risk Arbitrage group at Salomon. He was laser-focused on the risk side of the equation. Once he left, nobody stepped in to fill the void (except that LTCM guy). It decided to crank up the securitization machine and to play accounting gimmickry, circa 2004: the SPV game. It pushed hundreds of billions of dollars of CDO exposure off-balance sheet, meeting the accounting critieria for de-consolidation while retaining enough risk to have the assets come flying back onto its books if certain "unlikely" things happened. Well, they did and they did, and these SPVs, which enabled Citigroup to present financial statements and footnotes that drastically understated its real exposure, were the key contributor to its undoing. While this was certainly an accounting game, it was also a severe breakdown in risk controls because regardless of where these assets were housed, Citigroup retained real economic exposure to their performance. And Citigroups risk management team, without question, fell down when it came to taking these SPV risks into account.

Government Policies

While Sandy set the table, Hank and Friends have been trying to clean it up, without much success. First a $25 billion injection, no strings attached. Then a massive backstop deal whose cost is currently unknown, but is many multiples of the original staggeringly large cash injection. Yet the problems still remain. Why? Because the Treasury has been reluctant, for some reason, to get tough with Citigroup's management and to clean house once and for all. Take over the firm. Employ a good bank/bad bank strategy. Force mark-to-market accounting across the banking sector and see exactly which institutions are the walking dead, which are broken but can be repaired and which are a.o.k. Develop a consistent plan. Execute the plan. Stop with the one-off, band-aid solutions. Citigroup needs a redo, just like the auto industry. And just like Social Security. Wipe out common and junior debt holders. Sell off good assets to the private sector or spin them off. Warehouse bad assets and work them out over time. But Sandy was right; shareholders and the Government permitted Citigroup to become too big to fail. Well, it needs to fail. Just not in the haphazard, destructive way that Lehman failed. It can be done much, much better.

Someone needs to take Citigroup out behind the barn and shoot it. Because if we don't, it just may kill us in the process.