One of the lessons of the recent crisis is that managers who unduly impatient and unhelpful in 2006 and 2007 were, quite consistently, those firms who appeared to protect themselves ahead of their investors at the end of 2008.
Leo Kolivakis publishes a great blog called Pension Pulse, and recently wrote a long post about the brewing scandal involving alternative managers and the placement agents they hire to secure public pension fund capital.
It seems a middleman's work is never done: Feeder funds like Fairfield Greenwich charged investors exorbitant fees for "access" to Madoff; while placement agents like Searle & Co. did it the other way, charging funds like Quadrangle exorbitant fees for "access" to pension fund investors. I await the logical next step: the revelation that one firm played both sides.
Reading Warren Buffett on the importance of earning power over tangible common equity when valuing a bank got me thinking about, of all things, how hedge fund managers think about taxes, something I've touched on in the past.
American family offices that invest in hedge funds care about taxes in a way that other institutional hedge fund investors--pensions, endowments, offshore money--do not. In the course of their due diligence, these family offices will typically ask a prospective manager how he thinks about taxes, that is, how does he go about trying to maximize his limited partners' after-tax returns rather than pre-tax-returns.
The typical answer from the manager is something like this: "Of course I think about post-tax returns a great deal, because my entire net worth is invested in the fund and I'm a taxable investor, so I invest the fund with my own tax situation in mind. Our interests are closely aligned."
This answer makes sense, but it's also an example of Nabokov's doughnut truth: it's the truth, the whole truth, but with a hole in the truth (thank you Seth Roberts). Here's why:
A hedge fund manager actually has two net worths. The first is the "tangible net worth" represented by his interests in the fund of which he's a general partner. On a look-through basis, these interests correspond to actual stocks, bonds, derivatives, etc. that can be traded and valued presently.
The second net worth, sort of a shadow net worth, is the manager's earning power, the capitalized present value of the income to be earned from managing other people's money. This depends on the future returns of the fund AND on the amount of capital to be raised in the future. The latter matters more because it's much easier to double the size of a hedge fund by taking on outside money than by earning 100% returns on existing capital. Most of the outside money invested in hedge funds is non-taxable, so a hedge fund manager can maximize his second net worth more easily by behaving in such a way as to increase the amount of non-taxable money managed, which makes minimizing taxes a lesser priority.
An ambitious hedge fund manager, confident in his ability to generate future returns and desiring to make a lot of money personally, keeps a close eye on his shadow net worth, although he seldom discusses it in public. So should you, and in particular you should look for managers ethical enough to constrain their ambition in the interests of serving their investors. The ideal money manager is someone who is very rich, the result of a successful track record over time, but much less rich than he could be.
An unambitious hedge fund manager may behave differently but to my knowledge there is no such thing. If I ever meet one I'll report back to you.
Warren Buffett may be the most well-connected businessman around. In the past, some have argued that it's this quality that enables his great success, even more than his own intelligence and judgement. His investment results are better, this rather sinister argument goes, because his information is better.
From the same Fortune interview, here's Buffett on how he evaluates John Stumpf, CEO of Wells Fargo:
Well, John [Stumpf] is in charge. Dick is a terrific help to John. I
play bridge with John on the Internet. He plays under the name of HTUR.
His wife's name is Ruth. My bridge partner, who I probably play bridge
with four times a week, developed online banking for Wells. A woman
named Sharon Osberg. And she's worked with those people. And she told
me about John Stumpf ten years ago. I've had some insight through her
on these people. But the real insight you get about a banker is how
they bank. You've got to see what they do and what they don't do. Their
speeches don't make any difference. It's what they do and what they
don't do. And what Wells didn't do is what defines their greatness [my emphasis].
I apply this logic to the world of money manager selection. Manager selectors spend a lot of time on reference checks, talking to people they know who also know the manager they're trying to evaluate, just as Buffett talked to Sharon Osberg about John Stumpf. Manager selectors, myself especially, also spend a lot of time evaluating investors communications: their investor letters, speeches, interviews, etc.
All of these things are important, especially in a world like mine in which the lack of information about people is the singular feature. But it's important to realize that in the final analysis, reference checks and manager communications matter less than direct observation and interpretation of a money manager's behavior. The real insight you get about an investor is how they invest.
Here's Buffett again, from the same Fortune interview, on the metric he uses to value a bank:
It's earnings on assets, as long as they're being achieved in a
conservative way. But you can't say earnings on assets, because you'll
get some guy who's taking all kinds of risks and will look terrific for
a while. And you can have off-balance sheet stuff that contributes to
earnings but doesn't show up in the assets denominator. So it has to be
an intelligent view of the quality of the earnings on assets as well as
the quantity of the earnings on assets. But if you're doing it in a
sound way, that's what I look at.
Warren Buffett does a lot of interviews, and I must say that most of the time the questioners repeat the same questions and he repeats the same answers. But in this Fortune interview on Wells Fargo he reveals some new information about how he values banks and bankers.
Here is his response to a question about tangible common equity, a topic of great importance to banking analysts and regulators:
What I pay attention to is earning power. Coca-Cola has no tangible
common equity. But they've got huge earning power. And Wells ... you
can't take away Wells' customer base. It grows quarter by quarter. And
what you make money off of is customers. And you make money on
customers by having a helluva spread on assets and not doing anything
really dumb. And that's what they do . . .
You don't make money on tangible common equity. You make money on the
funds that people give you and the difference between the cost of those
funds and what you lend them out on. And that's where people get all
mixed up incidentally on things like the TARP. They say, 'Well, where'd
the 5 billion go or where'd the 10 billion go that was put in?' That
isn't what you make money on. You make money on that deposit base of
$800 billion that they've got now. And that deposit base I guarantee
you will cost Wells a lot less than it cost Wachovia. And they'll put
out the money differently.
Ackman fascinates me. No other hedge fund manager challenges the skills of the manager selector more than he does. He's smart and well-pedigreed and very philanthropic, a hedge fund celebrity, extremely persuasive in both written and spoken communications, closely aligned with value investing, can point to an excellent track record, is backed by some of the best in the business*, and is very rich. And yet his first investment vehicle, Gotham Partners, was forced to close amid a lawsuit and massive redemption requests, while his latest, formed solely to invest in Target, at one point was down 90%.
If you'd invested with Ackman's various vehicles proportionately to what each vehicle represented as a portion of Ackman's total outside funds under management, I wonder what your total return would have been over time?
*In June 2007 Leucadia National Corporation invested $200 million in Ackman's Target vehicle, representing 10% of the LP interests. Leucadia marked this investment at $36.7 million as of 12/31/08. The following is an excerpt from Leucadia's 2008 annual letter to shareholders:
Over the past several years we have invested our excess cash with various outside managers with a view towards receiving a good return and hoping to uncover investment opportunities. We were disappointed with the results. The returns were not good and we did not uncover investment opportunties.** With few exceptions, our fund investments were not immune to the market upheaval experienced in 2008, but the overall return since inception was minus .5%. It could have been worse. For the most part, we do not intend to continue this activity.
**I'm always interested in examples of great investors, which Leucadia certainly is, who have proved to be poor investors in investors. From what I can tell, George Soros is another one. It leads me to believe that while there is a large amount of overlap between the two skill sets, there are also differences. I hope to explore this further in a future post.
I came across this New Yorker article from 2000. See especially part 4 about structured interviewing.
The more I do it and speak to other practitioners, the more I realize that the singular feature of money manager selection is the lack of information available to the selector with which to make judgments about people. There is no SEC in this game, no entity that forces a money manager to make the disclosures deemed necessary for investors, the way public corporations are forced to.
The face-to-face private interview is one of the best ways to gather what limited information we can, but as Gladwell shows, an interview is fraught with the potential for many types of miscognition. So you have to learn how to interview well.
This applies also to hedge fund managers themselves. Many very successful investors are notoriously poor "investors" in human capital--simply put, they hire poorly and suffer high turnover as a result.