The Investor's Consigliere

David Swensen vs. Funds of Funds: The FoF Strikes Back (and the Consigliere Decides!)

In January I linked to a WSJ interview with David Swensen in which he attacked hedge funds of funds.  Here is the relevant excerpt:

Mr. Swensen: Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There's also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as much resources were it not for fund of funds.

In last Monday's FT, Paul Isaac, the CIO of fund of funds company Cadogan Management, answered Swensen's accusations.  Cadogan has a good track record, and a reputation for being a "non-mainstream" FoF company, down to its choice of office location near the Flatiron building.  When the Madoff news hit, Cadogan put out a statement that it had successfully avoided any exposure, something many of its peers did not do (avoid exposure I mean, not put out a release). Isaac spoke at the 2003 Grant's Spring Conference, so he is a legitimate spokesman for his industry, not just any geek off the street.

Go read the Swensen interview, then read Isaac's rebuttal, then come back and we're going to have a little trial, with moi as judge and jury.  I used to evaluate litigation for a living (actually I was the guy who helped the guy who evaluated litigation for a living) so I'm a trained professional at this, sort of.

Oh, I almost forgot: I went to Yale and am a proud alumnus, consider Swensen my manager selector role model, and, um, I interviewed at Cadogan once, with an emphasis on the "once."  So think of me as the uglier version of this guy.  If this were any state except New Jersey, I'd no doubt have to recuse myself from this trial.  Fortunately, I happen to be from New Jersey.   So let's begin:

First let's summarize Swensen's case against funds of funds.  FoFs are a cancer because :

1)  They facilitate the flow of ignorant capital, as unsophisticated investors who can't pick managers themselves cannot pick manager selectors either.

2)  They charge an extra layer of fees and deliver nothing in return for it.

3)  Fund of fund money is unreliable, therefore the best hedge fund managers don't want it, and you can't be successful investing in hedge funds unless you invest in the best.

Issac does not address these assertions in order.  Instead his first rebuttal one is a clever one:

It cannot be funds of funds per se to which Mr Swensen objects. He runs one. A large endowment like Yale maintains a sizeable professional staff to research, vet, select and monitor the endowment’s investment in a number of hedge funds comparable to a FoHF portfolio. Yale reportedly is unusually successful in demanding transparency, negotiating fees and selecting managers. It does so while incurring relatively low expenses at the university level. That Yale does so well is an argument for FoHFs.

Yes, but . . . we need first to define our terms (it's remarkable how many legal battles turn on differing definitions of a single term).  Per Isaac, a fund of funds is simply a pool of capital that maintains a staff to research, vet, select and monitor investments in a number of hedge funds.  By that definition, Yale's endowment is a fund of funds, as is Cadogan, as is a family office that invests in a number of hedge funds, etc. 

But is Isaac's definition of a "fund of funds" the same as Swensen's?  No it is not.  Let's go to Swensen's own words on the subject, from pages 309-310 of the new edition of Pioneering Portfolio Management. This section of the book is called "USE OF INTERMEDIARIES," and the relevant excerpt is as follows (my emphasis added):

In an effort to pursue an active management program without committing the required time, energy, and resources, many institutions take the shortcut of using a fund of funds or consultant.  Unfortunately, the use of external agents (instead of an internal investment team) leads down a path to suboptimal results, as the interests of the fund of funds manager or investment consultant inevitably diverge from the interests of the institutional investor . . .

Fund of funds managers provide the service of making investment decisions for fiduciaries.  By pooling assets, usually from less sophisticated investors, fund of funds managers argue that economies of scale allow professional staff to manage monies in institutional fashion . . .

In spite of the purported benefits from employing fund of funds managers, substantial risks stem from imposing a filter between the investment manager and the ultimate client . . . Clients unable or unwilling to understand the underlying manager characteristics rely solely on performance to evaluate investment strategies.

Isaac's definition of a fund of funds turns on WHAT it does.  Swensen's definition turns on FOR WHOM and WHY it does it.  Per Swensen, a FoF is defined by its role as agent, a paid intermediary that performs a task (manager selection) on behalf of a principal (an investment fiduciary) who is unwilling or unable to do it by itself.  By Swensen's definition, Yale's endowment is not a fund of funds, as Yale performs manager selection entirely in-house, without the use of any agents, and commits substantial time, energy and resources to do so.  Cadogan, on the other hand, most certainly is.  When you and I and the world think of what a fund of funds is, we think of the Swensen definition, not the Isaac definition.  All of Swensen's problems with FoFs stem from his (and our) definition of it as an agent, so Isaac creates a straw man by creating his own definition.  

Round 1 to Swensen.

Isaac's next argument is that hedge funds of funds can add substantial value to their end-clients:

Although Mr Swensen has a laudable track record, it is unlikely his team is the only one to have added value over the past couple of decades. In fact, as a substitute for equity investments over the past 10 years, the HFRI Composite FoHF Index has performed remarkably well, returning 5.4 per cent a year versus a return of -1.4 per cent for the S&P 500, with a volatility of 6.2 per cent versus 15.1 per cent for the S&P 500.

Those "remarkable" numbers certainly sing a seductive siren song, don't they?  But tie yourself to the mast and let your consigliere set you right:

1)  Isaac's second sentence is a non-sequitur.  Extrapolating from Swensen's common-sense definition, a fund of funds adds value not by outperforming equity markets via investment in hedge funds.  A fund of funds adds value by outperforming (after fees) what a fiduciary could do on its own by investing in hedge funds directly.  Isaac is arguing the wrong thing. 

2)  Isaac errs by invoking an INDEX of FoFs to justify the ACTIVE investment fund of funds industry.  That such a thing as the HFRI Composite FoHF Index even exists is strong evidence that it's possible for a fiduciary to construct a hedge fund portfolio WITHOUT having to pay an intermediary a lot of money to do it for you, and belies Isaac's claim that "index investments in alpha generating strategies are in their infancy and have yet to prove themselves".  Just do your best to replicate the index.  You won't do it perfectly, but you don't have to in order to benefit from saving 1 and 10.  What Isaac should have argued is that there are many funds of funds like Cadogan that add value by exceeding the performance of the index.  That he did not is telling.  That Yale does (see page 23 of the pdf, aka page 21 of the report) is also telling.

Round 2 to Swensen.

Isaac's next two arguments concern Madoff.  Here is the first one:

Contrary to Mr Swensen’s insinuation, the Madoff scandal is remarkable for how many FoHFs consciously rejected investing in Madoff for all the right reasons.

I believe the legal term for this argument is "WTF?"  Given what they charged and their purported expertise, the correct number of funds of funds that should have invested in Madoff is precisely zero.  The correct number of "quality" funds of funds should have been less than zero--they should have led the fight to unmask him.  The actual number was way higher than zero, AND included some of the leading names in the industry (Bramdean, Fairfield Greenwich, Maxam, UBP, EIM, Merkin, etc.). I can't see how the fund of funds industry distinguished itself in the Madoff affair.  I can only see the opposite.

Round 3 to Swensen. 

Here is the second Madoff-related argument:

Ironically, in the post-Madoff age, the FoHF has become an even more important tool for institutional investors. Many institutions cannot afford to put themselves in the spotlight by selecting a specific hedge fund that might in the future have public difficulties.  A FoHF investment represents a diversification tool and a layer of protection for the reputation of the institution.

Several things come to mind when I consider this argument.  I could, for instance, recall how many Jewish/Chinese/Armenian/etc. tax collectors died at the hands of angry peasants while providing a layer of protection for the reputation for the rulers who were reluctant to put themselves in the spotlight by collecting taxes directly.  I could even point out how the Pharisees of Judaea were an important tool for their Roman overlords who could not afford to put themselves in the spotlight and required a layer of protection for their reputations when it came to dealing with a certain itinerant rabble rouser.  But I won't, because I'm not an expert in those subjects and am sure to say something incorrect.  It will suffice simply to point out that you should always look through, and that the imposition of a middleman does not absolve an investor of any of its fiduciary or ethical obligations. 

Round 4 to Swensen.

How does Isaac respond to Swensen's assertion that FoFs represent unreliable capital, and that therefore the best hedge fund managers shun them?  He responds as follows:

While it is axiomatic a FoHF portfolio wants the “best” hedge fund managers, the goal is to construct a portfolio that will give investors the greatest likelihood of reaching a return goal with limited volatility.

There is no common definition of a “best” hedge fund. Certainly, more than 10 per cent of all managers can be potential parts of a given portfolio when the goal, and not just the components, define the objective. The ability to substitute managers, rather than being wedded to an underlying manager, can be useful for FoHF managers seeking to represent their investors’ interests.

Isaac is correct that FoF managers should be judged on their portfolios as a whole rather on the the performance of their component parts, and that theoretically it's possible for a hedge fund portfolio that consists of less-than-top-decile funds to combine in such a way as to produce an attractive portfolio return.  But the combination of the typical 2 and 20 charged by the underlying hedge fund, and the typical 1 and 20 charged by the FoF, makes it almost impossible for the end user to get a value-added product unless both layers are in the top tier of what they do.

Round 5 is a tie.

Regarding Swensen's assertion that fund of funds fees are unjustified, Isaac correctly points out that "the fees charges by FoHF's vary," and that "They key is to find value for fees paid."  I believe Swensen would reply that empirically, most FoFs fail to provide value for money.  2008 is good evidence for that.  It's hard enough to beat the market via direct active investing; doing it via an extra layer of fees is even harder.  Also, it's generally true that the lower the fee charged by a FoF, the more closely it resembles one of the "index investments in alpha generating strategies" that Isaac derides.

Round 6 goes to Swensen on points.

Finally, as the recipient of a Jesuit education (thank you Dr. Stewart!), as the descendant of a distinguished family of talmudic scholars, as a former copy editor, and as an admirer of George Orwell, I must point out this example of Mr. Isaac's tortured language:

The idea that no one but Mr Swensen should invest in only passive vehicles is condescending and limiting.

Strip out all the double negatives and you'll find that Isaac meant the opposite of what is written, i.e. the idea that only Mr. Swensen should invest in active vehicles is condescending and limiting.  Giving Isaac the benefit of the doubt that the sentence was just a typo, it still misstates Swensen's position.  Swensen's position is that those who wish to invest in active vehicles should not hire agents to do so on their behalf, but rather must devote the time, energy and resources to do it themselves.  Be a principal, not an agent.

Final round to Swensen. 

Overall verdict: David Swensen.  Go Bulldogs.

P.S.  In a future post I hope to play devil's advocate regarding Swensen and his record.  Is it really as good as his drooling idolators (I'm wiping my mouth as I write) assume?  Stay tuned. 

  

The Tyranny of Corporate Capital Allocation: Who is the Real "Investor"?

Yesterday I attended the Columbia Investment Management Association (CIMA) annual conference, a very well-attended series of panel discussions and Q&A featuring famous value investors.  It was off the record, so I can't really blog about it (FYI that was me very timidly asking David Einhorn whether his recently disclosed investment in gold contained a margin of safety). 

One question struck me in particular.  A young man (I think his first name was Omar) asked one of the panels how, being capital allocators themselves and knowing how hard it is to do well, they evaluate the capital allocation ability of the managements of the companies in which they invest.  The panelists, almost all of whom names you would know and who profess to follow in the steps of Graham and Buffett, either misunderstood the question or chose not to answer.  Which is a shame, because because the question is all-important.  Here is how I would have answered:

That's a great question, Omar.  It may be the most important question a modern value investor asks himself.  A little arithmetic will illustrate what I mean.

Let's say your goal in life as an investor is to earn 15% per year over the long term, which would be truly outstanding.  Broadly speaking your ability to earn this 15% depends on three factors:

     a) The size of the discount to intrinsic value at which you're able to purchase an investment.

     b) The growth in intrinsic value of your investment during the time you own it (or more strictly speaking, the additional growth in intrinsic value over and above what's already reflected in the price of the investment).

     c) The time it takes for either the discount to narrow, or the IV to grow.

Factor c) is hard to predict--that's why you try to invest with a margin of safety.  Let's focus then on the first two factors.

Back in the day, when Ben Graham and Walter Schloss were doing their thing, there really was such a thing as a 50-cent dollar.  That is, you could look for something worth 100 that was trading for 50, hold it for five years, and earn your annual 15% without any intrinsic value growth whatsover.  That is, it's worth 100 today and it will be worth 100 in five years. 

At the risk of speaking famous last words, today there are very few true 50-cent dollars available, especially for those managing larger pools of capital.  The value investor who wishes to earn his 15% must therefore get some help from the growth in intrinsic value of the companies in which he invests. Suppose you can only find a 67-cent dollar, i.e. something trading at a 1/3 discount.  If you hold it for the same five years as above, and you want to earn your 15%, then the discount to IV must go away and the IV must grow at an annual rate of 6%, which, as it happens, is about the rate Corporate America as a whole grows annually on average.

By now you see the relationship:  The greater the growth rate of an investment's IV during the time you own it, the less of a discount you have to buy it at in order to earn your required return.  If your company is a true cigar butt (e.g. a company with a hidden portfolio of bonds) generating no capital to allocate one way or the other, then you have to find a 50-cent dollar, which is hard work.  If your company's ability to allocate capital is just about average, then you only have to find a 67-cent dollar.

But what if your company's ability to allocate capital is above average?  What if your company has the ability to grow its IV at 10% annually?  In that case, you need only find an 80-cent dollar in order to earn 15% per annum over five years, assuming the discount narrows to zero.  An investor who only has to find 80-cent dollars rather than 50-cent dollars has a much easier time of it, especially today. 

You may have noticed that I'm equating "the ability to grow intrinsic value" with "the ability to allocate capital."  That is on purpose.  With very few exceptions, a company's ability to grow its intrinsic value over time is basically equivalent to its ability to allocate capital.  The growth in IV tracks closely the amount of capital added to the enterprise over time, which in turn depends on how much capital the enterprise generates, how much it retains, and the return on the capital generated and retained (and reinvested, etc. etc.), which in turn is what we mean by "the ability to allocate capital."  I can think of only three exceptions to this rule.  One is companies like Ebay that benefit from network effects--once they get their mousetrap going, it grows without their having to add more capital to it.  Another is companies like Dell in its heyday, who have such good working capital dynamics that their customers essentially provide the capital needed to grow.  The third is companies that can simply raise prices year in and year out, like newspapers once upon a time. 

So a company's ability to allocate capital well is hugely important to the modern investor.  It's what I meant by the title of this post.  We the value investors of today, the owners of passive minority stakes in companies, are essentially hostages of the "real investors" upon whom we depend to earn our required return: those making the capital allocation decisons at the companies themselves.

I have yet to answer the question asked.  All I've done is remind everyone how important it is (much more important than the guy who asked about gold's margin of safety).  So how then do you evaluate the ability to allocate capital?

The first thing to realize is that the ability of a company to allocate capital well, unfortunately for those who believe in the Great Man theory of business, depends to a great extent on the industry a company is in.  With very few exceptions, public companies must reinvest the capital they generate in something similar to what they already do.  If you are in the horse and buggy industry, you can be the best CFO in history and it won't matter--your ability to allocate capital won't lead to much growth in intrinsic value.  Conversely, if you're in a fast-growing industry with stable market shares, you've got the capital allocation wind at your back (think of Coke in the late 80s).  Most companies are somewhere in the middle--figuring out exactly where is part of your job as an investor.

The second thing to realize is that over the course of a few years, a company will make many many capital allocation decisions, all of which are available for you to investigate and judge.  You can start in the obvious place, the financing section of the cash flow statement, and evaluate the dividend policy.  If the company is earning a lower return on capital than Corporate America as a whole, why isn't its dividend higher?  Conversely, if the company has a high return on capital (and on the marginal capital it retains), why does it pay a dividend at all?  In the same section, evaluate the share repurchase/issuance decisionmaking: Is the company buying back overvalued stock?  Is it issuing undervalued stock?

Then you can move up to the investing section of the cash flow statement.  Are capital expenditures leading to gains in IV, or are they simply needed for the company to stay in place?  Have the company's acquisitions turned out well?  In the operating section you can look at working capital management, an often overlooked consumer of cash for growing companies (and another reason why EBITDA - capex is an incomplete measure of cash flow).  Think of a retail location with fast-growing same-store sales.  If those sales come at the expense of even faster-growing receivables and inventory, the company may not be deploying capital well.

That's six capital allocation factors so far: dividends, share repurchases, share issuances, capex, acquistions, and working capital.  All of them represent capital allocation decisions in management's discretion, and with a little work you can figure out how good these decisions have been.

But don't stop there.  Many capital allocation decisions show up on the income statement.  When a company like Coke spends heavily on advertising, accounting treats it as an expense but you should really think of it as a kind of capital expenditure, a discretionary decision to allocate capital in a particular way.  Soon after Berkshire Hathaway acquired full control of GEICO in 1995, it stepped up spending on advertising.  Not only that, but GEICO thinks about the productivity of its paid advertising by also keeping close track of unpaid advertising, i.e. word of mouth referrals and customer retention.  A new customer you acquire when their friend tells them about the company is a customer you don't have to acquire yourself.  A customer who renews his policy with you because he's happy is a customer you don't have to reacquire through advertising.  All of this comes under the heading of "ability to allocate capital."  When Goldman Sachs steps up headcount and compensation expense, it's also allocating capital by "investing" in talent.  And like all capital allocation decisions, it is subject to evaluation--does it increase the intrinsic value of the company over time or not?

Harvard Endowment Down 22%

Harvard University has reported that its endowment fell 22% in the four months since June 30.

When I was in college, I would often hear my fellow students complain about how stingy the university was.  "We have a multi-billion dollar endowment, why don't we spend more of it?"  was the common refrain. 

"You idiots don't understand!" I would stew to myself (I never actually argued out loud, especially to a girl.  I didn't talk to a girl at all until second semester senior year).  "You can't just spend all of the endowment now!  Don't think of it as $XX billion you can spend, think of it as an asset that produces an annual cash flow stream that you can spend.  In a world of perfect foresight, you'd smooth your spending perfectly, spending the same amount on an inflation-adjusted per-student basis every year between now and the end of the world.  In the real world you don't have perfect foresight--you don't know how well the endowment will perform or how many students will exist in the future or how available alternative forms of income will be--so you make an educated guess on how much to spend today (at my alma mater it was called the spending rule).   When you spend too much today you're taking it away from future students, who have as much right to benefit from the endowment as you do!"  I did a lot of stewing in those days, as you can see. 

That was then.  Today the thing to keep in mind is that it works in reverse too:  when you spend too little today, you punish the present to benefit the future.  Not only that, but harsh cutbacks in financial aid, staffing, and other spending can do long-term damage to the school's reputation.  I don't know all the details, but unless President Faust is simply trying to talk down the budget expectations of the various deans, which is the eternal task of a university president, that's the risk Harvard faces.

The $8.2bn decline in the endowment's value looks large and is large, but it's not as large as it looks.  First, as Felix Salmon points out, the total value is just back to what it was in 2006--two "lost years" is not a big deal if you're 372 years old and consider yourself immortal.  In addition, the pain such a decline will inflict on annual spending, present and future, doesn't have to be that bad:

The endowment's value as of June 30 was $36.9 billion.  Suppose the spending rule percentage, absent any market value decline, would have been 4.5%.  Therefore the total annual spending would have been $1.66 billion. 

Now suppose that come June 30 of next year the endowment declines by the 30% estimate Harvard is assuming, to $25.8 billion.  If the spending rule remains constant at 4.5%, then annual spending would decline by an identical 30%, to $1.16 billion.  That's $500 milllion less spending.  If you've ever tried to cut $500 million from a university's budget you know how miserable life can be.  And if you'll permit me to get on my high horse, it's not the tenured professors who will really suffer.  It's the secretaries and staff, construction workers, part-time faculty, and others who truly depend on the school for their livelihood.  It would be somewhat ironic for an institution that very publicly (and admirably) dedicates itself to the betterment of humanity as a whole to refuse to take care of its own. 

But what would happen if instead of maintaining a constant spending rule of 4.5% in the face of the decline--spending $1.16 billion--the university decided instead to maintain the actual dollars spent at $1.66 billion?  (On the new lower denominator of $25.8 billion, that would increase the spending rule percentage to 6.43%.)  The $500 million in "excess" spending can be thought of as dipping into principal, which in certain old Boston families is worse than adultery, but in this case represents only 1.9% of the new principal amount of the endowment.  That would be the penalty imposed on future generations, and that's the number to weigh against the pain current budget cuts would cause. 

I suspect that the real problem Harvard faces is a simple cash crunch.  It committed to spending a large percentage of its operating budget--i.e. predictable, recurring, difficult-to-take-back obligations--with endowment income, but chose to fund those obligations not with similarly predictable and recurring cash flows but with their polar opposite--hedge fund, PE and VC fund LP interests.  This would explain its recent fire sale of PE fund interests, its move to issue new bonds, and its decision to reduce the risk of the endowment portfolio.  As David Swensen has shown, embracing volatility and illiquidity in pursuit of superior long-term returns is worth doing.  But there is a price.

 

Family Foresight Hall of Shame: Sheldon Adelson

My Family Foresight Thought Experiment is not a completely hypothetical exercise: 

1)  In 2006 Sheldon Adelson and his wife established a foundation to fund medical research into life-threatening diseases, especially cancer, with an innovative and much-needed emphasis on scientific collaboration.  At the time Adelson, CEO and principal owner of Las Vegas Sands Corp, was the third richest person in the United States, with a fortune estimated by Forbes at $20.5 billion (it would grow to over $30 billion at its 2007 peak).

Medical research, especially cancer research at the cutting edge, is a multi-decade project.  Any assets set up to fund it should be invested with a matching time horizon. 

2)  In yesterday's post on endowments I wrote the following:

It raises the eternal question: What do you do when a high percentage of your yearly spending comes from income on an investment portfolio whose deliberate pursuit of high long-term returns almost always means it's subject to significant fluctuations in annual returns?

Answer one, unsexy though it may be, is to build in enough margin of safety in your annual consumption expenditures (including debt service from leverage!) that you can tolerate (downward) volatility in your annual income.

What's true of households is true of companies.  In 2005 Las Vegas Sands covered its interest expense obligations with pretax income by a ratio of 4.0x, a comfortable margin of safety.  Two years later, after a debt-fueled expansion of the company, that ratio had shrunk to 1.56x.

3)  The company's debt maturity schedule was admirably long-dated, with only about $260mm due before 2010, out of a total of $7+ billion.  But the devil is in the details.  From a company 8-K filed on November 6 [my emphasis in bold]:

   Commencing September 30, 2008, the U.S. senior secured credit facility and FF&E financings require our Las Vegas operations to comply with certain financial covenants, including to maintain a maximum leverage ratio of net debt, as defined, to trailing twelve-month adjusted earnings before interest, income taxes, depreciation and amortization, as defined (“Adjusted EBITDA”). In order to comply with the maximum leverage ratio as of December 31, 2008, and subsequent quarterly periods, we will need to (i) achieve increased levels of Adjusted EBITDA at our Las Vegas properties; (ii) decrease the rate of spending on our development projects; (iii) obtain additional financing at our parent company level, the proceeds from which could be used to reduce our Las Vegas operations’ net debt; (iv) elect to contribute up to $50.0 million of capital from cash on hand to our Las Vegas operations (such contribution having the effect of increasing Adjusted EBITDA by up to $50.0 million per quarter for purposes of calculating maximum leverage (the “EBITDA true-up”)); or in some cases (v) a combination thereof.

     As our Las Vegas properties did not achieve the levels of Adjusted EBITDA necessary to maintain compliance with the maximum leverage ratio for the quarterly period ending September 30, 2008, we completed a private placement of $475.0 million in convertible senior notes with our principal stockholder and his family and used a portion of the proceeds to exercise the EBITDA true-up provision. The convertible senior notes bear interest at 6.5% per annum, payable in quarterly installments, and mature on October 1, 2013, unless earlier converted or repurchased by us, with an initial conversion rate of 20.141 shares of common stock per $1,000 principal amount. Following any fundamental change, as defined in the agreement, that occurs prior to the maturity date, we will be required to make an offer to repurchase the convertible senior notes at 101% of the then outstanding principal amount. Our principal stockholder and his family were granted pre-emptive rights with respect to any future proposed issuance or sale by us of equity interests (including convertible or exchangeable securities), pursuant to which they will be able to purchase a portion of the offered equity interests based on their fully diluted common stock ownership in the Company. The EBITDA true-up, by itself, would not have been sufficient to maintain compliance with the maximum leverage ratio as of September 30, 2008. Accordingly, the entire proceeds from the offering were immediately contributed to LVSLLC to reduce the net debt of the parties to the domestic credit facilities in order to maintain compliance with the maximum leverage ratio for the quarterly period ending September 30, 2008.

     Based upon current Las Vegas operating estimates for the quarter ending December 31, 2008 and quarterly periods during 2009, as well as the fact that we have continued to fund our development projects outside of Las Vegas, in whole or in part, with borrowings under the U.S. senior secured credit facility, we expect the amount of our material domestic subsidiaries’ indebtedness will be beyond the level allowed under the maximum leverage ratio. If our Las Vegas Adjusted EBITDA levels do not increase sufficiently, we do not adjust spending on our global development projects, which we are currently evaluating, and the EBITDA true-up is not sufficient or available to enable us to maintain compliance under the maximum leverage ratio, we will need to obtain significant additional capital at the parent level. As previously announced, we are working with our financial advisor to develop and implement a capital raising program that would be sufficient to address our current and anticipated funding needs; however, no assurances can be given that the program will be successful. If none of the foregoing occurs, we would need to obtain waivers or amendments under our domestic credit facilities, and no assurances can be given that we will be able to obtain these waivers or amendments. If we are unable to obtain waivers or amendments if and when necessary, we would be in default under our domestic credit facilities, which would trigger cross-defaults under our airplane financings and convertible senior notes. If such defaults or cross-defaults were to occur and the respective lenders chose to accelerate the indebtedness outstanding under these agreements, it would result in a default under our senior notes. Any defaults or cross-defaults under these agreements would allow the lenders, in each case, to exercise their rights and remedies as defined under their respective agreements. If the lenders were to exercise their right to accelerate the indebtedness outstanding, there can be no assurance that we would be able to refinance any amounts that may become accelerated under such agreements. Under the terms of the U.S. senior secured credit facility, if a default or a material adverse change, as defined in the agreement, were to occur, it would preclude our domestic subsidiaries from accessing any available borrowings (including the $400.0 million under the Delayed Draw II Facility, which expires November 23, 2008, and $201.1 million under the Revolving Facility, which includes approximately $7.7 million committed to be funded by Lehman Brothers Commercial Paper Inc.). If the capital raising program is unsuccessful and we do not have access to the available borrowings under the U.S. senior secured credit facility, we would need to immediately suspend portions, if not all, of our ongoing global development projects and consider other alternatives. These factors raise a substantial doubt about our ability to continue as a going concern. The condensed consolidated financial statements for the quarterly period ended June 30, 2008, do not include any adjustments that might result from the outcome of this uncertainty.

4)  Sheldon Adelson is a million times the businessman I'll ever be, and given his philanthropy and his honorable decision to commit $1 billion of his own money to save his company (a huge chunk of his reduced net worth), he's a million times the mensch as well.  But in no way can he call himself the victim of this so-called "unprecedented" crisis.  In the final analysis, he put an empire of over $30 billion at the mercy of a single 12-month earnings covenant in a single credit agreement, with almost no margin of safety.  His foundation, and those who would benefit from it, have sufferred as a result.

Harvard Endowment Problems

Blog benefactor Felix Salmon points us to a speech by Harvard president Drew Faust, in which she warns that the financial crisis will likely lead to reduced endowment spending. 

In their size, long time horizon, general reliance on outside money managers, and ultimate purpose (to invest capital in order to provide a more or less steady income stream for present and future generations) university endowments closely resemble family offices.  So if you're a rich family it bears watching what endowments are up to.

In Faust's words, "endowment income has come to fund more than a third of the University's annual operating budget."  That struck me as high, although my alma mater's is currently 37% and headed higher (although this number should not be confused with the "spending rule"--the percentage of an endowment's value that is spent in a given year, which is closer to 5%).  For some family office clients it can be even higher, as high as 100%.

It raises the eternal question: What do you do when a high percentage of your yearly spending comes from income on an investment portfolio whose deliberate pursuit of high long-term returns almost always means it's subject to significant fluctuations in annual returns?

Answer one, unsexy though it may be, is to build in enough margin of safety in your annual consumption expenditures (including debt service from leverage!) that you can tolerate (downward) volatility in your annual income.  The institutional imperative makes this almost impossible for a place like Harvard to do--in flush times it always manages to find more ways to add to overhead, and overheard is very painful to reduce at a university.  Theoretically rich people should have it much easier--they can just live a little less richly for a few years.  In practice it doesn't always work that way.

Answer two, also unsexy, is to reduce annual volatility of income by investing chiefly in low-volatility assets, like cash and fixed income.  Unfortunately you almost always have to sacrifice long-term returns in order to do this, which means present consumption gains at the expense of future consumption.

Answer three is to smooth consumption, spending less in good times in order to spend more in bad times.  This is what endowments are supposed to be doing, but it's hard to do unless you have liquidity.  To spend more in bad times you likely have to eat into your principal--nothing wrong with that--but it's painful to eat into principal when that principal is shrinking and you have to sell illiquid assets at firesale prices.  Not only is it painful but it penalizes future returns.  Harvard's recent moves to sell some of its private equity LP interests, at steep discounts no doubt, may be an example of this.

Answer four is to try to do the (near) impossible: find an investment that delivers the long-term returns you want without the volatility you don't want.  I used to work for a firm that has managed this feat for over a quarter-century, but that is extremely rare.  Many hedge funds have promised to do this, but 2008 will end in tears for many who believed them.

I'm very curious to see which endowments and family fortunes have best managed to prepare for and navigate the current crisis in such a way that preserved both current and future consumption, which is what it's all about at the end of the day. 

Wealth, War & Wisdom

Barton Biggs is known for his years as a highly regarded, and highly quotable, investment strategist at Morgan Stanley.  In 2003 he left that firm to form a hedge fund called Traxis Partners, and wrote a fun and popular book called "Hedgehogging" about that world.

Less fun and less popular was the book he published in 2008, called "Wealth, War & Wisdom."  It's a little all over the place--part narrative history of the greatest events of World War II, part mini-biography of that war's leaders, part stock market history, part argument for the wisdom of crowds, and part disaster survival guide.  However I think behind it all is a unifying insight.  Although he doesn't express it in so many words, and I'm going to have to stretch some definitions in order to argue my point, I believe the book is ultimately about liquidity vs. illiquidity, about safe vs. risky assets, as broadly understood. This unifying insight is very useful for our mythical family patriarch, on whose investing success over 100 years the fate of civilization depends.

To start with one of Biggs' main points:  For the preservation and growth of purchasing power over long periods, equities are the place to be relative to "safer" assets like government bonds and cash, even during periods of crisis like war and even, a little surprisingly, for the defeated countries.  They best allow you to benefit from compounding (of companies' retained earnings) and are the best, although still imperfect, long-term inflation hedges. 

However, to get the superior returns available from equities requires that you commit to holding equities.  As David Swensen points out in the introduction:

. . . investors benefit from the long-run returns in the stock market only if investors own stocks.  Maintaining exposure to the stock market requires the courage to hold (or even add to) positions in the face of extreme adversity. 

In other words, don't be fooled by what Keynes called "the fetish of liquidity."  Stocks may be liquid as conventionally defined--you can sell them whenever you want--but successful equity investment, for the vast majority of investors, requires a deliberate embrace of illiquidity.  Furthermore, especially during wartime, liquidity has a disturbing tendency to evaporate, or exact a terrible penalty, just when you need it.  Great Britain essentially confiscated its citizens' holdings of US securities in order to raise badly-needed foreign exchange during the war.  Even without the government getting involved, chances are that when you desire the liquidity the most, everyone else does too--just read today's newspaper.

That's not a particularly new or interesting insight.  What is interesting is that Biggs makes this argument alongside many stories of people--many of them the patient, long-term investors whom Biggs and Swensen would ordinarily praise--whose wealth and lives were destroyed by the war.  It seemed incoherent at first, but as I thought about it I came to understand what Biggs was trying to say:  Your embrace of illiquidity/"risky" assets in one sphere must be balanced, or hedged, by great liquidity, broadly defined, in another. 

This is true most simply in the literal financial sense.  You can't get the benefits of long-term equity investing without having sufficient liquid assets, either cash reserves or secure cash income, to meet your needs while you're waiting.  And "to meet your needs" includes all debt service obligations, including the dreaded margin debt, which, as Biggs points out, undid even Keynes himself.

But it's also and more crucially true in the metaphorical sense of liquidity.  If literal liquidity refers to the ability to exit an asset quickly and without financial penalty, then by metaphorical liquidity I mean the ability to exit a geographical location like a country, a lifestyle, even a conception of oneself, in a similar way.  Many a German Jew lost his fortune in the war because he was long an asset that the Nazis rendered illiquid through punitive taxes and capital controls.  But how many lost their lives because they were illiquidly long Germany itself and their place in it, with neither the physical (assets in a safe haven country, jewelry to sell on the black market) nor the psychological (the ability to leave your comfortable life behind and start again) means to exit?

If you, like our family patriarch, are investing for the next 100 years, then there is little doubt that you will endure a war, maybe more than one.  History shows that the time to think about it is well before it happens, as events nearly always overtake you.  The books has many concrete suggestions about what to do but I think the main point is that you must combine illiquidity and liquidity, literal and figurative, in order to preserve both your wealth and yourself.

Evaluating Value Investors: Two Questions

Some well-known value investors are selling stocks they very recently thought were undervalued bargains.

When I evaluate a money manager who espouses the value investing philosophy, the first question I ask myself is "Is this person really a value investor?"  This question carries more weight than you might think.  For while it's not remarkable that (given its association with very successful practitioners like Warren Buffett) many describe themselves as value investors, what is remarkable is how few really are.  Scratch the surface of a self-described "value investor" and you'll often find a momentum player who simply buys what's popular and is going up, a closet macro short-term speculator who says things like "in a recession people play the lottery, therefore lottery stocks will go up this year", someone who can identify a great business but not the greatly inflated price it's selling for, or some other wolf in sheep's clothing. 

This first question filters out a lot of money managers.  But even if I've found a value investor who actually practices value investing, I'm not done yet--there are good value investors and less-than-good ones, and my job is to separate the two.  The next question I ask myself is "Is this money manager essentially a 'naive' value investor or does he/she add value as a business analyst?"

By "naive" I mean this:  The value investing strategy has been demonstrated to work successfully even when relatively little attention is paid to the businesses being bought.  Simply buy stocks that are "cheap" based on various historical measures like low P/E or P/B ratios and you can do OK.  Fama and French, Ben Graham's "net-nets," even Magic Formula Investing all demonstrate this.  It's the kind of thing you can do yourself with a computer stock screen. 

Naive value investing may work well, but it's not something you should have to pay for.  A jockey isn't great simply because the horse he's riding is.  Nor is a money manager worth paying if what he/she is ultimately doing, when all is said and done, is buying stocks that are "cheap" based on historical measures.  What makes a value investor good is the ability to go beyond the naive stock screen to really understand and evaluate the businesses being purchased.  This is what I try to answer with my second question.

I won't name names, but read the WSJ article I linked to above and ask yourself whether some of those money managers, all very famous, really understood certain businesses well enough to commit capital to them. 

 

Mickey Drexler, The Gap, and My Theory of Business Fractals

Several months ago I linked to an interview with J. Crew CEO Mickey Drexler, who as head of Gap Inc. brought it to greatness before getting fired.  "PCC" made the following comment to that post:

It's interesting that Gap, even with all its advantages of scale and brand, and with this talented CEO at the helm, could not prevent its decline. There's an interesting case study in there somewhere.

Ever since that day I've been haunted by PCC's challenge.  OK, not really haunted, at least not haunted enough to do a full case study.  But I came across some articles that shed some light on the question:

1)  First was this recent Fortune article on CEOs who got fired.  In a sidebar, which appeared in print but which I can't seem to find online, Drexler blamed his fall on the decision to open too many stores.  Intriguing but vague.

2)  The plot thickens with this New York Times article by Joe Nocera, published in March [By the way, does anyone else hate it when www.nytimes.com publishes Olympic results, right in front of your face in big bold headlines, before you get a chance to see it on TV?]    Here is the money excerpt:

For most of his time there, he had a magical run. Behind the scenes, however, he had a contentious relationship with the company’s founder, Donald Fisher, who also held the title of chief executive (Mr. Drexler was president). In 1995, Mr. Drexler became chief executive. And then came the late 1990s, and it all started to unravel.

As president, Mr. Drexler did what came naturally — obsessing about clothing and style and stores and customers. But as chief executive he suddenly had a whole new set of issues to deal with at a very large company, which Gap had become. “Mickey was suddenly underqualified to make decisions about real estate, cash flows, debt levels and employment problems,” Mr. Jaffe said.

Worst of all, customers stopped buying his clothes. “I made some mistakes,” Mr. Drexler acknowledges today. “I lost some of my confidence.” It seems clear now, though, that the real problem was that as he focused on all the things that consume a modern C.E.O., he lost touch with the customer. The customer, it turned out, was his muse.

3)  Finally, this 2004 article from New York Magazine:

 

In May 2002, however, Drexler found himself in trouble. The veteran retailer had many skills, foremost among them a seemingly magical ability to divine what clothing styles would separate consumers from their money. But recently, Drexler had made a series of bad calls. Faced with increasing competition from a pack of imitators—everyone from Abercrombie & Fitch to Wal-Mart—he decided to steer the Gap away from its signature basics look to a trendy, Britney-esque aesthetic: cropped T-shirts, low-rider pants, brighter colors. The result was a 29-month slump. Drexler had lived through ups and downs before, but nothing like this. “I was damned nervous,” he says. “I kept thinking, We’ve got to fix it. The press and the stock market were killing us.”

Even as Drexler mounted a massive turnaround effort—firing staff, transferring executives, commissioning new merchandise—tensions that had long simmered between him and the Gap’s board began to boil. Having come of age in the sixties, Drexler was a retailing maverick. When choosing product, he made decisions with his gut, not market research and spreadsheets. As a manager, he let it all hang out, doing a victory dance when he was pleased, yelling when frustrated, leaving endless “What if . . . ” “Why not . . . ” voice mails. There was a time when that kind of freewheeling spirit suited the Gap; you could argue that it was vital to the company’s success. But the Gap was a Fortune 500 megalith now—more grown-up, more corporate—and there were rumblings on the board that Drexler was no longer the right man to lead the company. “Mickey wasn’t so passionate about compensation committees and budgets and strategic plans,” says a former board member. “We knew the company couldn’t continue to operate with a master merchant driving the brand. My own view was that there should be a transition to a more management-oriented CEO.”

It didn’t help that friction was growing between Drexler and Gap founder Donald Fisher, whose family owned one third of the company’s stock. “Mickey was given 99 percent of the credit, but Don had started the company, and maybe he felt he deserved more credit than he was getting,” says John Bowes, a philanthropist and high-school classmate of Fisher’s, who invested in the launch of the Gap and was on the board for 21 years before retiring in 1997. Two of Fisher’s sons had worked at the Gap during Drexler’s tenure. “It puts extra strain on the relationship,” says Bowes, “when the founder’s kids come in and start running a division.”

As I read these accounts I was struck by how familiar they would seem to any businessperson, large or small.  I believe that "business anthropology" is essentially fractal in nature.  Wikipedia defines a fractal as "a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole."  What I mean is that if you'd followed Jack Welch around during his glory days as CEO of the gargantuan General Electric--sat in on his meetings, listened to his direct reports, watched him deal with the business and human problems that came up--and then done the same with a GE divisional junior vice president in Worthington, OH with just 100 people under him, you would have found that the two led essentially the same lives.  With the exception of scale, life in the C-suite looks a lot like life in a small division of a large company or in a small business.  Personality clashes, people being promoted to jobs for which they're ill-suited, even resentment caused by nepotism--it's there no matter how high you go.

GEICO Case Study

In response to my post on GEICO a few weeks ago, commenter PCC asked "What factors led to GEICO's near failure in the 1970s, and if someone had bought the stock in 1951 and been holding it for two decades, would they have been able to foresee the problems?"

For all my happy talk of "hit the beach" investments, the truth is there is no such thing.  The world is always changing, as are companies and the people who run them.  The ability to spot when things are starting to go wrong, or when the future looks less bright than the past, is essential to a great investor.  If Buffett has bought 1,000 stocks in the course of his life, that means he has also sold nearly 1,000, so the ability to know when to say goodbye is just about half the battle.

Therefore I have to train myself in this ability, so I can use it myself and so I can spot it in others.  PCC's questions provide a perfect opportunity.  So here is a little case study in what went wrong at GEICO and whether its problems were foreseeable:

Going back to Buffett's article, in 1951 GEICO was an excellent business because:

1. Its product, auto insurance, was a necessity, and did not require large investments in inventory or accounts receivable.  Nor was it subject to labor problems, raw material problems, or technological obsolescence.  Because premiums are received in advance of claims being paid, it generated "float," capital it could hold and invest for additional profit.  It was Buffett's kind of business.
2. It deliberately focused on a narrow customer pool--government employees, armed forces personnel, academics, defense workers, and stockholders--chosen for its good underwriting risk characteristics.
3. Having chosen to concentrate on a narrow pool of insureds, it developed expertise in the risk characteristics and behavior of this pool.
4. Because it sold insurance directly to consumers, without the traditional use of agents or branch offices, it saved on "middleman" costs and passed along these savings to customers in the form of significantly discounted insurance premiums. 
5. Its underwriting philosophy valued profitability over growth in premiums or market share.  It turned away business rather than take on unacceptable underwriting risk.
6. Because of its direct sales model and commitment to profitable underwriting, it enjoyed very high operating margins.  Put another way, its combined ratio (the sum of underwriting losses plus operating expenses, divided by premiums earned) was very low.  Put still another way, shareholders got to keep a high percentage of each premium dollar, in addition to the earnings on float.
7. Company president and founder Leo Goodwin was outstanding.  Investment genius Benjamin Graham was chairman of a board that in aggregate owned about one third of the stock.

Still a young company in 1951, with a very large untapped market notwithstanding its narrow focus, GEICO's future looked very bright.  "Don't change a thing, just keep doing what you're doing" would have been Buffett's prescription to GEICO's managers.  Which is largely what they did, until they didn't.  What happened?

The first change came in 1958, when Leo Goodwin retired.  His very able successor was Lorimer Davidson, who is famous in Buffett lore for having agreed to meet with the 21-year old Buffett when he made an unannounced visit to GEICO's offices on a Saturday in 1951.  Under Davidson, who retired in 1970, GEICO's premium volume grew from $40mm to over $250mm, a compound growth rate of over 16%.  Davidson retired as chairman in 1970, and GEICO's big problems began soon after.  I don't think it's possible to draw a simple line from Goodwin and Davidson's departures to GEICO's problems, but I bring up the point because:

a) Management succession is an unavoidable issue for even the most buy-and-hold investment.

b) The quality of the person at the top is extremely important.  Although I can't prove it, I don't believe GEICO would have had the problems it did had Goodwin (who died in 1971) and Davidson still been closely involved.  So while the GEICO investor of 1958 or 1970 could not have foreseen what was to come, he could have foreseen that the likelihood of something going wrong was probably higher as a result of their departures.  This is not something you can necessarily cure--it's just hard to replace great managers with equally great managers.  

c)  Management succession is EXTREMELY difficult to do well.  I have been continually shocked by how often companies and their leaders get it wrong, or completely bungle it.  There is no rule that a great company or even a great CEO will choose a great successor (In fact sometimes I feel it's the opposite--that there is some force (beyond simple reversion to the mean) that compels a great CEO to sabotage the future of his company after he's gone, lest his own glory be diminished).  To take just a few examples:

• The current saga of Anheuser Busch.  The Busch family hardly owns any stock and yet if your name is Busch and has a roman numeral after it you don't have to worry:  The "independent" board of directors will decide you are the best person out of 6+ billion to run the company. 
• Sandy Weill's handpicked successor at Citigroup, Charles Prince, was by all accounts a failure.  Meanwhile, Jamie Dimon, whom Weill fired, is the new king of Wall Street.
• Roberto Goizueta of Coca-Cola was one of the great CEOs in modern history, but his successor Douglas Ivestor lasted only a few painful years.  Buffett was on the board of directors and presumably blessed Ivestor.
• Michael Eisner of Disney was notorious for driving potential successors out of the company.  When he tried to groom a successor from outside, he chose Michael Ovitz.  It didn't work out.

So pay attention to management changes.  And by the way, "management" means the people who actually show up each day and run the place and give it their full attention--you can take little comfort from the fact that the chairman, the chairman "emeritus" who still has an office there, and/or a major shareholder is someone you like and trust.  GEICO is a perfect example.  It ran into trouble while Ben Graham was still a major shareholder, and while Lorimer Davidson was still on the board of directors.  Both of them were retired from active business activities at the time, so they don't count.

What else went wrong at GEICO?  The world in which it operated changed.  First, in the form of two kinds of inflation:

• The general inflation that affected the entire economy in the early 1970s.
• "Social" inflation that affected the insurance industry in particular, as new no-fault laws and changing jury attitudes combined to increase the cost of paying automobile insurance claims.

Inflation is bad enough for you and me, but for insurance companies back there was an added wrinkle.  Recall that insurance underwriters generate float, and hold most of it in the form of bonds.  In the 1970s, accounting rules allowed these bonds to be valued at amortized cost, regardless of their market value.  During that period of rising inflation, the increase in interest rates that accompanied it pushed bond prices down.  This reduced the "economic" net worth of insurance companies that held bonds, but as long as these bonds were not sold, insurance companies would not have to recognize these losses and penalize net worth.  In effect these assets became frozen, unable to be sold to pay claims.  But the claims didn't go away--in fact they were increasing with general and social inflation.

Second, that period saw the introduction of mandatory state approval of insurance rate increases in response to public outrage over previous insurance rate increases.  So it became harder for insurance companies to raise rates.

So if you were Ralph Peck, the new head of GEICO during this period, you had a problem:

1)  Your costs of doing business--claims--are going up.

2)  The main asset with which you pay those claims--float held as bonds--is essentially unavailable to you.

3)  Another way of paying those claims--via higher rates on new business--is harder to accomplish.

4)  You're the new CEO and its past record of growth doesn't help you much.  You want the company to continue growing on your watch.

What did Peck do?  He tried to grow his way out of the problem.  Insurance's great blessing--you get paid up front by your customers--became a curse.  It was too easy to just write more new business at old prices and the cash came in right away, cash to be used to pay claims without having to sell bonds or raise rates.  In a short period GEICO abandoned its niche and started insuring higher risk drivers from the general population, entering competition with the larger underwriters that themselves were trying to grow out of trouble.

The results were predictable.  With little expertise in this new category of drivers, and having written all this new business at old cut-rate prices, GEICO (and much of the rest of the industry too, by the way) incurred massive underwriting losses.  Compounding the problem for GEICO--and this is where management quality comes in, especially in insurance where liabilities are necessarily estimates--it severely underreserved for these losses.  When the bill came due, GEICO's stock went from a high of $61 to $2 a share and teetered on the edge of bankruptcy, before Warren Buffett and John Byrne rescued it. 

So that's my understanding of what happened.  I don't know if a GEICO investor could have predicted it at the time, but I hope that by studying it now, I can better predict something like this the next time it happens.  For instance, there is a risk that certain monoline insurers may try to meet their existing obligations by underwriting new business in a big way, which will lead to inadequate pricing and a future day of reckoning even worse than the one currently envisioned.