The Investor's Consigliere

Perot Hedge Fund Sued

Via Bloomberg.  I suspect there will be more stories like this of rich families whose net worths and reputations suffer from soured hedge fund (and PE) investments.

I also speculate that this is another example of a mini-theme of this blog:  A legendary businessman (and whatever you think of his politics, that is what Perot is) finds himself liquid after selling the company he founded.  Transforming from a businessman to a investor, he risks leaving behind his hard-won expertise in evaluating living, breathing companies to invest capital in the "finance" industry, an area in which he has much less expertise--in this case a leveraged credit hedge fund.  Trouble ensues.

Harvard Endowment, cont.

Daniel Gross of Slate writes about Harvard's endowment.

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. 

Family Foresight Hall of Fame: Wise Matriarch Edition

Even though the diamond business put food on my childhood table and paid for my education, I've always had contempt for those who would spend so much on so little.  "All for the vanity of a woman," as the saying goes.

Not so fast, Consigliere.  I still have much to learn about the ways of this world.  This weekend's FT special supplement featured an interview with legendary diamantaire Laurence Graff, in which he said the following:

I always advise people: when you’re up, buy jewels – women in particular, because a piece of jewellery is hers: of all the goods that you can invest in, a house is shared property, as is art, but a ring or a necklace is a different story.”

Yes he's selling his book, but it's something I've never thought of before. 

Hempton on International Diversification

John Hempton of Bronte Capital blogs about the real-world--as opposed to academic--importance of international diversification.

If you are a superwealthy American, one of the greatest risks to your grandchildren's wealth is a change in fortunes of the United States.  History strongly suggests that its global economic dominance will not last.

History also suggests that it's very difficult for the wealthiest people in the wealthiest nations to avoid complacency about their place in the world (The wealthiest people in the poorest nations tend to know better).  European jews before World War II are a conspicuous example, both in Germany and elsewhere.  Another example, which I'm currently reading about and hope to address in a future blog post, is the British aristocracy of the later 19th century.

 

 

UBS Wealth Management Troubles, cont

Via the Washington Post.  Leaving aside the ethics of tax avoidance, any American who had an undeclared offshore bank account at UBS made a bad decision.  Whatever they saved in taxes was more than outweighed by the risk and consequences of being caught.

The article mentioned that about 1,000 out of the 20,000 American clients of UBS Switzerland did disclose their bank accounts to the IRS.  Which to me means they maintained these offshore accounts not for tax avoidance/secrecy, but for other reasons, perhaps related to our Family Foresight Thought Experiment.  I'm not yet an expert on the subject but the idea of offshore safe havens fascinates me.  Not the tax part--if you're American you should pay your taxes, especially if you're already rich--but the idea of a place where your money is safe from the depradations of war, pogroms, dictators, etc.  I hope to do more research on this subject and address it in a future post.

 

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.

Family Foresight Hall of Shame: Aubrey McLendon

Another CEO who got a margin call.  Fortunately, according to Forbes he diversified.

May 16 Update:  The Manual of Ideas reports on a letter sent by the general counsel of McLendon's company.  It's just one data point, but to me this is an example of there never being only one cockroach in the kitchen.  A CEO who does foolish things with his personal capital, like heavily margining the shares of his company, may be more likely to do foolish things with the capital of others.  The ability to truly compartamentalize your life, to mix disclipline in one area with profligacy in another, is actually pretty rare.

It works the other way too.  In his biography of John Rockefeller, Ron Chernow writes of a period of Rockefeller's life in which he suffered something like a nervous breakdown, brought on by his inability to allocate his philanthropic capital as well as he had allocated the capital of Standard Oil.  A businessman who cares about capital allocation that much is my kind of businessman.

Antinori Family on 60 Minutes

It looks like your consigliere has the same foresight as his mythical family patriarch--no sooner do I mention the Antinori winemaking family than 60 Minutes does a profile of them.  Here is the video and transcript.