The Investor's Consigliere

Marc Dreier Profile on 60 Minutes

Watch it here.

Moore Capital and Sticky Capital

In his annual letter to Moore Capital investors, Louis Bacon wrote about his fund's new marketing strategy:

Bacon also said it's looking to attract longer-term investors after its performance was restrained by redemptions during the financial crisis.

Moore Capital has a new marketing team, which "has had very good success in attracting what we hope is sticky capital from more institutional investors," he wrote in the letter.

Bacon is a rock star among hedge fund rock stars. His fund has returned over 20% for over two decades. My understanding is that he charges above-market fees and has a long lock-up. If even he needs stickier capital, imagine how difficult it is for everyone else. And how important.

My working hypothesis about attracting sticky capital is that it is a two-part process. The first part involves, as Bacon notes, attracting more institutional investors with a long-term capital base. This is not easy, but it is simple: everyone knows who these investors are. You might think of this as "structural stickiness": that portion of an LP's propensity to redeem capital from your fund that can be explained by the type of investor it is (pension, endowment, fund of funds, high net worth, etc). The way to increase the aggregate structural stickiness of your capital base is to attract LPs in the right categories. Simple but not easy.

The second part of the process is more amorphous and intangible. It is the effort to increase an LP's "non-structural stickiness," which can be defined as that portion of an LP's propensity to redeem capital that cannot be explained by its category. High non-structural stickiness can overcome low structural stickiness. That is, an investor in a category known for being flighty can sometimes be your most loyal investor. Consider Warren Buffett's father-in-law:

"Doc Thompson was the kind of guy, he gave me every penny he had, basically. I was his boy."

That was in 1956, and it worked out well. Non-structural stickiness is a function of persuasion, positioning, and underwriting.

I've created a new category called "The Search for Sticky Capital" in which I plan to explore these issues further, the search for both structural and non-structural sticky capital. I will explain what I mean by "persuasion, positioning, and underwriting." The presence of sticky capital is a significant source of competitive advantage for a hedge fund, so the ability to attract it and create it is crucial.

I confess I am a novice in this area, so I welcome any thoughts you may have.

P.S. On the flip-side, from the perspective of a prospective investor in a hedge fund, sticky capital is also very important. You want to spend time learning about how a fund goes about increasing the stickiness of its capital, both structural and non-structural.

Singapore Moving Away from the Harvard Model of Endowment Investing

Gillian Tett column in the FT. An excerpt:

. . . After all, the whole point of a sovereign wealth fund (or endowment fund) is that it is supposed to take a long-term perspective, which should enable it to ride out any temporary storms.

However, in the past two years, sovereign funds discovered that the long-term mantra provides far less protection than previously thought. For by investing in private equity and hedge funds, the GIC (and others) ended up being exposed to the vagaries of their co-investors - and some of those had short-term horizons, or mark-to-market triggers. Thus what hurt groups such as the GIC was not just the issue of asset correlation, but a contagion of investor style as well.

That raises some big questions about how the GIC (and others) should conduct themselves. Should they only co-invest with similar investors in the future? Could they now demand detailed lists of their co-investors (even if they hate providing such data themselves)? Could they ask to be paid for assuming illiquidity risk? Or should they dump external managers altogether, and bring that activity "in-house"?

BTW, if someone is moving away from it, it's called the Harvard model. If someone is moving towards it, it's called the Yale model.

A Better Measure of Risk: Unencumbered Cash

A forthcoming paper argues that a hedge fund's unencumbered cash is a better measure of its risk than value at risk or the leverage ratio.

The paper's full title is: "Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage" by Suresh Sundaresan and John Dai.

Investing and the Misfit

Via Seth Roberts blog commenter Patrik comes this speculative but very interesting paper titled "Why Are Modern Scientists So Dull?," which argues that modern science has evolved to favor individuals with high agreeableness and conscientiousness at the expense of intelligence and creativity.

Without accepting the paper's conclusions entirely I think you can ask some version of the same questions for the hedge fund industry.  Does the modern hedge fund industry, which is orders of magnitude more institutionalized than it was decades ago, select for agreeableness and conscientiousness more than it used to?  Does very successful investing require some combination of traits that put you closer to the "social misfit" category?

Put another way: what are the chances that someone who ran away from home in high school, then proceeded to attend college under protest, then proceeded to drop out of Wharton in order to attend the University of Nebraska, then got rejected from Harvard Business School, then applied to Columbia Business School via a personal letter, would get a good hedge fund job today?  What are the chances that a Hungarian who attended a college known for its socialist leanings, who preferred (and prefers) philosophy to finance, and who bounced from one menial job to another would get a good hedge fund job today?  What are the chances that someone who left a very prestigious Wall Street job to run off to New Zealand and write a novel would be allowed to return and start his own hedge fund?

David Tepper Wall Street Journal Profile

The WSJ profiles hedge fund manager David Tepper of Appaloosa, whose fund was up 120% in 2009.

Tepper's success this year is a testament not only to his gutsy bets, but to successful positioning.  After the annoying experience of having been unduly influenced by his investors not to short the Nasdaq in 2000, he resolved more or less to ignore his LPs.  By the time I got to Wall Street a few years later, Appaloosa was well-known as a fund that made bold bets, which would produce very great years but also some very stressful years.

If even I knew this, then Appaloosa's investor base knew it too, which reduced the fund's asset/liability mismatch in terms of risk tolerance.  A bold portfolio required bold capital providers, and over time that is what the fund has attracted,

Ultimately, this "everyone on the same page" state allowed Tepper to make his 2009 moves relatively unmolested (Alan Shealy of Boise does not count as a molester).

Terra Firma/Citigroup Lawsuit Over EMI

Bloomberg article here.

You can learn a lot about an investor when he sues someone or gets sued.  A lot is revealed through discovery and depositions and testimony.  It will probably become a bigger part of money manager due diligence, at least in the world of private equity.

The other thing to examine, as the article mentions in passing, is the use of the lawsuit as a tactical or strategic instrument, as itself a type of investment.  To pursue a civil lawsuit requires an outlay of money, time, effort, and reputation in the hope of achieving some monetary reward.  A large corporate lawsuit can rival a good-sized PE acquisition in terms of the financial and human resources required.  Each lawsuit has its own prospective risk-adjusted return which can be evaluated (some even do it professionally), and when a professional investor like Terra Firma sues someone, that lawsuit becomes another portfolio asset and a subject of due diligence. 

 

Bryan Burrough's Vanity Fair Profile of Marc Dreier

Anyone who co-wrote Barbarians at the Gate belongs in the Business Writers Hall of Fame.  Anyone who wrote Vendetta about Edmond Safra also belongs in the Hall of Fame.  Anyone who wrote The Big Rich about the great Texas wildcatters belongs there too.  Bryan Burrough did all three, which puts him on Mt. Rushmore. 

Now that I've regained my composure:  The November 2009 Vanity Fair features Burrough's extended profile of Marc Dreier, which Dreier cooperated with.  It's a shame Bernard Madoff came along and ruined everything because Marc Dreier's scheme was even more audacious and difficult to imagine.  It's one thing to go after and defraud the naive and the gullible, rich widows and orphans and status-seekers who don't know much about investing, and to do it via a Ponzi scheme, which has an internal logic to it that makes it easier to prolong.  Dreier just "went full con artist", which everyone knows you should never do (start watching at 0:25 and stop at 1:10), and he went after and defrauded the best, stealing from a who's who of hedge funds.  

The obvious question is how someone like Dreier could have stolen so much from people who are so good.  And he stole the most from the best--you're just going to have to trust me when I say this.  Without knowing the details of the scheme in full, all I can say is that if Dreier had had to deal one-on-one with the managers of these hedge funds, rather than with people who reported to them, he would not have had a prayer of success.  It's one of the buried risks of investing in large funds--the founding genius can't oversee everything.

Michael Moritz on Talent Scouting

Out on bail, fresh out of jail, Consigliere dreamin' . . . 

Just kidding, I haven't been in prison.  I've been locked in my apartment working on a writing project, a real grown-up one that I may even get paid for.  But I miss my blog and speculate that by continuing to write for it it will help me write the other thing.  Practice makes perfect.  So expect more posts.

Here's a little one, more for the personal file of this self-styled "investor talent scout":  Fortune magazine recently devoted nearly an entire issue to Steve Jobs of Apple.  It featured an interview with famous venture capitalist Michael Moritz,  who wrote a book about Apple a long time ago when he was just a reporter for Time.  As I've blogged before, I like to study successful venture capitalists because they are supposed to be experts in spotting human talent, a skill that's relevant to investment manager selection.  Moritz was asked about this and here is what he said:

How has your study of Jobs and Apple helped you in your job as a venture capitalist?

Extraordinary, rare companies -- like Apple in those first two or three years -- have some common traits. The individuals will be different, the businesses will be different, the decade will be different, but the purpose, the drive, the sense of mission, the intelligence of the founders -- those will be common. If you have been around the start of success, it's far easier to recognize it again.

I think the last sentence is key.  If your job is to recognize something--e.g. a young company that's about to be very successful--what makes it far easier is not necessarily the ability to divine the future of a product or be a genius or something complicated like that, but simply the experience of having already observed that something before.  They used to think that chess grandmasters had a special kind of intelligence, a way of seeing many moves ahead that others lacked.  But over time, people who study chess intelligence have de-romanticized that opinion, and now think that skill at chess is a more simple matter of having studied and memorized positions and how they were played out, and having the ability to recognize patterns so that, when a novel position is confronted, the grandmaster can relate it to one he (or she) has seen before and knows the "answer" to.  Moritz is saying that the experience of observing the young Steve Jobs in action has by itself made it far easier to recognize what a successful company founder looks like, even though no founder is exactly the same.  I think the same thing applies to successful investors--the experience of having observed and studied them in action makes it easier to evaluate young investment talent.  I've never seen Warren Buffett in action but through study I've come about as close as possible to it, and when I meet with a new investor I'm simply asking myself "how close is he to Buffett"?  I did have the good fortune to work for a hedge fund manager with one of the best long-term risk adjusted records ever, so I have seen him in action, which helps me know what to look for in a successful young hedge fund manager.

By the way, a similar logic applies to the craft of investing itself.  Warren Buffett is a genius in terms of IQ and computational ability and all that, but a large part of his success comes from that fact that he's studied and memorized more business and investing "chess positions" than anyone else and knows how they've played out.  When he confronts a new position, then, he can relate it to one he's seen before and knows the "answer" to. 

Galleon Due Diligence

From the FT.  An excerpt from one due diligence report:

“Crudely, there are three ways to make money as a hedge fund manager,” said one large multi-billion dollar asset manager.

“You can take advantage of trading technology, but few do.

You can be more intelligent than others, but few are.

“Or you can have some specialised source of sustainable information. Unless that information is from fundamental analysis – and in Galleon’s case it did not all seem to be – then that’s a red flag for us.”