Thursday, May 24, 2007

Let Me Call You Sweetheart

If any of you Dear Readers out there doubt that there is drama concealed underneath the dry prose and completely off-putting format of disclosure documents filed with the SEC, you have only to visit Michelle Leder's blogsite footnoted.org to have the wool pulled back off your eyes. The SEC's requirement that publicly traded companies disclose material information and events leads to all sorts of goodies reaching the public domain, even if management or the directors would much prefer they didn't. And, notwithstanding corporate lawyers' best efforts to wrap such dirty laundry in sixteen double-layer, airtight garbage bags' worth of impenetrable legalese, the diligent reader is still able to get a satisfying whiff of scandal.

The latest such goodie to cross my (virtual) desk is an SC 13D/A filed today by Houston-based air freight forwarder EGL, Inc., which has been smack dab in the middle of a hotly contested takeover battle. On one side is Jim Crane, founder, Chairman, President, and CEO of the company, who teamed first with private equity shop General Atlantic and later with Centerbridge and Woodbridge to make an offer to take the company private at $36 and later $38 per share. On the other side is Apollo Management and its recently acquired portfolio company, CEVA Logistics, which has been conducting a very public campaign to counterbid, including suing the company earlier when it claimed it was not given a fair opportunity to submit an initial bid.

Well, the latest twist in the long-running saga is that EGL's Special Committee announced today that Apollo and CEVA have finally won the war, and will buy the company for around $2 billion, or $47.50 per share. As previously agreed with the Crane group, EGL will pay a $30 million break-up fee to them to go away. Now, I know Jim Crane, and I can tell you that notwithstanding a substantial goodbye kiss and $47.50 per share for his 17.4% of the company, he will not be a happy camper to be sent packing from the company he built with his own two hands. I can imagine that the post-deal debrief over at Camp Crane is not a pretty sight, with recriminations flying left and right and fingers being pointed liberally.

For proof, we have this gem from today's 13D amendment:
SCHEDULE 13D/A

EXPLANATORY NOTES: This Amendment No. 8 to Schedule 13D (this "Amendment") is being filed by James R. Crane and the other reporting persons (collectively, the "Reporting Persons") signatory hereto as identified in the Schedule 13D filed on January 22, 2007, as amended by [blah, blah, blah—trust me, you are missing nothing important here] ... Capitalized terms used but not defined in this Amendment shall have the meanings given in the Schedule 13D.

The Reporting Persons wish to make clear that Mr. E. Joseph Bento, who was one of the signatories to the Schedule 13D filed on January 22, 2007 and to Amendments No. 1 through 7 thereof as previously filed, was not a signatory to Amendment No. 8 to the Schedule 13D and is not a signatory to this Amendment.

The Reporting Persons have excluded Mr. Bento as a signatory and as a member of the group because they believe, based on reliable information, that Mr. Bento, while purporting to cooperate with the Reporting Persons in their offer to acquire the Issuer, in fact has been secretly and improperly cooperating with Apollo Management VI, L.P. and its portfolio company, CEVA Group Plc (collectively, "Apollo/CEVA") in the competing offer by Apollo/CEVA to acquire the Issuer.

The Reporting Persons further believe, based on reliable information that, while holding himself out to the Reporting Persons as a person cooperating with the Reporting Persons' bid for the Issuer, Mr. Bento in fact has, without the prior knowledge of or permission from the Reporting Persons, improperly shared confidential information relating to the Reporting Persons' bidding strategy and other confidential information regarding the Reporting Persons' offer to acquire the Issuer. The Reporting Persons cannot give any assurance that prior statements of Mr. Bento in the Schedule 13D as to his intentions were in fact truthful and accurate.

The Reporting Persons intend to explore all appropriate remedies, including legal action for damages and other relief, that they may have against Mr. Bento.

Ooooh, Mr. Bento! Juicy, if true. A rat, a mole, a squealer, buried deep in the heart of the management bidding group. The skin tingles.

Apart from being an entertaining soap opera and a rare instance where the corporate litigators are likely to earn more than the investment bankers, the whole EGL saga illustrates a few salient points about the current private equity boom that are worth noting.

First, the take private played out the way it did initially because it was launched by current management, in this case a dominant entrepreneur-founder with close to an effective blocking stake in the company stock. The initial agreed deal of $38 per share was viewed by many outsiders as too low, but no-one could see how another bidder could get around management's sweetheart deal. Conclusion #1: Big management equity stake = potential for a sweetheart MBO deal. Caveat investor.

Second, EGL's board was packed with Mr. Crane's golfing buddies from Houston (Jim is a single digit handicapper, apropos of nothing), which he clearly dominated and directed how to behave. To no-one's surprise, the Special Committee deputized to run a fair process apparently did a crap job, effectively signing a $38 per share deal plus a break-up fee with the Crane group without giving Apollo a chance to table a competing bid (or so Apollo claimed in its initial lawsuit). Only when Apollo did sue and went public with its complaints, did the Special Committee begin to behave in a fiduciarily responsible manner. (Let's give one lackluster cheer for Special Committee advisor Deutsche Bank.) Conclusion #2: Run a fair process, or the other side's attorneys will force you to.

And third, if there ever was a "gentleman's agreement" among private equity shops not to jump each other's agreed deals—which I doubt was very strong if it did exist—those days seem to be drawing to a close. However, it could be argued that Apollo/CEVA really represented a competing strategic bidder, not a pure PE shop, and one which was strongly motivated to buy EGL because it represented a rare opportunity to acquire a substantial freight forwarding business to integrate with CEVA's contract logistics business. Perhaps that is why Apollo fought so hard, and Apollo/CEVA ended up paying a very full price for what has been viewed as a distinctly second-rate property in the marketplace. Conclusion #3: Hell, I don't know. You figure it out.

In any event, the EGL take private is a nifty example of how private equity can indeed do the right thing by existing public shareholders in a situation where entrenched management can potentially deter competing bids. While EGL shareholders did not recoup their 52-week high stock price of $51.49, they did end up receiving a 59.5% premium to the pre-deal announcement share price. I only hope Apollo's limited partners make out as well.

© 2007 The Epicurean Dealmaker. All rights reserved.

Nobody Expects the Spanish Inquisition

Guns don't kill people.
People kill people.
With bullets.
From guns.

— Anonymous

FT Alphaville took gentle exception a couple of days ago to some remarks made by Professor Robert Merton—of Black-Scholes and Long-Term Capital Management fame—in this past Monday's interview in the Financial Times.

The "impish" former academic did say one or two things that could be construed as controversial, but the following is not one of them:

"The major advantages of using derivatives are that they are efficient in transferring huge amounts of risk. ... Derivatives are like anti-lock brake systems in a way—there is no question that they can make things safer, but only if people choose to use them that way. Often they don’t—they might choose, for example, to drive faster in worse weather. Often we have chosen to use these tools not to decrease risks but to increase the benefits of taking the same risks."

True, true, and true. But note his critical distinction that derivatives "transfer" risk. They do not eliminate it: they merely allow the separation, alteration, and recombination of risk inherent in securities and other financial instruments, and its subsequent repackaging and resale to other investors. Risk is incompressible: it cannot be eliminated, only transferred (for a price).

This is a point I think many people do not understand, or glide over if they do. All the wonderful risk transfer instruments that have been developed over the past several years—credit derivatives, total return swaps, collateralized debt and loan obligations, etc., etc.—have not eliminated one iota of risk in the global financial system. They have merely spread it around, presumably more efficiently, to the investors who want to hold it.

Some people argue that this broad-based, system-wide transfer of risk has indeed made the world's financial markets safer and better able to withstand shocks. For example, credit risk has been largely taken away from a limited number of structurally highly leveraged market participants—the commercial lending and investment banks—and distributed through CDOs, CLOs, and credit derivatives to a large number of hedge funds and other investors with an appetite for risk (and the accompanying yield).

All this is sensible, and probably true. But can we say that systemwide risk has indeed been reduced? To say that convincingly, you would have to argue that the hedge funds and others buying credit risk are somehow "better owners" of such risks; that in fact traditional balance sheet lenders were inefficient holders of credit risk, and hedge funds know how to price credit risk better than commercial banks. But is this true? I for one find it hard to believe that a collection of ex-Wall Street bond traders and fixed income quants—who are the guys buying this stuff for hedge funds nowadays—actually have superior credit skills than the green eyeshaded legions at JP Morgan, Citibank, and Bank of America who used to originate and hold corporate debt. After all, let's not forget that someone has to own that risk while the underlying credit obligation(s) are outstanding. Not everyone can trade it away when things turn sour.

Instead, I think a case could be made to support Merton's alternate hypothesis that drivers on the Credit Highway have indeed speeded up a little, confident in the belief that their anti-lock credit derivatives have reduced the risk of them crashing their own vehicle. (The historically low credit spreads and decreasing covenant protections for corporate debt in the face of dramatically increased volume for riskier credits certainly supports this contention.) But, if so, the analogy is imperfect, and may reflect a misunderstanding of the situation.

Unlike anti-lock brakes—which for a given level of speed and road conditions should reduce an individual driver's probability of a crash—the use of credit derivatives does not decrease the likelihood of an underlying security's default at all. (Remember, it has only transferred that risk to someone else: it has no preventive effect whatsoever.) Rather, it is as if a driver has sold off some or all of his individual "crash risk" to one or more of the other drivers on the same road. The driver who sold the risk is presumably better off (if slightly poorer), but what happens if the one who bought the "extra" risk crashes (i.e., ex post "mispriced" the purchased risk)? What happens if he crashes in front of our clever low-risk driver and causes a multi-car pile-up? After all, don't you think that the fact you could sell your crash risk to other drivers through the magic of Crash Transfer Derivatives would encourage more people to drive, and drive faster, in less safe conditions, than they would have otherwise?

Furthermore, just where is all this securitized risk going? Is it spreading out nice and smooth across hundreds of diversified hedge fund portfolios, so that no one risk event or connected series of risk events (e.g., Amaranth) could cause a pile-up on the Global Market Highway? Or is it collecting stealthily into large, concentrated, correlated pools of which their owners may or may not be aware (e.g., LTCM)? The former condition would indeed be a big improvement over the historical concentration of risk in a few large, highly levered commercial banks and broker dealers. The latter would be no improvement at all, and might be worse.

Only time will tell. And, in the meantime, I am afraid we will have to take the hedgies' word for it that they know what they are doing. I would feel better if I believed that, but I have seen too many examples of supposedly brilliant people acting like complete and utter horses' asses (Exhibit A: Professor Merton and his cohorts at LTCM) for me to rest easy. And, eight years after the implosion of LTCM, Professor Merton still has not learned enough about the functioning of markets to avoid saying claptrap such as this:

The causes of [LTCM's] collapse, though, are widely misunderstood, says Robert Merton. While some observers blamed events on the faith that the fund placed in financial models—founded on a belief in rational markets—Prof Merton says the real problem was the way that LTCM’s counterparties behaved.

When the $100bn fund started to suffer losses, the counterparties did not behave as proponents of finance science—or rational markets—predicted. Instead, they sold assets in a seemingly indiscriminate panic, triggering market swings more violent than anything Merton had expected.

Pace our Nobel laureate, there was nothing irrational about the behavior of LTCM's counterparties. The ones who sold outright sold fast and at almost any price because they knew or suspected that 1) LTCM had mammoth deteriorating positions on the same side of the market that were compounded by crushing leverage and 2) in the face of spiking volatility and vanishing liquidity they had better get out before the doors closed completely. The buyers on the other side of LTCM's positions knew the same damn thing, and just sat and waited for LTCM to completely collapse so they could swoop in and snap up its positions at fire sale prices. (That many of these selfsame counterparties and buyers happened to be LTCM's prime brokers—Wall Street's best and brightest—just makes the irony that much greater. Never let it be said that Wall Street is a pretty place.)

Notwithstanding the clever maths Professor Merton and his pocket protector set used to model continuous time finance processes in order to derive the simple and practical Black-Scholes model, real market participants bear very little resemblance to gas molecules diffusing in a jar. For one thing, I am not aware of any gas molecules that modify their behavior based upon the observed behavior of other gas molecules. Markets are not inanimate, robotic price discovery mechanisms that unconsciously seek out "rational" equilibria. They are composed of living, breathing, conscious agents with mortgages and demanding spouses who explicitly work to maximize their own advantage, especially in times of crisis.

Besides, nobody expects the Spanish Inquisition.

© 2007 The Epicurean Dealmaker. All rights reserved.

Tuesday, May 22, 2007

Look On My Works, Ye Mighty, and Despair!

Well, my call for reader nominations for the best articles posted on this site since its inception came a cropper. The deadline for entries came and went yesterday, with absolutely no-one sending in a submission. Were I in possession of a less well-defended ego, I might actually even be hurt.

As you might suspect, I have developed a number of hypotheses for this deplorable lack of feedback from you Dear Readers, which I am happy to share.
1) Many of you did indeed try to select the best of my posts, but were overwhelmed by their uniformly superb quality, and abandoned any effort to differentiate among the jewels on display.

2) Some of you were inspired to write in, but were terrified that I might sic Equity Private on you if I found your entries displeasing, as I had indeed threatened. I must say that your fears were probably unfounded—I am more of a pussycat than I seem—but I agree that it was tactically unwise of me to dangle such a harrowing prospect over your heads. (EP can be a bit of a Gorgon sometimes, can't she?)

3) A far higher percentage of my audience than I had previously suspected do not have opposable thumbs.

4) As I feared, all six of you were indeed out of town.

In any event, I no longer have any reason to perpetuate the sham of soliciting your opinions, so I will do what I had originally planned to do anyway and choose the winners myself. Without further ado, here they are:

THE CANON
Mine's Bigger than Yours: Investment bankers compare size, and clients look on appreciatively
Dance, Monkeys, Dance: TED revels in the beauties of the Internet, and later gets depressed
Jabberwocky: The Blackstone Group lifts the kilt to show all of us what's underneath (with support from Crooked Timber and Would You Buy Stock from this Man?)
L'État c'est moi: Little Stevie Schwarzman throws himself a party (with follow up in The Self-Made Man Club)
Life During Wartime and Woe is me: The sad story of the investment bankers everybody loves to hate
A Simple Request, A Modest Proposal, and Not Far Now: Sundry shots across various bows

Consider this a reading list for those long, boring conference calls on supply-demand dynamics in the Norwegian herring fishing industry.

You are welcome.

© 2007 The Epicurean Dealmaker. All rights reserved.

Monday, May 21, 2007

Fingernails that Shine Like Justice

The Financial Times published a front page article this past weekend on how investment banks are trying to manage their way around the current shortage of investment bankers—I kid you not: it's true—by attracting former i-bankers of the female persuasion to rejoin their firms.

It turns out that there aren't enough worker bees to process all the sausage being pushed through the financial market meat grinders right now, and the (male) powers that be have realized there is a vast unexploited untapped group of lonelyhearts trained finance workers out there just waiting by the telephone for Big Strong Silent Bank to call:
"Financial institutions are finding there is an enormous talent pool of women out there and they need to find a way to give them a second shot at ambition"

says one yenta source. Supporting the decision of these poobahs to bolster the distaff side of their organizations is the dawning realization that a growing number of their actual clients happen to be women, as well. Who knew?

The scarcity of women in investment banking seems to be mirrored quite faithfully across the principal-agent divide in private equity, as a recent article in Portfolio magazine reported. The testosterone concentration in private equity seems to be easily explainable, however, as a by-product of the scarcity of women at investment banks, which have typically comprised the bulk of the farm teams for PE professionals. However, why the fairer sex should have remained a stubbornly small minority of i-bankers, after a couple of decades of banks trying rather heroically (in their eyes) to increase their penetration, remains somewhat of a mystery, at least to me.

Back in the Dark Ages, when Yours Truly took on the yoke of indentured servitude, there were generally only two kinds of women in investment banking: personal assistants, and the well-coiffed wives waiting at home to hand the Master of the Universe a dry martini when he strode in half-soused from the 8:14 to Greenwich. (Many of the former, of course, hoped to transform themselves into the latter with a carefully planned indiscretion at the office Christmas Party, but that is another story.) The professional women I met who worked in the industry were very few and far between, and they tended to oscillate between the two extremes of shellshock and hysterical aggression. In other words—except for the Chanel suit and the higher vocal register—it was hard to tell them apart from the men.

But over the past couple of decades, I have witnessed and participated firsthand in sustained and determined efforts to increase the number of women recruited into investment banks, and it is true that the number entering each year in first-year analyst and associate classes has increased markedly from my youth. However, what is also true is that very few of these women stay. The ones I know who do genuinely seem to enjoy their work, and they can cut the balls off a charging rhinocerous (or CEO) with an indenture with the best of them, all the while making their doltish male colleagues think impure thoughts about their pantyhose. In other words, I am of the opinion that smart, aggressive women have a distinct advantage over men in investment banking. Why, therefore, aren't there more of them?

I will venture a short distance onto politically incorrect thin ice and suggest the reason is that—for whatever reason—most women just do not like investment banking. The other reasons I have heard offered for their scarcity just do not wash, based on my experience. They do not get paid any less than their male peers—although, like every one of their male peers, they are each convinced that they personally get screwed in compensation discussions. They do not suffer from the (demonstrable) lack of potential female mentors, for the very reason that no-one in investment banking ever finds a mentor they can trust for more than one bonus cycle. They do not face anywhere near the kind of sexual harassment that they used to, but they do face the same kind of cruel, relentless, insensitive abuse that their male colleagues do, from superiors as well as clients. (If you are looking for a profession where people like you and you can easily make friends, you are in the wrong zip code, my friend, male or female.) And every co-head of investment banking on Wall Street or elsewhere loves a banker who can make money, regardless of their character, creed, or personal plumbing. There is a big fat bonus waiting for every ruthless, aggressive, and talented i-banker out there, even if (s)he is a three-headed, purple-skinned hermaphrodite with bad breath.

And don't tell me that babies and family are any barrier to a career in i-banking, either. I have one too many true stories of female managing directors screaming negotiating instructions for a live deal into a cell phone from the hospital delivery table to buy that one. There is absolutely no reason on earth why a woman can't be just as much of a heartless, disconnected, absentee parent as a man. She just has to want it enough.

So there it is, why most men in the business believe there aren't more women in investment banking: most women just don't want it enough. Now, whether it is something you should want enough to make the sacrifices required is a personal decision each man or woman needs to make on his or her own. I would simply observe that most of the women who do stay are pretty kick-ass good, and just like any industry investment banking can use all the talent it can get.

So, come on, girls: jump on in. Investment banking needs you.

I want a girl with a mind like a diamond
I want a girl who knows what's best
I want a girl with shoes that cut and
Eyes that burn like cigarettes

I want a girl with the right allocations
Who's fast and thorough
And sharp as a tack
She's playing with her jewelry
She's putting up her hair
She's touring the facility
And picking up slack

I want a girl with a short skirt and a lonnnng jacket......

I want a girl who gets up early
I want a girl who stays up late
I want a girl with uninterrupted prosperity
Who uses a machete to cut through red tape
With fingernails that shine like justice
And a voice that is dark like tinted glass

She is fast, thorough
And sharp as a tack
She's touring the facility
And picking up slack

I want a girl with a short skirt and a lonnnnng.... lonnng jacket

Na na na na na na ...

I want a girl with a smooth liquidation
I want a girl with good dividends
At Citibank we will meet accidentally
We'll start to talk when she borrows my pen

She wants a car with a cupholder armrest
She wants a car that will get her there
She's changing her name from Kitty to Karen
She's trading her MG for a white
Chrysler LeBaron

I want a girl with a short skirt and a lonnnnggggggggg jacket

Na na na na na na ...


— Cake, "Short Skirt / Long Jacket"

I'll take my martini with two olives, thanks.

© 2007 The Epicurean Dealmaker. All rights reserved.

Friday, May 11, 2007

Not Far Now

Professor: When the three planets are in eclipse, the black hole like a door is open. Evil comes, spreading terror and chaos.
See the snake, Billy: the ultimate evil. Make sure you get the snake.
Billy: [drawing] Yes, I've got your snakes. I've got all the snakes.
So when is this snake act supposed to occur?
Professor: Huh? Well, uh ... if this is the five, and this is the one ... [calculates] ... every 5,000 years.
Billy: So ... I've got some time then.

— The Fifth Element

Alpha Male over at AllAboutAlpha.com posted an interesting article yesterday about the concept of kurtosis, or "fat tails," as they relate to hedge fund returns. In it, he debunks the notion that having a fat tailed return distribution necessarily makes a particular investment "riskier" than one with a more "normal" or even thin-tailed distribution. (Normal distributions by definition have kurtosis—or "excess kurtosis"—of zero.)

In the way normal humans understand and talk about risk, a "riskier" investment is clearly understood by all to mean one that has a higher probability of a loss of a given size than another investment. We need not resort to a discussion about fat tails to understand that this depends on the return variance (σ2)—or, the related concept of standard deviation, or volatility (σ)—of the investment in question. Take, for example, a gander at the following normal Gaussian distributions (remember: kurtosis = 0 for all of these):


With the exception of the squirrelly distribution plot with the purple line (where the mean, or average (μ), equals –2)—which you should ignore—all of these normal distributions have the same mean and the same cumulative probability distribution function. They all just have different variances (red = 0.2, green = 1.0, blue = 5.0). Believe it or not, none of them have "fat tails."

Now, even an idiot—are you listening, Frank Willicott?—can see that the cumulative probability of suffering a "loss" of –1.0 or more (the area under each curve bounded by –1.0 on the right and negative infinity on the left) is substantially different among the different curves: pretty small for the red curve, bigger for the green curve, and pretty scary for the blue curve. Absolute realized returns follow a distribution pattern dictated by the volatility.

So, you can imagine a "fat-tailed" return distribution (where the probability under the "peak" of each normal curve is squooshed further out into the tails, thereby "fattening" them) will indeed have a higher probability of a loss of given amount than a normal curve of identical variance. You can also imagine that a curve with positive excess kurtosis but a standard deviation of 0.45 (σ2 = 0.2)—a "flattened" red curve, if you will—might have a lower cumulative probability of loss of –1.0 or more than the green curve, with σ2 = 1.0. (Although the advantage could dissipate pretty quickly if the kurtosis is high enough.)

This is what Alpha Male was trying to get to, and I think we can all agree with him that we have to pay careful attention to volatility when we are evaluating the riskiness of an investment. Pace Mr. Male, however, we cannot ignore kurtosis, either. So much for the arithmetic.

Unfortunately, the rest of his post is pure sophistry.


Mr. Male cites at length a presentation made at a recent hedge fund industry confab by Alexander Ineichen of UBS. (Loyal readers know that UBS does not rank high in TED's honor roll at present.) In it ("Food for thought: 2. Loss potential"), Mr. Ineichen trots out a chart (shown above) based on monthly return data between January 1990 and September 2006 for "multi-strategy" hedge funds compared to returns for the individual stock components of the S&P 500. Retrospectively analyzing this data, the crack UBS team comes up with the following:

How do we read the graph? The arrow in the graph points to two occurrences where a multi-strategy fund lost between 65% and 70% of its value in one month. One of these two occurrences was Amaranth’s September 2006 return of -69.8%. (The other occurrence as well as the one observation in the -80% to -85% return bucket was from an obscure fund that we believe managed less than one million in assets and closed in November 1996.) Given that the graph is based on 28,420 monthly multi-strategy returns, we can back out a probability of 0.007% for the probability of a monthly loss in the -65% to -70% return bucket. This is, by coincidence, nearly identical to one of the 500 constituents in the S&P 500 experiencing such a loss in a given month.

More relevant than the probability in a given bucket is the probability of a loss exceeding a certain threshold. For the sake of argument, we examined the probability of a monthly loss exceeding 50%. In the case of multi-strategy funds, there were four occurrences exceeding 50%. This means the probability is in the neighborhood of 0.0141%. What does that mean practically?

This means that if we assume we only invest in one multi-strategy fund for one month we can expect a monthly loss of 50% or more every 7,105 months, i.e., once every 592 years. ...

How do these probabilities compare to the stock market? The probability of losing 50% or more with a S&P 500 constituent is 0.0600%. This means, if we assume we only hold one S&P 500 constituent for one month, we can expect to lose 50% or more once every 139 years. (Note that the probability of losing 50% or more over three, six or twelve months is an entirely different story.)

Well, Mr. Ineichen, thanks for that last little qualification, but I have to say the rest of your analysis is just crap.

First, observed event frequency ex post is not the same thing as expected probability ex ante. Taking historical performance to be a reliable indicator of future behavior is a predictive assumption—one you clearly admit to, for sure—but one I would characterize as pretty near heroic, based upon a data set of four outlier observations over 17 years. You are confident, are you, that an investor in multi-strategy hedge funds could expect a monthly loss of 50% or more once every 592 years? Not 591? Or 593?

Second, even though you do not share it, I have a problem or two with your data. For one thing, where is Long-Term Capital Management, which lost $4 billion in 1998? Gee, I thought LTCM was a "multi-strategy" fund. Was I wrong? (And, even if I am wrong, why the hell would you put up an analysis purporting to describe the loss history of hedge funds since 1990 without making sure to include LTCM?) Furthermore, notwithstanding the fact that you admit not recognizing many of the hedge funds in your database, you are "comfortable," are you, that your "data is of high quality and reasonably complete"? No gaps from selective reporting, especially by—let's say—hedge funds which happened to blow up a month or two after they stopped reporting returns data?

Third, you compare the returns history for multi-strategy hedge funds with individual stocks in the S&P? Are you fucking kidding me? What's the matter: couldn't you find data for the monthly returns of a diversified basket of stocks—say, for example, the S&P 500? I know: let's do a companion study to yours, in which we analyze monthly returns data for diversified long-only equity mutual funds compared to the performance of individual pork belly futures on the Chicago Board of Trade. Ya think that'll provide a balancing perspective?

I am sure the hedge fund audience in Greenwich—UBS's current and potential prime brokerage clients—really ate up your concluding remarks:

Former Harvard president Derek Bok was once quoted saying:
"If you think education is expensive, try ignorance."
By examining the graph above, could not one rephrase the quote to:
"If you think hedge funds are risky, try stocks."

No, sorry, one could not.

This type of article does not even come close to addressing—on a serious, sustained level that does not treat its lay readers as utter morons—the legitimate concerns which investors, regulators, and policy makers outside the hedge fund industry have about its stability, risk controls, and ability to weather unexpected exogenous shocks. (And we're not concerned that you might lose your 34,000 square foot mansion in Greenwich to foreclosure and never get sex again from someone half your age—we're worried about what one of you blowing up is going to do to the rest of us.)

I have a general suggestion for the gentlemen (and ladies?) of the hedge fund industry if you want to seriously play in the marketplace for ideas:

Up your game.

© 2007 The Epicurean Dealmaker. All rights reserved.

Wednesday, May 9, 2007

P(x) = 1/1,000,000,000,000,000,000,000,000

In the first months of 1998, markets were smooth. ... The mood at Long-Term was relaxed, too. Though the fund's leverage was up, and though the partners had taken out huge personal loans, their exposure seemed tolerable. ... According to their models, the maximum that they were likely to lose on any single trading day was $45 million—certainly tolerable for a firm with a hundred times as much in capital. According to these same models, the odds against the firm's suffering a sustained run of bad luck—say, losing 40 percent of its capital in a single month—were unthinkably high. (So far, in their worst month, they had lost a mere 2.9 percent.) Indeed, the figures implied that it would take a so-called ten-sigma event—that is, a statistical freak occuring one in every ten to the twenty-fourth power times—for the firm to lose all of its capital within one year.1

Let's see if I have this right. Long-Term Capital Management failed in 1998 due to a combination of the following reasons:

1) A coincidence of unusual and unforeseen exogenous events, capped by Russia's default, which led to severe and ongoing market disruptions and a convergence in correlations (and covariances) of returns across different markets and different risk classes

2) Personal greed on the part of the fund's principals

3) Credulous and scale-independent application of supposedly sophisticated value-at-risk models

4) Massive up-risking of LTCM's portfolio into non-core trade positions when returns in its core business diminished due to increased competition

5) Excessive leverage, both on-balance sheet and off, facilitated by short-sighted, uninformed, and greedy prime brokers

6) De facto coordinated attacks by other market participants (including its prime brokers) when LTCM got into distress

7) Institutionalized arrogance and hubris

LTCM did not blow up because its principals were stupid or inexperienced, in a conventional sense (pace Nassim Taleb). Say what you will, you cannot accuse people like Meriwether, Hilibrand, Scholes, Rosenfeld, and Merton of being stupid or inexperienced. It also did not blow up because they had bad ideas, per se. Leveraged arbitrage—which, cutting through the crap, is what LTCM did, at least until it got greedy (or desperate)—is a time-tested trading strategy.

It failed due to the human element: vanity, hubris, greed. Oh, plus an unlooked-for exogenous event or two.

Nowadays, with orders of magnitude greater capital invested with hedge funds committed to chasing down ever more fleeting market opportunities, it strikes me that the pressure on hedge funds to deliver returns is no less than it was for LTCM in 1998. Plus, the last time I looked, no-one had repealed human nature, or its foibles. Finally, the nature of unlooked-for exogenous shocks is such that—*ahem*—they are unlooked-for.

So explain to me, all of you strident hedge fund apologists, why "It's different this time."

Go ahead: I'm listening.

1 R. Lowenstein, "When Genius Failed: The Rise and Fall of Long-Term Capital Management," Random House, 2001, pp. 126–127.
© 2007 The Epicurean Dealmaker. All rights reserved.

Call for Entries

TED has reached a milestone, of sorts, with the publication yesterday of our fiftieth1 post on this site. In celebration, we will shortly inaugurate a new topic category tentatively titled "classics" or "the canon" or somesuch other modest sobriquet befitting the weight and importance of our most significant writings. We intend to leaf back fondly through our output and anoint those pieces particularly worthy of permanent preservation2 with said modest sobriquet, the better to allow the forgetful, the uninitiated, and the just plain unwashed among you to find our most earth-shattering work.

We, of course, have our own candidates in mind for this honor. But, in a gesture of remarkable yet characteristic noblesse oblige magnanimity3, we have elected to solicit opinions from you, our Dear Readers, as to which entries you think best deserve canonization. (I know, I know, you don't deserve me.)

Therefore, take pen, pencil, or keyboard in hand, and write to me posthaste at epicureandealmaker [at] hushmail [dot] com with your suggestions. The person who provides the most interesting list (i.e., the one closest to my own) will win a prize of staggering generosity of a yet-to-be-determined nature. Runners-up will receive a handsomely framed specimen of bupkus.

All entries, bribes, and other monetary "gifts" submitted will become the sole property of The Epicurean Dealmaker, to do with as I see fit. Particularly egregious examples of mendacity, stupidity, or cupidity will be forwarded to Equity Private at Going Private, who has been strictly charged to shame and excoriate you in public in the most humiliating and sardonic way possible. (You have been warned.)

Every effort will be made by this establishment to return the electrons, photons, and neutrinos comprising contest entries to their natural habitat after the competition. No assurances can be given, however, as to the treatment of any Higgs Bosons we might or might not find in our inbox.

The entry deadline is Monday, May 21, 2007 at 1700 hours, New York time, unless all six of you are out of town, in which case we will close the contest when we damn well see fit.

Get cracking!

1 Clever readers will note that fifty posts have not yet been published here. (I have been holding some particularly devastating ones in reserve.) Extra credit and a personally autographed centerpiece from Steve Schwarzman's sixtieth birthday celebration to the first reader who writes in with the correct number that have appeared on this site.
2 "But wait!," you exclaim, "Surely all of your precious pieces are worthy of elevation to the literary and philosophical Pantheon, are they not?" Yes, yes, child, of course. But we needs must make some distinction amongst our beautiful children, no?
3 [Edit as of 1950 hours, 9 May 2007:] Sorry. While my Noblesse is certainly frequently obliged among you little people, I knew there was a better word for what I was aiming at when I wrote this piece. Who knew it was a solid, five syllable word of impeccable Anglo-Saxon pedigree? I think Hemingway called these "ten centers."
© 2007 The Epicurean Dealmaker. All rights reserved.

Tuesday, May 8, 2007

Ozymandias

I met a traveller from an antique land
Who said:—Two vast and trunkless legs of stone
Stand in the desert. Near them on the sand,
Half sunk, a shatter'd visage lies, whose frown
And wrinkled lip and sneer of cold command
Tell that its sculptor well those passions read
Which yet survive, stamp'd on these lifeless things,
The hand that mock'd them and the heart that fed.
And on the pedestal these words appear:
"My name is Ozymandias, king of kings:
Look on my works, ye mighty, and despair!"
Nothing beside remains: round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away.


— Percy Bysshe Shelley, "Ozymandias"

Jeff Matthews is freaking me out. He travelled to Omaha, Nebraska this past weekend to attend the annual meeting for Berkshire Hathaway, and he has posted the first in a series on his journey. So far, the full story has yet to be told, but Mr. Matthews has set the stage with an extensive description of his travels.

I do not know how Mr. Matthews feels about Warren Buffett, but I will say that he makes a pretty good reporter, if this post is any indication. It is not his writing per se that bothers me. No, what gives me the willies is his description of his journey to a small, nondescript Midwestern town in terms more apt for a pilgrimage to Lourdes, or the hajj to Mecca.

The crowds are, as were those I saw waiting for our flight, mostly white (more on this later), mostly middle-to-old aged, and mostly couples, dressed casual-nice, with men in short-sleeved shirts and women in pant suits. In addition to the couples there are those young-to-middle-aged men who look like they’re going to one of the Police reunion concerts, so eager are they to hear the teachings of the Master first-hand.

A Hilton Hotel is attached to the Qwest complex, and from its doors a more prosperous, jacket-and-tie group of shareholders is walking into the arena. The Hilton, I am told, is where the Buffett elite stay, and it is impossible to book no matter how far in advance the average shareholder tries.

In fact, there is a pecking order to the entire affair that will persist all weekend, at each event: an individual’s status is determined by the length of time the person has been attending a Berkshire meeting.

Mr. Matthews has me hooked: I definitely want to see how his trip turned out, and how he feels about the "Sage of Omaha." But his piece smacks a little too much of Pilgrim's Progress, or the Nuremberg Rallies, not to give me the shivers.

Contrast this with an opinion piece (subscription required) by John Kay in the Financial Times this morning. In it, he comments on a new book on the halo effect by Phil Rosenzweig.

There is a large element in performance that is random, or at least outside the control of the individuals and organisations concerned. The environment changes more than the personalities and corporations that populate it. Winston Churchill was a disastrous chancellor of the exchequer in Britain’s depressed 1920s, but the man of the hour when the country faced Adolf Hitler alone in 1940.

But our search for excessively simple explanations, our desire to find great men and excellent companies, gets in the way of the complex truth. The power of the halo effect means that when things are going well praise spills over to every aspect of performance, but also that when the wheel of fortune spins, the reappraisal is equally extensive.

I tend to think such reappraisals, when they do come, are exaggerated in the short term by the sense of betrayal many people feel when their heros let them down, the outrage from having had the wool pulled over their eyes. The demigod whose feet you kissed a year ago becomes the charlatan you string up from a tree the next. (A recent rereading of the story of the rise and fall of Long Term Capital Management, When Genius Failed, has been instructive for me, especially in light of the current frenzy for alternative investment strategies.)

The people who ride these waves of adulation tend to become convinced of their own greatness and goodness (because so many people tell them so), and they are usually the most surprised when the worm turns. Just think of Richard Grasso's shock, outrage, and—yes—hurt when the Great Men of Wall Street he counted as admirers and friends turned praise into condemnation.

The picture—at least for business figures—is complicated in the United States because it appears that F. Scott Fitzgerald was wrong: there are second (and third, and sometimes fourth) acts in American lives. Rudy Giuliani is living proof.

Corporations may not have the same resiliency as individuals. Mr. Kay writes:

For corporations, the lesson is that there is no recipe for enduring excellence: the distinctive characteristics that yield competitive advantage, because they are hard to replicate or emulate, will inevitably be more appropriate for some conditions than for others. If you top the list of most admired companies, there is only one direction in which your ranking can go, and it will.

In any event, there is one thing of which I am certain. Investment firms and investment gurus, of whatever stripe, are not immune from these laws. Trees do not grow to the skies. Flipped coins do not turn up heads indefinitely. Sooner or later, a reckoning is coming, for all of us. And the ones at the top of the mountain will have the furthest to fall.

Who is next? Steve Schwarzman? James Simons? Warren Buffett?

Hero? Or goat?

Who's your daddy now?

© 2007 The Epicurean Dealmaker. All rights reserved.

Sunday, May 6, 2007

A Tedious Argument of Insidious Intent

My Devoted Readers may have trouble believing this, but it can get a little lonely here on occasion in the volcano lair. This blogsite as yet does not attract the sort of voluminous and incisive correspondence that certain reclusive, sardonic, and reputedly attractive private equity memoirists receive. (I am not surprised: who would not rather suck up to a potential fee-paying client—no matter how sardonic—than a logorrheic investment banker?)

Every now and then, however, the little red flag on TED's virtual mailbox pops up, and we get to indulge in a little epistolary back-and-forth with one of you. Today, for instance, a kind reader wrote to reassure me that, pace my recent worrying in these pages, (s)he has no trouble understanding my writings. However, citing what (s)he obviously considered a particularly egregious example of what I might characterize as literary overreach, (s)he remarked:
Strunk & White (probably too provincial for your Cosmopolitan grammatical palate) advise writing in nouns and verbs, not adjectives and adverbs. Otherwise "turgid and elephantine" prose results. It would be dishonest of me to say that phrase has never crossed my mind whilst reading your posts.

("Strunk & White," for those of you in the audience who are numerate yet illiterate, was not a predecessor firm to legendary white shoe investment bank White Weld, later subsumed into Merrill Lynch. It rather refers to that wonderful guide to writing in the English language, The Elements of Style, by William B. Strunk Jr., with revisions, an introduction, and a chapter on writing by E.B. White. Highly recommended for all current and aspiring belle-lettrists.1)

I can certainly appreciate why some might agree with my nameless correspondent's characterization of my outpourings as "turgid and elephantine." I, however, prefer to view them as "turbid and orotund."

In any event, I cannot fault my correspondent's taste in style manuals. In fact, after I concluded our exchange, I took down my dogeared and dusty copy of S&W to leaf through its pages of wisdom yet again. Of course, the book naturally fell open to what is perhaps S&W's most famous dictum, Principle 17 of the Principles of Composition:

"Omit needless words."

For the nonce, I have decided to take that advice.

Okay.
















1 Whatever you do, however, do not buy the awful 2005 edition of S&W with the hideous pink cover and the insipid illustrations by Maira Kalman. Illustrated Strunk & White? The mind reels.
© 2007 The Epicurean Dealmaker. All rights reserved.

Saturday, May 5, 2007

All Rights Reserved

If—and the thing is wildly possible—the charge of writing nonsense were ever brought against the author of this brief but instructive poem, it would be based, I feel convinced, on the line (in p. 18)
"Then the bowsprit got mixed with the rudder sometimes."
In view of this painful possibility, I will not (as I might) appeal indignantly to my other writings as a proof that I am incapable of such a deed: I will not (as I might) point to the strong moral purpose of this poem itself, to the arithmetical principles so cautiously inculcated in it, or to its noble teachings in Natural History—I will take the more prosaic course of simply explaining how it happened.1

Selective market research by Yours Truly among my cherished readership has led me to the unfortunate conclusion that—on any given day—no more than two of you can figure out what the hell I am talking about in these posts.

I have developed a number of hypotheses for why this might be the case, which I am happy to share with you while I continue to formulate a fully fashioned theory to explain the data:

1) On any given day, no more than two of you are Not Complete Idiots

2) The University of Central Iowa was fresh out of CliffsNotes® ("rip it™ and cram it: Fuel your brain with rip it™. Learn fast with CliffsNotes™") when you took the introductory lit course "Classic Novels by Dead White Males" freshman year

3) You have not seen a dictionary since your grandmother gave you a Websters Condensed edition in fourth grade, and you are not sure you would know how to use it if you stumbled across one

4) MSN Explorer cannot properly display words containing more than two syllables or ten letters

5) My writing is too obscure

Naturally, I included that last one only in the interest of theoretical completeness, and I am inclined to discard it out of hand as being nonsensical. Something tells me, however, that there may be a germ of truth in it, no matter how painful that fact may be to me.

Unfortunately, even if I wanted to there is no way I could dumb down my writing style to a level appropriate for regular watchers of American Idol

"Fish gotta swim, birds gotta fly,
I gotta love one man 'til I die"

—but I can perhaps assist my readers in their enjoyment of my Terpsichorean prose with a little more background. In that spirit, I have offered below some glossarial guidance on the blog topics regularly addressed in these pages. To the extent new topics are added in the future, this list will grow as well. Please, use this list responsibly.

TOPICS ADDRESSED IN THESE PAGES

ad hominem — Scurrilous slander, vile calumny, and cheap shots levelled at those among the Great and Good deserving of such treatment (i.e., most of them). A perennial favorite of our readers, and one guaranteed to continue ad infinitum, given the reliably ludicrous and pathetic behavior of said G&G.

bon mots — Memorable quotes and other tidbits authored by persons not formally employed by TED or its Cayman Islands affiliates.

Folly — A catch all topic, which should be self-explanatory to anyone with more than a third grade reading level.

fourth estate — Affectionate gibes and tender pokes at the follies, pretensions, and general misdeeds of our fellow bloggers and friends among the financial press and mainstream media. Always good for a cheap laugh.

ghost in the machine — Discursions on financial bubbles, the madness of crowds, animal spirits, and other evidence that the relationship of rationality to human behavior in the business and financial spheres is tenuous, contingent, and highly suspect.

gray flannel suits — Dispatches from the bowels of Corporate America, in all its craven, sclerotic, and bombastic glory. Proven to be an effective antidote to overdoses of Fortune, BusinessWeek, and other corporate panegyrics.

over there — Our intrepid reporters scour the globe for proof that countries other than the United States are also blighted with stupid, deceitful, and foolish morons cluttering the business, financial, and economic landscape. We have warehouses full of supporting evidence, which only await translation for publication.

philosophy — The occasional descent into mawkish self-regard, gratuitous pontificating, and specious sophistry you would normally expect from a website named after a long-dead Greek philosopher.

private equity — What, have you been asleep? Fail to renew your subscription to all newspapers and magazines other than Hello!? I fear this topic will continue to balloon in number of posts contributed as long as the current (May 2007) boom in PE fundraising and investment continues. After the bubble bursts, this topic should fade into justified obscurity on the dusty back shelf of the archives room, where it belongs (and where many of its practitioners would prefer it had remained).

selling short — Shits and giggles about hedge funds and their peccadilloes, large and small. Most of these guys have more money than Henry Kravis and less time to have gotten used to it. A promising topic, from which we at TED expect a lot in the future. Timmberrr!

The Life — Inside dirt on investment banking and other such whores financial service providers. Sort of like The Godfather, but with classier cufflinks.

1 Lewis Carroll, "The Hunting of the Snark: An Agony in Eight Fits," Chatto & Windus Ltd., 1981, p. v.

© 2007 The Epicurean Dealmaker. All rights reserved.

You Know Much That Is Hidden, O Tim

Deal Journal at WSJ.com interrupted UBS investment banking satrap Huw Jenkins at his Supervisory Board-mandated yodeling and alpenhorn practice earlier today to discuss the Swiss chocolate maker watch manufacturer universal bank's credit policies, which have been faulted for the inability of the firm to punch as many leveraged buyout tickets as its competitors in the current deal frenzy.

The interview was apparently kept short, but a smiling Jenkins did drop a minor bombshell of sorts:
The company already has taken steps to make improvements amid widespread griping within its banker ranks, by hiring McKinsey & Co. around the end of last year. That sped up the lending process by giving more decision-making power to people within the investment bank and increasing their client-funding capacity, some inside the firm say.

McKinsey? Fuck me. That's a sorry-assed commentary on UBS's internal management capabilities when they have to ask a bunch of pencil-pushing Powerpoint witch doctors from McKinsey to tell them how to run an integrated banking and lending practice. That's what universal banks do.

No word yet as to whether McKinsey will give the UBS Credit Committee seminars on how to go to the bathroom without pissing on their shoes.

I know what Long or Short Capital would recommend: Short UBS in size. More aggressive traders can leverage their short with barrier put options on Lindt chocolate and cuckoo clocks.

© 2007 The Epicurean Dealmaker. All rights reserved.