Monday, December 30, 2013

Academic Research and Wall Street: What Do You Expect?

Academic Research and Wall Street: What Do You Expect?

The New York Times explores the link between academic research and Wall Street in a lengthy story about a couple of professors who received financial support for work on the role of speculators in the commodities market.[1]  Professors Craig Pirrong at the University of Houston and Scott Irwin at the University of Illinois have written and testified extensively on the general benefits of financial speculation in the commodities markets.   In this context, speculation means investing in a commodities contract with no intention of actually taking delivery of the underlying commodity.  The Times article principally focuses on the lack of transparency concerning Professors Pirrong’s and Irwin’s industry affiliations. 
Sales Forecast (2008)
Unfortunately, The Times investigation is wholly unsatisfactory.  The article fails to show that any of Pirrong’s or Irwin’s research is incorrect.  It only illustrates that their findings are generally supportive of their industry benefactors.  This shouldn’t come as a surprise.  Academics who receive financial backing from industry tend to produce research that backs the industry’s position.    Industry paid for the work, and they’re not going to want it disseminated if it doesn’t serve their interests. 

Mr. Pirrong’s reaction to The Times inquiry is disappointing and predictable.  He asserts that his research is unbiased and that there’s no conflict of interest between his work and the source of his funding.  Of course, if the Professor had admitted that bias might slip into his work, or that there was the possibility of conflict, he would have been the first researcher ever to make such an admission.  It’s just like politicians who tell us that campaign contributions don’t influence their policy positions. 

The Times ignores another major issue in industry-sponsored research: access to data.  Whether its research on hedge funds, private equity, or commodities, much of the data needed to conduct studies is not publicly available.  I suspect that many academics have to affiliate with industry in order to get the data on trades or deals necessary to produce a paper.  Those professors who remain independent are at a distinct data disadvantage.

Rather than picking on two professors, The New York Times would better serve the public if they took a broader look at the extent to which Wall Street and money managers are underwriting business and economic research.  From my experience, Wall Street is a major underwriter of business schools and economic departments.  Wall Street never underwrites anyone without getting something back.


Thursday, December 26, 2013

Making Money Doesn’t Mean One Added Value

Making Money Doesn’t Mean One Added Value

Carl Icahn made over a billion dollars by restructuring part of CVR Energy (NYSE: CVI) into a Master Limited Partnership (MLP).  As a regular corporation CVR had to pay corporate taxes, and investors had to pay taxes on any dividends.  As an MLP all the tax liabilities are passed through to investors, and double taxation is eliminated.  As David Gelles points out in The New York Times,[1] there’s been a steady stream of MLP deals since 2007.  Investors are eager for the yield produced by these sorts of investments. 

The details of Mr. Icahn’s exploits are ably laid out in Mr. Gelles’ story, so I won’t repeat them. Mr. Icahn’s use of the term “value” caught my attention.  He said, “We saw the added value of creating a M.L.P.”  As far as I can tell Mr. Icahn followed a well-established tax strategy, rather than creating any particular value.  Investment bankers and investment managers tend to prefer talking about value creation rather than making money.  Describing an investment as having “added value” tends to confer a touch of economic validity to a moneymaking trade.

There's little doubt that Mr. Icahn made a lot of money adopting the new legal structure. CVR Energy is still in the refining business, and day-to-day operations weren’t improved in any way. Mr. Icahn merely took advantage of the tax code.  The initial public offering of the MLP allowed the company to pay Mr. Icahn a hefty dividend with the proceeds.  Moreover, as investors chased after yield, the MLP’s value escalated.   Mr. Icahn deserves credit for making a shrewd investment.  However, he didn’t create any real value.


Tuesday, December 24, 2013

Christmas Cookies and Managing Money

Christmas Cookies and Managing Money

At the close of trading on December 23, 1992, I ended my career as a hands-on institutional portfolio manager.  That year is not very memorable in stock market history.  After a bunch of ups and downs, the market posted a 7.6% gain.  Although the market eked out a small return for the final month of the year, my portfolios, representing about $3.5 billion in client assets, gyrated wildly.  As December began, I’d built a 2.5% lead over the S&P 500 in a year where institutional managers were struggling to beat the market.
Merry Christmas and Happy New Year !
My computer screen had a small box in the upper left corner that continually compared my performance to the S&P 500.  I hated that box, and it produced endless bouts of stress.  In August, IBM had driven me out of the office when it announced that mainframe sales had gone flat.  The stock plummeted and my lead over the S&P 500 vanished.  The managing directors at my firm kept walking into my office asking me what I was going to do about IBM.  They offered conflicting opinions.  I bolted, driving the back roads around Westchester Airport and walking the trail along the Byrum Gorge to calm my nerves.  I’d do anything to get away from that little box on my computer screen.

By December, I had my lead back as well as a conviction that I needed to stop managing money.  Around the middle of the month several key holdings started to falter.  There were rumblings that lawyers were about to have a breakthrough in a series of lawsuits against the makers of gel breast implants.  I owned Corning Glass and Dow Chemical.   They jointly owned Dow Corning, an implant manufacturer.  I also held Bristol Myer, which had a subsidiary that made implants.  Those stocks started trading lower and my advantage shrank.

My analyst, Cathy Moore, got on the phone with the companies and various Wall Street analysts.  It was hard to gauge the outcome of the litigation.  The managing directors camped out in my office pressing me for answers.  They especially wanted to know if I was going to beat the S&P 500, because they’d been telling clients we were ahead of the market.  One of the managing directors was a chartist and kept telling me that one stock chart or another “looked horrible” or “had bounced off an important support level [I think that’s supposed to be good].”  My trader was telling me the markets were very illiquid, and I wouldn’t be able to buy or sell any of these securities without disturbing the market.

On December 23rd, a jury awarded Pamela Jean Johnson $25 million from a subsidiary of Bristol Myers.  She’d sought $63 million.  With Wall Street preparing for the holidays, there weren’t too many investors or traders around, and the selling precipitated by the jury decision turned into a rout.  Suddenly the market was convinced that the hundreds of other pending lawsuits might in fact succeed.  My lead over the S&P 500 was gone, and so was I.

At the close of trading, I wished everyone a Merry Christmas and went home for the remainder of the year.  There was no sense in trying to move the portfolio around and trade my way out of my growing deficit against the S&P 500.  I joined my wife and kids in baking cookies and ignored the stock market.

I spent the week after Christmas with family and friends, and avoided the little box on my computer screen.  On January 2nd, I returned to the office to discover that my portfolios had rallied and I’d eked out a 70 BP (0.70%) margin over the market.  In the end, baking cookies with the kids was far more rewarding than beating the market.

Monday, December 23, 2013

Non-Remedy Remedies

Non-Remedy Remedies

For the past couple of days, I’ve been examining a report issued[1] by the North Carolina State Treasurer about placement agents.  So far I’ve looked at the procedural recommendations, (see, “When Lawyers Manage Investments”) and the substantive findings (“Unbaked Bread”).   Today I’m going to explore the remedies and fee concessions obtained from eight of the nine managers discussed in the report, as well as the decision by one manager not to negotiate.[2]  I’m sure a great deal of work went into the report and investigation.  However, the remedies and monetary recoveries leave something to be desired.
Division of Labor (1999)

There’s virtually no substance to the four remedies negotiated by the pension plan.  The first remedy bans gifts to employees of the plan.  It’s not much of a sanction, since the Treasurer has already enacted a Code of Ethics that bans gifts from all money managers.  Next, the eight managers agreed to a ban gifts to charitable causes on behalf of an employee of the plan.  Again, the Code of Ethics has the same ban applied to all managers.

Then the eight managers agreed to a ban from using a placement agent to solicit new business from North Carolina.  This remedy should be called, “the money manager profit enhancement act.”  Since the managers already have a relationship with the State, they really don’t need a placement agent.  However, if they wanted to pay a placement agent a fee for this service, it would be their money and not the pension plan’s money going to waste.  The State is saving these eight managers from themselves.  It’s also worth pointing out that Angelo Gordon agreed to a ban on placement agents although they’d never used one.

The final remedy bans the eight managers from making campaign contributions to anyone running for the office of State Treasurer.  The SEC already limits campaign contributions by money managers to $350 or $150 depending on whether they can vote for the candidate.  This ban will save the eight firms some pocket change.  If the State Treasurer is worried about appearances, she shouldn’t take contributions, however small, from the pension’s     existing or prospective managers.

Refunds and Discounts

At the beginning of the report, the authors herald an estimated $15 million in refunds and discounts.[3]  These numbers don’t bear up under scrutiny.  For example, any money collected isn’t a refund.  The pension plan didn’t pay the placement agent; the managers did.   The report speculates that the fees might have been lower if the placement agents hadn’t been involved in the first place.  The pension plan collected the refunds because the managers wanted to keep their multi-million dollar relationships. 

The Retirement System failed to reach an agreement with C.B. Richard Ellis and as a result, the report states that the pension system “will not engage in any further business with CBRE in the future.”[4]  CBRE had no incentive to reach an agreement.  The investment, CBRE Strategic Partners IV, has generated an annual loss of 27.34% since 2005.[5]  Moreover, CBRE has already charged most of the fees it will receive, as Partners IV is beyond the investment period.[6]  In short, CBRE knew they weren’t going to be rehired anyway, so they had no incentive to reach a settlement. 

In the case of Avista, a private equity manager, the report says that the pension plan saved  $3.2 million because Avista will offer a 25BP discount if the pension decides to invest in Avista’s next fund.  I think there’s a very good chance that the pension plan would have gotten the discount anyway.  As a large, three-time investor this kind of fee concession wouldn’t be unusual.  In addition, the present value of the fee discount is significantly less that $3.2 million, since it would be realized over the next five to ten years.

The lion’s share of the refund claimed in the report is generated from Longview, a global equity manager, which agreed to pay $10 million through a quarterly $500,000 fee reduction.  This arrangement is a decent result for Longview.  While they could be terminated at any time, under this contract they need to remain a manager with the pension for five years in order for the pension plan to receive the full refund.   My guess is that Longview is making at least $5 million to $7 million a year in management fees.  Assuming no market appreciation, Longview will still generate $15 to $25 million after paying the “refund” over the next five years.[7]  I had to guess  at Longview’s fee arrangement because North Carolina does not disclose the fees it pays to managers.

Conclusion: After a four investigation the pension plan will be, according to the report’s math, richer by $15 million or a mere 0.018%.  I hope the various studies, consultants, lawyers, and other expenses put into this project didn’t cost more than $15 million.  Of course, those items aren’t disclosed, so we don’t know how much this special report has cost the pension plan. 

[2] C.B. Richard Ellis refused to settle.  
[3] Report, Tab1, page 3
[4] Report, Tab 2, Page 8
[5] Report, Tab 2, Page 17
[6] The management fee is usually cut in half at the end of the investment period.  The investment period is typically a five to seven year period during which a manager invests capital in deals or real estate.
[7] Earnest Partners agreed to rebate $660,000 in fees.  My guess is that they make about $1.3 to $1.5 million per year, and of course have made a lot of money over the past ten years.  Moreover, they manage a small piece of the North Carolina Supplemental Retirement Plan.[7]  So the rebate from Earnest was very modest.

Friday, December 20, 2013

A Brief Primer on the Realities of Placement Agents and Investment Consultants

A Brief Primer on the Realities of Placement Agents and Investment Consultants

I thought it might be helpful to my readers to explain the role of placement agents and consultants in the hiring of money managers.  After reading “Report Concerning Placement Agent Review,” I think the authors of the report would have benefitted from a better understanding of the realities of each of these advisory businesses.

Placement Agents

Placement agents are retained and paid by money managers as third-party marketers.  Although their fee is only a small percentage of the assets raised, the overall fee can quickly add up to a seven-figure payday.  However, in the absence of the placement agent, the money manager would probably have to pay that seven-figure amount to a group of internal marketers.  While most placement agents will do some due diligence on their money management client, their primary role is to provide access to potential investors.  An investor should never rely on the placement agent’s due diligence.

Some placement agents, particularly those housed in large banks, may also offer compliance services to money managers so that the money manager doesn’t run afoul of securities laws involving the solicitation of private offerings.  Many placement agents also coordinate the scheduling and logistics of taking the money manager on multi-city tours to visit potential investors.

While you may not like the sound of it, a placement agent gets paid for obtaining access to potential clients.  That’s their job, and it is valuable to money managers; otherwise they wouldn’t engage placement agents.  Pension plans and endowments are buried in deep piles of investment proposals and offering memoranda.  If the money manager doesn’t have a marketer with the requisite experience or contacts, it is going to be extremely difficult to obtain even an introductory meeting.  So the placement agent’s job is to get someone at a pension or endowment to take a meeting with a money manager and hopefully get them interested enough to do due diligence and make a commitment.

A good placement agent can save an investor a great deal of time by helping to point out opportunities that warrant the investor’s attention.  Admittedly, some placement agents are just pests who bombard the investor with all sorts of potential investments.  On occasion in my tenure with the pension plan, a placement agent turned out to be extremely useful in convincing the money manager to give me critical due diligence information.  After all, the placement agent doesn’t get paid unless the investor makes a commitment.  Thus the agent had a big incentive to convince his client, the money manager, to satisfy all my due diligence needs.

There’s nothing unusual about managers using multiple placement agents or placement agents hiring sub-agents.  Some agents have better contacts at public funds and others are more experienced with endowments.  Money managers are more likely to use placement agents when they market overseas even if they have a deep marketing team.  A local placement agent is going to have a better contact list and knowledge of the legal necessities of marketing.

As I see it, there are two potential problems with placement agents.  First, there’s the placement agent who is more than an introducer, and who gains influence over the investor’s decision-making process.  As CIO for North Carolina, I always told placement agents that I preferred that they not attend meetings.  However, if they insisted on showing up, I didn’t want them to speak at all.  I wanted the money manager and not the placement agent to answer my questions.  Nonetheless, I’ve seen placement agents get too involved.  Ironically, it’s not the politically connected sorts of  placement agents who cross this line.  They don’t know enough about investments to interject.

Second, there’s the placement agent who is conveniently injected into the hiring process in order to get paid.  In other words, the investor was inclined to meet with the money manager, and the investor had a hand in putting the placement agent in front of the money manager.  This kind of activity was at the heart of improper practices in California and New York and led to Treasurer Cowell’s examination of the practices under her predecessor.

There’s a huge irony in the crackdown on placement agents by North Carolina and other states.  While those placement agents with political or personal connections with investment decision-making are suspected of undue influence, the placement agents with the biggest influence get to fly under the radar.  The big placement agents, particularly those associated with big banks, can show that they have no direct political or personal connection.  However, because their firms offer all sorts of other financial products and services, they can gain access and influence that is far beyond the capabilities of your average local politician.  Moreover, the new regulations imposed by the SEC and the various states are a minor cost for the big boys.

Investment Consultants

Investment Consultants are hired by investors to supplement the internal capabilities of their staffs.  The idea is to hire someone who can screen investment opportunities, conduct due diligence, and make recommendations.  At various points in the Treasurer’s report, there are references to “independent” or “objective” consultants; the inference being that these folks provide an unbiased set of services.  In thirty plus years, I’ve never met an investment consultant that satisfies either of those terms.  There is no business more prone to conflict of interest, client pressure, and biased advice than investment consulting.  Much of the problem stems from consulting’s business model, which provides scant profit margins while evaluating managers making big fees.

While some consultants strive to achieve the report’s ideal, most of them fall short.
The goal of the consultant isn’t to provide impartial advice, it’s to keep the relationship with the investor.  Thus, the advice is often tailored to what the investor wants to hear.  If the investor is inclined to make an investment with a particular manager, the consultant’s report will be shaded.  The consultant isn’t going to want to write a report that will embarrass the investor or wind up in the investor’s files as fodder for an auditor or public records request.

Because the profit margins are slim, consultants often engage in other businesses.  Some consultants provide advisory services to money managers in order to help them better position their product.  I trust you see the potential conflict in this line of work.  Other consultants run fund of funds businesses.  In other words, they’re not only recommending investments for consulting clients, they are also investing in managers through their fund of funds. 

Late in my tenure with the state, we had a consultant who also ran a fund of funds.  We were making a second investment with the manager and requested a $100 million allocation.  The manager tried to cut us back because our consultant had also requested an allocation.  In other words, the consultant was benefiting from our due diligence and relationship.  I don’t know if the consultant got an allocation, but after a phone call the pension plan received its full allocation.

Investment consultants purport to provide customized research tailored to specific clients.  I know of only one or two consultants who did this, and they are overworked people.  Customization is an anathema to consulting.  Unless you can recommend a manager or use investment studies for multiple clients, the business model just doesn’t work.  An investment consultant can ill-afford to do tailored work for a client.  However with a computer and PowerPoint, it’s not hard to generate impressive looking reports that justify whatever the fiduciary or staff has decided to do.


Neither the placement agent nor the consulting businesses are pristine endeavors, and no amount of internal policies will change that fact.  In the case of placement agents, the economic proposition is clear: it is fees for access.  In the case of investment consultants, the economic proposition is harder to discern.  However, most of the consultant’s fee is earned for providing the pension plan with political cover.

If you really want to understand how influence works in a public pension please read, “Private Equity: Democratic Style.” (November 21, 2012).  It is the story of how Steve Rattner (Quadrangle Group, and ex-auto czar) and Ron Burkle (Yucaipa Companies) managed to get to the front of the investment queue even though there wasn’t a placement agent, consultant, or  prior relationship in sight.  It takes trust and not voluminous policy manuals to deal with these situations.