Monday, March 31, 2014

Investment Advice from the World’s Largest Money Manager: Part 2

Investment Advice from the World’s Largest Money Manager: Part 2

In my last blog post, I discussed a research report from Blackrock that explored the new frontier of equity investing that lies beyond the developing markets.  Today, I want to explore Laurence Fink’s letter to corporate CEOs.[1]  Mr. Fink is chairman of Blackrock and has a huge business interest in maintaining the health of long-term investing.  Blackrock’s index mandates, exchange trade funds, and even some of its active mandates hold equities over extended periods of time.  These investment products are highly dependent on good corporate governance, since they don’t sell holdings at the first sign of trouble.  Ironically, Blackrock also offers hedge funds and fund of funds that are the target of Mr. Fink’s concern.
Wye River 1 (1998)
In the letter, Mr. Fink counsels corporate executives to keep their eyes on the long-term interests of shareholders.  Mr. Fink is legitimately concerned that companies will pay dividends, buy back stock, and/or leverage the company in order to placate activist investors or other short-term speculators.  For index investors these types of scenarios are a nightmare, because the short-term appreciation in the stock is unsustainable.  Long after the activists have sold their shares, index investors will still be holders of the company’s stock.  Having failed to invest in research and development, new products, or capital improvements, the company will be a hollow shell.

There are, of course, times when a company should be returning cash to investors either in the form of dividends or share repurchases.  A basic financial principle states that a company should only invest back into the business if it can at least earn its cost of capital.  If a corporate investment returns less than the cost of capital, it simply destroys shareholder value, and a company’s stock will decline.  The financial landscape is littered with companies that poured money into unproductive projects or senseless acquisitions.  In other words, activist investors do, from time-to-time, perform a useful function by pressuring management to cease mindless empire building in favor of productive actions.

However, all too many activist investors are simply rewarded for generating short-term profits.  Their fees and incentives are tied to making money over short periods of time.  If they can drive a quick profit by holding a company and its management hostage, they’ll gladly do so.  Thus the financial landscape is also littered with the carcasses of companies stripped of value by short-term quick fixes.  As institutional investors pour more and more money into activist strategies, I think it is well worth heeding Mr. Fink’s advice.

From an investor’s perspective, the key question is whether the management and the board of directors are maintaining a long-term focus, and whether they are making sound judgments when it comes to deploying capital or returning it to shareholders.  As the largest manager of index products, Blackrock has but one tool for influencing the people who run and oversee companies: the proxy.  According to David Benoit and Liz Hoffman of The Wall Street Journal, Blackrock has taken a more active role in recent years.[2]  As a result, Blackstone should be an ally of activist investors when they pressure a company that has grossly underperformed.  Unfortunately, many mutual funds and institutional investors have become so short-term focused that they don’t take the proxy and corporate governance seriously.  Instead of just writing to corporate CEOs, Mr. Fink should be also be talking to his fellow investors.  Collectively they’re the ones who own the companies.


Saturday, March 29, 2014

Carlyle Follow Up: A Big Change in Incentives

Carlyle Follow Up:  A Big Change in Incentives

A few days ago I wrote about Michael Cavanagh’s departure from JP Morgan to become co-President of Carlyle (“Money and Culture at Carlyle [March 27, 2014]”).  The outlines of Mr. Cavanagh’s new financial arrangements have been filed with the SEC.[1] As expected, he won’t be taking home as much cash as he did at JP Morgan.   However, he will be receiving three years of guaranteed cash bonuses to smooth the transition. He’ll also be granted a couple million dollars worth of deferred restricted stock units (DRUs) each year. 

There are two aspects of his deal that are worth mentioning.  First, Mr. Cavanagh will get 933,146 DRUs to compensate him for roughly $30 million in JP Morgan equity that had not yet vested.  Second, Mr. Cavanagh’s hiring has forced Carlyle to create a new key executive incentive program, which will apply to the co-Presidents and the CFO.  As I noted in my previous post, the founders and Glenn Youngkin have been significant investors in Carlyle’s funds.   Newly hired executives have not had the financial wherewithal to make sizable investments in the funds.  Moreover, Carlyle has given carried interest to the professionals making investments, rather than to senior executives.  Thus it was difficult for senior professionals to be aligned with their investors.

Mr. Cavanagh’s arrival signals an important change.  The co-Presidents and CFO will receive a small percentage of carry that will be paid in DRUs.  Carlyle's SEC filing makes clear that this program can be expanded to other senior executives.  In other words, Carlyle will begin paying people carry even though they aren’t directly involved in sourcing, managing, and realizing investments.  This is the kind of incentive program one tends to see at banks and investment banks, where senior executives get overrides just because they can.  While this new program will probably make Mr. Cavanagh extremely wealthy, it will also help to undermine the culture and cohesiveness at Carlyle.

There’s one more amazing detail.  Mr. Cavanagh is entitled to a piece of any carried interest generated from investments in 2013 and 2014.   That’s a pretty good deal considering Mr. Cavanagh was working for JP Morgan when most of the relevant investments occurred.

Shareholders and investors at Carlyle should be asking questions, because this isn't the deal they signed up for.


Friday, March 28, 2014

Investment Advice from the World’s Largest Money Manager: Part 1

Investment Advice from the World’s Largest Money Manager: Part 1

Blackrock is the largest money manager in the world, with $4.3 trillion in assets under management.  In the last week, I’ve collected two interesting items issued by the firm. The first is a research piece issued by Blackrock Beta Research Group that makes the case for investing in the farthest reaches of the developing markets; places like Kenya, Lebanon, and Sri Lanka.[1]  Blackrock calls these countries the frontier markets.  The second item is a letter written by Blackrock’s chairman Laurence Fink to the chairmen or CEOs of every company in the S&P 500 urging them to resist the short-term orientation of activist investors.
Venn Diagram (2000)
Blackrock manages $1.7 trillion in index investments, $1.4 trillion in active strategies, and 0.9 trillion in exchange-traded funds.   When Mr. Fink speaks about corporate governance it is worth listening, because Blackrock holds $2.3 trillion in equities.[2]  Moreover, as an index manager Blackrock is truly a long-term investor whose sole instrument for affecting corporate behavior is proxy voting.  I’ll discuss Mr. Fink’s letter Monday.

The research paper, “Crossing the Frontier: Accessing new sources of growth and diversification with frontier markets” illustrates the distances to which investors have to go to find new sources of return and diversification.  Thirty years ago, US investors sought out the developed markets of Europe and Asia for a new source of investment and risk reduction.  About twenty years ago they pursued opportunities in the emerging markets for the same reasons.  Today any institutional or retail investor can quickly create exposure to foreign markets without giving it a second thought.  However, as these markets have become integrated into the global financial system, their returns and risk have become more correlated to the US markets.  In short, the benefits have faded as we’ve integrated these equity markets into our investible universe.

Blackrock has identified the next frontier, where expected growth rates and risk are high but where correlations (the relationships between those markets) are still low.  As Blackrock’s research shows, the currencies of these countries are relatively stable versus the dollar.  All of this makes for a very attractive investment opportunity.  And as long as we observe those markets and don’t try to invest in them, Blackrock’s research will look compelling.  I’ve included below two key charts from the research that illustrate the stability of their currencies versus the dollar and the low correlation between their markets.

However, these markets are relatively small, since most of their investment capital is either supplied locally or by very adventurous foreign investors.  What do you think happens when American, European, and Asian investors begin to pour money into index funds, ETFs and active strategies targeting frontier markets?  Invariably, the correlations will begin to rise as the capital inflows wash through those markets.  In addition, the currencies will begin to swing because foreign investors will now be buying large quantities of Kenyan schillings, Lebanese pounds, and Sri Lankan rupees.  Of course, when foreigners periodically sell, the currencies will swoon and those local markets will shudder.

I’m not suggesting that adventurous investors should avoid the frontier markets.  There’s nothing wrong with building a very diversified portfolio of frontier markets with a small portion of an investor’s capital.  However, the attractive characteristics described by Blackrock are going to be fundamentally changed when American and other investors from developed markets invest their capital in the new frontier.

The very same phenomena took place when American equity began investing in earnest in Europe and Japan, and again when we discovered Korea, Taiwan, and Eastern Europe.  The lesson is straightforward.  Observations about markets seldom account for the impact that investors have when they arrive en masse to exploit the apparent opportunity.


Thursday, March 27, 2014

Money and Culture at Carlyle

Money and Culture at Carlyle

Yesterday Michael Cavanagh left his post as co-leader of JP Morgan’s investment bank in order to become co-President of Carlyle Group.  Mr. Cavanagh has worked with Jamie Dimon, Chairman of JP Morgan, since Mr. Dimon was at Citigroup well over a decade ago.  He followed Mr. Dimon to Bank One and remained a confidant during the merger between Bank One and JP Morgan.  According to various press reports, Mr. Cavanagh’s departure came as a surprise to Mr. Dimon and was prompted in part by the increasingly strict regulatory environment confronting banks.
State College Quant (1999)
In my view Mr. Cavanagh’s departure has a great deal to do with money.  Carlyle Group, is as a diversified alternative money manager, enables Mr. Cavanagh to reach a new level of compensation and wealth.  As I’ll explain in a bit, I think the transition to Carlyle may prove to be more difficult as Mr. Cavanagh moves into a brand new culture.

Mr. Cavanagh was doing quite well for himself at JP Morgan.  As the bank’s CFO, his compensation and stock ownership were reported in JP Morgan’s annual proxy statements.  In 2010, he was made about $10 million after two relatively lean years in which his total compensation was $7.6 million and $6.1 million respectively.  He also owned or was entitled to about 1.4 million shares through various stock and option programs, which would be worth about $85 million today.  In 2010, he became CEO of Treasury and Security Services and then ascended to co-head the investment bank.  Although his compensation and holdings are no longer reported, we can be sure he made a lot more money and received more stock incentives in his new roles.

In fact, the heads of JP Morgan’s Retail Financial Services, Investment Bank, and Investment Office were making significantly more money and building up more equity than Mr. Cavanagh when he was still CFO.[1]  He needed to sit atop a profit center within the bank in order to reach the next level of remuneration.  We can get some idea about how much he made because the co-head of the Investment Bank, Daniel Pietro, was listed in the 2012 proxy statement with total compensation of $17 million.[2]  

In order to see what Mr. Cavanagh could make at Carlyle, we need to take a look at Glenn Youngkin’s compensation and holdings, because he is the other co-President.   As we examine the sources of Mr. Youngkin’s wealth and compensation, we’ll also see some possible signs of what might undermine their partnership at the helm of Carlyle.  In 2013 Mr. Youngkin made $10.6 million, which was down 39% from the $17.2 million he made in 2012 and down even further from his total compensation of $21.3 million in 2011.[3] Mr. Youngkin’s total compensation appears to be falling because his carried interest payments from his previous role running buy-out funds are slowly winding down.   Without those payments, Mr. Youngkin only took home about $2.5 million per year.  While this looks like a far cry from what Mr. Cavanagh earned at JPM Morgan, it doesn’t begin to describe how Mr. Youngkin makes his money.

Mr. Youngkin also owns some 5.7 million shares in Carlyle worth about $187 million. These shares pay hefty annual distributions.  Last year the distribution was $1.97/share or roughly $11.2 million.  By the way, the three founders of Carlyle earned about $230 million from their distributions. 

Mr. Youngkin has also been a long-time investor in Carlyle’s funds.  In the last two years he has received $48.7 million in distributions from various funds.  Investing in your own funds is particularly lucrative, because private equity executives don’t pay management fees or carried interest.  In other words, they probably make 25% to 35% more than their clients on the same investments.

While we can expect Mr. Cavanagh to get a hefty salary and a slug of stock appreciation units for signing on at Carlyle, he can’t possibly replicate the sources of Mr. Youngkin’s income any time soon.  Moreover, Mr. Cavanagh continues to invest heavily in Carlyle’s products.  In the past two years he’s invested $24.7 million in various Carlyle offerings, while committing to invest $92.0 million over the next several years.  Carlyle has hired a host of other executives in the past several years, and none of them have the financial wherewithal to invest the way the founders and Mr. Youngkin invest in Carlyle’s products. 

In the past two years, the founders of Carlyle have committed $1.8 billion to various funds.  This commitment appears to be important to Carlyle’s culture and distinguishes the firm from other publicly traded private equity firms.  Henry Kravis, George Roberts, and Leon Black aren’t making nearly the same commitment at KKR or Apollo Global.[4] 

While there’s plenty of money to lure new executives to Carlyle, including Mr. Cavanagh, I’m betting that the old guard and the new guard will chafe over time.  The founders and other long-term executives at Carlyle have worked together and made their fortunes in a certain manner.  The recruits have twenty or thirty years working with very different incentives.

You’d think that everyone should be extremely happy because they are making so much money, no matter the source.  In money management, no one remains happy for long when it comes to money.

[1] For example, Ina Drew made $15 million as Chief Investment Officer, Charles Scharf earned $12 million as CEO of Retail Financial Services and James Stalely made $17 million as CEO of the Investment Bank. at page 16.
[2] at page 23.  The 2013 proxy statement will be available to about two weeks.
[4] Blackstone doesn’t provide this type of data in its proxy.  Steve Schwarzmann received $78 million in distributions in 2013 from existing funds, but we don’t know how much he committed to new funds.