Tuesday, September 30, 2014

Setting Up Shop at Janus Isn’t Okay: William Gross Leaves PIMCO

Setting Up Shop at Janus Isn’t Okay: William Gross Leaves PIMCO

Pacific Investment Management Company (PIMCO) is scrambling to set up meetings with concerned institutional investors and conference calls to try to stanch the redemptions of mutual fund shareholders.  Meanwhile, William Gross is already into his second day as an employee of Janus Capital Group.  There’s something wrong with this picture, and I think the following statement by Mr. Gross captures it:

[A]fter having spent considerable time serving in senior management, it is a time for me to reduce executive and people management responsibilities at a larger firm and focus on the pure aspects of portfolio management at a smaller one.[1]

Mr. Gross seems to be telling us that his management duties at PIMCO interfered with ability to manage the $223 billion Total Return Fund, roughly $80 billion in 16 other funds, and another $153 billion in 128 accounts.[2]  Under Mr. Gross’s leadership, PIMCO had been experiencing significant turmoil for some time.  According to various press reports, various maneuvers were underway to terminate Mr. Gross’s employment. 

His inability to focus over the past year or two isn’t surprising.    However, this state of affairs is completely inexcusable.  Mr. Gross’s primary duty should have been to his investors spread across all of the offerings in which he was listed as their portfolio manager.  While PIMCO was all too happy to earn billions of dollars of fees based on Mr. Gross’s investment reputation, Mr. Gross and his colleagues seem to have devoted too much of their time and energy to office intrigue and their own financial well-being.

In many other professions, Mr. Gross wouldn’t be allowed to set up shop over the weekend.  If Mr. Gross were an airline pilot or doctor, his conduct and performance would probably subject him to some level of scrutiny before he’d be allowed to open for business again.  He’s leaving a big mess behind at PIMCO that should be properly understood before investors trust him with their assets.   The stock market isn’t thinking about such niceties.  Janus’s stock was up 43% on Friday (it sold off 7.5% yesterday).   Investors are betting that Mr. Gross and Janus will be able to crank up their marketing machine and reel in assets.  The market is usually right about such things.  Nonetheless, if I were an investor in Mr. Gross’s former products or a prospective client for his new offerings, I’d be steering clear.

Monday, September 29, 2014

CalPERS Didn’t Exit Hedge Funds

CalPERS Didn’t Exit Hedge Funds

Thousands and thousands of words have been written about CalPERS’ decision to exit hedge funds.  Reporters and commentators have questioned whether this is the beginning of a trend or merely an isolated decision.  For example, Gretchen Morgenson wrote a column last week entitled “Slamming a Door on Hedge Funds” based on the implications of a CalPERS’ eliminating hedge funds from their roster of assets.  The Wall Street Journal led with “Calpers to Exit Hedge Funds.” Every bit of this analysis is based on a false premise.  Only David Ranii of the News & Observer asked CalPERS the relevant question: are you exiting all of your hedge fund exposure?[1]  Mr. Ranii’s article focuses on North Carolina’s intention to continue investing using hedge funds.  Along the way Mr. Ranii unearthed the real story at CalPERS.  Here’s what Mr. Ranii reported:

Although CalPERS appeared to be saying it was ending all hedge fund investments, spokesman Joe DeAnda confirmed that it actually is eliminating a specific hedge fund investment program, which it calls its Absolute Return Strategies program. ARS programs typically involve diversified investments aimed at lowering risk while still generating good returns.

“The decision only impacts our ARS program,” DeAnda said in an email.
“ ‘Hedge’ strategies in other asset classes are not affected.”

In other words, CalPERS is shutting down a specific program but will continue to employ hedge funds in other areas.  Absolute Return Strategies are a cocktail of different hedge fund strategies designed to produce consistent investment returns with low year-to-year volatility.  CalPERS has merely concluded that this specific program doesn’t work.  In my role as CIO for North Carolina, I set up this type of program in 2002.  As I’ve written before, this experiment did not produce either the returns or reduction of risk I expected.  As Mr. Ranii reports, North Carolina has been winding down its absolute return program since 2009.  Rather than being in the vanguard as press reports indicated, CalPERS is following North Carolina, Pennsylvania State Employees Retirement System, and other pension plans in questioning absolute return strategies.

Unfortunately, we’ve made little progress in addressing the high fees, hidden exposures, dearth of adequate benchmarks, and lack of transparency represented by hedge funds. CalPERS’ investment program and those of most other public funds are going to continue hiring hedge funds, and the industry’s share of assets will continue to grow.  It turns out that nothing has changed.

[1] http://www.newsobserver.com/2014/09/27/4184322_nc-pension-fund-remains-committed.html?sp=/99/104//&rh=1

Sunday, September 28, 2014

Quick Read: Carlyle Tracks Its LPs at Conference

At Carlyle Group's recent conference for its LPs, it used chips in the name tags to track where its investors went during the conference.  According to the attached article, it isn't clear whether Carlyle told investors beforehand.  Even if they did, this is creepy.


Thursday, September 25, 2014

Cross-Investments: The SEC Settles with Lincolnshire Management

Cross-Investments:  The SEC Settles with Lincolnshire Management

One of the problematic areas in private equity or real estate investing is known as cross-investments.  The SEC has just settled a case that barely scratches the surface of this issue.  A cross-investment occurs when a portfolio company or real estate asset is owned by two or more funds managed by the same manager.  The SEC has just reached a settlement with Lincolnshire Management, a relatively small private equity firm with $1.6 billion in assets.  According to the SEC, two of Lincolnshire’s funds each owned separate businesses which were eventually merged.  As a result, each fund wound up owning a pro rata share of the merged company.  The SEC seems to have had two questions.  First, were the merger expenses allocated equitably between the LPs of the two funds?  Second, did Lincolnshire have policies and procedures for dealing with the equitable distribution of expenses?  No and no. As a result, Lincolnshire agreed to pay a $2.6 million penalty without admitting or denying the charges.[1]

This is the first settlement with a private equity manager resulting from the Office of Compliance Inspections and Examinations’ investigation which was summarized in a speech by Andrew Bowden in May.  Mr. Bowden, my former colleague at Legg Mason, indicated that his examiners had found a significant number of irregularities.[2] In my experience, the SEC always finds a bunch of irregularities when it begins examining a new area of the investment world.[3]   In 1998, the SEC did a sweep of soft dollar practices and found a number of abuses among the 280 money managers they investigated.[4]  In short, there’s no surprise that some PE firms have violated SEC rules, and this particular violation, misallocating expenses, doesn’t seem a particularly egregious sin.   I suspect that there are cost allocation practices used by some private equity firms that are much more troubling. For an example, see my column in the News & Observer, entitled “Raleigh company’s IPO offers look into world of private equity.”[5] 

Nonetheless, lawyers and compliance officers are going to try to figure out if there’s a broader message in the SEC’s settlement with Lincolnshire.  However, a single settlement doesn’t really tell us much.   At a minimum, the Lincolnshire settlement is a reminder of one standard message that the SEC has followed for decades.  No matter the asset class or strategy, the SEC expects to see written procedures, and it expects them to be followed.  It doesn’t take a great deal of sophistication or analysis for the SEC to figure out that procedures were inadequate and/or not followed.  Thus, I expect that a great many alternative managers will be looking through their procedure manuals to see if they’ve spelled out how they deal with cross-investments.

Obviously I don’t know if the SEC is systematically looking at the practice of cross-investments.  The next settlement may be in a totally different area.  However, cross-investments are fertile ground because they are rife with conflicts of interest, and require extensive procedures in order to treat the LPs of each fund equitably.  The typical cross-investment occurs because a manager wants to acquire an asset that is too large for any one fund.  An old fund and newly raised fund both contribute capital to the acquisition.    Making the cross-investment is the easy part. 

However, cross-investments raise much thornier questions than cost allocation.  What happens when the jointly owned company needs more capital or wants to make an acquisition?  Will both the old and new fund be able to continue to maintain their pro rata shares in the company?  In many cases the old fund will be at the end of its investment period or simply have too little capital.  As a result the new fund will start to dilute the new fund’s ownership.  What happens if the business isn’t yet ripe for sale, but the old fund is in liquidation mode?  Who will buy the old fund’s interest, the new fund or a third-party?  The questions go on and on, and require extensive procedures involving advisory committees, third-party valuations, and allocation procedures in order to make sure the LPs in both funds are treated equitably.  The demise of the Internet bubble in the early 2000s exposed the perils of cross-investment as portfolio companies and funds scrambled for capital.  The credit crisis of 2007 exposed another set of cross-invested deals to a variety of conflicting interests. 

Alternative investments are a vast landscape, and the SEC’s resources are limited.  I’d bet that if the SEC continues to look at cross-invested deals, it will find situations that are far stickier than Lincolnshire’s misallocation of expenses.

[1] http://www.sec.gov/litigation/admin/2014/ia-3927.pdf
[2] http://www.sec.gov/News/Speech/Detail/Speech/1370541735361#.VCK8QytdXMU
[3] http://www.bloomberg.com/news/2014-09-22/sec-finds-misrepresentations-by-hedge-funds-bowden-says.html
[4] http://www.sec.gov/news/studies/softdolr.htm#sweep
[5] http://www.newsobserver.com/2014/09/20/4161162/andrew-silton-raleigh-companys.html

Wednesday, September 24, 2014

Hedge Funds Aren’t An Asset Class or a Strategy

Hedge Funds Aren’t An Asset Class or a Strategy

Stephen Davidoff Solomon, the Deal Professor at Dealbook.com makes the case for hedge funds as an investible asset class in the wake of CalPERS divestiture.[1]  While he makes a number of valid points, his arguments in support of hedge funds and those who argue against them are having a debate based on a flawed premise.  Hedge funds are neither an asset class nor a strategy.  They are merely privately structured investment vehicles utilizing a myriad of strategies and fee arrangements that invest in public or quasi-public securities.  The same logic goes for mutual funds and ETFs.  Until we describe HFs accurately, the debate is going to remain muddled. 

Hedge funds are merely a different way of actively managing money.  In the end, the question is whether any of the strategies can add value over an appropriate benchmark, net of all fees.  Conventional money management doesn't add value, so there's no reason to think hedge funds will either. However, the dismal record of active management hasn't stopped sophisticated managers from allocating to conventional managers or hedge funds.  In due course, CalPERS will be lured into some strategy that is packaged as a hedge fund.  Very few can resist the promise of superior performance even if it is fleeting or non-existent.

[1] http://dealbook.nytimes.com/2014/09/23/hedge-funds-are-still-finding-love-just-not-at-calpers/