Wednesday, December 31, 2014

Too Many Incentives for Whistleblowers

Too Many Incentives for Whistleblowers

Congress and various federal agencies continue to expand the role of and financial awards to whistleblowers.  Steven Davidoff Solomon, the Deal Professor of Deal Book, wrote a thoughtful year-end post on the subject.  Mr. Solomon questions whether the rising number of big awards and the increasing presence of lawyers seeking clients on a contingent-fee basis represent appropriate public policy.[1]  He also points out that sometimes wrongdoers are able to profit by also being whistleblowers.

I think Mr. Solomon’s concerns about the big awards are well founded.  Although whistleblowers are putting their careers at risk, I don’t think they should be sharing a portion of any settlement or judgment the government gets from a company.  Rather, the government ought to set aside a portion of the proceeds to compensate whistleblowers who lose their jobs as a result of their action.  Whistleblowers should be compensated for their economic loss rather than enriched.  Moreover, the compensation shouldn’t depend solely on whether the government reaches a settlement or wins a case.

There’s also something perverse about Congress’s continuing encouragement of private whistleblowers while simultaneously stripping the regulatory agencies of their authority and budgets.  If the regulators were properly funded, perhaps we wouldn’t have to rely as heavily on whistleblowers to unearth improprieties.


Monday, December 29, 2014

A Battle Won in a Losing War: Private Equity

A Battle Won in a Losing War: Private Equity

Many of the big private equity firms are succumbing to investor pressure by crediting 100% of those pesky monitoring, consulting, and directors fees charged to portfolio companies against the management fee charged to investors.  For example, when some private equity firm receives $5 million per year from a portfolio company for consulting services, they will now turn around and reduce the management fee to their investors by the same amount.  As The Wall Street Journal reports, the large firms will forego millions of dollars in revenues as a result of this concession.[1] 

Although investors and the SEC can take some comfort from this emerging trend, you and I should remain vigilant.  Professor Greg Polsky at the University of North Carolina continues to remind us that private equity firms are taking every opportunity to convert ordinary income into capital gains and maximize every possible deduction.  As Mr. Polsky points out, some of these practices are legal but should be stopped by Congressional action, and some of these practices are probably illegal.  The wholesale deduction of monitoring fees is just one of PE’s practices that doesn’t stand up to scrutiny. Most of the fees are simply an arbitrary number that don’t compensate the PE firm for any measurable services provided to the portfolio company.   They shouldn’t be deductible.  In my view, they shouldn’t be charged in the first place.

At long last, large investors are starting to exert a bit more influence as a result of the public pressure exerted by private equity critics and the SEC’s Office of Compliance Inspections and Examinations.   The developments reported by the Journal are a tiny step in reigning in the influence of private equity firms.  However, the big firms have already taken major actions that more than offset the fee offsets granted to investors.  They’ve expanded into hedge funds and other asset classes, they’ve raised new sources of investment capital, and they are figuring out how to get into the retail business on a mass scale.  They have become lightly regulated banks.

The members and staff and the Senate Finance and House Ways and Means Committee ought to spend the holidays reading Professor Polsky’s latest paper.  It’s available at:
The paper is a roadmap for needed reforms (e.g., ending the capital gains preference for carried interest) and understanding what’s improper about certain other strategies to convert ordinary income into capital gains and/or claim illegal deductions.  In reality the folks in Congress will be too busy organizing fundraisers where private equity executives can make huge contributions to the committee members under the recently enacted campaign laws.

Investors may have won a battle with private equity, but we are losing the war.


Tuesday, December 23, 2014

Proving our Gullibility: An Investment Product That Doesn’t Stand up to Scrutiny

Proving our Gullibility: An Investment Product That Doesn’t Stand up to Scrutiny

I’m beginning this blog with one of the most compelling investment marketing pages, I’ve ever seen.  It comes from an investment presentation made in 2013 by a firm called F-Squared.  It contains numbers that would induce institutional and retail investors alike to invest with the manager.  Even if you are a financial novice, you will be amazed by the numerical comparisons that appear on the right side of this page. 

Who wouldn’t be attracted to a money manager who had achieved a cumulative return of 368.2% versus 76% for the S&P 500 since 2001?   The manager has soundly beaten the market in every time period.  Astoundingly, these returns were achieved with 50% of the volatility of the stock market.  The standard deviation for this wonderful product was 10.4%, while the market’s volatility was 15.5%.   Notice the numbers in red, which show the maximum decline from high to low of the AlphaSector Premium Index versus the S&P 500.  While the S&P 500 suffered a maximum drop (known as drawdown) of 51%, this product only dropped 13.5%.  Sign me up.

There’s one small problem.  This presentation is Exhibit 1 of an Administrative Order filed by the Securities and Exchange Commission against F-Squared.[1]  The numbers from 2001-2008, which accounted for the bulk of the superior performance, were made up and the manager knew it.  Nonetheless, $28.5 billion of investor capital flowed into funds using F-Squared’s investment model.    The firm has agreed to pay a $35 million fine and has admitted that the data supporting this product was false.

In marketing the product, F-Squared’s founder and former CIO claimed that he’d found a proprietary algorithm that could predict which sectors of the market would perform well and which wouldn’t.  He developed a sector rotation product that would purchase attractive industries using exchange-traded funds and sell those industries that were less attractive.  It turns out that the back-test for the algorithm was flawed, but the CIO didn’t care.  Moreover, he pretended that the back test was actual investment performance.  In other words, when prospective investors received his marketing pitch, they were led to believe that the numbers were accurate and that they represented actual investments. When the SEC corrected the data, the investment performance became rather ordinary.  F-Squared’s marketing exhibit wouldn’t have been particularly compelling using real data.

I think this case says more about us than it says about F-Squared or its former CIO.  As investors we tend to be extremely gullible.  Give us a couple of compelling charts and precise looking numbers, and we’ll reach for our checkbooks.  In my investment career, I’ve learned that when numbers appear to be extremely attractive, its time to be extremely skeptical.


Monday, December 22, 2014

Perhaps Legal, but not Ethical: Campaign Contributions in the Chicago Mayor’s Race

Perhaps Legal, but not Ethical:  Campaign Contributions in the Chicago Mayor’s Race[1]

Recently Rahm Emmanuel publicized his record on ethics as he runs for re-election in Chicago, even as he takes in large amounts of campaign cash from the financial services industry.  Those contributions include money managers who do business with the city’s public pension plans.  The Mayor’s race in Chicago and the recently concluded Governor’s race in Illinois demonstrate the short supply of ethical behavior is a bi-partisan affliction.  I’ve previously written about Governor-elect Bruce Rauner, the founder of private equity firm GTCR.[2]  Unfortunately, Mayor Emmanuel is engaging in the same unethical campaign finance practices.  The reporting comes from David Sirota of the International Business Times, who has tirelessly unearthed large campaign contributions emanating from money managers who do business with Chicago’s public pensions.

In Mr. Sirota’s article last week, he documents $100,000 in contributions from senior executives at Madison Dearborn Partners, a private equity manager, and $50,000 from John Buck, the principal of the John Buck Company, a real estate manager.    As Mr. Sirota has reported in previous articles, these contributions are part of an ongoing effort by money managers to finance Mr. Emmanuel’s re-election bid.[3]  As Mayor, Mr. Emmanuel appoints some of the trustees to the city’s public pensions.  Those trustees, in turn, hire money managers.  While the lawyers representing Madison Dearborn and John Buck may have found a narrow path to make these donations legal, they can’t make them ethical.

It’s clear that Mayor Emmanuel has a potential legal problem, because he has asked the City’s Ethics Commission to declare that the city’s public pensions aren’t city agencies for the purpose of banning campaign contributions by vendors.  The Commission’s opinion may make the Madison Dearborn and John Buck contributions legal, but it doesn’t make them ethical or any less corrupting. 

These contributions also have to pass muster with the SEC’s “pay-to-play” rule, which severely limits the amount of money a money manager can contribute to the campaign of anyone involved in hiring the money manager or appointing the folks who hire money managers.  Once again, we’re seeing the lack of ethical standards on the part of the Mayor and the money managers.  In each case the money manager’s contribution is meant to slip past the SEC’s restrictions in order to deliver large sums of cash to the Mayor’s campaign.   In Madison Dearborn’s case, they are trying to hide behind the fact that they manage money for a city pension through Adam Street Partners, a fund-of-funds.  Thus, they haven’t been directly hired by the City, which might put them beyond the reach of the SEC.   By sticking an intermediary between themselves and the pension, Madison Dearborn may have found away to skirt the SEC and prevent the public from knowing how much they are charging the pension for their services.   The fund-of-fund structure also obscures the PE firm’s investment performance. Madison Dearborn most assuredly has the legal resources to vet their campaign contributions.  After all, they are major donors to all sorts of campaigns (Republican, Democrat, PACs).  This isn’t about ideology.  It’s about business.  It’s a win for Mr. Emmanuel and Madison Dearborn, but not for the pensioners or the public. 

John Buck isn’t hiding behind a fund-of-funds.  The real estate firm is claiming that since they’re not registered with the SEC, the agency’s pay-to-play rules don’t apply.  Mr. Buck writes large campaign checks (e.g., $94,500 to Mr. Rauner’s Gubernatorial campaign).  Thus, we can assume he has hired some savvy lawyers and compliance officers to steer his campaign contributions through legal channels.  Even if the SEC ultimately agrees that Mr. Buck’s contributions to the Mayor are beyond the reach of their rule, the contributions aren’t ethical.

Between the Citizens United and the bi-partisan legislation enacted by Congress last week, we have few, if any, limits on campaign contributions at the national level.  In Illinois and Chicago, we see can see how big campaign money works.  The checks may be legal, but they make a mockery of ethics.

[2] “When a PE Executive Runs for Governor: Bruce Rauner in Illinois”, 10/3/14.

Saturday, December 20, 2014

Wall Street Gets Another Christmas Gift: Volcker Rule Delayed

Wall Street Gets Another Christmas Gift: Volcker Rule Delayed

Last week, the legislative branch gave Wall Street a present when it repealed a section of Dodd-Frank pertaining to derivatives.  This week, the executive branch delivered a gift when the SEC delayed implementation of the Volcker Rule until 2017.  The investment banks argue that they need more time in order to comply.  The rule is supposed to force the banks to divest their holdings of hedge funds and private equity.   Mr. Volcker’s reacted with appropriate criticism:

It is striking that the world’s leading investment bankers, noted for their cleverness and agility in advising clients on how to restructure companies and even industries however complicated, apparently can’t manage the orderly reorganization of their own activities in more than five years.  Or, do I understand that lobbying is eternal, and by 2017 or beyond, the expectation can be fostered that the law itself can be changed?[1]

The former Fed chairman is right.  The investment banks’ claim is ridiculous.  They’d restructure their private equity and hedge fund holdings within 90-days, if it were in their interest to do so.  Given their victory last week on Capitol Hill, I’m certain that they’re playing for time and will try to repeal the Volcker Rule in the next session of Congress.  They’ll probably succeed.