Friday, May 30, 2014

KKR’s Error Misses The Real Problem: Extra Fees

KKR’s Error Misses The Real Problem: Extra Fees

Any number of private equity and real estate funds have set up subsidiaries to provide services to their portfolio companies.  More than a dozen years ago, KKR set up an entity called Capstone.  The firm was designed to replicate the services provided by management consultants to KKR’s portfolio companies.  KKR probably thought it was a nice way to make a little bit of money and control their consultants.   Since Capstone doesn’t represent a monitoring or investment banking fees, KKR figured that it didn’t have to share Capstone’s fees with its investors, which is something it had promised in its 2006 fund.   Unfortunately for KKR, a small collection of its partnership documents wound up being disclosed on the website of the Pennsylvania State Treasurer.  Ives Smith blogging on Naked Capitalism did an excellent job of digging through the partnership agreement and discovering the Capstone snafu.


KKR immediately began to distance itself from Capstone by claiming that Capstone isn’t an affiliate and therefore isn’t subject to any fee sharing arrangements.  It seems like there are all sorts of bits and pieces of evidence that Capstone is an affiliate and therefore subject to fee-sharing arrangements.[1]

Naked Capitalism’s analysis comes after the SEC’s charge that a large number of private equity firms aren’t properly disclosing fees and expenses to their investors.  As a result, we have the makings of a worthwhile news story.

I’m in favor of fully disclosing to LPs any and all fees collected by private equity firms from their portfolio companies.  However, I’ve always thought the fee-sharing arrangement is a scam.  First, it distracts LPs from asking the more important question: why are these fees being incurred at all?  LPs pay good money for GPs to source, monitor, and restructure portfolio companies.  I’ve never understood why there are additional charges, whether they are shared or not. 

Second, since the PE firms control both the portfolio company and professionals or affiliates providing services, they are fairly free to set whatever fee they’d like.  For example, if a PE firm is charging $2 million a year for monitoring fees and is pressured to share 50% of that fee with its investors, there’s little to prevent the firm from jacking up their fees in the future to offset some or all of the fee sharing arrangements.

The blogosphere is treating the KKR documents as if Edward Snowden unearthed this material.    There’s nothing atypical about KKR’s agreements.  There’s a trove of material sitting at http://www.seanc.org/legislative-action/retirement/retirement-investigation/public-records-received/ as a result of SEANC’s public records request in North Carolina.  Most of the material hasn’t been read.  However, it’s a virtual encyclopedia on the legal arrangements between GPs and LPs, along with the GPs twisted logic when it comes to trying to hide from the public records law.  I’m sure there are more interesting tidbits in those materials.

I’m glad that bloggers and reporters are digging into private equity and hedge fund fee arrangements.  I’m thrilled that the SEC is rooting about in this matter.  Disclosure would be a good first step.  However, I’d really like the LPs to wake up and put an end to a lot of these fee arrangements.





[1] http://online.wsj.com/news/articles/SB10001424052702303749904579576171785616910

Wednesday, May 28, 2014

Liquid-Alternative Investments

Liquid-Alternative Investments

In the past couple of weeks, the financial press has carried a number of stories on the amount of capital flowing in Liquid-Alternative Investments (LAIs).  For those of you who stick with plain-old stocks and bonds, liquid-alternatives are hedge fund-like strategies packaged in a mutual fund wrapper.  It’s an appealing name because it combines the daily liquidity of a mutual fund with the supposed sophistication of a hedge fund.  For fund distributors, money managers, and brokers, the recent proliferation of the LAIs is a welcome development.  Mutual fund investors have been slowly pushing down fees by reallocating assets into index funds and ETFs.  LAIs offer Wall Street a break in these trends.  Last year investors poured $40 billion into LAIs mainly through financial advisors at major wire houses.  The level of money flowing into LAIs doesn’t yet compare to the amount of money allocated to conventional investment categories, but LAIs are very profitable to Wall Street.



Interestingly, LAIs appear to be less expensive than many conventional hedge funds.  Rather than paying 2% and 20% plus fund expenses to a hedge fund, high net worth investors can pay 1.5% to 2.5% for LAIs without lock ups and other liquidity constraints.  From what I can tell, the performance isn’t much different.  Some LAIs have performed reasonably well, others have flopped, and most are very difficult to measure.  All that’s lacking is the cachet of being able to tell your friends that you employ a hedge fund manager.

While LAIs may be less expensive than hedge funds, they are nonetheless, expensive.  In addition, many of them have active trading strategies that cost investors a great deal although the expenses isn’t captured in the fee data.  I spent a few hours looking at the holdings of three of the largest LAIs (MainStay Marketfield  (MFLDX), Gateway  (GATEX), and Goldman Sachs Strategic Income  (GSZAX).  The first two funds are equity long-short strategies and the third fund is non-traditional bond fund.   There’s nothing particularly impressive about any of these offerings. 

Mainstay is slightly long the equity market with short positions created in large measure through ETFs.  As I looked at their holdings I kept wondering why I’d pay an active money manager to buy or sell ETFs on my behalf.  Moreover, I’m pretty sure an individual investor could create the same hedge with a few puts, by writing some calls, or holding a bit of cash. 

Gateway only charges 0.96%, but it’s a long-short fund that isn’t running any shorts.  In fact Gateway looks like a closet index fund that has wildly underperformed the S&P 500.  

Goldman is both leveraged and hedged with a net negative exposure to bonds.  Given the fund’s turnover and number of holdings, this fund is a goldmine for Wall Street traders.  Again, investors could replicate this fund at a fraction of the 0.99% that it charges.


Liquid-Alternative Investments are a fad that is working.  It’s just not working for investors.

Tuesday, May 27, 2014

Finding a Middle Ground in Holding Financiers Accountable

Finding a Middle Ground in Holding Financiers Accountable

Mehafarid Amir-Khosravi, an Iranian billionaire, was the first of four men hanged for committing bank fraud.   Mr. Amir Khosravi and his colleagues were convicted of embezzlement, bribery, forgery, and money laundering to the tune of $2.7 billion.   Apparently the scandal involved 14 state-owned and private banks and officials close to former Iranian President Mahmoud Ahmadinejad.  According to Reuters[1], 33 bankers and government officials were also given long sentences.  Neither the State prosecutor nor the Iranian Supreme Court held a press conference.  They just made a brief announcement.



Last week Attorney General Eric Holder held a press conference and issued a lengthy press release after getting Credit Suisse to plead guilty to a single charge of tax evasion (see, “Headline Justice: Credit Suisse Pleads Guilty and Chinese Indicted [May 20, 2014].”  Mr. Holder proclaimed, “When a bank engages in misconduct this brazen, it should expect that the Justice Department will pursue criminal prosecution to the fullest extent possible, as has happened here.”

I’m an opponent of the death penalty, and Iran’s record of imposing capital punishment is appalling.  Thus Mr. Amir-Khosravi’s execution for an economic crime is particularly outrageous.  However, the U.S. Department of Justice might learn a couple of things from the Iranians.  Instead of conducting press conferences laden with all sorts of heated rhetoric, our law enforcement officials would be better served by letting their cases speak for themselves.  Of course, the DOJ’s actions would seem particularly hollow without the rhetoric, because their favorite tactic is to fine financial institutions large sums that they readily can afford to pay.  So the second thing DOJ could learn from the Iranians is to prosecute some of the senior executives responsible for financial irregularities.  Prosecutions would send a much stronger message than press conferences.






[1] http://www.reuters.com/article/2014/05/25/us-iran-corruption-execution-idUSBREA4O08J20140525

Friday, May 23, 2014

Creating a Muddle: San Francisco Contemplates Hedge Funds

Creating a Muddle:  San Francisco Contemplates Hedge Funds

The Chief Investment Officer for the San Francisco City & County Employees' Retirement Systems, with $20 billion in assets, has proposed a new 15% allocation to hedge funds and a 12% allocation to alternative equity allocations.[1]  The allocation to alternative equity allocations would include a disparate collection of activist managers, country specialists, sector specialists and long-short managers, according to William Coker, San Francisco’s CIO.  In other words, it’s a broad classification of hedge funds that utilize equities in some capacity.  Even as the nation’s biggest public pension plan, CalPERS, scales back, the alternative bubble continues to inflate.


The foray into hedge funds will turn San Francisco’s asset allocation into a muddle.  Traditionally, there has been a clear distinction between equity (public stocks, private equity), debt, and real estate.  As I’ve written repeatedly, hedge funds aren’t an asset class.  Rather they are strategies that can encompass any or all of the traditional asset classes.  As a result, San Francisco isn’t going to have a very precise picture of the risks that it is taking.

Fortunately, some of San Francisco’s trustees are skeptical.  One even wrote Warren Buffet a letter, and Mr. Buffet counseled him to avoid hedge funds altogether.  Pensions & Investments reported a bit of Mr. Coker’s response to the trustees:

Mr. Coaker insisted that the pension fund would assemble a top-grade hedge fund staff and a top hedge fund consultant, and would do extensive due diligence to ensure that only top-grade hedge funds with strong return potential would be hired.

“We need to be very selective,” he said.

I hope that this wasn’t his best argument for making the changes to the allocation, because the rationale is laughable.  Who isn’t going to try to assemble a top-grade staff and top hedge fund consultant?  Who isn’t going to promise extensive due diligence?  Who wouldn’t want to hire top-grade hedge funds and insist on strong return potential?  As the umpteenth public fund to invest in hedge funds, there’s little hope of San Francisco meeting any of these thresholds.  Mr. Coaker can promise his trustees that he’ll be extremely selective, but it’s unlikely the better hedge fund managers will allow San Francisco the luxury of selectivity.

It’s hard to resist the lure of hedge funds.  I’m hoping San Francisco can.






[1] http://www.pionline.com/article/20140522/ONLINE/140529931/san-francisco-cio-proposes-major-asset-allocation-overhaul

Thursday, May 22, 2014

Not Wanting to Pay for the Government’s Protection

Not Wanting to Pay for the Government’s Protection

May be it’s just me, but I’m having trouble reconciling the Department of Justice’s indictment of five Chinese officials for stealing corporate secrets with Pfizer’s ongoing attempt to acquire the British pharmaceutical company AstraZeneca.  As I wrote on Tuesday, the indictment seems to be more symbolic than real, since the indicted officials are beyond the reach of the American judicial system.  However, it is clear that U.S. corporations are interested in receiving as much help as possible from the U.S. government in order to thwart Chinese hackers.  Undoubtedly, Westinghouse, SolarWorld, U.S. Steel, Allegheny Technologies Inc. (ATI), the United Steel Workers International Union, and Alcoa were harmed by the systematic hacking by Unit 61398 of the Third Department of the Chinese People’s Liberation Army.   Moreover, the Chinese government has invaded the computers of hundreds of other U.S. corporations, including Pfizer.


Meanwhile, Pfizer is trying to acquire AstraZeneca in order to become a British Corporation and substantially reduce its tax burden.  Pfizer is following in the footsteps of other companies who have altered their corporate structure in order to avoid U.S. taxes.  For example, Apple has an intricate structure that enables it to allocate its profits to very low corporate tax jurisdictions.  Nonetheless, these companies expect the rest of us to foot the bill so that the U.S. government can protect their intellectual property, strategic plans, and pricing strategies from Chinese hackers. 


Putting aside the NSA’s programs to track and store massive amounts of personal information, the NSA also invades foreign government and corporate computers in order to advance trade negotiations and related economic matters.  Once again, the average taxpayer pays for NSA efforts (legal or not), while all too many U.S. companies figure out how to avoid paying the government for these services.