My Review of Fortress: On Valuation and Rationality

So it finally happened: Fortress Investment Group is now a public company. Congrats, guys. I’ve met a few of the principals over the years and they are super-smart, very commercial, savvy guys. Obviously. They were the logical first U.S.-based hedge fund to go public, and I’ve written about them quite a bit during my tenure as a blogger:

08/14/2006: Hedge Funds as Asset Management Complexes - The Day Has Come
09/15/2006: Fortress Going Public? The Writing’s On The Wall
10/03/2006: Venture Capital - Becoming Like the Hedge Fund Industry?
12/05/2006: Citadel’s Bond Financing: We’re Going Public, Baby
12/26/2006: Hedge Fund Convergence: Strategy vs. Structure

So Fortress going public was clearly going to happen, it was logical it should happen, and now it has happened. But the response to the Fortress offering was, well, demonstrably insane. The salient details of yesterday’s offering are chronicled in the today’s Wall Street Journal:

Fortress Investment Group LLC, which manages $30 billion, became the
first private-equity and hedge-fund manager to sell shares on U.S.
markets and promptly emerged as one of the hottest initial public
offerings in years. Its shares, issued at $18.50 apiece, opened for
trading at $35 amid frenzied demand and closed at $31 — 68% higher
than its IPO price.

********************

Fortress estimates its private-equity funds have averaged 39.7% annual
returns since 1999 and its hedge funds have averaged 14% annual returns
since 2002. Fortress has been among the fastest growers in the
business. In 2001, it managed $1.2 billion, and that rose to roughly
$30 billion last year — a 97% compound annual growth rate.

********************

After Friday’s close, Fortress shares traded at roughly 40 times last
year’s earnings. Investment-banking giant Goldman Sachs Group Inc., by
contrast, trades at 11 times earnings. Legg Mason Inc., a mutual-fund
firm, trades at 24 times earnings.

Friends, I am generally not one to talk about stock valuation in the absence of empirical data from the Internet, but I simply can’t remain silent in the wake of investors’ response to the Fortress offering. FIG’s shares at 40x P/E? Are you stoned? It is a great firm run by top pros (as I’ve written many times), but the profit dynamics of the business simply don’t support that kind of a multiple. I was interviewed a few months ago about how a firm like Fortress might be valued, and I responded in what I thought was a logical and fact-based manner. Basically, the firm has two components:

Annuitized cash flows relating to management fees. This is a function of fee level, asset level, asset growth, tenor of lock-up and the probability of assets being redeemed. I would afford this type of stream a high multiple - say 20-25x earnings - due to its persistence, stability and growth potential.

Variable cash flows relating to performance fees. This is a function of fee level, asset level and performance. FIG’s performance variability is cushioned by the fact that it runs a highly diversified portfolio, likely offering benefits of non-correlated returns similar to a fund-of-funds. That said, correlations generally rise in market downdrafts and fees are driven by absolute - not relative - performance. Therefore I’d afford this stream a lower multiple of earnings - say 12-18x earnings - due to the risks involved but greater diversification than, say, Goldman Sachs.

Is this a rational way to look at it? I think so. So how does one get to 40x earnings? Probably if you expect FIG’s AUM to grow for a long time at its 5 year historic rate of 97%. Is this realistic? I mean, FIG isn’t a business that scales like Google. At least I don’t think so, but others clearly do. I think they are mistaken. First of all, investment management at FIG isn’t just a model business (which is more like what Renaissance is like) - it’s a people business. People require management. People have egos, tempers, dreams, and attitudes. These all need to be managed. It’s hard and it poses a risk. Doubling in size every year will place such dramatic stress of the FIG management structure (not to mention infrastructure) that something will break. It has to. And it will tarnish returns.

This is not a comment on the capabilities of the Big 5 at FIG - it is a comment on the Law of Large Numbers and the challenges of scale. I could rattle off another 10 reasons why this valuation is in cloud cuckoo land but I won’t. You probably know them as well as I do. And I really wasn’t planning on writing another post on Fortress given all that I’ve written in the past - but at a 40x P/E I felt compelled to say something. WAKE UP, PEOPLE.

Tweet

“Implicit” Hedge Fund Regulation: Moving in the Right Direction

Today’s article in the Financial Times chronicling concerns over hedge fund collateral has only reinforced a theme that I’ve pounded on for the past six months: HEDGE FUNDS ARE ALREADY REGULATED. Why this realization is only now coming to the fore in mainstream media and, potentially, in our regulatory bodies is beyond me, but thankfully it seems to be here. Now this is an issue worth thinking about. And it is properly being addressed to the banks and prime brokers extending credit to hedge funds, in their capacity as entities regulated by the Federal Reserve and the OCC.

US, UK and European regulators have expressed concern in recent
meetings that investment banks may be allowing hedge funds to increase
their borrowing capacity using collateral that could lose its value
rapidly in a financial crisis.

The regulators have asked banking
executives in the meetings on Wall Street to detail exactly how they
use portfolio netting, a practice that allows hedge funds to use
relatively illiquid securities such as credit default and total return
swaps as collateral to reduce overall margin requirements.

The
fear among some regulators and outside observers is that in a big
market dislocation the funds might be unable to sell those securities,
increasing the likelihood of widespread defaults.

********************

One Wall Street executive acknowledged that regulators had a
“legitimate concern” that such agreements might not be enforceable in
the face of a hedge fund collapse. However, he did not believe
regulators would find that banks were taking on excessive risk.

The
questions are part of a broad new effort by the New York Federal
Reserve, the Securities and Exchange Commission, the Office of the
Comptroller of the Currency, the UK’s Financial Services Authority and
European regulatory bodies to understand better how much exposure large
banks have to hedge funds and whether that could present a significant
risk to the financial system in the event of a market disruption.

So
far, detailed discussions have been held with a group of five of the
largest Wall Street securities firms that some time ago agreed to
volunteer for a “consolidated supervised entities programme”. Members
of the programme are among the most active in lending to hedge funds.

Officials
have found that some firms have been extending credit on less liquid
instruments but relatively little credit is being extended under these
circumstances - and at higher cost to borrowers, regulators say.

This is great stuff. This is the way it should work. Regulators spending time interviewing the market participants in order to gain a deep understanding of the issues. They then develop cooperative relationships with the top players in the market in order to standardize data collection, have early visibility into trends across the industry, and have a direct line into senior management should urgent questions or concerns arise. This is a process for intelligent, fact-based oversight outside the reach of political agendas and perverse motives. What a breath of fresh air.

And the issue they’ve targeted, the appropriateness of collateral practices, seems particulary timely in light of the frothy markets and ever-tightening credit spreads (the FT is on a roll - they also had a story on this today). The credit markets appear priced for perfection, and we know what happens when most large players are caught leaning one way: inevitable pain and suffering ensues. Selling premium seems like a good way to generate returns; I mean, the real economy is strong, earnings are strong, corporate balance sheets are healthy (except those that have been LBO-ed in the private equity frenzy), so what could go wrong? Oh, I don’t know, maybe Iran, Iraq, terrorism, return of Russian stateism, and about 300 other things? Naaaaah. And this same motivation is what can drive, shall we say, more liberal collateral lending practices in the prime brokerage community? This would seem to be a logical extension of tightness in the credit derivatives market, but somehow I’m not getting this vibe. Banks have gotten much, much smarter in the wake of LTCM and other hedge fund meltdowns. Risk controls have, in fact, gotten much more sophisticated and robust. This doesn’t mean that someone won’t drop a several hundred large in some purportedly 10-sigma outcome (ha!), but I really don’t think that banks are going hog wild lending to hedge funds. The risk/return is just not skewed in their favor by making stupid loans with crappy collateral. They don’t have to do this to mint money. I mean, they’ve still got stock lending, right?

Anyway, I am just happy to see the bodies that should be doing the overseeing actually doing it without the assistance of Congress or like bodies in the UK. Let’s hope this favorable trend continues for the good of the hedge fund community, the financial markets and investors everywhere.

Tweet

Proxy Voting and Economic Ownership: Getting the Big Things Right

Paul Atkins, a commissioner at the SEC, is in a snit over the potential influence of hedge funds in the wake of proxy voting reform. This was chronicled in an article in today’s Financial Times:

Short-termist activist hedge funds could gain undue influence on
companies’ boards as a result of expected new rules allowing
shareholders to vote on company directors, Paul Atkins, a commissioner
at the Securities and Exchange Commission has warned.

In a speech
to company directors and corporate governance experts on Monday night,
Mr Atkins said giving investors greater say on the composition of
boards could have the unintended consequence of increasing the power of
hedge funds.

He said hedge funds’ ability to borrow and short-stock before
crucial corporate meetings and use financial derivatives to own shares
without having an economic interest in the company could lead to the
appointment of “special interest directors”.

“What if a
shareholder who participates by voting at a meeting holds no economic
interest or possibly a negative interest in the corporation?” Mr Atkins
said at the Corporate Directors’ Forum in San Diego, California.

“Who is making the nominations and what are the interests and the conflicts involved?”

********************

The SEC is expected to revisit the issue in coming weeks, four years
after an earlier attempt to allow such access failed. The subject is
part of growing calls by investors for greater influence on corporate
governance matters after the scandals of the past few years.

********************

Opponents of such access, chiefly the Business Roundtable
and US Chamber of Commerce, have long argued that opening up the proxy
for voting purposes could allow companies to be “hijacked” by special
interests - usually a reference to unions and environmental activists.

But
Mr Atkins said the increasing role of hedge funds and other activist
investors in pushing for change to underperforming companies, or
influencing the outcome of takeovers, means any debate should now also
include the role of such interests.

********************

“As the financial markets are moving towards instruments where you can
artificially boost your shareholding it is important to have
disclosure, and a system that shouldn’t be able to be gamed by people
who have marginal economic interest,” Mr Atkins told the Financial
Times.

Quite frankly, Mr. Atkins, I agree with you. It is great that the SEC has finally reached the level of sophistication where an issue this subtle - voting power vs. economic ownership - is in the minds of its commissioners (though, to be fair, this issue was first flagged in Europe. Those European derivative shops were ahead of the game, let me tell you). The concept of the bifurcation of vote and value has long been a bedrock in the fields of taxation and partnership structuring, not to mention in the dual class shareholding structures so prevalent in the media business. But let’s not confuse the issue of proxy voting reform with the particular issue you raised. They should be dealt with separately and in a focused manner.

There is no question that proxy voting needs a face-lift and that entrenched Managements and Boards of Directors need the bejeezus scared out of them (if not appropriate checks-and-balances) to do what they are, in fact, hired to do. If I read of one more example of a stupid, irresponsible Board or of a self-serving, self-aggrandizing, shareholder-unfriendly CEO I seriously might barf. The necessity of reform is simply a fact, regardless of the cronies populating the Business Roundtable and US Chamber of Commerce who are against such changes. All I have to say to them is - grow up and lose that sense of entitlement. Hijacking by special interests? You’ve got to be kidding me. This isn’t a movie, guys. This is life. Get on the clue bus, ok? It’s leaving the terminal as we speak.

Now the issue raised by Mr. Atkins is legitimate, to be sure. Anyone who has been hanging around M&A, derivatives or prime brokerage knows of the ability to split off voting power from economic value, which can be used to great effect during hotly contested corporate fisticuffs.  And I’ve got to say it does seem somewhat unethical (if not illegal) to wield voting power in the absence of economic interest or, more precisely, to use disproportionate voting power to impact a substantially smaller economic interest. It doesn’t cost that much to buy votes, and if it can be used to sharply increase the odds of maximizing value on a position without risking a like amount of capital that is pretty cool. But is it fair, and does it go against the very principles or one share/one vote, when the shares and votes cease to be inextricably linked? I am neither an ethicist nor a moralist, but I can certainly appreciate the objections to this type of financial engineering.

In sum, two thumbs-up for proxy reform as well as a review of the voting power vs. economic ownership issue. These are the kinds of substantive, non-trivial discussions I like to see being had by the SEC. Let’s hope they can stay on track and get the big things right. Because it is easy to get tangled up in the details.

ADDENDUM: Today’s Wall Street Journal has a big article on this very issue. It raises a lot of the same points noted in my post, as well as providing some examples of when these tactics were used to sway outcomes.

Tweet

SAC Rips It In 2006: I Told You So!

Remember in mid-September, when Stevie Cohen was the subject of a big story in the Wall Street Journal in which he was practically pessimistic about the likelihood of putting up big returns given the increasingly crowded and competitive environment? I posted on this two days later, in which I basically said: this is a load of crap. Steve and his team at SAC are a bunch of forward-looking rock stars with great brains, great technology and the resources and vision necessary to stay a step ahead. Don’t believe me? Here are excerpts of what I wrote on September 18th, 2006:

This does not sound like a multi-billionaire
running an eleven figure sum for some of the most powerful investors in
the world. Where’s the hubris? What has changed? Is he right that the
easy money has been made and it will be tougher sledding from this
point forward?

I’m not buying any of this. SAC and its team
is way, way too smart to be pigeon-holed by a single strategy. If there
is too much money chasing too few ideas, invariably there is a lot of
dumb money out there that can be exploited by someone smarter and more
experienced. I mean, come on, he is up 18% YTD on a big, big number.
That is pretty good based upon the stats I’ve seen.

********************

Given the trend towards more and better data
and information being put out there on the Internet, it will be those
with the vision, the brains and the tools to take advantage of this
alternative data set that will establish a true edge on the
competition. Again, SAC is a very forward-looking organization with the
resources and trading acumen necessary to exploit the massive
opportunity for discovery that is the Internet, so I am also certain
that they will lever their expertise into this area as well.

So, from my vantage point things don’t seem
so bad for Stevie. Maybe he is showing his soft side so we’ll all get
complacent and he’ll clean our clocks! That seems far more likely than
the defeatist attitude on display in the WSJ article.

So now the numbers are in: Stevie and Co. put up 34% (on $10+ very, very large) during 2006 vs. 12%-14% for most of the hedge fund indexes.  So who was right - me or Stevie? Answer? ME! But he’s taking home 10 figures and I’m taking home - well, let’s just leave it there. I appreciated his humility and willingness to let us all inside the tent a bit, but at the end of the day he is a smart, resourceful, competitive performer at the top of his game, and there is no doubt in my mind that he is ultimately confident in his ability to find new and improved ways to make money, regardless of the environment (and regardless of what he says). Thought he shaded it during his interview, I called bullshit. Hooray for me. And hooray for him.

Tweet

Who Says Hedge Funds Aren’t Regulated?

So it came across Bloomberg this morning that the SEC (US), the New York Fed and the FSA (UK) are doing an investigation into the margin requirements of the leading hedge fund prime brokerage units:

Jan. 9 (Bloomberg) — U.S. and European regulators, turning
a spotlight on one of Wall Street’s most profitable businesses,
are conducting a joint probe into whether banks and securities
firms set strict enough limits on loans to hedge funds.         

The U.S. Securities and Exchange Commission, the Federal
Reserve Bank of New York and the Financial Services Authority in
London met last month with some of the biggest lenders to the
hedge-fund industry, seeking information on how they decide the
amount of collateral required, SEC Commissioner Annette Nazareth
said in an interview in Washington. Swiss and German authorities
were also involved.         
      

“The purpose of the meetings was to discuss margin
practices,” Nazareth, 50, said. “It was a fact-finding
effort.”

********************

Officials want to know how much margin banks require hedge
funds to provide up front to obtain loans and cover potential
losses. They’re hoping to avoid the kind of turmoil that engulfed
financial markets when Long-Term Capital Management LP’s losses
forced the Fed to organize a rescue in 1998.         

For hedge funds, private pools of capital that speculate on
everything from interest rates to weather patterns, leverage also
can multiply trading losses and put stress on the financial
system.
      

“We are doing work on credit-risk management with the
SEC,” said David Cliffe, a spokesman for the FSA in London.
“It’s looking at the prime brokers in relation to the hedge
funds.” The Swiss Banking Commission in Bern has worked with
British, U.S. and German authorities on the issue, spokeswoman
Tanja Kocher said.

********************

The meetings last month included New York-based Goldman
Sachs Group Inc., Morgan Stanley, Bear Stearns, Merrill Lynch &
Co., Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and
Citigroup Inc.; UBS AG and Credit Suisse Group, both based in
Zurich; and Frankfurt-based Deutsche Bank AG, according to a
person helping to direct the examinations. All of the firms
declined to comment.         

The person, who declined to be named because of the
confidential nature of the discussions, said the regulators are
concerned that there has been a decline in lending standards
because hedge funds are such lucrative customers. The agencies
plan to meet in the next couple of weeks to decide what to do
with the information, the person said.         

Now doesn’t this sound like, uh, regulation of hedge funds? Not to play the “I told you so” card, but here is text from a post I had written about six months ago titled “Much Ado About Nothing - the Hedge Fund Regulation Debate:”

Hedge funds are already subject to significant regulations, SEC rule or not.
The SEC can ask for a hedge fund’s books and records if they have basis for a
concern that places investors at risk or believe a violation may have taken
place. Investors can (and often do) request extensive information from hedge
funds during the due diligence process, and this process can often take months
for large, sophisticated institutions. Furthermore, investors who are also
fiduciaries (like pension funds) have an obligation to do thorough due diligence
prior to investment in order to protect the individuals who make up their
constituency. Finally, the allocators and managers of risk capital, the prime
brokers, can alter margin and credit requirements based upon the strength of a
hedge fund’s management structure, risk reporting, operating environment and
returns.

So here we are, with the “Big Three” overseers of the lion’s share of global hedge fund AUM examining the prime brokers and their lending practices. This is exactly the kind of regulation I was talking about when I scripted the July 16, 2006 post. Writers, politicians and many in the general public just don’t seem to get it - an SEC “hedge fund rule” or not, much more powerful levers are already controlled via oversight of broker/dealers, federally chartered banks and the ability to walk into any hedge fund at any time if there are suspicions of fraud or malfeasance. Today’s Bloomberg article goes on to say some stuff that really worries me:

Nazareth said it’s not clear what steps, if any, the regulators may take. New
York Fed President Tim Geithner described the question of margins as “very
complicated” in comments to a Nov. 29 meeting of the American Institute of
Certified Public Accountants in New York.

Because hedge funds let managers participate substantially in the gains on
money invested they provide an incentive to boost returns with extra leverage.
Fed officials have been troubled for months by the possibility that banks may be
cutting margin requirements for hedge funds too far and in some cases demand no
margin at all for potential losses on over-the-counter derivatives.

“It’s very hard to figure out what’s right,” Geithner, 45, said at the
November meeting. “It’s maybe as hard or harder to try to figure out whether
you can bring about change that may be in the broader interests of all market
participants.”

When you have the President of the New York Fed saying that the issue of margin requirements is “very complicated” and that “It’s hard to figure out what’s right,” I’d be very afraid of the potential outcome. Mr. Geithner is right - margin requirements are extremely powerful and complex tools. And they need to be examined very carefully and with the utmost care before change is enacted. And hopefully Mr. Cox of the SEC will prevail upon him and his UK-based colleagues in the FSA to proceed thoughtfully. Because abrupt changes in things like margin requirements can have very powerful (and unintended) ripple effects throughout the financial markets and, therefore, the real economy. So don’t tell me hedge funds aren’t regulated. They are and they always have been. The SEC and the Fed has the equivalent of “regulatory nuclear weapons” at their disposal, and this is just one of its potential manifestations. Let’s hope the suitcase with the red button remains in storage for a long, long time.

Tweet