Stephen’s Posterous

Ralph Cioffi and Matthew Tannin, two former Bear Stearns hedge-fund managers, were acquitted of securities fraud. They were accused of lying to investors by telling them that they were optimistic about their funds, while privately worrying about the funds.

The funds collapsed in 2007, prior to the mortgage crisis that later took Bear Stearns down. The acquittals are a setback for the U.S. attorney's office in Brooklyn, New York.

Many U.S. attorney's offices are investigating Wall Street for possible criminal wrongdoing that lead to the credit crisis and affected many large companies like Lehman Brothers, Fannie Mae, and AIG.

This case came down to this simple question: Were the two men misleading investors, or simply putting a positive spin on sagging returns?, writes The Wall Street Journal writers, Amir Efrati and Peter Lattman.

The Jurors in Brooklyn found there was no evidence beyond a reasonable doubt that the defendants had criminal intent and conspired to mislead their investors.

Messrs. Cioffi and Tannin were the first and only Wall Street executives to face criminal securities-fraud charges resulting from the crisis.

The two former hedgefund managers faced a maximum of 20 years in prison for each of the five fraud counts and five years on a conspiracy charge, if they had been convicted.

The government displayed supposed incriminating emails by Mr. Tannin in which he expressed his fear about the markets in 2007. Defense lawyers said the prosecutors were taking the emails out of context.

What the email showed was that Mr. Tannin also said the men could choose to make aggressive bets rather than close the funds, the lawyers argued. The Jurors believed the defense's narrative.

Cioffi and Tannin still face a civil-fraud lawsuit, which was brought alongside the criminal charges last year, by the Securities and Exchange Commission. John Nester, an SEC spokesman, said the agency expected to go forward with the litigation.

Someone commented on the article in the Wall Street Journal writing, "Great decision. Finally we can look beyond finding scapegoats and work towards rebuilding the financial institutions in this country."

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FINalternatives reported that a New York-based hedge fund, Hayground Cove Capital Partners, will launch a student loan fund at the end of June 2009.

FINalternatives writes:

The Hayground Cove Student Partners Fund will acquire loans that have a backstop guarantee, or insurance, from the U.S. Department of Education, according to fund documents. DOE guarantees have carve-outs for fraudulent origination or servicing defects.

According to the firm, the Federal Family Education Loan Program has exceeded $700 billion in loan origination since inception in 1965, with more than $500 billion since 1990, and there are currently over $300 billion of loans outstanding. The loans’ principal and interest are guaranteed by the U.S. government in event of default. The fund is looking to return approximately two-thirds of committed capital to investors within 12 to 14 months of their initial investments.

The fund will charge a typical 1% management fee and a 20% incentive fee. Jason Ader, Daniel Silvers and Daniel Pianko head the fund and will invest 10% of their own capital. Hedge Fund Alert lists the fund at $100 million with contact information of Jason Ader, HCSP Manager, (212) 445-7800.

Total Alternatives said that most of the underlying loans will be at a floating rate with floors to protect against deflation but no caps. Suzy Kenly writes in an article from Total Alternatives that the loans will be acquired with a base gross IRR target of 14.5%. Hayground believes that markets are in a temporary deflationary cycle.

Ms. Kenly writes:

Ader, Silvers and Pianko will take an active role in managing the accounts to ensure that the loans stay current, and will also keep up a dialogue with the borrower and the borrower's family. Returns will also be driven by anticipated "improved liquidity in the student loan secondary market and the potential for applying modest leverage to the portfolio if the credit market stabilize," the presentation said.

Hayground manages a long/short equity strategy, a leveraged fund, a market-neutral strategy, and also has sponsored a number of special-purpose acquisition companies. Mr. Adler founded the firm in 2003 and the group manages over $3 billion according to Total Alternatives.

On a separate note, Newsday reported that New York risks a serious rise in student loan defaults in the current economic downturn according to a report released today by New York State Comptroller Thomas P. DiNapoli. The report found that the average cost of a college degree has increased by more than 30 percent over the past five years, more than double the rate of inflation during the same period, forcing more reliance on borrowing to finance education expenses than ever before.

According to Newsday, the study concluded that:

Private loans have expanded nationally by more than 600 percent over the last decade. As of 2007, nearly two-thirds of college students graduating in New York state were in debt. The national student loan default rate rose to nearly 7 percent last year, up from a recent average of 5 percent; and Sallie Mae, which controls almost 45 percent of the loan market, reported that its default rate rose to 10.2 percent in the same period.

The Optmist by Jesse Eisinger, Portfolio.com

Bill Ackman’s friends describe him in two ways. They offer the euphemism that the prominent hedge fund manager “does not suffer from low self-esteem.” Then they observe that he is optimistic, almost clinically so. A pop psychologist might diagnose Ackman with hypomania, a condition notable for persistently elevated moods but without the self-destructiveness of true mania.

“He doesn’t register reversals and defeats and hard feelings the way other people do,” says David Klafter, a former colleague. I ask Ackman about the condition while he is driving in a car with his family. He hasn’t heard of it, but says he is an “extremely resilient person.” His 11-year-old daughter playfully chides from the backseat, “And you’re modest.”

Warren Lichtenstein's Proposal Resisted by Jenny Strasburg and Joseph Checkler, WSJ.com

Investors owning more than half of the assets in Warren Lichtenstein's biggest hedge fund have asked to pull out their money, resisting a push to convert the fund into a publicly traded partnership.

In a letter sent to clients last week, the hedge-fund manager wrote that investors representing just 36% of the assets in Steel Partners II Master Fund had agreed to support the conversion plan, while the rest either didn't vote or asked to pull out of Mr. Lichtenstein's fund. A non-vote is equivalent to asking for money back, according a March letter that outlined the options facing investors.

Instead of selling holdings quickly and giving clients cash refunds, Mr. Lichtenstein proposed spinning Steel Partners II into WebFinancial, a public company controlled by his firm that that aims to be a holding company for entities such as small banks and insurers.

Despite the lukewarm support, Mr. Lichtenstein told clients that he is proceeding with the conversion anyway. "We would like to take this opportunity to inform you that the name of 'WebFinancial L.P.' has been changed to 'Steel Partners Holdings L.P.,"' he wrote in last week's letter.

Further details on the plan will come "in the near future," Mr. Lichtenstein added. Plowing ahead could inflame tensions between Mr. Lichtenstein and investors who already were skeptical of the conversion plan after the activist hedge-fund manager floated the idea in December.

An entity controlled by billionaire investor Carl Icahn and a separate group of Steel Partners clients has sued Mr. Lichtenstein and his firm over the transaction, claiming it would benefit the hedge-fund manager but not his investors.

Critics of the unorthodox conversion plan also contend that a publicly traded company with uncertain value is no substitute for the private hedge fund in which they invested. According to last week's letter, the 43-year-old Mr. Lichtenstein is in settlement talks with some investors. Details on the discussions weren't disclosed.

The situation reflects a broader tug of war between hedge-fund managers and investors over who should call the shots when a fund's bets go bad: hedge-fund executives who claim they know best how to rebound from recent losses, or clients who counter they are entitled to what's left of their money?

Before 2008, many hedge-fund managers raked in money by touting themselves as capable of making money no matter how the markets performed. Last year's turmoil undid many of those claims.

In the wake of steep losses, big hedge funds such as Harbinger Capital Partners and Citadel Investment Group limited investor withdrawals. Other funds that let clients pull out their money are now far smaller and trying to fight their way back to profitability.

Mr. Lichtenstein announced the conversion plan as his fund was facing requests by many clients who wanted to bail out. The fund's 2008 decline was double the average hedge-fund loss and worse than that of the Standard & Poor's 500-stock Index. It has about $1 billion in assets, down from $2 billion.

Last year's slide was a stark comedown for Mr. Lichtenstein, who started his firm in the early 1990s and had never suffered a money-losing year, typically outperforming most of his rivals over time. He often makes concentrated investments, pressuring companies in Japan and elsewhere to change their structures and management.

In the past, Mr. Lichtenstein has talked about wanting to be like Warren Buffett and run a conglomerate like Berkshire Hathaway Inc. WebFinancial was a prime opportunity that also would offer investors transparency and a stream of future profits, he told clients. Steel Partners investors were told they could vote on the proposal and that it required their approval.

According to last week's letter, 52% of the hedge fund's investors by headcount expressed support for the conversion, seeing the move as their best bet to recover losses. But those investors collectively hold less than 40% of the fund's assets. Many of the clients backing Mr. Lichtenstein are smaller investors.

"These results confirm that the Funds' investors have objectives ranging from a need for cash in the immediate future to maximizing value over the long term," Mr. Lichtenstein's letter said.

It's unclear how Mr. Lichtenstein will proceed if he doesn't reach a compromise with dissenters and still lacks sufficient support from clients in the hedge fund. A person close to Steel Partners said the plan is likely to move ahead, though there could be a liquidation of certain assets to allow some clients to exit. Meanwhile, another Steel Partners fund that makes concentrated bets on Japanese securities has been selling assets to pay out client redemptions.

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In a move likely to be watched by peers, the giant California pension fund Calpers is considering expanding its own internal hedge-fund investments even as it presses established external funds to cut fees and make other client-friendly changes that many money managers have resisted.

Calpers is raising the prospect of providing start-up money to new and relatively unknown teams of traders and portfolio managers, with hopes that the best would spin out later as bigger, independent firms with many additional clients, according to public documents from Calpers.

The proposed seeding program, which the California Public Employees' Retirement System says is designed to counteract declining hedge-fund returns and give it more control over its money, would mirror an approach the $175 billion pension fund has taken with private-equity managers.

Not every other public pension has the heft to seed hedge-fund managers. But Calpers is a bellwether in the money-management business. After a year when hedge-fund managers disappointed some clients, pension-fund managers are likely to take an interest in any moves to cut investment costs and gain more control.

In the public documents, on Calpers's Web site, Calpers notes that last year, "almost all hedge funds lost money, regardless of strategy or leverage." Calpers points out that its hedge-fund investments as a whole "protected capital in the face of some of the worst markets since the Great Depression," but too many fund managers showed they couldn't adapt to the volatility or cut risks to avoid losses during market swings.

Calpers's hedge-fund proposals are part of a comprehensive review of Calpers's $5.9 billion in direct investments with 26 hedge funds and nine other firms, called funds of funds, that distribute money to multiple funds. The proposals are on the agenda for Calpers investment committee meeting on April 20, 2009.

The current market environment has been tough for hedge funds, which had their worst collective loss in 2008 despite beating major stock indexes. Hedge-fund assets are on track to shrink to about $1 trillion this year, roughly half of the industry's peak about a year ago.

Calpers and other big investors have said this is an ideal time to help talented money managers get started, as well as to demand fee cuts from existing hedge funds that for years typically have charged 2% of assets they manage plus 20% of profits. Calpers also wants to know more about how the funds it hires are investing.

Those demands were laid out in a March 11 memo sent to hedge funds where Calpers has money; it was reviewed by The Wall Street Journal. Calpers's track record in picking hedge-fund managers has been about average since 2002, when it started putting money with the private investment funds, according to its review and industry data.

Last year took a bite out of Calpers's returns just as it did for most hedge-fund clients. Calpers's hedge-fund holdings posted a 19.6% investment decline in 2008, slightly worse than the 19% average decline of hedge funds globally, according to Chicago research firm Hedge Fund Research Inc. Since April 2002, Calpers has made a 4.3% profit on average per year from its hedge-fund investments, slightly trailing the 4.7% average return of hedge funds globally.

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If the Wall Street investment bank was supposedly trampled by the panic of 2008, someone forgot to tell Goldman Sachs. The credit crisis killed off Bear Stearns, Lehman Brothers and ended Merrill Lynch’s independence. Goldman, the last of its peers to go public, has recovered from its fourth-quarter loss to make $1.8bn in the first three months of the year, more than double analysts’ estimates.

And that’s despite some poor numbers in some of its core businesses: incentive fees on hedge funds were virtually non-existent, principal investments recorded a $1.4bn net loss and depressed equity and mergers and acquisitions markets hit investment banking fees and prime brokerage revenue.

In truth, it’s hard not to gander at Goldman’s earnings and conclude the firm, which along with rival Morgan Stanley sought refuge by becoming a bank holding company, is trying to prove the investment bank model it appeared to have dropped is still alive and kicking. For starters, the firm’s black box trading operations provided most of the juice. Second, in an act that seems like biting its thumb to Congress, Goldman set aside more revenue to pay staff, both as a percentage of revenue and on an absolute basis, than last year.

And Goldman executives also appear to have called a halt to shrinking the group’s balance sheet. Sure, assets only rose by 5% since last quarter to $925bn, but that’s a stark change to the deleveraging that has beset the financial sector for a year or more.

Those are some punchy tactics for a firm hoping to convince the Treasury to allow it to pay back the $10bn of taxpayer-funded capital foisted upon it last autumn. But Goldman appears to have the numbers to back it up and to persuade shareholders to stump up for its $5bn stock sale. If Goldman is any evidence, Wall Street isn’t in its coffin just yet.

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Just when venture capitalists think they’ve safely avoided the crosshairs of regulators, they find themselves lumped together again with hedge funds and the scrutiny that comes with it.

In his testimony today about regulating risk (read the transcript here), U.S. Treasury Secretary Timothy Geithner proposed that hedge funds, private equity firms and venture capital firms should be required to register with the Securities and Exchange Commission.

No further details were provided, but it’s implied that Geithner is aiming to follow the proposals outlined in a recent bill titled, The Hedge Fund Transparency Act, which calls for these investment firms to file with the SEC and publicly divulge the value of their funds and the names of their investors.

This blanket-like proposal infuriates the venture industry, which has largely escaped the regulatory clutches of the SEC and Treasury Department. The National Venture Capital Association, which represents the venture capital industry, has lobbied hard to drive a wedge between it and hedge funds, characterizing venture firms as job generators and innovators, not wealth creators. Venture capital is a long-term business and an engine of the nation’s economy, it argues.

But with legislators pressured to heal a sickly economy and prevent another financial catastrophe, nearly every private pool of capital faces regulatory oversight. It’s why the Obama administration, which has generally befriended the venture capital industry, didn’t exclude VC firms from its plan to tax carried interest at the higher ordinary income rate.

We chatted today with Mark Heesen, the president of the NVCA, to talk about Geithner’s latest proposal. Here’s an edited excerpt of the Q&A:

Q. What is your reaction to Geithner’s testimony?

There are a couple of things that jump out to me in his discussion about “hedge funds and other private pools of capital.” No. 1, he says they’re looking at those types of funds that “individually or collectively pose a threat to financial stability.” As much as we want to talk about how the world revolves around venture capital, the fact is that it’s a very small asset class, relatively speaking.

We’re talking about $30 billion being invested per year. If suddenly you were to lose it all, would that pose a threat to financial stability? No. When you’re seeing buyout funds or hedge funds that raise one fund that is almost the entire amount raised by the entire venture industry, you have to realize these are very different asset classes.

The other thing that jumped out, he says, “…in the wake of the Madoff episode it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage.”

Well, our investors, those that invest on behalf of college endowments and pension funds, are not only highly sophisticated within the bounds of law, there even more sophisticated than the law requires them to be. They aren’t your individual, everyday investors in venture capital. These people aren’t going to get ripped like Madoff’s investors did.

Q. Is this your worst nightmare as the head of a venture capital trade group that venture firms are being wrapped in with hedge funds with regards to regulation?

Absolutely. This is déjà vu. After 9/11, when the Patriot Act came out, the Treasury was going to register a lot of different financial institutions because of the threat that they might be used by foreign entities for illicit purposes, like laundering money.

We were swept into that. So we sat down with the Treasury and Department of Homeland Security, and asked them, “Do you really think a terrorist group would put $5 million into a venture capital fund and sit there for 10 years until they got a return?” They of course said, “That’s not going to happen.” This is kind of the same idea.

Q. Do you think that Congress has enough of an understanding about venture capital to exclude these firms from regulation?

We’re at a point where policy makers have too much on their plate. They are not by and large educated in distinguishing between hedge fund and buyouts and venture. They’re expected to know everything, but they can’t know everything. So a simple solution is to use a broad brush. We have to be there to continue to educate.

History repeats itself, it’s kind of like Sarbanes-Oxley. There was a rush to regulate and then take care of problems that arise from it afterward. You’re seeing that now with a group of policy makers that “want to get something done.”

They have real pressure from their constituents who have lost their jobs or their mortgages. So they’re trying to get something done quickly. This is very much a Washington issue: We’ll deal with it now and clean it up later.

Q. Do you think it’s practical for the SEC to suddenly oversee hundreds of more firms?

I think you need to balance oversight and regulation with the practicality of government bureaucracy. The government can only do so much with the amount of people and money they have. They need to pinpoint the major concerns and work on those as opposed to trying to cover the ocean and do every job simultaneously.

The SEC goes to the hill every year and requests more people and more money. I don’t begrudge them for that. But should they spend time reviewing hundreds of venture capital registrations each year, or more financially questionable issues from other entities out there?

Q: So what happens from here for the NVCA?

We’ll talk to the treasury folks, but Obama has appointed very few people to key positions. You have your career bureaucrats, but they don’t make these policy decisions.

So getting into the Treasury to talk to those who make policy decisions as opposed to technical ones is hard. It’s only going to get more problematic going forward, Geithner can’t keep working for 23 hours a day. He needs help.

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It’s a natural response to a cold environment. Faced with a wave of redemptions and pounded by losses, almost 1,500 hedge funds out of some 10,000 closed shop last year. Although some 650 new funds were launched, the net shrinkage looks set to continue.

Hedge funds suffered net outflows of more than $154bn last year as bedraggled investors pulled their money out, according to Hedge Fund Research. Most respondents to a Deutsche Bank survey of investors with $1,100bn managed by hedge funds expect more than a fifth of hedgies to fold in 2009. Close to a third expect outflows to top $200bn this year.

After 2007, when net inflows topped $194bn, hedge funds only enjoyed about half a year of decent returns before they hit the buzz saw of the credit crunch. So it’s not surprising to see hot money heading for the exit. Investors who plan on sticking round, such as big institutional investors, are mainly interested in larger funds with long track records.

Small funds will suffer most. The old business model of a 2 per cent management fee and 20 per cent of profits is finished. Some funds are now marketing their services at 1 and 15. If that becomes the new norm and even that may be high smaller funds, even if able to attract investment, will find it hard to attract talent and pay the bills.

In the future, big funds will therefore likely get bigger as smaller managers combine or disappear. Talent will become stickier. Economies of scale mean young bucks who might have struck out on their own two years ago during the wave of easy money will be more likely to stay put. A smaller industry will make it easier for investors to sift through competing funds to find the best managers making the rationale for the existence of the fund of funds industry ever more dubious.

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Steve Cohen is making up for his pickled shark. The hedge fund mogul who famously spent $8m on Damien Hirst’s preserved shark in a tank of formaldehyde dropped a reported $1bn on contemporary art during its recent bull market.

Now he’s built a 6% stake in auction house Sotheby’s for his hedge fund SAC Capital. Luckily for his investors, this bid looks better timed than his personal indulgences.

Of course, that is a low bar of comparison. Cohen bought his dead fish from Charles Saatchi, one of the largest predators of the contemporary art ecosystem, at the top of the cycle. The original formaldehyde-injected shark rotted over time, forcing Cohen to shell out over $100,000 for a new creature.

His fund’s investment in Sotheby’s, revealed in a regulatory filing, is relatively small beans. SAC now owns 5.9% of the stock. Given the auction house’s $650m current market capitalisation, that is a mere $38m stake.

But the tiny gamble should prove a better investment. Sotheby’s stock has fallen 70% over the past year as investors worried its practice of guaranteeing artwork would lead to heavy losses in a weak market. It has now reduced its outstanding guarantees to virtually nothing, lessening its downside risk.

The upside could be considerable. The company can earn close to $150m in free cash flow in a good, if not vintage, year. That’s about what it made in 2004. Moreover, Sotheby’s owns 70% of its London headquarters, which is worth perhaps $1bn, according to JMP Securities. The firm’s net debt of $246m doesn’t appear too burdensome either.

Some think Cohen is actually planning a bid for the whole company. But that would likely represent too big a slice of his investment pie. He’s better off profiting from Sotheby’s shares. Then he, and maybe some of his investors, can use the proceeds to buy some more sensible wall-hangings.

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Leon Black set up Apollo Management in 1990 to invest in buy-out deals and the debt of troubled companies. Apollo now has about $45bn under management, with a war chest of $13bn to take advantage of new opportunities at a time of unprecedented volatility and distress in the markets.

While other firms have often run into trouble because of ill-thought out diversifications, Mr Black has been judicious in his expansion and is currently looking at investing more in commodities and commodity companies.

Mr Black's early career was at the old Drexel Burnham Lambert, a pioneer in making debt capital available to companies with low credit ratings, where he learnt the discipline of debt investment.

From his office overlooking Central Park he can see many of the institutions on whose boards he sits, including the Metropolitan Museum of Art, the Asia Society and Mount Sinai Hospital. Mr Black graduated from Dartmouth College and received his MBA from Harvard.

Mr Black sees little sign of reaching the bottom of the market soon, predicted more challenges in commercial real estate, and said the name of the game in general is surviving to play another day.

How does this macro cycle compare to previous macro cycles?

I would have to say that in my business career, which now spans some 32 years, this has to be the worst economic cycle that I've ever experienced. It is really affecting every asset class, every industry, maybe with the exception of government workers .

When did you start to get nervous?

I guess that at Apollo, which is both in private equity and in a number of credit funds, we first started seeing a lot of credit tremors and nervousness in the summer of 2007.

Apollo is kind of a fund for all seasons, because on the private equity side you can take advantage of times when conditions are good and on the distressed debt side you can profit when times are bad.

What are the signs you will look for that say the bottom is near, and do you see any today?

I wouldn't call them lights at the end of the tunnel, I would say they're more flashes in the dark right now. The banks [are] really only part of the way through. They started with the terrible corporate credit problems they had to get off their balance sheet.

However, when you then look at the other things on their balance sheet: it's credit card debt and student loans . . . [on] residential mortgages they are halfway through, probably they have unloaded or written off half a trillion there. There is probably another half a trillion to go.

And then you have the black hole of commercial real estate, and that hasn't happened yet. Usually, that lags 12 to 18 months [behind] the rest of the financial problems and there you are sitting with $4 trillion of debt and you know not all of it is bad but a lot of it is diminished, and that really hasn't yet been addressed.

What you suggest about commercial real estate would lead me to believe that there is, in fact, a whole other leg down?

Ah, there well might be, and that is one of the big question marks out there in terms of what still has to be addressed and how big a hole there is to cover. Some people have estimated [the additonal bank clean-up] at $1 trillion but I think that it could be as much as $2 trillion.

You grew up in a world of figuring out what companies had too much debt, how to refinance that debt. What do you see happening to the defaults in this cycle?

In general, defaults have to go up. If you look at JP Morgan's expert predictions you know they are talking of 10 per cent to 15 per cent and that's probably right. Very high prices were paid for companies and they were bought with a lot of debt although some of the debt has no default triggers so [it] really depends on which sectors and which companies you're looking at.

Where earnings are down, cash flow is down, and you have a lot of leverage, there will be more defaults. There are some exceptions to that and a lot of the companies that were financed in the past few years had varied capital flexible structures, and therefore I believe many of them will find ways to delever outside of bankruptcy to get through to a recovery.

This is what you're good at, finding opportunities in the debt. But how perilous is that game now?

I think it's time for defence and offence. On defence, the focus on existing portfolio companies is to take out costs, manage capital better and capture debt discount to delever the balance sheet. On offence, there are great opportunities in distressed for those with dry powder, but it isn't for the faint of heart due to mark to market considerations and intercreditor disagreements.

So, what does the world look like when we come out?

Probably, there will be more regulation. Some of it will be good. I think some of it will be bad and will make doing business probably harder. I think companies will have to put more equity into deals, so that they will be less leveraged.

In order for that to happen, the equity markets, the prices, will have to adjust because otherwise the math just doesn't work. You know, if you've paid less for the asset, you can still make the math work very well in terms of getting good returns.

When do you shift to more offensive mode? When do you say, "this is the right time to go in with both hands"?

It will be when I feel that we have done everything we can that is possible for our existing portfolios, and that they are really on even keels, and that our investors are protected, and we've stabilised all those situations. Then, and only then, will we shift to playing full offence.

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