Hedge Funds, IPOs and Pop Medleys

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Hedge funds.

BlueCrest is a hedge fund firm that "this month decided to return all outside money to focus on managing the wealth of its founder Michael Platt and other staff." It was already doing some of that, running an internal fund for its staff (called BSMA) alongside its hedge funds for outside investors, and it turns out that the staff was doing much better than the outside investors:

BlueCrest International was down by 0.17 per cent at the start of this month, following a 0.1 per cent gain in 2014 and a loss of 1.56 per cent in 2013, net of fees.

One person familiar with the BSMA internal fund, which does not charge the same “2 and 20” fees as its public equivalent, said that it was up by “about 60 per cent” over three years, placing it among the best performing hedge funds in the world over that period. BlueCrest declined to comment.

That's not the best of all possible looks. A simple dumb model of hedge fund management would be that investing skill exists, and that if you have it, you should:

  1. Invest your own money in a way that maximizes dollar returns to you, and
  2. Invest outsiders' money in a way that maximizes dollar returns to you.

Strategy 1 is, like, buy stuff that will go up. Strategy 2, though, probably implies that you should scale up your fund and raise your fees until you have captured for yourself all of the alpha that you can generate. If you read that model extremely literally, you'll end up making 60 percent on your internal hedge fund and basically nothing on your external one.


Hedge fund closures surged in the three months to the end of September as money managers reeled from declines in commodity and equity markets, while high-yield credit spreads widened.

So 257 funds closed in the quarter, up from 200 the previous quarter, as it was just a horrible time for hedge funds. Also though: "The number of new hedge funds rose to 269 during the quarter, compared with 252 in the previous three months." The article includes a graph of the last seven quarters, and from eyeballing it, I assert that:

  1. The number of hedge funds started in a quarter always exceeds the number of hedge funds closed, and
  2. The correlation seems to be positive.

It's a triumph of hope over etc.

The IPO ratchet.

When Square went public last month, it sold shares at a price lower than the price guaranteed to some of its Series E investors, and made it up to them by giving them extra shares. A weird thing about this "ratchet" feature is that some of Square's underwriters were also Series E investors, so they had incentives to push for a lower deal price so that they'd get more shares. Here is the Wall Street Journal with more on those conflicts:

Some in Silicon Valley worry that banks’ dual roles as owner and adviser could set the stage for tension around future offerings.

Banks are “inherently conflicted because their clients are both the investor buyers of the shares and the company that is selling the shares,” noted Spencer Rascoff, chief executive of online real-estate company Zillow Group Inc. and a well-known angel investor. “This conflict is further exacerbated when the banks have also invested directly in the company pre-IPO.”

As I wrote last month, these conflicts are well known and there are established mechanisms for dealing with them, like having at least one "qualified independent underwriter" (for Square, Morgan Stanley) without a conflict to opine on the price. Of course those mechanisms aren't perfect, and if JPMorgan and Goldman Sachs (who both profited from the ratchet) had pushed hard for a lower price, they might have persuaded the company. On the other hand, the conflicts will frequently go the other way: If an underwriter is also an investor, it will usually want a higher price so that the value of its investment is higher, though ratchets complicate that.

More generally, an initial public offering is always about managing conflicts of interest. Underwriting banks sit between a company, which wants a high deal price, and investors, who want a low deal price. If the price is high, the banks will get paid more, the company will be happy, the banks will get more repeat deal business, etc. If the price is low, the investors will be happy, the banks will get more trading business, etc. The point of hiring underwriters to do an IPO is that everyone knows those conflicts exist, and that everyone hopes they balance out and lead the underwriters to an outcome that is more or less fair for everyone. Left to its own devices, the company would overprice the offering; left to their own devices, investors would underprice it. The underwriters act as (conflicted) referees. Underwriters who are also shareholders will have extra conflicts, though it is not ex ante obvious which way they'll cut. But their whole business is about conflicts; they'll manage.

Stock splits and un-splits.

We talked a bit yesterday about Kansas City Life Insurance Company's 1-for-250 reverse stock split, followed immediately by a 250-for-1 forward stock split. The idea is that shareholders will be left exactly as they are, except that shareholders with fewer than 250 shares will be cashed out at $52.50 per share, leaving the company with few enough shareholders that it will be able to stop filing Securities and Exchange Commission reports. To get shareholders to approve the deal, KCLI had to offer a small premium to the cashed-out small shareholders; the stock closed at $48.61 on Tuesday, the day the shareholders approved the deal, so the $52.50 price represented about an 8 percent bonus for the departing small shareholders. A reader pointed out that "a good small fry arb" was to buy 249 shares of stock on Wednesday for (say) $51, hold it for a few hours, and get cashed out by the company at $52.50, for a quick riskless profit of $373.50 ($1.50 per share). It won't make you rich, but it is free money, and it attracted a lot of people; out of 988 trades in KCLI's stock on Wednesday, 104 were in multiples of 249:

It is pleasing to know that, in the face of goofball stock-split engineering, markets remain efficient. The stock was down yesterday. Elsewhere, CoSine Communications announced that it will be doing a 1-for-80,000-for-1 split/unsplit, as part of a plan to get its current 80.3-percent owner up to 100 percent.

People are worried about unicorns.

Look, I know that it is hopeless, and that nothing I can say here will change things, but still it is a moral imperative that I tell you: Don't make corporate song parody videos. It is a bad genre. Every year venture capital firm First Round Capital makes a song-parody-medley video, and every year it manages to be both the absolute best thing in the genre, and also terrible. Here's this year's video. "Another year, we're still here, new unicorns, big press releases," they sing, ominously. But the Music Unicorns  (Tunicorns? Tell me there's not a venture capital a capella group called that) have a serious message, too. They sing: "Does your website work in Safari? Yeah I know Fidelity marked you down, and we all know your stock price now." That neatly captures the two big unicorn worries: How rich private valuations will fare in a world of increasing scrutiny of late-stage investments by big institutional investors, and Safari compatibility.

In other year-end parodies, here's "The Night Before Fintech Christmas," which, mercifully, no one seems to have sung. Here is Izabella Kaminska on fintech, "originate to distribute" and reputational risk. Elsewhere, Theranos, the Blood Unicorn, continues to come in for criticism for its opacity, this time from Roger Parloff, who wrote a 2014 Fortune cover story about Theranos that said that it "currently offers 200—and is ramping up to offer more than 1000—of the most commonly ordered blood diagnostic tests, all without the need of a syringe," and who says now that that was "a whopping false statement." And: "I was a 3nder 'unicorn' — an unattached female user of the trendy dating app that matches people seeking threesomes or more."

People are worried about bond market liquidity.


Avenue Credit Strategies Fund, a high-yield fund run by Marc Lasry’s Avenue Capital Management, put about 45 percent of its portfolio into cash earlier this week after another high-yield fund with a similar name, the Third Avenue Focused Credit Fund, froze redemptions last week.

Avenue Capital was worried that clients would confuse the names and pull money from its fund, said Todd Fogarty, a spokesman for the firm.

The big bond market liquidity worry has always been about the "liquidity illusion," in which investors in bond funds expect more liquidity than the underlying bonds allow for. I have been a bit skeptical about that worry, because it is discussed so incessantly that I have trouble believing anyone could still have any illusions about it. But Avenue is worrying about a very different and much stupider liquidity illusion, in which investors in its bond fund think it's a different fund with a similar name. It's a useful reminder that investors can have pretty much any illusion about anything, and that run risk is not entirely about rational behavior.

Elsewhere: "The Specter of Risk in the Derivatives of Bond Mutual Funds." And U.S. investment-grade bond funds saw record redemptions of $5.1 billion in the week ending Wednesday, which was also the day the Fed finally raised rates, and you'd have to say that given the rate increase and the record redemptions, corporate bonds have held up rather well so far.

The FRED blog.

The Federal Reserve Bank of St. Louis has an excellent and well-known economic database, called FRED. FRED has a blog, called The FRED Blog. It has a dorky charm:

Christmas in Connecticut is a classic romantic comedy from 1945 that depicts, as the title strongly implies, some holiday hijinks in the Nutmeg State. Although FRED does not offer much romantic intrigue, it can tell us how the retail sector is doing in individual U.S. states. The graph above shows definite seasonal regularity in Connecticut’s retail employment (the blue line) that’s associated with retail sales around Christmas.

Me yesterday.

I wrote about Martin Shkreli. So did Ezra Klein, and his post is very good:

Shkreli definitely doesn't strike me as a good guy. But the hatred for him seems more about our hatred for the downsides of Twitter, pharmaceutical pricing, and patron-supported art than anything else.

Shkreli is unusually public and brazen about his operations in these markets, but if he didn't exist, other wannabe masters of the universe would be doing the exact same things, with the exact same effects, but with much less public knowledge. In some ways, that makes me prefer someone like Shkreli, who at least publicizes the problems he takes advantage of, to his quieter, classier colleagues.

Things happen.

Ukraine Defaults on $3 Billion Bond to Russia. Governor of Puerto Rico Warns of Looming Default Without Bankruptcy Plan. Fed Raised Rates Without a Hitch, and It Only Took $105 Billion. A Missed Opportunity of Ultra-Cheap Money. We Can't Even With This Millennial ETF. Libor Oversight Chief Was Forced Out. House Approves Bill to End Tax-Free Real Estate Spinoffs. Former Chief of BTG Pactual, André Esteves, Is Freed From Jail. Former MIT dean, son sentenced for hedge fund scheme. A Look Inside the Sweetest Corporate Director Posts in America. The Whole Foods Co-CEO Has Saved Up 338 Days of Vacation Time. U.S. Chief Justice Roberts Overlooked Stock Conflict in Case. On the Use of Market-Based Probabilities for Policy Decisions. It's been a rough year for molybdenum. "It’s rare that you travel to a country — however small — and find that your family used to own it." Junk stocks. Questionable chocs. Netflix sox. Twitter bots. Comedy wildlife photography.

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To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

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Brooke Sample at bsample1@bloomberg.net