Herding, Hearings and Proxy Fights

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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Crowded trades and killing fields.

The famous line about hedge funds is that they are "a compensation scheme masquerading as an asset class," and there is some bare factual sense in which that is true. A hedge fund is just a pot of money, not registered as a mutual fund, that invests in things and pays its manager a fee. It can invest in whatever things it wants. You can have a hedge fund that just buys stocks, or a hedge fund that does capital-structure arbitrage in corporate credit, or a hedge fund that makes macro bets on currencies, or a hedge fund that just buys puts on the S&P 500 to prepare for the coming crash, or whatever. There is no obvious directional bias to "hedge funds" as a category (unlike mutual funds, which are categorically long publicly traded stocks and bonds), and part of the marketing for hedge funds, as a category, is that they attract mavericks and contrarians and lone geniuses who are too creative and original to fit in at more conventional Wall Street employers.

But of course some strategies are more popular than others, and while "hedge funds" aren't an asset class, they are more of a constellation of strategies than a blank slate for novel investment thinking. And it can be hard to escape the herd. Dan Loeb's gloomy quarterly letter to investors in his Third Point fund has gotten a lot of attention; the much-quoted gory passage runs like this:

Making matters worse, many hedge funds remained long “FANG” stocks (Facebook, Amazon, Netflix, and Google), which had been some of 2015’s best performing securities. Further exacerbating the carnage was a huge asset rotation into market neutral strategies in late Q4. Unfortunately, many managers lost sight of the fact that low net does not mean low risk and so, when positioning reversed, market neutral became a hedge fund killing field. Finally, the Valeant debacle in mid-March decimated some hedge fund portfolios and the termination of the Pfizer-Allergan deal in early April dealt a further blow to many other investors. The result of all of this was one of the most catastrophic periods of hedge fund performance that we can remember since the inception of this fund

"There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies," concludes Loeb, and there is something sort of unsettling about the categorical underperformance, and the ease and generality with which Loeb can describe it. Like: There are a lot of ways to be "market neutral." (Hold cash!) There are even a lot of ways to be "market neutral" and levered. (Go long 100 betas of XYZ and short 100 betas of ABC, or vice versa.) It's not strange to see a market neutral fund lose money -- there are no perfect hedges, and "low net does not mean low risk" -- but it is a little odd to see lots of market neutral funds lose money in the same ways at the same time. If they're all doing the same thing, why are there so many different funds?

Similarly, it's not weird for a long-biased concentrated value equity fund to lose money, but it's weird if they all lose money on the same stocks at the same time. But here we are, with the FANGs, and the Valeants, and the herding:

“The bottom line is, hedge fund herding is not going away anytime soon,” said Andrew Karolyi, a professor of finance at Cornell University. “If anything, we are now seeing the early signs that this type of hedge fund herding is spilling over into herding of large institutional investors. To the extent that that spillover grows and expands, then we will be concerned.”

On the other hand, while I can understand the concept of a "crowded trade" for hedge funds (a stock owned by lots of hedge funds), it is weirder to think about the concept of a "crowded trade," for a stock, generally. The thing about stocks is that each share of stock has to have at least one owner, and at most one owner. (I mean, if there is short selling, some shares can have two owners, but lots of short selling is not normally understood to make a stock "popular.") So this is kind of weird:

More than in past quarters, owning popular stocks this month has resulted in disproportionate pain when company earnings failed to live up to forecasts, according to Sanford C. Bernstein & Co.’s quantitative analyst group headed by Ann Larson. 

But at some basic level every stock is equally popular; each share is owned by exactly as many people (one) as every other share. "The Bernstein analysis measured crowding based on institutional ownership, sentiment and expectation metrics like earnings forecasts and valuation," fine, and obviously some stocks can be unusually crowded with institutions. (Other stocks are unusually crowded with retail.) The question is whether the crowd tends to move in unison, and obviously, with some sorts of institutions, the answer is yes.

Elsewhere in crowding, perhaps, the Curse of the Dow has struck Apple. And this Cullen Roche post on the future of active management strikes me as right.

Valeant.

Speaking of crowded hedge fund trades, Valeant was in the news yesterday, huh? Most notably, the Senate Special Committee on Aging heard testimony from Bill Ackman, Michael Pearson and Howard Schiller, perhaps the three men most publicly associated with Valeant even though none of them quite work there? I mean, Pearson does -- he's the chief executive officer -- but he's on his way out, with Joseph Papa set to replace him on Monday. Ackman is an investor and relatively new director, while Schiller was the chief financial officer (and was briefly interim CEO) and is now just barely hanging on as a director. It is an odd crowd to defend Valeant's drug pricing policies. No one really did; even Pearson said that "it was a mistake to pursue, and in hindsight I regret pursuing, transactions where a central premise was a planned increase in the prices of the medicines." Still, Ackman at least mounted a rousing defense of Valeant's strategy of developing drugs by acquisition rather than by research and development, arguing that "a drug company can do as much or more for innovation in pharma by acquiring other drug companies and licensing drugs than by developing drugs internally":

Most innovation in pharma in recent years has come from start-ups, biotechnology companies, non-profit research labs, and university research programs. For this reason, the Pershing Square Foundation has focused on funding early-stage research programs at universities and non-profit research labs like Cold Spring Harbor. This shift from large R&D programs housed within big pharmaceutical companies to partnerships with and acquisitions of drugs from smaller, more entrepreneurial companies is analogous to the transformation that has taken place in the technology sector, where the large, internal R&D programs of decades ago have largely been overtaken by innovation in start-ups and smaller, more entrepreneurial businesses that can develop new technologies much more efficiently.

You can see the appeal to hedge funds. Valeant's promise was that financial innovation could not just make it a more profitable drug company, it could also make the process of drug development more efficient and more productive, leading to more innovation in actual drugs. It's financial engineering to cure cancer. It did not quite work out that way. The senators were not amused. Ackman "said he would use a board meeting on Thursday to recommend sharply reducing the price of some its most contentions medicines." 

Meanwhile, outside of the hearings, Valeant disclosed the pay package for Papa, the new CEO, which includes a $1.5 million salary, a $2.25 million target bonus, an $8 million payment to compensate him for forfeited Perrigo shares, and a pile of restricted stock and options that could be worth over $500 million if Papa can get the stock to $270 by 2020. Obviously if he can do that -- which would create over $80 billion of value for shareholders -- he'll be worth it, but you can see how the timing of the disclosure might be awkward. Also, Valeant will be shaking up its board.

Yahoo.

Starboard Value's proposed proxy fight with Yahoo was always a little weird insofar as Starboard's main platform was that Yahoo should sell its core Yahoo business, and Yahoo has been working diligently to sell itself, so the only real issue for the proxy fight was whether someone was lying. That is kind of a dumb thing to have a proxy fight about, especially while the company is in the midst of, you know, working diligently to sell itself. So yesterday Starboard and Yahoo finally settled, giving Starboard four seats on a board that has been expanded from nine to 11 members, and allowing Starboard to pester management about the sale process from inside the boardroom rather than in public filings. That seems like an obvious improvement for both sides.

Here are the settlement agreement and the 8-K filing; the agreement mostly covers the board arrangements, and a Starboard standstill, but there is also this:

Yahoo will submit any decision to engage in a sale of all or substantially all of the assets of the Company’s operating business to a stockholder vote.

Because of course that is not a given. Asset sales do not generally require a shareholder vote. Bids for Yahoo's core business seem to have come in at a range of about $4 billion to $8 billion, about 9 to 17 percent of Yahoo's $45 billion of book assets (and just 11 to 23 percent of its $35 billion market capitalization). Yahoo, as a portion of Yahoo, is just not that important to Yahoo; without that Starboard agreement, the board could conceivably have just sold it without asking the shareholders for permission. 

Anyway, good work Starboard. Here's an article about its "Rise to Activist Prominence." And here is a Bloomberg Businessweek feature about core Yahoo's struggles.

Bank earnings.

"Under-promise and over-deliver" gets a lot of lip service in the financial industry, but it is a testament to Deutsche Bank co-CEO John Cryan's glorious gloominess that the stock soared on this news:

Co-Chief Executive John Cryan told analysts that the bank is seeing enough improvement in its operations potentially to be “on the cusp” of a small profit this year, but cautioned that it was too early to tell.

That is ... that is clearing a low bar. But Deutsche Bank beat expectations; "primary drivers included lower legal costs and results from businesses the bank expects to sell or wind down, while core trading revenue and wealth-management results were weak." Here is the press release. Bloomberg Gadfly's Duncan Mavin argues that "investors should be troubled by the bank's better-than-expected results," since after all Cryan himself said that "a bigger profit might be a hallmark of us not having achieved what we want to achieve." Oh man, that is some good expectations management right there.

Elsewhere: The credit markets aren't that enamored of Deutsche Bank. "Lloyds Banking Group said on Thursday that its first-quarter profit declined 44 percent from a year earlier, as the redemption of bonds it issued during the financial crisis and other charges cut into its results." And the big private-equity firms have reported weak earnings "as volatile markets hurt the value of their investments and made it hard to do more buyouts or sell off companies they already own."

Margin loans.

If you subscribe to my simple dumb model that most companies are good at doing one thing, then it would make sense that a company that makes space rockets would be separate from a company that makes electric cars and from a company that sells solar panels. Those are just pretty different businesses; it would be weird to combine them. It just so happens that the founder of each of those companies, Elon Musk, transcends the usual bounds of human competence, and has some ideas about how to do all of those projects. But he quite sensibly offered investors three separate companies, so that investors who like electric cars can buy Tesla, investors who like solar power can buy SolarCity, and investors who like space rockets (and are accredited) can buy SpaceX, the Rocket Unicorn, which is still private.

On the other hand, one good counterargument to the idea that each company should be good at one thing is that sometimes cash from one profitable thing can cross-subsidize another thing with great potential that is currently going through a rough patch. So for instance if the space-rocket business is taking off (I am sorry), while the electric-car business is facing delays, then the space-rocket business could lend the electric-car business some money, if they were part of the same company. But they are not. 

But they are all part of the same informal Elon Musk ecosystem, so there are ways to do it, as the Wall Street Journal reports. So for instance, after SpaceX won a big government contract, "Mr. Musk personally borrowed $20 million from SpaceX. In the interview, he said the loan was 'to help fund Tesla.'" SpaceX has been a buyer of SolarCity bonds more recently. And Musk has $475 million worth of personal credit lines, secured by about $2.5 billion worth of SolarCity and Tesla stock, that he has drawn on to invest in his companies. 

Should you care? This seems strictly preferable to his running the three businesses as a conglomerate, no? Of course there are conflicts of interest: Either those SolarCity bonds are cheap (in which case they're a bad deal for SolarCity), or they're expensive (in which case they're a bad deal for SpaceX), though the fact that there are outside buyers suggests they're more or less fair-ish. The margin stuff has never bothered me that much; the Journal says that "few top executives use their shares as collateral for personal loans because it can be risky to other shareholders and also raises concerns that the executive’s personal interests could conflict with the company’s interests," but those risks and conflicts are fairly remote. The risk is that if the stock drops by a lot, Musk might get blown out of his margin loans, pushing the stock down some more. But the loan-to-value on Musk's credit lines is less than 20 percent; if SolarCity or Tesla fall by more than 80 percent, shareholders have bigger problems than Musk's margin loans. "The odds that a margin call cannot be addressed are almost zero," says Musk, and while I realize that sounds like bluster, he does have quite a lot of other money.

This is a weird way to finance a group of related but distinct companies, but the question generally is whether it is better than the alternatives. Sometimes financial engineering really can add value. Elsewhere in Elon Musk: OpenAI.

Poor Sergey Aleynikov.

Somehow Goldman Sachs, which had Sergey Aleynikov arrested twice for stealing high-frequency trading code, is still fighting his demand that Goldman pay his legal fees, even though he's had the charges tossed out twice, after spending about a year in prison. Goldman's argument is that only corporate officers get their bills paid, and Aleynikov's vice-president title didn't make him an officer. "As a result of title inflation, there are many vice presidents." That last part is of course correct, but still it seems sort of mean-spirited not to pay his legal bills after all he's been through. I wrote about this case about a year and a half ago, and it seems like nothing has changed in the interim. Disclosure: I used to be a Goldman Sachs vice president too, though I never gave them any occasion to pay, or refuse to pay, my legal bills.

In other Goldman Sachs news: checking accounts? I guess I should also disclose that, unlike John Carney, I was able to open a Goldman Sachs Bank savings account, though I have not yet succeeded in funding it. I await my toaster eagerly.

Kids these days. 

I've mentioned teen hedge fund manager Jacob Wohl around here before, so I suppose I should point you to this update on his life and business, which includes both a "trading education course that costs $4,999 per week and included sleepovers" and a fund with a Sharpe ratio -- as reflected in "rough draft" promotional materials -- of "7.87%." 

People are worried about unicorns.

It is quiet on the unicorn front, but Uber, the Ubercorn, seems to be worried that it may have to reveal financial metrics in its $100 million settlement with drivers. It does somewhat ruin the fun of being a private company if you need to disclose financial details anyway. And: "Do You Earn Less Than a Silicon Valley Intern?"

People are worried about bond market liquidity.

"Bond Market Liquidity? Look to the Buy Side," writes Tabb Group's Anthony Perrotta, citing a poll finding that a majority of investors now think that all-to-all trading of corporate bonds is now possible. Dealers remain more skeptical.

Things happen.

Fed Signals No Rush to Raise Rates. Bank of Japan Keeps Policy Unchanged; Yen Rises. The AAA rating is overrated. Portugal and the Awkward Power of Credit Ratings. Zuckerberg seeks to tighten grip as Facebook results surge. Stock-Tracking System Years in Making Gets Renewed SEC Push. Protesters Have a Long History of Crashing Buffett’s Annual Party. Puerto Rico Risks Historic Default as Congress Chooses Inaction. The Braves Play Taxpayers Better Than They Play Baseball. André Esteves, Freed From Jail, Returns to BTG Pactual. Putin's Decade-Old Dream Realized as Russia to Price Its Own Oil. Ex-Citigroup Executive Sues Claiming Whistle-Blower Mistreatment. Toby Nangle on the productivity slump. Maybe Harvard should spend more of its endowment. "Our boss will fire us if we don’t sign up to be a liver donor for his brother." New York man punched in the face because he 'looks exactly like Shia LaBeouf.' Rapping about credit card fraud. Protest insurance. Hydrox comeback. Digital smell. "There are alternatives to hugs, like scratching or belly rubs."

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net