So, say you went to Stanford and are a smartie.  Your parents both attended law school at Yale and, at least when they were younger, practiced law.  They then went into politics and public service.  After graduation, you follow in your father's footsteps and become a Rhodes scholar, then return to the U.S.  You could just be a party girl, but that's not for you.  You want a career.  A real career.  Should you go to law school?  No way.  You go to work for a hedge fund.

Chelsea Clinton, 26, now works for a hedge fund, Avenue Capital Group.  After beginning her career as a consultant at McKinsey, she will now (according to People magazine) "easily double her six-figure starting pay at her old job" and travel less.  Her boyfriend is an investment banker at Goldman Sachs.  The new power couple?

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WSJ Blog posts today that the San Diego County Employees' Retirement Fund is suing Amaranth Advisors.  The fund lost $100 million as part of the natural gas trading losses incurred by Brian Hunter of Amaranth, who we have mentioned before.  The fund invests 20% of its assets in hedge funds.  Does no one in San Diego remember Orange County?

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If you are interested in corporate governance, Bill Bratton's new paper, Hedge Funds and Governance Targets, is a must read. Bill presented the paper here last week, and it is an impressive first empirical project. The bottom line: hedge funds have had "an enviable record success in getting targets to accede to their demands, using the proxy system with remarkable, perhaps unprecedented, success," but returns from activism have been low, suggesting that "hedge fund activism is a more benign phenomenon than its critics would have us believe."

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Lots of interest is being pointed at Amaranth Advisors, a hedge fund who until recently heavily touted its superstar energy trader, Brian Hunter.  In fact, Amaranth Advisors was considering creating a fund that focused solely on energy trading.  However, this week, Mr. Hunter's trading strategy went sour as his long-term positions crept into further and further time periods where liquidity is thin and volatility is assured.  So this week, he lost $5 billion of the fund's $9 billion in assets.  (He was up $2 billion for the year, so we should just say he lost $3 billion, to be fair.)  This WSJ article today explains how natural gas futures trading is much more volatile than other types of commodities, i.e. risky, even when done by 32-year-old math whizzes like Mr. Hunter.  So, we have already read how hedge funds are risky (but with hopes of high returns), so doesn't it follow that a hedge fund that focuses on natural gas trading would be risky *squared*?  Why are we so surprised here?

Immediately come claims that some crime must have been committed, some law violated.  Exactly what law is a little unclear.  The law of probabilities?  The law of math?  Volatility works both ways, and the losses seem to be unpleasant but not improbable.  If your 401k gained $200 last week, but lost $500 this week, would you suspect that a crime had been committed?  Ellen Podgor also weighs in on the "so big it must be a crime" theory here.  UPDATE:  TomK also ponders the fascination here.

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Hedge funds seem to turn all conventional wisdom on it's head.  Hedge funds don't act like other shareholders -- they get seats on boards, push through reform, that kind of thing.  Now, investors in hedge funds don't act like regular investors, either.  The WSJ reports today that investors in Lipper Convertibles (the article calls it an investment partnership, so we'll assume it's an LP) are suing former investors.  Lipper Convertibles was flying high and making large distributions at one time, apparently due to some profit inflation by the portfolio manager in an attempt to attract new investors.  During this time of 40% profit inflation, some investors took their distributions and cashed out.  The ones that didn't, and the ones that invested during the inflationary time, are now suing the investors who cashed out, saying that the profits were "unjust enrichment."  (OK, so the investors in question are people like Sylvester Stallone, John Cusak, Ed Koch, and Henry Kravis' kids, but that's not the point.)

The point is whether there is any sort of theory of recovery here.  In corporate law, shareholders who sue the entity for 10b-5 causes of action or otherwise look to the entity for recovery, not the current shareholders, or even the anonymous shareholders who sold the overpriced shares to them.  This has led some to argue that private securities litigation is nothing but an intra-shareholder wealth transfer, which I've blogged about before.  These hedge fund investors have a leg up on shareholders in a publicly-held corporation, however:  they know the exiting investors.

Lipper Convertibles, of course, is not a corporation, and so the theory would be slightly different for a limited partnership.  (Other hedge funds named as examples in the article facing investor suits are LLCs.)  Generally, we don't look to limited partners, current or former, to disgorge prior distributions that were larger than otherwise available under the partnership agreement due to fraudulent bookkeeping on the part of an employee of the partnership.  (Is that right?  I think I may be convincing myself otherwise.)  The partnership agreement could have a clawback provision that would operate either upon discovery of an accounting error, such as this one, or upon some other happening.  I can imagine an investment partnership with illiquid assets such as real estate having provisions that allow partners to exit but be subject to an earnout provision or clawback over time.  However, the WSJ article does not mention any sort of partnership agreement provision.  These suits seem to be following some sort of theory based on fraud, unjust enrichment and fairness.

One of the suits mentioned involved a fund that was in bankruptcy, and the trustee is attempting to clawback distributions under the bankruptcy code.  That trustee may have a doctinal leg to stand on, but I'm not sure if the other cases do.  I would be happy to hear what others think.

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This W$J article notes how the pension bill going through Congress would make it easier for pension funds to get into hedge funds.  Sounds scary and risky, right?  It shouldn't.  Under current law, if an investment fund takes more than 25% of its money from pension funds (and isn't a "venture capital operating company" or VCOC - long story), the hedge fund becomes an ERISA fiduciary, which apparently is a pain in the behind.  The bill would exempt public employee and government pensions from counting against the 25%. 

I think this makes sense -- public employee pension funds (think CalPERS) are usually big powerhouse players who can figure out which funds are better to invest in, and the 25% rule can make it difficult for pension funds to get into the best funds.  A few questions, though:

1 -- Instead of drawing a line based on public employee vs. private pension funds, why not draw a line based on the size of the pension fund?  Presumably size is a better proxy for sophistication than govt vs. private. 

2 -- Couldn't Congress turn the rule around to look at the percentage of assets that a pension fund invests in a given hedge fund rather than the the percentage of money in a hedge fund that comes from pension funds?  I'd be concerned if my pension were all invested in one hedge fund, but not if 15% of my pension money is spread across five different funds. 

3 -- Why do we think hedge funds are more dangerous than venture funds?  I think the purpose of the rule here is to discourage pension fund managers from pushing their fiduciary obligations off onto other passive investment managers who aren't ERISA fiduciaries.  VC funds can fit into a different policy box because they actively exercise management rights.  They aren't passive investors.  (I think a lot of private equity funds also manage to fit into the VCOC box, but I'm not sure.)  As hedge funds become more active investors, then maybe the right policy choice here would be to loosen the VCOC rules a little, not change the 25% rule. 

If that's not the rational for the VCOC exception, then what is?

Anyone know of a good law review article that talks about these rules? 

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Remember Bazooka bubble gum and baseball cards?  Where have they gone?  That's what Pembridge Capital Management wants to know. 

Pembridge has helped organize a proxy fight at Topps, the baseball cards and bubble gum company.  Pembridge and another hedge fund have formed the Topps Full Value Committee to propose their own slate of directors.  According to its letter to shareholders, gum sales for Topps have dropped 60% over a twenty-one year period.  In 1985, gum sales hit $26.2 MM.  In 2006, they were at $10 MM.  Even a Topps managing director admitted that the company had "almost missed an entire generation" by failing actively to market the Bazooka brand.  "Bazooka disappeared from the airwaves and virtually all other forms of communication for over a decade."  Apparently, Bazooka can't be sold to big box warehouse stores like Costco because their retail prices for bubble gum were lower than Topps' manufacturing costs.

Pembridge is pushing for asset sales as well as seats on the board.

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This is "the golden age of hedge funds," says dailyii.com. I'll say! Two hedge fund managers pulled down over $1 BILLION in compensation last year.

One of them was T. Boone Pickens!

Sure beats fighting over hostile takeovers in the Delaware courts.

HT Paul Kedrosky.

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Many thanks to Gordon, Christine and Vic for allowing me to guest-blog for the past two weeks. I’ve really enjoyed the chance to participate in this excellent forum.

Additionally, I wanted to close by passing along news of a recent development relating to the issue of hedge fund/private equity fund convergence on which I previously wrote. Following KKR’s recent investment in GMAC’s Commercial Holding Corporation last week, GM is expected to announce today an even larger ($14 billion) strategic investment in GMAC Finance by a different consortium of investors. (NYT article here). Any guesses on who led the transaction? If you guessed the hedge fund (Cerberus Capital) that nearly beat KKR in last week's GMAC transaction, you’d be correct. In fact, Cerberus and KKR appear once again to have been the primary contenders in the auction. (Why do I suspect there is no love lost between the general partners at KKR and Cerberus?) While it’s uncertain if the transaction will solve GM’s financial woes, it certainly underscores the potential convergence of hedge funds and private equity funds.

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I was recently informed of a large VC investment made last week in a start-up called Salick Cardiovascular Centers, Inc. The company develops medical centers that provide diagnostic and treatment services for cardiovascular disease on an outpatient basis. Last week Salick announced that it had raised $75 million in a first round financing. What I found especially interesting about the financing was that it was led not by a traditional venture capital firm, but by Warburg Pincus—a private equity firm known primarily as an LBO/buy-out shop (for instance, they were part of the LBO consortium that bought Neiman Marcus last year for $5.1 billion). The conventional wisdom about private equity is that it consists of “venture capital funds” and “buy-out funds,” but deals such as Salick signify how this categorization can often be quite misleading. In fact, Warburg Pincus is not the only buy-out firm that dabbles in start-ups. For instance, KKR—arguably the quintessential “buyout” shop—has done several, including a whopping $250 million financing of a start-up called Jazz Pharmaceuticals in 2004. Traditional venture capitalists, for their part, have also tried the occasional leveraged buyout (the most recent one that comes to mind is New Enterprise Associates’ failed buyout of m-Qube earlier this month).

The blurring of lines that occurs among buy-out firms and venture capital firms is also occurring more generally between private equity and hedge funds. In theory, hedge funds are supposed to engage in sophisticated trading strategies that allow them to exploit inefficiencies in the public markets and realize value in short periods of time. In recent years, however, a number of hedge funds have begun to invest in private equity transactions. The reasons for this trend have been discussed elsewhere, so I won’t go into detail here. But the general theory is that as the number and size of hedge funds have increased, the market has become intensively competitive, causing some hedge funds to look to private equity as a means of achieving superior investment returns. Cerberus Capital has been especially active, nearly defeating KKR in the $5 billion auction of Toys-R-Us last year, and just this month, it came close to out-bidding KKR again in GM’s $8.8 billion auction of its GMAC financing arm. In response to this new competition, some of the most prominent buy-out firms have recently established hedge funds (e.g., KKR, the Carlyle Group, Bain (via Sankaty Advisors) and Blackstone). I suppose one could call it a turf war of sorts.

From a legal perspective, the hedge fund/private equity convergence suggests yet another problem with the SEC’s new rules requiring the registration of hedge fund advisors. In proposing the rules, the SEC rightly noted that traditional private equity firms do not pose the same types of concerns that have been voiced about hedge funds—in particular, the “retailization” of traditional private equity funds has not occurred as it has with hedge funds. Consequently, it sought to remove private equity funds from the scope of the registration requirement by exempting any private investment fund that allows its investors to redeem their securities within two years of purchase. Traditionally, this would have excluded venture capital and buy-out funds that require investors to be locked into the investment funds for several years (usually 10-12 years) to permit sufficient time to realize value on their illiquid investment portfolios. Hedge funds, in contrast, have historically permitted investors to enter and exit funds at any time, which posed little problem for funds that are invested in liquid, publicly-traded securities.

The convergence of buy-out and hedge funds indicates that the SEC’s attempt to distinguish between hedge funds and private equity funds may ultimately be unworkable from both an economic and a legal perspective. Economically, is Cerberus more properly classified today as a “hedge fund” or a “private equity” fund? Likewise, the economic convergence of private equity and hedge funds undermines the SEC’s legal standard for distinguishing between the two. The free redemption model of traditional hedge funds only works so long as a fund is invested primarily in liquid securities. Not surprisingly, as hedge funds have moved into private equity investing, they have required investors to agree to “side pocket” provisions with lengthy lock-ups that prevent investors from freely redeeming the non-liquid portion of their capital accounts. Consequently, many hedge funds have bona fide business reasons for requiring lock-ups that exempt them from the SEC’s new rules. (This is to say nothing of the ease by which even a more scheming hedge fund advisor can avoid the registration requirement by simply imposing a two-year lock-up provision—an incentive that only accentuates the agency risks of investing in a hedge fund.)

Fundamentally, the problem with the SEC regulation stems from the fact that the SEC chose a legal standard that has nothing to do with the reasons for exempting traditional private equity funds in the first place. If the SEC was worried about the retailization of hedge funds, it seems a more direct approach would have been advisable. In fact, why even turn to the Advisor’s Act? Why not instead tighten the investor suitability requirements under Reg D/4(2) as they apply to the private placement of investment funds?

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Read all about carving up the bonus pool at Goldman Sachs.  Thanks to David Zaring for the tip.

It's interesting that even Goldman Sachs is feeling the pressure of "2 and 20" -- losing people to hedge funds who are lured away by the promise of the industry standard 2 percent management fee, 20 percent profits interest comp structure at hedge funds.  I've finally settled on a topic for my next tax paper:  The tax consequences of 2 and 20.  I'll be pointing out how the tax law subsidizes the 2 and 20 structure.  (As if hedge fund managers weren't making enough money already.) 

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Many thanks to Vic, Gordon, and Christine for inviting me to join in for two weeks.  I'm really looking forward to it.  I'm hoping to spend a little more time on some of the issues that regularly get batted around by the business law blognoscenti, such as SSRN, Eliot Spitzer, and Sarbanes-Oxley.  And the timing seems especially auspicious given the Ideoblog takeover by the "Truth on the Market" folks.  Nice title, by the way -- could we call it "the Truth" for short?  I'm sure Paul Pierce or Carl Williams wouldn't mind.

Hedge funds have been all the rage recently, both for wealthy investors and for blogging profs.  When I saw the New York Times article, my first thought was that hedge funds had officially jumped the shark.  There has been such a craze over hedge funds that we seem to be entering a familar loop: (1) below-the-radar investment vehicle gets above-average returns, (2) the financial press starts to make noises about this great! new! thing!, (3) positive news stories start appearing in the mainstream press, and (4) money from semi-sophisticated investors starts pouring in.  What generally happens after that?  (5) Everyone is talking about this great new investment vehicle, (6) some commenters start making knowing asides with pessimistic predictions, (7) the vehicle gets even stronger, despite the odds, (8) some negative stories start coming in -- fraud here, poor returns there, (9) the vehicle hits an abrupt speedbump, and (10) the bottom falls out.  It happened with "junk" bonds in the 1980s and high-tech stocks in the 1990s.  Frank Partnoy makes a persuasive case that it has happened and will happen again with derivatives.

Hedge funds seem particularly likely to flame out because of the ease of setting up a hedge fund as well as the secrecy associated with them.  Unlike high-tech stocks or junk bonds, you don't need sophisticated Wall Street banks to set up the vehicle or manage the IPO.  All you need are a bunch of rich folks and a dream.  When will we read about a "hedge fund to the stars"?  (Maybe I missed it already.)  You could hedge with Paris Hilton!  I had hoped that the coming hedge fund implosion would only really affect investors who should know better, but the NYT article dispelled some of that hope for me.  Further evidence that pension funds will be the S&Ls of the new century.

I suppose these stories also include (11) Regulation is imposed after the implosion, but it is criticized as "too late" or "too intrusive".  I agree with Vic that maintaining ERISA's presence here is not a bad thing.  But hedge fund managers hate the new SEC rules, which seem somewhat benign as well.  I'm not sure what the overall answer is.  But I've seen this story before, and it seems fairly inevitable that before too long I'll be able to buy a hedge fund puppet on eBay.

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The NYT had a story yesterday about the trend of pension funds pouring money into hedge funds.  Thanks to JJ Prescott for pointing me to the story.

Pension funds and hedge funds go together like milk and orange juice.  The hedge fund industry hasn't done a good job of managing its brand image.  Hedge funds have lost their original connotation of being a hedge against the market, and many laypersons instead equate hedge funds with gambling.  If hedge funds were called "absolute return funds," i.e., funds designed to produce steady returns in any market conditions, they would actually seem a perfect fit for pension funds. 

With the equity markets rather flat, pension funds are hungry for "alpha" -- positive risk-adjusted returns.  Hedge funds claim to be able to provide that.  The law, however, is getting in the way.  If hedge funds accept more than 25% of their assets from ERISA plans, the fund's assets become "plan assets," making the hedge fund managers subject to ERISA's fiduciary duty requirements.  The hedge fund industry is pushing to move the limit from 25% to 50%.   

In a sense, hedge funds just want to compete on equal footing with venture funds:  venture funds can avoid ERISA by becoming a VCOC (venture capital operating company) if they make so-called qualified venture investments.  Hedge funds have no similar exemption, in part because there is less of a difference between what many hedge fund managers do (manage a portfolio of investments in liquid securities) and what pension fund managers do (the same). 

I haven't yet heard a compelling argument for lifting the ERISA limit from 25% to 50%.  As long as we're going to have ERISA, it should have some bite.  (More on this another time.)  ERISA could help keep hedge fund managers in line.  The hedge fund industry is not yet a mature industry.  And as I've argued before, the typical compensation structure gives hedge fund managers an incentive to take on more risk than its investors would like.  Until reputation becomes a more effective constraint against this moral hazard risk, hedge fund managers who want pension money should be willing to take on ERISA fiduciary status.  The fact that some hedge fund managers already do this voluntarily suggests, to me, that change is unnecessary. 

But I haven't yet heard the arguments on the other side, so maybe I'm missing something.  Why do hedge fund managers want to avoid being ERISA fiduciaries?  Does ERISA force more disclosure?  If so, why is that so bad? 

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Today's W$J contains a sobering article on shareholder activism by hedge fund managers. The motivation for activism is that "it is getting tougher to show top-notch returns as more hedge funds pursue similar investment ideas and overall market volatility drops." This is the best argument against shareholder activism that I have seen in a long time. Does anyone (other than a hedge fund manager) believe that hedge fund managers know more about the companies in which they invest than the officers and directors of those companies?

This reminds me of the 1980s:

A chief complaint is that many companies are sitting on oodles of cash earning paltry returns, and it should be returned to shareholders through share buybacks or dividends. Companies in the Standard & Poor's 500-stock index have accumulated more than $650 billion in cash, up from $329 billion five years ago, and almost a third of the nonfinancial stocks in the S&P 500 have more cash than debt. Other companies are sitting on valuable real estate that isn't being appreciated by the market, restive investors argue.

If you need a refresher on the 1980s, I would recommend this article by Michael Jensen, which discusses the adverse incentive effects associated with large free cash flows. Here is the abstract:

The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why diversification programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidation-motivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

I do not intend to condemn the 1980s wholesale, but I believe that the virtues of leverage often were exaggerated, especially at the end of that decade. Perhaps the time is right for an academic defense of cash stockpiles.

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