NYC is not Toronto

This is not a novel point, if you’ve ever had the luxury to suffer with a stint at a Wall Street-type firm in New York City. This came to mind yesterday as I took flak from a blogger who shields his/her identity but claims to be a New York-based “Vice-President at a middle market LBO firm”. The good news is that the blog is a decent attempt to be funny, and perhaps reflects someone who is both a frustrated novelist at heart and has more time on their hands then I’d honestly think is available if you are actually working at a NYC mid market LBO shop at the height of the PE boom – but maybe with over 2,500 mid market PE firms in the U.S. chasing the same 4x, 5x, 6x, 7x, 8x, 9x, 10x, 11x trailing EBITDA deals he/she might not be as busy as you’d think; stuck there in that NYC career category between the Associates and the MDs. Not busy enough to be working on a Saturday like a NY-based Analyst or Associate, but doesn’t yet have enough heft to get a Saturday-night reservation at Le Cirque, either.

Or maybe he/she isn’t making enough money at this unnamed NYC PE shop to go away every weekend to the Hamptons or South Beach or TPC No. 2 or Vail with the real shooters, and is left to blog. But I disgress.

I was reminded about why NYC is not Toronto when I got this “are you so stupid or a socialist” comment yesterday about my Winding up Amaranth post. My first reaction, as Rick Segal would say, was: “whoaaaaaa”.

The person who claims to be a VP-at-a-mid-market-NYC-PE-shop (let’s just call him/her “Mr./Ms. No G5 Yet” for short) felt it was necessary to remind us all that hedge funds are not for the faint hearted (nor the widows and orphans):

“Hedge Funds like Amaranth are not typically capital preservation instruments. They are risk taking vehicles. The indemnification of employees and principals is well disclosed to investors who take the time to read the offering materials and offerings are restricted to sophisticated investors.”

Now I would never take issue with that statement, but what I’ve been trying to get across for some time is that the comp structures of the hedge funds need to change. Back in September, I made the following point(s):

The lesson for Limited Partners from all of this [Amaranth’s blow-up] isn’t that they should require stricter controls on risk, or more consultants to analyze which hedge funds to commit funds to (there are plenty of those). The lesson is simple: be consistent across all of your investment categories.

In our world (same goes for merchant banks and venture funds), if we made a sufficient return in 2005 to warrant a “sharing of the upside” with our limited partners, but then had a loss in 2006, we’d have to return the upside we’d earned in the prior year…as it hadn’t actually been earned over the life of the fund. Makes sense, doesn’t it? If you don’t make money for your LPs over the life of a fund, there’s no upside for us to share in.

LPs go so far now as to require all individual participants in the General Partner to guarantee their own share of the promote, in case they take a payout this year and then leave the fund during a down year when the subsequent returns would nullify the prior year’s payout.

In the hedge fund world, if you make $1 billion profit this year and meet the hurdle rates, the GP might keep $200 million of that upside for the team. Good for everyone. But if you lost $1 billion the following year, the members of the GP still get to keep that $200 million. Or at least the summer home in France that you bought with your share of the two hundo.

Herein lies the problem. Conservative pension funds, seeking higher alpha, have put over a trillion dollars into the hedge fund asset class. Unintentionally, they payout system incents hedgies to swing for the fences. If you connect one year, as Brian Hunter is said to have done in 2005, you might clear US$80 – US$100 million personally. Yet unlike every other fund type his LPs have invested in (infrastructure, buyout, venture, mezz and sub debt), he keeps that money and never has to work again. Nor do his kids or their kids.

Institutional LPs need to think hard about the cause and effect of the annual non-recourse hedge payout system. It’s not that Amaranth’s risk management system failed. It’s that by condoning the payout structures, their LPs unintentionally encouraged them to take the very risks that cost them two thirds of their capital in six short weeks.

As a respectful blogger, I thanked Mr./Ms. No G5 Yet for the comment and tried to outline where I was coming from in a quick, but personal, email. (“Obviously if you think I’m a total idiot you must misunderstand….” That kind of stuff.) So this is what I get back from Mr./Ms. No G5 Yet:

How would you contrast the hedge fund structure and VC structure, exactly? Are you trying to tell me that VC is less volatile than most hedge funds? (hint: better check your stats). That VC funds don’t do 2/20 structures? Or are you arguing that VC structures, by virtue of their lack of monthly incentive payments to management, are better? That would have the ironic effect of causing you to argue that a far less liquid investment also highly sensitive to macro conditions is less risky. An interesting position to take.

Swinging for the fences is fine. So long as people pay attention to modern portfolio theory and blend risky investments (and particular kinds of risk) with more conservative investments.

At the core, your argument is against risk taking. It might as well, therefore, be against investment of any kind.

At this point I feel like I’m on a Fox News show.

Mr./Ms. No G5 Yet, if I may disagree I think you missed the point. I didn’t suggest that LPs shouldn’t have investment choices, nor that pension fund LPs shouldn’t have the right to lose their money, even if those funds are actually being managed for actual widows and orphans as they often are.

Risks are disclosed to investors, that’s true, but the roadshow materials and LPAs invariably talk about multifaceted risk mitigation tactics that reduce beta, etc. No pitch says: “if things don’t go well you’ll lose all of your capital”. They say the opposite, in essence: “that our fund is structured and managed so that 100% wipeouts cannot happen”. And for all the legalese in the LPA about risks, the section on risk mitigation is, I’ll wager, a trifle longer.

I’m not saying the Amaranth team should be liable for natural gas trading losses (absent fraud). I’m saying that the hedge structure, unlike the merchant banking, mezz, venture debt and VC payout formulae, is – as a result – geared to encourage people to swing for the fences by paying out the promote on an annual basis; with no clawback or team guarantees regarding those bonuses. And I also believe the LPs are as much to blame for allowing that difference within the same asset classes (they call it “alternative investments”) as are the hedge fund management teams who clearly benefit from it.

I am suggesting that the payout structures need to be changed.

The Amaranth debacle is not the only example of what happens when a guy can make $100 million in one year using a risky trading strategy (in hindsight), and in the following year, if the strategy turns out to have been flawed – he keeps his $100 million and the LPs lose every penny.

The excuse I always hear is that hedge funds allow immediate capital withdrawals if a limited partner gets cold feet, unlike the PE, mezz, venture debt and VC structures, so therefore the 100% annual payout and zero preferred return is appropriate. Nuts.

Most GP/LP PE, mezz, venture debt and VC structures now have a “no fault” divorce clause which permits 75% of the LPs to band together to shut the fund or fire the team; which is really not much different that the so-called hedge fund redemption right. Its actually more effective, in fact, as we saw with Amaranath.

When things don’t go well at a hedge fund, and hedge fund LPs try to redeem their capital, the management teams have the right to invoke the clause as mentioned in Mr./Ms. No G5 Yet’s blog, which overrides the capital withdrawal request. That was disclosed to investors, as well, of course. But the withdrawal right is a false sense of comfort, as we are now learning.

In my mind, if you don’t make your investors a meaningful return over the life of the fund, you shouldn’t be keeping any promote; there was no upside to have shared! But it sounds as though my friend Mr./Ms. No G5 Yet has a fundamental disagreement with that philosophy; to boil down his/her argument: Even if you didn’t actually earn your investors anything in the end, and you can take $100 million off the table on the way by, that’s just called capitalism – isn’t it great!!! And so, this online tennis match serves as another reminder as to why NYC is not Toronto .

Oh, and one other difference: our young NBA team is at the top of its division, and your Nets/Knicks are not. Regardless of today’s game. 😉

But, being Canadian and to show there are no hard feelings for calling me an idiot on our own blog, I’ll gladly host Mr./Ms. No G5 Yet at a Raptor game (2nd row, too – try to swing those at The Garden) should your middle-market LBO fund ever send you up to Toronto to look at a deal. Heck, maybe we’ll even provide you the subdebt on the deal! After all, Canadian prime is 225 bps below the U.S., and that subprime thing is going to screw around with your access to credit. C U soon I hope.

MRM