Hedge Funds: The Protean Survivalists

TABLE of CONTENTS

Chapter 1 Introduction
1.1 Statement of problem
1.2 Aims of the study
1.3 Importance of the study
1.4 Brief overview of the study

Chapter 2 The history of hedge funds
2.1 In the beginning
2.2 Definition of a hedge fund
2.3 Revival,again and again
2.4 Summary

Chapter 3 The evolution of the hedge fund industry
3.1 Investor profile
3.2 Hedge fund management and investment strategies
3.3 Relationship with investment banks
3.4 Summary

Chapter 4 Shareholder activism and corporate governance issues
4.1 History of shareholder activism
4.2 Impact of hedge fund shareholder activism
4.2.1 The Deutsche Börse case
4.2.2 The McDonald’s case
4.2.3 The Medidep SA case
4.3 What the future has in store
4.3.1 Corporate governance under siege
4.3.2 Shareholder activism challenged
4.4 The future of shareholder activism for hedge funds
4.5 The King Cong Funds
4.5.1 Eddie Lampert’s ESL
4.5.2 Kennith Griffith’s Citadel
4.5.3 Stephen F. Feinberg’s Cerberus
4.5.4 Summary

Chapter 5 Conclusions and recommendations

Appendix A: Hedge fund definitions continued

Appendix B: 10 reasons to consider a virtual shareholder meeting

Appendix C: Cerberus & Icahn funds vs. Index graph

Foreword

The term ‘Protean Survivalists’ in the title refers to Proteus¹, a mythical god in Homer’s ‘The Iliad’. Proteus is depicted as a god who lives at the bottom of the sea and possesses the ability to prophesy. Proteus is adamantly reluctant to share his gift and defends his right to silence by using his other supernatural abilities to change his shape and form in order to discourage would-be pursuers. It is however said that whoever can constrain Proteus through his shape and form-changing episodes is eventually rewarded with a true prophecy. In their brief history, hedge funds appear to have developed the ability to change shape and form; whether they also have the ability to reward with true prophesies remains to be seen.

Chapter 1 Introduction

In 2005, assets managed by hedge funds globally exceeded the $1 trillion dollar mark (i.e. $1,000 billion) for the first time in their history. Although this still falls a long way short of the $ 25-plus trillion that is currently estimated to be invested in mutual funds, pension funds and insurance companies, it however endorses the industry’s growing influence in the global financial market space in terms of physical presence and buying power.

Thus, it seems surprisingly that only a decade ago, hedge funds were fighting for their existence following the now well-chronicled near collapse of Long Term Capital Management (LTCM), a hedge fund which promised - and for a short-while achieved - to earn returns that were up to 40% per annum. The active involvement and management of the fund by no less than two Nobel laureates and other academic and financial market luminaries made the prospect of consistently attaining returns far in excess of the market index an almost tangible and persistent reality. The financial practice known as leverage refers to the process of investing with borrowed money as a means of amplifying potential gains. LTCM’s excessive use of leverage in conjunction with other factors such as the lack of transparency in the industry, negligible knowledge of total credit risk exposure by the creditors of LTCM resulting from limited information-sharing, as well as the attraction of investing in a fund managed by proven brilliant academic and financial luminaries all contributed to the systemic risk exposure that LTCM presented until the US Federal Reserve-led consortium eventually stepped in to finance a rescue plan.

Gregoriou and Rouah (2003)², aptly noted that the current problem with hedge funds is that there is a dearth of academic literature available defining their operations as “most of the literature and analysis of hedge funds has focused on assessing their performance”. Significant volumes of academic literature investigating hedge fund performance now exists and includes research by Argarwal, Naik, Brown, Goetzmann, Fung, Hsieh, Schneeweis and others. The first hedge fund, accredited to Alfred Winslow Jones, was a straightforward long/short structure, making its classification fairly easy.

‘Going long’ or ‘going short’ on a stock had been around long before Mr Jones; his genius was merely in putting the two together in a single structure, a concept which today may sound as easy as turning on a light-bulb.

Hedge funds have become more diversified in their investment strategies since then and therefore accurate classification is now a much more challenging prospect. The term hedge fund is often commonly, but erroneously, used to define the entire class of alternative investment vehicles. The increasing visibility and presence of other alternative investment vehicles such as private equity and venture capitalism has gone a long way to rectifying this misconception although hedge funds remain the most pre-eminent. This is due both to the amounts of money they continue to attract and to the headline-grabbing media reports that seem to follow their every move.

Notwithstanding the trillion-plus dollars entrusted to them, hedge funds continue to be mistrusted and in some quarters, openly disliked. A 2004 master’s thesis study of the hedge fund industry in South Africa by Mutingwende (2005)³highlighted that despite continued allegations of lacking transparency to the greater detriment of investors specifically, and the financial markets in general, most of the hedge fund operators surveyed were in fact strongly in favour of improving disclosure standards as they recognised the opportunity to mitigate the stigma of being high risk investments and to attract more capital as a result of improved transparency and clearer communication to investors.

The commonly-held view used to be that research on hedge funds and their activities was being inhibited due to the lack of disclosure by the hedge fund industry participants themselves⁴(Murguia, 2004). Another finding from the study (Mutingwende, 2005) was that the hedge fund managers still maintained that the challenge of providing relevant information timeously to investors had to be managed in conjunction with the threa ts presented by copycat funds as well as other market participants.

1.1 Statement of problem

In the 1980’s and 1990’s, hedge funds were generally following global macros, equity long/short and event-driven investment strategies. Unsurprisingly, most of the hedge fund operations were established by investment bank traders and corporate financiers who left the ambit of the larger investment houses to seek new business challenges and possibly the prospect of being able to determine their own bonuses.

As hedge funds diversified their investment strategies and attracted more assets under management, the hedge fund operators were faced with managing significantly larger volumes in their middle and back-office operations. Outsourcing was identified as the most viable and sustainable solution, and for a negotiated fee, the large investment banks that already had the personnel and systems in place were willing and prepared to take-on the additional administration functions. Out of necessity, the relationship between hedge funds and large investment was born and hedge funds had further endorsed their credentials as financial market survivalists. Faced with the risk of missing out on a viable investment prospect and the risk of losing highly-rated employees to competitors - and more importantly the cash-flush investors that such high profile employees typically attract, investment banks then seized the initiative by offering to provide seed capital to establish hedge funds for their most prized former employees. This paper questions and investigates the nature of the relationship between the hedge funds and large investment banks.

Accusations of “conspicuous consumption” and “malfeasance” highlighted by the Tyco, Enron and other scandals emphasised the challenges of maintaining acceptable standards of corporate governance in publicly listed firms over the last couple of years. Subsequently, the actions of executive and non-executive company directors, shareholders and stakeholders alike, have come under greater scrutiny than at any time before. Previously hedge funds restricted participation by demanding prohibitively high minimum investment requirements and by strictly adhering to private placement policies, which ensured that they remained accessible exclusively to wealthy and sophisticated investors.

Today, with the minimum investment requirements of some hedge funds significantly lower (e.g. US $ 50,000) and with now the option of investing into fund of hedge funds (a.k.a. fund of funds); the retailization of hedge fund investment vehicles has meant that the lower net-worth individuals and income earners (i.e. Joe Citizen) is now able to invest in them too.

1.2 Aims of the study

This paper aims to highlight that hedge funds are survivalists by nature and therefore their current relationships with large investment banks were predictable and can be expected to grow for the foreseeable future. It will also investigate the growing influence of hedge funds in the corporate governance decision-making processes of companies, more especially on the extent to which this development has been fostered by the explosion of participants in the hedge fund industry over the last 10 years; and the resulting erosion of investment opportunities that such a large influx of market participants can be reasonably expected to entail.

1.3 Importance of the study

Hedge funds used to raise the ire of regulators and stakeholders alike most when they ‘shorted’ stocks; that is, took trading positions that would earn them a positive return when the share price of the targeted stock fell below a certain level. Nonetheless, and to their credit, these actions also brought liquidity to the market as they often took positions that contradicted existing market trends, as well as contributing to the improvement of stock-market pricing efficiencies. As mutual funds, pension funds, university endowments and investment institutions have sought greater portfolio diversification for their investments; more money has flowed into hedge fund coffers. Being a lightly regulated industry gives hedge funds a distinct competitive advantage over mutual funds for example, and when coupled with the financial muscle that hedge funds present in terms of assets under management, results in them having unparalleled market clout, pound for pound, dollar for dollar.

More recently, hedge funds have opted to take positions in more prominent companies such as the Deutsche Börse AG, Daimler-Chrysler AG, Siemens AG, McDonald’s, Time Warner, Toys R Us Inc. and General Motors Inc.

Whilst General Motors Inc. is currently a distressed stock, the other aforementioned firms can not be said to have significantly under-performed the market or their peers. Some hedge funds have used their significant shareholding votes as well as the support of proxy votes to acquire company board seats either for their own employees or other nominees whose views they support (see Medidep SA, Deutsche Börse and Blockbuster). By so doing, these hedge funds have now put themselves in positions where they can influence the near-term and long-term strategic structures, goals and objectives of the companies.

Private equity managers and venture capitalists usually have a five to seven-year investment horizon when investing in a firm and they typically bring a track-record of successfully managing corporate rescues. Recent public shows of shareholder activism aside, whether hedge funds have either the patience or the intention to take decisions that are in the long-term interest of the firms and the other shareholders remains to be seen. “Hedge-fund Activism Sparking Concerns”⁵; “Schröder to Urge Stronger Controls On Hedge Funds”⁶; and “U.K. Regulator Targets Hedge Funds⁷“ are all financial newspaper headlines calling for the respective regulatory bodies to curb the actions of hedge funds through more stringent regulation and supervision. In summary, it is for the above-mentioned reasons that this study recognises the need for more research to be undertaken to investigate the impact of ‘activist investing’ on corporate governance and its consequences for company performance.

1.4 Brief overview of the study

This paper attempts to highlight (i) the dynamics of the growing relationship between large investment banks and hedge funds; and (ii) the new hedge fund investment environment, including their increasing appetite for shareholder activism as an investment strategy.

Chapter 1: Introduction

The problem statement and aims of the study are stated with emphasis on the relevance and importance of the study to the field.

Chapter 2: The history of hedge funds

Looks at the history, definition and legal and financial characteristics of hedge funds.

Chapter 3: The evolution of the hedge fund industry

Looks at the changes that have taken place in the industry to date in terms of the fund management, investor profile, investment strategies, new sectors and markets (e.g. financing Hollywood movie productions); as well as their relationship with large investment banks.

Chapter 4: Shareholder activism and corporate governance issues

Looks at the history, impact and possible future of shareholder activism for small, medium and large hedge funds, as well as at the potential impact of such action on the corporate governance policies and processes of firms. The involvement of hedge funds in the Deutsche Börse’s take-over bid of the London Stock Exchange, Medipep SA and McDonald’s will be reviewed. The future for hedge funds will be discussed, including the raison d’être of conglomerate funds and why they will remain for the foreseeable future.

Chapter 5: Conclusions and recommendations

Provides the conclusions of the study and recommendations for stakeholders for dealing with this challenge.

Chapter 2 The history of hedge funds

Alfred Winslow Jones⁸, a journalist-turned-investment-guru, is generally accredited with the creation of the first hedge fund⁹. The investment strategy of‘going long’ on a position (i.e. buying a security with the expectation that the asset value will rise) and that of ‘going short’ on a position or ‘shorting’ (i.e. selling a borrowed security with the expectation that the asset value will fall enabling the manager to replace it at a cheaper price) had both been developed before Jones. His contribution was to ingeniously combine both strategies into a single investment structure. Therefore, by going long on the stocks that he believed were undervalued and going short on the stocks that he felt were overvalued in the same portfolio resulted in the portfolio being effectively “hedged”; gains from one position could be used to offset losses from another position. Thus the term “hedge fund” was born.

Figure 1: Hedge Fund Timeline

illustration not visible in this excerpt

2.1 In the beginning

Jones was so convinced in the financial potential of his discovery that he introduced two new features that have remained pillars of the hedge fund industry set-up. The first feature was the introduction of a compensation fee of 20% of the fund’s realised profits for his managers. Secondly, both to underline his commitment and to allay the fears of potential investors, he personally invested significant amounts of his own money into the same funds, thereby irrevocably tying his financial future with that of his investors. With the remuneration question and the agency problem seemingly addressed, Jones set about marketing his concept to the investing public. Despite attaining significant performance success, it was not until Carroll Loomis, a reporter with Fortune magazine wrote an article titled “The Jones that Nobody Keeps Up With” (Loomis, 1966)¹⁰describing how through the diligent application of this investment strategy, Jones’ hedge funds had out-performed the best performing mutual funds - net of fees, that hedge funds were introduced to the mainstream public. Caldwell (1995)¹¹notes that a survey carried out by the SEC in 1968, two years after the Loomis article, showed that of 215 investment partnerships registered, “140 of these were hedge funds, with the majority having been formed that year”.

2.2 Definition of a hedge fund

However, as they developed, many new strategies were integrated under the banner of hedge funds, and over time, these newer categories steered away from the originally ascribed definition. The divergence from the original definition has become so pronounced that there is today, no common definition of what a hedge fund actually is. Below are selected examples of hedge fund definitions:

"A hedge fund is an actively managed investment fund that seeks attractive absolute return. In pursuit of their absolute return objective, hedge funds use a wide variety of investment strategies and tools. Hedge funds are designed for a small number of large investors, and the manager of the fund receives a percentage of the profits earned by the fund. Hedge fund managers are active managers seeking absolute return."¹²

"The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the contributions of its investors in order to invest in a variety of asset classes, such as securities, futures contracts, options, bonds, and currencies."¹³

" In fact, the term 'hedge fund' is used to refer to funds engaging in over 25 different types of investment strategies .…"¹⁴

“A hedge fund is a "private investment partnership (for U.S. investors) or an off- shore investment corporation (for non-U.S. or tax-exempt investors) in which the general partner has made a substantial personal investment, and whose offering memorandum allows for the fund to take both long and short positions, use leverage and derivatives, and investment in many markets. Hedge funds often take large risks on speculative strategies, including [program trading, selling short, swap, and arbitrage. A fund need not employ all of these tools all of the time; it must merely have them at its disposal."¹⁵

"There is no precise definition of the term 'hedge fund,' and one will not be found in the federal or state securities laws. …Hedge funds are no longer defined by the strategy they pursue. While a number of today's funds pursue the hedged equity strategy of Jones, numerous different investment styles are embraced by hedge funds.… Hedge funds are defined more by their form of organization and manner of operation than by the substance of their financial strategies."¹⁶

In the view of the author, the definition that best encapsulates a hedge fund is given by Bookstabber (1991) who wrote:

“In terms of leverage, hedge funds are the entire universe except those funds that are restricted to leverage no greater than 1. In terms of positions, they are the entire universe except those funds that are restricted to long only. In terms of securities, hedge funds are the entire universe except those funds that are restricted to a somewhat arbitrary and generally evolving set of traditional assets”.¹⁷

2.3 Revival,…again and again

The growth of hedge funds was significantly curtailed by the bear markets of 1969- 70 and 1973-74, respectively. Nonetheless, like Asterix’s small village of Gauls, some investment managers refused to be swept away by investor malaise and remained committed to further developing the hedge fund investing art, albeit in niche investor markets. A 1986 Institutional Investor article reported that Julian Robertson’s Tiger Fund had earned a compounded annual return - net of expenses and fees - of 43% during the first 6 months of its operation. Subsequently hedge funds began to be touted as the investment vehicles that could earn absolute returns irrespective of the direction of the market. As was the case in the aftermath of the Loomis article, new funds quickly sprouted on the investment stage as high profile investment (and other less known and accomplished) managers established their own hedge funds.

Not all funds were successful and numerous highly publicized blow-ups ensued, most notably the Long Term Capital Management (LTCM) hedge fund. Two features of LTCM’s downfall ensured that the fund’s name would go down in the history books and would serve as a reference point for the majority of articles that would be written on the hedge fund industry. The first feature was that LTCM’s use of leverage was so extreme at its peak that the collapse of the fund was considered a threat to global financial stability- a veritable systemic risk. The second feature was that the threat of this colossal disaster had materialized despite the fund being managed by a host of financial and academic luminaries, including two economic Nobel Prize laureates. The learning outcome for the general public from this experience was that if the smart fellows could not get their heads around the riskiness of hedge fund investing, then there was a pretty good chance that it was just a matter of time before other hedge funds also imploded.

Fearing a systemic failure, the Federal Reserve-led consortium comprising of large US and European Banks facilitated a $3.625 Billion credit-package to mitigate the fall-out risk. At the time, US Federal Reserve Bank Governor Alan Greenspan remarked that the risk presented by LTCM "... could have potentially impaired the economies of many nations, including our own¹⁸."

Following the rescue, a President’s Working Group was tasked with preparing a report to determine how the situation at LTCM had developed despite the check- and-balance structures that normally provide financial market oversight, as well as to assess the threat posed by hedge funds in general. Concerning the former; it was discovered that LTCM had continuously negotiated and received very large credit lines from various banks, and due to the absence of effective inter-bank communication channels, was able to keep negotiating for more extensions even when collectively managed risk management systems would have denied their later applications. Subsequent to the LTCM saga, international banking authorities introduced systems and mechanisms whereby credit exposures are now regularly communicated between financial lending institutions.

This author was fortunate to attend a finance seminar¹⁹in January of 2006 where Dr. David Mullins, a founder of LTCM and current Chief Economist of both Vega Institutional Advisors (USA) LP and Vega Asset Management (USA) LP, gave a presentation on credit risk and answered questions regarding the LTCM saga. In Dr. Mullins’ view, LTCM’s collapse was due to two key contributory factors namely time horizon confusion and the “herding effect”. He asserted that some of the investment decisions and positions taken preceding the blow-out were statistically sound and would have yielded great returns in the medium term. The problem was that the investment managers, leaning more on their statistical models than on business experience underestimated the market’s reaction to the associated, but predicted short-term volatility.

The other factor mentioned by Dr. Mullins was that the negative impact of the herding effect had been exaggerated as other market participants sought to close their own exposures - albeit in unrelated markets, and sold off investments in the markets where LTCM had its exposure. This assessment was endorsed by others, including Mackenzie (Peltz, 2004)²⁰who suggested that “…Even trades that ought to have gone in LTCM’s favour went against them, because others who had been imitating them were trying to unload similar portfolios”.

The view taken by the regulators thus far has been that because hedge funds traditionally required investments of $1 million plus, there was thus no real need for the regulators to get involved. For the most part, economic history has shown that rich people in general became rich by dabbling in risky ventures anyway; and therefore as long as the entry requirements excluded the average citizens, the rich could, and should, be allowed their indulgences. It can also be generally assumed that an incident where a group of millionaires lost money in a risky venture would create little if any political fallout problems for the regulators themselves.

2.4 Summary

Teething and other setbacks aside, the hedge fund industry has grown both in stature and in complexity over the years. From a simple long/short strategy envisioned by Alfred Winslow Jones, through to arbitraging at Julian Robertson’s Tiger Fund and the use of leverage by LTCM and others, and now to the market presence that recently topped 1 trillion dollars of assets under management, hedge funds - if anything, have proven their resolve to remain a permanent fixture of the financial landscape.

Chapter 3 The evolution of the hedge fund industry

The new Chairman of the US Federal Reserve Bank, Benjamin Bernanke, was once famously quoted as having said that, fixing the US economy was like trying to do repairs on a car…, whilst it was moving. As was shown in the preceding chapter, ascribing an accurate definition to a hedge fund is equally as challenging given the fast changing nature of the environment in which hedge funds operate.

Eichengreen and Mathieson (1999)²¹identified three main classes of hedge funds namely; macro funds, global funds and relative value funds - classifications by which the funds represented themselves. They however acknowledged that even further diversity lay within each of these classes. Billingsley and Chance (1996; as cited in Fung and Hsieh (1999)) identified 11 different categories in their study. In recent times, there has been a move away from this form of classification to one that focuses on the actual investment strategy followed by the fund. However, even this classification form has its shortcomings as some funds follow more than one strategy in any given period.

Furthermore, hedge funds have in general sought atonement for the ‘transgressions’ of LTCM which was at one time reportedly leveraged to a ratio of US $300:1, i.e. US$300 borrowed for every US$1 of investor capital. The average U.S. onshore and offshore hedge fund has a ratio of 1,6:1 (Lacey, 2003)²². Hedgefund.com reports that for their hedge fund rating criteria, Van Hedge Funds consider funds ratios above 2:1 as “high” and those below as “low” leverage.

3.1 Investor profile

In the US, hedge funds are restricted to accepting no more than 99 investors as partners, including the General Partner. The partners are required to be investors who qualify either as “accredited investors” or an unlimited number of “qualified purchasers”.

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¹"Some have the gift to change and change again in many forms, like Proteus, creature of the encircling seas, who sometimes seemed a lad, sometimes a lion, sometimes a snake men feared to touch, sometimes a charging boar, or else a sharp-horned bull; often he was a stone, often a tree, or feigning flowing water seemed a river or water’s opposite a flame of fire.” - Ovid, Metamorphoses 8.731

²Gregoriou, Greg. N. & Rouah, Fabrice. 2003. Hedge Funds: The Steel Wave. Journal of Pensions Management. 9 (1), p 22-33.

³Mutingwende, Russell. 2005. The Challenge of Reigning-in Hedge Funds through Regulation and the Need to Improve Disclosure Requirements. Unpublished Thesis; Master of Commerce (Business Management) Stellenbosch University.

⁴Murguia, Alejandro. 2004. An Alternative Look at Hedge Funds. Journal of Financial Planning, (Vol.1): 42-49. January 2004.

⁵Wall Street Journal-News Roundup. 2005. Schröder to Urge Stronger Controls on Hedge Funds. 14 June 2005, p A2

⁶BECK, Rachel. 2005. Hedge-fund Activism Sparking Concerns. Online at

www.detnews.com/2005/business/0505/22/biz-188504.htm (Accessed 4 September 2005)

⁷Wall Street Journal, Breaking News. 2005. U.K. Regulator Targets Hedge Funds. 24-26 June 2005, p M8

⁸Caldwell, T. 1995. Introduction: The Model for Superior Performance. (In: Ledermann, J & Klein, R.A. (eds)) Hedge Funds. New York: Irwin Professional Publishing, p1-17

⁹ Barton Biggs, former Morgan Stanley banker, current hedge fund manager and author of bestselling book “Hedgehogging” (Wiley Publishers) believes that John Maynard Keynes was a hedge fund pioneer long before Alfred Jones.

¹⁰Loomis, Carroll. 1966. The Jones Nobody Keeps Up With. Forbes Magazine. (1), p 237-247. April 1966.

¹¹Caldwell, T. 1995. Introduction: The Model for Superior Performance. (In: Ledermann, J & Klein, R.A. (eds)) Hedge Funds. New York: Irwin Professional Publishing, p1-17

¹²Jaeger, Robert. A., 2003. All About Hedge Funds: The Easy Way to Get Started. McGraw-Hill Publishers, New York. 2003.

¹³The Secretary of the Treasury, The Board of Governors of the Federal Reserve System, The Securities and Exchange Commission, A Report to Congress in Accordance with § 356(c) of the USA Patriot Act 2001 (2002).

¹⁴Managed Funds Association, Hedge Fund FAQs 1 (2003). Online at www.mfa.org

¹⁵Downes, John & Goodman Jordan, E., Barron’s, Finance & Investment Handbook, 358 (5th ed. 1998).

¹⁶Lederman, Scott, J., Hedge Funds, in Financial Product Fundamentals: A Guide for Lawyers 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000).

¹⁷Bookstabber, Richard, M. 1991. Options Pricing and Investment Strategies, Third Edition. Chicago, Illinois: Irwin Professional Publishing.

¹⁸On extolling the contribution of the short selling contrarian strategy adopted by a significant number of hedge funds, Alan Greenspan praised hedge funds as being ‘an antidote to the sometimes excessive enthusiasm of long-only investors’.

¹⁹The Campus for Finance: Fixed Income- Lending, Borrowing and Taking Risk seminar at the WHU - Otto Beisheim School of Management at Vallendar, Germany. January 12-13, 2006.

²⁰Peltz, Michael. 2004. From Harvard to Hedge Funds. Bloomberg Markets, April 2004 edition, p 49-54

²¹Eichengreen, Barry & Mathieson, Donald. 1999. Hedge Funds - What Do We Really Know? International Monetary Fund. IMF: Washington D.C., September 1999.

²²Lacey Jr, Donald, E. 2003. Democratising the Hedge Fund: Considering the Advent of Retail Hedge Funds. International Finance Seminar Paper. M.A. Harvard Law School. Online at http://www.law.harvard.edu/programs/pifs/ifllmpapers.html