Ball Busting – LEVERAGED BURNOUT

I’m Back. Markets Are Not.

The bull market is dead, LONG LIVE THE BULL MARKET!

This fucking virus, man.

I’m not an epidemiologist or virologist, so I’m just going to focus on the market impact here. Cities around the world are effectively shutting down in an effort to contain COVID-19. Aside from the loss of life, these measures are also presenting real challenges to the short-to-medium term viability of the global economy. Credit is freezing up, equity investors are getting hosed and the real economy is suffering from reduced spending. So, what’s going on here?

The credit markets are shutting down, a la ’08-’09. Anyone that lived and/or worked through the GFC knows this all too well.

The first major problem is the commercial paper market. At a high level, this is where corporations come to finance their payroll, accounts payable and other short term costs. Essentially, a company will issue a short term note (usually for a few days but no longer than 9 months), issued at a discount to the par value of the note, in exchange for cash now. The notes are issued at a discount to par which then becomes the investors’ return upon repayment. Since we’re talking unsecured notes, the credit quality of the companies issuing commercial paper is relatively high quality. This is a very mature market that normally functions incredibly well.

Enter COVID-19. As citizens around the world hunker down to “flatten the curve” of new virus cases, the obvious concern for investors has become the implications of what it means to shut down the global economy and how that impacts the liquidity profile of companies. We should even be discussing whether certain companies will be able to operate as a going concern in the future. Worries about liquidity have forced the hand of commercial paper investors: if they’re not sure whether you’ll be generating enough free cash flow through ordinary operations to pay back the notes, then they’re also not sure they’ll lend you the money.

Were the entire market to seize up like it did in the GFC, the effects on both the real and financial economy would be devastating. You’ll see companies struggle to make payroll and pay their bills, which will lead to lay offs and plummeting share prices as equity investors try to assess what it all means for profitability.

The second major problem we have on the funding side is the repo market. This is where banks and financial institutions come for short term financing (similarly to the commercial paper market for companies). A borrower will sell high grade paper (usually government bonds or agency-backed paper) to investors, with a contractual agreement to repurchase the collateral from the investors at a slightly higher price in the future. The repo market is massive, trading anywhere between $2 trillion – $4 trillion EVERY. DAY.

There is an immense amount of friction within the repo markets at the moment. Banks see that a recession (possibly depression) is now inevitable, and there will absolutely be some corporate casualties. They’re becoming more and more skeptical of lending to each other and any market analyst worth their salt knows this is always the kiss of death. The Fed has implemented a handful of programs in excess of $2 trillion to keep the repo market open, but the impact of even those efforts has so far been, muted. If you need just one example of how exacerbated the issue has become, look no further than the mREIT space.

While most people are familiar with the equity REIT space (buying properties and profiting from rents and/or capital appreciation), mortgage REITs (or mREIT) are a bit more opaque. Their business model is to borrow in the repo market at 4-5x leverage in order to finance the acquisition of mortgage-backed securities or originate whole loans themselves. Here’s a one month look at what happens to a highly-leveraged repo participant’s share price when the market starts to freeze up:

That’s not great! The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.

But here’s my number, so call me maybe…

Equity markets are plummeting. Gold was rallying but then fell off a cliff. Bonds rally and sink every other day. Oil isn’t remotely putting up a fight. Even fucking bitcoin looks like shit. Everything is selling off. How can that be? Where are the safe havens? Oh, that’s right:

SELL IT ALL! The ultimate feedback loop. Markets spiral > PMs sell to cover margin calls > forced selling tanks markets further > PMs sell more to cover more calls.

The stock market has been on an 11 year tear. The economy has been on fire, juiced (perhaps irresponsibly) by the Trump tax cuts. Credit has been pretty loose in a post-GFC era. It’s not difficult to imagine why portfolio managers around the world borrowed money to buy stocks and, to be fair, I don’t think you can ask a PM to hedge for pandemic-related exposures, either. After all, they don’t make a derivative for that (paging all structured products desks).

That said, none of that matters in this moment. The leverage in the system has exacerbated the equity sell off we’re seeing now, and it’s impact is going to be felt not just by fund managers, but by anyone with a 401-k, IRA or brokerage account. Those are real losses that are going to trickle up into the economy via reduction in consumer discretionary spending.

C.R.E.A.M.

The dollar is absolutely ripping, no surprise. There are a few reasons for this outside of the traditional safe haven trade.

The first is that since the U.S. capital markets are so dominant in the global economy, international investors have a lot of U.S. exposure. Typically, they’ll hedge their FX risk by selling USD and buying their local currency in their portfolios. The problem is that when U.S. markets start collapsing or fund managers begin selling, they’re left with hedges that are notionally too large for their overall U.S. equity exposure. This leads the international fund managers to scramble for the dollars needed to pare down their USD shorts in their portfolios.

The other reason, which hasn’t been in the headlines yet, will end up being the Eurodollar market. A Eurodollar is essentially a USD-denominated bank deposit that lives outside the U.S. financial system. The purpose of this market is avoiding U.S. capital requirements. In a Eurodollar transaction, an international bank will issue a short term deposit instrument to investors that will be denominated in USD. The deposits immediately become a USD-denominated liability on the bank’s balance sheet. This is all well and good in prosperous times. However, the rapid ascent in the value of onshore dollars during a crisis has a devastatingly deflationary effect on the international bank’s USD-denominated liabilities. Every time the USD increases in value, it costs more money for the international bank to repay the deposit instrument (their liability). This will likely force the international banks to go to market and purchase dollars as quickly as possible to avoid any more losses, akin to a short squeeze:

Combine the traditional safe haven trade, a general unwind of FX hedges and a Eurodollar squeeze, and you’ve got the recipe for a global dollar funding shortage – better known as a good ol’ fashioned liquidity crisis.

Where do we go from here?

The pain is likely to just be getting started. As quarantines become more prevalent, so will their impact in the economy. Institutions will continue to have difficulty funding their operations and share prices will continue to fall. Aside from markets imploding, however, there will be real human costs to this crisis.

There are thousands of restaurants and bars across the country (and millions across the world) that will never open again. Those people will lose everything and so will their employees. The supply chain is going to become increasingly strained as borders shut, likely inducing shortages of some goods. People are going to lose their savings, and that will take an indescribable toll on some.

Who knows what the next 12-18 months holds in store for everyone. All I know is that it’s getting weird out there and I’m not sure I have enough wine stockpiled. All we can do is sit back, go cash and enjoy the show.

Waiting for the coming recession is going to be like ordering an UberX: you know it’s going to be a terrible ride, but you won’t really know just how bad until that black Camry with seat protectors pulls up.

Fund Manager Forgets Bill Ackman Has a Thing for Telling Investors to Get Fucked

AVI – an Angry, £1B Fund Manager – “We are writing this open letter to you following the outrageous decision by the Board to sanction the issuance of $400m of twenty-year debt without, as far as we are aware, any consultation with shareholders unconnected to the Investment Manager. The issue of such long-dated debt materially constrains the Board’s ability to manage PSH’s persistently wide discount to NAV, at a time when doing so should be their primary focus. We are staggered that the Board has decided to further tie its hands in this way.”

Bill Ackman had the idea to raise a permanent capital vehicle a few years ago via a closed end fund (CEF). Without getting too much into it, many times a CEF’s stock will trade at a discount to its net asset value (NAV). This can happen for several reasons: (i) the fund has a high concentration of illiquid assets, (ii) it may have an outsized amount of leverage within the vehicle, (iii) it may just be a function of the yield / distributions, etc. Many times when the discount persists, funds will use cash flow to buy back stock, close the discount gap and keep investors happy. Bill Ackman is not doing this. He has instead decided to raise $400M in new debt and ante up, which has rightfully pissed off investors. Their argument is essentially:

“Look – we understand using leverage to increase returns for equity investors, but there are two ways to do that. Instead of raising new debt to purchase additional assets, why wouldn’t you just buy back a bunch of stock to reduce the discount to NAV? You could’ve easily done that and gotten your leverage ratio to the same levels as you did by borrowing the new money and forcing additional free cash flow to interest and principal payments.”

I’m not gonna lie, either – they’re right. It really doesn’t make any sense, when you have two options for levering up, to choose the option that is less advantageous for your shareholders – unless you understand Bill Ackman. AVI alludes in the following quote that Billy Boy is motivated by one thing only – greed:

“We note Bill Ackman’s comments in PSH’s annual report on buybacks and leverage: “Buybacks have other drawbacks as they reduce our shareholders’ equity and increase our leverage. We would not be surprised to find that a higher leveraged PSH trades at a greater discount to NAV when compared to a less leveraged PSH”. Given gearing was at 20% when this report was written and the new debt issue will see this increase to 25%, it seems Bill’s aversion to an increasing leverage ratio could more accurately be described as an aversion to shrinking the assets on which management fees are earned.”

While true that Ackman would lose fee revenue by shrinking the equity float, this isn’t why he’s chosen to forgo that strategy. Anyone who has been following Ackman throughout his career knows he isn’t motivated by greed – he’s motivated by his insatiable need to prove how great an investor he is. The real reason he’s decided it’s better to lever up with new debt vs. shrinking the float is that he believes he has a real, long term winner lined up and needs some capital to play with. In his mind, he is going to out gain any short term stock improvement from buybacks with good old fashioned alpha generation.

You have to remember, though, that Bill Ackman is the best, but he’s also the worst. He’s the guy that correctly called the subprime crisis and made a killing on his MBIA play. He’s the guy that parlayed a $60M investment in General Growth into a $1.6B stake post-turnaround. He’s also the guy that blew up his first fund, Gotham Partners, by piling capital into a portfolio of illiquid investments and golf courses. He’s the guy who lost, quite publicly, billions of dollars on a poorly executed bet on Valeant. Lastly, he’s the guy who picked a fight with both Herbalife and Carl Icahn, only to lose more money and his own dignity, on national TV, in the process.

That’s why I have zero sympathy for this rinky dink fund that is upset with this atrocious allocation of capital. Ackman is undoubtedly smart. Ackman is undoubtedly smug, as well. You pay him to manage your money, not the other way around. So don’t sit there and be a backseat driver while he’s out here picking winners (or massive losers). That’s always been Billy’s style and your diligence team should’ve picked up on that. Regardless, you’re about to make a lot of money or lose it all. The only thing you can do is sit back, enjoy the ride and just:

Here’s One Deal Toy Blankfein Will Be Leaving at 200 West

“Bloomberg – Goldman Is Fighting a New Abacus Battle With an Angry Hedge Fund”

I wrote a blog in March about Barclays paying $2B to settle it’s final outstanding DoJ suit related to the 2008 financial crisis. The opening line went a little something like this:

“The gift that keeps on giving: the 2008 financial crisis.”

Well six months later that statement still rings true, of course, as we see one of the juicier stories of the crisis resurrecting itself: Goldman’s family of Abacus CDOs. While this isn’t the same exact Abacus deal that placed Goldman and Paulson & Co. into the crosshairs of regulators, I can’t pass up an opportunity to discuss some crisis-era structured credit.

Goldman sold investors a synthetic CDO called “Abacus 2006-10” in the early spring of ’06. A synthetic CDO is a bit arcane of a concept but not that difficult to understand if it’s explained properly. Basically, Goldman had exposure to a bunch of mortgage bonds, known as reference obligations, and they were looking to hedge the risk of the bonds from default. They found a group of savvy investors to fund a special purpose vehicle (“SPV”) that would write Goldman a credit default swap on their reference obligations and Goldman would pay the investors quarterly premiums for that protection (just like insurance). But, if any of the reference obligations defaulted, then the investors would have to pay Goldman on that loss. At the end of the trade, the investors get back anything that’s left in the SPV (hopefully 100% of their principal) plus the premiums they had been receiving all along.

When the investors buy into the CDO, they don’t keep a bunch of cash in the SPV, though. That cash is managed by Goldman to build out a portfolio of high quality bonds, known as the collateral pool. Then, if any reference obligations default, the collateral is sold down to pay out Goldman. However, if nothing defaults then Goldman gets to keep any of the carry generated by the collateral pool – the CDO investors see none of it (which may sound unfair at first). But! While Goldman gets to keep any carry generated, they also need to reimburse any losses the pool suffers from poorly performing collateral so, ipso facto the CDO investors shouldn’t care about the collateral pool performance, just the reference obligations (which is exactly what they signed up for). The performance of the collateral pool has no bearing on the CDO investors’ return profile – only reference obligation performance does. It sounds quirky but this is just how the synthetic CDO market is structured and it’s players can at least agree on that much.

Here’s where it gets hairy. This distressed credit fund, Astra Asset Management, is claiming that Goldman breached the CDO’s collateral pool requirements in 2013 by purchasing riskier bonds that didn’t meet quality requirements laid out in the indenture. They’re now suing to terminate the CDO contract as of 2013 and insisting that Goldman return $124M in default payments that they received from the CDO over that period. On top of that, wouldn’t you know it, the CDO is overcollateralized by ~$70M and Astra wants that too. Although, it seems pretty clear cut the excess collateral belongs to Goldman – not sure what the legal basis would be for that.

Goldman’s counter to all of this is that the indenture is pretty clear that they’re responsible for any collateral shortfalls like I mentioned above, so even if they technically did breach the agreement they never put any CDO investors at risk as they’d make the pool whole. That makes sense, but it also makes sense that if there’s a technical breach of contract the infringed upon party has some sort of recourse. In the end, I doubt this moves works for Astra but kudos to them for trying. Either way, I’m just happy to be talking about Abacus deals again.

Stop Me If You’ve Heard This Before: Houston-based Power Traders Blow Up Another Region’s Power Market

“Bloomberg – On June 5, GreenHat received an invoice from PJM for $1.2 million to cover losses. It didn’t pay. On June 21, PJM declared GreenHat in default. Losses have continued to mount, according to PJM. The portfolio has more hedges that will probably keep losing money for three years…”

I love these types of stories. Pull out a big Wall Street pot and mix in equal parts of leverage, some win at all cost trading and an esoteric financial instrument. Kick in a dash of regulatory incompetence and you’ve got yourself one delightful tale about how someone inevitably blew up their book and caused some turmoil in the broader market.

We see these messes pop up every so often and they usually play out the same way: (i) someone has a “brilliant” trade that almost always includes derivatives or a structured product; (ii) they get caught flat-footed as the market turns against them; (iii) they try and trade their way out; (iv) other market participants catch wind of their troubles; and (v) the book blows up and regulators step in. The only thing that really changes is the asset class. Well gather round, folks: today we’re talking about power markets.

I’m not sure if the general population understands how wholesale power markets even work, so I suppose a quick intro couldn’t hurt. As a result of deregulation in the 90s and early 00s, two distinct market structures developed: (i) traditional, regulated markets in which a single utility company is responsible for generating and transmitting power to both wholesale and retail end users and (ii) RTO/ISO markets where private companies own the generation plants and transmission lines of a particular region. The generation companies participate in auctions, run by the RTO/ISO, for the ability to sell wholesale power into the market based on the energy efficiency of their plants. Once they win the auction, they’ll pay transmission companies a toll to use the grid to deliver the power. In layman’s terms, power generation companies say:

“Hey – we can provide xx megawatts of power at this price because we have a brand new, natural gas powered plant. The other guy who burns coal can’t come close to our price so we should win the bid.”

And that’s exactly what happens. The company with the new, more efficient plant is awarded the contract and is now obligated to provide a fixed amount of power into the system, in the future, at a certain price – done and done. In a vacuum the system works perfectly – but the world doesn’t operate in a vacuum. Sometimes power demand is higher than normal (like during a heatwave) so the system becomes congested, leading to higher tolls for the power plants and eroding their profits in the process. Well here in America we like profits, so the RTO/ISO markets decided to develop a financial product to hedge against fluctuations in the tolls, which is where our friends at GreenHat Energy come in.

I don’t want to get into all the nuance of what happened with these guys but here’s the skinny. The two traders, Andrew Kittell and John Bartholomew, took a look at historical congestion trends in the PJM market (the largest RTO/ISO in the country) and decided not only would that historical pattern continue to play out, it would be exacerbated into the future. They then went out and amassed a huge portfolio of hedges that would payout were their thesis to come to fruition (mind you these guys weren’t hedging exposure, they amassed a naked, speculative portfolio of power derivatives). The problem for these two rocket scientists was that they didn’t factor grid equipment upgrades / repairs into their congestion models. The aforementioned upgrades reduced congestion rates materially over the last few years, slowly eroding the value of their portfolio until 2018 when the floodgates opened.

According to RTO Insider, the derivative portfolio represented a hedge on 890 million MWh of generation – an absolutely massive financial liability for a fund of their size. The value of the portfolio continued to deteriorate and is now facing estimated losses of $145M… and counting. It doesn’t even matter for GreenHat, either – they’re already in default and thus the losses will be absorbed by PJM and it’s participants (including retail customers). So how were these two guys able to use so much leverage to put together, and subsequently blow up, a portfolio and pass the losses on to everyone else? Put quite simply the problem was poor market structure and lax regulatory oversight.

There were two key weaknesses in the way PJM ran the market that brought GreenHat where it is today. The first is that market participants don’t pay for the contracts in full until settlement which is normally a few years out. GreenHat was able to operate on 100% margin and, as long as their trade was profitable at settlement, never had to worry about paying out on losses (kids, hubris is a terrible risk management strategy). Now is the point where you should be asking yourself about collateral requirements:

“Well, sure – they didn’t need to pay out on the contracts yet, but of course they had to post collateral as the portfolio fluctuated in value. Right?”

Wrong, actually! The collateral requirements are determined on a portfolio-level basis, not a position-level one. This past April, PJM changed it’s credit policy for market participants which would have resulted in a $60M collateral call for the GreenHat portfolio. However, market participants were given thirteen months to comply with the changes and rework their trading strategies. GreenHat used this window to amass enough new, profitable positions on 100% margin to negate the $60M collateral call coming down the pipe for their losing positions. Lipstick, meet pig. The window dressing worked for a bit until those positions moved against them as well, sewing the seeds of GreenHat’s demise and sending PJM and FERC scrambling to stop the bleeding. Regulators and market participants are currently kicking around different ideas on how to best equitably absorb at least $145M in losses.

I’m not exactly sure these guys are two of the most prudent fiduciaries out there. However, while I wouldn’t sign up to be a LP in their next venture, I have to point out that they operated within the framework that PJM and FERC had laid out for them. This will obviously force PJM and the rest of the RTO/ISO markets to restructure their credit policies going forward, hopefully they can figure one out that works this time.

Fortress Doesn’t Believe in (Possibly Care About) Conflict Checks

“NY Post – SoftBank’s Fortress Investment Group is raising a $400 million fund to sue tech companies over intellectual property infringement…”

Before we get started, I know that Mike Novogratz left his life’s work years ago, but who else am I going to put up there to represent Fortress?

Now, I have to admit I was ready to poke some fun at SoftBank for this one. How can a conglomerate, with telecom, semiconductor and robotics interests allow one of its portfolio companies to be an outright patent troll? How can SoftBank, who has $195B in committed capital for it’s tech-focused investment vehicles, allow Fortress (“FIG”) to shakedown the very companies in which they seek to invest? Well after a while, it hit me: whether purposeful or not, this is probably a great way to hedge a tech-centric private equity portfolio. Outside of proper due diligence, managing FX / rates exposure or structuring capital calls to meet specific milestones, there aren’t many ways to manage the downside risk of making poor investments in the first place – especially when deploying capital into intellectual property-heavy tech industry.

Odds are, you’re investing in a tech company because it claims to have a new technology that can streamline business processes, enhance end-user experiences or is simply a brand new class of product. With new technology comes the prospect of a high adoption rate and, of course, multiples of invested capital. It’s not all glitz and glamour though, and there are real risks to investing in the tech space, more so perhaps than any other industry. The costliest mistake you can make in tech investing is, by a wide margin, not conducting the proper diligence around a target’s intellectual property / patent portfolio. Does the company really own this IP? Are they infringing on someone else’s IP? Who’s line of code is this, truly? Are there any outstanding lawsuits? What about imminent filings? Tons of these lawsuits are filed every day around the world by what are known as “patent trolls” – individuals or funds that buy random portfolios of IP and lawyer up to shakedown other tech companies for infringement. Rarely do the lawsuits reach a decision as they’re usually settled outside of court, which is exactly what the patent troll wanted. It’s a pretty scummy industry, but it’s also pretty lucrative – which is why FIG wants a piece of it. If a respected NYC asset manager raises $400M with the intention of suing nerdy Silicon Valley idealists into oblivion, the nerds will pay up to settle. Cash burn is fine when it serves whatever “mission” the unicorn de jour says it has, not when it’s being wasted on lawyers.

That brings us to the impact of this new FIG vehicle on its parent, SoftBank. Taken at face value, it seems like FIG is raising two birds toward everything SoftBank has built it’s reputation on – investing in and building out new technologies. If you take a forest vs. tree view, though, a successful patent troll investment platform can hedge against IP-related losses SoftBank portfolio companies may incur. Obviously a $400M investment is an irrelevant hedge for a $195B portfolio, but it’s a start. It’s not unthinkable that were this initial foray to be successful, that FIG would double or triple down to target more or larger targets. I also wouldn’t discount the idea of SoftBank seeding a larger IP strategy within FIG were they to succeed with this initial vehicle – that would be something special. This will be an interesting story to follow in the next few years and, no matter what happens, it’ll be a great exercise in thinking outside of the risk management box for SoftBank.

CEO Invests in Local Bodegas (Plus Blog Update)

First things first: I’ve taken a bit of a hiatus recently and haven’t posted anything for the last six days. I’ve been pretty busy with work, not to mention the IT nerds at my firm decided to block my own domain. I’m working with them now to get it sorted out but, until then, we’ll be doing limited posts from my phone or during the evening.

Now that we have that out of the way, lets take a second to bask in the glory that is Kam Wong, CEO of Municipal Credit Union (MCU), who has no grasp on how to commit bank fraud or what to do with the ill-gotten gains:

“CNBC – The CEO of New York state’s oldest credit union swindled his institution for years out of millions of dollars and blew a whopping $3.55 million on lottery tickets, federal prosecutors charged Tuesday.“

There are two main takeaways from this story. The first is that Kam Wong is either a woefully inept CEO, or he’s a woefully inept criminal – and I’m going with both here. Forget that he embezzled over $6M from his own company, the way he pulled it off is next level stupid. The guy was running your standard insurance fraud racket in order to collect cash on $6M worth of bogus dental and long term disability claims. So what did he do when he had the money – well, withdraw $1.9M from ATMs via 2,592 transactions and write over 200 checks to a bodega in Elmont, NY. You would think a banking CEO would be able to cook up a better way to embezzle and launder money than that.

The second takeaway and obviously the most important, is that Kam blew almost $4M of the money on…

Lotto tickets. You remember those bodega checks he was writing? Yeah, he wrote all of them to the bodega in order to feed his insatiable scratch off habit. Here’s The Post:

“In a weird twist, about $3.9 million of the ill-gotten gains allegedly went to fund a “lottery habit” near his office and his home in Valley Stream, Long Island.

Wong, who made more than $684,000 a year, wrote 216 checks to two bodegas and withdrew $1.9 million from ATMs a total of 2,592 times for the lottery tickets — sometimes multiple times a day, according to the complaint.

On weekends, Wong “spent hours … purchasing and playing lottery tickets,” according to the Justice Department complaint filed by Manhattan US attorney Geoffrey S.”

What a weird guy! I just can’t wrap my brain around buying $4M worth of lotto tickets. Did he play 200,000 twenty dollar games or 4,000,000 one dollar games? How much did he actually win on them? How upset is the bodega owner who just lost his $4M scratch off customer? Why did a CEO clearing almost $700K a year live in Valley Stream and hang out in Elmont? I doubt we’ll ever know the answers, but if you think I’ll ever stop searching for them, you’re probably right. I’ll definitely enjoy myself a nice chuckle when I see a headline buried in the “Local” section of the NY papers when he gets sentenced. That’s it, though.

But seriously, thoughts and prayers to the bodega. They’ll need to sling a whole lot of these bad boys to make up for the Kam Wong revenue shortfall going forward:

I Say We Bail Out the Hedge Funds, Too

“Bloomberg – At Milken, Hedge Fund Managers Swap Ideas on Staying in Business”

Won’t somebody please think of the fund managers!

I wanted to write a blog about how out of touch this group of millionaires is that they felt it necessary to take to a public forum to complain about how difficult it is for them to make money. Because when you’re blaming your own investors, stating their risk aversion has “sowed the seeds of very mediocre returns and high fees”, you’re not doing yourself any favors.

The truth is, though, they’re partially right. Now before we get into it, it’s important to understand that while the average American probably views fund managers as overpaid leaches, sucking economic value from the public system for their own private gain, they serve an important role in a modern economy. Traditionally, fund managers have offered three key benefits to investors and the market as a whole: (i) they assist institutional investors such as pension funds and insurance companies diversify their portfolios across different sectors and strategies, creating a more predictable return profile to match their long-term liabilities, (ii) they offer other sophisticated investors the opportunity to invest in more illiquid strategies like real estate, commodities and derivatives, and (iii) they provide liquidity to the broader market and enhance price discovery. Historically speaking, hedge funds have been pretty good at generating benchmark-beating, uncorrelated, risk-adjusted returns, and they collected fat fees for doing so. After all, investors were generally beating their benchmarks, even after the funds collected their fees, so nobody cared. Times are different now, though, and that’s where the plight of the hedge fund comes into play.

The rise of passive/index investing has been pretty detrimental to the traditional hedge fund model for a number of reasons, however it’s not just the strategy itself, but the time in which it came to prominence which ended up being the perfect storm for hedge funds. According to EY, the ETF market increased from $700B under management in 2008 to over $4.5T at the end of 2017 – for the people at home, that’s an increase of 543%. What’s more, 2017 alone saw inflows of $464B into passive vehicles. The explosion in passive products and their AUM has either democratized or socialized the markets, depending on who you ask. Either way, they have given all investors the ability to target as broad or narrow an investment strategy as they like, from simply buying the S&P 500 or small cap energy stocks, to shorting the VIX and beyond. As more and more money flows into these products, the asset managers need to go out and buy more stocks to replicate the underlying indices, therefore inflating individual stock prices in the process.

This is the problem for hedge funds. We’ve been on an almost ten year tear after bottoming out in the financial crisis, with the S&P 500 up +259% over that period. When you combine such strong, broad market performance with the explosion in passive capital basically bidding up individual stocks on a daily basis, it is nearly impossible for traditional fund managers to generate any alpha – and ladies and gentleman, if there’s no alpha, there’s no fees to collect for the fund managers. As a result, you’ve seen many large investors wonder out loud why they’re paying fees to managers who can’t beat the market, which has led to an all-out exodus from the hedge fund model. Even behemoth pension funds such as CalPERS are ditching managers for the passive life. Doing away with fund managers in the name of saving money on fees may prove to be penny wise and pound foolish though, as any deep correction in the market would likely be amplified by the fact that so many investors have plowed money into these products. At the end of the day, these guys are called hedge funds. They aim to provide appropriate risk-adjusted (i.e., hedged) returns. If you’re just super long energy stocks through an ETF and there’s another 2015-2016 episode, you’ll wish you had paid some fees and been hedged through an experienced energy fund manager who would’ve had proper risk management systems in place to mitigate downside risk.

Regardless, at this moment the hedge fund model is broken and if they want to survive, they’ll need to adapt. I saw an interesting piece in Bloomberg the other day that encouraged managers to ditch 2/20 and actually pay all their LPs a guaranteed fixed rate over the benchmark returns to manage their assets. Anything generated over that fixed rate would remain with the fund manager. The investors would generate a guaranteed return, similar to a fixed income product, and the manager would retain any alpha generated. It’s an interesting idea, but not likely. It’s good to at least see people thinking outside of the box.

Here’s The Mooch Getting Spiritual After Missing Out on $100M Payday

Let me start out by saying my firm has blocked Leveraged Burnout on our network, so I’m blogging from my phone. Apologies if there are typos, rambling sentences or any weird formatting issues.

“Bloomberg – HNA Group Co. and SkyBridge Capital have agreed to drop the Chinese conglomerate’s plan to acquire the investment firm.“

Anthony Scaramucci: everyone’s favorite hedge fund giant and real life short guy. There was a time when The Mooch had it all. After a bunch of fundraising for then-presidential candidate Trump, he was finally offered the position of White House Director of Communications after the Sean Spicer experiment. As is normal for cabinet members, he began to divest of assets that could conflict with his duties as a cabinet member, in this case, his stake in the well known fund-of-funds he built, SkyBridge Capital (actually a solid shop, did business with them at one point). The deal was valued at $180M, which would net Scaramucci about $100M at closing.

Anyway, he oddly chose to sell the firm to HNA, a giant Chinese conglomerate, and subject the transaction to CFIUS (which is a council that decides to approve or deny material foreign investments into U.S. companies). This was pretty dumb because after all the Trump-China campaign rhetoric, The Mooch decided to sell out to the Chinese tax free in front of the whole world. Predictably, the whole thing became a drawn out mess because of how high profile the sale was. It also didn’t help that he told a reporter what he really thinks about Steve Bannon and Reince Priebus, leading to him being unceremoniously (but hilariously) fired after 10 days in office.

Welp, that all leads us to yesterday’s developments, where SkyBridge and HNA decided the CFIUS process was too laborious and expensive and moved to kill the deal. So now The Mooch is out $100M and will be returning to the firm he built, which I suppose isn’t the worst thing. Maybe he’ll do the right thing and give Gary Cohn a job, too.

P.S. – Tell me this guy’s tenure at the White House didn’t play out exactly like you thought it would.

It was Inevitable…

As I speculated previously, Deutsche Bank is going to be firing a bunch at 60 Wall any moment. Per Bloomberg:

“Deutsche Bank AG is abandoning its ambitions to be a top global securities firm as it embarks on possibly the most sweeping overhaul yet of its struggling investment bank.“

Sheeeeesh. I suppose this is for the best, though, take a look at these highlights:

1Q net revenue EU6.98 billion, down 5%; analyst estimate EU7.27 billion
1Q sales and trading revenue EU2.45 billion, down 17% while U.S. counterparts rose 12%
1Q net income attributable to shareholders EU120 million

Look at that last one! Ladies and gentlemen, €120M is NOT a lot of money.

Sewing knew coming into his new job that this had to be a “rip the band-aid off” type of restructuring and I commend him for wasting no time in getting down to business. They mentioned on the call that there would be a “significant reduction” in headcount this year, and they’re targeting U.S. rates S&T, U.S. corporate finance and the coup de grâce, global cash equities trading. If you don’t make markets in rates and equities or advise companies on raising capital in the U.S., are you even really an investment bank? Maybe in practice you retain some IB capabilities, but people won’t be doing business with you in an IB capacity – which is fine. Sewing’s job, first and foremost, is to make money, and he’s going to do it the only way he knows – traditional commercial and retail banking, with a sprinkle of asset management. So good luck to Sewing, and even more best wishes to all of the DB employees updating their resumes right now. Don’t cry because it’s over, smile because it happened.

Netflix Likes On-balance Sheet Debt, Too

“Bloomberg – The world’s largest online television network sold $1.9 billion of senior bonds in its largest-ever dollar-denominated offering“

Here’s an unpopular opinion: Netflix really isn’t that great of a product – like, at all. I’ve always felt that their movie catalog was downright awful, filled to the brim with low-budget features that close to zero people have ever heard of. Their television and original series content definitely offers a better selection, but they’ve never been able to convince me to pony up cash on a monthly basis. Alas, the numbers don’t lie – Netflix continues to beat street estimates for new user growth quarter over quarter. So when they announce they’re issuing a bunch of high yield debt to finance new licensing acquisitions and original content production on the back of parabolic customer growth, it shouldn’t surprise anyone. But I’m a cynical numbers guy, so I’m here to poke some holes in everyone’s favorite stock (and one of my least favorite products).

The content industry is very fond of off-balance sheet transactions, and Netflix is no different. The transactions materialize in the form of commitments to purchase content from production houses (Disney, Warner Bros., NBCUniversal, etc.) in the future for a few billion dollars. This ensures that Netflix is able to provide newer content for its audience as tastes change. The weird thing here is how these transactions are accounted for. Netflix amortizes these costs, through COGS adjustments, across the shorter of (i) what they deem to be the length of time viewers will continue to stream that particular show/movie or (ii) ten years, starting on the date that the content becomes available for streaming. As of 12/31/2017, Netflix had amassed $17.7B in content acquisition liabilities, of which $10.2B never makes an appearance in their financial statements as the content isn’t yet available for streaming on the platform.

Once you adjust for the off-balance sheet obligations, Netflix’s total liabilities jump from $15.4B to $25.6B at YE 2017 and $27.5B after this latest bond offering. Normally this wouldn’t be worrisome as your assets and liabilities rise in tandem – or so you thought, until you find this gem they buried in the footnotes of their 10-K:

“…content assets, both licensed and produced, are reviewed in aggregate at the operating segment level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the net realizable value or fair value may be less than amortized cost. To date, the Company has not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost, net realizable value or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off.”

Ah, yes – there’s always the risk that all of those content assets acquired in the off-balance sheet transactions may not really be worth the acquisition cost, in which case there will be sizable charge-offs that will directly impair their free cash flow (which is already running huge losses as they follow the Amazon business model). As the company continues to grow its customer base, it will need to go to market and increase the size of their content acquisitions, which will inevitably lead to a few charge-offs as their content portfolio expands. This isn’t really an issue from a microeconomic standpoint. It has the ability to become a macroeconomic issue though, if content providers decide they want a bigger slice of the Netflix pie and start jacking up rates for licensing, even as Netflix begins to experience some standalone charge-offs. Any rate increases will continue to hit Netflix right in their cash flow statement. This is the point at which they’d need to pass those costs onto consumers, but who is to say they’ll continue to pay up? Netflix has the benefit of being structured like a low-cost gym membership, where customers forget about (or don’t mind) the cheap, recurring charge hitting their account each month. Were those costs to rise, customers may be a little more sensitive as to what they really gain from their membership, and whether or not it’s worth it.

I’m not saying any of this poses a going concern risk for Netflix, either. I do, however, think it does pose downside risk for equity investors, especially if you’re buying at these levels. Institutional investors are well aware of the off-balance sheet transactions and their cash impact, they just haven’t cared because customer growth has acted as a buffer. If there are any hiccups in customer growth or worse, retention, then lookout below as content cost and cash flow profile move up the ladder of importance in valuing the company.

P.S. – If they knock The Irishman out of the park I will disavow everything I just wrote. Can’t lose with Scorsese directing that cast.