Your Hedge Fund Questions, Answered
A few days ago, we solicited your questions for hedge fund manager Neil Barsky. As always, your questions were terrific, and so are Barsky’s answers, below.
One thing that surprised me, however, is that nobody asked Barsky, a former Wall Street Journal reporter, what he thinks about Rupert Murdoch‘s purchase of the Journal (and the rest of Dow Jones). This is probably a good indicator that journalists care a lot about the business of journalism — look at the thousands of column inches the Times and the Journal itself have devoted to the deal — but that nobody else really does.
Anyway, since I cared, I asked Barsky, and you’ll find his reply at the end of this hedge-fund Q&A. Enjoy, and thanks again to you all for the questions and to Neil for the answers.
Q: (1) Do you think the Senate proposal [to raise taxes] really could cause a flight of the industry overseas, as Ben Bernanke hinted? (2) Do you think any reasonable objections can be raised against the proposal, considering that private equity fund managers, besides making a token co-investment whenever they put together a deal, surely don’t face the kind of risk faced by an entrepreneur or major investor?
A: First, let me state the obvious: there is no public policy reason for hedge fund and private equity managers to pay a lower tax rate than teachers, doctors, or lawyers. Yes, we live in a society where the market decides how much to compensate people for their work — baseball players make more than teachers, hedge fund managers make more than doctors. That’s capitalism, and while our system produces more than its share of inefficiencies, it works pretty well over time and for most people. But part of the bargain in the U.S. is our progressive tax code — the more you earn, the higher your tax rate. This tends to have the practical effect of raising more revenue for the government, and it also has an perceived fairness component.
I suspect that this debate is the result of a quirk in the tax code: hedge and private equity funds are set up as partnerships, and partnership accounting allows incentive fees to receive “tax treatment,” which means the gains are taxed according to the tax basis of the underlying stocks in the portfolio. Certain congressional bills want to tax those gains to the manager as ordinary income. No legislator in his right mind ever said, “We have to tax hedge fund managers this way, otherwise they’ll have no incentive to work hard!” So let’s not kid ourselves — the tax code is a gift to the industry.
Of course, accountants and some managers will find clever ways to circumvent the new laws, so perhaps the proposed bills won’t generate the revenue they are meant to. But from a fairness perspective, it is a no-brainer. The notion that the most profitable industry in the history of mankind (I hyperbolize, but on a per-person basis, this might in fact be true) requires a lower tax rate to take risk and make investments, simply does not square with logic. I know of no manager who would stop working or stop investing as a result.
Q: I’m curious as to what degree the emergence of hedge funds has changed business strategy. Do the large swings of capital from hedge funds, etc., cause firms to focus so strongly on short-term performance that they compromise their sustainability in the long run? Does the structure of our current capital markets threaten the stability of the economy by creating companies so focused on quarterly returns that they lack the ability to adapt to a changing economic landscape?
A: This is a great question: does the presence of short-term-oriented investors such as hedge funds alter the behavior of the companies they invest in? Let me throw a few more questions out there: To what extent does widespread options issuance create an incentive for a CEO to focus on his or her stock price to the exclusion of building long-term business value? Does the ubiquity of earnings estimates cause companies — unconsciously or, ahem, intentionally — to distort their business practices in order to please investors? Does all the money sloshing around hedge fund coffers allow them to throw their weight around and often force managements to make bad business decisions?
My answers would be: Yes. A lot. Yes. Yes. Short-term thinking infected Wall Street some time ago, and I would suggest it was performance-obsessed mutual funds that got the ball rolling back in the 1980s bull market. Not all hedge funds are activist or short-term thinkers, of course, but the rise of “activist” hedge funds and private equity firms certainly have exacerbated the situation.
I believe the chickens are coming home to roost, however. Often, companies go private when activists chase management into the arms of LBO shops willing to put a level of debt on corporate balance sheets that public investors would find imprudent. As the economy slows or credit markets tighten, these companies will have trouble making their debt payments, and — just as the LBO boom in the 1980s burst — lenders and possibly private equity investors will be left holding the bag.
Q: Do you believe that hedge funds provide a social good? Predominantly (if not exclusively) these funds are available only to the wealthy (notwithstanding the fact that some pension funds may invest a portion of their assets in hedge funds). It seems to me that while working-class schlubs (or even upper-middle-class schlubs like me) could never even dream of investing in these types of funds, their function net-net is merely an extension of the old saw of helping the rich get richer while foreclosing financial windfall opportunity to the bottom 95 percent. What are the specific benefits to society as a whole that are provided by hedge funds?
A: I don’t believe hedge funds necessarily provide a social good, but I also do not believe they are a social evil (generalizations are always dangerous, but bear with me here). Certainly the fact that non-wealthy folks are deprived of their right to invest in hedge funds seems to be a victimless crime, no? And for those eager to invest in hedge funds, but who don’t meet hedge fund minimums, rest assured there are funds of funds and other vehicles that can give you exposure to the industry.
But let’s deal with the larger, philosophical question: What specific benefits to society as a whole are provided by hedge funds? I do believe that, starting with the 1980s bull market, we have seen a society-wide reallocation of human resources. And it is unfortunate that the “best and the brightest” no longer seem to want to go into government or medicine or teaching (I did say I’d be generalizing here), and instead seem to gravitate to the best-paying professions. In other eras, I believe that was not the case to the degree it is today. Hedge funds didn’t make this happen — back in the 1980s and 1990s it was the investment banks that siphoned off the talent — but the industry has certainly made matters worse.
I might be stretching here, but I will offer some examples of how hedge funds — or certain hedge fund managers — help society. The best hedge funds I know (and they number in the dozens) are managed by smart, ethical managers who are able to generate superior returns without taking undue risk. Many of their investors are hospitals, university endowments, and charitable foundations. To the extent that these investors are spared the performance of the mediocre world of mutual fund managers, then they and the people they support benefit. To the extent that these managers earn handsome fees and are generous souls (and many of them are), then society benefits when they donate portions of their wealth to charity.
In general, the compensation differential between jobs in finance and jobs in virtually every other part of society is sad.
Q: How far are we away from hedge funds being a regulated investment option (and thus available to non-qualified investors)? How different will they be compared to the type of investment pools that they are today? Also, once hedge funds become regulated, will they lose their ability to extract value from market inefficiencies due to transparency?
A: I believe it is only a matter of time before hedge funds are required to register with the SEC. I also believe it is only a matter of time (how much time, I don’t know) until hedge funds are no longer deemed too “risky” for mom and pop, and are available to average investors. Over time, I believe we will see a convergence of the traditional long-only mutual fund industry and the hedge fund industry. I could make a good argument why a hedge fund with 50% market exposure whose manager does not get paid if she loses her investors’ money is considerably less risky than a mutual fund where the manager has no capital in his own fund, where he is paid merely to beat an index whether the market goes up or down, and where his company is 90% focused on asset gathering. But that would be self-serving.
Q: Jeremy Grantham recently wrote in one of his investor letters:
To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist. I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire.
The feeling I have today is that of watching a very slow motion train wreck.
What do you think of Grantham’s comments on the overstretched financial system and its impact for hedge funds?
A: Mr. Grantham is looking pretty smart these days, isn’t he? There has been a “repricing” of risk these past few weeks, and leveraged players have been slaughtered. Some hedge funds, those focused more on the credit than the equity markets, I believe, have shut their doors. The subprime mortgage market has shut down. Banks are on the hook for tens of billions in loan commitments to upcoming LBOs that no longer make economic sense. I am more concerned about the overstretched financial system’s impact on the economy than I am about hedge funds. Overall, I would observe that the U.S. economy has historically proven very resilient in the face of the inevitable excesses that flow when money is too available, and I tend not to be an alarmist. As for hedge funds, I’m not concerned. Some will fail and some will thrive.
Q. As a former Wall Street Journal reporter who now toils in the trenches of finance, how do you assess Murdoch’s purchase of Dow Jones?
I think Murdoch’s purchase of Dow Jones is sad, and mostly inevitable. Sad because I know how passionate the people at the Wall Street Journal are about hard-hitting independent journalism. While many of us assume that virtually all journalists have deeply ingrained biases and agendas, my experience in the industry is the opposite: most reporters I know are independent thinkers who would knock down walls to get to the bottom of a story (many would knock over one another to boot).
Will Murdoch change that? At first, I suspect he will behave well, raise salaries, hire more reporters and let the chips fall where they may. He is nothing if not a patient and smart businessman who is willing to lose money for years, mindful that a large payoff is up the road. The Fox television network and Fox News are examples of this. The historical record, however, suggests Murdoch will eventually marry his political and business interests, much like the press lords of old.
My view is that Murdoch’s properties — mainly the New York Post and Fox Television — have lowered the quality of discourse in our country. They’re outrageous, brass-knuckled, often hysterically funny, and clever outlets. But they are also mean-spirited, reputation-ruining, and often truth-distorting. Put another way, I think all journalists and news organizations have certain biases; News Corp’s properties seem to have agendas.
That said, it must also be understood that this takeover was allowed to happen because Dow Jones management — and its board — has been asleep at the wheel for a long time. Before Murdoch stepped in, the stock was lower than it was in 1983. Think about that. In 1983, Dow Jones was like 19th century Britain — it ruled the seas. It was the most dominant, well-known business brand in the world. There was no Bloomberg, no internet, no CNBC, probably Reuters and the Financial Times weren’t much, either. A series of management missteps — selling cable properties, buying and writing off Telerate, failing to invest in business television, and on and on — led to a punk stock price, and opened the door to Murdoch.
Unfortunately, the newspaper industry is in the throes of real technological disruption. While big-city dailies and the nightly news once dominated, the world is now chopped up into a million little pieces. Murdoch understands this; the Dow Jones board and management didn’t.