By Eric Jackson
03/09/09 - 08:19 PM EDT
The Canadian banks have been getting a lot of attention lately. Last October, the World Economic Forum rated them the best in the world, ahead of Sweden, Luxembourg and Australia.
Compared with their basket-case brethren in the U.S., they look positively healthy. They never took on excessive mortgage risk, as Canada was never awash with subprime mortgages or securitization of the loans after the fact. Things like "no documentation of income" never flew in Canada, where bankers have always tended to be pretty bankerish, generally demanding 20% down.
The Canadian economy hasn't been prone to economic booms and busts like the U.S.' Equities never went up as much in the dot-com heyday, and home prices increased over the last few years, but not like the overheated U.S. markets. Also, Canadians never had the same wealth created (or credit available to them) over the past few years to allow a large number of families to buy second, third and fourth investment properties to the extent that happened in the U.S..
So as the banks around the world have imploded, the six largest Canadian banks: Royal Bank of Canada(RY Quote - Cramer on RY - Stock Picks), Bank of Nova Scotia(BNS Quote - Cramer on BNS - Stock Picks), Toronto Dominion Bank(TD Quote - Cramer on TD - Stock Picks), Bank of Montreal(BMO Quote - Cramer on BMO - Stock Picks), Canadian Imperial Bank of Commerce(CM Quote - Cramer on CM - Stock Picks), and National Bank of Canada (TSE) -- have looked like stalwarts.
Most are still reporting earnings, have relatively low exposure to U.S. loans, and are in strong capital positions to expand their market positions globally as others wilt.
So, the question is why haven't these banks' stocks done even better over the last few months. The five U.S.-traded Canadian banks have all lost over half their value in the last year. They've certainly done better than Citigroup(C Quote - Cramer on C - Stock Picks) and Bank of America (BAC Quote - Cramer on BAC - Stock Picks), but that stock performance is only roughly in line or worse than JPMorgan Chase(JPM Quote - Cramer on JPM - Stock Picks). Shouldn't these stocks be doing appreciably better, if the banks are that much stronger?
I think the management teams and boards of the Canadian banks should be congratulated for managing their businesses so well, especially when compared to the greed and recklessness that their global competitors were operating under. I believe the market's discounting of the Canadian banks stock prices in the past year is not a reflection of what they've done, but concern over what's ahead.
The biggest concern facing Canadian banks is the future health of the Canadian economy. Although Canada rode the oil and resource boom through last June to low unemployment and a booming dollar (which at its peak was worth C$1.10 for every US $1), and many in Canada assumed that the country was "decoupled" from the problems afflicting the U.S. even as late as last September, we now know that the northern economy is tightly connected to the U.S. and world economies.
In the '80s and '90s, Canada consistently and stubbornly hung on to a higher unemployment rate than the U.S. Canadian workers have been less mobile than their American counterparts, and retraining certain swaths of society has been difficult. In the last major downturn or the early '90s, the spread between Canada and U.S. unemployment grew to over 4%.
What's more, this gap remained at these levels until 1998, when the gap started to close to only about 2% by 2002 and recently closed entirely as the U.S. rate started to tick up before Canada's did.
Quite simply, Canada lags the U.S. when it goes into an economic slowdown and takes longer to come out of it. Despite the resource boom, a large part of Canada's economy remains tied to manufacturing and shipping those goods to the U.S. A weaker Canadian dollar for much of the last decade gave these Canadian manufacturers a big advantage sending goods to the U.S. As the Canadian dollar rose to parity with the U.S. dollar in the last 18 months, that cost advantage went away, but oil, resources and the Canadian economy remained healthy.
Now, six months after Lehman collapsed and the world economy has gone into free fall, the Canadian economy is hurting. In January, the Canadian economy lost 129,000 jobs and saw its unemployment rise 0.6% to 7.2%. That same month, the U.S. economy lost more than 500,000 jobs and saw its unemployment rate climb 0.4% to 7.6%.
The rate of job loss is rising faster in Canada, and remember that Canada is 10% the size of the U.S. Imagine if the U.S. Department of Labor had announced the American economy had dropped 1.3 million jobs in the month of January, and you understand what is going on north of the border.
We know the U.S. unemployment rate is now up to 8.1% through February, but the Canadian government has yet to provide comparative data. You can expect the job losses to continue to pile up over the coming months. If the U.S. finally tops out at 10%-11% unemployment next year, as many economists call for, it is not unreasonable to expect Canada to go back to its 4% spread of 14%-15% unemployment. It is this scenario that worries Canadian bank investors and the banks' potential future losses on credit cards, auto loans and mortgages (both consumer and commercial).
There are silver linings for the Canadian economy and its banks. The Canadian dollar has already dropped to being worth US 80 cents and it could go lower, which helps Canadian manufacturers compete against U.S. companies for jobs. Canadian consumer indebtedness is healthier than in the U.S., which hopefully contributes to continued spending in the domestic economy. The Canadian government has also done little to stimulate the economy and is in a strong fiscal position to do so, if needed.
The Canadian banks are in a strong capital position to weather the coming storm and will certainly use that strength to expand into the U.S. opportunistically at some point in the next three years. But investors might choose to wait on buying these "soundest banks in the world" until they better understand how long and how deep the recession will last in Canada.
At the time of publication, Jackson had no positions in stocks mentioned.
Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.
Tuesday, March 10, 2009
Friday, March 06, 2009
By Eric Jackson
03/06/09 - 11:05 AM EST
Last November, fund-of-hedge-funds manager Sandra Manzke of Maxam Capital Management sent out a Jerry Maguire-esque letter to her investors in which she stated that she was "appalled and disgusted" by the behavior of hedge fund managers today.
They no longer acted with investors' interests in mind, she said, as they did 25 years ago when she founded Tremont Capital. Managers today followed questionable practices like "gating, side pocketing, suspension of redemptions ... attempting to get their money out ahead of investors, [and] eliminate[ing] high water marks".
At first, Manzke was portrayed as a whistle-blower trying to get the rest of her greedy industry in line. Then, Bernie Madoff happened. In the fallout, it came to light that both Tremont and Maxam were heavy Madoff investors. Earlier this month, both firms separately announced they would have to shut down as a result of Madoff-related losses. Ironically, the firms (like many Madoff investors) did little to no meaningful due diligence and were content to play middlemen for a performing product and collect their fees. The would-be reformer should have started her efforts in her own backyard.
Hedge funds are much maligned in the press and by politicians these days. They do have some failings which need correcting, which I plainly see as a hedge fund manager myself. However, the industry will continue to attract talent, innovative strategy, and capital as a result in the coming years. Here are some of the problems with hedge funds but reasons why the industry is still an attractive place for your money.
Gating While Charging Fees is Unacceptable
A number of funds -- large and small, including ones with formerly sterling reputations such as Citadel, Farallon, and DE Shaw -- have exercised their rights to enforce a gate in the last few months, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.
John Paulson, whose fund was up 38% in 2008, has criticized fellow managers for invoking gates, and Leon Cooperman, who runs Omega Advisers, told The New York Times "you'd have to lower me into the ground before I'd put up a gate."
In my view, erecting gates is not ideal but defensible for a manager, since the possibility is fully disclosed to investors up front. However, it's deplorable that so many hedge fund managers have recently put up gates and then continued to charge fees after doing so. That certainly hasn't engendered goodwill with investors.
Among the funds still charging full or partial management and performance fees after erecting a gate, according to several industry participants I've spoken with: Citadel, Cerberus, and Highbridge Capital Management. One fellow manager expressed deep frustration at this practice of charging fees post-gate: "It's almost criminal. It gives all of us in the industry a bad name." Some funds are doing the right thing: Farallon is not charging fees to its investors kept in by their decision to use a gate last fall.
And, of course, just as no one is paying attention to the consumers who never got themselves into a loan they couldn't afford, let's not forget the many funds that had down years in 2008 and yet imposed no gates. They've given up fees on capital that left but could have been forced to stay. Some of the funds taking the high road are Atticus, Clarium, Harbinger, Maverick, and Tremblant. These funds faced the same "unprecedented" or "Perfect Storm" market conditions and yet were still able to maintain adequate liquidity and confidence in the marks on their positions in order to pay out requested capital to their investors. These funds are taking the long-view on this issue and will benefit in future fund-raising when this current down cycle turns.
Pay for Performance Works
Hedge fund critics are quick to jump on the issue of manager compensation. Critics say hedge fund managers should always make money, no matter the market or the strategy being followed. But not every hedge fund manager is following an absolute return strategy. One of the great things about hedge funds is that there is such a diverse choice of strategies and exposure levels.
Sadly, some hedge fund managers don't help themselves in the court of public opinion -- call it John Thain-itis. Most profiles of hedge fund managers include references to private jets, homes in the Hamptons, and flashy lifestyles. Discussions about managers giving to the Robin Hood Foundation are less common. A fund-of-hedge-fund manager recently told The Wall Street Journal: "I was definitely overpaid in the good times and now I'm definitely being underpaid in the bad times."
Those comments don't put anyone in the industry in a good light (especially that manager) but, at the end of the day, these comments or whether some manager buys a flashy car, has no predictive value on whether a hedge fund is a good investment. The truth is that hedge fund managers basically will only survive as a firm if they perform. If not, they'll be out of business (as many will in the next six months) and going into a different industry.
Most investors I know don't mind paying fees, as long as they get acceptable performance. When they don't, they redeem -- as they are in spades at the moment in the industry.
Don't Tinker With High-Water Marks
Hedge funds typically have high-water marks, which require managers to make their investors whole before resuming paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years. Ken Griffin of Citadel, which dropped 55% in 2008, said recently that he and others at his shop would only be working for "psychic income" for the next few years, as they crawl out of their negative performance hole.
Some critics have said that high-water marks are not the panacea they seem. If you have a down year, these critics say, you can just shut down your fund to avoid the pain of making back past losses and open another shop up across the street. Although this can and does happen, it's equally common for hedge funds to honor their high water marks instead of taking the "easy" way out and shutting down, eliminating the high water mark, and re-opening later.
There are examples of shirking performance responsibility in smaller hedge funds. In early 2008, before the real stock market pain hit, Dan Zwirn was forced to shut his hedge fund DB Zwirn & Co. when it came to light that he had improperly paid for a jet with investors' money (amongst other back-office issues). His performance had been steady and successful prior to those revelations. Zwirn claimed the improprieties were the fault of poor back-office oversight by his CFO and wasn't linked at all to the strategy he had overseen successfully.
Because his strategy involved stakes in many illiquid assets, it will take time to fully wind down DB Zwirn. However, only a few months after the decision to shut down, rumors began to circulate that Zwirn would be launching ZLC Global -- a new fund following exactly the same strategy as DB Zwirn & Co. Many DB Zwirn & Co. investors were going to be investing in ZLC Global, according to reports. It is puzzling that some investors can be so forgiving, but this behavior is isolated and does not undermine the value investors' gain from high water marks.
Some hedge fund managers have tried to bend the rules in their favor to collect more in fees. For example, Steve Mandel of Lone Pine Capital abides by a high-water mark but can get some portion of a performance fee the next year, if he surpasses a hurdle. In other words, you don't always have to live off psychic income if you had a bad previous year.
Another bad practice that should be changed is when hedge funds insist on long lock-up periods -- say three years -- during which they still pay themselves management and performance fees annually. They don't typically claw-back their year one performance fees if they have a major performance drop in year three.
Investors will rightly have less tolerance for these "innovations" going forward. If managers screw up, they need to pay the consequences. It's that Darwinism which makes the industry strong and should give no investor qualms about having to pay performance -- or more correctly stated, revenue-sharing -- fees.
The hedge fund industry will work out its excesses carried over from the last five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons should be learned. But in one, five, and 10 years from now -- no matter the macro environment -- investors will still flock to hedge funds because it attracts the best managers with the most creative strategies.
Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.
Thursday, March 05, 2009
By Eric Jackson
March 5, 2009, 12:01AM EST
BusinessWeek reader and hedge fund manager Eric Jackson considers the pros and cons of his industry
Not too long ago, practically every newly minted MBA wanted to be a hedge fund manager, and investors—including many conservative pension funds and endowments—rushed at the chance to place assets in hedge funds. Yet hedge fund managers were blamed for both artificially inflating the price of oil last summer and, when prices dropped, for contributing to the looming recession.
The mainstream press has now taken to derisively calling them "former masters of the universe," while noting that compensation is still "obscene." As quickly as assets came in during the up market, they have gone out in a declining market. In the last quarter of 2008, $152 billion in hedge fund assets were redeemed, even ones with positive returns in 2008.
As a hedge fund manager, I'm neither an apologist nor a cheerleader for my industry. Like any business, the hedge fund world has good and bad practices and managers. All managers need to accept accountability for the trying times we are living through. But it's fanciful to suggest hedge funds are about to disappear. Quite the opposite: The industry will be thriving even five years from now because it will continue to attract the best managers and the most sophisticated investors seeking alpha through innovative strategies. Here are some of the good and bad practices in the industry today:
Barbarians at the Gates
Hedge funds have long had "gates" as options available to the fund and/or manager included in their subscription documents. All investors reviewed these prior to making an investment. You haven't heard much about them because hedge funds haven't gone through a sustained down period the way we have in the past six months. As a result, a number of funds have exercised their rights to enforce a gate, reducing how quickly investors can redeem out of the fund. The intent of a gate is to prevent a panicked run on the fund, requiring forced selling, which can be very difficult for funds holding illiquid assets, and which further lowers the value of the remaining investors' assets in the fund.
Gates are a perfectly legitimate operating mechanism and will continue to be part of hedge fund investing. Moreover, as so many funds have decided to use them in the past four months, it is unlikely any one fund will be unfairly penalized by investors when they raise new funds down the road. The managers who will be penalized for putting up a gate are the ones who continue to charge fees after doing so. That's their right under their agreements, but it certainly doesn't engender goodwill, and investors tend to have elephant-like memories.
Overpaid and Underperforming?
Critics have attacked the standard hedge fund compensation model of 2% annual management fee and 20%-of-profits performance fee in light of the industry's poor 2008 performance (-19.2% for the average fund, according to Hennessee Group). Yes, many hedge fund managers made bad calls in 2008, but one-third of hedge funds made money in a year when the Standard & Poor's 500-stock index was down 40%. Only 1 in 1,700 mutual funds made money in the same period, meaning you were 50 times more likely to make money in a hedge fund compared to a mutual fund last year. What is that worth in fees?
Sadly, some hedge fund managers don't help themselves in the court of public opinion. Call it John Thain-itis. Many media profiles of hedge fund managers mention private jets, homes in the Hamptons, and flashy lifestyles, none of which has any predictive value about whether a hedge fund is a good investment. It's always been about the returns over a specific period of time, and the comparable risk-reward of other alternatives to invest their money.
Eyeing High-Water Marks
Hedge funds typically have high-water marks, which require hedge fund managers to make their investors whole before paying themselves performance fees. These high-water marks are going to cast a large shadow in the industry for the next few years.
What high-water marks also do—from an investor's perspective—is level the differences between a hedge fund and a mutual fund or other asset manager. Any investor has to pay a percentage of assets in management fees to a money manager. In the case of hedge funds, an investor pays performance fees only when the manager makes money. Investors also know that hedge funds will invariably attract more talent because the compensation levels are higher than the mutual fund industry or elsewhere.
Some observers feel that high-water marks are not the panacea they seem. In a down year, they argue, you can just shut down your fund to avoid the pain of making back past losses and open up another shop across the street. Although this can and does happen, it's just as common for hedge funds to honor their high-water marks instead of taking the easy way out and shutting down, eliminating the high-water mark, and reopening later.
Bottom line: If managers screw up, they need to face the consequences. It's that kind of Darwinism which makes the industry strong. Investors shouldn't have any qualms about having to pay performance—or more correctly stated, revenue-sharing—fees.
With over 10,000 hedge funds worldwide in 2008, funds naturally vary in size and strategy. Some pursue absolute returns, always seeking to grow capital, no matter the market; others aim to beat the S&P or other benchmark on a relative basis. Absolute and relative performance strategies have different levels of volatility due to the different types of risk they take on.
James Simons of Renaissance Technologies recently announced that his firm would not charge fees to existing investors for its Institutional Futures fund, which was down 12% in 2008, but would still charge fees on its Institutional Equities fund, which was down 16%. The difference between the two funds? The first follows an absolute return strategy, while the second aims to beat the S&P 500 by 4% to 6%, which it did.
There is no question that there's a sea change taking place in the hedge fund industry, which saw its assets decline by $782 billion, to $1.21 trillion, in the past year. That's a Detroit-like drop in demand on a year-over-year basis. Within five years, it's likely the mega-funds will dominate, similar to the private equity world, where you have KKR, Bain, T.H. Lee, and a lot of small fry.
Man Group in Britain will be the model for the biggest U.S. hedge funds, running multiple strategies and catering to the institutional investor and pension fund community. It's likely the funds with more than $5 billion in assets today will assume the mega-fund mantle in the future. Funds under that level will shrink or sell out. However, niche hedge funds will continue to thrive, as long as they have unique strategies that are successful.
Most will prosper with a couple hundred million dollars in assets, although some niche strategies can handle up to $2 billion. This is where a lot of innovation and outperformance in the industry will emerge. For example, the most feted hedge fund manager of the past two years is John Paulson, who made billions betting on credit default swaps, which predicted the severe souring of the housing market.
Prior to 2007, Paulson's firm was best known for its unremarkable, yet steady positive returns and merger arbitrage expertise. It's likely that he couldn't have made his bearish housing bet at a bigger shop. The perceived risk he was taking on with the CDS, especially going against the conventional wisdom at the time that housing would rise steadily because it always had in the post-World War II era, would have been rejected. Investors will be always on the lookout for the next great manager whose wave they can ride—and it will come from the smaller, more entrepreneurial managers.
Here's a scary thought for hedge fund investors: Hedge funds domiciled offshore (e.g., in the Caymans or British Virgin Islands) have boards of directors that tend, in my experience, to be far more lax and chummy than most corporate boards. (U.S.-based funds typically do not have boards as they operate as general partnerships.) These offshore boards tend to be small, typically two or three people, one of whom is often the hedge fund principal. Since the board oversees the investment manager's mandate, this is a huge conflict of interest that most hedge fund investors don't talk about.
Although it would be wrong to have a large bureaucratic board for a relatively small and entrepreneurial organization like a hedge fund, small boards often encourage managers to ask "friends" to fulfill this role. As a result, board meetings tend to be informal, tough questions don't get asked, and a real debate of legitimate risks facing the fund is avoided.
Many funds end up appointing a "rent-a-director" who lives locally and usually is recommended by, and affiliated with, the offshore lawyer working for the fund. These professional board members often have no job except serving on dozens of similar fund boards. They are simply there to be paid, so they clock in and clock out of meetings with a 9-to-5 mentality that would make a Dilbert character blush.
There are excellent hedge fund directors. However, perhaps not as many funds would be imploding this year had their boards done a better job at holding managers' feet to the fire when times were good.
The hedge fund industry will be working off its "too big, too fast" growth in the coming years. We're going from 10,000 hedge funds to perhaps 6,000 in the next few months. Performance, operational, and increased regulatory issues will weed out one-third of all hedge funds within two years. Remaining fund managers will have fewer staff, less leverage, and less compensation.
Those hedge fund managers with creative and differentiated strategies (and a track record and a background check that pass due diligence muster) will always find investors. Anyone worth their salt will stick it out; the dead weight and hangers-on will leave. That will make for a better overall industry.
Amid this upheaval and in the wake of the recent Bernard L. Madoff scandal, two hedge fund-related service providers will flourish: (1) third-party administrators who independently calculate a fund's month-end net asset values (NAV) for investors, and (2) third-party due diligence consultants who will scour the backgrounds and documents of fund managers looking for red flags to warn potential investors. I am amazed that these are still not considered absolutely required by investors before making an investment.
Who will wilt: the big fund-of-hedge-funds. Investors want managers who create value. Middlemen who take margin out of the value chain will be forced to defend their existence. Maxxam, Tremont, and Fairfield Greenwich showed us through Madoff that too few funds-of-hedge-funds do meaningful due diligence on their investments that they promised their partners. Funds-of-funds won't die but will drop away in large numbers. Only those that are truly differentiated will survive.
Investors will (and should) place more conditions on fund managers and demand more transparency. Although it will be much easier to do this in a post-Madoff world, an investor's size relative to other investors in a fund will still determine his power to demand this transparency.
Politicians on both sides of the aisle have called for more oversight on hedge funds, including a suggestion for mandatory "registration." What would registration really accomplish? Many hedge funds will continue to reside outside the U.S. and not need to register. But the largest hedge funds—with a majority of assets—in the U.S. already have registered and file their 13-F list of holdings on a quarterly basis. Registration for registration's sake, giving the government an abundant amount of data to do nothing with, seems a waste of time. Madoff, by the way, was registered with the Securities & Exchange Commission.
If the government wants to help improve capital markets, they should be prosecuting scammers and Ponzi schemes like Madoff, preventing "naked" short-selling abuses, and making it easier for shareholders to oust lazy and nonperforming members of corporate boards.
The hedge fund industry will work out its excesses carried over from the past five years and become a stronger collective of funds and fund managers. Most of the lemmings will leave, until the industry once again begins to experience excessive growth. Oversight must and will improve. Lessons will be learned. And investors will continue to flock to hedge funds because the industry will continue to attract the best managers with the smartest strategies.