Vertical Pulse

HF Manager: Sub-prime To Get Worse

Ho-hum, another day, another hedge fund rocked by the sub-prime avalanche.  The Wall Street Journal reported several hours ago that Sowood Capital Management, a hedge fund firm, "has suffered significant bond losses lately and is down about 10% so far this year." The story went on to report that the fund does not plan to close up shop just yet. Sour sub-prime investments are affecting investor sentiment, and as I am writing this the Dow Jones Industrial Average is down 50 points today. What happened to our bull market?

Things are only going to get worse for those investors holding onto CDOs containing sub-prime mortgages. A number of those loans, which are given to people with questionable credit histories, are scheduled to reset between this summer and next year. With home values dropping quicker than the Dow, credit hedge funds and other investors with CDOs should be bracing for hard times considering sub-prime homeowners will have a very difficult time refinancing their mortgages. Wait ... here come the banks and regulators to the rescue. Well, may be not.

This is a good one. In today's Finalternatives newsletter, reporters interviewed a couple of hedge fund managers about the sub-prime meltdown. "Banking systems and regulators, in their infinite wisdom, have tightened up standards, making it nearly impossible for many of these people to refinance, so we see a coming deluge of forced foreclosures and sales," James Melcher, founder of New York-based Balestra Capital, told Finalternatives. "The psychology has clearly changed here from the home as a great way to make money to people being underwater."

Retail investors are having a tough time fighting the equity market's downturn because of the sub-prime situation. Now, they have to contend with the banks and regulators too. Thanks guys!

A Cause Of Good

As we all know state pension funds are significant investors in hedge funds and private equity funds. For the last few years alternative asset classes have yielded good returns for pension funds, which represent hundreds of thousands of state and municipal workers who depend on their pension plans for a comfortable retirement. It has been reported in the immediate past that the success of hedge funds and private equity funds has nearly closed the funding gap between politicians' promises and financial shortfalls.

The state that needs the most help from the alternative asset class in financing state workers' retirement plans is New Jersey. In yesterday's New York Times it was reported that the Garden State will experience a $58 billion shortfall, the amount needed to provide all the health care its politicians have promised current and future state worker retirees. The state stopped placing money in a fund to pay for health care for its retired public workers in 1994 under Republican Governor Christine Todd Whitman.

"That’s nearly twice the state budget and nearly twice the amount of its outstanding debt. And because of the step it took in 1994, the state has virtually no money in reserve to cover those costs," the Times reported. The newspaper went on to spin that a national health care plan would be the solution to New Jersey's woes. However, for those of us who know better, realize that this would be only a short-term solution and would end up costing taxpayers even more of their hard earned money while destroying innovation in the medical industry. 

I will not go on to pretend that I know the solution, but among all the state's politicians' possible options, one should be to take some the money earmarked for the pension plan and invest it in a vehicle of the alternative asset class. Also, members of unions should suggest to their top leaders that private equity and hedge funds are a cause of good (yes, they do fire union workers, but experts have argued that such employers would collapse if it were not for outside investors' cash infusion) and spare them from losing their jobs. Also, voters, especially the ones in New Jersey, should tell their representatives in Congress to drop all proposals that would raise taxes on organizations that are partnerships (i.e., hedge funds, private equity, venture capital, REITs, etc.).

Forbes Magazine CEO and President Steve Forbes wrote in The Wall Street Journal yesterday that increasing taxes on private equity is "an ill-conceived idea that will ultimately affect all of us, and not for the better."

Indeed.

Subprime Summer

The tempestuous debt market is making it difficult for Chrysler to raise $20 billion - money that would maintain its operations once sold off from its parent company, DaimlerChrysler AG. "Low interest rates and plentiful capital are the key enablers to Detroit's restructuring," John Casesa, managing partner of the Casesa Shapiro Group, told The Wall Street Journal yesterday. Daimler decided to sell its North American automaker unit to Cerberus Capital Management, a New York-based hedge fund, several months ago.

For the last couple of years debt has been cheap for private equity firms and hedge funds looking to take companies private, which allows them to turn their acquistions' operations around, and then sell them for a profit. However, recent troubles in the sub-prime sector have made many debt investors nervous, who are now calling for more protections when lending money. This has increased interest rates and terms to loan covenants.

Several hedge funds have imploded recently because their sub-prime holdings have suffered a dramatic decline in value since the winter. It appears the sub-prime bug knows no bounds. In Sydney, Australia where Basis Capital, a popular hedge fund manager, recently alerted investors in its Basis Yield Fund that the value in the fund’s illiquid securities has been reduced by more than half. What is being labeled as the "Sub-prime Summer," people are divided on how it will affect the overall market over the next several months.

Hedgeworld.com reported today that "Economists and bond market participants are divided into two camps on the relationship between the subprime/credit headlines and the dollar. Some believe that the effect of the U.S. subprime crisis will be limited and that the economy is in growing mode. They tend to anticipate that the Federal Reserve Board will lean toward a tightening policy this year, either because they see that U.S. growth can't be sustained without a serious risk of inflation or because they already worry about price increases. The other camp believes that the subprime 'disease' is spreading across the credit market, the economy and the dollar. Their view is that the Fed is likely this year to postpone rate hikes or may even ease up, because they see the housing and credit markets as having the potential to slow down the U.S. economy."

The sub-prime issue will be discussed at IncreMental Advantage's Oct. 16 Hedge Fund Due Diligence Conference in NYC. For more information please visit www.incrementaladvantage.com.

Lennar Fights to Protect its Reputation

According to an article in The Wall Street Journal, a Florida-based real estate agent has orchestrated a campaign against Lennar Corp., one of the nation's largest homebuilders. The real estate agent, Mike Morgan, claims that he is owed over $200,000 in commissions in home sales that he made but that were later rescinded by Lennar. (Lennar accommodated some 130 home buyers who got cold feet when Florida's real estate market began hitting the skids.)

Mr. Morgan's website www.defective-homes.net points to many alleged shortcomings of Lennar's homes.

It is interesting to note that Lennar is highly concerned about defending its reputation in this dispute. Stuart Miller, Lennar's CEO, is quoted as saying, "As a company with a 50-year history of exemplary customer service and integrity, we are left with no choice but to vigorously defend our company against those who attack our name and reputation with unfounded allegations."

Perhaps partly because Mr. Morgan is using his site for private gain, a federal magistrate judge recommended a preliminary injunction preventing Mr. Morgan from using the word "Lennar" in Web-site domain names.

These are some of the issues that will be discussed at IncreMental Advantage's Reputation Management Conference. Visit www.incrementaladvantage.com for more details. Or contact Neomi Barazani at neomi@incrementaladvantage.com or 609-919-1895 ext. 100. 

Michael Vick and Nike

Allegations now abound that pro-football star, Michael Vick, tortured his dogs. These allegations caused Nike to suspend the release of its latest product line named after the Atlanta Falcons quarterback. There is an interesting question here: when a sponsor endorses a celebrity and the celebrity brings bad press, when must the the sponsor break its contract to protect its reputation. This is one of the issues that will be discussed at the Reputation Management Conference.

Whole Foods CEO Damanges His (Firm's) Reputation

It was recently revealed that John Mackey, CEO of Whole Foods, assumed a fictitious online identity to praise Whole Foods and castigate its rival, Wild Oats Markets. While there may not have been any laws broken, Whole Foods' reputation will clearly take a hit. The irresponsible actions of a CEO negatively impacts his company's relations with its employees, vendors, customers, media and community. Whole Foods has already attracted a flurry of unflattering media attention and its share price has dropped since this story broke.

Many facets of Reputation Management will be addressed at IncreMental Advantage's Reputation Management conference on November 6 in New York City. Further information can be obtained by visiting www.incrementaladvantage.com or by contacting Neomi Barazani at 609-919-1895 ext 100 or by emailing neomi@incrementaladvantage.com.

Shareholder and Judicial Resistance to Private Equity Deals

There is growing concern that senior management teams are receptive to being acquired by private equity firms - not for accretive value to be shared throughout the shareholder base, but rather because of the financial benefit senior executives expect to reap should their companies be acquired by financial sponsors. Institutional investors are increasingly sensitive to this issue as are judges from venues such as the Delaware Court of Chancery.

In some instances, CEOs have been negotiating deals alone. Also, many CEOs stand to receive lucrative pay packages as well as benefits through their pension funds should their companies be acquired. Some companies courted by private equity firms have not sought bids from potential corporate acquirers or have failed to tell their boards that they were shopping their companies. Recently, judges have excoriated executives for not disclosing competing bids and for failing to inform investors that many senior managers would stay on at the acquired company with tantalizing pay packages.

The real question is: Are senior managers willing to sell their companies for below market rates in return for personal financial gain?

These are some of the questions that will be addressed at IncreMental Advantage's Mergers & Acquisitions Due Diligence and Structuring Private Equity Conferences. For more information, please visit www.incrementaladvantage.com or email Neomi Barazani at neomi@incrementaladvantage.com.

Uranium Exploration

There was a huge glut of uranium from about 1978 to 2004. Many of the uranium geologists left the industry. Then in about 2002, many geologists came back to uranium as uranium prices started to soar due to the shortage. Most of the founders of the current crop of uranium exploration companies are older people. Uranium is destined to stay hot due to the nuclear reactors being built in China. About 20% of the nuclear fuel used in the US comes from Russian nuclear warheads. In 2004, in the state of Wyoming (which is where most of the Uranium is in the US) there were about 10 permits granted for uranium exploration. In 2006, there were about 17,000 permits granted for uranium exploration. However, almost all uranium activity in the US is exploration. There is currently very little production of uranium from these exploration activities in Wyoming.

These are some of the issues that will be discussed at IncreMental Advantage's Metals and Mining Conferences. For more information about these conferences, please visit www.incrementaladvantage.com or send an email to neomi@incrementaladvantage.com.

Another One Bites The Sub-prime Dust; Global FDI In Trouble

Another hedge fund bites the sub-prime dust. According to Reuters, Braddock Financial Corp. announced yesterday that it will be liquidating its $300 million Galena Street Fund after concerns of its sub-prime mortgage exposure triggered investor redemptions. This is the third hedge fund to fall apart in the last few days because of the sub-prime mess. By now we have all heard of the other names that collapsed under the weight of the mortgage-backed securities meltdown: Dillion Read Capital Management, Bear Stearns, Queen’s Walk Investment, and now Galena Street Fund.

Probably the most obvious way to detect if a hedge fund is in trouble is when management halts investor redemptions. It was reported that one of the Bear Stearns’ funds stopped honoring redemptions in May, about a month before its troubles made headlines. Earlier this week United Capital Asset Management LLC, in Key Biscayne, Fla., stopped letting investors withdraw money from four hedge funds. The Wall Street Journal reported that Galena lost about $100 million from its sub-prime holdings.

The WSJ also reported that prices have been depressed by investors "flooding the market" with asset-backed securities. "In addition to technical weakening in the market, many [asset-backed] securities continue to perform poorly. As a result, Wall Street has taken what we believe to be a very conservative approach to pricing and leveraging of securities, further dampening liquidity."

On an unrelated topic, but also a stroke of bad news for hedge funds, private equity, and for the economy in general, the WSJ reported that many countries are starting to erect, or are considering, barriers to curb foreign direct investment (FDI). Can anyone say Smoot-Hawley Act of 1930. One of the main engines of global economic growth is investors pouring money into promising investment prospects around the world. If governments start blocking inflows of money the repercussions will be felt far and wide.

The Smoot-Hawley law triggered other nations to put up tariffs and trade restrictions causing the Great Depression to go global and creating monsters like Adolf Hitler, Mao Zedong, Benito Mussolini, and others of that time. Not suggesting that today’s movement to curb FDI will cause the next depression, but such political posturing is short-sighted and dangerous.

Even more disturbing, the U.S. Congress is what instigated this latest round of protectionism by blocking the Dubai Ports deal last year. Now it is about to extend the Committee on Foreign Investment in the United States review period from 30 days to 45 days. I think they should be finding ways to streamline the cumbersome process to reduce the review time from 30 days to 15.

The U.S., supposedly the advocate of free markets and free trade, is sending the world the wrong message. After all, we have the most to lose if globalization slows down considering we are the second largest recipient of FDI (nearly $100 billion in 2005) in the world. But it seems, politicians want to end the party.

These are some of the issues that are discussed at IncreMental Advantage’s conferences. For more information please visit www.incrementaladvantage.com.