In the movie “Philadelphia”, Denzel Washington’s attorney character had a habit of asking people to explain things to him as if he were a six-year old. The point was to break free from any personal bias or distracting details and focus on the simple, underlying issue as only a persistent child can. At the risk of appearing overly simplistic, naïve or idealistic, here are a few current issues that call out for some childlike clarity.
Why are investors so willing to pay hedge fund fees? If you believe their press, hedge funds are run by investment geniuses who have great latitude in their investment strategies and make their affluent investors returns that are unavailable to the general public while earning themselves billions. But the privilege of investing in hedge funds has its price.
Hedge funds typically charge fees of around 2% annually to cover operating costs, have required holding periods and restrictions on withdrawals and share in profits by taking up to 20% of profits off the top. When hedge funds have a period of strong performance, the manager usually attracts plenty of new investors or opens a new fund at the same onerous fee structure and restrictions. When a fund has poor performance to the point where it would take a long time for it to recover to the level at which the manager would share in profits again, it is not uncommon for the manager to simply liquidate the fund and return investors’ money, albeit at reduced values.
As with any investment, it is dangerous to evaluate hedge funds by simply looking at those currently hitting home runs. According to Hedge Fund Research Inc., hedge funds overall lost 19% in 2008, with nearly 1,500 funds, or 16% of the total, closing during the year. Through November, hedge funds had gains of 19% in 2009, heading for their best annual gains in a decade. As it turns out, those are the exact performance numbers posted by Morningstar’s Conservative Allocation category for mutual funds, at a fraction of the cost.
Why don’t lavish lifestyles draw more suspicion? As the saying goes, when the tide goes all the way out, you can tell who’s not wearing a swimsuit, and the depth of the financial crisis exposed plenty of investment scams. Most of these scams are simply variations of the classic Ponzi scheme in which early investors are paid from the funds of later investors, and the fraud eventually collapses because there are never any actual investments made by the crook and the pool of investors dries up. How these schemes succeed has been pretty well examined, from charismatic sponsors to investors who suspend their better judgment and think they can receive big returns with no risk.
But almost without exception (and Bernie Madoff, accumulating his wealth over many years of fraud, was a bit of an exception), these crooks come out of nowhere and almost overnight become very conspicuous consumers and large contributors to charitable organizations. Consider just one recent example, Scott Rothstein, a Florida attorney who pled guilty to a $1 billion scam involving phony legal settlements. His holdings included an 87-foot yacht, 20 luxury cars, a share of Gianni Versace’s former mansion in Miami and up to 24 other homes and other properties. He actively courted politicians and celebrities and wired $16 million to a bank in Morocco and fled there before returning to Florida and being arrested. Even if legitimate, there is no possible way his earnings from his investment pool could have supported his lifestyle.
Why do investors buy private-equity backed IPO’s? Whether it’s referred to as private equity or its earlier version of leveraged buyouts, the model is fairly straightforward – buy a company with little money down and lots of debt, spruce it up with new management and obvious simple improvements, maybe sell off a piece or two, pay yourself hefty ownership dividends (even though the down payment was a fraction of the purchase) and eventually make a significant profit by issuing stock through an initial public offering (IPO). But since the process is so well known, why would anyone buy the IPO when the easy money has already been sucked out of the company and the IPO’s are usually at the high of the market for the company?
Influencing these IPO’s is the partial ownership the private equity firm retains after the IPO, which means they still have an interest in the long-term value of the company rather than just the IPO sale. And the performance of private-equity sponsored IPO’s is decidedly mixed, with a number of studies comparing results to other IPO’s showing results heavily dependent on the time period of the evaluation and on the market, with US and European IPO’s differing over similar periods. Call this one a draw.
Why do banks make short sales so difficult? A short sale is one in which the proceeds of a property sale fall short of the balance owed on the property’s loan. It is widely believed that lenders fare better by agreeing to accept less than the loan balance than by foreclosing on the property, incurring carrying, improvement and maintenance costs and later selling the property on the market.
There are many factors complicating lenders’ approval of short sales, with multiple loans on the same property, mortgage insurance companies protecting their interests and personnel that are trained to lend, not to evaluate and minimize the lender’s exposure to declining real estate. Still, borrowers and real estate agents complain that sales have fallen through due to delays in lender approval of a short sale price.
Complications aside, it should be simple for a lender to determine a policy of whether they will participate in short sales, and if so, how much below the loan balance they would be willing to accept before foreclosing. The irony is that, two years into the foreclosure epidemic, few lenders have recognized the opportunity to set themselves apart from their maligned peers by responding more quickly.
In December, the Treasury proposed guidelines to speed up short sales. Mortgage servicers would have 10 days to approve or disapprove a request for a short sale, the transaction must fully release the borrower from the debt and claims of subordinate lenders (second mortgages, etc.) would be capped. Mortgage servicers would receive a $1,000 payment to encourage short sale approvals and borrowers would receive $1,500 in relocation expenses.
The financial world is, by its very nature, filled with misplaced self-confidence, confusing terminology and creative hyperbole. At the same time, most people have much better things to do with their time than to become fully versed in all things financial. Still, if a little simple logic and common sense raises red flags or questions that are not easily and clearly answered, it is best to be cautious.