KeitH McCu lLoUgh W IT H R i C H
B L AK E
Diary of a Hedge Fund Manager
i
Diary of a Hedge Fund Manager From the Top, to the Bottom, and Back Again
KEITH MCCULLOUGH WITH
RICH BLAKE
John Wiley & Sons, Inc. iii
Copyright © 2010 by Keith McCullough and Rich Blake. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 7622974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: McCullough, Keith, 1975– Diary of a hedge fund manager : from the top, to the bottom, and back again / Keith McCullough with Rich Blake. p. cm. Includes index. ISBN 978-0-470-52972-0 (cloth) 1. Hedge funds. 2. Investment advisors. I. Blake, Rich, 1968– II. Title. HG4530.M39 2010 332.64⬘524–dc22 2009035907 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1
For Jack
Contents
Introduction Chapter 1: Chapter 2: Chapter 3: Chapter 4: Chapter 5: Chapter 6: Chapter 7: Chapter 8: Chapter 9: Chapter 10: Chapter 11: Chapter 12:
1
Catch a Wave Shipping Out Welcome to the Jungle Snapshots from the Dot.Com Bubble Discovery Flying with the Giants Shifting for Myself Sucked In Worlds Collide Exile on Wall Street Lifting the Curtain The Great Squeeze
Epilogue Acknowledgments About the Authors Index
9 17 29 39 61 79 97 115 123 139 157 185 197 205 207 209
vii
Introduction
M
y final day in the hedge fund business was Friday, November 2, 2007. I’d enjoyed nearly a nine-year run on Wall Street, first as a junior analyst at Credit Suisse First Boston before landing on the buyside, working for hedge fund pioneer Jon Dawson, and then eventually co-founding a hedge fund with my partner, Harry Schwefel. Our fund was later absorbed into multi-billion-dollar Magnetar Capital. My last-ever hedge fund job was running money as a Portfolio Manager and Managing Director at Carlyle-Blue Wave Partners. At the time I worked at Carlyle-Blue Wave (February through November of 2007), the Carlyle Group—already well known around the world for its private equity prominence—was pushing into the hedge fund business. Its new hedge fund arm, Blue Wave, a joint venture with two ex-Deutsche Bank executives, made me Partner and gave me a seat on the fund’s Investment Committee, representing the Long/Short Equity side of the business. On the morning of what would turn out to be my last day in the business, I ducked out of our Midtown office right before noon 1
introduction
and walked down Fifth Avenue to buy a new pair of black loafers. The soles of the ones I had on weren’t exactly worn out and might have even lasted me another six months, but with my son Jack due to be born in the coming week, I felt it was time to start the next chapter of my life. So did my bosses at Carlyle-Blue Wave. Later that afternoon I was told I was being let go. My days trading a “book” for a hedge fund were over. I packed up my personal belongings, books, files, and notebooks into a couple of cardboard boxes, but I left my old shoes in the office. When those dusty loafers were mailed to me a month later, I had already forgotten about them. But I smiled. ■
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During my brief time at Carlyle-Blue Wave, the first cracks in private equity and in hedge funds—and in the financial markets in general— were starting to manifest. The widening subprime mortgage crisis was starting to dominate the financial press. It was clear, to me anyway, that a top had been reached and probably surpassed. My final month of trading on Wall Street was a profitable one. My shorts were finally beginning to work out. But there was just no denying that I had turned in an unprofitable third quarter of 2007. Although the market took a nosedive in the early part of that August, it whipsawed right back up again later in the month and into September. In the end I’d been too bearish, too soon. Now I was being shown the door. I had enjoyed the ride, made my eight figures, notched positive returns in 21 of 24 quarters. Still, unless you run the place, the hedge fund business is about being right each and every quarter. Being right early is called being wrong. But it seemed my last “call,” on the global market and on the asset management industry, was turning out to be right after all. 2
Introduction
As my hedge-fund trading days came to a close in the autumn of 2007, the seeds of a new type of real-time research firm—something akin to a virtual hedge fund—took root in a financial blog I had begun writing. My audience at first included a few friends and former colleagues from the Street, but I mostly wrote for myself. For years, I’d diarized all of my investment decisions, logging observations and data points meticulously into 10 × 77/8 inch collegiate style composition notebooks, marble covered, 100 sheets per notebook. With spare time no longer a scarcity, I started writing every day, often recalling my experiences as an analyst and as a fund manager. And I kept making calls on markets, and wrote about them, to keep an on-the-record hand in the game. One day, when my son was old enough, I could show him that in the last game Dad ever played as a hedge fund manager he got kicked off the team when an MVP trophy would have been more appropriate. Having closed on October 9, 2007, at a record high of 1565.15,* the S&P 500 reached 1576.09, intra-day, on October 11, before entering the initial stage of what would be a monumental decline. Convinced the worst was yet to come, I began sharing my market views with anyone who cared to read them. I published a blog, MCM Macro, my token attempt to bring some semblance of transparency to the investing world, starting with publishing every call I was making and articulating the reasons why. Every call is still up there on that site. I made short-term, and longer-term forecasts, always owning up to miscues, always an open book insofar as my rationale was concerned. Never that strong a writer, I was finding I enjoyed it, looked forward to it, and tried to improve. I wrote constantly. I wrote from a position of truth. I had no agenda other than to chronicle my process and thoughts. No such “open book” existed in the hedge fund world, or for that matter at the large *
According to FactSet Research Systems Inc.; all of the market and securities data contained in this book, in fact, came from FactSet.
3
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banks and investment brokerage houses that sell research. In a market growing more perilous by the day, I was now giving former colleagues, family members, and friends full access to my portfolio management process. They saw every call in real time. In an industry that needed to creatively destruct before it could truly change, I felt like I would do my small part by being accountable in the meantime, even if I was merely a virtual Portfolio Manager. On Tuesday, April 1, 2008, I posted a three-month performance report for my MCM Macro model portfolio: +2.2 percent, compared to –10 percent for the S&P 500 and –14 percent for the Nasdaq. Along with a few partners, I officially opened the doors of Research Edge, my new firm, that month in New Haven, Connecticut, in a restored mansion once owned by hefty ex-U.S. President William Howard Taft, just a short walk from the Yale University campus. As it turns out, my idea for a fresh approach to investment research had some heft of its own. I’ve since hired some 30 full-time employees, many of them former hedge fund analysts, including a few ex-Blue Wavers, at a time when the Street was laying off thousands. The roster of buyside firms that have regularly come to rely on our research has swelled from just a few to more than 100.
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Why this book? Why now? Since leaving Wall Street to do real-time macro research, the facts have largely played out on my side of the macro calls, calls that sorely needed to be made. I don’t think there was any remarkable genius to my viewpoints; oncoming financial catastrophe was readily apparent to anyone who was allowed to be objective. Unfortunately, the hedge fund business pays a higher multiple for short-term performance than it does long-term adherence to principles. 4
Introduction
We’re only now seeing the ugly side of that reality. Wall Street’s latest cycle of earnings gamesmanship and off-the-charts leveraging constituted an ambitious compensation mousetrap, not a sustainable business model. When former Trader Monthly (now defunct) executive editor Rich Blake and I embarked on the early brainstorming for what would become this book, around December 2008, the timing and collaboration felt right. Wall Street was on its knees. Bernie Madoff was exposed. Rich and I both agreed our overriding goal would be to provide a stark, insider’s view of the hedge fund world, famously secretive and not well understood. Criticism would be meted out with context. While the hedge fund industry has just gone through a significant shakeout, we expect even more contraction going forward. Assets in hedge funds, once estimated to be as high as $2.9 trillion in the second quarter of 2008, dipped to $1.8 trillion as of the second quarter of 2009, according to HedgeFund.net. On average, hedge funds lost 18.3 percent in 2008, according to Hedge Fund Research. Many funds faced an onslaught of redemptions and requests for redemptions and, factoring in both outflows and investment losses, saw their assets cut in half during the financial crisis. Looking at the deep end of the pool, some 268 U.S.-based hedge fund management companies had at least $1 billion in assets as of July 1, 2008, controlling a collective $1.68 trillion, according to Hedge Fund Intelligence. The number of U.S.-based management companies with at least $1 billion in hedge fund assets had, by the second quarter of 2009, dipped to 218 companies controlling a collective $1.13 trillion, according to HFI. HedgeFund.net’s database of individual funds with at least $100 million under management numbered 1,748 in June 2008; in June 2009, HFN said there were only 1,129 funds that big. At one point prior to the market meltdown, the total number of hedge funds was believed to have exceeded 10,000, according to HFN. Likely there were even more 5
introduction
individual funds, or limited partnerships (LPs), than the estimates could capture when one considers enigmatic offshore vehicles. Hedge Fund Research says 1,471 hedge funds liquidated in 2008, with 778 of those happening in the fourth quarter alone. That’s a 15 percent lop off. Another 668 funds liquidated in the first half of 2009, according to HFR. While performance seems to be turning around at some funds, and new vehicles are always starting up, I still would not be surprised if another 10 to 15 percent of all hedge funds shuttered over the next year or so. I would not be surprised if such a pace of hedge fund shuttering continues in 2010. For those who are still specifically working at hedge funds, and in the financial industry in general, who survives and who thrives will depend on who among the pack most enthusiastically embraces principles and sound practices, old-fashioned concepts such as putting customers first, no matter what. Now is the time to look in the mirror and rebuild the trust that has been destroyed. Work ethic and handshakes are important to me. I think they are to other people, too. Accountability and trust are transcending “trends.” I believe these trends are just now taking hold and that the U.S. financial system is headed in a new direction. Just as politics were transformed by YouTube and Twitter, so too will the financial markets as they inevitably succumb to unprecedented transparency. From Madoff to AIG, financial cataclysm has drastically changed the way the industry is perceived. The barn door has been blown off its hinges, and the public at large continues to stare inside with disbelief. Some 92 million Americans have money invested in mutual funds, according to the Investment Company Institute. Around 62 million Americans participate in some form of retirement plan, according to the Employee Benefit Research Institute. An estimated 47 percent of American households, or 54.5 million households, have some form of ownership of stock or bonds, according to a joint study done by the ICI and the Securities Industry and Financial 6
Introduction
Markets Association. Has anyone from Wall Street told them anything about the financial meltdown that they can understand? Or believe? No matter what you glean from reading about my experiences, I trust you can see that the highs, lows, and lessons of a hedge fund manager are of no greater significance than those of any other profession. We all share the same intrinsic motivations, in work, and, for that matter, in life: to create; collaborate; meet challenges; take worthwhile risks, and avoid unnecessary ones. Money may or may not be the root of all evil, but we all crave validation. We all get up every morning hoping that everyone else is doing the right thing when nobody is looking. What follows is a glimpse, mine, of what hedge funds were doing during this past decade. Keith R. McCullough CEO, Research Edge New Haven, Connecticut Third Quarter 2009
7
Chapter 1
Catch A Wave
9
T
he recruiter’s message was garbled and vague: Large, well-known private equity player looking to launch multi-strategy hedge fund. It was late November 2006. I already worked for a large, well-known hedge fund firm, Magnetar Capital. Magnetar was launched in April 2005 by a 39-year-old numerical savant named Alec Litowitz, formerly the Head of Equities at Citadel Investment Group and considered to be a master of merger arbitrage. Litowitz had joined forces with ex-Glenwood Capital Partners president Ross Laser. Man Group Plc had acquired Glenwood in 2000, producing a nice windfall for Laser; Litowitz, meanwhile, had been producing handsome profits at Citadel. Together, the two set up headquarters in Evanston, Illinois, outside Chicago and not far from Northwestern University. Magnetar opened its doors for business with $1.7 billion in assets under management. At the time, it was one of the largest hedge fund startups ever. Less than two years later 11
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Magnetar’s assets neared $4 billion, it had expanded its reach to open offices in New York and London, and it was charging after numerous forms of portfolio strategies not limited to merger arb or equities. Around the time Magnetar was forming, I launched, along with my partner Harry Schwefel, a hedge fund management company called Falconhenge Partners, and a flagship hedge fund of the same name. We put up some impressive numbers, which eventually came to the attention of Laser, who proposed folding our team into Magnetar. Laser wasn’t alone in his pursuit during the first half of 2006. Dan Och of Och-Ziff Capital Management was also courting Harry and me. Deciding which offer to take put us in an enviable position, although it was still a difficult choice. In May 2006, we chose Magnetar. The recruiter called not long after I’d joined Magnetar’s New York office, and I wasn’t looking to leave. So I ignored the message. Most hedge fund portfolio managers (PMs), if they’re any good, can expect to hear from a headhunter now and again, perhaps every other month. In the latter half of 2006, with hedge fund mania spiking, it seemed like I was getting calls from PM-seeking recruiters every other week. Later that same November afternoon, the recruiter called again, and I let her go to voice mail again. This time, she mentioned the name of the firm looking to get into the hedge fund business: The Carlyle Group. After the close, I called her back. ■
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In terms of sheer size and clout, few investment firms are on Carlyle’s level. Around the time it set out to conquer the hedge fund business, Carlyle’s total assets under management were nearing $60 billion, spread across 50-plus funds, mainly in private equity vehicles, and via 12
Catch a Wave
those funds Carlyle controlled huge stakes in hundreds of companies all around the world. With alternative asset management rivals The Blackstone Group and Fortress Investment Group both preparing to go public, it was hardly a secret that Carlyle might be entertaining a similar course. Based in Washington, DC, the firm was setting up its new hedge fund arm, Carlyle-Blue Wave Partners, in the heart of Midtown Manhattan, securing prime commercial real estate on the Avenue of the Americas just south of Central Park, the New Wall Street, post9/11. I was told Carlyle was sparing no expense, setting a launch target of $1 billion. Considering the firm’s access to institutional channels, corporate and state pension funds, nonprofit foundations, and university endowments, not to mention the world’s wealthiest individuals, such a goal did not seem like a stretch. To Carlyle, $1 billion was strategically nimble. My curiosity sufficiently aroused, and having apparently passed the recruiter’s smell test, I soon sat down with the two ex-Deutsche Bank executives who had been tapped by Carlyle CEO David Rubenstein to create Carlyle-Blue Wave. Rick Goldsmith and Ralph Reynolds had formed a joint venture along with Carlyle that August and promptly set about building one of the largest, most ambitious hedge fund startup teams yet created in an era marked by a series of sizable, noteworthy hedge fund startups. Reynolds had been Deutsche Bank’s global head of proprietary trading and would serve as Carlyle-Blue Wave’s CIO; Goldsmith, who had been in charge of a highly profitable hedge fund division of Deutsche Bank, would be the Chief Executive. They teamed up on fundraising and recruiting fund managers. They made quite a pair—Reynolds reserved to the point of saying next to nothing but listening intently, Goldsmith doing all the talking, amiable and sharp. Following a second episode of the “Rick and Ralph Show,” I found myself on an impromptu tour of Blue Wave’s new digs, completely empty at the time except for some workers doing 13
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renovations. The trading floor would be top flight, ultramodern, and it would be enormous, taking up the office tower’s entire 16th floor. The space previously had been occupied by Archipelago Holdings, the electronic trading platform which one year earlier merged with the New York Stock Exchange. Around the floor’s perimeter were several spotless glassed-off rooms, earmarked for various sector teams that were in the midst of being assembled. Carlyle-Blue Wave, I’d been told, was building a dream team, and I didn’t doubt it. A few months earlier, after hedge fund heavyweight Amaranth Advisors imploded, a number of hedge fund competitors scrambled to pick off the firm’s most talented traders not based in Calgary, Alberta.* Several of them, including long/short veteran John Bailey, would be joining. I stared around the room at the rows of empty workspaces. Goldsmith said the floor plan had my group, Long/Short Global Consumer, situated in the dead center of it all. At some point after that second meeting, Goldsmith was feeling me out for my “number,” which meant my compensation requirement—what would get me to leave my current employer? Thankfully, this wasn’t my first negotiation rodeo. In the end, “Rick and Ralph” came back with an offer that would be very hard for me to turn down. But I’d had some other requirements as well. I would get to handpick my own investment team, whomever I wanted. Of course. Additionally, I would need to attend any industry conference event anywhere on the planet—travel anywhere my research led me. Not a problem. As a kicker, and since I commuted into Manhattan *
Amaranth, based in Greenwich, was felled in September 2006 by one trader’s staggering losses—about $6 billion all told—linked to outsized, highly leveraged, long bets on the direction of natural gas prices. The aggressively bullish position, doubled down upon as prices were falling precipitously, was the handiwork of a 32-year-old trader named Brian Hunter operating from a satellite office in Calgary.
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Catch a Wave
from Westchester County, I wanted to be put up one night a week in a four-star hotel, of my choosing, near the office. Done. That night, I talked over Carlyle’s offer with my wife Laura. She’d worked on Wall Street, too, and knew this was a rare opportunity. Few hedge fund jobs on the Street were of this magnitude. As a Carlyle-Blue Wave PM, my research team, my access to executives, my sphere of influence, would be scarcely matched. Corporate America was at my disposal. “This is what you’ve always wanted, isn’t it?” she’d asked. I suppose. But the decision had come down to the money, the title, and the prestigious platform versus the satisfaction of working with a close, collaborative team. That’s what I had with my existing colleagues, particularly Harry, my thought partner of nearly four years. Money and title versus loyalty. I took the money and the title. ■
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That December, the Carlyle-Blue Wave gig largely secured, my bank balance about to reach a level I never dreamed possible, and the holidays approaching, I boarded a flight, along with my wife Laura, to Thunder Bay, Ontario. A snowy Christmas in Thunder Bay surrounded by family and friends had become an annual grounding ritual, no matter what was going on in my life. Certainly, I had come a long way. In just under one year I’d gone from running a startup hedge fund with tens of millions, to overseeing hundreds of millions, to now, at age 31, becoming part of a group that was seeking to start off with $1 billion housed within a still larger group that managed north of $50 billion. My ascent through the hedge fund ranks had been a rocket ride at a time when the industry was erupting, in terms of numbers of funds, assets in them, and compensation totals for the guys in charge. Whether I realized it at the time—and in 15
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some ways I think I did—the apex of the hedge fund bubble was at hand. Sitting around the Christmas tree with my family, the Wall Street world, for the moment at least, did not exist. Apart from my dad and my younger brother Ryan, who asked me questions now and again about what it was that I actually did for a living, no one else back home knew much of anything about what I was up to in the Big City. It’s not that people from Thunder Bay disliked hedge fund managers; they just didn’t give a hoot. Which was fine by me, and one of the main reasons why I always return there.
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Chapter 2
Shipping Out
17
T
he city of Thunder Bay, actually an amalgamation of two cities, Fort William and Port Arthur, sits atop Lake Superior in northwestern Ontario, right smack in the middle of the continent. It’s an hour’s drive from the U.S.–Canadian border, not far from Duluth, Minnesota. Actually one of North America’s earliest known trading hubs (Paleo-Indian, pelts, we’re talking 1,000 years ago), Thunder Bay has long been a gateway for freighters carrying lumber and wheat from Western Canada down through the Great Lakes and into the St. Lawrence Seaway. Towering steel grain elevators, black and gray, still mark the lake head to this day. The city maintains a viable forestry industry, and transportation sector manufacturer Bombardier has a plant here, too.
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To Canadians, though, Thunder Bay is best known for producing something far more valuable than timber or subway cars. Thunder Bay makes hockey players. ■
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Growing up, kids get fitted for ice skates around the time they learn to walk. I was skating at 3. My first House League games were played as a 5-year-old. I came of age following the exploits of a fellow Ontario kid named Wayne Gretzky at the dawn of his career, first in the World Hockey Association and, after it folded, with the National Hockey League’s Edmonton Oilers. All of us kids idolized The Great One, and of course, we all watched the Toronto Maple Leafs on CBC’s Hockey Night in Canada, and we all dreamed of someday playing in the NHL. For some of us, playing professionally wasn’t all that far-fetched a proposition. My hometown has produced a steady torrent of NHL players over the decades, and nine current players. The most famous are the Staal Brothers, Eric, Jordan, and Marc, who grew up on their dad’s sod farms about 20 minutes from my house. Bill “Goldie” Goldthorpe, a semi-pro legend and the inspiration for the Ogie Oglethorpe character in Slapshot, lived and played in Thunder Bay. Though not in the same league as Slapshot, the 1986 Rob Lowe flick Youngblood contained an epic goon character, “Racki,” of the Thunder Bay Bombers. Around the time Youngblood came out, I was one of Thunder Bay’s rising Squirt prospects in my age group. Aggressive and quick to the puck, I always led my teams and my leagues in scoring. My mom Vivianne, an elementary school principal, and dad John, a firefighter who’d played competitive hockey in Thunder Bay, drilled it into my melon that if I worked hard, if I put in the ice time, I could one day make it to the NHL. Playing for the Leafs became my dream. During the winter, I woke up at dawn to get in some extra ice time before school. I shot pucks in my basement and in the backyard. 20
Shipping Out
I shot pucks at the side of the garage and at my little brother. I hung around the outdoor rinks all day, skating with the older kids in the neighborhood—no referees, parents, or rules beyond “be home in time for dinner.” In a city teeming with hockey talent, I thought if I worked that much harder than everyone else, I would have an edge. Shivering in the front seat of my dad’s pickup truck at 5 a.m. on absurdly cold winter mornings, I might not have fully appreciated the value of preparation, but I’ve since found it trumps all else, in sports or business. By the time I was a freshman in high school, I was playing for the top all-star team in the region, the Thunder Bay Kings. Only three teams mattered in the T-Bay feeder system when I was growing up, and they were the two Triple-A Kings teams (one for 13-year-olds, the “Pee Wee” division, and one for 15-year-olds, or “Bantams”) and the Junior Hockey powerhouse Thunder Bay Flyers. In Canada, Junior Hockey is a big deal, and features numerous leagues and thousands of the best young players, between the ages of 17 and 20, battling for an invitation to the Junior-A leagues, such as the Ontario Hockey League, part of the Canadian Hockey League, a direct pipeline to the NHL. Important NCAA Division I scouts mine Canada’s Junior leagues for talent as well.* I was determined to play for the Thunder Bay Flyers, and I couldn’t turn 17 fast enough. As a 14-year-old I played on the Kings’ 15-yearold team, and I helped the team reach the Canadian Tire Cup tournament where we lost in the provincial tournament to the Toronto Red *
A 1999 research paper “The Chances of Making It in Pro Hockey for Ontario Minor Hockey Players” by Jim Parcells of the Ontario Minor Hockey Association, which looks specifically at players born in Ontario in 1975 (McCullough’s birth year) found that out of approximately 22,000 players active in either minor or junior level hockey, just 41 of them, including McCullough, played NCAA Division I hockey. The study also found that of Ontario players born in 1975, only 48 were drafted to the NHL; four others signed as free agents. At the time of the study, 35 players from the sample group had been signed to NHL contracts and 26 had seen NHL action, making 1975 Ontario’s best birth year ever in terms of players drafted to the NHL.
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Wings. At 16, I wanted to try out for the Thunder Bay Flyers, but the coach, Dave Siciliano, told me in no uncertain terms I wasn’t ready for the Flyers. My dad always told me “don’t be the big fish in the small pond.” He always prodded me to compete with the older kids. Instead of waiting another year and playing on the Kings within my age group, my dad convinced me that I had to compete in the big pond. In 1991, a Central Junior Hockey League team, the Brockville Braves, then coached by Rick Ladouceur, invited me to come to their training camp. I made the team. I had my shot to play junior hockey, pretty much unheard of for a kid my age. No one I knew from Thunder Bay had ever left town at 16 to go play Junior-A hockey. If you did try to play outside the T-Bay system, you were pretty much blackballed from then on. I packed some clothes, my blow dryer and a boom box into a blue tickle trunk (with gold buckles) that my dad went out and bought for me, and just like that I was shipped down to Brockville, a 15-hour drive to the southeastern part of Ontario. Well, it took me a while to adjust to being away from home. I missed my mom and my younger sister Cheryl more than they’ll ever know, although I didn’t miss my little brother quite as much, not at first anyway, because growing up we shared a room and that arrangement had run its course. But soon enough I ended up missing him too. I lived with a billet, or “host” family,” Roz and Eric Verbrughe, terrific people, and hell-bent on feeding me humongous plates of food. Coming up through the T-Bay hockey system, I was 5'7", 150 pounds, so as a 14-year-old, coaches thought I was going to have some size when I got older. But I never grew any more. When I arrived in the CJHL, I suppose I was considered something of a runt, but I chased after the puck with a vengeance. The guys on the team naturally called me “Mucker.”* I remember the feeling
*
Old mining camp term referring to the lowest-paying, least desirable job—that of sifting through rocks, mud, and muck, shoveling ore into buckets, and loading them onto conveyor belts.
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Shipping Out
when I stepped on to the ice for my first game, hearing my dad in the back of my head saying that it was better to be the small fish in the big pond and realizing in the seconds before my first shift that all my prior accomplishments on the ice back home had absolutely no bearing on the moment at hand. Hockey is a violent sport. If you consistently put the puck in the net, opposing teams will come after you, and come after you hard. I learned to take a beating, which would be invaluable to me years later on Wall Street. In my playing days, I’d had my throat slit open by a skate blade and my cranium split by a slapshot. I’ve lost teeth, broken my wrist, my hand, and multiple fingers. I’d also generally been subjected to miscellaneous beatings. During my rookie season in Brockville, playing in a game on the border of Quebec against the Hawkesbury Hawks, I “snowed” the opposing goalie, using my momentum, skate blade, and the surface to spray him with a coating of ice shavings. It was a rookie move, not lost on a burly, 6⬘3⬙ Hawks defenseman named Dan McGillis who crosschecked me as payback. On instinct, I turned around and took a swipe at him with my glove. McGillis ripped the face cage off of my helmet, plastic and screws snapping, and then proceeded to use me as his personal speed bag as a French-Canadian deejay at the Hawkesbury arena provided a disco soundtrack to the entire spectacle. McGillis would go on to play in the NHL. During my second season with the Braves, I blew out my knee, badly, after colliding with another player. Now in my second season, I was, at only 17, one of the top players a third of the way through the 1992–1993 season. But it didn’t matter. Playing hurt, I was noticeably wobbly. I’d lost a stride. The Braves coach, Fred Parker, who had arrived in 1992 to replace Ladouceur, told me one dark December day after practice to head up to the General Manager’s office, tucked above the stands, almost in the catwalk of the Brockville arena. Parker was kind of a meathead type. He never 23
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liked me; I wasn’t his guy, and I didn’t suck up to him. The rink was dim, quiet, as I hobbled up to the cramped office, hockey photos and memorabilia strewn everywhere. Parker was sitting inside drinking a coffee or something with the GM, a grizzly old timer with white hair and a red face named Mac MacLean. “We’re trading you,” MacLean informed me with all the emotion of a butcher weighing a half pound of ground chuck. I was stunned, and angry. Traded? Traded where? I’m fairly certain I told them both to shove off, except I think I used much harsher phrasing. I left the rink feeling lost and alone. It was freezing cold, a few days before Christmas. I was real homesick. It was, literally, at the time, anyway, the worst moment of my life. I phoned my mom from the Verbrughes’ kitchen. “I’m coming home,” I told her. “Hockey’s finished.” “For the season?” she’d asked. “No,” I replied. “Forever.” ■
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I flew home the next day, really glad to be back in Thunder Bay, eating my mom’s food, seeing friends, although immediately I could tell there were some people in my hometown who were pleased I had failed. Or rather, they were pleased I did not succeed. Over the Christmas break my knee healed up and I began skating again, spending hours alone with my thoughts, and feeling guilty about quitting. Out there on the outdoor rinks, the hockey bug bit me all over again. I started going to Thunder Bay Flyers games with my friends. Sitting in the stands, watching, I observed the players I grew up with, more as a scout than a fan, picking up strengths and weaknesses. I knew in my heart that I could skate with them. I always had. Late in December, the Flyers gave me a tryout of sorts, and I skated well, but it was brutal. No one on the team wanted me there (the players saw me as a threat to their ice time 24
Shipping Out
and the coaches disliked that I’d gone outside their system) and, in the end, once again, the coach told me I wasn’t quite Thunder Bay Flyers material. As it turned out, right around the same time, that old battle-ax Mac MacLean wound up arranging another trade, one that shipped me 17 hours southeast to Pembroke, Ontario, to play Center for the Pembroke Lumber Kings. I jumped at the offer and vowed to my dad and myself not to let it go to waste. In my first games with the Lumber Kings I was still a half-stride slower than before, but I learned how to grind and help the team win. The Brockville Braves were in our division, so we must have played them a half-dozen times a year, and I think we beat them fairly consistently. Whenever I put one in the net, I’d skate by the Braves bench and yell to Coach Parker some profane instruction on what he might do with each puck. In hockey that’s called chirping. I liked to chirp. Playing for the Lumber Kings, my game excelled. That’s where I came into my own as a player again, as a winner. When I was named team captain in 1994 it was one of the proudest days of my life. I felt blessed to have been given a second chance to play the game I loved. Playing for the Lumber Kings taught me the importance of believing in myself. It gave me confidence. It’s how I ended up going to Yale. ■
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My first day walking around the Yale University campus in New Haven, Connecticut, I kept looking around thinking to myself the whole time: Wow, these are the top students in the world; what am I doing here? Most likely many of these same students stared back at me wondering why is that guy wearing cutoff denim shorts? I was assigned to the third floor of Vanderbilt Hall on the Old Campus. Most Yale students, even the upperclassmen, tended to live 25
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on campus. I quickly made friends with a couple of the guys in the four-man suite next to mine, one of whom was an easy-going tennis player from North Carolina named Reid Lerner, and the other, Michael Blum, the Hong Kong–Montreal-Cologne—reared son of a German textile industry executive. Hockey practice started up right away, so between classes, ice time, weight training, and a tutor, I stayed busy. I majored in Economics only because it sounded like it had something to do with business. I wanted to learn something here that might help me start a small business one day. Back home, in the summertime, when I wasn’t playing hockey, I ran a six-man landscaping-contracting company, called the College Gophers. My dream to play professionally led me to play an extra year of junior hockey, trying to make up for my lost season in Brockville. When I was recruited to Yale by the team’s assistant coach, C.J. Marottolo, I was a 20-year-old freshman, and I had lived much of the time on my own since age 16. I remember pledging a fraternity those first few weeks of school and realizing midway through the second pledge ritual that frats were not for me; I didn’t do groupthink, and I didn’t bow down to anyone. Plus, I was swamped. Hockey dominated my life. I was at ease in the locker room. We had one of college hockey’s greatest coaches, Tim Taylor. Taylor seemed to be in a soul-searching phase of his career, having just wrapped up a disappointing stint as coach of the U.S. Olympic Hockey Team, which had not fared well during the Lillehammer Winter Games in 1994. His program’s mantra seemed to be relegated at the time to “just being competitive.” I think the general attitude around Yale (which had competed in the first collegiate hockey game ever played, a century earlier) was that the Bulldogs simply were never going to be an elite NCAA program but should at least be able to compete. In the previous two seasons the Bulldogs had finished in last or second-last place. But I looked around the locker room. I saw we had a stellar freshman goalie, Alex “Westy” Westlund. He was a ridiculous competitor who would not settle for 26
Shipping Out
backup status very long. My first season, 1995–1996, Yale had one of its single worst years ever, losing 23 games, a school record at the time. I played every game that year. When Coach Taylor would say after a loss, “Hey, you guys competed right there with those guys— you should feel proud.” I’d look at Westy and see he had the same look on his face I did, a perplexed grimace that said I don’t just want to compete, I want to win. In my sophomore season (1996–1997) we played better, and improved to 10 wins, 19 losses, and 3 ties. I led the team in scoring and penalty minutes that season. The next season, my junior year, we did more than compete. The team registered the winningest season in the history of Yale hockey, an honest-to-goodness Cinderella story. With a 23–9–3 record, the Bulldogs notched the most wins in the history of the program at that time and won the school’s firstever regular season Eastern Collegiate Athletic Conference (ECAC) Championship. Our team Captain, Ray Giroux, was named ECAC player of the year; Westy brought home the Dryden trophy for the league’s best goalie. We were the toast of New Haven—students and people affiliated with the university were ecstatic about the program’s newfound glory, including alumni and former Yale hockey players. One of those former players wound up offering me an internship at his securities trading firm in the summer of 1998 prior to the start of my senior year. His name was David Williams, but everyone knew him by his nickname, Tiger. Thanks to him I was about to earn my first stripes on Wall Street.
27
Chapter 3
Welcome to The Jungle
29
O
n the first day of my summer internship at Williams Trading, I strolled in at 7 a.m., figuring I was way early. Turned out, I was a half-hour late. Meanwhile, I’d decided to wear the nicest set of clothes I owned at the time—a black silk dress shirt, and my lone tie, maroon, adorned with bald eagles. Both were gifts from my mom. When I walked into the Rockefeller Center office,* one of the traders, Ray “Razor” Letourneau, a former equities trader at J.P. Morgan Securities and also a former Yale hockey player, looked me over, incredulous. “What the hell are you wearing?” he asked. Here I was, at what some might consider the nexus of the hedge fund universe, and yet I was about as oblivious as Forrest Gump at a Black Panther meeting. I’ve always thought of my career trajectory on Wall Street as having something of a Forrest Gump-type quality *
Williams Trading is currently located in Stamford, Connecticut.
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to it, intersecting with historical turning points and major figures now and again. But even Gump would have had the good sense not to show up on a trading floor wearing a shirt that looked like something purchased at Chess King.* Later that summer I bought two suits—one blue, one gray—which I rotated every other day. The Williams crew wore ties, but they looked low key, like their trading setup. In fact, the whole operation was just four guys, an administrative assistant, and some computers set up in a small room. But man, did these guys have discipline, and a process. Williams had launched his firm one year prior, in 1997. The captain of the 1983–1984 Yale hockey team during his senior season, Williams started out on Wall Street in 1987 as a floor clerk for E.F. Hutton. He was trading on the floor of the New York Stock Exchange on “Black Monday,” October 19, 1987. Williams then became an equity sales trader for CS First Boston, which was created in 1988 when Credit Suisse took a controlling stake in the First Boston Corporation. Eventually, Williams became a Vice President and Senior Equity Trader at Donaldson Lufkin and Jenrette, before it merged with Credit Suisse as well. Williams’ big break came in 1993 when he joined up with an iconic hedge fund manager named Julian Robertson, Jr. At that time, Robertson’s firm, Tiger Management was (and while closed to new money it remains) among the most storied money management operations of all time. The fact that David “Tiger” Williams wound up joining a firm called Tiger Management was pure happenstance—the Tiger moniker had already stuck to him during his hockey playing days as a kid growing up north of Boston, on account of Williams’ sharing the same first and last name as the infamous NHL brawler (and the league’s all-time
*
Chess King was a retailer of quintessentially cheesy 1980s clothing particularly popular on Long Island and in New Jersey. It was acquired in 1993 by Merry Go Round, which entered Chapter 11 bankruptcy one year later.
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Welcome to the Jungle
career penalty minutes leader with 3,966 minutes over 15 seasons, the equivalent of nearly three days in the penalty box) Dave “Tiger” Williams. The fact that Tiger Management produced hedge fund managers the way Thunder Bay produced hockey players was no coincidence. Robertson picked and mentored the best analysts and traders in the business. Several former Tiger employees wound up leaving to launch their own funds in the early- to mid-1990s, students of Robertson such as Lee Ainslie of Maverick Capital, John Griffin of Blue Ridge Capital, and Stephen Mandel of Lone Pine Capital; several more of Robertson’s brightest pupils, such as Dwight Anderson, Paul Touradji, and Andreas Halvorsen, all also would go on to launch sizable hedge fund companies in the decade to come. Collectively, they were called the “Tiger Cubs.” Seeded by Robertson, these new funds began life with tens of millions in assets, fairly puny on a relative basis. They were modestly staffed and usually sublet office space from larger trading firms or money managers, which gave rise to the whole concept of hedge fund hotels. But because smaller money managers with their smaller orders tended to get relegated to the bulge bracket’s pay-no-mindlist, these new hedge fund firms needed help and expertise executing their trading strategies. That’s where Williams came in. He had a vast network of potential trading counterparts, all over the Street. He’d been Tiger Management’s Associate Director responsible for trading the Domestic Equity portfolio at a time when Robertson’s hedge fund firm saw its assets grow from $3 billion when Williams joined up in 1993 all the way to $15 billion by the time he left in March 1997. Williams Trading, formed the following June, was not a hedge fund; it was created to be the execution-only, outsourced-trading-desk-of-choice for startup hedge funds. In addition to Williams, who functioned as captain, coach, and head trader, there was “Razor” Letourneau, who was pretty much Williams’ right-hand man, and Rob “Laffer” Laferriere, who’d played hockey at Boston College and Princeton, and the 33
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one non-hockey guy, the operations/compliance chief, Danny “the Dirty Dog” Dispigna who handled reconciling all the trades, a mundane but critical function known on the Street as the “back office.” There was also Elodie Fielding, the administrative assistant. She held her own and kept things running smoothly. As the intern, I had four mundane tasks of my own to worry about: Collect the Buy/Sell tickets that were manually written out with every single trade (black ones for Longs, red for Shorts); file the tickets with Dispigna, who entered them into a computer; open the mail; and order lunch. I came to learn that of these four jobs, the failure to properly carry out a timely, well-executed lunch order was the gravest of infractions, although if I inadvertently mismarked a ticket that wasn’t a good thing either because it caused headaches for Dispigna. No one likes to get yelled at. But when I screwed up and he had to stay late to fix my error, I felt terrible that I had let down a teammate. Williams ran his firm like a hockey team. The environment was intensely competitive, every minute. Some trading floors may have stories of guys having hilarious side bets (hundred bucks says you can’t eat 72 Chicken McNuggets ) and ribald rituals, but the Williams crew was strictly business. For one thing, they were always busy, taking orders and calling around the Street to get them carried out. My first week there was the most intimidating period of my life, because I was out of my element. I didn’t know the securities market jargon—I didn’t understand the game. I couldn’t see it being played in front of me. Not at first anyway. Not only was I learning that teamwork existed on Wall Street (which I’d presumed was every man for himself ), I was beginning to understand how markets functioned. Mega, long-only, taxfree retirement asset-laden mutual fund companies, such as Janus, Fidelity, Putnam, T. Rowe Price, et al., carried enormous clout in the market, and these were household names across America with the S&P 500 cranking out a fourth straight year of double-digit returns 34
Welcome to the Jungle
and the Nasdaq soaring.* Hedge funds held sway in the market, too, increasingly so, but most people outside of the clubby Wall Street set had zero clue hedge funds existed. When I came to Williams Trading in June 1998, there were, according to various industry estimates, somewhere between 3,000 and 4,000 hedge funds totaling roughly between $300 billion and $400 billion. I’d barely even ever heard the term “hedge fund” and neither had most Americans, but nevertheless by the late 1990s there were many established hedge funds managers that had asserted themselves as world-class investors, taking up some of the highest rungs of the sellside pecking order. There were the Godfathers of the Game, guys like Julian Robertson, George Soros, and Michael Steinhardt; and next generation traders, or so-called gunslingers, such as Paul Tudor Jones and Steve Cohen; expertly trained ex-Goldmanites, such as Leon Cooperman, Richard Perry, and Dan Och; research intensive stalwarts such as Art Samberg and Jon Dawson; and statistically driven Big Brains, such as Jim Simons and David Shaw. These latter types, the so-called “quants,” were really starting to rise to the fore amidst technological and academic advancements. One of the largest, most talked about funds that summer, Long Term Capital Management, had been started a few years earlier in Greenwich by an ex-Salomon Brothers bond trader, John Meriwether, along with esteemed economics professors Myron Scholes and Robert Merton who matched up cutting-edge mathematical theory with sophisticated computer models. During my junior year I’d gotten a taste of the highest academic echelons, taking an Economics course taught by Professor Robert Shiller, who would become famous for the housing price index he helped create, the S&P Case-Shiller Home Price Index. Economics didn’t mean jack to me before I took his class. He was the first professor who made economics seem relevant, practical. Everything I’d *
The Nasdaq Composite Index finished 1997 at 1570.35. It ended 1998 at 2192.69.
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learned in the classroom had been statistical, theoretical, hermetically sealed concepts: supply, demand, inflation, deflation, stagflation. Shiller used real-world illustrations and historical examples, and he always had decades of data to illuminate how market forces behaved, how patterns tended to repeat. Except, of course, when they don’t repeat, which is why that giant quant fund co-created by those economics professors wound up getting into serious trouble* later that summer of 1998, and why for the first time millions of people around the world first realized hedge funds existed and the extent to which they could impact the world’s financial machine. That summer at Williams Trading, I came to begin to realize the true scope, depth, and dynamics of this vast expanse of money flowing in and out of securities, around the world, in different ways, to achieve different outcomes, by way of often drastically different approaches. Once I understood that, okay, sure, people were either buying shares of something or selling them, building a Long position or covering a Short one, I started to pick up how certain participants traded. Some money managers were fading the market; other ones were chasing. I saw how the surge in the morning between 9:30 a.m. and 11 a.m. forestalled a lunchtime lull (it’s a wildly simple phenomenon: traders eat lunch). It didn’t all make perfect sense to me, but I liked the buzz and camaraderie. I knew for the first time that if my professional hockey aspirations didn’t come to fruition,
*
Hurt badly in August of 1998 by wrong way derivative bets on bond yield spreads amidst a global currency crisis sparked by Russian bond defaults and widening to Asia, and compounded by the $10 billion fund’s use of leverage on top of leverage leading to approximately $100 billion in balance sheet exposure, LTCM was in September of that year forced into a form of liquidation. This outcome involved a consortium of creditors, 14 institutions in all, including almost all the major investment banks at that time, infusing the fund with $3.6 billion in capital (i.e., a private bailout) at the emergency prompting of the Federal Reserve Bank of New York, which at the time feared that total failure of the fund would jeopardize the stability of the financial system.
36
Welcome to the Jungle
perhaps this Wall Street thing could be an option. But my hockey playing days weren’t over just yet. ■
■ ■
My senior season at Yale, 1998–1999, I was named captain. We still had a great team, so there were a few NHL scouts coming to our games. We turned in another solid campaign, winning 8 of our last 13 games to win a share of the Ivy League crown along with Princeton, even though our best player, Ray Giroux, possibly the single best player in Yale history, had graduated. Off the ice I was crafting my senior thesis, in which I was attempting to identify key traits common to successful entrepreneurs. I struggled to write the paper, although I enjoyed the research part of it. Keep in mind that the very first English Literature composition I turned in my freshman year had come back to me marked “ungradable.” The school gave me a tutor, but writing remained a struggle. Still, I embraced my thesis. I built upon some themes I had developed writing an earlier paper about my Grampa Alphonse, one of 19 children from the French-Canadian logging town of Long Lac and who wound up starting a string of successful small businesses, including a restaurant, a general store, and a ladies clothing store. I started thinking about the all-time greatest businessmen and naturally arrived at Warren Buffett as the focus of my thesis. To understand what made Buffett so great, I examined his early years. Buffett’s autobiography, The Making of an American Capitalist, provided the bulk of my source material. Both my Grampa and The Oracle of Omaha, as far as I could tell, believed in themselves and cared little about what others may have thought of them. If I could redo the thesis today I’d keep it simple. What makes a really successful entrepreneur? Drive, hard work, and a mind of your own. As my time at Yale wound down, the hockey season dwindling to the last 10 games, it was clear there were no scouts waiting to 37
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talk to me outside the locker room. I began to face up to the fact that my hockey-playing days were coming to an end. In the locker room after my last game, March 13, 1999, a crushing 7–2 loss at home in the ECAC playoffs to Colgate, I hit a wall of despondency. I’d suffered a groin injury and didn’t have the greatest game. When it was over, the game, my career, was over, really over, the idea that I would no longer be a hockey player rolled over me like a Zamboni. I wouldn’t take my equipment off. My boom box cranked out a song by Garth Brooks, “The River.” I just sat there playing the cassette tape over and over. I think I played “The River” nine times in a row. The tune is about someone who follows his dreams as far as they can take him, until his “river runs dry.” I wasn’t crying, because much like baseball, there’s no crying in hockey. But I was empty inside. I was 24, and didn’t quite know who I was, or what I was supposed to do next. This was the low point of my entire life. As for where the “river” would take me next I was not exactly sure, maybe back to Thunder Bay for one last summer landscaping with the Gophers and hanging at the Lake. But it wouldn’t be long before the path ahead of me took shape. I mean, I was about to be a Yale graduate, captain of the hockey team. Wall Street came knocking. And I answered.
38
Chapter 4
Snapshots From The Dot.Com Bubble
39
“
D
o you have a ball?” The Lehman Brothers executive met my question with a blank stare. He either didn’t expect a lowly member of the Class of 1999 to ask him a question—he was, after all, interviewing me—or he didn’t appreciate it, because the guy looked at me like I had just made a rude comment about his wife. We were seated across from one another in a New York City hotel during the investment brokerage house’s spring “Super Saturday” recruiting event. Lehman had invited me and around two dozen other graduating, mostly Ivy League, seniors to compete for about six entry-level positions. Most of the banks put on a “Super Saturday” event, part junket, part steeplechase. I refused to be intimidated. “A ball?” he asked. “What do you mean?” “A ball,” I said, smiling, cocky. “That thing you throw. Tennis ball, soccer ball, any ball. Do you have one?” 41
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“What’s your point?” This whole exchange had started with him, somewhat condescendingly, asking me why I believed I was Lehman material. What set me apart? I told him: “If you took every college recruit here, put us all in a room, and then shut the doors and turned off the lights, so it was pitch black, and then threw a ball in the room for us to chase around . . . I can guarantee you . . . that I’d be the one coming out of there with that ball.” The Lehmanite, trim, jockish, and in his early 30s, flashed me a smile as the bewilderment vacated his eyes. Extending his arm in a handshake, he practically shouted: “That’s the best answer I have ever heard!” Although the dot.com era was well underway, Wall Street still had its pick of the roughly one million or so college seniors who graduate every May. But they were more vigorously pursuing the best and the brightest in 1999 now that they had to compete with Silicon Valley. I ended up getting an offer from Lehman, but wound up taking another job. I was going to work for Credit Suisse First Boston (CSFB).* It was the summer of 1999 and there was no hotter firm on Wall Street than CSFB. ■
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Many corporations, blue-chip investment banks included, place their greenhorn university recruits into training programs designed to matriculate them through a series of temporary sojourns across divisions. A bank or investment brokerage house might rotate a new recruit through stints in sales, trading, and research. When I joined, *
Credit Suisse Group’s investment banking business, CS First Boston, was renamed Credit Suisse First Boston (CSFB) in 1996. One decade later, the franchise was renamed again, becoming simply Credit Suisse.
42
Snapshots from the Dot.Com Bubble
CSFB had exactly such a trainee rotation program. But these were not normal times. Technology/dot.com fever reached epidemic proportions, partly fuelled by the growing awareness of the ubiquity and power of the Internet, and partly by massive amounts of spending connected to so-called Y2K concerns. Under CEO Allen Wheat, CSFB, the New York–based global investment banking arm of Zurich-based Credit Suisse Group, was proving to be an epicenter of “tech stock” mania. One year earlier, in mid-1998, Wheat snared Midas-touch investment banker Frank Quattrone and his entire Menlo Park, California– based technology group, recruiting them away from the Deutsche Morgan Grenfell unit of rival Deutsche Bank. Prior to Morgan Grenfell, Quattrone had worked at Morgan Stanley where he’d been a colleague of Mary Meeker, one of the technology sector’s best-known analysts and most vociferous boosters. By mid-1999, Quattrone’s tech/dot.com IPO machine was cranking out shares at a breathtaking clip. In 1998 alone, Quattrone led 138 IPOs, according to BusinessWeek. Technology mutual fund managers from the Back Bay section of Boston to the Cherry Creek section of Denver contorted themselves to get dialed into the CSFB platform, and many of the funds and their investors were being treated to some of the lowest-hanging fruit ever harvested on Wall Street. Instead of doing mini-stints in a series of varying departments, I was dispatched to Equity Sales. My immediate bosses, Steve Keller and Tom Ferraro, were two of CSFB’s most senior-ranking equity salesmen. I’d been assigned to support them as the junior member of their team, effectively doing whatever they told me. Title-wise I was an “analyst,” but my business card may as well have said “Mucker.” Our group was part of an equity sales group of around 150 persons around the world, part of the larger global equities division at CSFB. This division was headed up by a 43
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veteran derivatives trader, Brady Dougan, and employed more than 3,000 people in 1999. My being included among those ranks owed to an Ivy League/ jock connection. Keller, the captain of the 1990–1991 Yale basketball team, personally recruited me. He and Ferraro spearheaded CSFB’s equity sales effort, selling into the burgeoning hedge fund channels. They focused on the largest firms in New York and Connecticut. If Keller asked me for a spreadsheet of phone numbers of every hedge fund firm with more than $100 million in assets under management based in Greenwich and Stamford, I asked: How about e-mails, too? I felt like a junior hockey rookie all over again, thrown right onto the ice, or in this case, into the fire. I was no doubt a cog in the wheel, a foot soldier in a campaign that amounted to an ambitious sales effort, nothing more. Nevertheless, I made a pledge to myself: to be the best teammate I could be, to do the best job I possibly could—nothing half-assed, not too much partying, or at least not during the week. If I could make Keller and Ferraro look good, then maybe I might get paid a nice bonus at the end of the year to go with my mid-five-figure base salary. Dougan had made a pledge of his own. He set an almost mythical goal in 1996 when he took over as CSFB’s global head of equities, determining that the division would produce pretax, pre-bonus profits of $1 billion by 2000. This target, if met, would represent a 17-fold increase from CSFB’s 1995 pretax, pre-bonus profits. Dougan and his disciples called it “sticking to the program.” As programs go, mine wasn’t too terrible. I settled into the job, future shock gave way to an agreeable routine. I lived in a high-rise apartment on 34th Street, between Park and Lexington Avenues, in the Murray Hill section of Manhattan. I decided to bite the bullet and pay up for a location just blocks from my office. I’d moved in with my old Yale buds, Reid Lerner and Francois “Frenchy” Magnant (a Bulldog defenseman), who were working as bankers. 44
Snapshots from the Dot.Com Bubble
I walked to work every day. The CSFB offices were located in the Flatiron District on Madison Avenue at 28th Street, in an impressive art deco building that originally belonged to MetLife. Inspired by the Williams Trading experience, I was, without fail, at my desk by 6:30 a.m., which at CSFB meant I was among the first handful of people in the door. If one of our roughly four dozen or so hedge fund clients rang the equity sales desk at sunrise expecting to get Keller or Ferraro’s voice mail, I’d pick up the phone to let him or her know that the message would be delivered personally. This allowed me to get know the hedge fund people, sometimes PMs or analysts, sometimes their junior counterparts. Quickly I realized that I knew some of those junior voices on the other end of the line— junior buyside analysts who had been peers of mine at Yale. I could skate with them, I thought, I could be the one placing orders, not taking orders. Still, I enjoyed what I did. My daily work environment was boisterous, exciting, like being in the infield of a horse race, with this exception—you couldn’t actually see the horses. Rather, you could only hear the raised, hurried voices of those who were placing bets. You heard the action, and soon it was obvious to me which funds on the other end of the line were running at a gallop and which ones were content to trot. I did not see hedge funds start to break ahead of the field, I heard and sensed them. And due to the massive volume of trading hedge funds did on the Street, we jumped at the chance to do their bidding. To understand the distinction between an equity sales trader and an equity salesman, look a little more closely at how an investment bank such as CSFB functions, how it’s organized. In 1999 and into 2000, CSFB primarily existed as a factory manufacturing and distributing shares of new companies. CSFB “brought” these “startups” to the public equities markets. Once those companies began trading, usually on the Nasdaq, CSFB provided money managers with “coverage,” ongoing research, crucial, and not so crucial, nuggets of 45
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information, often gleaned (or spoon fed) directly from management. Bankers such as Quattrone, working with a network of “venture capitalists,” found the startups, deemed them worthy of public consumption, structured the IPO deals, and, key to the whole program, lined up big institutional buyers for the newly minted shares. CSFB analysts followed these companies’ every move, guiding the institutional owners of the shares as to where revenues, earnings, and share prices might be heading. Nailing the quarterly earnings per share or revenue number before it was released was the investment and trading industry’s Holy Grail. Our analysts were closely followed, not so much for reports and recommendations but for reliable, almost to the penny estimates. Much of Wall Street’s “research” from this era has been characterized as conflicted and thus unreliable for investors, but such a broad stroke critique, while in some ways accurate, still misses a more nuanced picture of what was taking place, at least with respect to my employer. Believe me, institutions hung on our analysts’ every update. Although I sat amidst our sales traders, the ability to be effective in my job hinged on keeping communication lines open with the research analysts upstairs, so as to not miss even a single new crumb of information coming in the door from the various analysts, many of whom were out on the road or jammed up with meetings. I figured out fairly quickly that as a junior analyst barely through the Series 7, my access to CSFB analysts was nonexistent. I could not expect to get a major CSFB analyst such as telecom all-star Dan Reingold or our software industry stalwart Wendell Laidley to call me up with the latest guidance on WorldCom or Veritas. But if I befriended the junior analysts in each sector, then my access to information increased many-fold. So I sidled up to as many of the junior analysts as I could, any chance I could, in the CSFB cafeteria or in its gym. I made it my mission to make friends. Keller told me that clients told him I was doing well, which was motivational. “Keith gets it,” one client had said. Keller began to let me call more 46
Snapshots from the Dot.Com Bubble
and more clients directly, because I could hold my own and because sometimes I had the scoop first. My workstation was right on the equity trading floor, or rather directly adjacent to it, down a ramp from an elevated group of equity sales traders, which, it should be pointed out, are a different species of Wall Street animals than my brethren in equity sales. CSFB was not peddling the kind of retail-oriented, “Buy/Sell/ Hold” reports that became prevalent during this period. CSFB had a few individual clients, but no army of brokers like Merrill’s Thundering Herd who were dialing for dollars or churning accounts. Which is not to say CSFB didn’t have stock ratings.* No, our clients were considered “institutional” money managers—large, sophisticated investors: mutual funds, separate account managers, and, increasingly, hedge funds. These types of asset manager clients, collectively referred to as “the buyside,” oversaw accounts of, at minimum, many millions and, in most cases, many hundreds of millions or billions. These types of gargantuan clients weren’t interested in ratings or recommendations, but they were interested in knowing what our analysts knew. The CSFB analysts prided themselves on living, breathing, eating, sleeping, and excreting the companies they covered. Equity sales persons, such as Keller and Ferraro, took up the same ethos, facilitating the dispensing of the nuggets of analyst knowledge to buyside clients, employing a pecking order that hinged upon trading revenue. We were always calling around to large clients with the latest information on the companies being covered, and believe me, these PMs wanted those calls and wanted them before anyone else. To get them, the PMs traded with CSFB. Sales traders took their orders. The equity sales team sat right next to the sales traders, who sat next to position traders. Sales traders handled the intake of trading orders *
CSFB indeed had a four-tiered rating system, Strong Buy, Buy, Hold, Sell.
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from clients, buys or sells, normally in giant “blocks” of thousands or more shares. Clients—fund managers—paid us ample trading commissions, pennies or more per share, as a way to compensate the firm for research, research that had been produced by analysts, concerning companies birthed and baptized by bankers, and delivered via equity sales people. Sales traders shouted out the client orders to the farther side of the trading floor, to position traders. The position traders made and moved markets and in doing so made CSFB money, and on and on the dance went. Because I sat in between the equity salespeople and the equity sales traders, I began to pick up on which buyside portfolio managers commanded the most attention, which ones warranted the “first call” or were among the first few called, when any new piece of information on a company, good or bad, came in over our transom—and of course the most attention was lavished on the largest clients in terms of their trading orders, and the ones that traded most frequently. Revenue providers were tracked to the penny. As mentioned, I was witnessing a changing of the guard in terms of Wall Street’s pecking order. Who got the first call? Often, it went to hedge funds, such as Steve Cohen’s SAC Capital. The single largest hedge fund at that time was Pequot Capital, managed by Art Samberg and Dan Benton. Hedge funds were moving up the ladder alongside the likes of the most popular mutual fund managers such as Fidelity and Janus. Record-setting mutual fund inflows were greatly impacting the stock market, but so were hedge funds, which were not necessarily the biggest boats in the ocean but which were capable of making the most waves. They were amassing assets, commanding the highest fees, which allowed them to hire the best talent. New funds were sprouting up every day. I was getting to know who was who, sometimes on a first name basis. It felt like I was talking to all of them, and my bosses were giving me more and more latitude to get involved in the game.
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One of my foremost regular tasks was to scribble down notes during the 40-minute Morning Call meeting that took place every weekday around 8:00 a.m. and then write a report for my bosses. These meetings were fast-paced and brimming with news and developments. Staffers gathered in a spacious meeting room at the end of the trading floor. The room reminded me of a college classroom, with standing room only if you were late, although most people listened in by phone. The Morning Call maestro was Terry Cuskley, a Managing Director and one of the top drill sergeants in the equity sales group. Cuskley commuted into Manhattan every morning from his home outside Philadelphia. He ran the meeting with intensity and without suffering fools whatsoever. Al Jackson, global head of equity research at CSFB and his various sector analysts chimed in with quick takes, notes, comings, goings, updates, happenings, and observations, often calling into the conference from the road having “just met with management.” Mere seconds after new information would make its way from the analysts to the sales force via the morning meeting, if Ferraro found it relevant to a large hedge fund client, he was already on the phone calling that client. This literally was the proverbial “first call,” and if Ferraro felt he could duck out of listening to the rest of the meeting he did so, knowing that I was taking meticulous notes and would write him a summary. This day-in, day-out note taking and subsequent regurgitation became another way I could contribute. The CSFB supply closet had piles of collegiate-style, marble-patterncovered notebooks and I filled them furiously. ■
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Another major task of mine at CSFB was to arrange and chaperone management team sit-downs for important clients. Meeting facilitation was a staple in our suite of research “products.” CEOs and CFOs
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from Silicon Valley would come to New York eager to meet with large hedge fund shareholders, packing their schedules with up to a dozen meetings in two days. Hedge funds paid us to set up meetings with these C-Suite occupants. The PMs and analysts loved to be face to face with executives, close enough to where they could read even the slightest facial tic or lower lip quiver, relaxed enough to draw out of them even the subtlest financial cues. This was all about getting an edge, any edge, and hedge funds played the game with fervor, and more intensively than, say, long-only mutual fund managers, which were beginning to build up their own in-house teams of analysts. It fell on me to handle the logistics of these management meetings. I’d really made it: I was a professional meeting organizer. While Keller and Ferraro expected me to stay chained to my desk, I always tried my best to attend the meetings I arranged, both to make sure they went off without a hitch and to meet people. Assembling in hedge fund office lobbies, I’d shake hands with the management teams and succinctly set the stage for the sit-down ahead. Many of these meetings took place in Midtown Manhattan. Sometimes, we’d all travel by car or limo service to Greenwich, Stamford, Westport, Southport, Fairfield, hitting the major hedge fund firms sprinkled all over the area in hour-long slots. I would sit in on the meetings, never saying a word, but taking it all in. At first these meetings always seemed the same, yet I soon came to see they were actually quite different. At times it was as if I were watching the same theatrical production, just with different actors doing similar lines, with subtle reinterpretations. But I listened intently and began to observe the hedge fund guys, picking up on their tricks and approaches for how to glean meaningful information, whether by stare down techniques (which reminded me of hockey face-offs) or drill-down interrogation paths that painted CEOs into corners so tight there’d be no way out other than a convincing answer—and because hedge funds went short they could pounce on any fudge. Some guys kept it 50
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so informal and asked such intelligent, well-prepared questions that the management teams sort of became smitten and lost in the conversation and clues emanated unconsciously. No one asked for or got “inside information.” More commonly, half-pieces of data fell into place nonchalantly, which if then extrapolated and placed into the proper framework could be the cornerstone piece of data that gets you to the “number,” to the Grail. The eyeball-to-eyeball read on just how the quarter was shaping up became a form of art and science. Ultimately, though, in August 2000, the Securities and Exchange Commission saw to it that these management-PM/analyst meetings became even more about unspoken language with the passing of Regulation Fair Disclosure. This rule meant that officers at publicly traded companies could no longer disclose to one particular analyst or PM any piece of information that could impact his or her company’s share price without disclosing it to all investors. The sitdowns became less verbose affairs with everyone afraid of violating Reg FD, but they still took place nonetheless. The rules changed a bit, but the game continued. Executives were prohibited from releasing anything material to the company’s financial state to one analyst without releasing it to everyone, so for the most part meetings overnight became devoid of specifics. Still, useful albeit cryptic clues and cues could be extracted if you asked the right questions. In addition to putting management teams from public companies in front of hedge funds, I also spent a good deal of time assembling management teams from companies about to go public so that they could get in front of hedge funds. In order to get these meetings, I had to go through the CSFB “Roadshow Desk,” a team of bankers and analysts who worked with management teams to put on sessions called “Teach Ins” to drum up interest in a new issue, sometimes as many as three different company performances per day. When I wasn’t attending meetings or jotting down notes from meetings or setting up more meetings, I was out at night, at least 51
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once or twice a week, entertaining hedge fund clients, usually the traders. These weren’t the investment decision makers; they were the guys who executed trades for the PMs as part of the implementation of fund investment decisions. The hedge traders could direct large orders to CSFB. Even the junior traders had the power to drop huge orders. This was my target wine-and-dine audience. Once in a while senior PMs came along on the outings. We took hedge fund clients to baseball games at Yankee Stadium and Shea, to Rangers and Knicks games at the Garden, Jets and Giants contests at the Meadowlands, the U.S. Open in Flushing Meadows, assorted concerts, you name a tough ticket event, I probably went—I kept a shoebox filled with ticket stubs because at the time I thought I was living out some sort of dream and needed to keep some form of proof. To me, a plane trip from Thunder Bay to Pembroke was extravagant. Now I was eating at places like Sparks and Peter Luger at least twice a week (I choked down my weight in porterhouse at all the great New York steakhouses and consider Sparks and Luger to be the best, with my personal favorite being the latter) ordering for the table, selecting wine—what did I know about ordering wine? Nothing. I just ordered one of the most expensive bottles the restaurant had on hand. CSFB one time put on an in-house wine seminar, held right at the firm, specifically for sales people, replete with tastings and a sommelier. The event could have been called How to Order Fine Wine Without Looking Like a Moron. No one should get the impression I was really living any dream (that’s just what I thought). Looking back, my time at CSFB was mostly spent on the telephone calling around to clients with the latest info on the latest company CSFB took public. My phone skills were starting to improve from decent to good. Little did I know the start of the era of Instant Messaging on Wall Street was not far off. ■
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If I wasn’t out entertaining, I stayed at my the desk until my bosses left, usually around 6 p.m., then I’d work out in the CFSB gym until 7 p.m. when I could grab a free meal in the CSFB cafeteria, always chatting away with the junior analysts I was courting. Then I’d go back up to the desk to see if there were any other messages or whether any of our clients needed anything, then I would go home by 8 p.m., then straight to bed, and then back up at 6 a.m. for another go-around. Much of my time was spent calling around to hedge fund PMs and analysts, proactively, leaving messages, sometimes catching them late, basically letting them know whenever a manager at a company they owned, long or short, so much as changed deodorants. These seemingly throwaway threads—a curious travel stop, an insider stock sale—were the added-values that the sellside could provide to the buyside, and why buyside firms traded large orders through our equity desk. Access to Quattrone’s IPO calendar didn’t particularly hurt, either. You might say, with some technology IPOs jumping tens of points per trading session and with CSFB controlling who got to scoop up the hottest issues as they were coming out of the gate, that what we were selling was free money. Most people think of the sellside research of the late 1990s as being connected to investment banking, and it was. Companies looking to select the best possible banker to take them public could be swayed to go with the firm with the highest rated sector analyst, the ones who held No. 1 spots on Institutional Investor’s All-America Research Team. CSFB’s investment banking allure centered more around Quattrone and his network of tech gurus and money manager pals. He became synonymous with tech IPOs. Banking fees during this period were pouring in. Quattrone and his team, snagging a hefty share of tech and dot.com IPO assignments, would bring in $686 million in stock underwriting fee revenue in 1999. CSFB’s share of overall equity underwriting grew from 3.8 percent in 1998 to 8.6 percent 53
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in 1999, and it went from No. 8 to No. 4 in Thomson Financial’s* closely watched league tables. Just as closely, though, the research function was simultaneously tethered to the trading side of the business. Firms paid CSFB for the research they consumed—and the IPO shares they were allotted— by trading large orders through the CSFB equities desk, generating commissions. Although I never did get to meet the dapper, mustachioed Quattrone, I did get to help sort out the sensitive assignment of deciding who among our top clients got to attend Quattrone’s annual technology conference. Here was a shindig layered in an extravaganza wrapped in a boondoggle, held just after Thanksgiving in Scottsdale, Arizona, at a super swanky golf resort called The Phoenician Hotel, one of the most expensive hotel developments in history, financed at the height of the junk bond era by Charles Keating’s Lincoln Savings & Loan. Frank’s Conference was a way to get technology company executives in the same cozy confines of those PMs who owned their shares and who were in a position to gobble up more shares, and moreover, to tell all their smart and important hedge fund friends to do the same. The whole event cost $2 million to put on, and performers like Robin Williams used to headline. I did not attend—wasn’t even invited. Years later, I’d learn how the talented Quattrone fellow landed himself in hot water over some of his activities during the tech bubble era, although investigators were hardly interested in how he doled out invites to his conference. But in 1999–2000, the Quattrone IPO machine was humming along unfettered, a blender set to puree. The tech IPO market of that two-year period would produce 637 public companies with a combined market capitalization, on paper, of $400 billion. Much of that would be erased by the time the bubble burst. *
Now Thomson Reuters.
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One of the companies that we took public and that continues to stick in my craw was good old FogDog.com. I think that since FogDog sold sports equipment over the Internet I could at least relate to this business, for the simple reason that I bought a few pieces of hockey equipment in my day. I was more cracked up than convinced—because I simply couldn’t see buying hockey skates off a web site. Some non–Kool-Aid–inhaling hedge fund clients of ours pegged companies such as FogDog as emblematic of the froth and hype surrounding dot.coms. While a lot of funds were set up to take advantage of the scorching momentum growth associated with the tech names, other hedge funds began to short the more absurd companies. I’d sit in on meetings in which PMs short the stock would intentionally goad management into saying the most utterly ridiculous things about potential for growth, just to gauge how ludicrously the company’s prospects had become decoupled from reality (and sometimes just to be assholes). “So you guys think you can quadruple your sales in Latin America in the next five years?” Uhhh, yeah . . . One of my most vivid memories of the tech bubble, as seen from my seat, came during the middle of the summer of 1999. The Nasdaq Composite Index was midway through what would end up being a stupefying 86 percent annual gain in 1999. As indicated, Quattrone and his minions were literally birthing sometimes as many as three new companies per day. One morning, some executives from one of the dot.coms we’d just helped go public (an online music download provider) paid a visit to the CSFB trading floor to mark the company’s debut trading on the Nasdaq. These guys, thirty-somethings, dressed in suits, were completely over the moon. They had a domain name, and a dream, and now a ticker symbol, and the market said cool. Investors bought hundreds of millions worth of their stock the first day alone. I recall watching the CEO as he whipped out a camera and started excitedly snapping pictures of himself, taking different angles to make sure he 55
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captured one of our traders’ screens showing his company’s symbol and price in the shot. I recall thinking to myself, well this market is topping out. Of course, I had to learn to spot some things the hard way. CSFB had a policy that employees could buy shares in the companies we took public as long as we held them for at least 30 days. I used to watch some of these stocks jump multiple points in a day, which, unless there was some merger or acquisition news or major regulatory firestorm, was unheard of on Wall Street before 1999. But some dot.com come latelys would fall just as fast, even in the heyday. I once bought three lousy shares of a company that CSFB took public, a software developer that had opened spectacularly. After tripling in a few days, the company’s stock eventually fell into the tumbler. That 30-day rule made me grind my teeth. I was soured on stockpicking, on the technology boom. This was a valuable lesson, though. It showed me how the Street works. I knew hedge fund managers didn’t have any 30-day minimum holding period. One other distress signal I picked up fairly clearly came on a Saturday morning not long before the Quattrone conference. The doorman of my building called up to my apartment and told me that some wine had arrived for me. A hedge fund client had not just sent me a few bottles; they’d sent me a few cases—and it was expensive wine, too. I was a junior analyst and big-time money managers were sending me cases of wine. ■
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Brady Dougan’s goal of $1 billion in pretax, pre-bonus profits was met in 1999. In the first quarter of 2000, around the time that the Nasdaq was nearing its peak, I was paid my bonus, which, combined with my base salary, meant I was making nearly six figures. This was more than my dad made in a year as a fireman, more than my mom made as a teacher. 56
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By then, though, I’d begun to hear whispers of the dollars that some of my classmates were making working as analysts at the big hedge fund firms, such as Soros’ shop and Robertson’s Tiger. Some were even acquaintances of mine from Yale. Here they were, making twice as much as me. Wheels start turning when you hear stuff like that, I must admit. One of the larger hedge fund firms that I personally helped cover was called Dawson-Samberg Capital Management Inc., the firm that had produced Pequot Capital. Based in Southport, Connecticut, Dawson-Samberg originally opened in January 1981 as Dawson-Henry Capital Management. Less than a decade later, the partners, Jon Dawson and Clifford W. Henry, split up. Henry, a growth stock guru, would go on to create a hedge fund called Worthington Growth LP. Dawson, a Princeton lacrosse player who got his start in the investment management business at Weiss, Peck & Greer, soldiered on, tapping Art Samberg as his partner in 1985. Samberg was a fellow Weiss, Peck alum and a pal of Dawson’s. Soon after his arrival, Samberg helped Dawson launch a fund called Pequot Partners, named after the avenue in Southport on which the firm’s office was located. In 1989, Dawson changed the name of his firm to Dawson-Samberg Capital Management. More Pequot funds followed. The “family” of funds flourished as cutting-edge investors lined up to pay an off-the-top management fee of 1 percent of assets, as well as 20 percent of the fund’s gains (otherwise known as “1 & 20”). With bonds and bond traders still at the forefront of the Wall Street scene in the late 1980s and early 1990s, Dawson embraced growth stocks, and he added talented analysts and new funds to his tent. His core strategy was classic long/short equity, with a disciplined value-oriented bent, despite his gravitation toward growth. Samberg perfectly complemented him, espousing a style that could be best described as value technology. Between 1990 and 1996, Dawson-Samberg’s assets grew from roughly $350 million in assets to more than $2 billion, largely on the strength of the 57
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first wave of tech stocks. Around that time, Dawson-Samberg became one of the few hedge funds to garner much if any media attention when it became entangled in a 1996 SEC investigation into “soft dollar” abuse. The miniature “scandal” ultimately failed to mushroom beyond a difficult-to-decipher web of allegations tied to asset managers, including hedge funds and mutual funds, brokerages and improper use of “credits” generated by trading commissions that were supposed to be earmarked for research purposes but used to pay non-research items, such as travel expenses. In the end, Dawson-Samberg paid $100,000 in penalties to settle a “failure to supervise” charge without admitting to anything, according to the SEC. In January 1999, the insanely successful Pequot family of funds (which in addition to technology also focused on healthcare and media/communications) were formally spun off into a separate, Westport, Connecticut–based company, Pequot Capital, a move that had been announced a few months earlier. Samberg became chairman of Pequot, and his golden boy long/short tech PM, Daniel Benton, became the president. Benton had joined Dawson-Samberg in 1993 from Goldman Sachs, where he’d been a No. 1 ranked Institutional Investor tech analyst. Pequot had $4 billion when it commenced operations as a separate firm. Amid one of the zaniest bull markets for any one sector since the Netherlands overdosed on tulip bulbs in 1637, Benton’s tech fund returned more than 100 percent in 1999. Pequot became a money magnet in high-net-worth individual and Ivy League endowment circles, despite its steep fees. Dawson, meanwhile, plugged along, taking on yet another new partner, a gifted energy PM named Tony Giammalva. While Dawson had been eclipsed by the success of Samberg and Benton, his Southport shop continued to manage around $1 billion, at that time still a humongous pile on which to be earning 1 & 20. Dawson and Giammalva were supported by a team of a dozen or so analysts and execution traders. Additionally, Dawson had 58
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opened a small New York office, located in Midtown off Lexington Avenue. The head of the office was Dawson’s 26-year-old protégé, a University of Florida graduate named Russell Herman. Herman had been trading stocks in his own account since his college days, when he would punch in his trades by phone. On January 1, 2000, Herman launched a new hedge fund called the Southport Millennium Fund, not to be confused with the betterknown Millennium Fund managed by Israel “Izzy” Englander. Herman was fairly well under the radar relative to Englander who had been caught up in the Ivan Boesky scandal a decade earlier, an episode chronicled in James Stewart’s Den of Thieves (Simon & Schuster, 1991). Dawson flew under the radar as well. Hedge funds were not yet explosive (LTCM aside) or en vogue. But the industry, once an obscure corner of asset management and the domain of the superrich, was starting to take off, and the financial media was starting to take notice. The Dawson/Samberg separation made some waves in the financial press, which portrayed it as mainly amicable. Behind the scenes, though, it was said that Benton could no longer tolerate Dawson. And Samberg, who had been friends with Dawson going back to their days at Weiss, Peck, and who benefited from Dawson’s patience during some rough patches in the pre-Benton early 1990s, wanted a bigger piece of the pie. So he and Benton went off together. After that, you were either with Dawson, or you were with Samberg and Benton. My bosses continued to cover Samberg, and they let me take Dawson. It was nothing personal. Keller and Ferraro dedicated 80 percent of their time to covering the top dozen largest hedge fund clients, which is why I got to cover any hedge fund clients at all. So that’s how I got to know Russell Herman. He had been the guy who once told my boss “Keith gets it.” And in the third quarter of 2000 he—and the hedge fund world—got me.
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Chapter 5
Discovery
61
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y maiden visit to Jon Dawson’s Southport, Connecticut, hedge fund shop was in the spring of 2000. A few months earlier, the firm’s name officially, legally changed for the third time, this time going from Dawson-Samberg Capital Management to DawsonGiammalva Capital Management. The surroundings were way different than the environment at CSFB. I knew the buyside life was a bit more relaxed than the frenetic sellside, but I didn’t expect a group of 20 or so people sitting around quietly in a three-story former factory that had been partially converted into office space. It was cozy, and I felt like I was back in Thunder Bay at my buddy’s moose hunting lodge. Dawson wore a button-down shirt, denim pants, and cowboy boots. His spacious office, decorated with photos spanning a long career rubbing shoulders with corporate America, was on the second level, just off from the trading floor. Analysts, administration, and operations folks were on the ground level or upstairs, on the 63
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third floor. When Dawson wanted to do a trade, he opened the door of his window-enclosed office and shouted out the order to his traders sitting just outside, loud and deliberate, piercing the otherwise laid-back aura. I took the train to Southport specifically to meet Dawson. His protégé, Russell Herman, was trying to get me to come work with him in Dawson-Giammalva’s New York office. I was also being recruited by the head trader at Viking Global Investors to come work on its execution desk. Viking was cofounded in 1999 by former Tiger Management equities chief (and Norwegian SEAL Team member) Andreas Halvorsen, who served as the firm’s CIO. Halvorsen exploded out of the gate with 80 percent plus returns in 2000. While it was tempting to hitch my wagon to Halvorsen’s star, the fact remained that I had a natural rapport with Herman. Besides, I didn’t want to execute someone else’s trades—I wanted to make them. Dawson-Giammalva had just hired a former teammate of mine at Yale, Daryl Jones, an Albertan and a hardnosed defenseman. Jones landed in Dawson’s New York office as a junior analyst; someone young and raw, whom they could train and—at least initially—not pay that much. Jones had spent two frustrating years training as an investment banker at J.P. Morgan. After a discussion with Tiger Williams, in which Williams compared I-bankers to figure skaters and hedge fund managers to hockey players, Jones had decided to get into the hedge fund game. I’d passed Jones’ resume along to Herman, and Jones was hired to work on a newly launched tech fund being run by another Dawson protégé, an analyst named Geoff Gross. Gross had become a tech PM following two years spent as a tech analyst, which he became after Art Samberg and Dan Benton went off on their own. Samberg and Benton ended up turning Pequot into a $16 billion hedge fund empire by the end of 2000, making it for that period the single largest hedge fund operation the money management industry had ever seen. Within a year from that pinnacle, though, Samberg and Benton split up. 64
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Although I was tight with Herman after months of covering him at CSFB, my joining the firm was hardly a done deal. I still had to go meet Dawson. I remember him telling me to sit down and then immediately launching into a barrage of questions. Most of them were geared toward finding out exactly who I was, with less emphasis on my abilities as an analyst. Where was I from? What did my dad do for a living? Why did I play hockey at Yale? Why did I want to work at a hedge fund? He was reading me, not interviewing me. Honestly, I can’t recall any of the answers I provided during the probe. But I do remember what Herman told me later that night, about what Dawson had told him. I was on the train back to the City, and Herman rang my cell phone to give me a briefing. “Well, Keith, Jon doesn’t think you know anything about investing. And he told me he thinks I’m taking a risk hiring you. But he liked meeting you. He said he thinks you’re a winner.” Game on. I would be working as a junior analyst supporting Herman on his Southport Millennium fund, which had $12 million in assets at launch. My base salary would be around six figures, and, depending on Millennium’s annual performance, I stood to potentially earn a bonus of up to 100 percent of my base. My entry into the hedge fund industry came just as the tech bubble was bursting. CSFB apparently didn’t get the memo. After Herman made me the offer, I met with my boss, Keller, to give him the news. He made me a persuasive counter offer: I would be fasttracked to associate level, without having to get my MBA, which was the norm for someone on the analyst (entry) level at CSFB; and my base salary would be increased to low six figures. I agreed to give it some thought out of respect for Keller and Ferraro, who had been great to me, but the next day I was out of there. Both of them wished me well. ■
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Working in the New York office of Dawson-Giammalva was not nearly as hyperkinetic as the CSFB trading floor, nor were our surroundings as spacious as Dawson’s Southport digs. Our office was small and plain, which produced a mellow, collegial environment, heavy on thoughtful interaction, although Herman would occasionally unleash his temper. I was assigned to an office that was more or less bolted onto the back of Herman’s like an annex, and we were always popping back and forth, discussing stocks. Sometimes it felt as if we were conjoined at the hip, or at least people saw us that way, which was fine by me because I was learning a ton from him. Outside our doublewide office was another similar two-man setup, this one shared by a pair of analysts, energy expert Kevin “Comco” Comcowich, who hailed from Hawaii and who had been at the firm several years, and Tom Tobin, a New England native and former Dartmouth biochemistry PhD candidate who had just joined Dawson from money manager W.P. Stewart, where he was a junior analyst. Tobin did healthcare research. The tech team of Geoff Gross and Daryl Jones shared a third office. Hedge funds for the most part were being set up in the mold of Julian Robertson’s Tiger, with a full team of sector analysts feeding ideas for longs and shorts and tracking existing positions to the Portfolio Manager, who pulled the trigger on trades. The best analysts eventually transitioned into PMs. Straight away, Herman assigned me coverage of consumer and retail stocks. No one told me why exactly at the time, but later on I figured it out—consumer-retail was considered the easiest sector to cover. I was no CFA and my analyst title at CSFB was just that, a title. Restaurant chains, gaming and lodging companies, shoes, apparel, these were entities that from a research standpoint stacked up in similar fashion—they all tracked their sales data intensely. Retailers were either growing market share or they weren’t; cash registers were either ringing more or they weren’t. My life began to revolve around the first Thursday of the month when retailers released same-store sales data from the prior 66
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four-week period. The term “same-store sales” ( jargon meaning a set of sales data from individual stores that have been open and operating for at least one year so as to provide a comparable measurement) was practically tattooed on my forehead. To get a sense of how a quarter was shaping up, I obsessed over this data and past statements, came up with projections and bounced them off management teams, and then plugged all my known information into well-designed forecasting models. Herman gave me assignments and also asked me to come up with ideas. He essentially told me to go forth and get him as much useful information as I could on the retail sector and trusted me not to feed him bunk. Many hedge funds were being built and run on momentum and growth, but Dawson’s investment style was more value driven, with an eye toward identifying oversold companies about to benefit from some form of catalyst. We called it “value with a catalyst” but were loath to latch on to any particular compartment. How Dawson and Herman ran their hedge funds does not require all that much detail or distillation; they kept things remarkably straightforward. Herman, as Southport Millennium’s sole PM, screened for stocks using broad criteria zeroing in on those companies seemingly gaining momentum and poised for a meaningful run of revenue growth. Conversely, he could use the same data mining approach to identify a company on the downward slope from fiscally great to merely good. “What matters in this business all happens on the margins,” Herman would always say, repeating a timeless Dawson utterance. So, for example, when a shoe company that increased its same-store sales by 10 percent in the first quarter year-over-year goes on to announce in the second quarter that same-store sales only rose 8 percent yearover-year—well before that is known, any hedge fund worth his performance fee is already out of the stock. Or if a company that has been beaten down only expects to lose $12 million after losing $14 million the prior quarter, it pays to know in advance that such 67
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a lesser of evils is likely going to be the verdict. A favorite line around the office was “cover your short before it goes from toxic to bad.” To spot the stuff that happened on the margins, Herman constantly crunched numbers and pored over filings. He followed the market like a true old-fashioned stock operator, a dying breed with algorithms and MIT programmers and PhDs taking a firm hold on the market (despite the LTCM debacle that was supposed to spell their doom). Herman sure as heck didn’t use computer programs to trade. I’ll never forget the day I looked into his office and saw Herman pressing a blank sheet of paper up to the computer screen on an angle like a crude slide ruler in an attempt to measure a set of closing price data. To me, a know-nothing Canuck, it looked as if the man in charge was dithering, confused, perhaps attempting to block out his trading screen. Was it hurting his eyes? I soon realized he was deep in his own process of establishing whether a company had made a higher high or a lower low, the foundation of any true chartist or market technician. It was Herman who taught me that closing prices are the ultimate driving forces in the final analysis, and I never forget that. When Herman dove into a stock, he knew everything, every angle, who else owned it, how the options were being priced, and who owned the options. If he saw something worth chasing after, Herman would assign me or one of the other sector analysts to dig deeper. He used the Street for meetings. Herman played the game, and he knew how to play it, having learned from one of the best. The prevailing modus operandi, passed down to him and Gross by Dawson, was this: You did more management meetings than anyone else, and you built out the best possible models to forecast earnings. Between kick-ass models (factoring together key business drivers, like operating margins, projected sales, etc.) and an exhaustive amount of one-on-one meetings, preferably with the CFO or COO, 68
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doing whatever it took to fill in the blanks short of explicitly asking, you nailed down whether a company would hit its numbers. That’s how you earned your “2 & 20.”* I learned the art and science of modeling from Comco, who was the best I have ever seen at building an Excel spreadsheet and cramming it with just the right ingredients, relevant data points, factors, inputs, and I mean boatloads of inputs, from the fairly standard to the wholly original. He and Tobin were cordial neighbors, always willing to show me a trick or shortcut or just answer some basic balance sheet question whenever they could see I was lost or clueless, which for the first few months was pretty much all the time. Modeling is a science and an art, and if you do it right you can get the “number” (earnings per share, total revenue) down to the penny. A lot of Wall Street critics used to say that the stock market became a rigged game of earnings guidance, with management teams managing the Street’s expectations down to the penny, and surely some gaming went on—particularly in the days before the disclosure rules changed. But I can say that I never had anything hand delivered or gift wrapped, apart from maybe that wine. After Regulation FD** came along in the fourth quarter of 2000, the game of extracting information from a CFO or COO became far more challenging, but not impossible. No one gave you “the number” (they couldn’t; *
As mentioned earlier, hedge fund managers typically collect two kinds of annual fees from their investors, a straight-off-the-top management fee, often 2 percent of the assets in the fund, and a performance fee, often 20 percent of the profits, leading to phrases such as “2 & 20,” although for many years the prevailing jargon in the industry was “1 & 20,” a reflection of the more modest fees typically collected by the earlier generations of hedge fund managers. Southport Millennium, incidentally, charged “1.5 & 20.” **
Passed by the S.E.C. in August 2000 under then Chairman Arthur Levitt and officially taking effect later that year, the Fair Disclosure rule, commonly referred to as Reg FD, was a response to concerns that executives at publicly traded corporations were too selective in disclosing to Wall Street analysts and large investors guidance and information used in forecasting quarterly earnings, creating, the SEC reasoned, an uneven playing field.
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it would, under the new law, potentially be considered insider trading), but if you had worked up your models right, and if you extracted the right linchpin figure, perhaps some profit margin guidance relative to historical margins, it was often possible to fill in the mosaic and nail down the number, or come close. Even a seemingly throwaway crumb obtained during a one-on-one meeting could help to crystallize a working forecast. Dawson was the master of the one on one. He never went in unprepared. Dawson had a regimen: pre-prepped information packets. No one went into a meeting without having prepared a packet of all the vitals, charts, models, annual reports. The idea was to be so well prepared it was possible to convey almost a sense of omniscience, where we knew more about the company than the CFO did. Corporate executives enjoy nothing more than to engage with someone as insanely steeped in the minutiae of their business as they are. As you might expect, a lot of these guys were stiff, but nothing with Dawson was ever forced during the one on ones, questions were never delivered from a script; it was all about finesse, knowing what to ask next should the answers inadvertently trip a trapdoor or diverge from what you expected. I’d personally gone through a Dawson interrogation when I sat down to meet him prior to joining the firm. He read people incredibly well, but at the management team sit-downs, Dawson was more charming than aggressive, the wise father figure whom CEOs knew had the buying power and the network of New York and Connecticut hedge fund buddies who collectively could put a stock on the road to righteous appreciation, or to perdition. Dawson would ask about things that he knew management had not thought of yet just to watch them think in real time. And he usually got the information he needed. ■
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One of the first research assignments thrown my way was to investigate video games, the ones being played at home on Nintendo 70
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consoles. One of the companies I researched, Midway Games (NYSE: MWY), traced its roots to the early days of arcades and pinball machines. Midway had been a division of Bally and then was spun out on its own. Midway’s gaming software arm, Midway Home Entertainment, were the people who brought “Mortal Kombat” and “Ready 2 Rumble” into our living rooms, and while modern civilization may or may not have further eroded as a result, these cartridges were flying off shelves. In late 2000, the market for virtual violence appeared ready for even further growth. One afternoon, the gregarious CEO of Midway, Neil D. Nicastro, came by the office to chat about how his quarter was shaping up and did several things that struck me as curious, not the least of which was how he strolled in chomping on a cigar. I would wind up shorting the living pinballs out of Midway throughout my career. Another retail company I followed fairly closely in 2000, and into the summer of 2001, was Pacific Sunwear of California (Nasdaq: PSUN), an Anaheim-based seller of surf clothes, shades, and sandals. But could they sell board shorts in the heartland? Was it a fad or for real? Every major sector has its conference circuit, and I began to attend these events, usually put on by a sellside analyst from a major bulge bracket firm. Just as Frank Quattrone and CSFB put on a massive technology conference at The Phoenician in Scottsdale, Arizona—golf, booze, and shoulder rubbing couched under the guise of riveting panel discussions on industry trends—all the banks did some sort of conference. The major banks would all put on elaborate sector conferences, including retail. Lehman Brothers, for example, put on one of the biggest retail conferences every spring. These types of events usually featured management teams from household name companies. In spring of 2001, at one such event, I sat down with PSUN’s Chief Merchandising Officer, Timothy Harmon, an upbeat, 71
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curly-haired fellow. Because of his permanently gelled curls, I mentally assigned him a nickname that meant no disrespect, but which amused me: Perma-fro. He met with me and one other hedge fund analyst (a “2-on-1”). I came away from the conversation with the impression that PSUN’s sales in their second quarter (the company’s prior fiscal year that year ended February 4, 2001) were actually going to be closer to rad than gnarly. My fellow hedge fund analysts all agreed PSUN’s future looked bright, or rather we agreed to agree on what we just heard. I believe even more favorable sentiment was bandied about later that night over cocktails: “We like PSUN,” one hedge fund analyst declared to another who replied, “We like it, too.” Hedge funds cherish privacy and go to great lengths to stay out of the public eye, but the notion that hedge funds are secretive is a something of a myth. Many hedge fund managers like to share their ideas, and they like to copy other managers’ ideas because a group hug can drive the share price up in a sort of self-fulfilling prophecy, which CEOs love. Who else owns it? That’s a question most hedge fund managers ask first and foremost. This clubby, influential New York City/Connecticut area hedge fund sphere was sometimes referred to as the hedge fund mafia. Sufficiently impressed with my own “research,” I began to speak up loudly about the company at our morning meetings, and on my recommendation, Dawson and Herman were both buying up PSUN ahead of their first quarter earnings announcement scheduled for later that May. All they wanted to know from me, was PSUN going to hit its numbers? Yes, I told them, I had just met with management. I had learned that if you want to get a hedge fund Portfolio Manager’s attention, tell him or her you just met with management. A week or so after I met with Perma-fro, Pacific Sunwear announced that its COO had resigned and that sales at stores open at least a year decreased 4.1 percent for the four weeks ended May 6. Chairman and Chief Executive Greg Weaver said in a statement: 72
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“April was disappointing.” The stock got hammered, and Dawson and Herman questioned my call, but since I had just met with management, I countered that the stock was still looking good—the negativity was overboard, business was on the upswing, and they’d do better in their second quarter. They would grow in the second quarter over the same period a year earlier. PSUN, I was sure, would shine. Later that July, as I prepped for the daily morning call with the whole firm on the squawk box, during which I knew I’d be asked again about Pacific Sunwear because its June sales numbers were coming out, I saw an item come over the Reuters tape that made my heart jump. PSUN missed; June sales had sucked. The stock sold off. The phone rang. It was Jon Dawson, and he was not happy. Before he hung up on me, I heard him yell to his traders to “sell!” He was selling at a loss. I felt like an idiot. PSUN fell about $2.50 that day from the open. We’d been gobbling it up, long, for weeks. Perma-fro had played me. I was a lemming. From that experience I learned a few things: One, stocks don’t lie. People do. And two, if you just go along with what everybody else thinks, if you confuse popular consensus for an honest research process, you’re setting yourself up for failure. I’d been drawn in by the guidance game, by hedge fund groupthink syndrome. That whole system had failed me. Yet Herman and Dawson never held the PSUN fiasco over my head, and we moved on; they gave me the chance to take shots and miss. As my idol Wayne Gretzky once said, “You will miss 100 percent of the shots you don’t take.” While that holds true, there’s nevertheless a distinct line in the hedge fund business between a few missed shots and outright poor performance. In 2000 and 2001 I’d watched my former Yale hockey teammate Daryl Jones struggle along with Geoff Gross running the 73
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Southport Technology Partners fund. I looked at Jones as being twice the analyst I was. Here was a guy with talent and a tremendous work ethic to go along with it. But the tech fund had been launched at the top of the market, the market cracked, and then they got sucked into a summer of 2000 bounce, doubling down with tech about to come apart completely. By the summer of 2001, the Nasdaq had melted away.* Eventually, the Southport tech fund was closed down and Jones left the firm to go to business school. Jones, whether on the ice at Yale or in the office, was one of the hardest workers I’d ever observed. He and Gross had done everything right and they couldn’t make it work. What hope did I have? That’s when I realized that the hedge fund industry had nothing to do with work ethic or basic principles. It had everything to do with performance. Nothing else mattered. ■
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The demise of the Southport tech fund caused me anxiety and angst in the summer 2001. But like everyone else, the events of 9/11 left me feeling deeply disturbed and questioning the whole way I viewed the world around me. Jon Dawson, myself, and one of the firm’s senior analysts, George Larguay, had traveled to San Francisco for the Banc of America Securities Annual Investment Conference scheduled for September 10–14, 2001. For years, the event had been staged by revered West Coast technology juggernaut bankers Montgomery Securities, which was acquired in 1997 by NationsBank, which in turn merged with Bank of America in 1998. By any name, this confab by the Bay was like Burning Man for growth managers and corporate executives with any sort of growth story to be conveyed *
After closing March 10, 2000, at 5048.62, the Nasdaq Composite Index fell to 2470.52 by the close of the year, and down to 1638.80 in April 2001. The Nasdaq closed 2001 at 1950.40.
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with a straight face. While our funds were more value-oriented when it came to our longs, we were there to grab meetings, possibly as a way to spot some potential shorts for the second half of the year. We had access to a slew of executives from the dozens of public corporations slated to present. One of the other major stories playing out on Wall Street at the time besides the tech wreck was the shake out in the telecom sector, which was starting to falter after a seemingly unstoppable run, with high flyers such as WorldCom, Qwest, and Global Crossing coming back down to earth even as AOL Time Warner and AT&T supposedly were in talks to create a combined broadband behemoth. On Tuesday, September 11, the conference, held at the San Francisco Ritz-Carlton Hotel, was to feature a noon keynote address by AOL Time Warner Chairman Barry Schuler. That luncheon would be cancelled. On Monday night, exhausted after a long day of meetings (with executives from MGM Grand and Starwood Hotels) following a cross country flight, I set my alarm for 2:30 a.m. so I could prepare to speak at the morning meeting, which would be 5:30 a.m. West Coast time. Jet lagged and wine groggy, I embraced four whole hours of sleep as pure upside. I got up and looked out the window. The rest of the hotel was dark. Sometimes when I did my get up at 2:30 a.m. West Coast routine, if a view was available to me, I took note of the lights coming on as night crept toward dawn, and reveled in knowing that I’d been up longer than anyone. On the morning of September 11, I turned on CNBC and began to jot down some notes for the meeting. I was looking into casino operators at that time, and had identified MGM Mirage (NYSE: MGM) as the best bet in terms of our value with a catalyst prism. Slot machine maker IGT was another casino/gaming company I followed. I was long Vegas, and gambling in general. Right after I finished chiming in, relieved to be finished talking, I looked over at the television. CNBC had cut to a live shot, the terrifying 75
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footage of the smoking North Tower against blue sky. In a split second our conference call devolved from lively discussion into stunned murmur. Then the second plane hit. We’d watched it live. Right then, George Larguay, who had the floor, and who like me was dialed into the call from his room at the Ritz-Carlton and tuned in to CNBC, stopped his financials spiel and said, “Okay, guys, that was no accident.” That morning call was over. Most of the New York guys left the office. Just bolted. I bolted, too. I’m not sure what I was thinking, but all I wanted to do at that point was get out of San Francisco. Fearing that perhaps the Golden Gate Bridge was next I wound up getting in touch with an old Yale buddy, Michael Blum, who was based in the Bay Area working for a web-based startup company. He picked me up in his car and we hightailed it out of San Francisco using back routes he’d already premapped in case of an earthquake. I couldn’t get through to anyone on cell phone—I wanted to let my parents know that I was okay just in case they had even a remote inkling I was at the World Trade Center that day. We drove down the coast on Highway 1 and ended up in Monterey 100 miles south where we met up with Daryl Jones, who had driven up from a technology conference in Los Angeles. We stayed a couple days, and I ended up going back to the RitzCarlton where I holed up for the next week, still semi-shocked, unable to get a flight, trying to make sense of the world. Dawson had somehow rented a car on 9/11 and drove across the country to get back to the office. As we waited for markets to open, we continued to do our morning meetings with Dawson chiming in from out on the road. “I just stayed in some dump in the middle of nowhere,” he’d say to begin the call, then tease me for racking up a massive bill at the Ritz. The way I saw it, what did it matter? Everything just fell by the wayside for those first few days. I was glued to the television. Eventually, I snapped out of it and began to think long and hard about what this all meant. I was feeling extremely grateful no 76
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one I truly loved and cared about had been killed. Like many people I was soul searching, not sure what I might find. As I finally boarded a flight home a full week later (I still keep my boarding pass from that flight in my wallet), I was still reflecting on what had happened and how I felt. Would I change going forward? What really struck me was how something unthinkable, unimaginable, had in fact happened. No one saw it coming. Here I was, obsessing over all these individual companies, and never once giving thought to the bigger picture, geopolitical or otherwise. I not only was missing the forest for the trees, I had my face pressed up against the trunks so closely I had eyefuls of bark. What was the point of any of the research I did if I couldn’t see an event like 9/11 coming? All the meetings and models in the world were useless if I couldn’t see the unforeseeable. What was the point? I vowed that I was going to try to do more macro research and risk management, a high concept that had permeated the hedge fund world after LTCM, but that I and a lot of others viewed with ambivalence. And while I’m not saying that I ever thought for a second that I could be in a position to spot the next 9/11-type event, damned if I wasn’t going to try my best to watch for signals of impending calamity on the horizon—no longer would anything be considered “unthinkable.” I would make it part of my job to think about things that no one else was thinking about. Working alongside our energy guys, Comco and Giammalva (who, it should be pointed out, in addition to being a world-class trader, was once a globally ranked professional tennis player), I picked up on their macro overlay process, which is required when trading oil markets. In my world numbers came out every month like clockwork—I didn’t need to worry about Nigerian labor strife or the demographic shifts in Shanghai. At least I thought that I didn’t. As a hockey player, when our opponents slowed down and played a more physical, defensive-minded game, it was crucial as a player to adapt and play that game in front of you. Continuing with a 77
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wide-open, speed approach in such a situation could burn you. You could get outmuscled. I needed to adapt and play the game in front of me. ■
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When the markets re-opened on Monday, September 17, Herman, with my input, started loading up on what we called “Bunker Down” plays, including consumer staples, as well as defense and security stocks. Most everyone was bracing for another attack, and we looked at it from the other side of that trade, or rather from a standpoint that more likely there would not be another attack, based on what we read on the M.O. of past Al Qaeda events, which were often planned out over many years. The market tanked nonetheless on general geopolitical uncertainty, with airlines taking the brunt of the panic selling. The market stayed volatile in October as the bombing campaign on the Taliban in Afghanistan began, and rallied in November, only to be ravaged again by the collapse of Enron in December. Still, by the end of the year, most of our big bets had paid off. Herman and I both took our risk management game to a new level. By the start of 2002, I was trading. Herman gave me responsibility for a “carve-out” percentage of the Southport Millennium Fund. Although informal, non-audited, and only a small piece of the overall fund, it was still tens of millions of dollars. Frankly, I was both nervous and thrilled to be playing with live ammo, but more than anything I was psyched for a clear-cut, apolitical, put-up-or-shutup opportunity to prove myself. I would have discretion over my own trades and be paid on the performance of my P&L. I could make some real money. Maybe even a million dollars. My chance to make it as a hedge fund manager, or to embarrass myself, had arrived. 78
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Flying With The Giants
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s it turned out, the secret to managing money was having money to manage. Now that I was running a piece of Herman’s Southport Millennium fund, I worked longer and harder than I ever have in my entire life. I got up earlier, too. I was always up by 5:30 a.m., but now I started to whittle my wake-up time down into the 4:45 a.m. vicinity, no later than 5 a.m. I traveled more, attended, impossibly, more conferences, more management meetings. I was a road warrior, a freakishly frequent flyer; seriously, I must have done 200 management meetings in 2002. (I would set a personal record two years later with 256 meetings in a 12-month period.) I engrossed myself in the markets (and not just my narrow sector) with an invigorated fervor. I read everything, papers, magazines, biographies, white papers, anything that told me about the world beyond my reach, challenged my assumptions, using plane trips to catch up on materials I collected like a pack rat in freebie canvas conference bags. 81
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My hockey philosophy kicked in full force. I clung to the concept that only harder work could separate me from the rest of the pack. Mostly, though, I didn’t want to be wrong. I absolutely hated losing. ■
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My first year making my own trades, 2002, was nothing short of a taxing slog through hideous markets. It would be our third straight year of making money in a down tape. Upon reflection, I would not have wanted it any other way. There’s something to be said about turning in positive absolute returns in a bear market, which is what I presumed hedge funds, with their steep surcharges, were supposed to achieve. No matter what, no excuses. Most mutual fund portfolio managers hugged their benchmarks, which is why the industry dubbed many of them “closet indexers.” Fund managers weighted their portfolios in line with the index by which they were measured, whether the Russell 2000 Small-Cap Index or the S&P 400 Mid-Cap Index, even if it meant negative returns. Hey, as long as they weren’t down worse than the benchmark, right? Managers who did underperform had plenty of cover. The post tech bubble, post-9/11, post-Enron markets went from bad to worse, and then straight to hell, a months-long assault that wore people down, emotionally and physically. The S&P 500 briefly treaded above 1500 in August 2000, having rebounded somewhat following the initial bursting of the tech bubble that creamed silly dot.coms and flimsy cash flow situations the way a tsunami takes out the beachfront property before a second surge wreaks inland havoc. By July 2002, with increasingly appalling book cooking scandals manifesting themselves around every corner, the S&P 500 had dropped below 800. That summer, Tyco CEO Dennis Kozlowski, who’d been named one of BusinessWeek’s Top 25 corporate managers of 2001, was indicted by the Manhattan District Attorney’s office for 82
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criminal tax evasion. More charges of corporate malfeasance would follow, as would tales of Sardinian bacchanalia and wildly expensive shower curtains.* Some of the top managers in Corporate America had been telling analysts and the public one thing, while behind the scenes they were looting and scheming, abetted by conflicted accountants and auditors signing off on their fudged math. Seizing upon the backlash against corporations and Wall Street enablers, an ambitious 43-year-old New York Attorney General, Eliot Spitzer, was on the verge of being reelected to a second term and had quietly placed biased investment bank research practices on his “to crackdown on” list with mutual fund/hedge fund collusion not far behind that. The obligatory period of reckoning after a bust was in full finger pointing mode. The attacks of 9/11, meanwhile, continued to reverberate in ever-expanding ways, putting the country onto war footing and casting a pall over the world economy. With consumer retail as my sandbox, I could at least gravitate toward standby, sturdy, Clydesdale-type companies; buying on the dips, selling on highs, riding those horses on the long side, long term, with more active short selling (borrow, sell, cover, close, borrow, sell, cover, close, repeat) to mitigate the risk of being long *
Former Tyco International Ltd. (Bermuda) CEO Dennis Kozlowski was initially charged June 4, 2002, with conspiring with employees of art galleries and art consultants to avoid paying sales taxes on millions of dollars worth of artwork, according to the New York County District Attorney’s Office web site. The following September, Kozlowski was indicted along with two other Tyco executives on more serious charges of enterprise corruption and grand larceny in connection with the looting of some $170 million from Tyco via unauthorized bonus payments and loans subsequently never repaid and concealed from Tyco’s board of directors. Among the various details of opulent expenditures connected with Kozlowski’s pilfering ways to emerge from the criminal investigation (which was accompanied by an SEC civil suit) and widely reported: a $6,000 shower curtain purchased for the maid’s room of Kozlowski’s Fifth Avenue apartment and $2 million spent on a birthday party on the Italian island of Sardinia for Kozlowski’s then-wife Karen who later divorced him. Kozlowski was convicted in 2005 and sentenced to a minimum of eight and one third years in prison.
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and concentrated. Dawson always talked about buying companies that were positioned to benefit first from recovery, and eventually, we all reasoned, a recovery would come. I knew about the business cycle and understood that overall activity would go from slow to less slow to even busy. With that as my working thesis, I ended up supplying our office with Staples (Nasdaq: SPLS), which had one of the most impressive management teams I had yet seen. The top offices at the office-supplies company were stocked with regular people, like the CFO John Mahoney, who reminded me of a blue-collar guy like my dad, and not a too-slick, best-face-forward Central Casting C-Suite type I so often encountered. Based in Framingham, Massachusetts, outside of Boston, the Staples management team to me seemed plainspoken and incapable of mischievous accounting. I told everyone at the firm that SPLS was my singularly best idea on the long side. To buttress my conviction (and, you know, hedge), I shorted Office Depot. On a Friday in late July of 2002 I recall telling Herman that I felt the stock market, beaten to hell by dot.com hysteria, terrorism, corporate skullduggery, economic slowdown, was, finally, ready to turn around. At six times my cash flow estimate, Staples was fairly cheap ($14–$15). Word in the tight-knit New York hedge fund mafia was that the shorts were nervous and starting to cover. With Herman’s blessing, I aggressively doubled my longs and by the fall the market began to climb again. Staples finished the year at around $18, and eventually it went to $27. I’d picked a winner. This was the most rewarding time in my brief financial career, my first taste of autonomy. That’s what hedge funds did in the 1990s and early 2000s, and why the industry so mushroomed in those years and in the years to follow. A classic long/short equity strategy is only scalable to a point (maybe $1–2 billion, although some hedge fund operations have staked their businesses and public capital on the premise that indeed you can go higher) before you went from nimble woodland fox to lumbering hippopotamus. Better, the best 84
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managers reasoned, to seed new talent to chase down their best ideas. And so they trained younger guys, kept close track of the most talented ones, and then staked them, saying, here kid, go forth and do what you have to do to make money. Use leverage. Short. Go with your “best ideas.” Given enough rope, some guys either hung themselves or lassoed a double-digit return and the chance to run more money, with the cream of the crop eventually hanging out their own shingles. Julian Robertson’s Tiger Management operation spawned a throng of disciples, a group that would eventually number more than three dozen that came to be called Tiger Cubs, guys such as Andreas Halvorsen, Stephen Mandel, Chris Shumway, Paul Touradji, and Dwight Anderson, all running their own hedge funds, growing their subsidiary assets from tens of millions to hundreds of millions to ultimately billions. And while Robertson personally stopped running other people’s money, his 101 Park Avenue offices would serve as home for another group of younger employees at Tiger, next generation Cubs, so to speak, who were running new Tiger funds, guys such as Chase Coleman who ran Tiger Technology, now called Tiger Global, and Tom Facciola and Michael Sears who ran TigerShark Management. Similar hedge fund family trees branched out across the industry. Dawson had recruited Samberg back in the 1980s; Samberg had plucked Benton in the 1990s; Benton went off and founded his own firm (Andor Capital) in 2001 with Chris James as his understudy. Hedge funds were hiring up the best analysts, giving the best of the best assets to manage, and so on, and so on. Along the way, I’d even hired a guy from the sellside to help me follow retail, Harry Schwefel, a Jersey kid who had played hockey at Harvard. Hard working, a tremendous listener, Schwefel worked under the highly regarded Bear Stearns transportation analyst Ed Wolfe. Schwefel turned out to have three times the intellectual firepower I did. While technically he reported to me, it wasn’t 85
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long before I began to consider him less of a protégé and more my equal and partner in analytical pursuits. If the investment banks began having to hike their compensation for talent during the hedge fund bubble years, then Bear Stearns losing an analyst such as Harry Schwefel to the three-year-old Southport Millennium Fund was one of the reasons. Guys weren’t necessarily leaving the Street for more money, rather the future opportunity to make more money. Dawson’s top protégé Herman was putting up impressive returns. Since inception in January 2000 through the end of 2003, the Southport Millennium fund produced a four-year cumulative return of 137 percent. My “carve out” was consistent with those numbers, having helped produce them. I was no Paul Tudor Jones but with a few years of experience under my belt I was putting the arts and sciences of investing, risk management, and macro, to profitable use. Using my composition notebooks as daily logs of everything I was observing during the course of looking at the markets, I found if I wrote something down I remembered it, and I could process it. As a creature of habit, I still used the marble pattern–style notebooks I used when I was at CSFB. I used my notebooks as daily repositories of any relevant fact that I felt I needed to be on top of. I was compulsive. I put in colored tabs to delineate weekly and monthly diary sections, and I was always going back and re-reading sections, always trying to tie the fundamental or micro research—balance sheet data, the bark on the trees in the proverbial forest—with what I was observing above the forest. This renewed fervor with how I conducted my research was right around the time when I realized the importance of grasping macro concepts such as what was happening in China. The rate at which they manufactured goods for the United States and consumed goods themselves bellowed to me that they were going to need raw materials, such as copper. That copper, I theorized further, had to come from somewhere.
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Confined to retail, I nonetheless began following mining stocks, as an aside at first, but by 2003 I not only started to view mining stocks favorably I tried to wrangle a green light to buy some. But whenever I mentioned my idea, all Dawson ever thought of was Bre-X,* the infamous Canadian mining company that in 1997 turned out to be one of the biggest shams in history. Dawson and Herman told to me to stay in my box, and for the most part I did. In 2003, I added some more horses to my stable, sticking with companies I could trust that had macro trends on their side. One of my best positions was McDonald’s (NYSE: MCD). I choked down more Mickey Ds than John Candy in his SCTV prime. I owned MCD in the low teens, and it went to $30. I bought Nike, Inc. (NYSE: NKE), which went on a nice run. I was always buying Nike, my whole career. Following Phil Knight’s Beaverton, Oregon–based footwear juggernaut as closely as I did led me to become pretty good friends with a Morgan Stanley analyst named Brian McGough who knew that company better than anyone and who I found to be one of the few credible sellside analysts. McGough actually went on to work for Nike in its IR (Investor Relations) division as well as a variety of finance jobs for a brief period before returning to Morgan Stanley. Herman and I also hit on our casino consolidation parlay, as Caesars Entertainment and Mandalay Bay both wound up merging, with Harrah’s and MGM Mirage, respectively. My research process was evolving, improving. *
Based in Calgary, Alberta, and trading eventually on the Toronto Stock Exchange, mining company Bre-X Minerals Ltd. in 1996 reported, fictitiously, to have discovered gold deposits worth billions deep in the jungles of the Indonesian island of Borneo, eventually leading to a run up in its stock price that was ultimately obliterated after the fraud was exposed in 1997 following the mysterious death of a Bre-X geologist who either jumped from or was pushed out of a helicopter. The fallout included millions in investor losses and Bre-X remains the biggest securities fraud case in Canadian history.
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To stay grounded, I only traded in basis points.* So if I wanted to buy up more shares of Staples, instead of telling the traders, buy me an impressive round number of shares, instead I’d say, “Buy 25 basis points of SPLS,” which meant to increase the size of the position by one-fourth of one percent of the existing amount of the position, so it didn’t matter if I was moving hundreds of thousands of dollars at a clip, as long as I traded in basis points, or “bips,” to me it could have just as easily been a few hundred dollars. This way, I never let absolute dollar amounts or size influence my trades, because if you are too self-aware, you can feel yourself start to wig out, especially if a position starts to go against you. But honestly, even from my earliest trades I never gave much thought to absolute dollars made or lost. To me, investing was a daily competition and the scoring system was simple: Either the market was ahead of me by a few basis points or I was ahead of it by a few, and I just wanted to win in the worst way. I’ve known PMs that keep ongoing track of their net worth increases down to the last tick, and I’ve heard PMs shout “buy me 200,000 shares” of something because it sounded impressive. Some guys just do it differently, and I liked trading in basis points. Most of the time I was calling my trades into the Southport desk from the road. I lived at conferences because it placed all or many of the management teams I covered in one setting. And of course I always wanted to say, “I just met with those guys.” In an industry that went to great lengths to obtain a research edge, a fresh, from the horse’s mouth update from management was the kind of thing analysts prided themselves on and PMs ate up. By 2003 my new normal was making seven figures. The question in my head was, Could I make eight? Southport Millennium was up 12.47 percent in 2004 and had garnered new assets, including some institutional money. Herman’s *
One one-hundredths of one percent, basis points, first associated with bond yields, are commonly used throughout finance to determine the exact up or down percentage change in the value of any given instrument.
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Millennium fund, while still not as well known as Englander’s Millennium, was now in excess of $800 million. Jon Dawson, meanwhile, had changed the name of his firm for the fourth time, from Dawson-Giammalva Capital Management, to Dawson-Herman Capital Management. ■
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Manhattan real estate prices rocketed in tandem with the rise of the hedgehogs, starting in the 2003–2004 period. Having a penthouse apartment in a trendy neighborhood was one measure of wealth, sports cars and Hummers another. While I had no interest in keeping up with the Tudor Joneses, I did buy land in Thunder Bay, right on Lake Superior, and built a three-story log cabin–style home. I recall asking my younger brother Ryan to find the best possible piece of for-sale shorefront available, and he found one of the last lots that had not been built on. In December 2003, while I was home for Christmas, Ryan and I had trudged through snow up to our waist, through a forest of towering pines, and onto a rocky stretch of beach on Lake Superior. In a scene straight out of a Gordon Lightfoot ballad, or maybe The Beachcombers, the wind was whipping in off the lake, the temperature so low it defied thermometer. My younger brother, who’d done a lot of carpentry and contracting work, looked out at the steel gray water and asked me what I thought. “We have to build a house here,” I said. “Yeah,” Ryan nodded. “Yeah, we do.” I hadn’t made it to the NHL, as many from my hometown had done. But I would have the biggest house on the lake. ■
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My ascent up the income ladder coincided with the hedge fund industry’s coming out party. BusinessWeek did a cover story in July 2003 89
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titled “The Most Powerful Trader on Wall Street You’ve Never Heard Of.” The story, which was on Steven A. “Stevie” Cohen’s SAC Capital Advisors, began: A gunmetal-gray BMW 745 Li sedan slips out of Steven A. Cohen’s 14-acre walled estate. The chauffeured car races along the winding backcountry hills of ultrawealthy Greenwich, Conn. At around 8 A.M., it powers into the parking lot of SAC Capital Advisors.
On Wall Street, Cohen was godlike. No one on the sell or buyside did not know who he was. That his trading operation was said to represent as much as 3 percent of NYSE trading volume, as BusinessWeek asserted, would have not come as a shock to anyone in the business. Hedge funds and the ever-gaudier compensation that became associated with them were becoming exposed in the mainstream. That shocked people, even on the Street. Institutional Investor launched a sister publication, Alpha, to cover the hedge fund scene. Its inaugural list of the richest hedge fund earners came out in 2002, with George Soros at the top, having earned $700 million. Alpha’s Top 25 hedge fund rich list wound up getting coverage in the New York Post’s Page Six column. New York magazine, chronicler of Big Apple trends since the days of the mini-skirt, published a story in November 2004, “Get Rich Quickest,” which led with the tale of a 27-year-old former snowboarder turned hedge fund employee named Zachary R. George of Norwalk, Connecticut–based Pirate Capital. In the opening anecdote, George busts the chops of a CEO who is more than twice his age, and he gets away with it because the $200-million-in-assets Pirate was the guy’s largest shareholder. “I’m not trying to be an asshole,” George explains to the CEO at one point in the top of the article, emphasis on the word trying. The phrasing, coupled with a reference to a life-size wooden pirate in a conference room, suggests that the young hedge fund guy may indeed be one. The article, by Steve Fishman, continued: 90
Flying with the Giants In the past few years, running a few hundred million dollars for a hedge fund—and taking tens of millions for yourself—has become the going Wall Street dream.
Around the same time that article ran, a brand-new glossy magazine was launched, created by a 30-year-old former Refco futures trading executive named Magnus Greaves. Billed as GQ meets Forbes, Trader Monthly threw two launch parties, one at the Hard Rock in Chicago and another in a ballroom on the top of the Mandarin Oriental Hotel at the just opened Time Warner Center in Columbus Circle featuring cigars, cognac, a contortionist, and a James Brown impersonator. The magazine published its own ranking of the highest earning hedge fund traders, putting Cohen at the top of its inaugural list with an estimated 2003 income of at least $500 million. Within a few years Cohen and a slew of other hedge fund managers would supposedly earn more than twice that in their capacity as owners of their asset management businesses, with fee revenue estimates based on assets under management and investment return estimates serving as the editors’ starting off point for an extrapolation of a hedge hog’s total annual take-home, after expenses. The magazine’s early Top 100 Highest Earning Traders lists in some cases failed to capture hedge fund income ranges, which more often turned out to be even higher than what had been estimated. A period when individual earthlings could pay themselves ten figures for one year’s work was at hand, and it wasn’t just in New York. London’s trading scene exploded with equally staggering sums of money in play, as the city’s Mayfair section, historically home to old London money, was transformed into Hedge Row. Hedge funds were being formed in the money centers (New York, London, Chicago) by increasingly younger money managers, with astounding infusions of money right out of the gate. Eric Mindich, a 37-year-old partner at hedge fund farm system Goldman Sachs (which produced Leon Cooperman, David Tepper, Tom Steyer, Dan Och, 91
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and Richard Perry, among others) started his fund operation, Eton Park Capital Management, in late 2004 with $3.5 billion in capital commitments, believed to be the single largest hedge fund startup ever. “Whippersnapper” William von Mueffling bolted from Bruce Wasserstein’s prestigious Lazard Asset Management in 2003 at age 34 to start his own firm, Cantillon Capital Management. Within two years he was running as much as $8 billion. After Enron imploded, one of its Houston-based energy traders, a 27-year-old named John Arnold, after helping the wounded company unwind its huge positions in the market, started up in 2002 a hedge fund, Centaurus Energy. Within a few years he made nearly “two thousand bucks”* on a massive natural gas short squeeze. Another participant in the hedge fund youth rally was PayPal cofounder Peter Thiel, who became a multimillionaire when eBay bought PayPal in 2002. But before he became well known as an entrepreneur, Thiel traded derivatives at Credit Suisse. After his PayPal success, Thiel focused on his global macro hedge fund, Clarium Capital Management, which would eventually make him a billionaire. Ken Griffin, the founder of Chicago-based Citadel Investment Group, made the Forbes 400 list in 2003 at age 34, although his hedge fund journey had begun back in November 1990 with $4 million. Lehman-slayer David Einhorn started his Greenlight Capital fund in 1996 at age 27 with $900,000 borrowed from his parents, and he was managing $6 billion by the time he finished with Dick Fuld. Einhorn had started out on Wall Street and insinuated his way into the hedge fund field, like a lot of guys did and a lot more were trying to do. Former investment bankers formed hedge funds ( John Paulson, who made billions shorting subprime, was a product of the Bear Stearns M&A department); former mutual fund managers, such as ex-Magellan helmsman Jeffrey Vinik and ex-Pimco fixed-income *
On Wall Street, a “buck” became code for one million. Seriously.
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PM Anthony Faillace, started funds. Non-financial types got into the game too: Phillip Goldstein, the hedge fund manager who successfully sued the SEC to thwart regulation of hedge funds, worked as a civil engineer for the City of New York before starting his fund. T. Boone Pickens turned his experiences as an oil company geologist into what at one time was a multi-billion-dollar hedge fund. Jim Simons, at one time a Department of Defense code breaker, was a math professor at Stony Brook University on Long Island before he created computer model-based monstrosity Renaissance, now one of the largest hedge fund operations in existence. Hedge fund managers became stereotyped as entitled, arrogant pricks, but there were so many different subsets of personalities in play in the industry that it was ludicrous to try to label them in any regard. That said, hedge fund managers could be brainy quants such as Simons or David Shaw; totally under-the-radar types like Seth Klarman of Baupost Group; fun-loving high rollers like Jim Chanos and Paul Tudor Jones, whose Robin Hood charity gala became one of the biggest events of the year not unlike his mansion’s Christmas lights unveiling; or your activist ball-busters like Einhorn, or Dan Loeb of Third Point and Bill Ackman of Pershing Square. Jocks like me who played Ivy League hockey took their place in the line dance, with unassuming guys such as Phil Falcone (Harbinger) and Tim Barakett (Atticus), both of whom played hockey for Harvard, becoming owners of their own hedge fund firms and managing billions. Some hedge fund managers, such as Dmitry Balyasny, were not yet 30 but pulling down tens of millions. Balyasny had come out of a daytrading firm, Steve Schonfeld’s shop, one of the few survivors from the tech bubble era. Twenty-somethings who once joy rode stocks like JDSU to the tune of hundreds of thousands were now decamping from the sellside and running million-dollar hedge funds, mostly seeded by other hedge fund managers. Hedge funds became the new dot.com phenomenon, the place to be, the thing to do. In December 2004, Mark Cuban, who made enough money selling his 93
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Broadcast.com to Yahoo! during the height of the tech boom to buy the Dallas Mavericks, announced that he was forming a hedge fund. So the dot.com bubble had given way to a financial bubble. Against this backdrop, in January 2005, Jon Dawson gave the green light to the creation of a hedge fund that I would personally manage, and in the process made me the number three PM at the firm behind Herman. The Southport Consumer Discovery Fund was formed quietly in that first quarter with some friends and family money, a few million, some of it my money. It’s what’s known in the industry as a “soft launch.” I now had more sway in the overall operation. Although Dawson had rejected my idea to name the new fund the Vancouver Discovery Fund, after explorer George Vancouver whose ship was called The Discovery. Harkening back the Bre-X scandal and other episodes that had tarnished the reputations of the Calgary and Vancouver stock exchanges,* Dawson basically told me my fund naming idea was a nonstarter. As a young portfolio manager, I began to constantly try to reconcile my inclination to make bold concentrated bets with the other part of me that wanted to break free from my sector vacuum to find a way to own a collection of uncorrelated assets that put me in the position of having a winner somewhere in the portfolio; a scenario plan that would better allow me to run the fund day to day without being perpetually terrified of losing money. My attitude, shared by my colleagues, was to do so much intensive, hands on, outside conventional thinking research, such exhaustive homework that there could be no second guessing ourselves, so steeped we’d be in our convictions. We were getting really good at what we did *
Bre-X originally traded in cents on the Calgary Stock Exchange; it and the Vancouver Stock Exchange became notorious for supposed lax listing standards, leading to scams and swindles tracing back to scandals involving bogus uranium companies five decades ago, according to a New York Times article written in 1997 by Floyd Norris.
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and always pushing ourselves harder. To better spot deception during research meetings Tom Tobin and I read books on Kinesic* interview techniques. Something happened in the first quarter of 2005 that convinced me that perhaps I was not in over my head, that likely I was as good as any hedge fund manager out there. Wal-Mart was hosting an investor gathering in China for PMs and analysts from all over the world to come and get a firsthand overview of the big picture as it related to the future of the Bentonville, Arkansas–based retail monstrosity and its symbiosis with China where most of the cheap goods it sold were being made. I boarded a Cathay Pacific flight to Hong Kong, the first leg of the journey, and happened to notice that a few rows ahead of me in first class was one of the biggest, best-known hedge fund managers in the world. I’ll call him “The Giant.” I watched him on and off for pretty much the whole 14-hour flight. While I devoured the contents of multiple canvas bags overstuffed with reading material, there’s The Giant, sprawled out like he’s in his home theatre, shirt open, shoes off, stuffing his face with all the free caviar the stewardesses could feed him (and free caviar wasn’t all you got when you flew Cathay Pacific to Asia; there was also wine, shrimp, cheese, sweets). This guy, The Giant, he watched movies, he racked out. Meanwhile, I read, researched, worked. I came away that night-day convinced The Giant was weak, and that if this was how the biggest and best hedge fund managers rolled, well, I needed not ever worry again about how I measured up. I wasn’t just as good. I was better. *
The study of nonverbal communication (body language) pioneered in 1950s by anthropologist Ray Birdwhistell. Specifically, we read two books on Kinesics, The Art of Lying by Kazuo Sakai, M.D., and Nakana Ide, and Principles of Kinesic Interview and Interrogation by Stan B. Walters.
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n April 13, 2005, not long after my 30th birthday, the following e-mail was sent out all over Wall Street: To: Our Friends From: Jon Dawson We would like to announce formally that during the first quarter, we launched the Southport Consumer Discovery Fund—a long/short equity fund concentrating on global consumer companies. The Fund is managed by Keith McCullough. Keith joined our firm nearly five years ago. Through a combination of hard work (a grueling travel schedule), a solid sense of macroeconomics, a keen sense of judgment, and a commonsense approach to investing, Keith has made a meaningful contribution to all our firm’s products. He has proven a leader of our consumer team. Keith also serves on our firm’s board of directors. He has managed a carve-out of Millennium 99
d i ary of a h e dg e f und manag e r for over three years with impressive success as well as a carve-out in Millennium Microcap since its inception in January 2004. In the difficult first quarter of 2005, Consumer Discovery had modestly positive results. If you have any interest in the new Fund, please contact Noreen in our Connecticut office.
Now I can’t say Noreen was deluged by inquiries. But for a well-respected, trail-blazing hedge fund manager such as Jon Dawson to sing my praises in print, to people in every corner of the money management, banking, and securities trading industries, that was profoundly legitimizing, and meant the world to me. It was like being made, not that I saw myself as part of the hedge fund mafia. Far from it. Ever since the Pacific Sunwear fiasco I made it a habit not to consort with my hedge fund brethren during conference events or following 3-on-1 meetings, which put a CEO or CFO in a room with three analysts or PMs at a time. These meetings were starting to become the norm because of how many hedge funds were paying for access to management—they couldn’t all be accommodated. If, after a meeting ended, I saw that one of the other analysts or PMs was even remotely looking in my direction I simply pretended to be on the phone. Sometimes, when a group of buysiders approached me to “pick my brain” (confirm that my takeaway jibed with theirs) I just began talking to myself as if I were sporting the world’s most inconspicuous hands-free device, an absurd, not at all sly, but nevertheless effective antidote to poisonous groupthink. Yet for all of my efforts at nurturing self-discipline and to steadfastly stand apart from the hedge fund mafia crowd, there were times when I fell right into the honey traps of life in the hedge fund bubble. In the middle of the summer of 2005 I was part of a small group of analysts and PMs invited by a major bank to an exclusive golf outing at the world-renowned Bandon Dunes Golf Resort out on the majestic, jagged Oregon coastline, billed as the best golfing anywhere this side of Scotland. Where Bill Gates golfed. Golf heaven. 100
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At this time I still had a significant long position in Nike and a short one in Reebok International (NYSE: RBK). I might have noticed all of the Adidas golf shoes in the pro shop and on the links, but if I didn’t, it may have been because by day’s end I had a cigar the size of a striped bass lodged in my teeth and an unlimited array of vintage Scotch whiskeys. Not much was on mind as my hedge fund brethren and I sat around a fire pit outside the restaurant, looking out on a vast expanse of beautifully manicured landscaping, like a group of turn-of-the-century industrialists. Sufficiently gassed up, feeling as if this one time I could sleep in, I set my alarm for 5:30 a.m. instead of my usual 2:30 a.m. West Coast routine. I woke up hung over, beyond parched, my mouth tasting as if a smoldering campfire had been emptied into it. No matter how much I gagged or spit or coughed or gargled or brushed my teeth, I couldn’t lose the sludge-like film that permeated my tongue and throat. The phone was ringing off the hook but I didn’t answer—I couldn’t talk. Finally, I answered. It was Harry. Reebok was being acquired by Adidas-Salomon AG. My short position was getting clobbered! What should they do, what the heck happened, where the hell have you been? Reebok, taken out, and not only was I short, not only did I not see it coming, I didn’t even know it was happening now. I had no access to a computer or a television, or my cell phone, and most cruelly, no ability to formulate sentences. I tried to mumble something, but what came out was the unmistakable sound of a cat spitting up a hairball. This was an ultimate crushing. Somewhere a French Canadian deejay spun a K.C. and the Sunshine Band 45-inch record and gyrated hyperactively in my honor. I can still taste that stogie. Typical. The one time I decide to sleep in, I get jumped. But I couldn’t beat myself up too much. The merger would have gone down regardless of whether I was up crazy-early. No one held it against me. I’d make it through this earnings season, shake off the Dunes debacle. But I was already 101
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starting to question the idea of working my tail off for someone else. I was shifting to a new mindset myself. ■
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As the summer of 2005 wore on, new hedge fund firms continued to pop up, with new launches continually outmatching the previous ones. In Boston, Jack Meyer, the outgoing CIO of Harvard Management Company who had used alternative investments such as hedge funds and private equity to grow the university’s endowment from $5 billion to $20 billion in a decade and a half, was said to be readying a hedge fund outfit, Convexity Capital, expected to open with between $4 billion and $6 billion, which if achieved would make it the largest hedge fund launch ever. Convexity’s minimum investment threshold would be $25 million. Meanwhile, outside Chicago, in Evanston, Illinois, the 39-year-old former head of equity trading at Citadel, Alec Litowitz, was building a 12,000-square-foot headquarters in preparation for the co-launch of a $2 billion hedge fund operation, Magnetar Capital, which would be among the top four largest hedge fund launches of all time. Portfolio managers such as Litowitz, from well-established firms, such as Citadel, were marching off on their own and starting vehicles that even before they officially open for business attract commitments of multiple billions. Everyone in my industry ran the calculations: Start off your fund with even $1 billion; factor in the off-the-top management fee of 2 percent (the standby “1 & 20” was long gone, with some guys commanding “3 & 30” and even higher), it wasn’t a second and a half before you realized you could pocket “twenty bucks” just for turning on the lights. We all did the math. While I wasn’t averse to making more money, thrilled with how well I was doing, my motivations at this time, looking back, had more to do with turning 30 and feeling the need to ditch the 102
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Manhattan bachelor life for something more stabilizing. I bought a spacious house next to a horse farm in a woodsy area of Yorktown Heights in Westchester County. Something about the still very rural parts of the area (minutes from the Taconic Parkway and within a few miles of the Jefferson Valley Mall) reminded me a little bit of Thunder Bay. Personally, I was done with one way of life and opening myself up to another. Not long after I flipped this switch, I began steadily dating Laura, a sellside analyst and a former classmate at Yale who would never go out with me in college. Professionally, though, I could not resist the siren song of starting my own fund. With Southport Consumer Discovery I had a taste of running my own business and wanted to experience the real thing. True autonomy. I wasn’t sure how I was going to break the news to the people who took a chance on me and made my career, but toward the end of the third quarter of 2005 this Mucker’s mind was made up. I spoke with Harry. It was time.
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Falconhenge Partners, LLC, took flight in the late autumn of 2005 operating out of a sparsely furnished spare bedroom on the second floor of my house in Yorktown Heights. Harry and I arrived at the name Falconhenge after careful deliberation, utilizing the same diligence and thoughtful analysis we normally mustered for our investment research. Some guys named their funds and/or their management companies using street or city names (Pequot, Southport) or their last names (Paulson & Co., Perry Capital) or an initials/last name combo (D.E. Shaw) or just their initials (SAC Capital, ESL Investments) or their middle name (the Moore in Moore Capital Management is Lewis Bacon’s middle name) or an amalgam of the founding partners’ initials (Noam Gottesman, Pierre LaGrange, 103
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and Jonathan Green formed GLG) or invoking Greek mythology (Stephen Feinberg’s Cerberus Capital Management, named for a Hades guarding, multi-headed dog-beast) or Greek etymology ( Jim Chanos’ Kynikos Associates is named for the Greek word for cynic) or science (George Soros’s Quantum fund) or prehistoric creatures ( Jim Pallotta’s Raptor funds) or perhaps, most suitably considering the times, astronomical terms—Alec Litowitz’s Magnetar was named for a powerfully magnetic neutron star and while it sounds like a mythic beast Centaurus is named for the constellation. A bird of prey inspired ex-Tiger Management trader Dwight Anderson, who named his fund Ospraie. I am not sure if Harry or I thought about that when we began to gravitate toward the idea of using “falcon” in our name but a masterful hunter bird was only a part of the riff we had going. (Citigroup would later launch a credit fund named Falcon Strategies that got absolutely hammered). Since we were determined to build something long lasting, Stonehenge was another word we bandied about until ultimately we decided to merge the two, agreeing to think the falcon part through even more because we didn’t want to find out later something about the way falcons behaved that might undercut what it was we were trying to convey. When I set my mind to something, I didn’t go halfway—remember, before leaving Dawson-Herman, Tom Tobin and I were in the midst of studying kinesics techniques—so it should be of no surprise to learn we actually traveled to Vermont to attend a Falconer course at the British School of Falconry at a resort called The Equinox. So if anyone asked us “why Falconhenge?” we could at least discuss the origins of our chosen identity with some level of understanding of the ways of a falcon—how it studies its surroundings, hones in on its prey, swoops down, and strikes its victims flashing talons in a blink of an eye before making a speedy getaway. I noticed when shopping for prime brokers how everyone we spoke with asked us about the name, but no one ever really listened when we gave them the story. 104
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Identifying a prime broker was one of the first things on the hedge fund startup “to do” list. The PBs essentially did concierge for hedge funds, dispensing teams dedicated to handling funds’ bookkeeping, asset custody, the clearing and settling of all of their trades. The PBs loaned hedge funds money, margin accounts (funded by further borrowing), and finally, but not least important, the PBs introduced hedge funds to sources of capital (“Cap Intro”) such as other hedge fund managers and feeder funds a.k.a. funds of funds and major Wall Street figures with their own millions to invest. Finding a prime broker is but one of a multitude of tasks involved in starting up a hedge fund firm including, but not limited to, hiring lawyers, an administrator, auditor, accountant, key staffers such as an operations manager, a compliance director, and someone to head fundraising (directly on staff or as a third-party marketer). Also high up on the to-do list: preparing Offering Documents, including the Private Placement Memorandum (which is not unlike a mutual fund prospectus, spelling out the specifics of the fund and its fees and objectives) and the Subscription Documents for investors to fill out. Then there’s the task of organizing under the laws of Delaware as a management company, specifically as a Limited Liability Company, or LLC. This structure is used for favorable, pass-through* tax treatment and, as the corporate distinction implies, to limit the principals’ liability. The actual funds are structured as Limited Partnerships, or LPs, also pass-through entities, but slightly different from LLCs in that an LP better allows General Partners flexibility to control the fund and invest in it alongside Limited Partners while enjoying the same protections. And if legally incorporating isn’t mind-boggling enough, then there’s securing a Portfolio Management System; sorting out a world of IT issues; creating a pitch book/electronic slide show with which to court *
The profits and losses of LLCs, unlike corporations, are not taxed at the entity level. Instead, they pass through and are taxed at the general partner and shareholder level.
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investors such as large feeder funds, also known as funds of funds; finding office space; did I mention getting furniture? For this I was fairly lucky; my younger brother Ryan was a handy craftsman. He’s the kind of guy where if you give him some tools and some materials and he can make anything. I had him come to my house and build me a customized, multi-level trading desk. At first, the spare room office was just me, and Harry, who still lived in Manhattan, commuted to my home office in Yorktown Heights. We sat around for days on end going over all the preparation. Some quick hires made things easier. For head of operations I tapped my old Yale bud in the Bay Area, Michael Blum, who had ended up working for PayPal and who made out when it was acquired by eBay. He was just about to head off to Hong Kong when I convinced him to join us at Falconhenge, which meant instead of the Far East Michael would be living in Far Westchester, at my house. We decided for practical purposes to ditch the enormodesk my brother had built and instead install smaller desks purchased at Ikea, but when we went to move Biggie we found we couldn’t get it out the door—knowing my specs, my brother had started construction from scratch right in the room. Anyone who ever fancied hedge fund managers living glamorous lives should have seen Michael and me, both wielding power saws, carving this wooden creation into firewood late into the evening. But we got the job done. Vikram Pandit couldn’t have dismantled a trading desk with any more efficiency. ■
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For the role of chief asset gatherer/head of marketing, we tapped my old boss at Credit Suisse, Tom Ferraro, a guy considered one of the industry’s most talented equity salesmen, and who had run the Street’s top technology research sales team. He covered all the biggest hedge funds, such as Pequot and SAC. Due to our history, 106
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Falconhenge went with Credit Suisse as prime broker. PBs were and remain a vital component of the hedge fund scene, a reason why some funds were able to grow so large so fast, and every major bank (Goldman, Lehman, Morgan Stanley) chased the prime brokerage business greedily, gravitating, of course, with laser-like focus, to the largest funds. This left smaller ones to make due. Because Credit Suisse knew us, we figured we’d get better service than if we were a low fund on the Morgan Stanley or Goldman totem pole. We (and a lot of people in the buyside community) viewed Morgan Stanley as being the best PB on the Street at that time. MS had the most experienced prime brokerage team; the best technology; and their model was most aligned with putting the client first, with senior people focused on helping even small funds such as ours achieve success. Goldman we found less impressive. In fact, the firm’s PB representatives behaved with a nauseating sense of entitlement. During our meeting with Goldman, it was insultingly apparent they’d sent in the B-team. I could tell they had very little experience on Wall Street and here they were telling me what I should be doing to get Goldman’s attention. It was ass backward, so much so that in the middle of the meeting I stood up, walked out, went and got coffee and then came back. I realized that with Goldman, if you weren’t a $1 billion fund, you got the B-team. Suffice to say Goldman wasn’t getting my business. One of the lesser understood elements of the hedge fund boom is just who were all these people so willing to plunk down all this money, and at such steep fees, with such little information flow and restrictive lockups? Whose $1.5 trillion—the amount estimated to be sitting invested in hedge funds by the end 2005—are we even talking about? A lot of the money belonged to institutional investors, pension funds, insurance companies, sovereigns, Swiss banks, and a lot of it belonged to rich individuals, family offices, real estate moguls, or Middle Eastern sheiks. I can tell you also that many hedge fund “clients” in many cases were the very people who worked on Wall Street 107
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and used their connections to gain admittance to the best-performing funds. There was a time when to invest in a hedge fund you had to be considered an “accredited” or “qualified” investor, or someone with a total net worth of $1 million or annual income of $200,000; now, as hedge funds became increasingly sought out, their minimum investments could be as much as $5 million or higher, meaning that many of the types who could afford such minimums worked in high-paying industries, such as those working on Wall Street, and at hedge funds. Make no mistake, our fund targeted big hedge fund managers as potential investors. Right away, Ferraro helped me secure an audience with a slew of hedge fund heavyweights looking to park some of their own wealth in outside funds, some of them I had seen before while a Credit Suisse grunt, some of whom I’d seen in other circumstances. Sure enough, one day I found myself seated across from none other than The Giant. I half expected him to belch caviar on me. He sat slumped back behind a conference table, leaning back in his chair, hands crossed behind his head, his tie flipped back over his shoulder, looking at me with a vague sense of knowing who I was and sounding like every other hedge fund guy, asking me “so, what’s your best idea?” First of all, the tendency for industry members to frame everything into “best ideas” on the one hand is sort of useful, makes sense, but yet on the other hand, it’s the exact same question everyone else is asking, parroting, unoriginally what they think is the expected language of the realm. But since I was looking to make an impression (The Giant by this time had certainly made one on me) and seeing as I had fairly recently attended the annual Prospectors & Developers Association of Canada expo at the Metro Toronto Convention Centre, one of the largest, most important gatherings of mining industry executives from all over the world, I was bullish on mining, and told The Giant as much. Turns out, I said, one of the richest gold mines in the world operated in Red Lake, Ontario, just north of 108
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Thunder Bay where I had contacts on the ground, guys in the industry that my brother knew. The Giant gave me a look that said I know you, you’re that retail guy from Jon Dawson’s shop, what the Christ do you know about mining stocks? And then, in a gruff, gravelly tone, he just blurted it out: “Mining stocks? What do you know about mining stocks?” My back stiffening up, and speaking in brisk sound bites, I went on the offensive, rattling off some macroeconomic trend observations (global inflation, rising commodities prices, demand for raw materials in China) but it was clear to me he wasn’t hearing any of it. What did I know about mining? The Giant’s disdain infuriated me to no end. Here I had told him of one of the most informative research trips I had ever taken—I had done a sort of mining industry immersion, met all the main players—and I had sources on the ground miles from a mining hub, what did I know—what did he think he could possibly know about mining sitting here one block from Park Avenue? Anyway, I told him my best ideas were FreeportMcMoRan Copper & Gold (NYSE: FCX) and Phelps Dodge Corp. (NYSE: PD) and thanked him for his time. When I left the office I was practically running a fever. The Giant passed on the investment opportunity. Within the year, FCX and PD announced they were merging in a deal valued at $26 billion. I would later find out FCX became one of The Giant’s single biggest positions. ■
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On January 3, 2006, Falconhenge Partners officially began trading. We bought shares of our favorite mining, restaurant, and hotel companies, executing my trades through Williams Trading and logging them into my notebook by hand. This was capitalism. I loved it. By this time, Harry, Michael, Tom, and I had moved into office space at a trading firm called Pali Capital in Midtown. Pali, one of the industry’s many “hedge fund hotels,” sublet to several other 109
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funds, many of them momentum growth funds. Most of Pali’s “guests” tended to trade through their execution desk, sending the firm per share commissions to help offset the cost of renting space (but we paid for the space in hard dollars and used Williams Trading, where I had once interned, for execution). Williams had since relocated to a much larger space in Stamford, Connecticut. Our fund was no record-breaking startup, mainly my own money and friends’ and colleagues’ money. We were close to landing a major endowment as well as a private Asian investor. After a normal gestation period, our prospects looked favorable. As our prime broker, Credit Suisse had provided a softwarebased connectivity system so that the trades we executed through the Williams desk could be synced up and reconciled with our actual dollar denominated assets held in an account with the prime broker who would track the value of our positions at the end of each day’s market session, in effect settling our scores in cyberspace, scores to legally be settled up via the Depository Trust & Clearing Corporation (DTCC). It takes up to four days for shares of stock to go from electronic line item in some bank or broker’s system to a point where the shares, bought or sold, are actually delivered to the DTCC, sort of the giant escrow account in the sky. The DTCC is a joint subsidiary of all the big Wall Street firms, not a government entity, and shares are not so much delivered as they are entered into an electronic system at the DTCC. However, the more important transactional element to keep in mind for this whole diversion here is this: money and shares changing hands. When I did a trade, I assumed that the system we had set up tracked that indeed money changed hands. However, due to a problem with the software that our prime broker contact at Credit Suisse foisted on us, a system purported to be their own but which turned out to be a third party, our trades that very first day could not be settled up. When we checked our balance at our prime brokerage account online, it read zero. 110
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Michael Blum, our German-born, Asia-reared operations chief, hand calculated the trades we’d done so we had some semblance of an idea how we’d done our first day and what we were working with. Then he complained to our prime broker, who sent us some kid to sort it out. This fellow didn’t know a thing about the glitch that was keeping our accounts from reconciling and said he’d look into it, although instead of looking into it he sat around the office trying to pitch us on a bar-restaurant he had designed and was trying to open in Manhattan. By our third day, due to this same glitch, none of trades had actually been executed, or rather there was no record of them having been executed. This was going to be a huge problem because by day four the DTCC’s delivery rules would come into play, and there would be confusion and consternation and questions about the legitimacy of our trades, which so far our prime broker had no record of ever having been transacted. One week in and we were already stumbling around, not how I envisioned it. I yelled at Blum who yelled at the guys at Credit Suisse, who ultimately fixed the problem, but whom we ultimately fired as our prime broker. We replaced Credit Suisse with Morgan Stanley, which took over the account as of the end of the month. ■
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During the first quarter of 2006, Tom Ferraro, Harry, and myself probably met with representatives of more than a dozen funds of funds, self-appointed gatekeepers, toll collectors more or less, or what they would pitch as one-stop shopping for high-net-worth individuals and institutional investors looking for a diverse palate of top performing hedge funds, as well as some professional oversight. Even a state pension fund system with a sizable staff of young and veteran professionals (as well as seasoned outside consultants at their disposal) still did not have enough resources to truly make sure the money managers, hedge funds or otherwise, that they hired and entrusted 111
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with retiree assets actually did what they said they were going to do. FOFs sold the pension funds and endowments and family offices on the idea of a fund of other hedge funds with due diligence and supervision as a selling point, justifying not one but two sets of fees, the FOF’s fee and the ones charged by the funds in the FOF. When Madoff was exposed so were the funds of funds that sold themselves on due diligence. I still shake my head at FOFs. My career had not been without raw moments of supreme disillusionment, but the series of meetings I had with this crowd left me with almost the same foul taste in my mouth as the Bandon Dunes stogie. First, the FOF crowd did not take kindly to the fact that most of the money in the fund was my own. This meant, according to their logic, I was disinclined to take risk, and they wanted funds that took risks. It was clear to me from my experience talking with FOF gatekeepers that with their two layers of fees they needed someone in their stable of funds to always be knocking the cover off the ball to make up for any other lost ground or mere moderate performance. The FOFs usually asked us about our Fund Overview materials. Sometimes we sat in a room with the presentations right up there on wall as a PowerPoint slide show. Harry and I poured our time and energy into the darn thing and sure, it’s just a set of investment-speak bullet points, but the way we summed up the investment approach was as important as anything else we did launching the fund. The FOF crowd not only didn’t seem to get our mission statement/pitch materials, they sometimes seemed put off by them. No one could take issue with our objective: To achieve positive absolute returns irrespective of global equity market conditions. But when we got into our Investment Approach the responses could get interesting. For example, we wrote: Our Mission: To Manage a High Conviction, Highly Concentrated Portfolio. Process driven, cash flow focused. Our proprietary modeling and valuation process uncovers undervalued cash flow opportunities that are out of favor with conventional consensus. The FOF people 112
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asked, what are you saying, that you’re smarter than everybody else? We wrote: Short Selling for Absolute Return not to manage Net Exposure. Our idea generation on the short side is born out of a pool of consensus, hype, and momentum. Their response: You short momentum? But most of our funds are momentum! I suppose I might have picked up on other fund managers in the elevators or lobby of the Hotel Pali Capital, with everyone talking up “mo stocks” but I had my own style, and let’s just say it wasn’t what the FOFs were looking for. ■
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Disillusioned with funds of funds and fund raising in general, not to mention prime brokers, I focused on the one thing I could control—investing. For the first quarter of 2006, Falconhenge Partners I produced a return of +6.43 percent, 270 basis points better than the S&P. Among other things we booked some solid gains on a long position in Cracker Barrel (NYSE: CBRL). We reported our performance to our small community of investors in a client letter dated April 3, 2006. This letter contained one other crucial piece of news. The hunters had become the hunted—we were unraveling the fund.
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hen stars many times the size of our sun burn out in that cosmic conflagration known as a supernova, they leave behind a dense field of remnant particles, a mass that spins furiously around into a brand new kind of star, known as a neutron star, emitting magnetic fields one-thousand-trillion times more powerful than earth’s magnetic field. Imagine a magnet so strong that if pointed at the Empire State Building it would cause the skyscraper to twirl like a paper clip, with its attachment occurring in the blink of an eye. Astronomers call these magnetic stars magnetars. In the summer of 2006, a team of scientists at the National Radio Astronomy Observatory detected never-before seen activity coming from one particular magnetar an estimated 10,000 lightyears away. The object originally had been discovered in 2003 by NASA scientists and named XTE J1810–197. Magnetars did not emit radio waves, or at least they were not believed to. Bursts of 117
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X-rays, yes; radio waves, no. But a Columbia University astronomer named Jules Halpern surprisingly discovered that this XTE J1810–197 was, indeed, mystifyingly, emitting radio waves. Baffled astronomers around the world took aim at solving the puzzle. Scott Ransom of the National Radio Astronomy Observatory issued the following statement in August 2006: “We’ll continue monitoring this crazy object with as many telescopes as we can get our hands on and as often as possible. Hopefully seeing all these changes with time will give us a deeper understanding of what is really going on in this extreme environment.” ■
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It didn’t take a NASA scientist to see what was going on in the superheated hedge fund industry, i.e., hot money chasing hot returns, competing for the same ideas, crowding into the same trades. The ability for hedge fund managers to keep up with demand for returns, while amassing increasingly enormous sums, produced a sort of global scale arms race less reminiscent of the Cold War and more in line with that annual event in which a bunch of English hooligans chase a rolling wheel of cheese down a steep hill. Few money managers had shown the ability to be able to both run a book and run a business. Running a hedge fund meant finding the best people, itself a gamble with a fleeting upside. If a trader was any good, he or she demanded a bigger cut of spoils or left to make more money somewhere else or launch his or her own fund. If a trader wasn’t any good, well, he or she lost money. By the time we closed the books on the first quarter of 2006, our first ever quarter in operation, Falconhenge was getting noticed. We were being approached by other, larger hedge funds with offers to run significant amounts of money. This was interesting. Some of our Global Consumer ideas—the LBO horse was out of the barn and we’d identified several companies, such as Outback Steakhouse 118
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and Four Seasons Hotel, as prime takeover candidates—were going to play out over the ensuing quarters. To truly participate in and profit from the cycle, we needed capital, now. We saw our window. The funds that looked at us did not want to be our client; instead, we would become part of their company. One manager’s pitch involved the chance to run a book in the neighborhood of $300 million. Timing and size was everything in this business. The magnetic pull of the economics of such a large pool was too powerful to resist. That pitch had been made to us by Ross Laser, the co-founder of Magnetar Capital. Laser and Magnetar’s co-founder, ex-Citadel star trader Alec Litowitz, were creating one of the most talked-about hedge funds in the business. By the second quarter of 2006, around its one-year anniversary, Magnetar was coming up on the $3 billion mark, remaining in explosive growth mode, attracting money and industry talent in neutron-star–worthy fashion. Magnetar was attempting to create one mother of a “Multi Strategy” hedge fund, comprising a wide range of a dozen or so separate strategies, dabbling in standard and exotic asset classes, scouring markets in every corner of the planet. The fund mixed merger arbitrage, in which Litowitz specialized at his former employer Citadel, along with other forms of arbitrage, as well as long/short global equity, long-only equity, event driven strategies, distressed credit, private placements, direct lending, and PIPEs (Private Investments in Public Equities). It even embarked on a reinsurance industry strategy, setting up a Class 3 Bermuda company, Pulsar Re, to take advantage of opportunities caused by the fallout in the reinsurance industry following Hurricane Katrina. Magnetar was also a major investor in asset-backed instruments called collateralized debt obligations, or CDOs. Some of these CDOs comprised pools of mortgage streams, and some of those streams including debts pegged to riskier than normal borrowers, mortgages known as subprime. Using his prime broker contacts at Morgan Stanley (and not radio telescopes) Magnetar’s Laser spied our little Falconhenge and 119
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our +6 percent first quarter and approached us about the possibility of Magnetar’s pulling in our entire team to help round out its long/ short equity platform handling consumer-retail stocks. Surely the hedge fund industry was getting ahead of itself if a firm like Magnetar was coming after us despite our firm only having existed for exactly one quarter, or maybe talented PMs just were not in abundance. The Wall Street universe has always revolved around an unending quest for talent. We took Magnetar’s offer. We sent the following to Falconhenge clients on April 3, 2006: April 3, 2006 Dear Friends: We are pleased to report two points of news. First and foremost, we had a successful first quarter of 2006. As of Friday’s market close, we have achieved an approximate gross return of +6.43% in Falconhenge Partners I, LP and an approximate gross return of +6.39% in Falconhenge Partners II, LP since January 3, 2006. Second, we are excited to announce that we have come to terms to join forces with Alec Litowitz and Ross Laser of Magnetar Capital. From our perspective, Harry and Keith being offered the mandate to build out our Global Consumer platform with the world class investment team that Alec and Ross have assembled is a once in a lifetime opportunity. Michael and Tom are also looking forward to considering an opportunity to work with Magnetar. With over three billion dollars in assets under management, and not yet one year old, we think the prospects for Magnetar’s rising star are as bright as any other in the industry. On March 31, 2006, we liquidated the portfolio holdings of the two funds currently advised by Falconhenge Partners, LLC, Falconhenge Partners I, LP and Falconhenge Partners II, LP (the “Funds”). Investors in the Funds are expected to receive 90% of the final March 31, 2006 value of their investment with the respective Fund within 10 days of the date of such portfolio liquidation. The remaining portion of the Funds’ assets 120
Sucked In will be held in reserve and will be repaid to the investors promptly upon the determination that all of the Funds’ outstanding expenses have been satisfied. In general, while the books and records of the Funds will not be audited due to the brief period of the Funds’ operation, each investor in a Fund is expected receive a minimum of a 6% return on his or her initial investment net of fees and expenses. The Funds will then be dissolved in accordance with their governing documents. We have always believed that there was a special place in this world that would embrace our investment vision and intellectual property. Ultimately, Falconhenge Partners was born out of that conviction. However, upon further review, our objective analysis has led us to conclude that Magnetar’s platform has superior longterm competitive advantages. In addition to the obvious advantages of scale that Magnetar ’s platform presents, we think that its team culture embodies the virtues of integrity and trust that are important to us as people. For entrusting your capital with us at such an early stage, we feel it is appropriate to waive all our management and incentive fees for 2006 to date. We are proud to have posted the aforementioned gross performance numbers and are hopeful that these closing financial terms are satisfactory to you in both practice and in principle. One of our investors recently sent us an inspirational book by Peter Drucker, which contained a strikingly simple but powerful message that summarizes our conclusions of the last few weeks: “The best way to predict your future is to create it.” Thanking you for believing in us. Harry, Keith, Michael, and Tom Falconhenge GP, LLC
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fter Magnetar acquired my team and drew us into their universe managing a portion of its long/short equity book as the Global Consumer Long/Short team, my life as a hedge fund manager took yet another turn. I was now spending sometimes one week out of the month in suburban Evanston, Illinois, living out of a hotel across the street from the Northwestern University campus. By this time Laura had moved in with me in Yorktown Heights, and we were planning to get married. She was used to my constant traveling, and we made it work. Ross Laser ran the Magnetar business while Litowitz ran the book. Litowitz, a highly skilled merger arbitrage trader had been promoted from PM into the hybrid role of PM/Leader of Other Traders. He gave it his best, and was hands on in this regard, always
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asking questions of his PMs, getting us to defend our positions in terms he could understand. Litowitz was in a way sort of the flip side to my first hedge fund teacher, Russell Herman. Herman looked into stocks and charts and fundamentals and balance sheet clues and wanted the beat of the Street, wanted to hear what management was saying; Litowitz looked at computer-driven models, numerical patterns. He taught me how to analyze the risk factors associated with stocks that were outside what I normally considered being retail risk factors. So while I understood how a highly publicized food poisoning incident could leave a restaurant chain’s share price heaving, what Litowitz showed me was how to analyze risks using purely agnostic statistical factors such as liquidity, volatility, and volume and a host of others that I’m sure he’d prefer I didn’t disclose. “So what’s your bet?” Litowitz would ask me. He wanted to know price objective, timing, upside and downside, and he wanted it in cold stark numerical conveyances. Litowitz didn’t care about what management had to say, he didn’t follow stories or sentiment. He was purely a numbers guy. Although when it came to stocks there was one thing Litowitz had in common with Herman—they both always wanted to know who else owned it. ■
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My group set up shop in Magnetar’s New York office right across the street from St. Patrick’s Cathedral. To get into the office before 6 a.m. I took such an early train the only other people on it besides me were Metro North railroad employees, domestic workers, and construction laborers. Reading a stack of research materials, newspapers, and magazines in the still click-clack of the pre-dawn train into Manhattan had a calming effect on me. Seeing the laborers reminded me of my dad. I thought of myself as being out of the station first each day and told myself that my contemporaries 126
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would not be able to catch me. By the time I got in there was only one other light on—Harry’s. Magnetar’s multi-strategy offering, the Magnetar Capital Fund, was becoming the new beast on the block. One of the various routes Magnetar traveled under the rubric of multi-strategy was private equity investing. The hedge fund and buyout worlds had by this time already begun to converge. Carl Icahn was no longer a corporate raider; he became an activist fund manager. Bill Ackman, founder of hedge fund Pershing Square Capital Management, became Carl Icahn. Stephen Feinberg’s Cerberus mixed hedge funds and private equity funds under one roof in the same way alternative giants The Blackstone Group and Fortress Investment Group both did. In July 2006, Magnetar recruited Michael Gross, the former founding partner of Leon Black’s venerated private equity vehicle, Apollo Advisors (and not the Michael Gross who played the father on Michael J. Fox vehicle Family Ties) to head its credit and private investment business. Pairing up credit and private investments under one senior partner’s purview made perfect sense, practically and on paper. The huge private equity boom that was well underway in 2006 was being fueled by newly created debt instruments. Companies were taken from the hands of public shareholders and into private hands via mountains of what were essentially grandiose IOUs that were being issued by consortiums of private equity firms such as Blackstone, Apollo, and KKR and structured by bulge bracket bankers. The private equity paper was rated as suitable for consumption by rating agencies. Then it was lapped up by hedge funds who borrowed heavily from their prime brokers, housed as units of investment banks who borrowed heavily* from commercial *
In 2004, the SEC—responding to a regulatory gap in the oversight of investment banks that was created by an unintended consequence of the Financial Services Modernization Act of 1999 (also known as the GrammLeach-Bliley Act) that gave commercial banks, brokerages, investment banks,
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banks who borrowed from Central Banks during one of the lowest rate environments in the history of lending. In some cases investment banks levered up their balance sheets to more than 30 times what capital they kept on hand to fund their various activities, not limited to but very much focused upon the ongoing private equity and hedge fund booms converging right before my eyes. My role as a hedge fund manager was being impacted by the goprivate movement. Wall Street banks facilitated meetings for me as they always had, except now sometimes instead of me sitting down with corporate executives or with analysts, I was now sitting down with “coverage guys,” bankers who covered the buyout funds, helped structure their deals. Obviously, they couldn’t tell me about specific deals they were involved with, but these bankers could give me a sense of where they saw the trends heading in various subgenres within the retail-consumer sector, such as casino and gaming stocks. A buyout, or “take private,” bid, once revealed to public markets, can and insurance companies the ability to merge under one roof, combinations previously restricted under the 1933 banking reform law known as the GlassSteagall Act—created the Consolidated Supervised Entity program, which took effect in 2005. This “self-regulatory” body encompassed five large investment banks that were also broker-dealers, which at that time were Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. All five were granted exemptions from a rule-capping broker-dealer debt to net capital ratios at no more than 12 to 1. Debt to net capital ratios were set for broker-dealers by the SEC in 1975. The five broker-dealers that were connected to the investment banks covered by the CSE program were effectively given permission to increase leverage beyond 12 to 1 but in line with Basel standards. Created in 1974 and comprising central bankers from around the world, The Basel Committee on Banking Supervision, a nonbinding, “informal” forum purportedly promoting global banking standards and best practices, has over the decades put forth a series of accords regarding basic capital requirements, the more recent of which, known as Basel II, established twotiered, “risk-based” capital requirement guidelines that seemed to be aimed less at ensuring a minimum, sensibly adequate cushion for a bank to have on hand at all times, and more about giving banks maximum flexibility to model their risk away as they see fit.
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often send a stock’s price hurtling upward, depending on how much of an above-current-per-share-price premium is, or isn’t, built into the bids, which usually get revised a few times before a deal closes, as other suitors join in the dance. It’s a dance that can become a routine out of Stomp! Particularly if you are short the company that supposedly is in play. For example, word leaked in the press in the fall of 2006 that Apollo and another private equity firm, Texas Pacific Group, had approached Harrah’s Entertainment about partnering on a leveraged buyout of the casino giant at $81 a share. Keep in mind that when financial reporters at the Wall Street Journal, New York Times, and the Financial Times break stories about major deals that are supposedly in the works (and the reports wind up being repeated on CNBC and Bloomberg), the sources are almost never named. But if you follow deals for a living and have any feel for the market at all, it’s often clear which side is doing the leaking, drumming up attention, angling for a higher or lower price, trying to get the market to support its angle. A week or so after the first media reports surfaced that a buyout was being proposed by Apollo and TPG (reports that Harrah’s later “confirmed”), the deal price was upped to $83.50 a share. The price was upped yet again in December 2006 to $90 a share, making it the single largest casino LBO ever announced, although the deal still had to win the approval of the Nevada Gaming Commission, as well as several other state gaming commissions, a process that could take about a year. By the time the deal finally got done, the gaming industry would first begin to notice a trend that did not bode well for them. People were starting to gamble less. Higher gasoline bills and ARM adjustments cut into casino budgets. My own economic and macro research led me to see this was an unfolding trend, or at least I thought so. And though I never traded Harrah’s, my attempts to short other casino stocks (such as MGM) were constantly being upended by the latest rumbling of a buyout. 129
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By the middle of 2006, it was starting to become clearer to me that the hedge fund industry was becoming a dangerous bubble, with too much money chasing the same trades. This was leading hedge funds down narrower and narrower paths in which they bought riskier credit instruments to round out their strategies, and they morphed into lenders and purveyors of private placements, fueling a private equity bubble forming alongside an even larger housing bubble all contained within an even larger credit bubble, or what George Soros would call the “Super-Bubble,” formed over three decades of credit expansion going back to the Reagan-Thatcher era of laissezfaire market conditions. Hedge funds morphed into private equity funds, and vice versa, with more money flowing into both types of funds, including money earned from within the securities industry. The securities industry, in turn, was recording never before seen profits, boosted in large part by proprietary trading and prime brokerage. These two business lines were being fueled by easy credit and were largely accounting for year-end performance-based compensation (“bonus”) pools that were more like bonus lakes. Wall Street was in an epochal feeding frenzy. The New York State Comptroller’s office, which tracks bonus and compensation figures for New York City–headquartered securities industry firms, released an estimate at the end of 2006 that pegged the total Wall Street bonus pool as around $24 billion. Salaries for the CEOs at firms such as Citigroup, Credit Suisse, Goldman Sachs, J.P. Morgan, Morgan Stanley, Lehman Brothers, Merrill Lynch, Bear Stearns, and others would be publicly reported and draw most of the media attention even as their paydays were being dwarfed by star traders and bankers underneath them. But no one made as much money in this period—or, for that matter, in any other period in history—as hedge fund managers. In its third annual take on the industry’s highest earning traders, Trader Monthly magazine in the spring of 2006 wrote that in 2005 “even the lowest rent hedge hogs needed to bring home $40 million to make the cut.” Two traders on the Trader Monthly list, Boone 130
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Pickens and Steve Cohen, each made north of $1 billion. In one year. Nine others on the list were each estimated by the magazine to have earned north of $250 million. In 1971, the entire hedge fund industry only had assets of $3 billion, according to a study done by New York–based hedge fund advisory firm Hennessee Group. Now a handful of elite managers were taking that much home per year in just pure profit from investor fees. Incidentally, back in 1971, hedge funds had gone through a bit of a mini boom period, having grown in numbers from just 30 funds with less than $1 billion in 1960 to 140 funds with combined assets of $3 billion by 1971, according to the Hennessee study. These were the first wave of hedge fund managers who grew fat on the growth stocks being created, called conglomerates, which were the dot.com stocks of the 1960s. As long as these companies (Textron, LTV, Teledyne) were continuously acquiring new brands and businesses (on the strength of their highly priced shares) the “con gloms” produced new streams of revenues, multiples expanded and valuations swelled. This continued only as long they kept doing new deals. But to maintain their growth levels, the conglomerates had to chase larger and larger deals. Eventually, the investment fad ended the way most of them do, with a reversal of the trend that led to a downward spiral. Before he became known as the man who broke the Bank of England in the early 1990s, Soros put himself on the asset management map with another famous trade in the late 1960s. Soros was short conglomerates, as was another hedge fund pioneer of that era, Michael Steinhardt. By 1974, the conglomerate boom was very much over and the market staggered along, stung by Nixon, Watergate, Vietnam, rising world inflation, and the 1973 OPEC oil shock. The number of hedge funds was back to just 30; their assets fell to $2 billion. The first hedge fund industry “bubble” garnered some attention. In a January 1970 Fortune magazine article, Carol Loomis wrote that the 131
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hedge fund industry had been swept up in a craze for performance between 1966–1968, and that many funds got clobbered in the bear market of 1969. Loomis attributes some of her assessment to none other than Alfred Winslow Jones, a former U.S. diplomat and Fortune magazine editor, and who is largely credited with creating the first hedged fund in 1949. Jones started with around $100,000. Loomis pegs to Jones the assertion that all sorts of money managers, including those in his own shop, got overconfident about their ability to make money. A.W. Jones & Company by 1968 was said to have produced 1,000-plus percent returns, cumulatively, for its investors over the prior decade. Jones always stayed tight-lipped about his investment secrets, a tradition the industry has held onto with a grip worthy of Brazilian jiu-jitsu. Despite the downturn in the early 1970s, hedge funds continued to grow steadily over the ensuing decades. By 1993, there were 1,000 funds with assets of $50 billion, according to the Hennessee study. Between 2000 and 2006, just during my time in the business, hedge funds went from numbering 4,000 and holding $324 billion to numbering 8,900, with assets of $1.2 trillion. ■
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While at Magnetar, I began to worry that the industry in general was heading over Niagara Falls (the Canadian side) in a barrel, but then again here was this LBO cycle well underway, and I was controlling hundreds of millions in capital. If my best long-term, long ideas played out, I could make a bunch of money. I had two choices. I could leave the industry, or continue to do my best to produce positive results. I stayed. But I could not deny several unsettling conclusions. Many hedge funds, for starters, didn’t hedge. And risk management also appeared to be in short supply. Toward the middle of 2006, a $10 billion hedge fund called Amaranth imploded almost overnight due to one trader named 132
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Brian Hunter, who operated from Calgary, Alberta, and who was allowed to make enormously levered bets on the direction of the price of natural gas, wrong-way long bets that ended up causing the fund operation to shut down. The ex-Enron trader John Arnold of Centaurus, who was short, had almost singlehandedly squeezed Hunter dry. If there were any risk management procedures in play, and Amaranth would insist there indeed were, then Hunter must have been allowed to operate outside them, which defeats the purpose of having risk management procedures. If you are going to make bets as big and levered as Hunter’s, you’d better be right. I never, ever, used leverage. Leverage is a disease. My mentor, Russell Herman, never used it, and I never thought to dabble. It may sound corny, but I simply was not brought up to borrow money that I didn’t need, or spend (or gamble) money I didn’t have. To this day I’m convinced there’s no place for leverage in investing. And while I never used leverage during my career, it was not like I hadn’t ever been on the wrong end of a squeeze. One retailer I routinely shorted was that darling of luxury brands, Coach (NYSE: COH). In something of a luxurious cycle, Coach’s stock price had climbed steadily higher since its debut in 2000 and made a lot of hedge fund managers wealthy. The amount of disposable income these guys could then blow buying nice things for their wives and daughters could not have been a bad thing for Coach, whose share price seemed to be perpetually on the rise. You pay attention to that kind of thing when you’re short. At one point while running my own fund in early 2006 I made some money being short COH at a time when it announced disappointing quarterly earnings—for the most part I got squeezed for the better part of the rest of the year. Call me bitter, but to me, Coach was emblematic of hype-fed investing. The company came on the scene right around the time I started to follow retail. Its CEO Lewis Frankfort guided the Street 133
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about as skillfully as any executive ever has, delivering on growth quarter after quarter. Frankfort had a son who was in equity sales at Bear Stearns. If you were part of Frankfort’s circle, you knew that. You believed his story, and he did not disappoint. In roughly the same period that I followed retail-consumer stocks, COH’s annual earnings grew from tens of millions to nearly half a billion. Its share price went roughly from $3 to $54, split adjusted during that period. Meanwhile, Frankfort became one of the retail industry’s highest paid executives. I told anyone who would listen that Coach was the most overly hyped stock I had ever seen. Once a division of the Sara Lee Corporation, Coach went public in October 2000 on the idea that boiled down to women of all ages and income brackets, from Palm Beach to Sri Lanka, needing at least one $250 handbag per year, if not several, possibly even one for each season. The idea that the company’s whole entire revenue growth outlook relied on women buying four expensive Coach handbags per year boggled my mind. Sure some might buy four, but all from Coach? And listening to Lew Frankfort talk about ladies’ accessories in a thick New York City accent was comical on a whole other level. He’d be riffing on charm bracelets and the sweet spot between modest and luxurious, speaking in the tones and cadence of a Jets fan calling into a sports talk radio show. Coach would not be the only momentum retailer that I was short during this period, but it would be the one that bothered me the most. Shorting momentum stocks in a bubble environment was like trying to spit chewing tobacco out of the window of a speeding car. You can do it, but you wind up getting splattered. But I have to say my year at Magnetar for the most part was a successful and happy one. Occasional trips to Evanston to meet with Litowitz were always learning experiences, and the laid-back pace of suburban Chicago suited me. I truly enjoyed working alongside
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Harry every day, although the physical attributes of our adjoining work spaces at Magnetar’s New York office proved a humorous study in contrasts, with mine all pristine, not a paper clip out of place, while Harry’s area was practically cordoned off by a beaver dam of printed research and folders. That summer of 2006 Laura and I were married and we took a two-week honeymoon vacation in Cabo San Lucas. Earlier that summer I’d had 25 guys up at the Lake House for my bachelor party. My honeymoon was the most time off—the first extended time off—from the business that I had had since entering. Heading into the fourth quarter of 2006 I was completely recharged. More than my sunny, relaxed state, there was a calm that came with the fact that Harry and I had done ridiculous amounts of research on our ideas, and plus, the timing was incredible. Here we were investing in what we considered were the best Global Consumer companies during the largest global consumer spending boom mankind had ever seen and at the start of an LBO cycle that could bring us huge gains. For years Harry and I had loved Four Seasons Hotels. For one thing, I knew the product. During the course of my extensive travel routine, I had stayed at the Four Seasons dozens upon dozens of times, although never on my own dime. In terms of a luxury hotel experience that is second to none, one that embodies the concept of staying in The Best Hotel, and an experience that could be replicated and delivered around the world, from my firsthand knowledge, no lodging company was even close to these guys. Second, a lot of the consensus on Wall Street was that Four Seasons was way overvalued. I loved operating contrary to the prevailing beliefs of the hedge fund mafia. Four Seasons indeed had a high price to earnings ratio. I expected and enjoyed that a high P/E ratio, more than 30 for example, scared people away or inspired short selling, because I’m about relative value, with a catalyst, and moreover, I never paid an ounce of attention
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to P/Es. Using a P/E to snap judge a stock is not unlike pre-judging a human being based purely on his or her appearance. What’s on the inside matters most, and P/Es are a feeble scratch-at-the-surface measure, not moored to the company’s actual balance sheet, often very complex and impossible to convey in a single metric. In other words, earnings can be overstated (undermined by debt exposure) or understated (obscured by confusing financial issues or costly but worthwhile initiatives), so I avoided P/Es and did what I could to put a company’s earnings into full and proper context. By snap P/E basis, sure, why would a crowd follower not see Four Seasons as overvalued? But to us, it was actually undervalued, P/E ratio be damned. We took into account all of the company’s most important under-thesurface attributes (it had net cash and fantastic operating margins), and we studied their plans for expansion (eight hotels per year, which we deemed feasible), and we took time to understand its dual business model whereby FS owned some hotels and managed others under contract for outside owners, thus reducing fixed costs. We got our heads around their complicated currency conversion issues (which was another reason some hedge funds shunned Four Seasons the Stock even as they dropped tens of thousands hanging out at the Four Seasons the Hotel and, for that matter, Four Seasons the Restaurant). Over the years we’d gone to Toronto and sat down with the chain’s founder, Isadore Sharp, who is among the single most sincere executives I’ve ever met. He wasn’t concerned with the quarter, nor did he care what people thought of him. CEOs like Sharp and Nike’s Phil Knight, these guys aren’t looking to beat quarterly expectations—they’re looking to beat the world. That’s how I felt heading into the end of 2006, like a world beater. I was competing at the highest level. My fourth quarterly returns looked to be heading toward double digits. This was the quintessential time in my hedge fund career, a culmination of chance
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and design. I was benefiting from both my persistent hard work and in many ways, at the same time, just plain luck. I’d stumbled into the hedge fund industry: I had randomly been assigned consumer stocks at a perfect time. I would always work hard. But I had to wonder how much longer would it be before my luck, and my industry’s, ran out.
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Chapter 10
Exile on wall street
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ome people on Wall Street used to describe Frank Quattrone as a “force of nature.” But there are no forces of nature on the Street, only forceful desires to make money. If forces are at work, they are employed to raise and address these questions: Who is making money? How are they making money? How can we get in on that? There were always two main types of traditional “Wall Street” firms, even if they weren’t all technically located on Wall Street, and those are banks and brokerages, or “investment brokerage houses.” These latter types of firms have also generally been thought of as “investment banks.” The Big Five, or “Bulge Bracket,” historically consisted of Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns.* *
Since the financial crisis began in 2007, all five Bulge Bracket investment banks shape-shifted, having either been reclassified as bank holding companies (Goldman and Morgan Stanley converted from investment banks to
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By any name, bank, investment bank, these entities could make money a couple of ways. They sell their “services” (stock research analysis and prime brokerage, to name two small examples) or sell, to investors, securities and security-like instruments that they create and distribute to investors for a taste of the profit. Securities can be anything from a stock IPO to something more exotic, such as a “credit derivative,” like “asset-backed securities,” which are basically IOUs linked up to some future incoming stream of assets, perhaps many years worth of mortgage payment streams. Or banks can do what banks have been doing for half of forever: lend money. In this regard, hedge funds became banks even as banks were becoming hedge funds. An image of a frantic, smock-wearing floor broker at the New York Stock Exchange tells the average person no more about the way the Street works as does a news anchor reading that day’s Dow Jones Industrial Average percentage move. Getting down to even a basic understanding of the Wall Street world requires an appreciation for how many different individual business lines and divisions, with distinct subgroups, areas, sectors, silos, compartments, all wrapped up under broad banners such as Capital Markets (banking and trading) and Asset Management. Within these major groups are numerous smaller subdivisions and units, and teams, all of which are pursuing different moneymaking opportunities and markets, around the world, all interacting with each other, creating a giant web of interconnected financial relationships. ■
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Federal Reserve protected bank holding companies in September 2008), were acquired by banks (Merrill Lynch that same tumultuous month was snapped up by Bank of America) or collapsed; Bear was carted off in a $10-a-share fire sale by J.P. Morgan in March 2008 while Lehman went bankrupt in September 2008 with some of its remnants snapped up by Barclays Plc.
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One type of moneymaking business that the banks went after in a full gallop following the shakeout of the March 2000–October 2002 bear market (during which time the S&P 500 lost 50 percent over 31 months) not surprisingly was the hedge fund business. Not content to serve as the hedge fund industry’s brokers/lenders/ enablers, the bulge bracket banks cultivated their own hedge funds, buyside fiefdoms within sellside empires, centered around internally run hedge funds under divisions that had standalone names, such as Goldman Sachs Asset Management (GSAM) and Bear Stearns Asset Management (BSAM) and Deutsche Asset Management (DeAM). Each of these entities within larger entities had, accordingly, many subdivisions on top of subdivisions. One of the main components of GSAM was a lineup of quantitative absolute return hedge funds. BSAM, in addition to offering investors separately managed portfolios, mutual funds, and funds of funds, offered them individual hedge funds. Two examples of hedge funds housed within BSAM (housed within Bear Stearns): the “High-Grade Structured Credit Strategies” and “High-Grade Structured Strategies Enhanced Leverage” funds. DeAM had within its asset management umbrella a hedge fund business that it called DB Absolute Return Strategies. DB Absolute Return Strategies in turn contained a hedge fund operation called DB Advisors Capital Management. DB Advisors contained within it a hedge fund operation called QVT Financial, which was run by a well-regarded trader named Dan Gold who in turn had his own teams of people investing in a vast array of securities. In 2003, QVT was spun out of DB Advisors, seeded with Deutsche Bank money. A few years later, the head of DB Absolute Return Strategies, Rick Goldsmith, along with a colleague, Ralph Reynolds, the head of proprietary trading at Deutsche Bank, formed a hedge fund partnership with private equity player The Carlyle Group.
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Just as banks wanted to get in the hedge fund game, so did private equity players, such as Carlyle, which had taken a few small strides but nothing like what was going on at Blackstone and Fortress. Hedge funds were becoming banks and taking companies private; private equity funds were becoming hedge funds and looking to go public. With money in supply, the financial industry got while the getting was good. The Carlyle Group would take a 25 percent ownership stake in the hedge fund partnership that it formed with Goldsmith and Reynolds. The new joint company was to be called CarlyleBlue Wave. The first fund under its umbrella was dubbed Carlyle Multi-Strategy Partners. It would comprise a slew of teams and sub strategies, as I would find out on the day in November 2006, when an executive recruiter called me up out of the blue and told me all about Carlyle’s plans, and how I fit into them. After meeting with the top executives in charge of launching Blue Wave, I signed on, around Christmas 2006. Accepting the invitation to head up the Consumer team at what could turn out to be one the biggest new hedge funds in the industry was easy. The hard part would be telling Harry. He and I had been doing the finest work of our careers. Four Seasons had just gone through the penthouse with the recent news that the company was going to be taken private in a $3.7 billion buyout by a group that included Microsoft founder Bill Gates and a wealthy Saudi, Prince Alwaleed Bin Talal Alsaud, both existing shareholders. Their $82-a-share offer represented a 28 percent premium, and the stock soared in early November. Everything was working for us. Our value with a catalyst approach was the investment style that dominated in Q4 of 2006—that quarter was one of the best I had ever had with my quarterly return in the high teens. That’s why Carlyle thought I was a rainmaker. Harry and I had taken our best ideas and done the work, and we’d seen them through to the payoffs.
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Now I had to tell Harry I was out. Telling him I was leaving, for me, was the worst feeling, like I had a pineapple lodged in the pit of my stomach. It was the worst I had felt since my last hockey game at Yale. Harry took the news disappointedly but didn’t say anything to make me feel worse about it. He couldn’t have. ■
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By the time I left Magnetar at the end of 2006 to join CarlyleBlue Wave in February 2007, hedge fund/private equity mania was approaching its zenith with the much-heralded IPO of a hedge fund/private firm, Fortress Investment Group. Fortress, headquartered in New York City, was co-founded in 1998 by a former Lehman and BlackRock executive named Wesley Edens, along with two other partners, Randal Nardone and Robert Kauffman, both of whom had also worked at BlackRock. Fortress featured private equity and hedge funds, including its mighty Drawbridge Special Opportunities Funds and Drawbridge Global Macro Funds. Standing guard over the Fortress Drawbridge were a pair of former Goldman partners, Peter Briger and Michael Novogratz, both of whom also became principals at Fortress, and in doing so, extraordinarily wealthy. Initially priced at $18.50 on the day before its February 9, 2007, trading debut, the stock (NYSE: FIG) ultimately closed its first session at $31, making on-paper billionaires out of all five of the Fortress principals. Later that spring 2007, Blackstone would announce that it was selling a 10 percent stake in the 22-year-old alternative fund management company to the Chinese government for $3 billion, which pegged a nifty back-of-the-envelope valuation on the entire firm: $30 billion. ■
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Carlyle-Blue Wave was fully operational by April 2007 after several months of preparation and fundraising. Large public pension funds were among its first investors. Blue Wave, if it reached its goal of $1 billion (and by April 2007 assets were just inside that), would still only represent a fraction of Carlyle’s total fund assets, mainly private equity. At one point in 2007 Carlyle’s assets under management reached $75 billion. As I had at Magnetar, I stumbled performance-wise out of the gate, and unlike at Magnetar, I didn’t bounce right back. Every time I shorted a company, a rumor of a buyout or merger or publicly filed activist fund stake would send the stock moving higher, and of course it bothered me that my research was of no use in an environment this frothy. If Bill Ackman bought a 5 percent stake in a company and then filed his 13-D, that was enough for other hedge fund managers to go along with him, trumping any practical or logical valuations. When Ackman started aggressively building his position in Minneapolis-based retailer Target in the spring of 2007 at around $60 a share, I was on the short side of the trade. Having tracked U.S. consumer spending data, as measured by the U.S. Department of Commerce, my whole career, I knew a streak of 60-plus straight quarters of positive spending rates going back to Bill Clinton’s first term was an economic hitting streak on the level of Joe DiMaggio’s 1941 feat. Once consumer spending turned negative, which I thought could happen by the end of the year or in early 2008, there was likelihood it might remain negative, as in 1973–1975 when consumer spending was negative in four out of six quarters. But what was historical analysis compared to Ackman’s latest 13-D? “Okay, here we go, merger Monday! Who’s next?” I would shout out to no one in particular. A few fellow traders in our sparkling Midtown digs shot me looks that said, “Hey, guy, tone it down.” As the most active trader, I sat in the middle of our trading floor, as Rick and Ralph had promised, facing our head trader, Steve Markowitz, who understood my sense of humor. I’d do presentations 146
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with fellow PMs and put up things on the white board, but I could tell it wasn’t resonating. I had a thing for acronyms and my favorite was R.I.P-TE. For me it worked because it had the Rest In Peace thing happening, and if sounded out it was like “Ripped,” as in we could see a lot of people getting ripped a new one on account of a confluence of factors, mainly Rates (mortgage loan reset anyone?), Inflation (coming soon: $5 gas), Protectionism (what if China doesn’t want to hold all those U.S. Treasury notes?), Taxes (the Democrats are coming, the Democrats are coming), and Employment (or lack thereof). No one seemed to get either my double word score or my macro thesis, and I swear during the meeting I overheard someone snickering, something like, “Oh God, Keith’s doing his macro thing.” Ralph tended to agree with much of what I was saying, but most of our other top investment minds seemed to believe that I was way too bearish. I suppose my disappointing investment performance (I was down a few percentage points out of the gate) wasn’t endearing me or my methods of expression to my fellow Blue Wavers. After all, I did macro, and you couldn’t get that spoon fed by management. The job was still invigorating, and as a member of the Carlyle fold I enjoyed unprecedented one-on-one access to management teams in an environment in which it wasn’t uncommon for corporate executives to meet with five PMs or analysts in one shot, there were that many hedge funds paying the Street for meetings. At retail conferences, all the other analysts who I had known my whole career, and who knew that I’d just done an intimate sit-down with this CEO or that CFO, would approach, possibly just to say hello, more likely to try to “pick my brain,” and by this time I had an actual hands-free phone, on which I always seemed to be talking during industry gatherings. I’d hired a tremendously talented team of analysts, culling from a pool of more than three dozen people I interviewed personally. One of my “wingers,” Homayoun Saleh, had come from Ziff Brothers, a private money management operation in charge of the Ziff family 147
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publishing fortune. Saleh, a Harvard Business School Baker Scholar,* was so smart there was almost a perception he was too smart. The other analyst I hired, Erik Hess, had been the youngest managing director at I.S.I. Group, Ed Hyman’s legendary macroeconomics research shop. I had two other team members as well. Hamesh Mehta, a management consultant at McKinsey, joined as a junior analyst. He grew up in Singapore where military service is mandatory, and had been voted top soldier by his peers. Rounding out the team was Tanya Clark who had been skillfully handling office management duties for me since my days at Dawson-Herman. ■
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I had an unlimited travel budget and doors opening up for me as never before, but on some gut level my whole regimen was less satisfying. This went beyond my losing money, which, let’s face it was humiliating and something I wasn’t used to. But I still gave the job my all, taking a 4:03 a.m. train to get in by 5:15 a.m., first one in the door. I tuned out the backlash I was getting over my negative posture on the markets. If anyone in my office shared my beliefs, they weren’t vocal about it. I didn’t care. I ignored the media hype surrounding the mere words “hedge fund manager” and didn’t worry about how much money I stood not to make that year if things continued. I certainly enjoyed making money as much as the next guy, but there had always been more intangible rewards that came with trading a book, the thrill of the hunt, I suppose. Or maybe it was proving others wrong. What always motivated me most were people telling me I couldn’t do something. You can’t play for the Thunder Bay junior team, you’re not ready. You can’t follow mining stocks, you’re a consumer-retail guy. You can’t do macro, you’re not *
Highest HBS academic honor, given to students who graduate in the top 5 percent of their class.
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George Soros. You can’t time the market, you’re no smarter than the rest of the pack. Now my peers were mocking me behind my back, some were openly mad at me. I felt I was putting my career at risk by speaking up in investment meetings against the hysteria in the markets, the bubble in our very industry, and what’s more, I don’t think I even cared. I never cared what people thought about me. I’d always been a “chirper” on the ice, and if people didn’t appreciate it, that was their problem. I knew from studying the life of my grampa Alphonse that being able to ignore what everyone else thinks was the reason he ever started his many business ventures because all of his friends and family told him he couldn’t do it. I had just read David Nasaw’s Andrew Carnegie. The great steel titan, I’d learned, used to leave the United States for long stretches, retreating to the rural hills of Scotland to relax in a giant castle and fish in the loch, but also to think about the world differently from his industrialist rivals. Then he would kick their asses because he knew what was coming. ■
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My talk of and belief in the gathering economic storm clouds was by no stretch lost on everyone at Blue Wave, and certainly by mid2007 there were hedge fund managers such as Peter Thiel and John Paulson who were betting that the housing bubble would collapse. NYU professor Nouriel Roubini and Yale professor Robert Shiller had both by this time been quite vocal about similar issues, though for the most part, like Roger Babson in September 1929, they were written off as cracked, doomsday theorists. Another group who saw trouble on the horizon, and were free to talk about it, were the management teams at restaurant chains that had been taken private. No longer shackled to the overly fanciful notions of eternal quarterly growth (let’s open a combination Pizza Hut/Taco Bell on the moon!), the guys running restaurant companies that had been bought out, and were no longer public, gave me refreshingly 149
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honest assessments of what they were seeing in their chains. I used to meet with the team from OSI Restaurant Partners, which operated Outback Steakhouse and which was taken private by a consortium of two private equity firms, Bain Capital and Catterton Partners, and some senior Outback executives, in a deal that was announced in late 2006 but which did not win shareholder approval until June 2007. After the deal closed, my discussions with OSI were frank, and it was clear to me that the outlook was tempered in the face of what appeared to be less discretionary spending. People could no longer fill their faces with Bloomin’ Onions like they could previously, for the same reasons they couldn’t gamble in casinos as much, or go on depraved leather handbag binges at Coach, or fill up two carts worth of diet green tea at Target, because they were getting squeezed, by higher energy prices and credit card bills and home investments that weren’t panning out now that their mortgage rates were resetting from wonderfully low to unmanageably high. I called it the consumer getting R.I.P.-TE. Common sense dictated that my bearish stance be at least considered, yet when I spoke of such things, dare even utter the word crash, at investment committee meetings, I got looks that could have been interpreted as concerned pleas for me to check into a rehab clinic. Other hedge fund managers in my vicinity on the trading floor understood certain elements of what I was saying, but I felt my aggressive shorting of the market continued to hurt my standing. While I didn’t turn into a pariah, I was becoming the guy who was getting hurt by his shorts. Suddenly, Keith the guy “who gets it” was Keith the guy who was giving away the puck in his own zone. I was pretty young, relative to most other members of the investment committee, so I suppose some of them thought, What does Keith know? One of my colleagues would say something along the lines of, “Hey, the guys over at such and such hedge fund love this stock, Keith, and they are the best. Why are you short it? Bill Ackman thinks Target could double in a few years, why are we short it?” 150
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And all I could do was stick to my thesis, which was my own, hand plucked from lots and lots of research and not spoon fed to me in a public filing or gleaned from listening to and mimicking any one academic. This was my thing, because I knew no one could hang with me on the consumer spending debate and declared as much, which probably made me sound arrogant, and which is maybe why some of my Blue Wave colleagues weren’t buying any of it. ■
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I went home for Canada Day, July 1, 2007, and sat by the lake, drinking ice-cold Molson Canadian beer with my brother, Ryan. Although Lake Superior is one of the deepest lakes in the world, the water on the shoreline is really shallow, so you can walk 100 or so meters out into it and still only be up to your knees, so we’d wade out with our beers to cool off and stare back at the beach. Ryan liked to invest and loved it when I gave him my ideas, particularly when they worked, and he’d been losing money. For the first time since he’d been following my ideas, Ryan was losing money, and he knew my feelings on the economy in general. Two weeks earlier, the first reports had surfaced about of a pair of troubled Bear Stearns Asset Management hedge funds. Bear Stearns would let one collapse and issue a credit line to the other, but $1.5 billion of investor money had been wiped out. This news, however, had not prevented Carlyle from creating another new affiliated fund company, this one called Carlyle Credit Corporation (CCC), in which Carlyle owned a 15 percent stake, and which was about to begin trading on the Euronext Amsterdam stock exchange. CCC existed to buy up, using leverage, the same kind of risky mortgage-backed securities that had undone the BSAM funds. Meanwhile, Blackstone had just gone public, as sure a sign as any that last call at the bar could not be too far off. 151
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Ryan was looking back to shore, at the spectacular three-story log cabin–style house he and my dad had built with their bare hands, and which I had paid for, and asked me what I thought about the market. I told him I was as F-ing bearish as I had ever been in my life, even more so than earlier in the year, and that I was going to double down on my shorts. “So you really think this whole thing is going to end badly?” he asked. “Yes,” I said. “When does it end?” I recall looking back at the beach and the great big house and saying this to him. “Now.”
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Except that now wasn’t the end, not yet anyway, and the only barometer most of Wall Street paid attention to, the stock market, the Dow, the S&P 500, kept going up. There was a month-long period from mid-August through mid-September, when European banks were being roiled by the fast-moving problems in the U.S. subprime mortgage sector and dicey credit securities were losing value, prompting some hedge funds to dump liquid assets, causing tremors in the stock market. For a while there it looked like my bearish bets were finally going to pay off. But the central banks pumped in liquidity to stave off calamity; the U.S. Fed on August 17 fell in line, cutting the discount rate (the rate at which it lends) by half a percentage point. Putting together my daily “investment diary” on August 24, 2007, I pasted onto the page a series of research snippets someone had sent me on the unfolding subprime crisis (Lehman announced it would close its subprime unit, Russia’s central bank was propping up the ruble, the WSJ had reported some lenders were tightening guidelines and raising rates on auto and personal loans, 152
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Fitch had placed $92 billion worth of securities backed by subprime mortgages under analysis, a harbinger of possible downgrade) and then I wrote at the top: “2008 = Financial Event or ECONOMIC RECESSION?” ■
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After Labor Day, a legion of hedge fund traders, the levered-long crowd, tanned, rested, and ready to rock after an August in the Hamptons, pushed down on the throttle. During the first full week of September, the S&P 500 actually finished +2.2 percent en route to a +6.7 percent gain, between September 10 and the end of October, despite the fact that UK mortgage lender Northern Rock, having lost huge amounts of money via sub prime exposure, had an old-fashioned run on the bank, something not seen in Great Britain in a full century. And yet, bolstered by the Fed rate cut and perhaps a sense that the “subprime crisis” could be contained because as a percentage of the overall mortgage market it was only a small piece, the equity market kept charging ahead, kept climbing higher. My shorts (Google, Williams-Sonoma, Target, Wynn Resorts) got steamrolled. Wrong again. But then I’d think, no, I’m not wrong. I’m right. Signals kept flashing. One was right in my face: The Carlyle Group announced it was selling a 7.5 percent stake to Mubadala Development Company of Abu Dhabi for $1.35 billion. Every day, I filled my notebook with new information, pieces to a disturbing puzzle. I was sure I was seeing the picture emerge plainly into view. October 3, 2007>N Rock up 10% on J.C. Flowers/Cerberus speculation: Hope syndrome to a market is like cancer . . . October 8>(written next to a clipping of a story about a 26-year-old hedge fund trader losing $353 million) Bull market absurdity . . . 153
d i ary of a h e dg e f und manag e r October 15>(next to clipping of Barron’s headline, Just How High Can China Go?)
Fox BIZ Channel LAUNCHES<mkt top
One of the last things I wrote in that particular notebook, which covered August/September/October 2007, was after the last trading day of October. I quoted an old proverb: “Listen or thy tongue will keep thee deaf.” ■
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Around lunchtime on Friday, November 2, 2007, I popped out of the office and strolled down Fifth Avenue on a mission to buy a new pair of loafers, black Ferragamos. My first child was due to be born in one week, and I was overcome with a feeling, as if I were closing the chapter on one part of my life and beginning a new one. The pressure was off me somewhat as my shorts were finally starting to work. The fourth quarter would bring me, I was certain, the redemption I so craved. When Audra Paterna, the head of HR at Carlyle-Blue Wave asked me to meet her, Rick Goldsmith, and Ralph Reynolds in the conference room, I figured they were going to give me my due. I got to the conference room and sat down. Ralph was his usual quiet self and Rick, normally jovial and talkative, seemed distant. He started talking about the credit side of the business collapsing, how they foresaw times getting tougher, and how they needed to cut back, and “since my team had the largest cost structure . . . ” his voiced trailed off and he stopped looking at me even though I was right across the table. I rolled up my sleeves and put it right out there: “Are you guys firing me?” “We have to let you go.” You’d think I would have gotten upset, as amplified as I had been at Carlyle during 2007, but I didn’t lose it. Rick and Ralph both genuinely seemed to feel bad, and I told them plainly, “You know, guys I only wish that I had been part of 154
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the dialogue that led to this, but thanks for the opportunity. I think I’m going to be right here. I know you think I’m not.” Then I had to go fire my team and clean out my desk. I’d never been fired before. I’d never been cut from a team. I think maybe instead of me being Zen when the door was shown to me, I was more likely in shock. I took the elevator down by myself and walked to Grand Central. I said goodbye to myself. Goodbye and good luck. ■
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On Wednesday morning, November 7 at 4:02 a.m. my wife Laura delivered a healthy 8 lb., 6 oz. boy who we named John Henry after our fathers. We decided we’d call him Jack. Standing in the delivery room at Columbia Presbyterian, the sun just coming up, I could see the New York skyline and I remember thinking how glad I was to be out of the hedge fund racket. From now everything I do, is for them. One part of me was still bruised at having been booted from Blue Wave, but at the same time this was one of the most liberating periods of my life. I slept in, sometimes until 5:30 a.m. I was reading nonfiction voraciously. When former colleagues, friends (or headhunters) called or e-mailed to check up on me, I told them I was done, retired. The industry had been good to me; I’d banked enough money to take some time off and enjoy spending time with my family. I couldn’t help but follow the tension in the market. The S&P high water close of 1565.15, reached October 9, was getting further and further away in the rear view mirror. I’d been on record at Blue Wave as saying that I thought there was a strong chance that U.S. consumer spending was going to turn negative some time in the first half of 2008 as credit mechanisms (banks lending money) broke down. Daryl Jones, my old hockey bud and fellow Dawson-Herman analyst, rang me up just after Thanksgiving to say hello. I’d been taking a stab 155
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at writing a financial blog and sending it around to people I knew and Jonesy told me how fresh and spot on some of my takes had been. A few people started telling me: “You should start a research firm.” The signals were flashing sell. I was short my own industry, and I told anyone who would listen as much. Hedge funds weren’t going to be sustainable, because they weren’t being run as businesses and had no emphasis on establishing clearly defined processes for reproducing results on a consistent basis. Hedge funds were being run more as vehicles for producing fee revenue for the hedge fund management company, but with less than the adequate downside protection that the hedge was supposed to provide. Hedge funds had originally been conceived as sophisticated vehicles for delivering Wall Street’s finest investment acumen, with built-in downside protection, i.e., the hedge. Now, they had devolved into nothing more than highly touted engines for producing excessive compensation. The industry had been oversupplied with inferior talent. I got to know them because we all traveled in the same circles. In a different generation, there had been a handful of talented PMs, Soros and Robertson and Steinhardt and Cooperman. They charged a 1 percent management fee off the top, not 2, and they took it upon themselves to make damn sure they earned it. Somehow, somewhere between “1 & 20” and “2 & 20” and funds of funds and rich lists, the industry went off the grid in terms of basic principles. Hedge funds had gone from being an obscure corner of high finance to some scary gargantuan bubble. Since around 2005, people on Wall Street and in Washington and in the media had been saying this bubble would burst, and when it did, watch out. Of course, it was bound to burst. Sooner or later it had to. Better that I was out, having made my money, more money than I ever thought I would ever make in my lifetime, by 100 times. Because the hedge fund bubble wasn’t just about to pop. It was going to explode.
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Chapter 11
Lifting The Curtain
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ne of the things I most missed about being in the hedge fund game was my getting to engage in my process. I hated getting up so damn early, trust me. But I enjoyed cramming my notebook and my head (if I wrote something down, it became committed to memory) with informational points of reference, price points, levels, headlines, global macro observations, you name it, and then connecting the dots. One of the reasons I started blogging was to go through the exercise of connecting dots, making calls and proving myself, not just passing the time. I’d look at my son, small enough to fit into a golf club sock, and think to myself, one day he’ll be old enough to know what happened to me on Wall Street. I wanted to show him my side of it. To me it felt like I’d been booted from the team for giving away the puck in my own zone when in reality I felt I was playing the best game of my life. 159
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So I got up, made coffee, slurped down my oatmeal, and began my process, except there would be no veil, wall, or bunker of secrecy. I was going to do my thing out in the open, my new normal. I called my web site MCM Macro (for McCullough Capital Management) and cranked out content every morning, usually posting around 5:30 a.m. I didn’t take to the Internet trying to be the next big thing in financial blogging. I didn’t envision myself as a challenger to The Big Picture or Seeking Alpha, two of the most popular financial blogs; nor did I have an axe to grind (okay, maybe a hatchet); rather, I mainly wanted to let a little sunlight in, speak out some against the levered long bulls on Wall Street who were perpetuating self-fulfilling agendas. In one of my earliest postings, in mid-December of 2007, I took aim at the levered long crowd, the hedge fund bulls that gored me. This was a crowd not unlike the one that each July goes streaming through the narrow old streets of Pamplona dressed in white, convinced of safety in numbers when the undeniable facts on the ground were they were extremely close to mortal danger. I’d come to believe this crowd had not only created a bubble but were now living in one. Here’s the entire blog entry from that day, with typos included for posterity: Wednesday, December 19, 2007 MCM Macro Morning 12/19/07 . . . ‘The Tide Rolls Out: Revealing the Goldman Levered Long Guys’ I suppose that its only fitting that i was pumping Goldman’s tires ahead of their conference call yesterday, only to see their shares technically breakdown and close at new 7-week lows . . . Good thing i am not long GS! or worse, long that so called “hedge fund” that they call the “Global Alpha” . . . Alpha, incidentally, per Wikipedia is a (risk-adjusted measure of the so-called “excess return” on an investment. It is a common measure of assessing an active manager’s performance as it is the return in excess of a benchmark 160
Lifting the Curtain index or “risk-free” investment) . . . Since this weekend’s MCM Strategy note focused on the [efficiency] of analyzing economic cycles, is there any irony that Goldman’s share price peaked on at $247.92, in sync with the peak of Wall Street’s “Its Global This Time” bullish narrative in October? It might be too Ben Steinesque for one to suggest that its even more ironic that the date on that share price peaking was October 31st, the month end performance reporting date for a lot of hedge funds looking to raise money—so i wont do that! Goldman’s shares are down 18.7% from their cycle peak, and Chinese Shares (Shanghai Composite kind) are down 18.2% from theirs . . . I know, thats probably just one of them squirrely ironies, or “statistical aberrations,” that some of the “Quants” (like Goldman Alpha) were blaming their August performance problems on . . . There can be great ironies revealed by economic cycles . . . particularly this one, since its “Global This time” . . . Good luck out there today, KM
I included, along with my “Early Look” essay/ramble on the macro picture, a few down and dirty observations on Asia, which I was watching warily as part of my thesis on global consumption slowing. So in addition to my note on Asia (the Shanghai Composite had finished positive, Hong Kong had closed up as well, but on low volume, and Japan was down), I wrote on Europe (European Central Bank President Jean-Claude Trichet had signaled that credit squeeze or no credit squeeze, he was not planning on cutting rates, so I turned negative on the UK after a neutral stance that I had taken specifically to avoid getting run over by a surprise rate cut), and on South Africa (which had gotten pummeled for the second day in a row), and on Brazil (I was bullish), and commodities (gold, I wrote, looks as solid as it feels if you bite into it, an inflationary play and the leading commodity play for the week), and currencies (the U.S. dollar was holding strong). I even weighed in on what was 161
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happening on the Street. I wrote that federal prosecutors were investigating a Bear Stearns MBS PM for unloading $2 million of his own money, prior to losing all of his clients’ money, and ahead of his subprime implosion, allegedly. From the blog that day: . . . but this is just a disaster, any way you want to look at it. . . . Bear Stearns was once regarded as one of the finest investment firms in the financial industry, and now we’re seeing the greed and irresponsibility of a certain few individuals wash out decades of relationship and trust building . . .
BSC, at the time I wrote that, in mid-December 2007, was down 43 percent on the year, and now there was talk that Jimmy Cayne and his team were not going to pay themselves bonuses this year. The curtains are up, I wrote. For good measure, I finished my blog post with some macro themes, ongoing, working riffs in process, such as “Fed Centric, Fed Cut Bull Case Is the Tree, Access to Credit/Capital is the Forest,” “Bonds, Banks, and Bailouts,” and “U.S. Bottoming Is a Process.” I even logged some trade results out there, nine longs, including eBay, which I bought at $31.70 and sold at $34.91, and a couple dozen shorts, including WYN, which I shorted at $28.19 and covered at $27.39. The trades, I should point out, were done “on paper,” but I conducted my PM process as I always had, and kept at my blog every day to hold myself and the industry accountable for whatever came next. I wrote from a standpoint of full disclosure, total transparency, accountability, concepts desperately lacking in the fund industry, which may as well have operated out of windowless underground bunkers. No, there was one window in: the client letter. Nothing quite sums up the arrogance and opaqueness of the hedge fund industry as the monthly or quarterly Dear Client
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letter, the only public peephole a fund will offer its investors and which at their best are as readable and informative as one of those holiday cards from the self-important family needing to catch you up on various members’ trivial goings on. Most hedge funds don’t want clients to know much, if anything, about the activities of the fund. Because client letters often find their way into the hands of the media, they are issued reluctantly and crafted lawyerly inside pressurized chambers of compressed air. I’m not sure it’s even relevant to refer to hedge funds as having investor relations.* True enough that a lot of rich guys give money to the best hedge fund managers, and leave them alone, and don’t want to know and only think to seek out any transparency when things go bad. By that time, there are lawyers involved, and it’s too late. The best money managers hate to be trifled by pedestrian investors asking uninformed questions, especially when they call only when things go wrong, never when the fund is roaring along. But having no clients and only trading on paper, I figured, why not let people know exactly what I am doing? In addition to establishing some transparency, I’d set the stage for at least a debate between the bears and the levered long crowd. I received plenty of feedback, some dismissive, some constructive. Once in a while I’d get a hateful e-mail, usually from a hedge fund guy who was levered long. That just made me chirp all the louder because I knew I was going to be right. Here’s another post from Sunday, January 6, 2008:
*
During a January 2009 panel discussion sponsored by Institutional Investor magazine and attended by a few dozen hedge fund marketing executives, the state of client communication was a source of consternation, according to a panelist, Thomas Walek, a top PR Man for hedge funds. Describing that II event during the course of a subsequent presentation, Walek said: “Overall the audience was frustrated and confused about its inability to communicate with clients . . . to quote one observer ‘the environment is brutal, just brutal.’ ”
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d i ary of a h e dg e f und manag e r Sunday, January 6, 2008 MCM Macro Weekend Strategy, 1/6/08 . . . ‘Real Hedge Funds Hedge’ If you really want to annoy the mentally inflexible, levered-long and/ or concentrated hedge fund managers in this business, remind them how right you were in making a “macro” market call on the bearish side, and then ask them why they didn’t see it coming . . . The most recent edition of the Hedge Fund game has become very peculiar that way; it’s really the only game i know where losing is met with relative performance justifications. On Monday, the internal dialogue at most US hedge funds will go something like this: ‘but we’re only down a couple percent . . . ‘hearing another guy is getting wrecked, though’ . . . ‘have you heard anyone else’s numbers?’ . . . ‘how’s Stevie doing—hearing he’s upset’ . . . ‘did you call the CFO yet? what’s going on in this stock’ . . . ‘this stock is just too cheap here’ . . . Now, imagine if real athletes (the only other professionals i can find with the same performance-based compensation packages) behaved this way. What if Pittsburgh Steeler’s quarterback, Ben Roethlisberger, went back to the dressing room after last night’s 31–29 playoff loss to Jacksonville last night and whispered to the guy next to him ‘but the Redskins lost to the Seahawks by more’ . . . or, worse, ‘those interceptions i threw don’t matter; i have my contract guarantee’ . . . ?? The only guarantee i have for you is that if this bearish market action persists, the US Hedge Fund business will prove to be as dangerously cyclical as the U.S. Economy, and the U.S. Banking system have, alike.
I ended this post with an intermediate-term “Trend” that is, I had a negative outlook for the U.S. Market, but I also recommended a nearer term “Trade,” to cover oversold shorts and lock in some gains. My trend versus trade approach gave my readers some 164
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coverage in the intermediate term because I’d been burned so many times by the bulls. But I was not backing off my long-term trend; trades play out over days or a few weeks, trends play out over months. As I figured I would, I got grief from some hedge fund managers who didn’t appreciate my views. “I’ve had enough of your self-important drivel—you are a failure—why don’t you just shut up and go away?” And that was from a former friend of mine! Tom Tobin, a colleague of mine while at Dawson-Herman and who at that time had jumped to another hedge fund, e-mailed me to say he was happy to see my morning missives again and that he was enjoying them. He reminded me of some my most favorite days doing research as part of a close-knit team, and how even back then I was spouting off my views whether people asked for them or not. But the right people (guys like Tom, my old college pal and Falconhenge co-conspirator Michael Blum, my brother Ryan) gave me enough positive reinforcement—and the hedge fund industry had paid me enough money—that in early January 2008 I began to think seriously about starting my own company based around intense investment research. Rigorous, conflict-free, totally transparent research, both macro and sector specific, had to be, I reasoned, in demand. I wanted to take what I did as a hedge fund PM and put it on display for anyone to see, unheard of in asset management but exciting to me. I relished the idea of building a business solely around giving clients the best possible research edge. Just as when I started Falconhenge, I called Michael Blum. He was always my operational guru. After I left Magnetar in early 2007 to join Carlyle-Blue Wave, Michael went to Asia to do consulting work for the gaming industry as numerous projects were underway in Macau and Hong Kong. Michael, in turn, had helped launch an investment fund focused on ancillary businesses tied to the gaming and hospitality surge, partnering with his brother, and he seemed committed to that business. He told me as much when I called him 165
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looking to get the band back together. But he did agree to take a month off to come to Yorktown Heights to help me see through my new vision for a type of research firm. I told him that my 2-monthold Jack might keep him up now and again but that he was welcome to crash in one of our spare bedrooms. Michael soon arrived. We were like peas and carrots again. One of the first things Michael suggested was that we tap a creative czar to help design our visual brand. We wanted something truly twenty-first century and user friendly. Michael suggested a guy named Mick Malisic, a former colleague of his at a Bay Area company called frog design, and who was a student of product design guru Hartmut Esslinger. Esslinger had crafted the physical dimensions and look of the first Apple computers. Mick had just relocated from the West Coast to the West Village, so on Michael’s urging, he came out to Yorktown Heights on the train to see me. Our discussion would address my concept of throwing open the curtain and stripping out a true professional hedge fund research process for mass disbursement, of democratizing the proverbial first call. I’d do the work and make the right calls, calls in need of being made, so that regular individual investors and big buyside PMs alike get my morning overview, my short-term calls, my long-term calls, shorts and longs, in real time, with total transparency and 100 percent accountability. Mick told me later that he immediately began to see a control board in his mind, flashing signals. We brainstormed screens and systems by whiteboard all morning and into the afternoon. Laura baked cookies. Jack rolled around on the carpet. It was quite a scene. With a crazy mop of dark black hair that was part guitarist from the Replacements,* part mad scientist, this skinny dude Mick from California was a long way from Wall Street and knew very little about it. Which was perfect. *
Tommy Stinson, specifically his hair as worn circa 1989.
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Strangely, that same day that I had Mick over at the house, I got a phone call from an old contact on the Street, Brian McGough, who had worked as an analyst at Morgan Stanley covering Nike and who ended up going to work there. When I was covering Nike, which was my whole career, it was not unusual for McGough and me to speak once a day. As it happened, McGough had left Nike and his home in the Portland area to come back East, rejoining Morgan Stanley as Executive Director of Research. He’d been receiving and reading my digital macro missives over the past few weeks and had decided to reach out to me. Talk about timing. Unsatisfied working for an investment-banking powerhouse, McGough was considering decamping for a startup research firm, and he wanted to know what I thought of his move. “Here’s what I think,” I said. “I think you should pull over on the side of the road, turn around, and come to my house right now.” McGough was at the time we spoke on his way from his home in suburban Connecticut to his office in Manhattan, and while he did not follow my orders (he had to at least show up for work), by day’s end McGough was in my house and joining in the marathon brainstorm session, and eventually in our partnership. McGough would run our research department. His rolodex alone could bring us an immediate institutional client base. Since we didn’t operate a brokerage arm and since hedge funds usually pay for research using trading commissions, we explicitly set up our model to take hard dollar payments. We knew we had to prove our mettle among the large buyside consumers of macro research before we could try to distribute into a more mass audience, and there’s no tougher way to show your added value than to get money managers to pay you in actual cash. McGough and I would focus on this side of the business, which we knew could produce an immediate revenue stream on day one. Meanwhile, Mick and Michael went to work on building out the individual investor
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side of our company, which would pick up on Mick’s vision for a control panel and flashing lights, which by late January had been transformed into a set of blueprints. Eventually, anyone large or small could get access to world-class, unconflicted, actionable, investment calls, in real time, color coded and scored daily, the proverbial open book. We called that product Hedgeye and hoped to unveil it by the end of 2008. Next we needed to get someone to help us with our technology platform. Michael had a contact in San Francisco named John Taylor, an engineer and strategist who had started out his career as a nuclear physicist, highly skilled in overseeing heavy-duty software development or technical projects, such as the building of our front-end and back-end systems used for disseminating our informational products. Taylor would be based in the Bay Area and, as head of technology operations, coordinated efforts with a local team of IT consultants. The first time I actually met Taylor, he’d come out East to meet at my home, and before we even talked about a word of business we had become engrossed in a discussion about philosophy and democratic principles. He was my kind of guy; anything but an empty suit. With Michael, Mick, McGough, and Taylor on board as founding partners, we had our company, which we called Research Edge. By this time, late January, I had more than 100 people on my distribution list. While consumed with the task of creating a new company, I still got up every morning and did my macro process and distilled/regurgitated it, and while I would not say I had a cult following, I could see that many more people beyond my direct recipients were reading my stuff as it was being forwarded around. Those hedge fund guys who disagreed with me about the world of hurt that I was predicting was going to rain down on them and on the U.S. financial system let me know that they disagreed in terms I can’t print because I know my mom is going to be reading this. In early February we set out to find office digs, somewhere far enough away from Wall Street, even set off from the beehives of 168
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trading that were Greenwich or Stamford, someplace conducive to slower paced, thoughtful research, someplace where I felt at home. I settled on New Haven. Fairly quickly, and not surprisingly, considering what was happening to the economy, I found a vacated law office, right across the street from Yale’s campus. The space needed some work but had its charms. It was a restored three-story mansion once owned by our 27th President, William Howard Taft, who upon leaving the White House in 1913 became a professor at Yale Law School. It was more space than we needed, but we’d grow into it, I thought. We signed the lease in March and prepared to open for business in April. McGough and I were recruiting aggressively through the winter. We would order up the finest restaurant analyst I knew, Howard Penney. Penney has been recognized by Institutional Investor as one of the top restaurant analysts. He’d started out on Wall Street in the mid-1990s as a tobacco analyst and then a small-cap strategist at Morgan Stanley before going to work for SunTrust Robinson Humphrey and FBR. Todd Jordan would also join us from his post as a PM and analyst for Jefferies Asset Management. Jordan, who has worked on the sellside for Raymond James and Dresdner Kleinwort Wasserstein, would become our gaming ace in the hole. My old friend Daryl Jones, who by this time was working for a private equity firm in Miami, agreed to assist me with doing pure global macro research. To round out the team, we also brought in some more junior guys, including a few former Yale hockey players just out of school. One of our other key, if not counterintuitive, hires was Andrew Barber, McGough’s roommate at the College of Mount Saint Vincent in the Riverdale section of the Bronx. Barber had grown up the son of a retired Army general in upstate Waverly, New York. Barber was an interesting guy. He had traded derivatives on the Street during the late 1990s, and then tried his hand at journalism. Barber brought a unique point of view, a solid understanding of markets, and an elephantine memory. 169
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The firm would be run much like all the hedge funds I had worked at, with lots of dialogue and brainstorming, right down to the holding of daily Morning Meetings. We’d get paid for providing access to our real-time process and our research output. The Wall Street crisis was growing more disturbing by the day, although the mainstream media was too busy devouring the death of Anna Nicole Smith to notice. With the failure of Bear Stearns, scooped up in a fire sale on St. Patrick’s Day by JPMorgan Chase for the equivalent of a few stick-on shamrocks per share, no one could ignore the cracks in the system any longer. Trumpeting a ten-page special report on the Wall Street crisis, the cover of The Economist March 22 showed a photo illustration of a marble façade emblazoned with a gold-plated WALL STREET. Depicted as running down the middle of the facade, top to bottom: a gaping crack. Eyes wide open, who could deny any longer that the industry, the market, the country, were descending down a steep, perilous path, what with firms such as Merrill Lynch controlling $1 trillion of assets via levered-up liquid assets of only around $30 billion; with the outstanding Street value of some forms of credit derivatives, specifically credit default swaps, reaching $45 trillion; with finance industry profits accounting for 40 percent of all U.S. corporate profits? U.S. consumer spending accounted for 70 percent of GDP. I felt few could hang with me on the consumer spending conversation. I’d tracked it my whole career, watched all those consecutive quarters of positive spending levels, and I had specifically been on the lookout for changes on the margin. I certainly took note that the Department of Commerce had reported that the fourth quarter of 2007 marked the 64th straight quarter of estimated increased consumer expenditures. Except that in recent quarters, spending increased by smaller percentages. When great goes to good, remember, that’s bad. I was convinced consumer spending
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was about to turn negative at some point in 2008* which would, according to my thesis, feed on itself, and impact the economy in a frightening way, instigating a downward cycle likely to, when combined with the mortgage crisis, send the United States into a tailspin and batter the stock market. The whole country was over-levered. And I wasn’t the only one saying this. YouTube it.** Who could ignore the signals that the wheels were coming off the wagon, besides Larry Kudlow? Try the levered-long bulls; try hedge funds. ■
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Uncertainty reigned on the Street, and after Bear Stearns blew up on March 17, a wave of downsizing began, and a distinctly ominous unsettling chord was struck. Which investment bank would be next? Our phones were ringing and resumes were coming our way from people worried about losing their jobs and about the entire construct of Wall Street being rendered obsolete. We continued to hire. Frustrated with the hedge fund game, Tom Tobin, my old colleague from Dawson-Herman who by this time had joined a different fund, came on board to do healthcare. I considered him to be among the best at what he did, and since we had worked so closely together back in the day, I knew his rigorous approach firsthand and I knew that he was the perfect teammate. My employees were paid less in salary than what they would make on the Street, but they had equity in the firm and a job they enjoyed, *
In the third quarter of 2008 the Department Commerce estimated real consumer expenditures had declined for the first time in 66 quarters. ** Footage of economic luminaries Ben Stein and Arthur Laffer wholly dismissing prescient meltdown predictions made in 2006 and 2007 by blogger/ commentator/trader Peter Schiff during live cable news point/counterpoint segments became YouTube fodder in the aftermath of the crash of 2008.
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and, in some cases, a clearer conscience. Working on Wall Street for many of my guys had become an exercise in dysfunctionality. Clients came in from all directions as our stuff was being passed around widening circles of hedge funds and other types of money management firms that appreciated being told how it is, not what everybody wanted to hear. I was ready to tell them, and to tell the world what we were up to. On Tuesday, April 1, 2008, I wrote the following post: Dear MCM Friends, We closed out Q1 of 2008 on a positive note. Despite not having a research team or a trading desk for the 1st time in my career, MCM’s Global Long/Short portfolio compared favorably relative to all of the major US market indices. MCM’s March end and YTD Performance: +2.15% for the YTD (calc. on a gross basis) . . . Index Performance for YTD, ended 3/31/08: Dow Jones Industrial –7.55% S&P 500 Index –9.92% Nasdaq Composite –14.07% Russell 2000 –10.19% The more important news is that i now have a research team! We opened our office this afternoon on the edge of Yale’s campus, and we’re happy to announce that we have started doing business as Research Edge. Our evolutionary operating system is called Hedgeye.com, and our web site splash page launched today in conjunction with the firm’s opening. Your objective feedback throughout this process of innovation has been critical to my decision making, and i am looking forward to keeping our respective dialogues open. My distribution list was under 100 people, and I’ll always remember these last 5 months as some 172
Lifting the Curtain of the most enjoyable of my career. Unfortunately, I had to reintroduce the alarm clock to my life again this morning. Please login to www.Hedgeye.com, sign up, and pass along the good word. I am fired up to be back in a dressing room with a great team! My new contact info is below. Many Thanks, Keith Keith R. McCullough CEO RESEARCH EDGE New Haven, CT ■
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On June 11, 2008, at 7:50 a.m. Eastern Standard time, I wrote a morning note asking what I considered to be a pressing but ambiguous question: “What Is a Crash?” Bear market moves of 20 percent, peak to trough, are often labeled crashes, although I tended to define them mathematically as a three standard deviation move versus expectations. Incredibly, a prevalent bullish narrative reduced the upheaval in the going-straightto-hell financial world as a buying opportunity, and was still vying for dominance. Bears had been laughed at on CNBC; Jim “there’s always a bull market somewhere” Cramer shouted down those who were bearish on financial stocks—such as Bear Stearns. Trader Monthly still produced lists of the highest paid traders and threw parties honoring their “30 Under 30” in venues such as the showroom of Manhattan Motorcars. Outside, a Grand Prix for the ages was being staged between the bulls and the bears. But one side was running out of gas, and facts. As so many commentators have alluded to, the market was indeed reminiscent of the old Road Runner cartoons when Wile E. Coyote runs off a cliff but is momentarily suspended in mid 173
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air prior to plummeting into a ravine; the market was being sustained by nothingness, air, whether some new rumor of a possible leveraged buyout or the latest Bill Ackman 13D filing.* The longer the levered long community believes, the higher the probability of a U.S. market crash, I wrote in June. I’d seen the formation and the bursting of the tech bubble, experienced firsthand the hedge fund bubble, and then the private equity bubble. The dots connected. I had been saying since late 2007 that this movie was going to end badly. Back then, when I started mentioning, out loud, to the members of Carlyle-Blue Wave’s investment committee, the possibility of a crash, I wasn’t shooting from the hip. I was not playing a hunch. Nor would I even consider it a prediction. My observation was born of a repeatable process. Every morning I was still up before 5 a.m. consuming news and data, plotting charts, analyzing statistics, like the positive U.S. consumer spending streak that I was sure would soon snap. When spending did turn negative, I knew it was not going to last six weeks. I’d spent countless hours tracking the politicizing of the Fed, and the U.S. government– approved leverage fest, including the little noticed but hugely pivotal exemption in 2004 of net capital ratios for the Big Five investment bank/broker-dealers on Wall Street, ratios originally meant solely for broker-dealers and once capped by regulators at 12:1 but which were allowed, starting in 2005, to in effect grow, in the case of Lehman Brothers, to 32:1. With more freedom to tap their balance sheets, using their assets in hand as collateral, often mortgage-backed securities that themselves were tied to other people’s borrowings, the investment *
Pursuant to Section 13(d) of the Securities Exchange Act of 1934, institutional money managers that amass more than a 5 percent stake in any public company’s shares are required to fill out within 10 days a Schedule 13D, which are made public, representing one of the only public portals into a hedge fund’s activities, besides the client letter.
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banks could borrow more, which meant they could lend more, to hedge funds placing bets, creating a scenario involving leverage on top of leverage on top of leverage. Regardless of all the many signals, no one set of factors can or will ever tell an entire story. History will assign a neat set of reasons for this past crash—the popping of the housing bubble, one created in large part by the U.S. government–sponsored entities Freddie and Fannie, exacerbated by an overindulgent credit derivatives market. Sounds right. Future generations will wonder how it was allowed to happen, why no one saw it. In fact, though, there were many people who saw it coming. Plenty of people. The bulls just outshouted the bears. Just as Wall Street mocked Roger Babson when he warned of the Great Crash of 1929 (Babson, a businessman, stock analyst, and sometimes trader who published his observations in a newsletter, gave a speech in September 1929 famously saying “sooner or later a crash is coming and it may be terrific”) so too was NYU professor Nouriel Roubini snickered at back in 2006. Roubini predicted the looming housing slump and the financial crisis it would bring during a speech before the IMF. He was viewed by many fellow economists and the investment community alike as some kind of a fringe player, a doomsday theorist prone to hyperbole. There are always going to be voices in the wilderness that go ignored. If history has proven anything, it’s that patterns repeat, again and again. Greed takes over and the self-fulfilling groupthink of the herd trumps rational process. But damn if my macro models didn’t continually point out the misalignment of expectations leading up to the crash of 2008. Call it managing expectations, or even controlling risk. To understand my approach to investing and risk management is to get your head around one basic premise: prices rule. Forged by legions of traders from Mumbai to Miami wielding trillions of dollars, tilting up and down and sideways, tick by tick, minute by minute, 175
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hour by hour, in an endless ebb and flow of greed and fear, prices, in everything from gold bars to baskets of Bolivian stocks, are the vital signs of that pulsating beast of global financial interplay otherwise known as the market. Even more specifically, I’m interested, or rather obsessed, with closing prices; closing prices are factored into my thinking, my modeling, not all the noise and emotion in between. People talk about fundamental research, and while I am all for kicking the tires there is, to me, nothing more fundamental than price. I often can’t stand it when people say “at the end of the day” to frame whatever summary point they are about to make, but literally at the end of the day you have the price and price is everything, where the market forces arrive and have spoken. My process for tracking and reading these endlessly blinking and changing vital signs, not too dissimilar from the way a doctor examines a patient, really would begin at the end of the day. Others may be heading off to Happy Hour; I am writing down dozens of closing prices, entered by hand, in pen and ink, into my notebooks. Culling from both a geographical cross-section and all the major Macro asset classes, I watch the S&P, the Nasdaq, the Dow; I track stock indices linked to Asia, Europe, Latin America, the Middle East; I check off rates, yields, bond prices, Libor, corporates, junk, mortgage backeds, Treasuries, all durations, from three months to 30 years; I follow oil and gas, metals and softs; the dollar, the Euro, the peso. Before I’d go to bed, I checked Japan and other Asian indices, as those markets were opening. At 4:03 a.m. the alarm sounded and the closing price collection quest continued. It continued until the left side of my notebook was filled with the dozens of closing prices, color-coded, green for positive movement, red for negative. When all of the vital signs are in hand, and checked off, I then could begin the second phase of the diagnostics test—examining the dynamics of all those prices relative to one another and that means asking lots and lots of questions. By 6:30 a.m., my brain a swirling cavalcade of closing price data, the right side of my notebook filled up with multiple macro themes, 176
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my belly filled with oatmeal, I would sit down at the computer for the writing of my morning note, which I began calling Early Look. From all of the chaos and complexity, I tried to transcend the mathematical monster, honing in on the simplicity and underlying patterns, visible to me if for no other reason than all these years filling up these notebooks. And in writing, I’m asking questions. If I’m not up earlier than the next guy, asking questions first, and asking the right questions, then someone else is. 07/29/2008 8:03 AM ET Who Do You Trust? A crisis of confidence in the leadership of the U.S. banking system is not going to help any asset class, globally. 08/05/2008 7:39 AM ET Ben’s Spinal Tap One by one, all of the asset bubbles perpetuated by politicized central bankers and levered long investors alike are popping. ■
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In August 2008, Carlyle announced it was shutting down the Blue Wave fund, which had by then dwindled to $600 million as a result of severe losses tied to the credit crisis. Blue Wave had failed to reach “the critical mass of assets under management necessary to support a multi-strategy fund infrastructure,” Carlyle’s spokesman said in a statement issued at the time. “This is an orderly liquidation,” the spokesman had said. The same could not be said for another Carlyle fund entity that blew up earlier in the year. Carlyle Capital Corporation, which was 15 percent owned by Carlyle Group and which had gone public in July 2007 listing on the Euronext Amsterdam, debuting in July 2007 at $19 a share. Designed specifically to use lots of leverage (30 to 1) 177
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to buy mortgage debt issued by Fannie Mae and Freddie Mac, CCC, its reason for being and timing couldn’t have been more disastrous. CCC’s CEO, John Stomber, had told investors in early March 2008 that the firm was not experiencing margin call pressure. Within days, it was clear that the company had, in fact, failed to meet margin calls of $400 million and soon was at the mercy of its creditors. Showing no mercy, two of CCC’s largest creditors, JPMorgan Chase and Deutsche Bank, led a group of chagrined lenders in the dumping of some $5 billion worth of the mortgage-backed securities that Carlyle Capital held. In the span of a week, the company’s share price fell 97 percent to 35 cents. And to think Carlyle-Blue Wave had canned me in 2007 the week my son was to be born for losing what amounted to a few million dollars. ■
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As the summer of 2008 wore on, Research Edge continued to grow its audience and expand its reach. We would form a major strategic alliance to function as a research arm of LaBranche & Co. at a time when LaBranche was transitioning from being basically just a Specialist* trading outfit into more of a full-service financial services firm. * Once a mainstay of the New York Stock Exchange, Specialist traders, located in designated stations on the NYSE floor, were historically responsible for making markets in shares of specific NYSE-listed companies with each Specialist trader responsible for a handful or more companies. Traders off the floor called down to floor brokers who executed buys and sells with Specialists. Stung by scandals involving allegations of front running and pretty much made irrelevant by wholesale structural changes to the way the NYSE conducts transactions, i.e., the rise automated electronic trading, Specialists went the way of the dinosaur starting around 2005–2006; in fact, the NYSE traders formerly known as Specialists are now called Designated Market Makers, or DMMs, who can’t trade for themselves alongside clients, as Specialists had been permitted to do.
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All summer long, fears spread and festered, fear that the federal government might have to nationalize Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, both drowning in toxic assets, and losing billions. In July, the Treasury Department and the Federal Reserve announced steps to provide liquidity infusions to the troubled GSEs (which Congress passed without much attention paid to it), but the growing perception that the government might realistically be forced to place Fannie and Freddie under conservatorship left the markets spooked. Now it was serious. My morning notes took a distinctly more urgent tone, and I took aim at the treasury secretary. Writing my daily note before the sunrise on the morning of August 22, 2008, I literally called on Paulson not to bail out his friends on Wall Street: Hank, we are depending on you. The time is running out on your clock as head of the U.S. Treasury. History has a not so funny way of writing itself accurately. I am 85% in cash, and my savings account earns an embarrassing rate of return for my son and family because you’re overseeing a U.S. Financial system with increasing risk to the downside. I’m not laughing. ■
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The state of the financial system was turning downright scary. Looking back now on the notes I was writing then, I can say that I was making the calls that needed to be made and saying the things that needed to be said. But at the time, the blowback from leveredlong hedge funds against me only became increasingly vitriolic. Not only were my colleagues and I not second-guessing ourselves, but the decibel level of the feedback served as reinforcement. Some guys I once considered friends of mine or mentors were telling me I had gone off the deep end. Hate mail poured in. Inside the office, we went about our research calmly, enjoying our process and each 179
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other as a storm raged outside. I’ve never seen a group of guys more assured of being right than my group in the late summer of 2008. Every day we came in expecting to be proven correct on everything we were saying, and believe me, we were not mincing words: 09/03/2008 7:55 AM ET Weathering the Storm As global growth slows, the levered bet on global commodities pops. As commodity levered hedge funds liquidate, the commodity “prop desks” at U.S. investment banks have to de-lever. As the world de-levers, the velocity of capital markets screeches to a halt. Asian growth slows, their currencies break down, and all that “Sovereign” cash begins to deflate. 09/04/2008 8:20 AM ET Pit Bull vs. Knuckles Knuckles Obama vs. Pit Bull Palin. This is getting good! Both of these young guns can give a speech cant they? They better—we could be facing the largest cross currents of global economic and geopolitical hurricanes since 1930. 09/05/2008 8:00 AM ET Resolution & Trust? Those who have proactively prepared for this global financial tsunami are going to be rewarded in the coming months . . . ■
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On September 7, 2008, the federal government announced it was taking over Fannie and Freddie. They were deemed too big to fail. Paulson said publicly that: “A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. 180
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And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.” About a week later, on Monday, September 15, Lehman Brothers filed for Chapter 11 bankruptcy, one day after Merrill Lynch was pushed into a forced marriage with Bank of America. Meanwhile, news was breaking that insurance giant AIG would report that it had lost $13 billion and that it would need to raise at least $40 billion to stay solvent. On that Monday alone AIG shares lost 61 percent of their value. The Dow fell 283 points. For those on Wall Street who had refused to face up to the reality that what they hoped was a bump in the road was in fact an express lane to a financial abyss, there could be no more self-delusion. Earlier that day I’d kept my morning note brief: 09/15/2008 8:14 AM ET Call Us—We’re Hiring We have an 84% cash position, and we are hiring. That’s it. That’s my morning call. Please forward all resumes to our President and Director of Research, Brian McGough
Two weeks after Lehman failed, Paulson and Bernanke broke glass and pressed an emergency plan into action, asking Congress to approve a federal bailout package of $700 billion to stave off systemic bank failures. Leaders were aghast. Senator Chris Dodd went on television, and, looking as if he had seen a ghost, described the behind-closed-doors tension of a meeting during which Bush Administration officials told Democratic leadership what could happen if the bailout money wasn’t approved. The air left the room, Dodd had said. I don’t doubt it, though I wonder if this was before or after Paulson supposedly got down on one knee and begged Nancy Pelosi to support his plan. I had given my subscribers a plan to follow, and it didn’t require Congressional approval—I pegged Friday October 3 as a day to circle, especially 181
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for those investors who proactively prepare for market risk. This day, according to my probability chart, had become a potential day for the U.S. stock market to crash. To this day there are hedge fund managers out there who continue to thank me for this proactive risk management call. While October 3 was in fact a down day, sadly, the worst, the Crash, Black Week, was still yet to come. On Monday, October 6, the market began a sickening slide—the Dow lost 18.2 percent in the single worst weekly decline ever—one that people will perhaps be talking about a century from now. During the eight trading sessions between October 1 and October 10, the Dow would drop 2,379.88 points, or 21.97 percent. The S&P 500, meanwhile, had closed September 30 at 1164.74. By October 10, the eighth trading day of the month, the S&P closed at 899.22 for a 22.9 percent loss during that period. After that horrific week was over, the bulk of the e-mails I received were from grateful money managers who had followed my research and my prompts—I’d gone to 96 percent cash in my asset allocation model, starting around the middle of September. Most of the e-mails were short and to the point, letting me know that my research had been valuable to them and encouraging me to keep up the good work. Then there was the e-mail I got from one of the very same hedge fund managers whom I’d been pissing off for months: “You were right.” Some very big hedge funds who followed our research would later inform me that they had followed our lead and avoided the carnage of Black Week, which was gratifying. But I wasn’t doing victory laps—the world had just become a terrifying place. Banks, the banking system, were seen as perilously close to breaking down, and the wheels of global credit mechanisms were grinding to a near full stop. I was more troubled than celebratory. On October 9, 2008, on the one-year anniversary of the S&P’s highest ever close, I wrote a note that began with a quote from Mohandas Gandhi: To put up with distortions … and to stick to one’s guns 182
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come what may—this is the gift of leadership. Then I continued: Today is the anniversary of the top of the mania—no, not a mania, THE Mania. On October 9, 2007, the S&P 500 closed at 1565, marking the top in all that drives the madness of a global crowd. From “event-driven” super duper concentrated activist butterfly wing nut “hedgies” to those private equity marauders who bought grain elevators and fleets of rail cars stocked chock full of potash, it’s all history now. ■
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The one-year cumulative decline in the U.S. stock market was nearing 40 percent. People were seeing their retirement savings wiped out. But the only savings accounts being prioritized by the U.S. Treasury Secretary were those maintained by Investment Banking Inc. Paulson had clearly articulated who he felt needed to be saved first—his friends. The mere sight of Hank the Tank marching up to a podium put capital at risk. People were too caught up in the moment and the shock of the monetary losses endured to realize where a week of trading fit within the context of U.S. economic history, but this Canadian native knew right away that the world had just seen something truly unforgettable. I felt good about what I had done to pull away the Wall Street curtain, and I began to think about my next big call based on and considering the notion that much more transparency and accountability not only was needed, it was on the way: In less than 30 days, we will have a new President, I wrote Oct. 9. That will mean the end of the reactive Paulson “plans,” and that has very positive investment implications. In between now and then, a lot can happen. That’s probably why I am reading Gandhi. ■
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The worst thing about crashes is more often than not the wellintended solutions wind up begetting worse crashes down the 183
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line. It’s akin to infusing a marathon Monopoly game on the verge of conclusion with a fat sack of new funny money, thus allowing otherwise wiped-out players to stay in longer. So we had a crash that played over years, and then months, and then weeks. Market conditions had grown worse and worse until the facts could no longer be shouted down or hoped away. I continued to chirp, and to do research and to ask questions, of myself, of the industry. To hedge funds that made money being short at the right time, I said “Bravo”—and they didn’t cause the crash. Short sellers were some of the only bright lights we had in the dark. To the levered long crowd, on Wall Street and at hedge funds, to all those in a position of authority in our financial system who dared to use the phrase “no one saw this coming,” I had to ask one thing: As a fiduciary to your shareholders and investors alike, what is it, exactly, that you do?
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The Great Squeeze
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fter the Crash, and the bailout, came the backlash, against banks, and against AIG and AIG’s risky hedge fund type operation, AIG-FP, and hedge fund managers in general, who, depending on the day, either caused the financial system to collapse via aggressive short selling or rumor mongering, which even if you buy those arguments, was still the equivalent of trying to call out a handful of rowdy fans for ripping down stadium goalposts when 80,000 people rushed the field. In the midst of all this outrage and pandemonium, the signals, surprisingly, were flashing positive. ■
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For all these years I had been logging price data and a multitude of other economic factors into notebooks and checking them with either a red colored X (bad) or two red Xs (awful), or three (toxic), 187
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or, conversely, a green check mark (three check marks = really good). It was this process, a difficult daily grind but one I have to do, day in, day out, that led me to make a call that a crash was brewing. E-mails were still pouring in from grateful clients who moved to cash on my prompting (more than a couple of the biggest hedge funds, mutual funds, and pension funds in the business were, by the summer of 2008, using Research Edge for macro calls and had, indeed, moved to cash ahead of “Black Week”) when I realized I needed to reverse course—I had to become bullish. This was not about me; I wasn’t trying to be different, or a contrarian’s contrarian, although my shift in outlook would certainly seem counter to prevailing wisdom, that Financial Armageddon was at hand. At the time, with such historic tumult gripping the world’s attention, a bullish take would surely be met with some skepticism. But I could simply not ignore that the market appeared to be bottoming, having moved radically too far to the downside. The developments leading me to this thinking, as always, were on the margins—housing stats going from toxic to merely bad—but slowly a body of evidence was leading me to conclude that most likely the worst was over. The hyper-bearish voices had the fresh autumn of trauma on their side of the debate. I didn’t really blame them for sticking to the doomsday script that by now everyone was allowed to see albeit in the rear view mirror; it is hard to look past a horrifying, blood-oozing, head-split-wide-open wound, even as other vital signs are simultaneously stabilizing. The “Depressionistas,” as I came to call the Nouriel Roubinis and Paul Krugmans and Joseph Stiglitzs of the world, had the floor, and everyone’s attention, but at this stage of the game they had to be tuned out. These guys are professors; they are not stock operators, nor are they risk managers. They were getting too negative. In mid-October, I moved my model portfolio from 100 percent cash down to 96 percent cash. One of the factors that had me buying a bit, in addition to falling energy prices and indications that the Case-Shiller index was in a bottoming process, was political. 188
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The market, the banking system, and the financial regulatory structure were drenched in egg splatter and sorely needed more transparency and accountability, and the United States looked like it was on the verge of electing a president who could steer us closer to that kind of environment. Another sign developing: A crowd of hedge funds, the same one that had all followed each other into the big swinging front doors of levered long insanity, were now suddenly all charging for the same set of back exits trying to short the market in freefall. A bear stampede. Everyone, it seemed, was loading up on canned goods and prepping for an era of scavenging wastelands for food, riding corn syrup–fueled motorcycles made from junked parts. The louder the Depressionista voices grew, the more my signals flashed green, even if the pundits were sounding all-hands-on-deck alarms. But the facts on the ground changed. I had to change with them. I’d say around the last week in October I started really turning bullish. I wrote this on Halloween. Cowboy Up 10/31/08 7:52 AM ET “I don’t like Bull Riders . . . They’re little men with big egos. Besides, he’s got one of them skinny butts like the rest of ’em.” —Kellie Frost One of my favorite movies of all time is “8 Seconds” (1994), the story of rodeo legend, Lane Frost. Kellie Frost was, of course, Lane’s wife . . . and in the beginning, she didn’t like bulls anymore than the bears like me right about now. We aren’t mincing words. We remain bullish for the “Trade” here. I am so bullish that for Halloween I am dressed up like a cowboy at the office. I have my highest allocation to Equities in 2008. I am all bulled up, snake skin boots on and all. My friends up in Calgary, Alberta might not find it to be much of a costume, but if I pranced 189
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Heading into 2009, the bears still owned the debate on Wall Street. Funny, after neglecting to heed more than one year’s worth of warnings, missing the Crash completely, the same herd now agreed to agree that far worse financial chaos was in store and the prevailing trade was short the S&P. One of the leading voices overblowing the Next Great Depression narrative the way I used to do my hair in the early 1990s, was the overnight academic sensation, Dr. Doom himself, Nouriel Roubini. He’d been one of the earliest and loudest voices predicting a housing bubble burst that would wreak havoc on the world’s economy. Writing in the January/February 2009 issue of Foreign Policy magazine, Roubini, professor of economics at NYU’s Stern School of Business, chairman of a financial consulting firm, and, many believed, the second coming of Nostradamus, had this outlook for 2009: Last year ’s worst-case scenarios came true. The global financial pandemic that I and others had warned about is now upon us. But we are still only in the early stages of this crisis. My predictions for the coming year, unfortunately, are even more dire . . .
Such sentiment led Wall Street firms, Morgan Stanley for one, as well as a lot of hedge funds, to turn incredibly bearish. Bears turned more bearish. Bears who made money were now actually losing money precisely for being too bearish. For example, Peter Thiel’s Clarium had piled up massive returns during the first part of 2008 riding its call on the collapse of the mortgage market, but now was giving it all back. I had a dozen or so data points anchoring a 190
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thesis I called the MEGA Squeeze of Depressionista influenced short sellers—I’d returned to my macro acronyms, with MEGA referring to Mortgage Rates, Employment, Gas Prices, Assets—leading me to stay bullish. Meanwhile, the mainstream press was finally catching up to a Wall Street R.I.P. story, a strong signal that such a narrative was not only overhyped but turning slowly on the margin, and if you looked you could see the signals. But, again, I was in staunch opposition to the sentiment of the crowd, including many hedge funds, which were now staking what was left of their assets in a bet on continued meltdown in the markets. Hedge funds that were shorting the market reacted to my bullish morning notes with the same antagonistic fervor of the levered long guys who told me to go F*** myself when I was bearish and predicting a crash. I told them they were going to be wrong, they told me I was going to be wrong, and the to and fro reminded me of my hockey playing days when I would tell a rookie player across the face-off circle from me exactly which direction I was going to go with the puck after I won the face-off. I’d always enjoyed telling someone I was going to run them over and then doing it. Where Did All The Bulls Go? 12/17/08 08:10AM EST “If it’s a good idea, go ahead and do it. It is much easier to apologize than it is to get permission.” —Admiral Grace Hopper At the end of the day, this business isn’t about having “ideas”. . . it’s about asking the right questions first, acting ahead of the crowd, and being right on those ideas. We’ve been saying this for the last 12 months, and we’ll hammer it home one more time this morning—those who do not respect the history of how manias and markets move are doomed to repeat its mistakes. While we can get the “knucks” for having called the market crash, I am much more proud of 191
d i ary of a h e dg e f und manag e r our recent wins in being able to be long China, Hong Kong, Brazil, and the U.S.A. before these massive one day rallies. It’s one thing to be a perpetual bull or bear. It’s entirely another thing to have a business model that’s driven by one cause—to be right. That’s why I started this firm. That’s what gets my feet on the floor to write this every morning.
Not to chirp too much on Roubinism, but I still can’t help but wonder if guys like him had any actual daily risk management process that guided all the doom think, or were these folks just sticking to the same script they had been using for two years. Either way, my team and I were committed to having our feet on the floor every morning at 4 a.m. watching the indicators and continuing to recommend actionable trade ideas. The signals continued to blink green. My firm’s consumer maven Howard Penney wrote this gem while pinch hitting for me in early March: The Wall of Worry 03/06/09 08:28AM EST It’s human nature to lose confidence when you become seriously ill. You feel worthless and it feels like anything you say is meaningless and everything you do is pointless. Everything you do is just plain wrong! Yes, that is ANXIETY! Anxiety robs you of your personality, kills your confidence and thus, you lose your identity. Sound like a typical description of the U.S. stock market! The good news is your confidence and personality gradually return, building up in layers, until eventually you feel like the person you were before you became ill. In the end, you grow into a stronger person. So today is tomorrow—Nice. This is a metaphor for how most people feel about the US stock market. Everywhere you turn and everything you read increases your anxiety level. Over the past week there are some leading indicators that things might be bottoming, like retail sales, the move in copper prices and the news from the early cycle technology names. Unfortunately, we are not in control of our own destiny any more. Without the 192
The Great Squeeze Chinese, we would likely go down a lot more. How high does your anxiety level go, knowing that we need the Chinese to fund our deficits and without further stimulus, the global economy suffers? Talk about a position of strength! The next politician who thinks he can bad mouth the Chinese or push them around needs to be given a “time out,” like a child who hasn’t learned discipline. The Chinese own us! This morning it looks like we are going to get a horrific jobs number with expectations that payrolls could decline by 650,000, the most in a generation. Since the Chinese control us we need to think more like they do. Someone in the Labor department needs to “make up” a really horrific number and get all of the bad news on the table so we can move on. Anticipating a really bad jobs number, early indication is that the dollar is declining, which will help to stabilize, if not allow the market to rally today. That’s been the US Strategy trade of 2009, US Dollar UP = SP500 DOWN. Reverse that intermediate Trend of US$ strength, and stocks find stability. That’s how “re-flation” works. Last night as I drove home from New Haven, I listened to a debate on Bloomberg Radio about whether Obama is to blame for the decline in the market this year. He definitely didn’t create this mess, but he was elected to fix it . . . and the market discounting mechanism suggests he’s not getting the job done. I know my anxiety level increases knowing that we are dependent on the politics of Washington to get us out of this mess. In the end, pointing fingers is a waste of time, I just want results! At this point, it is hard to tell which sector is going to lead us out of the doldrums! There is not a single sector in the S&P that looks good. The “safe and boring” sectors like Consumer staples are not working in a down tape. We are dependent on Washington to restore consumer confidence, which will help the discretionary names. Utilities are not going up as interest rates go up. Healthcare is re-testing the lows and is in a cloud of uncertainty, but a rally from here would be very bullish. The Financials continue to be a toxic waste land. Energy and Materials are not going up unless the Chinese re-flate the global economy. That leaves us with Technology . . . On a relative basis, 193
d i ary of a h e dg e f und manag e r Technology is starting to outperform more consistently, but most are closet industrials. Who wants to own an industrial? This unemployment report is due out in 30 minutes—it’s time to get back on that Wall. Function in disaster; finish in style . . . Howard Penney Managing Director
Among the signals, Penney and my other analysts were seeing falling gasoline prices, which were significantly boosting household disposable income, allowing for more spending toward discretionary categories. Some other leading indicators suggested that things might be bottoming, including retail sales, a move in copper prices and the news from the early cycle technology names. Not to be outdone by my colleague—we were all on the same team and on the same page—I followed up Penney’s pinch-hit morning note with one of my own, on March 9, and it was called “The Great Recession.” It began: Now that CNBC is running segments titled “Recession or Depression,” and Bloomberg’s No. 1 “Exclusive” story this morning is titled “Depression Dynamic Takes Hold,” what more evidence do we need? I gave readers my latest move—as the U.S. stock market hit new lows on the prior Friday, I had started buying U.S. equities more aggressively. I had taken our Asset Allocation Model Portfolio to 24 percent in U.S. equities, and took down my cash position from 70 percent to 58 percent. As I did, I noticed my inbox was being flooded by the same people who mocked me when I was short Goldman prior to the crash and who were now laughing at me for being long Goldman. One reason I was recommending buying U.S. stocks was because I didn’t have a boss telling me I couldn’t. I ended the note that day saying that the market was close to three standard deviations oversold. ■
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The day my “Great Recession” note was published, the S&P 500 bottomed at 676. Over the next three weeks it would rally to north of 800, a nearly 40 percent move. Untold numbers of Depressionista hedge funds which were short the market got squeezed royally. This was one of the greatest single squeezes since the era of Jesse Livermore.* Hedge funds that missed one of the biggest down moves of all time had now missed one of the greatest up moves ever, and worse, many of them had been short. Hedge funds, conceived as vehicles to make profits in any kind of market, had once again chased the consensus, using a one-factor model, momentum, copying each other’s ideas. At Research Edge, we stayed focused on our proactive process. By April, we had 30 long ideas and just 8 shorts, which reflected a view that the rebound in the stock market still had some legs in the intermediate term. But longer term, I was spotting a dollar crisis on the horizon. In May, we began to proactively worry about a crash of the U.S. dollar, and we turned a bit bearish, perhaps too early. Michael Jordan has famously pointed out that he missed more than 9,000 shots in his career and that 26 times he missed gamewinning shots. “I’ve failed over and over and over again in my life,” Jordan said. “And that is why I succeed.” As for what was next, all I could do was keep at my process, keep enhancing it, and keep making calls every day. I’m bound to get some wrong. But at least I’ll be taking the shots, ones the consensus isn’t allowed to take.
*
Famously shrewd Wall Street trader in the early part of the 20th century, Livermore’s exploits, including shorting the market during panics, forcing prices down amidst a scarcity of capital, which squeezed sellers, became the basis for the Edwin Lefevre book Reminiscences of a Stock Operator.
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Epilogue
I
t’s a few minutes before 8:30 a.m., Tuesday, June 2, and I’m just about to sit down at the head of the table in our quaint conference room. My colleagues are assembled waiting to begin our Morning Call. Dozens of Portfolio Managers, analysts, and traders from around the buyside community who follow our research and pay us to be able dial into the call every morning are standing by. Some of our investment calls of late have not been exactly stellar. We missed a 2.6 percent move in the S&P over the past few days, although I still can’t justify making bullish calls with the U.S. dollar under pressure. But I also can’t avoid the obvious. I lean into the squawk box, and, turning up the volume, I just say it, loud, direct: “Okay, so we got our doors blown off.” With the uncomfortable admission behind me, I continue on with my morning macro overview, delivering in rapid-fire succession a barrage of facts and factoids, takes and observations, glancing at my notebook now and again, but the material pours out because it’s burned on my brain and needs to come out. I cover currencies, 197
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countries, commodities—gold is a buy today if it’s down, but longterm I’m selling if it goes over $1,000—and as I touch on rising oil prices and the weak dollar I move farther and farther away from my act of contrition, because as obvious as it was to call myself out, today is another day. I’ve been up since 4 a.m. going over world markets, price data. I’ll forge ahead to get it right today. I’m making shortterm and long-term calls and holding myself accountable in real time, every day. I do this for my subscribers, and I do it to push myself. Also, as far as I can tell, no one else in money management does it. Money managers want you to know as little about their process as possible and rarely own up to their mistakes unless they absolutely have to and even then they make excuses. Either way by then it’s too late to do anything about it. I want to be an open book, so my clients trust Research Edge’s process, so they know we are going to be at this again and again, providing far more right calls than wrong ones, and not just saying what everyone else is saying even if in the short term we end up looking like we’re out of the loop. Toward the end of the meeting someone from our audience e-mails us a question about inflation. Am I concerned about it, and if so, why am I not short the stock market? I’ve been watching the dollar break down and the data is troubling. In the immediate term, I explain, I am concerned about inflation in the fourth quarter; but today we are in the second quarter—in the short term I can’t justify shorting the S&P as a macro call. Knowing a trend versus a trade is a key part of what it is I do. ■
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I could, and just might, write a book on investing for the long term versus the short term. But suffice to say, I’m duration agnostic. This is an approach I’ve come to understand more clearly over the past year and a half, and now I have an investment framework that takes three concurrent durations into account. 198
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In my framework, a TRADE is three weeks or less. A TREND is three months or more. A TAIL is three years or less. Tail risk—the kind of rare event that strikes like a bolt from the blue and upends all fundamental research and preparation—is perhaps the hardest kind of risk to manage due its inherent unpredictability—but that doesn’t mean I can’t try. (People have always told me I can’t do things, and it’s been a constant source of inspiration.) There’s a lot of complexity and chaos theory behind these durations and why I have come to view investing this way. I finally understand, I think, that the global investment landscape is as interconnected as it has ever been across asset classes. Like any complex system, the individual factors embedded within it are very dynamic—they change constantly—and unless you have a flexible investment process that allows you to bob and weave within different duration strategies, you’re going to get run over. For those “invest for the long run” marketing campaigners—I have one thing to say. I agree. Provided, however, you have the timing right. A long-term portfolio set up and abandoned between 1990 through 2000 would be a better performer than one, say, set up between 2000 and now. I’ll hold names that I bought in February 2009 like Starbucks and Yahoo for the rest of my career, provided that the global macro and company specific facts don’t change relative to my original investment thesis, that is, value with a catalyst. But I am simply never going to just sit back and hope my picks win out in the long run or advocate that any investor do that. I’m sure there are many people who let their assets just sit when the market collapsed and some of them are probably thinking that they did the right thing when the market came back. But check your statements. You’re not doing as well as you thought because your original capital base was depleted. You were within reason to hope the market would come back, but trust me, you need to hope it comes back much farther before you get back to whole. As I’ve said many times, hope is not a process to which I subscribe. 199
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Whether you are rich enough to invest in a hedge fund or if you trade your own account online or if your brother-in-law the Financial Planner handles your portfolio, the time has come for more people to take a more proactive approach to their financial health. Let’s start with hedge fund managers. This is a group that has to get more proactive in a variety of areas starting with ditching their dirty secret—crowding into the same trades and going into positions based on which other hedge fund managers are in them. Looking back on how the whole mess played out in the summer and fall of 2008, something struck me as truly preposterous, and that was the sheer amount of time it took—more than a year— before cold hard facts on the ground—waning consumer spending, deteriorating bank balance sheets, sketchy rating agency practices, government missteps, Wall Street’s leverage overindulgence, the unraveling of the mortgage market—piled up high enough to finally bring about the kind of stock market crash seen in the first week of October 2008. That such a steep drop or even something close to it didn’t happen far sooner was the real shocker when we look back at 2007–2008. What kept the market going? I honestly think it was the deal cycle, the buyout craze, the convergence of cheap money, hedge funds and private equity funds, doing each other’s bidding and wringing every last drop out of possible profit out of the markets before last call. They had a window and nearly destroyed one another and the rest of us trying to rush through it. In the end, the levered long hedge fund crowd grasped for straws and emergency rate cuts to keep the game going. Gone now are the days of hedge fund managers coasting on consensus, enabled by cheap money and markets that are going up, enchanted by a special handful of Super Smart Hedge Fund Guys with Big Ideas. We’re no longer likely going to see multi-billiondollar hedge funds raised overnight to take positions in one single stock. We’ve seen how that kind of thing has worked out for guys like Ed Lampert and for Bill Ackman, who held himself accountable 200
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by tearing up at a Target shareholders’ meeting. Come on, there’s no crying on Wall Street! The crowds might still be propped up by delusional groupthink, had it not been for the failure of Freddie and Fannie, the obliteration of Lehman Brothers, and the near nationalization of AIG. It took Hank Paulson on bended knee for the stock market to go through the kind of correction myself and others had been predicting. Then again, whether such a crash happened earlier or in less severe or more orderly fashion would likely not have mattered. Everything for a reason, a reason for everything, as my dad used to say. No sense trying to figure out the madness of crowds—I’ll leave that to other writers, students of history, behavioral economists, and brain scientists.* One of the other things I came to appreciate going through the process of recreating my personal journey from hedge fund lemming to industry iconoclast is really how much admiration I have for certain managers. Ultimately, I have faith that a large swath of the industry has nothing to hide or apologize for and that even those that do still can improve and build on the things that drove the industry to such heights in the first place, that is the ability to consistently produce positive returns, after fees, in any market. According to Hedge Fund Intelligence, just one quarter of America’s hedge funds** were able to produce positive returns in both 2008 and through the first seven months of 2009. Only 20 percent of *
According to Scientific American, an experiment reported in March 2009 in the Proceedings of the National Academy of Sciences USA by brain scanning researchers at the University of Bonn in Germany and the California Institute of Technology lent support to the theory that a specific part of the human brain within the prefrontal cortex, an area called the ventromedial prefrontal cortex (VMPFC), produces a type of “money illusion,” prompting most normal people to ignore obvious information and instead rely on faulty logic to convince themselves of the potentially enriching prospects of their investments, such as real estate purchases or shares of Target. ** Includes U.S., North America, and South America.
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equity hedge funds, including long and short equity, made money in both periods, HFI says. About 60 percent of the U.S. funds in HFI’s database remained below their high water marks as of July 2009. Clearly, hedge fund managers at large have to work extra hard to reestablish sound practices. Putting up gates to keep investors from taking their money out is not the kind of practice I’m referring to. Going forward, clients are going demand three things: LIQUIDITY, TRANSPARENCY, and RETURNS. A hedge fund can charge “5 & 50” if it wants to, but if it can’t give clients all three of these things, in markets that don’t go straight up, if up at all, that fund’s survival odds are slim. The industry is going to change for one simple reason: Clients are going to demand it. The days of stringent lockups,* and of garden-variety client letters as the sole source of sunlight on the fund are, I put forth, numbered. Some level of real-time communication will one day be the norm—the hedge fund industry grew from the “managed account” business that catered to rich people who demanded service, and the main attribute of managed accounts, accountability, is coming back. Most individual investors will go through life never having a money manager so involved in the process of looking after their portfolios that they shed tears or for that matter feel much if anything, except grateful, for the account, which if parked away in a mutual fund or annuity product, is earning fees regardless of what the market does, so really, what do they care? One of the goals I had when I set out to do this book is inspire some people to take up greater self-involvement in investing. If a hockey player named Mucker from Thunder Bay can do this, anyone can, or least get to a point where with some help you can take
*
Unlike mutual funds, hedge funds more often than not restrict their investors’ ability to redeem their assets from a fund, locking up assets for specific periods of time, particularly in down markets to prevent a downward spiral of selling assets to raise cash to meet redemptions.
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a role that goes beyond just hoping the market comes back. I repeat, hope is not an investment process. I’m not only predicting a rise in the ranks of self-directed investors, I’m banking on it and building a business around it. Individuals have to get more involved and take back the reins from industry people who get paid to keep them in the dark. Just as hedge fund investors are going to demand liquidity, transparency, and returns, rising numbers of smart people who know how to invest and want to invest and who just need some tools and information, these individuals, the kind of men and women who never asked for or expected a bailout when they faced financial problems, will command transparency, accountability, and a sense of trust. The self-directed crowd, for all of the measures made by the government to level the playing field, measures like Reg FD and decimalization, have still never been able to compete with Wall Street and hedge funds. They’ve never gotten the first call. Or any call. In fact, Wall Street brokers in the past decade have been encouraged to shed small fry clients too expensive to service. Don’t fret if you are one of them—they are doing you a favor. ■
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Back at my research meeting June 2, I’ve got Tom Tobin on the squawk box. He’s all over the healthcare reform issue, the ramifications of which are being built into our models for health insurance stocks. An interesting stock to watch, Tobin points out, is UNH. Some fear it will be put out of business by health reform—Tobin thinks that Obama’s public plan is in for tough sledding come August. Time to buy UNH? It’s been rallying lately, which doesn’t bode well for reform. Next up, Todd Jordan, our gaming, lodging, and hospitality analyst and who is sitting to my left, weighs in on Carnival, the cruise ship line. “The Street is way too high on 203
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Carnival’s 2010 estimates right now,” Jordan says. I like where he’s going. When I overlay my global macro thesis on energy prices into this picture, it seems to me the last thing you want to own in this environment is a thing that floats on water—with fixed costs. Howard Penney, our restaurant analyst, is next up with a quick dot connect on falling cheese prices, swine flu, and Chuck E. Cheese, and then globe-scouring analyst Andrew Barber contributes his report on a full-blown speculative soybean bubble as well as a bearish signal he’s spotted in the form of a bullish India fund recently created and named after the song “Jai Ho” from the popular movie Slumdog Millionaire. Lots to chew on, and this gang could go all day, but the meeting has to wrap up. This kind of give and take, discussion, team interplay, is what I most adore about the investment business. It’s what gets me up in the morning. At 4:01 a.m. Every morning. It’s what I do. And that’s all I have to say about that.
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Acknowledgments
T
he Authors wish to thank the following people: Andrew Barber, Kerry Bauman, Michael Blum, David Bragnalo, Zachary Brown, Chris Butler, Forrest Chang, Tanya Clark, Darius Dale, Jeff Dawson, Christian Drake, Todd Enders, Casey Flavin, Josh Friedlander, Chris Gillick, Rory Green, David Homonoff, Matthew Hedrick, Emilie Herman, Daryl Jones, Todd Jordan, Jen Kane, Allison Kaptur, Meryl Paula Kaye, Adam King, Larry Kirshbaum, Rick Ladouceur, Michelle Leder, Wayne Lee, Eric Levine, CJ Marotollo, Anna Massion, Cheryl McCullough, Cole McCullough, Jack McCullough, Jenine McCullough, John McCullough, Laura McCullough, Liam McCullough, Ryan McCullough, Vivianne McCullough, Brian McGough, Howard Penney, Rich Peterson, Alexander Richards, John Reitano, Rebecca Runkle, Hank Scott, Harry Scott, Pam Scott, Peter Scott, Moshe Silver, John Taylor, Tim Taylor, Tom Tobin, Pamela Van Giessen, Andrew Walsh, Karrin Weisenthal . . . and Mick, the skinny dude from California. A special thanks also to FactSet. 205
About The Authors
K
eith McCullough is the Founder and CEO of New Haven, Connecticut–based independent investment research providers Research Edge. McCullough is a widely followed global macro strategist who spent nearly a decade on Wall Street, starting as an analyst at Credit Suisse in New York before joining the hedge fund industry. He would eventually manage hedge fund portfolios for four firms: Dawson-Herman Capital Management, Falconhenge Partners (which he co-launched with Harry Schwefel), Magnetar Capital, and Carlyle–Blue Wave Partners. McCullough grew up in Thunder Bay, Ontario, as the son of a firefighter and a schoolteacher. He played several seasons of Canadian Junior-A Hockey and later played four seasons for Yale University, where he graduated in 1999 with a degree in economics. This is his first book. Rich Blake is the former cofounder and executive editor of Trader Monthly magazine and a past National Magazine AwardReporting finalist. He is currently a contributing editor of
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about th e auth or s
Institutional Investor magazine. A native of Buffalo, New York and a 1990 graduate of St. Bonaventure University, Blake is also the author of two other non-fiction books, Talking Proud: Rediscovering the Magical Season of the 1980 Buffalo Bills and The Day Donny Herbert Woke Up.
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Index
Ackman, Bill, 127, 146, 150, 174, 200 Adidas-Salomon AG, 101 AIG, 6, 181, 187, 201 AIG-FP, 187 Ainslie, Lee, 33 Alpha, 90 Al Quaeda, 78 Amaranth, 14, 132–133 Anderson, Dwight, 33, 85 Andor Capital, 85 Andrew Carnegie (Nasaw), 149 AOL Time Warner, 75 Apollo Advisors, 127, 129 Archipelago Holdings, 14 Arnold, John, 92, 133 Asia, 161 Asset Allocation Model Portfolio, 194 Asset-backed instruments, 119 Asset-backed securities, 142 Asset Management, 142 AT&T, 75 A.W. Jones & Company, 132 Babson, Roger, 149, 175 Bailey, John, 14
Bailout, 187 Bain Capital, 150 Balyasny, Dmitry, 93 Banc of America Securities Annual Investment Conference, 74 Bank holding companies, 142 Bank of America, 74, 142, 181 Banks, 141, 142, 187 Barakett, Tim, 93 Barber, Andrew, 169, 204 Barclays Plc, 142 Basel Committee on Banking Supervision, 128 Basel II, 128 Basis points, 88 Baupost Group, 93 Bear market, 173 Bears, 190 Bear Stearns, 85, 86, 128, 141, 142, 170, 173 Bear Stearns Asset Management (BSAM), 143, 151 Benton, Dan, 48, 58, 59, 64, 85 Bernanke, Ben, 181 “Bips,” 88
209
index Black, Leon, 127 BlackRock, 145 Blackstone Group, 13, 127, 144, 145, 151 Black Week, 182, 188 Blake, Rich, 5 Blogging, 159–164, 180, 181, 189–190 Blue Ridge Capital, 33 Blue Wave, 1, 144, 155, 177 Blum, Michael, 26, 76, 106, 111, 165 Boesky, Ivan, 59 Bombardier, 19 Bond ownership, 6 Bonuses, 130 Brazil, 161 Bre-X Minerals Ltd., 87, 94 Briger, Peter, 145 Broadcast.com, 94 Brokerages, 141 Broker-dealers, 128 Brooks, Garth, 38 Buffett, Warren, 37 “Bulge Bracket” investment banks, 141–142 “Bunker Down” plays, 78 Bush Administration, 181 Buyouts, 128–129 Caesars Entertainment, 87 Cantillon Capital Management, 92 “Cap Intro,” 105 Capital Markets, 142 Carlyle-Blue Wave Partners, 1, 12–15, 144, 146 Carlyle Capital Corporation, 177–178 Carlyle Credit Corporation (CCC), 151 Carlyle Group, 1, 12, 13, 143, 144, 153, 177 Carlyle Multi-Strategy Partners, 144 Carnival, 203–204 Case-Shiller index, 188 Catterton Partners, 150 Centaurus Energy, 92, 133 CEOs, 49, 50, 70, 72 CEO salaries, 130 Cerebus, 127 CFOs, 49, 68–70 Chanos, Jim, 93
Chess King, 32 China, 86, 95, 109 Chuck E. Cheese, 204 Citadel Investment Group, 11, 92, 102, 119 Clarium Capital Management, 92, 190 Clark, Tanya, 148 Client letters, 202 Clients, 172, 202 Clinton, Bill, 146 “Closet indexers,” 82 Closing prices, 68, 176 Coach, 133–134, 150 Cohen, Steven A., 35, 48, 90, 91, 131 Coleman, Chase, 85 Collateralized debt obligations (CDOs), 119 Comcowich, Kevin “Comco,” 66, 69, 77 Commodities, 161 Compensation, 130 Conglomerates, 131 Consolidated Supervised Entity program, 128 Consumer spending, 170–171 Convexity Capital, 102 Cooperman, Leon, 35, 91, 156 COOs, 68, 69 Copper, 86 Cracker Barrel, 113 Cramer, Jim, 173 Crash of 2008, 173–175, 182–184, 187, 188, 190 Credit derivative, 142 Credit Suisse, 106–107, 110, 111 Credit Suisse First Boston, 1, 32, 42–49, 51–56, 63, 65, 66, 71, 86 Credit Suisse Group, 43 Cuban, Mark, 93 Currencies, 161 Cuskley, Terry, 49 Dawson, Jon, 1, 35, 57–59, 63–65, 67, 68, 70, 72–74, 76, 84–87, 89, 94, 99–100 Dawson-Giammalva Capital Management, 63, 66, 89 Dawson-Henry Capital Management, 57 Dawson-Herman Capital Management, 89
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Index Dawson-Samberg Capital Management, 57, 58, 63 DB Absolute Return Strategies, 143 DB Advisors Capital Management, 143 Dear Client letters, 162–163 Den of Thieves (Stewart), 59 Depository Trust & Clearing Corporation (DTCC), 110, 111 “Depressionistas,” 188, 189, 191, 195 Deutsche Asset Management (DeAM), 143 Deutsche Bank, 12, 43, 143, 178 Deutsche Morgan Grenfell, 43 DiMaggio, Joe, 146 Dispigna, Danny “the Dirty Dog,” 34 Dodd, Chris, 181 Donaldson Lufkin and Jenrette, 32 Dot.com bubble, 94 Dot.com era, 42 Dougan, Brady, 44, 56 Dow Jones Industrial Average, 142, 152, 181, 182 Drawbridge Global Macro Funds, 145 Drawbridge Special Opportunities Funds, 145 Drucker, Peter, 121
Faillace, Anthony, 93 Falcone, Phil, 93 Falconhenge Partners LLC, 12, 103–104, 109, 113, 118–121, 165 Fannie Mae, 179, 180, 201 Federal Reserve, 142, 152 Feinberg, Stephen, 127 Ferraro, Tom, 43–45, 47, 49, 50, 65, 106, 108, 111 Fidelity, 34, 48 Fielding, Elodie, 34 Financial bubble, 94 Financial Services Modernization Act of 1999, 127 Financial system, 179 First Boston Corporation, 32 Fishman, Steve, 90 Fitch, 153 Fortress Investment Group, 12, 127, 144, 145 Four Seasons Hotel, 119, 135–136, 144 Frankfort, Lewis, 133 Freddie Mac, 179, 180, 201 Freeport-McMoRan Copper & Gold, 109 Fuld, Dick, 92 Funds of funds (FOFs), 111–113
Early Look, 177 eBay, 92 Economic storm clouds, 149 Edens, Wesley, 145 E.F. Hutton, 32 Einhorn, David, 92, 93 Employee Benefit Research Institute, 6 Englander, Israel “Izzy,” 59 Englander’s Millenium, 89 Enron collapse, 78, 92 Equity salesman, 45, 47 Equity sales trader, 45, 47, 48 Esslinger, Hartmut, 166 Eton Park Capital Management, 92 Euronext Amsterdam stock exchange, 151, 177 Europe, 161
Gandhi, Mohandas, 182, 183 Gates, Bill, 100, 144 George, Zachary R., 90 Giammalva, Tony, 58, 77 Giroux, Ray 27, 37 Glass-Steagall Act of 1933, 128 Glenwood Capital Partners, 11 Global consumer spending boom, 135 Global Crossing, 75 Gold, Dan, 143 Goldman Sachs, 58, 91, 107, 128, 141 Goldman Sachs Asset Management (GSAM), 143 Goldsmith, Rick, 12, 13, 143, 144, 154 Goldstein, Phillip, 93 Goldthorpe, Bill “Goldie,” 20 Go-private movement, 128 Government-Sponsored Enterprises (GSEs), 179 Gramm-Leach-Bliley Act, 127
Facciola, Tom, 85 FactSet, 3
211
index Great Crash of 1929, 175 “Great Recession, The,” 194, 195 Greaves, Magnus, 91 Greenlight Capital Fund, 92 Gretzky, Wayne, 20, 73 Griffin, John, 33 Griffin, Ken, 92 Gross, Geoff, 64, 66, 68, 73, 74 Gross, Michael, 127 Halpern, Jules, 118 Halvorsen, Andreas, 33, 64, 85 Harmon, Timothy, 71 Harrah’s, 87, 129 Harvard Management Company, 102 Hedge fund clients, 107–108 Hedge fund industry, 143, 156, 162, 201–202 Hedge fund industry bubble, 16, 130, 131, 156 Hedge fund industry, coming out party of, 89 Hedge fund industry contraction, 5–6 Hedge Fund Intelligence (HFI), 5, 201–202 Hedge fund managers, 91–94, 95, 118, 130, 187, 200 Hedge fund managers, compensation of, 130–132 HedgeFund.net, 5 Hedge fund numbers grow, 132 Hedge Fund Research, 5–6 Hedge funds, 48 Hedge funds, awareness of, 35 Hennessee Group, 131 Henry, Clifford W., 57 Herman, Russell, 59, 64–68, 72, 73, 78, 84, 86, 87, 94, 126, 133 Hess, Erik, 148 Hockey playing in Canada and at Yale, 20–27, 37–38 Hong Kong, 161 Hopper, Grace, 191 Housing bubble, 149 Hunter, Brian, 14, 133 Hwang, Bill, 85 Hyman, Ed, 148
Icahn, Carl, 127 IGT, 75 Initial public offerings (IPOs), 51, 53–54 “Inside information,” 51 “Institutional” money managers, 47 Internet, 43 “Investment banks,” 141, 142 “Investment brokerage houses,” 141 Investment Company Institute, 6 I.S.I. Group, 148 Jackson, Al, 49 James, Chris, 85 Janus, 34, 48 Japan, 161 Jones, Alfred Winslow, 132 Jones, Daryl, 64, 66, 73, 74, 76, 155, 169 Jones, Paul Tudor, 35, 86, 93 Jordan, Michael, 195 Jordan, Todd, 169, 203–204 J.P. Morgan, 142 JPMorgan Chase, 170–178 Kauffman, Robert, 145 Keating, Charles, 54 Keller, Steve, 43–47, 50, 65 Kinesic interview techniques, 95 KKR, 127 Klarman, Seth, 93 Knight, Phil, 87, 136 Kozlowski, Dennis, 82–83 Krugman, Paul, 188 Kudlow, Larry, 171 LaBranche & Co., 178 Ladouceur, Rick, 22, 23 Laferriere, Rob “Laffer,” 33 Laffer, Arthur, 171 Laidley, Wendell, 46 Lampert, Ed, 200 Larguay, George, 74, 76 Laser, Ross, 11, 12, 119, 125 Laws of Delaware, 105 Lazard Asset Management, 92 Lefevre, Edwin, 195 Lehman Brothers, 41–42, 71, 128, 141, 142, 152, 174, 201
212
Index Lerner, Reid, 26, 44 Letourneau, Ray “Razor,” 31, 33 Leverage, 133 Levitt, Arthur, 69 Lightfoot, Gordon, 89 Limited Liability Company (LLC), 105 Limited Partnerships (LPs), 105 Lincoln Savings & Loan, 54 Litowitz, Alec, 11, 102, 119, 125–126, 134 Livermore, Jesse, 195 Lock up assets, 202 Loeb, Dan 93 Lone Pine Capital, 33 Long/short equity strategy, 84 Long Term Capital Management, 35, 36 Long-term portfolio, 199 Loomis, Carol, 131–132 Lowe, Rob, 20 LTV, 131 MacLean, Mac, 24, 25 Macro research, 4, 77 Madoff, Bernie, 5, 6 Magnant, Francois “Frenchy,” 44 Magnetar Capital, 1, 11–12, 102, 119–121, 125, 127, 132–134, 145, 146 Magnetar’s multi-strategy offering, 127 Magnetars, 117 Mahoney, John, 84 Making of an American Capitalist, The (Buffett), 37 Malisic, Mick, 166, 167, 168 Management fees, 69, 102, 156 Management meetings, 81 Management team sit-downs, 49–52, 70, 147 Mandalay Bay, 87 Mandel, Stephen, 33, 85 Man Group Plc, 11 Manhattan real estate prices, 89 Markowitz, Steve, 146 Marottolo, C.J., 26 Maverick Capital, 33 McCullough, Cheryl (sister), 22 McCullough, John (father), 20 McCullough, John Henry “Jack” (son), 155, 166
McCullough, Laura (wife), 103, 125, 155, 166 McCullough, Ryan (brother), 89, 106, 151–152, 165 McCullough, Viviane (mother), 20 McCullough Capital Management, 160 McDonald’s, 87 McGillis, Dan, 23 McGough, Brian, 87, 167, 168 MCM Macro, 3, 4, 160 Meeker, Mary, 43 MEGA Squeeze, 191 Mehta, Hamesh, 148 Merger arbitrage, 119 Meriwether, John, 35 Merrill Lynch, 47, 128, 141, 142, 170, 181 Merton, Robert, 35 Meyer, Jack, 102 MGM casino stock, 129 MGM Grand, 75 MGM Mirage, 75, 87 Midway Games, 71 Midway Home Entertainment, 71 Mindich, Eric, 91 Mining stocks, 108–109 Mission statement, 112 Momentum stocks, 134 Money managers, 198 Montgomery Securities, 74 Morgan Stanley, 43, 87, 107, 111, 119, 128, 141, 167, 190 Morning Call, 49, 197 Mubadala Development Company, 153 “Mucker,” 22, 43 “Multi Strategy” hedge fund, 119 Mutual fund portfolio managers, 82 Mutual funds, 6, 48 Names of funds, 103–104 Nardone, Randal, 145 NASA, 117 Nasaw, David, 149 Nasdaq Composite Index, 35, 45, 55, 74 National Radio Astronomy Observatory, 117, 118 NationsBank, 74 Nevada Gaming Commission, 129
213
index New Haven, 169 New hedge fund firms, 102 New York State Comptroller’s office, 130 New York Stock Exchange, 14, 142 Next Great Depression narrative, 190 Nicastro, Neil D., 71 Nike, Inc., 87, 101, 167 Northern Rock, 153 Novogratz, Michael, 145 “Number, The,” 69–70
Prince Alwaleed Bin Talal Alsaud, 144 Private equity boom, 127 Private equity funds, 144 Private Placement Memorandum, 105 Proactive approach to financial health, 200 Prospectors & Developers Association of Canada, 108 Pulsar Re, 119 Putnam, 34
Och, Dan, 12, 35, 91 Och-Ziff Capital Management, 12 Offering Documents, 105 Office Depot, 84 OSI Restaurant Partners, 150 Outback Steakhouse, 118, 150
Quattrone, Frank, 43, 46, 53–56, 71, 141 QVT Financial, 143 Qwest, 75
Paulson, Hank, 179, 180, 181, 183, 201 Pacific Sunwear of California, 71–73, 100 Pali Capital, 109–110 Pandit, Vikram, 106 Parcells, Jim, 21 Parker, Fred, 23–24, 25 Pass-through tax treatment, 105 Paterna, Audra, 154 Paulson, John, 92, 149 PayPal, 92 Pelosi, Nancy, 181 Penny, Howard, 169, 192–194, 204 Pequot Capital, 48, 57, 58 Pequot Partners, 57 Perry, Richard, 35, 92 Pershing Square Capital Management, 127 Phelps Dodge Corp., 109 Pickins, T. Boone, 93, 130 PIPEs (Private Investments in Public Equity), 119 Pirate Capital, 90 Portfolio Management System, 105 Portfolio managers (PMs), 12, 47–48, 50, 66, 72, 88 Position traders, 47–48 Price to Earnings (P/E) ratio, 135–136 Prime broker (PB), 105, 107, 110, 113, 119
Ransom, Scott, 118 Reagan-Thatcher era of laissez-faire market conditions, 130 Reebok International, 101 Regulation Fair Disclosure, 51, 69, 203 Reingold, Dan, 46 Reminiscences of a Stock Operator (Lefevre), 195 Renaissance, 93 Research, 4, 86, 87, 94–95, 151, 165 Research analysts, 46 ResearchEdge LLC, 4, 168, 178, 188, 195, 198 Retirement plans, 6 Retirement savings, 183 Reynolds, Ralph, 12, 143, 144, 154 R.I.P.-TE, 147, 150 Risk management, 77 “Roadshow Desk,” 51 Robertson, Julian Jr., 32, 33, 35, 66, 85, 156 Roubini, Nouriel, 149, 175, 188, 190, 192 Rubenstein, David, 12 Russell 2000 Small-Cap Index, 82 Russia’s central bank, 152 S&P Case-Shiller Home Price Index, 35 S&P 44 Mid-Cap Index, 82 S&P 500, 3, 34, 82, 152, 153, 182, 183, 195 SAC Capital, 48, 90 Saleh, Homayoun, 147–148
214
Index Samberg, Art, 35, 48, 57, 59, 64, 85 “Same-store sales,” 67 Sara Lee Corporation, 134 Scholes, Myron, 35 Schonfeld, Steve, 93 Schuler, Barry, 75 Schwefel, Harry, 1, 12, 15, 85–86, 103, 104, 111, 127, 135, 144, 145 Sears, Michael, 85 Securities and Exchange Commission (SEC), 51, 69, 127 Securities Industry and Financial Markets Association, 6–7 Self-directed investors, 202–203 Shanghai Composite, 161 Sharp, Isadore, 136 Shaw, David, 35 Shiller, Robert, 35, 149 Short sellers, 184 Shumway, Chris, 85 Siciliano, Dave, 22 Silicon Valley, 42 Simons, Jim, 35, 93 Slumdog Millionaire (movie), 204 Soros, George, 35, 90, 130, 131, 149, 156 South Africa, 161 Southport Consumer Discovery Fund, 94, 99, 103 Southport Millennium Fund, 59, 65–67, 78, 81, 86, 88 Southport Technology Partners, 74 Specialist trader, 178 Spitzer, Eliot, 83 Staal brothers, 20 Staples, 84 Starbucks, 199 “Startups,” 45, 46 Starwood Hotels, 75 Stein, Ben, 171 Steinhardt, Michael, 35, 131, 156 Stewart, James, 59 Steyer, Tom, 91 Stiglitz, Joseph, 188 Stock market, 152 Stock market crash of 2008, 200 Stock market decline, 183 Stock ownership, 6
Stomber, John, 178 “Subprime crisis,” 153 Subprime mortgage crisis, 2 Subprime mortgages, 119, 152, 153 Subscription Documents, 105 Taft, William Howard, 4, 169 Tail, 199 “Take private” bid, 128 Taliban, 78 Target, 146, 150 Taylor, John, 168 Taylor, Tim, 26, 27 Technology/dot.com fever, 43 Telecom sector shake out, 75 Teledyne, 131 Tepper, David, 91 Terrorist attacks of September 11, 2001, 75–77, 82 Texas Pacific Group, 129 Textron, 131 Thiel, Peter, 92, 149, 190 Thomson Financial, 54 Tiger Global, 85 Tiger Management, 32, 85 TigerShark Management, 85 Tiger Technology, 85 Tobin, Tom, 66, 69 95, 104, 165, 171, 203 Touradji, Paul, 33, 85 Trade, 199 Trader Monthly, 91, 130 Trend, 199 Trend versus trade approach, 164, 198 Trichet, Jean-Claude, 161 T. Rowe Price, 34 Tyco, 82–83 UNH, 203 Vancouver, George, 94 Vancouver Discovery Fund, 94 “Venture capitalists,” 46 Verbrughe, Roz and Eric, 22 Viking Global Investors, 64 Vinik, Jeffrey, 92 von Mueffling, William, 92
215
index Walek, Thomas, 163 Wall Street Journal, 152 Wal-Mart, 95 Wasserstein, Bruce, 92 Weaver, Greg, 72 Weiss, Peck & Greer, 57 Westlund, Alex “Westy,” 26–27 Wheat, Allen, 43 Williams, David “Tiger,” 27, 32–34, 64 Williams, Robin, 54 Williams Trading, 31, 33, 36, 45, 110 Wolfe, Ed, 85
WorldCom, 75 Worthington Growth LP, 57 W.P. Stewart, 66 XTE J1810-197, 117–118 Yahoo!, 93, 199 Yale University, 25–27 Y2K concerns, 43 Ziff Brothers, 147–148
216
“An engaging and fascinating memoir of a Wall Street insider who foresaw the crisis and lost his job for it. McCullough has written an insightful firsthand account of our modern Rome before—and after—its fall. The author stands head and shoulders above his peers with his phenomenal trading track record, personal integrity, and skill at communicating his unique experiences.”
— Richard L. Peterson, MD, Managing Director, MarketPsy Capital LLC; author, Inside the Investor's Brain “If an unholy offspring of Lester Bangs and Don Cherry traded and wrote a financial market diary, it might be something like the smart, hip, and crunching commentary hedge fund manager Keith McCullough delivers every day. Keith is on a short list of must-reads in a business filled with also-rans.”
— Dr. Paul Kedrosky, Editor, Infectious Greed; Managing Director, IG Holdings; Senior Fellow, Kauffman Foundation “Diary of a Hedge Fund Manager should be added to the list of must-read books on Wall Street. It is very rare that readers get this kind of insight into the world of what Wall Street calls the “smart money”. McCullough’s exciting and inspirational story reinforces the fact that hard work pays off. The book does a great job of pointing out that, on Wall Street, common sense and hard work trump a PhD—without actually saying it. His honesty is refreshing and reminds us all that the giants of the hedge fund world are mere mortals. This story is one that both Wall Street and Main Street can relate to and learn from.”
— Douglas M. Famigletti, CFA, Managing Director, Griffin Asset Management, Inc. “Like Liar’s Poker and Fiasco before it, Diary of a Hedge Fund Manager offers a fascinating, funny, and frightening account of life on the Street. An indispensable account of how the financial-industrial complex destroyed so much of the ‘value’ it purported to create.”
—Dan Burrows, Senior Writer, DailyFinance “The hedge fund world is notoriously secretive. But in Diary of a Hedge Fund Manager, Keith McCullough reveals what's behind the curtain to show an industry that frequently is little more than a lot of smoke and mirrors, much the same way that Toto revealed the Great and Mighty Wizard of Oz to be nothing more than an ordinary man.”
—Michelle Leder, founder and Editor, footnoted.org; author, Financial Fine Print
