March 21, 2023

The Trade: Pruning Hedge Fund Regulation Without Cultivating Better Rules

John Paulson is famous for having shorted the housing bubble, making billions. Then his returns nose-dived.Eduardo Munoz/ReutersJohn Paulson is famous for having shorted the housing bubble, making billions. Then his returns nose-dived.

Fresh from having declined to constrain money market funds, the Securities and Exchange Commission has moved to loosen marketing constraints on hedge funds.

Two weeks ago, the agency threw up its hands and said it would not be able to defend millions of investors from money market funds that do things like invest in dodgy European bank bonds yet proclaim themselves to be perfectly safe.

Instead, the S.E.C. — mandated by Congress through its misnamed and harmful JOBS Act — proposed rules last week to lift advertising restrictions for hedge funds and other kinds of private investment offerings. The rules haven’t been completed, but we can look forward to an ad featuring a wizened couple in matching tubs overlooking a sunset, holding hands and talking about how they just put money with the next George Soros.

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The old rules for hedge funds make little sense. Surely, hedge funds should be able to promote themselves to investors with data about their returns and methods. But there’s a problem: The S.E.C. does not have any new resources and has not put in place any policies to police these promotions.

Letting slip the dogs of advertising comes as some professional investors and academics doubt that the industry can continue to produce outsize investment returns — if, in fact, it ever did. As they get bigger, hedge funds struggle to score good results. As investments have become increasingly correlated and interrelated, it gets harder to execute safer and unique strategies.

In a perfect world, hedge fund advertising would improve the world of investing. Hedge funds, after all, are wildly misunderstood. A good hedge fund seeks steady returns in good markets and bad. Many of the best-managed funds aren’t actually trying to beat the market in its best years. And many of the good funds seek uncorrelated results, so that the returns don’t move in lock step with the stock market.

And, honestly, few things could be worse than mutual funds, which in aggregate underperform the stock market and charge too much to do it.

The problem is that the way this loosening looks on paper and the way it will play out in the real world are a tad different.

If Groucho Marx were alive today, he’d say that he would never want to invest in a hedge fund that would have him as a limited partner. One doesn’t see Le Bernardin and Château Lafite filling the airwaves during N.F.L. games. The ban on law firm advertising was lifted in the 1970s. Today, Jacoby Meyers advertises on television; Sullivan Cromwell does not. Drug ads have wrought a parade of patients demanding new (high margin) medicines from their doctors that often offer few benefits over the old (off patent) ones.

Even professionals have a problem in evaluating hedge fund performance, because distinguishing skill from luck and excessive risk-taking is extremely difficult. For instance, funds often don’t even let their own employees know how much leverage they are taking.

Take the case of John Paulson, who is famous for having shorted the housing bubble, making billions. The result is that many, surely including Mr. Paulson, were convinced of his brilliance.

Before his world-renowned score, he was a grinder, eking out decent returns with a relatively small fund. Afterward, his fund grew exponentially to tens of billions under management.

Then his returns nose-dived. His main fund plunged 36 percent last year and has dropped another 13 percent this year, according to The Wall Street Journal.

Last week, after Citigroup’s private bank pulled out of his fund, Mr. Paulson convened a conference call with Bank of America investment advisers and their clients to explain what was going so horribly wrong with his funds.

It turns out that Mr. Paulson was like the Old Man in the Hemingway novel: He happened to be the guy, through some skill and some luck, to land the biggest fish in the world. How much of each did he have? No one can know.

Another lesson from Mr. Paulson’s experience is that even if a fund manager is smart, people who put their money into them are dumb. Citigroup and Bank of America look as if they were typical. Average investors chase performance, putting in money after the great years. Then they panic, pulling their money out at the bottom.

Look for this to be replicated frequently when hedge funds start advertising. Simon Lack, in an important recent book “The Hedge Fund Mirage” (Wiley), argues that hedge funds have been great for hedge fund managers and not so great for their investors. The managers get huge fees. Investors would have been better off investing in Treasury securities, he says.

The hedge fund trade group says that Mr. Lack has it all wrong. Their logic, however, hasn’t been persuasive. Felix Salmon, a blogger for Reuters, wrote that the hedge fund group’s complaints had “convinced me of the deep truth of Lack’s book in a way that the book itself never could.”

At least hedge funds specialize in separating people from their money through excessive fees. Other types of offerings prefer to do so through less savory means. The opening of hedge fund advertising has garnered much of the attention, because of the tantalizing idea that we will all soon be able to invest with the best minds on the planet. But the S.E.C. is also lifting rules on other kinds of securities offerings from small companies. Many of these will require less disclosure and will be particularly ripe for fraud.

So the best case from the agency’s move is a bunch of Paulsons, while the worst case is a bunch of Madoffs. It doesn’t seem like a great bargain.

The S.E.C. declares in a fact sheet that it will keep the rules about who can invest. Yet the victims of Bernard L. Madoff, who orchestrated the largest Ponzi scheme in history, were accredited investors. The agency does not plan to mandate any new process to ensure that investors are accredited, or whether their investments are appropriate for them.

This is all harks back to a precrisis specialty: get rid of supposedly outdated regulation, but create no new limits or powers to keep things from blowing up.

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Email: Follow him on Twitter (@Eisingerj).

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The Raider in Winter: Carl Icahn at 75

“What else would I do? Play shuffleboard somewhere?” Mr. Icahn grumbles into the phone from his vacation home in Indian Creek, Fla., the rarefied enclave near Miami.

It’s an old line, the one Mr. Icahn huffs, with over-my-dead-body pique, just about every time the subject of retirement comes up. No, at age 75 and a billionaire several times over, Carl Icahn will not go quietly.

Mr. Icahn has spent four decades making trouble for corporate America — and making a lot of money for himself and his investors. But now, midway through his eighth decade, he has begun to contemplate his legacy, and the future of the Icahn empire hangs in the balance. What will they say about him? He bristles at being called a corporate raider, though if you Google the phrase you’ll soon find his name. He prefers something friendlier: activist investor.

So behold the raider — or the activist, take your pick — in winter: rich, yes, but so entranced by the game that he can’t quite let go. One of his chief lieutenants, an up-and-comer, recently abandoned him: Keith A. Meister, widely considered his right-hand man, left the fold late last year. Mr. Meister was a pivotal player at Mr. Icahn’s multibillion-dollar hedge fund, as well as at his flagship Icahn Enterprises, his investment holding company. But with $250 million from George Soros, Mr. Meister opened a hedge fund of his own. He was joined in January by Rupal Doshi, formerly chief operating officer of the Icahn Group. (Both declined to comment for this article.)

Shortly afterward, Mr. Icahn abruptly announced he would close his own hedge fund. He had opened the fund, to much fanfare, in 2004. But Mr. Icahn lost so much money during the financial crisis that he is still a bit shaken by the experience. He is returning all outside investors’ money. Henceforth, Carl Icahn will manage money only for Carl Icahn.

In a March 8 letter to his fund’s investors, Mr. Icahn said he was still unsettled by the events of 2008, when his fund plummeted 35 percent.

“Given the rapid market run-up over the past two years and our ongoing concerns about the economic outlook, and recent political tensions in the Middle East, I do not wish to be responsible to limited partners through another possible market crisis,” Mr. Icahn wrote in his letter.

Managing other people’s money was a headache, Mr. Icahn says. Besides, he thinks the markets are headed for a fall. “You’ve got to be a fool if you don’t think there will be a correction,” he says.

And so, with Mr. Meister gone, Mr. Icahn’s son, Brett C. Icahn, waits in the wings. The younger Icahn, 31, entered the family business after graduating from Princeton and spending a few relatively fruitless years directing movies.

Carl Icahn says his son is ready for more. But he denies he has anointed him as his successor, as many outsiders suspect. “I give him more and more responsibility because he’s earned it, but it’s not nepotism,” Carl Icahn says of his son. “He’s got good instincts.”

Brett Icahn — or whoever succeeds his father, if anyone really can — has some big shoes to fill.

“When it’s a company that’s so identified with the style, personality and skills of a single owner, you really don’t know how it will evolve,” says Stephen M. Davis, executive director of the Millstein Center for Corporate Governance and Performance at the Yale School of Management. “Carl Icahn has a skilled team — there’s no doubt about that — but it really does rest upon his leadership.”

CARL ICAHN runs his investment business from elegant offices 47 floors above Fifth Avenue in Midtown Manhattan. He declined to be interviewed in person for this story.

Instead, he spoke by phone, from his offices in New York and his home in Florida, over the course of several weeks, a dozen or so conversations in all. He orchestrated the interviews as if he were cutting a deal, which, in some ways, he was: he spoke on the condition that he could vet every quotation.

What, really, is left to say about Carl Celian Icahn? Even those who are too young to remember his exploits in the 1980s know the stories. Born and raised in Queens to parents of relatively modest means, Carl helped pay his way through Princeton with winnings from poker. His parents wanted him to become a doctor, so the obedient son went to medical school. Then a patient with tuberculosis coughed on him.

“I said,” he recalled, “I’m done — I quit.”

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