Winding up Amaranth
Here is a great, long, summary of the challenges of winding up Amaranth Advisors, that once feared $7 billion hedge fund. If you’re a fan of legal docs, this one is a doozy.
If you read the fine print, you get a sense of why it is inconceivable that pension funds can continue to support the idea that hedge fund managers:
– have a zero cost of capital
– pay out all of the “promote” based upon a single year’s performance rather than the performance of the team over the life of a fund
– do not ask the team to sign guarantees should the fund explode, and the promote that was paid earlier in the life of the fund is no longer “earned” based upon the fund’s overall performance
Here is an excerpt from Amaranth’s LP agreement regarding imdemnification of employees (note the reference to “gross negligence” vs. mere “negligence”; confirms that no employees, regardless of the financial losses, are liable unless there was intentional misconduct (I’m assuming that intentionally laying on disasterous natural gas arbitrage trades doesn’t count as misconduct):
The Limited Liability Company Agreement further provides that the Master Fund will indemnify, defend, and hold harmless the managing member, its Affiliates and, at the discretion of the managing member, the Master Fund’s agents, employees, advisors and consultants from and against any losses arising as a result of business or activities undertaken on behalf of the Master Fund, other than such losses as result from the bad faith, fraud, gross negligence or reckless or intentional misconduct of such parties, or the violation by such parties of such lesser standard of conduct as under applicable law prevents that indemnification, or as a result of actions so found by a court of competent jurisdiction, after entry of a final judgment, to have been taken without a reasonable belief that they were properly authorized by the Limited Liability Company Agreement. All such rights of indemnification shall survive the dissolution of the Master Fund.
MRM
Why on earth would anyone work for a firm that did not indemnify them from negligence? Such clauses, as we see here, are standard and reflect the generally accepted practice that we do not brand people on the forehead for taking risks.
Hedge Funds like Amaranth are not typically capital preservation instruments. They are risk taking vehicles. The indemnification of employees and principals is well disclosed to investors who take the time to read the offering materials and offerings are restricted to sophisticated investors.
Using simple negligence in cases like this means that every loss of any size would likely be followed by a lawsuit. After all, isn’t it entirely negligent not to diversify? Most hedge funds that seek outsize returns don’t dervisify much. That’s the point.
Your concerns seem naive to me in the context of a free capital market structure with a specialized investment system.
-ep
Thx for the comment. Think you missed the point, however. I didn’t suggest that teams shouldn’t be indemnified. I was suggesting that the pay structures need to be changed. And there was some tongue in cheek there as well (even sardonic?), as the original Equity Private posting had a specific reference to Mr. Hunter. This sentence is from the original EP posting: “There was, as I recall, some question about liability for the Brian Hunter’s of the world. Have no fear, Brian Hunter, (absent fraud).”
Risks are disclosed to investors, that’s true, but the roadshow materials invariably talk about multifaceted risk mitigation tactics that reduce beta, etc. No pitch says: “if things don’t go well you’ll lose all of your capital”. They say the opposite, in essence: “that our fund is structured and managed so that 100% wipeouts cannot happen”.
I’m not saying the team should be liable for natural gas trading losses. I’m saying the hedge structure, unlike merchant banking, mezz, venture debt and VC payout formulae, is – as a result – geared to encourage people to swing for the fences by paying out the promote on an annual basis; and no clawback or team guarantees regarding those bonuses. And I also believe the LPs are as much to blame for allowing that difference as are the management teams who clearly benefit from it.
This is what happens when a guy can make $100 million in one year using a risky trading strategy (in hindsight), and in the following year, if the strategy turns out to have been flawed – he keeps his $100 million and the LPs lose every penny.
The excuse I always hear is that hedge funds allow capital early withdrawals, unlike the PE, mezzz and VC structures, so therefore the 100% annual payout and zero preferred return is appropriate. Nuts. Most GP/LP structures now have a “no fault” divorce clause which permits 75% of the LPs to band together to shut the fund or fire the team; which is really not much different that the so-called hedge fund redemption right. Its actually more effective.
Of course, when things don’t go well at a hedge fund, and hedge fund LPs try to redeem their capital, the management teams have the right to invoke the clause you mentioned in your blog, which overrides the capital withdrawal request. That was disclosed to investors, as well, of course. But it is a false sense of comfort, as we are now learning.
Nothing naive in those observations, I humbly submit.
MRM
Are you trying to tell me that investors don’t read the disclosure materials and, instead, rely on road show pitches? If that’s the case I have exactly zero sympathy for them, especially given the complexities and depth of SEC regulation on the private placements that rule hedge fund marketing.
How would you contrast the hedge fund structure and VC structure, exactly? Are you trying to tell me that VC is less volatile than most hedge funds? (hint: better check your stats). That VC funds
don’t do 2/20 structures? Or are you arguing that VC structures, by virtue of their lack of monthly incentive payments to management, are better? That would have the ironic effect of causing you to argue that a far less liquid investment also highly sensitive to macro conditions is less risky. An interesting position to take.
Swinging for the fences is fine. So long as people pay attention to modern portfolio theory and blend risky investments (and particular kinds of risk) with more conservative investments.
At the core, your argument is against risk taking. It might as well, therefore, be against investment of any kind.
-ep
—- No pitch says: “if things don’t go well you’ll lose all of your capital” —-
You’re right. They say things like:
“The maximum loss is limited to the initial investment.”
“…losses may equal your original investment. Indeed, in the case of some investments the potential losses may exceed the amount of initial investment…”