Agency Costs and Hedge-Fund Size

(Bloomberg View) -- Financialization.

If you just knock around in the world for a bit, you will read stuff about finance that comes at it from let us say a popular point of view. Without trying to define it too strictly, this point of view is suspicious of financial engineering and derivatives and stock buybacks. It worries that executive pay is too high and too complicated. It worries that companies borrow too much. It wants things to be simple and normal and calm, and is repulsed by complexity and risk. 

It is fun sometimes to read papers by financial economists because they are ... different. Here is an NBER working paper from Jongsub Lee and Junho Oh of the University of Florida and David Yermack of New York University on "Credit Default Swaps, Agency Problems, and Management Incentives" (free version here):

We show in a theoretical model that credit default swaps induce managerial agency problems through two channels: reducing the opportunity for managers to transfer value to equityholders from creditors via strategic default, and reducing the intensity of monitoring by creditors, which leads to greater CEO diversion of assets as perquisites. We further show that boards can use compensation awards that increase managerial performance incentives (delta) and risk-taking incentives (vega) in order to mitigate these two agency problems, with increases in managerial vega being particularly useful to alleviate the strategic default-related agency problem.

The problem that they have identified here is too little default. "Managers may engage in less strategic debt default than optimal, since creditors will bargain harder due to the presence of the CDS insurance contract": You are less likely to successfully restructure your debt if the creditors can get paid off on their CDS after liquidation. (This is not always true.) The solution to the problem is to get managers to take more risk: They can't bargain their way out of a risky situation by restructuring the debt, so the only fix is to double down on risk to try for a recovery. Or at least, the solution is to give CEOs more volatile compensation -- more "vega," that is, exposure to volatility -- in order to get them to take more risks when things are going poorly:

This logic implies that a firm’s shareholders who see their strategic default opportunity diminish after introduction of CDS in the market are more likely to increase their CEO’s managerial vega. This would motivate their CEOs to work harder when facing significant incentive dilutions due to increasing default probability

Another problem is that creditors with CDS won't monitor managers as closely, so the managers may get lazy or give themselves too many perks. The solution to that is to give the managers more stock, so that they want to work harder to make themselves richer.

I think the three things to say here are:

  1. This line of thinking -- worrying that managers are taking too little risk, and trying to make managers manage better by giving them more stock -- is quite standard in financial academia.
  2. It seems to accurately describe the world, in that companies really do seem to give managers more stock and options once CDS is introduced. (Lee, Oh and Yermack look at the data for companies before and after CDS is introduced, and find "that managerial vega increases by 133% from its sample average following the inception of CDS trades." They also find that CDS leads to managers getting more share-based compensation.)
  3. It seems nuts, if you take the popular point of view.

Or, not nuts exactly. Just a different emphasis. I think you could construct a popular narrative here that goes like: When credit-default swaps were introduced at companies, those companies' creditors stopped having real long-term relationships with those companies, and started being purely mercenary market actors. The managers, cast adrift in a cold heartless world with no deep ties to their creditors, stopped caring. To get them to care more, boards gave them more stock and more stock options, which encouraged them to take more risk (and buy back more stock), and also made them richer. Derivatives led to risk and overpaid managers; financialization in one place led to financialization everywhere; the inexorable logic of finance made companies a bit worse on every dimension (that the popular view cares about). And then, to add insult to injury, some academics went and wrote a paper with a bunch of Greek and pseudo-Greek letters justifying all of this.

Deep down, a lot of the recurring sections of Money Stuff are about this tension. People are worried about stock buybacks because they feel fake and enrich managers, but corporate-finance theory -- with its focus on shareholder value and constraining managerial discretion -- tends to be pro-buyback. People are worried about index funds being anti-competitive, but indexing and diversification are some of the great practical triumphs of modern scientific finance. Academic finance set itself a list of problems -- agency costs, risk/return optimization -- and then went and solved them, or at least, came up with a generally accepted list of best-practices solutions. And then the financial industry, and business generally, more or less adopted those solutions in practice. Scientific thinking was applied to business, and produced recommendations, and the recommendations were successfully applied in the real world. Progress was made! And yet people don't exactly seem happy about it.

How big are hedge funds?

There is a generally accepted vague sense that the hedge fund industry has about $3 trillion under management, but here is a research note from Winton Capital Management, the U.K. quantitative hedge fund (or is it?), questioning that number:

Depending on the definition of a hedge fund, the assets managed could range anywhere from $800bn to $3.6tn. Furthermore, we find that the $800bn figure accords more closely with the common perception of a hedge fund.

The $800 billion number is for extremely classic hedge funds that charge management fees of at least 2 percent and performance fees of at least 20 percent, use leverage or shorting and are in lightly regulated vehicles. That seems a bit strict for my tastes: Hedge-fund fees are coming down generally, and 1.5 and 15 is the new 2 and 20. But even if you restrict the universe to funds that charge at least 1 and 10 you get about $2 trillion of hedge-fund assets, less if you require leverage or shorting or light regulation.

The rest of the $3 trillion of hedge-fund assets -- something like half the industry, more or less -- probably aren't really hedge-fund assets in any strict sense. But because a lot of hedge-fund firms have grown, over time, to become large general-purpose institutional asset managers, they end up having billions of dollars of assets that are invested in conventional (or conventional-ish) active (or "smart beta," etc.) management strategies, with conventional (ish) fees, but get counted as "hedge fund" assets anyway.

So much bitcoin.

Bitcoin futures start trading next week, and people who have spent the last few years convinced that bitcoin is a dumb bubble are very excited to finally be able to put their money where their mouths are and start shorting bitcoin. But is this right?

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

I mean, it's not wrong. Bitcoin futures do make it easier to go short: Borrowing bitcoins to short them physically is difficult and expensive; shorting them through futures should be straightforward. Bitcoin futures also make it easier to go long: Buying bitcoins to own them physically is rather annoying for institutional investors; if you own a lot of bitcoins you have to worry about getting them hacked or stolen, or you have to store them in cold storage (slips of paper, safes), which makes them inconvenient as trading assets. It is strictly true that bitcoin futures will do more to make shorts easier than they will to make longs easier -- just because being long bitcoin, now, is easier than being short -- but I am not sure that that will be net bearish. If there are 100 people lining up to go long once it gets 10 percent easier, and 10 people lining up to go short once it gets 50 percent easier, then making it a little easier to go long and a lot easier to go short may just lead to more longs. 

Also here's a guy:

Some see the bitcoin market as “one of the greatest shorting opportunities ever,” said Lou Kerner, a partner at Flight VC who invests in the cryptocurrency. “You have a lot of zealotry, and a lot of people, including me, who think it’s the greatest thing to ever happen in the history of mankind. You have a lot of people who think it’s a bubble and a Ponzi scheme. It turns out both of them can’t be right.”

I appreciate that he is aware of and appreciates the divergence of opinion on the matter, but nonetheless not only is on balance bullish, but thinks it's the greatest thing to ever happen in the history of mankind. It's hard to go back to "we think the fundamentals of XYZ are fine but we are a Sell on valuation" after getting involved in an asset class that is either a Ponzi or mankind's salvation. 

Elsewhere hey look it is factor investing in cryptocurrencies:

According to Hubrich, three factors work in the major digital currencies: value, carry and momentum. The philosophical challenge is finding a way to replicate those traits. They’re reasonably straightforward in stocks, say, measuring value through a company’s price-earnings ratio.

To find a crypto corollary, Hubrich gets creative. He translates value to mean the token’s market value versus the dollar volume of blockchain transactions. For momentum, Hubrich uses a four-week horizon because of limited historical data, rather than the 12 months typically used for equities.

There are two deep theories of what factor investing is. One theory holds that the "factors" are risk factors, and that -- say -- the value factor has above-market returns because value stocks have some additional risk that investors need compensation for. The other theory holds that the factors are behavioral anomalies, and that -- say -- momentum investing has above-market returns because humans predictably like to buy things that are going up. If you believe the first theory, it would be a little weird to extend it too literally to bitcoin. But if you believe the second then, I mean, go nuts. There is no market more ... behavioral ... than bitcoin.

Israel’s Natural Resources Holdings Ltd. is the latest company to benefit from blockchain stock magic as it shifts from from digging for minerals to mining digital currencies.

Shares of the company, which invests in metals mines located mostly in North America, rallied 159 percent to 2,540 shekels ($727.63) in Tel Aviv after disclosing to regulators Sunday it is about to acquire a 75 percent stake in Canadian cryptocurrency mining operation Backbone Hosting Solutions Inc., also known as Bitfarms.

"Shares of Natural Resources have soared more than 2,000 percent since the company said on Oct. 17 it plans to change its name to Blockchain Holdings and that it was seeking an acquisition of a cryptocurrency mining operation." You might think that there are no synergies between mining for gold and mining for bitcoin, and you'd be right, but that is not quite what is going on here. Natural Resources Holdings Ltd. is not the sort of mining company that has any revenue from mining operations. It's the sort of mining company that was "formerly known as Cidav Printed Circuits Ltd." As I said about Grand Pacaraima Gold Corp., another sort-of-gold-miner that renamed itself First Bitcoin Capital Corp., "here in 2017, not finding bitcoins is a vastly more lucrative business than not finding gold."

People are worried about unicorns.

People are worried about the souls of unicorns! When the Enchanted Forest gets a little too real for you, you go to the spa. Or retreat center or commune or whatever it is:

And so Silicon Valley has come to the Esalen Institute, a storied hippie hotel here on the Pacific coast south of Carmel, Calif. After storm damage in the spring and a skeleton crew in the summer, the institute was fully reopened in October with a new director and a new mission: It will be a home for technologists to reckon with what they have built.

Here's Esalen's new director, Ben Tauber:

“There’s a dawning consciousness emerging in Silicon Valley as people recognize that their conventional success isn’t necessarily making the world a better place,” said Mr. Tauber, 34, a former Google product manager and start-up executive coach. “The C.E.O.s, inside they’re hurting. They can’t sleep at night.”

Just read the whole thing. There's an ex-Google baker who says "Everybody's got a soul. It's about finding it." There's the competing "tech and soul center" whose goal is to "recognize that the blazing success of the internet catalyzed powerful connections, yet did not help people connect to themselves." There's "a trough of warm, foaming mushroom drink." There's "the chief evangelist of brand marketing at Google," who runs an Esalen class called "Connect to Your Inner-Net." ("One of the portals we use to put the technology for the body at peak performance is music.") If you like the jargon of Silicon Valley, and you like the jargon of hippie self-discovery, then you will love the jargon of Silicon Valley hippie self-discovery. 

Elsewhere, literally, Steve Case and J.D. Vance are still out roaming the countryside trying to develop unicorns in the Midwest. (They're connecting to the inner-net of America!) Here's a dispatch on their progress from Andrew Ross Sorkin: Their fund is called Rise of the Rest, and its investors include Jeff Bezos and Eric Schmidt and Michael Milken and Ray Dalio and the Waltons and the Pritzkers and the Kochs and a lot of other famous people. "All told," writes Sorkin, "it may be the greatest concentration of American wealth and power in one investment fund," though in the next sentence he notes that it has raised $150 million. So, you know, on the small side for the greatest concentration of American wealth and power. I look forward to reading more glowing articles about their quirky travels, and who knows maybe they'll even fund some successful startups.

Me earlier.

Yesterday the U.S. Securities and Exchange Commission brought its first enforcement action against an initial coin offering. I wrote about it here.

Things happen.

Mueller Subpoenas Trump Deutsche Bank Records. How AI Will Invade Every Corner of Wall Street. Wall Street Banks Eye a $600 Million Payday on CVS, Aetna Deal. The CVS-Aetna Gamble: A Health-Care Giant Not Built Around Doctors. Broadcom Proposes Unseating Qualcomm Board as Takeover Fight Escalates. Merrill Lynch Says It Will Remain in Broker Recruiting Pact. Morgan Stanley Launches ‘Robo’ Advice Service. Deutsche Bank to rebrand its asset management arm. New CFPB Chief Curbs Data Collection, Citing Cybersecurity Worries. ECB set to rethink plan for curbing eurozone bad loans. Goldman Sachs to beef up Polish operations. Justices Suggest They May Let States Legalize Sports Gambling. "The economy is continuing to create more of our core customer," says the CEO of Dollar General. How New Yorkers Would Lose Under the Republican Tax Bill. Senate Bill ‘Bombshell’ Could Raise Taxes on Tech. Companies Push to Repeal AMT After Senate’s Last-Minute Move to Keep It Alive. "The population growth of captive Asian elephants explains the cross-section of expected returns of size-value sorted portfolios with a cross-sectional R^2 of 93% and a t-statistic of 4.0 for the market price of risk."  ‘Arnold’ the angry alligator captured in Long Island home.

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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

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