Editor's Note: This is an extended version of the interview that appears in print in the October 2006 issue of CFO magazine.
Hedge-fund managers have always been a shy breed. They like to guard their strategies — and their identities — closely. But lately, government regulators have been trying to cast more light on the mysterious ways of hedge funds. Everyone from Congress to the New York Stock Exchange is clamoring for more transparency and regulation. Given the proliferation of funds (9,000 and counting) and the assets under management (more than $1 trillion), the current scrutiny doesn't surprise Lee S. Ainslie III, managing partner of investment giant Maverick Capital Ltd., with more than $9 billion in assets under management. It's just one more reason he likes to keep a low profile. (He agreed to an interview, but declined to have his picture taken.) That doesn't mean he wants to be ignored, though, especially not by companies in which his firm takes large positions.
How does Maverick Capital's investment style differ from that of traditional hedge funds?
The term "hedge fund" has come to represent so many different styles and strategies that I'm not sure what a traditional hedge fund is. Some [people] associate hedge funds with a great deal of risk or a very-short-term trading orientation, but Maverick is differentÂÂÂÂ . We've always been longer-term strategic investors, [and] every decision is supported by a tremendous amount of due diligence. This is an oversimplification, but we tend to look out two or three years in every industry in which we invest and identify what's winning and what's losing. Then we [look for] discrepancies between our views and those of the market..... We also spend a lot of time trying to understand the fundamentals of the business. [We look closely at] the management teams: their integrity, their dedication, and their desire to create shareholder value.
Do you specifically evaluate the CFO?
We hope to interact with many levels of management, including the CFO. [And from the CFO’s input] we try to understand the rationale behind what we believe are very, very critical decisions regarding capital allocation. We also [try to] understand the conservancy of accounting treatments and the controls that are in place. And of course, we’re very focused on CFO’s integrity and dedication to create shareholder value. To judge these attributes we find conversations with current and former associates as well as investors to be quite helpful.
What are positives on a CFO's track record?
Number one is good capital-allocation decisions. We, and other equity investors, have been rather frustrated by the record levels of corporate cash when the real cost of money is as cheap as it's ever been. Last fall, we had negative real rates in the United States for the first time in 25 years. Yet we also have record-low levels of debt. So when we see an inefficient capital structure and there's no proactive program to find ways to return that capital through buybacks or dividends, we want to understand why.
What are the best pieces of information that CFOs can give you?
The most common is to think about incremental returns on invested capital and how that compares to the cost of capital. We spend a lot of time trying to make sure that the incremental returns on invested capital definitely exceed the cost of capital and we spend a lot of time trying to understand how sustainable that will be.
CFOs often view hedge funds with some trepidation. Should they be concerned?
They should have concerns, but at the same time they need to recognize that hedge funds account for a very significant percentage of trading volume. And it's really shortsighted not to have positive interactions with the larger, more thoughtful fundsÂÂÂÂ . Fortunately, [at Maverick Capital] once we've had some of those interactions, management teams quickly realize that we've done a great deal of work, that we're going to focus on some critical issues, and, perhaps most important, that we can be helpful from time to time.
How should the CFO deal with a hedge fund that's taken a large position in his company?
It's only prudent to [determine] if this fund is going to be a partner or if it is going to have a more antagonistic approachÂÂÂÂ . At Maverick, for instance, we think it's awfully important to view these relationships as partnerships. When we come across situations where we think it's in the shareholders' interest to have change, we're quick to express those views, but we try to do so in a way that is private and appropriate.
There is a concern, however, about the aggressive tactics some hedge funds use to gain information. How can companies avoid running afoul of Reg FD?
My best advice is to be as straight-forward as possible because we will cross-check information with peers within the company as well as competitors, suppliers, and customers. We certainly respect the need to comply with Reg FD and do not want to see a company’s adherence [put] in question. Now, unfortunately, we have no way of monitoring what a company has disclosed in a public forum and therefore it really is the company’s responsibility to maintain consistent disclosure. But if someone says, look it, I’d love to discuss this in more detail but unfortunately I can’t because of Reg FD, we certainly respect that response.
Does the proliferation of hedge funds bother you? We are up to 8,000 funds at this point.
Actually we’re up to 9,000ÂÂÂ .But does it concern me? We recognize it’s becoming a more challenging, competitive environment, but I think that’s only natural.
But there’s only a finite amount of investment opportunities, isn’t there?
The average hedge fund is less than $150 millionÂÂÂ I'm more concerned about the competition from the larger, more thoughtful funds that have a greater depth of resources. At the end of the day, our job is to take advantage of the spread between the best and the worst performing stocks. Now if you just look at the S&P 500 and look at the performance of the top quartile and the bottom, the spread between them has averaged about 70 percent per year. And there’s little evidence to demonstrate that these spreads have narrowed. But I would argue that the stocks that comprise the best and worst performers have changed. And as there’s more capital doing more work, like any other competitive business, it’s important that we try to stay a step ahead.
Are you surprised by the attention focused on the hedge-fund industry right now?
Not really. The growth of hedge funds and the influence they have on the market deserve scrutiny. We've been registered [with the SEC] since 1994. And from our perspective, thoughtful regulations that offer incremental protection for hedge-fund investors would be welcome.
Finance executives might argue, however, that hedge-fund positions place downward pressure on their companies' stock prices.
Sometimes short-sellers become a convenient excuse for declining stocks. I still remember the management teams of Enron and WorldCom constantly blaming and complaining about shorts when, in reality, fundamental issues were the true drivers of their poor stock performance. It's difficult, if not impossible, for a short-seller to profit from driving the stock price down if the company's fundamentals are still intact. Really, the only guaranteed buyers of a stock are those that hold short positions, because at some point they have to buy to realize their gains.
When you hear government officials saying that hedge funds are an "emerging threat" to investors, how do you react?
It really surprises me. To put it in perspective, of 9,000 hedge funds, only about 50 have been prosecuted for fraud by the SEC in the past five years. Meanwhile, we have 6,000 public companies, and, just to pick one issue, the SEC has said 80 are being investigated for backdated options. From my perspective, whenever you have 9,000 people doing something, the odds that all of them are going to be honest are virtually zero. So I do think that hedge-fund investors should be wary, but I disagree with the idea that, as a group, we should be considered an emerging threat.
Does it worry you that Congress may step in? It’s reminiscent of how they stepped in after the accounting scandals?
I would argue that Sarbanes-Oxley was an overreaction. And I would be concerned if I thought there would be [similar] legislation for the hedge-fund world. I don’t see that happening, but obviously in the political environment things can change. But there has not been the same widespread abuse and the same impact on a large portion of society compared to some of the sad circumstances which led to Sarbanes-Oxley.
Still, one reason for the push toward more regulation is the fear of a hedge-fund meltdown.
You're dealing with 9,000 funds investing in a wide variety of strategies and taking a wide variety of risks. Sometimes those risks won't turn out the way managers hope. Having said that, I think most hedge funds have a more conservative risk profile than other equity investments. And the fact that most hedge-fund managers have a significant portion of their net worth invested in their funds gives them the motive to maintain a certain level of prudence. So I don't have great concerns that we will see widespread fraud and failure in the hedge world.