The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (30 page)

Dear Directors:

Third Point LLC, as the beneficial owner of 5.2% of Yahoo! Inc.’s (“Yahoo”) outstanding shares, remains extremely troubled by news reports regarding the dysfunction and inequity being exhibited in the process of maximizing stockholder value that the Board is allegedly “managing”. We are disturbed but not surprised by this mismanagement given the history of strategic bungling by Yahoo Board Chairman Roy Bostock and Founder Jerry Yang, which has been chronicled in our previous letters and in numerous critical media and analyst reports. As significant shareholders with our own fiduciary duties to investors to uphold, we cannot stand by silently if such reports are accurate and Yahoo, a company in no need of cash, plans to engage in a sweetheart PIPE deal which will serve only to entrench Mr. Yang and the current board while massively disenfranchising public shareholders and permanently robbing us of the opportunity to obtain a control premium.

We are not alone in our concerns. Shareholders, analysts, and the media are questioning the integrity of the process currently underway. As stewards of our assets you are charged with a duty to place stockholder interests above personal gain or other motives. In order to allay the concerns and uncertainty permeating the marketplace and provide much needed transparency on the supposed “process” that Yahoo is undertaking, we ask that you immediately make public the letter(s) in which Yahoo invited third parties to make proposals for the Company (the “Process Letters”). We assume that Yahoo’s Process Letters did not place
any
artificial restrictions on the proposals that the Yahoo board was willing to consider in its search for strategic alternatives, such as discouraging, or even prohibiting, bids to purchase Yahoo in its entirety.

The private equity deals were scuttled and in the New Year the changes Loeb demanded began taking place. First, Yang resigned from the board. A week later, Bostock and three other long-standing directors announced that they would not seek reelection to the board; at the same time, two new members were chosen. “The shake-up appears aimed in part to blunt a possible challenge by Yahoo!’s biggest shareholder, the hedge fund manager Daniel S. Loeb,” reported the
New York Times
. “An acid-tongued activist investor, Mr. Loeb has been preparing for a possible board fight if the company does not make progress in generating better returns for investors.” The company also appointed a new CEO, Scott Thompson, who pledged to work to increase value for shareholders.

In February 2012, Loeb notified the company of his intention to nominate his own candidates to the board during the upcoming proxy season. Urging balance on the tech-dominated Board during a critical period at Yahoo!, Loeb recommended experienced media luminaries Jeffrey Zucker, the former CEO of NBC Universal, and Michael Wolf, the former president of MTV Networks and head of the McKinsey and Booz Allen Media practices. He also put forward Harry Wilson, a financial restructuring expert who led the U.S. Auto Task Force’s work to successfully turn around General Motors. Loeb also announced his plans to join the board as an advocate for the company’s beleaguered shareholders, many of whom contacted Loeb, commented on blogs, or tweeted their support for his endeavors.

In taking on a $20 billion Internet legend, Loeb has seized on an extraordinary opportunity that bears the hallmarks of his successful past investments using his evolved techniques. Pursuing better corporate governance on behalf of shareholders, unlocking value with consistent catalysts, and seeing a major value proposition that others had given up on requires a unique combination of contrarian thinking, keen financial valuation skills, understanding catalyst-driven investing, and an ability to stand up and fight. The Yahoo! campaign represents the essential Dan Loeb.

The Third Point Tao and Team Approach

Now 50 years old, the trim, 5′10″ Loeb leads an active physical lifestyle that would put many men half his age to shame. A lifelong surfer, Loeb also competes in triathlons, lifts weights, runs, swims, bikes, and skis, in addition to practicing yoga. “I think yoga and meditation are good for your brain and body. They help you think more clearly, improve your memory, and help you become a more balanced, self-aware person. And I think those are all really important things that make a good investor.” He shares his interest in yoga with his wife, Margaret Munzer Loeb, to whom he has been married since 2004. The couple has three children.

Right now, Loeb is concentrating on continuing the path of excellence he has established. “I love what I do,” he says. “I love the investing process—the problems and the puzzle-solving and testing my wits. But I have also really enjoyed building an organization. That realization came to me later in life, but as fine as building a great portfolio is, building a great organization with great people is even better.”

When Loeb looks to hire people, he tends to value training and experience over formal education. “Before you can get into all the nuances of investing and understanding how to do a due diligence process and question a management team,” he says, “you’ve got to have the nuts and bolts of finance down. Almost everyone who’s worked at Third Point has at least gone through a two-year training program in an investment bank, plus done a couple years at a private equity firm, doing modeling and valuation work.” For Loeb, having an MBA isn’t as critical as having the training. New hires need about two or three years of experience in a field other than the public investment world, like mergers and acquisitions. “I don’t like the word ‘instinct,’” says Loeb, “because it just sounds like a gut thing. I think what we call instinct is really a type of pattern recognition, which comes from experience looking at the companies and industries and situations that work.”

Loeb looks for another quality as well: success at something other than work and school. “We’ve had a lot of excellent musicians and athletes here,” he says. “I don’t want to dismiss the importance of academic credentials, but we want bright people who are really diligent and hardworking, but also have real tenacity and grit who enjoy what they do and have an incredible passion for investing.”

In evaluating his team, Loeb says that he emphasizes process over outcomes. “Ultimately, of course, you want people with good processes
and
good outcomes, but I’d rather have somebody working for me who had a good process and a bad outcome in a given year that somebody with a bad process and a good outcome.” Most dangerous of all, according to Loeb, is a manager with a bad process who has become overconfident because of undue success. “It’s like somebody who plays Russian roulette three times in a row without the gun going off, and thinks they’re great at Russian roulette,” he says. “The fourth time, they blow their brains out.”

For anyone contemplating a career as a hedge fund manager, Loeb offers three points of advice. “First, make sure you’re passionate about investing,” Loeb says. “I have seen too many people go into this because they’ve done the math on the business model, and have concluded that it’s a very lucrative business to be in. But I’ve never seen anyone with that approach really make it as an investor. The great hedge fund managers, guys like Bill Ackman, David Einhorn, David Tepper, Kyle Bass, and Alan Fournier, are super-passionate. If you aren’t going to match them, don’t bother.”

Second, while you’re being passionate about investing, don’t forget about running your business. “Make sure you spend enough time, maybe 20 percent of your time, thinking about your business process in your organization,” advised Loeb. “Ask yourself, what kind of culture do you want? What are you going to look for in hiring people? How do you want to organize yourself? How are you going to pay your team? How are you going to measure and reward performance? You will have to answer all of these questions eventually. Better to answer them in an intelligent considered way than as an afterthought.”

Finally, of course, make sure you have confidence. Loeb feels that managers who lack confidence go out of their way to try to anticipate what their investors want them to do. “Look, this is a business that requires willingness to take risks and to generate returns. You can’t do that unless you have a healthy appetite for risk. Too many of my colleagues have sacrificed a performance culture for one of low volatility and risk management. It’s sapped the industry of creativity and diligence, because people are basically fear based, and they think that if they have that bad month or quarter or year, that they’re just going to go away.”

On the precipice of his eighteenth year running Third Point, Loeb has demonstrated that his essence remains even while he honors his own evolution in portfolio and team management. The new Loeb is savvy about managing downside portfolio risk, always willing to take a hard look at how Third Point can improve, and committed to creating a lasting organization that lives and breathes the Third Point investment framework and process. The essential Loeb—a direct line traced from young surfer to aggressive salesman to forthright activist investor—is confident, contrarian, aggressive, willing to take big risks and to be a rabble-rouser for what he thinks is right. “The hedge fund industry is littered with eunuchs trying to run hedge funds,” says Loeb, “and it’s not a business for eunuchs.”

Chapter 8

The Cynical Sleuth

James Chanos

Kynikos Associates LP

Shorting is not a criminal trial. It doesn’t have to be beyond a reasonable doubt. There just has to be a preponderance of evidence.

—James Chanos, February 2011 interview

There’s a lot about Enron that still hasn’t been fully explained or written about,” Jim Chanos says earnestly one February afternoon in his office. Snow falls on Madison Avenue as Chanos searches his memory for details. He is tanned, having just returned from a conference in Miami. With wavy light brown hair and glasses, Chanos looks at home behind his gargantuan circular chestnut desk in a deep blue suit. The 54-year-old head of Kynikos Associates LP was the first to uncover the shocking accounting scandal after a friend flagged a “Heard in Texas” story in the
Wall Street Journal
in September 2000. He thought the article was right up Chanos’s alley.

The story by Jonathan Weil was about energy companies using accounting ploys. “Much of these companies’ recent profits constitute unrealized, noncash gains,” Weil found.

“Almost immediately after reading the article I pulled up the financial statements for Dynergy, Enron, Reliant, and Mirant. And it was very clear from them that the biggest and baddest was also the murkiest—Enron,” says Chanos. So he first dug into the quarterly (10Q) and annual (10K) financial statements.

“I remember the numbers had gotten worse over nine months,” says Chanos. “We looked at insider selling, which was a huge pattern of Ken Lay and other top officials selling hundreds of millions of dollars worth of stock before the implosion. As our research read the situation, they were admitting Enron is a black box. We couldn’t figure out how they were making their money, yet there was a very low return on capital.” The company had 80 percent of its profits allocated towards energy trading, and was charging 10 percent to get access to capital, which struck Chanos as pretty high. “The more I looked,” he says, “the more things didn’t make sense. How could they be producing 7 percent return on capital while the cost of that capital exceeded 10 percent?” Gradually, it came out that Enron had many maneuvers. “One partner suggested then that Enron was ‘a hedge fund in disguise’—and not a very good one,” says Chanos. “Investors were crazy to pay six times book value to own the stock.”

One scheme Enron used was its accounting approach for its contracts to sell future delivery of natural gas as a security. They took advantage of “gain-on-sale” accounting rules allowing a company to estimate the future profitability of a trade made today, and book a profit today based on the present value of those estimated future profits. Enron immediately recorded all anticipated “profits” on these delivery contracts as profits. Since no markets existed for these delivery contracts, Enron aggressively valued them at “mark to model” based on highly favorable assumptions that went undisclosed. Enron, Chanos says, was addicted to the crack of “gain-on-sale” accounting, taking on bigger and bigger deals. This helped Enron to pump up revenues, which explains how Enron rocketed so quickly into the ranks of ExxonMobil, Walmart, IBM, and other $100 billion revenue companies.

Enron also used complex dubious energy trading schemes, such as the “Death Star,” initially routing energy to “congested” lines but then rerouting power to uncongested lines to collect a congestion fee from California.

Another ploy: more than 4,000 off-balance sheet partnerships were created as “special purpose entities” (SPEs) to hide massive losses and debts from investors while enriching senior managers, artifices even the board neither saw nor understood. Neither did analysts and investors. “We read the footnotes in Enron’s financial statements about these transactions over and over again but could not decipher what impact they were having on Enron’s overall financial condition,” Chanos says. “They seemed to be selling parts of themselves to themselves.” Since at least 3 percent of the SPE total capital was owned independently of Enron, they escaped consolidating these liabilities onto Enron’s balance sheet. Enron would hide bad bets by selling these “assets” to the partnerships in return for IOUs backed by Enron stock as collateral. The SPEs helped Enron reduce tax payments while inflating income, profits, and credit ratings.