Tuesday, April 21, 2009

Vulture Funds and Angel Investors... Similarities?

Looking into the mirror to see your true reflection. I've been watching the news lately about the bad rep that short sellers have been getting in the market. They are perceived as being ruthless profiteers who will cut throats in order to make a buck. While there is a lot of justification for this view by the media, I would like to make the case for efficient markets and perhaps putting short sellers and other seemingly "evil" profiteers (such as vulture funds) in a unique light.

The first complaint about our market crash was that we should have seen it coming. PE ratios were high, LBOs were progressively looking less attractive (but still being done). All the signs were pointing to the market being generally overbought (too much money chasing too few investment opportunities). While most people agree that bubbles were forming, no one was willing to really do anything about it. Except, that is, the short sellers.

Short sellers are blamed with the precipitous decline of the market. By betting against the highly valued stocks, they are blamed with triggering the stop loss sales of equity associated with the rapid decline in price. Although I don't doubt short selling triggered the decline, I would also emphasize that they put themselves in a position of great risk. After all, no position in the stock market comes free, and a short position is decidedly not "group think" in the stock market, the giant positive reinforcement machine as described by Jim Chanos in Hedge Hunters. It is notable Chanos' short biased firm was among those asking the right questions which highlighted the accounting irregularities (and eventual fraud) at Enron. However, the real cause of the precipitous decline in equity prices is the automated stop loss sales.

Stop loss sales are limit orders placed on stocks by traders who essentially say this: "If the stock drops below a certain price, I want to sell of my position to prevent further losses". If I own 100 shares at $20, I want to sell it if it goes to $10 to recover $1,000, rather than lose all of it if it drops to $0. It is an automated stop gap measure to prevent total loss. However, look at the underlying logic: "I understand that there is a possibility that what I'm holding isn't worth even $10."

While incredibly oversimplified, this fundamental doubt acknowledges the distinct possibility that the stock is overvalued.

For those who said that the stock market was overvalued in 2007 / 2008 and that this crash is a "reckoning of careless and risky capitalist pursue of profits", the correction of such an oversight would be to bet against the market (ironically, also framed as a "risky capitalist pursuit of profits" but in the opposite direction).

I don't feel it is entirely fair for those who complain about the market being over valued to also complain about those who agree and are willing to put their money where their mouths are (by positioning themselves in a risky position against the consensus of everlasting growth).

Having said that, is it entirely fair that some companies crashed, reaching a point where they are utterly distressed? Again, in an efficient market, I would say yes and no. A company that has crashed beyond it's intrinsic value immediately becomes a target for a vulture fund. If it's equity is depressed because of overselling by emotionally panicked investors, I think this is a golden opportunity for vulture funds to step in and pick up cheap investments with the intent of saving the company.

The risk profiles of vulture funds and angel investors (venture capital) is surprisingly similar (except that I would assume vultures to be assuming more risk... The momentum is in the wrong direction). I would even go so far as to say that vulture funds are the last chance before the capitalism hell of bankruptcy (as Elizabeth Warren describes on the Daily Show: "Capitalism without bankruptcy is like Christianity without hell"). Metaphysically, I suppose a logical question to this analogy is are you selling your soul to the devil or seeking divine redemption as your escape?

This means that if a company is worth saving, even malicious intent by unscrupulous traders should be offset by intelligent analysts who can see value and pick up depressed stock prices (to the loss and chagrin of the "evil" short sellers). This is directly similar to my previous post about the mechanics of sales and trading. In an efficient market, even those who want to cheat should (and would likely) get burned.

In an ideal scenario, if companies became TOO distressed and all their financial vehicles (bonds, mezz, equity) became overly depressed, if the company could still be saved (good fundamental business model), this is a textbook example of how investors could come in, acquire a controlling share of the company and turn it around.

Yes, concessions and covenants have to be made, but without the assistance of vulture funds providing additional financing, the companies are about to go bankrupt anyways. The mechanics of short selling and vulture funds are simply investment and trading mechanisms, and like any technology can be used for "good" or "evil". However, I think it would be a error to generalize and mistake the white knight for the dragon.

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