Specialty Moves for Market Players

A look at short-selling, hedge funds, and convertible bonds

By CHERIAN GEORGE

ILLUSTRATION BY TIM BOWER

THEY TEND TO HIT THE HEADLINES for the wrong reasons.

The practice of short-selling made news after the attacks on the World Trade Center and the Pentagon. Initially, terrorist groups were suspected of profiting from their foreknowledge by taking short positions in financial markets.

Hedge funds came under the spotlight when their activities contributed to the 1997 Asian financial crisis and when Long Term Capital Management almost precipitated a global crash in 1998.

However, these seemingly pariah branches of the financial industry are being taken more and more seriously by both participants and researchers.

Thus, when the Stanford Business School launched a new, one-week program of seminars for its second-year MBAs, finance professor Darrell Duffie decided to use the opportunity to discuss these specialized areas. The September seminar, limited to 10 students, focused on hedge funds, convertible bonds, and securities lending, which is a prerequisite for short-selling. “These are topics that tend to be left out of most introductory finance courses and textbooks, but they are, in fact, fairly important,” said Duffie, who is the James Irvin Miller Professor of Finance and codirector of the Credit Risk Modeling for Financial Institutions executive program.

One sign of the times is the impending launch of EquiLend, an automated software platform for securities lending. Until now, most banks have brokered the transactions manually. Ten top banks—including Goldman Sachs, JP Morgan Chase, Merrill Lynch, and Morgan Stanley—are due to launch EquiLend in 2002 to streamline and standardize the connections between borrowing and lending institutions.

Following is a summary of Duffie’s seminar.

SECURITIES LENDING and SHORT-SELLING

Palm Inc.’s handheld computers may be icons of efficiency and systematic organization, but to academics studying finance, the company’s initial public offering has come to represent something else altogether. For a few months in 2000, its stock price seemed downright irrational. “It was a truly weird situation that caused a lot of head-scratching,” said Duffie.

Scholars now point to the Palm case to illustrate how things can go wrong when the practice of short-selling isn’t working as it should. Short-sellers move in when they expect a stock’s price to fall. They borrow the stock, sell it, and later buy it at a lower price to return it to the lender.

This strategy of selling high and then buying low depends on a properly functioning securities-lending market—stockholders who are prepared to loan out their equity for others to trade with in return for cash collateral. Following its IPO, Palm was ripe for shorting, but would-be short-sellers were thwarted by a sluggish securities-lending market.

The IPO resulted from a decision by parent company 3COM to carve out 3 percent of its stake in Palm. 3COM said that it would spin off its remaining Palm shares by year-end, with shareholders promised 1.525 shares of Palm for every 3com share they owned. Logically, one 3COM share had to be worth more than 1.5 times the price of a Palm share.

After the first day of trading, Palm closed at $95.06 a share. 3COM’s stock price should have been at least 1.5 times that, or $145. Instead 3com fell to $81.81 a share. The market thus implied that 3com’s non-Palm assets and businesses had a negative value of $63—a plainly absurd proposition.

Hence, the opportunity for short-selling. In this case, anyone who bought 100 shares of 3COM and shorted 150 shares of Palm would have basically been getting the non-Palm part of 3COM for minus $63 a share. Enough of these transactions would have quickly corrected the mispricing. Yet the imbalance lasted more than two months.

Why? First, traders found it difficult to get their hands on stocks to borrow. This is generally true of IPOs, when there are often restrictions on lending. Second, even stockholders willing to lend their equity demanded prohibitively high fees. The standard practice is for lenders to rebate interest on the cash collateral to the borrower, but when borrowable equity is scarce, the rebates shrink. Such arrangements, called “specials,” are in effect a premium lending fee.

Palm’s mispricing was not unique. Owen Lamont and Richard Thaler of the University of Chicago found five other cases between April 1996 and August 2000 in which parent companies were valued unambiguously lower than the firms they had just carved out and were going to spin off. In each case, the market eventually corrected itself—but only gradually. “The mispricing persisted because of the sluggish functioning of the shorting market,” the researchers write.

Another study suggests that such dynamics may have helped inflate the Internet bubble. Eli Ofek and Matthew Richardson of New York University’s Stern School of Business have found that shorting was more difficult for Internet stocks than for other stocks. Pessimists—read “realists”—who wanted to short-sell patently overvalued stocks couldn’t. With more and more optimists arriving in the market, the researchers write, “it becomes like a stampede, without any initial way of stopping it.”

Thus, although shorting is a layer of securities practice that lies below normal trading, its effects do filter up and affect prices of stocks and bonds, Duffie notes. It is a layer that is being taken more seriously by financial institutions that have securities to lend or that are in a position to act as brokers between borrowers and lenders. For some banks and brokerages, securities lending has become a major source of income. (The fine print on brokerage agreements may allow them to lend out retail investors’ holdings without needing to seek permission each time they do it.)

Also growing in number are exclusive lending agreements between brokers and institutions with large, long-term investments. One such deal was struck in November 2000 between a pension fund, the California Public Employees’ Retirement System (CALPERS), and Credit Suisse First Boston. The lockup enables CSFB to be a major broker in securities lending.

ILLUSTRATION BY TIM BOWER

HEDGE FUNDS

Dominic DeMarco, MBA ’96, bets on companies that most large investors don’t think are worth their time. He is a principal of Stadium Capital Partners, a hedge fund that focuses exclusively on small-cap firms—the 75 percent of U.S. public companies with market capitalizations of under $500 million.

DeMarco, a guest speaker in Duffie’s seminar, provided an insider’s view of the secretive world of hedge funds. Stadium Capital, he said, has produced annualized returns of 30 percent since its launch four years ago by focusing on undervalued stocks in the chronically ignored market segment of small-cap public companies. Such returns seemed low in the NASDAQ bubble years but now look relatively healthy. “The bad news in a good market was that nobody cared about our stocks. The good news in a bad market is that nobody cares about our stocks,” De Marco said.

The low correlation between hedge funds’ performance and the market’s ups and downs is the main reason why such funds are valued as alternate investment vehicles. They essentially exploit market inefficiencies, using long or short positions to offset market risks.

By one estimate, the number of hedge funds grew tenfold in the 1990s, exceeding 3,000 last year. The most famous is probably George Soros’s Quantum Fund, which reportedly made $1 billion by betting on the British pound’s devaluation in 1992. Such a fund, focusing on global, macroeconomic trends, represents just one possible strategy. Others include event-driven funds that focus on mergers and bankruptcies, for example.

Hedge funds are private investment vehicles set up as partnerships. As such, they have more freedom and flexibility than mutual funds, which represent the more common form of pooled investment. By dealing with wealthy individuals through word-of-mouth instead of soliciting business from the public, hedge funds are exempt from various registration and disclosure requirements in U.S. securities laws. Investment advisors warn that this greater freedom also amounts to a greater risk of fraud, especially as the number of funds multiplies. They are probably best left to sophisticated investors who are able to exercise their own oversight.

Hedge fund managers have strong incentives to perform. They receive an annual management fee of 1 to 2 percent, plus an incentive fee of 15 to 20 percent of profits. The latter is subject to a high-water mark, earned only when the fund recovers past losses. As the industry matures, investors are also demanding hurdle rates: The fund is expected to surpass some minimum rate of return. Managers also tend to invest heavily in their own fund, and many are general partners with liability for losses.

A study by Carl Ackermann, Richard McEnally, and David Ravenscraft notes that hedge funds’ organizational features help align the interests of their managers and their investors, whereas most mutual fund managers do not receive incentive-based rewards.

Mutual fund managers also enjoy less latitude, because they are more regulated and attract less sophisticated investors. “This combination of incentive alignment and investment flexibility gives hedge funds a clear performance advantage over mutual funds,” they write.

Another guest speaker, Joseph Grundfest, who is a professor at Stanford Law School, highlighted the impact of the high-water mark on managers’ psyches. “Say the high-water mark is 100 and you lose one-third of its value, to 67. You must then work for free to increase its value by 50 percent to get your head above water.” This means that hedge fund managers must control risk, contrary to their popular image as “wild, swing-for-the-fences types,” he noted.

For Stadium Capital, the way to control risk has been to conduct in-depth research. Its principals believe that 6 to 10 positions are sufficient to eliminate 80 to 90 percent of portfolio volatility risk.

Indeed, a much larger portfolio would be too difficult to keep tabs on. So it targets just 10 to 15 positions at any one time. It takes at least one or two months to study a company, including long meetings with its management and conversations with its customers and vendors, before making a core investment.

With one investment, it even meant standing in front of a Kmart store to ask 300 consumers what they thought of the target company’s brand. “In this market segment, hard work yields real, proprietary information,” explained DeMarco.

For most hedge funds, however, private information is virtually impossible to get, argued Grundfest. “You have to play a level up,” he said. “If venture capital is like playing poker, hedge funds are like chess. You’re all looking at the same board. If the other player sees mate in four, can you see mate in three?”

CONVERTIBLE BONDS

More companies than ever before are issuing convertible bonds as a way to raise capital. According to conventional wisdom, these hybrids—part bond, part stock—attract investors because they promise the security of a bond, plus the option to convert to equity should the company’s market valuation rise. For the issuing company, convertibles require lower interest payments than ordinary bonds—or, increasingly, no interest at all.

To Duffie, however, these explanations for convertibles’ popularity do not make sense on their own. Since their advantages already may be priced in through lower interest rates, convertibles may not actually represent a better investment than bonds or equities. “Among those who suggest that they really like convertible bonds, there’s no one who says, convincingly, that he’s getting a bargain when he buys them,” he noted. As for the issuing company, the option component on the convertible means it may have to give away stock in the future, thus diluting earnings per share.

One intriguing theory is that the rise of convertibles is being fueled partly by certain tax advantages. Two second-year MBA students, Jen Bergeron and Cheryl Frank, examined this tax incentive in a recent study done for a finance class cotaught by Duffie and Kenneth Singleton, the C. O. G. Miller Distinguished Professor of Finance.

The pair looked at the case of Alza, a pharmaceuticals firm based in Mountain View, Calif., which issued a 20-year convertible bond in 1994. Like many others, the Alza convertible includes a provision allowing the issuer to call the bond before maturity and thus force conversion. If the issuer exercises this call when the market price of its stock is rising well beyond the conversion price, investors would be virtually certain to opt for conversion into equity, rather than ask for their principal back.

Curiously, however, researchers have observed that firms often choose to keep their convertibles alive. This was the case with Alza. At the first call date, July 1999, the conversion price was $17.69, which was still higher than the prevailing stock price. However, from April 2000, the convertible was consistently in the money for more than a year: At its peak, Alza stock traded at 144 percent of the bond’s conversion price. Yet, Alza did not exercise a call on the bond.

Bergeron and Frank suggest that the most compelling reason is the tax shield provided by the bond. The bond promises a yield of 5.25 percent a year until maturity. Being a zero-interest bond, no annual coupons are actually paid out to investors. However, Alza’s books must increase the value of its debt by 5.25 percent each year. The company can write off the year-to-year accretion value as an interest expense. Thus, in 2000, Alza expensed $22.7 million of interest on this debt. At a tax rate of 35 percent, it was able to retain almost $8 million in cash, shielding this amount from the taxman’s grasp.

Of course, there is no guarantee that the bond will continue to be in the money indefinitely. The issuer must weigh the tax incentive for not calling the bond against the value of exterminating the convert option by calling it. In this case, it seemed the bond was so deeply in the money that Alza did not envisage much likelihood of ever having to pay out the cash representing the accrued interest; it has until 2014 to call the bond if investors do not convert first.

What about the tax implications for the bondholders? The interest expense that is treated as a tax write-off by the issuer must be declared by investors as interest income—even though, in the case of zero-coupon bonds, this income is not realized in cash. Investors need to price in this tax when buying the bonds. However, many buyers of convertibles are offshore, or otherwise tax-exempt, investors in hedge funds.

“It could be that convertibles have been so popular because their tax advantages are so distinct,” Duffie mused. “In other words, the Internal Revenue Service may be subsidizing both the investors and the issuers of convertible debt.”

FOR FURTHER READING:

SHORT-SELLING

Securities Lending, Shorting, and Pricing, Darrell Duffie, Nicolae Garleanu, and Lasse Pedersen, Graduate School of Business, Stanford University

Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs, Owen Lamont and Richard Thaler, Graduate School of Business, University of Chicago

Limited Arbitrage in Equity Markets, Mark Mitchell, Todd Pulvino, and Erik Stafford, Journal of Finance, February 2002

DotCom Mania: A Survey of Market Efficiency in the Internet Sector, Eli Ofek and Matthew Richardson, Stern School of Business, New York University

HEDGE FUNDS

The Performance of Hedge Funds: Risks, Return, and Incentives, Carl Ackermann, Richard McEnally, and David Ravenscraft (1999), The Journal of Finance, LIV, No. 3 (June), 833–74

A Primer on Hedge Funds, William Fung and David A. Hsieh (1999), Journal of Empirical Finance, 6, 309–331

CONVERTIBLE BONDS

Call Considerations in Zero-Coupon Convertible Bonds: Alza Zero Percent 2014, Jen Bergeron and Cheryl Frank (2001), unpublished

To Call or Not to Call Convertible Debt, Louis H. Ederington, Gary L. Caton, and Cynthia J. Campbell (1997), Financial Management, 26, No. 1 (Spring), 22–31