By Janet Tavakoli
When performing due diligence, investors consider capacity, capital, and character. Investors will develop a subjective opinion of character informed by their own standards and those of the society in which they live.
If Novak Djokovic, Roger Federer, and Rafael Nadal showed up for Wimbledon sporting Speedos, they’d look outstanding and get a lot of publicity. Yet they don’t cite their fame and high player rankings to argue they should be exempted from the dress code. They show up in appropriate tennis outfits. Why? They’re top professionals who understand the spoken and unspoken rules of the game. Hedge fund managers who want special exemptions would be better served to follow the example of tennis champions.
According to Mannet Ahuja’s book, The Alpha Masters (P. 115), Bill Ackman, head of Pershing Square, addressed students at the Wharton School and claimedsex is the primal driver that motivates people to succeed and most people won’t admit it. This isn’t the first time he’s pushed his theory. Does Ackman believe he can read minds? Perhaps others simply disagree that it’s the most important primal driver.
Abraham Maslow’s 1943 treatise, “A Theory of Human Motivation,’ posits a hierarchy of needs and puts sex somewhere in the middle. Maslow views hunger for food (among other things) as a more basic primal driver. The more than 46 million Americans on food stamps might side with Maslow.
Even with a mixed track record, Ackman is riding high charging hundreds of millions in fees on billions under management. One would think he could show more public decorum. Investors may merely have a good chuckle at Ackman’s student psyop, if he delivers alpha (excess return over the market, adjusted for risk) and stays away from past hard-to-defend fund strategies.
Other hedge fund managers may have a tougher time getting a laugh. Investors may not think a hedge fund manager is a catch, if they worry he may have something catching.
Prostitution: Illegal in Most of the U.S.
Illegal behavior, and often even the appearance of illegal behavior, is usually a deal killer. Except for a few counties in the state of Nevada, prostitution—and being the customer of prostitutes—is illegal in the United States. The New Yorker reported that the insider trading investigation against Galleon included an anonymous tip from an untraceable source:
[A]n anonymous letter arrived at the S.E.C.’s offices, postmarked Queens, March 13, 2007. “. . . . Prostitution is rampant for executives visiting Galleon. You will find that the Super Bowl parties for the executives, paid for by Galleon Group, include prostitutes and other forms of illegal entertainment. In return, the executives provide Galleon the unfair edge that the fund leverages so well.” (“A Dirty Business,” by George Packer, June 27, 2011.)
Whether or not the anonymous allegations against Galleon are true, they made the news because they are consistent with the alleged sleaze surrounding Galleon’s business practices.
Some hedge fund managers feel they are above appearances, if not the law. Some investors believe prostitution isn’t a big deal, too. But there’s a large cohort of investors that won’t go near a hedge fund manager with a reputation for using prostitutes.
What else could go wrong? If a prostitute is in a hedge fund manager’s apartment when he’s not home, what is she doing? Who else is she letting in? Does she have friends who are good at hacking computers? What if the hedge fund manager gets caught up in a legal sting? That could distract him from fund management for a while. Investors have a tough enough job performing due diligence without these potential problems.
Prostitution: What if It Were Legal?
Would due diligence be easier if prostitution were legal? Consider the European allegations against Dominique Strauss-Kahn. Strauss-Kahn is a Frenchman, and prostitution is legal in France. His current wife (his third) seems fiercely supportive. If the law is okay with this, and his wife is okay with it, why should anyone care if he spends his free time with prostitutes? It’s all about the potential fallout. If you have a high profile and you hang out with people who aren’t too particular about how they earn their money, bad things tend to happen.
Strauss-Kahn is a very high profile public figure and was involved in a highly charged political situation. He was also the head of the International Monetary Fund (IMF). Prostitution is legal in France, but aggravated pimping is not, and Strauss-Kahn now faces allegations of this illegal behavior (among other allegations). This particular case seems to hinge on evidence provided by the prostitution ring with which the former IMF head associated. Would it surprise anyone if his accusers were bribed to provide false evidence, because that’s how they roll? From a business standpoint it doesn’t matter anymore if Strauss-Kahn is innocent or guilty. He’s embroiled in cross-continental legal battles.
It’s Like “Buying Kidneys”
A European fund manager raised the most uniquely-phrased objection to prostitution I’ve ever heard. I’ll call him David (not his real name). He invests in hedge funds and lives in a city where prostitution is legal and seems to carry no stigma. David’s objection to investing with hedge fund managers that frequent prostitutes is based on his perception of strength of character:
“I have the same reaction to it as buying kidneys. The kidney sellers cajole and flatter the buyer and fight for the first place in line. The kidney sellers are compliant and ever smiling. The kidney buyer never asks himself whether it is in the interest of these people to sell a kidney, and he doesn’t care. When a seller can’t spare another kidney, they are gone. The kidney buyer is basted with insincere adulation and fake power as long as the money lasts.”
David believes weak men surround themselves with petitioners that reinforce a self-serving point of view, and he suspects they crave flattery and mental comfort too much. One needs to hear opposing points of view. It takes character and guts to pull the plug on a strategy that’s too early, too late, or just plain wrong. Yet the market includes outside actions based on opposing points of view that may—temporarily or otherwise—adversely affect investment returns.
If a hedge fund manager’s audited returns are consistently large and show he generates high alpha, David is willing to overlook a few missing kidneys. But there are very few hedge fund managers who can claim that kind of track record.
People are sometimes unfairly judged by their age, race, birthplace, gender, height, deformities, or handicaps. Those are factors that are completely beyond their control. Yet some hedge fund managers complain about being judged for behavior that is completely within their control. Their complaints fall on deaf ears, because judgments are all part of the game they signed up to play.
It’s as if the complainers were Speedo-wearing tennis players shouting “unfair” as the Wimbledon crowd boos them—an interesting tactic, but no one buys this act. The players can’t pretend that the problem is that others are too easily shocked. They aren’t. The problem is everyone thinks they’re acting like spoiled brats. If hedge fund managers want to flout convention they can exercise that choice, but investors may choose to tell them to play with someone else’s money.
Whatever one’s opinion about a hedge fund manager’s behavior, the fact remains that it will be judged—unfavorably or favorably—by investors. Character judgments aren’t just fair game, they’re a necessary part of due diligence.
Endnote: Readers may be wonder where I personally stand on the issue of prostitution. In the venues in which I reside and work it’s illegal. I uphold the law and don’t endorse the actions of those who do not. Even if the U.S. has a spotty record of enforcing these laws, the U.S. is still a country that claims rule of law. If you’re in the camp that feels there is an argument that trumps this law, you are free to lobby to change it. I’ll oppose your argument.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago’s Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (Wiley, 2008), and Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009), a book about early warnings and the causes of the global financial meltdown. Her new e-book is The New Robber Barons (2012).