Wednesday, June 11, 2014

Goldman Stars Fall Back Down to Earth?

Miles Johnson of the Financial Times reports, Goldman stars fall back down to earth:
Of all the Wall Street tribes rendered extinct by the financial crisis, few carried the same symbolism as the Goldman Sachs proprietary trader.

While many financial institutions employed traders to make bets using their own capital, the prop traders of Goldman managed to attain a near mythological status for their ability to make the bank, and themselves, vast amounts of money.

Archetypes of the modern day financial “Masters of the Universe,” the Goldman traders were revered inside the bank for the billions of dollars in profits they generated, and eyed suspiciously by outsiders for their pay packets, along with their potential to generate conflicts of interest with the bank’s regular clients.

But the party was brought to an end by the post-crisis “Volcker Rule” in the US, which effectively banned banks from speculating using their own capital. Scores of these often young, predominantly male, residents of the prop desk were shown the door.

The logical next career step was to continue trading by launching their own hedge funds. Helped by their own legend, many of Goldman’s highest earning prop traders raised billions in capital by investors who were confident they could replicate their success at the bank.

Yet several years on, several of the highest profile hedge fund launches of the alumni of the Goldman Sachs prop desk, referred to inside the bank as its Principal Strategies unit, have not gone to plan.

Last week KKR, the private equity group, closed a $510m internal hedge fund which Bob Howard, ex-head of Goldman’s US equities and credit proprietary unit, was hired to run in 2010, along with a team of traders from the bank.

Industry observers are asking why traders who managed to make consistent returns while at Goldman have struggled when operating within their own hedge funds.

While there is a long tradition of bank traders graduating to become fund managers in their own right, investors in hedge funds are quick to point out that running an investment business requires very different skills from working on a prop desk.

“When you are prop trading you only have one client: your boss at the bank. That is very different to running a hedge fund where investors will scrutinise everything you do,” says Troy Gayeski, a partner and senior portfolio manager at SkyBridge Capital, a $10.5bn fund of hedge funds investor.

“When you add in regulatory and compliance, and the need to raise money, it is a daunting task,” he says.

The closure of Mr Howard’s KKR hedge fund was the latest in a string of post-crisis hedge fund ventures by esteemed ex-Goldman traders that have shut down.

Edoma Partners, founded in 2010 by Pierre-Henri Flamand, a former co-head of Goldman’s prop desk, closed down just two years after raising $2bn in one of the most hyped hedge fund launches. Mr Flamand, who lost his investors 7 per cent of their capital, cited “unprecedented market conditions” for the closure.

Four months later Benros, a London-based fund co-founded by Daniele Benatoff and Ariel Roskis, both ex-Goldman prop traders, closed down after its largest investor pulled out its money.

One factor hedge fund investors point out as potentially disadvantaging former prop traders who go it alone is the absence of the same quality of information as when they were working in banks. While so-called Chinese walls are in place to stop any bank trader receiving non-public information, more general information relating to trading flows can help traders have a better idea of the direction of markets.

“We always ask them if they will be as ‘in the flow’ as they used to be when running proprietary capital,” says Alper Ince, managing director at Paamco, a California-based fund of hedge funds that selects emerging managers.

Similarly, where once bank prop traders were allowed to run books with high-leverage multiples – meaning that small profits, or losses, were vastly amplified – few investors in hedge funds will permit their managers to borrow at a similar level. This, says one veteran hedge fund manager in London who has never worked on a bank prop desk, can mean traders are unable to make the same returns once they are on their own.

However, most investors agree that the struggles of prop traders who set up hedge funds simply reflect a brutally competitive industry where any mistake is quickly made public, and few manage to stay in business for long. “Whether a new hedge fund will work well is idiosyncratic to each manager,” says Mr Ince. “While many have failed, there are also many examples of very successful prop desk spin-offs which have built strong track records”.

Not all of Goldman’s post-Volcker generation of former prop traders have failed at launching hedge funds. Morgan Sze, another former co-head of Goldman’s Principal Strategies group, raised $1bn in the launch of his Azentus fund in Hong Kong in 2011 and has increased its assets since.

Learning curve

While some of Goldman Sachs’s recent alumni have struggled in setting up hedge funds, the bank has a long record of launching the careers of some of the industry’s most successful managers, writes Miles Johnson.

Och-Ziff was founded by Daniel Och, a former Goldman proprietary trader, in 1994 and has since grown to become one of the world’s largest hedge funds by assets. Ahead of the financial crisis Mr Och took the then rare step of listing the company on the New York Stock Exchange.

Eton Park, another successful US hedge fund, was founded in 2004 by Eric Mindich, who had worked as a proprietary trader at Goldman for over a decade, as did Kenneth Brody and Frank Brosens, who co-founded the Taconic hedge fund.

Most recently Anthony Noto, who in his role as global co-head of technology banking at Goldman led stock market listings for companies such as Twitter, joined the Coatue hedge fund.

Apart from Goldman, alumni from several other former bank proprietary traders have succeeded in creating some of the world’s largest hedge funds. The British-born Alan Howard, co-founder of Brevan Howard, worked as a fixed-income trader at various banks before building Brevan into managing about $40bn.

However, all of these former prop traders launched before the financial crisis, when investors in hedge funds were more willing to back new managers.

Investors argue that launching a hedge fund in the 1990s was even easier, as there was less competition for good trades and capital.

“It was much easier to launch back in the 1990s, when there were more market inefficiencies,” says Troy Gayeski of SkyBridge Capital, a fund of hedge funds. “Now there isn’t nearly as much low-hanging fruit in the majority of strategies as there was then.”
I discussed this article in my last comment on whether a stock market correction is overdue, stating the following:
These are tough markets and I warned all you Soros wannabes to forget about starting a hedge fund. I don't care if you are a "star" prop trader at Goldman, you're going to get killed in these markets. Stick with Goldman, at least there you can make millions front-running your pension fund clients.

I sent that article to a few people. One of them was Francois Trahan, another former colleague from BCA Research and one of the best strategists on Wall Street (now at Cornerstone Macro). Francois closed his hedge fund for personal reasons but he also shared this with me: "....one my three reasons for winding down was my piece from early May on the new normal ... a world where PEs go up is a shitty one for hedge funds. Nobody wants 2/20 and single digit returns when the S&P500 goes up 30% in a year."

Another hedge fund manager shared this with me:
I also think that once a trader moves from the confines of a prop desk, with its near infinite supply of low risk capital, to a place where they have to draw on capital that likely includes their entire net worth, that they assess risk/return in a different way. Also, when you have to start factoring in things you never really had to deal with when trading at the bank - commissions, margin limitations imposed on you by your prime desk, etc.

Also, it takes a lot of time to either replicate or match the trading systems that they had at the bank. I know at our firm, it took the one partner (who handles the trading platform) months to build everything and integrate with third-party systems. I know he wasn't really happy till a couple of years after they opened up and to this day he spends a considerable amount of time tweaking and refining it. So if these guys are true traders, rather than more cerebral research types (who trade once in blue moon), and they don't have a technical background, it can be very difficult to be the same trader you were at the bank.

Also, once the market closes you have start your second job as small business owner. That doesn't help thing at all.
Bottom line, as I wrote in my comment on the Tiger fund burning bright, most hedge funds stink and there are too many bozos who think they can run a hedge fund that are going to get their heads handed to them.
I read the comments at the end of the Financial Times article and one of them really stuck out:
As a consultant who assists start up hedge funds, I have seen that many struggle not for any specific reason, but for a combination of reasons. Most have never had management or board level responsibilities so actually "running" a business is a new skill to acquire and they no longer have the infrastructure of their investment bank (no operations department, no IT department, no premises department, no HR, no compliance or legal department, no training department, no finance department) to assist in running the business. That is a big wake up call, that their success was dependent on a lot of people that they never knew about, saw or cared about.

While they can outsource some of these activities once they start out on their own, they will still remain responsible for things that always just happened for them that they don't really understand and that is a pretty big learning curve, even for a master of universe. The petty admin of record keeping and getting agreements signed is hard if you are doing with one or two other portfolio managers or traders who have never done it either.

At the same time, they are trying to raise capital and get decent performance, because if you don't have decent performance in the first year or two - you are dead in the water.

Having a successful hedge fund after being a prop trader is not as easy as it looks, or as people think it will be.
I remember having a conversation with Ron Mock, CEO of Ontario Teachers, where he told me running a successful hedge fund isn't just about performing well, it's also about running a successful business.

To be honest, there is a ton of bullshit that goes along with running a hedge fund. I truly think people have to be insane to want to start a hedge fund in this environment. It's not just increased regulations, it's all the compliance and institutional demands.

I remember a time when I was flying all over the world meeting with directional hedge fund managers we invested with or who were looking for an allocation. My favorite part was talking markets and challenging their views. The part I dreaded the most was going over all the silly due diligence questionnaires and legal paperwork.

So why do people want to start their own hedge fund? There are a lot of reasons. Working at a bank, even one as prestigious as Goldman, really sucks. Banks are exiting prop trading activities and the ones they keep, they are squeezing traders to death, increasing their targets and lowering their compensation.

Second, there is a lot of internal politics at a bank which can drive anyone insane, especially prop traders who are always under the gun to deliver results. At one point, the very best traders reach their boiling point and literally say "fuck this shit, I'd rather be on my own than deal with assholes at my bank."

Third, and most importantly, the thirst for fame and extreme wealth is insatiable, especially for young thirty or forty year old men who literally think they are the next Soros (delusions of grandeur). Who doesn't want to run a successful hedge fund, ramp up assets under management, and start collecting 2% management fee on multi billions in good and bad times? With that kind of dough, you can hire top compliance, finance and marketing people and boast to the world that you're a "master of the universe."

Well, to all you aspiring "big, swinging dicks," save yourself a lot of time, money and aggravation and invest in a decent penis pump. Below, Daniel Tosh gives his hilarious review of the Bathmate Hydropump. Keep pumping away, you'll have a better chance of attaining mythological status (lol).