More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  AS FARALLON WAS BIDDING FOR BANK CENTRAL ASIA, another adventure half a world away was proceeding less smoothly. Steyer had gone into business with a Colorado rancher named Gary Boyce, a flamboyant horse trainer and dreamer of wild dreams about the wealth in the valley of his childhood. Boyce had approached Farallon with a plan to buy land in the valley and pump water from the aquifer beneath—the water could supply Boulder, Colorado Springs, and even Denver. Farallon’s alliance with the Yale endowment made it alert to the potential of “real assets” like water. Steyer and his team invested.

  Southern Colorado’s valleys were as remote in their own way as Jakarta’s back alleys. To get to Gary Boyce’s homestead, the Farallon people had to fly to Denver, then drive south for four hours to Alamosa, a small town with a True Grits Steakhouse, a Trop Arctic Lube Center, and a store plastered with posters announcing Tecate Imported Beer, Extra Gold Lager, and new Bud Light Lime—lattes had some competition in this neighborhood. After Alamosa, the visitor pressed on into the San Luis Valley, past lonely trailer homes, over pancake-flat land covered in harsh scrub, under cotton-candy clouds that sat motionless on distant mountains. At the far edge of the valley lay Gary Boyce’s ranch house: a handsome adobe structure with hollow walls to keep out the heat. Boyce wore shirts with mother-of-pearl studs on the pockets. On the desk in his study lay a pair of ornate pistols.

  You could see why Steyer and his team took this man for the perfect local partner. Boyce grew up poor in the San Luis Valley, then became the three-time winner of the Colorado dirt-biking championship. He was a veteran of the politics of water: During a fight over an earlier venture to tap the San Luis aquifer, he had founded a newspaper called the Needle to pierce the developer’s bubble.32 And while Boyce was a true local, he was also worldly: He had grown wealthy training horses for upper-crust Virginians, and wealthier still by marrying an MGM heiress. Confident that Boyce had the moxie to get a new version of the water project launched, Steyer created a partnership to finance his ambitions. Half the capital came from Farallon and the other half came from Yale, though Yale played no role in managing the project.

  Backed by Farallon’s money, Boyce duly bought a ranch in the San Luis Valley in 1994, outbidding the Nature Conservancy, which wanted to turn the land into a national park. He spent $3 million on an environmental study that showed water could be extracted without damaging the local soils. He hired lobbyists to plead for the project in the Colorado legislature. Meanwhile, Boyce spent half a million dollars on collecting signatures to get two referenda in front of Colorado’s voters. The first measure required valley farmers and ranchers to place consumption meters on their wells; the second forced farmers to pay user fees for some types of water. Both measures were essential to Boyce’s scheme, since they would establish a fair price for the resource he would be selling. Boyce spent another $400,000 on advertisements to build support for his ballot initiatives, assuring his partners at Yale and in San Francisco that they would be voted through. Steyer went out to the valley to visit, bringing his mother along for a vacation. She bonded happily with Boyce and tried her hand at elk hunting.33

  Not everyone was happy, however. The farmers in the valley revolted against Boyce’s proposals: They were outraged at the prospect of a user fee, and they claimed that the valley’s sandy soils would clog the meters. As the arguments grew heated, Steyer began to wonder if he had chosen the right local partner after all.34 Being born locally was not the same as being respected locally; perhaps the mother-of-pearl shirt studs and decorative pistols marked Boyce out as a poseur, not a regular local with Colorado credibility. When it came time to vote, in November 1998, Boyce’s water initiatives were defeated by a large margin. Steyer and his Yale partners had spent four years and more than $20 million on the project, but now they had no choice but to recognize its failure.35 Casting about for an exit, Farallon invited the Nature Conservancy to revive its old plan for a national park, and the two sides signed a deal at the end of 2001. But then an obstacle cropped up. Boyce blocked the path to the exit by filing a suit against Farallon.

  Boyce’s argument in court was that the water scheme was still viable. By bailing out prematurely, Farallon was damaging the value of Boyce’s stake in the project. The lawsuit delayed the sale to the Nature Conservancy, and soon various onlookers saw an opportunity to make mischief. Colorado senator Wayne Allard accused Yale of profiting at the expense of Colorado’s taxpayers, who would bankroll the Nature Conservancy’s purchase, and demanded that Yale lower its asking price of $31.3 million—even though Yale’s role was merely that of a passive investor.36 Allard suggested Farallon had misled Yale about the environmental costs of the project, even though Boyce’s referenda had failed because of the proposed user fees and meters, not because anyone had shown that his environmental study was faulty. For nearly all of its history, Farallon had tried to stay out of the headlines, and it was certainly not accustomed to public abuse from a senator. The involvement with Boyce was growing ever more uncomfortable.

  At the start of 2004, Farallon emerged victorious in its legal struggle against Boyce, and pressed to conclude the sale to the Nature Conservancy. To buy peace from the critics, Yale announced it would donate $1.5 million to subsidize the cost to Colorado’s taxpayers. But Farallon was soon ambushed by another surprise: A bizarre coalition of protesters announced itself on several college campuses. Its leaders declared that they were part of an “unFarallon campaign” aimed at forcing college endowments to withdraw their capital from Farallon. A protest soccer game at the University of Texas featured players dressed up as crony capitalists. A “transparency fairy” in a feathered mask waved her wand outside Swensen’s office at Yale, willing the endowment to be more open and accountable.37

  The street theater drew attention to a new unFarallon Web site, which listed all manner of supposedly nefarious activities. It cited Farallon’s investment in a coal-fired power project in Indonesia: Coal was evil. It invoked Farallon’s investment in Argentina: The workers had suffered. It paraded the plight of the tiger salamander on a California golf course in which Farallon had invested: Unless the golf lords dug some ponds, the salamanders would be threatened.38 Indeed, Farallon was complicit in no less a crime than the Iraq war: It owned a $3 million stake in Halliburton, the oil-services firm once headed by Vice President Cheney. The activists demanded that Farallon’s secretive mastermind meet them to discuss “the ethics of Farallon’s investment practices.” “We are stakeholders in the investments you make with university money,” they lectured Steyer, apparently imagining an adversary with a monocle and top hat. “We do not want our universities to profit from investors that harm other communities.”39

  Steyer did his best to stand up for himself. He wrote to the unFarallon campaign, pleading that he cared as much as anyone about strong business values. He wrote to Farallon’s investors, stating the obvious truth that the Web site was “factually inaccurate.” But the demonstrations continued. In April students held a rally in front of the office of Yale’s president. They staged a mock attempt to extract water from an aquifer under the campus, and they broke ground for a new coal-fired power plant. When the students showed up at a meeting of Yale’s Advisory Committee on Investment Responsibility, David Swensen’s patience was stretched even further.40 After sitting through a recital of complaints about the endowment’s failure to disclose the details of its investments, he decided it was time to engage his tormentors, and he approached them after the meeting: A tall, wiry figure in a fleece vest, towering over a group of grungy students, arguing intensely. The students’ demand for more transparency was simply impractical, he explained; in order to compete successfully in markets, investors must protect proprietary secrets. If Yale wanted to reap the benefits of hedge funds, it had to promise not to leak information about their dealings: It needed to ensure that it was “the highest-quality limited partner possible.” The students were unmoved. “I think it’s more important to look at Yale as the highest-quality globa
l citizen,” one of them retorted.41

  In picking on Swensen and Steyer, the students had chosen two of the least appropriate targets in the hedge-fund universe. Far from being a Cheney acolyte, Steyer was an open-fisted backer of the Democratic presidential candidate, John Kerry. Far from being a money-obsessed monster, Swensen had missed a chance to be a billionaire because of his “genetic defect.” But none of this mattered. Hedge funds had grown with the help of college endowments. They could not expect immunity from the vagaries of college politics.

  FARALLON CLOSED THE SALE TO THE NATURE CONSERVANCY in September 2004. The water project had been a failure, but the land had gained value, so Steyer and his partners came out with a small profit. But the Colorado episode exposed a vulnerability—both in Farallon and in ambitious bargain-hunting funds more generally. Bargains often lurk in quirky places: in the details of the junk-bond market’s debris, in postcrisis Indonesia, in tangled feuds between ranchers and farmers in a remote Colorado valley. To invest successfully in these sorts of situations, you need to understand the traps in the terrain, and young hedge funds sometimes lack the manpower to survey it adequately. If Farallon’s people had spent more time in the San Luis Valley, they might have realized that Gary Boyce was an unsatisfactory partner.42 But in a fund that doubles its assets every four or five years, it can be hard to grow in-house expertise as fast as incoming capital.

  But the vulnerability in Farallon-style funds goes deeper than that. Their returns partly reflect a willingness to buy illiquid investments. If busted junk bonds represent value, it is probably because most investors are frightened to buy them—so if you decide you want to sell later, such assets will be hard to exit. If you buy a bank in Indonesia, the same argument applies; if you make a mistake, you can’t expect to get out easily. In ordinary liquid markets, prices are fairly efficient and second-guessing them is hard. In illiquid markets, by contrast, there are bargains aplenty—but mistakes can be extremely costly.43

  Hedge funds that buy illiquid assets benefit from an accounting quirk that can flatter their performance. By definition, it is hard to know what an illiquid asset is worth—you lack the continually updated price discovery that comes with constant trading. As a result, hedge funds with illiquid assets don’t so much report their profits as estimate them—there is no objective price for much of what they hold, so they have to come up with a subjective value. In a few cases, hedge funds may take advantage of this murkiness to exaggerate their returns, though this game is not sustainable. But even if funds make every effort to report their results honestly, they cannot help but “smooth” them. A hedge fund may estimate the value of an illiquid asset every few weeks; if it rises 5 percent and then falls back within that period, it will be recorded simply as flat—with the result that some sharp volatility along the way is not acknowledged. As a result, hedge funds with illiquid assets are not as stable as their numbers suggest. Their risk-adjusted returns look wonderful because some of the risk goes unreported.

  But the biggest danger for buyers of illiquid assets is that, in a crisis, these assets will collapse the hardest. In moments of panic, investors crave securities that can be easily sold, and the rest are shunned ruthlessly. Long-Term Capital’s apparently diverse portfolio concealed a single bet that the world would be stable: When this proved wrong, apparently unrelated positions collapsed simultaneously because many of them boiled down to an attempt to harvest a premium for holding illiquid assets. Likewise, apparently diversified event-driven funds may be taking a concentrated bet on illiquid investments. In 1998, Long-Term Capital paid the ultimate price for taking too much of this sort of risk. In 2008, buyers of illiquid assets paid heavily again, as we shall see presently.

  13

  THE CODE BREAKERS

  Not so many hedge funders have been to East Setauket. It is an hour’s drive from Manhattan, along the Long Island Express-way; it is separated from the hedge-fund cluster in Greenwich by a wedge of the Atlantic Ocean. But this sleepy Long Island township is home to what is perhaps the most successful hedge fund ever: Renaissance Technologies. Starting around the time that David Swensen invested in Farallon, Renaissance positively coined money; between the end of 1989 and 2006, its flagship fund, Medallion, returned 39 percent per year on average.1 By the mid-2000s, Renaissance’s founder, James Simons, had emerged as the highest hedge-fund earner of them all. He was not the world’s most famous billionaire, but he was probably its cleverest.

  Simons was a mathematician and code breaker, a lifelong speculator and entrepreneur, and his extraordinary success derived from the combination of these passions. As a speculator, he had dabbled in commodities since his student days, acquiring the trading bug that set him up for future stardom. As an entrepreneur, he had launched a string of businesses; the name of his company, Renaissance Technologies, reflected its origins in high-tech venture capital. As a code cracker, Simons had worked at the Pentagon’s secretive Institute for Defense Analyses, where he learned how to build a research organization that was closed toward outsiders but collaborative on the inside. As a mathematician, he had affixed his name to a breakthrough known as the Chern-Simons theory and won the American Mathematical Society’s Oswald Veblen Prize, the highest honor in geometry. In an expression of his diverse passions, Simons used a wedding gift to speculate successfully on soybeans, got fired from the Institute for Defense Analyses for opposing the Vietnam War, and drove from Boston to Bogotá on a Lambretta motor scooter—all while still in his twenties. Having grown to know Colombia at the end of that road trip, he teamed up with some local friends to launch a tile factory in the country.

  Simons’s early adventures in markets had little to do with mathematics. He traded commodity futures on the basis of hunches about demand and supply, riding the wild booms and busts of the 1970s. But the mathematician inside him yearned to substitute models for seat-of-the-pants judgment, and he loved the idea of a machine that would do his trading for him. Starting in the late 1970s, Simons recruited a string of outstanding mathematical minds to help create such a machine. There was Leonard Baum, a cryptographer who had worked with Simons at the Institute for Defense Analyses. There was James Ax, a winner of the American Mathematical Society’s foremost prize in number theory. And there was Elwyn Berlekamp, a Berkeley mathematician who was yet another veteran of the Institute for Defense Analyses. The names and ownership structures of Simons’s various ventures changed along with the collaborators he drew into his net. He had an investment fund in Bermuda and a company on the West Coast, as well as the operation on Long Island, where he had chaired the math department of Stony Brook University before quitting in 1977 to focus on his businesses.

  It was not just that Simons’s recruits were intellectually formidable. Their experiences in cryptography and other aspects of military communications were relevant to finance. For example, Berlekamp had worked on systems that send signals resembling “ghosts”—faint traces of code in seas of statistical noise, not unlike the faint patterns that hide in broadly random and efficient markets. Soldiers on a battlefield need to send messages to air cover that are so wispy and translucent that they won’t betray their positions: Not only must the enemy not decode the messages; it must not even suspect that someone is transmitting. To Berlekamp, the battlefield adversaries fooled by such systems bore a striking resemblance to economists who declared markets’ movements to be random. They had stared at the ghosts. They had seen and suspected nothing.2 The Simons team took their experience with code-breaking algorithms and used it to look for ghostly patterns in market data. Economists could not compete in the same league, because they lacked the specialized math needed to do so.

  The early efforts of the Simons team were only moderately successful. Despite his preeminence as a mathematical modeler, Leonard Baum quickly tired of the quest for golden algorithms; he read the business papers and took a huge bet on the British pound, which paid off handsomely. James Ax stuck with the computer-trading project; but he was a volatile per
sonality and his system’s returns could be volatile also. Still, by 1988 Simons had built the platform for his later success. Together with Ax he launched the Medallion Fund, named in honor of the medals the two men had won for geometry and number theory. Medallion traded commodity and financial futures on the basis of computer-generated signals; and although the heart of the system was unremarkable—it was a trend-following model not unlike the one built at Commodities Corporation more than a decade before—a small portion of the money was deployed according to a different set of rules. This was the kernel of the future Simons fortune.

  The kernel was the brainchild of Henry Laufer, a member of the mathematics faculty at Stony Brook University.3 Laufer was a self-contained figure. Once, following an argument, Ax had tried to punish him by refusing to speak to him for months; Laufer had failed to notice. But Laufer’s eccentricity was matched by his talent. In a triumph of ghost hunting in the mid-1980s, he had spotted patterns in the way that markets move right after an event perturbs them. In the period after a new data release, a commodity or currency would spike upward and downward as different investors reacted, and although the jiggering appeared random to the naked eye, a scientist with high-resolution statistical goggles could make out patterns in the movements. It was not that a commodity would jigger in the same way following every piece of news: That would have been too obvious. But if you scrutinized thousands of reactions to thousands of events, certain sequences emerged in slightly more than half of all the observations. By betting on those sequences repeatedly, the Simons team would win more often than it lost. And by betting enough times and in great enough size, it could be assured of handsome profits.4