Condé Nast Portfolio
December 2007 issue
By Daniel Roth
In late August, Jeff Tarrant was driving home from his midtown Manhattan office when he heard a radio report on a topic that he knew intimately: the subprime meltdown. The founder of Protégé Partners, a fund of hedge funds, Tarrant had had a good year betting that the mortgage mess would continue and was following the story closely. Still, he was taken aback when a young investor interviewed on the segment suggested that the crisis should be contained by regulating hedge funds. "I'm sitting back and thinking, 'Subprime had nothing to do with hedge funds,' " Tarrant recalls. "It was rating agencies. The funny thing is, here's a kid on the street. He probably had $10,000 in his I.R.A., and he's blaming the hedge funds! How did that happen?"
Hmm, how did the average investor come to be suspicious of secretive, ultrawealthy money movers?
It doesn't take hours at a Bloomberg terminal to come up with the answer. Perhaps Tarrant and his peers should be wrestling instead with how to fix the problem. Because, while it may be technically correct to say that hedge funds aren't to blame for the subprime-mortgage market's collapse, reality is sometimes trumped by perception. And hedge funds, in an increasingly populist America, are not perceived positively.
What's needed is a correction. For these money managers not to be seen as the Legion of Doom, they have to win back the public's confidence, or more realistically, its ambivalence. Players big and small should start asking—and answering—uncomfortable questions about how they make their money and how much they give back. They should tone down the hubris. Show up in the cheap seats at a ballgame. Or at least mingle with the fans after buying the team.
A few in the industry have actually admitted that they're feeling queasy. In June, Nicholas Ferguson, chairman of SVG Capital, a British private equity shop, told the Financial Times that he couldn't figure out why he and his peers were "paying less tax than a cleaning lady." On this side of the pond, when Congress held hearings in September on the special tax rates for the alternative-investment industry, venture capitalist William Stanfill spoke out. Stanfill, the founder of TrailHead Ventures, in Denver, told Charles Rangel's House Ways and Means Committee that it isn't "fair for teachers and firefighters to subsidize special tax breaks for me and other venture capitalists or for private equity and hedge funds." Today, Stanfill says reaction in his office to his testimony was so negative, "I was tempted to ask Chairman Rangel if he could get me into the federal witness protection program."
During their recent rise to glory, the private equity and hedge fund industries built a gilded wall around themselves. Even as Stephen Schwarzman threw himself a $3 million sweet-60th birthday party and hedge funds racked up $4.8 billion through initial public offerings, the money industry typically ignored criticism. When asked to explain their work, hedge funds and private equity firms hid behind a law that forbids the hawking of unregistered securities to the public. Yet for the most part, no one cared. These guys were getting richer than most, but everyone was doing okay.
By summer, however, public sentiment had begun to shift. Homeowners were defaulting on subprime mortgages and credit markets had dried up. Suddenly, these risky investments had a human face: people being booted from their homes. Sure, investment banks, mortgage brokers, and others all had a hand in the mess, but those businesses were blowing up as well. There were no comments from the hedge fund managers who had helped contribute to the situation, nor did these people come forward to help ease the pain their partners, the investment banks, were going through: "Chutzpah, thy name is private equity," commented legendary short seller Jim Chanos at a conference this fall.
When the biggest players in the industry finally did begin to speak, all they talked about was, well, why they shouldn't have their taxes increased. The House of Representatives had suggested that carried interest—the cut of a fund's profits (typically 20 percent) that managers take as pay—be taxed as ordinary income. To fend off legislation, Blackstone, Carlyle, and other heavy hitters helped establish a trade group, the Private Equity Council, in December 2006. "The next generation of private equity entrepreneurs may well set up in London or Dubai rather than in New York or San Francisco," warns Robert Stewart, the council's vice president of public affairs.
That kind of talk—and $6 million worth of lobbying—worked wonders. In early October, the Senate dropped its tax plans, and the House bill doesn't seem likely to go anywhere. But by defeating the tax issue, the money managers ended up in the land of unintended consequences: They created a presidential-campaign issue for the Democrats and even for a few Republicans. Mike Huckabee took a jab at hedge fund managers in one debate, pointing out that they earn 2,200 times the pay of the average worker. Barack Obama complains that leaders of both parties coddle elite investment firms while middle-class families struggle to pay their taxes. Meanwhile, Rangel says he's planning the "mother of all reforms," and the investment industry is in his sights.
So how should the industry cope? The more it is willing to step into the light and reveal what it's doing, the better chance it has of building goodwill before Congress starts taking its cut. Some industry leaders are embracing change. John Paulson, the head of Paulson & Co., racked up an estimated $8 billion by betting that foreclosures would only increase. While Paulson won't talk about the investments, his spokesperson feels compelled to point out, "Paulson isn't for homeowners being driven out of their homes." And in October, the firm donated $15 million to help families fight foreclosure in court. It's a good start.