The Hedge-Fund Witch Hunt

Eliot Spitzer’s latest investigation is pursuing the wrong guys.

Now that the big investment banks have capitulated, New York State Attorney General Eliot Spitzer and enterprising journalists have trained their guns on hedge funds, the secretive investment vehicles that cater to the rich and are largely beyond the purview of the Securities and Exchange Commission.

In late January, the Wall Street Journal reported that Spitzer and the SEC have been listening to complaints from publicly held companies—including insurer MBIA and the Federal Agricultural Mortgage Corp. (Farmer Mac)—that a group of hedge funds collaborated to spread negative information about them in an effort to drive their stocks down.

While one of the accused hedge funds may have engaged in other suspect behavior—and has since folded—it’s difficult to see precisely what the complainants are beefing about. In the ‘90s, when investment bankers, analysts, company executives, and mutual-fund managers cooperated to spread positive information about companies, and hence drive their stocks up, nobody squawked. And we now know that there were all sorts of conflicts of interest hidden in that dank web of relationships. By comparison, the accused hedge funds were free of such conflicts and moved by motivations that are easily discernible.

Farmer Mac and MBIA have complained that the hedge funds in question—now-defunct Gotham Partners (not to be confused with the larger, and still operating, Gotham Capital), Greenlight Capital, Aquamarine Fund, and Tilson Capital Partners—set out to sandbag their stocks.

There is evidence that the managers of these funds were well-acquainted. The managers of Gotham Capital (William Ackman and David Berkowitz), the Aquamarine Fund (Gus Spier), and Tilson Capital Partners (Whitney Tilson) all attended Harvard Business School in the early ‘90s. Last November, Ackman, Spier, and Tilson were on an HBS panel about “Starting a Hedge Fund.” (No word yet on when Ackman will return to host “Closing a Hedge Fund.”)

Every hedge fund looks for an edge—proprietary trading algorithms, uncanny stock-picking ability, connections that afford a leg up on the competition. For these thirtysomething managers, part of their edge was the ability to use the evolving investment culture of the ‘90s—with its Web sites, TV financial punditry, and public conference calls—to broadcast and amplify their views on individual stocks.

These fund managers spoke loudly perhaps because they had such small sticks. According to the Wall Street Journal, Spier’s Aquamarine Fund has just $30 million under management. When it decided to shut down its main fund last December, Gotham was down to $300 million. Giant hedge funds, by contrast, are reclusive. SAC Capital Management and Omega Advisors, two multibillion-dollar hedge fund complexes, don’t maintain Web sites, and their principals rarely appear on CNBC.

Last spring, several managers of the questioned funds began to focus on Farmer Mac, the government-sponsored farm lending enterprise whose business and executive compensation practices have given rise to plenty of legitimate criticism. In April, Spier, Tilson, and Ackman went to a meeting with Farmer Mac CEO Henry Edelman and asked unkind questions. A month later—and a few weeks after the New York Times wrote a piece critical of Farmer Mac—Gotham published a bearish research report on the company. Tilson dissed Farmer Mac on the Motley Fool. On the Web, and on conference calls, the three continued to raise questions about Farmer Mac. The company’s stock fell nearly 50 percent in the spring and summer of 2002 but recovered nicely in the second half.

Last December, Gotham posted a report on its Web site questioning whether the insurer MBIA was worthy of its lofty credit rating and noted that the fund was short the company’s stock. On his Web site, Tilson suggested that investors dump MBIA and mentioned Gotham’s research. Greenlight Capital panned MBIA in a letter to investors, and several of the fund managers asked pointed questions about MBIA on conference calls hosted by Moody’s and Goldman Sachs in December.

It’s hard to see what’s illegal, or even unsavory, about this—unless the information they propagated was maliciously false, or if their actual stock positions were at odds with their recommendations. That’s something Gotham may have done in another case. Last November, Gotham published a favorable report on Pre-Paid Legal Services, noting that it held 1 million shares in that company. It continued to disseminate favorable information about Pre-Paid in December, even as it was selling the stock. That’s plainly problematic.

But with regard to Farmer Mac and MBIA, the hedgies’ main sin seems to have been making public criticism of entrenched management teams who were unaccustomed to negative ink of any kind.

While both Farmer Mac and MBIA have fallen in recent months—along with the rest of the market—it’s hard to ascribe their declines to the actions of these small funds. Indeed, there was something earnest about this gang of like-minded fund managers. They evidently talked about stocks, came to common investment conclusions, and acted upon them. Unlike most investment analysts, they were willing to speak truth to power and put their money where their mouths and Web sites were. The compensation and net worth of hedge-fund managers depend entirely on the annual performance of their portfolios—not on investment banking fees or other inducements. Their fortunes rise and fall directly with the quality of their judgment on stocks.

When hedge funds melt down, the manager always suffers more than his investors. The recent implosion of Eifuku, the phonetically indelicate Japanese hedge fund, may have cost George Soros $180 million. But manager John Koonmen lost a far greater chunk of his net worth and the business he had founded three years before.

There’s no doubt that some hedge funds have skirted close to the murky ethical boundaries of trading. But it’s more likely that the successful ones should be investigated, not the marginal players like Gotham Partners. With all the sharks still thriving around Wall Street, Spitzer and other regulators have better things to do than pursue the minnows, especially when the minnows don’t seem to have done much, or even anything, wrong.