This private investor document perfectly shows why people are sick and tired of hedge funds

Mason MorfitChannel 9Mason Morfit, president of ValueAct Capital.

Hedge funds have been getting throttled since the beginning of 2016, and because of that people are starting to ask questions about their worth.

(As you know, people tend not to ask questions when they are making money.)

All of a sudden investors want to know how their money was lost, and what strategies and thought processes contributed to it vanishing into the market ether.

They do, after all, pay very high fees for the services of hedge fund managers.

And so in the spirit of pursuing that knowledge Business Insider’s Rachael Levy published excerpts of private due diligence documents from ValueAct Capital, the almost $16 billion activist hedge fund.

It shows you exactly why investors are getting sick and tired of hedge funds.

The docs

Here’s what we learned from the documents. First off, ValueAct doesn’t think it has to benchmark itself against any metric in the market. It stands alone on whether it makes you money or not.

This is nonsense. The point of a hedge fund is actually to invest in something that compares itself to the market. A hedge fund is supposed to be uncorrelated to the market, so by definition you have to know how the market it is uncorrelated to is doing.

This is a sign of the industry run wild. A hedge fund now just means that you pay a management fee and a performance fee to someone who is supposed to be a whole lot smarter than you, so much smarter than you that they can beat the market.

That’s why, according to ValueAct, you should throw your money at them and then just say, “awesome, thanks.”

The documents also disclosed that ValueAct only invests in large companies, above $3 billion. This has got to be helpful, since it means everyone else is covering them too. It also means, however, that some of these companies are as big as they’re going to get — not a ton of growth potential there.

The last key thing we learned from these documents is that if ValueAct investors want to know where their money is going, they have to sign a non-disclosure agreement.

This makes sense. Hedge funds started out as small secretive institutions available to only the most elite investors. The last thing any hedge fund manager needed was some loudmouthed drunk investor talking about the fund’s position at the Maidstone Club some afternoon.

But in a world where hedge fund managers are constantly talking to each other at conferences and idea dinners, where long positions are disclosed on a quarterly basis, we see how this could be a bit onerous too. And of course, once the fund starts to lose money there are those questions.

ValueAct was down 2.2% in 2015.

Jeff ubben valueactKellogg School of Management/YoutubeValueAct CEO Jeff Ubben motions during a speech at Northwestern University’s Kellogg School of Management in January 2015

When they come

The questions also tend to come when your hedge fund has to pay an $11 million settlement with the Department of Justice for failing to properly notify authorities that it was purchasing shares of Halliburton and Baker Hughes during their proposed merger in order to influence its outcome.

ValueAct tried to argue that it was acting as a passive investor (not really their thing by definition), the government didn’t buy it.

This is much like the argument that Bill Ackman and Valeant Pharmaceuticals are making in a California court right now. Both of them are being sued by investors in Allergan, the drugmaker, on allegations of insider trading. Back in 2014 Ackman and Valeant teamed up in order to push Allergan into a Valeant hostile takeover.

It didn’t work, but since Ackman and Valeant had bought a bunch of Allergan stock in order to influence the board to accept the deal, they made a killing anyway when a white knight bought Allergan.

Another big investor in Valeant at the time was (and still is) ValueAct. ValueAct had gotten into Valeant before Ackman came along, and according to the insider trading complaint, its president, Mason Morfit, was part of the team that tried to decide if doing this Valeant-Ackman tag team deal would be a good idea.

From the complaint:

On February 19, 2014, Morfit, members of Valeant’s senior management and its audit and risk committee discussed the structure of the contemplated Allergan acquisition with their lawyers from Sullivan & Cromwell and Olser, and formally decided to move forward. The next day, February 20, Valeant and Pershing amended the February 9, 2014 Confidentiality Agreement. Over the next five days, between February 20, 2014 and February 25, 2014, Valeant, Pershing and their respective counsel negotiated the letter agreement and the terms pursuant to which Ackman would acquire the nearly 10% toehold in Allergan common stock.

As you probably know, Valeant has since become a hedge fund graveyard. The stock is down around 90% since October, when government scrutiny over the company’s high drug prices and accusations of malfeasance from a short seller revealing a secret in-house pharmacy called Philidor forced its collapse.

Think about it: Valeant purchased the option to buy Philidor for $100 million, consolidated Philidor’s revenue into its own accounting, and was allegedly perpetrating insurance fraud with it (according to an investigation by US Attorney Preet Bharara) and ValueAct, an investor in the company for years, was blindsided by Philidor’s existence.

Of course, so was much of the rest of hedge fund land.

In its documents ValueAct says it takes a bottom-up approach to stock picking. First they look at the stock, then the sector, and so forth.

Ideally, one would find a Philidor at the bottom of this approach. Ideally.

Two kinds of crowds

Part of what is ruining hedge funds, any hedge fund manager will tell you, is that they’re all chasing the same ideas these days. It was fine when everyone was also making money being in the same 20 stocks, but now they’re not.

That is why a bunch of money is getting thrown into passively managed funds. If you’re only going to make a few percentage points on your money, you might as well do it cheaply.

ValueAct just announced a $1.1 billion stake in Morgan Stanley. It also said it doesn’t plan to shake up the company in any meaningful way, though analysts have argued that the bank has much to do if it wants to reach its goal of 10% return on equity (it’s at about 8% now). That lack of action defies ValueAct’s name and purpose.

Any investor might as well just turn around and buy the stock themselves, really.

The conditions for our low yield world aren’t necessarily going away either, so this is a trend that probably isn’t going away.

Hedge funds that can’t make the cut are going to get stomped out, and documents like ValueAct’s show you a little bit of why investors are likely all-too-ready to tell hedge funds to take a hike.

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