Cash & Hemlock Partners LLC

December 27, 2006 1:58 PM

EarthShell, a small Maryland company that makes environment-friendly packaging (among others) may wink out of existence thanks to PIPEs, or private investments in public equities. Who likes PIPEs? Hedge Funds, mostly. Companies that take the pipe, as it were, may be sealing their doom. 10 percent of PIPE deals done this year are 'death spirals', where the company's stock price plummets from short selling by the financiers who structured the deal in the first place. And of course it's legal if you don't get caught shorting the stock naked and covering with the shares from the PIPE. (BTW, http://www.earthshell.com appears to be on the margins now or I'd have linked it).
posted by nj_subgenius (24 comments total)

It's almost as if the causes for the Great Depression weren't taught in business school: it's pretty scary how large chunks of the global economy are propped up on hedge funds, which are attractive, among other things, mainly for how little regulation exists over them.
posted by Blazecock Pileon at 2:11 PM on December 27, 2006

it's legal if you don't get caught

Nice logic there.
posted by Crash at 2:17 PM on December 27, 2006

it's the logic they use.....
posted by nj_subgenius at 2:20 PM on December 27, 2006

it's pretty scary how large chunks of the global economy are propped up on hedge funds, which are attractive, among other things, mainly for how little regulation exists over them.

Hedge funds have little regulation, unlike mutual funds, because only the ultra-rich are allowed to invest in them. Some of the requirements for being an unregistered investment company (of which hedge funds are a subset) are:

1. all investors must be accredited. In other words, they need a net worth of greater than $1 million, or need to have made $200k a year for two years in a row or more

2. no advertising

3. no more than 100 investors

LTCM, the company linked to above, pissed off their brokers who then called in their margin loans as soon as they possibly could. A few months after the LTCM "bailout" the banks and brokers who "rescued" LTCM made large profits on their share of the portfolio.

Interestingly, LTCM had given investors back their money shortly before they fell apart. The only losers were LTCM management and the employees who were allowed to invest in the fund. However, the employees' experience is more than sufficient to gurantee them great jobs on wall street.

LTCM didn't do anything illegal or immoral. They were a bit lazy with their mathematical modeling, and rude to the wrong people. More regulation would have done nothing to change the situation at LTCM.

Finally, PIPEs are financing methods of last resort. You only take a PIPE if you can't get money elsewhere. Most companies that take a PIPE will die, but they do get a small amount of time to try to fix things.
posted by b1tr0t at 2:55 PM on December 27, 2006

I didn't see an explicit link between EarthShell and PIPEs anywhere -- did I miss it?

As b1tr0t suggests, the use of a PIPE would seem to indicate a longer period of shaky capitalization and risky expansion bids.
posted by dhartung at 3:08 PM on December 27, 2006

b1tr0t, I don't think you want to give people the impression that only big investors get hurt in hedge funds. Hedge funds hurt us all by creating and then trading on volatility market-wide. Check this out, courtesy of Patrick Byrne, CEO of Overstock.com, which is a bit painful but instructive if you have an hour to give away.
posted by nj_subgenius at 3:12 PM on December 27, 2006

dhartung, take a look the the cornell partners website over once again. Then look at when EarthShell stock price tanked.
posted by nj_subgenius at 3:15 PM on December 27, 2006

I'm watching the overstock slides now, but until they are done:

1. Hedge funds are anything but uniform. Some create volatility, others consume it. Still others are actually just private equity funds that operate like mutual funds (mostly long positions).

2. A bit of volatility is a good thing. We certainly havn't had anything approaching dangerous volatility in the last 5 years, so if hedge funds are creating the vol we see now, we probably need more of them, not less.

3. LTCM, in particular, had models that assumed international debt volatility would remain relatively consistent. Due to the large positions LTCM and copycat funds took, the expected volatility began to erode quickly. Their previously uncorrelated positions became highly correlated, and weakness in one sector (russian debt) brought everyone down.

4. Volatility does not tend to expand without limit. If you can create volatility, someone else can make money by arbing the contract in question back to its theoretical value. Arbitrage opportunities in equities have been declining over the years, so I have a hard time buying your claim that hedge funds are creating lots of dangerous volatility. If they are, someone is arbing the profits away before they show up on 15-minute delayed quotes. Perhaps some daytraders are getting hit by this, but I have a hard time caring.
posted by b1tr0t at 3:32 PM on December 27, 2006

b1tr0t, Greenspan said "the probability that LTCM’s collapse would unravel the entire world financial system was significantly less than 50 percent.".

Which implies, to my mind, that it was north of 25%, or he would have used that number instead.

I'd say "wrecking the world economy" would rank up there in immoral behavior.
posted by Malor at 3:38 PM on December 27, 2006

An interesting read entitled "Hands Off Hedge Funds" from Foreign Affairs. I disagree with the conclusion, but it's full of great information and definitely presents an interesting argument.
posted by SeizeTheDay at 3:55 PM on December 27, 2006

I'd say "wrecking the world economy" would rank up there in immoral behavior.

You could say that, but you would be wrong. LTCM was like a kid playing with a stick of dynamite. They were dumb, but not malicious. The kid lost his hands, but the bystanders (LTCM's banks and brokers) not only handed the dynamite to the kid (who assured them he knew how to use it safely), but also managed to sell the burnt bits of flesh and bones for a huge profits. The banks knew they shouldn't hand dynamite over to children, but this particular kid was extremely persuasive. The banks had to break their own rules. If anyone was behaving improperly, it was the banks. LTCM didn't get their math right, but they literally had the best people in the business and from academia working for them. No amount of regulatory oversight would have stopped LTCM.

LTCM used the best risk management tools available at the time. Unfortunately, their trading strategy was too advanced for their risk management strategy. Since LTCM, funds have enhanced their risk management systems, and now there are likely hundreds of funds turning reliable profits with risk-reduced versions of LTCM's strategy.
posted by b1tr0t at 4:01 PM on December 27, 2006

I would recommend looking at Overstock/Patrick Byrne's past few archived quarterly conference calls. The live ones are frequently difficult to get into because anyone involved in the financial industry knows that he's going to turn it into a total freak show and make a spectacular jackass of himself.
posted by milkrate at 4:06 PM on December 27, 2006

Patrick Byrne isn't exactly the most objective critic. I'm not sure if this is discussed in the slides nj_subgenius linked to, but Overstock.com has been involved in a legal battle with a research firm and hedge fund that are short on the stock. I'm not up to speed on all the details, but I know enough that I'd take whatever Byrne says with a heavy dose of skepticism. But I'm probably biased since a friend of mine used to work for one of the companies involved in the legal case.

But b1tr0t is on the money here--hedge funds can't really be summed up so easily. They're not all trying to be LTCM and they're not all distressed PIPE investors.
posted by mullacc at 4:16 PM on December 27, 2006

So far Bryne reminds me of Michael Moore - good information combined with wild speculation and bits of information that are just plain wrong here and there. In particular, Bryne likes to conflate naked short selling with delivery fraud, almost certainly a NASD violation. Like Moore (and Adam Curtis, who tends to omit rather than directly mislead), Bryne provides some interesting topics for discussion and research, but would be an extremely poor single source of information.

For those interested in learning more about LTCM's trajectory, Roger Lowenstein's book is a good place to start.
posted by b1tr0t at 4:28 PM on December 27, 2006

Yeah, Byrne is not objective. He's got something of a vendetta against Rocker Partners and Gradient. Mutual funds are taking a stronger percentage of the PIPE market, although hedge funds this year are taking over a third of the business.
posted by nj_subgenius at 4:37 PM on December 27, 2006

A PIPE dilutes existing equity; of course the stock falls after a PIPE. But it would fall just as much if the company just sold more shares to the public or took on a big bunch of debt. Blaming the PIPE doesn't make a lot of sense.

The insider-trading actions linked seem to be more about trading on nonpublic information than about doing something nasty with a PIPE that couldn't be done with some other form of investment.
posted by Mid at 4:48 PM on December 27, 2006

EarthShell is in the dump because their their OpEx grossly exceeds their Revenues; not "thanks to" a PIPE.

@b1tr0t: Anyone can invest in hedge funds in Australia
posted by fourstar at 6:04 PM on December 27, 2006

fourstar - I'm not a securities lawer, but I'm pretty sure the US SEC doesn't regulate Australian hedge funds!
posted by b1tr0t at 6:09 PM on December 27, 2006

b1t: no shit. What is your point?
posted by fourstar at 6:21 PM on December 27, 2006

To reiterate what everyone else said, companies generally accept PIPES because of a preexisting problem. This method lets them get a cash infusion for less cost than a public bond or equity issue. The PIPE is rarely the cause of the problem, even though it is obviously correlated with the a problem.
posted by subtle-t at 7:57 PM on December 27, 2006

Extra "a" there, whoops.
posted by subtle-t at 7:57 PM on December 27, 2006

Patrick Byrne:

During the session, Byrne admitted to making up stories about being gay and a coke-head in the hopes of uncovering a mysterious group short-sellers led by a "Sith Lord." These individuals allegedly engineered an intricate conspiracy to cripple Overstock. Part of the conspiracy included tapping Byrne's phone calls and apparently some kind of spy ring.

I'm sure there's lots of crazy shit that goes on in the financial world, as elsewhere, and just because you're paranoid doesn't mean they're not out to get you, but I'd find Dr. Byrne more convincing had he been making these allegations back when he was a media darling for being clever enough to buy up the detritus of erstwhile dot-coms cheap.
posted by IshmaelGraves at 8:07 PM on December 27, 2006

During the session, Byrne admitted to making up stories about being gay and a coke-head in the hopes of uncovering a mysterious group short-sellers led by a "Sith Lord."

I am trying -- but failing -- to understand how admitting to homosexual proclivities and drug addiction would assist in uncovering a mysterious group of short sellers lead by a "Sith Lord". I suspect we're not being told the entire story.
posted by little miss manners at 10:38 PM on December 27, 2006

Ha ha ha, that's hilarious fourstar. Their numbers are even worse over at Yahoo finance. Google rounds everything to the nearest $10,000 which boosts EarthShell's revenue by 20%.
posted by ryanrs at 11:48 PM on December 27, 2006