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Uninformed Musings On Shkreli, Wall Street, Funds


Percy

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I haven’t been round these parts for ages. Haven’t been reading or writing much for that matter. This is an overdue post on a topic that’s out of the headlines now but I figured I’d drop this here anyway.

 

As a practice, I pay scant attention to the daily news. Reasons for this range from the pragmatic to the political to the philosophical, but for now my deliberately uninformed existence has me ticking along nicely. I get the headlines (mostly via the Captivate screen in the elevator of my office building but that’s neither here nor there) so I’m not completely illiterate when it comes to the churn of world events. Once in a while a topic piques my interest enough to delve into the details.

 

Back in December, when Martin Shkreli was arrested by the FBI for securities fraud, I wanted to get the details. The only thing I knew about Shkreli to that point was that he became CEO of a pharma company and jacked up the price of a drug needed by AIDS patients. The securities fraud arrest seemed like an odd twist. What was the securities fraud connection to his role with the drug company? Out of curiosity, I read an article in either the WSJ or NYT – the two papers that sit in the lunch room next to the Scrabble board – and learned that the fraud charges were related to actions pre-dating his involvement with Turing where he was CEO and raised the drug price. The alleged fraud had nothing to do with the price increase or his current company. This information further piqued my interest because in the photo I’d seen of Shkreli (on that Captivate screen), he looked quite young. Certainly he’d looked young for a CEO and now I was learning that he’d had a career as a fund manager prior to heading up the pharmaceutical company. I turned to Wikipedia to get details on his age. This appears to be the trajectory of his career:

 

1983: Born
2000 (age 17): began working in an internship position at hedge fund while in high school/college
2005 (age 22): Undergraduate degree awarded
2006 (age 23): Started his first hedge fund <= this one was abandoned when Lehman Bros. won a default judgment against it
2007 (age 24): Started his next fund <= this is the one where he took actions the FBI arrested him for
2011 (age 28): Founded a biotech company - Retrophin ç improprieties in the relationship between this company and the fund he started above led to his being fired in 2014 and were part of the FBI investigation
2015 (age 32): Founded a pharma company - Turing - where his actions put him in the world headlines

 

The fact that he founded two hedge funds before the age of 25 bothers me. Hedge funds, right? Simplistically, the people who start these things are going around and getting other people to invest money in their fund. They have to convince these people - wealthy individual investors, people that control large sums of money like the Firefighters Retirement Fund for Hometown, USA - that their idea/business plan/strategy of investment is going to offer up large returns. If they can convince those people that they do have a good investment strategy, then money comes rolling in.

 

So, let me ask you – how many 23 year olds would you entrust hundreds of thousands of dollars to? And I’m not talking about morally trust them. I’m not speaking about whether a 23 year old will steal the funds. I am asking how many 23 year olds have the business acumen, the experience, the judgment needed to manage that type of money? This leads me to the question of who were Shkreli’s initial investors in the fund he started at 23? What led them to believe that he would make good on the expected/promised returns?

 

Now, there are brilliant 23 year olds out there in many disciplines. Silicon Valley is filled with them as are sports, and the arts. I get that. And maybe Wall Street thought they had found a finance genius, after all Shkreli apparently shorted a stock successfully when he was at his hedge fund internship in college. So maybe the early investors in the fund did think they were investing with a Mozart managing their money. Wall Street is filled with gamblers and I’m sure there are those who straight out got a thrill of rolling the dice with their money on Shkreli. His age just increased the stakes and their high.
There are certainly understandable reasons why people would legitimately give their money to this 23 year old fund manager. Unfortunately for them, this 23 year old was apparently not a wunderkind and eventually the FBI caught up with him with accusations of running a Ponzi scheme.

 

Ponzi schemes are nothing new to Wall Street. I’m sure there are some big ones running right now that will eventually go bust. The thing about Ponzi schemes is that the early investors can come out unscathed and collect a load of money on top of their initial investment. Of course all that money coming in, it’s not from investments. It’s the money that the second round and third round of investors gave to the fund manager. In a Ponzi, the fund manager has to keep bringing in new investors in order to keep the scheme going.

 

Wall Street is not stupid. I can’t help wondering if any of those early investors in the 23 year old Shkreli’s fund wondered how he was going to make this work. Wall Street trades on names and reputation as much as on numbers. Shkreli used the name of the firm he interned at and his history with them to lend credibility to starting his own fund. Could some less than ethical early investors have reasoned out something like:

 

1) This kid might be legitimate or he might be trying to pull a fast one.
2) If he’s legit, I stand to make or lose some money.
3) If he’s got a scheme going, I make money off of it because:
a- He’s personable enough to convince people to invest with him
b- He’s got some connections from his internship days
c- I can recommend some other investors to him and since my reputation is good, they’ll invest
d- I’m an early investor so if this is a scheme, there will likely be enough investors after me that I’ll make back my money and more

 

I really do question the ethics of the early investors in any Ponzi scheme but especially in this one where, on the face of it, you would think that the age and inexperience of the fund manager would alone have been enough for people to ask hard questions. And to be fair, there were probably a lot of people on Wall Street who did ask hard questions and walked away without investing. But I wonder whether at least some of Shkreli’s investors suspected from the start that there was a good chance he was pulling a fast one and they were betting they’d be in it early enough not to get burnt.

 

As a matter of fact, they probably figured they could help the scheme be successful by recommending Shkreli and his fund to their friends. The more investors, the more legitimate he appears. The longer the scheme runs, the more it’s likely to attract big-time investors.
And who are the big time investors? Believe it or not, it’s people like you and me. The big time investors are the pension funds for the state teachers’ union, the retirement funds for your state employees. That’s where the big money is and it’s your money and my money – all those little percentages deducted from our paychecks. We’re crowd funding a retirement fund. And granted, the managers of those big retirement funds don’t invest 100% of our money into a single hedge fund – Shkreli’s or anyone else’s. They diversify so that if there is a loss, we don’t lose everything. But when our retirement funds get caught up in fraudulent schemes, they do lose money. They are losing our money. The problems of Wall Street do trickle down so-to-speak.

 

The FBI does, when it investigates Ponzi schemes, look at who made money off this scheme. They look beyond the Shkrelis of the world. But it’s hard to prove, right? What an early investor might have thought or suspected? Did they know for sure that there was fraud? Or did they just suspect and hold their nose because they were at least going to make their money back? Or did they suspect and help it along by referring future investors? Or was that early investor completely clueless, thinking that they were handing their money over to a 23 year old financial genius?

 

What is unethical and what is criminal? Where is the line? How aware is Wall Street of when they are crossing it or are they in such a bubble they can't even see it anymore?

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This article from the New York Magazine gives a better explanation than what I gave in my blog on how hedge funds operate and function. Also - BOOM! - some of the big investors are dropping hedge funds.  Market correction in the works!

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