As McKinsey Sells Advice, Its Hedge Fund May Have a Stake in the Outcome

Here's the delicious summary from Matt Levine's "Money Stuff" Bloomberg column:

> Incentives

All else equal, would you rather hire an evil investment bank to underwrite your stock offering, or a good investment bank? I think there are good arguments both ways. An evil investment bank might do evil things to you, which you won’t like. On the other hand, it might do evil things to investors on your behalf, which you might like; if there is evil in the world, you might as well hire it so it’s on your side. Also an evil investment bank might hang out with all the evil investors, who have a lot of money and will buy your stock, while a good investment bank will only hang out with good investors, who have less money.

Or whatever, I don’t know, it’s a model. More generally, if your model is “the whole financial system is evil,” then evil investment banks should be preferable and more successful, because they will be better plugged in to the (evil) networks of the financial system.

Here’s a fun paper from Thomas Roulet of Cambridge’s Judge Business School, whose model really is kind of “the whole financial system is evil”; as the school’s blog summarizes it:

The study concludes that negative coverage actually helped banks gain IPO business from corporate customers, as those corporates view certain banking practices widely criticised after the financial crisis (such as appetite for risk, short-termism and big bonuses) as consistent with industry norms, thus suggesting quality of service.

“This study shows how divergence in audiences’ perception of typical industry behaviours can make wrongdoing beneficial,” says the paper authored by Dr Thomas Roulet, University Senior Lecturer in Organisation Theory at Cambridge Judge Business School. “Most audiences tend to disapprove of wrongdoings, but specific stakeholders may interpret this disapproval as an indication of the focal organisation’s level of adherence to professional norms.”

The model is roughly that “professional norms,” in business, are evil, and so businesses looking to hire qualified professional investment banks tend to look for the ones who are most evil. And so winning IPO mandates is correlated with negative press coverage. What kind of negative press coverage? These delightfully specific kinds:

The media coverage was evaluated based on a list of 204 words built on a qualitative analysis of a sample of opinion articles. The articles were then coded on the basis of how those words were associated with the banks. The words were grouped into four factors that have been heavily criticised since the financial crisis:

Greed: words such as “obscene”, “excess”, “selfish”, and “shameless”. Violence as in a battleground: “assault”, “frenzy”, “vicious”, “fierce”. Opacity as in fostering secrecy: “covert”, “cryptic”, “dubious”, “hazy”. Risk-taking behaviours: “casino,” “tempt”, “daring”, and “gamble”.

“This study suggests that the coverage of misconduct can actually act as a positive signal providing banks with incentives to engage in what is broadly perceived as professional misconduct.” It is broadly perceived as professional misconduct, but it is narrowly perceived—within the profession, and its target audience of businesses—as proper professional conduct.

Obviously you can tell this story without using the word “evil,” and I am joking at least a little bit when I use it. The work of finance is esoteric, and its norms are specific and contextual; in many cases, those norms look bad to outsiders but are sensible and useful in their context. Trading ahead of a client order for a foreign-exchange fixing can be perfectly appropriate hedging, but looks like bad bad front-running when it is exposed as an FX scandal. Taking large risky positions in derivatives can be a perfectly appropriate way to facilitate clients’ hedges, but looks like bad scary prop trading when it loses money. Pricing and allocating an IPO so it is likely to trade up probably serves the goals of banks and investors and issuers, even though outside commentators regularly describe it as “leaving money on the table” for issuers. Sophisticated clients tend to understand what banks are doing and why, and not to take the criticisms too seriously, although I still find it a bit counterintuitive that they’d think more criticisms would be good.

I used to work at Goldman Sachs Group Inc., including during a period when it was heavily criticized for being, um, “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” We did fine. There was a distinct sense that clients thought we were evil but smart, and that they’d rather have us on their side than against them. Also I would sometimes go pitch oil companies, and they would welcome us warmly and thank us for being so widely hated, because it made them look good by comparison. I suppose this is evidence for the “the whole financial system is evil” view.

[1] https://journals.sagepub.com/doi/abs/10.1177/001872671879940...

The substance of the article strikes me as, "potentially really bad, but no obvious smoking gun".

MIO is a special situations hedge fund, meaning that it looks for companies that desperately need capital for one reason or another, and who have been poorly served by the market for capital because some aspect of their story is messy and/or tough to understand, and provides them capital on terms that give MIO a lot of upside if the company gets back into good shape.

An important thing to understand about special situations investing is that it's usually very active relative to other types. That is to say, I can run a successful long-short equity fund and literally never once interact with any of the leadership of any of the companies in which I take positions; I can, for example, go long Verizon and short T-Mobile and never have to deal with either of those companies' management teams. For special situations on the other hand, the entire value proposition of the fund manager is what they can deliver through their active involvement with the portfolio company that takes the fund's money. So, you'll see special situations funds get super involved in issues like renegotiating long-term leases, or investing in sales teams, or reconfiguring operations to run on a single ERP system, etc -- activities which are right in the wheelhouse of former Big 3 consultants, whose work consists of bouncing from tough problem to tough problem at high-paying clients.

So it's not hard to understand why McK made the decision to found MIO. It kills multiple birds with one stone:

- Makes partners more money through an asset class that tends to post good returns

- Helps their recruiting pipeline because it makes it easier to capture aspiring buy side bigwigs out of college (perennially McK's Achilles heel vs. i-banking)

- Provides outgoing partners with something to do in semi-retirement; MIO employs a shit-ton of semi-retired McK partners to do deep dives on various topics. This importantly has the positive effect on McK's culture of helping clear out the top of the pyramid so young partners don't feel like their career is going nowhere

Anyway, much of what's in the article sounds concerning. For example, the still-serving head of McK's bankruptcy practice was on the board of MIO when it was considering an investment in a coal company that was going bankrupt. On the one hand, this raises hackles; on the other, it's really only a PROBLEM problem if McK was advising that coal company, or had advised them recently prior to the MIO investment. And that might have been the case, but the article does not say whether it was.

The description of the McK's interactions with Guo Wengui is....I'm not sure what point they're trying to make? And similarly, with Valeant, the NYT's gripe is that another fund in which MIO invested went long Valeant at the same time that McKinsey was advising Valeant to increase the price of certain medications.

If I had to guess I'd say that McK has advised 90% of the F500 at one point or another and is actively advising about 30 or 40% of the F500 on something at any point in time. So, I really don't think that McK giving Valeant pricing advice through a consulting project at the same time that a fund MIO invested in was buying Valeant -- with both parties expressly prohibited from communicating with each other and no evidence they did -- as incriminating, though a multiple-hundred percent increase on pricing for any drug is obviously icky.

Anyway, there could be other shoes to drop here, and they could be really bad (e.g. if there were secret backchannel communications regarding the coal company). But I don't see anything in this article that's incriminating on its face.

And the attempt to make Guernsey look like some shady nefarious offshore destination that confers fishiness on anyone whose business dealings go through that jurisdiction? GIVE. ME. A. BREAK. Probably almost half of the hedge funds in Europe are domiciled there, it's like the Caymans or Delaware, talk about a red herring.