Posted by: JamJam
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It’s the rare hedge-fund manager who would rather talk about regulation than the markets. But Richard Breeden, 62, is much more likely to turn the conversation to international banking regulations and domestic money-market reform than he is towards portable alpha or credit trading.
Breeden founded Breeden Capital Management in 2005 after a career in law and government service. Most notably, he headed the Securities and Exchange Commission from 1989 until 1993, under President George H.W. Bush (and six months under President Bill Clinton). “It’s sometimes a cruel joke being appointed a regulator in a Republican administration,” he says. “You quickly lose all the friends you have.”
That didn’t keep him from implementing some significant changes as SEC chief, many of which directly influence the way he manages his $600 million fund. For instance, he changed proxy rules to make it easier to replace corporate directors and created a safe harbor that allowed institutional investors to discuss problems at the company with each other without running afoul of proxy rules.
He also authorized the first exchange-traded fund, now a $1 trillion industry; helped Eastern Europe, Latin America, and China establish their markets; and enabled companies to buy and sell certain private investments to one another. “I’m a pro-market regulator,” he says. “That’s a dying breed.”
BREEDEN SOMETIMES SLIPS INTO a ruminating monologue that can make it easy to miss a Star Wars Sith reference in the midst of a discussion on Sifis, or systemically important financial institutions, a favorite topic among regulators (and former regulators) of all stripes today. The notion of creating the Financial Stability Oversight Council (as mandated by 2010′s Dodd-Frank legislation), which taps all the chief regulators to monitor companies that are too big to fail, he says, is unlikely to prevent a future crisis. “If you create a department of Too Big To Fail and you tell people to find companies that are too big to fail, I guarantee you they will find some,” Breeden says. Instead, he says, more regulation creates more moral hazard, since it changes behavior in ways that can be hard to predict and can create implicit support for companies to over-lever themselves.
“Over the years, I have come to question the presumption that more supervision makes the markets safer,” he says. One example: the first Basel meeting of international banking regulators in 1988, which set the minimum capital requirements (8% of assets) that banks had to hold in cash to minimize credit risk. Government bonds, though, were exempt from any capital requirement, encouraging banks all over the world to load up on sovereign debt. “So I could buy $50 trillion of government bonds and have no capital requirement, or make business loans that require me to keep 8%. Obviously that changes behavior. It shifts capital, and creates risk elsewhere,” Breeden says. “Politically we have to say that all sovereign debt is the same, but wouldn’t a loan to a French or German business have been less risky than buying Greek government bonds?”
GOOD REGULATION ALLOWS BUSINESSES to evaluate the risks in their behavior and, if those risks become a reality, it’s the business that should pay the price. “At some point we have to bite the bullet and say the Fed needs to get out of the bailout game,” says Breeden, who presided over the unwinding of Drexel Burnham Lambert after SEC charges of insider trading and securities fraud brought the junk-bond firm down.
If a bank were to threaten the economy by needing to close its doors, Breeden says, the first step the government should take is to make that bank smaller: “We need to quit deciding that institutions are too big to fail.”
The same idea goes for money-market reform. “Even though the legal structure is clear, you know that most people think of them like a bank account,” Breeden says. “But I’m not convinced more regulation will work. Perhaps there shouldn’t be so much money in money-market funds. Maybe you have an inherently unstable creation and something that forces investors to realize that they are not inside the safety net would be helpful, too.”
His extensive background in regulation informs his investing—which is good, since prior to starting his fund in 2006, he had no background in investing. “I worry a lot about risk and it shaped the kind of fund we set up,” Breeden says. “We didn’t create a long/short fund trading everything in the world. We don’t use leverage. My goal was to generate returns from research and from good decisions, not from piling leverage on.”
His fund Breeden Partners was launched with seed money from Calpers, the California state agency that manages the largest U.S. pension plan. Calpers is probably best known for its activist investing, often using proxy voting and other shareholder-friendly methods to change corporate behavior.
Like most activist and value funds, this one has had some serious clunkers. But in the three years ended March 31, 2012, Breeden Partners returned a total of 66%.
Breeden limits his portfolio to just a dozen or so undervalued stocks and often engages with management. That engagement is quiet, though—he doesn’t have the high-profile battles of Bill Ackman or Carl Icahn. He focuses on small- to mid-size companies that are generally, though not always, receptive to his input. “I like companies that have complex issues that are difficult to sort out,” he says. “I like a challenge. Intellectually, what we do is very similar to private equity.” He’s invested in 42 companies since the fund’s inception, but he’s taken a board seat only four times. Breeden also generally limits his investment to less than 10% of the company; crossing that threshold prompts a host of reporting requirements and often implies a more aggressive stance.
Breeden sits on the board of Steris (ticker: STE); he joined in 2008 immediately after a new CEO was hired. Steris, which has a market cap of $1.8 billion, makes high-tech hospital products, including many that sterilize medical equipment. Breeden has encouraged the company to cut overhead and make its research and development more efficient. Today, 25% of its revenue comes from products launched in the past five years. The stock has provided Breeden with a 30% return since he bought it.
His largest holding is also his best performer. Helmerich & Payne (HP) is a contract oil and gas driller. The stock, now at $52.87, has more than doubled since Breeden first bought it in January 2007. For years, the company was misperceived as a pure play on natural-gas prices.
H&R Block (HRB) was last year’s best performer, returning 43% in 2011. The troubled company was in even worse shape when Breeden led a proxy battle and became chairman in 2007, remaining there for four years. He shut down H&R Block’s subprime-mortgage lending, sold off noncore units to pay off its debt, and refocused the company as a tax specialist rather than the financial supermarket it was trying, and failing, to become. Breeden stepped down from the board a year ago, and has been reducing his position since. It’s still a challenge for him; the stock fell to $14.95 as layoffs and store closings were announced this past week.
Jewelry retailer Zale (ZLC) hasn’t worked out, though Breeden retains a piece of the $85 million small-cap company. The stock was around $18 when Breeden took a seat on the board in 2008, rose to nearly $32, then plummeted to less than $2 in 2010, at which point he left the board. He’s invested at $2.64 a share, in large part because the downside risk is so negligible and he maintains that the right moves—including breaking up the company—could double or triple the value.
“I always assume I’m not the only one to notice this sort of thing,” he says, adding that it’s just a tiny part of the portfolio. “We’ll get out of it eventually, but not at $2.64.”