Hedge Funds Could Lose Nearly Half of Assets Under Proposed SEC Rule

A proposed SEC rule could starve hedge funds of cash by making it nearly impossible to raise money from pension funds. From the magazine Risk:

Pension funds in the US may be unable to invest in hedge funds if a sweeping package of financial reforms by the markets regulator is passed in its current form, warn hedge fund managers and lawyers.

The US Securities and Exchange Commission is proposing a rule that aims to stop private fund managers evading legal liability for actions leading to investment losses. Hedge funds depend on this indemnity to obtain insurance.

The SEC released the proposed rule in February. From the SEC’s press release:

The proposals also would prohibit all private fund advisers from engaging in several activities, including seeking reimbursement, indemnification, exculpation, or limitation of liability for certain activity…

Without indemnification, insurance becomes prohibitively expensive or completely unavailable. And without certain types of insurance, institutions including pensions won’t invest in a hedge fund.

This could starve hedge funds of cash. A huge percentage of hedge fund assets come from pension funds.


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An exact count of the percentage of hedge fund assets that come from pensions is difficult to find, given limited disclosure requirements. But investment data company Preqin estimates that 40% of hedge fund assets come from pensions.

Public employee pensions alone invest hundreds of billions of dollars in hedge funds, with even more coming from private company pensions.

If this SEC rule passes in its current form, hedge funds could lose nearly half their assets. It will be difficult to find another source of such huge sums.

You can bet that hedge funds will fight this rule like hell. And with their high priced lobbyists, they may well succeed in killing it.

But if not, hedge funds may be facing some very lean years ahead.

Do you think the SEC will cause a mass exodus from hedge funds? Leave a comment at the bottom and let me know.

Have a wonderful weekend everyone! 👋

More on markets:

Archegos Used Swaps to Hide Positions; Other Funds Are Too

Melvin Capital Faces Investor Revolt

AMC Fails to Deliver Pass 1.3 Million in Latest Report

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Archegos Used Swaps to Hide Positions; Other Funds Are Too

Bill Hwang, founder of Archegos Capital Management, was charged yesterday with racketeering and securities fraud. How Hwang hid his positions teaches us a lot about how markets work today.

How Total Return Swaps Work

Archegos Capital Management controlled a majority of the shares of several large public companies without making any of the usually required disclosures. It was able to do this because it used a derivative called a total return swap.

A total return swap is pretty much like owning a stock. You get the gains if the stock goes up, you lose money if it goes down.

But you don’t technically own any shares.

Instead, you have a contract with a bank to get the gains and pay the bank for any losses. To hedge its risk, the bank will buy the shares, rather than you buying them.


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Hedge funds like Archegos love this arrangement because it lets them hide positions from the market and exempts them from disclosure requirements. Bankers love it because the swap comes with juicy fees.

These swaps even let you trade on huge margin. And they’re easy to get.

What’s a Few Felonies Between Friends?

Hwang had been convicted of fraud for actions at his prior fund, Tiger Asia. He was also banned from continuing to trade in Hong Kong, so he switched to US stocks.

But why let a few felony convictions get in the way of a great deal? Credit Suisse booked $16 million in fees from Archegos in 2020, likely leading to fat bonuses for the bankers involved.

How Hedge Funds Can Use Swaps to Hide Short Positions

Hwang used total return swaps to hide bets that stocks would go up. But they could just as easily be used to hide huge short positions.

If a hedge fund wanted to short a stock without anyone knowing how big their exposure is, a swap would be the natural choice. The fund could do numerous swaps with different banks, as Archegos did.

With the hedge fund’s bets split between various banks, no one would know how vulnerable the fund is to a short squeeze.

Had Melvin Capital been smart enough to do this last year, retail traders might never have known how exposed it was to GameStop Corp. shares. But they did know, and they used that knowledge to squeeze Melvin.

You can bet that other funds have learned from Melvin’s mistake.

What Investors Should Know

The bottom line is that it’s extremely easy for hedge funds to hide their positions today. It’s happening every day, and we only heard about Archegos because it blew up.

But you can be sure that other funds are out there hiding massive positions at this very moment.

What trades do you think hedge funds may be hiding? Leave a comment at the bottom and let me know!

More on markets:

Melvin Capital Faces Investor Revolt

Citadel Under Federal Investigation

FBI Raids Short Sellers

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The Startup Pitch Checklist

Last Thursday, I was preparing to judge a startup pitch competition. I thought to myself, “How can I make sure every startup hits the key points?”

Then, it came to me: a checklist!

Every time you pitch investors, you need to give them certain key pieces of information. Without those details, they may just move on to the next company.

Make sure that never happens to your business! Whenever you pitch, make sure you check off these 6 key elements:

1) ☑️ Problem. What problem do you solve? For example, Uber solved the problem of expensive, hard to get taxi rides.

2) ☑️ Solution. How do you solve that problem?

Uber makes it easy to get a ride with a simple smartphone app. You always know exactly what you’re paying and where your driver is.

3) ☑️ Traction. Show us a chart of your revenue, broken down monthly or quarterly. Also, compute a growth rate using a tool like this.

Investors want to see a strong growth trend. Make absolutely sure you give them that, if at all possible.

Don’t have revenue yet? Show us monthly active users, signups, etc.


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4) ☑️ Market + Competitors. How big is your market? Who do you compete with?

I don’t get too hung up on complicated market size calculations, but here is a resource on how that is typically done.

I’m more interested in your competitors. Who do you lose deals to? Who do you beat for deals? And why?

Hint: “we don’t have any competitors” is rarely the right answer. Maybe no company does exactly what you do, but who is close?

5) ☑️ Team. This is especially critical for early stage startups. At this point, there usually isn’t a ton of performance to sell.

So you have to emphasize the quality of the team. Why are these the best possible people to take on this challenge?

6) ☑️ Ask. Here’s one of the strangest things I see: a founder telling a great story with solid traction, and then saying “thank you” and sitting down.

Umm, don’t you want something from us? 🙂

Never forget to tell the investors exactly what you’re asking for! Tell us how much you’re raising, at what valuation, and specify if that’s pre or post-money. (If the valuation includes the money you’re raising, that’s “$X post-money,” also referred to as “$X cap.”)

It’s also good to specify what type of fundraise you’re doing. Is it a SAFE, a priced round, or a convertible note?

Say something like this: “We are raising a $1 million SAFE at a $10 million cap.”

If you hit these 6 key elements, you’ll have a solid pitch that gives investors the details they need. You’ll also have a leg-up on other founders who provide incomplete or unhelpful information.

Best of luck on your fundraise!


What do you think makes a great pitch? What did I miss?

Leave a comment at the bottom and let me know!

More on tech:

How Startups Can Dominate the Elevator Pitch

How to Write a Deal Memo

Startups’ Secret Marketing Weapon: Blogging

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Melvin Capital Faces Investor Revolt

Just after announcing plans to re-institute performance fees, failing hedge fund Melvin Capital has backtracked. From the Financial Times:

The US-based firm, which lost 53 per cent in January last year after betting against retail investor favourite GameStop, had written to investors only last week with plans to remove a so-called high-water mark, which stops a fund charging performance fees until losses have been recovered.

But within a matter of days, after receiving “candid” feedback from some investors, founder Gabe Plotkin has admitted he was “initially tone deaf”. 

After being shellacked last January, Melvin was down 39% for 2021. It lost another 21% in the first quarter of this year.

That puts the fund down approximately 52%, or more than half its capital.

Hedge funds generally charge 2% of assets a year in management fees. They also take 20% of all gains as a performance fee.

The performance fee is the real prize. But there’s a catch: the fee is governed by something called a “high-water mark.”

This means you can’t lose money, then charge investors a performance fee as you make it back.

High-water marks exist for a very good reason. Without them, a fund could be incentivized to repeatedly lose money then earn it back, collecting fat fees every time while investors make nothing.

To attempt to remove the high water mark, and charge people a fortune to make back the billions you lost, is the height of hubris.

Plotkin’s investors seem to be as affronted by his proposal as I am. So where does that leave Melvin Capital?

Since investors won’t let them remove the high-water mark, it could be years before Melvin can charge performance fees again, if ever. Their better traders are likely to leave for greener pastures.

Meanwhile, the fund is also caught up in a federal investigation of improper activity by short sellers.

With angry investors, no juicy fees in sight, and a federal investigation looming, I expect Melvin to shut down soon. This would leave Plotkin free to create a new fund and start earning fees again while distancing himself from the Melvin dumpster fire.

For those who will be tempted to invest with Plotkin again, remember these wise words:

What do you think is next for Melvin Capital and Gabe Plotkin? Leave a comment at the bottom and let me know!

More on markets:

Melvin Capital Under Federal Investigation

Melvin Capital Down 21% in Q1

Mass Firings at Citadel Right Before Federal Probe

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Behind the Scenes of WeCrashed

We walked through the bowels of a large warehouse shrouded in darkness. I rounded a corner and shoved open a heavy door with no idea what was on the other side.

Suddenly, we were in the world headquarters of WeWork.

The famous startup led by Adam Neumann seemed to take over the world before it crashed just as quickly. And now, it had become a TV miniseries called WeCrashed.

At Goldman Sachs headquarters
Close-up

I had the joy of being a background actor (also known as an extra) on episode 7 of this fascinating show! I played a Goldman Sachs investment banker, hard at work on winning WeWork’s business for its IPO.

Light poured in from above on the set of WeWork’s headquarters, which nailed the company’s funky aesthetic. Concrete columns framed long sofas in bright colors.

I even got to see the famous WeWork gong! Unfortunately, I was not allowed to ring it.

We filmed a scene where a senior Goldman banker tried to impress Neumann by quoting Bob Marley. I had to look like the serious banker, but it was all I could do not to burst out laughing.

Then, Jared Leto made his entrance.

I can’t imagine what it must be like to be him; everyone staring at you, knowing who you are, without you knowing anything about them. I gushed to my fellow extras about what a great actor Leto is, and he nodded to us politely as he passed.

What came next is the best acting I’ve ever seen in person.

Leto was rejecting a proposal from a venerable Wall Street bank, and went through his scene again and again. He delivered the same lines with every possible combination of intonation and inflection, one right after the other, until he determined which was right.

Far away, I quietly remarked to one of the other extras that Leto’s accent sounded a bit heavy. Just minutes later, I noticed he had corrected it.

In between takes, he went into a small room with an assistant to prepare for his next scene. I felt a little sorry for him…we could laugh, joke, and make new friends when we weren’t busy, but he could not.

The crew’s attention to detail amazed me.

At one point, they gave us iPads as props. On the screen was a copy of WeWork’s actual S-1.

In other scenes, we had to use our imagination.

At the Goldman offices watching Neumann announce the IPO, we were actually looking at a green screen. The TV broadcast was added later in post-production.

Filming WeCrashed was a wonderful time! I got to be a small part of a story that fascinates me and see one of my favorite actors at his best!

If you haven’t seen the show, I encourage you to check it out! Leto plays the charismatic, out of control Neumann with uncanny accuracy.

And if I may say so, my big bald head adds a little something too! 🙂

More on entertainment:

What It’s Like to Be on Law & Order: SVU

Filming a TV Show in NYC in a Pandemic

At the Sopranos Convention!

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Feds Charge Stock Manipulators Who Stole $194 Million

The federal government has charged a fraud ring that manipulated numerous US stocks. The group netted $194 million in ill-gotten gains over several years.

From Compliance Week:

The SEC’s charges, contained in three separate complaints filed in the U.S. District Court for the Southern District of New York, allege that the defendants secretly held large, controlling positions in so-called “penny stocks” issued by microcap companies.

From 2013 through at least 2018, defendants’ goal was to secretly gain control of thinly traded microcap companies, hire stock promoters to generate demand for their shares, and then profit by selling those shares illegally to unsuspecting investors,” stated one SEC complaint.

The criminals hid behind a variety of shell companies and offshore accounts. They employed various schemes such as “painting the tape,” or trading shares between each other at inflated prices to make the stock seem more valuable then it was, according to the DOJ press release.

This is a common strategy. Once the price has risen artificially, the shares are then dumped on an unsuspecting bag holder who thinks he’s bought a “hot stock.”


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The defendants are charged with securities fraud, wire fraud, money laundering, and other charges. They could face up to 20 years in prison, per count.

The key point to remember is that this type of manipulation happens in securities markets every day. And it’s not confined to small stocks.

As investors, we have to be on the lookout for it.

And just as there are conspiracy to pump stocks, there are conspiracies to crash them.

Short selling hedge funds Melvin Capital and Citron Research are being investigated by the FBI for possibly conspiring with research firms to publish false reports on stocks. Sabrepoint Capital paid a researcher to publish false, negative information about Farmland Partners on Seeking Alpha, a recent court case uncovered.

Here are a few guidelines to avoid being caught up in these schemes:

1) Don’t believe everything you read.
2) Don’t buy a stock just because it’s going up.
3) If someone you don’t know calls you to promote an investment, hang up.

I hope the DOJ prosecutes this fraud ring vigorously. I also hope they uncover the many more that are still in operation.

What do you think about this massive fraud? What other frauds do you think may be lurking in financial markets?

Leave a comment at the bottom and let me know!

Have a wonderful weekend everyone! 👋

More on markets:

AMC Fails to Deliver Pass 1.3 Million in Latest Report

NYSE Investigating Shopify Stock Plunge; Citadel Involved

AMC Now #4 Most Shorted Stock

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Startups’ Secret Marketing Weapon: Blogging

For startups, customer acquisition ain’t what it used to be.

Apple effectively ended ad targeting last year. Google plans to do something similar in 2023.

Without targeting, you could be advertising a US woman’s underwear brand to men in Germany. Those precious marketing dollars go…poof.

But some startups have found a secret weapon. Hint: you’re reading one right now.

Blogging for Customer Acquisition

Every day, your potential customers are searching Google to find solutions to their problems. You can help solve their immediate problem, while subtly directing them toward your service.

Let’s look at a startup with an excellent blog: Capbase. (I’m a small investor in the company.)

Capbase makes software to incorporate, manage your cap table (list of company owners), handle employee stock options and a lot more.


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Capbase’s potential customer may be a new founder who isn’t sure how to get started. How do I incorporate, or pitch investors?

So the company wrote an excellent article on the do’s and don’ts of investor pitches. This helps solve a problem a new founder is likely to have.

At the same time, Capbase subtly introduces them to its software. This platform can solve the problems they’ll have in the near future, like incorporating and issuing stock options.

Keeping it Fresh

Notice that Capbase doesn’t just have a bunch of text posts by a single author. It has a mix of authors with different perspectives, and even includes podcasts to keep things interesting.

So how can you come up with topics?

Think about problems your potential customers might be having. You can even interview current customers to find out.

Or if your startup is solving a problem you’ve had yourself, draw inspiration from your own life!

Evergreen topics are best. Provide content that will be useful years from now, rather than topical commentary that will be outdated in days.

This helps you capture traffic in the long term.

Keeping it Consistent

You should publish articles on the same days, regularly. If every day is too much, try Tuesday and Thursday, for example.

The key is consistent new content.

Readers like it. So do Google search algorithms.

Wrap Up

Online ads are not as well targeted as they once were, and are only likely to get worse. Meanwhile, a search shows user intent.

If I search “how to pitch investors,” I’m probably a startup founder at the early stage. So, I’m an ideal Capbase customer.

If I search “how to meditate,” I’m already interested in meditation. Perfect time for an app like Calm to slide in and give me some tips, while also making me aware of their product.

A company blog can deliver more customers than online ads while costing far less. Master it and stop handing your money to trillion dollar corporations that provide little in return.


Do you have a company blog?

If so, what have you learned from writing it? If not, why not?

Let me know in the comments at the bottom!

More on tech:

How to Write a Deal Memo

How to Ace a 3 Minute Pitch

The Lean Startup

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AMC Fails to Deliver Pass 1.3 Million in Latest Report

Fails to deliver in shares of AMC Entertainment Holdings, Inc. passed 1.3 million in the latest SEC report. In nearly a year of reporting on this, this is one of the highest figures I’ve seen.

Fails to deliver hit 1,327,129 on March 23. They settled at 103,223 at the end of March, the last date for which information is available.

Even that is an exceptionally high level compared to other stocks.

AMC sometimes does a lot of volume, so we should correct for that.

Let’s compare the fails to deliver and number of shares traded for AMC and a few major stocks. Below, I use volume data from Yahoo! Finance.

Here are the numbers for March 23:

StockFails to DeliverVolume% Failed
AMC1,327,129170,142,6000.780%
AAPL1,15098,062,7000.001%
AMZN812,790,6000.003%
GOOG01,265,1000%
MSFT260825,715,4000.010%

If you look at another day, the numbers change a little, but the overall picture remains the same. AMC has far more trades failing to clear than other stocks, both in absolute number and as a percentage of shares traded.

Why are so many AMC trades failing to clear? In stocks with a persistent pattern of fails to deliver, such as AMC, naked short selling is a common culprit.

Naked short selling is the mostly illegal practice of selling short shares you did not borrow first. Later, the trade fails because the shares never existed in the first place!

This is a powerful way to push down a stock’s price. If you need not find shares to borrow, you can sell short as many as you like, putting the stock under pressure.

Moreover, the SEC fails to deliver numbers may be an undercount.

Once a trade has been failed for an extended period, the Depository Trust & Clearing Corporation (DTCC) puts it an “obligation warehouse.” Once the trade is there, it effectively disappears.

Poof.

I suspect hedge funds are using naked short sales to manipulate the price of this popular stock. And the DTCC is making it easy for them by wiping their obligations.

To me, the only real question is, how long will they be allowed to get away with it?

Why do you think AMC fails to deliver are so high? Leave a comment at the bottom and let your voice be heard!

More on markets:

FBI Raids Short Sellers

NYSE Investigating Shopify Stock Plunge; Citadel Involved

Citadel Paying Over $1B a Year for Order Flow

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Coffeebots and the Search for the Perfect Cup

A robotic arm carefully grips the cup as frothy milk cascades onto smooth espresso. It gently places the cup before you.

Coffee is served.

I’m a little obsessed with coffee. I have five coffee makers at home, each for a different style.

But if the next generation of robotics companies has their way, they might all be replaced by a skillful droid.

Founded in 2015, Cafe X makes full-service robocafes that can be found at San Francisco International Airport and elsewhere. Today, they are only sold to commercial customers, but can the home version be far away?

Cafe X’s intelligent robots can make a drink in as little as 20 seconds. It can even make multiple drinks at once!

Best of all, the price is less than half what Starbucks charges.

CEO Henry Hu was inspired by the robotic arms that build automobiles.

A simpler coffee machine could make drinks, but the robotic arm is much more versatile. It can also serve snacks or even be used in restaurants.

The pandemic hit Cafe X hard, but it’s back in service in SFO, Dubai and elsewhere.

The machines cost about $200,000. A quick Indeed search shows most barista positions in the NYC area paying between $13 and $30 per hour.

If the average is even $20 per hour, and a human-staffed store is open perhaps 90 hours a week, it costs $93,600 to staff the store with even one barista for a year.

In an ever tighter labor market, once employers go bot, they may never go back.

Cafe X isn’t the only company bringing Star Wars to Starbucks. In Nashville, Panera Bread is rolling out coffee robots from Miso Robotics.

Unlike Cafe X, Miso’s robot is barely noticeable. It discreetly monitors temperature and time to ensure a perfect brew, but there’s no robotic arm to whisk the drink to you.

The system is designed to assist workers, not replace them.

Miso Robotics also makes Chippy, which fries tortilla chips at Chipotle, and Flippy, which flips burgers for White Castle.

In a white hot labor market, these robots may not cause unemployment. But my concerns about restaurant automation run deeper.

When I go to a cafe, I sometimes chat with the barista and have a little laugh. In a world of sensors and robotic arms, I’ll have no one to talk to.

Those little interactions aren’t the substance of our social life, but they can be enjoyable sprinkles on the top.

Cafe X’s robot amazes me and manages to be cute to boot. But I find a world without anyone to share a brief chuckle with a melancholy one.


Would you try a robocoffee? And what do you think about the future of restaurant automation?

Leave a comment at the bottom and let me know!

More on tech:

Robot Pizzas and the Future of Fast Food

What if Everyone on Earth Had Super Fast Internet for $1?

Robot Hands, Vertical Farms, and the Future of Food

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More on Fundrise in this post.

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Misfits Market

My wife and I have gotten organic produce shipped to our house by Misfits for over a year. It’s never once disappointed me.

Every fruit and vegetable is super fresh and packed with flavor.

I thought radishes were cold, tasteless little lumps at salad bars until I tried theirs! They’re peppery, colorful and crunchy!

I wrote a detailed review of Misfits here.

Use this link to sign up and you’ll save $15 on your first order. 

How to Write a Deal Memo

Everyone running a startup knows about the deck.

There are countless tutorials about how to write this PowerPoint presentation that forms a key part of a startup’s pitch. Shoot, I’ve even written one.

But what about the deck’s mysterious cousin: the deal memo?

Founders generally send potential investors a deal memo along with the deck when they’re trying to raise money. You would generally send one once you’ve confirmed some interest from the investor. (For the first introduction, a short deck is good.)

But when an investor is ready to take a serious dig into your business, it’s time for the deal memo. So what does a good deal memo look like?

I see over 200 of them every month as an investor. Here are how some of the best look:

Length

Generally more than 2 but fewer than 10 pages. About 6-8 pages is good.

More important than the exact length is that you cover important elements thoroughly but concisely.

Which brings us to…

Topics

Here are the sections I like to see, ideally in this order.

A paragraph or two for each section is good.

  • Deal Terms: How much are you raising at what valuation? And what type of security is it (SAFE, priced round, etc.)?
  • Prior Investors: Who has invested before and who is investing in this round?
  • Company Description: What do you do?
  • Traction: Show us your revenue growth in a monthly or quarterly chart. If you have no revenue, at least show us user growth. You should also compute the growth rate for the last 6-12 months using a tool like this.
  • Market Opportunity: How big is this market? Show VC’s that your market is big enough for you to become a billion dollar company, because that’s what they’re looking for.
  • Why Now?: Why is now the right time for this company to dominate? Why is the market ready? For example, imagine starting a videoconferencing company in 2019 versus 2020. The 2020 market would’ve been far more receptive.
  • Why Us?: Why are you and your team the right people to take on this problem? Tell us about your skills and also why the problem matters to you. If you’re solving a problem you’ve had yourself, you’ll probably be better at it and less likely to quit.
  • Competition & Defensibility: Who are your competitors, and why is your solution better? Many companies say “We don’t have any competitors. No one else does what we do.” That’s usually not a good answer. Maybe no other company does exactly what you do, but who is close? And why are you the better bet?
  • Use of Funds: What will you use the money you’re raising for? A simple breakdown like 60% engineering and 40% sales is fine.
  • Hiring: Who are you hiring now? Investors might be able to introduce you to a great candidate!
  • Key Risks: What are the top few reasons this business could fail? For example, you may struggle to hire talented engineers in this tight labor market.

Wrap-Up

Writing a good deal memo is a lot of work. But when investors are seriously considering your company, this document can seal the deal.

Leave nothing to chance! Get the deal memo right and give yourself the best shot at a fat check.

What questions do you have about deal memos? What did I miss?

Leave a comment at the bottom and let me know!

Glad to be back with you guys for another fun week! 👋

More on tech:

How to Ace a 3 Minute Pitch

The Lean Startup

Robot Pizzas and the Future of Fast Food

Photo: “Asleep at the Wheel” by Aaron Jacobs is marked with CC BY-SA 2.0.

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