Banking With Hedge Funds

Before I delve into today's topic, let me be get this off my chest: the U.S. housing market is nowhere near the bottom and this credit crisis will continue to wreak havoc on the global economy for several years. (That's right, years, not months; if you do not believe me, then read Dean Baker's expert analysis at the Center for Economic Policy Research)

Of course, markets are driven by greed and fear so expect a wild ride as we purge the global financial system of all its excesses. We will see many sucker rallies along the way but you can be sure that this mess will not magically disappear because some Wall Street guru tells us to "buy now because we hit bottom".

Take the time to listen to three interviews with Barry Ritholtz, CEO of Fusion IQ and editor of The Big Picture. Mr. Ritholtz thinks we just saw the latest in a series of predictable bear market rallies and that we won't be done until the Dow is below 10,000. As far as home prices are concerned, Mr. Ritholtz notes that home prices rocketed well above trend in the past five years and they have only just begun to deflate to more normal levels (Also, see the Financial Ninja's comment, The 'Recast' Bomb). Finally, as far as investing is concerned, he warns investors that you can ignore deteriorating fundamentals at your peril.

Deteriorating fundamentals are weighing heavily not only on equities but on alternative asset classes like hedge funds, private equity and real estate. Why? Because the global financial Ponzi scheme is unraveling fast and the assets that were most levered on the way up are going to be the ones that will get whacked hard on the way down as deleveraging enters full force.

But not all hedge funds are suffering from the deteriorating fundamentals; some are profiting handsomely. In particular, the credit crisis has been a boon for asset based lending (ABL) hedge funds that fill a credit void for small and medium sized enterprises (SMEs) who have been shut out of traditional lending markets.

I quote from the article above:

Yet with the credit crunch pushing many major U. S. banks to set tougher lending standards for small and medium-sized businesses, hedge funds have stepped in.

The money isn't cheap, with interest rates of 14% or more. But small businesses have few places to turn. "A major void has been created in the marketplace by banks tightening their credit standards and trying to stabilize their balance sheets," said David Grin, co-founder of Laurus-Valens, a hedge fund with about US$1.7-billion under management. "From the investment point of view, this is as good as it gets."

Laurus-Valens provides loans to public and private companies with average revenues of US$30-million to US$50-million. The fund charges interest rates of about 10% to 11%, and takes equity stakes in the companies. Laurus-Valens's lending to small companies is up about 50% from a year ago.

Small businesses are considered a linchpin of the U. S. economy, forming the backbone of the country's jobs market and playing a crucial role in creating jobs. According to U. S. Census Bureau data, the United States had 112 million paid employees in 2002. About 56.4 million worked at companies with fewer than 500 employees.

Hedge funds have been lending to small companies for decades. But as they exploded in recent years to become a US$2-trillion industry, small business lending has also taken off -- since credit markets turmoil began a year ago and the funds sought other investment after conventional markets turned sour.

Interestingly, asset-based lending has been around for many years and was traditionally offered by commercial finance companies, including major banks and credit boutiques who provided much needed financing to companies unable (or unwilling) to borrow from a bank. However, new competitors like cash rich hedge funds and private equity funds have muscled into this domain and reaped huge returns by offering more flexible terms to SMEs looking for bridge financing.

Hedge funds have been particularly aggressive in the ABL space. Jan Vilhelmsen and Niels Jensen of Absolute Return Partners discussed ABL at length in their July newsletter. They note the following:

Historically, net returns to investors in ABL funds have been in the range of 10% to 14% per annum which many saw as boring because of the attractive returns on offer in equities, bonds and commodities in recent years. In today’s environment those returns, combined with very low volatility, have suddenly become an attractive proposition.

Hedgefund.net has been running an ABL index since 1989 which has generated a compound annual return of 12.3%.

...Interestingly the ABL Index has experienced only one down month since HFN began tracking the industry back in 1989. This happened in May 2006 which we all remember as a rather chaotic month for financial markets. Due to the stable return pattern, volatility is extremely low. The standard deviation for the ABL Index over the entire period is 1.31%. This compares favourably with that of hedge funds in general (6.67%), bonds (6.12%) and equities (13.82%).

On a risk-adjusted basis, because of the very low volatility, the ABL Index outperforms all of its peers.

Mr. Vilhelmsen and Mr. Jensen also raise two other important features of ABL strategies, namely, their counter-cyclical nature and their attractive portfolio diversification features:

Another interesting feature specific to the ABL industry is that it is almost counter-cyclical. When money is plentiful and banks are keen to lend, returns for asset based lenders come under pressure. On the other hand, when money is scarce and banks are nowhere to be seen, pricing power returns and the overall performance of ABL funds improves.

The final point we wish to bring to your attention is the attractive portfolio features of ABL funds. Whereas hedge fund returns in general have experienced a steadily rising correlation with equity returns, ABL returns continue to be virtually uncorrelated to equity returns, making the industry an extremely attractive diversifier. As you can see from exhibit 6, ABL returns are virtually uncorrelated to both equity, bond and hedge fund returns, whereas the correlation between equity returns and hedge fund returns is higher than most investors realise (0.69).

There is little doubt that ABL hedge funds have reaped huge gains during this credit crunch. I know of a few pension funds that have aggressively allocated to this strategy before the credit crisis hit and continue doing so. They are also reaping windfall gains from these investments.

But ABL strategies are not a panacea and their low volatility is understated. There are important risks that stakeholders need to know. These risks will vary depending on the transaction but they generally involve risk of fraud, high interest rates and low transparency. As new players enter the field, these risk are magnified.

Another important point that stakeholders need to monitor is the benchmark used to compensate their pension fund manager who is allocating to these strategies. The expected returns on ABL strategies is anywhere between 8% to 16% per annum.

If the benchmark used to evaluate the pension fund manager does not reflect the risk/return properties of the underlying portfolio, including liquidity risk (some strategies have important lock-up periods), then chances are you are over-compensating your pension fund manager(s).

I believe that top ABL funds will continue to thrive in this environment but if things get really bad, many ABL hedge funds will lose money as companies are unable to meet the terms of the deal. Stakeholders need to be vigilant and make sure they understand the risks of all strategies their pension funds are investing in. It is is up to the pension funds to clearly present the risks and return expectations of all investment activities in their investment policies.

For their part, stakeholders need to make sure they are properly compensating their pension fund managers and not paying them for taking excess risk or for beta, even if it is "alternative beta".