Wednesday, December 3, 2008

Harvard's Horror Will Decimate Pension Funds


Stocks finished higher today despite dismal economic data:

The Fed's report, known as the beige book, said the country's economic picture has deteriorated, with Americans hunkered down heading into the holidays. The report suggests the economy was sinking deeper into recession.

Earlier, the Institute for Supply Management, a trade group of purchasing executives, said the nation's services sector contracted dramatically in November as slower spending hurt insurers, retailers and hotels. And the Labor Department reported that productivity growth slowed in the third quarter.

The market, which also fluctuated sharply on Tuesday before closing higher, has now advanced in seven of the last eight sessions. The winning streak was broken only by Monday's big decline that took the Dow Jones industrials down nearly 680 points; even with that plunge, the blue chips still have an advance of nearly 1,040 over the eight-day stretch.

Still, stocks are expected to see more volatility as the week progresses, especially with November retail sales figures being released Thursday and the government's employment report due Friday. Wall Street has been locked for months in a pattern of surging higher only to fall sharply on negative news about the economy and the financial services sector.

The Dow rose 172.60, or 2.05 percent, to 8,591.69. The blue chip index has gained more than 442 points in the past two session, wiping out more than half of Monday's slide.

Broader indexes also closed higher. The Standard & Poor's 500 index rose 21.93, or 2.58 percent, to 870.74, while the Nasdaq composite index rose 42.58, or 2.94 percent, to 1,492.38.

The Russell 2000 index of smaller companies rose 11.94, or 2.70 percent, to 453.76.

Advancing issues outnumbered decliners by about 3 to 2 on the New York Stock Exchange, where consolidated volume came to 6.01 billion shares, up from 5.79 billion on Tuesday.

This rally is a welcome relief to most hedge funds, mutual funds and pension funds but it will not save them from the brutal losses they suffered in Q3.

Even the mighty Harvard endowment fund will post negative returns this year. According to the Harvard Crimson, Harvard’s endowment—the largest in higher education—fell 22 % in four months from its June 30 value of $36.9 billion, marking the endowment’s largest decline in modern history:

The precipitous drop will require Harvard’s faculties to take a “hard look at hiring, staffing levels, and compensation,” wrote University President Drew G. Faust and Executive Vice President Edward C. Forst ’82 in a letter informing the deans of Harvard’s losses.

The decline, which amounts to more than $8 billion, is larger than the endowments of all but four other universities—Yale, Princeton, Stanford, and MIT. In the same period, the S&P 500 fell 24.6 percent. The index has fallen an additional 12.4 percent since then.
The estimate of 22 percent may not fully capture the actual losses from this period, Forst said in an interview yesterday, as some of Harvard’s money is invested with external managers that have yet to report their latest figures. Faust and Forst wrote in yesterday’s letter that the University should plan for a 30 percent drop-off in endowment value for the year ending June 30, 2009.

The news comes during the worst economic turmoil in decades. University endowments across the country have begun announcing unprecedented losses and instituting hiring or construction freezes in an effort to save funds.

The Faculty of Arts and Sciences placed a freeze on staff hiring last week, following a cautionary letter from Faust a month earlier that warned of cutbacks ahead.

Yesterday’s figure dwarfs Harvard’s worst single-year endowment loss of 12.2 percent in 1974. The endowment has clocked only three years of negative returns, all under three percent, in the subsequent three decades.

Forst said University leaders have delayed setting the endowment payout rate for the next fiscal year—a figure generally announced the December before—until Harvard’s schools can reevaluate their budgets.

“Given the extreme volatility in the markets, I don’t expect [the payout rate] will be set until we have a much more concrete sense about financial plans and endowment performance,” Forst said.

Yesterday’s letter did state that University leaders expect to spend a higher percentage of the endowment next year in an effort to buffer the immediate impact of the losses.

The letter also stressed the possibility of slowing construction projects or reevaluating “staffing levels,” and Forst confirmed that the University will reevaluate the scope and pace of every major capital program—including Allston expansion plans and House renovations at the College.

“We expect that every part of the University is going to have to find ways to reduce its operating expenses,” Forst said.

The need for budget reductions could have particular impact on employee salaries and benefits, which make up half of the University’s costs, according to yesterday’s letter.

Forst would not say whether more hiring freezes would follow last week’s freeze in the Faculty of Arts and Sciences, but said individual schools will need to “take a hard look at compensation generally.”

The central administration will work closely with leaders at the schools to tailor solutions to their individual circumstances, Forst said, adding that Faust convened a two-hour meeting yesterday morning to discuss the latest financial update with the deans.

“Obviously, no one is happy with the endowment being down,” FAS Dean Michael D. Smith wrote in an e-mail to The Crimson yesterday, “but it does help out planning efforts to understand where the portion of the endowment that we can measure stands.”

While the schools struggle to budget for this new development, Harvard’s money managers plan to increase the University’s financial flexibility by upping cash holdings and reducing the amount of risk in the endowment portfolio.

Leveraging its strong credit ratings—the highest granted by rating agencies Moody’s and Standard & Poor’s—Harvard will issue new taxable fixed-rate debt. Unlike tax-free debt, these bonds can be used for any University expenditure and thus increase Harvard’s cash flexibility, Forst said.

The University will also convert existing short-term tax-exempt debt into bonds with longer maturities, allowing the University to postpone short-term payments to debt holders and retain a larger financial cushion to the volatility in the credit markets.

Multiple media outlets recently reported that Harvard was also seeking to shore up endowment holdings by selling $1.5 billion of its private equity portfolio at a drastically reduced price, but Forst declined to address those reports yesterday.
According to Bloomberg, Harvard's unloading of their stakes in private-equity funds is flooding the market, driving down prices for the world’s best- known buyout firms:

Investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion, may increase so-called secondary sales of private-equity funds to more than $100 billion during the next year, overwhelming available pools of capital. Interests in funds managed by KKR & Co., Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent, according to people familiar with the sales.

Crippled financial firms such as American International Group Inc. and bankrupt Lehman Brothers Holdings Inc. are joining strapped endowments such as the ones at Columbia University in New York and Duke University in Durham, North Carolina, in trying to sell private-equity stakes. A deepening global recession that is crimping the value of buyout firms’ holdings is forcing further price cuts in a market where buyers already are scarce.

“There’s a huge supply-demand imbalance,” said David De Weese, a general partner at Paul Capital Partners in New York, which manages $6.6 billion. As much as 10 percent of the world’s $1.2 trillion of private-equity interests may change hands next year in the so-called secondary market, up from an average turnover of about 1 percent, De Weese said.

In his Streetwise blog, Andrew Willis of the Globe and Mail cites Dealscape to say the losses could end up being a lot higher because of private equity and real estate investment values that have yet to be updated:

Web site Dealscape reported Thursday: "The school is expecting a 30% loss for the year, but it could be even greater than that as valuations for the fund's real estate and private equity holdings have yet to be updated."

The decline in private equity is even hitting top buyout funds like Carlyle, who today announced it is cutting 10% of its staff:

The Washington, D.C., buyout shop will cut about 100 of its 1,000-person staff. It is the first firm-wide layoff in Carlyle’s 20-year history. Other large firms are also considering cutbacks, according to two people familiar with discussions.

The layoffs emphasize how no part of Wall Street’s ecosystem is immune from the current recession. There was a widely held belief that private-equity firms would be a refuge from the financial crisis, but that hasn’t been the case. For firms like Carlyle, declining asset values and a paucity of new deals has taken its toll.

Carlyle had aggressively hired in the past 12 months, and the layoffs return the firm to its 2007 staffing levels. As part of this retrenchment, the firm will close its Silicon Valley office, which has been open less than a year.

“In response to extraordinary market conditions, Carlyle has taken measured steps to balance its cost structure with the current investment climate,” said a Carlyle spokesman. “The firm is well positioned to take good care of our investment portfolio and has the resources to create and respond to compelling investment opportunities.”

Private-equity activity has disappeared in tandem with financing necessary to complete deals, a full reversal from the leveraged buyout bonanza of 2006 and 2007. During that stretch, private-equity shops snapped up companies valued at roughly $1.4 trillion in debt and equity, according to data provider Preqin. Adjusted for inflation, that is about one-third of all LBOs ever.

Like its peers, Carlyle has had a difficult year, registering high-profile losses from the collapses of its mortgage-securities hedge fund Carlyle Capital, energy-trading concern SemGroup and telecommunications operator Hawaiian Telecom.

Despite its woes, the firm remains a fund-raising juggernaut, recently closing on $14 billion for its next buyout fund. Across its 64 funds, Carlyle has about $40 billion of uninvested capital. The firm also executed one of the year’s largest buyouts, a $2.54 billion acquisition of Booz Allen Hamilton’s U.S. government-consulting business.

And who are they raising all that dough from? You guessed it, big public pension funds who can't get enough of private equity.

Now stop and think about how perverse the situation has become. On the one hand, you got what is arguably one of the best funds in history - Harvard's endowment - selling its stakes in venture capital and buyout funds and decreasing risk across the board.

Then you have huge public pension funds continuing to recklessly plow billions of dollars into these buyout funds, picking up some of these stakes in the secondary market. Who is the smart money and who is the dumb money in this alternative investment beauty contest?

It never ceases to amaze me how stupid some pension funds can be, blindly throwing money into alternative investments. They followed Harvard's lead entering these assets, why don't they follow its lead to exit them now?

To be fair, some public pension funds are decreasing their allocations to private equity. As public equities got clobbered many pension funds, including CalPERS, reduced their stakes in private equity funds to rebalance their asset mix to the appropriate weights. This is what happened at the Caisse too.

But others remain undeterred, increasing their risk and recklessly allocating billions into alternative investments. I guess they believe they are buying at the "bottom" and can hold on to rise the bull again. They will be waiting a very, bvery long time.

Listen to me carefully: the bloodbath in hedge funds, private equity, and real estate funds is far from over. In fact, it is only going to get worse in 2009, especially for illiquid private markets.

In Asia, hedge funds are cutting fees and locking up investors’ money for longer to buy distressed assets:

Merrill Lynch & Co.’s prime brokerage unit has been approached by at least eight money managers about starting such funds in Asia to buy beaten-up fixed-income securities such as convertible bonds, said Eddie Guillemette, the firm’s regional co-head of global markets financing and services. Some of the hedge fund managers are offering to reduce management and performance-based fees by as much as 50 percent, he said.

“You’ve got people who are now setting up vehicles with long lockups to take advantage of distressed or stressed asset classes where the pricing is now at a multidecade level of cheapness,” said Richard Johnston, Hong Kong-based Asia head of hedge fund consulting firm Albourne Partners Ltd. The UBS Convertible Asia ex-Japan Index is down 37 percent in dollar terms this year.

The fee cuts come as the hedge fund industry endures its worst year in almost two decades because of stock-price declines and a credit freeze that started with rising defaults on subprime mortgages in the U.S. The market slump forced money managers to sell assets to meet $40 billion of investor redemptions in October, according to Chicago-based Hedge Fund Research Inc.

The longer lockup periods are aimed at giving hedge funds managers some respite from pressure to sell assets to meet monthly redemptions before the markets recover, said Albourne’s Johnston.

These longer lockups may make sense, but I warn pension fund managers that they can spell disaster if credit conditions persist for a lot longer than you can possibly fathom.

I believe there will be a premium on liquidity in the next few years and if this is the case, you do not want to be locking up your money with hedge funds, private equity or real estate funds.

Trust me, as good as it sounds -and their marketers will pitch you a million arguments to lock up your money - just resist the temptation.

A more intelligent approach is to look at more liquid hedge fund strategies that will do well in 2009. Some hedge funds like Augustus Asset Managers, a fixed income and currency macro hedge fund, have bucked market trends and doubled their assets:

Augustus, formed from the management buyout of Julius Baer Investments, said assets at the JB Global Rates Hedge Fund have grown to $308.8 million (208 million pounds) in the year to end-October, up from $134.8 million.

During the period the fund, which takes directional bets in fixed income and currency, has returned 13.56 percent.

Augustus has assets under management of about $12 billion in long-only, absolute return and hedge funds.

During recent months a number of hedge funds have imposed longer lock-up periods on certain funds in the face of heavy investor redemptions and falling returns.

Global macro funds -- which take bets on the direction of asset classes, usually through futures -- is one of only three hedge fund strategies to have delivered positive returns this year.

According to Hedge Fund Research, macro funds have returned 3.57 percent year to date. Only hedge funds specialising in short selling have returned more while the industry as a whole is down 16.41 percent.

"Current market dislocations amid rapidly slowing global economic growth are presenting some interesting fixed income opportunities," Adrian Owens, manager of the fund, said.

Next year he said opportunities will arise in inflation-linked securities and currencies as value and fundamentals reassert themselves as key drivers of markets rather than deleveraging.

But most hedge funds continue to struggle. According to executive from Man Group, the largest hedge fund investor, up to a fifth of managers in the $1.6 trillion hedge fund industry are at risk of going out of business in the next two years.

I think that is a conservative estimate. Even J.P. Morgan's once-hot Highbridge is going cold:

Highbridge Capital Management helped its owner, J.P. Morgan Chase & Co., become one of the biggest hedge-fund managers in the world. But like many prized assets roiled by this year's markets, Highbridge has shrunk considerably, and now many investors want out.

Investors have asked to withdraw 36% of the assets from the firm's flagship multistrategy fund, the firm's biggest. The exodus, combined with investment losses, could reduce the once-$15 billion fund to $6 billion, according to people familiar with the fund.

The decline means J.P. Morgan will miss out on hundreds of millions of dollars in fees that Highbridge contributes ...

Those reduced fees mean less bonus money to go round. That is why Merrill Lynch announced it is cutting bonuses by 50% as revenues slump.

It will be a long Siberian winter in the financial services industry, but this isn't necessarily a bad thing for the economy. As Paul Voclker told Charlie Rose, it is going to be good to see less financial engineers and more civil, mechanical, and electrical engineers.

I already alluded to the problems in private equity, so let me bring to your attention some more gloomy articles on commercial real estate.

According to Barclays, commercial mortgage delinquencies rose in November and will climb as the economy slows and unemployment grows:

Payments more than 60 days late on commercial real estate loans that were bundled together and sold as bonds increased to 0.69 percent last month, compared with 0.57 percent in October and 0.51 percent in September, Barclays data show.

The “relative spike” in delinquent loans marks the “beginning of a sustained, upward trend,” Barclays analysts led by Aaron Bryson in New York said in a report yesterday. “We have repeatedly stressed that CMBS delinquencies are a lagging indicator of performance and tend to lag changes in employment by close to a year.”

Commercial property owners are having a harder time making debt payments as the recession curtails spending and crimps business growth. U.S. companies from Citigroup Inc. to General Motors Corp. eliminated an estimated 250,000 jobs last month, the most since November 2001, ADP Employer Services said today. Concern that defaults may rise caused commercial-mortgage bonds to soar to record yields above benchmark interest rates.

The gap, or spread, on top-rated commercial mortgage bonds relative to benchmarks is about 11.9 percentage points, Bank of America Corp. data show, compared with 0.82 percentage point in January.

Waning demand for the bonds, which are backed by pools of commercial mortgages, caused sales to slump to $12.2 billion this year, compared with a record $237 billion in 2007, according to JPMorgan Chase & Co. estimates.

And the Guardian cites research from IPD saying that four out of five commercial properties could still be overvalued, casting doubt on the worth of property funds:

Property measurement group IPD, whose figures are used for benchmarking fund manager performance, for real estate derivatives and for spread betting, says up to 82% of the valuations of properties in its index may be wrong.

It says anyone using its information should be aware that many figures "underpinning rental returns and capital values have been issued with warnings about heightened uncertainty".

It blames "market instablity" for these warnings although it believes its figures are still the "best indication".

NB Real Estate, a commercial property agency, says valuations of properties within funds have now lagged too far behind the real price at which properties are being bought and sold.

Over the past year, the IPD main index has fallen by about 20%.

But NB Real Estate believes the real property market fall is 30-35%.

"This is based on actual transactions where real cash changes hands rather than on valuations where the property is not for sale. The collapse of Lehman Brothers is a factor in accelerating the fall in prices," says Peter Trinder at NB. "Valuations are especially difficult when the volume of sales through the market is so low.

"This is why many property funds and listed property companies are trading at such a discount to their net asset value; they are reflecting the real prices at which properties are selling at and factoring some further declines in values going into the new year.

"Valuing commercial properties is a tough job at the best of times but the gap now between real prices and official valuations is significant."

This is bad news for investors in insurance and unit trust-based property funds, some of which have banned holders from cashing in as property market sources suggest cash buyers - few can borrow from banks - are all holding out for deals where they can see a total return approaching 15% per annum over the medium term, which means prices may still have some way to fall.

Trinder said: "The only substantial sellers of commercial property in the market are those funds that need to because of redemptions and other cash-strapped forced sellers."

What does all this forced selling mean for pension funds who bought billions of commercial real estate properties? It means that the good times in real estate are over.

Moreover, beware of lagged real estate valuations that are padded to make it look as if the assets are worth more than they can actually fetch in these markets.

It's time to face the music because going forward, alpha is not going to come from real estate. In fact, pension funds are going to get creamed from their real estate holdings, which is why you will see many pension fund managers scramble to change their real estate benchmarks to "adjust"' for changing market conditions.

(The public market guys are rightfully disgusted with this state of affairs because they can't conveniently change their benchmarks when stocks or bonds tank).

The big party in alternative investments is over. The bells are ringing from Harvard to Kansas, to all over the world. And now pension funds are waking up to the stark reality that this huge financial mess isn't going to go away any time soon.

Finally, I want to take the a moment to bring to your attention that today is the International Day of Persons with Disabilities. To mark this day, the Canadian Labour Congress has released a new study on the employment realities of Canadians with disabilities:

The paper outlines the barriers to equal participation in society that Canadians with disabilities face, including exclusion from the workplace and a lack of accommodation in the workplace.

Unemployment rates for workers with disabilities remain unacceptably high, which is why so many live in poverty.

A major part of the problem, according to people with disabilities, is not skills, knowledge or ability, but the lack of accommodation, even though Canadian employers have a legal duty to accommodate and even though the measures to do so are generally inexpensive.

The study concludes by calling for changes to income support programs, which often leave people trapped in a choice between low benefits and working for poverty wages. The study also calls for new supports and services in the workplace, home and community as well as support from both employers and government for workplace accommodation.

The study is available on the Canadian Labour Congress web site: http://www.canadianlabour.ca/
I can tell you from first hand experience that lack of accommodation and outright discrimination are all too present when you struggle with a disability.

Luckily, there are still some government organizations that do make a serious effort to hire and accommodate people with disabilities.

I look at the Crown Corporation where I am currently working on contract and I see all the doors are fitted with buttons so they open automatically (even when you swipe your card to get in). I see people in wheelchairs working side by side with others who do not have any disabilities.

In short, I see true diversification, not just token words that "we are an equal opportunity employer".

I mention this because most public pension funds in Canada do not have proper representation of all minorities, including people with disabilities.

Unfortunately, as that report from the Canadian Labour Congress highlights, the plight of most people with disabilities is ignored and most are condemned to living a life of poverty, denied the dignity of work despite being more than capable to perform their duties if they are given an opportunity and some accommodation.

During these tough economic times, I want you to think about the dignity of work and how millions of people with and without disabilities are struggling to cope to make ends meat.

For far too many people with disabilities, however, a recession isn't a cyclical thing, it is a lifelong battle that they constantly struggle with.

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