Thursday, December 4, 2008

Should Pension Funds Prorogue Their Results?

Guess which country decided to prorogue its parliament until January? Zimbabwe? No. Burma? No. Congo? No, but you're close; it starts with a "C".

It's my very own country, the democratic and usually peaceful nation of Canada. The Governor General, Michaelle Jean, has granted Prime Minister Stephen Harper’s request to prorogue Parliament:

This has prevented a Liberal-NDP coalition with support from the Bloc Quebecois from defeating the Conservatives in a nonconfidence motion on Monday (December 8).

Liberal leadership candidate Bob Rae told CBC Radio that he “deeply regretted” that the Governor General’s decision, but added that he held Harper responsible.

“This man has suspended Parliament,” Rae told CBC Radio. “This man has suspended Parliament in an unprecedented fashion.”

Parliament will resume on January 26 with a speech from the throne, followed by a budget on January 27.

Today's political volatility played out perfectly in the financial markets as the Loonie swooped, recovered and dropped as the drama unfolded.

I am not going to get into politics but it's painfully obvious that Prime Minister Harper is fighting for his political life. His critics claim that he only has himself to blame for this latest political fiasco.

But I think our Prime Minister is onto something. In fact, I wonder if a few presidents of public pension funds might want to rip a page off the old Harper Handbook of Political Survival and prorogue their results.

Don't laugh. If you think the politicians in Ottawa are slimy, you haven't seen the politicians in public pension funds working their dirty tricks.

They are probably holding "emergency board meetings" to discuss how they are going to spin their pathetic results, emphasizing that they "invest for the long-run" (Keynes is probably tossing in his grave!).

Yesterday's comment on Harvard's endowment fund and the fallout in alternative asset classes caused many of you to write me and call me with your comments.

One astute reader commented: "so you can imagine what is happening to the others," to which I replied "DESTRUCTION".

If Harvard's endowment is at risk of losing close to 30% this year (once they update their private equity and real estate holdings), large public pension funds in Canada and in the U.S. who "invested like Harvard" are going to get slaughtered.

The bad news in alternative investments keeps pouring in. Hedge funds keep chalking up more losses and some big names are suffering:

Some of the biggest names in hedge funds lost money in November, including Dan Loeb and Kenneth Griffin, but John Paulson was among the few who made money for their investors.

Hedge fund investors around the world lost money for the sixth straight month as many in the industry reported steepening declines, investors said on Thursday.

Dan Loeb, an activist investor known for his sharply worded letters to poorly performing companies, told investors that his Third Point Offshore fund lost 28.24 percent in the first 11 months of the year after the fund slipped 2.6 percent in November.

James Pallotta's Raptor Global Fund lost 1.51 percent last month, leaving the fund off 17.36 percent for the year.

Martin Hughes' Tosca Fund Ltd fell 5.15 percent and is now down 67.54 percent for the year.

And Kenneth Griffin's Citadel Investment Group, which boasts one of the industry's longest winning records, lost roughly 13 percent last month, swelling its year-to-date losses to about 47 percent, investors said.

The numbers came as investors suffered through more sharp stock market gains and losses that left many managers ill-prepared, if they were long or short, investors said.

Funds also felt the impact of frozen credit markets.

While many hedge fund managers are still compiling their numbers for the month, early indications show the average fund lost 2.25 percent, leaving it down 21.31 percent for the year, according to data from data tracking company BarclayHedge.

Groups that monitor performance like Hedge Fund Research and Hennessee Group are expected to announce November returns in a few days.

Fed up with the industry's worst-ever returns, endowments, pension funds and private investors demanded more money back, which forced even more selling among hedge funds, managers said.

In October, industry assets shriveled 9 percent to $1.5 trillion, their lowest level in two years, according to data from Hedge Fund Research. Data for November is not available yet.

"Money is coming out of the system, and people are redeeming because they need the money," said Antonio Munoz, who runs EIM Management USA, a fund of hedge funds.

But some hedge funds managed to deliver absolute returns:

While many fund managers are nursing heavy losses there are also a few bright spots.

Fund manager John Paulson, one of the first investors to bet that housing prices could decline on a national basis, made more money for his investors in November when his roughly $5 billion Advantage Ltd fund gained 2.04 percent. That leaves the fund up roughly 21 percent since January, according to an investor.

Paulson's roughly $10 billion Advantage Plus Ltd fund rose 3.19 percent in November and is now up 33.52 percent year-to-date.

Louis Bacon's Moore Global Investment Fund gained 3.74 percent through Nov. 26, leaving the fund down only 4.76 percent for the year so far.

And Bruce Kovner's Caxton Global Investment fund is up 11.52 percent for the year.

The difficulties experienced by some hedge fund stars is not unusual. Even the best hedge funds can suffer significant losses.

However, stakeholders have a right to know if their pension fund invested in these hedge funds. I do not care what Claude Lamoureux says, proactive disclosure is better than no disclosure at all. Pension funds should come clean with where and who they invested with.

In private equity, we learned that it was a year from hell:

The entire private equity model is broken, says Brett Hellerman, chief executive of New Haven-based Wood Creek Capital Management, citing the firms' reliance on leverage that's no longer available, and on easy exits that are no longer viable.

"The world's in workout right now. I don't care who you are," he says. "All these investors were expecting cash back on all their private equity investments within a three- or four-year time [frame]. That's been pushed back now, in some cases as far as the 10- to 12-year [goal] of the private equity fund. A lot of these investors are really having liquidity problems" as a result, he says.

Debt defaults are up nearly fourfold this year amid weaker economic conditions and uncertainty about the financial services industry, Diane Vazza, managing director of Standard & Poor's Global Fixed Income Research, said in a Nov. 19 report. And most of them bear the private equity stamp.Of the 86 companies around the world that have defaulted on their debt, 53, or more than 60%, were involved with private equity deals at some point.

This year alone, 39 U.S. companies purchased by private equity investors through leveraged buyouts had filed for bankruptcy as of Oct. 7, according to, a Web-based public forum for the industry.

The number of recorded defaults would be even higher had banks refused to waive strict debt covenants in credit facilities they granted companies in recent years, while credit spreads were still tight and lenders worried about losing customers to their competition.

Without covenants—which require borrowers to maintain certain financial ratios and profitability levels—it's harder to spot potential liquidity problems and more difficult for senior creditors to accelerate debt payments once a company gets into trouble.

The impact of the defaults and bankruptcies is potentially dire for the backers of the private equity funds, as many of them—known as limited partners—are pension funds and endowments that may now have to wait much longer than they expected to see the promised returns on their investments.

According to the Times, the 'lazy' days of financing in private equity are over:

Private equity firms got “a bit lazy” in the good times, the head of their own trade body said, as 3i, Britain's biggest, prepared to lay off 100 staff in the face of more hostile conditions.

Simon Walker, chief executive of the British Private Equity and Venture Capital Association (BVCA), conceded that before the credit crunch some private equity firms had prospered on leverage alone. “There is some truth in the accusation that in recent years, with the availability of easy credit, private equity has maybe got a bit lazy,” he said.

“With people falling over themselves to lend and to get a piece of the private equity action, the role of leverage became increasingly important. That has all changed.”

Instead of focusing on financial engineering, firms now had to be more creative, rely less on borrowing and be more skilful in producing operational improvements, Mr Walker said.

While making a plea for regulators not to strangle the industry with red tape, he admitted that the jury was still out: “What these tougher times will also reveal is whether private equity really does make a difference ... or whether, as its critics claim, it is simply stuffed full of people who have brilliant degrees in maths, know how to do clever financial modelling but don't actually know how to run a business.”

Worse still, some private equity investors, like Thomas H. Lee, invested in hedge funds and is now mulling over whether to shrink or close their funds:

Private equity investor Thomas H. Lee may shrink or shut down two funds that had $1.5 billion in assets after suffering losses of about 40 percent this year, the Wall Street Journal reported on Thursday, citing people familiar with the situation.

Hard-hit hedge funds run by Lee farmed out investor money to about 110 other funds, including SAC Capital Advisors and D.E. Shaw Group, according to the paper.

While Lee designed the so-called funds-of-funds to have low volatility with steady, consistent returns, he borrowed heavily to multiply the size of his bets, piling up debt of as much as $3.2 billion, the sources told the paper.

The strategy backfired, and the net asset value of the hedge funds tumbled to just below their level when launched in 2005, the newspaper said, citing an investor.

Lee declined to comment.

Lee launched the namesake private-equity firm in 1974. It has since grown to be one of the largest in the United States. Since quitting the firm in 2006, Lee has focused on a new private-equity firm called Lee Equity Partners and his hedge-fund business, Thomas H. Lee Capital Management LLC, the paper said.

The Boston-based buyout firm which bears his name, Thomas H. Lee Partners, is known as THL.

So-called funds of hedge funds that seek to spread the risk of investing by creating a portfolio of many hedge funds have seen a wave of redemption requests from investors that has forced them to ask the underlying funds to return their money.

Lee's fund started redeeming hedge funds early this year, a source familiar with the situation told the paper. It has about $2.7 billion in assets under management.

The fund started in 2000, and took in outside investors in May 2005.

Finally, there is the upcoming commercial real estate debacle. Yesterday I posted an article from the Guardian which casts doubts on real estate funds, claiming that commercial property remains overvalued (if you did not read this article, read it carefully!).

Today the Guardian reports that more job losses could hammer U.S. commercial property:

Job losses hurt demand for office space, retail and hotel space, so if the United States lost more jobs in November, it could mean a hard knock for U.S. commercial property.

The U.S. Department of Labor Friday is due to release its monthly non-farm payrolls report at 0830 EST on Friday. Economists polled by Reuters anticipate that the economy lost another 340,000 jobs last month.

Jeffrey Havsy, global strategist at Property & Portfolio Research Inc (PPR), explained that employment drives demand for all commercial space.

U.S. commercial real estate, which includes office buildings, shopping centers, apartment buildings, hotels and warehouses, has been grappling with tight credit markets, and heightened pressure on rental and occupancy rates as job losses mount and the U.S. recession deepens.

So far this year the U.S. economy has shed 1.2 million jobs, with about 40 percent of them having been office workers.

Commenting on high number of lost office jobs, Ken McCarthy, an economist with real estate services company Cushman & Wakefield, said: "What this is telling us is what we're in is a white-collar recession."

The global financial crisis has cut into demand for office space, particularly in large markets. One of the hardest hit markets is expected to be Manhattan. With 395 million square feet of office space, this market is larger than Chicago, Washington, D.C., Boston and San Francisco combined and largely dependent upon the financial industry because it takes up large chunks of very pricey space.

As banks and investment firms have consolidated and laid off workers, they have given up space.

The Manhattan office vacancy rate climbed to 7.8 percent in November from its lowest rate of 5.7 percent in December 2007, according to Cushman & Wakefield. From January through November, 8.7 million square feet became available for rent in Manhattan. Sublease space accounted for 4.3 million square feet, Cushman & Wakefield said.

The company is forecasting average Manhattan rent to decline between 10 and 20 percent by 2010, and between from 5 percent to 15 percent nationally.

In addition to financial institutions, retailers have had declines in sales as consumers curtailed spending and the prices of food and other essentials rose. More than 6,000 stores have closed year-to-date, and there have been many layoffs from stores and restaurants.

"Certainly, as the credit crises widened and the downturn in what was the financial economy spilled over into the real economy, we've now seen almost all sectors of employment impacted by this recession," said Michael Cohen, PPR senior research strategist.

PPR expects retail rents to be down 1 percent this year and 3.3 percent 2009.

Warehouse vacancy is expected to rise to 10.7 percent by year end and to 11.5 percent from 8.8 percent in December 2007, PPR said. Rents are expected to fall to $5.09 at the end of 2009 from $5.26 at the end of 2007.

PPR has forecast an average increase in apartment rents of 0.2 percent in 2008 compared to an increase of 4.8 percent in 2007 and a decline in average rent by 2.1 percent in 2009.

Because the values of buildings depend upon the rent they can generate, commercial real estate prices are expected to tumble.

PPR said overall U.S. real estate prices could fall about 20 percent from their peak in 2007 if the recession does not worsen. JPMorgan has forecast a decline of 25 to 30 percent, depending upon the quality and location of individual properties.
Getting back to my initial question, I wonder if pension funds might want to prorogue their results until January 2019. It really is that bad.

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