Thursday, January 22, 2009

Alternatives Nightmare Continues

Stocks got clobbered again today but pared some of the losses stemming from Microsoft and bank woes:

Wall Street has again succumbed to a disheartening reality -- the recession is taking a heavy toll on U.S. companies.

Stocks closed sharply lower Thursday on more bad news about earnings and ever-increasing worries about the banking industry. The major indexes, which plunged and then soared the first two trading days of the week, ratcheted up and down during the course of the session; the Dow Jones industrial average fell as much 271 points, came close to breaking even and then slumped before closing down 105.

"We're seeing a little bit of increase in volatility because things have not gotten much better," said Scott Fullman, director of derivatives investment strategy for WJB Capital Group.

Microsoft Corp. set the tone for the day and made clear more pain was to come before an elusive economic recovery would emerge. The company surprised investors Thursday morning by reporting its fiscal second-quarter earnings early -- and the news was not good. The software giant posted an 11 percent drop in profit and said it will slash 5,000 jobs over the next 18 months.

Microsoft said deteriorating global economic conditions and lower revenue from PC software forced it to cut back. The company also said it is unable to provide any profit and revenue forecasts for the rest of the year because of the market volatility.

Uneasiness about financial companies still plagues investors, and many bank stocks took another beating Thursday. Quarterly financial reports showing steep profit declines and big loan losses have investors worried that the financial crisis is far from over, and that the government's efforts to prop up banks might not be enough to prevent a major failure.

Bank of America Corp. said former Merrill Lynch & Co. Chief Executive John Thain resigned. The company didn't offer a reason for Thain's departure, but it follows news that Merrill Lynch had moved up its year-end bonuses, handing out payments just days before it was officially acquired by Bank of America on Jan. 1. Moreover, some analysts expected that Thain would leave; it's almost inevitable that in the marriage of two big companies, one of the former CEOs leaves soon after the deal is closed. Bank of America fell 15 percent.

More downbeat economic readings, including an increase in the number of weekly jobless benefit claims and a sharp drop in home construction activity, added to the day's gloom.

Investors found some encouragement after two House committees prepared President Barack Obama's economic stimulus plan for a floor vote next week. Still, there were still clear signs that it wasn't gaining as much Republican support as the new administration had been hoping for.

The Dow fell 105.30, or 1.28 percent, to 8,122.80.

Broader market indexes recovered some of their losses but still showed big drops. The Standard & Poor's 500 index fell 12.74, or 1.52 percent, to 827.50. The technology-heavy Nasdaq composite index dropped 41.58, or 2.76 percent, to 1,465.49 after the Microsoft news.

The Russell 2000 index of smaller companies fell 13.91, or 3.05 percent, to 442.85.

Declining issues outnumbered advancers by about 4 to 1 on the New York Stock Exchange where consolidated volume came to 5.75 billion shares compared with 6.33 billion shares traded Wednesday.

Bond prices were mixed. The yield on the benchmark 10-year Treasury note, which moves opposite its price, rose to 2.60 percent from 2.55 percent late Wednesday. The yield on the three-month T-bill, considered one of the safest investments, slipped to 0.09 from 0.10 percent late Wednesday.

The dollar rose against other major currencies, while gold prices rose.

Light, sweet crude rose 12 cents to settle at $43.67 a barrel on the New York Mercantile Exchange.

Insurance companies also came under pressure today as AFLAC (AFL) lost 37% on concerns about exposures within the insurer's investment portfolio. Traders are now making bets on the insurance sector and my feeling is that insurance companies are the next giants to crumble.

Importantly, regulators have no idea about the capital positions of many insurance companies as well as the toxic debt they are hiding in their books. Today's news should raise concerns.

But the real scandal of the day revolved around John Thain who resigned under pressure from Bank of America on Thursday after reports he rushed out billions of dollars in bonuses to Merrill Lynch employees in his final days as CEO there, while the brokerage was suffering huge losses and just before Bank of America took it over.

As if that wasn't bad enough, news then broke out that Mr. Thain spent over $1 million to redecorate his office. Stakeholders beware, ask the presidents of your pension fund how much they spent redecorating their offices. I am sure it's not $1 million, but if they redecorated using public money, then stakeholders have a right to ask how much was spent.

In fact, all expenses at public pension funds should be monitored closely, including external managers' fees, vendor licenses, legal expenses, corporate accounts and traveling expenses which tend to add up, especially for those guys and gals that invest in external funds. They often fly first class and collect the points on their personal credit cards (I never understood why they are allowed to rack up the points when it is for business).

We are in a recession and if stakeholders have to tighten their belts, then public pension funds should control their costs too.

But the biggest cost of all comes from external managers, especially hedge fund managers, private equity fund managers and real estate fund managers.

So how are these alternative investments doing? Not good. The bubble in alternative investments imploded and now that they can't use leverage - the oxygen that inflated this bubble - they are all suffering and dealing with deleveraging doldrums.

Bloomberg reports that hedge fund assets may fall by $450 billion after worst performance ever:

Hedge funds lost more money in 2008 than any year on record. It may get worse in 2009, forcing fund managers to overhaul investment strategies, reduce fees and make it easier for clients to withdraw cash.

The $1.2 trillion industry may shed as much as $450 billion in assets, or 37 percent, through market losses and client withdrawals this year, according to Morgan Stanley analyst Huw van Steenis in London. That’s on top of the $600 billion that disappeared last year and would leave hedge funds with $750 billion, the lowest since 2002.

“It’s hard not to be bearish in this environment,” van Steenis said in a telephone interview.

But many investors remain undetterred. Even as more hedge fund managers are getting caught swindling investors, institutions are not ready to close the door on hedge funds.

I was reading an article in Hedge Funds Review that stated that Corazon Capital was tapping into super funds through a fund of hedge funds offering:

The fund has launched because a number of the world's best hedge funds over the last decade have re-opened for investment for a limited time.

These funds are difficult for individual investors to access as the minimum investment levels are high and the funds are rarely open to new investors.

The funds include Odey European fund, Man AHL Diversified Fund, Winton Futures Fund and Paulson International. Each of these funds has given composite annualised returns of over 15% with volatility of 6% since October 1998.

Paul Meader, director of Corazon Capital, believes the FoHF will allow investor to access managers with superior skills who have managed positive returns in the most hostile markets.

"The track record of these managers, particularly their cash-plus performance during 2008, proves their ability to produce positive returns in turbulent markets. It is for this reason that most have not been open to new investors for several years, so we are understandably delighted to be able to offer these managers to our investors," Meader said.

As great as this "super fund of hedge funds" sounds, I warn investors to look into the fee structure, liquidity terms, clauses for gates and most importantly, I warn investors not to expect the same stellar performance going forward (if you're confused, read Nassim Taleb's book, Fooled by Randomness).

Even the best alternative investment shops got clobbered in 2008. According to FINalternatives, BlackRock’s hedge fund and private equity co-investments took a big chunk out of its profits last year:

The firm wrote down $293 million on the value of hedge funds and private equity vehicles it invests in alongside its customer. All told, BlackRock’s net income plummeted 84% to just $53 million, with declines in the firm’s own alternative investments business also contributing to the decline.

Investors redeemed some $2.9 billion from BlackRock alternatives funds in the fourth quarter, pushing the firm’s performance fee income down 84% on the quarter to $23.7 million. BlackRock said that it was able to meet all withdrawal requests.

While the firm’s overall assets under management fell by just 3.6% last year, that had little to do with its alternatives business. The firm’s more conservative funds brought in $129.1 billion in new money, including $101 billion in toxic credit assets that BlackRock is managing on behalf of the U.S. government and four banks.

So what are the prospects for private equity? In particular, is it gloom, boom or doom in private equity:

Money for private equity firms may not have been available on tap, as it was in 2007, but a report from Preqin, a London-based alternative assets research and consultancy group, seems to suggest that fund-raising in 2008 was not as bad as it was made out to be.

Over the year, 768 private equity firms raised capital commitments of $554 billion. That's second only to the $625 billion garnered by 1,045 funds in 2007, the report said.

Prequin further goes on to estimate that the total amount of "dry powder" or the amount of funds that all PE firms have on call now is $1.02 trillion (including funds raised in previous years).

The first question that comes to mind is how much of this is actually dry powder waiting to find the right opportunity for deployment. 2008 was no ordinary year.

Investors who had committed funds to these firms may themselves have gone bust (especially if they were hedge funds or such), may be bleeding profusely from calls gone wrong in other asset classes, or may just have become tight-fisted in a financial environment clouded with ambiguity.

It's all very well for private equity managers to say the industry has $1.02 trillion on call. Anecdotal evidence of investors wanting to get rid of their commitments to others (in industry jargon, these others are called secondary specialists), seems to suggest that reality lies somewhere miles away. Put differently, there are distinct possibilities of investors dishonouring their commitments.

The second aspect in the report that raises an eyebrow is that of the $554 billion raised, $216.1 billion is accounted for by buyout funds. And I needn't tell you the extent of leverage buyout funds had taken on themselves in the previous few years when credit flowed like wine in Caesar's palace.

Research from Boston Consulting Group (BCG) and University of Navarra's IESE Business School (in Barcelona) indicates that "at least 20 percent of the 100 largest leveraged-buyout private equity firms – and possibly as many as 40% - could go out of business within two to three years.

More disturbingly, most private equity firms' portfolio companies are expected to default on their debts, which are estimated at about $1 trillion." The credit spreads of 328 leverage buyout portfolio companies analysed by BCG-IESE in November showed that roughly 60% of this debt was trading at distressed levels. The spreads could have narrowed now, but it still leaves a large proportion of companies with distressed debt.

So buyout funds, which find themselves in such unfamiliarly rough terrain, could well use the $216.1 billion they managed in commitments in 2008, to salvage their existing portfolio. That could leave them with just a little something for fresh deployment.

Other surveys show that even though institutional investors remain committed to private equity as an asset class, they are shunning large buyouts:

Institutional investors (Limited Partners) are radically re-assessing their investment plans in the light of the atrocious performance of the large buyout funds last year, according to the latest survey undertaken by Almeida Capital, a leading fundraising advisory firm.

The survey of 150 of the world’s most active and influential investors in private equity funds, including pension funds, insurance companies, endowments and charities, revealed that interest in the asset class is still strong but allocations will be re-directed towards other categories of private equity.

Key findings of the survey include the following:

  • Less than 20% of institutional investors regard large buyout funds as offering attractive investment opportunities in 2009
    This is an aggregate drop of 25%, from last year’s survey, of institutional investors who regarded investments in large buyout funds as attractive or very attractive. Only 2% of institutional investors plan to increase their allocations to large buyouts whilst 56% plan to decrease their allocation this comes on top of a 49% aggregate decrease in allocation last year to this category. North American institutions are the most negative on buyout funds with no investors planning to increase allocation and 62% planning to decrease in 2009.
  • Overall allocations to private equity will drop but surprisingly the majority of LPs claim their allocation plans are not negatively affected by the downturn
    A surprising 78% of institutional investors are claiming that their total allocations to private equity will remain the same or increase compared to 2008. Over two-thirds of them plan to commit more than $100m and 10% plan to commit over $1bn this year. The resilience to market conditions illustrated in the survey is based on the fact that many of the respondents are experienced long-term investors and see the dramatic falls in valuations as indicating a great time to invest.
  • Interest in the secondary market has grown substantially with 70% of LPs regarding 2009 as a good time to buy secondary interests
    The secondary private equity market, in which investors buy and sell participations in private equity funds or in vehicles comprising portfolios of stakes in private companies, has moved centre-stage this year. Many investors who previously invested only in primary (‘new’) funds, or restricted their secondary activities to investments in secondary fund managers, are now eager to purchase directly interests in existing funds or company portfolios. Over half of institutional investors (55%) think it is a good time to invest in secondary fund managers who invest in secondary opportunities. Institutional investors clearly regard 2009 as a buyers market with only 15% thinking attractive returns can be generated by selling funds, down 27% from last year.
  • All categories of private equity, except secondary investments, are deemed to be likely to deliver lower returns but special situations and small and medium buyouts remain the most attractive areas
    Special situations funds rank as the most attractive fund type in 2009 compared to the third most attractive last year, with 76% of all LPs regarding it as attractive or very attractive. Small and medium buyouts retain their places in the top three most attractive investment categories but in both cases they are seen as less attractive than last year with a 6% decline for small buyouts and an 11% decline for medium buyouts.
  • Mezzanine funds showed the biggest increase in interest, after secondary investments, with an additional 9% of LPs regarding the category as attractive
    The collapse in valuations of portfolios held by buyout firms and the poor prospects for leveraged buyouts over the next year have driven many institutional investors to reconsider the risk/return profile of their investment strategy. As a result many a considerable number are looking at mezzanine funds as attractive investment opportunities this year. North American investors are the most positive about the opportunities for mezzanine and the category has shown a 17% increase in its attractiveness ranking compared to last year.
  • Virtually all regions are deemed to be less attractive than last year but LPs maintain their strong interest in emerging markets
    The rapidly developing private equity markets of CEE, India and China are firmly established as the most attractive regions, after North America and Europe, with 57% to 59% of institutional investors regarding these areas positively. Interest in other emerging private equity markets has waned significantly as investors perceive other parts of South-East Asia, Japan and Australia as being exposed to significant economic downturns.

“The survey clearly shows that institutional investors believe the large leveraged buyout model is not viable – at least for 2009” according to Richard Sachar, Managing Director of Almeida Capital.

“However, they remain convinced that the asset class will continue to generate attractive returns over the long-term and they will look harder and further afield for investment opportunities. It’s more bad news for the mega funds but potentially good news for private equity managers who invest in special situations, and lower or middle markets or in emerging markets, and create value in their portfolio companies rather than rely on leverage”

Finally there is commercial real estate that continues to slide lower. According to Moody's Investors Service, commercial real estate prices dropped 3.4 percent in November compared with the previous month, sinking to a level not seen since the start of 2006:

November's Moody's/REAL Commercial Property Price Indices were down 14.3 percent from a year ago, and down 14.5 percent from their peak in October 2007, Moody's said.

With November's numbers, the indexes appeared to have resumed a downward trend after hovering for several months at a level about 11.5 percent below the October 2007 peak value, Moody's said. November's 3.4 percent drop was the second-largest monthly decline in the eight years the indexes cover.

The index is based on repeat sales of the same properties across the U.S. at different points in time.

Moody's on Tuesday also reported a drop in transaction volumes, which were at their lowest level since mid-2004.

Any way you look at it, the outlook is bleak for commercial real estate in 2009:

Is there a light at the end of the tunnel for commercial real estate? Brokers got their answer Wednesday morning, when Rance Gregory, CEO of NBS Real Estate Capital, gave a presentation of the same name.

“I actually just learned the title of (my presentation), so I’m missing the slide that just says ‘no,’ ” he joked to a room full of brokers, who laughed nervously.

At the Commercial Association of Realtors quarterly breakfast, Gregory said brokers may face more complicated deals in the near future. Economists don’t expect the market downturn to reverse course until 2010.

Gregory said he was not typically known for his optimism.

“We got into this as a credit market problem,” Gregory said, “and there’s no way to get out of it without first healing the credit market.”

Billions of dollars in financing have been lost, he added. He calls it a lending industry “death spiral,” with the nationalization of banks not far off.

Yet Gregory said that private firms such as NBS Real Estate Capital could be there to “fill the gap.” His company, for one, has about 39 investments already worth about $500 million.

But eventually, he said, banks will have to take on more debt.

Gregory expects a lot of activity to surround brokers, primarily in regard to maturing debt. If investors do not have maturing debt, then it’s best to ride out the market, he said.

He likes the multifamily market despite an emerging shadow market of single-family homes for rent. Industrial property, considered months ago to be one of the better-performing markets, is showing signs of weakening.

The office market is performing adequately, but only for investors who have stellar credit.

“Underwriting corporate credit is just becoming a nightmare,” Gregory said.

The less said about retail the better, he added.

He said one way to stay ahead of the current crisis is through loan syndication and “spreading the risk” around.

The trends may be bad, but they can’t get much worse, he said. “There aren’t going to be very many new deals this year,” he added.

So there you have it, my snapshot of alternative investments. As you can see, serious headwinds still hamper alternative investments where the nightmare continues.

Finally, please take the time to listen carefully to Charlie Rose's conversation with Yale's David Swensen.

In the investment world, there are few people worth listening to, and David Swensen is one of them. Pay particular attention to what he thinks ails the financial system and how we should address the derivatives mess.

Swensen thinks there will be a dip in hedge funds, but they will come back. I agree but the key is only the best will survive and they will need to provide their investors with more transparency and more liquidity.

I also agree with him that income distribution is the key challenge that needs to be addressed in the development of economies, particularly among the poorest nations of the world.

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