Thursday, January 8, 2009

Bailout for Alternative Investments?


More bad news for private equity. Fundraising data today confirmed what every private equity firm knows — fundraising is incredibly tough right now, and is likely to get even harder:

Figures from Dow Jones Private Equity Analyst show fundraising ground to a near halt in the fourth quarter. 99 funds raised $43 billion in the fourth quarter, down from the nearly $100 billion raised by 208 funds during the same period in 2007.

Overall, 363 U.S.-based private equity funds raised $265.6 billion in 2008, 18 percent below the recorded $325.8 billion raised by 506 funds in 2007.

Jennifer Rossa, Managing Editor of Dow Jones Private Equity Analyst, said in a press release: “While 2008 was still easily the second-best year on record, the decline we saw in the most recent quarter may steepen in the coming months, as some large buyout shops are considering fund size cuts and many limited partners are going to have trouble finding money to commit.”

But I wouldn't shed a tear for those poor private equity funds. As millions of Americans struggle to find work and pay their mortgages, a bill circulating in U.S. Congress could make leverage popular again, effectively bailing out private equity:

Since Election Day, Washington has been talking of a massive recovery package to be passed early in an Obama presidency. As Congress gets underway--and two weeks before Obama is sworn into office--details of recovery and stimulus ideas are emerging from Washington.

One idea, introduced into the Senate on Tuesday night (and enjoying the support of business lobbyists), is a measure to give businesses a tax break when they buy back their own distressed debt. Help settle bad debt and clean up balance sheets: seems like a no-brainer.

One problem: "For the vast majority of businesses out there, particularly small businesses, I can think of an enormous number of things that would be more help," says Dean Zerbe, a former counsel to the Senate Finance Committee, now with the specialty tax firm Alliant Group.

The way the provision works is this: Say a company borrows $1 million--down the road, they're having trouble paying it back, so the lender agrees take $600,000 and be done with it. Under current law, the borrower would record this as a $400,000 gain and pay income taxes accordingly.

In normal times that might be reasonable--if you borrow a million dollars and only give back $600,000 that's a gain for you. But, say the bill's proponents, special measures are needed right now to help companies deleverage. To help companies reduce debt, the measure would not require that $400,000 to be reported as profit. In a recovery plan presented Wednesday morning, the Chamber of Commerce called for the relief to be temporary, perhaps lasting a year or two.

"This is really being pushed by a handful of companies particularly keen on it," says Zerbe. "It's particularly helping private-equity folks--they're the ones who were out there taking significant leverage against their assets."

Last year was a rough one for investors who took that approach, as the deteriorating economy eroded the value of their acquisitions, leaving mountains of debt against assets that have lost value. The tax break would give such firms a window to buy their way out of deals gone sour (if they can still raise the money) without taking a profit.

Smaller businesses, on the other hand, tend to have much less leverage with their lenders. Will an incentive for a small business provide incentive for the banks to help them reduce their debt? Probably not much.

Bruce Josten, the top lobbyist for the Chamber of Commerce, says that while the provision would help some private equity groups, it's aimed to help a much broader array of companies, both public and private, and would be particularly important for the commercial real estate market that has enormous debt obligations in the next two years.

Sen. John Ensign (R-Nev.) introduced a bill Tuesday night that includes the provision. Ensign had previously suggested the idea to incoming White House Chief of Staff Rahm Emanuel, during discussion of stimulus ideas between the incoming administration and Congress, said Ensign's spokesman Tory Mazzola. The Chamber of Commerce said it has also discussed the idea with the Obama transition team.

Obama is expected to publicly outline his priorities in a speech on Thursday. Before anything ever reaches his desk, however, it will be run through the Congressional meat grinder. A big factor in those debates will be cost. Since the provision is a tax break, it would not require government outlays but would result in lost revenue. The potential cost of the bill has not been scored yet, according to Mazzola.

Tom Donohue, the president of the Chamber of Commerce, says the government does not calculate and is not expecting a specific revenue stream from debt repurchase at lower prices. The government is, however, expecting revenue from corporate income. In addition, with the tax break, the strength is that there's "no benefit gained unless someone takes private money and buys down private debt," says Donohue.

The real question, says Zerbe, is not what to do now (it's bailout season, everyone is probably ending up with a piece of the pie) but what to do in the future. "The tax code is already enormously biased in favor of interest, not equity. Bias is toward leverage." he says. "What are we going to do going forward to discourage over-leverage?"

And the private equity titans are not only focusing on the U.S. The latest news from Bloomberg is that Japan may axe a 40 percent capital gains tax for most foreign investors to spur Middle Eastern sovereign funds and private equity firms such as Carlyle Group to pump 10 trillion yen ($110 billion) into its sagging markets:

The trade ministry plans talks over the coming months with buyout firms and state funds from Saudi Arabia, the United Arab Emirates, Qatar and Kuwait to outline proposed changes to its tax regime, said a senior ministry official working on the matter, who declined to be named because details haven’t been finalized.

Japan taxes foreign funds more than any other nation in the Organization for Economic Cooperation and Development and has ranked last among member countries as a destination for foreign direct investment for more than a decade. The proposed changes could come as early as April 1 -- subject to parliamentary approval -- and boost investment from foreign funds fivefold over the next few years from 2 trillion yen, the official said.

“This is a significant step,” said Hideki Hashiguchi, chairman of the Japan chapter of the Alternative Investment Management Association. “Japan is at a crossroad in becoming a leader in Asia with its financial industry, and such changes will definitely provide a positive impact for the private equity industry and overseas investors.”

Under the revised law, Japan would become more competitive with the U.S. and Europe by exempting foreign investors from paying capital gains taxes when stakes are held via funds with locally based arms, according to a document outlining the changes that was shown to Bloomberg News.

Carlyle, KKR

Separately, foreign investors who invest in Japan through funds abroad would be exempted from tax if they hold their stakes longer than a year. Investors who hold more than 25 percent in a Japanese company would remain subject to the current taxes, the official said.

Hedge funds, which often hold stakes for short periods, are not the target of the proposed changes, the official said.

He named Washington-based Carlyle and Kohlberg Kravis Roberts & Co., the New York buyout firm planning to list shares publicly this year, as foreign investors the government is aiming to woo with the new tax regime.

“This is a good indication that Japan is committed to attracting foreign investment,” KKR’s country head in Tokyo, Shusaku Minoda, said via a spokeswoman.

Carlyle officials declined to comment because the changes remain subject to approval by lawmakers. It last month raised a $13.7 billion fund, the firm’s fifth for U.S. buyouts, amid a worldwide slump in deals. Blackstone Group LP, the biggest private-equity firm, in 2007 raised a $21.7 billion fund, the industry’s largest.

Benchmark Slumps

The value of investments held by pension funds and endowments has dropped amid the global credit crisis and simultaneous recession in Japan, Europe and the U.S., making competition for foreign investment fiercer than ever. Clients of private-equity funds pledged $82.3 billion to finance their operations in the third quarter of last year, the lowest amount since 2005, according to London-based researcher Preqin Ltd.

In Japan, some $3.9 billion private equity and buyout deals were announced last year, according to data compiled by Bloomberg. That compares with $90 billion in North America and $73 billion in Europe, according to the data. Tokyo’s benchmark Nikkei 225 Stock Average has slumped 39 percent during the past 12 months, compared with 31 percent for the Dow Jones Industrial Average and 28 percent for London’s FTSE 100 Index.

In an earlier move in June last year to attract more foreign funds, Japan’s Financial Services Agency issued a clarification that exempted managers of offshore investment funds from corporate tax, provided they prove their assets are managed at local discretion.

Also last year, the trade ministry sent a delegation for the first time to meet with state funds in oil-producing nations, including the Saudi Arabian Investment Co.

You can't blame the Japanese for trying to reflate the alternative investment bubble. Their pension funds lost 16.5 percent of their value on average in April-December due to the deepening financial crisis.

Canadian pension funds are also reeling after getting pummeled in 2008:

Not surprisingly, Canadian pension plans took a drubbing in 2008, with values plunging from a double whammy of the stock market crash and sharply declining interest rates. The Mercer Pension Health Index fell to 59%, down 23% from the beginning of the year (click on chart above).

“Most equity markets fell by more than 30% last year in local currency,” said Yvan Breton, Business Leader for Mercer’s investment consulting business in Canada. “Even for plans that benefited from the fall in the Canadian dollar because they did not hedge foreign currency exposure, pension fund assets were hit hard in 2008.”

According to Mercer Retirement Professional Leader Paul Forestell, pensions took hefty losses on both sides of the balance sheets, with lower long-term interest rates raising their liabilities. “The new rules for determining the lump sum value of pension entitlements, which many jurisdictions will allow to be used early for 2008 year-end solvency valuations, will only partially mitigate the losses, reducing liabilities generally by only a few percent.”

However, some corporate financial statements at year-end 2008 will show gains in pension plan funded status over the year, despite the investment losses. "As credit spreads have widened, rising corporate bond yields will result in lower disclosed pension obligations at year end,” Forestell said.

A typical balanced portfolio lost 14.1% in 2008 , with a 6.5% hit in the last quarter. Canadian bonds would have softened the blow. The DEX Universe Bond index returned 6.4% in 2008, including a 4.5% return in the fourth quarter. Short term bonds gained 8.6%, miid term bonds rose 7% and long bonds 2.7%.

The S&P/TSX Composite index was the worst performing equity market in Canadian dollar terms, losing 33% in 2008. Two thirds of this fall took place in the fourth quarter. Among the worst hit sectors were Information Technology, down 54.2%; Financials, down 36.4%; and Consumer Discretionary, down 35.4%.

Canadian small cap stocks (i.e.the BMO Small Cap Blended weighted index) fell 46.6%, while the large caps comprising the S&P/TSX 60 index fell 31.2% in 2008. Value stocks did slightly better than growth stocks, losing 33.2% and 36% respectively.

The weakening of the Canadian dollar against the US dollar helped U.S. and international index returns for Canadian investors. In Canadian dollars, the MSCI EAFE index lost 28.8% in 2008, compared to a 40% loss In local currency terms.

South of the border, the S&P500 fell 21.2% (in Canadian dollar terms) in 2008, compared to a 37% loss in U.S. dollar terms.

And after leading the performance charts the previous five years, Emerging Markets slumped 41.4% in 2008 in Canadian dollar terms.

So what are those "sophisticated' Canadian pension funds going to do to get the "juice" they need to meet their actuarial rate of return? Hmmm, why not invest in hedge funds that are lending money during the credit crunch:

With banks and other traditional lenders sitting on the sidelines in the credit crunch and refusing to lend, hedge funds, funds-of-funds, and other alternative investors are stepping in to fill the financing void. Today, they are hard-money lenders to scores of businesses in need – de facto lenders of last resort.

The lending is much broader than transactions involving commercial real estate, though these are among the most common. Hedge funds are providing asset-based financing for a variety of transactions, involving both large and small businesses, loans to private equity and other hedge funds, fund formations, venture capital and real estate firms.

Right now the biggest players are hedge funds which view the lending as a way to diversify their portfolios during a time of economic tumult while collecting double-digit returns. Many funds charge interest rates double what a conventional bank would charge. The universe of funds currently involved in lending is relatively small, but it promises to widen in coming months as more banks curtail lending.

“We're lending to extraordinarily good credits right now. The complete shutdown of lending by many money centers, traditional lenders and regional banks has allowed us to lend on very favorable terms (as it has with Warren Buffett).

We are getting high coupons, good loan-to-value ratios, and very attractive potential equity upside. Current cash pay coupons are well in excess of 10 percent,” says Lawrence Goldfarb, chief executive officer of San Francisco-based LRG Capital Group, a global investment, banking and advisory boutique, and portfolio manager of its hedge fund subsidiary, LRG Capital Funds. The firm has been lending capital since 1998.

“There's a real situation now in which borrowers of almost any kind are unable to get financing, and these aren't just speculative borrowers. They're solid borrowers who would normally be borrowing from banks, but because of the credit situation are unable to do so,” says Ben Shoval, managing director of Ambit Funding, a Wilkes-Barre, Pa., firm that has dedicated $250 million in two hedge funds toward commercial real estate lending. “We're essentially filling the necessary role in the credit market that nobody else is willing to fill.”

Recently, the firm made an $11 million loan to a large New Mexico developer who had commitments in place from several big box stores, but the bank had pulled out at the last minute. “We were able to step in and provide short-term financing that will allow them to get over the hump until they're able to get a bank loan,” says Shoval.

Terms were highly favorable. “This is a first position mortgage,” says Shoval. “Our collateral is at 38 percent loan-to-value and we have it personally guaranteed by all the principals.”

“We're seeing the acceleration of a trend of evolution in the hedge fund industry,” says Ken Heinz, president of Hedge Fund Research in Chicago. Today, as many as 145 funds specialize in fixed income or asset-based securities, 154 funds concentrate on distressed assets and 58 specialize in alternative yield assets, according to HFR. Of these, approximately 140 hedge funds focus on a combination of distressed asset and fixed income securities lending, and also provide commercial real estate lending.

Often, transactions involve hedge funds not only originating new high quality debt, but funds buying bad debt from banks themselves. Michael Gray, head of the fund formation and investment management practice group at Chicago law firm Neal Gerber & Eisenberg LLP, says: “I've got some clients who are buying debt from banks. Some are doing new money; some are buying the actual paper at a discount. The bank loaned about $25 million, and they're buying (the debt) for $10 million.”

Big Opportunities for Investors in Distressed Assets

Gray points to the recent popularity of distressed securities and increased vulture investor activity as the driving force behind much of this lending. “Most of the situations do have some level of distress,” he says. Collateral can be most anything – accounts receivable, inventory, equipment, real estate, intellectual property. One hedge fund client, Gray says, even made a loan based on the trademark of the retailer, which had significant value.

Liquidity at a Cost

Gray feels hedge funds are providing a legitimate contribution to the business landscape, because they offer financing when no one else will. However, the terms that they negotiate are much more aggressive than with traditional financial institutions. Returns range from 10 percent to 12 percent, or more.

Ambit Funding, for example, typically gets 13 percent, plus two points up front on its loans and two points on exit, according to Shoval.

To be sure, there are risks such as potential defaults. The softening economy remains a serious threat. But the hedge funds say they are protecting themselves by being highly selective. “Only two to three deals get done a month, out of a much larger universe of potential deals,” says Goldfarb.

Gray feels that distressed assets, the basis of much of the lending, are going to be a huge area of activity for hedge funds until traditional sources of funding come back. That could be one to two years or more, he says.

“You're dealing with turnaround situations and distressed situations. There's always more risk than if you have a nice company that has been plugging and chugging along for 20 years with the same revenue and profitability,” says Gray.

I already discussed asset-based lending in Banking with Hedge Funds so I am not going to get into details here. When money was cheap, asset-based lenders made a killing lending to businesses that needed financing.

However, I warned investors:
...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).
The issue of benchmarks is very important. Say your pension fund manager who invests in external hedge funds is being compensated based on an absolute return benchmark of T-bills + 500 or 700 basis points.

Well, he sees traditional hedge funds lost 18.3 percent in 2008, their worst year on record, so he decides to shove a whack of dough into asset-based lending (ABL) hedge funds who are returning 12% to 14% in a tough economic environment with zero correlation to traditional stocks or bonds.

Fine, no problem, but does that benchmark of T-bills + 500 or 700 basis points really reflect the liquidity risks and other potential risks of that strategy? I don't think so. Moreover, how many hedge funds really have the skill set to be good asset-based lenders? Most of the big players exited the market or significantly curtailed their lending activity because the risks are high right now as the economic downturn deepens and money isn't cheap.

There is another perverse twist to all this. Pension contributions are being invested with hedge funds that are basically providing financing to desperate businesses that are unable to access financing through traditional lenders because of the credit crunch or because of poor credit history and these hedge funds are collecting huge premiums for this "alpha".

It almost makes me want to collect money from a few ultra high net worth investors and start a new hedge fund. I think I'll name it Loan Shark Capital Management, lend money at double or triple the prime rate, and hire Tony Soprano as my Chief Intimidation Officer.That should keep the default rates extremely low.

And if things go well, I will hire a few quants to show how my "alpha" is truly uncorrelated to the market and in no time I'll have pension funds toppling over themselves to invest in my fund, charging them 2% management fee and 20% performance fee.

As for the private equity titans, they do not need to bother with all this because they've got the politicians in their back pocket. It's all part of what the late George Carlin called "the American Dream".

***Comment from an avid reader***

Here is an excellent comment I received from an avid reader:

Some more great comments on Private Equity and Hedge Funds Leo. The Forbes article on bailing out PE firms to me sounds like a gross misallocation of societies resources. The ones with the power seem to be having an influence on government. Tax breaks on distressed debt will in the long run only encourage the behaviour that got us into this mess.

For quite some time now I've had a thought picking at the back of my head that says 'What really do investors get with Private Equity?'. Time and time again the conclusion I come to is illiquid, leveraged, infrequently priced stock. At the heart its ownership in a business and I would much rather use the simplicity (relative to PE) of public markets for that exposure.

There was a luncheon a few weeks ago where a private equity manager was speaking. Without taking his statements too far out of context, I was shocked when he stated that public equity returns leveraged to PE levels would have provided similar returns over the last 30 years. Then why on earth would I pay 2/20 and deal with capital calls for private equity!!!

In that light, your comments on hedge funds acting as banks really struck a chord. If as an investor I want to be lending to high quality companies why on earth would I go through a hedge fund vehicle with its hefty fees and lack of transparency.

How about an indexed investment grade corporate bond fund. Good yields, transparency, low fees, providing liquidity in a market that needs it and liability matching. I was once
told that if you live by the KISS (Keep It Simple Stupid) philosophy life becomes easier. Maybe I'm oversimplyfing things but this is not a time where pension plans need to be complicating their world.

Thought I would share my soap box thoughts.


One note: in the past, unlike public markets, there was performance persistence in private markets. The top decile funds tended to outperform median funds by a considerable amount and they consistently did so. If you were not in top decile funds, you would have been better off in the public markets (after adjusting for lags and leverage). We'll see if this trend continues in the future but for now most private equity funds are performing dismally.

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