Thursday, February 19, 2009

A Shift in the Balance of Power?


Before delving into tonight's topic, let's check out the action at the casino. The Dow ended the day at its lowest close in almost six years:
An important psychological barrier gave way on Wall Street Thursday as the Dow Jones industrials fell to their lowest level in more than six years.

The Dow broke through a bottom reached in November, pulled down by a steep drop in key financial shares. It was the lowest close for the Dow since Oct. 9, 2002, when the last bear market bottomed out.

The blue chips' latest slide dashed hopes that the doldrums of November would mark the ending point of a long slump in the market, which is now nearly halfway below the peak levels reached in October 2007.

The market's inability to rally signals that investors see no immediate end for the recession, which is already 14 months old and one of the most severe in decades. Investors also haven't been impressed with two major economic initiatives from the Obama administration this week, an economic stimulus package and a mortgage relief plan.

"It is definitely, definitely a blow to psychology," said Quincy Krosby, chief investment strategist at The Hartford, referring to the Dow's finish. "There is more pessimism in the market as to when the economy is going to pick up steam."

The Dow had been teetering close to November bottom since Tuesday, when the index tumbled 300 points on worries about the economy and the stability of banks in Eastern Europe. Stocks had barely finished above the November low on Tuesday and Wednesday.

On Thursday, worries about financial and technology stocks weighed on the market, with steep drop-offs in financial bellwethers like Citigroup and Bank of America leading the way downward. Both stocks tumbled 14 percent and closed below $4, less than the cost of a latte in some coffee shops.

"The Dow represents, to the average investor, the American economy," Krosby said. While professional investors often look at indexes like the Standard & Poor's 500 index, the Dow's slide is an unwelcome milestone. "It's a tenet of the market, selling begets selling. You're going to see the market on guard."

The Dow lost 89.68, or 1.2 percent, to end at 7,465.95.

The blue chips have fallen 9.8 percent in the last eight sessions.

Broader indexes also fell. The Standard & Poor's 500 index ended down 9.48, or 1.2 percent, to 778.94. The index finished above its Nov. 20 close of 752.44, which was its worst finish since April 1997.

The technology-heavy Nasdaq composite index suffered the biggest hit Thursday after Hewlett Packard Co. tumbled 7.9 percent after posting worrisome results. The Nasdaq fell 25.15, or 1.7 percent, to 1,442.82.

The Russell 2000 index of smaller companies fell 6.47, or 1.5 percent, to 416.71.

Declining issues outnumbered advancers by more than 2 to 1 on the New York Stock Exchange, where consolidated volume came to 5.64 billion shares compared with 5.65 billion shares traded Wednesday.

Dan Cook, senior market analyst at IG Markets, said the Dow's move lower is unnerving because it forces many investors to reassess their expecations of how far the market could slide.

"It's kind of like if we're walking across a frozen pond. If that ice starts to crack a bit we're going to be very wary," he said.

I got a better analogy. It's kind of like hitting a massive iceberg that is several miles wide, several miles deep and will take you a few years to drill through.

A buddy of mine called me tonight and asked me "when is the hemorrhaging going to end?" I told him what another buddy of mine who trades currencies for a living told me: "The market inflicts the maximum amount of pain on the maximum amount of people."

We have not crossed the threshold of "maximum pain for maximum people" yet, but at this rate, we are going to get there sooner rather than later.

It's a bloodbath out there and I am feeling it too. My short-term portfolio is mostly in cash, but my long-term portfolio is almost exclusively in solar stocks that got slaughtered as redemptions forced hedge funds to unwind their long positions and dump those shares.

But I am not panicking. I am using this as a buying opportunity to lower my average cost which is what most of you relatively young investors should be doing. Focus on solid companies with secular growth prospects that got crushed and average down at these depressed levels (read my Outlook 2009 for ideas but don't rush to buy if you can't stomach volatility).

The weakness in the stock market does not augur well for private equity where funds are now waiving fees:

Private equity firm Bain Capital is proposing temporarily waiving management fees for investors in its private equity funds, three sources familiar with the matter said.

Under the proposal, which was put to investors last week, Bain would recoup the fees when investments in the funds were realized, the sources said.

The waiver would probably only apply to the older of its private equity funds, the sources said. Those have little unspent capital remaining and need to conserve that to make follow-on investments in current portfolio companies.

Private equity firms typically charge management fees of around 2 percent on a quarterly basis. Bain would have the option each quarter to defer the fees, one of the sources said.

The fee waiver was first reported by peHUB (www.pehub.com), part of Thomson Reuters.

Bain declined comment.

Private equity firms have been struggling to keep portfolio companies healthy during the economic crisis, while having few opportunities to recoup money by selling their investments.

Meanwhile investors in private equity funds, known as limited partners, are less willing to commit more funds to the asset class.

Carlyle Group co-founder David Rubenstein said at a recent conference that limited partners will have more power to dictate fees and fund sizes, and predicted that for the next few years, they will hold the balance of power.
There is no question that the the balance of power in alternative investments is swinging to investors. Given the ongoing carnage, it's hardly surprising that limited partners of private equity can extract more from the general partners.

I think the focus on fees is missing a bigger point. Even if they waive the fees, private equity will not come roaring back because the stock market is in the doldrums and because they will not be able to finance deals using cheap debt (remember, leverage is the oxygen of alternative investments).

Also, as I wrote yesterday, why bother with expensive illiquid investments when the real opportunities in the next few years (once the recovery kicks in) lie in liquid stocks and corporate bonds? In short, why pay some hedge fund or private equity fund fees for beta?

But others think private equity is staging a comeback:

Michael McDonagh, a corporate finance partner in KPMG’s Private Equity group, is finding reasons to be cheerful as he surveys the prospects for mid-market transactions in the coming year. In his view, the market hit bottom in the last quarter of 2008, and is likely to remain there until the third quarter of the current year, as private equity houses lick their wounds, draw a deep breath and count the considerable cost of the gathering recession.

According to some observers, many investors will be on the receiving end of some very bad news in the coming weeks, as letters drop onto the mat informing them that the investments they made at the height of the boom have now shrunk by as much as 30 per cent.

McDonagh takes a glass-half-full view of the situation and reckons that, although we may have to wait a while for the jam to return, bread-and-butter deals should be back on the menu come the second half of the year.

He says, “The market hit bottom in the last quarter of 2008. In terms of transactions, it was as quiet as it could get, and is likely to remain that way for the first half of 2009.”

Tight cash flows
Any recovery will depend on a number of factors, says McDonagh: “In the mid-market, there will be debt available for the right transactions, although there are very few to look at. However, activity will return, subject to an alignment of price expectations as much as anything.”

Even in the hardest times, a certain number of transactions trickle onto the market, albeit reluctantly. Often these are dictated by the harsh side effects of the downturn, as firms struggle to maintain cash flow.

McDonagh calculates that, come the half-year turn, transactions will be driven more from choice as investors better understand the economic climate’s impact on company results, and discover a freshly whetted appetite for investment. “They will be able to take a much more rigorous view of the risks they are taking, and how to price those risks,” he says.

He warns, however, that there will be no return to the heady days of the past few years, and companies seeking private equity funding will have to accept that they must sacrifice more equity than they might like. It follows, therefore, that since private equity houses will be in a position to drive a harder bargain, money invested now will be well spent. “Perversely, money invested in 2009 will see some very good returns indeed,” McDonagh explains.

Guarded optimism
Over at Preqin, a private equity research organisation, managing director Mark O’Hare is also in optimistic mood – and his bright outlook is backed up by statistics. “Our prediction for this year is that things aren’t quite as gloomy as everybody else thinks they are,” he says.

He also points out that, although PE has received a pretty bad press over the past year or so, the evidence reveals that it has provided better returns than any other asset class: “Admittedly, there may be some nasty shocks coming, and the way PE funds are valued means that they will become evident over the next three to six months when general partners (GPs) put a value on their portfolios.

“There are a lot of limited partners (LPs) sitting in their offices and waiting for the bad news to land on their doormats, but it remains to be seen how extensive the problem will be,” says O’Hare.

“Our view is that it is largely funds from the 2005-06 vintage that will be badly hit because they were invested most heavily in 2006-07. Even then, not every fund will be a loss-maker.”

A buyer’s market

Preqin believes that, when the dust dies down, investors will look around and see that private equity has suffered no more than any other asset class. “Once the paralysis we are in has passed, LPs will start committing again to new funds,” says O’Hare. “We are in a hiatus, which will be followed by a short ‘nuclear winter’ in which few funds are raised, but sometime soon – possibly in the second half of the year – things will come back.”

Meanwhile, the time has come to make hay. O’Hare says there have rarely been better opportunities to “buy low and sell high”, which is a compelling reason for investors to commit to funds.

For managers who have already raised funds but not yet invested, the immediate future is positively golden. “The opportunities are phenomenal,” O’Hare says.

McDonagh would agree. “History shows that the returns that PE houses make from money invested at the bottom of the cycle are the best returns they get,” he comments. “That’s a reason to be cheerful – and they are very hard to find these days.”

Hot investments

Preqin’s Mark O’Hare singles out a number of hot areas where he believes there is opportunity for well-informed investors:

Distressed debt funds – He believes these are going to do “incredibly well” as the economy recovers over the coming months and years: “There are lots of companies going into liquidation, no matter what their ownership, and that situation presents opportunities.”

Turnaround funds – These also view the current climate as fruitful as liquidations increase. Woolworths and Waterford Wedgwood are prime candidates for this type of investor, and there will be many
others as the recession deepens.

Mezzanine funds – O’Hare feels these are making a strong comeback after several years out in the cold. Until recently, there has been so much cheap cash sloshing around in the system that mezzanine specialists have found few opportunities. He believes this will change.

Emerging markets – He particularly tips these to perform well: “In the current crisis, the risk premium has gone up and people are shying away from emerging markets, but if you stand back and look at the fundamental growth story in these markets, it’s much more robust than in the developed economies.”

Clearly some segments of private equity will do better than others, but the golden years of private equity are gone.

The same can be said about commercial real estate where property activity is at a 12-year low:

U.S. commercial real estate activity slowed to its weakest level in 12 years in the fourth quarter, signaling another six- to nine-month slump, the National Association of Realtors said on Thursday.

Commercial real estate prices, meanwhile, fell 14.9 percent in 2008 to levels last seen in 2005, Moody's Investors Service Commercial said in a separate report on Thursday. From their peak in October 2007, prices have fallen 16 percent, Moody's said.

The NAR's index of commercial brokerage activity declined 6 percent to 109.2 last quarter from a downwardly revised 116.1 in the third quarter, the industry group said in a statement. It was the lowest reading since the last quarter of 1996, an NAR spokeswoman said.

The index is down 9.1 percent from a year ago, driven by the lack of credit for commercial property and as the U.S. recession reduces demand for office, industrial and retail buildings, the trade group said.

"A lack of commercial credit is a serious threat to the overall economy," Lawrence Yun, chief economist at the NAR, said in a statement.

Increased stress in commercial real estate led the Federal Reserve last week to include the assets in a program to expand consumer lending, which it also boosted in size to up to $1 trillion from $200 billion. The term asset-backed securities lending facility (TALF) is set to be launched soon.

Office and retail markets will likely take the brunt of the slowdown, the NAR said.

In offices, vacancy rates will probably rise to 16.7 percent by the third quarter from 13.4 percent in the year-ago period, it said. Retail vacancy rates may climb to 13.4 percent from 9.8 percent in that period, it said.

And Canada is not immune to the commercial real estate slump as returns hit a 14 year low.

Finally, there are hedge funds where high-quality funds will emerge stronger from the war of attrition:

Hedge fund managers, once the swashbuckling frontiersmen of international finance and subject of fawning cocktail party banter, have quickly gone from hero to goat. As the global credit bubble burst with a vengeance in 2008, so too did the oft-touted myth that these alternative strategies could deliver positive results in any market.

But those claims painted the universe with too broad a brush. There has always been a difference between arbitrage funds that isolated structural inefficiencies, and speculators that either didn't hedge or used the ability to short stock as a means of leveraging directional bets. Clearly it should never have been expected that a fund that was short financials and long commodities, as many hedge funds were last year, would have a market neutral, "absolute return" profile. The majority of Canadian offerings fall into that camp, so it's no surprise we've seen stark declines among many of our homegrown funds.

To be sure, even many arbitrage funds have been badly stung, and many, many hedge funds will disappear in the next six months as a war of attrition rages. But the ones that survive may just find that the next two years are very good to them.

The return of mispriced assets

Arbitrage opportunities are the low hanging fruit of modern investing. In their purest form they represent the chance to make risk-free profits because some inefficiency has caused two identical securities to temporarily diverge in price. These opportunities are the bread and butter of most traditional hedge fund strategies.

In the years preceding the current mess, with the size of the hedge fund world expanding apace, as soon as the price of anything broke out of its normal range there was a wave of capital pushing it back in line. The increased competition had killed, or at least badly maimed, the golden goose. That's one of the reasons equity volatility was so muted between 2002 and 2007, despite major events like the Iraq War, Hurricane Katrina, and the $6 billion implosion of hedge fund Amaranth Advisors. It also explains why hedge funds were strapping on more and more leverage: the size of the mispricings had become so small they needed to magnify them artificially, and credit was abundantly available.

Now some of that low hanging fruit is back. With volatility at record levels and desperate hedge funds reversing their trades to get out of them quickly, mispricings are everywhere and those with the means can take their pick of compelling opportunities.

Indiscriminate selling

With redemption requests flooding the inboxes of hedge funds and mutual funds alike, good names are being dragged down alongside the bad as investors rush for the nearest exits in equities and corporate bonds.

While the direction of markets is unpredictable in the near term, it seems reasonable to assume that quality companies will once again be separated from their weaker counterparts. Hedge funds that can buy an industry's leaders and short its likely casualties are poised to benefit from that differentiation, even if a broad-based rally is slow to materialize.

Food for vultures

The current crisis had its roots in esoteric derivatives that repackaged subprime mortgages. In fact, anything with an acronym -- CLO, CDS, ABCP -- seemed to draw some blame for the ensuing rout. Complex instruments were uniformly scorned and experienced sell-offs of massive proportion.

Invariably the pendulum swings too far in both directions, and as time passes there will likely be tremendous buying opportunities in areas like convertible bonds and asset-backed securities. This is a realm of the market that most pension and mutual funds don't venture into, either because it's not in their mandate or they don't have the analytical resources. Look for a few well-capitalized hedge funds to swoop in for major bargains in some of these complex securities.

There will also be the potential for strategic acquisitions. In financial markets, disaster breeds opportunism, and as large companies and trading operations teeter on the brink of failure there will be self-interested parties ready to scoop them up on very favourable terms. The winners in this game will be those with flexible mandates and access to cash. When Amaranth collapsed in the fall of 2006, J.P. Morgan Chase and hedge fund Citadel Investment Group bought up the fund's entire trading book at distressed prices. More recently, manager John Paulson, whose hedge funds are among a small group that experienced significant gains in 2008, was one of the acquirers of failed Californian bank IndyMac, along with fellow hedgie George Soros.

As many observers have noted, the global hedge fund industry has begun, and will continue, to go through a well-needed shakeout. Lured by hefty paycheques, traders and rocket scientists began opening hedge funds to the point of saturation, with fewer and fewer market opportunities to justify their existence. From the perspective of unitholders, certain structural aspects of the archetypal hedge fund are undesirable, such as high fees and poor disclosure, and these will need to improve as the asset class matures.

Many funds will soon close their doors forever, but those that survive will emerge with increased market share and a renewed chance to make big profits across the spectrum of tradable securities. As high-volume, fast-acting trading entities, hedge funds are still very important prime brokerage clients for the major banks. Having that VIP status, large hedge funds will be among the first to regain the ability to apply leverage and borrow stock.

Canadian hedge funds are still narrowly focused within the commodities space, and long-biased, so investors seeking market-neutral opportunities will be hard pressed to find them within the stable of domestic managers. But many Canadian-based funds of funds have a global scope, and thus may provide indirect access to a broader swath of strategies.

As the bifurcation sets in between the quick and the dead, monitoring the group's results will be harder than ever. Hedge fund index statistics will be unreliable as survivorship bias takes on more and more significance. Even numbers that incorporate fund failures, such as the returns on funds of funds, will, by averaging out the winners and losers, mask the extremes at either end.

Beware of hedge fund indexes like Tremont which got burned by Madoff. [Note: The Caisse uses Tremont as their hedge fund index.]

As hedge funds and private equity funds get regulated, only the very best funds that cater to stringent institutional requirements will survive. I believe there will be a premium on true alpha, transparency and liquidity in the hedge fund space.

To sum up, the balance of power has shifted and limited partners need to refocus and carefully think about how or even if they will invest in alternative investments.

I will come back this weekend to write a piece on putting teeth into pension transparency.

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