Friday, March 6, 2009

Death of Highly Leveraged Illiquid Strategies?

It was another volatile session in the stock market on Friday following the dismal jobs report:

Wall Street ended another difficult week with an equally difficult session Friday: Stocks rose, fell, then clawed their way back to a mixed close after the Labor Department released its February jobs report.

But while the market finished well above its lows -- the Dow Jones industrials had a modest gain after falling more than 120 points -- many market watchers say there's no reason stocks can't slide further, even as the major indexes are near 12-year lows.

"My sense is we haven't discounted all the negatives out there as of yet," said Rob Lutts, president of Cabot Money Management.

Big institutional investors are still largely waiting for positive signs from the economy before making any major commitments. As a result, the market is largely being driven by "short" traders, who sell borrowed stock and then buy it back later in hopes that the price will decline in the meantime. That makes for a choppy, unpredictable market -- one that analysts expect to stay erratic for the forseeable future.

"The shorts are having a complete field day in this environment," said Kent Engelke, managing director at Capital Securities Management in Glen Allen, Va. "Right now you have everybody so fearful, and these shorts are controlling the market."

Some of the week's economic data, including retail sales and factory orders on Thursday, were better than expected but not enough to encourage investors to buy. The February jobs numbers on Friday were worse than analysts forecast, but not as bad as some investors had feared; but that also didn't motivate many investors to take chances on stocks.

Employers cut 651,000 jobs last month, and the unemployment rate jumped to 8.1 percent. The government also revised its December and January job loss figures up to 681,000 and 655,000, respectively.

News of continuing struggles in the banking industry and concerns about General Motors Corp.'s survival are only intensifying the market's uneasiness. Wells Fargo & Co. became the latest bank to cut its dividend, and the market waited to see if GM would be forced to seek bankruptcy protection.

You can bet that many banks will follow Wells Fargo, slashing their dividends in the next few months. And as terrible as those job cuts are, the worst is yet to come:

Over the last six months, 3.3 million jobs have been lost. That's the largest six-month job loss since the end of World War II.

Even adjusting for the large growth in the nation's job base in recent decades, this is still the biggest six-month job loss since March 1975.

Economists say the steepness of this decline will make it tougher for the job market to improve any time soon. The increasing job losses create a downward spiral in which businesses, faced with lower demand because people can't afford to buy their products, lay off even more people.

"The dramatic hemorrhaging of jobs means we're in this for the long-haul," said Heidi Shierholz, economist with Economic Policy Institute, a Washington think tank supported by foundations and labor unions.

Another reason why this downturn is more painful is because the layoffs have come from companies in virtually all parts of the economy.

"There's no place to hide in terms of job losses," said Lakshman Achuthan, managing director of Economic Cycle Research Institute. "And when measuring the impact of job losses, it's very important how pervasive the losses are. That's what makes this the worst since the Great Depression."

Achuthan points to something called the diffusion index of employment change, which showed that three out of four business sectors cut jobs in February. Job losses were even slightly more widespread in December and January, meaning that 83% of industries have lost workers over the last three months.

According to Achuthan, this was the first time in the past 30 years that there have been job losses in more than two-thirds of the sectors of the economy. When the recession started in December 2007, about 58% of industries were still adding jobs.

February marked the 14th straight month of job losses, the third-longest streak since 1939.

This long period of job losses is swelling unemployment rolls to record levels and causing long-term unemployment to rise sharply.

In February, 3.4% of the nation's workers had been out of work for 15 or more weeks, with nearly 2% of that total being out of work at least six months. Several states' unemployment funds have run out money as a result.

And most economists think the job market woes are far from over. Many economists are projecting job losses through the end of the year.

But even when the job losses end, the unemployment rate is likely to continue rising. That's because the modest hiring that will follow the downturn won't be enough to make up for population growth and unemployed Americans who had become discouraged starting to look for jobs again.

With that in mind, Dean Baker, co-founder of the Center for Economic and Policy Research, said he thinks the unemployment rate will hit a peak of above 10% sometime in 2010.

Finally, economists caution that the unemployment rate only captures a portion of Americans unable to find full-time jobs. It doesn't count people working at part-time jobs but cannot find a full-time job, for example.

And the average number of hours worked per week is now at a record low, according to Labor Department readings.

The unemployment rate also doesn't count many people who tell the Labor Department they want to work but haven't looked for work recently.

The government has a so-called underemployment reading which counts people working part-time jobs for economic reasons rather than by choice, as well as some who have become discouraged from looking for work.

That measure hit 14.8% in February - the highest reading since the Labor Department started calculating it back in 1994.

But there are other discouraged job seekers who are not looking because they don't think they can find work, have decided to return to school, or for other personal reasons. Counting all of those people in the underemployment rate takes it to 16.7% in February.

Comparable figures aren't available from the Labor Department for the pre-1994 period, but there are full-year government estimates for those outside the labor force who wanted to work in earlier years.

Using those figures, the underemployment rate reached a high of 21.5% in November 1982. While that's higher than this February, it's probably not fair to compare the current reading to the worst result of that downturn since most believe this jobs crisis is far from over.

"No one is going to tell you we're at the trough," said Baker.
As stated in the first article above, big institutional investors are in no hurry to buy stocks, waiting for some sign that the economy is bottoming. That's why short sellers are betting the market will continue to fall.

As some hedge funds are making money (short-sellers), most are struggling in these markets. Reuters reports that hedge fund investors likely lost money again in February as some high profile managers, including John Paulson, reported small declines:

Paulson, who correctly predicted the subprime crisis, saw his $3.5 billion Paulson Credit Opportunities fund and his $2.3 billion Paulson Credit Opportunities II slip 0.93 percent each in February, people who saw the funds' numbers said.

Since January, these funds are up only a smidgen, disappointing investors who still swoon over their 589.62 percent and 351.72 percent returns, respectively, in 2007.

[Note: Paulson made a killing last year betting against everyone. Don't expect him to ever repeat that performance.]

For investors in activist manager William Ackman's fund that bets exclusively on retailer Target, February brought more bad news with the fund off 33 percent after having lost 40 percent in January, people familiar with the numbers said.

William von Mueffling's well-respected $1.8 billion Cantillon World Ltd fund was down 2.19 percent in February even though the fund is up 7.55 percent year-to-date.

Mark Mobius' $1.3 billion Templeton Emerging Market fund lost 0.88 percent last month, putting it down 13.13 percent for the year.

James Palotta, who split from Tudor Investments and is now running his own firm, said his fund was off 2.15 percent in February, leaving it off 2.47 percent for the year.

And Paul Tudor Jones' $6.8 billion Tudor B.V.I. Global Fund inched up 1.71 percent in February, leaving it up 4.61 percent year-to-date.

Overall the average hedge fund will likely be down slightly in February after having gained about 1 percent in January, industry analysts who track performance said on Thursday.

Trackers like Hedge Fund Research and Hennessee Group will begin to release their numbers in the coming days.

Even though these loosely regulated portfolios again outperformed the broader Standard & Poor's 500 stock index, industry analysts said these numbers and overall nervousness about stumbling markets will prompt investors to keep pulling money out of the once red-hot asset class.

"We expect that there were more outflows in February," said Conrad Gann, president of research group TrimTabs. "We are seeing money flow out of the market on all sides -- mutual funds, exchange traded funds and hedge funds," he added.

In January, TrimTabs said investors pulled $93 billion out of hedge funds after having pulled out $118 billion in December, which was the bulk of the $167 billion taken out in all of 2008.

Since hedge funds are only loosely regulated they are not required to report performance or assets and so any information on their returns is closely scrutinized.

Even large hedge fund firms like Och-Ziff Capital Management Group LLC, which manages roughly $22 billion and is one of the few publicly traded hedge fund firms, is bracing for more redemptions.

"We believe the industry-wide redemption cycle is not yet over," the company's chief executive officer, Dan Och, said last month after investors pulled an estimated $5.4 billion out of the company last year.

Industry analysts expect global hedge funds, which boasted $1.9 trillion in assets at the start of 2008, to shrink to about $1 trillion this year.

The reason why the redemption cycle is not over is simple: most hedge funds did not hedge properly in 2008. They got slaughtered just like everyone else and to add insult upon injury, they closed the gates of hedge hell, collecting management fees while gating.

The road back for hedge funds will not be easy. The Chicago Tribune reports that Citadel Investment Group posted its second straight profitable month in its two largest hedge funds, which declined in value by 55 percent last year:
The Kensington and Wellington funds gained 2.6 percent in February, according to sources. That builds on a 4.75 percent uptick in January for the $10 billion funds.

Last year was the worst performance in the 19-year history of the firm, which transformed its founder, Ken Griffin, into a billionaire by repeatedly besting the markets.

After losses in 2008, Kensington and Wellington need returns of more than 90 percent before Citadel begins collecting performance fees again.
In these markets, there is no way they will return 90% on those funds, which is why Citadel decided to roll out several new funds, including one with lower fees that will aim to make money on currencies, interest rates and other trades based on broad economic trends:

The firm hopes to raise $2 billion in coming months and could raise $5 billion for its new Citadel Global Macro Fund Ltd, the paper said citing marketing documents.

Citadel is also preparing to market a fund focused on stocks and another focused on convertible bonds, the Journal said citing people familiar with the matter.

Ken Griffin is no idiot. He is shrewd and he knows there is a shift in the balance of power going on right now. In order to survive, he is lowering his fees and moving into liquid global macro strategies, which allows him to scale up (so lowering the fees will not hurt as much if he finds enough investors to commit some sizable amounts to these funds).

He wants a piece of that global macro pie, knowing full well that highly levered illiquid strategies are dead for a long, long time (if you have any doubts, click on the chart above displaying the dismal performance of the Palomar Structured Credit Hedge Fund Index).

But if you really want to look at highly levered strategies getting pummeled, look no further than private equity. Bloomberg's Matthew Lynn writes that private equity needs fixing before it's too late:
Bankers, regulators and politicians are behind the curve. They are like workers rushing to clear up a car crash armed only with aspirin and Band-Aids: too late on the scene, and not able to do much when they get there.

The next phase of the credit crunch, and quite possibly the ugliest as well, is plain to see. The leveraged-buyout funds have loaded up too many companies with too much debt at the wrong prices. They are like planes still in the air with no fuel left in their tanks. Crashes are inevitable.

Private equity needs to be fixed now, with refinancing, stress tests, and government stakes if necessary. There is no point waiting until it is too late.

The pain is evident in the shares of the publicly listed funds. Blackstone Group LP, the world’s largest quoted private- equity firm, has slumped to about $5 from more than $30 in 2007. Last week, it reported a fourth-quarter loss of $827.1 million.

In the U.K., 3i Group Plc has dropped to less than 2 pounds from 11 pounds in late 2007. Shares in Candover Investments Plc are close to 2 pounds after trading at more than 22 pounds last year. The company said the value of its assets halved last year. In response, it has scrapped the dividend and said it will cut jobs. Meanwhile, KKR & Co. said this week the value of investments in its publicly traded buyout fund fell 32 percent in the fourth quarter.

Signs of Trouble

Six months ago, the slumping share prices of many banks were sending clear signs of trouble ahead. Buyout funds are emitting the same distress signals now. Worse, that is just what we can see. Most private-equity investments are exactly that: private. We have no way of knowing what the whole picture looks like. It is hard to believe there won’t be a lot more pain, just as there was in the banking industry.

There is no big mystery about that. Private equity was partly about re-invigorating tired and lazy management. In fairness, it often did that job a lot better than many critics gave it credit for. It was still mostly about re-engineering balance sheets so they supported more debt. With loans evaporating fast, a lot of companies will run into trouble.

Typically, buyout funds liked to purchase big companies in solid industries, the kind that employ lots of people. It doesn’t matter that much when a few bankers lose their bonuses. If businesses controlled by buyout funds collapse, tens of thousands of people will be thrown out of work.

Cash in Bank

First, the buyout funds need to start restructuring their deals now. There is no point waiting until the last minute. If this is the deepest recession since the 1930s, only businesses with rock-solid balance sheets will pull through. They are going to need cash in the bank. And they will have to be in strong enough financial shape to borrow more if necessary. Not many private equity-owned companies fall into that category. They need to start working on that immediately.

Next, the regulators have to stress test every major private-equity deal of the past three years. Buyout firms bought a lot of companies at the top of the market. In many cases, the bondholders will have to swap debt for equity, and that equity is probably going to fall in value, sometimes sharply. That is just tough. The bondholders will lose money anyway. They might as well not take businesses down with them. But the regulators need to knock heads together now so they accept that.

Lastly, governments in the U.S., the U.K. and elsewhere may need to step in. Where there are problems restructuring debt into equity, there may be no alternative to government stakes in businesses, even if only for a short period. The state may end up owning shares in some odd-looking enterprises. Yet even six months ago we wouldn’t have thought such a situation was possible with many big banks. It is better than doing nothing.

We hear a lot of rhetoric from governments around the world about what they are doing to cope with the crisis. Unless they are willing to get ahead of the curve, it is mostly just hot air. Fixing the private-equity bust is the place they should start.

Mr. Lynn still doesn't get it. The party in alternative investments is over and private equity will go through its worst crisis ever. The only PE funds that will survive this brutal shakeout are the ones that have managing partners with real operational experience (not financial engineers, but guys and gals that can roll up their sleeves and restructure a company from the head down).

Importantly, private equity lags public equities and the economic recovery. Unless we get clear indications that the economic recovery is underway, there is simply no reason to believe that private equity (or real estate) will recover any time soon.

In an era of deleveraging, deflation and D-process, highly leveraged illiquid strategies are dead, busted, finito, tutta kaputo. Given the destruction they have caused, I say good riddance!

No comments:

Post a Comment