Tuesday, March 10, 2009

The Inner Circle of Systemic Risk?


Wall Street had its best day of the year, storming higher after some good news from Citigroup:
Citigroup Inc. says it operated at a profit during the first two months of the year. That energized financial stocks and in turn, the entire stock market. Surprised investors drove the major indexes up more than 5.5 percent to their biggest one-day rally of the year. The Dow Jones industrials shot up nearly 380 points.

However, many analysts are still cautious -- noting that Wall Street has seen many blips higher since the credit crisis and recession began. Word of Citi's performance broke a months-long torrent of bad news from the banking industry but analysts weren't ready to say the stock market was at a turning point and about to barrel higher after a slide that's lasted more than 16 months.

"To have a sustained rally, we have to have a shift in sentiment," said Kurt Karl, chief U.S. economist at Swiss Re. "One day isn't going to make a trend."

Still, the Citigroup news offered investors some hope that the first quarter will show signs of improvement.

In a letter to employees Monday, Citi Chief Executive Vikram Pandit said the performance this year has been the bank's best since the third quarter of 2007 -- the last time it booked a profit for a full quarter. Based on historical revenue and expense rates, Citi's projected earnings before taxes and one-time charges would be about $8.3 billion for the full quarter.

Pandit declined to say how large credit losses and other one-time items have been that would at least partially offset profit.

Citi surged 38 percent while Bank of America Corp. jumped 27.7 percent. The stocks are among the 30 that make up the Dow. All the components of the index climbed Tuesday.

Today's action reminded me of what happened back on September 18th when Operation "AIG" went into full effect. On that day too, financial dogs rallied sharply as short-sellers covered their positions and the Dow surged 410 points (3.86%) in a frenzy of short-covering activity.

The explosive rally followed comments that the SEC may revive the "uptick" rule and that Federal Reserve Chairman Ben Bernanke was considering modifying mark-to-market accounting.

The question on everyone's mind is whether this rally has legs. David Spurr writes this rally is the real deal (for a while anyways), but the Financial Ninja reminds us that you don't put THE bottom with a spike in Libor.

I chatted with my favorite strategist this afternoon, Martin Roberge of Dundee Capital Markets, who recently called for a second chance in the second quarter:

Need a psychological boost as U.S. stock markets touch new 12-year lows? In addressing the key issue of whether this latest dip will be temporary or sustained, Martin Roberge, portfolio strategist at Dundee Capital Markets, believes the answer is temporary. But you may have to wait until the second quarter to see any gains.

He pointed out that global cyclicals (including energy stocks, materials and technology) have recently outperformed defensive stocks (consumer staples, telecoms and utilities), which suggests that investors are not positioning themselves for a sustained stock market trough.

“Thus, as long as liquidity/credit conditions are thawing, market breadth is resilient and global cyclicals' outperformance is maintained, investors should not assume sustained new market lows,” he said, in a note.

He said that if history is any guide, then the first quarter will mark the low point for the stock market, while the second quarter – hey, just one month away – will mark a recovery. For that reason, he is bullish on crude oil and energy stocks.

“Surprisingly, history shows that crude's upside potential is the highest when supply is contracting and demand… falling,” he said.

We will see how things shape up in the coming days and weeks in the stocks market, but I am cautious knowing that it could just be another massive short-covering rally.

The possibe changes to mark-to-market accounting, however, couldn't come soon enough for private equity feeling the pain as investment values fade:

For a brief moment, as record after record was smashed, it seemed that private equity buyout prices were destined to keep rising.

As the last few weeks have demonstrated, it was a falsehood – and a grossly expensive one at that.

After the boom period saw private equity firms compete among themselves to buy ever bigger companies for even bigger sums, the value of those investments is now tumbling.

Last week, Candover Investments and SVG Capital, which are listed, wrote down their 2008 net asset value by 50pc and 64pc respectively. Both are now reviewing their strategic options.

3i, meanwhile, saw the value of its top 50 investments fall 21pc in the fourth quarter.

Of the unlisted firms, Guy Hands's Terra Firma wrote down EMI, its biggest investment, by €1.3bn (£1.2bn), while Permira made the unusual (for it) decision to confirm it too had written down its portfolio, by 36pc.

Of the US firms, Blackstone wrote down its private equity portfolio by 20pc for the fourth quarter, while KKR Private Equity Investors – known as KPE, it is the New York buyout giant's listed arm – reported a 47.5pc annual decline in NAV.

That included a $170m (£121m) writedown on Alliance Boots, the high street chemist and wholesaler. The sale of the FTSE 100 group was one of the most high-profile private equity deals of recent times, selling in 2007 to Kohlberg Kravis Roberts and Stefano Pessina, the group's deputy chairman, for £11.1bn.

Private equity firms use various means to value the companies and stakes they acquire. The most common is earnings multiples at comparable public companies and share prices. As the credit crunch and economic gloom widen, these indicators have tumbled to new lows, and firms have had to adjust values – even if the individual businesses are not always performing badly.

Private equity investments are held for the long term, normally for between three and five years. So even if values are falling in the short term, there is every chance comparable prices will recover by the time it comes to exit. But under new accounting rules, firms must value companies as if they were being sold today. Hence the flurry of miserable updates from the normally opaque world of private equity.

And few expect the bad news to stop here. "There will be more impact from comparable multiples in the short term," confirms Iain Scouller, analyst at Oriel Securities.

Share prices are already lower than they were since the start of the year, with the FTSE 100 off nearly 900 points, and no one is convinced that the market has hit the bottom.

As one private equity insider notes: "We have got to be realistic about these things. Public companies have come off substantially and it's a really difficult world out there. Will there be more writedowns? It's just impossible to say."

Analysts find it less impossible, however, and expect more to come through this year as the recession takes hold and the profits and earnings at portfolio companies start to suffer.

Some in the industry have sought to address this early. Nicholas Ferguson, chairman at SVG Capital, said there was a "reasonable cushion" in the 2008 writedowns.

Speaking after the firm's results last week, he added: "We live in challenging and uncertain times, no one knows what's going to happen. The sensible assumption is that it's going to remain difficult."

SVG wrote down values across the portfolio, including Valentino Fashion Group, the majority shareholder in Hugo Boss. SVG wrote down its investment by £92.2m to £78.6m, but was harsher with others: it cut Gala Coral's value to zero. Two other firms own the gaming group with SVG: Candover has confirmed it has written down its investment to zero and Cinven is also thought to have.

There is some good news to be garnered from all this misery, however. The first is the growing expectation of a flurry of secondary buyouts this year. Mr Scouller said that as stock markets continue to fall, some investors – particularly the larger insurance companies and pension funds – may feel too exposed to private equity and seek to exit investments as they rebalance portfolios.

Likewise, a number of private equity firms will not be prepared, or for some even be able, to hold on to badly performing assets.

According to the latest 2009 Preqin Global Private Equity Review, cash is available. While previously strong fundraising dropped off in 2008, "eight of the 20 secondaries vehicles currently on the road are targeting commitments of $2bn or more. If these vehicles were to close on target in 2009, they would raise aggregate capital of almost $27bn."

The private equity market is by no means over. Buyouts will resume: many firms have cash, but are hampered by credit markets grinding to a halt. Long term, analysts expect valuations to rise again – although the optimism is tempered by a significant caveat.

"The biggest downward risk to values is with the large leveraged deals," says Mr Scouller. "Where values will hold up better is the mid-cap, European deals. 3i is quite well positioned from that point of view, because it hasn't been chasing the really mega deals that KKR or Permira were."

In other words, some private equity firms paid too much at the top of the market and even over the long term, values are unlikely to recover to such heady levels.

Yet smaller, less high-profile deals – where acquired companies were not loaded up with as much debt – should fare better. And after all, the long term is what private equity is all about, no matter what records, high or low, are broken in the short term.

As Mr Scouller notes: "In private equity there are only two numbers: the price you pay for the business and the price you exit the business for. What happens in between shouldn't really matter."

That is why some people think that all that matters is valuing private equity at cost and at sale when you exit the deal (cash on cash returns). The problem is that you still need interim valuations as you hold illiquid investments on your books.

Private equity's woes are now hitting pension funds that are under pressure to meet private equity calls:

Pension funds could come increasingly under pressure to meet private equity fund call-up obligations in the medium to long term, a report a Preqin reveals.

The research firm’s 2009 global private equity review said some institutional investors have expressed concerns about their ability to meet these obligations due to liquidity issues.

It quoted a European investor saying “all limited partners should be worrying about meeting fund call-up obligations” in the longer term.

Despite this, Preqin said 92% of investors surveyed did not anticipate being unable to fund capital calls in the next 12 months, 6% said they might and 2% said they were unsure.

The report also said there were cases of pension funds becoming overweighted towards private equity due to the decline of public market valuations. The California Public Employees’ Retirement System (CalPERS) currently has 13.3% of its total assets allocated to private equity, while its target allocation to the asset class is 10%.

The survey found 21% of investors have already exceeded their optimum level of exposure.

It said many investors took actions to alter their short term plans for investing in private equity because they unexpectedly found themselves closer to their targets – although a majority of them (79%) said they had not exceeded their target allocations to the asset class.

In alternative, some investors widened acceptable private equity allocation ranges to overcome to rebalancing issue.

The California State Teachers Retirement System (CalSTRS) opted to widen the its investment range from 4%-11% to 3%-15%, when it found itself overallocated to private equity with 14.4% of its portfolio invested in the asset class.

In terms of future commitments to the asset class, 40% of respondents said their plans had changed and 56% said they would continue to invest in the asset class as normal.

Of those, 35% will be making fewer investments in 2009 than they had in recent years, 17% have opted not to make any further commitments to private equity and 17% will be more cautious than before.

Investors are right to proceed cautiously in private equity. All they have to do is listen to Stephen Schwarzman, chief executive of the Blacktone Group, who sounded a down note today:

“Between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half” by the global economic crisis, Mr. Schwarzman told an audience at the Japan Society in New York on Tuesday, according to Reuters. “This is absolutely unprecedented in our lifetime.”

Mr. Schwarzman said he saw potential in Treasury Secretary Timothy F. Geithner’s plan to unfreeze credit markets through a new program that would combine public and private capital to buy toxic bank assets of up to $1 trillion.

“In all likelihood, that will have the private sector buy troubled assets to clean the banks out in terms of providing leverage,” he said, “so that we can get more money back into the banking system.”

He said he expected the private sector to end up making “some good money doing that,” but added there were complex issues on how to price toxic assets.

Mr. Schwarzman is feeling the pain of the economic crisis. Earlier this month, Blackstone disclosed that his 2008 compensation had fallen 99.8 percent, to $350,000, as the private equity firm earned virtually no incentive fees from harvesting profitable investments.

Mr. Schwarzman also warned against regulation which he thinks could hurt young people’s desire to enter the financial services industry. (Our society should only be so lucky!)

Finally, on the issue of regulation, Private Equity Beat's Shasha Dai writes on the inner circle of systemic risk:

Does private equity pose a systemic risk?

That’s an issue much on the mind of the industry of late, as the world’s governments start addressing how to better regulate financial institutions that do pose systemic risk, so that we can in future avoid a crash of the type that we’re currently living through.

Regulators aren’t getting too detailed on this particular issue just yet. While a recent European Commission proposal identified PE firms (and hedge funds) as “systemically important,” Federal Reserve Chairman Ben Bernanke didn’t mention either in a speech this morning in which he outlined a potential path forward for regulators. (Although we wouldn’t have either, given that Carlyle Group’s David Rubenstein was moderating the speech, to the Council on Foreign Relations.)

For the academic view, we turn to professors at New York University’s Stern School of Business, who step directly into this thicket in a recent white paper entitled “Regulating Systemic Risk.”

The paper defines systemic risk as “the failure of a significant part of the financial sector – one large institution or many smaller ones – leading to a reduction in credit availability that has the potential to adversely affect the real economy.” It argues - uncontroversially - that commercial banks aren’t the only ones that present systemic risk. So too does the “shadow banking sector,” which consists of “investment banks, money-market funds, insurance firms, potentially even hedge funds and private equity funds.”

The paper calls for banks to pay a “tax” on their systemic risk that would look something like the insurance that commercial banks buy for their deposits with the Federal Deposit Insurance Corp. Banks could be required to buy insurance against a potential loss to the financial system caused by their failure, the paper says. If they fail, the payout from insurance companies would go to a federal “systemic crisis fund,” instead of to the institutions themselves.

Viral Acharya, a co-editor of the paper, said that more regulation of private equity firms is needed because they receive cheap financing from banks, and if their portfolio companies do poorly, that in turn hurts banks and the broader economy. However, he doesn’t think the tax scheme outlined above should be applied to PE firms.

While regulators can use some transparency into how private equity funds operate, like how their portfolio companies are being run, Acharya said, the private nature of those entities should be protected because “by and large, we find private contracting is quite efficient.”

“If you regulate the banking sector right and tax systemic risk of banks, that will indirectly make it more expensive for private equity firms to borrow from banks,” Acharya said. “I don’t find a strong rationale for directly regulating the shadow banking system. The problem is not private equity funds per se. If banks were not lending so cheaply, private equity funds would not have levered up so much. You need to fix the banking sector, rather than going after private investors directly.”

In a way, what Acharya has in mind is different layers of regulatory oversight, for lenders and for those they lend to. That idea is one that is gaining credence elsewhere. The International Monetary Fund proposes just that in a recent paper, writing that “a two-tiered approach with an outer and an inner perimeter is envisaged.All financial institutions within the outer perimeter would have disclosure obligations to allow the authorities to determine the potential of the institution and its activities to contribute to systemic risk.

Those institutions within the wider groups that are recognized as being of systemic importance, based on broadly agreed and disclosed parameters, would be in the inner perimeter and subject to higher levels of prudential oversight.” The inner circle, the IMF said, would consist of both banks and non-banks.

The NYU paper and others will be published in an upcoming book, called “Restoring Financial Stability: How to Repair a Failed System.” The executive summaries can be downloaded here.

I would add pension funds into the equation as their reckless actions often go unreported but clearly they too contributed to systemic risk by investing trillions into alternative investments.

Moreover, many pension funds invested using "portable alpha" strategies that rely on swaps, exposing them to potentially serious counterparty risks.

Any measures to "regulate systemic risk" must include pension funds into the equation as they go unnoticed but their allocations to alternative investments and exposure to counterparty risk can lead to disastrous results.

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