Wednesday, January 27, 2010

Private Equity to Gain from New Glass-Steagall?

President Barack Obama's State of the Union address Wednesday is unlikely to translate into dramatic congressional action anytime soon, but it was a phenomenal speech.

The focus was clearly on jobs, which remains the most pressing concern as over 7 million US citizens lost their jobs during this recession. However, President Obama also made it clear that health care reform will remain among his top priority and he urged Congress to finish the job.

One interesting swipe came when President Obama took issue with a recent Supreme Court decision to allow for unlimited campaign donations by corporations (read about the pros & cons of this decision here). The president's comments drew an irate response from Justice Samuel Alito who was obviously one of the judges who voted for this stupid decision.

This brings me to my latest topic, private equity. The Lords of finance were out again, talking up private equity. Jennifer Rossa of the WSJ reports, Apollo's Leon Black Staunchly Defends Buyout Industry:

Leon Black, president and chief executive of Apollo Management, defended Wednesday the private-equity model and the deals done by big buyout shops during the boom years.

"I think it's a pretty good model for an asset class," Black said in a keynote address at the Private Equity Analyst Outlook conference. "I believe in it. I put my own money in it."

Discussing deals done at the top of the boom, he questioned whether Apollo and other firms like it were wrong to pay as much as they did for companies. They were willing to pay more then because the companies for sale were better and because the financing was "incredibly attractive," he said.

"Now you can say these guys overpaid," Black said. "When you look at things at the nadir of the cycle, you're right."

Black agreed that Apollo has made its fair share of mistakes but said that overall he believes the good outweighs the bad by far.

"Apollo has done bad deals in its history," Black said. "Linens N Things was a terrible deal. Having said that, if you look at [the fund that did the deal], we made 21 investments. That portfolio was the best portfolio in our history." He said that fund, Apollo Investment Fund VI LP, has generated a 64% internal rate of return.

Results like this make it easier to have tough conversations with limited partners, Black said. California Public Employees' Retirement System late last year pushed Apollo for more favorable terms, including a lower management fee.

Black didn't directly address the Calpers discussions but said he believes the firm's management fee is already quite low.

"I think we've had a 20-year relationship with our LPs," Black said. "They have every right to complain ... but I do think they believe this is still a very good asset class if you're with a top-quartile performer."

Black also said he believes the opportunity to invest in distressed commercial real estate will be huge and that Apollo will be a player in this area. And he seemed sanguine about the possibility that carried interest taxes may be raised, telling the audience that a higher tax "wouldn't be the worst thing in the world."

Reuters was more specific on where Black sees opportunities in real estate and commodities:

Private equity firm Apollo Management founder Leon Black said on Wednesday he sees investment opportunities in commercial real estate, commodities, metals, energy and agriculture.

He expects to do more distressed investments on a select basis, and sees opportunity for investing in finance-related assets. Black was speaking at a private equity conference in New York sponsored by Dow Jones.

Apollo, which has investments in firms including gaming company Harrah's Entertainment and real estate broker Realogy, has been an active investor in credit and distressed assets.

It said in November it had $13.4 billion of uncalled capital commitments -- or "dry powder" to spend.

Its latest fund, the $14.7 billion Fund VII, started investing in January 2008 in the midst of the economic downturn.

Black conceded that Apollo has done some bad deals, citing Linens 'n Things, a retail investment that filed for bankruptcy protection as sales slumped.

"Linens was a terrible deal but if you look at Fund V, which Linens was in, it was the best (overall) portfolio in our history, and Linens was a wipeout."

Apollo has also been moving closer to following rivals onto the New York Stock Exchange, and in November it updated a regulatory filing regarding its plan. Rival Blackstone Group listed in 2007 and Kohlberg Kravis Roberts & Co, which is listed on Euronext, is expected to move to the NYSE.

Apollo originally filed with the U.S. Securities and Exchange Commission in April 2008 -- before the market slid -- to register securities already traded on a private exchange and said it planned to list them on the NYSE.

Black said on the sidelines of the New York conference that he hopes the shares will be listed by the end of the first quarter, but said the timing was up to the SEC.

Asked whether he expected tax on carried interest to rise -- a controversial debate for private equity -- he said that "when you're dealing with the world of politics nothing is inevitable."

The U.S. House of Representatives has several times voted to increase taxes on carried interest -- compensation earned by hedge fund and private equity fund managers for money management.

These individuals now pay a capital gains tax of 15 percent. The proposal would treat such compensation as income and therefore be taxed at 35 percent.

U.S. President Barack Obama included the proposal in his 2010 budget, though the idea has failed to gain momentum in the U.S. Senate.

"The government is, as it should be, looking for every revenue source," said Black. "It wouldn't be the worst thing in the world for some adjustment," he added.

Others are also selectively betting on commercial real estate. Lavonne Kuykendall reports in the WSJ that Weak Commercial Real Estate Market Hides Deals:
Bonds aren't getting a lot of love lately, as high-profile investors such as Warren Buffett say they favor equities right now.

Bill Bemis, portfolio manager for Aviva Investors, a unit of Aviva USA Corp., manages the group's securitized asset portfolio. He believes there are some great bond deals to be had, particularly in securities backed by commercial mortgages--even as expectations for a downturn in that market grow.

Aviva Investors is a global asset manager whose customers are primarily institutional investors. The group had $362 billion in assets under management at June 30, 2009.

Aviva Investors' fixed income capabilities can be summarized by comparing the net performance of their Core Aggregate portfolio to the Barclays U.S. Aggregate. In the fourth quarter of 2009, Aviva Investors rose 0.77%, compared with the benchmark's 0.2% rise. Over three years, Aviva Investors rose 7.33%, compared to 6.04% for the benchmark.

The minimum investment required for the Core Aggregate portfolio is $25 million. "We expect higher delinquencies, falling property values and lower rents, and commercial mortgage property values will decline in 2010 as well," Bemis said. Market fear over the performance of commercial mortgage bonds is still high, he said, but "that doesn't necessarily mean there is no value in [commercial mortgage-backed securities]."

Even though he said he expects to see the commercial real estate market continue to deteriorate for at least the next year, Bemis said his group is adding exposure to commercial mortgage-backed securities, but only at the highest credit enhancement level, which typically means the triple-A or most protected of the securities.

Bemis buys securities backed by "seasoned" 2005 and earlier mortgages. After that, underwriting on the loans began to deteriorate, he said, just as it did in the residential market, though not to the same degree.

"Our view is that currently you are getting more than compensated for the risks which lie ahead in the commercial real estate market," Bemis said.

Bemis is more bearish on mortgage-backed securities packaged by Fannie Mae (FNM) and Freddie Mac (FRE), the government sponsored enterprises that ran into trouble as the residential mortgage market imploded over the past two years. Bemis expects those securities to underperform in 2010, as the Federal Reserve pulls back on purchasing.

"That is a general theme for 2010," Bemis said. "What happens as the government starts to pull back on some of the stimulus they have put out there?"

For his part, Carlyle Group co-founder David Rubenstein said the private equity industry is still weighing its response to proposals from President Barack Obama’s administration related to limiting banks’ risky bets:
“The private equity industry is not certain what position to take because if we come out in favor, it may not pass, so I’m not sure we should say anything,” said Rubenstein. “I suspect something along those lines will get done in a transition in three to five years so no dramatic affect right away.”

Obama made a proposal this month to limit the size of banks and prohibit them from investing in hedge funds and private equity funds as a way to reduce risk-taking and prevent a repeat of the financial crisis. The plan would also bar banks from running proprietary trading operations solely for their own profit.

Congress may pass some regulatory reforms because of public pressure, though the final outcome remains unclear, Rubenstein said. It is too early to know whether new regulation will be “good or bad” for private equity firms, he said.

Getting national regulatory solutions is “difficult enough,” so getting multilateral solutions are “almost impossible,” he said.

Some think the new reforms will benefit the private equity industry. Jim Kim of Fierce Finance asks, Private equity to gain from new Glass-Steagall?:

Wall Street collectively shuddered at the thought of a new Glass-Steagall. But not all sectors of Wall Street will be affected in the same way. The private equity industry--firms that are not owned by banks anyway--may even gain.

The Financial Times notes data from consulting firm Prequin that shows banks provide only 9 percent of all private equity investments. So the top banks in this arena, mainly Goldman Sachs (GS) and JPMorgan (JPM), do not stand to be affected in the main.

The wider industry may also welcome the changes. If a bank ends its private equity investment business, "it will no longer get first look at deals the investment bank is working on. Smaller fund managers will welcome the level playing field."

At the same time, if a target goes bankrupt, will the bank be able to assume ownership? It's unclear. If a bank will not be able to hold principal investments, that line of assumed protection goes away. Costs may rise, but that may not be the case. There may be a fine distinction.

Let me end by stating that my favorite part of President Obama's speech was how he ended by talking about the growing cynicism gripping Americans. He made reference to the "resilience" and "values" that helped shape America. He also noted, in the past, politicians didn't sign bills for the next election, but for the next generation. Let's hope this wasn't empty rhetoric and that both he and Congress will pass meaningful reforms.

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