Friday, August 31, 2012

Will The Fed Give Into QE Brats?

Pinchas Landau of the Jerusalem Post reports, We want quantitative easing now:
There is something profoundly pathetic about the fact that the dominant concern of the entire financial world for the last two weeks has been what the chairman of the Federal Reserve Board, Ben Bernanke, will say at the annual late-summer gathering of central bankers and senior economic figures, held at Jackson Hole, Wyoming. The words that will issue from Bernanke’s mouth will, supposedly, be critical for the financial markets and for the American and global economies.

This is what it has come to, five years into the global economic crisis and four years after the “Lehman moment” that sent the crisis spinning out of control and placed the entire world on the very edge of a major depression. It is axiomatic in mainstream financial circles that: a) the actions of Bernanke and his fellow central bankers at that time prevented the descent into depression; b) his subsequent policies, meaning various iterations of “unorthodox monetary policy,” aka “quantitative easing” (QE), have enabled the American economy to mount a slow recovery from “the Great Recession” that occurred in 2008-09; c) ergo, if Bernanke will announce another round of QE, or some other form of what is now being called “unorthodox unorthodox policy” – since the old “unorthodox” is the new “orthodox” – then the outlook for the American and world economies will instantly brighten.

Thus, if Bernanke announces, or even discusses, or merely hints in his speech on Friday that the Fed will pump several hundred billion dollars into the markets, every market in the world will rally. If, on the other hand, he fails to announce, discuss or even hint that action is coming, then he will be deemed as having “disappointed” the markets, and they will promptly plunge.

Furthermore, it had been hoped or believed that Bernanke’s opposite number at the European Central Bank, Mario Draghi, would also attend the Jackson Hole conference and that he, too, would announce new steps, measures, actions – or at least substantive plans – whereby the ECB would buy large quantities of sovereign bonds of crisis-ridden European countries such as Spain and Italy. However, earlier this week Draghi announced that he was canceling his participation in the J-Hole show. That meant he had nothing to say there – and the cause of his silence is no secret, since the argument between him and the German central bank, the Bundesbank, and its representative on the Governing Council of the ECB, is being played out in full public view in the newspapers, news services and financial TV daily and almost hourly.

No such open opposition faces Bernanke. Nevertheless, after literally millions of words of analysis and commentary had been spoken and written during August as to whether and what he would say on Friday, a consensus emerged this week, one that embraced even the perma-optimists among the financial houses and their strategists: that he would not announce, discuss or hint at anything new or substantive.

Against this background, the hopeful expectation that had permeated the markets turned to ex ante disappointment, so that on Thursday the mood turned negative and the direction of prices of shares and bonds across the world followed suit.

However, what is both pathetic and tragic is the very fact that what Bernanke or Draghi say or do is seen as the be all and end all of financial and economic developments.

Implicit in this approach is not merely the belief, noted above, that the central bankers saved the world last time and their subsequent actions have kept things steady, but that they can and will do so again – and again, as many times as necessary. This is such obvious drivel that one wonders how anyone can believe it – after all, if a policy of zero interest rates and central banks buying government debt is so desirable, why did nobody do it before 2008? And if its benefits are so clear-cut, then why is there any hesitation or debate? Bring it on – the sooner the better, and the more the better.

Yet the Germans will not let Draghi run amok, and something is holding Bernanke back as well. This is actually not very mysterious, because any objective examination of the impact of the policies followed over the past four years reveals that each round of QE has had successively less impact, and that impact has lasted a shorter period each time. That’s what economists call “diminishing returns.” In addition to declining benefit (some leading economists believe there was none and that it was fiscal policy, especially the Chinese stimulus program, that saved the day in 2008), the pursuit of unorthodox monetary policy has costs, and these actually rise cumulatively. The distortions introduced into the economies of countries subjected to QE-type policies make it an unsustainable approach in the long run.

But the essence of policy these past few years has been to survive in the short run and push off the inevitable day of reckoning. In that context, QE makes a warped kind of sense – and that’s why the markets want it, if not now, then soon. The possibility that it will not come, or that if it comes it won’t work, is unpalatable – because the alternative to the make-believe “recovery” it sustains is unthinkable.
Whoah! Yesterday afternoon spoke to a sharp hedge fund manager in New York who was explaining to me how most economists and fund managers simply don't understand the way banks create money and the monetary policy transmission mechanism, "which is why guys like Paulson are snapping up gold believing QE will cause inflation" (he's in the debt deflation camp).

He also told me that the day the psychological effect of the Bernanke put is over, "will be the scariest day ever in financial markets." Luckily, he doesn't see such a doomsday scenario anytime soon, but if the Fed does go ahead with QE and markets don't react, or a significant selloff ensues, that will be damn scary.

We also talked about the pathetic performance of hedge funds and he agreed with me, most won't survive another annus horribilis. "The year is effectively done. With only 10% beating the S&P, the best they can hope for is a market crash in the next three months so their performance doesn't look as lousy." He added: "I agree with you, don't see a crash coming."

Not only do I not see a crash coming, regardless of what Bernanke of Draghi say or do, I see the opposite, a rally in risk assets. In fact, I have openly stated that the Fed doesn't need to engage in another round of quantitative easing, stoking another bubble. The US recovery is taking hold and employment data over the next six months will demonstrate this. Moreover, stock market is close to new highs, hardly any reason to panic.

But watching market action lately has been painful, akin to watching paint dry. It never fails to amaze me how risk assets drip lower right before a major monetary policy announcement as the brats on Wall Street want to force the Fed into action, providing them more money for nothing and risk for free.

Well, sorry to disappoint these brats but they can forget about more quantitative easing this Friday. If the Fed caves into their demands, it might backfire in a spectacular way, something that they can ill-afford at a time when the recovery is finally taking hold.

I for one think the Fed did an excellent job, managing the crisis as the political loonies demand more austerity. They used quantitative easing when they felt they had to and are going to take a wait and see approach before committing to more action (update: I was right).

Let me end by stating that markets will likely sell off on the news of no news, which will lead people will panic over the weekend. Whatever happens, don't panic, risk assets will come back, especially if the August US jobs report due out next Friday shows employment growth picking up stream.

If I was the Fed, I would disappoint the Wall Street brats looking for their QE fix. A polite but firm "fuck you" and let's all get back to investing and stop waiting for more Fed action.

Below, Federal Reserve Bank of St. Louis President James Bullard said he’d like to see more economic data before deciding on “big action” at the next meeting of policy makers. He speaks on Bloomberg Television's "Bloomberg Surveillance."

And Bloomberg's Peter Coy, Tom Keene and Sara Eisen discuss whether the markets need more quantitative easing by the Federal Reserve. They speak on Bloomberg Television's "Bloomberg Surveillance."

Finally, Michael A. Gayed, CIO at Pension Partners, was interviewed on Bloomberg discussing Europe, the ECB, stocks, bonds, and more. Listen carefully to his comments on 'central bank paranoia' and what will happen if stock markets collapse.

Thursday, August 30, 2012

Changing Of The Old Private Equity Guard?

Greg Roth of Reuters reports, Wisconsin jettisons stakes in Blackstone, Carlyle, KKR:

The $83 billion State of Wisconsin Investment Board last month sold $1 billion worth of funds, at least three of them managed by publicly listed private equity firms, in part because those firms could no longer demonstrate that the pension fund's interests came first.

The pension fund joins a wave of limited partners that are selling interests in funds, including the New York City pension system and the California Public Employees' Retirement System. Many cite a desire to shrink their private equity portfolios to make them more manageable. Wisconsin may be the first to publicly cite a misalignment of interests with public firms as a reason to sell.

Wisconsin's private equity adviser, StepStone Group, advised the pension that "select mega buyout firms have embarked on initiatives that reduce the alignment of interests between GPs and LPs, including: asset aggregation and going public or selling stakes to third parties." Implied is that publicly traded buyout firms, in serving the interests of public shareholders, may not always act in the best interest of their limited partners.

If other pension funds were to follow Wisconsin's lead, it would almost certainly cause private equity firms that were considering IPOs, or selling stakes to third parties, to reevaluate those plans. Wisconsin's secondary sale included positions in 12 funds managed by six private equity firms, including The Blackstone Group (BX), Kohlberg Kravis Roberts & Co. (KKR) and The Carlyle Group (CG), according to Wisconsin spokeswoman Vicki Hearing.

Meantime, the $122 billion New York City pension system just completed a secondary sale of nearly $1 billion in private equity stakes in 11 funds managed by nine different firms.

"We clearly have too many relationships," said Barry Miller, the private equity chief for the New York City pension system. "We want to write larger checks to fewer managers," he said, adding that the ideal number of GP relationships was in the "50 to 70 range."

New York City's secondary sale helped reduce the number of relationships to 99 from 108, a drop of nearly 10 percent. It also helped to raise money that can now be allocated to New York City's current stable of managers.

The city's pension system has been trying to shrink its roster of GP relationships ever since Lawrence Schloss became the system's chief investment officer. Among the positions discarded in the sale were commitments of $215 million to two funds from Clayton, Dubilier & Rice; $227 million to two funds from Silver Lake Partners; $75 million to a fund from Thomas H. Lee Partners, and stakes in funds from AEA Investors, Ethos Private Equity, HM Equity Management, New Spring Ventures,Tailwind Capital and Vitruvian Partners.

The $240 billion California Public Employees' Retirement System also has been eager to shrink its stable of private equity relationships. But the motivation of Joe Dear, CalPERS' chief investment officer, isn't just to make things more manageable for the pension's staff. Having too many relationships and too many funds "drives the performance toward the median," said Dear in an August interview. "We want to have a more concentrated, selective portfolio that produces a higher return," he said.

CalPERS has further to go in culling relationships than most funds, mainly because of its giant size. Even after three recent secondary sales, the pension fund still has more than 350 GP relationships and more than $46 billion in private equity commitments, making it the largest and most diversified private equity program in the nation. Even so, said Dear, as he discussed the restructuring, "we're making good progress."

I haven't spoken to Réal Desrochers in a while but surely he's busy cleaning up CalPERS' private equity portfolio since being named its head last June. When running private equity at CalSTRS, prior to joining CalPERS and a brief stint in the Mideast with another large fund, Réal had a simple philosophy of writing larger cheques to fewer funds.

This is fast becoming the norm in the pension industry as investors realize that too many relationships with GPs are hard to manage and worse still, you end up getting some sort of PE index performance with huge performance dispersion between top decile managers and the rest.

What about Wisconsin Investment Board last month sold $1 billion worth of funds, at least three of them managed by publicly listed private equity firms, in part because those firms could no longer demonstrate that the pension fund's interests came first?

I saw this coming a mile away and will caution anyone else in the alternatives industry thinking of going public, if you don't maintain alignment of interests, you're toast!

Of course, don't shed a tear for the Carlyles, KKRs and Blackstones of this world, they're doing just fine, still raising billions in buyout funds, refocusing their attention on carve-outs.

Carlyle just announced its acquisition of DuPont's auto-paint unit for $4.9 billion, becoming the most active US private-equity buyer this year in part by employing a 25-year-old strategy that helped fuel its growth: taking over unwanted businesses from large companies.

But pension funds are starting to wake up with hedge funds and private equity funds, emphasizing alignment of interests. In private equity, there is a shift from the old guard. PEHUB reported that New York committed $600M to Ares, Trilantic and Palladium:

New York City’s five pension funds made $600 million in fresh commitments to three private equity funds, according to a spokesman for the New York City Comptroller’s Bureau of Asset Management, which manages their assets. As of June 30, 2012, the five pensions had combined assets of $122 billion.

The three new commitments are $300 million to Los Angeles-based Ares Management’s Ares Corporate Opportunities Fund IV LP, $200 million to New York-based Trilantic Capital Partners’s Trilantic Capital Partners V LP, and $100 million to New York-based Palladium Equity Partners’s Palladium Equity Partners IV LP.

Ares Management’s newest fund closed in August, having reached its $4.7 billion hard cap, which was substantially more than its original $4 billion target. The firm needed just six months to reach that mark, and the results from prior funds may explain why.

The previous fund in the series, the 2008 vintage Ares Corporate Opportunities III LP, had garnered a net IRR of 25.5 percent and a 1.7x return multiple, according to New York City pension data from Dec. 2011. Funds I (2003) and II (2006) also performed well, with both of them delivering net IRR’s above 13 percent and return multiples of 1.6x. Fund IV marks the fourth time New York City’s pension system has contributed to Ares.

And the New York City pension system is not alone in its interest in Ares. Other pensions to have committed to Fund IV are the Florida State Board of Administration, which committed $200 million; the New York State Common Retirement Fund, which committed $150 million; the State of Wisconsin Investment Board and the New York State Teachers’ Retirement System, each of which pledged $100 million; and the New Mexico State Investment Council and Indiana Public Retirement System, each of which contributed $75 million.

The New York City pension system’s $200 million pledge to Trilantic’s Fund V is also notable. Trilantic, which was spun out from Lehman Brothers in 2009, is looking to raise $2 billion for its new fund. The vehicle has already gathered $100 million from the Pennsylvania Public School Employees’ Retirement System.

This is the third time the New York City pension system has pledged to a Trilantic fund. The previous fund, the 2007 vintage Fund IV, raised $1.9 billion, and has so far generated a 13.9 percent net IRR and a 1.3x return multiple, according to New York City data from Dec. 2011. Fund III, which closed in 2004, was returning a 13.4 percent net IRR and a 1.5x return multiple, according to the data.

The third and final fund that the New York City pension system committed to was Palladium’s Fund IV. The city’s pension system contributed to Palladium’s prior fund, the 2004 vintage Fund III. That fund was returning a net IRR of 15 percent and a 1.5x return multiple as of Dec. 2011.

Fund IV is looking to raise $800 million, so New York City’s commitment will represent an unusually large 12.5 percent share of the fund’s overall holdings. One other pension known to commit to the latest fund from Palladium was the Los Angeles Fire and Police Pension System, which pledged $10 million to the fund this month.

The five municipal pension funds that are managed by the Bureau of Asset Management are the New York City Employees’ Retirement System, the New York City Teachers’ Retirement System, the New York City Police Pension Fund, the New York City Fire Department Pension Fund, and the New York City Board of Education Retirement System.

New York City’s municipal pension system has 6.8 percent, or $8.4 billion, invested in private equity. The system’s private equity target is 6.5 percent, and the system’s managers say they need to commit $2.5 billion to private equity each year just to maintain the program’s current size.

I can tell you Ares, Trilantic and Palladium are not the big brand names of the past but they're delivering strong, if not exceptional, performance and managing the size of their funds carefully, aligning their interests with their pension fund investors.

In Canada, earlier this month, the Public Sector Pension Investment Board (PSP Investments) announced that it's returning to the secondary market to shop about $1.5 billion in private-equity fund stakes:

The portfolio for sale is made up of concentrated positions in large buyout funds managed by private investment firms including Apollo Global Management LLC (APO) and Apax Partners LLP, according to the people, who asked not to be identified because the information isn’t public.

Cogent Partners, an advisory firm based in New York, is managing the sale. Mark Boutet, a spokesman for Montreal-based PSP Investments, declined to comment.

Again, these too are well known funds up for sale in the secondary market, which goes to show you even brand name funds get shunned by big investors when they don't perform up to snuff.

In the case of PSP, the secondary sale is also part of an effort to bring more assets internally to invest directly in private equity, lowering fees and having more control over investments (just like CPPIB, PSP typically co-invests with funds).

One private equity expert shared these thoughts with me:

It's not alignment of interest issues driving this, it's lack of performance, and/or as likely expected portfolio problems during the immense refinancing to come in 2013 to 2015. The great myth is that these name brands have delivered, in fact most of their performance is highly transient and cyclical, and based on the logarithmic growth in the industry performance remains mostly reliant on the valuation of unrealized portfolios of huge scale.

If investors focused on life IRR net of fees and F/X costs the picture would be more straightforward, not necessarily bad but just more obvious as to the risks and full cycle reality. Also, private equity programs need to be measured with the portion of life IRR identifying realized vs. unrealized returns. It's not hard to do this. Valuation is imprecise, and that's ok, just don't declare victory on unrealized performance.

Low transparency and annual or even shorter term score cards for long term investors has led to epic capital market distortions, the outcome simply favouring the short term trading model of investing, and current short term yield at the expense of capital preservation - which approaches may indeed have huge investing merit for the times, so its not really bad for investors, but it is bad for companies and economies which have long term needs that are not being consistently served, especially smaller companies.

It's also usually very costly to vend to the secondaries markets, institutions who are reversing decisions in illiquids are not long term investing, and probably washing out much of their historical net life IRR with these sales. Irresponsible or brave and wise decisions? Depends on the philosophy driving the decisions.

Private equity as an activity remains viable, but only at a regional or specialized boutique scale, or if at larger scale in highly flexible and/or low transaction volume mandates (which would not fit into typical allocator benchmark frameworks and/or diversification preferences). This is how the industry was born, and original track records of appeal were created.

The idea of writing large cheques to fewer firms is a step in the right direction but in effect contains/sustains the problem, and is not the solution. It's simply hard to do private equity well, at any scale and especially at large scale, and requires sustained resources and high efforts. Large cheques to large firms appear to be decisions of expedience and convenience, rarely the qualities behind good investing decisions.

Large private equity funds and firms are in effect awkward conglomerates without synergies among holdings, and no liquidity and huge frictional costs associated with buy and sell/IPO of holdings. Remember what happened to the 1960's conglomerates? Bad business model.

The good news is the industry will fade and right size (just as large scale venture investing died slowly over a long time) along with the timeline of the larger than life personalities behind it, hopefully some younger and/or less fashionable minded people will create new and flexible boutiques under the radar and allow for transformation to a more useful scale and style of investing.

The private equity renaissance will be quietly supported by high net worth people, and smaller institutions with open minded ways of solving for the timeless investment conundrum. And, some secondaries investors will do really well, if the underlying franchises can transform/survive, or at least liquidate with necessary patience.
Great insight. Below, Cristina Alesci discusses private equity groups that are involved with government contractors. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock."As you can see, big government means big business for big PE funds. Oh, the irony!

Wednesday, August 29, 2012

Annus Horribilis Seals Hedge Funds' Fate?

Kate Kelly of CNBC reports, Paulson & Co. Facing Some Frustrated Investors:
Many of Paulson & Co.'s investors hung with it last year despite an annus horribilis in which the company's flagship hedge fund lost 35 percent. But with returns continuing to sag amid a rising equities market, some of those investors are now jumping ship.

Citigroup (C) announced last week that it was pulling Paulson off its hedge-fund investment platform and planned to take back $410 million in assets.

Morgan Stanley's (MS) brokerage firm has reportedly had the fund company on watch for possible removal from its hedge-fund platform for months now. And other investors big and small are considering redeeming their capital soon as well, say bank officials and fund of funds managers.

During a phone call with clients and employees of Bank of America late Tuesday, Paulson & Co. founder John Paulson said he was “disappointed” about the loss of Citigroup as an investor, according to someone briefed on the call, but noted that the bank’s platform accounted for less than 2 percent of his company’s overall investments. Paulson also said that he wanted to “reaffirm” his commitment to the flagship fund and the “entire business,” this person added.

Still, the investor scrutiny comes at a sensitive time for the money manager.

These developments come at a difficult time for John Paulson, the former Bear Stearns banker who opened his eponymous hedge fund eighteen years ago.

Paulson has gone from managing more than $38 billion in assets at his company's peak to $19.5 billion today. And while a number of his funds are up this year - including the merger fund, which is up 3.6 percent, and the recovery fund, which is up 3.9 percent - his flagship funds, which consist of holdings that represent an array of different strategies, continue to suffer.

Even worse has been Paulson’s gold fund, which he acknowledged during the BofA call as the worst-faring in his portfolio so far this year. But given the tumult in Europe, which the fund-company founder thinks could benefit the yellow metal, Paulson remains bullish on gold over the next five years, according to the person briefed on the call. (Indeed, the Bank of America executive who led the call described Paulson’s funds as a great way to play the “gold miner thesis,” this person added.)

So far this year, Paulson's main flagship fund, known as Paulson Advantage, is down about 13 percent, according to people familiar with the matter, and its levered sibling, Paulson Advantage Plus, is down 18 percent. And while the so-called redemption window - the moment at which investors can pull back, or redeem, their capital from a hedge fund - varies for Paulson investors according to which fund they are in and when they invested, the protracted slump in the flagship funds is prompting hard looks at investor portfolios.

"Given the success he had, [Paulson] is going to have a longer leash than other managers. But at some point, every investor has to decide to lock away if they don't see it coming again," said Nick Bollen, a professor of finance who studies hedge funds at Vanderbilt University's Owen Graduate School of Management.

Even though Paulson performed phenomenally well during the credit crisis, Bollen added, "there's no assurance that he'd be able to make similar timely calls in the future."

One fund of funds manager who redeemed investor money from the Advantage fund during its downturn last summer said he thought that Citigroup was simply late to recognize a plummeting investment, and that the bank should have fired Paulson months ago.

Still, other investors said it made little sense to redeem their money even after the losses of 2011, given that Paulson is now so far below his high-water mark - the asset level at which he must stay in order to charge fees to his investors - that he is now essentially managing their money for free.

In addition, added a second fund of funds manager, pulling Paulson off a platform like Citigroup's is problematic because it runs the risk of locking in losses, rather than letting clients who still like Paulson's funds to remain involved and potentially enjoy future upside returns.

"Clearly, [Paulson] has not performed well," said the money manager.

"We'll certainly discuss the pros and cons with our clients prior to the [next] redemption date," he added, which, in his case, would be the end of this year.

Paulson investor redemption windows vary according to individual fund and the timeframe of the original capital inflows. Some Advantage investors, for instance, are on quarterly redemption time frames, while others are on semiannual or even annual ones.

In all cases, investors must provide 60 days' notice if they want to pull out their money.

While Citigroup has already closed Paulson funds off to new investors, its redemptions will play out over a yearlong period that begins in March 2013, said someone familiar with the matter.

I agree with the investor who pulled out of Paulson months ago. I would have invested with Paulson prior to the crisis and jumped ship after his outsized returns during the crisis.

As I wrote in the rise and fall of hedge fund titans, the media portrayed Paulson to be some sort of investment god, and many dumb funds chasing performance got whacked investing in his funds after the crisis.

Reuters reports that Paulson soothes nervy investors on BofA conference call, but Josh Brown of the Reformed Broker blog commented that it was a tough crowd on the Paulson call:

Using my advanced ninja skills I got myself onto the Bank of America Wealth Management-hosted conference call starring John Paulson of Paulson & Co this evening.

The notoriously press- and attention-shy Paulson agreed to be on the call a week after Citigroup pulled $410 million from the hedge fund manager and so at least some part of this was about damage control.

Paulson was quick to point out that Citi's financial advisors had not pulled their support for him directly, rather it was Citi's feeder fund. He also expressed gratitude to the BAML advisors for their longstanding relationship with Paulson & Co.

And then it was game on.

I have a few observations I'd like to make, in no particular order...

First, Paulson was measured during his introductory remarks and did not at all come off as defensive. He seemed to have kept his cool through a barrage of questions, some smart and some stupid, that were lobbed at him from the brokers.

Also, the fact that he agreed to the call counts for a lot, many upper-tier hedge fund managers would simply say, "they don't like the performance or the strategy? Let 'em leave." Which you can still do when you're running $19 billion, even if your AUM was double that 24 months ago.

The Merrill guys did not seem to be overly hung up what's already gone on, although they did reference it in framing their questions. No, they were much more curious about the current strategy and holdings, which is how it ought to be.

One question concerned the Recovery Fund which over the last three years seemed to have missed out on the recovery, with almost flat performance in the context of the ninth biggest bull market in history.

Specifically, John was asked to defend his overweights to the casinos like MGM and CZR. The concern seemed to be Macao was cooling off and Vegas was dead - what's the thesis here? John made the case that in a truly robust economic recovery (which has yet to materialize) these positions would be highly levered to the upside.

Another advisor asked about the various positions that seemed to contradict each other - "crosscurrents within the portfolio." He's referring to being long gold and short the euro for example, trades that would appear to cancel themselves out. "How do I frame this for clients and in what environment would this portfolio work?" the perplexed advisor wanted to know. JP's answer was that a lot of these should be looked at as hedges as opposed to opposing trades.

There were a few questions about personnel at the firm. One advisor asked about whether it was a coincidence that a bank analyst departed around the same time that Paulson & Co trimmed some of their bank holdings and I don't recall if there was a straight answer or not.

The real question is whether or not the call did more good than harm. I truly came away from it with a deep respect for John's thought process but not a lot of clarity in terms of how this collection of trades is meant to work going forward. I wanted to be more impressed than I was.

The intro to the call by the Merrill guy was about how Paulson had evolved from an arb guy into an investor who is much more macro-oriented as a result of his experiences during the 2007-2009 Greatest Trade Ever era. But of all the macro calls I've been on - and let me tell you something, I've been in meetings with Felix Motherf*cking Zulauf and at dinner with Jim Chanos - this one gave me the least confidence that there is any kind of hidden depth or the potential that the manager is seeing something no one else sees.

So to sum up, I have a ton of respect for John Paulson...but if I were a Merrill broker with a lot of client cash parked in his funds, I might be facing a really tough decision this fall about whether to stick it out.

That's a nice way to say if he were a broker with a lot of client cash parked in his funds, he'd be nervous as hell now.

Go back to view Paulson's holdings in my comment on top funds activity during Q2 2012. As shown below, Paulson significantly increased his stake in 15 holdings, chief among them was the SPDR Gold (GLD) Trust (click on image to enlarge):

Bloomberg reports that Paulson & Co., which owns the biggest stake in the SPDR Gold Trust, increased its holdings to 21.8 million shares in the three months through June.

The question that all investors should be thinking hard about is why pay Paulson, Soros or some other 'hedge fund god' 2 & 20 in fees to go long gold? Paying 2 & 20 for beta on a gold ETF is simply insane!

Moreover, brokers were right to note "crosscurrents in the portfolio". Paulson hedged his outsized bet on long gold/ short euro by adding a new stake in JP Morgan in Q2. In my opinion, that was his best move last quarter.

The most ridiculous comment I read above is that given that Paulson is now so far below his high-water mark - the asset level at which he must stay in order to charge fees to his investors - that he is now essentially managing their money for free.

Really? For free? That 2% management fee is being charged regardless of the terrible performance and that goes for all hedge funds and private equity funds. Come rain or shine, you can be sure these funds are collecting that 2% management fee!

When pensions invest billions in alternatives, these management fees alone add up to a huge chunk of change. And when they invest in hedge fund or private equity fund of funds, they get a double-whammy on fees (an extra 1 & 10 over the 2 & 20).

Luckily, many large US pension funds are finally waking up and taking action. aiCIO reports that MassPRIM has no regrets over breaking up with funds-of-funds:

The Massachusetts’ public pension system is adamant about directly investing with hedge funds—and its initial foray into the strategy has been an unqualified success.

“All indications so far say it was the right thing to do,” Board Chairman and State Treasurer Steven Grossman told aiCIO. “It’s going well—we’re steadily moving funds. Certain assets we can get at right away, others we have to wait.”

The Massachusetts Pension Reserves Investment Management Board (MassPRIM) is just over a year into the process of pulling out nearly all of its funds-of-funds investments, cutting ties with most of those asset managers, and reallocating those assets directly into hedge funds.

At this point, Grossman estimated, about 60% of MassPRIM’s hedge fund allocation is directly invested, with the target being 85%. Pacific Alternative Asset Management Co. (PAAMCO) takes the entire remaining 15% for funds-of-funds investments heavy on emerging managers. “That’s an area we want to broaden our outreach to, and we’re doing that through PAAMCO,” he said.

“We were paying an extra 84 basis points over standard direct management fees on our funds-of-funds investments,” said Grossman. “On $5 billion, that’s $36 million. We hadn’t been particularly happy with our returns on those investments. And with funds-of-funds, they do the due diligence, and we’re simply more comfortable doing it ourselves.” Given all of these factors, the $48.8 billion fund’s board “carefully, thoughtfully decided to make the move.” And move it did.

MassPRIM started with a $500 million pilot project to work out the legal and logistical kinks involved in withdrawing the equivalent of Barbados’ GDP from roughly 200 illiquid investments. “We wanted to test everything out first, and make sure we knew all the details before going ahead with it,” explained Grossman.

Cliffwater, MassPRIM’s advisors for this whole process, concluded that optimal diversification could be reached through direct allocations to roughly 20 hedge funds, as opposed to the more than 200 indirect, often redundant, funds-of-funds investments MassPRIM had been dealing with (and paying for).

And now, a little over a year into the process, what’s the verdict? “You might as well own directly, get close to the source, keep due diligence internal, and save $36 million,” Grossman said. “We’re looking forward to cutting out the middle man and working closely with a group of 20 or so hedge funds that we’ve selected ourselves.”

Smart move, there is no need to allocate to over 200 funds through funds of funds, getting raped on fees, not knowing your risk profile as many positions overlap. Moreover, I like the use of PAAMCO specifically to find emerging managers. This is where funds of funds can add real value and justify their fees.

As far as Cliffwater's assertion that 20 is the 'optimal number' of hedge funds, take that with a grain of salt. Those academic studies have been around for years and have more holes in them than Swiss cheese. 200 funds is ridiculous but so is 20 when you are the size of MassPRIM!

Let me end off by examining the question I asked in my title, will hedge funds survive another terrible year? My short answer is most won't. Paulson has the funds to survive the coming shakeout in Hedge Land but he will likely suffer a long wave of redemptions as investors grow increasingly frustrated with his poor performance.

But most funds that don't have Paulson's multi-billions, and even some that do, are going to struggle to keep their doors open as investors pull the plug on them and funds of funds. It will be very tough, if not impossible, to defend the industry's embarrassing performance two years in a row.

This last point was underscored in a Forbes article from Nathan Vardi looking at the fallout of hedge funds getting clobbered in 2012:

The hedge fund crowd is licking its wounds heading into the Labor Day weekend after getting clobbered by the market. As hedge funds look toward the homestretch of 2012 they will have to pull off a sector-wide miracle to stop 2012 from being one of the worst years their rich industry has ever experienced.

The numbers are truly terrible. Bank of America Merrill Lynch’s investible hedge fund composite index shows hedge funds are up 1.85% so far in 2012. That means investors in many hedge funds are paying big fees for the luxury of getting creamed by the U.S. stock market, which has returned 13.8% in 2012, at least as measured by the Standard & Poor’s 500 index. Goldman Sachs has put out a report showing that the average hedge fund is up 4.6% in 2012 and that only 11% of the hedge funds it tracks have beaten an ordinary S&P 500 index fund.

The big question is whether investors will overwhelmingly lose faith in hedge funds and start heading for the exits in a big way. So far they have only been creeping toward the door, although there are signs investor patience might be coming to an end. Reuters recently reported that a hedge fund administrator’s redemption indicator hit its second-highest level of the year in August and that big investors, like Citigroup’s private bank, in John Paulson’s prominent but struggling hedge funds have requested to redeem hundreds of millions of dollars. Man Group, the world’s biggest publicly-traded hedge fund, has seen its stock drop by 40% this year after its assets under management fell by almost a third.

Investors have stuck with hedge funds through rough times before and have shown they are willing to forgive one bad year. But 2011 was also a loser for most hedge funds. It was one of the hedge fund industry’s worst years ever, with the average hedge fund falling 5% while the S&P 500 returned 2%. Two bad years in a row might be tougher for some investors to accept.

I think two bad years in a row will be the final blow to investors who piled into hedge funds hoping for absolute returns and getting absolute garbage. Could be wrong but the fascination with hedge funds is over as most investors get a rude awakening paying high fees, getting low profits in return.

The best hedge funds will survive this shakeout. Just like in private equity, the divide between the haves and have-nots will grow ever wider but the industry as a whole is playing a loser's game and will suffer the wrath of frustrated investors.

Below, leave you with a fascinating CNBC interview with Tom Barrack, CEO and founder of Colony Capital, discussing why now is the moment to make long-term contrarian bets in real estate and other sectors. Barrack is betting on a US housing recovery (Bloomberg interview) and added to his Mideast portfolio in 2011, another contrarian bet. Watch both interviews below.

My long-term contrarian bet remains in Big Coal, a sector which has suffered a terrible slump due to an 'unusual confluence' of negative factors. Even with all these headwinds, I'd take a position in Big Coal over Paulson's bet on gold over the next five years. Unfortunately, I don't have the luxury of charging 2 & 20 for such beta bets! -:)

Tuesday, August 28, 2012

Defusing Japan's Pension Time Bomb?

Kanoko Matsuyama of Bloomberg reports, Wrinkled Workers Help Defuse Japan’s Pension Time Bomb:

The thought of retiring after more than four decades made Hirofumi Mishima anxious. Instead of looking forward to ending his three-hour daily commute, Mishima wanted to work, even if it meant another hour on the train.

“Keeping a regular job is the most stimulating thing for me,” said Mishima, 69, who spent six months trawling the vacancy boards at a Tokyo employment center after retiring from his $77,000-a-year job as an industrial-gas analyst in 2009. “If I was at home all day, I’d get out of shape and my wife would fret about all the extra chores she’d have to do.”

Mishima is one of 5.7 million Japanese older than 65 still in the workforce for money, health or to seek friends -- the highest proportion of employed seniors in the developed world. While European governments struggle to convince their voters to sign up for longer work lives, Japan faces the opposite issue: how to meet the wishes of an army of willing elderly workers.

Japan’s lower house passed legislation this month that would give private-sector employees the right to keep working for another five years, up to age 65. With the world’s longest life expectancy, largest public debt and below-replacement birthrate, curbing spiraling welfare costs by keeping people in jobs longer may help defuse a pension time bomb that threatens to overturn or bankrupt developed-world governments.

“The raising of the retirement age, it’s a good thing, and more importantly, we have no alternatives,” said Michael Hodin, a researcher at the Council on Foreign Relations in New York specializing in health policies and aging populations. Current concepts of retirement don’t make sense in the context of 21st century demographics, and governments are looking to reframe the social contract, he said.

‘A Disaster’

“If we don’t do that, we’re leading to a disaster,” Hodin said.

The World Economic Forum went further in its Global Risks 2012 report, saying a scenario in which the largest population of retirees in history becomes dependent on already heavily indebted governments could bring lawlessness and unrest to formerly wealthy countries.

Warning signs have started to appear. Unsustainable retirement expenses have helped push cities from Stockton, California, to Central Falls, Rhode Island, into bankruptcy. Illinois lawmakers last week failed to agree on cuts to help plug an $83 billion hole in the state’s pension plans that make them the nation’s most underfunded. Efforts by Greece’s government to reduce spending on pensions and health care sparked riots and strikes earlier this year.

Pension Time

Japan is taking steps to avoid going the same way, as life expectancy -- predicted to exceed 90 years for women by 2050 -- threatens to prolong the time seniors are drawing pensions.

Even without the new legal entitlement, people already stay working in Japan longer than in other developed countries. Men exit the labor market on average at 70 and women at 67, the Organization for Economic Cooperation and Development said in a report last year.

Within four decades, almost half the people in the world’s third-largest economy will be 65 years or older, compared with one in four now. Japan’s working population has fallen 3.9 percent to 65.5 million people in 2011 from the peak in 1997, according to data from the country’s Statistics Bureau. And at 1.4 babies per woman, the birthrate is below the two or more needed to stop the trend.

From April, citizens will have to wait an extra year -- until they are 61 -- to become eligible for their old-age pensions, rising to 65 by 2025.

Welfare costs in Japan are projected to increase 36 percent to 148.9 trillion yen ($1.9 trillion) by 2025, the equivalent of 24 percent of gross domestic product, according to Cabinet Office documents released in March.

Miscalculated Benefits

Delaying the retirement age is one way Japan can plug a shortfall in pension provisions, said Martin Schulz, a senior economist at Fujitsu Research Institute in Tokyo. The deficit is a result of benefit miscalculations made in the early 1970s that led to snowballing public debt, he said.

“Japan’s public-debt problem is just starting,” Schulz said.

More than half of the 34 OECD’s member nations have increased the starting age for pensions. Men in 17 states become eligible for pensions at 65, while more than a dozen countries are delaying it to 67 or later, as governments link pension-age to life expectancy, the OECD said in a report this year.

‘Golden Age’

“Today’s retirees are living through what might prove to have been a golden age for pensions and pensioners,” the Paris- based group said in an editorial accompanying the report. People in future will have to work longer before retiring and live off smaller public pensions, it said.

Japanese like Kazuyoshi Hirota have already accepted that fate. The 69-year-old works 24 hours a week as a manager-cum- janitor of an apartment building in central Tokyo. He retired seven years ago from his full-time security job at the head office of Asahi Group Holdings Ltd. (2502), a brewer.

“The pension isn’t enough to live comfortably,” said Hirota, who lives with his wife Yoko, a cleaner of the same age, in the two-story suburban Tokyo house he bought 40 years ago for 4 million yen -- about $13,000 at the time. “Life is boring without work. My wife says the same.”

Japan, where babies born today can expect to live to 83, has the highest proportion of working seniors in the developed world: 20 percent of people over 65, compared with 14.5 percent in the U.S., 6.3 percent in the U.K., 3.4 percent in Germany, 3.1 percent in Italy and 1.3 percent in France, according to data compiled by Japan’s Statistics Bureau.

Health Costs

Longer working lives do have downsides, including a reduction in per-capita productivity, said Peter Tasker, a founding partner of hedge fund Arcus Investment Ltd. “You are trying to increase the supply of workers even though demand isn’t increasing,” he said. “That probably means the wages go down for everybody.”

Still, keeping senior workers can save on health costs. Nagano in central Japan has the highest proportion of working seniors of any prefecture and its elderly spend the least on health care, according to a 2007 white paper from the Japanese health ministry. In contrast, Fukuoka in the southwest has one of the lowest ratios of working seniors in the country and the highest health costs.

Aging Planet

The University of Tokyo’s Institute of Gerontology is running projects to assess whether jobs at farms, nursing homes, restaurants and kindergartens enable seniors to enjoy a more active, healthier lifestyle, said Hiroko Akiyama, a professor at the institute. The researchers want to create a model that can be adopted across urban Japan, where aging will accelerate as baby boomers retire, she said.

Worldwide, the proportion of people older than 60 years in the population is increasing at more than three times the total growth rate. Within five years, adults 65 years and older will outnumber children younger than 5 for the first time. By 2050, there will be 2 billion people 60 years or older, from 605 million in 2000, the World Health Organization said.

Aging is occurring fastest in low- and middle-income countries, according to the Geneva-based agency, which dedicated this year’s World Health Day to aging and health.

“A transition towards an older society that took more than a century in Europe is now taking place in less than 25 years in countries like Brazil and China,” WHO Director-General Margaret Chan told a meeting on gerontology in Havana in March. “The window for preparatory action has become much smaller.”

It may be easier for Japan to accommodate older workers than elsewhere. Its unemployment rate is 4.3 percent, compared with 8.3 percent in the U.S. and 11 percent in the Eurozone, according to data compiled by Bloomberg.

Komatsu, Mitsubishi

Still, companies would prefer not to be required by law to retain older workers, said Yasuchika Hasegawa, head of the Japan Association of Corporate Executives, the nation’s second- biggest business lobby.

“It’s difficult for businesses to keep everyone,” said Hasegawa, 66, who is also chief executive officer of Takeda Pharmaceutical Co. (4502), Asia’s largest drugmaker. Employers should instead create an environment that enables the elderly to work until they are about 70, he said.

Komatsu Ltd. (6301), the world’s second-biggest construction- equipment maker, rehires 90 percent of its retirees with a 40 percent cut in salaries. “I’m happy to keep workers on after 65, but I don’t think many are physically capable,” Chief Executive Officer Kunio Noji, 65, said in an interview. “Also, it may take away job opportunities for younger people.”

Mitsubishi Estate Co. (8802), Japan’s largest developer by market value, says 11 percent of its workers are over 60 years old and four out of five of those workers stay for another five years.

Precious Resource

“When the working population is falling, the elderly become a precious part of the workforce, and it’s meaningful to hire people with motivation,” the Tokyo-based company said in an e-mail.

That’s not something industrial-gas analyst Mishima lacks. Fifteen days a month, he rises at 4 a.m. and commutes two hours each way to work an 8-and-a-half-hour shift overseeing the supply of hydrogen gas to buses.

“Before my retirement, I worked for the company and got satisfaction from contributing to its profit and growth,” he said. “Now, I work for my health. I’m very happy my job gives me mobility and helps me stay active.”

I like the way this article ends because many older workers are often discriminated against and yet they have the best attitude toward work.

Only mention this because I remember speaking to a young man who just obtained an MBA from a top university and he was complaining that he wasn't getting the 'right offers' to start working.

Told him straight out: "Lose the attitude bud, you're not worth the money you think you're worth. Find a job where you will learn from your colleagues, grow and be happy. Money isn't everything."

Of course, he didn't take my advice. He ended up at some investment bank where he worked insane hours and is now likely complaining about his "shitty bonus" just like most of the greedy, self-entitled, slimy weasels in that field (truly pathetic how warped most are).

Back to Japan. The government is implementing the right measures, raising the age that private sector workers can keep on working but will it be enough? Even Japan's giant pension fund is struggling to solve its funding problems.

Everyone keeps citing Japan's 'public debt problem' and 'scary demographics' but once again, it amazes me how smart people simply don't understand economics and productivity growth. Kate Mackenzie of the FT recently looked into labour productivity vs demographics:

To what extent has Japan’s soft growth over the past 20 years been due to its population ageing? And to what extent unfavourable demographics can be offset by increases in labour market participation (especially by old people) and/or labour productivity gains?

Citi’s Nathan Sheets and Robert Sockin have put together a very useful comparison of (mostly supply-side) measures for the US, Japan and eurozone that examine these questions. They’ve “decomposed” real GDP-per capita down into labour productivity, employment rate, labour force participation, and the share of the working-age population.

Their conclusion: in all three areas/countries, productivity growth has been fairly solid and looks likely to more than offset the increasingly unfavourable demographic changes.

I will let you read this interesting article full of charts to back up their conclusion but the main point is that all the doomsayers warning of Japan or Europe's demographic time bomb are clueless and don't understand how productivity growth is offsetting unfavorable demographic trends.

Below, Bloomberg's Aika Nanao reports on how the Japanese employment agency is catering to its elderly population. Other nations, especially those entering the demographic danger zone, can learn a lot from the way Japan treats its older workers.

Monday, August 27, 2012

Split in Private Equity Funding?

Gregory Zuckerman of the WSJ reports, Split in Private Equity Funding:

The private-equity industry is dividing between haves and have-nots.

As investors become pickier and more closely scrutinize recent performance, some big names are finding it hard to raise as much money as they would like.

But other buyout specialists are seeing a surprising surge of interest, helping them raise big, new buyout funds.

"There's polarization" in the private-equity business, said André Bourbonnais, who oversees the Canada Pension Plan Investment Board's private-equity investments. "It's a tough environment for fundraising for many funds," but those with stellar recent returns are tapping a gusher of cash, he said.

Among those dealing with some investor indifference: Wilbur Ross Jr., the billionaire specialist in distressed assets. Mr. Ross's WL Ross & Co. recently closed a $2.2 billion fund, well below its original $4 billion target, despite two years of marketing. "The environment has been difficult," said Mr. Ross. "Strangely enough, smaller funds will likely produce higher returns by being invested more rapidly."

Providence Equity Partners LLC, a high-profile buyout group focused on media companies, is raising a new fund that is expected to be much smaller than its last after recent mediocre performance. Providence declined to comment.

Some firms are even throwing in the towel on fundraising. Charterhouse Group Inc., a 39-year-old New York firm, for example, has stopped fundraising for its latest fund, after two years of marketing. "As the market has evolved, we are returning to investing on behalf of" a small group of investors, rather than raising money from institutions, said Thomas Dircks, Charterhouse's managing partner. Charterhouse's decision was reported earlier in industry publication

Despite the challenges, Ares Management LLC, a Los Angeles-based firm managing $54 billion, last week closed a $4.7 billion new fund, Ares Corporate Opportunities Fund IV LP. Ares raised $3.5 billion for its last fund. Ares is run by run by Tony Ressler, one of the last bidders for the Los Angeles Dodgers last year, though he lost out to a group including former basketball star Magic Johnson. He also is the husband of actress Jami Gertz and brother-in-law of Apollo Global Management LLC founder Leon Black.

Another big Los Angeles firm, Leonard Green & Partners, LP, a consumer-products specialist with stakes in Whole Foods Market Inc., J. Crew Group and Petco Animal Supplies Inc., recently closed a $6.25 billion fund, topping its last $5 billion fund, investors said.

Two months ago, American Securities LLC, raised $3.6 billion for a new U.S. buyout and investment fund, up from a $2.3 billion fund in 2008 and above a $3 billion target.Some are hitting fund targets in record time. Earlier this year, Centerbridge Partners LP, one of the fastest-growing firms in private equity, raised $2 billion in 10 weeks for a new distressed-debt fund.

A disparity in recent returns is part of the reason why some funds are fighting off investors while others search high and low for them.

Ares, which specializes in buyouts and debt investments, has scored annualized returns of about 26% from a fund launched in 2008 and 13% for funds launched in 2003 and 2006, after fees, according to its investors. Ares has seen big profits from GNC Holdings Inc., GNC +1.66% the parent of retailer General Nutrition Centers, which managed to increase revenue and profit throughout the economic downturn.

By contrast, Providence has seen annualized gains of about 4% and 6% for funds launched in 2005 and 2007, after fees, investors said. That is well below returns of as much as 78% in the 1990s. Providence has seen losses from investments in broadcaster Univision Communications Inc. and Spanish cable-TV operator ONO, though it has winners in online video service Hulu and New Asurion Corp., a provider of wireless subscriber services and extended service contracts.

Providence has raised about $4.5 billion for its latest big fund, well below the $12 billion size of a fund raised in 2007 though more than its $4.2 billion from 2005, according to people close to the matter.

"You have to be blemish-free" and have exited investments over the last two years "to be successful in this market," said Tim Kelly, who invests in private equity for Adams Street Partners. That's true for "even for the strongest brand names."

Pension plans, sovereign-wealth funds and other investors remain keen on private equity, which survived the economic downturn better than most investment alternatives. Some firms are seeing expanding pools of cash from sovereign wealth funds and other sources, they said

But investors complain that too many private-equity firms continue to sit on investments made years ago. And some private-equity firms made big buyouts just before the downturn, and have turned in disappointing returns.

More investors are narrowing the private-equity funds they are willing to work with, causing a scramble by funds for cash. Some investors are proving slow to sign up for new funds because they know they don't have to rush to write checks to these firms, since there are so many looking for investors. Others are just not as enamored with large funds as they once were.

That is partly why KKR& Co. and Apollo are expected to see new, key funds that are substantially smaller than their last, investors say. Their funds likely will be larger than most in their history, despite the new challenges. Firms like KKR and Apollo may be raising smaller private-equity funds, but they are seeing more interest in other kinds of funds they manage, such a credit funds.

KKR and Apollo declined to comment.

"One of the challenges with the big firms is that investors have the luxury of time to make a decision since there's no chance of getting shut out," says John Morris, a managing director at Harbourvest Partners LLC, which invests in LBO funds. He says firms are taking longer to close big funds, encouraging investors to take their time writing a check, as they asses a firm's performance and weigh rival funds. "We all know that big funds are not the flavor of the day they once were," he says.

"Many groups are test marketing to existing investors," Mr. Morris says. "If they are getting negative feedback, then they are simply delaying officially coming to market" to avoid striking out with new funds, something that could force the firms to shutter.

Mr. Morris says a number of firms are foregoing new funds after getting negative reaction from investors.

I remember a time when Providence didn't have to bat an eyelash to raise multi-billions for a new buyout fund. Those days are over. PE giants are adapting to the new normal but it's a very tough environment to raise funds.

The split in private equity funding shouldn't surprise anyone. In fact, it's a trend that began after the 2008 financial crisis and will continue as large investors retrench, focusing on fewer and fewer funds. The same thing is happening in hedge funds where the top 25 funds account for the bulk of the assets under management.

The main difference between hedge funds and private equity is liquidity. In private equity, in order to receive carried interest, the manager must first return all capital contributed by the investors, and, in certain cases, the fund must also return a previously agreed-upon rate of return (the "hurdle rate" or "preferred return") to investors. The customary hurdle rate in private equity is 7-8% per annum.

Private equity funds only distribute carried interest to the manager upon successfully exiting an investment, which may take years. Hedge funds typically invest in liquid investments, enabling them to pay carried interest ( "performance fee") annually, if the fund has generated a profit for its investors.

What hedge funds and private equity funds have in common is that they typically charge 2% management and 20% performance fee on their assets. The 2% management fee is usually paid in quarterly installments regardless of whether the fund has made any investments (PE funds) or whether the fund is underperforming (hedge funds). When you have billions in a fund, this adds up to a significant chunk of change.

This is why large, sophisticated investors will often co-invest along private equity funds to lower fees by half (1 and 10) and enter separate managed accounts with hedge funds to do the same. The larger you are, the more influence you have over fees.

Unfortunately, most US state pension funds are paying high fees and getting low profits as they run out of alternatives, piling into these investments. Indeed, investing in hedge funds and to a lesser extent private equity, increasingly looks like a loser's game.

Finally, there are succession issues in all these alternative investment funds. Reuters reports that Blackstone is grooming six executives for Schwarzman’s job:

When Blackstone Group LP (BX.N) named a new global head of private equity last month, Chief Executive Stephen Schwarzman was looking for more than just a business unit chief.

Even though the buyout king has no plans to retire, the appointment of Joe Baratta, a 41-year-old dealmaker credited with building up the firm's European buyouts practice, was the latest step in a wider succession plan, Blackstone insiders said.

Baratta joins five other senior Blackstone executives from whose ranks the successor to Schwarzman, 65, will eventually emerge, the sources said. The others are Jonathan Gray, 42, real estate chief; Bennett Goodman, 54, co-founder of the credit business; Tom Hill, 63, who runs the hedge fund team; Laurence Tosi, 44, the chief financial officer; and Joan Solotar, 47, who spearheads investor relations, the sources said.

Blackstone declined to comment on succession planning and on behalf of the executives.

Blackstone's arrangements, as revealed by these sources, bring into sharper focus how and whom it will choose to lead the world's largest alternative asset management house.

They also highlight the succession issue confronting other private equity firms launched in the leveraged buyout revolution of the 1980s and 1990s, whose larger-than-life leaders are now close to or past retirement age.

Those include Henry Kravis, 68, and George Roberts, 68 at KKR & Co LP (KKR.N); and David Rubenstein, 63, William Conway, 63, and Daniel D' Aniello, 65, at Carlyle Group LP (CG.O).

To be sure, the selection of a CEO is not as important as in the firm's early years, given the growth in headcount and resources at Blackstone, which now employs close to 1,600 professionals.

With equity and bond markets uncertain and many of the world's major pension funds underfunded, investors are more concerned about solid returns than an affable personality in the firm's leader.

"We pay out about $64 million every month to over 35,000 retirees," said George Hopkins, an executive director of the Arkansas Teachers Retirement System, a Blackstone investor, when asked about the succession.

"We are not interested in people who are good conversationalists and good company; we are out for people who make us money," he added.

Exactly, "show us the money" and leave your colorful personalities and ultra egos checked at the door. This reminds me, time for many of you to show me the money by contributing to my blog at the top right-hand side (tip or better yet, subscribe!).

Below, as private-equity investors become pickier and more closely scrutinize recent performance, some big names are finding it hard to raise as much money as they would like. Greg Zuckerman has details on Markets Hub.

Sunday, August 26, 2012

Are Hedge Funds Playing a Loser's Game?

A follow-up on Friday's comment in defense on the hedge fund industry. Jonathan Ford of the FT reports, The hedge funds are playing a loser’s game:
The financial crisis trashed many reputations in the City of London and on Wall Street. But not those of the financial aristocracy – the hedge fund bosses. While the bankers took it in the neck for the carnage, some of the savvier hedgies – such as John Paulson, who made billions shorting the US housing market – actually saw their stock soar ever higher.

Other investment vehicles may have become pariahs but hedge funds have remained stubbornly fashionable. Since 2009, investors have pumped nearly $150bn of net new money into them, allowing the industry not only to rebound from the crisis but to resume its expansion. At last count, hedge funds managed $2.1tn in assets, more than they did on the eve of the financial crisis five years ago.

Among the most enthusiastic buyers of hedge fund services have been pension funds. Driven by the need to fulfill past promises made to beneficiaries, trustees have been prepared to punt ever more money on so-called alternative investments. Some US retirement funds intend to put up to 15 per cent of their assets into hedge funds in coming years against the 5-10 per cent many have invested now.

This is an ill-judged bet that gets ever harder to justify as hedge funds get bigger. For all its self-proclaimed brainpower, there is little evidence that the industry has the capacity to earn superior returns on the vast ocean of cash it already has at its disposal – let alone all this new money. Even before the financial crisis, results were fairly lacklustre and they are worse now.

Far from carrying all before him, Mr Paulson is making thumping losses. Other “masters of the universe” – most recently Louis Bacon of Moore Capital – have been handing funds back to investors, in part because of the difficulty of earning satisfactory returns. George Soros, fabled as the “man who broke the Bank of England”, gave his investors all their money back last year.

Hedge fund bosses blame many of their difficulties on the dire financial environment and it is true that low interest rates and limited liquidity have conspired to crimp trading opportunities. But it is hard to avoid the impression that hubris is also a factor: hedge funds are now too big and numerous for their own good.

While the industry seems loath to accept the idea that there should be any limits to its size, there are clear problems associated with scale. It becomes harder to devise distinctive strategies. Funds find it more difficult to trade in and out of markets without moving prices against themselves.

An even bigger concern is that size has turned the industry into what is known as a “loser’s game”. This is one in which victory goes not to the player with the best offensive strategy but to the one who makes the fewest mistakes – and has the lowest costs. Hedge fundery has become a loser’s game because the funds themselves are no longer the exotic and small offshoot of mainstream fund management they were in the 1990s. Increasingly, they are the market.

Although hedge fund assets account for less than 10 per cent of investment funds worldwide, they account for a far bigger proportion of all trading on UK and US stock exchanges. The industry is increasingly engaged in a zero-sum game in which one fund’s profit is another’s loss, less the costs of the transaction. Given the high fees and trading expenses incurred by hedge funds, the majority are mathematically likely to disappoint.

This is not a problem the industry finds easy to address. Although some star managers – such as Mr Bacon – may have the self-confidence to limit the size of their funds, many are beguiled by the industry’s lucrative fee structure into gathering assets without much thought as to whether they can put them to profitable use.

Discipline can only be imposed by outside investors. A good place to start would be to take a hard look at the way hedge funds report returns. This has obscured the size-related decline in performance. The industry uses “time-weighted” figures that simply record the return of each fund irrespective of how big it is. So a huge return on a tiny fund has the same weighting as a mediocre return on a giant one.

This, given the constant budding of tiny spin-off funds, which (if they report figures publicly at all) tend to perform well at least in their early years, has flattered the indices.

A better way to assess the merit of a hedge fund investment is to use a “dollar-weighted” approach, meaning looking at what happens to dollars when they are actually invested. This is more akin to calculating a profit and loss account for hedge funds and, as such, takes size into account.

At the start of this year, Simon Lack, a hedge fund investor, performed precisely this analysis for the whole industry going back to the 1990s. The results were miserable. Mr Lack concluded that investors would have been better off putting their money in US Treasury bills yielding just 2.3 per cent a year. Roughly 98 per cent of all the returns generated by hedge funds, he estimated, had been eaten by fees.

Tellingly, the Alternative Investment Management Association, the hedge fund industry body, has devoted a great deal of effort to rubbishing Mr Lack’s claims, recently publishing a 24-page paper (after six months of study) seeking to rebut his argument point by point. But far from demolishing his analysis, the series of quibbles the organisation ultimately offered actually (if unwittingly) reinforced it.

There are great hedge funds and investors have done well by backing them. It is not clear, however, that there would be many more such funds were the industry to have $3tn of assets rather than the current $2.1tn. “Large amounts of money under management and high fees spell eventual performance disappointment,” observed the late investor Barton Biggs. If the pension fund industry does not learn this lesson then it – and its beneficiaries – may face a rude awakening.

Earlier this week, I commented on how cash-strapped US pension funds are running out of alternatives, piling into hedge funds and private equity funds to achieve their ridiculous investment target of 7.5% to 8%.

But Simon Lack is right to sound the alarm because as more money flows into hedge funds, returns are coming down in all alpha strategies. The fact that AIMA has spent time and money vigorously defending the industry's embarrassing track record just goes to show you that Simon has touched a very sensitive hedge fund nerve.

While there will always be exceptional alpha managers, for the most part, hedge funds are nothing more than overpaid glorified beta funds burning investors, charging alpha fees for beta or sub-beta performance. In justifying these fees, they all claim to offer high risk-adjusted returns, but that is pure rubbish and the proof is in the data (especially when you take the selection bias into account).

The problem is that pension funds are hooked on the notion that more alternatives is the way to go. Spurred on by their clueless consultants, they refuse to see this strategy has delivered nothing more than high fees and low profits. It's all great for the hedge fund and private equity industry, but not sure how this benefits pension beneficiaries who are trying to keep the costs of managing their plans down.

Ironically, the institutionalization of hedge funds has become the industry's worst enemy. To a certain extent, I agree with those who are calling hedge funds the new dumb money. For example, Beverly Goodman at Barron's reports, Hedge Funds Trade More Bonds, Do Badly in Stocks:

Efforts at regulating the financial industry can seem like a game of whack-a-mole. This past week, for instance, it became clear where all those proprietary trading desks went—into hedge funds.

Regulators are putting the final touches on the Volcker Rule, which prohibits banks from trading their own, proprietary money in an effort to boost profit. Even though that change won't take effect until January, banks have been disbanding these trading desks, many of which have found a home in the hedge-fund world, as evidenced by a pickup in the funds' activity.

Hedge funds generated nearly a quarter of overall trading volume in the fixed-income markets in the 12 months through June 30. That's more than 30% above the level in the corresponding period a year earlier. "With all the regulations we've seen, there's definitely been a shift in bank proprietary trading desks moving to hedge funds," says Brian A. Jones, vice president for Greenwich Associates, a research and strategy consulting firm that has published a report on this topic. "Hedge funds are not buying and holding; they're trading huge volumes in milliseconds."

Trading volume in Treasury bonds, of course, was high across the board. Investors vacillating between "risk on" bets in riskier stocks and bonds and "risk off" assets, such as Treasury securities, certainly contributed to the overall volume. Treasuries are the most liquid securities, with some $1 trillion traded every day, says Andy Nybo, a partner with the Tabb Group, another research and strategy firm. "That's very attractive for funds trying to get in and out of positions quickly," Nybo says. The pickup in hedge-fund trading volume far surpassed the 20% increase among all institutions and the 14% rise among other types of funds and advisers.

But what does this mean for investors? "When hedge funds go into a particular market, they shift market dynamics," Jones says. "People notice these huge moves, and they're seeing that hedge funds are back in play."

They might notice, but they don't all care. Other big bond traders, many of which, like Pimco and BlackRock, are much larger than most hedge funds, make macro-economic calls that determine when they buy and sell. And executing trades efficiently is hardly a problem for firms of that size. Security selection doesn't get much harder, either. The rapid trading of hedge funds doesn't do much to alter the fundamental value of the bonds, says Rick Rieder, chief investment officer for BlackRock's $624 billion in actively managed fixed-income assets.

That should come as some relief, since virtually everyone agrees that hedge funds are likely to increase their trading, especially as interest rates begin to rise and economic news shifts. "You definitely see a lot more trading around significant events, like when the Federal Reserve minutes are released and there's a change in tone, or on payroll days" when monthly employment figures are released, Rieder says. "Whenever there's a surprise, we definitely see hedge funds being more active around Treasuries. But they're mostly smoothing out the aberrations. Beyond that, we don't pay attention."

MAYBE ALL THAT FIXED-INCOME trading is an attempt to make up for some pretty abysmal stock returns.

A report released by Goldman Sachs last week focused solely on the equity trading of hedge funds. And guess what? The news wasn't good. Again. This year, just 11% of hedge funds are outperforming the S&P 500, and 20% are losing money. Even mutual funds, which also are underperforming the broad market, are doing so by a much less embarrassing margin. The average large-company mutual fund managed to return 10% through Aug. 3, the date that Goldman used for the performance figures in the report.

Sure, you can argue that it's not fair to compare the complex trading strategies of a hedge fund to the simple strategy of an index mutual fund. But hedge funds have been trending toward large-company shares for almost 10 years, and now 46% of their aggregate assets are in stocks with a market value exceeding $10 billion. So, when the S&P 500 returns 12%, as it has this year, and the average hedge fund returns less than 5% in the same period, as it did, the comparison seems more reasonable.

Hedge-fund returns depend highly on a few key stocks, the report notes. The typical hedge fund has 64% of its long equity assets in its 10 largest positions. While there are plenty of "focused" mutual funds as well, the typical large-company fund has just 36% in its top 10 holdings. Mutual funds focused on small companies—a sector to which, many argue, hedge funds could bring additional expertise and therefore excel—generally have just 18% of their holdings in the top 10. And index adherents have 21% of their assets in the top 10 companies in the Standard & Poor's 500 index, but just 2% in the top 10 in the Russell 2000.

When I see hedge funds aggressively moving into fixed income, I know they're chasing yield. And why not? The bond market is large, liquid and the so-called bubble isn't popping anytime soon.

Still, all this tells me is that most hedgies are overpaid momentum chasers, chasing beta in stocks and bonds. It will be interesting to compare their "risk-adjusted returns" when the next crisis strikes.

Finally, there will always be admiration for true pioneers in any field. Bloomberg reports that Neil Armstrong, who set mankind’s first steps on the moon during Apollo 11, has died. He was 82. Below, amazing footage of when the "eagle landed" back in 1969.