Thursday, April 20, 2017

Investors Rushing Into Alternatives?

A couple of weeks ago, Leslie Picker of CNBC reported, Private equity is breaking records left and right as funds rake in money:
Private equity is taking off, and breaking records along the way.

In some ways, private equity's gain comes at the expense of hedge funds' losses. In others, it is simply emblematic of the tremendous amount of capital sloshing around the world, with few other places to invest after almost a decade of low interest rates.

North American funds secured their highest first-quarter fundraising total ever, raising $62 billion, according to data compiled by Preqin, an alternative assets research firm. Worldwide, 253 private capital funds ended their fundraising process in the quarter, hauling in $156 billion, the data showed, which was the best first quarter since right before the financial crisis.

The momentum is likely to continue into the second quarter, with more than 3,000 funds currently marketing to investors, according to Preqin.

Apollo Global Management hopes to raise more than $23 billion in a fund that it is currently marketing to investors, according to three people with knowledge of the matter. That would be the largest private-equity fund ever, surpassing the nearly $22 billion fund raised by Blackstone in 2007. The closing could come as soon as next month, one of the people said.

Apollo declined to comment. Bloomberg reported last month that Apollo was fundraising.

For most investors in private equity, it all comes down to performance, at least in the long run. In the year 2016 through September, a Cambridge Associates index of private equity returns posted gains of 8.5 percent, which was about half that of any public stock index.

But in the long run — and for those investors expecting some sort of a decline in the public markets, it's all about the long run — private equity continues to outperform most equity benchmarks, with almost 11 percent returns over 10 years, according to Cambridge Associates.

Tough days for hedge funds

Compare those private-equity inflows with hedge funds, which saw investors pull out $106 billion last year, the most since 2009, after posting returns about half that of the S&P 500. Private equity's 8.5 percent gain net of fees surpasses hedge funds' 4.95 percent gain based on HFR's index over the same period.

Ironically, hedge funds also see value in the upswing in private equity. This week, fund manager Tiger Global bumped its passive stake in Apollo to 12.5 percent from a previously disclosed 7 percent, according to a filing.
M&A upswing? Not quite yet

Despite having plenty of capital to put to work, private equity firms have been muted when it comes to making acquisitions. Buyout activity fell in the first quarter to only 970 transactions, representing $53 billion, which was down from the 1,058 deals worth $89 billion during the previous quarter, according to Preqin data.

In some ways, this represents the double-edged sword of having so much capital in private equity. Plenty of managers are ready to deploy it, but as they chase assets, it can drive up prices, making them more expensive. Moreover, valuations in the public markets continue their upward climb.

As interest rates rise, however, private equity executives are hoping that the valuations will compress and they'll be able to become buyers again.
It was less than a year ago when Joe Baratta, Blackstone Group's top private equity dealmaker came out to publicly warn us that these are treacherous times for private equity.

Treacherous times for private equity? Sure doesn't look like it when you look at all the money these PE kingpins are raising in their new funds.  No wonder their publicly traded stocks have been on a tear in the last few months (click on image):


The truth is private equity funds have more money than they know what to do with. This isn't a bad thing (for them) as private equity firms typically charge a management fee on committed capital (the size of the entire fund) rather than called capital (the portion of the fund that has been "called" or collected from LPs by the GPs.

Typically fees are based on committed capital on the first 4-5 years. Once the investment period ends, they are calculated on invested capital.

You might think this is ludicrous but as Roberto Medri notes here, fees are computed on committed capital in the interest of aligning GP/LP incentives:
  • If fees were to be computed on called capital, GPs would have an incentive to invest too early at the expense of potential better deals later in the life of the fund
  • If on net invested capital (cost basis), GPs would have an incentive to invest early and exit late
  • If on committed capital, the fees are certain and don't depend on the timing of investments, which is clearly the best setup to focus on getting good deals. Committed capital is certainly the largest number to compute fees from, but you can just lower the fees percentage or come up with a declining fee structure, still independent from the timing of investments.
So why are big investors pumping billions into private equity at this time? I've already discussed some reasons. There is a major beta bubble going on in public markets and now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, pensions, sovereign wealth funds, endowments, insurance companies and other large investors are all looking to prepare for the next downturn.

The article above states that as interest rates rise, private equity executives are hoping that the valuations will compress and they'll be able to become buyers again.

But what if rates don't rise? What if we have yet to see the secular lows on interest rates? What if a big deflationary tsunami strikes the global economy? Then what?

Well, if that happens, it will be a challenging time for all asset managers in public, private and hedge fund markets. If you're investing in private equity because you think rates are headed higher, you might be sorely disappointed.

But you can make a case that public market valuations are frothy and that there are better deals to be had in private markets. Still, the good old days where private equity offered a big fat juicy premium over public markets are over and no matter what happens next, you need to prepare for lower returns in all asset classes, public and private.

What about hedge funds? Jeff Cox of CNBC reports they saw their biggest inflows in 20 months in March even after badly trailing the market:
After flocking from hedge funds in 2016, investors are beginning to find their way back.

In fact, March saw money came back into the $3.1 trillion industry at the fastest pace since August 2015 — a 20-month span that saw fund managers adjust fees and make other concessions as clients fled.

The month saw inflows of a healthy $15.7 billion, capping off a first quarter in which a fresh $21.9 billion in cash came in, according to industry tracker eVestment.

That follows a dismal year that saw $106 billion in outflows, the worst since the financial crisis, according to eVestment's count.

The interest this year has come despite a period that was nothing special return-wise. The funds that eVestment track saw a 2.63 percent gain, well below the S&P 500's 6.1 percent move for the first quarter. March's jump in cash accompanied returns of just 0.33 percent.

Moreover, investors have been putting their money in the wrong places so far.

More than half this year's inflow — $11.46 billion — has gone to macro-based funds, which have rewarded clients with a measly 0.77 percent return so far. Managed futures have been the biggest laggard class, down 0.3 percent, while still attracting a healthy $6.47 trillion in new cash.

Equity has been the best strategy, with a return just shy of 4 percent, and has attracted $5.64 billion.

Analysts at eVestment figure that clients are going to macro strategies in anticipation of "market turbulence" ahead. The category actually saw net outflows of $9.8 billion in 2016 and just $1.3 billion in inflows for 2015.

During January and February, more than 70 percent of funds produced positive returns; in March the number dropped to 60 percent, but both figures were above the two-year average of 56 percent.

Over the past several years, large funds have performed best, though this year funds with less than $250 million in assets have led, gaining 2.76 percent.
Make no mistake, despite the inflows in March, these are still brutal times for hedge funds. John Burbank's $2.5 billion Passport Capital is shutting its long-short equity fund, which managed about $833 million. According to people familiar with the matter, assets at the firm have been shrinking on the back of underperformance and investor redemptions.

ValueAct's Jeff Ubben, one of the most-respected activist hedge fund managers out there, is returning $1.25 billion to his investors because he is concerned about the stock market's high valuation.

Yesterday, a friend of mine sent me a Bloomberg story that Guard Capital was shuttering its $885 million macro hedge fund. The fund run by former Goldman Sachs trader Leland Lim lost 5.1 percent in 2016, even after recovering from steep declines early in the year.

While equity hedge funds are posting their best start of the year since 2013, macro funds have been struggling and this includes hot new funds run by top traders. Rokos Capital Management, one of last year’s best-performing macro hedge funds, lost 4.7 percent in the first quarter as macro funds struggled.

Again, none of this surprises me as I mentioned earlier this week that even Goldman Sachs's trading revenues took a hit last quarter in these brutal markets.

Does it mean that macro hedge funds are screwed and equity hedge funds will continue to outperform? Not necessarily, a prolonged bear market could hammer equity hedge funds that have a lot of beta embedded in their portfolio.

Anyway, faced with high public market valuations, investors are concerned about the next downtrun and they are voting with their asset mix, shifting ever more assets to private equity and hedge funds.

I understand the reasons behind this move but given the high fees and lackluster performance, I'm skeptical if this will help them weather the storm ahead. The evidence at US state pensions investing in alternative strategies has been mixed so I would proceed with caution.

But judging by the inflows into private equity and even hedge funds, it seems like large investors are going to continue plowing billions into these alternative strategies, which tells me that returns going forward will necessarily come down and there will be more attrition and closures in the future.

Below,  Matei Zatreanu, System2 CEO, discusses how hedge funds are using big data investing, as well as potential challenges. More evidence of quant funds taking over the world.

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