Hedge Funds Prepare For War?

Miles Johnson of the Financial Times reports, Hedge funds dig deep for greater returns:

When the latest intake of hedge fund analysts arrived for their first day of work they might have imagined a life of poring over spreadsheets, and routine research trips to shiny corporate headquarters.

More recently, however, they might instead be expected to scope out an egg factory in a remote war zone, or eye up the quality of the brick work on an office block in the north of England.

Faced with meagre returns on bonds and highly valued stocks, an increasing number of hedge fund managers are seeking out more adventurous opportunities in order to deliver the type of high returns investors expect from the industry.

“Hedge fund managers are looking at more esoteric investments when they are looking for yield,” says Russell Barlow, head of hedge funds at Aberdeen Asset Management. “Yields have come in across the board, and as yields continue to compress across the more mainstream asset classes some managers are choosing to look further afield.”

Many hedge funds that specialise in credit have reached a point in the market cycle where most of their successful trades have become crowded and difficult to navigate. Over the past year investors in these hedge funds say they have become more used to managers pitching them ideas that would previously have been seen as edgy for even the most risk-tolerant.

An investor describes a pitch by one hedge fund to provide working capital loans to food exporters in Ukraine, such as egg factories, where double digit returns were promised for tying up money for 60 to 90 days.

“These sorts of trades usually involve only a small amount of exposure, but you need to take on war risk and political risk to get it done,” the investor says. “These funds are not specialists in this sort of thing, but in a world where spreads are at all-time lows they are just trying to find returns.”

Another group of hedge funds, according to their lawyer, who wanted to remain anonymous, last year explored the idea of buying up the euro-denominated Cypriot bank accounts of Russian citizens who had been placed under sanctions. By offering a so-called haircut to the holders, they hoped to make a quick return once the situation normalised, but the scheme was eventually scuppered by compliance fears, the lawyer said.

Investors say that while hedge fund managers argue they only seek to take on small pockets of risk that they understand, most are reluctant to be seen in public to be dabbling in the darker corners of the international markets.

The shadow of the pre-2008 world of hedge funds betting on highly illiquid holdings only to lose large amounts of money during the crisis still hangs over the industry.

At the same time, some of their investors, many of whom are large institutions such as pension funds, are more willing to accept risker propositions at a time when they are starved of returns elsewhere.

“Some hedge funds are going out to less liquid instruments, but they also have their investors pushing them that way,” says Mr Barlow of Aberdeen. “We are reluctant to be taking that same path, unless we have a structure and a mandate to do this. The risk is investors are just focusing on yield and may not be focusing on things like liquidity risk.”

Other hedge fund managers have focused their efforts on the more humdrum world of peer-to-peer and secured property lending. Omni Partners, a London-based hedge fund, has recently raised $45m of a planned $250m fund that makes short-term loans predominantly to developers across the UK secured against their properties.

Steve Clark, Omni Partners’ founder, argues that the 10.4 per cent net return delivered by the first incarnation of the fund last year demonstrates it is possible to generate double-digit performance through alternative lending without taking on large risks.

“There’s continued demand from investors for an unlevered high yield strategy that has the key characteristics of superior asset quality and short tenor,” he says.

Yet for the hedge funds that are trying to navigate a world of meagre yields, there are others who have decided the best strategy for a market they view as overvalued is to bet against it.

Crispin Odey, in this case an investor focused on stocks rather than credit, recently became one of the first well known hedge fund managers to position for a big fall in the stock market, based in part on his belief that the end of quantitative easing in the US could trigger large and unintended consequences across global markets.

One part of this strategy has been to use the shares of asset managers as a proxy for betting on a sell-off in emerging markets, as well as taking out numerous other so-called short positions against unprofitable companies he thinks investors have tolerated only due to low interest rates.

Other equities-focused hedge funds have eschewed the larger macroeconomic call of Odey, and instead continued to look for individual opportunities to make money through short selling.

Kyle Bass, founder of Dallas-based Hayman Capital Management, earlier this year said he would bet against pharmaceuticals companies while at the same time mounting legal challenges against drug patents he believed were unenforceable.

Managers such as these will need to have strong stomachs to withstand the long periods of paper losses that contrarians must endure, and for now it appears only a few feel bold enough to make outright bets against the status quo. For the rest, if interest rates continue to remain low they may need to get increasingly accustomed to trips to war zones to make money.

Whenever I read comments like “hedge fund managers are looking at more esoteric investments when they are looking for yield,” my antennas immediately go up. While lending money to egg factories in the Ukraine sounds cool, it tells me hedge funds are increasingly taking dumber risks in search of higher yields.

Right now, credit hedge funds are on a rampage, poaching talent away from bond dealers and lending money to anyone who needs a loan. Lawrence Delivingne of CNBC reports, For small biz, hedge funds are the new banks:

Investor Leon Black, like many peers, has urged caution given high market valuations. But the Apollo Global Management CEO said his $163 billion firm is rapidly expanding one of its business lines: lending money.

"Credit in general is a huge, huge opportunity today," Black said last week at the Milken Institute Global Conference in Los Angeles, noting the diminished role of banks in providing loans.

Black's Apollo is one of many investors to see the opportunity.

A new paper from the Alternative Investment Management Association, a London-based hedge fund lobbyist, estimates that private debt funds—including hedge and private equity funds, among others—now manage about $440 billion globally, with $64 billion of new capital allocated to the sector last year alone, per Preqin data.

The surge in activity from private lenders, according to AIMA, is a boon for smaller companies.

"Many small and medium sized businesses would miss out on growth opportunities or fail altogether if it were not for the absolutely vital support of hedge funds and other alternative asset managers," AIMA CEO Jack Inglis said in a statement.

Hedge funds and others in the space usually provide loans of between $25 million and $100 million, often for periods of one to three years, according to AIMA's survey. About 65 percent of companies taking the loans typically have earnings before interest, tax, depreciation and amortization of between $5 million and $75 million.

The report notes that the companies lent to are typically too small to raise capital through the public bond market and banks have been more reluctant to lend to them because of stricter standards following the 2008 financial crisis.

The most popular sectors for lending are consumer goods and services, healthcare, industrial, and real estate, according to AIMA's survey of private fund managers.

Examples of recent loans from U.S. firms given by AIMA include private equity shop KKR & Co giving an approximate $12 million loan to help grow a Scottish wind farm; a $26 million loan from hedge fund firm Pine River Capital to an American aircraft parts dealer for purchasing a target company; and Avenue Capital, another hedge fund manager, lending money to investment firm H.I.G. Europe to help it buy consumer loan broker Freedom Finance Nordic.

Another benefit of the private lending, according to AIMA, is systemic: instead of a few big banks, there are lots of funds to share the risk, and the funds use relatively little borrowed money to amplify their bets, so-called leverage.

So hedge funds and private equity funds are now lending to small businesses starving for credit. Having worked as a senior economist at the Business Development Bank of Canada (BDC), a Crown corporation that finances and consults small and medium-sized enterprises, I can only wish these private debt funds a lot of luck making money in this area.

True, U.S. job growth rebounded last month and the unemployment rate dropped to a near seven-year low of 5.4 percent, which bodes well for lending to small and medium-sized enterprises, but there's still plenty of slack in the economy with the number of Americans not in the labor force rising to a record 93.2 million (most of those unemployed are women). Moreover, America's risky recovery poses serious challenges to the economy and can come back to haunt these private debt lenders.

Does this mean hedge funds are better off following Crispin Odey and Hayman Capital Management and short the stock market as a whole or segments of the stock market? Nope. I don't buy arguments from Bill Gross and others that the end is near and think stocks are heading much higher but it will be a tough slug making money in these markets.

Still, all this talk of a buyback and biotech bubble is pure nonsense. Apple (AAPL) dove into the bond market this week, completing an $8 billion bond sale and said it will use the proceeds to help pay for share buybacks and dividends, part of an expanded capital-return program for shareholders the company announced last month.

And just this week, Alexion bought out Synageva BioPharma (GEVA) for $8.4B, sending its shares soaring by more than 100% (click on image):

And who are the top institutional holders of this biotech? Who else? The Baker Brothers and their biotech parner, Big Boston (Fidelity), which pretty much own all the top biotech companies out there (click on image):

Tell Julian and Felix Baker the biotech bubble is about to burst as they laugh all the way to the bank! This is why I track their portfolio along with that of other top funds every quarter. They don't always pick ten baggers but they've scored huge on a number of their top picks.

Getting back to hedge funds preparing for war, I think the big war they need to prepare for is institutions looking to transform their fee structure. In fact, one of the questions asked at the SALT Conference in Las Vegas this week was whether hedge fund fees are too high.

Consider this, in the hedge fund world, even a mediocre year can be a very lucrative one:

Last year, the world’s top 25 hedge fund managers earned roughly half their 2013 income and the smallest amount since the 2008 financial crisis. But that still translated into astronomical paychecks: their collective income was $11.6 billion.

Consider the estimated 2014 paycheck for Jonathon S. Jacobson, founder of Boston-based Highfields Capital Management. The former Harvard University endowment manager accustomed to rock star status in his field made $50 million, according to an annual list published this week by Institutional Investor’s Alpha, a trade publication.

Jacobson’s compensation may seem spectacular, but it amounted to just one-tenth of the $500 million he is estimated to have made the previous year. And Highfields, which manages $12.5 billion, produced a percentage return only in the low-single-digits.

Among the top 25 hedge fund managers, the average pay was $467 million last year, down from $846 million in 2013, according to Institutional Investor’s calculations. Three earned more than $1 billion last year. Jacobson just barely made the top 50, coming in last on the list.

The only other Massachusetts investor on the roster was Seth Klarman, chief executive of Baupost Group, one of Boston’s largest hedge fund firms, with $28.5 billion under management. Klarman ranked number 26, with estimated pay of $170 million last year.

Klarman is considered a value investor who looks for bargains and unusual investments. As energy investments tanked last year, for instance, Baupost started looking for deals, according to a Bloomberg News report.

The firm delivered returns of 7 to 8 percent last year, according to a person briefed on the results.

That may sound modest to ordinary investors, who typically gauge their returns against the Standard & Poor’s 500 index of large stocks, which rose 13.7 percent last year. But that’s not the only measuring stick many hedge fund clients use.

Industrywide, the average hedge fund return last year was 2.9 percent, according to the Barclay Hedge Fund Index, which gathers data from thousands of firms. Within that universe hedge fund managers produce varying results with many approaches, from betting that stocks will rise or fall to investing in bonds, commodities, market sectors, and numerous other styles. Many of those funds struggle in periods when stocks are rising sharply.

“The equity market has been having quite a nice run. Almost anything that diversifies away from that will be lower [in returns] by definition,’’ said Robert J. Waid, a managing director at Wilshire Associates Inc., a Santa Monica, Calif., investment consulting firm.

Historically, many hedge fund managers have become famous, and wealthy, with aggressive strategies that produced big returns. Investors have been willing to pay their large fees — typically, 2 percent of assets plus 20 percent of profits — in the search for substantial gains.

But many institutional investors, like pension funds and endowments, allocate a portion of their money to hedge funds for an entirely different reason: to protect them when the market falls.

The Massachusetts state pension fund has 9 percent of its $61 billion in hedge funds, even as the nation’s largest public pension fund, the California Public Employees’ Retirement System, last year said it would exit the sector entirely.

Michael Trotsky, executive director of the Massachusetts fund and a former hedge fund executive himself, said he looks for hedge fund returns to come out somewhere between those of bonds and stocks. More than anything, he wants them to be less risky than stocks.

“Hedge funds are not as volatile as stocks — or as the S&P 500 — nor should they have the same returns,’’ Trotsky said.

He said there are some “great hedge funds” that don’t go up and down in ways tracking stock market performance. “We’re willing to pay for that,” Trotsky said.

The Institutional Investor’s rankings, now in their 14th year, are estimates based on such factors as the hedge funds’ rate of return and the fees they charge investors. Neither Klarman nor Jacobson would comment on the report.

Despite last year’s relatively low return numbers, investors are still putting money in hedge funds because they think they’ll outperform other investors over time, according to Institutional Investor’s editor, Michael Peltz.

“They’re looking at net returns after fees,” Peltz said. “And more often than not, these top managers over time have net returns better than the overall market.”

MassPRIM's Michael Trostky sounds like the typical hedge fund industry claptrap, making lame excuses for many underperforming hedge funds charging astronomical fees as they deliver mediocre returns.

Sure, there are great hedge funds but I couldn't care less if Ken Griffin dethroned David Tepper as the king of hedge fund pay, this is all nonsense to me. These overpaid hedge fund managers are raking in unbelievable fees because dumb pension and sovereign wealth funds are toppling over themselves to pile into hedge funds and other alternative investments instead of chopping their fees in half and doing away with that goddamn management fee which promotes asset gathering at the expense of performance when hedge funds get too large. 

Should Ray Dalio, Ken Griffin, David Tepper, Jim Simons, Bill Ackman and a host of other well known hedge fund gurus charge a 2% management fee on the multi billions they manage on behalf of hard working teachers, police officers, firemen, and public sector workers? Hell no! These guys and their grossly overpaid private equity counterparts are raking it in, moving up in the ranks of the world's rich and famous all because of the collective stupidity of global pensions and sovereign wealth funds.

"Leo, Leo! You're too harsh on hedge funds and private equity funds just like you're too harsh on Gordon Fyfe, PSP, the Caisse and Canada's pension plutocrats." Maybe I'm too harsh but I'm not collecting multi billion or multi million payouts gathering assets from dumb institutional investors or beating bogus private market benchmarks over a four-year rolling return period. I make my money one trade at a time, and I earn it the good old fashion way, by working my ass off to make money in increasingly schizoid markets.

But that's one aspect of my life I truly love. Making money in stocks and then going to the gym and hitting a nice terrace for lunch to enjoy the beautiful weather we've been blessed with in Montreal. It would be nice if all these overpaid hedge fund, private equity and pension fund managers I routinely rip into subscribed or donated to my blog, but I understand, why feed the 'monster' which exposes your industry's dirty little secrets? -:)

Better yet, why don't all these hedge funds with more money than they obviously know what to do with give me some funds so I can gather talent and set up a hedge fund right here in Montreal? I guarantee you we'll perform better than most top funds gathering assets and we'll definitely make more than funds lending money to egg factories in the Ukraine. And we'll charge you 1 & 10 until we raise a billion after which it will be 0.25 & 10!

On that note, I am off to enjoy my day. Below, Kynikos Associates founder Jim Chanos discusses short selling, his investment ideas and hedge-fund manager Daniel Loeb’s comments on Warren Buffett. He speaks on "Market Makers" from the 2015 Las Vegas Skybridge Alternatives Conference.

Dan Loeb can trash Warren Buffett all he wants but if you ask me, the Oracle of Omaha and the undisputed king of hedge funds, George Soros, are right to warn pensions to steer clear of hedge funds. Most institutional investors are clueless on the real risks of hedge funds and other alternative investments.

Also, York Capital Management's Michael Weinberger discusses the state of capital markets and the outlook for M&A activity with Bloomberg's Stephanie Ruhle and Erik Schatzker at the SkyBridge Alternatives Conference in Las Vegas. I like Chanos and Weinberger, unlike most hedge fund clowns, they know what they're talking about. Listen carefully to their comments.