Roger Ehrenberg’s latest post, “Alternative Asset Managers and Down Market Cycles: What to Expect,” isn’t quite as blunt as my headline above, but it comes pretty close. He at least says that suffering, while common, will not be universal.
Cheap funding was important to the success of hedge and LBO funds and its evaporation will lead to a reversal of fortune. Moreover, while many hedge funds relied on leverage to produce their outsized returns, even some who didn’t are confounded by the divergent-from-historical-patterns trading markets we are facing now.
Let me digress with a wee story. In the stone ages, when I was young, I was sent to work on a Treasury study. The firm I worked for had never advised a Treasury business; this was one of the very biggest operations in London that had gone from making money to losing lots of it. The only reason I was sent was that, unlike everyone else on this project, I had at least been in a dealing room.
We really had no idea what we were doing, and even worse, the partner wanted to find a way to beat the foreign exchange markets with four months of end of day trading data (meaning the closing price) in four currencies. It was a thoroughly miserable experience, particularly since the main reason for the client’s troubles was one we could not readily solve, absent a massive change in personnel.
This was 1984, a strong dollar environment. The FX traders had all learned the business when the dollar was weak, so their reflexes were all wrong.
I think we will see a lot of this sort of problem.
While the tough times for hedge funds are not surprising, private equity funds maintain that they add fundamental value by improving operation, not by mere financial engineering. Yet it isn’t hard to imagine that this claim is exaggerated. Why? Look at how hard public companies have been working to wring out costs any way they can. Any low hanging fruit is long gone. Indeed, the main benefit of being private these days is to get out of the glare of the spotlight and be able to pursue long term strategies. But it isn’t clear to me how much private equity talk along those lines is really sincere.
Ehrenberg says that LBO firms will either put their money into lower return deals or into PIPEs. Personally, PiPEs are the worst of both worlds. You have a big enough stake to be visible and thus have difficulty exiting, but by virtue of have a holding in a public entity, you as an investor cannot get inside information. One of the big advantages of being private is you can know everything about your investment if you have the time and energy.
Ehrenberg fails to consider a third possibility: that investors will demand a reduction in commitments. In the dot-com bust, it was evident that venture capitalist were not going to be able to put all the money they had raised to work. Investors were unwilling to pay 2% (the annual commitment fee) on funds that would never be put to work, and successfully demanded reductions, often as much as 50%.
The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:
The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.
The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.
Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:
For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.
Hedge funds used to be a lot more hedged than they are today….hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).
Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.
Let’s see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you’ve got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both…..
Bridgewater also had some cautionary words for the private equity industry:
Private equity also looks vulnerable… One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.
I heartily agree. This is an area I’ve written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR’s investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we’ve witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we’ve become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.
So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won’t be pretty but we’ll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.