Transition Management: When Fund Managers Are Changed

At certain times during the lifespan of a fund, the manager will be changed.  This may happen due to poor performance, the manager leaving for another fund, two funds merging or the fund is being liquidated.  The new manager will want to re-structure the portfolio of the former manager.  Other funds will be watching this and may have the ability to negatively affect the performance of the fund by selling its current assets or by buying the assets that the new manager likes.  During this period, the fund may hire the Transition Management team of a sellside bank to preserve the value of the portfolio until the new assets are in place.  The team is given a target portfolio from the new manager.  The positions being changed are sold off by the transition manager.  The goal is to minimize market impact and execution costs for the incoming manager.  If there is a long interim period between managers, then the transition manager will be tasked to keep the fund's performance in-line with the market.  Of the large investment banks, Credit Suisse was rated the top transition manager in June 2010 by Global Investor Magazine.

Tail Risk Investing

There was an interesting article in the Economist magazine about tail risk investing.  There are some hedge funds that buy assets that should rise in market sell-offs.  These funds lose about 15% in a normal year.  When the market loses a lot of value, then returns average 50% to 100%.  Buyside firms like Black Rock and PIMCO and sellside firms such as Deutsche Bank have tail risk products.  Deutsche Bank has created the Equity Long Volatility Investment Strategy (ELVIS) index.  This index generates positive returns when market volatility is high.

Electronic Execution Services

One of the services that investment banks provide hedge and mutual funds is trade execution.  These fall under a variety of terms such as program trading, direct market access and algorithmic trading.  The services generally are automated services that are run by expensive technology.

Program trading is loosely defined as a transaction involving 15 or more securities worth at least $1 million in capital.  They are usually executed by computers but there are some that are done by traders.  A lot of program trading is involved in index arbitrage.  In this strategy, the investor finds discrepancies between the values of index futures and the stocks composing the index.  Based on the difference, the investor will short/long the futures and long/short the stocks.  The leading banks for program trading are Goldman Sachs and Morgan Stanley.

Direct market access allows fund managers to trade directly with an exchange instead of going through an intermediary such as a bank.  They do use applications created and managed by the banks but no trade is routed through a salestrader.  It gives them control over how a trade is executed.

Algorithmic trading is more popularly known as black box trading.  Here the fund manager implements a trading strategy that is executed by a computer.  The manager can set the timing, price and share amount of the order.  Investment banks give access directly to the manager or through a third party interface such as Bloomberg.  High frequency trading is when a computer program combs through market data to determine if certain preset conditions are met and initiates trades if it is.  Again, the rules come from the fund manager.  This approach has very short holding periods.  Since computers can recognize pricing patterns faster than humans, the fund gets first mover advantage.  Credit Suisse and Goldman Sachs have won numerous awards for algorithmic trading.

The advantages of these types of trading are lower commissions, privacy and speed.  Ten years ago, the pressure from new execution facilities and decimalization virtually broke the agency trading business.  The manager can compare trading performance of the program by comparing actual transaction prices against a benchmark.  There are two standard ones: volume weighted average prices (VWAP) and time weighted average prices (TWAP).

Hedge Funds and Their Private Equity Positions

During the heady days before the credit crisis, hedge funds had expanded into private equity deals.  During the crisis, these illiquid investments had been placed in side pockets.  Essentially, investors cannot retrieve their capital from the fund.  Side pockets are used when assets cannot be valued accurately due to the markets being frozen.  If investors are allowed to pull money from the fund, then the liquid assets are sold first.  The remaining investors are exposed to the full risk of the hard-to-sell investment such as private equity.

Hedge funds may be looking to sell up to $55 billion in holdings.  They need to unload them in order to raise money to open other funds.  Investors are starting to pour money into hedge funds but are wary of investing money with managers that have side pockets.  Private equity managers and specialty secondary market investors are the most active buyers of these positions from hedge funds.

The source for this post is an article in the magazine Pensions & Investments.

Growth in China Deals

An article in the March 2011 issue of Global Finance magazine (http://www.gfmag.com) said that Chinese companies had raised $4 billion in 31 new depository receipt programs in 2010.  This represents 80% market share of Asian receipts.  In terms of global IPOs (including common stock and depository receipts), China had 18 of the largest 25 deals and raised 26% of the world's capital.  The activity was caused by improving equity markets and by many companies deciding to expand after the economic crisis.  The threat of inflation is the only overhang in the present.

The article references a table from Citi Depository Receipts year-end 2010 report.  The top 10 Asian companies, in terms of volume, include Baidu, Taiwan Semiconductor, JA Solar Holdings, Suntech Power Holdings and United Microelectronics.

Sample Calculation of Private Equity Fees

In the previous post, it was noted that profits for a private equity fund can be based on an aggregate level or individual transactions.  Let's take a quick look at a simplified calculation, using round numbers, to compare the methodologies.  For a fund, the manager has invested $150 million in two portfolio companies.  The first company was bought for $100 million and sold for $120 million.  The second company was bought for $50 million and sold for $30 million.  For this exercise, the hurdle rate is 10% and there is no clawback option.

If you total all the numbers, $150 million were invested and $150 million were realized.  There was no gain on the investments and the manager would not receive an incentive fee.

If you look at each investment separately, the first investment would have a return of 20%.  This triggers the performance fee calculation of $20 million x 20% = $4 million.  The second company has a return of -40% and would not trigger any incentive fees.  The fund manager would still receive $4 million.

How Profits Are Distributed for a Private Equity Fund

There are a number of different methods of calculating private equity fees for general (fund manager) and limited partners (investors).  These terms are spelled out in the limited partnership agreement.  The purpose of the fee structure is to align the interests of the investors and fund manager in order to obtain the best returns possible.  The most important fees are the management fees and carried interest.  Management fees are between 1%-2.5% of committed capital.  Carried interest is usually about 20% of profits.

Profits for a fund can be based on an aggregate level or individual transactions.  For the investor, it is best if the aggregate calculation is used.  For the manager, it is best if profits are based on an individual investment basis.  The manager shares in the profits as soon as the IPO or other exit strategy is done.  This approach may cause the manager to exit his investment prematurely, before its full value is realized.

To earn the carried interest, the manager has to hit a target return rate.  The average rate is 8%.  They are usually 5%-10% and tied to the risk-free rate.  The hurdle rate is applied to buyout and European venture capital funds.  There are two types:  hard and soft.  The hard rate allows the manager to share in the profits above the hurdle rate.  This is used in European funds.  US funds are more likely to use the soft rate calculation which allows the manager to share in all the profits.  The distribution of the fund's proceeds follow this pattern:

• Investors' capital is returned
• Investors' profits are paid up to the hurdle rate
• Fund manager's profits are paid up to the hurdle rate
• Any profits above the hurdle rate are split between investors and manager according to the limited partner agreement

An additional clause to protect the investor called a clawback can be added to the limited partner agreement.  It ensures that the investor receives, at least, the hurdle rate return.  The manager must return any incentive fees to the limited partners.  However, the effectiveness of the clawback is dependent on the ability of the manager to re-pay the money owed.  The investors can have some of the carried interest placed in an escrow account to cover any possible clawback.

Unlike hedge funds, private equity fees are paid out as profits are realized.  Hedge funds are paid out based on the current market value of the portfolio.

The information above is a summary of a paper written by Didier Guennoc, Pierre-Yves Mathonet and Thomas Meyer called Distribution Waterfall and is part of the CAIA curriculum.

A New Dynamic Between Institutional Investors and Hedge Funds

There was an interesting article in Reuters about how institutional investors are getting more leverage with hedge funds.  They are asking managers to reduce fees and for more flexible redemption terms.  They are doing more due diligence;  sometimes doing six months of research before investing.  Recently, D.E. Shaw reduced fees. A manager profiled in the article actively looks for hedge funds that charge management fees of 1%-1.5%.  He also test drives a fund by investing a smaller amount before committing a large amount of capital.  The increase in investments by pension funds is another factor driving this shift.  Pension fund money is placed in the largest hedge funds.  In the past, pensions used to invest in funds through a fund of funds to escape the extra layer of fees.  They demand more transparency and a monthly redemption cycle.

An Interview with Warren Buffett of Berkshire Hathaway

I was alerted to this article of an interview by the Financial Crisis Inquiry Commission in May 2010.  The interviewee is Warren Buffett, world famous CEO and investment manager of Berkshire Hathway.  I do not think he needs an introduction here.  Some topics discussed were:

• Ratings agencies
• Credit bubble
• Invest in companies with pricing power
• Mark to market accounting
• Fannie Mae and Freddie Mac
• Derivatives
• Government intervention during the crisis in 2008
• AIG
• Management compensation

List of 10 Hedge Fund Risks

I was alerted to an interesting article written by Stuart Fieldhouse and Hans-Olov Bornemann of SEB Asset Management.  They listed the 10 mistakes to avoid with hedge fund managers.  They are:

• Fraud / misrepresentation - stealing from investors, assigning high valuations to illiquid assets
• Operational risk - counterparty risk, NAV calculations, key personnel leaving
• Concentration risk - too many assets in one sector, country or asset class
• Leverage - net and gross
• Liquidity risk - not being able to sell assets when needed
• Funding risk - mismatching borrowing and asset maturity dates
• Too many assets under management - not all managers can handle an increase in money
• Copycats - other managers following the same strategy
• Being front run - other funds trading ahead of a large fund
• Forced unwinding - funds may be forced to sell assets to make margin calls and client redemptions

Proprietary Traders and Hedge Funds

As a result of the Volcker rule, banks have begun divesting themselves of their proprietary trading desks.  Goldman Sachs has led the way.  Two superstar traders have raised $1.6 and $1 billion dollars for their own hedge funds.  JP Morgan will move its traders to the asset management division and Morgan Stanley will spin-off its quantitative team - Process Driven Trading.

The Reuters article believes that 10%-15% of the trading desks will become hedge funds.  However, investors are cautious about committing capital to them.  A Credit Suisse survey has only 52% of investors would seed a fund if it had a three year history.  Not enough is known about a prop trader's performance.  How much can be attributed to the trader and how much can be attributed to the bank's assets - name, balance sheet, execution platform, etc.?

Private Equity Portfolio Construction

The returns of a private equity fund are driven by the fund manager, how the portfolio is built and how capital is invested.  Funds that perform in the top 25% earn returns that are twice as high as the average fund.  It is important to find and retain these managers.  In a prior article, researchers had found that a successful fund manager continues to outperform.

The manager has to balance between risk and returns when constructing the fund's portfolio.  Diversification of holdings may reduce risk.  The manager may use the traditional or core-satellite method.  Traditional diversification requires investing in the best assets based on returns, risk and correlation potential.  The core-satellite method has a diverse and low risk portfolio to generate stable returns as its base.  The satellite investments are small and riskier than the core holdings.  They are to add extra return.  This approach allows diversification with extra returns, ability to customize portfolio to specific investor goals, ability to obtain desired levels of exposure to certain risks and ability to concentrate on the satellite investments.

An investor builds a portfolio by using a bottom-up, top-down, mixed or naive approach.  In the bottom-up method, the investor identifies the best managers through screening, due diligence and analysis.  Then investments are made across the highest ranked funds.  However, this may lead to an unbalanced portfolio.  As an analogy, during the technology bubble, the highest ranked mutual funds had large holdings in the same sector.  Even though an investor may have directed capital to multiple funds, there would be little diversification in the portfolio.

In the top-down method, the investor selects sectors or strategies that will outperform.  The general macroeconomic picture will be predicted to determine the asset allocation of the portfolio that will perform the best.  Capital can be spread among different countries, strategies or sectors.  A disadvantage of top-down is that there are not enough good managers to achieve the desired asset allocation.

The mixed method combines the other two.  This involves identifying the top funds and diversify across different strategies.  The naive method invests in all funds of the portfolio equally.

Generally, investing in 20-30 funds can achieve diversification.

Private Equity Fund of Funds vs. Direct Investing

There are private equity funds of funds that invest in individual private equity funds just in the same manner as hedge fund of funds invest in other hedge funds.  There are some advantages in using a fund of funds to invest. There are two primary costs involved as well.  Investors in funds of funds have to pay for two layers of management fees.  They have to pay the private equity fund and the fund of funds.  The other cost is the double layer of carried interest / performance fees.

What do investors get by going through funds of funds?  They get a diversified portfolio of different managers with, hopefully, different investment strategies.  Funds of funds managers can give smaller investors access to an investment with a large minimum commitment amount by pooling their capital.  They provide research, do due diligence, monitor investments and manage liquidity.  They give investors access to top quartile funds that would not be possible for new investors.  They make the fund raising process easier for fund managers by having a ready group of investors.

In order to pay the additional layer of fees, the fund of funds needs to outperform direct investors by 0.7% to 3.4%.

When a Private Equity Manager Underperforms

In a private equity firm, the limited partners are the investors and the general partner is the fund manager.  Since the portfolio is generally illiquid, the investors cannot sell the fund for a fair price if it is underperforming.  They may sell it on the secondary market at a discount.  Here are some other actions that they may take:

• The investor may decline to invest in the manager's next fund
• The investor may negotiate to reduce the size of the next fund or have the manager address the issues causing the underperformance
• The manager may lower the management fees
• The investor may threaten legal action or fire the manager in extreme cases
• The investor may default as a last resort

TXU Corp: When A Buyout Does Not Work

In 2007, Kohlberg, Kravis, Roberts (KKR) and Texas Pacific Group (TPG) teamed up with Goldman Sachs Capital Partners to buy TXU Corporation.  The deal was valued between $45 to $48 billion with an $8 billion equity investment and the rest in debt.  The secured (backed by collateral) bonds are trading at 86 cents on the dollar and the unsecured bonds are trading at 55 cents.  Total debt is $36 billion.  KKR has marked its equity investment at $1.6 billion, an almost unthinkable 80% discount.  Last week, the credit default swaps tripled in price.  $22.5 billion of debt is due in 2014.  To pay back this large sum, the company, now called Energy Future Holdings Corporation can sell assets, have an IPO or ask current debtholders to trade their bonds for new bonds that have a later maturity date.  The catalyst for the fall in bond and rise in swaps prices was a claim by a hedge fund, Aurelius Capital Management, that the company technically defaulted on an intercompany loan i.e. loan between the parent and a subsidiary.

The company is not generating as much revenue and cash as was projected during the formation of the leveraged buyout because the price of gas is about $4 (per million British Thermal units.)  To pay off the loans, gas has to be between $7-$8.

There are two articles about TXU Corporation:  one at the Wall Street Journal and one at the New York Times.

Inflation and Oil Prices

I was alerted to a posting at www.hedgeworld.com by Irene Aldridge, portfolio manager at ABLE Alpha Trading, about the relationship between oil prices and inflation.  One of the major factors affecting inflation is the amount of money supply in the US.  The Federal Reserve Bank has added almost $500 billion in the past year as part of Quantitative Easing 2.  Based on historical patterns, the Fed would take money out of the system due to the recent rise of oil prices due to the unrest in the Middle East.

Manager Selection Process for Private Equity

For investors, the manager selection process begins with their investment strategy.  Using this as the baseline, they identify which fund managers match their strategy.  The managers may be ranked in various categories based on their performance and experience.  Any team not falling in one of the following would not be invested in:

• Star - top quartile returns for at least 3 funds for at least 2 business cycles
• Established - top quartile returns for most of its funds (at least 3 funds) for at least 2 business cycle
• Emerging - new fund manager team with limited history in working together
• Re-emerging - turnaround situation;  previously star or established team that is being re-structured, had bad returns or had operational issues

The investors should use their network to find good investments and quality managers.  Star teams are referred to new investors by their current universe of investors.  New investors should establish a relationship with star managers before they start raising funds for their next follow-on funds.

In the prior post, we read a study on how private equity fund manager performance persists from one fund to another.  Therefore, successful managers are oversubscribed when opening a new fund.  They will first allow the investors of the original fund first crack at investing in the follow-on fund.  Because of this, the fund will generally be closed before new investors are invited.  Fund managers tend to retain known investors as fund raising can be time consuming and expensive.  New investors that could be invited to the fund would be those with industry experience or can help in exiting positions.

Once a manager is found and is receptive to having the new investor in a fund, the next step for the investor is to conduct due diligence on the manager.  The first step is screening.  This means eliminating funds that do not have the right investment strategy or performance/quality requirements.  About 1/3 to 1/2 of funds are pass this stage.  Then the investor interviews the manager to get a detailed understanding of the organizational structure, people, office dynamics, experience and track record.  Based on the information gathered, fund managers are evaluated to choose the best investment.  Funds are graded based on a relative ranking and much of the decision making is subjective.  More detailed due diligence is done for funds that get through the evaluation process.  The investors look at any legal issues, any issues from the initial due diligence phase and check references from co-investors, competitors, officers from past investments and past investors.

The investors decide whether or not to invest in a particular fund.  It does not mean that the investors will not look at the team again for another fund.  On the other hand, the manager has to accept the new investor into the fund.  The manager may reject the new investor if there is too much money invested already or if the investor has a history of defaulting on investments or causing problems for the manager.

Private Equity Return Factors

Six researchers from Germany wrote a research paper about the different factors that affect private equity fund returns.  The researchers were Philipp Aigner, Stefan Albrecht, Georg Beyschlag, Tim Friederich, Markus Kalepky and Rudi Zagst.  They analyzed 358 funds and found the following results:

• Fund manager performance persists from fund to fund.  For managers ranked in the top 25%, 41.7% returned to the top 25% in their follow-on fund.  For managers ranked in the second 25%, 50% moved up to the top 25% in their follow-on fund.
• Diversifying the region and sector of the fund does not affect returns
• Diversifying the financing stages of the investments positively affects returns i.e. the more diversified the fund is, the better the returns
• General partner/manager experience has a positive affect on returns
• Performance of publicly traded markets has a positive effect on returns i.e. higher returns in the public markets mean higher returns for the private equity fund.  But good performance of the markets during the vintage year affect the fund returns negatively.  The vintage year is when the fund is opened and receives investment capital.
• Interest rates have a negative effect on returns i.e. higher interest rates mean lower returns
• Gross domestic product growth has a positive effect on returns.  If the growth is during the vintage year of the fund, then it has a negative effect on returns.

An Interview with David Einhorn of Greenlight Capital

I was alerted to this great transcript of an interview by the Financial Crisis Inquiry Commission in November 2010.  The interviewee is David Einhorn of Greenlight Capital.  David is a famous hedge fund manager for his public short positions on the Ambac, MBIA and Lehman.  But let's be clear.  His strategy is not only shorting.  His fund has a net long position in the market.

Some topics discussed were:

• Ratings agencies
• Credit bubble
• Risk management using Value at Risk
• Mark to market accounting
• Short selling

Municipal Bond Prediction by Nouriel Roubini's Firm

Roubini Global Economics has published a research report about the municipal bond market.  It predicts that defaults will total $100 billion over the next five years.  Actual losses to investors will be $35 billion because of the high rate of recoveries for these bonds.  This prediction is in line with Bill Gross of Pacific Investment Management Company and much more optimistic than the $2.9 trillion worth of defaults foretold by Meredith Whitney, the eponymous analyst of Meredith Whitney Advisory Group.  The report was written by David Nowakowski and Prajakta Bhide.

Nouriel Roubini, also known as Dr. Doom, is famous for forecasting the credit crisis and is the chairman of Roubini Global Economics.

Sample of Sellside Global Strategy Research Report

During large scale events such as the ongoing situation that started in Tunisia and has moved on the rest of the Middle East and North Africa, sell side institutions may publish a combined research report from multiple departments.  This is the case with the Strategy Snapshot from Credit Suisse.  Here the fixed income division writes about commodities, foreign exchange, mortgages and emerging markets.  The main themes are:

• If oil prices reach $150/barrel or gas prices reach $4.50/gallon, then they will negatively affect any economic recovery
• Italy will be most affected by Libya's turmoil but should be able to obtain energy from other sources
• Any Algerian trouble will affect Spain and Italy
• Major concerns of the US markets are Government Sponsored Enterprises reform, debt ceiling for the federal government and 2012 US budget
• Recommended emerging markets currencies to invest in are the Mexican peso, South Korean won, Chinese renminbi, Indonesian rupiah, Israeli shekel, Polish zloty, South African rand and Turkish lira.