Managing Counterparty Risk for Prime Brokers and Hedge Funds

Before the failures of MF Global, Bear Stearns, Lehman and Merrill Lynch, hedge funds and their investors gave no or little thought to the idea of measuring counterparty risk.  Fund managers should perform due diligence at the onset and during their relationship.  The same analysis should be done on any third party service providers such as auditors, fund administrators and lawyers.

Here is how hedge funds manage counterparty risk of their prime brokers:

• Use multiple brokers
• Add "amber" terms to the prime brokerage agreement.  If the credit default swaps spread reaches a certain figure, then the fund's assets should be moved to a separate account.
• Discover the exposures of the prime broker
• Buy credit default swaps on the prime broker

The source for this article can be accessed here.

Notes on China's Government Debt

In the November 2011 issue of Global Finance magazine, Thomas Clouse wrote an article about China's government debt.  As part of the stimulus plan enacted by Beijing, local governments must fund infrastructure and public projects.  Since they cannot issue bonds or levy property taxes, they use real estate to fund them.  Local government investment vehicles borrow money using the real estate as collateral.  Lately, the real estate market has been cooling down which will cause losses on these loans.  Who will take on the losses?  The banks, local governments or the central government.  There are $1.5 to $2.1 trillion in loans which is 70% of China's Gross Domestic Product.  Stephen Green of Standard Chartered Bank believes that the central government's balance sheet surplus and taxation authority can resolve this high level of debt without triggering a banking crisis - as long as there is strong nominal growth.

S&P Downgrade Is Sent in Error

The ratings agencies Standard & Poor's, Fitch and Moody's have had a rough time in the 2000's.  Between missing the disasters at Enron, WorldCom, Tyco International, the credit crisis of 2008 and the downgrading of US debt, they have been under fire for conflicts of interest and incompetence.  On Thursday, Standard & Poor's sent out an email message to its subscribers of its Global Credit Portal that French debt was downgraded from AAA.  Two hours later, S&P corrected it and affirmed that France was still rated AAA.

Market reaction was swift and immediate.  The Stoxx Europe 600 Index kept falling 1.5% and French bonds yields rose 28 basis points on the ten year debt.  When yields rise on bonds, prices fall.  Commodities, US Equities and the Euro fell briefly.

The source for this article can be accessed here.

Investors Ignore Smaller Hedge Fund That Have Better Returns

In earlier posts, we noted that smaller hedge funds had better returns than large ones.  PerTrac did a study named Impact of Fund Size and Age on Hedge Fund Performance.  There were six conclusions from the research report:

• From January 1996 to December 2010,  hedge funds managing less than $500 million outperformed funds above that threshold in 10 of the 15 years.
• The smallest funds had the best performance.  Funds with less than $100 million in assets under management (AUM) had a return of 13.6% for the same timeframe.  Funds with $100 million to $500 million in AUM had a return of 10.87% and those with over $500 million in AUM had a return of 10%.
• In 2008, during the credit crisis, the reverse was true.  Large funds with over $500 million in AUM had better returns.
• In the first six months of 2011, the trend continued with large funds returning 0.83%.  Funds with less than $100 million in assets under management (AUM) had a return of 1.02%.  Funds with $100 million to $500 million in AUM had a return of 1.05%.  

However, institutional investors are not heeding this data.  According to Russell Investments, 80% of hedge fund assets are managed by funds with AUM over $1 billion.  The largest 10% manage 15% of the total assets.  Funds that are larger than $5 billion in AUM manage 62.4% of the industry's AUM.

The article was written by Michael Beattie, President and Chief Investment Officer of Tradex Global Advisors, and can be accessed here.

Some Hedge Funds Benefit from October's Rally

The Standard & Poor's 500 stock index rose 11% in the month of October.  There was no real change in the economic outlook.  The rally was based on an external event;  that the European debt crisis would be resolved.  Some hedge fund managers such as Jim Simons at Renaissance Capital and Robert Gibbins at Autonomy Capital built on this year's successes.  The Renaissance Institutional Equities Fund rose 5% in October and is up 33% year to date.  The Global Macro fund of Autonomy Capital is up 2.7% in October and 13.9% for the year.    Other managers merely pushed into positive territory.  David Einhorn of Greenlight Capital rose 8.5% for the month and is up 1.87% for the year.  Bill Ackman of Pershing Square was up 14.4% and is even for the year.  John Paulson of Paulson & Company made some gains during the month but is still down substantially.  Some managers such as Daniel Loeb of Third Point Capital and John Thaler of JAT Capital had reduced their risk exposures to the markets in September.  When the rally came in October, they missed out on the gains.

The source for this article can be accessed here.

Insider Trading: SAC Capital Trades Flagged

The Financial Industry Regulatory Authority marked nineteen SAC Capital trades as suspicious and forwarded them to the SEC.  They included drug companies such as Genentech Inc., ViroPharma Inc. and United Therapeutics Corporation.  These trades were flagged because they were executed around major news announcements.  In 2003, Genentech's rose 45% after it published the positive results of a drug study for Avastin.  SAC made $158,500 by buying days before the news.  Same situation occurred in 2007 with United Therapeutics.  Just before the positive results of a drug trial were announced, SAC took a position in the stock.  SAC made $2.3 million when the stock rose 38%.  SAC shorted ViroPharma in 2009 - just before its drug trial was pronounced ineffective.

Other trades being investigated were made before merger and acquisition activity.  Two of them are Hologic Inc.'s 2008 buyout of Third Wave Technologies Inc. and Johnson & Johnson's purchase of Couger Biotechnology.

Over the last ten years, SAC Capital has made $14 million on these trades.  For enforcement purposes, only the trades in the last five years count.  There is a five year statute of limitations on insider trading.

The source for this article can be accessed here.

Private Equity Funds in India

Private equity investors have favored India as a source for their emerging markets investments.  Recently, China and Indonesia have supplanted it.  All three countries have a need to build out infrastructure, education and healthcare systems but a few trends that have tipped the scales away from India.

The Chinese government is supporting domestic, local currency private equity funds with less regulatory oversight and restrictions on ownership.  Carlyle Group, Blackstone and Texas Pacific Group have invested in joint ventures with Chinese state-owned enterprises and governments.  The Indian stock market is performing poorly and not conducive to IPOs.  Capital flows have been negative as foreign investors have been de-risking.  Meanwhile, China's markets are restricted to local investors which makes it easier to exit private equity positions.  Indian fund managers lean towards the deal-making side and not on generating high returns by adding value to the portfolio companies.

The Securities and Exchange Board of India (Sebi) has proposed some restrictive rules.  Private investments in public equity (PIPE), private equity and infrastructure funds should register with Sebi.  The general partner of a fund has to invest at least five percent of the fund assets.  This restricts large funds to be managed by the Blackstones of the world.

India has an inefficient stock market with many small and mid-cap companies that are not adequately covered by research analysts.  Unlike the standard private equity deal, some fund managers take minority stakes of 2% to 7% in these public companies and work with their managers to improve their businesses.  Meanwhile, they work with the sell-side to raise their companies' profiles to investors.  When the stock prices rise, they sell their position on the secondary market.

The source for this article can be accessed here.

An Interview with KStone Partners

Finalternatives.com held a recent interview with Joseph Marren, President and CEO of KStone Partners, a fund of fund manager that has three funds with $125 million in assets under management (AUM).  Their returns are +20% for 2009, +8% in 2010 and in positive territory in 2011.  KStone offers access to diversified alternative investments to institutional and high net worth investors.  They use 25 to 33 managers in their funds that have a low correlation to the equity and debt markets.  They find their managers through their networks mainly.

He believes that there will also be a role for a fund of funds manager.  Small and medium institutional investors need them to provide access to a diversified hedge fund portfolio.  They do not have the scale (in AUM).  As for large institutions, the current trend is self-management of portfolios.  Marren thinks that investors will discover that they do not have the personnel to create an alternative investments portfolio and will return to the fund of funds model.