Update on TXU Corporation LBO

In 2007, a group of private equity firms and investment banks bought TXU Corporation for $45 billion in the largest leveraged buyout transaction.  The company changed its name to Energy Future Holdings Corporation but the fact remains that it is in trouble.  This is due to lower gas prices (the U.S. fracking expansion) and demand (from the recession and jobless recovery).  Two years ago, the debt associated to the deal was trading at a discount.  As of March 31, 2013, KKR has thrown in the towel and is valuing the bonds at 0.05 of cost.

On April 15, the company proposed to re-structure its $32 billion in debt.  Equity owners would be wiped out and the senior debt owners and the original private equity consortium would split the company 85%/15%.  Already, distressed debt managers Franklin Templeton Investments, Apollo Global Management LLC, Centerbridge Partners and Third Point LLC are buying debt which would be converted to equity stakes in case of re-structuring or bankruptcy proceedings.

A few institutional investors were unlucky enough to have negotiated terms to invest directly in the buyout.  Others were only invested in the private equity funds leading the deal.  Some of them are the biggest pensions such as California State Teachers' Retirement System, California Public Employees' Retirement System, Washington State Investment Board, Oregon Public Employees' Retirement Fund, New Jersey Division of Investment and Pennsylvania State Employees' Retirement System.  According to TorreyCove Capital Partners LLC of La Jolla, California, KKR 2006, the fund with the TXU deal, will still have a higher return than the S&P 500 in 2012.  KKR 2006 returned 7.09% versus 3.25% for the index.  The privileged co-investors included California State Teachers' Retirement System and Government of Singapore Investment Corporation.  There is no word if either managed to offload their direct investments through the secondary market.

In another twist, some fund managers think that Energy Future Holdings could extend its debt into the future. Since 2009, the company has re-financed $25.7 billion of its debt.

The source for this article can be accessed here.

CalPERS Reviews Hedge Fund Strategy

The California Public Employees Retirement Systems (CalPERS) is in the midst of changing its allocation strategy for its hedge fund investments.  There are $5.2 billion in assets out of a total of $254.9 billion.  As part of its total portfolio, it is not that important but the absolute dollar numbers are impressive.  They are seeking to reduce their equity exposure by investing in assets that are not correlated with long only funds, private equity and high yield bonds.  Edigio Robertiello, senior portfolio manager of absolute return strategies, has proposed the following changes:

• CalPERS will have to raise the percentage of assets allocated to hedge funds to much more than currently
• Classifying the hedge fund allocation separately from the global equities allocation
• Limiting the beta to global equity markets to 0.20 
• Setting a standard deviation target for returns to 8%

While CalPERS is considering Robertiello's recommendations, he is reviewing the current hedge fund investments and making the following changes:

• Reducing the number of hedge funds to concentrate assets in fewer strategies
• Reducing the fund of funds allocation to 15% from 29%.  Emerging fund of funds will have a 10% allocation.
• Reducing the investments in Asia and Europe to 5% from 19%
• Increasing the allocations to equity market neutral and global macro to 10% each
• Adding an allocation to event driven to 5%
• Increasing the allocation to equity long/short to 15%

Since the portfolio has underperformed its internal benchmark by 2% since it was begun, Robertiello is hoping that the changes will improve its performance.  Against this backdrop, CalPERS is evaluating whether or not passive management is more efficient than active management.

The source for this article can be accessed here.

Private Equity: End of Life Fund Assets

The traditional methods of exiting private equity investments (i.e. IPO) are not working for many investments bought in 2006 to 2008.  These companies were acquired using unrealistic projections or at high prices and have no buyers.  They are perhaps the last holdings of a fund.  According to Andrew Hawkins, CEO and Founder of NewGlobe Capital Partners, there are $75 billion worth of companies in this category.  NewGlobe and two other firms, Vanterra and Hamilton Lane, will buy these assets, allowing the private equity fund to close and return cash to its investors.  This allows the fund manager to start up a new fund.  What does NewGlobe receive?  Oversight of the new fund and a chance to invest in the new fund.

There are two other exits that are available:  (master limited partnerships (MLPs)) and employee stock option plans (ESOPs).  The fund would sell the company to the MLP.  Then the MLP would offer an IPO.  This would be a good resolution for a company that is still too small to be publicly traded or have a low valuation.  The ESOP route would sell the asset to the employees and management of the firm.

The source for this article can be accessed here.

Allocation Targets of Public and Corporate Pension Plans

I found this interesting post on the AllAboutAlpha.com website that I access through my CAIA membership.    The author refers to two surveys on pension funds from Pyramis, a part of FMR Management, and JP Morgan.  In previous posts sourced from Pensions & Investments, pension funds are planning to allocate more assets to alternative investments.  The Pyramis study breaks down the pensions into public and corporate plans.  US public plans are allocating 13% while US corporate plans are allocating 5%.  Both figures are well below other western nations.  Canada and countries from the Nordic Region are planning a 20% allocation.

The JP Morgan survey looks at public pension funds, corporate pension funds and endowments/foundations.  Hedge funds, private equity and real estate are the major alternative investments.  Corporate pensions have a higher allocation in hedge funds (4.6% to 4.2%) while real estate (4.6% to 3.5%) and private equity (8.1% to 3.3%) are more popular with public pensions.

Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Management Fees and Investor Alignment in Private Equity

In an article in Pensions & Investments, the Blackstone Group announced that it does not count management fees as one of the items that align general partner and investors' (i.e. limited partners) interests.  Instead, the company's investment in its own funds removes that issue - according to Steven Schwarzman, Blackstone founder, chairman and CEO.  During the company's twenty year history, it has invested $6 billion in its funds, alongside their clients.  For example, they committed $826 million in capital for the Blackstone Capital Partners VI LP, a $16 billion fund.

However, Blackstone is one of the few publicly traded private equity firms.  It is in the interest of management, who have large holdings of the stock, to maximize their management fees versus their performance fees.  The reason is that research analysts value these companies based on their management fees and/or assets under management.  Performance fees are too volatile and unpredictable to include in their analysis.  Instead of concentrating on a fund's performance, the company would be gathering assets.  Also, if performance fees are already high, there is less incentive to hit the hurdle.

Charging management fees was originally used to help private equity funds keep the lights on while investing capital.  For larger funds, the fees can be much more than the basic costs.  According to the Institutional Limited Partners Association, management fees should be based on reasonable operating expenses plus reasonable salaries.  In the second quarter of 2012, Blackstone had $373.4 million in fees, $113 million in expenses and $269 million in salaries.  Some institutional investors are pushing back on management fees and receiving fee discounts of 25 basis points if they invest $100 million or more.

The source for this article can be accessed here.

A Study on Infrastructure Investments

In recent years, a new asset class investing in the infrastructure of a nation has been classified for use in asset allocation models.  What is infrastructure?  It is commonly known as assets in the transportation, telecommunications, electricity and water sectors.  Emerging and developed nations need to build out their infrastructure for different reasons.  The former due to population growth and economic development.  The latter to upgrade and replace existing infrastructure.

Usually, these projects would be financed by local or national governments.  The developed world is still recovering from the credit crisis in 2008 and dealing with the continuing Eurozone situation.  The emerging world, other than China, does not have the financial resources.  They are unlikely to meet global need for infrastructure investments.  This could be as high as US $70 trillion for 2005 to 2030.  Hence, the call for private investors such as pension funds and private equity firms.

Investors may invest directly into infrastructure assets through Public Private Partnerships or project finance structures.  They are exposed to disadvantages such as liquidity risk, very long investment time horizon, political risk, concentration risk, regulatory risk and high capital requirements.  They can buy securities of companies directly or buy funds/indices in sectors related to infrastructure.  The reduces all risks except for political and regulatory.  Market risk is higher in this case.

In the article Risk, Return and Cash Flow Characteristics of Private Equity Investments in Infrastructure in the Alternative Investment Analyst Review, Florian Bitsch, research assistant at the Center for Entrepreneurial and Financial Studies; Axel Buchner, postdoctoral researcher at Technische Universitat Munchen and Christoph Kaserer, professor at Technische Universitat Munchen obtained detailed private equity deal information, including monthly cash flow data, from the Center for Private Equity Research for 363 infrastructure and 11,223 non-infrastructure deals from January 1971 to September 2009.  The deals had to be exited and spanned the alternative energy, transportation, natural resources, energy and telecommunications sectors.


From the data they find:

• Infrastructure investments have shorter time horizons
• Infrastructure investments are twice as big as non-Infrastructure deals
• Infrastructure does not offer more stable cash flows
• Infrastructure investments have higher returns and lower risks.  They have lower default rates and better returns than non-infrastructure deals.
• Brownfield investments of established companies have lower risk and default rates.  They have better returns than greenfield investments.  Private equity and venture capital deals were used as proxies.

The factors affecting fund performance were:

• Excess investment capital does not bid up asset prices for infrastructure deals as it does for non-infrastructure
• Data is inconclusive that infrastructure investments are an effective hedge against inflation
• Infrastructure deals are correlated to the markets
• Infrastructure deals are not correlated to the broader economy, as defined as GDP
• Infrastructure and non-infrastructure deals are negatively affected by interest rate changes
• Fund manager experience has no influence on returns
• Longer dated deals have better returns as poorly performing deals are exited quickly
• A fund requiring additional rounds of financing usually have poor returns
• The size of the deal does not affect infrastructure deal returns
• European infrastructure deals have the best performance
• Transportation is the best performing sector  

Investment Ideas in Real Estate Markets

As a member of the Chartered Alternative Investment Analyst (CAIA) Association, I am fortunate enough to attend various learning events.  Last week, I listened to four investment professionals about their views on the Real Estate Markets.  Real estate may be termed the original alternative asset.  They were Rod Hinze, Founder and Portfolio Manager of Keypoint Capital Management;  Richard Adler, Managing Director and Co-founder of European Investors Inc;  Michael Stratta, Investment Analyst of Aviva Investors and Scott Yetta (sic) of Cerberus RMBS Opportunity Fund at Cerberus Capital Management.  They have different viewpoints on the markets.  Hinze manages an equity long/short hedge fund.  Adler invests in REITs and directly in real estate.  Stratta manages funds of funds and private equity funds.  Cerberus has launched a fund that invests in structure finance.

Keypoint's portfolio is market neutral.  It seeks absolute return by investing in real estate related securities.  Hinze was long on several subsectors such as student housing, data centers and movie theaters.  He was short on big box retailers, toxic debt structures in mortgage REITs and the standard overvalued securities.  Last year, the real estate appeared correlated to the equity markets.  But if the subsectors were analyzed, there was much variation.  Class A malls and self-storage were up and banks were down.  Keypoint's beta or correlation to the markets ranges from 0.1 to 0.2.

On the private equity side, Stratta is seeing a continuation of a trend for better liquidity terms for investors.  The preference is for an open-ended fund with quarterly availability for redemptions.  The classic closed-end fund with a ten year lockup is losing its popularity as more investors are looking for yield and dividends; not for appreciation.  Stratta covers the Americas and has investments in Brazil (Sao Paolo and Rio de Janeiro).  He is already looking at opportunities in what he terms the next emerging markets:  Panama, Peru, the Dominican Republic and Colombia.  Canada is divided into two parts:  Vancouver and everywhere else.  Asian banks control most of the real estate transactions in Vancouver.  Other banks cannot crack the market.

European Investors Inc's regional allocations are:  overweight in Asia, underweight the US and standard weighting for Europe.  Adler invests in REITs and real estate.  They have a portfolio of $1.5 billion in direct investments.  He spoke extensively about the increased volatility and correlation to financial stocks of REITs.  Due to the new ETFs on REIT indices, electronic arbitrage trading is causing large market moves in the same manner as the equity markets.  Regarding investment ideas, he is positive on Thailand, the Philippines, Turkey, Israel and Brazil because the general or macro conditions are favorable.  Mortgage REITs, such as Annaly Capital Management, have a 15% interest rate.  He expects that to retreat to the upper single digits - which is sustainable over the long term.  There is a also a new REIT asset class with the single family house rental as the underlying.  These homes may be a straight lease or lease to buy.  In five years, there are projected to be two to three million homes in this category.  The expected returns for this investment is 8%.  The first deal in this REIT was in April 2011 in a deal co-sponsored by Fannie Mae and Credit Suisse.

The final speaker from Cerberus Capital had recently launched a $1 billion hedge fund focused on Residential Mortgage Back Securities (RMBS).  For a fund manager, he gave a surprising amount of detail to non-investors.  He split his investment universe into agency and non-agency securities which are a $10 trillion market.  Agency securities are created by government sponsored entities such as Ginnie Mae, Fannie Mae and Freddie Mac.  Their main risk is pre-payment of loans and mortgages.  Non-agency securities have credit and interest rate risks.  The fund managers analyze RMBS based on a number of factors:

• Yield is analyzed based on the behavior of the borrowers.  Of the universe of borrowers within an RMBS, they look at how many will pre-pay (i.e. re-finance), pay late, get loan modifications or default.   Scott is seeing value in borrowers with hybrid loans such as the 5/1 homeowner loan where the first five years are fixed rate and then the rate floats.  The most interesting borrowers are two to three years into the floating rate period.  They are pre-paying their loans by re-financing into fixed rate loans at historically low rates.  Many of these loans may be found in a mezzanine tranche.
• The recovery value of houses liquidations is viewed on a state by state basis because of differing state foreclosure laws.  A house in California can be foreclosed without going through court approval;  not so in New York and Florida.  The shorter the period, the higher the rate.
• Built in expectations that there will be another 10% drop in real estate
• Investors need conservative assumptions on the above three factors as a cushion for credit risk.  2011 returns were down because of two macro events:  the Eurozone crisis and the delay in the selling of Maiden Lane II, a huge loan portfolio of the Federal Reserve Bank of New York.  In the third and fourth quarters, funds hedged against a drop in RMBS - anticipating that Maiden Lane II would cause an oversupply of this product.  They hedged using residential indices such as the ABX and Prime Index, commercial index (CMBX) and high yield/investment grade indices.  Paying for the loss protection caused real estate hedge funds to underperform the market.
• Documentation and loan servicers are understaffed and large institutions are selling their units
• Government policy directly affects agency securities.  Cerberus has some insight into the federal government by having Dan Quayle and Jack Snow as staff and by owning GMAC.

Thank you, CAIA, for organizing this great event.

SEI's 2011 Private Equity Survey: Investor Demands Since 2008

411 private equity fund managers, investors and consultants participated in SEI's 2011 Private Equity Survey.  Due to underperformance in the years since the credit crisis, fund managers have been providing more transparency and liquidity.  Management and incentive fees have been lowered.  22% of investors are paying lower management fees and 38% are paying lower incentive fees.  37% of fund managers lowered management fees and 11% lowered incentive fees.  Size also matters.  The larger institutional investors were more likely to have their fees lowered while the larger private equity funds were more likely to lower them.  Managers were also trying to make their investors comfortable with their infrastructure, giving them solid performance data and educating them on the portfolio.

Factors to consider when raising capital:

• Have a clear investment philosophy
• More transparency
• Turn client service into asset growth

The source for this article can be accessed here.

Private Equity Firms During the Credit Crisis

Through Global Finance magazine, I was directed to a white paper on Merrill DataSite called Riding Out the Storm:  How Private Equity Firms Survive and Thrive During Tough Economic Times.  The global recession that began in 2007 change private equity investment conditions drastically.  Financing deals grew more expensive as banks tightened their loan procedures.  Company valuations declined as the equity markets tanked.  Deals fell apart.

The private equity firms that did well during the recession followed these basic practices:

• Apply sound business discipline to their investment practices
• Good personnel
• Portfolio diversification
• Have proprietary deals
• Overseas investments
• Stellar professional reputations

The firms that did not do well made these mistakes:

• Difficulties fund-raising
• Lack of due diligence on portfolio companies
• Pay too much for debt
• Did not add value to portfolio companies
• Disorderly change of management at portfolio companies

In the future, the paper concludes that private equity firms should concentrate on their core strengths, reduce their debt and practice honesty and fairness to weather the next economic crisis.

Institutional Investors Favor Emerging Markets and Alternative Investments

In an article published by Pensions & Investments, the Deutsche Bank 2011 Institutional Survey shows that investors are planning to shift their capital into the emerging markets and alternative investments (commodities, hedge funds, private equity and real estate) over the next year.  They will be moving out of the US stock and government bond markets.  The survey was conducted for 101 investors with $1.2 trillion in assets.

The source for the 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.

Another Private Equity Shop Wants an IPO: Carlyle Group

Following in the footsteps of Blackstone and Apollo Management, the private equity company Carlyle Group has filed an IPO with the SEC.  It should be closed in the first half of 2012 and raise $100 million.  Carlyle had first attempted to go public before the credit crisis of 2008.  The other private equity firms' stock prices have been failures, to say the least.  Blackstone went from $31 to $12.50 and Apollo's stock is down 33% since the IPO.  John Duffy of Keefe Bruyette & Woods had predicted this outcome.  He said, "If guy like Schwarzman are selling, I don't know if you want to be on the other end of the trade."

Sources for this article can be accessed at Crains and Finalternatives.com.

CDO: Alternative Assets Being Used as Underlying Assets

CDOs were created to use bonds, mortgages and commercial loans as the underlying collateral.  In the last ten years, they have begun to use alternative assets such as distressed debt, hedge funds, commodities and private equity as the underlying.  They have also created CDOs with one tranche.

Distressed debt is defined as securities of companies in default or that are trading below investment grade.  They have a yield of the Treasury rate plus 10%.  The portfolio of the CDO may include both distressed and not distressed debt.  By the structure of the CDO, the rating of the senior tranche is higher than the underlying portfolio.  Investors can gain access to distressed debt and limit their risk.  Banks are the main sellers of distressed debt to CDOs.  It cuts their losses on the debt, offloads their liabilities to the CDOs and frees up reserve capital by reducing their nonperforming assets ratio.

Collateralized fund obligations (CFOs) have multiple hedge funds as the underlying assets.  The institutional investors interested in this vehicle are pension funds, insurance companies, mutual funds and high net worth clients.  The hedge funds are aggregated under a fund of fund manager.  The manager has restrictions on the total number of hedge funds, number of investment strategies and percentage invested in each fund.  The restrictions are set by the rating agency.  When the payments are due to the investors of the CFOs, the fund of fund manager has to notify the hedge fund managers to redeem the investments.

Commodities can be the underlying assets for collateralized commodity obligations (CCOs).  More accurately, the assets are Commodities Trigger Swaps (CTSs).  These transactions trigger a payment when a condition is met.  An example would be when the price of the commodity hits a price target.  The CTSs would be based on a basket of commodities.  They would avoid extremely volatile assets.  The trigger events would have to be substantially spread out to avoid multiple payouts at the same time.

Unlike normal CDOs, single tranche CDOs (STCDOs), also known as bespoke CDOs or CDOs on demand, only create one tranche.  They are structured as synthetic CDOs, using CDSs to receive premiums to pay the interest rate on the CDOs' securities.  In this security, the investors have more control over the terms than in a CDO with multiple tranches and receive all cash flows.  The advantage for the sellers is that they are cheaper and quicker to issue.  In a normal CDO, the entire risk of the portfolio is transferred to the investors.  In a STCDOs, only a specific portion of the portfolio risk is transferred to the investors.  The seller is still exposed to the underlying assets in this case.

CDO squared invests in other CDOs.  This allows for more diversification and higher spread returns for the investor.  Losses are incurred based on where (the tranche) bond defaults occur.  In a normal CDO, losses are incurred based on the number of bond defaults.  CDO squared may be cash backed or synthetically created and may invest in different tranches or specialize in one tranche across multiple CDOs.  There is a danger that the CDO squared may invest in assets that are in multiple CDOs.  Rather than diversifying the portfolio, these overlapping assets cause the portfolio to be concentrated in them.  This would cause greater losses than expected if the underlying assets default.

Lastly, there also was a CDO created with private equity investments as the underlying assets.  As with CFOs, there were restrictions on the total number of private equity managers.

Coller Capital's Survey of Private Equity Investors

There was a recent article in Pensions & Investments that commented on the correlation of returns between the markets and private equity during the financial meltdown in 2008.  In a survey, 54% of investors were surprised that both assets moved down in tandem.  Other results from the survey were that 87% were not planning to re-invest with their managers due to poor performance.  There were also negative attitudes towards follow-on funds.  19% of investors believe 33% of the funds will not be able to raise capital for new funds.  24% believe 21%-30% will fail and 38% believe 10%-20% will fail.

A Different Way of Looking at the Current Investing Environment

Members of CAIA were invited to an event sponsored by the New York Hedge Fund Roundtable last week.  Mark Yusko, CEO and Chief Investment Officer of Morgan Creek Capital Management (with $10 billion in assets under management), presented on how to invest in the current low return environment that he called the 0-3-5 problem.  Cash is at 0%.  Bond yields are at 3% and stocks are expected to return 5%.  In order to attain returns in the high single digits that investors such as pension funds and university endowments need, he proposes that investors move to a skill based portfolio.  There were a multitude of themes presented.  They centered around the lack of returns in the developed world and the rise of the emerging markets.

The best portfolios will not have alternative investments as a separate asset class.  They will ignore these classifications and integrate them.  A traditional portfolio may be 50% US equity, 15% international equity, 30% fixed income and 15% in hedge funds.  The updated concept will ask where the hedge funds invest.  In this example, let's say the funds invest in US equity.  Then the asset allocation of the portfolio will look like this:

• US equity 65%
• International equity 15%
• Fixed income 30%

Adding assets with uncorrelated returns such as hedge funds "can boost expected returns, while reducing portfolio volatility."  Private equity returns for funds operating during a recession are higher.  Yusko encourages investors to take advantage while funds are having difficulty with fund raising.

That being said.  Investing in US markets will be difficult.  The US is in danger of mirroring Japan on government debt, low interest rates and low growth in GDP.  Investors should concentrate in Brazil, Russia, India and China (BRIC) with an overweighted allocation in Asia.  Over the last 10 years, this has returned 250% cumulatively.  The Standard & Poor's 500 and NASDAQ have negative returns.  Credit Suisse, the World Bank and PricewaterhouseCoopers have predicted that China will surpass the US as the world's largest economy by 2020.  The emerging markets have the same forces that propelled the US to become the largest economy in the 20th century:  population growth and low debt in local companies.

Commodity prices will rise as the emerging markets nations develop.  As China and India industrialize, oil demand will rise.  The best way to play this is to invest in oil services stocks or indices such as OIH (Oil Services Holders Trust Index) or OIX (CBOE Oil Index).  Gold prices will continue to reflect the rise in US government debt as a percentage of GDP.  Other commodities with rising prices are platinum, palladium, corn and wheat.

Yusko also commented on various risk factors in the current environment.  They were:

• Inflation - There will be none unless there is growth in the money supply.  The Federal Reserve Bank is putting money into the financial system but the banks are keeping it on their balance sheets.
• Valuation - Stock valuations have been above the historical average since the 1990s.  The market will be reverting to the mean.
• Monetary - The Fed's Quantitative Easing 2 Program will end on June 30th.  US equity markets will be discounting by 20% for that event before the date.
• Growth - Rise in unemployment may signal low growth in Gross Domestic Product.
• Wealth - Housing prices continue to fall in the US and developed nations (i.e. Western Europe).
• Demographic - The US is an aging nation that will spend and grow less.
• Government - Deficit levels are not sustainable.
• Default - Municipal bonds, especially in California, Illinois, New Jersey and New York are in danger of defaulting.
• Sovereign - There may be another debt crisis in Europe because banks own the bad debt of Portugal, Ireland, Greece and Spain.
• China - The renminbi was re-pegged to the US dollar in July 2008.  This caused the dollar to strengthen and commodity prices to collapse.
• Devaluation of the dollar - Largest risk for US investors

One old rule still applies - diversify your portfolio.  In addition to the ideas above, he listed other possible assets:

• International Real Estate
• Absolute Return Strategies as a substitute for bonds
• Distressed debt in US and Europe

Thanks for the roundtable for setting up the presentation and Mark Yusko for presenting their views.

How Private Equity Firms Are Changing

Private equity firms are expanding into hedge funds, fund of funds, underwriting stock and bond offerings, infrastructure and real estate due to a lack of investing opportunities and capital raising.  They are following Blackstone's example of becoming a publicly traded firm where they have to make themselves more attractive to institutional investors by diversifying their revenue streams.  The stock performance of these firms have been disappointing.  Blackstone's share price is 45% below the IPO price in 2007.  Apollo Management is down 4% since March.  Of course, private equity firms are known for buying low and selling high.  So, if they are selling...

The source for this article can be accessed here.

Private Equity Investors Say Brazil Beats China

A survey by the Emerging Markets Private Equity Association and Coller Capital, a firm that invests in the private equity secondary markets, has ranked the most attractive markets over the next 12 months as:  1.  Brazil, 2.  China  and 3.  Other Emerging Asian Markets (i.e. not China and India).  Brazil offers better values than China right now.  156 institutional investors provided answers to the survey.

Is Your Portfolio Truly Diversified?

During the credit crisis of 2008, all assets (equities, fixed income, real and alternative assets) declined in value.  Welton Investment Management wrote a research report regarding asset allocation.  According to Modern Portfolio Theory, the most efficient portfolios have assets that are not correlated.  This minimizes any excessive decrease in assets during a crisis.

They tested this theory by taking 24 indices representing the 4 asset types and calculated the correlation of returns over 10 years across 2.5 business cycles.  They discovered that 80% of alternative assets and 75% of real assets were correlated with stock returns.  The alternative assets were private equity, event driven, long/short equity, distressed securities, multi-strategy, fixed income arbitrage, convertible arbitrage and risk arbitrage.  Only global macro and managed futures were non-correlated.  For real assets, infrastructure, real estate and TIPS (Treasury Inflation Protected Securities) were correlated.  Commodities was the only real asset that had non-correlated returns against equities.

The 4 revised asset types should be:

• Equities, correlated alternative and real assets
• Global macro and managed futures funds
• Commodities
• Fixed income

The research report may be accessed here.

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.