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.