Tuesday, December 30, 2008

2008: Year of Reckoning for Pensions?


How will you remember 2008? Most investors will remember 2008 as a year of turmoil:

The past 12 months will be remembered as a gut-wrenching confluence of unlikely defining trends, almost all unpleasant: a puncturing of the housing bubbles in the U.S. and Western Europe; a paralyzing credit freeze among banks worldwide; an abrupt plunge in commodity and stock prices; global government bailouts of banking, auto and other sectors, and of consumers (through "stimulus packages"); and the re-emergence of unapologetic deficit spending to put an economic Humpty Dumpty back together again.

But the year is better understood as one of reckoning, of forced atonement for past sins. The industrialized world has long been living beyond its means, floating everything from unaffordable house purchases to highly leveraged corporate takeovers on a sea credit of unprecedented volume. When the tide of easy money that characterized most of the decade finally went out, crises long in the making suddenly emerged full-blown almost everywhere one looked.

The ceaseless reporting of crushing bad news – the U.S. housing collapse is killing our forest sector; the world's largest industrial enterprise, General Motors Corp., said in December it didn't have enough cash to make it to the end of the year – was so grim and unfathomable that it provoked comparisons with the Great Depression, when everything was falling apart and no one knew why.

The meltdowns in various realms of the global economy often have no equal since the Dirty Thirties, to be sure. But they have unfolded with predictable logic, as naturally as the connections made in a child's join-the-dots puzzle.

The only question is whether we will heed the lessons learned from this year's debacles, which come only a few years after the irrational exuberance of the tech- and dot-com collapse.

1. Housing bubble. This is ground zero for the worst global economic downturn since the 1930s. For about four years ending in 2007, a buying mania overcame aspiring homeowners in pockets of the U.S. (most notably California and Florida) and in Western Europe.

It was fueled by an unreasonably prolonged period of low interest rates; a mistaken belief, especially in the U.S., that house values never fall; and aggressive mortgage vendors whose terms were no down payment, no collateral, no proof of income, and initial low "teaser" rates that would "reset" at much higher monthly payments in years ahead, by which time the house would have vastly increased in value and become essentially self-financing.

That was the theory, and it held until last year when the U.S. Federal Reserve Board finally reacted to the overheated housing market by boosting its key lending rate to more than 5 per cent, just in time for the first "resets" to kick in.

By the fall of 2007, house prices in San Diego; Port St. Lucie, Fla.; Reading, England; and suburban Barcelona were beginning their plunge by 50 per cent to 70 per cent. (In Canada, where the phenomenon of subprime mortgages to high-risk buyers occurred on only a modest scale, average home prices slipped just 11 per cent from May to December of this year.) Tens of thousands of Americans and Europeans who had bought more house than they could afford simply walked away from their properties or lost them through foreclosure. And why not? There was no down payment to lose, only a string of modest monthly teaser payments.

There now remains a huge overhang of vacant properties that remain unsold even at knock-down prices because of the subsequent U.S. and European recessions. The current widespread fear of job loss trumps buying a home at any price – bad news for a Canadian forestry sector reliant on U.S. exports.

Lessons learned: For buyers, when a deal looks too good to be true, it is. For lenders, don't be surprised if you're stuck with vacant homes in which the buyers had not sunk much of their life savings. For central bankers, the economy pays a fearsome price for the reluctance to raise rates and end the party before the revelry gets out of hand.

2. Global banking collapse. Wall Street bundled those dubious home mortgages taken out by buyers with poor credit histories into packages of $250 million (U.S.) or so, and flipped them to banks, insurers, pension funds, hedge funds and other financial institutions worldwide, which re-flipped them, until no one knew who held the mortgage on the split-level at 83 Cherry Orchard Lane in a new Oakland, Calif., subdivision. It might be held by UBS AG or Royal Bank of Scotland PLC, the biggest banks in Europe and Britain, respectively; or by Citigroup Inc., the No. 1 U.S. bank; or by one of Wall Street's Big Five brokerages; or by the Canadian Imperial Bank of Commerce – all of which have written off several billion dollars worth of soured mortgages.

Because so few of these venerable, giant institutions had sufficient underlying capital to cover the loss if a sizeable chunk of those dodgy mortgages should fail, when the worst-case scenario occurred, the demise of Merrill and two of its Big Five peers was not far off.

Royal Bank of Scotland had to be nationalized in a British government bailout. And Uncle Sam twice injected emergency rescue funds into Citigroup last fall. To date, Washington has had to put up a stunning $8 trillion to prevent the collapse of America's banking system – a move replicated by most West European governments.

Lessons learned: All movements go too far. Couples with $30,000 in combined earnings should not be purchasing $650,000 townhouses. The noble goal of bringing home ownership within reach of all Americans, promoted by the Bush administration since 2002, should have proceeded with more safeguards for the lenders, who themselves were reckless in their pursuit of upfront fees on mortgage sales. And we learned that it's best for the risk attached to a loan to stay with the initial lender, which must satisfy itself that the borrower can handle the debt and is there to renegotiate the terms if the borrower runs into trouble.

3. Global recession. With troubled banks unable or unwilling to lend, even the most creditworthy consumers and businesses have been denied loans for a car purchase or plant expansion. And countless more prospective borrowers have lost their appetite for credit cards and lines of credit, as a growing fear of losing jobs and houses and of disappearing corporate profits has made concerns about a recession a self-fulfilling prophecy.

By year-end, Japan, the U.S., Canada and most of Europe were in recessions. Iceland, a member of the Organization for Economic Co-operation and Development, club of the wealthiest nations, became effectively insolvent. And the International Monetary Fund rushed financial assistance to Pakistan, Hungary and Latvia.

Lessons learned: Globalization is real. The freeze-up in credit for U.S. corporate borrowers has thinned the order books of industrial-equipment makers in Germany and Britain. American consumers who've snapped their wallets shut have doused the red-hot GDP growth of China, triggering civil unrest in that export-driven economy. Given the widespread wreckage from the troubled global financial system, the system will have to be rebuilt with uniform standards worldwide for lending practices and for monitoring banks and other lenders to ensure prudent risk management.

Financial authorities in Tokyo and Frankfurt will have to recognize that quick-buck purveyors of predatory mortgages in Alabama could someday pose a threat to Asian and European banks in the absence of co-ordinated global intervention to curb destabilizing practices.

4. Stock-market crash: In the short space of a few months in the summer and fall, stock-market prices plunged about 40 per cent in Canada and the U.S. in response to a global banking system that stubbornly refused to recover despite many government bailout attempts, which in turn signalled a halt in corporate profit growth.

The two-thirds plunge in crude oil prices from their peak in July, and rising jobless numbers in western economies (the U.S. lost two million jobs this year), were further evidence of a looming drought in profits and dividends. By late summer, investors had started stampeding for the exits, and mutual-fund withdrawals reached record levels. That was another self-fulfilling prophecy as selling begat more selling, blindsiding even the most sophisticated investors. Warren Buffett's Berkshire Hathaway Inc. lost about half its value by December.

Lessons learned: Vigilance is required in monitoring any investment that can go to zero. An investor in 2007 and into early this year who watched U.S. and European authorities cope with the global banking meltdown was adequately warned to get out. The Canadian market peaked in June of this year, and began its rapid plunge in tandem with weakening prices for oil and other commodities and worsening conditions in Canada's most important export market, the U.S.

5. Deficit chic. After decades of balanced-budget orthodoxy, North American and European governments cast aside fiscal surpluses as a policy goal, and embraced Keynesian pump-priming with as much vigour as Franklin D. Roosevelt did 65 years ago.

In the late fall, Ontario pledged to run a deficit rather than cut social services. By December, the federal Tories, who had projected a modest fiscal surplus for 2009 in the October election campaign, had embraced deficit spending on infrastructure and other programs to the tune of about $30 billion Canadian. Next month, the new Obama administration will roll out a stimulus package likely to top $850 billion (U.S.), despite a current-year deficit estimated at more than $1 trillion.

That radical shift in public policy – and the public-opinion support behind it – might be the most enduring legacy of 2008.

For pensions, 2008 will be remembered as a year of reckoning. All of them were highly exposed to equities and most of them followed the dumb advice of their consultants and diversified away from government bonds, investing billions into alternative investments like hedge funds, private equity funds and real estate that were suppose to offer absolute returns.

It all sounded so sophisticated and for many years it seemed like the winning strategy. But the music has stopped and all I hear is the deafening sound of silence as pension funds scramble to recover from a year of brutal losses:

The median public fund losses from the beginning of the year to Nov. 30, the most recent date for which data is available, was 28.7 percent, according to data from the Northern Trust, a company that represents hundreds of funds. A similar index, the Wilshire Cooperative Universe, has a median of 25.6 percent losses. The decline across the Standard & Poor's 500 pension funds index, according to a report released Tuesday, was 41 percent.

"To put that in context, that's by far the worst year we've ever seen, going back 30 years," said Bill Frieske, a Northern Trust consultant for investment risk and analytical services.

Let's attach some figures to these results. If your pension fund was worth $100 billion at the beginning of the year and lost 30%, it is now worth $70 billion (ignore contributions).

This means it will take four years growing at 10% to recoup those losses. And that is a very optimistic (and highly unlikely) scenario. The more likely outcome is that it will take a decade or longer before most of these large pension plans recoup these losses.

Let this be a lesson to all you retail investors who chase returns. What goes up fast typically comes slamming down hard, erasing all your gains. This is why you need to always think about minimizing your downside losses.

Very few pension funds thought that they would ever experience 30% losses in any given year. They were lulled into believing that a well diversified portfolio of stocks and alternative investments would by its very construction minimize downside losses.

Their consultants performed "stress tests" using sophisticated financial models but those models were largely based on erroneous assumptions that these asset classes would never be highly correlated.

As a practitioner who was working in many of these asset classes, I was always looking at the big picture and scratching my head in disbelief. I would go to conferences and hear things like "you can't lose money in hedge funds, real estate and private equity".

Yeah right! These large and sophisticated pension funds lost billions of dollars in these asset classes because they never stopped to think that what if this is all one HUGE bubble?!?!?

Now they are scrambling to redeem from hedge funds and many are selling their private equity stakes at deep discounts on the secondary market. I can hear the board of directors screaming "Just get us out of alternatives!!!".

The problem is that once you invest in private equity funds or real estate funds, you're pretty much stuck with it for a long time unless you are willing to take haircut and sell your stakes in the secondary market at deep discounts.

But unless public equity markets come back, there are no exit strategies for these private equity companies. This is why investors should be in no hurry to up the private equity ante:

Public markets and private equity can sometimes make uneasy companions. No more so than in 2008, when a combination of moribund debt markets, the limited ability of private equity companies to sell on their investments and fears over the underlying value of their portfolios caused the sector to fall to an all-time low.

Last month, listed private equity in Europe was collectively trading at less than half its reported book value – a 52 per cent discount to reported net asset value, cheaper than at any other point since the post2001 sell-off, its previous nadir.

Evidence of that predicament is everywhere. Shares in 3i Group, the British sector’s grandaddy, have lost more than three quarters of their value this year, making it the fifth-worst performer in the FTSE 100 and taking it below its issue price for the first time since it floated in 1994. Elsewhere, SVG Capital, which backs investments made by Permira, has written down the value of its funds by £467 million.

Two weeks ago it launched a heavily discounted £200 million rights issue. In total, the seven most closely tracked UK-listed private equity vehicles (see table) have lost more than 60 per cent of their value this year, a sharp contrast to most of this decade. In the five years to 2007, the AIC private equity price index rose by a compound 18 per cent a year, comfortably outpacing the FTSE all-share index.

But has the stock market overreacted to what might otherwise be seen as a cyclical setback in the industry’s long-term structural growth? Certainly, the short-term challenges posed by recession are formidable.

First, the default rate on leveraged buyout debt cannot help but rise. On Standard & Poor’s data, only 1 per cent of the debt payments backing private equity deals were not met in 2007, against a long-run average of about 4 per cent. However, with company profits starting to fall, more and more buyouts are set to run into debt-servicing problems. UBS expects default levels to rise to “at least” 10 per cent next year.

Second, having been reasonably stable in the first half of the year, net asset values for private equity funds are due to follow the stock market sharply lower. The value of quoted investments will be marked to market, while those of unquoted companies will have to reflect the decline in earnings multiples of their quoted peers – a drop that is all the more severe if those investments are also heavily geared.

Third, falling stock markets make it more difficult for private equity firms to realise cash from their investments. Flotations become unattractive or impossible to achieve, and potential trade buyers with the necessary funding can push for better terms. Not only are private equity investors not getting their cash back, but it becomes harder to finance further buyouts, meaning that they have to invest more equity and so dilute their returns.

It used to be that private equity funds had more cash than they could swiftly invest, leading to a “cash drag” on their portfolio returns. Now, however, the opposite problem applies: that they have committed to make follow-up investments that they cannot honour.

Fourth, some funds made the bulk of their investments near the top of the market, making the scale of potential writedowns all the greater. UBS points out that Electra Private Equity has a relatively immature portfolio, having made more than 80 per cent of its unquoted investments in 2006 and the first half of 2007.

Investors should be in no hurry to buy into listed private equity until the full-year reporting season provides greater clarity on how their portfolios are faring. But for those willing to be patient, and to take a three- to five-year view, discounts of the scale of those on offer historically have proved a good point of entry.

Although HgCapital Trust, up 5½p to 663½p, has not fallen nearly as far as its peers, because of its 493p a share in cash, its lack of gearing, its strong track record and its midmarket focus make it one of the better places to start.

And the problems in commercial real estate are only getting started. As residential house prices keep plunging, commercial real estate is going to suffer a multi-year decline in prices.

If you thought hedge funds putting up redemption gates or selling private equity stakes in the secondary market was bad, what are these pension funds going to do when they see the value of their most illiquid real estate holdings plummet?

It's going to get ugly in 2009 and it's going to take a long time to sort this mess out.

But the important question to ask is how did all these intelligent people fall prey to the illusion of stability? Why did they underestimate systemic risk? Why weren't they prepared for the worst case scenario?

Back in 2005, I was arguing that we'd better be prepared for the ripple effects of the collapsing U.S. housing bubble. I kept insisting that we take the deflation scenario very seriously in our asset allocation. As God is my witness, I knew this mess was inevitable and that when it all breaks down, pension funds would suffer unfathomable losses.

I will leave you with some food for thought for 2008. Today officials said that South Korea's state pension fund -- the country's largest institutional investor -- will post its first-ever loss this year due to tumbling stock prices:

The Ministry of Health, Welfare and Family Affairs, which supervises the fund, said the National Pension Service posted a 0.75 percent loss, amounting to 1.76 trillion won (1.4 billion dollars), as of December 26.

It marks the first annual loss since the fund, which now has more than 230 trillion won in holdings, was created in 1988.

The ministry said the problem stems from its investment in stocks, which reported a loss of 41.20 percent.

South Korea's benchmark KOSPI stock market index has fallen nearly 40 percent so far this year amid the global financial meltdown, with overseas bourses similarly hard hit.

Last year the fund reported a 7.05-percent return on assets.

The ministry said Monday the pension fund would reduce its stockholdings next year from the current 29.7 percent to 20.65 percent of total assets.

It plans to increase its holdings of bonds and other investments from 66.4 percent to 73.4 percent.

Let this be lesson to all those pension funds that blindly followed Harvard, Yale and Ontario Teachers' Pension Plan into alternative investments. Instead of losing 30% or more, you could have lost 0.75% just like the South Korean national pension fund did last year.

Importantly, it often pays to err on the conservative side and keep your asset allocation simple and safe.

Unfortunately, pension funds got too cute and too sophisticated with other people's money and taxpayers are going to end up paying for their lack of investment prudence and judgment.

Monday, December 29, 2008

Novices Running Pension Funds?


Let me ask you a question: should pension fund managers get high salaries and huge bonuses if they lose 30%, 40% or more in a year?

I know 2008 was a brutal year and we are going to hear a chorus of explanations from the presidents of the top public pension funds telling us that this was "a once in a lifetime event" and that we need to remember that they "invest for the long-term".

Give me a break! If you've been reading the Pulse regularly, you would see that these pension fund turkeys got clobbered because they all grossly underestimated the biggest risk in the financial system, namely, systemic risk - risk they helped fuel by blindly investing billions in alternative investments like commercial real estate, private equity, hedge funds, commodities and whatever else the investment banking sharks were peddling to them.

Importantly, they all fell victim to the illusion of stability, believing that things will continue to move along just as they did for the last 25 years. Now, they all got a rude awakening and they are left wondering how come with all their sophisticated risk management systems, they were unable to protect against severe downside risk.

The simple reason is that when systemic risk hits you, the only asset class that can protect you are good old government bonds. But these pension funds got out of bonds over the last decade to invest in stocks and "absolute return assets" like real estate, private equity and hedge funds.

It's hardly surprising that some are concluding that novices are running pension funds:

Stratford Finance Director John Norko wasted little time earlier this month when he learned Fairfield had likely lost $42 million in pension funds in a fraudulent scheme run by Wall Street trader Bernard Madoff, which may have cost his investors as much as $50 billion.

Norko went into work early on a Saturday to fire off a memo to town employees assuring them that Stratford had not invested in any of Madoff's funds and had not lost any money.

A similar reaction was played out across the region as the citizen volunteers who serve on town and city pension boards digested news of the Madoff scandal and counted their own good fortune for not having invested with the once-respected trader.

A former Nasdaq chairman, Madoff was arrested for orchestrating a maze of allegedly fraudulent investing schemes. Investors big and small could be out millions.

"Was it a wake up call?" asked Dan Roach, a longtime member of Bridgeport's Board of Police Commissioners, which also oversees the department's multimillion-dollar pension fund.

"No question about it. The first thing I thought was, 'are we affected by that.' Inquiries were definitely made and we had a meeting," Roach said.

Bridgeport, like other communities in the region, had not invested its pension funds with Madoff. Still, the financial nightmare Fairfield faces struck a chord with those who oversee retirement funds.

For the most part, pension boards are made up of ordinary citizens, and many of those unpaid volunteers have little financial expertise. Some towns place a city official -- either a finance director, treasurer or elected council member -- on the board, but that's more the exception than the rule.

These guardians are on their own, charged with making decisions about how to invest millions of dollars in an increasingly complex financial world. All pension boards in the region hire professional managers to offer recommendations and develop strategies, but at the end of the day each board member knows the buck stops with them.

"Sometimes I wonder myself," said Roach, who runs a Black Rock store. "I'm not a financial expert. The board members are not trained for this. We rely on the fund manager."Along with Roach, Bridgeport's police pension board includes several lawyers, the former president of the regional water company and a minister.

To understand what pension boards do, think of a 401(k) plan on steroids. The boards authorize investments in various types of funds, based on the fund's history and the likelihood of generating regular returns on the investment. The main difference is the amount invested by a person fund, and the risk is much greater than with any personal 401(k) plan.

Joseph Sartor, a retired air-conditioning technician, has served on the Milford Pension and Retirement Board for 24 years. Milford does not allow politicians or city employees to serve on its board, only citizen volunteers.

"We are all unpaid volunteers and we have exclusive control and power," Sartor explained. "And we take that role seriously."

Like most pension boards, Milford hires a manager or adviser to make recommendations and plot strategy. Sartor said the pension adviser is more crucial today than ever.

"In the old days we invested in stocks and bonds. Today, everything travels together. We have $300 million invested. It's a lot of money," Sartor said.

Sartor said he heard talk about Madoff and his supposed record of investing success, adding that some had urged Milford to invest with the trader. He was promising returns of up to 14 percent, an unheard of gain over the long term in the world of pension investments, Sartor said.

"Fairfield put too much money into it. You have to diversify. This guy was the biggest con artist. He had so many people snowed over," Sartor said.

"Our adviser is expensive, but we get every penny back. He gives advice and he knows the business. We set the guidelines," he said.

Dan LaBelle, a Westport lawyer and a member of Trumbull's pension board, agreed that board members rely on their adviser. "At the end of the day you have to trust that person," LaBelle said.

LaBelle said Trumbull looked closely at its fund and investment choices after the Madoff scandal became public.

"It could happen to anyone. The truth is people like myself are investing town pension money and you try to do the best you can. Who would have thought. You can't expect pension board members to know the in and out of every fund. You get quarterly reports and you ask questions. A lot of it is getting the diversity right," LaBelle said.

Stratford Town Councilman Joseph Kubic, R-9, is the chairman of the town's Pension Board.

He said the recent Madoff crisis is a "frightening example of what can happen because pension boards are comprised of mostly people who know very little about how to invest pension funds."

"These boards are made up of citizen volunteers with virtually no in-depth knowledge of the world of stock and bonds investments. This scandal must serve as a reminder that these investments must be made very carefully and conservatively, and only after consulting with experienced financial experts," Kubic said.

"It was a relief to know we had none of our investments tied up with [Madoff]," Kubic added.

After reading this article, you might might not be surprised to find out that three local public pensions for Houston government employees have declined by a combined $1.9 billion in value since the beginning of the year.

But what about those massive public pension funds in Canada and elsewhere which are comprised of board members with years of experience who get paid for their expertise? It turns out they didn't fare much better than those other boards made up of laypeople.

Moreover, some laypeople exercised a lot more caution when sitting on these boards than more "sophisticated" board members who took undue risks by blindly following the pension herd into alternative investments. They all got burnt this year.

And now that the Madoff scandal broke, expect a serious crackdown on hedge funds:

Half a dozen lawsuits have been filed by Madoff investors, mainly focusing on the failure of due diligence by the middlemen, such as hedge fund of funds, which channelled money to Madoff.

Paul Kanjorski, a top Democratic Congressman, on Monday said a hearing would be held next Monday to examine the alleged fraud and how it went undetected for so long.

The affair is likely to lead to a crackdown on due diligence by fund of funds – which hold more than 40 per cent of hedge fund money – according to hedge fund marketers and advisers.

Switzerland’s Union Bancaire Privée, the second-biggest fund of funds, last week said it would require funds in which it invests to use independent administrators.

One hedge fund adviser, who looked into investing with Madoff and declined, said: “This is just the start. Third party administrators, greater transparency in investments, more regulatory oversight – we can expect them all.”

Mr Madoff did not use a third party administrator – an independent company that values fund assets and creates investor statements. Many in the industry consider a requirement for an independent administrator to be best practice, but it is not widespread.

The scandal also highlights a gap in regulatory supervision and is likely to fuel fresh calls for oversight of hedge funds.

Yet despite the debacle in hedge funds this year, punctuated by the Madoff scandal, public pension funds aren't writing them off, at least not yet:

Chief investment officers for pension funds note that despite some worrisome drawbacks, hedge funds continue to outperform stocks, and by a good margin. Hedge funds are down less than 18% this year, while the Standard & Poor's 500 index has dropped close to 41%.

Huh? Since when did hedge funds cease to be absolute return vehicles and turn into relative return vehicles? If you want beta, you can obtain it for a fraction of the cost with zero risk of redemption withdrawals when systemic risk hits the markets!

Keep in mind that most pension funds that invest in hedge funds use a portable alpha strategy where they swap into traditional bond and stock indexes to invest the proceeds in hedge funds that were suppose to be non-correlated to traditional asset classes.

For example, say a $100 billion pension fund invested 10% of its assets in hedge funds using this portable alpha approach, it would pay Libor + a few basis points to swap into traditional bond and stock indexes and use the cash proceeds to invest in hedge funds.

If the hedge funds consistently produced T-bills + 500 or 700 basis points (the typical benchmark for pension funds' investing in hedge funds) with little or no correlation to traditional asset classes (ie. no beta, pure alpha), then they would add 50 to 70 basis to the overall pension fund returns each and every year. Although this does not sound like a lot, the cumulative effects increase the likelihood that the pension fund will meet its actuarial rate of return, which is an absolute return figure.

But all this breaks down in an environment where systemic risk hits and both traditional and alternative investments get clobbered. Worse still, for alternative investments, there are extra costs (management fees) and the cost of illiquidity.

That is why I have a hard time swallowing this line that hedge funds are down double digits but they outperformed mutual funds and the stock market. So what? The bottom line is that they are paid huge performance fees which should kick in once they start returning above T-bills.

The fact is that most hedge funds failed to deliver this past year which is why they are facing the wrath of investors who are redeeming. Some hedge funds put up gates and are freezing withdrawals, but they are only trying to buy time, delaying the inevitable.

And if you think hedge funds are going to get slaughtered, wait till you see what's going to happen with private equity and real estate funds. Indeed, most private equity groups face tough choices:

For Philip Davidson, head of European restructuring at KPMG, the speed with which recession has hit Britain reminds him of “Looney Tunes” cartoon characters like Road Runner and Wile E. Coyote.

“A year after we started to hear about the credit crunch, the economy ran off the edge of a cliff,” he says. “But like the Road Runner we kept on going, with the legs still spinning. But then in September we started to plunge towards the ground.

“That’s different from the past recession and it’s taken a lot of people by surprise.”

One of the groups caught out is private equity. The lack of availability of debt financing has not only made it difficult for private equity funds to put new deals together, it has also made it tougher for the companies in private equity portfolios to deliver targeted returns.

This, in turn, increases the reluctance of private equity backers to put money into underperforming funds.

Mr Davidson says: “The extent to which their portfolio companies have begun to feel the effect of the loss of top-line growth has had a rapid impact on a lot of private equity groups. There are a number of private equity companies we believe that are facing portfolios that are not going to be able to deliver the returns they promised.”

That is likely to lead to a rise in bank lenders forced into debt-for-equity swaps, he says, reflecting a realisation by banks that, since the last recession, they believe that they will have to take stakes in companies and engineer a turnround.

Moreover, unlike the past, private equity must now prove its value, leading Felix Salmon to ask what happens when private equity companies fail:

What happens when a private-equity shop fails? Boston Consulting Group thinks that will happen a lot in coming years:

The consultants expect 50% of all companies backed by private-equity funds to default on their debt; as many as 40% of buyout firms to shutter their own operations and only around 30% of partnerships to survive intact through the next few years.

A private-equity shop which loads up its portfolio companies with too much debt naturally stands to lose control of those companies if and when it fails to service the debt. That's not a major problem, especially if the companies in question have good businesses: if done well, bankruptcy doesn't mean closing down, it just means a change of ownership.

But what happens when the PE shop itself closes down? Who manages the portfolio companies which haven't gone bust? Do they just get liquidated or sold off in fire sales, with the proceeds then given to the limited partners? That could be very bad indeed.

But with their portfolios underwater and little prospect of performance fees in the future, it's easy to see why the general partners might want to give up the hard work of running their portfolio companies and retire to an island somewhere instead on all the money they've trousered thus far.

The same can be said about private real estate funds where the current spate of retailer bankruptcies and those expected in the new year - along with still-healthy companies limiting or stopping their expansions - could have a ripple effect on the commercial real estate market:

Burt P. Flickinger, managing director of New York consulting firm Strategic Resource Group, expects 2,000 to 3,000 U.S. malls and shopping centers to close in March and April.

General Growth Properties Inc., the nation’s second-largest shopping mall owner, already is in trouble. The cash-strapped Chicago company, which owns the Natick Collection and manages Boston’s Faneuil Hall Marketplace under a lease with the city, in mid-November warned of a possible bankruptcy filing it if couldn’t refinance $900 million in debt. It’s now trying to sell its management rights for Faneuil Hall management rights along with two properties in New York and Baltimore.

“The easiest way of looking at which shopping centers or (real estate investment trusts) are real cause for concern for potential reorganization would be any whose stock has declined 80 or 90 percent or whose stock is trading in the $1 to $5 range,” Flickinger said.

Normally, the large banks and financing companies would have adequate funds to “backstop” the REITs and other retail center owners. But so many retailers and property owners are either “retracting or collapsing” at the same time that there’s insufficient credit to save every one, according to Flickinger.

“It’s a natural falling out,” he said.

The United States had twice as much retail selling space than any other industrialized nation at the end of the 1990s. And since then, it’s added 50 percent more selling space to an already over-stored situation. Led by Wal-Mart, the nation’s top eight retailers alone built more than a billion square feet of selling space in the last decade.

The commercial real estate market could take as hard a hit as the residential real estate market did under the mortgage crisis, according to Michael Tesler, founder of Retail Concepts, a Norwell-based retail consultancy.

“Landlords are going to face a difficult reality,” Tesler said. “They’re going to have to adjust their rents, and they’re going to have a real tough time filling vacancies going forward.”

Guess who else is going to face a difficult reality? Pension funds who invested heavily in alternative investments and are now stuck trying to figure out how the hell they're going to get out of this mess.

I wish them luck because they are all ill-prepared to confront the massive challenges that lie ahead and many are perpetuating the same mistakes that got them into this mess in the first place, acting like novices running pension funds.

Friday, December 26, 2008

Boxing Day Specials?




I must admit that I hate Boxing Day. People lose perspective and rush out to buy whatever they can as retailers slash prices. I prefer waiting until the mad rush is over before I venture off into any shopping mall.

Then again, I always hated shopping and with MS, I have to plan my trips carefully so I do not waste time and energy browsing. I know what I want ahead of time and I call in advance to make sure they set it aside for me.

But today is a day for that all-American past time - now global past time - of shopping for deals to spend whatever they can after Christmas. I joke with my buddies telling them "Thank God for women or else we'd be in a Depression by now."

At the time of writing this commentary (mid day), stocks rose modestly in light post-holiday trading after the GMAC lifeline, but investors are still cautious about embarking on a year-end rally following dreary preliminary readings on holiday spending:
Not surprisingly, Americans spent much less on gifts this season than they did last year, according to SpendingPulse, a division of MasterCard Advisors. Retail sales dropped between 5.5 percent and 8 percent compared with last year, the data showed, or between 2 percent and 4 percent after stripping out auto and gas sales.

Personal consumption is a huge part of U.S. economic activity -- comprising more than two-thirds of gross domestic product -- so Wall Street is nervous that a more frugal consumer could keep the economy weak in 2009.

Investors did get a some good news on Christmas Eve, when the Federal Reserve allowed GMAC Financial Services -- the finance arm of struggling Detroit automaker General Motors Corp. -- to become a bank holding company and thus qualify for the government's $700 billion rescue fund. Analysts had said that without financial help, GMAC might have had to file for bankruptcy protection or shut down.

But so far, with just four trading days left in the year, no news has been upbeat enough to spark a year-end rally on Wall Street. December is usually a strong month for the stock market, with a flurry of trading known as a "Santa Claus rally" often seen in the month's final week.

In early trading, the Dow Jones industrial average rose 40.54, or 0.48 percent, to 8,509.02.

Broader stock indicators also advanced. The Standard & Poor's 500 index rose 4.18, or 0.48 percent, to 872.33, and the Nasdaq composite index rose 3.98, or 0.26 percent, to 1,528.88.

Trading volumes are expected to be extremely low on Friday as they were earlier this week. When trading is light, stock movements are often not indicative of broader market sentiment. Friday is also likely to be a quiet day of trading because there are no major economic or corporate reports scheduled.

Some retailers did report strong sales. Amazon.com Inc. (AMZN) said Friday that the 2008 holiday season was the online retailer's "best ever," with more than 6.3 million items ordered and 5.6 million units shipped during its peak day on Dec. 15.

This brings me to today's subject. The #1 question I always get is "Leo what should I buy?". I hate that question for the simple reason that nobody can forecast the movements of stocks so what I tell them is to forget the analysts and the cheerleaders on Wall Street and look at what the experts are buying, bearing in mind that even they have suffered huge losses this year.

Importantly, if my macroeconomic forecast of a decade of debt deflation becomes a reality, then your best bet is to keep buying long-term bonds - even at low yields - and forget about the stock market altogether.

But bonds are boring (just ask pension funds!) and people want yield - lots and lots of yield - so let's look at some stocks out there and try to find some bargains. I included a two year chart of Dollar Tree (DLTR) above (click on first image to enlarge), to prove a point that even in the worst environments, there are individuals companies that do well.

The trick of course, is finding which ones and having the conviction to buy their shares at the appropriate time. If you look at Dollar Tree's two-year chart, you'll see the stock tanked from low forties in mid-October 2007 to the low twenties in mid-January 2008 and then slowly climbed higher to reach the low forties again.

I like this chart because it shows you two things. First never buy after a major decline because in all likelihood, it will go lower, especially as you approach year-end where mutual funds sell their losers to window dress their books.

Second, after the second down-leg, good companies will rise in the first quarter of the year as investors snap up deals. You will notice that the shares kept making new highs after March 2008 and that was the breakout to buy (go back to read Boy Plunger's Pivotal Point Theory).

Dollar Tree, through its subsidiaries, operates discount variety stores that offer merchandise at the fixed price of $1.00 in the United States. In a bad economy, these discount stores do very well, so we shouldn't be surprised to see their shares rise.

So should you buy Dollar Tree now? I would say the upside is capped so you are better off focusing on other good companies whose shares got slaughtered in 2008 and who you think will do relatively well in a tough economic environment.

A small caveat, however, before I proceed. I believe that the financial services industry is heading towards a long-term structural bear market. The great bull market that was built on years of deregulation, excess leverage and speculative frenzy will give way to a long-term bear market in that sector that is based on a new era of regulation, cuts in leverage and a lot less speculation.

I mention this because some of my work colleagues think now is the time to buy Citigroup Inc. (C) and other banks that were mired in toxic debt. Why not? They are going to benefit from the government bailouts and even the world's super wealthy - like the Mexican tycoon Carlos Slim, the world's second-richest person - are placing big bets following the credit debacle:

Mexican tycoon Carlos Slim has taken advantage of market turmoil caused by the global credit debacle to place heavy bets on hard-hit companies, an old strategy that has made him one of the world's richest men.

Slim, whose main asset is Latin American cell phone giant America Movil (AMXL.MX) (AMX.N), recently increased his stake in U.S. luxury retailer Saks (SKS.N) to 18 percent, making him the company's biggest investor.

Last week, Slim's Inbursa brokerage in Mexico bought at least $150 million worth of Citigroup (C.N)(C.MX) shares as they sank to lows not seen since 1992.

It was unclear whether Inbursa bought the Citi stake on behalf of Slim, 68, or for other clients.

"He's taking advantage of prices," said Rogelio Gallegos, a portfolio manager at Actinver in Mexico City. "It's the best moment in the last five years to take stock market positions."

Building positions in Saks and Citigroup, both hammered recently by the U.S. credit debacle, would be true to Slim's "Midas" touch history of acquiring struggling, cheap businesses and turning them into profitable cash-cows.

"He tends to be a value investor, a contrarian investor as well," said Merrill Lynch analyst Carlos Peyrelongue. "He was fairly underinvested during this down cycle."

The son of a Lebanese immigrant, Slim is one of the world's three wealthiest men, according to Forbes magazine.

While I agree with some of his choices, I believe there are "slim pickings" (no pun intended) in the financial world. You are better off focusing on banks with little or no expsore to toxic debts who are growing their earnings in a weak economy (I do not know of any).

So what are the other sectors worth looking at now? Back in October, I wrote a piece on looking beyond the 2008 stock market crash where I tried to give you a sense on how I approach that difficult game of stock picking.

I like to look at what some of the top hedge funds and mutual funds are buying and I keep in mind the big themes that will likely play an important part of our future. Themes like deflation (focus on discount retailers like Costco [COST] and on-line discounters like Priceline [PCLN]); alternative energy (read my comment questioning the death of solar stocks); to biotech and medical devices (read my comment on the age of biotech); to infrastructure where there are plenty of heavy construction stocks to watch for in 2009 as well as ETFs to play the sector (I also like KBR Inc. [KBR] in this space).

There are many other companies worth tracking on your radar screen, including conglomerates like Textron (TXT) whose shares got clobbered recently and 3M Co. (MMM) who might also rebound before the global economy bottoms (3M's shares are forming a double-bottom at their two-year lows).

Keep in mind that stock markets will likely spend many years of range trading which is why many feel that the old buy & hold strategy will not work like it did in the past.

But others disagree, believing that buy & hold is the safest way to invest in stocks:

Lee Brodie calls the death of Buy-and-Hold based on the comments of Jeff Macke (Hattip Barry):

2008 is the year that will go down in history as the year that long term investment died as a thesis.

Jeff Macke may not be a fan, but calling the long term investment model a dead duck is absurd.

Lee suggests diversification as a solution, but diversification dilutes gains and brings you towards ETFism, then index funds, which invariably means a buy-and-hold strategy. It's not diversification or time frame that matters, it's risk management that's key. Taking money off the table is fine and dandy if your position heads into profit, but it doesn't protect you when things go against you (and frequently as was the case for many this year). It doesn't matter if you hold for minutes, hours, days, weeks, months or years - the principle for (re)action is the same.

For starters, Buy-and-Hold is not a returnless system; stocks falling under the buy-and-hold umbrella tend to be dividend payers with a history of dividend growth; growth which can produce stellar returns relative to the initial investment. The loss of a Buy-and-Hold limb (financials) was probably viewed by the good doctors to pronounce the patient dead, but the patient is still very much alive and well.

One only has to look at certain buy-and-hold favourites like Johnson and Johnson (JNJ) to see 2008 was no better or worse than prior years and this excludes the compounding dividend retur.

Buy-and-Hold is the safest way to own stock because it removes the whims of emotions; yes - many 401Ks were badly damaged this year, but would a more actively managed portfolio have performed better? Hmmmm.... those 'smart money' Hedge Funds are having a great 2008?

The Fast Money talking heads spout nonsense and fail to see the opportunity presented to them - the old 'can't see the forest for the trees'.

One only has to look at past market collapses to see the golden opportunity it provided for buyers. The key is not to put your eggs into one basket and try and time the market; it's about applying basic strategy.

The same sentiment was discussed by David Altig, senior vice president and research director of the Federal Reserve bank of Atlanta back in mid October:

I trust you will not judge me guilty of overstatement if I say that good news from equity markets has been hard to come by of late. So rough has been the ride that at least one (quite) famous pundit-analyst has taken measure of the landscape and concluded that the time has come to abandon the venerable “buy and hold” investment advice generally offered ordinary savers:

"It's time to unlearn a common myth about investing," Jim Cramer told viewers on Monday. "The best way to invest is not to buy a bunch of stocks and just sit on them."

As is usual in such cases, it is useful to have a look at the record. Though it’s not entirely clear what quantity constitutes “a bunch of stocks,” one reasonable definition would be a broad stock index. With that in mind, here is a look at the annualized three- and five-year rates of change in the S&P 500 index going back to 1941 (click on second chart above to enlarge).

This is not the return on an investment in the index, of course, as holding the portfolio of equities in the index would also generate dividends over the holding period. But it does give some sense of how the recent past compares with the more distant past. While it is true that things look bleak at the moment, this is hardly an unprecedented circumstance. If the buy-and-hold strategy had merit before, it really isn’t that clear things had changed that much through this past September.

You might reasonably argue that buy-and-hold really applies to horizons that extend beyond five years. Here, then, is the same sort of chart as above with index growth for 10-, 15-, and 20-year holding periods (click on third chart above to enlarge).

True enough, the past 10 years have been a little ragged, though again not really unprecedented. And if you were lucky enough to be a long-term saver—that is, held the index for the past 15 to 20 years—good for you. (And note that returns over these horizons are, not surprisingly, substantially less volatile than over the shorter periods.)

Ok, I hear you. Why did I conveniently stop just short of the dramatic decline in the stock market since September. Sure enough, things look substantially worse when the stock market loses over a quarter of its value in a month. For the sake of argument, let’s assume that the S&P average for October ends up at 900, or near the low so far this month. Redoing the three-, five-, 10-, 15-, and 20-year growth calculations would yield annualized rates of –8.9 percent, –2.8 percent, –1.4 percent, 4.5 percent, and 6.1 percent, respectively. Even with the major reversal of the last month, the implied returns on the 15- and 20-year holding periods look pretty good.

Of course, the “buy-and-hold is dead” idea relies on the presumption that the next 10 years are going to look a lot like the last 10 years. Only time will tell if the current growth rate on the three- to10-year holding periods is a trend, or just evidence that you won’t do so well when you get out of the market at exactly the wrong time.

I don’t know what the answer is—and I don’t offer investment advice—but the verdict of history is pretty clear.

Finally, read the following article from Jeff Saut, Chief investment Strategist at Raymond James which was reproduced on Minyanville. Mr. Saut concludes that:

Whatever the outcome, my firm has treated, and continues to treat, the October 10th “capitulation lows” as a bottom for the short-to-intermediate term, until proven wrong.

Still, this is the most difficult market we've seen since the 1970s, which is why we're employing a hedging strategy and continue to emphasize clean balance sheets, decent fundamentals, and dividends.

I couldn't agree more; this is the most challenging environment ever for retail and institutional investors.

I tell people to prepare for the worst, investing in bonds and particular segments of the stock market using market and sector ETFs. If you buy individual stocks, do your homework and make sure they are companies with solid balance sheets and good long-term prospects.

The reality is that the next ten years will be nothing like the past ten years, but this does not mean you have to be caught like a deer in headlights.

Remember to prepare for the worst and hope for the best. Difficult times require financial prudence, some foresight and some conviction that the world will eventually overcome this global financial debacle.

Thursday, December 25, 2008

A Bankers' Christmas?


There is not much to report about this Christmas except to tell you that the Massachusetts state pension fund lost $2 billion last month, bringing its loss for the year to $16.1 billion, the worst performance since it was formed:

The drop brings the assets under management in the fund, which is controlled by state Treasurer Timothy Cahill, to $37.6 billion, according to a memo from Stan Mavromates, the chief investment officer. He said the fund's emerging markets portfolio is leading the decline, falling 58.6 percent so far this year.

The return on the fund, which is used to pay the pensions of public sector retirees, is down 30.1 percent for the year through the end of last month, according to Mavromates.

Prior to this year, the worst year on record was 2002 when the assets under management dropped 8.9 percent, according to information obtained from the treasurer's office.

Francy Ronayne, a spokeswoman for Cahill, referred questions to Michael Travaglini, executive director of the state's pension reserve investment management board, which manages the fund, who didn't return calls seeking comment.
Given Mass PRIM's heavy allocation to equities and alternative investments, they will likely experience further setbacks in 2009. However, I will commend them on providing clear transparency on their benchmarks and investment activities.

You can expect most of the large pension funds who have similar exposures to equities and alternative investments to be down between 30% and 40% this year.

This isn't much of a Christmas for millions of people struggling to find work. Who is to blame for this global financial mess? I am with religious leaders who in their Christmas sermons blame the culture of greed and immorality within the banking system for the financial crisis:

Archbishops devoted their annual messages to the human suffering caused by the global economic downturn, and called for communities to come together to support those who lose most in the turmoil.

Dr John Sentamu, the Archbishop of York, attacked exploitative money lenders who pursued "ruthless gain" and urged banks not to "enrich themselves at their poor neighbours' expense".

He compared the looming recession to the conditions Britons endured during the Second World War, and called for a new generation to show the "Blitz spirit" that helped defeat the Nazis.

"True charity repudiates the idea of personal gain as a result of lending money to make ruthless gain – usury – bringing about permanent disappropriation and enslavement," he told a York Minster congregation including Conservative leader David Cameron and his family.

"In the present economic crisis we need to rediscover that spirit of togetherness that helped the British people during the Second World War to stand together in the face of food rationing and the Blitz.

"We had better stand together or we will all hang separately economically."

Dr Rowan Williams, the Archbishop of Canterbury, said that people should not waste time waiting for "larger-than-life" heroes to bring comprehensive solutions to the ills of the world.

Relief from the crisis will come through "small and local gestures" from individuals, he said at Canterbury Cathedral.

"In the months ahead it will mean in our own country asking repeatedly what is asked of us locally to care for those who bear the heaviest burdens in the wake of our economic crisis – without waiting for the magical solution, let alone the return of the good times."

Last week Dr Williams sparked a political row by criticising Gordon Brown's economic recovery plan, likening measures to boost consumer spending to an "an addict returning to a drug". He also claimed that the credit crunch was a welcome "reality check" for a society that has become driven by unsustainable greed.

Yesterday the leader of the Catholic church in England and Wales used his Christmas message to speak about the breakdown in trust prompted by the credit crunch.

Cardinal Cormac Murphy-O'Connor, Archbishop of Westminster, said that recent examples of "spectacular" misbehaviour by financiers would make it very difficult to rebuild trust in the global economic system.

In a homily at Midnight Mass in Westminster Cathedral – widely expected to be his last before the Vatican announces his successor in the New Year – he said that millions of people in this country now felt so let down by financial institutions that they were "deeply anxious" about the future for themselves and their families.

He said: "Christianity neither condemns nor canonizes the market economy – it may be an essential element in the conduct of human affairs."

"But we have to remember that it is a system governed by people, not some blind force like gravity."

"Those who operate the market have an obligation to act in ways that promote the common good, not just in ways that promote the interests of certain groups."

Thank God this world is not made up solely of greedy bankers. There are many good people out there spreading the Christmas cheer, including retirees who give back to their communities.

But those bankers and the pension fund turkeys who fell for their marketing ploys really irk me. I can't wait till Dennis Kucinich grills them the same way he grilled Neel Kashkari on the bailout scam (click on embedded video below).



I wish all of you a Merry Christmas and a Happy Holiday Season. I hope you enjoy many years of health and happiness with your family and friends.

Tuesday, December 23, 2008

The Grinch Who Stole Pensions' Christmas


Dear Santa,

2008 has been a terrible year for global pension funds. What looked like a contained subprime crisis spiraled into a full blown global credit crisis wiping out trillions of dollars from the balance sheets of global pension funds.

All asset classes got hit, including those beloved alternative investments that were suppose to deliver "absolute returns" when equity markets tank.

That's right, Santa, hedge funds are down this year and it now looks like private equity and commercial real estate are going to tank too.

How can you let this happen Santa? How can you allow the Grinch to steal precious alpha from our pension funds? Don't you realize that we invested billions of dollars into alternative investments so that we can go back to our stakeholders at the end of the year and claim we added significant added value in private equity, real estate and hedge funds?

It was all so beautiful while it lasted. We adopted ridiculous benchmarks in these alternative investments, taking on more risk and disguised beta, allowing us to reap huge bonuses at the end of our fiscal year.

For several years we managed to fool our board of directors, our stakeholders, the financial media and the general public. Hell, we even managed to fool ourselves believing that we were adding alpha and that the party in alternative investments would last for decades.

However, something went awfully wrong this year. We got our first warning back in June when the SEC charged two former Bear Stearns hedge fund managers with fraud.

But we chose to ignore it, believing in Alan Greenspan's theory that the U.S. economy and its financial system is "unbelievably resilient" and can withstand any financial shock.

Well, you know what happened next. Credit markets seized up, counterparty risk exploded, toppling giants like Lehman Brothers, AIG, and a slew of others. Then hedge fund liquidation set in and the markets capitulated...for now.

It turns out the Maestro was suffering from the same illusion of stability that made turkeys of global bankers and pension fund managers. The only "resilience" these days is the resilient economic downturn that threatens the global economy.

The decline in equities has hit pension funds across the world very hard. Today, Standard & Poor's said U.S. pensions are expected to register record underfunding levels for 2008:

Standard & Poor's analyst Howard Silverblatt expects pension funds of companies in the benchmark S&P 500 index .SPX to be underfunded by $257 billion in aggregate this year, beating the previous underfunding record of $219 billion set in 2002.

By contrast, S&P 500 pension plans were overfunded by $63.4 billion in 2007, S&P said.

"Any pension fund manager that came remotely close to breaking even in 2008 is quietly celebrating that they survived one of the worst markets in the modern era," said Silverblatt.

The Standard & Poor's 500 index has dropped about 40 percent this year.

At the end of last year, pension plans of S&P 500 companies had 61 percent of their money in stocks, 28 percent in fixed income, 4 percent in real estate and 7 percent in other categories, according to Silverblatt.

S&P noted that under U.S. accounting rules, companies typically smooth their pension funding status by averaging historical returns over several years, which actually reduces reported losses.

In the past few months, U.S. businesses have pressured the U.S. Congress for relief on 2006 requirements to fully fund their pension obligations.

Earlier this month, the U.S. Senate approved legislation allowing generally healthy multi-employer pension plans hurt by the decline in the stock market to avoid having to make drastic pension plan contribution increases to fund their plans.

[Note: President Bush signed that into law today]
Global pension funds are not faring any better. In Australia, pension funds have lost A$91 billion ($62 billion) in the year to Sept. 30, the equivalent of about 8 percent of the nation’s economic output, as the global credit crisis devalued assets globally.

In Britain, the savage fall in the market is wreaking havoc on corporate and public pension deficits:

Analysts at HSBC have carried out a controversial analysis that attempts to flag up those companies whose pension deficits could start alarm bells ringing in the next few years.

It makes intriguing reading. Top of the worry pile is UK Coal, with pension obligations equivalent to more than 320% of its market cap based on HSBC’s estimates using the 10-year average AA bond rate.

Next worst is Johnston Press, followed by National Express, Arriva, Fenner, FirstGroup, Croda International, Mecom Group, Kier and Currys owner DSG.

Other notable names in the top 20 include British Airways and Taylor Wimpey, the housebuilding giant.

HSBC reckons that in these difficult times, pension deficits could put additional strain on company balance sheets – especially if the pension obligations are many times bigger than the stock-market capitalisation of the business concerned.

And Santa, those alternative investments are turning out to be a real nightmare. With each passing day, the news keeps getting bleaker and bleaker.

Today the Blackstone Group announced it plans to liquidate two hedge funds as a lack of outside investing amid tight credit markets will prevent them from getting big enough to be meaningful to the company.

Another hedge fund, Cerberus Capital Management, is limiting investor withdrawals from one of its hedge funds after it lost 16 percent this year through November.

Yet another one, Tontine Capital, is liquidating two hedge funds after losses of more than 60 percent this year and plans to start a new fund in February.

Santa, even funds of hedge funds - the so-called experts of hedge funds - are struggling this year. And if Simon Hopkins, chief executive of Fortune Group, is to be believed, the pain is far from over, with a myriad of fund of hedge fund operators likely to bite the dust in the year ahead.

Perhaps this is why GAM, one of the biggest investors in hedge funds, will allow clients to withdraw from most of its funds of hedge funds only once a quarter rather than once a month, as the industry tightens redemption terms.

It is not just investment banks and hedge funds that must reinvent their business model. Private equity has to do things differently in the future, otherwise backers will disappear, the money will dry up and credibility for the profession will be destroyed:

Some of the problems are externally generated; but many are self-inflicted. The difficulties of 3i, its shares at a 75 per cent discount to book and below their issue price, is a demonstration of the underlying crisis.

Many limited partner (LP) investors are finding it difficult to meet their capital calls, thanks to a lack of liquidity.

Permira has already announced that it will not draw down 40 per cent of its last fund. Institutions over-committed to the asset class, assuming that cash returns would continue as normal. But exits have stopped, so LPs are getting no money back. Meanwhile their other allocations to assets including property and equities have plunged in value. SVG, the quoted fund of funds, has launched a rescue rights issue to prevent it defaulting.

Most major buy-out houses have carried out over-priced, over-leveraged deals that are underwater.

Examples abound: EMI, Boots, Countrywide, Harrahs, Hilton, McCarthy & Stone, GMAC, Chrysler, Freescale, Gala Coral, Pilgrim’s Pride and so on. In some, the bond prices indicate the equity is worthless; for others, the LPs have revealed huge writedowns. No doubt at year-end many auditors will insist on painful impairment provisions. The total paper losses will be at least $50bn (€36bn, £34bn) – and quite possibly more.

Inevitably, gearing has amplified these. An astute observer of the scene in New York suggested participants should assume a 40 per cent markdown in values from June to December this year.

As you can see, Santa, in private equity, it's not just a downturn, it's devastation. Perhaps this is why Barclays may sell its private equity business and why TPG Inc., manager of a $20 billion buyout fund, will allow investors to trim their commitments as they seek to conserve cash amid losses across financial markets:
The firm told clients in a letter that they can hold back as much as 10 percent of their original pledges, said the person, who asked not to be identified because the fund is private. TPG’s backers include the Washington State Investment Board and California Public Employees’ Retirement System, the biggest U.S. public pension plan. Calpers’s assets tumbled 28 percent in the past year to $182.5 billion.
Finally Santa, there is commercial real estate. This is the biggest bubble of all because pension funds refused to heed the warnings of smart real estate investors like Tom Barrack who warned us three years ago when he cashed out of real estate.

Now we are going to pay a dear price. Today, Moody's reported that commercial real estate prices as measured by Moody's/REAL Commercial Property Price Indices (CPPI) decreased in October by 2.4% over the previous month. Prices are down 11.5% from their peak in October 2007 and are 0.4% lower than they were two years ago:

For the past five months, the index has hovered about 11.5% below the October 2007 peak.

"Markets are rarely smooth as they go through the price discovery process," says Moody's Managing Director Nick Levidy. "We expected that the Moody's/REAL CPPI would experience some turbulence during this transition phase as overall price trends are captured in transaction activity."

Since the index first registered a decline in commercial property prices beginning in September 2007, ten of the last fourteen months have recorded negative price returns, with half of those ten declining more than 2%.

This month's report included the annual indices which, for the first time, all experienced negative growth.

The southern industrial sector saw the largest decrease in the annual indices, with prices falling 11% over the last four quarters. The three major office markets, San Francisco, New York, and Washington DC all saw decreases in property prices in October, although prices in all three cities are still significantly higher than they were two years ago.

As you can see, Santa, this isn't much of a Christmas for us pension funds. We were expecting another year of alpha in alternative investments and big bonuses based on bogus benchmarks at the end of the fiscal year.

Instead we are getting no diversification, negative returns, redemption withdrawals, illiquidity and all sorts of headaches that come along when a bubble burts and the hangover sets in.

Santa, given the circumstances and our complete underestimation of systemic risk, would you be so kind as to stuff our stockings with some alpha? Hell, we would even accept positive beta and will work to disguise it as alpha (we are very good at that).

At this juncture, we would also accept the safety of good old government bonds because after reading Martin Weiss' latest on the biggest sea of change of our lifetime, we are petrified of the prospect of deflation.

Finally Santa, if you do not have any alpha, beta or bonds left, we would not be ashamed to follow the big banks that got us into this mess and ask the government for a bailout. These days it seems that bailout madness is sweeping all nations.

What's the difference? Either way, the taxpayers are on the hook.

Thanks for understanding our plight Santa. We left you milk, cookies as well as some ABCP, CDOs and CDS by the chimney.

Sincerely,

The Association of Pension Funds ABCP.

Monday, December 22, 2008

Yale's Yardstick Leaves Pensions in Peril

Let me begin where I left off yesterday - the great alternatives pension debacle. Earlier this month, I wrote about how Harvard's horror will decimate pension funds.

Last week, Yale disclosed that its endowment had fallen at least 13.4 percent in the four months since June:

Richard C. Levin, Yale’s president, said in a letter to the university’s faculty and staff that the endowment totaled about $17 billion, and he warned that Yale could be facing a $100 million shortfall in the 2009 school year.

He said the value of Yale’s marketable securities had declined 13.4 percent for the first four months of the university’s fiscal year, which started July 1, and that it had since fallen even more.

Taking into account such illiquid assets as real estate and private equity, he said, the endowment, which is led by David Swensen, was down 25 percent, and Yale is now anticipating it will be down that much for its full fiscal year.

That figure is significantly better than Harvard’s endowment, which recently said that the value of its $36.9 billion endowment had fallen 22 percent during the same period and that the total decline for the full fiscal year is expected to be as much as 30 percent.

But the figures given by each university are essentially projections and could vary sharply from now to the end of the year, financial experts warned. “We have no idea to say where they are going to come out,” said David Salem, the president of the Investment Fund for Foundations, which manages money for endowed charities. “In this environment, the relative success or failure of any of these endowments will depend on how they mark to market all their nonmarketable assets at the end of the fiscal year.”

Endowment experts follow Harvard and Yale in particular because Yale has had the best performance with its endowment investments over the last decade, with Harvard a close second.

Yale, whose portfolio was expanded beyond stocks and bonds into alternative investments by Mr. Swensen in a widely imitated strategy, has posted a 16.3 percent average annualized return, while the comparable number for Harvard was 13.8 percent.
There is no doubt in my mind that David Swensen is one of the sharpest minds in the investment community. Mr Swensen was a student of James Tobin, one of the great Keynesian economists.

In his seminal book, Pioneering Portfolio Management, Mr. Swensen acknowledges Tobin's strong influence on his life:
James Tobin bears more responsibility than anyone else for the happy professional position in which I find myself. As my teacher, dissertation adviser, and friend at Yale, Jim provided the intellectual framework for my approach to understanding economics and finance.
I wonder what Jim Tobin would be advising his student and friend nowadays if he were alive to witness the follies in financial markets and pension funds that followed Harvard and Yale into alternative investments.

He would probably remind Mr. Swensen of the Keynesian beauty contest:

The Keynesian beauty contest is the view that much of investment is driven by expectations about what other investors think, rather than expectations about the fundamental profitability of a particular investment.

John Maynard Keynes, the most influential economist of the 20th century, believed that investment is volatile because investment is determined by the herd-like “animal spirits” of investors.

Keynes observed that investment strategies resembled a contest in a London newspaper of his day that featured pictures of a hundred or so young women. The winner of the contest was the newspaper reader who submitted a list of the top five women that most clearly matched the consensus of all other contest entries.

A naïve strategy for an entrant would be to rely on his or her own concepts of beauty to establish rankings. Consequently, each contest entrant would try to second guess the other entrants’ reactions, and then sophisticated entrants would attempt to second guess the other entrants’ second guessing. And so on.

Instead of judging the beauty of people, substitute alternative investments. Each potential entrant (investor) now ignores fundamental value (i.e., expected profitability based on expected revenues and costs), instead trying to predict “what the market will do.”

The results are (a) that investment is extremely volatile because fundamental value becomes irrelevant, and (b) that the most successful investors are either lucky or masters at understanding mob psychology – strategic game playing.

“Animal spirits” are now known as “irrational exuberance,” and this beauty contest model is an explanation for such phenomena as stock market bubbles. Contrast this model with efficient markets and present value.
Professor Tobin would also remind Mr. Swensen of Paul Samuelson's famous quote: “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Pension funds got bored "watching paint dry or watching the grass grow," so they all decided to follow Mr. Swensen and Jack Meyer (former head of Harvard's endowment fund) by diversifying away from government bonds into illiquid alternative investments.

The problem is that pension funds are not endowment funds and no matter how hard they tried, they never managed to produce the same stellar returns that these endowment funds were able to produce.

Sure, they allocated to private equity, hedge funds and real estate, but they never managed to produce the same returns because they were late in the game, they were not as aggressive in their allocations and even if they were, they couldn't get in with the top funds that both Harvard and Yale were investing with.

Instead, pension funds screwed it all up by blindly throwing billions of dollars into these asset classes, thinking that the party in alternative investments would last 100 years. In their insatiable thirst for alpha, they all contributed in destroying alpha by fueling a reckless bubble that will take years to clean up.

Consider the bubble in commercial real estate. Today I read that the commercial real state industry is seeking a bailout from the US government:

Some of the country's biggest commercial real estate players are asking the government for help, as their $6 trillion industry of hotels, office buildings and shopping malls faces a record amount of debt coming due in the next few years.

Trade association executives said that in the last few weeks they have met with members of President-elect Barack Obama's transition team, Congressional leaders and officials at the Treasury Department and Federal Reserve to make their case for assistance.

In the next three years, they pointed out, an estimated $530 billion of commercial mortgages will come due for refinancing -- with about $160 billion due next year, according to Foresight Analytics, based in Oakland, Calif. But with the credit markets virtually collapsed, thousands of those properties could go into foreclosure or bankruptcy if owners are unable to get new loans.

"If you can't get a loan and you owe the bank the money, you have to find the cash to pay the loan back or you default on the property," said Steven A. Wechsler, who has been lobbying as president and chief executive of the National Association of Real Estate Investment Trusts, a D.C. association with 3,000 members.

"Banks' jobs are to make loans, not own real estate. That's something we'd like to avoid. It could be a downward spiral that's driven by a compromised system of credit delivery. Some constructive step by federal policymakers would be wise and appropriate to be able to free up the market."

The real estate industry is going to the government for help because "they can," said Jim Sullivan, a managing director at Green Street, a real estate research firm in Newport Beach, Calif.

"They see what everybody else has gotten," he said. "Real estate is a capital-intensive business and there is no capital. They'll take cheap money from whoever is giving it out and now there's only one source -- the government."

The trade associations are asking that their members be included in a $200 billion lending facility that was created by the government to support the market for consumer debt such as car loans, student loans and credit cards.

In a recent letter to Treasury Secretary Henry M. Paulson Jr., industry leaders from a dozen groups described the troubled situation. "The paralysis of credit, which began in the short-term market, has coursed through the system and it now severely affects longer-term credit, especially secured and unsecured commercial real estate loans," they wrote.

When Paulson announced the $200 billion initiative, he noted that it could possibly be expanded to aid the commercial real estate market.

The real estate groups say they aren't asking for direct bailouts for their members, but rather for credit market support. "This is the same thing they're doing for car loans and student loans. We're asking them to help restart the credit markets for commercial real estate mortgages," said Jeffrey D. DeBoer, president and chief executive of the Real Estate Roundtable, a major industry trade group.

"Banks can't possibly absorb, manage and turn around properties at this scale if they come back to the lenders," he said.

The commercial real estate market boomed in the last few years, fed by easy credit. But starting in mid-2007, the credit crisis essentially froze the securities market.

The amount of new commercial mortgage-backed securities -- loans that are sliced, packaged and sold as bonds -- fell from $200 billion in 2007 to only $12 billion in the first six months of the year, Wechsler said. "We've gone from 55 miles per hour to zero," he said.

When money was flowing, investors drove up the prices of real estate, banking that rents and occupancy rates would keep going up. But cash from properties is falling as more space becomes available and rents drop, making it harder for owners to repay their debts.

While delinquency rates are low, they increased by one-third in November to .96 percent and could rise to more than 3 percent by the end of next year, according to figures from Deutsche Bank. Atlanta, Detroit, New York and Tampa are among the markets showing signs of rising defaults. In the Washington region, defaults are below the national average.

"It won't help the economy if commercial real estate continues to fall like residential," said Lisa Pendergast, managing director of commercial real estate finance at RBS Greenwich Capital Markets. "Then ultimately it will cause the recession to lengthen and deepen."

Too late, we are already heading for a long and deep recession. Let me ask you a question, who do you think was buying all the commercial mortgaged-backed securities and investing billions into private real estate funds? Who else? Pension funds searching for "alpha".

Bloomberg reported today that John Carrafiell, who helped oversee Wall Street’s largest real estate investment division as Morgan Stanley’s global co-head of property investing, will step down and become a senior adviser to the firm in January:

Carrafiell’s resignation follows the departures earlier this year of several Morgan Stanley real estate executives in Asia and job cuts in the division he helps oversee, which numbered more than 700 people as of Sept. 30. Kalsi declined to comment and Carrafiell didn’t respond immediately to requests for comment placed after regular business hours.

Real estate funds are reeling from the scarcity of debt financing and the outlook for falling rents and occupancy as the economy slows. Morgan Stanley posted a $2.2 billion loss for the fourth quarter ended Nov. 30, reflecting $1.8 billion of investment losses from real estate funds and other principal investing. At Goldman Sachs Group Inc., Stuart Rothenberg will leave as head of real estate investments at the end of the month after 21 years at the firm.

Morgan Stanley, whose property investments include London’s Canary Wharf, lost other real estate executives in Asia this year, including Zain Fancy, Roy Kwok, Bharat Khanna and Anand Madduri. The four in November joined Och-Ziff Capital Management Group LLC to build its business in Singapore, China, India and Hong Kong. Fancy had run Asian real estate investing excluding Japan and Kwok and Khanna had worked for the firm in China and India, respectively. Madduri was portfolio manager for the real estate unit’s Special Situations Asia fund.

Morgan Stanley likely will finish raising its new global real estate investment fund in the first quarter of 2009 instead of the end of this year, according to investors. The firm’s prior $8 billion fund, Morgan Stanley Real Estate Fund VI International, had a loss of 20 percent for the 12 months ended June 30, the investors said. Much of that fund has been invested in Japan.

Morgan Stanley also is phasing out the management of separate real-estate accounts to concentrate on managing high-yield funds. As part of that move, the firm is closing offices in Boston and Chicago and has reduced staffing in Atlanta.

“We are transitioning over time our separate accounts business to focus on our commingled funds business,” Ali said in a telephone interview earlier this month. She declined to comment on fund-raising or possible writedowns.

Once the second-largest U.S. securities firm, Morgan Stanley converted to a bank holding company in September and accepted $10 billion in government bailout funds to survive the credit crisis.

Banks and brokerages worldwide have disclosed $800 billion of writedowns and credit losses since the collapse of the subprime mortgage market last year, which led to a slump in markets ranging from commercial real estate to private equity, according to data compiled by Bloomberg.

How bad will things get in private equity? While some still contend that 2009 could herald strong returns for private equity, a new report predicts that between 20% to 40% of private-equity firms are expected to fail due to the current financial turmoil:

Heinrich Liechtenstein, a professor at Spain's IESE Business School, and Heino Meerkatt, a Munich-based senior partner and private-equity expert at Boston Consulting Group, predict in their report that about a third...(subscription required)

Finally, to round out alternatives, the Financial Times reports that hedge funds face failure and shake out:

Listed funds of hedge funds have been failing to produce any kind of positive return in the past couple of months, with share prices plummeting and some funds, such as F&C Event Driven, now planning to wind up.

In part, this failure has been due to the fall in share prices across all asset classes. But the funds have also been affected by the poor performance of underlying hedge funds, which have struggled to raise money and meet requests for redemptions. As a result, the hedge fund universe is expected to contract dramatically over the next year.

On average, listed funds of hedge funds have now lost 15.9 per cent in the year to date. For investors who thought they were buying into absolute returns and an asset uncorrelated to the wider equity market, this has come as a huge disappointment.

But analysts say there is still a significant difference in the performance of the funds. "It's almost as though investors haven't really differentiated between the different managers and the different styles," argues James Brown, analyst at Wins Investment Trusts.

As a consequence, analysts are continuing to recommend funds that they believe to be good buying opportunities.

Tom Skinner, investment companies analyst at Cazenove, is recommending AceniA and Absolute Return Trust. He also says investors can take advantage of wide discounts to the funds' net asset values, and buy in the expectation that they will be wound up. If this happens, investors will be paid the full net asset value per share, and so could potentially make a profit.

Skinner suggests Dexion Equity Alternative, currently on a 28 per cent discount, is one to watch. "I think it's quite likely that investors will be given the opportunity for a cash exit," he says.

Meanwhile, managers of funds of hedge funds are still aiming to find value within the hedge fund sector.

Ken Kinsey-Quick at Thames River Capital admits that funds of hedge funds showing double digit losses this year will "struggle to survive". But he believes funds sitting on cash are in a strong position to negotiate with hedge fund managers to buy in at a discount.

In fact, he says double- digit returns in the future should be possible, even "pretty easy". The reason he gives is the high return currently seen on credit, with investment-grade corporate bonds currently yielding more than 10 per cent. He also sees opportunities in refinancing the financials, healthcare and energy.

Peter Pejacsevich, managing director at CrossBorder Capital, an investment advisory firm, says managers should be looking for hedge funds that do not have strict redemption terms. "In times like this, it's important to know you can get your money quickly if you want to," he says.

Some investors are also realising that hedge funds may have previously outperformed simply because they were able to borrow money. In a rising stock market, this meant that their returns were amplified without any extra skill on the part of the fund manager.

"Now people will ask which hedge fund managers add alpha through stockpicking, rather than through leverage," says Pejacsevich.

He suggests this will mean a focus on hedge funds that are not too large, and hold a smaller number of stocks. "If you're a good stockpicker, you can't run huge portfolios, and you can't put huge amounts in as you'll shift the price," he explains.

"There's going to be a premium put on stockpicking which will mean hedge fund sizes diminish."

Andrew Ross, chief executive at Cazenove Capital Management, says the lack of positive returns in funds of hedge funds should not deter investors. Absolute Return Trust, for example, is down 7 per cent in the year to date, but he points out that was achieved against a background of the FTSE All Share index falling 22 per cent.

"Hedge fund longer-term returns are actually very like equities - returning 8 to 10 per cent, but with half the volatility," he argues. "And if you're only in cash and equities you have to wonder when to call the market."

Almost all the experts agree that the hedge fund industry won’t be quite the same again. The New York Times published an article from Richard Beales citing the six changes that hedge fund managers (who survive) need to prepare for:

Liquidity is the new watchword. Like investment banks, hedge funds didn’t think much about the structure of their financing during the boom times. But a flood of redemption requests in late 2008, just as they were struggling with illiquid markets and scarce credit, caught them out. Many hedge funds annoyed their investors by blocking withdrawals. In the future, funds that invest in illiquid assets will need to lock in their investors for longer. And those wishing to give investors regular access to their money will have to focus on liquid markets.

Fees will face greater scrutiny. The archetypal hedge fund charges 2 percent of assets and skims off 20 percent of investment gains, the longstanding “2-and-20” structure. But some funds have had to offer breaks on fees lately to persuade investors not to take their money out. Investors will be more selective and are likely to put downward pressure on fees. All the same, it is probably too soon to sound a Last Post bugle call for 2 and 20.

High water marks will blur. If hedge managers lose money, they normally have to get the fund back up to its previous high for each investor, the so-called high water mark, before the investor has to pay any more performance fees. Broadly speaking, a fund that is down 20 percent from its peak and has a standard high water mark mechanism would need to deliver returns of 25 percent before getting back to its high water mark and earning performance fees again on further gains.

That prospect is daunting. It can leave hedge funds short of cash and their employees wondering where their bonuses will come from. Some managers will throw in the towel. This is why some already use a modified mechanism allowing them to earn reduced performance fees on gains even before they have recouped earlier losses in full. Expect more funds to adopt similar policies.

Regulation will intensify. Many hedge funds, including big names like the Citadel Investment Group, have had a dismal 2008. But unlike the banking sector, they haven’t needed bailouts. That doesn’t, however, mean hedge funds will escape tighter regulation. Big losses, excess leverage, unexpected curbs on investor withdrawals, and the impact of short-selling on fragile markets make hedge funds easy targets for a crackdown.

Regulators also missed warning signs surrounding Bernard Madoff, who is accused of running a Ponzi scheme that cost investors as much as $50 billion. His investment operation appeared like a hedge fund in that it was private and he purportedly traded options as well as stocks. Watchdogs and investors will, therefore, share a desire for greater disclosure, so long as it is meaningful. The challenge will be in writing sensible regulations that can be applied across a diverse industry.

Concentration will accelerate. Consolidation among hedge funds was under way before the pain of 2008. Hedge funds are set to start the new year managing little more than half the nearly $2 trillion of investor money they held earlier in 2008. Only a handful of top performers — like Paulson & Company, which oversees $36 billion — are bigger than a year ago. Smaller firms, many of which have lost money and become smaller still, will be vulnerable to closure and consolidation. Funds under management will become increasingly concentrated among larger hedge funds, which are favored by institutional investors and in some cases have achieved better investment performance than their rivals.

Unleveraged returns should improve. The credit boom allowed funds to prosper even if their investment strategy was simply to use borrowed money to amplify tiny returns. But a smaller hedge-fund industry operating in a deleveraged financial world should be able to find more opportunities to make decent returns without exploiting leverage.

That’s another way of saying that after a rotten year, stable and committed hedge funds should be able to do well again. That’s cold comfort for those who have lost big. But it suggests that some in the industry will live to fight another day.
Hedge funds also got some relief from the government knowing they can now borrow from the Fed:
The government is committed to keeping the wheels of consumer credit greased. To
that end, it has launched a $200 billion effort to support the market for consumer receivables.

The Fed announced it will "offer low-cost three-year funding to any U.S. company investing in securitized consumer loans under the Term Asset-backed Securities Loan Facility (TALF)," reports the Financial Times.

"This includes hedge funds, which have never been able to borrow from the U.S. central bank before." The TALF will likely be expanded to cover mortgage-backed securities next year. We'll have to see if this really adds liquidity to the secondary markets.
So where does all this leave pension funds? It leaves pensions in peril. And here is the kicker: the U.S. Pension Benefit Guaranty Corp. (PBGC) - the government agency that insures pension retirement savings for roughly 44 million workers - tapped three investment firms to help manage $2.5 billion in real-estate and private-equity assets, segments the pension insurer's board approved earlier this year for expansion into:

BlackRock Inc. (BLK), Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM) were selected to manage the investments, provide support to PBGC's in-house investment staff and help build the corporation's institutional capacity.

"These relationships will benefit the PBGC, not only with private equity and real estate investments, but in risk analytics and mitigation, consolidated reporting and staff augmentation," said Director Charles E.F. Millard.

Last month, PBGC said it reduced its deficit by roughly $3 billion to $11.15 billion in its latest fiscal year but warned the ongoing financial crisis could cause fiscal instability in this new year. The agency had $4.34 billion in stock market losses for the fiscal year.

Wait till the PBGC gets clobbered in their real estate and private equity portfolios. These are the perils of following the herd who tried to follow Harvard and Yale.

And if you thought Harvard and Yale's returns were awful, wait until the large public pension funds report their results. Let's just say 2009 can't come soon enough for most pension funds.

The problem is that next year will likely be another tough year for pension funds who heavily invested in illiquid alternative investments like real estate and private equity.

The most important lesson in this alternatives pension debacle is that when you blindly follow the leaders, you risk being left out in the cold.