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why do pension plans choose hedge fund and private equity managers?

Published January 27, 2012 Getting financial advice , hedge funds , Private equity Leave a Comment
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private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?

correlation

The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

the SEC, Citigroup and moral hazard

Published December 1, 2011 Banks , Derivative instruments , Industry Analysis , Investment firms , moral hazard , securities markets , Securities regulation , short selling , Where are the customers' yachts? Leave a Comment
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This is an update and elaboration on my November 11th post about Judge Jed S. Rakoff, the SEC and Citigroup.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Bill Miller and the Legg Mason Capital Management Value Trust mutual fund

Published November 21, 2011 Current Market Thoughts , Getting financial advice , How your broker gets paid , Industry Analysis , Investment firms , mutual fund holders and financial advisors , Portfolio management Leave a Comment
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Last week, Bill Miller of Legg Mason announced that he is stepping down as portfolio manager of that firm’s Capital Management Value Trust fund after 20+ years at the helm.

Mr. Miller was once the envy of equity portfolio managers everywhere for the fame and fortune his beating the S&P 500 for 15 years in a row brought hi.  In recent times, he has become the embodiment of very pm’s worst nightmares, however.

His previously hot hand–which had earned him designation by Morningstar as a “Manager of the Decade” turned icy-cold in 2006.  Ensuing weak performance erased the gains in relative performance his portfolio had made since “the streak” began in 1991.  The assets in his fund fell by almost 90% from the peak of $21 billion +.

my thoughts

I should say at the outset that I don’t know Mr. Miller and that I haven’t studied his portfolio composition carefully.  And I’m not interested enough to look up his past SEC filings to try to document my impressions.  With that warning, here’s what I think:

1.  It took Legg Mason a very long time–and the loss of the vast majority of Value Trust’s assets–before it made the change.  At the asset peak, the fund was generating management fees for LM at a $140 million annual clip.  It’s now generating under $20 million.

Why not act sooner?

Part of the reason is likely that after sagging in 2006-2008, the Value Trust outperformed in 2009.  More important, I think, is that the fund’s marketing has been all about “the streak” and the extraordinary investing prowess of Mr. Miller.   It’s a good story and an easy sell.  But it’s a risky strategy.  If it’s all about the numbers, and someone with even better results comes around–and invariably someone will–what do you do? You’ve already made the argument to your client to switch into the Value Trust because of the numbers; how can you now argue against numbers that tell him to switch out?

This selling direction also gives the manager himself a huge amount of power.  What’s the Bill Miller show without Bill Miller?  So if Mr. Miller wants to continue to run a concentrated portfolio with a strong emphasis on financials, despite steady underperformance, how do you stop him not to?

2.  I’ve never regarded Mr. Miller as a typical value investor, although he’s always described as one and the Value Trust (note the name) is classified with other value vehicles by rating services.  I have two reasons:

–Value investors are belt-and-suspenders kind of guys.  They run highly diversified portfolios, typically with 100-200 names–sometimes more.  Growth investors, in contrast, typically hold 50-60.  Looking up the Capital Management Value Trust on Google Finance told me it has only 46 names. (By the way, in my experience ratings services never pick up high concentration as a source of risk.)

–Both value and growth investors look for “undervalued” securities (only shortsellers want to find overvalued stocks).  That isn’t what the “value” in value investing signifies.  It means a certain approach to finding undervaluation.

Value investors look at the here-and-now.  Their holdings are typically asset-rich companies that have encountered temporary difficulties, which have been crushed by Wall Street and which are now trading at unduly depressed valuations as a result.  Growth investors, in contrast, look for companies whose future earnings prospects are being underestimated by the market.

In this sense, too, I don’t think Mr. Miller is a plain-vanilla value investor.  He has been happy to hold large positions in stocks like Amazon or AOL (in its heyday)–names I think other value practitioners wouldn’t give a second look because the whole story has been the rate of future earnings growth.

I have no idea how Mr. Miller squares this circle.  (The fund’s largest positions are now in technology, according to Google Finance.  But it’s not the same thing.  Today’s stocks are eBay and Microsoft.  Apple, the largest holding, is still a growth stock, unlike the others.  But AAPL trades at a very low PE multiple of current earnings.)

3.  Despite this flexibility, and the issue of heavy concentration aside, it seems to me that classic value behavior has been the Value Trust’s recent problem.  Relative to history, financials were trading at low price to book value (i.e., the balance sheet value of shareholders’ equity) ratios when Mr. Miller bought them.  In hindsight, that was a mistake.

There may have been a second.  If the stocks a growth investor buys underperform, he typically stops buying or lightens up.  Value investors tend to do the opposite.  They regard such stocks as being even cheaper than when they initially bought–and double up.  I suspect the latter is what Mr. Miller did.

two oddities

1. In the early part of my career, alternating cycles of outperformance by value and growth stocks were relatively brief.  Given a year, or two at the most, there would be little to chose between the numbers generated by one style or the other.  The 1990s, however, saw a multi-year value cycle in the early part of the decade, followed by a massive multi-year growth cycle–culminating in the Internet Bubble–at the end.  Despite the fact that the tide was running strongly against value during the latter years, Mr. Miller continued to outperform the S&P 500.  If he did so with value stocks, that’s his crowning achievement.

2.  After creating a strong business franchise under the Miller name, neither he nor Legg Mason did much to protect it.

 

 

Citigroup, Jed Rakoff, MF Global and the SEC

Published November 11, 2011 Banks , Derivative instruments , Industry Analysis , Investment firms , Securities regulation , Where are the customers' yachts? 1 Comment
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There’s an odd asymmetry to the way the SEC works.

For example, it put Martha Stewart in jail but ignored Bernie Madoff.   It pursued Michael Milken vigorously after the junk bond market collapsed.   But it has, so far, left the heads of the major commercial and investment banks untouched, despite the fact that the toxic derivative securities they created were much more widespread and–as we continue to see–have damaged the world financial system much more severely than anything Milken did.

Raj Rajaratnam’s insider trading recently drew an 11-year prison sentence and a $93 million fine.

But the other side of the SEC has come to light again recently in the court of gadfly judge Jed Rakoff.  Judge Rakoff is being asked to approve a settlement of a case in which buyers of a Citigroup mortgage product lost $700 million.

The deal the SEC is offering?

–pay back $160 million, plus $30 million in interest and a $95 million fine;

–Citi doesn’t admit it did anything wrong;

–only low-level Citi employees are sanctioned.

–oh  …and the SEC wants to include an admonition to Citi not to do stuff like this again.  But, as Judge Rakoff points out, Citi appears to have violated such orders issued in prior settlements at least twice in the past decade and the SEC has done nothing.

You’d take a deal like that all day long.

A cynic might say that this behavior is related to the fact the current head of the SEC used to be in charge of the brokerage industry trade association.  On the other hand, I believe much of the toxic derivative activity was deliberately organized by the banks out of London because that put them out of the reach of US prosecutors.  So there’s not much the SEC can do.

…which brings me to MF Global.

There’s certainly a danger to generalizing from a small number of instances.  But, to me, what connects Martha Stewart, Michael Milken and Raj Rajaratnam is tha: t the issues are easy to understand, the names are high-profile, none were deeply plugged into the financial industry establishment and, although wealthy, none had the near-infinite resources of the large investment and commercial banks.

One of the issues that the Occupy Wall Street movement gives voice to is that after nearly destroying the world economy and forcing a high-cost financial rescue that all of us will be paying for for many years, no high-level financial commercial bank or brokerage executive has been prosecuted for anything.

What this adds up to, I think, is that the SEC will be scrutinizing the role Jon Corzine played in the demise of MF Global very carefully.  He’s a former head of Goldman Sachs but no longer an industry insider;  he’s an ex-senator and ex-governor; he’s wealthy–but not Bill Gates.   And, the question of whether the firm illegally took money out of customer accounts and used it to stave off margin calls is pretty clear-cut.  It may also be hard to say you didn’t notice an extra $600 million plopping into a portfolio you manage–especially so if you really needed it.

It will be interesting to see what happens–both whether the SEC finds a reason to prosecute and whether that will satisfy OWS.  My guess on the second count is that it won’t.

what I find strange about MF Global

Published November 3, 2011 Current Market Thoughts , Getting financial advice , Portfolio management Leave a Comment
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who MF Global is

In mid-2007 the glow of a multi-year bull market had not yet begun to fade.  That’s when the Man Group, the London listed hedge fund group, divested itself of its brokerage arm, which was renamed MF Global.

Looking back, this seems to me to be a standard move of a firm that is in both a fast-growing business (hedge funds) and a slow-growing one (brokerage):  split them apart to create two pure stock market plays.  That allows the strength of the fast-growing business to be seen more clearly, and hopefully gets that stock a higher PE multiple as a result.

As for the mature business, who knows.  There may be investors who want to hold it.  And in any event, the timing of the split-up seems to have gotten MF Global an initial valuation that was relatively high.

Sometimes these splits work out well for the apparent ugly duckling.  Coach, for example, was a spinoff from cakes and tee shirt maker Sara Lee, where it was starved of capital.  Free of a bureaucratic parent, that company has been a rocket ship ride for a decade.

Not the case here, however.  (For anyone who knows the Man Group well (not me), it might be interesting to go back and see how the management talent was apportioned between Man and MF Global.  My hunch would be that, if anything, MF Global was stocked with lesser lights.)

spreading its wings

MF Global appears to have intended from the outset to reinvent itself as an investment bank.  An early trading stumble highlighted management control deficiencies and brought in private equity firm, J C Flowers, as a shareholder.

So far, while things could have worked out better for MF, nothing so out of the ordinary.

the strange stuff

1.  the Corzine hire

In early 2010, MF installed a new CEO.  The new guy had built a reputation as a very aggressive and successful bond trader during the 1980s.  He’d been booted out of his two previous management jobs, reportedly for being unable to get along with others.  The most memorable moment of his public service career was when he survived a 90 mph crash in his New Jersey state car, which he habitually rode in without using a seat belt.

Tidbits of gossip aside, Mr. Corzine had been an individual star in a young man’s business.  But he’d been out of the industry for over a decade.  And whether he possessed any management talent was at least open to question, though New Jersey voters rendered their verdict forcefully in 2009.

Picking him, it seems to me, is like selecting a 60-something ex-athlete to be the star player on your team, not the manager.  The broad of MF seems to have had no problem with this.  Mr. Corzine himself appears to have been blissfully unaware that it might take some time to shake the rust off talents he hadn’t employed in the current century;  he appears to me to have committed the cardinal sin of underestimating the other side of the trade.

According to Reuters, MF paid Mr. Corzine $14 million + to drive the company into bankruptcy in under two years.

2.  the “Goldman” recipe

Robert Rubin, former Goldman partner, advised Citigroup to dive into proprietary trading when he joined the company board.  Disastrous results.

John Thain, former Goldman partner, expanded Merrill Lynch’s proprietary trading when he took over as CEO.  Disastrous results.

Jon Corzine, former Goldman partner,…     Sense a pattern here?

3.  where were the compliance people, or the CEO for that matter?

Press reports, including this FT post, indicate that a last-minute deal to save MF Global by merging it into another financial firm foundered when MF couldn’t account for large amounts of customer money.  As I’m writing this on Thursday morning, it sounds like someone in MF diverted $633 million out of customers’ accounts and into its own last week in order to cover trading shortfalls.

It’s hard to believe this is true.  Things like this might happen in Madoff- or Enron-land but they simply don’t occur in reputable firms.  Nevertheless, this is what the CME Group, MF’s regulatory supervisor is accusing MF of.

I also find it hard to believe, although I guess it’s possible, that Mr. Corzine didn’t have a detailed daily (if not real-time) report of MF’s overall trading positions.  It seems to me that the “magic” appearance of over half a billion dollars in the company’s accounts should have been evident to MF management almost immediately.

 

I don’t think the entire story has been disclosed yet.  The Wall Street Journal, for example, is pointing out the mismatch between Wall Street analysts’ research and Mr. Corzine’s public statements vs. what we now see as the underlying reality.  Stay tuned.

 

 

 

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