alternative investments, the SEC and Trump

My earliest experience with alternatives was as a rookie analyst in 1979. Among other things, I was covering small oil wildcatters who funded themselves by promoting oil and gas limited partnerships sold through retail brokers. The 1/2″-thick prospectuses laid out terms that were so unfavorable to limited partners that at first I couldn’t understand why anyone would buy them. So I asked the VP Finance of one of my coverage companies. He laughed, and said the offerings were not for people who wanted to make money. They were for people who wanted to tell others at a party that they were wealthy enough to have an income tax problem.

I remember a China-oriented private equity fund whose prospectus touted the promoters’ prowess through their extraordinary history of high returns. The returns were high–but, after fees, they matched almost exactly those of the Hang Seng index. Again, lots of sizzle but…

As part of the financial reform after the financial crisis, and because of widespread improprieties in the alternatives industry–like misstatement of returns, or professional credentials, or size of assets under management …or other stuff I’d call flat-out fraud–many alternatives providers were required to begin filing reports with the SEC, which has since prosecuted a number of high-profile cases of abuse.

Trump is now taking two actions in support of alternatives, both of which seem to me only to be pluses for dubious alternatives promoters. He’s proposing that ordinary investors be allowed to buy alternatives in 401k accounts (they’ve been barred as too opaque and risky). He’s also “solving” the issue of fraudulent reporting by ending the mandate that smaller alternatives firms to file their results with the SEC (removing the threat of Federal prosecution for, say, falsifying returns).

Neither makes any sense to me. Why do this? Maybe the same reason Trump has made no effort to keep his promise to eliminate the carried interest ploy private equity managers use to avoid income tax.

the Toys R Us Chapter 11 filing

Toys R Us (TRU) is no longer a publicly traded company.  After a very rocky period of being buffeted by Wal-Mart, Target, and with Amazon beginning to pile on, TRU was taken private in 2005.

Its fortunes haven’t improved while in private equity hands.  In addition, as private equity projects usually do, TRU acquired a huge amount of debt, as well.  In a situation like this, suppliers are typically very antsy about the possibility of a bankruptcy filing.  That’s because trade creditors have little standing in bankruptcy court; they usually can’t get either their merchandise back or payment on any receivables due.

When a reent press report appeared that TRU was considering Chapter 11, suppliers apparently refused to send any more merchandise to TRU on credit, demanding payment in full upfront instead.  The company didn’t have the cash available to pay for enough merchandise to fill its stores in advance of the all-important holiday season.   So it filed for Chapter 11 bankruptcy.

None of this is particularly strange.  Years ago, one of my interns did a study that showed that even in the early 1990s TRU was losing market share to WMT and TGT, and was making due mostly by taking share from mom and pop toy stores.  Then the last mom and pops closed their doors and TRU’s real trouble began.

What dd surprise me was the report in today’s Financial Times that the company’s notes due in 2018 were trading at close to par a couple of weeks ago–vs. $.28 on the dollar now.

How could this be?  Holders were apparently betting that TRU would limp through the holidays and then refinance its 2018 debt obligations–allowing these “investors” to collect a coupon and exit if they so chose.

The fact that professional investors would commit money to this threadbare investment thesis shows how desperate for yield they are in fixed income land at present.  As/when rates begin to rise, things could easily get ugly, fast.

Caesars Entertainment and private equity

I’ve been wanting to write about what might be called the private equity paradigm for some time. On the other hand, I don’t see any way for me as a portfolio investor to make money from research I might do–other than to keep as far away from private equity deals as possible–so I haven’t done as meticulous job of research on this post as I would if it involved a stock I might buy.  So regard this more of a preliminary drawing than as a finished picture.

When a private equity firm acquires a company, it seems to me it does five things:

–it cuts costs.  The experience of 3G Capital seems to show that typical mature companies are wildly overstaffed, with maybe a quarter of employees collecting a salary but doing no useful work.  Private equity also uses its negotiating power to get better input pricing, although it passes on little, if any, of the savings

–it levies fees to be paid to it for management and other services

–it increases financial leverage, either through taking on a lot of bank debt, or, more likely, issuing huge swathes of junk bonds.  An equity offering may happen, as well

–it dividends lots of available cash generated by operations and/or sales of securities to itself, thereby recovering much/all of its initial investment

–it then sits back and waits to see whether (mixing my metaphors) this leveraged cocktail to which it now has only limited financial exposure, sinks or swims.

 

Caesars Entertainment has added a new twist to this paradigm.  In 2013, its private equity masters seem to have decided that sink was the more likely outcome.  Rather than simply accept this fate, they began preparing a lifeboat for themselves by whisking away valuable assets from the subsidiary that is liable for the company debt into another one.  In January 2015, after this asset shuffling was done, they put the debt-laden subsidiary into bankruptcy.

Junk bond holders sued.  Litigation has been protracted and has reportedly cost $100 million so far.

Media reports indicate that the case is now approaching resolution–either through negotiation or court ruling.  My no-legal-background view (I was a prosecutor in my early days in the Army, but that says more about the Uniform Code of Military Justice back then than about me) is that:  these asset transfers can’t be legal; and the junk bond loan agreements should have had covenants that explicitly bar such action.  So I’m not sure what has taken this long.

Whatever the outcome of the case is, I think it will shape the nature of private equity from this point forward.

 

 

 

CalPERS is exiting its hedge fund investments

the CalPERS decision

The California Public Employees Retirement System (CalPERS), the largest public pension system in the US and an early adopter of hedge funds, has announced that it will terminate its entire $4 billion in hedge fund investments over the coming year.

The decision comes after a review of CalPERS’ hedge fund performance by its investment staff following the death from cancer of the organization’s Chief Investment Officer, Joseph Dear.  Mr. Dear, a strong proponent of alternative investments such as hedge funds, took the reins at CalPERS in early 2009.  His appointment came in the wake of a sharp, recession-induced drop in the value of CalPERS’ assets–and as an alternatives-related “pay to play” scandal involving pension consultants and so-called “placement agents” was unfolding (see my post).

The stated reason for the move is that hedge funds are too complex and too high-cost.  Reading between the lines, this seems to me to mean that the hedge funds CalPERS used didn’t provide either the promised diversification or superior returns.  My guess is that the professional staff, who have the best understanding of the products, wanted to act quickly, before a new political appointee could arrive to muddy the waters.

In one sense, the CalPERS move should come as no surprise.  Although there are a small number of hedge funds run by superb investors, the average offering has pretty steadily underperformed the S&P 500 for over a decade.  In addition, the elevated fee structure results in most of what profits there are going to the fund manager, not the client.  These factors call into question the rationale for having made the investments in the first place–to reduce the underfunding of pension plans through superior investment performance, so that higher contributions to the plans by the corporation or government body that sponsors them can be avoided.  The evidence seems to me to be that hedge funds generally make the underfunding problem worse, not better.

On the other hand, it takes a substantial amount of courage to fire managers who have strong local political connections.

investment significance

CalPERS is a trend-setter.  It may well be in this instance, too.  A lot depends on whether the next CIO supports the investment staff decision to end hedge fund exposure or overrides objections.  In the former case, this could signal the gradual return to less speculative trading-oriented, more fundamentally driven securities markets.