Private Equity and Hedge Funds Threats and Opportunities by trevorbowman

VIEWS: 86 PAGES: 26

									Private Equity and Hedge Funds: Threats and Opportunities
David Stowell November 2007

Hedge Fund Overview
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Hedge funds offer investors diversification by seeking returns that are uncorrelated with returns on public equity and debt markets Hedge fund assets under management exceed $1.7 trillion This amount is more than triple the $490 billion managed at the end of 2000
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Hedge Funds Overview
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Hedge funds usually add substantial leverage to their investments to increase returns: targeting 15-20% p.a. Based on an average leverage ratio of 3:1, total investments by hedge funds probably exceed $7 trillion This compares with assets under management by pension funds, mutual funds and insurance companies of $21.5 trillion, $19.1 trillion and $18.6 trillion, respectively
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Hedge Funds Overview
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As a result, hedge funds are the fourth largest investor category Over the past seven years, hedge fund assets have grown at a 20% compound annual rate, compared to the three largest investor categories, which have grown at between 5% and 10% p.a.
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Hedge Fund Overview
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Hedge funds should continue to grow in size, assuming no regulatory limitations
• High net worth investor category growing • Pension funds increasing allocation to hedge funds from 6% to 8%

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However, if returns drop, because of the high fee structure, investor interest in hedge funds could diminish The credit crunch that started in mid-2007 may produce a shakeout as interest rates rise and losses (that are leveraged) cause funds to fold

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Hedge Fund Overview
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Hedge funds are distinct from mutual funds in several ways
• High use of leverage • More diverse trading styles covering a wider range of asset classes and instruments • Less onerous regulatory constraints • Limited to wealthy and institutional investors • Higher compensation structure: 2% plus 20%

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Hedge Fund Overview
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In normal market conditions, hedge funds increase trading liquidity and innovation However, in turbulent market conditions, hedge funds might destabilize markets Systemic contagion spreading from hedge funds to the broader global markets is a risk
• Some research indicates that this contagion has declined as the industry has become more diversified and mature • However, systemic risk has recently been well evidenced and may prove to be greater than research suggests

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Private Equity Overview
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Private equity assets under management now exceed $800 billion. Since approximately one third equity and two thirds debt is applied to LBOs, this means that private equity firms have current buying power of over $2.4 trillion Private equity funds have grown at a compound annual rate of 15% over the past seven years The enterprise value of private equity owned companies is equal to 6% of all listed value on US stock markets and 4% of all listed value on European exchanges
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Private Equity Overview
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Private equity ownership is well suited to selected underperforming companies that have stable cash flow expectations Private equity owners have a unified voice in management and strong incentives to improve returns Adding debt to the company’s balance sheet forces managers to stretch to achieve high financial targets The result is cost cutting and, sometimes, improved operating efficiency and greater cash flow
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Private Equity Overview
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Over the past several years, global public-to–private transaction volume has exceeded IPOs During 2006, public-to-private transaction volume was more than double the volume of IPOs As a result, there has been a contraction of public company shares
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Private Equity Overview
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Some research suggests that where private equity firms are especially active in management of portfolio companies, performance and productivity have increased For two thirds of the companies studied, risk adjusted returns were twice the industry average Stock price of companies that later relisted on public stock exchanges performed better than the industry average
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Private Equity Overview
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The research is somewhat self selective: only companies that have characteristics which suggest that a restructuring will be beneficial are the subject of LBOs It remains to be seen whether the research results are sustainable If so, a growing number of other companies will need to scrutinize their performance and rethink their strategies This may lead to recapitalizations and productivity improvements without any direct investment by private equity firms
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Implications for Corporations
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The benefits of private equity ownership include:
• Higher leverage puts pressure on management to achieve operational and financial targets, often creating more efficiency and cash flow • Because private equity investors have a four or five year investment horizon, privately owned companies can undertake long-term restructuring and investments • Owners have direct say in governance, minimizing agency issues between owners and managers

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Implications for Corporations
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Private equity has caused competitive pressure on a broad set of listed companies that want to avoid takeover With the growth in private equity funds, companies as large as $50 billion in market capitalization are now becoming LBO targets As a result, CEOs and boards are reviewing their performance in an effort to increase shareholder value Share buy backs, as well as increased leverage, have been a frequent outcome of these reviews

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Implications for Corporations
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In the M&A market, during the first half of ’07, private equity firms represented more than one in three transactions As a result, corporations that decide to sell the entire company or a division of the company frequently find private equity funds on the list of prospective buyers This is especially so for companies that have stable cash flow projections and the capacity to leverage their balance sheets
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Corporate Strategic Considerations
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Companies should consider whether sustainable shareholder value can be best increased through a recapitalization process that leverages the balance sheet (add debt and buy back shares) and reduces costs without selling to a private equity firm Recently, a number of companies have independently recapitalized to either increase shareholder value or to avoid being acquired by an activist hedge fund or private equity fund Some of the investors in hedge funds and private equity funds are willing to invest directly in corporate recapitalizations without hedge fund or private equity participation
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August Credit Crunch
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Real estate collateral valuations dropped when sub-prime mortgage defaults mounted Hedge funds are the principal investors in collateralized mortgage securities, which are backed by sub-prime mortgages Prime brokerage arms of investment banks are the principal lenders to hedge funds As valuations dropped, prime brokers exercised margin calls, requiring hedge funds to repay part of their loans
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August Credit Crunch
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Hedge funds that were fully invested had to sell some of their assets to create cash to pay the margin calls, which reduced asset values This caused hedge funds and investment banks to mark down investment values in related securities, including asset backed mortgages and equity bridge loans Equity bridge loans are loans to private equity funds to facilitate acquisitions Equity bridge loans are designed to be syndicated up to 90% to other banks or hedge funds

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August Credit Crunch
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When valuations were marked down, banks decided to keep most of the equity bridge loans (hung bridges) and record accounting losses (instead of realized losses) This, along with mortgage related mark downs led to third quarter loss reports of up to $11 billion from the leading investment banks Estimates of outstanding hung bridges are: JP Morgan: $40 billion; Goldman Sachs: $32 billion; Deutsche Bank: $27 billion; Credit Suisse: $27 billion; Lehman Brothers: $21 billion; Morgan Stanley: $20 billion; BofA: $17 billion; and Merrill Lynch: $16 billion
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August Credit Crunch
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There was an almost complete shutdown of the main sources of leveraged finance capital during August, including CLOs, CDOs and hedge fund investing The high yield capital market and leveraged loan market significantly contracted Spreads between Treasuries and high yield securities widened significantly in the secondary market Libor spreads widened as well All of this impacted corporate borrowing and credit sources are still very cautious in providing capital
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August Credit Crunch
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Lessons learned include recognition that leverage has the effect of both expanding small profits into larger profits and expanding small losses into larger losses Credit and liquidity are inextricably intertwined: hedge funds receive margin calls when asset values decline, forcing sudden asset sales, which can create large losses when illiquidity creates a fire sale environment
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August Credit Crunch
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The large hedge fund losses in August, combined with the blow-up of two Bear Stearns credit strategies funds in June and the sale in July of Sowood Capital’s portfolio to Citadel after losses exceeding 50% has reinvigorated debate about further regulation of hedge funds But potential registration of hedge funds under the ’40 Act focuses on protecting investors and is not related to systemic risk In fact, registration might exacerbate systemic risk as it could inhibit the liquidity that hedge funds currently provide to the market
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August Credit Crunch
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Hedge funds are active providers of liquidity and credit to the market In this respect, they are becoming more like banks Unlike banks, however, hedge funds can withdraw liquidity at a moment’s notice This creates risks to the global financial system The question, therefore, is how much have hedge funds increased systemic risk and, do the benefits of allowing hedge funds to avoid regulation outweigh the risks
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August Credit Crunch Continues
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Citigroup took an up to $11 billion charge to third quarter earnings and CEO Prince resigned Merrill Lynch took a $8.4 billion charge and CEO O’Neal resigned Morgan Stanley took a $3.7 billion charge UBS took a $3.4 billion charge and CEO Wuffli resigned The top 10 investment banking firms share prices have dropped, on average, 27% over the past four months
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August Credit Crunch Continues
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More investment banking charges are expected during the 4th quarter: total write-downs could eventually be over $60 billion Merrill Lynch’s credit rating has dropped one notch to A+ and other investment bank ratings are expected to drop as well SIVs are an ongoing major problem: 30 funds own $300 billion in assets and are having difficulties finding new financing Rating agencies have lowered their credit ratings on $70 billion of mortgage related bonds and are getting ready to downgrade additional mortgage investments worth over $30 billion
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What’s Next?
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Dangerous territory Lots of hung bridge loans to get placed More downgrades ahead for investment banks and other financial institutions Possibly more regulation Probably new taxes on offshore income and carry for hedge funds and private equity Lower returns for hedge funds and private equity
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