Roger Ehrenberg’s latest post, ‘Alternative Asset Managers and Down Market Cycles: What to Expect,’ isn’t quite as blunt as my headline above, but it comes pretty close. He at least says that suffering, while common, will not be universal.
Cheap funding was important to the success of hedge and Leveraged Buyout funds (LBOs) and its evaporation will lead to a reversal of fortune. Moreover, while many hedge funds relied on leverage to produce their outsized returns, even some who didn’t are confounded by the divergent-from-historical-patterns trading markets we are facing now.
Let me digress with a wee story. In the stone ages, when I was young, I was sent to work on a Treasury study. The firm I worked for had never advised a Treasury business; this was one of the very biggest operations in London that had gone from making money to losing lots of it. The only reason I was sent was that, unlike everyone else on this project, I had at least been in a dealing room.
We really had no idea what we were doing, and even worse, the partner wanted to find a way to beat the foreign exchange markets with four months of end of day trading data (meaning the closing price) in four currencies. It was a thoroughly miserable experience, particularly since the main reason for the client’s troubles was one we could not readily solve, absent a massive change in personnel.
This was 1984, a strong dollar environment. The FX traders had all learned the business when the dollar was weak, so their reflexes were all wrong.
I think we will see a lot of this sort of problem.
Is private equity immune?
While the tough times for hedge funds are not surprising, private equity funds maintain that they add fundamental value by improving operation, not by mere financial engineering. Yet it isn’t hard to imagine that this claim is exaggerated. Why? Look at how hard public companies have been working to wring out costs any way they can. Any low hanging fruit is long gone. Indeed, the main benefit of being private these days is to get out of the glare of the spotlight and be able to pursue long term strategies. But it isn’t clear to me how much private equity talk along those lines is really sincere.
Ehrenberg says that LBO firms will either put their money into lower return deals or into PiPEs (Private Investment in Public Equity). Personally, PiPEs are the worst of both worlds. You have a big enough stake to be visible and thus have difficulty exiting, but by virtue of have a holding in a public entity, you as an investor cannot get inside information. One of the big advantages of being private is you can know everything about your investment if you have the time and energy.
Ehrenberg fails to consider a third possibility: that investors will demand a reduction in commitments. In the dot-com bust, it was evident that venture capitalist were not going to be able to put all the money they had raised to work. Investors were unwilling to pay 2% (the annual commitment fee) on funds that would never be put to work, and successfully demanded reductions, often as much as 50%.
You can read Ehrenberg’s post here.
Posted by Yves Smith on Naked Capitalism, Thursday 24th January