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Wednesday, 19 September 2012

Product Convergence or Incestuous Orgy in Alternatives - Part 2

The growth spurt in alternatives partly reflects the flow in capital to alternative managers from traditional ones, for various reasons diacussed below. Accepting plutocratic model of society, traditional manager’s time-vested and relationship-nested model of conducting a socio-politico driven economy is perhaps on the wane in its creative-destruction cycle. As an example, I am thinking of Fidelity Investment’s non-vogue long-only-securities investing since starting in 1946. Yet Fidelity is still the second largest mutual fund company in the US. In Europe, “Foreign and Colonial” a.k.a. F&C Asset Management plc, the world’s oldest manager of mutual funds, has seen its listed share price fall to a quarter of its value in 2000.   FPM believe innovation in the securities management industry with the newer mutual-fund models of Vanguard Group established in 1976, and the best of breed alternative-managers like Bridgewater, formed in 1975, are bellwethers. Additionally, lets not forget that the traditional brokers and manager’s spawned or trans-mutated into hedge funds and private equity. The ‘hedgies’ tended to be from the broking and agency or prop-trading side (secondary markets), while the corporate finance or investment bank teams did the transactions (primary markets), akin to PE-model. The closing yet untenable link between PE and hedge funds via their cross-holding ownership yet again inexorably questions Chinese walls issues. Our premise that creative-destruction via alternative assets is foreboding or to be emphatic, ill-auguring; and ultimately beneficial for FMTs.

By sampling the Carlyle Group's fund manager transactions, as one of the world's largest connected private equity investors, FPM believes their deals serve as a case study of ‘alternatives’ trends and consequences.   

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In literary terms we think The Carlyle Group’s [CG] activity represents Jacob Marley’s ghosts showing Ebenezer Scrooge things that have been in the past, are currently and will come to pass. Carlyle’s activity in asset management deals are complex if not opaque beyond the reported details. For instance, it is difficult to distinguish between their strategic and financial investment rationale for partnerships, despite rules of thumb about <20 being="being" financial="financial">30% being strategic investments.

Also weaving an entangled web to the already complex association of cross-holdings between asset managers, is through investments in the hedge fund and/or private equity fund (i.e. via LP shares of the fund). So we are now doubled up on exposure to GP stake and LP stake. For example, as cited in Carlyle’s activity table above, the sovereign fund of Abu Dhabi’s Mubadala Development Company also committed $500 mn to an investment fund managed by Carlyle. While the US$1.85 bn of capital involved in this particular investment is not suggestive of absolute catastrophe to Mubadala, yet considering the aggregated capital investment of other petro-dollar earning countries in the Middle-East region in global financial services, the impact maybe significant wealth destruction! The prototype for which has been set since the 2008 financial crisis. The illustrious manager of Pimco’s bonds funds, Mr William Gross, stated that on a long-term basis, governments are likely to use financial repression, where the rate of inflation is higher than bond yields, to erode the value of sovereign debt over time. The late great Barton Biggs also stated in Mid-2011 that debt devaluation via inflation is less painful than capital destruction as a long-term course. (A prophetic Barton Biggs interview)
The cross-holding in financial services, which is rhetorically seen as diversification benefits (and realistically, recycling of petro-dollar revenues etc) can insidiously become risky over-concentration in a financial assets. For example, the overall leverage Company A states on its books can multiply if its cross-held affiliate Company B takes a nose-dive due to its own leverage situation. Company A’s balance sheet asset takes a knock-on hit and deleveraging may be enforced. Remember that in financial services and corporate treasuries assets usually have a charge or liability against them. By putting an asset or capital to intensive use there is less cushioning from the negative domino or chain-reaction effects created by the weakest link in the chain.

Hence why every time there is a financial crisis, after the horse has bolted, so to speak, Basel regulatory capital reserve requirements convene special discussions. And After the financial crisis which unfolded in summer 2007, regulators and bankers from 27 countries gathered yet again in September 2010 to agree on the Basel III accord.

Evidence of a cross-holding implosion scenario: by cutting financing to hedge funds and raising ‘repo haircuts’ (basically ransoming the fund-firms to put up more assets / collateral to back their borrowing / leverage) prime brokers chain-reacted in the ensuing securitised mortgage crisis of 2007.  Amid systemic crisis this credit-squeeze also caused a series of hedge fund blowups, including Carlyle Capital, an affiliate of the Carlyle Group! Also see the case of Anger at Goldman Still Simmers.

Carlyle Capital Corporation, a publicly traded fund which at the time held US$21.7 bn of securities (though it had only raised $300 mn equity through the fund IPO and listing on Amsterdam Euronext exchange!), was served with a default notice from one of its prime brokers after it failed to meet initial demands for just $60m of margin calls in March 2008. This case and FPM’s database shows how hedge fund firms and their funds can blow-up even though they have a large and powerful affiliate. Carlyle Group which had assets of US$75 bn at the time provided only a $150 mn credit line to the fund, which was the limits of its exposure.

FPM reiterates a yellow-flag warning on the prospect of "distressed domino-effect sellers" of hedge fund and manager allocations. The author suggests a growing ‘secondaries’ in alternative manager and fund stakes.  The systemic-effect concern stems from numerous potential risk scenarios according to developments in hedge funds and the tectonic shift in financial services, which FPM monitors as Accumulating Risk Trends (ARTs). Some of these ARTs we follow at FPM are listed at the foot of this article. For example, the development of buyout firms buying stakes in the managers of hedge funds or other affiliations by varying degrees of investment poses threats. The author of this FPM alert experienced first-hand the UK split-capital investment trusts implosion (British version of mutual funds with preferential and other share-classes). Eventually these regulatory body authorised trusts, which were meant to be safe, were investigated and fined for mis-selling despite their hindsight-evident concomitant risks. A fiasco that ensued once cross-holdings multiplied the effect of leverage, leading to debt covenant breaches and fund closures at the height of a general market de-leveraging cycle of 2001-2003.

In extrapolating split capital investment trust experience, FPM foresees a scenario of hedge fund cross-holdings, especially between implicitly leveraged credit management units, turning sour! A domino effect of tumbling hedge- and private equity funds valuation, through LP-share redemptions or private market value (PMV) deterioration in the buy-and-hold GP stakes, would shake the foundations of alternatives if Carlyle experienced capital-flight for “whatever!” As a reminder, the tangled web-effects of Lehman’s cross-holding and counterparty relationships are still reverberating. As with Amaranth blow-up, long-term fund investors and GP stake-holders in it would have ended by receiving little residual value. In FPM research-integrity, we do not understate that Amaranth’s demise benefited the other sides of its failed trades, in the zero sum game.

To really get a domino-effect or contagion from a credit hedge fund blow-up scenario, a bubble first needs to blown. Last wave of fear was triggered in subprime mortage loans, could the next economic impalement come from leveraged loans tied to buyout activity in corporations souring! So noticeable that other large private-equity firms are inevitably buying CLO funds / contracts in a bid to capitalize on a recovery in loan prices (which we at FPM benchmark with S&P/LSTA US Leveraged Loan 100 Index). Carlyle joins Blackstone Group via its credit-arm GSO Capital Partners, and a host of other managers like Deerfield Capital Corporation, in acquiring investment firms or debt funds recently. Also, in June'12, in unison with other PE managers who have opportunistically expanded into traditional and alternative assets, Kohlberg Kravis Roberts, one of the oldest PE business models, purchased an existentialism-hit fund of hedge funds player Prisma Capital Partners. For Carlyle, this trend of PE diversification by adding alternative managers was envisioned and initially developed in 2008. However this attempt to add hedge funds failed when the firm liquidated a pool hurt by investments in mortgage securities as property prices declined and credit markets froze at the onset of the financial crisis. Highlighting such waves of consolidation in alternatives and considering their impact is this premise of this note, and consultancy service that FPM is embarked on. 

A large credit hedge fund blow-up may not cause economic waves but will have ripple-effects on already dented investment portfolios at pension managers, treasuries and other pooled financial savings. Needless to remind industry main-stayers of the widespread panic from LTCM-collapse ensuing from Russian debt debacle of Autumn 1998; similarly Lehman and Bear Stearns collapse from mortgage loans should loom large in memories still! These last two were larger interweaved entities that arguably should not have been allowed to founder by the authorities. While those and MF Global’s bankruptcy reach financial media headlines there are numerous others that will not be heard-of by busy investors. Hedge funds are not only getting larger in assets managed, but also in terms of their numbers, as the sub-text premise of this note indicates. So it stands to reason that some AI managers will become behemoths and others will launch with a strategic partner/s then strive to stay afloat or destruct on stormy / rainy investment days, with or without affiliate’s help.

And as if on cue to validate FPM visionaries: STOP PRESS! Stark & Roth LLC is winding down its multistrategy hedge fund. The firm better known as Stark Investments announced this in a filing with the state authorities in 6th July ’12 Friday. Also, read about related impact of shareholders of the crisis at broker Knight Capital Group. This thought-paper blogged at end-June!

One of the earliest observation of this cross-holding, in particular via FOFs in-play-transaction trend was in 2007 when TA Associates, a significant specialist player in financial services transactions / deals bought a minority stake in K2 Advisors, which was then a UDS$5.5 bn AuM FoFs. Which had been transformed into a US$10 bn AuM firm by mid-2011. TA Associates was not only acquiring steady and diversified revenue streams but also significant client relationships. Relationships that FPM understand will help identify single-manager hedge funds to be in distress or otherwise put into play as a fund manager transactions. Other positives that FPM notes from cross-holdings, since transactions have myriad and opaque motives would be in the interest of acting as a cabal, coterie or cadre. For example, affiliated M&A arbitrage hedge funds discretely cooperating can effect board changes without breaching “ownership-percent-threshold” and triggering ‘posion pills’ (which more than 2/3rd of S&P 500 companies have as defences against hostile takeovers). 

Finally, as a self-fulfilling flow to FMTs, we consider whether Carlyle will turn their 2011 interest in K2 Advisors fund of hedge funds into a financial or strategic buy from TA Associate and K2 management. Deal terms and intangibles willing.

Accumulating Risk Trends – ARTs in Alternative Investments:

Stability of repo financing arrangements
Limits of advisor / management’s exposure for losses
Effectiveness of reassurance about undrawn credit lines
Chinese wall issues between PE and hedge fund activities
Opaqueness of leverage levels from multiple prime broker use
Heightened government and regulatory environment e.g. new whistle-blower rules
Capacity constraints on performance of larger managers and ‘style drift’
Sub-critical mass of small to midsize management firms
Degrees of manager connectivity in fraud, insider dealing and other breaches
Loan servicing and refinancing difficulties in high interest rate environment
Commodity and leveraged loan products risk – a time bomb!
Mass wealth destruction in assets e.g. bonds via higher dispersed-inflation