The quarter paradox: IPOs and Meltdowns
Lipper HedgeWorld Staff.
Any discussion of the third quarter has to start with the turbulence that extended from US credit markets throughout the global financial industry. Rooted in credit derivatives that either contained, or were backed by, pools of sub-prime mortgages, the market gyrations of late July and early August claimed a number of levered hedge funds, including two run by Bear Stearns Cos. Inc.
Some parts of the credit markets seized up as investors tried to shed what they viewed to be toxic lower-rated paper. The contagion spread to higher-rated structured credit products, too, because of fears some of the loan pools might have exposure to sub-prime debt and because investors lost confidence in the bond rating agencies. Those agencies, including Standard & Poor’s and Moody’s Investors Service, came under fire for issuing high ratings to pools of debt that had exposure to sub-prime mortgages.
The problems evident by the end of the third quarter, sharply contrasted the almost giddy note on which the quarter opened with the last of the investment banking initial public offerings. Interspersed were some key personnel changes, including Peter Wuffli leaving UBS, and a host of new fund launches that displayed a growing emphasis on emerging markets and environmental and socially responsible businesses.
With that, let’s get into it, starting with the fallout from the sub-prime meltdown.
Results tell the story
Big losses at Goldman Sachs Group Inc.’s in-house hedge funds resulted in a steep decline in performance fee revenue for the year-to-date through August, but this was offset by a large increase in management fees from other asset classes. In the end, the loss in performance fee revenue turned out to be immaterial in the context of the bank’s total income. Goldman reported on 20 September that net income increased 79% in the turbulent three months ending on 31 August. Third-quarter earnings per share were $6.13, up from $3.26 for third quarter of 2006. Average return on common shareholders’ equity for the first nine months of 2007 was 37.5%.
Hedge funds were one murky spot in the generally bright Goldman record. The flagship macro-strategy fund, Global Alpha, lost 30% during the third quarter and faces more than $1.6 billion in redemption requests from investors, Goldman Chief Financial Officer David Viniar said during a conference call. He said redemptions at the other hedge funds were not very material. There have been widespread reports of losses and redemptions at Goldman’s hedge funds. Goldman Sachs Group’s Global Alpha hedge fund fell 22.5% in August, on losses from currency and stock trades Bloomberg News reported, citing an update sent to investors. The news service said the quantitative hedge fund had dropped by a third in 2007 and investors had notified the fund that they planned to withdraw $1.6 billion from the fund, or almost a fifth of its assets.
Goldman’s Global Equity Opportunities (GEO) Fund took the virtually unprecedented step of reopening itself to new and existing investors on 10 August, after it had lost 30% of its value over four days. The new investments generated paper profits of around $450 million, including $300 million for Goldman. However, the GEO fund and the firm’s flagship Global Alpha Fund each finished down for the month, said an investor familiar with the results. Goldman Sachs refused to comment about the matter. It also declined to say whether the fund remains open to new investors.
It is understood that Goldman chose to de-leverage GEO in response to the four-day plunge in early August. It could have liquidated positions to do so. However, in a bold manoeuvre, it opted to invest more capital after analysts judged its portfolio to be heavily oversold. Goldman is thought to have been wary of injecting debt financing, since it would have diluted other investors.
Dispelling PIPE Myths
Derek Buntain, Dundee Leeds Management Services Ltd, Bermuda.
PIPEs — private investments into public entities — are becoming an increasingly viable instrument in the alternatives space. Public companies both large and small are looking to the speedy financing benefits of these complex and illiquid vehicles, while both high net worth and institutional investors recognise the attractive risk/return prospects which PIPEs offer.
The PIPEs market continues to grow. Sagient Research Systems recently published data indicating that nearly 650 PIPE transactions totalling $22.14 billion took place in the first six months of 2007 alone, in comparison to a reported $28 billion for the whole of 2006. With big players including Lehman Brothers and Citigroup acting as placement agents, as well as large investment managers such as Iroquois Capital LP and Highbridge International dealing in PIPEs, this growth looks set to continue. This is despite some criticism from industry media about share dilution and suggestions that hedge funds exploit public companies through PIPEs, as well as suggestions that these deals are secretive and even ‘rife with abuse’.
PIPEs offer an alternative financing option for public companies that may not choose traditional financing routes. A variety of factors could influence this decision; for example, companies may rule out public market financing lest it degrade existing share value, or they may lack the foundation to issue debt instruments. PIPE fees are often less than traditional underwritings, and the transactions can be structured to fit the needs of both the company and the investor. PIPEs are particularly advantageous because of the speed and efficiency with which they can be negotiated, where a traditional option — such as an IPO or a bond deal — could take significantly longer. Companies seeking capital are able to complete financing in a matter of weeks and months, whereas traditional financing can take significantly longer.
One of the key factors which facilitates speedy PIPE transactions is the ability of the public company to issue shares which are not registered with the SEC. In order for companies to qualify for an exemption from the registration requirements of their private offering, investors in the PIPE deal must make certain representations in accordance with the 1933 Securities Act. For example, the Act restricts unregistered shares issued by the company from sale to the public until they have been registered, which investors must adhere to. Because of the risk associated with this lockup, shares are usually sold at a discount to market price. Shares are usually registered once the transaction is closed, which enables investors to get capital to the company speedily.
When compared to traditional capital-raising routes, the process of a PIPE deal is relatively streamlined. Typically, a public company looking to raise cash will contact a PIPE fund, and following initial due diligence, the fund may propose a term sheet which will be negotiated before the public company and the fund move to closing. At this point, the fund will carry out further due diligence which could include site visits, checking stakeholder references, in-depth financial analysis and background checks on management, as well as other qualifying criteria. After closing the deal, the fund will normally then file a registration statement for the resale of the shares offered in the PIPE, a process which can take anywhere from 30 days to six months.
A Progressive View of Real Estate Risk
Gerald Blundell, LaSalle Investment Management, London.
Real estate risk is back on the agenda after four vintage years for the sector of falling yields, positive cash flow on leverage and growing occupier demand. The current turmoil in the credit markets has thrown up enough dust to obscure a clear view of future conditions. It is a fair bet that when we revert to ‘business as usual’ the cost of real estate debt will be higher and values lower, even if the strength of occupier demand remains unchanged. Real estate risk is being repriced upwards, and we will enter a different world where the drivers of returns are income and income growth, rather than yield compression and leverage.
But what tools will asset managers carry into the new world to help them price risk? Sadly, while events move on, risk managers still seem fixated on the past. Events during the summer have, once again, highlighted the dangers attaching to backward-looking methods of risk management. Markets have been described as being hit by six sigma (standard deviation) events — events that should, on normal behaviour, occur only once every 6,000 years. The irony of this is that the data underlying such pronouncements only go back, at best, 25 years. It was only nine years ago the same sigma mantras were being chanted when Long-Term Capital Management collapsed.
Talking about multi-sigma events is arrant nonsense, based on the fallacy that the normal distribution of possibilities assumed by standard deviation, value at risk (VaR), etc fully reflects investment risk. It does not. Risk, in all financial markets, comes in different forms. Take, for example, default risk, a source of risk central to real estate. Tenants pay a steady yield until suddenly there’s an interruption and then there’s a large capital loss. This dispersion of return cannot be described by a normal distribution unless: (a) the defaulting income is part of a portfolio containing a large number of separate income streams; and crucially (b) those income streams are completely independent of each other. The second condition clearly does not apply to sub-prime instruments as they have all been systematically hit by rising interest rates. A systemic or contagious impact produces a highly non-normal pattern of return, rendering sigma a less then useful concept.
Look forward not back
In real estate problems with backward-looking measures, risks are even greater. Compared with bonds and equities, direct real estate is illiquid. It takes time to build a portfolio and it is not good enough to have to wait several years to learn its standard deviation of returns. How can that inform risk management at the time when the investment decisions were being made?
In order to combat these problems, we have developed a broader approach to risk analysis that single statistical measures of past returns, looking at a wide range of risk factors, not just the effect on returns, and looking for tools that could work at the level of individual asset as well as the portfolio.
Instead of analysing the past, our approach is focused on the ‘go forward’ risk associated with the existing assets in the portfolio. We developed a set of measures that could be traced to the individual asset and which relate to the sources of risk in portfolio.
Three Early Lessons from the Sub-prime Lending Crisis: A French Answer to President Sarkozy
Noel Amenc, EDHEC Risk and Management Research Centre, France.
Introduction
European leaders, eager for an explanation absolving them of responsibility, have, once again, laid blame on the seemingly detrimental role played by hedge funds in this summer’s crisis. France and its president1 were quick to cast these funds in their usual roles as scapegoats.
In a country with a social and political tradition of blaming its woes on the market, demands from abroad and international finance, this condemnation cannot but reverberate widely. We believe that not only is the criticism of hedge funds groundless, but that it helps to hide the true causes of this summer’s crisis. So, as a counterpoint to these French accusations, it seemed necessary to us to provide a French perspective on the lessons to be learned with respect to financial regulation in France.
Lesson one: hedge funds are not responsible for the current financial crisis
This crisis is the result of a sudden fall in asset prices, combined with increased aversion to risk on the part of investors. The sharp fall in value and the temporary illiquidity of asset-backed securities, commercial paper secured against high-risk mortgages supplied by sub-prime lenders, has sparked a crisis of confidence that quickly spread to the credit market as a whole, going so far as to affect the market for investment grade corporate bonds.
To suggest that hedge funds are to blame for this crisis is simplistic but tempting, as their speculative, unregulated, and opaque nature make them, once again, easy targets — the more delicate market and regulatory issues are avoided.
It is regrettable that even the most sober-minded economists, with neither facts nor figures, are attempting to lend credence to this accusation. Although it has long been discredited by both theoretical and empirical research, waving the spectre of the evil speculator who threatens the efficiency of the market and the good capitalism of the ‘real’ economy, continues to go over all too well.
It is hardly possible to deplore the lack of information about the risk exposure of hedge funds and, at one and the same time, to publish precise data on the asset-backed securities held by these very hedge funds. In fact, in the United States, the only reliable published data is made available through the Shared National Credit (SNC) programme. And this data does not distinguish among such non-traditional lenders as hedge funds, pension funds, insurers or, more generally, the entire community of institutional investors. It is only possible to state with certainty that, in the last five years, we have seen banks (to better manage and to diversify their credit risk, as well as to prepare for more stringent solvency requirements) use securitisation and credit derivatives to transfer (at a profit) a significant share of their debt.
Between 2002 and 2006, the proportion of non-bank lenders rose from 9.5% to 14.3%, and these lenders now hold 51% of high-risk loans. Investment in hedge funds makes up less than 5% of total institutional investment, and strategies with high exposure to credit risk account for 20% or less of assets invested in hedge funds, so it is hard to believe that all transfers of credit risk (in 2006, in the US market alone, $4.6 trillion worth of securitised debt, derivatives, claim transfers on secondary markets, and other debt instruments were issued) could have been done with hedge funds alone as counterparties.
Intelligent Commodity Investing
Edited by Hilary Till, Premia Capital Management, Chicago.
Until very recently, one could not have created a book like Intelligent Commodity Investing (Risk Books, 2007). But this has changed with the desire of investors to own a call option on Asian growth, along with the past five years of competitive returns from commodity investing.
That said, the debate on how best to obtain exposure to the commodity theme is definitely not resolved. In order to meet the market’s demand for education on this asset class, Joseph Eagleeye and I put together the multi-contributor book, Intelligent Commodity Investing, which draws authors from across the globe and across disciplines.
We have always enjoyed our involvement in the commodity markets as active participants. These markets are like a big tent that comfortably encompasses a wide variety of talented professionals and includes, for example, global-macro strategists, street-smart practitioners, careful fiduciaries as well as brilliant quants.
We have also enjoyed our participation in the commodity markets as statisticians. The advantage of commodities as an asset class is that individual commodity markets across sectors are frequently uncorrelated or even negatively correlated with each other. From a portfolio construction standpoint, the natural internal diversification provided by commodities is wonderful.
This article provides a window into opportunities in the natural resources market with brief excerpts from Intelligent Commodity Investing. Accordingly, we excerpt from the book’s sections on: (1) indexes; (2) active management; (3) risk management; and (4) the investor’s perspective.
Indexing
Structural shifts in commodity-index investing
Lewis (2007) provides an explanation of the curve dynamics in commodity futures markets. He shows how an investor can gain spot exposure to various commodities while maximising the roll benefit of backward-dated markets and minimising the roll cost in contango markets.
The following section excerpts from Lewis’ chapter.
The dynamic characteristics of commodity term structures are presenting new challenges to long-only commodity-index investors. The traditional approach to rolling commodity-index futures on a predefined monthly schedule is, in our view, in need of reform to address the implications that unstable term structures imply for the roll return within a commodity index.
One example of this commodity-index evolution is the Deutsche Bank Liquid Commodity Index — Optimum Yield (DBLCI-OY). Rather than rolling futures contracts monthly, the index rolls to that futures contract, which generates the maximum implied roll return from the list of tradable futures that expire in the next 13 months. The DBLCI-OY index consequently aims to maximise the potential roll benefits in backward-dated markets and minimise the roll-return cost associated with contangoed markets.
There have been many routes investors have used to gain commodity exposure. Historically, the most common approach has been via equity investment in major exchange-listed commodity-producing companies. Other vehicles have included owning physical assets such as forests, pipelines or royalty trusts, and even investing in resource-economy currencies such as the Australian and Canadian dollars. However, the emergence of a number of commodity-index products over the past few years has increased the popularity of commodity exposure via this route.
A benefit of investing in commodities via an index is that an investor can gain exposure to a broad range of commodities, which tends to enhance diversification, reduce volatility and maximise the Sharpe Ratio. In addition, index investing can exploit the benefits of downward-sloping forward curves, which deliver a positive roll return. Equity investment, meanwhile, has tended to be unable to give broad exposure to the entire commodity complex. Rather, it provides an investor exposure to just one sector or simply one commodity.
To assess the relative benefits of commodity-index investing versus an equity-investment strategy, Figure 1 examines the performance of the Deutsche Bank Crude Oil Index versus the Chicago Board Options Exchange (CBOE) OIX Oil equity index. The CBOE oil index is a price-weighted index of 15 companies involved in the exploration, production and development of petroleum. The DB Crude Oil Index is one of the sub-indexes of the Deutsche Bank Liquid Commodity Index, which can be measured on either a total-returns or excess-returns basis. We find that investing in the DB Crude Oil Index has significantly outperformed the OIX index — see Figure 1. Indeed, since 1999, the DB Excess Returns Crude Oil index has risen by just over 600% compared with a 130% rise in the OIX index. Both indexes reflect the benefits of a rise in the spot price of oil. The divergence in performance results from: (1) the roll returns accruing only on a commodity-index product; and (2) the inability of a broad equity index to track the underlying commodity price one-for-one. Note, however, that returns on the OIX oil index exclude dividend yield. We attempt to take account of this by tracking the performance of the DB Excess Returns WTI Crude Oil Index. However, this would require the dividend yield to be approximately equivalent to the cash rate, which may be valid only in the very short term.