Trends and Topics in Alternative Investments_Sergey Rumyantsev, Carlson Capital


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11.07.2013. Presentation at NES by Sergey Rumyantsev (MAE 2002), Investment Professional at Carlson Capital

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Trends and Topics in Alternative Investments_Sergey Rumyantsev, Carlson Capital

  1. 1. Trends And Topics In Alternative Investments Sergey Rumyantsev, Ph.D., CFA Carlson Capital L.P. June 2013 Disclaimer:  All materials and data are from publicly available sources  All opinions are personal
  2. 2. 2 Background: History and Classifications Of Alternative Investments  What Is Alternatives? Anything in the institutional investments markets beyond traditional stocks and bonds, major alternative asset classes are (non-institutional “exotics” such as wine/luxury are excluded):  Hedge Funds: Original term comes from A.W.Jones who launched his first hedge fund in 1949 with his own money after arguing in “Fashions in Forecasting” HBR article that it is impossible to predict future, later on he allowed other investors to join and pay management and incentive fees. Current types include: macro, equity L/S, distressed, FI arbitrage, event-driven, CTA, market-neutral, quant, volatility, other (structured products)  Private Equity: KKR founders are regarded as pioneers of traditional LBO-based model (Orkin buy out deal, 1964) which was expanded into LBO, growth capital, mezzanine capital, turnaround/distressed  Venture Capital: in 1946, 2 first VC companies – American Research and Development Corporation and J.H.Whitney and Co were created around future Silicon Valley area, currenlty classified by stages of investment – angel, early-stage, late-stage  Real Assets: real estate, infrastructure, farmland, energy, maritime and commodities  Classification Of Alternatives By Directionality and Liquidity Profile (One Should Also Keep In Mind Investment Capacity):
  3. 3. 3 Background: Investors’ Motivation In Alternatives  Why Invest In Alternatives – Early Movers? Yale Endowment Fund was one of the early pioneers, since 1970s heavily allocating to non-traditional assets and massively outperforming public markets (25-30% IRR in PE):  Why Invest In Alternatives - Proponents?  Alternatives offer superior risk-adjusted returns with lower correlation  Active managers do add value  Alternatives offer access to new investments  Why Invest In Alternatives - Opponents?  Performance data is noisy and does not include survivorship bias, manager skills are more about luck  Under efficient market theory most of alternatives can be replicated, “alpha” in returns is actually unknown “beta”  Typical U.S. Pension Fund Allocation – up to 14-15% in Alternatives
  4. 4. 4 Hedge Funds: State of The Industry  Already A Mature Industry? In 2013, HF assets are reaching 2.25 Tr USD with largest funds attracting most of new capital, returns YTD are on average lagging equity markets by ~8-10%
  5. 5. 5 Hedge Funds: Recent Blow Ups  Examples Of Big Hedge Fund Scandals – Still Nothing Compared to Lehman Collapse:  LTCM and Misuse of Leverage: Greenwich, CT hedge fund that employed Nobel prize winner Merton and Sholes, exploded in 1998 after Russian local debt default, recipe for disaster – 25X leverage and expansion from its original FI arbitrage strategies in US into EM markets and equity volatility arbitrage  Madoff Case: Bernie Madoff was running the biggest in US history Ponzi scheme from 1960 to 2008 when one of his sons revealed the truth. Estimated 18B USD losses to investors  Amarath Advisors And Natural Gas Single Bet Going Wrong: That was a Greenwich CT hedge fund with 9B USD of assets that lost 6.5B on a single bullish bet in natural gas futures by Bruce Hunter. Regulators charged fund and Hunter with market manipulation in 2007  Galleon Group and “Indian Circle”: Galleon was managing 7B USD at its peak before closing in 2009, as its founder, Raj Rajaratnam, and 5 others were charged with insider trading. Raj is serving 11 years in prison since 2011. Ex-McKinsey head, Rajat Gupta, is fighting a recent conviction decision  SAC Capital And Insider Trading Cases: 9 current and former traders of once one of the largest multi- strategy hedge funds, 14B AUM SAC Capital, run by Steve Cohen, were convicted for insider trading. SAC has been returning money in 2013 to outside investors to become a family office for Mr. Cohen. Investigations continue  Flash Crash of 2010: at 2.45pm on May 6, 2010 Dow Jones dropped 9% to recover within few minutes. The joint SEC report later identified that a large mutual fund upon mistake was trying to sell unusually large number of shares of E-Mini S&P 500 contracts, and upon sell off of 3-4% chain reaction got triggered by high-frequency trading robots that all started risk management/stop loss actions at the same time
  6. 6. 6 Selected Details on Investment Strategies  Event-Driven Investing: (most large managers started in this area e.g. Paulson, Cohen)  Focus on catalysts/events: M&A, spin offs, debt/equity buybacks, other  Binary outcome: creates a very low correlation of returns to public markets  Key terms: deal spread (potential upside) – typical range 100-300bps, deal closing date  Why does it work: historically 60-70% of announced deals closed  Challenges: IT revolution removed information asymmetry, M&A activity remains low  Long/Short Equity/Credit Investing: (SAC, Millennium, Citadel, Highbridge)  Most Popular Strategy: 30-50% hedge funds are involved in this  Manager Ability Is The Key: key premise is that manager is able to buy cheap securities and sell expensive ones  Is It Alpha Or Market Timing: No one knows for sure as back-testing does not help in predicting the future, managers are typically up to 20% net long/short  Challenges: lack of knowledge of macro trends, “crowding” of names (same research process)  Market Neutral Equity/Credit: (Carlson)  Focus on Alpha: no directional views, no net exposures  Manager Ability Is The Key: again manager claims that he/she can pick relative winners  Is It Alpha Or Noise or Carry: In the past, 2- 4% came from securities lending business  Challenges: in macro driven environment correlations are very high, cost of trading limits universe to most liquid securities  Macro Investing: (Soros, Bluecrest, Man, Winton, Bridgewater)  Macro Bets in Most Liquid Markets: FX, Rates, Futures  Soros Legacy: George Soros made macro investing notoriously famous after crushing British currency in 1992  Is It Macro or Geopolitics: It is both, investors try to predict political events and trends as well  Challenges: In recent years most of market moves were driven by political and QE decisions
  7. 7. 7 Selected Details on Investment Strategies (Continued)  Distressed Investing (Both Public and Private):  Debt Vultures: “distressed debt” is typically defined as anything with 10%+ risk premium  Corporates – Activist Approach: typically, funds are actively involved in restructuring process, trying to capture value after buying in a tier of debt (often secured debt)  Structured Products - Legacy Distress: After 2008, a large portion of US structured debt markets was very discounted allowing niche investors to capture price dislocations  Why does it work: for distressed deals, investor demand is much lower due to legal and operational complexity and illiquidity/complexity  Recent success stories: claims of Lehman and Madoffs, Greek debt restructuring, CDOs  Challenges: outside of US, legal regimes can be very different, proper restructuring often does not happen  Large Investors: Lone Star, Cerberus, Oaktree, Canyon, Centerbridge, Cerbesus, Third Point, Silver Lake, Baupost, WL Ross, Blackstone, KKR, TPG, Apollo, Fortress, Paulson  Quant Investing:  Math Geniuses Turn to Wall St: James Simon from Renaissance Technologies became a quant hero with 30%+ returns via secretive computer strategies  Technology Race: Quant funds tend to take pure data-driven approach and are run by IT and physics people with no view on economy, superior IT platforms is the key competitive advantages  Self-Destructing Patterns: As the most scalable strategy, quant traders tend to mimic each other fast thus “arbitrage” opportunities are self-depleted  Challenges: crowding out, more regulation of high-frequency traders after market failures (Flash Crash of 2010)  Large Investors: Renaissance Technologies, DE Shaw, Two Sigma, AQR, Getco
  8. 8. 8 Hedge Funds: Recent Returns Details – You Will Be Surprised  Most of recent top-performing hedge funds are in ABS/structured products with some in global macro, while CTA (commodities) and short-bias funds lagged: Barrons: Top Hedge Funds by 3-Year Annual Return Fund Assets 3-Yr Compound 2012 Total Firm 2012 2011 Fund Name (mil) Fund Strategy Annual Return Return Assets (mil) 1 1 Zais Opportunity Fund Class B $462 Structured Credit 52.39% 24.69% $5,400 2 N.R. Quantedge Global 488 Global Macro 50.07 39.46 488 3 N.R. Chenavari - Toro Capital IA (Euro) 362 Asset-Backed Securities 46.54 32.42 3,214 4 52 AQR Global Risk Premium–Full Risk 400 Global Macro 39.2 40.8 70,700 5 2 Metacapital Mortgage Opportunities Fund Ltd 1,440 Mortgage-Backed Securities 38.64 41.25 1,600 6 N.R. Hildene Opportunities Fund Ltd 655 Distressed Securities 30.62 45.46 1,070 7 N.R. STS Partners LP 652 Asset-Backed Securities 28.38 27.43 818 8 N.R. Asgard Fixed Income I Ltd (Euro) 348 Fixed-Income Relative Value 26.57 34.12 348 9 N.R. SPM Core Ltd 1,831 Mortgage-Backed Securities–Agency and Non-Agency 25.88 19.65 3,708 10 9 VR Global Partners LP 1,816 Emerging Markets/Distressed 25.53 20.62 1,816VR Advisory Services / Dubai AQR Capital Management / Greenwich, Conn. Metacapital Management / New York Hildene Capital Management / New York Deer Park Road / Steamboat Moma Advisors / Copenhagen Structured Portfolio Management / Stamford, Conn. Rank Company/Location Zais Group / Red Bank, N.J. Quantedge Capital / Chenavari Investment Managers / London
  9. 9. 9 Private Equity: Is It All About Financial Engineering?  History – Mega LBOs and Excessive Use Of Leverage (6-7X Debt/EBITDA, 1.5X HY markets and 2X IG markets):
  10. 10. 10 Private Equity: Does Manager Caliber Matters? Yes, It Does  Investors Still Find Excess Returns in PE:  Academics find 150-250bps annually of average excess returns in PE funds, attributed to (i) access to larger universe of private companies, (ii) usage of higher leverage and (iii) operational improvements  PE funds return dispersion is very high (20-25%) and persistent (top managers continue performing)
  11. 11. 11 Venture Capital: Out Of Favour Due To Low Returns  Venture Capital Funds – Low Chances of Success These Days:  Academic data shows less and less support for VC allocation with average returns in low single digits in US and only top 5-10% of funds beating the markets with too much capital chasing a “new Facebook”  Kaufman Foundation 2012 critique report: most VC funds are not making money and try to charge management fees, incentives are not aligned with new businesses creation
  12. 12. 12 “Real” Asset Investments: How Real is Real?  Real Assets – Tricky Definitions:  Broadly defined space - for any investable physical or inflation-protected assets: real estate/land, timber, commodities, agriculture, maritime, infrastructure and TIPS – traditional claim is that those protect against inflation and USD devaluation  Narrow definition – “real” cash flows: excludes commodities, gold, securities  Real estate – bulk of investment allocations: among real assets, real estate has the largest investment capacity across the whole spectrum of funds (debt, income, opportunistic, value-adding, specialized – office/retail/storage/multifamily, distressed)  Commodities – bets on inflation hedging and on gold being a “safe haven” have proven to be wrong: commodity markets continue to be dominated by volatile spot markets and high leverage in derivatives, gold has proven to be a tricky investment  Asset allocators (pension and endowment funds) are seeking “real” yields in the period of zero rates and growth of population and consumption in EM, most of opportunities are private:
  13. 13. 13 Key Trends in Alternatives And Summary Points  Industry Is Maturing And Consolidation Is Under Way And HF/PE Difference Is Smaller: as at 15% of investment universe (2Tr in HF, PE, RE industry each) and 60-70% of trading volumes and M&A deals alternatives have become “the market”, and as regulation is more costly, large funds are getting larger while start ups struggle. PE and HF “line” is crossed more and more with PE funds looking at public markets and vice versa  Hedge Funds – Winners Are Often Not Known In Advance But People Continue Looking At Past Results:  Past winners continue to be winners with only 51% probability according to Dr. Cochrane  In 2010-2012 best strategy was buying and holding distressed structured debt e.g. CDO, subprime, CMBS  In 2010, given lack of M&A activity and decline in commodities, risk arbitrage and CTAs did not perform  Recent market moves were dominated by big macro events – QE decisions by Fed and ECB  Hedge Funds – Is It Alpha or Beta?: Very hard to tell, as “alpha” is often a hidden risk factor, but academic studies do show that hedge funds do better on risk-adjusted basis with lower correlation to the markets  Private Equity – Leverage is Back: as PE industry on average continues to show higher returns (thanks to high leverage to a large extent), asset allocators continue chasing top performing funds as it has been proven that PE track records are persistent. Mega LBO deals could be back soon with Dell deal, leverage is at historically high levels as cheap financing in US is readily available and is again distributed via structured products  Venture Capital – A Lot of Talks, Not Delivering Returns: everyone wants to find/create a new Facebook but abundance of capital chasing a limited number of winners has compressed returns, making VC funds on average not attractive with only top 5% beating public benchmarks  Real Assets – Real Yielding Assets in Demand, Others Not: some “real” assets have been proven not to be so real (gold), RE markets continue to dependent on macro and supply/demand for a specific region  Fees – Continue to Decline: Industry is no longer a 2/20 model (2% management fee, 20% incentive fee) but rather a 1.5/15 average fees model, fees continue compressing given competition for capital
  14. 14. 14 CIS Alternatives: Domestic Long Term Capital Is Nowhere to Be Seen  Industry Structure – Challenging Limitations for Hedge Funds: predominantly selling Russian undervaluation story vs EM peers via long-biased long only or L/S concentrated strategies  Liquidity constraints: 90%+ of liquidity concentrated in top 10 names, with Sberbank and Gazprom capturing 50%+ liquidity (at 10-30M USD daily volumes, only 2-4 more names with 1M+ USD daily trading volumes)  Markets are dominated by external capital flows: all “alpha” research can be overrun by a massive macro shock and capital outflows as foreign capital dominates trading volumes at 80%+ and there is no local long- term institutional capital  Information flows are not symmetric: a lot of second-tier names can have spikes of trading activity ahead of events pointing out to insider activities  Danger of being an activist investor: Pushing for minority investors agenda has proven to be risky  Lack of clearing mechanisms in local FI markets: MICEX is finally moving to T+2 settlement and a central creating platform  Selective examples of CIS HFs – survival rates are not high post 2008 crisis:  Verno Capital: created in 2009 by ex-Kazimir Partners people, long biased long/short strategy, reported 200M USD AUM, received 100M USD anchor capital contribution from a ME SWF in 2010  Altera Capital: created in 2010, long/short catalyst-focused equity strategy, reported 600M USD AUM in hedge fund and private market strategies, reported 100M USD AUM in hedge fund strategy in 2011  Prosperity Capital: long-standing asset manager among its 3.8B USD AUM runs a number of long-only Russia-focused funds in both blue chips and small cap/special situation stocks, some are considered HFs  VR Capital: with one of its offices in Moscow but not a sole focus on CIS, this fund predominantly invests in various distressed situations in EM/globally, received top ranks for its recent performance
  15. 15. 15 CIS Alternatives: Do EM Hedge Funds Deliver Alpha?  Academic Evidence – Emerging Markets Hedge Funds Are Correlated to Markets: quite explainable by market structure limitations and long-bias nature  Survivorship bias – much more present in EM: a large share of EM hedge funds have closed after large sell offs, making industry data positive skewed. Lack of data is a general problem Is This Alpha or Beta (This Fund Does Charge Performance Fees)?:
  16. 16. 16 CIS Alternatives: Private Equity – A Rosier Picture For Best Funds  Private Equity Markets: CIS PE funds have tended to stay away from commodities industry and focused on growing consumer via financials, IT, retail, and RE investments. Industry was created in 1990s with involvement of EBRD and USAID, and has 4 groups of participants:  state-related entities (RDIF, VTB, VEB)  captive multi-industry holdings (Onexim, Interos, ICT, A1, Millhouse)  EBRD and USAID-linked funds (New Russia Growth, Delta, others)  and independent PE funds of different vintages (Baring Vostok, Russia Partners, UFG, Elbrus, Horizon Capital) including dedicated RE funds (O1, Raven, Jensen)  Vintage Matters Much More Aside from Manager Itself: a lot of funds were raised and invested at the peak of the market in 2007-2008 and never recovered, most experienced and patient managers preserves capital and track records and are able to raise new funds (Baring Vostok)  Not A Traditional LBO, More “Growth” Capital Mode: LBO/debt financial engineering is less prevalent, a lot of investments are done pre-IPO stage (e.g. MICEX) as otherwise it is challenging to find exits  Russian State – Much More Involved in 2012: Aside from state bank investing internal capital (VTB), Russian Direct Investment Fund has been increasingly active in investments and marketing of opportunities to foreign funds  Track record – limited but high dispersion is prevalent: top funds have achieved 20-25%+ IRRs for investors, bottom funds lost a lot after crisis
  17. 17. 17 Alternatives Use and Misuse: Few Case Studies  Biggest market losses tend to create biggest market opportunities (for others):  Lehman Principal Protected Notes – 80% loss vs 0% marketed: pre-2008 crisis, principal protected notes was a popular sector allowing investors to get exposure to other markets (e.g. 50% equity market participation) while supposedly have 100% principal protected. It was subject to counterparty credit risk, and after Lehman collapse investors found themselves in the pool of unsecured creditors, recovering 20-30 cent. At the same time, distressed investors made 50-100% returns buying Lehman claims at the lows  Greek debt restructuring of 2011-2012 – big losers, big winners: in the biggest ever sovereign debt restructuring, Greek sovereign has been written off twice, wiping 90% of value for original investors. Hedge funds stepped in and bought Greek debt after 2nd restructuring in 15-20 cents area and pushed EU/Troika to offer exchange terms in the fall of 2012 at 100% above the cost  CDO and other structured products market – a lot of blame still goes around: pre-2008, in the period of zero rates hunt for yield from investors and hunt for fees from Wall St led to a massive bubble of “re- packaged” products CDO/CLOs/CMBS with investors buying AAA CDOs for 10-20bps spread pick up. Post crisis, traditional investors lost 80-90% of value in those investments, while distressed debt funds allocating to the asset class in 2009-2010, made 30-40% IRRs  Eurozone crisis and banking sector deleveraging: as PIIGS banks continue writing off assets, distressed/PE funds are trying to buy those at heavy discounts and service NPLs better to extract value  Few observations:  Excess leverage is very dangerous as borrowed money can cause margin calls faster then you think  Investors often fail to understand products they invest in and marketing people are no better  Markets have short memory but panic faster then one can reposition  A lot of investors make decisions based on risk avoidance rather than returns seeking (“I’ll follow others”, “I won’t get fired for investing in a famous fund”)
  18. 18. 18 Conclusion: Few Questions on Investments Question 1: Would you invest in a Hedge Fund? Yes: No: Question 2: What investment strategy will work the best 2H 2013? Few options to be provided Strategy: Question 3: Would you want to create your own HF/PE/RE fund? Yes: No: Question 4: Will RUB depreciate during 2H 2013? Yes: No: Question 5: Will you prefer making 8% with certainty vs having 50/50 chances of making 20% or 0%? Yes: No: Question 6: What is your estimate for Moscow rental yields? Few options to be provided Yield: Question 7: Do you actively invest in financial markets? Yes: No: Question 9: Where would you buy RE right now? Few options to be provided Location: