Commentary

Was DP World Just the Beginning?

Nothing in life is simple. Just ask DP World, which, when it dutifully approached the Committee on Foreign Investment in the United States (CFIUS) in October 2005 (following the advice of former US President Bill Clinton) over its planned acquisition of British company P&O, it fully expected that its acquisition of the six port management leases P&O owned in the US would be approved. And it was, despite reservations raised by the US Coastguard.

Nobody in Washington DC's legal community, or in the US government, seem to have anticipated the furore that would be sparked off when Eller & Company, a Florida firm with two joint ventures with P&O, hired a semi-retired lobbyist to represent its objections to Capitol Hill. Once New York senator Chuck Schumer (D) had got on board, the story's profile was raised, provoking more questions in Congress, and ultimately led to the eventual sale of P&O's US operations to AIG for an undisclosed sum.

The important point here is the role played by CFIUS. The agency, which is tasked with ensuring that US companies that are of a nationally strategic character (including everything from software firms with government contracts to utilities) do not fall into the hands of hostile states, has been around since the closing days of the Reagan administration. During the Clinton years there was very little concern about foreign transactions in the US, and consequently CFIUS' role was somewhat overlooked in the euphoria that followed the end of the Cold War.

Since 2003, however, bids by companies from countries like China, France, Israel, and the UAE of course, have come under an enhanced degree of scrutiny. The Chinese National Oil Company's bid for Unocal was derailed in 2005, again by hostility to the deal in Congress.

Exchange Traded Funds

Hedge fund managers, like most other types of investors, appreciate streamlined tools and solutions that make it easier for them to deliver performance. In this space, both exchange traded funds (ETFs) and money market funds (cash funds) are winning loyal followings because they deliver efficiencies across a range of strategies and market exposures.


Utilising both sets of products more fully can free up a manager to focus on their core role of determining and capturing investment opportunities, as they can reduce the time and resources required to execute some of the possibly non-core investment duties that hedge fund managers must often undertake. A key area for consideration is designing and executing an optimal strategy for managing cash.

ETF boom

Q1 2007 Review

The first quarter started positively, with continued strength in equity markets and favourable economic news which was reflected in a slight rise in G7 interest rates. Things soured towards the end of February and during the first two weeks of March, however, as markets were hit by a steep sale of risky assets. Chinese equities fell sharply in conjunction with soft US growth data and ongoing worries about the US housing market. The resulting pain was felt across most asset classes. Emerging markets and high yielding currencies associated with the carry trade came under particular pressure.

In the last two weeks of the quarter, however, markets reversed and pushed higher as economic news, particularly from the labour market, surprised to the upside and concerns over US sub prime debt did not spread to the broad housing market. Over the quarter, the MSCI World Index gained 1.68% in LC.1

fig 1

 

Hedge funds performed well - except for managed futures

Hedge funds started the year well with all styles contributing positively. Only commodity managers struggled as crude oil prices declined sharply. The second half of the period proved a bit more difficult as equity hedged and managed futures had to cope with market reversals. However, by the end of March all styles except managed futures were in positive territory. Event driven was once again the best performing style as special situations and distressed managers weathered the choppy markets well. The HFRX Global Hedge Fund Index gained 1.57%.2

European managers outperformed US, Japan

Prime Broking: Myths and Reality

Many myths currently surround the relationship that exists between prime brokers and hedge funds, legends that have grown up over time, sometimes accidentally, sometimes deliberately perpetuated by one side or the other. In this article, we aim to dispel a few of these, and shed some light on what is actually going on, and how hedge funds in particular can more efficiently manage their mission critical broker relations.

After all, prime broking is one of the most important service provider slots that need to be filled when setting up a hedge fund, and it is hardly less important five years down the road. But in between, much can be achieved by the hedge fund which can manage its prime broker relationships effectively.

Multi-broker relationships

Endowments and Hedge Funds

According to many fairytales, ivory towers are frequently surrounded by high hedges, often thorny and there to keep out rescuers. In real life, the ivory tower of academe in the US has found that hedge funds are a useful source of diversification and growth for their endowments. In the rest of the world, endowments have been less speedy to take advantage of alternative assets, although this reticence is gradually dissipating.

Although they are often lumped in with other institutional investors such as pension funds, endowments and foundations have a very different raison d'être, time horizon and hence investment objective. Key to understanding this is the concept of 'perpetuity' - not quite as difficult to grasp as infinity but still radically different from the effect even of the long-term horizon of an open defined benefit pension fund. Most endowments exist to provide income for institutions engaged in charitable activities. They may not have significant amounts of new money coming in and they have an obligation to future generations to preserve the spending power of the endowment. 'Intergenerational equity', to use the phrase coined by James Tobin, an economist at Yale, requires the institution to balance spending to meet the needs of the current generation with the need to make sure it can meet the needs of future generations by a policy of purchasing power preservation.

"The endowment is managed in perpetuity," says Nick Cavalla, recently appointed CIO of Cambridge University's Investment Board. "With that in mind, it can afford to take a very long-term view." For this reason, endowments can have a different attitude to risk from funds that need to align their assets with their liabilities over a mere matter of decades instead of perpetuity.

Distressed Private Equity

Growth in assets under management and competition for attractive investment opportunities have not only caused hedge and private equity fund managers to broaden the range of prospects they pursue, but also to converge their investment styles. How this union works in practice has been exemplified by the emergence of distressed private equity. By borrowing strategy, skills and resources from both traditional distressed debt trading and mainstream leveraged buyout (LBO) models, this hybrid is in fact a discrete approach to a very specific type of investing. In order to fully understand the distressed private equity model and its growing signficance, it is helpul to consider how it is both similar to and different from its hedge fund and private equity parents, and how each 'traditional' model must be modified to accommodate the younger strategy.

Distressed debt trading

Distressed debt trading is, simplistically, short-term trading in troubled company debt. The strategy was born from the workout departments of commercial banks, where non-performing corporate loans were sold at a discount to par to investors taking a view on recovery values. Positions are normally held in a trading book, and revalued regularly on a mark-to-market basis. Credit, capital structure, bankrupcy process and cash flow analysis skills are critical to the investor who must consider the liquidation, breakup or restructuring value of the troubled company's debt.

Leveraged buyout transactions

Macroeconomic Outlook

Over the past month my macroeconomic outlook did not change significantly. The world economy continues to be in good shape, with overall growth somewhat slower than last year. The slowdown is mainly caused by slower growth in the US, with limited knock-on effects to the rest of the world. Inflation will generally remain relatively contained. Emerging economies are growing briskly, with the need for monetary policy tightening in some countries to avoid or combat overheating (India and China in particular).

The most important risks to the outlook for the world economy are:

  1. A return of risk premiums to more normal levels. Risk premiums continue to be very low. This is partly justified by better macroeconomic policies than in the past, better fundamentals in many emerging economies than in the past and by financial innovations which have increased the efficiency of risk allocation. However, it is also partly the result of the search for yield triggered by the loose monetary policies in past years. A reversal of risk premiums to more normal levels would trigger a correction in financial markets, with the most risky assets affected most. This could easily have a negative impact on the real economy. The correction of end of February was too limited and short lived to affect the real economy and its impact on financial markets has been more than reversed.
  2. A disorderly correction of global imbalances. This would mean a rapid and strong depreciation of the dollar and a sharp increase in interest rates. The implication would be a significant slowdown in world economic growth, including the possibility of a word wide recession.

Consumer Credit in China

China used to be a communist country with a command economy. In those days, the state's role in marshalling resources meant that personal consumption expenditure, even by the end of the 1980s, was just 52 percent of Gross Domestic Product (GDP). Today it is less than 40 percent of GDP. Two decades of unparalleled growth and development and personal consumption expenditure is low even by command economy standards. This perverse development is due solely to the fact that China's command economy banking system has been functioning as normal throughout this true 'great leap forward.' Things have changed. Private capital is now flushing the Chinese commercial banking system and the command economy banking system is withering on the vine. Now the banking system can do in China what it does in the rest of the world- take money from older generations of people who save and lend it to the younger generations who buy. This transformation of the Chinese banking system is less than two years old and it could be a key driver for global financial markets for decades.

The widespread growth of the hedge fund industry has been in an unparalleled era when the savings of one of the world's poorest countries supported the consumption of one of the world's richest. This under-consumption by China has been a key factor in depressing US Dollar (USD) interest rates and reducing inflation. Depressing the world's de facto benchmark interest rate and enhancing deflationary forces has produced positives for almost every global financial market. Japan has been the exception - where domestic policy errors combined with the disinflationary impact from China turned benign disinflation into the nightmare of deflation.

Pages

Subscribe to Commentary