Commentary

Don’t Ignore the Start-Ups

In today’s world it’s fair to say launching a hedge fund is not as simple as it once was. Gone are the days of one or two people, in a room with a small amount of their own cash and some more from family and so-called friends, trading away with little or no infrastructure.

Prime brokers were willing to accept them as clients, there were no minimum revenue requirements, and the Regulator was at arm’s length at best, providing light touch regulation. Some of those firms have gone on to become the so-called “Titans” of the hedge fund industry. Winton Capital for example launched from a small office in Kensington in 1997 with $1.6m under management and now manages some $28bn.

What does the landscape look like now? Very different is the answer and it doesn’t appear to be getting any easier for the entrepreneur money manager.

Figures this year show a global trend which has seen the lowest levels of hedge fund launches in the opening quarter of a year since 2004. In fact, more hedge funds managed in Europe closed than opened during 2015 - a first. At the same time however allocations to hedge funds still increase year on year.

So where does the money go? Well typically it goes to the “Titan” managers whose assets under management are in the multiple billions and whose owners frequently feature in the Forbes or Sunday Times Rich Lists.

Yet performance for most of the world’s hedge funds hasn’t been great and some of these managers have succumbed to the pressures of it all, returned capital to outside investors and turned themselves into quasi family offices, essentially running their own monies and those of their partners. This trend is likely to continue for the next few years at least or until the regulatory pendulum swings back, but that does not look likely to happen.

Investment Funds On Hook For US Pension Liabilities

Funding shortfalls have been growing in recent years for reasons including greater longevity and lower interest rates. Most pension funds do not have any hedges against rising life expectancy. Meanwhile, lower interest rates and tighter corporate credit spreads reduce the discount rate at which pension liabilities are calculated.

Additionally, many companies and pension fund sponsors around the world, including private equity firms, have been closing pension funds to new members, seeking to reduce benefits, and have ceased funding. Investors in distressed companies may have a particularly strong need to reduce costs in order to turn around firms and ensure they can survive post-bankruptcy, or possibly avoid going bankrupt in the first place. Defined benefit pensions, open to new members, are almost extinct outside the public sector.

But some recent US legal rulings are moving in the opposite direction of market and economic forces. Owners of US companies – including some private equity funds – could become more frequently liable for making extra contributions to remedy pension fund deficits, after a legal judgment in response to a case brought by a trade union. Sun Capital Partners was found liable for pension liabilities at bankrupt Scott Brass Inc. (Sun Capital Partners III, LP, Sun Capital Partners III QP, LP, and Sun Capital Partners IV, LP, v. New England Teamsters and Trucking Industry Pension Fund in 2013). This was despite Sun Capital following widely used structuring techniques to avoid liability.

Post-Brexit Aftershocks on the Horizon

The Brexit vote on June 23 came as a massive shock to financial markets, especially the British pound, which fell from 1.50 to the US dollar to 1.29 within a matter of days. Across the English Channel, however, the euro took the news with remarkable equanimity, and remained firmly in the upper half of the narrow 1.04 to 1.15 to the US dollar range where it has been trading since February 2015.

The aftershocks of Britain’s decision to leave the European Union are only just beginning. The first came in late September when Prime Minister Theresa May announced a date to set Brexit in motion: March 2017, for invoking Article 50 of the European Union that deals with a member-nation wishing to leave the economic and political grouping of 28 countries, including Britain. Markets perceived the setting of a date as increasing the probability of a “hard Brexit” in the absence of an agreement to extend Britain’s current relationship with the EU after a two-year withdrawal deadline in March 2019. More aftershocks may be on the way, and the pound may not be the only one reeling from the tremors.

Editor’s Letter - Issue 118

Hedge fund managers espouse diverse political views. Managers, including George Soros, Renaissance Technologies’ Henry Laufer and Paloma Partners’ Donald Sussman, donated far more money to Hillary Clinton’s campaign than to Donald Trump’s. Managers advising Trump include SkyBridge Capital founder, Anthony Scaramucci, Paulson founder John Paulson, and distressed investor Wilbur Ross, while activist Carl Icahn also supports Trump. What might Trump - and triple Republican control of the Presidency, Senate and Congress - mean for the industry? At this stage, only broad brush signals can be gleaned.

Trump transition team member Paul Atkins often opposed new regulations during his time as an SEC Commissioner. He also opposed escalating fines imposed on many parts of the financial services industry, arguing that these penalties unjustly punish shareholders - who are virtually never culpable. Republican proposals to apply a cost/benefit analysis to regulation make sense, but can they tame the regulatory leviathan? Though very few Republican lawmakers voted for Dodd Frank in 2010, talk of a wholesale repeal now looks unlikely. Trump’s “moratorium on all new financial regulations” seems even less probable, partly as over 100 Dodd Frank-related rules are still being shaped. Instead, new Treasury Secretary, and former hedge fund manager, Steve Mnuchin, aims to roll back particularly complicated parts of the gargantuan statute and those that hamper bank lending. Similarly, Mnuchin wants to address the complexity and subjectivity of the Volcker Rule. The objective seems to be selectively rescinding, streamlining, and rationalising, rather than revoking, these regulations.

Real Estate Equities

Real estate has an important role to play in any diversified portfolio. Global real estate has performed well historically, returning 7.5% p.a. over the 15 years to the end of 2015. It has typically provided a high income return component (over 80% of total return from income and 6.1% p.a. income return over the same period) and can provide inflation protection, making it a desirable asset class for investors and a core, though often overlooked, part of a mixed asset portfolio (see Fig.1). Critically, investable income producing real estate is estimated to have a gross asset value of around $34 trillion2 and represents some 18% of the total global real estate market of $191 trillion.

Accessing real estate efficiently can prove difficult for many investors, as building a diversified real estate portfolio directly through private ownership can be very challenging. In particular, this is because real estate assets are large and require specialised management and local expertise, making it difficult for investors without large pools of capital to invest at the required scale for both diversification and cost efficiency. An alternative way of gaining exposure is through the public market.

An Overview of the Italian NPL Market

In 2016 the gross book value (GBV) of NPLs on Italian banks’ balance sheets exceeded Euro 200 billion. Interest from foreign specialized investors has increased considerably in recent months. During 2016 we have seen an increase in the number of transactions but it is also true that this market has so far not expressed all its potential. Driven by the aim of helping Italian banks clean up their balance sheets, the Italian Government has put in place several initiatives both to facilitate the disposal of the NPLs and to reduce their occurrence going forward. These initiatives fall into four categories: (A) the introduction of a State guarantee scheme (known in Italy as “GACS”) whereby the Italian Treasury guarantees senior tranches of ABS backed by Italian NPLs; (B) the improvement of Italian bankruptcy and enforcement proceedings, (C) the introduction of new forms of security interests, and (D) opening up the market to direct lending by alternative investment funds (AIM). The idea is to make the Italian lending market more creditor friendly overall which in turn should encourage the further funding of the real economy.

The New Face of US Financial Regulation

While we have a new President elect in the United States, history suggests that the identity and leanings of the future Secretary of the Treasury and the appointees to the regulatory agencies may be just as important to the future of financial regulation. When all is said and done, it is the regulators who actually articulate, implement and enforce (or not) day-to-day financial services policies.

Though we may not yet know who those regulators will be, we do know some of the important issues that they will confront.

Perhaps one of the more significant issues is the increasing cost and burden of regulation. No comprehensive government analysis of the costs or benefits of the Dodd-Frank Act was done before it was enacted into law, and none has been done since. While no one can argue that financial institutions should not be closely supervised, the financial impact of the regulatory correction since the crisis has been staggering. On October 20, 2016, The Wall Street Journal reported that global banks have incurred $275 billion in costs penalties and compliance charges since 2008. The more meaningful point is the impact on the market – a $5 trillion reduction in lending capacity.

How global financial regulation is applied is also an important issue. The American Banker recently characterized the European Union’s indication that it will not follow the Basel Committee’s recommendation on standardized credit or operational market risk rules for fear of stifling economic growth as a “stunning move.” This underscores a concern in the United States that US regulators seem to enforce global standards with less exceptions for market-related considerations.

Luxembourg – The Better Compromise

The EU referendum in Great Britain has brought Europe’s achievements back into public consciousness; many people had started to take those achievements for granted. One such institutional achievement is the European single market, which has made cross-border financial services possible. The 1985 UCITS Directive (85/611/EC) was an extremely successful standard for investment funds applicable for the first time in all member states.

This directive has made Europe more attractive in terms of global competition, because on the one hand it enables regulated competition for the best jurisdiction for fund vehicles within Europe, and on the other because it gives the European Union a strong competitive position, above all in Asia and South America. Investors and asset managers value this variety within a reliable, modern framework. Above all, the passporting introduced with Directive 2009/65/EC further strengthened competition within Europe, because it means that it is significantly easier for a fund authorised once by UCITS in an EU country to apply for an operating licence for other member states.

The right choice of location
For providers of UCITS funds, finding the most suitable location within the EU is a decisive factor for its product and its investors. When Aquila Capital was looking for a jurisdiction for a UCITS platform a good ten years ago, there were good reasons for choosing recognised fund locations such as Germany, France or Ireland. After intensive scrutiny and consideration of all the relevant aspects, the choice fell on Luxembourg, where, after thorough preparation, the UCITS platform finally got off to a successful start in 2007. But it was already clear to Aquila which country would become the leading jurisdiction for UCITS funds in Europe in the aftermath of the economic crisis.

5th FERI Hedge Funds Investment Day

SPEAKERS

What is the Right Way? Offshore or UCITS?
Marcus H. Storr, Head of Hedge Funds, FERI Trust GmbH, Bad Homburg/Germany

Innovation is the Foundation for Systematic Investing
Harold M. de Boer, Managing Director, Transtrend BV, Rotterdam/Netherlands

A Disconnect in Global Markets
Crispin Odey, Founding Partner and Portfolio Manager, Odey Asset Management, London/United Kingdom

Deal Spreads and Flow Are Key
Steven R. Gerbel, Founder and CIO, Chicago Capital Management, Chicago/USA

A Fundamental Approach to Investing
Peter M. Schoenfeld, Founder, CEO & CIO, P. Schoenfeld Asset Management LP, New York/USA

***

What is the Right Way?
Offshore or UCITS Hedge Funds?

Marcus Storr, Head of Hedge Funds, FERI AG

Natural Gas

Natural gas prices around the world, from North America to Europe to Asia, are coming together after years of drifting apart. Before the natural gas production boom in the United States in 2007, prices in top consuming regions of the world were loosely connected. There was plenty of price-spread risk, even though the secular patterns were clearly linked. However, from 2008 to 2015, regional natural gas prices became delinked and danced to the tune of their own drummer. The reasons for this were varied. In North America, growing domestic supply was the real issue. In Asia, the challenge was the shutdown of Japan’s nuclear power industry after the devastating earthquake and tsunami. Europe faced tensions amid disruptions in Ukraine that escalated risks concerning gas supplies from Russia. Also, over the years, the practice of pricing natural gas in Europe and Asia benchmarked to Brent crude oil has been eroding to the point that the link is breaking as long-term contracts expire.

The collapse of crude oil prices in late 2014 was the catalyst for bringing regional natural gas prices loosely back in line with each other. But, over the decade of the price divergence, a lot had happened. The US created the capacity for liquefied natural gas (LNG) exports, and in September 2016 initial US cargos of ethanol started unloading in Scotland. New gas sources were developed in the Asia-Australia region to supply Japan. Russia inked a long-term natural gas deal to supply China. For these reasons, the question now is whether regional natural gas prices will stay engaged or if another bout of divergence is on the horizon. Interestingly, some clues may come from the evolution of electrical power generation. We turn first to the implications of the growing global role of natural gas in power generation. Then we provide some summary comments suggesting that prices staying connected is the more likely scenario than moving apart again.

Pages

Subscribe to Commentary