Like the Harvard and Yale endowments, the endowment at Dartmouth is feeling the pain of the slowing economy and falling market, losing 18 percent, or to $3 billion over the last year (see Bloomberg article). The losses are resulting in spending cuts of 8.6 percent. Of interest is that like its bigger Ivy League members, Dartmouth had only about 12 percent of its assets in US stocks. Like Harvard and Yale, it also had a number of illiquid assets (such as private equity) whose values have not been updated. To its credit, trustees at the college projected early last year that the US economy was entering a recession and subsequently lowered its exposure to corporate bonds and MBS, and began purchasing additional TIPS. Eighteen percent is painful, but foresight and diversification seem to have helped to ease the pain at Dartmouth.

Hedge Funds Review is reporting that hedge fund managers are investing less in distressed debt than one year ago, down 12 percent (48 percent to 36 percent) from last year (see article). This is somewhat counter to other reports that have discussed how other notable managers, such as John Paulson, are seeing distressed debt as an area with excellent opportunities. Many of the managers that are investing in distressed debt appear to be investing primarily in secured loans, utilizing a "loan-to-own" strategy. The feeling is that secured loans are less risky and provide more opportunity since if the company files for bankruptcy, the debt investors may have the ability to acquire control of the company if the borrower seeks to deleverage by exchanging debt for equity. Of course, this strategy seems viable only if there is an expectation that the levered company will eventually recover, and could explain why both the banking and energy industries are two of the more popular industries for employing the loan-to-own strategy. There is an expectation in the market that energy companies will continue to generate interest and capital, while the banking industry is likely to receive federal support to prevent total collapse.

Hedge Funds .... The New Investment Banks?

Posted by Bull Bear Trader | 1/22/2009 03:21:00 PM | , | 0 comments »

There is an interesting article in the Times Online that discusses potential changes in the hedge fund industry. Given the current shake-out, the article predicts that in the future there will be more multi-strategy funds as smaller and medium size hedge funds begin to consolidate, effectively organizing in a way to help reduce exposure to a single market strategy. This will allow hedge funds to mimic an investment banking model in that there will be numerous trading operations under one roof, essentially allowing the large multi-strategy funds to operate as a fund-of-funds. While the large multi-strategy funds will act like investment banks, smaller boutique hedge funds will continue to attract high net worth investors due to both their focus and their ability to adapt quickly to changing market conditions. While significant, such changes seem natural and present an opportunity for the industry. No longer would we need to talk about a Lehman or Goldman acting too much like a hedge fund. Now the hedge funds will be compared to the investment banks. What's old is new again, or do I have that backwards?

There have been a number of stories over the last few years of academic endowments moving into alternative investments, in particular hedge funds, private equity, real estate, and natural resources, such as timber. While many of these funds have been hurt during the recent downturn, many still found their portfolios falling less than the general market (see previous posts here and here). While losing "only" 20 percent is not as bad as 30-40 percent (although many with budgets getting cut would disagree with losing any money), other consequences of the move into alternative investments are often overlooked, including the valuation of such assets, funding commitments, and issues with liquidity.

A recent WSJ article highlights some of these difficulties. For one, hedge funds often have lock-up periods, keeping endowments in these investments at a time when shrinking budgets and donations are calling out for liquidity (see previous post here). In the case of private equity, the consequences of liquidity risk are even worse since not only is your investment "tied-up," but as a result of previous funding agreements, new capital calls may force you to commit another 50-75 percent of your initial investment, once again at a time when liquidity is tight and budgets are shrinking. While such need for liquidity is challenging for any fund, it is even more difficult for a fund that has decreased equity exposure to the 10-20 percent range, or lower, and has nearly all but eliminated interest bearing fixed income from the portfolio.

As with any shock to the system, strategies will be re-evaluated, and changes will be made. Unfortunately, for many academic institutions this will involve not only changes to the composition of their endowment portfolios, but also an evaluation of their capital improvements, expansion plans, operating budgets, and financial aid for students.

The Basel Committee on Banking Supervision is considering requiring banks to hold more capital to protect against losses on complex financial products (see Bloomberg article). Banks that do not thoroughly investigate the types of risks they are taking with certain complex instruments would also be required to increase capital requirements. The reaction is not really a surprise. Of course, while such changes seem to make sense and be expected - after all, many banks were taking too much risk and were not properly capitalized - the worry of too much regulation must be considered, especially in an environment in which there are on-going efforts to help increase lending and unfreeze credit. Many are critical of the Basel II regulations, but the criticism is somewhat two sided, with those wanting either more or less regulation citing the ineffectiveness of the regulation for preventing the current crisis. Something in the middle, that considers better regulation and not necessarily more or less, will hopefully enter the discussion and help prevent any over-reaction in either direction. Either way, there is no doubt that the Basel regulations will present a moving target for US banks as they implement the standards, and will continue to put into question the earning power and valuation of such firms.

A commodity analysts at Goldman Sachs is expecting a "swift and violent rebound" in energy prices during the first half of this year, with prices expected to rise to $65 a barrel (see Bloomberg article). The analyst also believes that the strategy of using supertankers to store crude oil to take advantage of the contango trade (see previous post) is “near the end of this process,” believing that the contango will likely flatten as OPEC and other producers cuts supply, decreasing the availability of cheaper crude oil for immediate delivery. OPEC in particular is beginning another round of cutbacks, with cuts expected to fall somewhere between 3-4.2 million barrels a day, help to meet a goal of reducing production to under 25 million barrels a day. If OPEC is able to continue with planned cuts, current crude oil and gasoline prices should find a bottom and show some strength. Whether the move is sustained after any "violent" snap back will certainly depend on the health of the US economy later this year - in particular how the economy responds to the proposed stimulus plan, as well as how both inflation and the dollar react to additional borrow and spending/taxes. Given the size of the proposed stimulus plan, along with previous TARP spending, both inflation and a weaker dollar seem poised to help support higher crude oil prices over the next year.

Some leading technical analysts are continuing to be worried about the major indexes potentially falling another 30 percent. Ralph Acampora believes that if the DJIA falls below the low of 7,552.29 it reached on November 20, that it could fall further to 6,000 (see Bloomberg article). John Murphy also believes that the November lows represent "a very, very significant area," since this is near the point where the market began to recover when the bear market ended in 2003. If we are to break these levels, the trend is expected to become very negative. Recent market action has not been encouraging. Louise Yamada expressed similar concern during an appearance on Fast Money late last year, where she also expressed concern that the DJIA could fall to 6,000. She had successfully predicted before the recent sell-off that the Dow could fall to the 8,000 range. Just last month, her website posted the following:

"The overall market picture still looks troubled. Both the S&P 500 and the DJIA have seen each recent rally (and potential bottom evidence) fail at a slightly lower peak. This progression of lower highs is evidence of supply -- price cannot rise to a slightly higher level because supply is being sold into the rally. ...... The recent pattern of sellers entering into each rally is characteristic of a downtrend, i.e., the failure of the rallies to get above the prior peak. In the study of supply and demand, which is the basis of technical analysis, this pattern represents aggressive supply. Contrarily, in a bottoming process or in an uptrend, higher lows are followed by higher highs, representing aggressive demand. .... Now, however, there is a confluence of sectors rolling over together, which is problematic. The majority of stocks are showing topping patterns."
Technicals are never the whole story, but they certainly help you to know where you have been, and how much trouble you may have getting to where you want to go. The data is certainly not encouraging for the bulls.