In the wake of some hedge funds pulling back risk, participants at a recent Investing Summit in Asia feel that private equity, boutique firms, institutions, and sovereign wealth funds will begin buying distressed debt (see FinanceAsia.com article). Many of these firms are expected to enter the secondary market for distressed assets given the opportunity to buy them at large discounts. Nonetheless, participants at the conference worried that all the "distress" was not currently in these assets, and that there was no reason to rush into buying them. Ed Altman, Professor of Finance with the NYU Stern School of Business, agrees, and predicts that the assets and the bargains will be available for another 6-12 months.

A combination of falling crude oil prices and falling US and world equity markets has caused stocks over the last four days to lose almost a quarter of their value in Dubai and 17 percent in Saudi Arabian markets, just less than a week after there was an expectation that these markets were immune from the financial problems in the West (see Washington Post article). Some stress that the problems in the Gulf are more structural, with the lack of transparency and information resulting in the markets being impacted more by unsubstantiated rumors and panic selling. Nonetheless, the level of exposure is still believed to be significant. Losses from sovereign wealth fund investing in the US and elsewhere are yet to be disclosed, but are expected to be significant, causing many funds and their capital to sit on the sidelines as the credit crisis to unfold.

The Financial Times is reporting how individual retail investment in U.S. equities has fallen to record lows (see article). This recent data highlights not only the nervousness of retail investors, but also illustrates the growing importance of institutional investors. By the end of 2006, retail investors owned 34 percent of all shares and 24 percent of the stock of the top 1,000 companies. These record low numbers are in contrast to when retail investors owned 94 percent of all stocks in 1950 and 63 percent in 1980. As comparison, institutions owned 76 percent of the shares in the biggest 1,000 companies in 2006, up from 61 percent in 2000.

Of course, one way to have the overall level of retail invest be down is for the large and rich retail investors to bail out of the market. A recent HSBC report (see Yahoo article) finds that the world's wealthiest people are moving their money out of stocks and bonds and into cash. As mentioned by Peter Braunwalder, chief executive of HSBC Private Bank:

"The first half of 2008 has seen a notable change in client expectations and investment choices. Faced with inflation worries, volatile asset prices and sudden changes in exchange rates, a majority of investors have reduced their transaction volumes in equities, bonds, and structured products."

Apparently, such movement into cash is greatest for clients from Asia, where their tolerance for derivatives and structure vehicles has decreased significantly as counterparty risks and volatility has increased. Given recent moves by the Fed and other central banks to increase liquidity in the wake of the credit crisis, some worry how this liquidity will eventually be removed from the market, and worry that interest rates will rise as a result.

Apparently, even large sovereign wealth funds may also be having second thoughts, or are at least re-evaluating how they deploy their ever increasing capital. An article from Asian Investor discusses how sovereign wealth funds, with their own mixed investment results allocating capital to struggling financial institutions, may now be looking for broad diversification, which will ultimately increase the amount of passive investments they make.

None of this really seems to be good news for the banks or the exchanges. As evidence of further weakening, derivative trades on the exchanges fell 13% in the second quarter (see Bloomberg article). This weakening comes as more exchanges enter the fray, causing the London Stock Exchange to cut fees as it deals with new competitors (see Financial Times article). The IPO market has also suffered recently (see Wall Street Journal article, Financial Times article). Only 25 companies priced their stock IPOs somewhere in the world in August, the lowest number of deals since Dealogic began tracking them in 1995.

Maybe even more troublesome than the reduced number of IPOs is the increased numbers of delistings that are also putting pressure on the exchanges. Year-to-date more companies have been delisted from the Nasdaq Stock Market than a year ago (see Financial Week article). To a lesser extent, NYSE listing are also up as companies fail to meet minimum listing requirements. So far, more Nasdaq-listed companies have been delisted for non-compliance this year than in the previous two years. As of August 7, 54 stocks were delisted. As comparison, only 48 total companies were delisted last year, with 52 delistings in 2006. For the NYSE, 11 companies were delisted as of July 1 of this year. This compares to 21 last year and 14 in 2006.

Along with a lower number of IPOs, the lower number of listings are affecting the profitability of the exchanges which derive up to 15% of their overall revenue from listing fees. While there have been more delistings on the Nasdaq, in part since smaller companies are more vulnerable during difficult times, companies pay much less to be on the Nasdaq (around $27,500 a year), so the loss of listing fees is not as severe. On the other hand, the NYSE will lose around $878,000 in annual revenue from IndyBank and Bear Stearns alone. When looking at the stock performance, the NYSE Euronext (NYX) stock has suffered over the last year and is right around its 52 week low near $40 per share. The CME Group (CME) has bounced slightly from 52 week lows near $300 a share to move near $340 a share, but is still struggling. On the other hand, the Nasdaq OMX Group (NDAQ) has recover to $32 a share after bottoming out around $24 a share in early July. The exchanges certainly have more issues to worry about than just delistings, and their stocks reflect this, but the continued fallout of the credit crisis is certainly continuing to find its way into more areas than the obvious players.

It seems that Sovereign Wealth Funds (SWF) are accumulating cash, but are having a difficult time managing it. As mentioned in a recent Financial Times article, even some of the smallest SWFs, such as the Timor-Leste Petroleum Fund, have already grown to over $1 billion. Estimates put the total amount of funds globally at $3,000 billion. Although the larger established funds have managers with ties to the hedge fund world, some of the smaller ones do not, and are at times struggling to keep up. While the SWFs appear to be attractive due to the scale of the available capital, the fees can be quite low compared to traditional hedge funds that are used to a 2-20 structure.

The shear magnitude of the size of each fund, as well as the increasing number of funds, could be a shot in the arm for a few depressed sectors regardless of how they are managed. Traditionally the SWFs have been conservative investors, putting most of their money into fixed assets. As they start to look at longer-time horizons, they initially step into the global equity arena, and then begin to move to more illiquid assets, such as private equity and real estate. Look for this trend to continue, and look for the influence of SWF in helping to keep companies and depressed sectors a float to continue. Of note is that while the limited influence of SWF investments can help deploy capital to certain sectors of the economy, the funds are less likely to find their way into commodities, especially crude oil. Many of the SWF are funded from commodity and crude oil revenues and are looking for ways to diversify their holdings. Therefore, those areas with low correlation to commodities are the ones most likely to see the benefits from the capital these funds can provide.

The Washington Post is reporting that sovereign wealth funds are becoming some of the largest commodity speculators. While the CFTC recently told Congress that its internal monitoring did not show influence by SWFs, it is believed by some that the CFTC may not be detecting their influence since the SWFs are working through swap dealers, which are often unregulated and operate through investment banks such as Goldman Sachs, Morgan Stanley, and Lehman Brothers. Officials have requested additional data from swap dealers, with these finding expected in September. It is believed that many of the foreign funds are coming from countries less familiar to SWF investing, such as Norway, Singapore, Kuwait, Australia, Russia, Libya, and even Iran. Estimates believe such funds represented 12 percent or more of investment bank commodity activity. The collective value of such funds is estimated at more than $2 trillion and is expected to increase 5-fold by 2012.

Since 2007, sovereign wealth funds have spent almost $80 billion to buy stakes in U.S. companies, in particular banks that were desperately in need of a capital infusion. Now, the International Herald Tribune is reporting that the lender of last resort may be having second thoughts. Even though most SWF don't have to report mark-to-market losses in public, they still want to make a return, and some high profile investments, such as those in Merrill Lynch (MER), are not turning out as expected. Many SWF are now entering "south-south" trades, or in other words, simply investing in other emerging economies. While the moves are being made to not only look for higher return, south-south trades also prevent emerging economies (many of which got their start-up capital from the West) from simply recycling their funds back into these same economies. Oil-exporting countries for one are looking to hedge against oil price fluctuations by becoming underweight assets correlated with oil prices, i.e., just about everything U.S. based. If this trend persist, then many small, medium, and even large companies may start depending more on alternative forms of capital, such as the hedge fund lending discussed in a recent post.

Tomoko Yamazaki discusses in a Bloomberg article how current market dynamics have created four new power brokers: Asian governments, oil exporters, hedge funds, and private equity groups. The four had a combined $11.5 trillion in funds at the end of 2007, and increased assets by 22% last year. As an illustration of their influence, Asian governments and oil-rich nations invested $59 billion in western financial institutions over the last 15 months. As for the numbers, Asian governments, including sovereign wealth funds, increased to $4.6 trillion over the last decade, oil exporter assets increased to $4.6 trillion by the end of 2007, private equity assets reach $900 billion globally, and hedge funds grew assets under management to $1.9 trillion in 2007.

While each new power broker has provided much needed capital and liquidity to the markets, there are also some potential problems listed. Most notably is how increased liquidity may spur asset price inflation, sovereign wealth funds might use their capital for political means, there is the potential for leverage abuses in the private equity arena, and hedge funds could exacerbate, or even start a financial destabilization given the herd mentality to invest in similar hot sectors, as well as utilize similar trading strategies. While it is mentioned by the author that the rise of the new power brokers could pose risks, it appears that all potential problems have either occurred at one time or another fairly recently, and/or are beginning to show their ugly side once again. Of course, capital and liquidity needs to come from somewhere, and the Federal Reserve and the government can only do so much. So while the trend is intact, we should continue to expect each power broker to have some influence on capital allocation going forward.

The Guardian is reporting that foreign sovereign wealth funds are increasing investment in London hedge funds, in particular funds of funds. The capital increase is coming at a good time for the hedge funds as the credit crunch has decreased debt funding. The magazine Hedge Fund Manager Week is reporting that sovereign wealth funds are on average looking to increase alternative investment allocations from 1% to 10% of total portfolio assets.