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Transcript of Trends inalternativeinvestments.sergeyrumyantsev 2013.07.16
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
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
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
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
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
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
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
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
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
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
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
“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
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
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
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
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
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
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: