Alternative Asset Managers and Down Market Cycles: What to Expect

The equity market has been a roller coaster, characterized by bone-jarring volatility and single-stock blow-ups that are enough to make even the most steely-eyed hedge fund manager cringe. And private equity firms have seen arbitrage spreads explode, fueled by the knock-on effects of broken credit markets and concerns over whether the PE firms or the banks will walk away from agreed-to transactions. But these are merely observations. The real question is, how will a persistent down market impact the returns of the hedge fund and private equity industries? My handicapping: most participants will suffer and suffer badly. Why? In summary:

• The net long exposure of most hedge funds will weigh on returns. Historically it has been difficult for most hedge funds to add significant alpha on the short side, the side which may well be the key driver of returns for quite some time.

• The excess capital across the private equity industry and sharply wider financing spreads will hurt new deal returns. An unfriendly equity market will make for a limited IPO calendar, eliminating an exit that has proved so fruitful for many of the largest PE firms and their investors over the past three years.

Bridgewater Associates had a very interesting report yesterday that addressed this very issue. Here are some of their thoughts as it relates to the hedge fund industry:

For the most part, hedge funds have gotten through the credit crunch relatively unscathed. For example, the average hedge fund generated a return of 12.5% last year and 2.5% in the fourth quarter. And private equity funds generated an average return of 11%. The main reason that these two groups held up as well as they did is because the equity market has not fallen nearly as much as the bond markets (i.e., spreads), and the majority of the risk allocation of these funds is in the equity market. And because their performance held up, they have not been forced into much asset liquidation to speak of. But stock market action is beginning to pressure the hedge funds and private equity players.

Hedge funds used to be a lot more hedged than they are today. Today, just about anyone who wants higher fees based on total return calls themselves a hedge fund, even if they are just a buyer of assets. And the fat cash flow yields in global stocks have also attracted a number of hedge funds into net long equity positions. As a result, hedge funds are now heavily long the equity market. Based on fund by fund holdings data we estimate that hedge funds are net long about $150 to $200 billion in U.S. equities (foreign equities are not included in this figure).

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Hedge funds are also highly leveraged. Losses raise a fund’s leverage ratio, which requires asset liquidations to bring the leverage ratio back to normal.

Let's see, big net long equity exposure + high leverage + down markets = not good. Clearly we are both taking an industry-wide view of things, but I think it is important to have a grip on the thematic issues in order to gauge possible broad-based effects. Earlier this week I wrote a post that identified industry-specific knowledge, liquidity and value-orientation as being key components for success in volatile markets. Let me add a long time horizon to that list. One of the big issues plaguing many hedge funds is a focus on managing to monthly and quarterly numbers. In real life, this is no way to run a business. Some of the greatest investments of all-time have looked really crappy at the beginning and the thesis has played out over time. If you've got the time, which means either long lock-ups, stable and mature investors, eye-popping long-term performance or both.

I happened to be at the Greenlight Limited Partners Annual Dinner last night, and David Einhorn did his usual impressive presentation of 2007 results with an overview of trends, risks and opportunities today and in the future. The great thing about David is that he is very honest, very humble and very, very focused on sticking to his long-term value mission. In quest of high IRR value-based ideas, wherever they be found, even if they take a long time to play out. He gave examples of positions that have been in the book for five years, making lots of money for investors on an IRR basis but only after the market finally bought into the Greenlight thesis. Several other funds I respect a great deal roll this way, including Rob Medway and Yale Fergang's Royal Capital and Seth Klarman's Baupost Group. It is funds like these that can withstand the pain, and which also have the skills and experience to manage an active short book as part of a true "hedge" fund portfolio.

Bridgewater also had some cautionary words for the private equity industry:

Private equity also looks vulnerable... One element that we showed was the recent deterioration in the yield on private equity deals, driven by too much money chasing too few good deals. This contrasts with the fat yields that existed a few years ago. Those fat yields contributed to the recent high returns on private equity (2007 private equity returns were 11% according to Cambridge Associates and the average return over the past three years was 20% per year). The recent skinny yields, combined with public equity market weakness, are a bad sign for future private equity returns.

I heartily agree. This is an area I've written about quite a bit, both about the glut of capital saturating the high end of the industry and new types of structures (like KKR's investment in Sun Microsystems) that might become the vehicles for deploying capital. Until credit market capitulation is complete, bank balance sheets have been rebuilt (through a combination of external fund-raising via SWFs and other deep-pocketed investors and internal fund-raising through a Fed-induced steepening of the yield curve) and investors have coughed up and marked-to-market all that seemingly low-risk paper trading at 20 in their books, it will be hard to see how debt capital formation will support the scale of private equity transactions we've witnessed in the 2005-07 period. So where does all that private equity go? Either to far less levered deals generating far lower IRRs than in recent years, or into PIPEs and other types of minority stakes that offer downside protection but with modest upside and 10-12% IRRs instead of the 25%+ IRRs we've become accustomed to. In short, it is hard to see the halcyon days for the private equity industry in the near term.

So in the final analysis I think we all need to dial down our expectations. Structural issues will continue to depress hedge fund and private equity returns until the credit cycle and its impact on global equity markets plays itself out. It won't be pretty but we'll all get through it. And some will thrive. Those who have the breadth of skills, the capital and the long-term orientation to take advantage of others less fortunate.