I am Back to Gloat

Thanks for the heads up!

shit

Wow, what prescience...thanks for coming back!

this post scares me... why didnt i go the pre-med route like my parents told me to do...

How about the good? There must be some sunshine somewhere no?

where's this "hall of fame post"?

shit. i just read that. balls on accurate as hell. that scares me. I was hoping bonbarb was full of it. The only question is: where to now?

Bond Arb, what's your take on the leverage finance groups?

dammit, i just graduated too...

Hey Bondarb,

It’s great to hear from you! Thanks for your insightful (and spiteful?) note. While I think much of the basic gist of what you say is accurate (yes, mortgage CDOs will not be as popular or profitable in the next 5 years as they were from 2003 to mid-2007), I also think that much is misguided. Let’s go through each “asset” class you identify; 1) I know the least about this group, so I won’t say a lot. But I will say that it’s not like some desks aren’t making money. As with almost every financial crisis, people who have traded on schemes that make money for a short period often blow up when the relevant “bubble” (term loosely used) bursts: yield curve climers in 1993, macro yield spread “arbitrageurs” (like LTCM) in 1998 (though I should note that a similar trade of shorting Japanese yen and buying higher-yielding government bonds in riskier nations persists today, partially responsible for an “irrationally” low valuation of the yen, in the minds of many investors), New Economy enthusiasts in the late 1990s...and proponents of the theory that risk in the credit markets was heavily reduced thanks to structured products in the mid 2000s (this actually wasn’t a “new” view—it can largely be attributed to Michael Milkin’s graduate thesis, and subsequent work at Drexel—though its implementation and institutionalization reached new heights in recent years). For sure, structured products desks at many banks have hemorrhaged money...but energy desks have made quite a bit, and part of the reason Goldman wasn’t hit nearly as hard as other banks was because one of its prop groups put a massive short on the real estate market. Sure, a lot of stupid traders (and some smart ones) are getting fired now (as in 1993, 1998, and 2001), but lots of smart ones get to stay, and a new investment strategy or bubble will probably arise in the next few years (clean/green tech is what many analysts suggest) for people to trade on. 2) Certainly, the PE scene has changed, but is PE dead. Well, for one, lots of buying opportunities exist right now. It’s no secret that a bunch of PE profits from ’02-’08 have come from cheap leverage, but the best firms have made money off of buying companies that look shittier than they are and selling them for more down the road, potentially after making operational improvements: TPG or Golden Gate Capital’s investments in down-and-out .com companies, levered modestly, in the early 2000s, come to mind (to the tune of ~35% returns). Yes, you’re right that PE firms are “guys with huge, illiquid, long-only equity stakes in private companies” (though many, like Bain Capital, TPG, Blackstone, Apollo, and Cerberus—for example—invest across the capital structure of companies in different industries and of different sizes, through their main PE funds or affiliates). That’s sort of the point of PE—and it’s why the best PE firms have 35% returns, while the best debt funds have 15% returns, and great hedge funds like DE Shaw have 20% returns (and the worst PE firms lose a lot of money): top quartile PE firms have great Sharpe ratios, and, thanks to illiquidity, (artificially?) low betas, which is probably a better measure of performance than risk alone. Are different PE firms going to do well in the next few years? Probably, would be my guess: those that relied on cheap debt to drive returns may do worse relative to those that restructured the operations of portfolio companies (Bain Cap), or that have a track record of picking up distressed companies that are stronger than their financials initially suggest (TPG, Cerberus) are best situated to do well. Firms that have started infrastructure funds, which many financial analysts consider a slam-dunk move considering the $1 trillion infrasctructure gap facing the US today, may also do well (Morgan Stanley’s investment group; Carlyle), representing a further understanding among PE firms that, yes, the game has changed, but that (large) profits remain to be made. It’s not like this is just my whackjob view: for example Bain Cap raised a $20 bn fund AFTER the credit crisis hit (they had initially raised a $10-15 bn fund, but increased its size), suggesting that institutional investors agree with the view that there are a lot of good buying opportunities out there (aggregate unlevered buying power among PE firms of ~$250bn, or 2% of GDP, corroborates this argument). As for compensation at those firms, even with more expensive leverage, the presence of cheap acquisition targets and funds twice as big as historically invested (with management and return fees staying about the same, and funds doing way less than doubling their number of investment professionals) suggests that it should remain quite healthy, at least at that “top-quartile” group. 3) I think that your point about consolidation (“consoliation?”) in the hedge fund industry is trite, to say the least. First: there are plenty of small funds out there that WANT to stay small (Sageview Capital, SPO partners, Bayside Capital, and Stadium Capital for starters). Second: I don’t know that giving money to a small fund with a track record of success presents riskier scenario than to a well-respected large fund, for three reasons. One: many large funds are overrated, and because of their large asset bases, profit off of management rather than return fees (e.g. Bridgewater with it’s 5% return rate over the past few years, John Henry’s Hedge fund, which has had significant redemptions and losses—40% on a $2.8 bn fund—over the past few years: http://hf-implode.com/ailing.html). Two: large funds aren’t immune to blowing up (e.g. LTCM in 1998--$7bn when that was a huge, Sowood last summer—a $3bn fund run by guys with a major track record of success managing the Harvard endowment, the Bear Stearns funds that crashed in June last year—average size of about $1bn each I believe). And Three: smaller and newer funds have the ability, motivation, and appropriate financial incentives to adapt to changes in the credit, commodity, derivative, macro-economic and corporate management worlds that have arisen in the last 12 months (because they don’t make a billion off of management fees alone in a year). You’re right, “how could you possibly give money to a small credit fund”...unless that fund were to demonstrate an investing philosophy that evolves from a comprehensive understanding of the recent crisis. That’s like asking how someone could give money to a Silicon Valley VC after 2000—but lots of “someones” did, and Web 2.0 made more “real profits” than the original .com boom. Yes, I agree that the credit crisis biases institutional and funds-of-funds investors towards funds that have a history of performing well overall, and especially in the recent markets (though DE Shaw is rumored to have lost about 10% on its flagship fund during the crisis; has never returned below 17% since inception, and averaged over 20%; and had no significant redemptions), but I think that lots of opportunities remain for well-run small funds (and is it really a good thing, anyway, if lots of opportunities existed for shitty small funds?), and that your analysis is incomplete, to say the least. In short, your analysis isn’t so different from what the bears said back in the early 2000s, though the limiting reagents at that time for banks returning to the profitability levels of the late 1990s were inability to regain public trust (conflict of interest) and the reluctance of investors to invest in assets that (unlike the writers of books like “Dow 30,000,” which suggested that the Dow should rise to that level because the aggregate domestic market was essentially a risk-free investment and should be discounted as such)—in this case, tech companies rather than CDOs. Though economic fundamentals (oil, other commodities, consumer confidence, low US savings, wartime spending creating national debt, dollar devaluation—which isn’t all bad, for sure, uncertainty in the anti-inflationary stance of the US central bank) are perhaps greater than before, understanding these issues also creates lots of opportunities to make money. It’s not like investing is dead—just ask the PE firms who have raised record-sized funds in the past few years—or like good investors no longer have a viable career. The truth is that institutional investors/FOFs have a lot of money right now that they want (need?) to invest, and the US savings rate is starting to (modestly) increase (and many economists—rightly, I think—forecast significant increases in the next decade), so while asset allocations may change among investment “classes” (PE funds, vs hedge funds, vs VCs, vs mortgage prop desks, vs debt funds, etc.), and between firms (e.g. DE Shaw vs. Sowood), there is a largely upward trend in invested dollars, and a significant amount of employment for investors/finance professionals to go with that in the medium to long run...even if the next 6 mos to 1 year seem grim. There’s no doubt that the market has changed—it does that a lot. I just don’t think that your comments are far more grounded in misplaced schadenfreudethan market data or firm understanding of what drives the actions of principle and institutional investors. Thanks for the comments.

Jesus... when was the last time you guys got laid?

you made some good points js09. Actually i was at a seminar yesterday in which the head of a major investment bank said effectively taht there is too much money lying around looking for returns for p.e. not be back in force pretty soon. I believe he said $400 bln= a few thrillion after leverage, even though i don't think that sounds like too much money (it gets hard to tell after awhile?).

ONe way or another, its going to be exciting for a few years. And money is more fun than sex Marcus

I would have to say that PE being illiquid and long-term is what makes it still attractive overall. Obviously investors prefer liquid, short-term investments but above that they want legitimate, higher-than-market returns. Working for a small PE I see more deals than ever and the fact that PEs, especially the larger ones, have the capital to fund these companies for many years they are positioned for extremely strong profits in the future.

Slow/down markets aren't a bad thing if you have the wealth or funds to weather the bad times.

What do you consider a decent Sharpe ratio for a top quartile PE firm? .6? .7? Also you have a misguided view of portfolio management if you think low beta is a strong indicator of performance.

from F-O-F's, I can attest that people are still lending. Ultimately, fund of fund guys need to feed the machine as much as PE funds and as much as banks do. We're fundraising a sub sr debt fund now, and as long as your portfolio is in good shape and you have an attractive leverage program in place, you're still delivering +15% IRRs. Not all portfolio companies are tanking, so it can still be an attractive proposition.

Ideating: your point is pretty nitpicky--all I was trying to say was that judging PE funds based on their risk exposure without looking at returns is silly, and to illustrate that point I included two commonly-used measures of risk/reward in investing: beta and sharpe ratio. While they're not perfect, I'm not sure that using them represents a "misguided view of portfolio management."

You're right that a low beta alone is not a strong indicator of fund performance. You'd also be right to suggest that the CAPM might not be the best way to test the risk-return tradeoff of an investment. There are lots of problems, ranging from the linear nature of the excess return/market correlation relationship (see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=495362), to the assumption that the only observable indicator to which utility is tied is the performance of some market index (not a particularly original criticism--see http://www.moneychimp.com/articles/risk/multifactor.htm).

That said, a lot of pretty successful academics and fund managers use beta in contextualizing their performance (if you know returns and beta, you can "solve" for alpha). For example, take a look at p. 3 of this article on Bridgewater's website (http://www.bwater.com/Uploads/FileManager/In_the_News/bridgewater_assoc…), where they suggest that low beta exposure makes their (low) returns largely alpha. A good summarization of some academic research on PE betas is here (http://www.advisoria.de/pdf/Current_research_in_private_equity.pdf). Feel free to PM me if you'd like to read more about this, and I can give you some more sources. Yeah, looking at beta in evaluating PE funds is especially problematic (stale assets are a bitch--http://www.edhec-risk.com/site_edhecrisk/public/research_news/choice/RI… they aren't absent from hedge funds and models that employ methodologies such as lagged betas address much of this risk evaluation), but lots of people have utilized the concept. So either lots of really successful academics (and a hedge fund returning 5% over the past few years--though way more before) are misguided in their view of portfolio management, or your views about beta are inconsistent with those individuals'.

As for sharpe ratios: they're tough to measure for PE firms (a sharpe ratio for stale assets would need to be measured over a long time horizon, which introduces significant measurement bias, as http://www.mgt.ncu.edu.tw/~chou/sharpe.pdf suggests), but that hasn't stopped some people. For example, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=871931 note that sharpe ratios aren't great for PE relative to the market, but that the performance distribution is highly skewed, such that if one were to imagine that the "best" (top quartile) PE firms didn't perform that way due to chance (unlikely due to significant correlation from fund to fund at the best firms), their sharpe ratios would be better than the market.

Your point was nitpicky, for sure, but also "misguided," I think--people (very smart and experienced ones, at that) do use the sharpe ratio and beta as indicators of risk in PE, though problems exist and adjustments must be made. I guess a little creativity goes a long way for people willing to tweak the simple concepts of sharpe ratio and beta...