Hedge Funds v/s Private Equity: Which industry will survive and thrive in the next two decades?

Loaded Naive Questions Alert: Apologies for the verbosity.

I recently read a thread on the hedge fund bloodbath. Coincidentally, I recently saw a video where Balysany spoke at Milken Institute's panel discussion and gave some profound advise on 'How to run a hedge fund?'; and just now I read that his fund is letting go 125 people - randomness giving some entertainment. In the last two weeks, I have been reaching out to ER analysts and somehow, everyone seems to be unanimous on one fact - sell side stock picking is dying, if not dead already. The buy side stock picking, especially the HF bloodbath, shows maybe the entire public markets' discretionary investment space is dead?

Here are the questions:
1. In the coming two decades, will we be left with a handful of hedge funds running on quantitative strategies with an iota of human contribution? If there is any contribution at all, will it be in actual idea generation or just in fund raising/IR?
2. Will the PE guys simply take over the entire alternate asset class (or most of it)?
3. The people who are sticking to the good old fundamental investing professionally will be left with just the copies of Intelligent Investor and their termination letters in their hands?

In case you choose to answer this and have an angle on APAC, kindly include that as well.

Comments (24)

Dec 5, 2018 - 1:31pm
DeepLearning, what's your opinion? Comment below:

Hard to say. I would be interested to hear from PE professionals how they believe rising rates will affect private equity. Even though rates are rising they are still far lower than they were 30-50 years ago. PE explosion coincided with extremely low rates. I've heard some people say that private equity can't survive in a high rate environment given the nature of LBOs. I'm curious if anyone agrees with that assessment to any extent.

Dec 5, 2018 - 1:48pm
MidtownParkAve, what's your opinion? Comment below:

PE will still have a role in a prolonged period of high rates. New LBO's will just have lower leverage such that the FCF makes sense. I would expect EV multiples to commensurately come down in this environment for obvious reasons, such that new LBO's wouldn't need as much leverage to make the IRRs work. The power of leverage can't be understated. Many times the only time a PE firm writes an equity check is on the initial platform investment. Then every bolt-on is funded with debt. Those bolt-ons would obviously have to be acquired at appropriate multiples and the pro forma CF obviously has to support the increase in debt.

Vintage LBOs will go distressed and restructure. There are plenty of ways PE can play through a Rx, either by the existing sponsor or by the usual dumpster divers (APO, Platinum, HIG, etc.), as there is no shortage of them.

Dec 5, 2018 - 3:47pm
traderlife, what's your opinion? Comment below:

A lot of mid-level pe guys are hoping for a recession or decline in values. That way they can make their career investing cheap and having huge returns in an upturn.

Dec 5, 2018 - 1:31pm
MidtownParkAve, what's your opinion? Comment below:

Whoever can secure lock-up or permanent capital will survive. It takes a long time for a crappy PE fund to die b/c of this structure. Most HFs get crushed b/c they run intra-year redemption vehicles and end up being foresellers during market draw-downs. It's difficult to invest over the long-term under this structure - schizo source of capital shouldn't force the manager to be a seller.

Dec 5, 2018 - 2:02pm
Skeptic Ape, what's your opinion? Comment below:

DeepLearning I am not sure about the entire low rates angle since I see several PE funds have enough dry powder to finance deals; saying this because I read recently that there has been a slowdown in hiring for the fundraising teams at the big-shot PE funds; especially in emerging markets, it seems they are demigods by all means. By any means, thanks for your response.

MidtownParkAve That was a perspective I did not examine. Thank you for your input.

I also see a more simplistic pattern - the fact that public markets are getting more efficient whereas PE deals are still based on human judgement. So, for the PE folks there is still a lot of money to be made by just capitalizing on the human errors of the person on the other side of the table whereas the HF guys are practically fighting with algorithms being optimized to fight against each other; the chances of winning against human errors seem brighter than those where it has become a more complex tussle of algorithms and AI.

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Dec 5, 2018 - 2:11pm
MidtownParkAve, what's your opinion? Comment below:

Having invested in both private and public, equity and credit, I am less convinced that algo trading will squeeze out every ounce of alpha. First, I would say robo trading is mostly limited to equities. Credit (actually the larger asset class) trading still has a large human element to it. Second, I have seen countless times an equity get crushed beyond its deep, fundamental value due to the technicals around capital outflows from indices, large existing investor needing to exit for whatever reason (maybe HF redemption), you name it...

Dec 7, 2018 - 5:26pm
traderlife, what's your opinion? Comment below:

Downside protection. PE has their leverage at company level. Therefore no margin calls. It's a matter of meeting debt payments and can use control to work with bank. Puts protect you from a margin call.

Dec 7, 2018 - 8:46am
Dr. Rahma Dikhinmahas, what's your opinion? Comment below:

I think it's all total nonsense.

It's not a secular shift, it's a pendulum. As things go more quant/passive, there will be fewer humans watching the market and more pricing dislocation. The people who stick with fundamental investing will do better in this environment.

Ultimately there is an equilibrium point where there is the right number of humans in the market. That number may be lower than the number of humans today, so yes maybe there is some net job loss.

But the idea that this is one directional and the future is primarily run by machines is total nonsense to me. If you don't believe me, go talk to some of these guys who are building quant funds right now . . "smart beta" and "quantamental" and all that stuff. I've talked to a lot of them, and they have a loooooong way to go before their machines come even close to keeping up with a an actual person who understands a business. As I said, if anything, their algos are just creating crowded trades and more opportunity at the moment.

I have total respect for those guys and their mission to build something efficient. I think they'll make some progress and those that do will make a lot of money.

But the guys in the fundamental crowd today who are waiving the white flag and being all like "what will happen to my job?" are simply people who should've never been fundamental investors in the first place. They should get out now and find something better suited to their style of thinking. Anyone cut from the right cloth to be a bottoms-up investor will see the quant movement as an opportunity instead of a threat.

Dec 7, 2018 - 9:40am
VALuation, what's your opinion? Comment below:

Howard Marks speaks well on this in his letters. The market operates in a lot of ways like an organism/ecosystem and adapts over time to the participants inside of it. Quant strategies have their place and they are pushing a lot in terms of efficiency, but over time competition and crowding-out could potentially push down their alpha, leaving opportunity for different strategies.

Most Helpful
Dec 7, 2018 - 10:32am
DeepLearning, what's your opinion? Comment below:

As a quant, I agree with a lot of this. Although, I would say that the type of price dislocations that are identified by quantitative models are entirely different from those discovered by fundamental analysts. Quant models are more about incorporating as many quantifiable data points as possible and extracting return from that data ASAP. As far as quants "keeping up" with human analysts, it's really an apples/oranges comparison. Obviously a machine or computer program does not have anything close to human level intelligence. Quants succeed because of scale. They can take a lot more bets in hopes that they are right on average. Fundamental analysts must be much more precise in order to succeed. And anyway, on a risk adjusted basis, quantitative funds have performed better on average than fundamental funds. But a lot of that has to do with the fact that there's a much lower barrier to entry to launching a fundamental fund.

The criticism that I have of the fundamental guys is the lack of interest in innovation. I'm not saying everyone has to learn to code or whatever but people seem very stuck in their own investment hypothesis frameworks and tend to be disinterested in determining if their framework is sensible in a systematic way. I have spoken to some fundamental analysts/PMs who are interested in trying quantamental approaches. The problem is that fundamental guys seem to have little respect for quants. They see it as "hey check to see if the data supports xyz trade". The problem with that is you can't discover good trades ex-post. You'll run into data snooping biases. You can't go out seeking a particular result when doing data analysis. You have to be agnostic. Unfortunately, fundamental analysts have little interest in being told by a computer program what trades to analyze. The only correct flow of information is data -> quant model -> confirmation by fundamental analyst. The reverse flow doesn't work.

The overall premise that fundamental analysts shouldn't be afraid is correct though but you have to be open minded. The world is changing and fundamental analysis must change with it. That might involve a portfolio manager giving the same respect to quants as they do ex bankers/PE guys, which trust me, would be a pretty big shift.

Dec 11, 2018 - 11:24am
Dr. Rahma Dikhinmahas, what's your opinion? Comment below:

You're right that data analysts can't go out seeking a particular result. But to me, that solves one problem and creates another. Data analysts can search through a limitless number of relationships and when they find one that works historically, they too often feel like the work is done. 99% of the quant models I've seen just assume that past relationships will persist into the future, without any underlying rationale as to why it even worked in the past, not to mention why it will persist. Doesn't matter though, as long as the clients aren't sophisticated they will believe anything that sounds quanty. Certainly makes them feel a lot smarter than their neighbor who is in a Vanguard index fund.

Risk-adjusted returns are a double edged sword. As a long-short guy myself, I certainly value risk adjustments because I need to explain why someone should invest in me when I'm up 5% and the market is up 15%. Thank god for CAPM and Sharpe when that conversation happens.

But ultimately, the only point of limiting your risk is to put you in a better situation down the road. It's still all about the total money you make in the end. So risk-adjusted return will get me through a short-term conversation, but after 5 years my clients better come out ahead of the S&P. And any quant fund that hugs the index while charging 1/10 will not. Same goes for fundamental index-huggers because they're out there too.

Dec 7, 2018 - 4:10pm
m_1, what's your opinion? Comment below:

PE has done well regardless of the macro environment really. Rx guys will clean house. My firm invested in two distressed deals last month so we can practice distressed and then hopefully make a few fun plays during the next downturn. Very very excited.

Dec 7, 2018 - 4:15pm
The Stranger, what's your opinion? Comment below:

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