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.

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Comments (18)

Dec 5, 2018

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.

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Dec 5, 2018

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.

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Dec 5, 2018

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.

Array
Dec 5, 2018

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.

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Dec 5, 2018

@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

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...

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Dec 5, 2018

Easy replication of pe. Buy the russel futures 2 times leveraged. Buy out of the money puts for 30% drawdown long term.

Array
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Dec 7, 2018

Why the puts? Not following.

Dec 7, 2018

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.

Array
Dec 7, 2018

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.

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Dec 7, 2018

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

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.

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Dec 11, 2018

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 11, 2018

This isn't true.

Quants are enormously careful about not using signals/correlations with no economic intuition. As far as the persistence of factors, that is also a huge area of research. Whether a factor is a risk factor or an alpha factor. Risk factors are thought to be persistent over time (cheaper companies outperform expensive companies). Alpha factors will decay over time, which is why quant funds employ analysts to discover new factors. So not sure what you mean there.

The role of hedge funds is not to beat long only indexes. Large institutional investors care about the predictability of their returns and overall hedge funds do help with that. And anyway, if a quant fund has a high sharpe, they can simply use leverage to juice returns if they or a client wants them to. Not sure what your point there is either.

If an active manager is hugging an index, they should get fired. But if you're running a quant book with a beta of 0 with a 5% return unlevered and a sharpe of over 1, clients will pay through the nose for that. The problem is that there are, as you mentioned, a lot of funds who are charging for beta exposure.

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Dec 11, 2018

Speak for yourself. If you're "enormously" careful, good for you. If you're delivering 5% with a beta of zero, good for you. Those are fantastic results.

Doesn't mean you need to defend your whole industry. I used to work at a quant shop too. I saw the bullshit in that space first hand, and it seemed prevalent to me. Lots of people crunching numbers with little understanding of where they come from, what they mean, how they can be manipulated. And most importantly: how they will be affected by the fact that lots of other people are now moving into the same strategy, creating various crowded trades.

You're correct to distinguish between alpha factors and risk factors. What so much of the industry fails to understand is that alpha factors are the only ones worth chasing. A true risk factor only compensates for risk, and risk (to your point) can be created through leverage anyway. Nobody should be compensated for providing access to risk. "Cheap companies outperform" is a truism, not a truth. If they are truly undervalued (i.e. alpha opportunity) then that makes them cheap. If they're just cheap because they have low ratios, they could be a value trap and there are certainly more value traps these days thanks to the litany of quant funds blindly crowding into low P/E and low P/B. Guess where my shorts come from!

I don't agree with you that the role of hedge funds isn't ultimately to beat long only indexes. I agree with you that's what many of them say. But the LPs who believe that are either dumb or in many cases, sucking up to the fund manager for their own career goals. Smart LPs know that they only need a small degree of predictability (for payouts) and the long term goal is total return. One reason so many funds are closing is that LPs have stopped buying the overplayed risk-adjusted return angle.

Again I'm not discarding risk-adjusted return outright. It's more relevant in shorter time periods. Many funds sat down with their LPs at the end of 2009 and had to explain why they couldn't beat the market's 40% return. Risk-adjusted makes sense because that was a risky time. But if that same fund is still behind in 2018 no smart LP is going to give a shit about risk-adjusted. You avoid risks so you can keep your capital and kill it in safer times. Its a practical point, not a technical one.

Dec 11, 2018

If a quant fund is providing just basic risk exposure than they are providing smart beta. There are ETFs for that and such funds will die anyway.

"Cheap companies outperform" is tied to fama-french 3 factor model (FF3). Value is the most statistically significant of the 3 factors with respect to predicting excess forward returns. Not exactly a truism. The point is on average, over a long period of time, long/short quintile spreads on book to price are positive. If your complaint is that quants do not carefully analyze their individual investments then okay? The point of quant funds is to be correct on average not to be particularly precise. Factor crowding on value isn't even the biggest issue anyway, it's factor crowding on momentum that blows up.

Smart LPs know that trying to time the market and buy into hedge funds at the "right time" is a fruitless exercise. The LPs who tend to shuffle their money around to time bull and bear markets tend to get screwed over.

Hedge fund assets are also up significantly in 2018 with several record launches (ExodusPoint, D1 Capital, relaunch of P72, etc)

Dec 7, 2018

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
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