Monday, December 1, 2008

Exotic Illiquid Investments Losing Luster With Pensions, Endowments

According to the Wall Street Journal, The Pennsylvania state employees' pension fund may be forced to make cash payments of $2.5 billion or more to Wall Street trading partners, due to investments in a "complicated" strategy referred to as "portable alpha."  Portable alpha is basically a leveraged bet on hedge fund performance.  An investor buys derivatives to match the market's return (the beta) and then uses the excess cash to invest in hedge funds (the alpha.)  According to the Wall Street Journal, an estimated $75 billion or more has been invested using portable alpha, with pension funds being eager players.  This strategy worked brilliantly from 2003-2006, as did pretty much any investment in anything during the bull market.  Leverage in a bull market is fantabulous.  Those who weren't around during the Long Term Capital kerfuffle in 1998 just recently learned: leverage in a bear market is deadly.  What has contributed to the deadliness of this credit market blow-out is the use of leverage to enhance returns on illiquid investments.  It's one thing to borrow a bunch of money to buy stocks or plain vanilla bonds.  The market goes down, you are forced to sell your stocks and bonds to repay your debt and it's over.  You're out of business but it's a pretty quick hit to the market.  However, stocks and bonds are fairly liquid.  What happens when you are leveraged and invested in illiquid assets, such as private equity funds, hedge funds, land, and oh, I don't know, timber?  Now you have a big problem.  Maybe you thought your hedge fund was liquid, but, um, no, now that it has frozen all redemptions due to the fact that it is down 65% for the year, and it was invested in all kinds of crap you never understood; not so liquid.  Your private equity fund?  Oh yeah, those guys have been in the business for years, everyone is clamoring to get into that fund because it's so prestigious.  I'm sure I can just sell my stake in the fund to someone else who really really believes in the Chrysler, GMAC, Freescale [insert name of highly cyclical company taken private at the peak of the economic cycle and loaded up with debt] turnaround story.  Except that, um, maybe not.  Because, you see, Harvard and a host of other investors who used to have a long investment horizon are now rushing to sell those stakes too at discounts of over 50%.  Also in line to punt private equity stakes are AIG (must repay government loan) and Lehman (must finish liquidating to complete bankruptcy process.)  The problem is; too many people rushing for the exits, and far too few lined up to buy either because they can't or because they believe that even a 70% discount is a crappy deal.
Investors have learned a very hard lesson in the past year.  The common refrain pitched by Wall Street to investors with supposedly long time horizons was that the extra yield offered by less liquid investments was worth the risk of tying up your money in assets that weren't easily redeemable.  Unfortunately, investors didn't demand enough of a premium for liquidity risk.  Now that they need the money, they are paying the price by having to sell their stakes at huge discounts.  What this has created is a yawning divide in the price between liquid and illiquid assets that, frankly, should've always existed.  Sure stocks are down around 40% on the year.  But many hedge funds are down more, and if they've frozen redemptions, good luck ever getting your money back.  Hedge funds have turned out not to be liquid investments.  Private equity funds don't have to mark to market, but given the lack of an exit strategy for most of their investments, they are facing a much longer time horizon than expected to reap any returns.  The time horizons, of course, will be shortened when a host of firms that were recent leveraged buy-outs go bankrupt because they were terrible investments. 
Given the horrible returns that pensions and endowments are certain to post this year, there will be a huge backlash towards the alternative investing that has been the rage for the past several years.  Risk premiums will return to more realistic levels without everyone chasing after the same investment strategies.  Ultimately, extraordinary investment opportunities will abound for those willing to take the risk.  Investors who have patiently sat on the sidelines for years because they didn't believe all the hype, will be in a position to cherry pick from a variety of investment options offering significant returns.  Fees for hedge funds and private equity funds will be reassessed and reduced significantly.  The alternative investment party is finally over.      

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