Brazil's 3G Capital Still Has More Appetite for Deals

From a recent blog post after the Heinz deal,

"We've written in this blog about Buffett's long relationship with Brazilian-led 3G Capital Partners which was behind its stepping up to help finance the purchase of Heinz, and about how that relationship would be a new model for Berkshire going forward, i.e. partnering with private equity to do bigger, better, and faster returning deals than BRK's working on its own.  Here is an example in this deal, and it sounds like it should work out well for the preferred holder, as that instrument has borne much fruit recently, as exemplified by the Goldman deal."

Now comes hunting season on the corporate savannah for new targets.  Campbell's Soup, as we've said before is a bad company that has confounded corporate makeover artists before: buying a bad company at a great price is not Warren Buffett's model.

Pepsi would be a very expensive deal, and it would have to feature the tired idea of spinning off the snack food business. The 3G model seems to focus on making operations better, including cutting costs.  Financial engineering doesn't seem to be in their wheel house.  As the Journal mentions, taking on part of the company might work, but this would take time, be complicated for Pepsi and wouldn't seem to offer the right size deal.

CalPERS Throws in the Towel on Hedge Funds

In organizing the posts on this blog, I've favored the label "alternative investments," as opposed to, for example, just "hedge funds."  In the past, we've written one of the most widely read posts about the public's "Two Faces on Private Equity." Rereading this, it is ironic that Warren Buffett, a vociferous critic in print at the time, has now thrown in with Brazilian private equity partners 3G on major investments.

The Yale endowment fund, led by Dave Swensen, has been one of the institutional models for successfully using alternative investments, including hedge funds, private equity, and real estate. Harvard's endowment has been in the news recently because of its falling down repeatedly in its once legendary investment management.  This post makes good background reading for today's issues about CalPERS.

CalPERS has assets of $298 billion in its investment portfolio to support 1.6 million members, either currently working or retired,or a stunning $186k per member, most of whom are working so the retirees should be quite comfortable.  The trouble is that for all their shareholder activism, self-promotion, and expensive internal management, CalPERS cannot select, construct and manage an alternative investment portfolio, in this case specifically hedge funds.

According to the Wall Street Journal, the fund's fiscal year-ended June showed its hedge fund portfolio of $4 billion returning 7.1% versus Vanguard's Balanced Index return of 12.5%.  The prior year too showed dramatic under performance at 7.4% versus 10.8% for Vanguard's Balanced Index.

The Journal notes that HFR's index of 2,000 hedge funds has been under performing its benchmark since 2009.  It points out that even in the down year of 2008 hedge funds lost 19%, not much less than traditional equity investors who lost 22.2%.  So, the $24 trillion hedge fund industry doesn't protect the downside in any significant way.

However, just to note that I got an interesting post from AQR's Cliff Asness which raises a very interesting point on which he has hammered for a while. To paraphrase, much of the institutional investor's market-like performance for hedge funds comes from the fact that their positions, whether in outside funds or in funds-of-funds, have too much of a net long position and therefore shouldn't be expected to perform too differently from traditional longs, like balanced funds. CalPERS and Harvard and others suffer from this disease of not being short enough in their hedge funds.

Proponents of hedge funds claim that there are good managers out there who can point to long-term out performance.  Who are they?  What's the basis for this claim?  What are the strategies and processes in this opaque world that can produce this alleged out performance?

Even Morningstar rates hedge funds for individuals.  If CapPERS concludes that hedge funds are too complex to manage, produce little diversification benefit, are too expensive and not scalable at their asset level, how can a small investor ever hope to benefit from these investments.  You can guess my answer.

New Study on Private Equity: Buyout Funds Add Value

Steve Kaplan is Professor of Entrepreneurship and Finance at the Chicago Booth School of Business. He and his two co-authors have published a paper which tries to systematically measure the comparative performance of private equity and venture capital funds against a public investment equivalent.  Private equity returns are anything but transparent.  Time series are subject to all kinds of bias in performance measurement, survivorship bias, absence of cash flow data, and no performance standards equivalent to AIMR standards which govern most mutual funds. 

This aura of mystery helps no one but the sponsors of these funds.  The authors have done yeoman's work in putting together this study, which is not definitive but certainly an improvement over what is uncritically reported in the financial press.

Broadly speaking, here are some highlights of the findings.  It has long been contended that buyout funds add value when they take over troubled firms.  The authors data analysis confirms these prior studies.

"Using cash flow data from 598 buyout funds and 775 venture capital funds from 1984 to 2008, the authors calculate the average public market equivalent ratio for each vintage year. They find that buyout funds did better than public markets in most vintage years since 1984. The average US buyout fund outperformed the S&P 500 by at least 20 percent over the life of the fund, or by at least 3 percent per year."

Venture capital funds, on the other hand, have decidedly mixed results.  Again, this confirms the broad conclusions of several other prior studies.  The authors find,

"The average venture capital fund, on the other hand, did better than the S&P 500 in the 1990s but not in the following decade. Kaplan thinks this is not surprising. The tremendous success of venture capital funds in the 1990s attracted a huge amount of capital in the early 2000s that subsequently contributed to lower returns."

I believe that there are other factors at work in the inter-decade performance of venture capital funds.  Larger capital flows are one issue; declining quality of the sponsors and their paucity of top talent are also important, but difficult to measure.  Hot sectors--one might call it luck--play an important role.  Healthcare and medical devices had its heyday before FDA issues, reimbursement issues, pricing pressures, and greater emphasis on clinical value conspired to put an end to outsized returns.  Technology investments also had cycles of innovation, followed by a host of 'me too' companies which were not worthy of their multiples.

Broadly speaking the outperformance of buyout funds remains consistent over the most rigorous transformations of consistent industry data sets.  Those of venture capital funds show consistent value-added through the 1990's, but not thereafter. 

So,  from the point of view of the asset class, private equity firms that buy troubled or undermanaged assets seem to turn them around, providing demonstrable value-added to return profiles over the life of the funds. 





 

Private Equity and Conservative Canadians

Now that our favorite Uncle Ben has promised the investment world the Fed will  mainline MSB purchases into the system until the unemployment rate reaches 7%, we are deeply conflicted.  In a surprising display of one-upsmanship,  Minneapolis Fed President Kocherlakota suggests using a threshold unemployment rate of 5.5% before the quantitative easings are unwound.  So, the hard-working, responsible saver faces a long horizon of low investment returns. 

Folks looking to build up balances for college tuitions or retirement are facing a trifecta of low returns, rising taxes and, eventually, rising inflation.  Meanwhile, we see political commercials for the supposed evils allegedly inflicted on coddled union workers by Bain Capital and other private equity firms.  Here we go again, Two-Face!

What's an institutional investor to do?  Really, public pension funds have no choice but to increase their allocation to alternative assets.  Otherwise, they should meaningfully decrease their expected rate of return on plan assets, thereby putting pressure on state and local taxpayers to make up the contributions to the gold-plated, public pension funds.  This would make taxpayer-voters pretty mad, unless the headlines are buried beside the obituaries in the paper.

Our conservative and circumspect Canadian neighbors to the north are planning to step up their allocations to alternative assets, according to a Royal Bank of Canada survey reported in the Globe and Mail.  According to the survey,

"Of those funds looking at boosting alternative asset holdings, 45 per cent said they planned to increase their real estate holdings, 34 per cent are looking at infrastructure, 14 per cent are planning private equity investments and 7 per cent are planning more hedge fund investments.


Mr. MacDonald said large public sector pension plans have had better performance in recent years due to their investments in alternative assets, and smaller plans increasingly want to emulate that success"

There is no doubt that public pension funds face challenges in matching the alternative asset class performance of funds such as the university endowment funds of Harvard, Yale and Columbia.  Smaller funds don't have the capabilities in-house to structure the right deals, and brokers often lead them astray.  Larger funds, like CalPERS are able to structure better deals, but even they have conflict of interest issues and other inefficiencies which come with a public organization. 

Bringing the capability entirely in-house, where the group actually finds, values and structures private equity investments for a public pension fund is something that is being tried by one large Canadian fund.  Even if it works for a time, the issue of compensation and culture will weigh on retaining that group for any length of time.

So, like our brown-suited Two-Face, we have to rail against the distorted, artificial low return environment in which Uncle Ben has trapped the economy.  Poor retail schmoes will face a limited set of expensive, unproven options for alternative investments. We can also posture for the press about the bogey-men of Wall Street, particularly in an election year.

At the end of the day, however, an investor has to find a way to reach for higher return, which means more risk.  Our chalk-striped half is outraged by the 2/20 fee structures and by the tax treatment of carried interest , but the alternative investment class should offer higher expected returns than the liquid asset classes of stocks and bonds looking forward in this surreal rate environment.  It makes a person's blood boil!

More on Yale, Alternative Investments and Individual Investors

As we've noted in a previous post, the Yale Endowment has taken a very aggressive position in using alternative investments in its portfolio's asset allocation. For the year ended June 30, 2011, alternative investments in total (absolute return hedge funds, private equity, and real assets comprised 81.5% of the portfolio!  Liquid investments (domestic equity, foreign equity, and fixed income) net of cash comprised 18.5% of the portfolio.

This statement appears in the annual report, "...the actual (2011) allocation produces a portfolio expected to grow at 6.3% (real) with a risk of 15.4%.  Disclosures in the report don't provide expected returns by asset class, nor do they suggest the distribution of expected portfolio returns for which 6.3% might be a measure of central tendency.  I confess to being surprised that the portfolio's expected real rate of return was not higher given the preponderance of alternative assets.

This, in turn, made me start thinking about other studies of expected return and about the gross distortions being introduced into financial markets by the Fed's enabling policy of spreading liquidity around  like Halloween candy. 

Vanguard's Capital Markets Model recently ran simulations on the expected average annualized returns for a 50/50 equity-bond portfolio.  Their results returned a nominal portfolio return centered in the range of 4.5%-6.5%, or in real terms an expected range of 3.5%-4.5% over the next decade.  These are pretty meager returns for most investors, especially when compared to historical returns over the Great Moderation. 

So, the Yale Endowment portfolio is expected to outperform the Vanguard investor's simulated, balanced portfolio by 180-280 basis points over the investment horizon.

Reading the Endowment's report for the period ended June 30, 2011 doesn't clear up some of the obvious questions.  Performance numbers are given in nominal terms. Yale's domestic equity portfolio returned 24.5% for the year, underperforming their benchmark index return, as opposed to the expected return, by 7.8%.  The foreign equity portfolio by contrast returned 18.6%, outperforming its benchmark index return 7.0%. 

The absolute return hedge fund asset class, 17.5% of the portfolio, returned 12.7% for the year.  From previous annual reports, one can read that this class is expected to return 12-13% per annum, and so this was right in line with expected returns.  Historically, absolute return funds as a class have produced a 10.2% annual return, so Yale's 2011 performance was better than the long-term historical  average performance of the asset class.  Given Yale's' assumption about correlations between absolute return and liquid equities being zero, and the variance of absolute return being about one-third that of equities, absolute return funds lowered the overall portfolio variance as well as raising its returns.  Almost a free lunch!

So, in this persistent, distorted low rate environment, ordinary investors are forced to chase yield and return. If investors are seeking to lower risk, they don't have the options that the Yale Endowment does, rather they have to fly to Treasuries and bid up their prices to the point where their risk may increase rather than decrease.  Talk about distorted market signals! 

Liquid investments, like domestic public equities, generally offer lower returns because this liquidity comes at a premium. However, in the low rate environment against a risky economic background, investors tend to pay too much for this liquidity, thereby depressing the likelihood of higher future returns.  Again, market prices are distorted from long-term, economic cash flow related valuations. 

Finally, corporations flush with cash focus on stock buybacks and dividend increases rather than on productive investments for the future, which don't offer the easy returns fostered by this low rate environment.  Berkshire Hathaway analysts have suggested that instead of more cash flow reallocation to insurance businesses within the portfolio, investments like Burlington Northern Santa Fe should be keeping their cash flows and making long-term investments to grow and maintain their economic moat in the future.  However, the promise of almost eternal low rates pushes even astute managers to take the easy road to short term gains. 

Alternative Investments and The Individual Investor

My previous post about alternative investments and the Yale experience drew considerable readership and a few questions.  In various talks, Dave Swensen has characterized alternative investments, e.g. real estate, commodities, and private equity, as offering higher returns in order to compensate investors for risk and for their illiquidity.   This makes them perfect vehicles for investors like the Yale Endowment which, as Swensen says, is built to be indefinitely lived and which should not have liquidity needs. 

In the previous post, we noted that the liquid part of the endowment offers a substantial cushion even in the unlikely event that the fund were to have liquidity needs.  So, an investor like the Yale Endowment is perfectly suited to maximize alternative investments in particularly illiquid vehicles like private equity.  To the extent that Yale has a long history with private equity fund managers, who in turn are attracted to Yale's size and appetite, Yale should be able to enjoy a higher return and lower risk profile for its alternative investments than other institutional investors.

Now, take the case of institutional investors like state pension funds.  As we noted before, they neither have the experience, competence or appetite for risk that the Yale Endowment does.  And, most importantly, state retirement funds may very well face liquidity issues in the future.  A significant body of academic research shows that the unfunded pension liability of state funds in Ohio, Illinois and Texas for example, will ultimately require large tax increases to pay for the tails in actuarial lives of current retirees as well as for future retirees.What if the taxpayers revolt?  What if these funds somewhere down the road are restructured into two-part vehicles combining a DB element with a DC element?  I'm not saying that this will happen, simply because of our politics.  However, unlikely doesn't mean improbable. Political forecasters do worse than economic forecasters, after all. As Dana Carvey's George H.W. Bush would say, "Gotta be prudent!" 

State pension funds cannot afford to reach for return in the way the Yale Endowment does.  Finally, the last group which is completely ill-suited for alternative investments is the average individual investor, who could easily be subject to unexpected events like a catastrophic, uninsured illness or unplanned for long-term care.

In what seemed to my readers to be a contradiction, Dave Swensen has advocated portfolio construction for individual investors from traditional asset classes, using low-cost index funds.  Alternative investments are a no-no for these investors, he says.  In fact, it's not a contradiction at all.

Two Faces on Private Equity

source: yahoo.com/movies.  Batman Forever

Warren Buffet's terse characterizations of private equity investors in his shareholder letters were on point: he portrayed bad PE actors who destroyed companies by drowning in them in debt while sucking blood out in management fees and special dividends.  Today's Star Tribune trots out the case of Buffet's Inc., which was beset by a predatory private equity group which also sucked blood out of a turnip and put the company into bankruptcy for the second time. 

So, as part of the  Presidential re-election propaganda machine's aiming at Bain-alumnus Romney, voters can  conclude that all  private equity firms are vultures, no investments ever add jobs, and all just feather the nests of billionaires.  It's certainly a great mantra for election time.

Now, however, go to the interesting case of Calpers, the monster public employee retirement fund of California, which is an institutional gorilla that can command preferences in the market place, but which is also deeply caring and crusading against all forms of corporate opacity, fraud, social insensitivity, environmental degradation, inappropriate political speech, and so on.  Calpers is just like Tommie Lee Jones' character "Two-Face" when he was a crusading district attorney. 

Ironically, many public pension funds are now plowing into alternative investments, principally private equity, chasing the performance enjoyed by Calpers in 2010 when private equity was their best performing asset class, returning 21.5%  and bringing AUM to $226 billion.  On the Calpers site, it appears that in their measurement system, all vintages of private equity investments have returned positive IRRs since their inception.  So, as investors(left side of Two-Face), Calpers is happy to take the outsize returns, but as crusaders for truth and justice, they are his right side and madder than Hades. 

So, which is it?  Private equity investments do create value and sustainable employment. They do no always employ slash and burn strategies in their portfolios.  Some firms, as we know, are bad actors.  Public employees, fresh from their Occupy Wall Street and other protests, can enjoy their enhanced returns from private equity.  It is amazing that Candidate Romney, who above all can speak knowledgeably from experience, about private equity, chooses not to educate the electorate with an informed and balanced view of private equity's role in corporate development. 

How to get justice for private equity?  How about flipping a coin?