Although I have never been a marketer, and am firmly on the buy side, being part of First Avenue Partners, effectively a marketing firm active in hedge funds, private equity and real estate, as well as a hedge fund seeder, gives me a very interesting view on what investors want. Being responsible for due diligence and manager selection for the hedge fund practice, I spend most of my time looking at the hedge fund industry, but I also keep track on the private equity and real estate fund management industry as there are often interesting overlaps.

It was very clear that in 4Q 2008, investors simply wanted out, they wanted to redeem from their managers and they often wished they had never been invested with the funds they were invested with, that they had never got involved in the dreadful investment game, and that they should all have been dentists instead. You get paid for pulling teeth, patching teeth, straightening teeth, and poking around in teeth. But the more teeth you pull, patch, poke or straighten, the more you get paid. In those times, investing was like having your teeth pulled and paying for the pleasure, a bit like being on the other side of the drill. It was not material which investment strategy you were in whether it was equity long short, merger arbitrage, relative value, event driven, credit, fixed income or macro. The pain was less in macro and risk arb, although so widespread was the pain and so punchdrunk were investors by the end of 2008 that many did not even realize that risk arb actually turned in a relatively strong performance, losing some money but mostly protecting capital for the year. Global macro made money, but even macro as a group saw investors making net withdrawals from the strategy. Investors wanted out. They just wanted to sell sell sell. Put or Call? Doesn’t matter. Sell sell sell. The redemption terms of hedge funds made it possible to forecast the degree of outflows since there is usually a long notice period of anywhere from 15 days to 180 days, although its more usually clustered around 30 to 45 days. Also, in the industry, people talk. And misery likes company. The anticipated and realized redemptions for September 2008 was high, but December saw a crescendo. Sentiment was terrible. And then some managers started suspending redemptions and applying gatesand side pocketing illiquid investments. For the most part, if you were in ‘traditional’ hedge fund strategies such as equity long short, merger arbitrage, statistical arbitrage, relative value, convertibles, global macro and CTA’s, you would have lost money but you would have got your money back. If you were in the less liquid end of credit, levered loans, LCDS, private convertibles, PIPEs, quasi private equity (PE without control, lovely), asset based lending, chances are your manager would not be able to get you your money back even if they wanted to. And to be fair some of them wanted to.

Human beings are predisposed to extrapolation. Estimates for the March 2009 redemption volumes ran to the fanciful. In the end, over a 6 to 9 month period ending March 2009, a 2 trillion USD industry had been halved. Hedge fund managers who once were Masters of the Universe were humbled. Funds that were closed to new investment were open again and their managers had to suffer the ignominy of presenting at capital introduction events.

We have seen evidence of interest in distressed credit, global macro, equity long short and convertible arbitrage.

Distressed credit is a strategy which according to investor survey’s conducted earlier in the year continue to see a lot of investor interest. In fact, distressed credit was a strategy offered in volume in late 2007 and which in 2008 burned a lot of investors. One factor in the disappointment was the lack of corporate defaults in 2008. Distressed investing worked only if you were ultra selective and if you went where the defaults were underway and not where they were waiting to occur. The place to be was arguably in the ABS market where RMBS and their CDO’s were already defaulting . In corporate credit, default rates are only now accelerating. The market expects default rates in double digits by the end of the year, arguing that investors were too early in 2008 but are likely to be right this time.

Global Macro in 2009. Think againwhere I argue that the easy trades are done, that the opportunities are still there, but the way one captures them, and the subspecies of manager required for the job, are different. But who am I to argue with the legions of investors who want to invest in Global Macro?

Equity long short is a perennial strategy. In the turmoil of the last 12 months, the strategy has had mixed success. The traders have done well as equity markets abandoned fundamentals and traded almost purely on psychology. There are signs that idiosyncratic risk is beginning to rise and that the day for the stockpicker is not far away. Of course the holy grail is finding the investment manager who both understands fundamentals and has the ability to trade, who has a full arsenal and can deploy the right weapon for the right battle for the winning of the war. As investors restore their risk, equity long short is one of the strategies that ranks high.

, the hedge fund survey’s find that there is a significant preference for lower fees, particular on funds of hedge funds, but also on the underlying funds themselves. My own anecdotal experience is that investors do not so much object to the level of fees but rather feel that fees could be better designed to be fairer and more efficient at aligning the interests of the manager with those of the investor. There is an argument that talent is relatively scarce, and that the current environment highlights this and therefore that fees should be more differentiated. I am fortunate to sit in the middle of a private equity, real estate and hedge fund practice and have the benefit of assimilating best practice from all three areas. PE style fees which pay on realization and are subject to clawbacks are attractive but should be used carefully lest they introduce unexpected and adverse behavior by the manager. Let the fee design fit the fund structure, fit the strategy. What we are seeing among investors is a definite improvement in the level of sophistication and understanding with regard to fee design.

In the area of liquidity, the recent hedge fund investor surveys point unequivocally to a preference for liquidity. Long lock ups, side pockets and gates are definitely not preferred. Fund of funds in particular, are having to restructure their portfolios for greater liquidity to meet the terms they offer their investors. Institutional investors are also leaning heavily in the direction of strategies with better liquidity as they face balance sheet issues. It is left therefore to the private investors, the family offices, who have more flexible investment processes and mandates to take advantage of the value of liquidity. Longer gestation strategies are seeing considerable value, almost certainly because of the dearth of capital exploiting these very opportunities. Fortunately, it is heartening to see, among some investor groups, the appetite for longer duration investments. Arbitrage is a terrible thing to waste.

While investors remain cautious, there are clear signs that they are no longer in selling mode but are more in watching and waiting to invest mode. As always, this generalization hides a multitude of situations. The willingness to assume risk is a good thing. A cautious attitude to assuming risk can only be a good thing.

Stronger than expected payroll numbers. US markets rallied in the morning and fizzled at the close. A few weeks ago, this sort of better than expected economic indicator would have fueled a rally of at least 2% for the SPY and the Dow. What happened on Friday smells like distribution to me.  The reality is that things aren’t really getting better, they’re just getting worse more slowly.

I agree with Krugman, there is no V-shape recovery (http://www.bloomberg.com/apps/news?pid=20601068&sid=aATifebEMcHE&refer=economy). I think there is behavioural science angle to why the markets staged the recent sharp rally. 2008 was a shock. Very few people saw what was coming. In the abyss in Sep/Oct, many thought the whole US financial system was going to collapse. The rate of bad news grew exponentially, and many thought Armageddon was around the corner. Now the rate of bad news has slowed (which is viewed as good news in itself) and people have mistaken this for a recovery. Panic has been replaced by mere anxiety. This change in mental state makes people feel better. It’s akin to losing 90% on investment but then making a 100% back. You feel better, but you’re still losing a bundle. The fact of the matter is things are still bad. What would economists have thought if they were told the US unemployment rate would be 9.4% in 2009 back in 2007?

In the Asian markets last week, we saw the rally tiring.  Markets rising earlier during the week, then falling and flatlining towards the close . More liquid markets like the HSI, running into serious resistance at the 19,000 level. The proverbial battle between the bulls and the bears continues. My guess is that the markets will probably sideways trade from here, with dumb money trying to buy on dips and smart money giving them stock at these levels, stopping the advance. It is true that certain markets are in bubble mode again, e.g. Hong Kong real estate, with lines of people queue in the rain for such crap projects such as “Lake Silver” in the New Territories. Hong Kong developers are taking advantage of this frenzy by putting up prices. The Lex column in the F.T. last week gives a good account:

It’s like the crunch never happened. Sino Land, the fifth-biggest Hong Kong property developer, plans to raise pricesat a sparkling new complex in the New Territories by up to 5 per cent. In five days of selling Sino has offloaded about three-quarters of the apartments on offer; the previous weekend an estimated 30,000 people had queued in atrocious weather to view them.

This is a bona fide mini-bubble. The six big listed property developers have seen their aggregate market capitalisation more than double since October last year. Sell signals are blinking red: the trailing price/earnings gap between the property sector and the benchmark, which has averaged 200 basis points over the past five years, is now a mere 40. Residential property prices, meanwhile, have climbed back up to December 2007 levels; the recent peak, in March 2008, is a mere 15 per cent away. Hong Kong’s banks, awash in liquidity, seem happy to respond to demand. According to the HKMA, total outstanding residential mortgage loans were up 1.3 per cent, year on year, in April, while overall lending shrank by 0.5 per cent.

Over the long term, however, property prices have never decoupled for long from economic fundamentals. Prices and median household income are pointing in opposite directions. Unemployment may reach 7 per cent this year, from 5.2 per cent currently. GDP was down 4.3 per cent in the first quarter from the fourth – the sharpest decline in history.

It is odd that Hong Kongers should be so in love with breezeblocks and mortar. Rental yields, falling since mid-2008, are near a two-decade low. Even with the recent lift, nominal prices per square foot are no better than where they were in January 1994 and more than 30 per cent adrift of the twin peaks they hit in 1997. A new generation of buyers should gird themselves for disappointment.

What to lookout for next?  For the moment I think the markets will trade sideways. There will be a trigger point when the markets will either continue their upward advance or reverse course. As one commentator put it a lot will depend if we face a severe inflationary/deflationary scenario.

Actually the scenario on equities depend whether your view in the near term calls for inflation or deflation. If you know which one wins then you should be able to properly assess your equity and bond exposure.

In short, the S&P 500 should be below 666 by September and probably much lower by 2010 if the deflation scenario materializes so let’s hope that the market is right and that we have stagflation.

The recent rally has been fuelled by a massive injection in liquidity by the central banks around the world and investors are expecting higher as a resul
t of the inflated FED balance sheet.

However, where I think the market is wrong and this is why I have remained so bearish lately (not because I want it but) is the velocity of that money supply is nil. Banks are simply not lending money. Therefore, the mass of money is staying in the FED and banks balance sheets but is not flowing into the real economy.

The consequences are: the deflation will remain the biggest threat and deleveraging will continue for consumers and corporates. Once the market has realized that (and I may be a bit early in my call but who knows how to time these things) then they will fly back to safety which means buying US 10 years treasuries and selling equities. My gut feeling (for that is worth) is calling for the market to double bottom by September.

If you want a similar period of reference you have to look at the depression of the 30s or the big recession of the 1870s. You can’t compare the current recession to the 90-91 or the 70s because they were different animals.

The month of June is replete with hedge fund conferences. Conferences earlier this year were either poorly attended, or else investors attended them for the free breakfast or lunch, a chance to commiserate with fellow sufferers of the global financial crisis/hedge fund witch hunt. What a difference a couple of months of rising markets make. A palpable optimism is creeping back into the industry.

I recently attended the Goldman Sachs European Hedge Fund conference held in London a couple of days ago. Over 50 hedge fund managers attended to present their funds and a rough count of what must have been over 300 investor groups showed up, if not to allocate soon then at the very least to window shop. 

The quality of managers was in general very high. Perhaps the weaker managers had been washed out or were facing legacy issues and thus not investable, there was clearly a Darwinian dynamic at work. The organizers would have been very selective as well so as not to waste investors’ time. Or maybe it was just that Goldman Sachs simply had a bigger client base and could move further into the right tail of quality. Or, dare I say it, Goldman’s clients were of a better quality. I don’t know, all I know is what I saw. 5o over managers, all to a greater degree, of investable quality if one was so inclined to their strategies. 

Many established managers previously closed to new investment, or usually reluctant to be presenting at capital introduction events were present. Only recently, Israel Englander’s much vaunted Millennium was out looking for new capital at a number of conferences around the globe. These managers have experienced outflows of capital, redemptions which may be uncorrelated to the quality of their performance in 2008, and find that they have capacity to replace this exiting capital, as well as are faced with rich opportunity sets upon which to capitalize and thus have improved capacity. 

Panel upon panel of strategy specific discussions were held and all well attended. Investors were clearly looking for new ideas, a sign of recovering risk appetite and the need to put capital to work. In every discussion, the macro landscape was an issue of great importance. At each panel, regardless of the uncorrelated or non-directional nature of the strategy from event driven to market neutral strategies, moderators and panel members were clearly focusing on the macro landscape, on regulation, on government intervention, and how these would impact the functioning of markets in which they invested. One thing was clear, there was no consensus as to the health of the global economy. Goldman Sach’s Head of Global Economic Research Jim O’Neill was of the opinion that the worst was over and that a V shaped recovery was underway. His team forecasts better than expected growth from economies like the BRICs driving global growth. Hedge fund manager’s, however, were almost evenly split 50:50 between bulls and bears, with the bears with the slight edge in extra time. Student’s of Murphy’s Law and other dynamic system theories will tell you that this is a healthy balance and likely to prolong current trends whether rising or falling and that reversals occur when the balance is jeopardized one way or the other. 

What was really interesting for this observer, was that despite the lack of consensus over economic growth and market direction, each manager saw immense investment opportunities in their own particular strategies and markets. This would appear to be an inconsistency at best and more cynically, disingenuity at worst. Not so, in my view.

Of all the strategies represented at the conference, there was consensus among the respective manager groups, that the opportunities for profit generation were great. Equity long short, Distressed Debt, Merger Arbitrage, Volatility, Multi Strats. They all saw ways that they could make money, yet none of them could agree on whether the economy had stabilized, whether growth would resume or falter, whether inflation would rise or sink into deflation, whether markets would rise or fall. There is a larger lesson for students of economics, but that is not our aim here. 

One can argue that macro leads micro, I’m not quite sure how yet, but in the narrower context of this discussion, micro leads macro. What these managers are individually telling us is that there are micro strategies that can be profitable. A macro analysis of the strategies that these managers employ will simply not be granular enough to capture the opportunities they talk about. And yet, when sufficient numbers of them make money, when sufficient capital is put to work in these opportunities, when sufficient time has elapsed, the macro structure of the trades becomes evident. This is the natural evolution of strategy. 

 Fees and Terms:

The industry has been debating if there has been any fee compression in the wake of the financial crisis of 2008, and hedge funds’ apparently failure to perform as advertised. I have defended the performance of hedge funds through the initial stages of the crisis, but that is the subject of another discussion. At the Goldman conference, there was definitely a growing number of managers charging less than the usual 2 and 20. 1.5 and 15, and even 1 and 10, fees were seen. Encouragingly, I met a handful of managers who were going beyond reducing headline numbers and either considering or in the process of establishing a holdback provision with a vesting period, on performance fees, whereby a portion (say 50%) of a year’s performance fees are held in escrow and a negative performance fee was applicable to the amount held back. 

Liquidity terms were also a lot more logical. Illiquid strategies did not shy away from lock ups, while well performing or big name hedge funds with liquid portfolios and strategies, passed on that liquidity to investors. Some managers went as far as to formally exclude so-called gates, restrict suspension of NAV rights to specific circumstances, and specify side pocket provisions more explicitly. It appears that the events of 2008 have precipitated a much welcome self regulatory campaign. 

Strategies:

Equity long short managers were in abundance, naturally, given their market share of the hedge fund industry. The diversity of styles withi
n what many consider a relatively simple strategy makes it a very interesting area to analyse and invest. There are managers who are driven by the philosophy that fundamentals, that is earnings, cash flow generation, financial strength, matter most in determining valuations. There are those who are traders, for which fundamentals are secondary, and what matters most is how a stock’s price has behaved and is behaving, and who owns what. Still others, have a macro or thematic approach, and apply these to equity investing. The trading style managers were bullish, arguing that increased volatility and dispersion in equity returns represented opportunity for profit. It also represents opportunity for loss as well of course. Alpha can be negative. Some of them were bullish on the market, some were bearish on the market, but there was general enthusiasm for the opportunity to trade. Fundamentally driven stock pickers were similarly upbeat about their strategy, arguing that the last 6 months have seen a wholesale disposal of risk followed by, in the last 6 weeks, a reversal of this risk aversion, and that such large systemic moves create mispricings in individual companies which they seek to exploit. As always there were some very clever approaches to equity long short. There was a manager who had a very strong macro view, and invested a lot of time in macro research, then researched company fundamentals in an attempt to understand the impact of macro developments on company fundamentals. There was another manager which analysed only audited financials and ignored all street and interim data, and then built sophisticated models to obtain their own more granular interim numbers. All these various managers had credible reasons why their approaches would work. In 2005, I would not have believed them; today I am a lot less skeptical. 

Convertible Arbitrage managers were conspicuously absent from the conferences. The best performing strategy in 2009, albeit the worst performing strategy in 2008, convertible arbitrageurs were too busy making money from the market to attend a capital introductions event. Moreover, who would listen, they would argue, most investors having being burnt in 2005 and then again in 2008? There are good reasons why the strategy is working and is likely to work further, but the managers were too busy working it than selling it. Good for them. 

Distressed Debt has been a preferred strategy since late 2007. That, however, was an expensive false start. By the end of 2008, with insufficient defaults and a catastrophic dislocation in credit markets ranging from LIBOR to swaps, from ABS to corporates, from cash to synthetics, distressed debt managers had suffered considerable losses. Rational, no memory investing would have suggested getting back into distressed investing in 2009 and to their credit, investors have been bullish on distressed investing once again. A number of surveys taken in 1Q 2009 ranked distressed investing as one of the top 3 hedge fund strategies among investors for 2009.

One of the least favored strategies, if investor survey’s are to be believed, is merger arbitrage. It may surprise one to learn that on a rolling 12 month basis, merger arbitrage has been one of the best performing hedge fund strategies, behind global macro and CTAs. Merger arbitrage, or risk arb, was well represented at the Goldman conference and it was clear that risk arbitrageurs were very much excited about the opportunities before them.

Since July 2008, M&A transactions numbered over 5000 representing over 1 trillion USD in value, and deal flow continues on the back of cashed up corporate buyers seeking strategic assets, distressed sales from corporate restructurings, distressed sellers and government interventions. Company’s are happier to do deals in rising stock markets and easing financing conditions. Also, BRICs and other EM markets outbound transactions have been strong and remain an area of considerable potential growth. 

Deal spreads have been volatile. The dislocation of markets in 2008 represent a stepwise repricing of an over arbitraged space. Deal spreads of circa 10-11% blew out to 50 – 60% before settling at current levels of 15 – 20% IRR.

The financial crisis of 2008 has also reduced the number of participants leading to a much less crowded space. Bank prop desks have exited or significantly reduced their books and hedge fund capital dedicated to risk arb has shrunk more than proportionately to the industry. Many risk arb funds drifted into a much too early play in distressed credit as quite often the resources if not the skill sets are the same. M&A very often wanders into litigation and distressed investing is very much about litigation. While a pure risk arb strategy would have done relatively well in the last 12 months, provided one avoided the obvious mega LBOs, the contamination from a catastrophic credit strategy has hurt many multi strategy funds with large risk arb books resulting in poor performance and redemptions. The reduced capital employed in risk arb not only results in wider deal spreads but allows more time for analysis and deal selection leading to more selective participation.

A renaissance for hedge funds:

Since hedge fund indices have been compiled, that is 1990, until the present, with the exception of 1998 and 2008, hedge funds have steadily generated positive absolute returns. These returns have seen varying correlations to the returns of other traditional asset classes such as equities and bonds, as well as varying information ratios over time. From 2005 to 2007 hedge funds’ returns exhibited increasing correlation to traditional asset classes, decreasing returns to invested capital, increasing inter strategy correlations and increasing leverage. These features are interrelated and are directly related to the amount of capital dedicated to hedge fund strategies.

With more capital deployed in arbitrage and relative value strategies, continuous risk was more evenly distributed, volatility was dampened, volatility of volatility and correlations was also dampened, credit spreads converged, other arbitrage and relative value spreads also converged. The only way to maintain return on equity was to increase the level of leverage, a practice eminently feasible in an environment of cheap credit. Return on capital at risk, however, compressed to unsustainably low levels.

Such periods of calm accumulate imbalances for discontinuities. It would seem that a protracted reduction in continuous risk results in an accumulation of gap risk. In 2008, that gap risk was crystallized resulting in a discontinuous reduction in systemic leverage and thus capital employed  in arbitrage and a concomitant system wide widening of arbitrage and relative value spreads.

This is one of the more plausible explanations for why, in an economy clearly in decline, with recovery highly uncertain and non-robust, with differing opinions and outlook for financial markets, arbitrageurs are optimistic about their profit generation potential across almost all, if not all, hedge fund strategies. 

Arbitrageurs will be required once again to police arbitrage and relative value spreads to bring convergence to no-arbitrage pricing, to bring relative value valuations in line and to aid in the efficient allocation of capital. In a sense, and to a certain extent, the real economy is reliant on the arbitrageur in the healing
process, and therefore, one factor for the rate of recovery, or repair, of the real economy, will be the rate at which capital is redeployed to take advantage of mispricings and other arbitrage opportunities.