Alternatives: Opportunities Abound if You Know Where to Look

There is nothing like a year or two of poor performance for investors to pronounce that an asset class is dead. I look forward to seeing the headlines such as: “Fears about the viability of [insert the alternative asset of your choice] after a challenging 2008”, all of which will be almost completely wrong.

Although 2008 was undoubtedly the most difficult year in many for hedge funds and private equity (the two alternative asset classes we will cover here) there should be many opportunities for investors going forward. We doubt that the events of 2008 will invalidate the case for these asset classes, and continue to expect strong inflows and investor interest in these asset classes in 2009 and beyond.

The lack of correlation with traditional asset classes over the investment cycle, the ability to access unusual sources of return, and the access to superior investment talent, all mean that these asset classes will continue to be a key component of individual and institutional portfolios. Hedge funds and private equity belong in most investor portfolios. 

Hedge Funds

It looks as if final performance for hedge funds will show that they are down in the high single digit percentage points in 2008, with most subcategories of hedge funds suffering in comparison with previous years.

Notable exceptions are those funds that trade global markets in currencies and commodities and some credit-focused funds that have found opportunities in the dislocation of credit markets. For this young industry (good data on hedge fund returns only exist from 1990) this would be the second worst year on record after 1994. There are, however, some good reasons (or perhaps excuses?): we have experienced a very difficult market environment for hedge funds, with significant swings, dramatic trend reversals in all markets, and interventions from central banks and governments. It has been difficult to manage risk in these markets given the active trading style of many hedge funds, and returns have been very difficult to extract.

Hedge funds navigated some of these trends pretty gracefully in 2007, but 2008 proved to be a different story. The poor performance has meant that many hedge funds, as dynamic allocators of risk, have now reduced risk and leverage. However, given their dynamic nature, it is likely that the risk dial will be turned up again when opportunities reappear.

Historically hedge funds have been very good at finding opportunities after major market dislocations. Also, given that this is a Darwinian industry, some of the weaker players will vanish, and those that survive will build on the experience and strength gained from these difficult times to deliver better risk-adjusted returns in the future. And finally, given the dramatic decline in risk appetite among banks and major financial institutions, the most talented traders are likely to migrate towards the hedge fund industry.  

If 2008 marked a year in which to deploy protective and defensive approaches in allocations to hedge fund strategies (as we did in our own Barclays Wealth managed portfolio, Primus), 2009 might be a year to be more aggressive and opportunistic. In 2008 hedge fund strategies focused on credit, and distressed credit in particular continues to be volatile as funds further reduce their exposure.

The lack of willing holders of distressed and illiquid securities caused significant declines in value, in a way that was probably out of all proportion to their long-term value: one widely followed distressed security index was down about 13 per cent in late 2008. In 2009 there will probably be many opportunities for those hedge funds that have access to secure term liquidity facilities. As the rate of defaults increases, the supply of distressed debt will probably increase, and for those hedge funds skilled at navigating this area 2009 should provide fertile pickings. Caution is the watchword as ever – given the scale of the dislocation, complex capital structures, and the entry of somewhat less skilled hedge fund players in this market. Careful manager selection is key. Having said that, we are likely to start significantly increasing our allocations to managers active in distressed and credit-focused areas in 2009.  

In the equity long/short space, the largest single strategy subgroup within the hedge fund business, 2008 has been particularly difficult. Things are unlikely to improve significantly until later in 2009. Highly directional managers in particular are nursing significant wounds. Managers who have held up well have been nimble, actively managing their portfolio gross and net exposure and giving healthy respect to the macro environment rather than following fundamentals alone.

Fundamental stock pickers will continue to find it difficult as macro concerns dominate company fundamentals. That being said, following the significant sell-off across the globe during 2008, there is value to be discovered by managers who have the skill to identify sectors expected to see improving fundamentals, and benefit from the new economic backdrop. By this I mean permanently higher commodity markets, growing emerging markets, and so forth. A very high degree of macroeconomic uncertainty will continue to see high volatility levels. This will favour managers with a high frequency trading style, who are quick to take profits when trading around corporate news flow, who have short to medium-term investment horizon, and strong risk management (active management of exposure). Managers who stick to liquid stocks while avoiding ‘value traps’ are likely to do best. 

In terms of regions, emerging markets, particularly in the Gulf, are expected to offer interesting investment opportunities, based on attractive valuations, continued economic growth and positive country fundamentals. That being said, weakening growth outlooks in some emerging countries and inflation pressures in the region will need to be closely monitored. A focus on more liquid emerging markets is crucial as they remain vulnerable to global risk sentiment. Highly directional beta players will no longer do well here, and identifying strong alpha managers is crucial. 

One final, intriguing thought: might 2009 be the year to increase exposure to managers involved in Japan?

Private Equity

Credit, the essential lubricant for the private equity business, was in very short supply in 2008 so it is not surprising that it was a more challenging time. Faced with declining cash returns, investors were becoming more and more cautious, and quick market exits were no longer supported by favourable market evaluations. Private equity should now be returning to fundamentals.

The next few years will be less about financial engineering and more about finding true growth opportunities, making significant strategic choices, and delivering improvements in management efficiency shielded from the glare of the public markets. So there will be a decided change in emphasis away from investments in managers who rely on excessive leverage, or who need access to the credit markets in order to deliver returns. 

The other elusive ingredient in the last year or two has been growth. Identifying growth opportunities will be key to finding significant opportunities in private equity in 2009. This will not be easy: we need to identify growth opportunities in a world where mergers and acquisitions transactions in developed markets have slowed to a trickle and where some of the emerging markets are likely to suffer from the aftermath of the over-valuation resulting from commodity and asset price bubbles. There are some unexplored but promising areas still remaining – these are risky in the short term, but hold promise in the long term.  

In terms of location, we are focusing our attention on Africa and Latin America as regions that may benefit from long-term improvements in growth prospects and economic management, and a generally higher level of commodity prices.

India and China are big secular growth stories, but one has to be more discriminating given how well known the China/India investment story is and how volatile the current markets are. We will be looking for funds in the emerging markets for investments likely to overcome obvious inefficiencies in the credit markets, the education sector and possibly infrastructure.

In terms of sectors, we are looking at distressed debt and financials. The financial sector might be particularly interesting: dislocations in the provision of credit and liquidity will mean that those funds that can identify value in restructuring liquidity-constrained financial institutions can do very well, and we are looking at various investments in this area for 2009. We also think that venture capital and technology might flourish at this point in the economic cycle – historically these points in the cycle have been interesting points at which to increase exposure to these sectors.  

The lack of liquidity and market risk appetite has also meant that secondary investments and markets in the older vintages may look more attractive than the recently invested funds. In addition, the debt component of private equity deals, particularly the provision of mezzanine finance, is now being conducted at much more attractive levels.  

Given these many cross-currents, we have recently appointed an external manager to create an opportunistic and diversified private equity programme for our clients: being diversified and opportunistic will be the keys to success in 2009.   

Ravi Bulchandani
Ravi Bulchandani is the Head of Alternative Investments at Barclays Wealth and is responsible for developing strategy, funds research, product development and structuring capabilities for investments in hedge funds, private equity, real estate and commodities. Prior to joining Barclays Wealth, Ravi was Managing Director, Head of Alternative Investments for Morgan Stanley’s European and Middle Eastern private client business. Ravi’s financial market career began at Goldman Sachs in New York in 1987, where as part of the top ranked international economic research team, he provided research support for the sales and trading businesses in currencies, international fixed income and commodities. At Morgan Stanley, where he spent 13 years, he had a variety of different positions within equity and economic research, fixed income and investment banking (M&A). His most recent responsibilities at Morgan Stanley included the origination and distribution of a wide range of alternative products, and the oversight of alternative asset management. He was also a member of the asset allocation committee that established guidelines for the asset allocation of private client portfolios. Ravi was educated in Economics at Queens’ College, Cambridge (First Class Honours), and has graduate degrees in international economics and finance from the London School of Economics and Stanford University.