Rachel Farrell, MD, Citigroup, Alternative Investments, Singapore
David Choy, director, ING Singapore
Michael Palin, SVP, EFG Bank, Hong Kong
Kenneth Sit, CEO Asia, Sarasin, Singapore
Tuck Meng Yee, head of product development, ABN AMRO, Singapore
What were the highlights of 2006, and what do they indicate about prospects for this year?
Rachel Farrell: For us, it was really the year of the illiquids. It was a tremendous year for private equity and real estate securities, which continued to perform well in 2006. High net worth investors began to get more excited about private equity as an asset class in 2006.
In the hedge fund arena, we expected event-driven strategies to do very well. We also expected catalyst-driven strategies û corporate restructuring and M&A, especially in Asia û to do very well. On the back of strong equity markets, long-short equity did well. We were disappointed by global macro. It seemed like a year of change, with dislocations in the market that managers should have taken advantage of, and some did. But as a whole it was a bit disappointing. We expected credit to provide more opportunities but nothing much happened.
How did your customersÆ requirements evolve?
Farrell: They became more interested in private equity and they also became more interested in investing in Asia, with Asia being seen as the driver of opportunities. Investors who have a global portfolio are seeking more investments in Asia.
Kenneth Sit: A lot of the alternative investment in Asia has been driven by China, India and other economies such as Vietnam. Sectors such as long-short, private equity and hedge funds have been popular. Many of the investors are from Europe and the US as well as from the region, and can be seen as latecomers. So we want them to be careful and we ask them to look at their investments within the framework of their overall asset allocation. What proportion of their total assets do they want to invest? The risk-matrix of these investments will be very different from what they will be doing in Europe, for example. Sectorally, we saw property and China equities outperforming last year. Commodities was less of a theme in 2006 than in 2005. Interesting alternative investments that have appeared for the first time include wine funds. The returns were quite different to traditional investments.
Would you also characterise them like Rachel as æil-liquidsÆ?
Michael Palin: Liquidity is improving, but we all know that selling out in private equity is not easy.
Tuck Meng Yee: It was really a year where investors saw superb returns in listed investments. So, it's no surprise that investors would ask themselves why they should invest elsewhere when listed securities have done so well. If you look at the traditional æfund of hedge fundsÆ, earning in the low double digits is not that exciting compared to equities in India, China and Vietnam. So for us itÆs been a matter of going back to basics and providing a mix of liquid listed investments and high return alternative investments. We have given them liquid alternatives in an illiquid space. That sounds illogical, but you can suggest clients take a look at listed private equity funds. The hedge fund Fortress was listed recently at some huge multiple, a price/earnings ratio of 40 times. Compare that to Goldman Sachs which trades at 11 times. This shows to me that while investors want stable returns, they are also willing to pay up for performance.
The experience last year was that markets were very good but that they can also be volatile in the alternative space. The challenge next year will actually be how to manage expectations.
Vietnam has been prominent from an investment perspective. There is a huge backlog of liquidity in Vietnam waiting to take a position in the Vietnamese Dong, as well as take pre-IPO positions in government companies. There is so little liquidity in the listed market that the pre-listed stocks are currently the main target, ie, for funds to be realistically invested, planned IPOs need to go ahead to soak up the liquidity.
In terms of the traditional hedge fund space, global macro and currency traders were pretty much trading in at the wrong times. Equity long-short has still performed respectably. But I think they were also caught out in terms of trends reversing û I mean, with Ben Bernanke making his tightening comments and then reversing himself, leading to that rally in September. At that point most equity longshort managers were short, and under-performed. Fixed income arbitrage has been a little bit disappointing. People have been looking for the yield curves to steepen, but they havenÆt. Event-driven investing, from a global M&A and liquidity perspective, has been fantastic, and I believe that will continue.
Sit: Why has global macro under-performed? ItÆs because the globalisation of information and huge liquidity has slowed down volatility. In the 1990s, a hedge fund could be big enough to move the markets. With the extra liquidity we are seeing, thatÆs less likely now. Currencies were also very stable in 2006, indeed it was the worst year for currencies in ten years. Look at the euro against the dollar: it was going nowhere. Bonds were very dull as well, with yields moving within very narrow ranges. In that environment, information arbitrage becomes far more attractive, so people access things like the Chinese stock market, which is far more proprietary. Look at those companies out of China last year: coming from nowhere and delivering spectacular out-performance and beating the Hang Seng Index by a long way. There was a clear switch of liquidity into the Chinese stocks. I think we are seeing a move away from blue chips into high-risk high-return plays now. People have made money and are looking for new lucrative investment opportunities. A blue chip offering 15% is now no longer enough.
David Choy: What we actually noticed last year was that clients were very disappointed in hedge fund returns û and not just in 2006, but going back to 2004. I think hedge funds have always been labelled as Alpha generators but they havenÆt really delivered. Hedge funds have traditionally prospered when trading in an illiquid environment, but liquidity has been massive. High-yield bonds have actually become investment-grade bonds, so investors have been desperate for returns, especially with the need to re-invest profits. ThatÆs what created demand for private equity last year, which on average returned something like 22% - better than hedge funds or global macro. Some markets are actually shrinking such as CB arbitrage. There has been a big style drift with people looking for opportunities to make money. I agree that at the moment people are very positive about event-driven investments.
Looking back in 2006, the market has rallied so well that clients are more willing to lock up their money for longer, since they are more confident. So I think the demand for private equity will continue.
Palin: My view on global macro is that itÆs not just looking at global events and oneÆs investment is usually completely at the discretion of the manager. Thus performance is very difficult to sustain and I only trust three per cent of our portfolios to macro managers. They are very directional and I shy away from that.
When people say 2006 was a difficult year, IÆm surprised: every year is a difficult year. Not just for hedge funds. I have heard that 20% of private equity firms are losing 20% per year!
I would maintain that there is an awful lot of risk in private equity, given that itÆs mostly about hard-tovalue companies with a long time horizon. I think itÆs been a graveyard for a lot of aspirations.
We had a great year: our modal average client was about 18%-20% up, concentrating quite heavily on emerging markets. We over-weighted CB arbitrage and one of our funds was up 25%. Our strategy is to take lower-risk investments and leverage them at the portfolio level.
I have many Americans coming into my office asking me to put them into Chinese private equity. I tell them I can get them 20% in hedge funds and decent liquidity. As a bonus they will be able to sleep at night! Why on earth you would want to wait for five years and send your finance director every month to check on things and so on. IÆm not a great fan of private equity in Asia.
So for you hedge funds still ruleà
Palin: My advice to clients is to buy, firstly, property û of course, itÆs cyclical, so you have to buy at the right time; itÆs probably the only tangible thing you will ever buy; and after that, hedge funds. So I do treat hedge funds as an asset class, but of course they are not û they are merely a means of treating conventional asset classes in a hedged manner. They encompass everything, so you are providing diversification. Whether you are a wealth generator or a wealth protector you donÆt want to be exposed to horrible shocks. And thatÆs why hedge fund are so important.
Farrell: We talk to clients and their appetite for private equity in Asia is not short term. They are operating their own businesses and they are looking at where economic growth is going to be created based on their sector experience, so private equity investment will give them a greater leveraged play on that view. ItÆs very different from what they look for in hedge funds.
Palin: Yes, itÆs different. Private equity is a rich manÆs game, given the high failure rate. The rule of thumb is that just one out of 10 private equity investments will succeed, one will muddle along, and 8 will fail. Your average high net-worth individual canÆt really afford that failure rate.
Looking at the clients, how can they get into private equity?
Sit: The entry level is probably around $250,000. For someone who is worth around $10 million, thatÆs a very reasonable exposure. We have seen lots of US realty investors cashing out very successfully there, looking to buy much, much cheaper property in Asia, for example in Macau. So I disagree with Michael private equity is getting much more affordable.
Farrell: Yes, with a $10 million portfolio, you can put 10% of your assets in private equity, and split that out as four, $250,000 investments in different funds. Private banks are providing vehicles to their clients.
Palin: ItÆs too early to say if these things are going to work or not.
Farrell: I canÆt agree. If you look at private equity in the developed markets, although you have to choose your managers carefully, private equity has performed very well. It has provided a premium over public equities. Are we going to see the same in Asia? ItÆs much earlier. LBOs are much scarcer. But clients are looking at this area in terms of the future, saying thereÆs no reason why that success in the West canÆt be repeated in Asia.
Palin: Of course, the majority of private equity firms and hedge funds are not successful. I came to Hong Kong 33 years ago, and I know many of the family offices of the major European families have been out here for a long time looking at private equity, and I assure you not many have made any money.
Yee:IÆm assuming you are directing your clients to global funds because Asian hedge funds have many of the same problems as those you described for Asian private equity funds.
Palin: Yes, because one of the problems with Asian stock markets is you canÆt short in many of them. Secondly, debt markets which I prefer to play in, are too shallow.
Yee: I just mean to point out that the more correct comparison is Asian hedge funds in Asian assets versus Asian private equity in Asian assets. Both are embryonic. The first class of hedge fund managers has graduated but we are still short of data and we have the market issues you mentioned. Basically, any leveraged beta fund, which represents the majority of hedge funds in Asia, would have made money last year. I think if you want to make a comparison between hedge funds and private equity you need to make a global comparison.
Palin: I certainly agree that private equity worldwide has done very well. I am merely addressing my remarks to Asia.
The lack of liquidity does seem a big handicap for private equity, given the ambiguous economic data coming out of the US. Do you think this could be disastrous?
Palin: Yes, if we go into a major recession. Basically, people here like quick returns û which makes private equity less popular.
Sit: It comes back to the basics in terms of asset allocation: risk versus reward. But there is a demand for innovative products from clients, ever since the 2000s. There is growing demand for alternative investments, private equity funds being launched by the big houses, and so on. If you want to survive you have to open up your spectrum of products.
Palin: yes, thatÆs typical of the æme-tooÆ philosophy that prevails in Asia. Whether they get the right advice is another matter.
Farrell: We are also seeing lots of demand for Asian private equity products from our Asian clients.
Choy: It very much depends on the client segment. Our firm has clients whose background is running long term businesses. They donÆt mind looking for the long term if there is a story in that market. Everybody is aware of Vietnam. If you look at the OTC market itÆs actually greater than the cash market in terms of market cap. This is very unusual, which is why private equity funds can exploit these market inefficiencies. The big fund management houses have been in Vietnam for 20 years and all have Vietnamese partners and have lots of private equity opportunities. So there is a track record even if itÆs unpublished.
Palin: In large parts of Asia you find many successful entrepreneurs who have run tremendous risks building up their own businesses. In our experience, these people are not interested in other people taking those risks for them, as is the case with private equity: they are happy to take the risk directly with their own businesses. Why would you give your money to somebody else?
Are we seeing a bubble in private equity? Is the heyday of private equity already over, like the heyday of the hedge fund is over, because of so much liquidity pushing up asset prices?
Palin: On the contrary, I basically would say everything is becoming a hedge fund. Lots of long-only funds are becoming absolute return funds or are using a shorting strategy. DonÆt forget that the more people enter an industry, the average return does drop. But the top people will continue to make money.
What about the private equity bubble issue?
Sit: You go into private equity based on the quality of the manager and the timing (less important as you move along the learning curve). But you should stick with somebody you trust and who can take the work off your hands. Investors are also often keen to look at managers taking the major position.
What is the fee/return equation these days in private equity?
Palin:You can expect 20% on an IRR basis every year. If itÆs any less, there is no point in going into it.
Is that credible?
Yee: Yes, with the provision that the managers are decent. ThatÆs because in all areas you face the issue of a compression of returns over time. Private equity is still very much a Western phenomenon. US and Europe are equal, and Asia is probably less than 10% of that. What might derail the process at some point is liquidity drying up and the inability of the funds to exit their investments. If that happens, rates will go up, markets will fall, and that will impact the listed markets that hedge funds trade in. But assuming the current goldilocks economy continues û and I think that was the most abused word last year û I guess things will continue positively.
Farrell: It depends on the offering. A fund of funds comes with an additional layer of fees, because a manager is carefully picking and choosing the underlying managers to build a portfolio. We also make available single-manager private equity funds to our clients. In general, private equity managers are charging anywhere between 1.5% and 2% management fees annually, plus a 20% carry. The carry is usually over some sort of hurdle, so they have to make a certain return, perhaps 8-10%, before they catch up and start taking their carry.
So what would you make after all the fees?
Palin: 20% per year. But thatÆs obviously not on every single deal û lots will fail! So people need to take a basket of exposure.
Farrell: As Tuck said earlier, there are so many components to private equity. 20% is perhaps a good average. If youÆre doing private equity in Asia then you are expecting more than a 20% IRR. If you are doing large-cap LBOs in the US or Europe, you are expecting 15-20% net returns.
Do you believe in the bubble theory?
Yee: Partly, but in the same way as people have been warning about EPS growth slowing in the US. ItÆs been going on for ages, but never actually happens. Now we are expecting EPS growth of roughly 10%. Really, who knows? ItÆs worth keeping the faith.
But if you look at comparisons with the previous private equity peak in 1989/90 in terms of comparable metrics, we are not seeing all that much of a bubble right now. In terms of LBO deals as percentage of market cap, we have less than 1% compared to 3% then; we have an average premium paid of 25-30% compared to the high 60- 80%; gearing of 20-30% equity and the rest debt, compared to equity as low as 10% back then. Remember, when KKR bought Safeway, the equity component was as low as 3%. So you could argue that todayÆs valuations are not excessive. In addition, these private equity firms have been around a long time, and the staff are very bright. The caveat is that bright people still do lose money û just look at Amaranth, LTCM and the Goldman Sachs Global Alpha fund!
Switching topic: what are the pros and cons of offering your own investment funds versus third-party funds?
Choy: We have a due diligence team to look at the third party funds. For us, the key thing is whether the underlying investment is sound or not. Any decision needs to be approved all the way up.
What about Citigroup?
Farrell: The issue is do you have your proprietary funds run by your own investment teams? And whatÆs their track record? If you do have your own funds and they are good, itÆs a huge advantage. We find our clients like investing with us. We have proprietary capital with our own management teams, so the client is investing alongside Citigroup. They like that û the managers obviously have skin in the game. But we are also open architecture. So if we do come across an exceptional product outside of Citigroup we make it available to our clients. We may even put in proprietary capital along side our clientsÆ capital. But you need your private bank to have relationships with these private equity funds in order to gain access. ItÆs not easy. You can go direct to a private equity fund, but the minimum will be very high and you may not get access even at this higher minimum.
Is there any fee bias?
Michael Palin, SVP, EFG Bank, Hong Kong
Palin: No, that should be a secondary issue. There is no distinction in fees whether you go in-house or third-party.
What are the actual mechanics of, for example, a young Chinese internet millionaire wanting to co-invest with Carlyle in Taiwan?
Yee: Such a person will go for the most aggressive option and highest allocation available. They are very self-confident and savvy. We would try to step in with some more subtle options, offering for example better return for risk taken products. WeÆd start with a fund of funds. For us there is generally no distinction in legal form between hedge funds, private equity and mutual funds. Our recommendations hinge on the client's investment needs and goals, risk appetite and financial sophistication. The only difference is whether a fund can be offered in a particular jurisdiction, and if not, whether there are solutions to enable that access. ThatÆs the real issue û itÆs not a matter of preferred access or a discount on fees. YouÆd have to bring something very special to get a discount from private equity funds û perhaps if you are an entrepreneur in your own right.
Farrell: But of course, itÆs a sellerÆs market right now. Private equity funds have got no incentive whatsoever to discount fees.
Which are more popular: funds of funds or single strategy funds?
Yee: We recommend a fund of funds first. We want our clients to become familiar with a relatively secure product, then give us feedback before possibly moving on to a more narrowly focused fund.
Palin: I never ask a client what he wants. I ask him what risk levels heÆs interested in and tailor my investment strategy to that. The actual product is immaterial. ThatÆs to say, we find the product suitable for the client based on his risk-return profile. Many clients donÆt actually know what they are asking for, and ask for the wrong thing.
From what you have all said today, access to these funds sounds like the key value offered by private bankers.
Choy: Yes, for hedge fund and private equity. Many of the best performing funds have actually already closed and are not open to subscription.
Palin: About a third of the hedge funds we deal in any given month are closed, but they open for us.
Many thanks to you all for all your comments today.