For private equity and hedge funds, the party isn’t over yet

For private equity and hedge funds, the party isn’t over yet

Just weeks ago, the raucous hedge fund and private equity party of recent years seemed to be fading.

Subprime woes rattled the stock and credit markets through late summer. Hedge funds were imploding almost daily, squeezed by banks calling in loans and investors demanding their money back. Private equity deals fell apart as the cost of borrowing rose.

Some of the competitive advantages of these firms, including a favourable tax structure, were also under intense scrutiny in Congress—and even from within its ranks.

“A tax loophole the size of a Mack truck is right now generating unwarranted and unfair windfalls to a privileged group of money managers," Leo Hindery Jr, a private equity executive, said last month. “To no one’s surprise, these individuals are driving right through this $12-billion (Rs47,280 crore)-a-year hole."

The grim mood was captured by Donald Putnam, founder and managing partner of Grail Partners Llc., a merchant bank: if a rising tide lifts all boats, a sinking ship sinks all ships. There will be many more losers than winners when this is through."

But perhaps the hats, balloons and streamers should not be put away just yet.

The forces that created these private investment vehicles—large institutional investors with long-term plans to diversify away from simple stocks and bonds—are likely to continue pouring billions into alternative investments, a category that includes hedge funds and private equity firms. And the effort to crimp the industry’s tax advantages has faltered—at least for now.

During the last two weeks of July and the first week of August, amid a widespread market meltdown, Citigroup Inc. surveyed close to 50 pension managers, who collectively manage more than $1 trillion in assets, from the US and Europe. The survey showed they would, on average, raise their allocation in alternative investments to nearly 20% by 2010 from 14% today. In all, that would mean another $1.2 trillion flowing into alternatives over the next two years.

The $112.5 billion Texas Teacher’s Retirement System, for example, announced in September that it would increase its allocation to alternatives to 29% from 8.5% over the next three years. The $250 billion California Public Employees Retirement System voted in June to double its investments in hedge funds and corporate governance funds to about $12 billion each.

“The sheer volume of money flowing into state and corporate pension funds and government coffers will lead to larger allocations to these strategies," said Mark Yusko, president of Morgan Creek Capital Management Llc. and former chief investment officer for the endowment at the University of North Carolina at Chapel Hill.

Endowments and foundations also continue to allocate more to hedge funds and private equity firms, even though they have significant investments there already.

“We’ve only seen the numbers going up," said P. Brett Hammond, chief investment strategist at TIAA-CREF, which conducts an annual survey of endowments with the National Association of College and University Business Officers.

According to the most recent survey, college and university foundations had, on average, 17.4% of their assets in alternatives (including private equity, venture capital, hedge funds, real estate and natural resources) at the end of July 2006. The figure was 5% a decade ago.

New investment dollars are also pouring in from abroad. Morgan Stanley estimates that there is currently $2.8 trillion in sovereign wealth funds —government-owned and managed funds that are, in most cases, invested in foreign currencies. Some of them are looking to alternatives to diversify and improve returns. The investment arm of the government of China, for example, invested in Blackstone Group LP in May before it went public.

West Asian nations, enriched by high oil prices, have been investing more in alternatives, following the lead of government funds in Singapore. In September, an investment group owned by the government of Abu Dhabi bought a 7.5% stake in the Carlyle Group for $1.35 billion.

“Sovereign funds are investing dramatically in alternatives," said David Rubenstein, co-founder of Carlyle. “That’s a trend that’s been going on and they are increasing their allocation." Stephen Jen, head of currency research for Morgan Stanley, estimates those sovereign funds could grow to $12 trillion by 2015, in part from oil profits as well as trade surpluses for most of the Asian countries.

Some in Congress say the Bill to raise taxes on these firms appears to have been set aside for this year. “Given the difficulty in getting any legislation through the Senate and the little time left this year for moving other issues important to the American public, it is unclear whether there is sufficient time to address the appropriate tax treatment of private equity firms," said Jim Manley, a spokesman for Sen. Harry Reid, Democrat, Nevada, the majority leader.

News of the likelihood that such legislation would not be discussed this year was first reported Tuesday by The Washington Post.

A separate Bill to tax publicly traded partnerships at a higher rate is likely to be attached to one of two pieces of legislation next week.

If projections for continued heady growth of assets flowing into hedge fund and private equity firms hold true, a remarkable trajectory for the industry will continue.

Assets managed by hedge funds more than quadrupled, to $1.7 trillion today from $257 billion in 1996, according to Hedge Fund Research Inc. (other studies put the figure closer to $2 trillion).

Tough markets resulted in a slowdown in new money over the summer—$16.8 billion of new funds flowed to hedge funds in July and only $8.9 billion in August.

But total net flows to the industry for this year through August, at $144.5 billion, already surpass the $126.5 billion record set in 2006. “Investors are continuing to focus on the longer-term merits of the industry," said Kenneth Heinz, president of Hedge Fund Research. “They are not impacted by one bad month."

The outlook for the favourable compensation structure governing many private equity and hedge fund managers dimmed this summer when Congress started to examine tax advantages enjoyed by the industry. Private equity firms are structured as partnerships, and pay tax rates of only 15% on the bulk of their compensation. Some hedge fund managers are deferring billions of do-llars offshore, where the money is compounding tax-free.

Then, subprime mortgages started defaulting at alarming rates, igniting panic in the markets and a sell-off among some of the largest hedge funds, including Tudor, Caxton Associates Llc. and Goldman Sachs Group Inc. Many funds appeared to have made similar trades, and Wall Street reined in loans that allowed funds to make bigger bets.

The August drubbing also seemed to undermine the pitch made by many hedge funds that they are differentiated from one another and from the market.

“I tend to view them as an increase in risk, not a risk mitigator," said Michael Nobrega, chief executive of the Ontario Municipal Employee’s Retirement System, a $51 billion pension fund.

The private equity industry sputtered as banks refused to extend more credit. But long-term institutional investors are not so easily thrown by such short-term problems. Many chief investment officers say the prospects for these alternatives are still better than those for the mutual fund industry, which is about five times the size of the hedge fund industry, not counting hedge funds’ ability to bulk up through leverage.

“You cannot make these massive shifts easily," said Nobrega, who is shifting to an allocation that will have almost half of assets in alternatives from a current mix of about 25% in alternatives and 75% in public markets.

Many pension funds started to invest in alternative investments when the technology bubble burst earlier this decade and shrank the value of their assets, some by as much as a third. A number of hedge funds made money in that rout, and large institutional investors started to recognize that they could get higher returns in less liquid investment—those which cannot be cashed out easily, such as private equity.

Others were looking for a way to diversify their portfolios, looking at assets such as timber or private firms in the hope that those assets would behave differently in a market downturn. Pension funds generally were late adopters of this strategy, following the lead of big-name university endowments, including Yale, led by David Swensen, and Harvard, which both aggressively embraced investing in alternatives in the 1990s and whose results continue to be strong.

“The major universities pioneered thinking about, and making, allocations to alternatives, and the smaller endowments and foundations have followed," Hammond of TIAA-CREF said.

The flows of money to alternatives inevitably will have cycles, and returns for many alternatives such as hedge funds and private equity may well come down over time. But, for now, the long-term prospects seem strong, according to many experts.

©2007/the new york times