Unhedged Commentary

Tuesday, February 10, 2015

Unhedged Commentary: Putin Will Never Back Down

   Bill Browder, Hermitage Capital Management (Photo credit:
Peter Lindbergh)

Nearly every investor, world leader and concerned citizen is looking at Vladimir Putin right now and wondering if he will back down or escalate Russia's military involvement in Ukraine. That one outcome will determine the future of European security and economic stability for years to come.

I'm afraid that, based on the reasons behind Putin's motivations for invading Ukraine in the first place, there is no chance that he will back down. To understand this, all it takes is a simple analysis of how this crisis unfolded.

First, Putin didn't start this war because of NATO enlargement or historical ties to Crimea, as many analysts have stated. Putin started this war out of fear of being overthrown like Ukrainian president Yanukovych in February 2014. Yanukovych had been stealing billions from the state over many years, and the Ukrainian people finally snapped and overthrew him. Compared with Putin, Yanukovych was a junior varsity player in the field of kleptocracy. For every dollar Yanukovych stole, Putin and his cronies probably stole 50. Putin understands that if he loses power in Russia, he and his underlings will lose all the money they stole; he will lose his freedom and possibly even his life.

Putin may not have been at risk of an imminent revolution in February of last year, but he could see the writing on the wall. So in March he took aggressive preemptive action. His 1999 invasion of Chechnya, which led to his presidential election, had taught him the value of war in shoring up his popular support.

As Putin and his colleagues evaluated their options, they realized they didn't need to launch an expensive and deadly invasion anywhere. Russia already had 12,000 troops in Crimea stationed at a naval base in Sevastopol — they could reclaim Crimea with almost no effort. In March 2014, using irregular troops and mercenaries, Russia retook Crimea with almost no loss of life. At the same time, Putin ran a propaganda blitz at home to convince the Russian people that the Ukrainians were fascist Nazis who were going to kill the "good Russians" living in Crimea.

Putin's plan worked perfectly, with his approval rating shooting up from 55 percent to 88 percent. Unfortunately, he couldn't just stop at Crimea. If he had, a more strident nationalist would have come along and accused Putin of being weak, taking his spot and putting him in the position he was trying to avoid by starting the war in the first place.

So Putin had no choice but to escalate by going into eastern Ukraine. Unfortunately for Putin, this didn't work out nearly as neatly as in Crimea. There were no Russian troops stationed in eastern Ukraine, and Russia had to send in much bigger groups of mercenaries, criminals and secret policemen. This group didn't hold up well when the Ukrainian army finally came in to challenge them, and to maintain the effort, Putin was forced to send in regular Russian troops and heavy artillery last summer. The shooting down of Malaysia Airlines Flight MH17 was the turning point for Putin. Europe imposed devastating sanctions on Russia.

The sanctions forbid Westerners from lending to Russian companies. This means that the $650 billion of hard currency debt owned by Russian companies can only be refinanced inside of Russia. This has led to massive capital flight, a devaluation of the ruble of more than 50 percent and a monumental recession, which is only just beginning.

Putin has never dealt with economic chaos before. Though some may argue that this will bring him to the table to negotiate with the West, in my opinion any negotiation would be seen as a sign of weakness and is therefore the last thing Putin would want to do.

Putin's only likely response is to escalate in Ukraine and possibly open up new fronts in other countries where there are "Russians to protect." But doing so will only harden the sanctions, leading to further economic pain in Russia — and further military adventures to distract Russia's people from that pain.

I cannot imagine a scenario in which there is any compromise, because for Putin compromise means being overthrown. Judging from all of his actions to date, he is ready to destroy his country for his own self-preservation.

We should start preparing ourselves for a war in Europe that may spread well beyond the borders of Ukraine. The only Western response to this has to be containment. This all may sound alarmist, but I've spent the past eight years in my own war with Putin, and I have a few insights about him that are worth knowing.

Bill Browder is the founder of London-based Hermitage Capital Management and the author of Red Notice: A True Story of High Finance, Murder, and One Man's Fight for Justice.

Friday, January 16, 2015

Unhedged Commentary: Why Friendly Activism Won’t Fly in Japan

   Tak Aoyama, AIFAM
By Tak Aoyama

A friendly approach to activist investing has been gaining steam in Japan and has proven successful in raising money — but not in generating excess returns above the market.

Since the end of 2012, Japan-specific activist funds fashioning themselves as friendly have doubled assets under management, to an estimated $8 billion. At the same time, activist firms that employ a more confrontational approach, such as Cerberus Capital Management and Third Point, appear to be reducing their exposure to Japan by not replacing positions in Japanese companies with new names, a move notably coinciding with the rally in Japanese equities. These hostile managers are not adopting a friendly approach; rather, friendly activist managers and entrants are gaining market share, touting that their approach is more suited for Japanese corporate culture.

While these managers may identify themselves as activists, their investors may have them earmarked for allocation to active Japan equity investments. Japanese equity funds have averaged a tracking error of 5 percent or less — too low to be considered active investments. Activist funds, with their potential for higher returns and concentrated position taking, are a good substitute for any investor outside Japan looking for Japanese equity with a kick.

Seeing the fundraising success of their overseas counterparts, domestic managers have launched funds in the past two years with hopes of attracting investments from domestic pension plans. They anticipate allocation from government pension plans — such as the ¥130 trillion ($1.1 trillion) Government Pension Investment Fund — that are expected to help carry out Abenomics, the round of stimulus measures enacted by Prime Minister Shinzo Abe after his election in December 2012. These managers’ marketing materials read like those of a venture capital fund or an early-stage private equity fund, avowing adding value to target companies through elaborative dialogues with management, proposing business plans, and offering corporate finance solutions and access to funding.

While a friendly approach purportedly works better than a hostile one in Japan, challenges remain. These funds typically take a nonthreatening minority stake, meaning they lack the clout necessary to implement meaningful and often painful changes, namely, restructuring or selling off noncore business lines. Corporate managers in Japan are typically appointed from employee ranks, and they tend to avoid laying off workers until their hands are forced by external pressure. A friendly minority shareholder cannot catalyze the kinds of big changes that may be one of the most effective ways to increase the value of a company.

Non-Japanese managers investing on behalf of opportunistic risk-on, risk-off investors may need to divest before an activist campaign has time to bear fruit. Since 2013 overseas investors have enjoyed a sizable return from Japanese equities as seen in the Topix return of 18 percent on a dollar basis and 65 percent on a yen basis. A downturn in the Japanese equity market would trigger redemption requests from activist managers, some of whom have seen this scenario play out before. And target companies and the activist funds investing in them may differ on expectations on exit timing. These conditions make it difficult for funds to sustain an effective activist strategy, and they may pursue a friendly approach at entry but not necessarily at exit.

Domestic investors are expected to be more loyal to domestic funds, but these managers have not been around long enough to demonstrate their capabilities. It remains to be seen how effective their activist strategies will be when the overall equity market is down.

While managers and investors may have initially entered activist investing with different motives, there is definitely a role to be filled by activists to improve the value of Japanese companies. Free advice provided by the minority shareholder is valuable for corporate Japan, where there is no custom of hiring external advisers. As Japanese management is often comprised of former employees with manufacturing or sales backgrounds, external expertise is particularly useful in areas of corporate finance.

The environment has become favorable to friendly activism in Japan as well. The percentage of non-Japanese shareholders has grown from less than 20 percent in 2000 to more than 30 percent in 2014, and the practice of cross-holding, where companies buy each other’s shares to be silent shareholders, has largely declined. The corporate climate has shifted emphasis on financial performance metrics from retained ratios closely tracked by debt holders to return on equity valued by shareholders. In February 2014 the Japanese government introduced its own stewardship code to improve dialogue between shareholders and management.

Despite these changes toward a more shareholder-friendly environment, the fundamental culture of Japan remains that management answers to customers and employees first. Uniquely, the same is expected of shareholders. Ultimately, this is an insurmountable challenge for would-be activist investors in Japanese companies — and that’s on top of potential traps an activist investor anywhere can fall into, such as stubbornly continuing an investment despite its deviating from the initial investment thesis or choosing to suspend investor redemptions over suspending activist goals.

Tak Aoyama is the CEO of AIFAM, an asset management and advisory firm focusing on alternative investments.

Wednesday, December 03, 2014

Unhedged Commentary: The Case for Nonprime Mortgage Loans

   Philip Weingord, Seer Capital Management
By Philip Weingord

Is there a prudent way to originate a mortgage loan that isn't prime? The answer is yes, there is, and it's time to start making nonprime mortgage loans again.

Of course, some products originated during the U.S. housing bubble made no sense; some loans should never have been made. But history is replete with examples of the pendulum swinging too far in response to crises, and that has been the case in mortgages.

You may recall arcane terms like subprime and Alt-A and Alt-B, which were used to describe mortgages but not broadly understood by the average borrower. The mortgage market today has a new mission and new monikers: qualifying mortgage, or QM, and non-QM. A QM mortgage meets new standards, including a debt-to-income limit of 43 percent and a 3 percent limit on points and origination fees; also, these mortgages don't have risky features such as interest-only payments. A QM provides lenders protection against lender-liability lawsuits. Non-QM loans do not meet QM standards and are considered riskier. (Jumbo mortgages are also non-QM, but they are not the focus of this article.)

There has been a lot of media coverage about the non-QM market, but origination volumes outside of jumbo loans won't even reach $1 billion in the U.S. this year. Why so meager? Some housing analysts have said rating agency requirements are too onerous to make securitization of non-QM loans appealing, but in fact, the economics of securitization appear quite attractive. Others have suggested that there is simply not enough demand — there are not enough borrowers with these credit profiles looking for mortgages. We find this hypothesis unlikely. Consumers are generally willing to take advantage of credit when it is offered.

Many point to the Federal Housing Administration as the reason that non-QM lending has not taken off, and this is valid to a point. FHA lending, which serves weaker borrowers, was pushed aside when subprime was in its heyday and grew back rapidly with the demise of subprime. Nonprime loans peaked at $1 trillion of origination in 2006; that year FHA originations totaled $80 billion. By the end of 2009, nonprime loans were at essentially zero, whereas FHA originations reached $451 billion.

The non-QM product, however, serves borrowers that FHA does not. FHA loans are difficult to obtain for self-employed borrowers and unavailable for second homes or investor properties, which continue to grow in share as home ownership continues to decline postcrisis. That financing has to come from somewhere. FHA loans are not available to borrowers with a recent short sale, bankruptcy or foreclosure (typically, within the preceding three years). They are not available above FHA maximum loan sizes, and although FHA programs allow fairly low credit scores, most originators won't go below a 640 FICO score because of additional scrutiny for lenders with higher default rates. Loans have to be sound, of course, and a non-QM loan needs mitigating factors that offset risk, in addition to appropriate risk-based pricing.

The greatest factor holding back volumes is that non-QM origination is simply not up and running. The nonagency mortgage origination business was decimated in the crisis and has not returned. An infamous blog called the Implode-o-Meter tracked the demise of 388 subprime mortgage lenders. The few companies that survived reinvented themselves as prime and/or agency lenders. The economics of originating agency mortgages have become more attractive with less competition, as the overall mortgage industry has shrunk. In addition, banks still dealing with the legacy of subprime are paying out huge settlements in lawsuits. For example, Bank of America Corp. is paying $17 billion.

As a result, origination platforms and brokers have been entirely committed to agency and jumbo mortgages for several years now, and with little capital flowing to the segment, nonprime has not been an area of focus. Non-QM lending is an attractive opportunity for investors because of its expected robust return profile and the market's scalability.

My firm started exploring the sourcing of non-QM mortgages in early 2013 and made our first purchases in mid-2013; we expect to do our first securitization in early 2015. We see this market growing to $150 billion over the next several years, with 80 to 90 percent of it being securitized. With return potential in the mid- to high-teens, we see the non-QM lending market as an ideal way to generate alpha.

Philip Weingord is the managing principal and chief executive officer of New York-based Seer Capital Management, a credit-focused investment firm.

Wednesday, November 05, 2014

Unhedged Commentary: Why Trust and Communication Trump Performance

By Amanda Tepper

   Amanda Tepper, Chestnut Advisory Group

The hedge fund industry is rapidly consolidating, all through market share shifts. The big are getting bigger every year, while smaller funds are finding it more and more difficult to attract and retain clients.

Last year hedge funds with $5 billion or more of assets under management received 65 percent of all net asset flows. The trend has continued this year, with the largest funds attracting 53 percent of all industry flows thus far in 2014.

Why is this consolidation trend occurring and showing no sign of abating? To answer this question, Chestnut Advisory Group reviewed investment performance and asset flow data over the past seven years for more than 900 asset managers and conducted a survey of institutional investors controlling $429 billion of capital.

We found that investment performance is not the primary factor driving asset flows. Although the common industry assumption is that capital will always follow investment performance, we have shown that is not the case. We analyzed eVestment data for 931 investment products for the period from 2006 to 2013, across four different asset categories. Our analysis yielded the following results:

• Asset managers who delivered the best investment performance did not raise the most capital.

• The top net capital flow gainers raised more than four times more capital than the best investment performers did. They raised this capital even though their performance trailed the top investment performers by 86 basis points annualized.

• The correlation between investment performance and capital flows is unexpectedly low: between 0.04 and 0.24.

As investment performance is clearly not driving asset flows, we turned to institutional investors themselves to determine exactly what does drive their asset allocation decisions. We learned that the traditional relationship-based sale is no longer effective. Instead, investors respond best to a new educational approach to marketing, where an effective investor relations program builds trust and a strong brand for the hedge fund over time. In fact, 93 percent of investors say they view investor relations as integral to any asset manager’s mission. Our research shows that trusted fund managers not only raise more assets, but are hired more quickly and fired more slowly than the general population of funds.

Investors today will not invest unless they have an understanding of exactly what their fund manager is doing with their money and why. In our survey, the top five factors driving investors’ decisions to hire a fund manager all come from the new educational approach to sales, and also drive investors’ trust. Some 95 percent of investors surveyed said a strong understanding of the firm’s investment process is important; another 89 percent said an asset manager’s credibility is important. Investors also cited as key factors a strong understanding of the firm’s risk management (82 percent), clear and consistent communications (77 percent), and confidence in the firm’s business structure and incentives (77 percent).

An outstanding IR effort provides investors with the understanding they need to build trust and to ultimately commit their capital to an asset manager. Investment results clocked in at a distant sixth.

To effectively build the necessary trust to commit their capital, investors told us they want to receive a steady stream of deep and relevant investment substance from their asset managers, delivered in a clear, concise and consistent manner. Meeting these expectations requires identifying target investors’ key concerns, along with a superior combination of deep investment knowledge and sophisticated communications skills.

Investor relations spending by hedge fund firms is heavily correlated to size. For example, funds averaging $1.5 billion in size spent $1.3 million annually on their IR efforts in 2013. In contrast, funds averaging $10 billion in size spent $7.8 million annually on IR, and the largest funds, averaging $36 billion in size, invested an average $15.3 million annually on IR. Clearly, these funds are seeing a good return on their IR program.

Our analysis shows that hedge funds that don’t effectively build investor trust are losing market share to those that do. Hedge funds that rely on investment performance to drive flows are living on borrowed time.

Amanda Tepper is CEO of Chestnut Advisory Group, a consulting firm providing outsourced investor relations to hedge funds and other asset managers.

Thursday, October 30, 2014

Unhedged Commentary: Why Pension Funds Actually Like Hedge Funds

   Richard Baker
By Richard Baker

Several articles on the California Public Employees’ Retirement System’s decision to divest its hedge fund portfolio make clear that there are still some questions about hedge funds and the benefit they provide many pension fund beneficiaries. A key part of the reevaluation being done by institutional investors is how they communicate to their beneficiaries the value hedge funds bring to their overall investment plans.

Let me try to clear those up by addressing the role hedge funds play in pension plan investment portfolios. Furthermore, I want to address questions about the impact CalPERS’ decision will have on the industry. Hedge funds do not just “typically bet on and against stocks, bonds or other securities.” This oft-cited oversimplification promotes a fundamental misunderstanding of the industry and the role it plays in investment portfolios. Successful funds diversify assets so risks are carefully weighed against returns. The industry is comprised of thousands of funds with varying strategies that help investors meet specific, individual goals within their investment portfolios.

Investors’ goals for hedge funds are more complex than simply achieving a high rate of return. The London-based research firm Preqin determined this summer that institutional investors, such as pensions, utilize hedge funds to achieve returns that are uncorrelated to equity markets, to earn better risk-adjusted returns, to dampen portfolio volatility and to mitigate investment risk. And a recent study from Deutsche Bank found that institutional investors were not only sticking with their hedge funds, but several were actually increasing their investments.

But don’t just take my word for it. The New York State and Local Retirement System said it in its 2014 annual report, “The portfolio seeks diversification through a multi-manager and multi-strategy approach, typically investing in vehicles which generate uncorrelated returns and those which can lower the overall risk and volatility to the fund.” The end result for the beneficiaries? A nearly 10 percent return. The pension system’s report also said the plan views its relationships with fund managers as “partnerships” with professionals “who have shown an ability to consistently deliver top-quartile returns.”

Glenn Becker, the chairman of the State Employees’ Retirement System Board in Harrisburg, Pennsylvania, discussed the issue in a recent letter to the editor of the Patriot News after the CalPERS news led some in his state to question whether Pennsylvania’s large pension plan should stop investing with these funds. Mr. Becker wrote, “Our plan uses hedge funds as an integral component of a well-diversified portfolio that is expected to provide risk adjusted returns over all types of markets. To date, the strategy has been working.” Mr. Becker went on to say that the returns generated by his plan’s investments — more than 11 percent from hedge funds last year — are saving taxpayers money by “making up for the past underfunding.”

So we’ve seen the benefit hedge funds can have for pension plans, but what impact does the CalPERS decision have on other investors? While CalPERS made headlines with its recent decision, investors overall remain very pleased with hedge funds’ ability to meet their objectives. The Preqin survey found that 84 percent of institutional investors said hedge funds met or exceeded expectations in the past 12 months, and 87 percent of institutional investors indicated they would maintain or increase hedge fund allocations over the next year.

The latest data on investment trends underscores investor satisfaction. An industry report released this month from Chicago-based industry tracker Hedge Fund Research noted that $18 billion in new capital was invested in hedge funds during the third quarter of 2014 — bringing the total inflow year to date to $72.7 billion. That marks “the highest inflow for the first three quarters of a calendar year since 2007.”

Yes, CalPERS is a big name in the pension universe. Its recent decision caught people’s attention, but it was a decision that was unique to CalPERS based on its size, its ability to scale its hedge fund program and the immediate needs of its investment portfolio. No other institution has to navigate the same unique factors, and no prudent investment officer will make an investment decision based solely on actions taken in Sacramento.

Rather, these trained investment professionals will continue assessing their institution’s needs and responsibilities, seeking out the most prudent investment opportunities to meet their individual objectives. In today’s complex financial landscape, that means the stewards of these state and municipal retirement funds need to diversify. They cannot elect to allocate all of their money to an index fund. The range of investment strategies offered by hedge funds today makes them a critical component in many global investment portfolios. If data from investors is any indicator, these partnerships will continue to grow for years to come.

Richard Baker is the president and CEO of the Managed Funds Association.

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