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GLOBAL CUSTODY: DEFINING THE NEW WORLD ORDER I S S U E T W E N T Y • J U LY / A U G U S T 2 0 0 7
The slow burn of UK REITs Balancing credit and risk in the sub prime market Why China believes in Blackstone
THE TWO FACES OF
GAZPROM: REDEFINING RUSSIA’S ENERGY POLITICS
ASIA TRANSITION MANAGEMENT ROUNDTABLE: THE CHALLENGES OF GROWTH
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Outlook EDITORIAL DIRECTOR:
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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
sia is the quiet thread of this edition. The surge of mergers and acquisitions in Asia’s financial services sector looks likely to be with us for some time, says the annual Financial Services M&A: Going for growth in Asia by PricewaterhouseCoopers. Financial services deal activity in the region is already at record highs; with disclosed deal value up 66% in 2006 on the previous year to total $64bn. However, the report cautions that high transaction prices in the region could create a deal barrier. Additionally, regulatory protectionism and the sheer diversity of the region might now begin to make cross-border deals more difficult. It is also likely that Asian buyers will increasingly look outside the region for buying opportunities. No surprise then, those holders of capital are already purposefully looking further afield. China’s State Investment Company’s $3bn stake in the US buyouts and investment banking boutique Blackstone’s planned initial public offering (IPO)—said to be worth at least $4bn—is one such development. The size of the stake is a benchmark of sorts and emblematic of China’s growing economic confidence and expertise in the global financial markets. It is also a sophisticated play, bringing China into the sphere of the American International Group, which owns 7% of Blackstone and Kissinger Associates, with whom the private equity maven has close ties. Four, it signals a shift away from China’s hitherto monoline investment preference in the US—namely to buy US treasury bonds. The State Investment Company will however, also find increasingly tempting opportunities closer to home. By the end of 2006, private equity investments grew to $33.4bn under management, up 27% over a two year period. Similarly, a new confidence is emerging in Asia’s fund industry. In financial hubs such as Singapore and Hong Kong, the pensions industry is growing fast and is expected to grow at a substantial 9% per year. Financial services providers are looking for prime mover advantages in this crosscurrent of liquidity. Not least among them transition managers, which are actively engaged in supporting the changes in investment trends throughout Asia. The Asian Transition Management Roundtable, highlights current trends. Beneficial owners in Asia are expanding their asset allocation strategies, increasingly incorporating foreign assets and multiple asset classes. The large custodian houses have so far dominated transition management in the region, but with so much change in fund mandates, the market is increasingly attractive to newcomers. Today transition management in Asia is a buyers’ market and the experts around the table analyse the impact of that salient fact. What is abundantly clear in covering the fecundity of the region’s financial markets is the growing sophistication of local investors. In turn, this creates an eddy in financial flows. In other words, Asia’s growth story is no longer just about money flooding into the region, it is also about money flooding out. That is where we came in.
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Francesca Carnevale, Editorial Director June 2007 COVER PHOTO: Russian president Vladimir Putin, left, and Gazprom CEO Alexei Miller during a meeting with executives from Shell, Gazprom and Japanese shareholders in the Sakhalin-2 energy project, in the Kremlin, Thursday, December 21st 2006. Gazprom has taken a 50%-plus-one share stake in the project for $7.45bn in cash. Pool Photograph by Yuri Kochetkov, supplied by PAPhotos/Associated Press, June 2007.
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Contents COVER STORY COVER STORY: GAZPROM’S ENERGY POLITICS ....................Page 43 As Europe’s biggest energy partner, Russia is redefining its role as an actor in global energy geopolitics. The future of Gazprom, Russia's largest energy company and the development of its future production capacities is in flux. Is the firm caught in a challenging vice? Or, is it political flim-flam? Francesca Carnevale reports on the sometimes unhappy dynamics of a giant trying to find its proper place in the world.
DEPARTMENTS MARKET LEADER
BALANCING CREDIT AND RISK IN THE SUB PRIME MARKET ....Page 6 Neil O’Hara explains the impact of hedge fund investing in the sub prime market
AHEAD OF THE GAME........................................................................................................Page 12 Peter Niven, chief executive, GuernseyFinance explains the jurisdiction’s success
ALGOs INCREASE COMPLEXITY IN FX TRADING MARKETS ....Page 16
IN THE MARKETS
Electronic trading has fuelled growth in the FX markets. By Neil O’Hara
CHINA LOOKS TO PRIVATE EQUITY FOR BETTER RETURNS ..Page 20 Ian Williams reports on the China State Investment Agency’s investment in Blackstone
COUNTING THE VALUE IN ASSETS......................................................................Page 24 Who provides fund administrators with asset valuations?
INDEX REVIEW
STOCKS, ROCKS AND ROLLS......................................................................................Page 26 Simon Denham, managing director, Capital Spreads, looks at the main indices
UK REITS: BULLDOG OR A LESSER BREED?
................................Page 27 Mark Faithfull looks at the slow start of REITs in the UK and assesses their prospects
THE GLOBALISATION OF THE MIDDLE EAST INVESTOR ......Page 32
REGIONAL REVIEW
Middle East investors’ increasing influence on the global property market.
A PLACE IN THE SUN
..............................................................................................................Page 35 The CBB makes a play for dominance in the Middle East fund market
CIMB–PRINCIPLE IN THE SPOTLIGHT
........................................................Page 38 Noripah Kamso explains the firm’s growth strategy
PRIVATE EQUITY INVESTMENT STRATEGIES INDEX REVIEW 2
HARLAN CASTLE: THE MILD-MID MARKET FORTRESS ............Page 45 Neil O’Hara profiles the conservative, top-rated US mid-market house
INVESTING IN EQUITY MARKETS VIA LONG/SHORT
............Page 87 Long/Short investing by Laurence Russian, principal, ABS Investment Management
WHAT SHOULD BENCHMARKS DO?
................................................Page 91 Lillian Goldthwaite discusses the implications of changes in index calculation Market Reports by FTSE Research ................................................................................Page 94 Index Calendar ................................................................................................................Page 104
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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Bridging the performance gap
Transition Management Portfolio restructuring can lead to major performance gaps. Whether you are restructuring a vanilla bond portfolio or diversifying into offshore markets and new asset classes, the team at Citi has been defining industry best practice for more than a decade. With a dedicated team of Transition Managers, we support the full range of transition services with a complete multi-asset platform, comprehensive real-time controls and exceptional project management. Put the most experienced team in the market to work for you.
Asia Pacific Transition Management Team cititransitions@citi.com To contact us directly: Mark J Levinson Michael Jackett-Simpson +61 2 8225 6149 +61 2 8225 6146 mark.levinson@citi.com michael.jackettsimpson@citi.com
Joe Kassel +61 2 8225 6288 joe.kassel@citi.com
Š 2007 Citigroup Pty Limited ABN 88 004 325 080, AFSL No. 238098. Citi and Arc Design is a service mark of Citigroup Inc. used and registered throughout the world. Citi and Let’s Get It Done are service marks of Citigroup Inc. CITI0040
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Contents FEATURES ASIAN TRANSITION MANAGEMENT ROUNDTABLE
THE CHALLENGE OF GROWTH ..............................................................Page 49 Transition managers working in Asia have never had it so good. Local asset owners are rapidly diversifying their investment allocations as their investment outlook becomes ever more complex and sophisticated, with a knock-on increase in transition mandates. However, new challenges are emerging. Competition for new business is rising. Demand throughout the region remains polarised and some clients are undertaking portfolio transitions on their own. How will the Asian transition management market evolve? A team of experts discusses the salient influences on new business growth
THE GLOBAL CUSTODY REPORT
TOWARDS A NEW WORLD ORDER
..............................................................Page 61 The global custody market is still reeling from the series of mergers announced earlier this year. While some service providers see market consolidation as an obvious opportunity, others wonder how they will compete with the new custody titans. More pertinently perhaps, what is the impact of consolidation on client service?
THE DEBT REPORT
THE UK DMO’s BROAD APPROACH TO DEBT ........................Page 70 The United Kingdom’s Debt Management Office has always had an innovative approach to the issuance of sovereign debt. Among the first to revive long bond and index-linked long bond issuance, the specialist fund raising agency is considering alternative instruments. What should the market look out for in 2007 and beyond? Francesca Carnevale reports
ASIA’S HIGH YIELD MARKET PLAYS FOR HIGH STAKES ..Page 75 Competition from the loan and equity markets has not only stalled the development of Asia’s bond market, it has also helped to loosen the covenant packages that investors in high-yield bonds demand. However, while some US investors have pushed back, it seems like bond investors from Asia and Europe are willing to accept the weaker terms on offer. Richard Jory reports
BRAZIL OPENS UP TO CORPORATE DEBT
..................................Page 77 In May Brazil took an important step in developing the country’s corporate bond market as Fitch Ratings and Standard & Poor’s upgraded the country’s sovereign ceiling rating to one notch below investment grade. It reflects the government’s retreat from debt, the US dollar markets and a reduction in political risk. Can Brazilian corporates now capitalise on the goodwill factor?
DEBT END? ..............................................................................................................Page 80 Fuelled by an unprecedented level of LBO activity, and a seemingly endless supply of foreign investment capital, conditions for corporate bond issuance have never seemed better. Still, some say the powerful debt market is ripe for a fall, though no one seems to want to say when. Dave Simons reports
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How to transition assets without holding your breath.
The changing investment climate causes you to shift your investment strategy. Problem is, the costs associated with the transition can cause fund underperformance. Breathe easier. Our transition management team is one of the most experienced in the industry. Perhaps that’s why more than half of the top 100 asset owners in the world continue to realize the benefits of using State Street’s Transition Management services. Throughout your transition, we use advanced risk management tools and trading technology to leverage our unrivaled liquidity and preserve the value of your fund. In fact, when it comes to providing innovative trading and research, we’re an industry leader. So it’s not surprising that so many sophisticated institutional investors get along swimmingly with State Street. For more information, please contact State Street Global Markets’ transition team at SSGM-sales@statestreet.com.
© 2007 State Street Corporation. Brokerage products and services offered in the US through State Street Global Markets, LLC, member SIPC. Transition Management is offered by State Street Bank Europe Limited across Europe. 07-SGM05370507
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Market Leader CREDIT DERIVATIVES: MANAGING RISK
BALANCING CREDIT AND RISK IN THE SUB PRIME MARKET John Lewis, chief executive officer of Risk Control, a London-based provider of risk management software for the financial services industry. The hedge funds that buy equity and mezzanine tranches of mortgage backed securities (MBS) and collateralised debt obligations (CDOs) run the gamut from big players that have top-notch risk management and analytics to small shops that tend to piggyback others' trades.“There are people investing in these without analysing the risk but as a proportion it is a very small amount,” says Lewis. Photograph kindly supplied by Risk Control, June 2007.
Credit derivatives have changed the fixed income markets beyond recognition over the past 10 years. Credit default swaps let investors hedge their book as never before while tranched credit structures allow them to fine tune how much risk they are willing to accept. Credit risk is no longer concentrated in the hands of a few large banks and insurance companies. Instead, leveraged hedge funds have become the main buyers of the riskiest tranches of mortgage-backed and asset-backed securities as well as collateralised debt and loan obligations. However, hedge funds borrow from prime brokers, who in turn borrow from banks. Are the banks really off the hook? Neil O’Hara reports. UB PRIME MORTGAGE originators in the United States were not the first to borrow wholesale from major banks to make retail loans the banks would not make themselves, after all. Thirty-five years ago a raft of so-called secondary banks grew up doing just that in the United Kingdom. Moreover, the credit market turned sour and the Bank of England, the union’s central bank, had to organise its famous“lifeboat”facility to keep the secondary institutions
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afloat while their loan books ran off. The similarity ends there however. That’s because in the 1970s credit risk stayed on the banks’ balance sheets. Today, the major banks often repackage loans as securitised instruments and sell on some or all of the risk, a role more akin to underwriting than traditional lending. Sub prime loan originators would not exist without warehouse lines of credit from the major banks, of course. Even so, these are quite different from
the unsecured lines that propped up the British secondary banks. “We would never lend money to these originators unsecured,” says David Martin, global head of rates at financial powerhouse UBS, “But secured? Sure.” Martin points out that as mortgage lending has evolved from a balance sheet game to a risk transfer market, regulators have lost the ability to monitor lending standards. “Private non-bank companies are linking borrowers to investors and they have no skin in the game,”says Martin. The regulators have no say, and the originators do not care as long as they can sell the loans. Fraud has played a part, too. Some borrowers buying properties for investment have claimed to be owner occupiers, in order to qualify for a lower rate because they are deemed by the lender to be less likely to default. To be fair also, lenders cannot
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Market Leader CREDIT DERIVATIVES: MANAGING RISK
easily test the borrowers’ intent; legitimate or not, they won’t move in until after the closing. Regulators have tried to encourage better risk controls through the Basel II capital adequacy framework, according to John Lewis, chief executive officer of Risk Control, a London-based provider of risk management software for the financial services industry. The new rules require lenders to set aside different amounts of capital depending on the credit risk of the counterparty: secured loans need less than unsecured loans, for example. In addition, regulators now insist that banks stress test their loan portfolios to see how they will perform in various market conditions in an attempt to identify and correct potential vulnerabilities before they cause trouble. None of this stopped the sub prime mortgage meltdown, but so far the effects have not spread to other sectors of the market or the economy as a whole. Lewis blames the mess on innovations such as “no document” loans for which the borrowers did not have to verify their income. Inflated valuations have played a part as well, as collateral for some loans has proved inadequate. The hedge funds that buy equity and mezzanine tranches of mortgage backed securities (MBS) and collateralised debt obligations (CDOs) run the gamut from big players that have top-notch risk management and analytics to small shops that tend to piggyback others’ trades. “There are people investing in these without analysing the risk but as a proportion it is a very small amount,” says Lewis. Moreover, although prime brokers finance these positions, the rating agencies provide another check on sloppy lending practices because prime brokers cannot afford the higher funding cost a rating downgrade implies.
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Mark Howard, managing director and cohead of research at Barclays Capital in New York. Howard attributes the burgeoning growth of the fixed income investor base over the past five years more to the spread of securitisation and derivative technology that delivers customised credit risk. Investors have become more sophisticated, too, and not just in the developed world. Photograph kindly supplied by Barclays Capital, June 2007.
Although some firms repackage sub prime loans and sell their exposure in securitisations, including the high risk residual tranches, others have set up dedicated proprietary trading desks to buy and hold MBS and CDO residuals just like the hedge funds. It is a strategy that could come back to haunt them if sub prime woes spread to other segments of the housing market, hedge funds stop buying residuals and securitisation volumes fall as a result.
The equity bear market of 2001/2002 sparked renewed interest in fixed income but Mark Howard, a managing director and co-head of research at Barclays Capital in New York, attributes the burgeoning growth of the fixed income investor base over the past five years more to the spread of securitisation and derivative technology that delivers customised credit risk. Investors have become more sophisticated, too, and not just in the developed world. And the ability to hedge has fueled the fire. “Banks are able to step up and provide massive amounts of liquidity,” Howard says, “They can turn around and hedge not just the interest rate component but also the credit component.”The ability to separate credit risk from interest rate risk through credit derivatives permits investors to tailor their exposure. Howard compares the modern credit markets to a salad bar. “When you can pick and choose what you want you are more likely not to leave anything at the bottom of your bowl,” he says, “And you are going to take more of the stuff you really want.” Whether an investor wants BBB exposure to California real estate or AA-rated French corporate credit, it is there for the taking. Where does the credit risk end up? Some stays at the banks, but not necessarily in its original form. For example, rather than holding traditional mortgages concentrated in their local markets, banks create and sell MBS. While they may retain part of their own AAA tranches, Jay Bryson, global economist at Wachovia in Charlotte, North Carolina, says banks have become big buyers of AAA tranches in others’ MBS deals to diversify their book. Wachovia, which used to have a traditional mortgage portfolio concentrated in Charlotte, can now cut that exposure and replace it with mortgage risk from across the country.
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Market Leader CREDIT DERIVATIVES: MANAGING RISK
Bryson notes that foreign investors have become big buyers of MBS in the US, which diffuses the risk not only throughout the American financial system but also around the world. In other words, should a housing market downturn occur, everyone will bleed a bit but no one will be gored. “You do not have as high a probability of second order effects where the financial system starts to cut back on lending to otherwise healthy sectors of the economy,”Bryson says. Banks and mainstream foreign investors tend to buy investment grade tranches, of course. The lower rated mezzanine and unrated equity tranches gravitate to investors willing to accept higher risk for the promise of higher returns: hedge funds. In one sense, what has become a risktransfer market is working as it should.“Part of the diffusion of risk is the concentration of relatively extreme risk in hands that are willing to hold
it” says Pierre Ellis, senior managing director and global economist at Decision Economics, a New Yorkbased consulting firm founded by Allen Sinai,“It is like insurance.” Ellis points out that risk management models have improved both as a result of technological advances and in response to weaknesses exposed in periods of market stress from the 1982 Mexican debt crisis to the 1998 collapse of Long Term Capital Management (LTCM). The evolution of the major Wall Street houses from partnerships to public corporations has ratcheted up the importance of risk management, too. “Managers know their stock price will be smashed if something comes to light that they did not prepare for,” Ellis says, “They have safety margins and firewalls that enable them to monitor risk more carefully and limit the losses should things go wrong.”
Jay Bryson, global economist at Wachovia in Charlotte, North Carolina, says banks have become big buyers of AAA tranches in others’ MBS deals to diversify their book. Wachovia, which used to have a traditional mortgage portfolio concentrated in Charlotte, can now cut that exposure and replace it with mortgage risk from across the country. Photograph kindly supplied by Wachovia, June 2007.
UNDERSTANDING CREDIT DERIVATIVES
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credit derivative is an over the counter (OTC) derivative designed to transfer credit risk from one party to another. Most debt instruments are traded OTC with investment banks making markets in specific issues. In the OTC markets large financial institutions serve as derivatives dealers, customising derivatives for the needs of clients. In the case of credit derivatives, by synthetically creating or eliminating credit exposures, they allow institutions to more effectively manage credit risks. Most credit derivatives entail two sources of credit exposure: one from the reference asset and the other from possible default by the counterparty to the transaction. Credit derivatives take many forms, but there are three basic structures and these are: A credit default swap: A credit default swap provides protection against specific events. In a credit default swap two parties enter into an agreement where Party A pays Party B a fixed periodic coupon for lifetime of the agreement. However, the Party B makes no payments unless a specified credit event occurs. A credit event might be defined as a material default, bankruptcy or debt restructuring for the assets in question. If a credit event occurs, Party B pays Party A, and the swap then terminates. The size of the payment is usually linked to the decline in the reference asset's market value following the credit event. A total return swap: A total return swap provides protection against loss of value irrespective of cause—such as a default or market sentiment causing credit spreads to widen. In a total return swap two parties agree to swap periodic payment over the specified life of their agreement. One party makes payments based upon the total return—coupons plus capital gains or losses—of a specified reference asset. The other makes fixed or floating payments. Both parties' payments are based upon the same notional amount and the reference asset can be almost any asset, index or basket of assets. A credit linked note: A debt instrument is bundled with an embedded credit derivative. In exchange for a higher yield on the note, investors accept exposure to a specified credit event. For example, a note might provide for principal repayment to be reduced below par in the event that a reference asset defaults prior to the maturity of the note.
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Market participants can take some comfort from last year’s collapse of hedge fund Amaranth, which trumpeted its risk management prowess only weeks before it imploded from outsized bets in natural gas that went bad. Although it roiled natural gas prices for a few weeks, the effects never spilled over into other markets. It was particularly remarkable given that Amaranth lost $6bn, almost three times the amount that broke LTCM. Despite those catastrophic losses, Amaranth went into orderly liquidation and was able to meet its obligations to Wall Street prime brokers in full. Although defaults on sub prime mortgages are mounting, UBS’Martin has seen little evidence of hedge funds in distress struggling to meet margin calls. The losses have hit sub prime originators and dealer inventories instead. Although Martin foresees a difficult housing market for the next two years as the market adjusts to tighter lending standards he does not expect any spectacular hedge fund blow ups. “Those who have lost money are big and liquid and it is a small part of their overall strategy,”he says. If Martin is right, the prime brokers won’t suffer credit losses attributable to their hedge fund clients. Even so, another senior banker believes Wall Street houses are still vulnerable. Although some firms repackage sub prime loans and sell their exposure in securitisations, including the high risk residual tranches, others have set up dedicated proprietary trading desks to buy and hold MBS and CDO residuals just like the hedge funds. It is a strategy that could come back to haunt them if sub prime woes spread to other segments of the housing market, hedge funds stop buying residuals and securitisation volumes fall as a result. These firms will not
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only suffer losses on their prop desk portfolios but will also be saddled with the costs of a securitisation infrastructure equipped to handle much higher volumes. Financial
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engineering may have succeeded in dispersing balance sheet credit risk but some major banks’ earnings could still look ugly when defaults take a turn for the worse.
We aim higher. The CISX A more personal Stock Exchange delivering professional services efficiently and responsibly to the global marketplace.
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In the Markets GROWTH IN GUERNSEY’S FUND INDUSTRY
Business growth in Guernsey’s investment fund industry is at record highs. A buoyant background market undoubtedly helps. However, inflows into the offshore jurisdiction are the result of growing interest from fund promoters and sponsors in Guernsey’s expertise and infrastructure. Indications are that the upward trends enjoyed by Guernsey will be sustained throughout the rest of 2007 – pushing the jurisdiction rapidly towards the £200bn benchmark for funds domiciled and administered in the offshore jurisdiction. Peter Niven, chief executive of GuernseyFinance explains how Guernsey continues to upgrade its service offering and business reach in an increasingly competitive marketplace.
AHEAD OF THE GAME OMPETITION BETWEEN INTERNATIONAL financial centres is at a premium. Two dynamics are adding to the pressure. The first is ever-more competition with the growth in the number of international finance centres. The second is that their business flows are (by their very nature) inextricably linked to the wider world economy and therefore subject to changes in the levels of global liquidity—where highs and lows tend to be cyclical in nature. Notwithstanding Guernsey’s success in attracting new business to date, to stay ahead of the competition and maximise business, work continues with the enhancement of the island’s fund sector. In February, Guernsey introduced a new registered closed-ended funds regime—a streamlined consent process that facilitates the domiciling of funds in Guernsey. The new process is simple and quick and
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Peter Niven, chief executive, GuernseyFinance. Photograph kindly supplied by GuernseyFinance, June 2007.
has had immediate results. According to the most recent figures issued by the Guernsey Financial Services Commission (GFSC), the island’s regulator, by the end of March this year the value of funds under management and administration in Guernsey had reached a new record high of £140.4bn—up by £10.2bn (7.8%) during the quarter and £29bn (26%) year on year. Additionally, Guernsey domiciled open-ended funds have breached a new record total of £58.7bn—an increase of £2.1bn (3.7%) over the first three months of the year and a rise of £5.2bn (9.7%) from the end of March 2006. Guernsey domiciled closed-ended funds meanwhile now stand at a new high of £56.4bn—up £7.9bn (16.3%) during the quarter and £22.6bn (66.9%) since the same time last year and the combined value of all these funds has now topped
£115bn. Non-Guernsey schemes, for which some aspect of management or administration is carried out in the jurisdiction has also reached a new high, and now stands in excess of £25bn, up 0.9% during the quarter and £1.3bn (5.4%) during the previous twelve months. Fund approvals also continue to run at record levels. Over the past twelve months, the GFSC has authorised 31 new open-ended funds and 124 new closed-ended funds, 155 in total, which is 89 more than in between the end of March 2005 and the end of March 2006. According to Peter Moffatt, director of Investment Business at the GFSC, “The record level of fund approvals seen in 2006 shows no sign of slowing down. There is a continuing flow of enquiries and expressions of interest from both new promoters and promoters already represented through their existing Guernsey funds.”
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In the Markets GROWTH IN GUERNSEY’S FUND INDUSTRY
Market conditions have undoubtedly played a part. Primarily though, the figures indicate how more and more fund promoters and sponsors are viewing Guernsey as an attractive location in which to conduct business. Traditional funds remain well represented in these increased business flows but they are increasingly being complemented by alternatives such as fund of hedge funds, private equity and property that are becoming ever-more popular amongst investors’ portfolios, as well as more esoteric asset classes such as timber, wine and fine art.
Fund-friendly environment Among the more prominent financial institutions that now use the island include Alchemy Partners, Terra Firma, Apollo and KKR (private equity) and Kenmore, Tilney Investment, Schroders and F&C (property). Guernsey also plays host to an extensive array of investment businesses, including investment advisers, stockbrokers and more than 50 fund management, custodian and fund administration service providers that, in combination, offer a range of products and services for both retail and institutional investors from the general to the more specialised. These service providers are comfortable with both non-Guernsey and Guernsey open and closed-ended funds. The international marketplace for Guernsey funds is illustrated by the fact that they are now promoted or sponsored by leading institutions in 45 countries. These funds can be established through a range of flexible investment vehicles such as unit trusts, limited partnerships, protected cell companies (PCCs) and incorporated cell companies (ICCs) and are supported by the island’s legal, accounting, valuation, registrar, company secretarial and audit services.
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Guernsey’s administrative heritage is increasingly being complemented not just by the availability of custody services but also fund managers, including those specialising in hedge funds, ranging from larger organisations such as, Financial Risk Management (FRM) to more boutique operators, such as BBBSA Strategic Management Limited. The jurisdiction’s location, its Crown Dependency status, including legislative and fiscal independence; and its unique relationship with the European Union, have provided reliable pillars on which its success is being built. Guernsey is growing, not only as a leading international funds centre but also as a premier domicile for a host of financial services, broadly-comprising banking, fiduciary and insurance. Its principal business segments are supported by a comprehensive network of complementary services, including legal, accounting, auditing and tax advisers. Alongside is the Channel Islands Stock Exchange (CISX), which now has over 2000 securities listed on its board. Guernsey also boasts a large pool of experienced and qualified non-executive directors. There are no direct rules on the make-up of the board for funds domiciled in the jurisdiction, but it makes practical sense that the majority of directors would be located locally. It also helps provide clear delineation between the onshore investment management and the offshore overall management and control of a company. Moreover, the island has acquired a reputation for strong corporate governance. Domiciling and administering a fund in Guernsey, particularly for investment managers in the UK, is also made easier by its location—in a time zone that allows business to be conducted with both the United
States and the Far East during the same day. There are frequent air and sea links to both Europe and the UK, with flights from London taking less than an hour. In addition, an extensive array and high volume of business can be carried out face-to-face and in a short amount of time because of the close proximity of key institutions and businesses in island’s business district. Guernsey is becoming a convenient, one-stop shop, for funds. The GFSC has built a robust, yet pragmatic regulation regime. Evidence of this approach is provided by the new registered closed-ended funds regime. Eighteen such funds have already been approved by the regulator, since the introduction of the new regime in February this year. The ‘registered fund’ regime streamlines the consent process—making domiciling funds simpler and quicker. Importantly, it shifts the burden of responsibility for reviewing the promoter, the investment manager and the prospectus (or admission document) from the GFSC to the proposed Guernsey licensed fund administrator. The regime is a refinement of the approach taken by the GFSC in respect of Qualifying Investor Funds (QIFs), the self-certification regime which enabled shorter authorisation times for funds targeting experienced investors. This streamlining has its origins in the root and branch review of investment sector legislation that was conducted by a working party under the stewardship of leading Guernsey advocate Peter Harwood. The Harwood Report recommended a number of enhancements to the funds regime, including the categorisation of funds into ‘regulated’ and ‘registered’ funds. The recommendations are being steadily implemented, and a new slew of improvements will come on-stream later in 2007 and into early 2008.
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In the Markets FX: THE IMPACT OF ALGORITHMS
Algos increase complexity in FX trading markets For an asset class traders were giving up for dead at the turn of the century, foreign exchange is in rude health. Spot trades, futures on the Chicago Mercantile Exchange (CME), forwards, swaps and options have all set volume records in the past 12 months. Electronic trading has fuelled the growth, bringing tighter spreads and transparency to a market once notoriously opaque to everyone except the banks. Money managers are applying algorithms developed for equity and fixed income markets to foreign exchange, too. But average ticket sizes have fallen, so back offices have to cope with exponential increases in ticket and messaging volume. Are they up to it? Neil O’Hara reports.
Sang Lee, a senior consultant at Aite Group says F/X is no longer a by-product of cross border transactions but has emerged as an asset class in its own right sought after by traditional asset managers, hedge funds, commodity trading advisors and proprietary trading desks. Photograph kindly supplied by Aite Group, June 2007.
2006, a 54% increase from 2004. Although robust global growth and globalisation of the supply chain have underpinned the market, they cannot account for such a dramatic expansion. Sang Lee, a senior consultant at Aite and author of the report, says FX is no longer a byproduct of cross border transactions but has emerged as an asset class in its own right sought after by traditional asset managers, hedge funds, commodity trading advisors (CTAs) and proprietary trading desks. In the derivatives world, the CME’s currency futures contracts, first introduced in 1972, went nowhere until 2000, when the exchange listed them on Globex, its electronic trading platform. Traders have flocked to the market ever since: average daily notional value hit $67.9bn in 1Q 2007,
a 43% increase over the preceding year, while contract volume also rose 40%. Although precise figures are hard to come by, Lee says trading in OTC currency options has surged as well. The FX market was long bifurcated between banks who traded with each other on tight spreads and customers who took whatever price their bank quoted. “When I first got in the business—almost 20 years ago—it was a cloak and dagger market,” says Russell LaScala, head of FX trading at Deutsche Bank in North America. That changed after 2000 with the advent of multibank electronic trading platforms, which for the first time allowed customers to see quotes from several sources at once. The unprecedented transparency caused bid-offer spreads to collapse—and volume soared as transaction costs
OREIGN EXCHANGE TRADERS were a gloomy lot in the late 1990s. They saw the advent of the Euro as a disaster because it replaced 11 currencies with one and knocked out 55 currency pairs in the Eurozone alone—and even more between the legacy currencies and the rest of the world. They were not entirely wrong. The triennial Federal Reserve Bank of New York survey of daily foreign exchange (FX) turnover in the United States dropped from $351bn in April 1998 to $254bn three years later. But the pessimism was overdone and by April 2004, turnover had rebounded to $461bn. Volume has ballooned since then. In a recent report, Aite Group, a research firm based in Boston, Massachusetts, estimates that global average daily FX turnover reached $2.8trn by the end of
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A LFI
Association Luxembourgeoise
des Fonds d'Investissement
&
nicsa The National Investment
Company Service Association
25 & 26 September 2007 Hemicycle of the Kirchberg Conference Centre, Luxembourg
THE 16TH ANNUAL Global Investment Funds Forum
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In the Markets FX: THE IMPACT OF ALGORITHMS
plummeted. Ten years ago, electronic trading was virtually non-existent at Deutsche; today, LaScala estimates it accounts for between 60% and 70% of order flow. “We have a whole new set of clients,” LaScala says,“People are taking models they developed for other asset classes and applying them to foreign exchange.”It isn’t only traditional asset managers, either. Hedge fund assets keep growing—over $1.5trn by some estimates and LaScala says managers are keen to trade an asset class uncorrelated to equities. At $3trn per day, liquidity in foreign exchange is deep enough to accommodate even the largest hedge funds. Retail interest in FX has exploded, too, now that investors can trade on what used to be wholesale terms. Following a pattern seen in other markets that switched to electronic trading, ticket numbers have grown even faster than dollar volume as average ticket size has dropped. On the busiest days—such as December 20th 2006, when CLS Bank, the central clearing system for foreign exchange, reported a record $6.6trn traded; or January 16th this year, when the number of payment instructions processed surpassed 700,000 for the first time—Deutsche Bank and other participants have hit some obstacles in the middle and back office. “It is amazing,” LaScala says,“This has been going on while volatility has steadily been dropping.” Deutsche has boosted its capacity to handle trades because it expects FX will continue to grow in both volume and the number of new clients. Linda Dunne, North American head of operations for State Street Global Markets, shares his concern. In addition to her role at State Street, Dunne chairs the Operations Managers Working Group under the auspices of the Foreign Exchange Committee run by
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the New York Federal Reserve Bank, one of several similar committees around the world that work together to keep the FX markets running smoothly. The challenges presented by burgeoning ticket volume often come up at her working group’s monthly meetings. The problems are about to get worse, too. Aite Group estimates that algorithms accounted for only 7% of FX trades at the end of 2006 but expects the proportion to rise to 25% by 2010.“Algorithms generate more trades, faster and smaller” Dunne says, “How do you keep track? Is there risk? Is someone arbitraging against you? Can you back out or have you already confirmed the trade? There is potential for increased operational risk in high velocity trading.”
“We have a whole new set of clients,” LaScala says, “People are taking models they developed for other asset classes and applying them to foreign exchange.” It isn’t only traditional asset managers, either. Hedge fund assets keep growing— over $1.5trn by some estimates and LaScala says managers are keen to trade an asset class uncorrelated to equities. In March, State Street took a front row seat in the fast trading arena when it bought Currenex, an electronic communications network (ECN) designed to meet the needs of hedge funds, CTAs and proprietary trading desks by providing low latency price feeds. The bank already operated FX Connect, a multi-bank electronic platform aimed at
traditional asset managers who don’t insist on instantaneous quotes, but wanted to expand its presence among active traders. A fast market environment with streaming quotes throws up more operational difficulties for Dunne. If Currenex trades are fed directly into State Street’s general ledger, they will slow down processing times and undermine Currenex’s competitive advantage. The trades could be held separate and fed into the general ledger later, of course, but if trades don’t match someone is left holding the bag. “If the trader is wrong way around, a buy that should have been a sell, if you wait and do that too late in the process what market exposure have you caused and for whom?” Dunne asks. Fast trading stresses on operational infrastructure generate lengthy discussions at her working group but no consensus has yet emerged on how to handle them. Dunne says that CLS Bank has gone a long way to eliminate the socalled Herstatt risk – named after the German bank that failed in 1974 and left counterparties in the lurch for one side of FX trades that hadn’t settled due to time zone differences. CLS (for continuous linked settlement) now provides real time settlement in 15 currencies to more than 70 member banks that process the lion’s share of global FX trading. It isn’t perfect, however. Members— including State Street—are pressing CLS to drop a rule that prevents members from submitting pre-netted trades because non-member banks have gained market share by offering to net trades and avoid CLS clearing costs. “It’s not a level playing field. Both settlement members and prime brokers have concerns about this,”Dunne says. The growing interest in FX by hedge funds and CTAs has led to the evolution of foreign exchange prime
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brokerage, which enables funds to trade FX with counterparties other than their securities prime broker. Andrew Coyne, managing director responsible for foreign exchange prime finance at Citi, says clients do incur ticket charges if they trade away, but if their house broker isn’t offering the best price they can easily make up the difference and more. Fx prime brokerage contributes to the fragmentation of order flow, of course. Coyne notes that huge increases in ticket volume not only stress operational performance but also highlight the cost per ticket. “Prime brokers are now looking at means by which they can process more efficiently to lower their ticket costs,” he says,“They are also making sure that when there is a systems issue that they can continue to operate.” Coyne believes the prime brokers were among the first to recognise the threat rising ticket volume posed and are already planning to boost their processing capacity. He has not heard of any major problems in the cash market (spots and forwards) and is even less worried about the swaps market where notional amounts are bigger but volumes are lower. Business continuity is a challenge for the ECNs, too, but Coyne points out the plethora of electronic platforms means that clients can always find somewhere to trade. Worst case, they can even do it the old-fashioned way and pick up the phone.“The reality is that problems are few and far between,”he says. That has not stopped “What happens when an ECN crashes?” becoming a hot topic for Dunne’s working group. “How do we know we get all the right trades back if it goes down?”she asks, “What technology do they have in place to make sure what they are sending you is accurate, quick and correct?” The committee draws some comfort from the privileged input
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about system performance it gets from the representative of EBS, the leading spot FX electronic trading platform. The foreign exchange markets have always been unregulated but Dunne expects that rising retail trading may encourage the authorities to take another look. Participants are already talking about the implications of the EU’s Markets in Financial Instruments Directive (MiFiD), which takes effect in November 2007 and will impose an obligation to provide best execution. It is one more burden on the operations side that will require banks and ECNs to modify their systems, Russell LaScala, head of FX trading at Deutsche Bank in and formal market North America. Following a pattern seen in other markets oversight would only that switched to electronic trading, ticket numbers have make matters worse. grown even faster than dollar volume as average ticket size Electronic trading is a has dropped. On the busiest days—such as December 20th double-edged sword, 2006, when CLS Bank, the central clearing system for foreign of course, because exchange, reported a record $6.6trn traded; or January 16th although it generates this year, when the number of payment instructions processed incremental volume it surpassed 700,000 for the first time—Deutsche Bank and also facilitates straight other participants have hit some obstacles in the middle and through processing so back office.“It is amazing,” LaScala says,“This has been going that trades can settle on while volatility has steadily been dropping.” Photograph untouched by human kindly supplied by Deutsche Bank, June 2007. hands—and free of errors. “Overall, it has had a the trades settled one way or another. So far, at least, the middle and back tremendously positive impact on minimising risk,”says Aite’s Lee,“That’s offices of the major players have kept one of the key drivers of electronic up with the boom in foreign trading.” It’s no surprise that prime exchange. But the heat is on as brokers are on the cutting edge as a algorithmic trading drives ticket result. In many cases, Lee says clients volume ever higher, let alone what treat prime brokers as an outsourced might happen if volatility spikes in a back office and figure it’s their job to get future currency crisis.
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In the Markets CHINA INVESTMENT AGENCY BUYS BLACKSTONE STAKE
China looks to private equity for investment returns China’s central bank governor Zhou Xiaochuan speaks at a press conference in Beijing in early March this year. Earlier in the month Chinese commerce minister Bo Xilai had rejected US pressure over China's soaring trade surplus, criticising proposed punitive tariffs as a violation of free trade that would hurt American companies. Photograph by Greg Baker, supplied by Associated Press/PAPhotos.com, June 2007.
It was a bombshell. In late May, the Blackstone Group, the global investment and advisory firm best known for its private equity activities, announced that it had secured a commitment from China’s State Investment Agency for a $3bn stake in its planned initial public offering (IPO), said to be worth at least $4bn. It was a coup in a number of respects. The State Investment Company, China’s official foreign exchange investment company, has yet to be established. The size of the stake is a benchmark of sorts and emblematic of China’s growing economic confidence and expertise in the global financial markets. It is quite a sophisticated play by China, bringing it into the sphere of the American International Group, which owns 7% of Blackstone and Kissinger Associates, with whom the private equity maven has close ties. Four, it signals a shift away from China’s hitherto monoline investment preference in the US, namely to buy US treasury bonds. Ian Williams reports. HINA’S STAKE IN the Blackstone Group is not significant in itself. $3bn is a small proportion of the total equity of the Group, an even smaller proportion of the private equity funds sloshing around the globe, and an infinitesimal chip from the $1.2trn reserves that China is holding. At 110% of Blackstone’s outstanding shares,
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China’s stake values the firm around $30bn. It is not even much of the reputed $200bn that the State Investment Company, which is said to be modelled on Singapore’s Temasek Holdings Pte., will be wielding. The deal is carefully structured to protect all parties. The Chinese will hold on to their stake, with a ceiling of 10%, for at least four years and in return they will
get 4.5% discount on the IPO price, which on current trends is likely to surge on issue. While the deal is small, it is nonetheless significant—all the more so for being inevitable. The real mystery is not that China should be turning away from US Treasury bonds (T-bonds), but that it has taken so long to shift some its reserves from such a low-return
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depreciating instrument. It has announced a moderate shift from dollar instruments to other currencies, but of course it has to be careful not to starve the golden goose. After all, Chinese domestic growth has hinged on pumping liquidity to keep the US economy up, running and buying. It cannot therefore risk too a precipitate shift from the dollar if it stifled its biggest market. The logical conclusion is to identify American assets with higher returns than T-bonds—hardly a difficult task—and then shift some of those reserves into them. That would continue to maintain the US economy while making more business sense. Of course, previous outward moves from China, such as the attempted purchase of Unocal last year by hydro-carbon major CNOOC, have not been greeted with any great rationality by US politicians. It is no surprise then that Beijing is cautious. Bill Reinsch of the US’s National Foreign Trade Council notes however that, “I didn’t hear a lot of complaints about this one. After all, it is a nonvoting investment, and relatively small. It is really an inevitable trend: after all [China] could not go on buying T-
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bonds forever with [its] growing reserves, and of all the things [it] could be doing, this is the least controversial, and low-profile. It’s not like the Japanese buying the Rockefeller Center, half of Nebraska’s farmland and the Pebble Beach golf course; the Chinese are behaving with exemplary caution.” Dr Denis Simon, the Dean of the State University of New York, Levin Graduate Institute of International Relations and Commerce, has an added explanation. He suggests that China’s strategy and tactics are influenced and informed by returnees. Known as “Sea Turtles,”these are young Chinese who have studied abroad and worked in places such as Goldman Sachs and have returned to work with Zhou Xiaochuan, governor of the People’s Bank of China, and now spearhead of many of China’s economic innovations. “Zhou Xiaochuan is a serious player and surrounds himself with good people,” comments Simon who has helped many of the fledgling financiers during their apprenticeships in New York. Simon adds “These sophisticated returnees have been working on the problem of how to recycle China’s trade surplus more effectively. They have a more global
outlook and they know how to play the game. They are more assertive in their outlook. China is moving into global finance in the same way it moved into manufacturing, commodities and R&D, but is not taking highly visible assets, the way the Japanese did, this is a much more nuanced play.” Simon sees the stake as “not just a dabble. After CNOOC, they are not going to make a move that has not been thoroughly thought out. China did not want to move until it was sure of the rules. Now it does.”If the stake had been higher than 10% it could have triggered a congressional review, which would have allowed politicians to grandstand any Sinophobia. Getting a discount before the IPO reveals an awareness of how to play the game, and gives a better yield than T-bonds, and it also adds to the learning curve. Its non-voting stake may not give a hand on the steering wheel, but it does guarantee being able to look over the shoulder of experiences equity players and to learn from how and where they steer. As part of the deal with Blackstone, China promised not to make another similar equity deal for at least a year, but
A POCKET DESCRIPTION OF THE BLACKSTONE GROUP
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ounded in 1985 by Peter Peterson and Stephen Schwarzman, the Blackstone Group operates in four segments: corporate private equity, real estate, alternative asset management, and financial advisory, Blackstone manages over $32.4bn through its Blackstone Capital Partners I, II, III, IV, and V and Blackstone Communications Partners funds. The firm has diverse holdings including Cadbury Schweppes, Deutsche Telekom, SunGard, Texas Genco Holdings, and publisher VNU, with a total enterprise value of all transactions up to the end of last year of more than $191bn. Most latterly, in mid-May the group acquired all of the outstanding common stock of Alliance Data Systems Corporation via Blackstone Capital Partners, in a transaction valued at $7.8bn (including the assumption of certain debt) and at a purchase price that represents a 30% premium over Alliance Data’s closing share price of $62.96. The company's Blackstone Alternative Asset Management unit handles $1bn in hedge funds for pension giant CalPERS. The Group’s management company earns its income from fees received for running the funds as well as profits from selling investments, earning $2.27bn in 2006, 71% more than a year earlier. Blackstone is selling a stake to the public in its management company instead of specific funds. The firm is the second US manager of hedge funds and private equity to sell shares, following Fortress Investment Group LLC's February offering. Pre-IPO sales of equity is not unusual. Ahead of its IPO, Fortress sold a 15% stake to Nomura Holdings Inc., Japan's biggest securities firm, for $888m.
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In the Markets CHINA INVESTMENT AGENCY BUYS BLACKSTONE STAKE
since it takes longer than that to put together such a transaction, no one is too worried. However, other funds will certainly already be checking out the prospects for tapping that $200bn pool and they will be looking for figures such as Antony Leung, the banker who was Hong Kong’s finance minister (and who as Blackstone’s Greater China chief executive officer, has showed that traditional guanxi still has an important role in the reformed China). Blackstone hired Leung in January this year to head its Asia Pacific operations, together with Ben Jenkins, a senior managing director who recently moved to Hong Kong from New York. Right now, the Blackstone stake is a straw in a wind that will certainly blow harder. Despite the relatively mild reception, there is still plenty of scope for Sinophobia and xenophobia to raise their heads in an election year. China will be a big issue in the Presidential elections. Moreover, elections are about votes and donations, not necessarily what makes long term sense. If Blackstone makes a major acquisition of an American company then we could have a resurgence of the nonsense about Lenovo’s purchase of IBM and the expedient suggestions of spyware planted in Department of Defense (DoD) computers. Conversely, if Blackstone makes a bid for major Chinese assets, this could raise worries about re-recycling Chinese liquidity into already inflated equity markets and could increase pressure to revalue the Yuan, with consequences for growth. China’s growth has been so fast that the rising tide has indeed floated many boats—but by no means all. Trickledown did not work too well in Reagan’s America, and the huge disparity in wealth and opportunity in China, with its consequent threat to social and political stability is a major factor for such decisions which is one of the reasons why the People’s Bank is
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so loathe to revalue in face of the risk of slowing growth at home. In fact, the Chinese stake is in the Blackstone’s management group rather than any of the funds, so although it may benefit from any investments that a fund may make in China, it will not provide the capital. But on the other hand, the funds will certainly benefit from the guanxi and expertise that the investment link implies. The rest of State Investment Company’s $200bn available could also lead to concern about the effects on western economies of adding to the flood of private equity that is already pushing up asset prices. Federal Reserve chairman Ben Bernanke has already pointed out the “significant risks” for banks of the private-equity boom, which some Cassandras are referring to as a bubble. On cue, within days of the Blackstone announcement, the Organisation for Economic Cooperation and Development (OECD) issued a warning; the boom in buyouts on excess liquidity and low yields is caused by “distortions” in the global system, which they identified as low domestic interest rates and exchange rates in Japan and China. “The present situation has elements of instability in excess liquidity that is difficult to control and leverage that is taking advantage of it,” the report warns. The OECD warned, “If the sources of global liquidity creation cannot easily be controlled, it is all the more important that financial institutions and levered market participants remain aware of the risk.” It would be ironic if election year Sinophobia in the US forced the Chinese to put more in private equity than in direct purchases than they would otherwise want to. There are indeed enough bubbles to go round. Blackstone itself bought the Equity Office real estate group for $36bn in
Stephen Schwarzman attends the 39th Annual Museum of Modern Art's Party in the Garden honoring Martin Scorsese, held at the Museum of Modern Art, in on May 15th 2007. The chief executive of Blackstone Group will pocket $449.2m and hold about 24% of the company after it goes public, the private equity firm said in a regulatory filing with the US Securities Exchange Commission (SEC) on Monday, June 11th 2007. Stephen Schwarzman, 60, also received cash payouts worth nearly $400m last year. Photograph by Jennifer Graylock, supplied by Associated Press/PA Photos, June 2007.
what it trumpeted as the biggest private equity real estate deals ever. Somehow, a coalescence of the Chinese, American real estate and private equity bubbles leaves a lot of room to worry about synergistic bursting. One could almost worry about the art market bubble that last year symbolically put a $17m price on the Andy Warhol portrait of Mao. We can only hope that the sea turtles in Beijing picked up some tips on global macroeconomics, in addition to expertise in playing the financial markets.
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THE FTSE HOW DO I GET INTO REAL ESTATE INDEX FTSE. It’s how the world says index. Real estate has outperformed both equities and bonds over the last 10 years. But getting into real estate hasn’t always been easy. That’s changed. Whether you are looking at REITS or want direct exposure to commercial property, FTSE has the world’s leading range of Real Estate Indices, helping you measure the performance of global real estate markets and invest more easily. www.ftse.com/invest_real_estate
© FTSE International Limited (‘FTSE’) 2007. All rights reserved. FTSE ® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.
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Regional Review ASSET VALUATIONS: A GROWING BUSINESS SECTOR
ASSETS: BUT AT WHAT PRICE? Independent asset valuation is a booming business. This year and last, vendors such as Standard & Poor’s and Reuters, have deepened and broadened their service range to cope with market demand. CCORDING TO REUTERS, more than half of Asia’s investors admit to struggling to price even their most liquid assets. In a survey of 120 senior portfolio managers, credit traders and analysts, conducted through April and May this year, Reuters and Pacific Prospect, an integrated Asian financial publishing, conference, research and consultancy business, found that: “liquidity, market transparency and accurate mark to market pricing are among the biggest challenges to investing in new structures and asset classes in the region. In turn, this poses a growing problem for middle and back office staff who are processing trades with some of the consequences being higher costs, greater risks and impediments to future growth.” It is not just in Asia where accurate asset valuations are required. The need for accurate portfolio evaluations, the provision of accurate asset prices for fund administrators, and risk managers is pushing business forward at a fast rate. Sarbanes Oxley, the Markets in Financial Instruments Directive (MiFiD), UCITs II and Basel II regulations have also spurred the rise of independent and reliable valuation services in the rest of the world. In Europe, the Alternative Investment Management Association (AIMA) issued guidelines in March this year on sound practice in hedge fund evaluation, for instance. In its policy
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paper, AIMA noted that; “conflicts of interest in the valuation process are usually best managed by the appointment of an independent and competent valuation service provider.” Independent valuation is a critical factor then, ensuring that the back office, rather than front office oversee month-end pricing. One effective way to ensure independence is for funds to appoint independent, third party administrators, tasked with overseeing the valuation process. Another is for the asset management firm’s back office to work directly with price vendors and third party valuation agents. Best practice principles in valuation encompass: “transparency in the valuation process, price consistency and the independent valuation process itself,” explains Peter Jones, director of securities evaluations at Standard & Poors. The applications are manifold. Not only fund administration specialists and asset managers require accurate asset prices. Software providers, such as Citadel and Xenomorph, increasingly rely on independent sources of pricing data to feed into their analytical models. Additionally, the rise of alternative asset allocation strategies has opened up a niche in the pricing of private equity, real estate and derivatives. The Reuters/Prospect survey found that while collateralised debt obligations (CDOs) and mortgagebacked securities (MBS) were the most liquid fixed income products in Asia (with credit default swaps (CDS), and corporate and convertible bonds also figuring highly) two-thirds of respondents reported that these assets were the hardest to price.
So far in Asia, only small numbers use independent sources of asset valuation. Most investors call brokers for prices, despite the obvious conflicts of interest, with only 10% using alternative sources of pricing, such as exchanges or in house methodology. According to Fabian Bulabois, senior fixed income evaluator at Reuters, independent valuers can provide “consistent pricing, even for illiquid stocks that are not always available to the market at large, that use a consistent methodology.” Market prices come from marketmakers, brokers, new issue information, credit ratings,“issuer news and industry developments, which can reveal systemic risks,” he adds. In Reuter’s case, its evaluation services are firmly rooted in the fixed income market and the firm has evaluated over 200,000 corporate and sovereign bonds to date, including fixed rate, callable and floating rate bonds. Reuters’s prices are derived through model based evaluations, which discount the cash flows of each security (which are particularly important, notes Bulabois, especially for securities with prepayment options). Additionally, securities such as government bonds and high yield instruments are priced by actual broker quotes. “It is not an exact science,” acknowledges Bulabois, “After all, it is an over-the-counter (OTC) market.” For now, Reuters is looking to diversify its pricing offering, with “interest rate swaps and OTC derivatives, natural growth areas and we can diversify across product,” he adds. Commodities and foreign exchange will also feature in the service range. “The general trend however is growth in instruments that offer yield, such as CDOs and ABS.”
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Index Review IS INVESTOR CONFIDENCE TOO HIGH FOR COMFORT?
Stocks, rocks and rolls With investor confidence high, most of the major indices are having a poke at new trading levels. The European and US markets seem to hit new peaks almost on a daily basis with the Chinese and Indian markets roaring away. How much longer can the good times continue to roll, asks Simon Denham? MID ALL THE plenty rolling round the world’s equity markets, have the FTSE 100 and Nikkei 225 been left behind? The FTSE 100 is doing fine on an absolute basis, yet it continues to underperform. For those who point to the dragging effect of a potential 6% base rate as being the major factor, the Nikkei 225 (struggling under the weight of 0.25% base rates) is doing even worse. At close on the 25th May the Nikkei had managed a massive 200 points to the upside since the turn of the year, a move of just 1% and all the while the yen has been in almost terminal decline. For a foreign investor in ‘Japan plc’ this has meant rather a nasty little dent on portfolio values. Since 2006 the FTSE 100 has put on some 6%—compared with 17% for the Germans and 10% for the French. Both the US and the UK are sitting with semi lame-duck incumbent leaders. So far that fact has not had an impact on the markets which have shown a refreshing ability over the past decade to virtually ignore political events. In the UK, this might change however.
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Simon Denham, managing director, Capital Spreads. Photograph kindly provided by Capital Spreads, December 2006.
The economic fortunes of the Labour government have been built on the corporate income of UK plc. The weight of regulation and taxation are beginning to slow the platform that was built in the 1990s and originally followed (in the first few years at least) by the then incoming administration. The City, as it has in the past, is likely to ride the waves but with rising inflation and interest rates and stagnating job growth it will prove ever harder to maintain growth throughout the economy. In fact if the UK government’s spending impetus is removed from the GDP data, the economy has not moved for some years. If spending is now reined in, the effect could be dramatic. US and Far Eastern markets look extended but (excluding China) not excessively so. The price to earnings ratio on the S&P500 is around 18x earnings reasonably well below the 20 year average of 22x, but prospects are currently struggling under US Federal Reserve rates of 5.5%. If, as expected, a halt is called to the current tightening cycle we could well see US markets go considerably higher as investors factor in rate cuts further down the line. US corporate profitability growth has managed to beat pretty optimistic analyst calls for some years and this cycle, based on recent company updates, seems no nearer to ending. Investors could even be looking at another 15% to 20% on US stocks
this year, but there are two problems. The first is US growth and the second, the overvaluation in the Chinese markets. US growth seems to have a number of influences pulling on it— not least the worries over housing valuation. On the inflation front, capacity utilisation seems tight [as does employment] however, consumer and purchasing managers confidence look fragile—which is, no doubt, why rates are on hold right now. A movement either side of this equation will take analysts down the road marked “Fed intentions”. Any indication that the Fed could be tightening once more could be taken as a bucket of cold water and could ignite a serious correction. Chinese equities meantime are trading on 43x expected earnings for 2007 on the Shanghai Composite Index. While China’s economic explosion is impressive, it is a leap of faith for the average stock to be trading at this premium. Interest rates are at 3% and are unlikely to go down. However, remember that the trigger for the February/March falls was an overnight 10% drop in the Shenzhen Index. The market now trading at alltime highs (around 4335) and we have seen a 62% rise so far this year alone. The market is going too far too fast and there is almost certain to be a correction. The serious question is whether that correction will overflow into other global markets? As always, place your bets ladies and gentlemen!
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Regional Review UK REITS: PICKING UP AFTER A SLOW START
UK REITs: A BULLDOG, OR A LESSER BREED? When a number of the United Kingdom’s property great and good gathered to ring the bell at the London Stock Exchange (LSE) in early February they had good reason to kick up some noise. A month earlier the lid had finally come off real estate investment trusts (REITs) in the UK and the FTSE’s first UK REIT index opened with nine members, quickly climbing to its current 14 and with several more due to join. Yet a quiet start to the financial year and consensus that an extraordinary property bull run is losing steam have caused analysts to question just how well the UK’s REIT market is performing and to put Britain bottom of the league. Is the prognosis bad? Many REITs themselves think not. Mark Faithfull explains why.
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E ARE DELIGHTED to celebrate the commencement of the UK REIT regime. The Exchange has worked hard with the UK property industry and with government to ensure the best possible conditions for UK REITS, and we are confident that the result will be cheaper capital-raising for companies and more opportunities for investors,” waxed Christopher Gibson-Smith, chairman of the London Stock Exchange (LSE) at the bell ringing ceremony.“UK REITs have got off to a good start as an asset class.” Six months on from their debut and, on the face of it, the response to REITs has been mixed. Some critics say REITs have not met initial expectations. Some Analysts have
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even downgraded the sector and called the end of a four-year boom in British commercial property. The UK is the only country where the REIT market, as a whole, is trading at a consistent discount to the net value of the underlying property assets. So what’s going on? After all the UK has one of the biggest, most active and most internationally seasoned property markets in the world. The domestic market has always attracted plenty of foreign investment—from institutional investors to megadevelopers to luxury private home buyers—while British property companies have consistently displayed an expansionist approach, developing and investing in properties globally. Traditionally, REITs trade at a
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Photograph supplied by iStockphoto.com, June 2007.
premium to net asset value (NAV), reflecting the vehicle’s tax-efficient structure. They trade on an average premium to NAV of about 35% globally but UK blue-chip British Land has been trading at a 12% discount, Land Securities Group trades at an 8% discount and Liberty International trades at a 5% discount, although these differentials are converging. In neighbouring France the premium is as much as 50% to 60%. UK REITs also pay lower dividends compared to earnings than their global peers and, combined with the fear of interest-rate increases, the sector continues to trade at a discount to NAV. In tandem, UK commercial property returns have fallen 8.3% in the year to date, according to the FTSE
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Regional Review UK REITS: PICKING UP AFTER A SLOW START
Meanwhile, UK pub and restaurant group Mitchells & Butlers (M&B) affirmed in May that most of its estate could be converted to REIT status as it confirmed that real estate tycoon Robert Tchenguiz is in pole position to buy around half of its property assets. The proposals would see the group include most of its £5bn worth of property in a new company, with Tchenguiz’s R20 investment vehicle buying the rights to half the business. EPRA/NAREIT Global Real Estate Index for April. “You have to look at the background and the performance in UK property,” counters Peter Damesick, head of research at agent CB Richard Ellis. “Last year was very strong; we saw capital up on the back of continuing yield compression. That growth is levelling out and investment yields are out of the compression chamber, if you like. Arguably there has been some over-exuberance over the past two or three years and this is what we have been expecting. UK REITs happen to have arrived just at this point in the cycle, but three months is a very short period of time to be assessing them.” Stephen Hester, chief executive of one of the UK’s biggest REITs, British Land, concurs and says that “uninformed comment” about performance to date “derives from a misunderstanding of what REITs are all about. They are about different taxation status, no more, no less and for us the changes are unambiguously positive.” Instead Hester says that the
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market is“at an inflexion point after an incredible bull run over the last ten years, especially the past three,” and acknowledges that market re-pricing has been going on, something which he believes was inevitable and is now complete. “We have a more realistic market now,”he adds.“That’s provided an opportunity for some to take profits from their stakes in property companies but now we have what I would call fair price, or equilibrium.” John Richards, chief executive of another major UK REIT, Hammerson, adds that property movement has also been aided by capital gains tax relaxation under REIT status, enabling property companies to sell or buy developments that previously may have been economically prohibitive because of the capital gains the deal would have attracted. Consequently, Richards believes that REITs are now easier to compare because value is not hidden by latent tax issues. “And that is attracting more overseas investors,” he stresses. “About 10% of Hammerson stock is now held by North American investors, a far higher proportion than in the past. It’s far too early to talk about disappointing REIT performance, ten years from now if there has been no big change in the market, no new players and no positive impact on the sector, then you can say it has been a failure.” Francis Salway, chief executive of the UK’s biggest REIT, Land Securities, similarly dismissed recent criticism of UK REITs’ poor performance at the company’s results in May. “The spread between yields and borrowing costs is less advantageous in the UK than in virtually any other country in the world,” he said. Analysts have been less positive, with Lehman Brothers discussing exit routes for REITs.“That is premature,” said Salway. “It was always going to be the case that some
Peter Damesick, head of research at agent CB Richard Ellis.“Last year was very strong; we saw capital up on the back of continuing yield compression. That growth is levelling out and investment yields are out of the compression chamber, if you like. Arguably there has been some overexuberance over the past two or three years and this is what we have been expecting. UK REITs happen to have arrived just at this point in the cycle, but three months is a very short period of time to be assessing them,” he says. Photograph kindly supplied by CB Richard Ellis, June 2007.
REITs would trade at a premium and some at a discount.”
New players Of course one of the major changes the switch to REITs was supposed to achieve was to encourage new players and specialist investment opportunities, creating more liquidity and greater investment access for all types of investors. To date the UK REIT market has been dominated by the same traditional, broad-church property players that led the market
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Regional Review UK REITS: PICKING UP AFTER A SLOW START
before December 31st 2006, which have transformed in order to benefit from the tax breaks on offer. However, a series of new REITs are being mooted or coming to market, despite some setbacks in the residential sector and this summer should see the first real step-change in the UK property market as a result of REIT legislation. In March, the Local Shopping REIT joined the LSE’s Main Market, becoming the first UK specialist startup REIT to be admitted. Specialising in local shopping assets in the UK, Castlemore Holdings launched the company to target neighbourhood and specialist property in urban conurbations, plus selective high street assets. The company raised £160m through its placing, which it proposes to use to grow to a diversified portfolio of just under 500 assets. Vector Hospitality, the UK’s first hotel REIT, launched its initial public offering in June, targeting a share price of between 995p and 1,115p valuing the company at £2.02bn to £2.26bn. Vector was formed by Alternative Hotel Group chief executive and property tycoon Richard Balfour-Lynn and ex-Hilton boss Sir David Michels, with the backing of the Bank of Scotland and Royal Bank of Scotland and the REIT includes 71 hotel assets throughout the UK operated by Hilton, Marriott, Rezidor, Thistle Guoman, Malmaison, Hotel du Vin, De Vere and Village Hotels and Leisure. The group is also contracted to acquire seven further Malmaison and Hotel du Vin properties, worth £113m, upon construction. Australian developer Lend Lease, which is best known in the UK as the developer and landlord of landmark shopping centre Bluewater, is planning to launch a £1.5bn residential REIT, made up of the 2012 London Olympic Village, which it is building. It plans to launch the fund in
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Cushman Wakefield’s head of capital markets, Tim Sketchley. He says that although the major companies maintain general strategies the market is likely to be far more “opportunity-driven, using property expertise” and that the impact of the current spate of portfolio realignments is still feeding through.“It is still too early to assess their impact in the UK, they need time to find their proper place” he reflects. “If you look at the US, the REITs there may be very successful now, but they have had a pretty chequered history.” Photograph kindly supplied by Cushman Wakefield, June 2007.
2009 as the largest UK-listed residential vehicle run by a consortium, including First Base and East Thames Group, comprising six zones of the Olympic Village which will include 4,500 homes, up to 500,000-sqm of offices and almost 40,000-sqm of leisure. Meanwhile, UK pub and restaurant group Mitchells & Butlers (M&B) affirmed in May that most of its estate could be converted to REIT status as it confirmed that real estate tycoon Robert Tchenguiz is in pole position to buy around half of its property assets. The proposals would see the group
include most of its £5bn worth of property in a new company, with Tchenguiz’s R20 investment vehicle buying the rights to half the business. Tchenguiz, who owns around 15% of the group, initially called for a spin-off of the firm’s entire property assets into a REIT structure. Although the group ruled out such a move it says a new joint venture company containing up to half of its assets could eventually be converted into a REIT. M&B rival Enterprise Inns has dropped heavy hints that it could enter the REIT market while, Rugby Estates raised £50m in May for its first
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REIT. However, the government’s plans to introduce REITs to alleviate the housing crisis in the UK have suffered a setback after it emerged in May that no residential REIT launches will go ahead this summer as had been planned. Invista Real Estate has been forced to delay its plans after it struggled to attract institutional investment, while a second residential REIT set up by up to 20 UK housing associations has also been postponed. Invista bought the £300m British Land residential portfolio last year as well as another portfolio from the UK’s Ministry of Defence. It had planned to put them both into a £1bn REIT, which it intended to float before June. “Currently we are only talking about previous property companies with a different tax wrapper,” says Damesick. “The emergence of alternative investment companies has taken a little time to play out but this summer we are seeing that change, which is where it starts to get interesting.”
Specialists “Inevitably you will see more REITs as specialists rather than the general portfolio companies we have now,” says Chris Jolly, managing director of Jones Lang LaSalle corporate finance. “Partly that is the new specialists coming to market—but also the larger companies will probably specialise. If you look at the US market, 98% of that is specialist,”he says.“That might be very specific, for example pubs, or even area specific such as the Olympic Village or King’s Cross. A lot of things are being positioned as the basis for a specialist REIT. “What we have had since the 31st December is not fundamentally different from what we had before and consequently neither are the types of investors but I would presume that companies are going to come under pressure on returns,
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Chris Jolly, managing director of Jones Lang LaSalle corporate finance.“Partly that is the new specialists coming to market — but also the larger companies will probably specialise. If you look at the US market, 98% of that is specialist,” he says. Photograph kindly supplied by Jones Lang Las Salle, June 2007.
Stephen Hester, chief executive of one of the UK’s biggest REITs, British Land, concurs and says that “uninformed comment” about performance to date “derives from a misunderstanding of what REITs are all about. They are about different taxation status, no more, no less and for us the changes are unambiguously positive.” Instead Hester says that the market is “at an inflexion point after an incredible bull run over the last ten years, especially the past three,” and acknowledges that market re-pricing has been going on, something which he believes was inevitable and is now complete
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whether that be from shareholders or from predators looking at the difference between company value and asset value.” At British Land Hester accepts that his group may seek to specialise in key areas, for example the booming London office market. “We are by far the most active recycler of property assets as we seek shareholder value,” he says. “Inevitably in a tougher market we will be drawn to high performing sectors such as the office market. Retail is at a different point, with a slowdown in consumer spending growth. It is still a net positive but we will be more discriminating about our investments. But I would say that for property companies this is simply a return to normality.” Cushman Wakefield’s head of capital markets, Tim Sketchley adds that although the major companies maintain general strategies the market is likely to be far more “opportunitydriven, using property expertise” and that the impact of the current spate of portfolio realignments is still feeding through. “It is still too early to assess their impact in the UK, they need time to find their proper place” he reflects. “If you look at the US, the REITs there may be very successful now, but they have had a pretty chequered history.” Even so, Richards stresses that the influx of specialist REITs will not change his own company’s focus. “Personally I think that new players are a good thing and I welcome them but my only concern is that new entrants will create a far broader spectrum of risk and that inevitably some people will lose their shirts on investments. We have built our business by diversifying and we will continue to do that. Is specialism right for new players? Yes. Is it right for Hammerson? No. Ultimately what people want is performance.”
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Regional Review MIDDLE EAST: INVESTORS OPT FOR CHOICE PROPERTIES
The globalisation of the Middle Eastern investor Real estate investment funds in the Middle East have not only piled money into their own booming economies but have spread their capital across the world, snapping up important properties from London to New York, Singapore to Sydney. With predictions that their property investment deals could exceed $20bn this year, Middle Eastern investors are not only having an increasing influence on global property markets, but Islamic financial influence is also behind the international rise in Shari’a-compliant financial products. Marc Faithfull reports F MIDDLE EASTERN investors do spend the predicted $20bn acquiring global real estate this year, it will represent an increase of more than 60% on 2006, according to figures from international property agent Jones Lang LaSalle (JLL). The six Gulf Cooperation Council (GCC) countries accounted for $13bn in global commercial property transactions last year, up 14% on the previous year, their economies buoyed by sustained high energy prices with collective income surpluses of $260bn. The United States was the biggest recipient of real estate investment, taking $7bn of the GCC property money, followed by the United Kingdom with $4bn and Germany and South Africa with $1bn each. “That number could go up to $20bn by the end of this year. Knowing some of the deals that have been talked about, I think that is entirely possible,”says Tony Horrell, chief executive officer (CEO) of the JLL’s International Capital Group. Although the US remains the largest single investment target (compared with 2005), there was a decline in the flow of funds into the US. Middle Eastern investors looked for new opportunities away from the mature markets of Europe and the US. It seems
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GCC investors are becoming increasingly enticed by higher risk, higher return markets in Asia. “I think partly it is in reaction to the atmosphere surrounding the aftermath of 9/11,” Horrell adds. He expects more Middle Eastern money to flow into Asian economic hotspots as investors from the region look to diversify their asset base. “We will see more activity and more interest in the emerging markets of Asia,”he adds. As exit deals on earlier real estate investments are concluded, GCC investors also sold more assets than before in 2006—with the sale of $2bn of investment grade real estate in both the US and the UK, an increase of 50% on 2005. Although Middle Eastern investors rank third in the international league table and remain significantly behind global and US investors, their impact on the global real estate market is fast becoming bigger than simply the monetary value of their direct transactions, says JLL. The firm estimates some 8% of equity invested by global funds originates from the region. The GCC money is also often without debt, so it is able to command a prime position on the investment spectrum. The biggest global funds
around the world typically use as little equity as possible and instead focus on structured debt, putting GCC investors at a natural advantage.“On a per capita basis, there is no greater region than the Gulf providing capital to real estate in the world,” says Blair Hagkull, JLL’s managing director for the Middle East and North Africa, who estimates that the GCC accounts for 25% of real estate development in the world.“GCC funds are focusing less on trophy assets and are making significant purchases in emerging markets, including the entire Cape Town waterfront development and Europe’s largest shopping centre in Istanbul. As well as looking for opportunities in emerging markets, GCC funds are also looking for value added opportunities,”says Horrell. Such investment can be seen in all the major real estate markets, as Gulf region investors take positions across national and property asset classes. In the current financial year alone several major deals have been concluded. For example, Bahrain-based International Investment Bank (IIB) has acquired a 95% stake in a $98m portfolio of commercial real estate properties in Munich, Germany. The Shari’acompliant real-estate investment marks IIB’s third real estate acquisition in
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Europe, aimed at providing the Bank’s GCC-based investors with access to the buoyant German commercial property market. “The success of our previous entry into the French commercial property market last year has so far proved to have been very good, and we are confident that we are also investing in the German market at the right stage of the property cycle,”says IIB executive director, Mohamed Hadi Mejai. IIB already owns a real estate portfolio in France valued at $105m and recently exited from its first European real estate investment, an office building located at Grosvenor Place in Belgravia, London. However, IIB also remains busy in its home markets and last year spent $180m in Dubai’s Business Bay development, which is being planned by the Dubai Government as the new downtown area for Dubai. These included investments in West Bay Tower and One Business Bay. IIB has also launched Ewaan, which will focus on investment in the Saudi Arabian real estate market and which is seeking to invest $533m in the Saudi property sector over the next three years. Moreover, Middle Eastern funds have also snapped up high profile sites in the major financial capitals. Last autumn Dubai investment house Istithmar bought the landmark W Hotel Union Square—a luxury hotel in Manhattan, New York—valued at $285m. It is the fifth hotel location the company has bought in the city and, the company says, reflects its aim to invest in gateway cities. Of course Istithmar is best known for its £1bn joint venture purchase of Cape Town’s Victoria & Alfred Waterfront in a deal with the UK’s London & Regional Properties. Khalid Affara’s Arab Investments has set up the world’s largest Shari’acompliant (adhering to religious strictures including prohibited business activities such as alcohol, pork production, casinos or
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Khalid Affara’s Arab Investments has set up the world’s largest Shari’a-compliant (adhering to religious strictures including prohibited business activities such as alcohol, pork production, casinos or ammunition) property fund to speculatively build the Helter-skelter office building in the City of London—which has been renamed The Pinnacle —and for which construction is scheduled to begin next year, with completion in 2011. The syndicate, known as Pinnacle Limited, bought the tower on Bishopsgate from German fund Union Investment Real Estate. Photograph kindly supplied by Arab Investments, June 2007.
ammunition) property fund to speculatively build the Helter-skelter office building in the City of London—which has been renamed The Pinnacle—and for which construction is scheduled to begin next year, with completion in 2011. The syndicate, known as Pinnacle Limited, bought the tower on Bishopsgate from German fund Union Investment Real Estate. “We believe in finding the right investment and raising the capital from investors back in the Middle East,”says Affara.“Some investors put in between £1m and £3m so everyone takes a bit of the action and spreads the risk. We all believe in the scheme—we have the most iconic and tallest building in the City for another 100 years.” Indeed, Shari’a-compliant investment—once a rarity in European and US deals—is becoming increasingly common. The European Islamic Investment Bank (EIIB) PanEuropean Islamic Real Estate Fund recently acquired five commercial properties in a $117m deal from a
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fund sponsored by Arab Bank International. The portfolio comprises offices, retail located in various regions of the UK. The acquisition is the first in the UK between two Shariah-compliant vehicles and accounts for the core UK allocation of the fund, which has a target size somewhere between $270m and $675m. Continental European property will account for the valueadded balance of the fund that will target, in the main, Central and Eastern Europe because of the potential for higher yields. The fund hopes for an 11% internal rate of return (IRR). EIIB head of asset management Jeremy Beswick describes the transaction as a “milestone not only for the fund but also for Islamic finance in London” and says the fund will take an opportunistic approach both geographically and in terms of property sub-class, although most will be in and around major cities. To date, the fund has appealed to Islamic institutional and high net worth investors from the GCC states and Europe. But Beswick says the fund could “quite possibly” attract non-Islamic investors, including European pension funds. “There is nothing to stop them investing,”he adds,“but there is a huge Islamic market and that’s our priority.” Meanwhile Qatar National Bank has launched a $400m global property fund through Ansbacher, a Londonbased wealth management group it bought two years ago. It has raised a first tranche of $200m from investors in Qatar and elsewhere in the Middle East and is now aiming for another $200m. The remit of the fund, which is advised by Strategic Real Estate Advisors (Stratreal), a boutique advisory firm, is to buy property in Europe, the UK and US. However, despite this international activity Middle Eastern investors have
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not forgotten their own markets and it is no longer just institutional money that is flowing in to the market. Record amounts of liquidity have moved into the GCC region in the past three years, encouraging many private equity firms to enter the region, mobilise this wealth and invest it in the region’s growing investment and economic opportunities. According to Private Equity Intelligence, a London-based tracking firm, there were over 6,000 private equity funds with assets totalling $1.4trn in 2005. In 2006, 684 new funds were launched, which raised another $432bn of new funds for investment. While the majority of the new funds were buyout funds ($212bn), real estate funds were the second largest category at $63bn. The bulk of these funds were invested in Islamic funds and closedend real estate funds. Because of religious sensibilities, there has been little interest in the region for fixed income or bond funds until the recent development of Sukuk (asset-backed securities). Lack of transparency has also concerned inward investors from outside the region and analysts believe that real estate and banking laws need to be more closely aligned to Western investment models before the region will become internationally attractive. However, there is clearly a shift taking place in the investment trend in the Gulf region. “Before 2001, Gulf investors preferred to keep most of their investments in the US and Europe, then came the big surge in investments within the Middle East region,”explains Chris Meares, HSBC’s global head of private banking. “Although the inward investments into the region continue to grow, there have been a growing number of investors taking exposures in emerging markets in Asia and private equity opportunities around the world.”
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Dr Omar Bin Sulaiman, the governor of the Dubai International Financial Centre (DIFC), said earlier this year that he believes the Middle East is poised for an asset management boom.“Today, as regional wealth is increasingly repatriated from overseas back to the Middle East, regional fund management has likewise assumed an increasingly prominent role,” he declared.“The ability to self-manage – and self-regulate – our economic affairs is vital to our shared future. The rise of a regional asset management sector, then, is an extremely positive step in that direction.” Photograph kindly supplied by the DIFC, June 2007.
Growing numbers of Middle East investors, especially high net worth individuals from the Gulf countries, are investing in Asian emerging markets as part of their portfolio diversification. Among the emerging markets, China, India and other Far Eastern markets top the investment destinations of Gulf investment money and real estate continues to attract a big chunk of that Arab investment.“Within the Middle East, there is a huge demand for real estate in the private portfolios. This trend is likely to continue as regional economies continue to experience
big growth and domestic liquidity,” says Meares. Dr Omar Bin Sulaiman, the governor of the Dubai International Financial Centre (DIFC), said earlier this year that he believes the Middle East is poised for an asset management boom. “Today, as regional wealth is increasingly repatriated from overseas back to the Middle East, regional fund management has likewise assumed an increasingly prominent role,” he declared.“The ability to self-manage – and self-regulate – our economic affairs is vital to our shared future. The rise of a regional asset management sector, then, is an extremely positive step in that direction.” Citing the DIFC’s Collective Investment Law, which provides the Middle East’s first legal framework for the funds industry, Bin Sulaiman added: “Regional fund management does remain very much in its youth, but the sector is becoming more mature by the day.” Certainly the growing dependence of Asian economies on Middle Eastproduced oil and gas suggests that closer business and political ties are inevitable, a trend already evidenced in the airline industry where increasing flight links are being developed between the GCC and key markets such as China, Hong Kong SAR and India. In the short-term at least real estate investment within the GCC and MENA regions will be dominated by regional investors, in part because of Shari’a requirements, in part because many Western investors remain cautious about investing in the area without the levels of financial transparency available in other markets. However, with an increasingly outward–looking perspective, the Middle East’s major real estate investment funds look anything but happy to stay at home.
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CBB RAISES THE REGULATORY STAKES
A PLACE IN THE SUN
HERE IS A new found confidence throughout the GCC, which is steadfastly beginning to describe its financial hinterland in terms of the wider MENASA region. Each of the GCC’s fast-flow financial centres—Dubai, Kuwait City, Riyad, Doha, Abu Dhabi and Manama—these days define their roles in the context of both the region’s overall geography and their particular financial expertise. In Manama, the CBB is at the heart of this definition, having passed a slew of regulations that have opened up the country’s investment services, banking, Islamic finance and
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In late May, the Central Bank of Bahrain (CBB) issued a new regulatory framework to govern the collective investment undertakings (CIU) industry. The new framework updates existing regulatory instruments governing mutual funds and includes new rules that will encourage a diversified range of CIUs, including hedge funds, derivatives and other alternative investment vehicles, to be domiciled and offered in Bahrain. It is all part of a concerted drive to develop the country as the fund services hub for the Middle East, North Africa and South Asia (MENASA) region. How far can the CBB reach in achieving this aim? Francesca Carnevale reports from Manama. insurance regimes to all comers. Bahrain has also led the region in successfully implementing the single regulator model, which has enabled the CBB to apply similar standards of
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regulation and supervision to all financial services providers, be they banks, insurance firms or capital market players.“The region’s financial services industry is standing on the
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There is also the category of ‘Exempt threshold of a new boom, driven by framework for CIUs, introduced at the unprecedented economic growth in end of May, is expected to spawn a CIU’, which can only be sold to a the broader region. The latest round of regional industry of hedge funds, restricted investor base, involving a regulations is comprehensive, taking derivatives and other alternative minimum investment of $100,000 and into account the most recent product investment instruments, “aimed at where investors have a minimum $1m innovations and demand for more professional and expert investors, who in financial assets and where the sophisticated financial instruments in are high net worth individuals or investor is fully cognisant of the the region and beyond,” explains institutions,” Al Baker. Tellingly, CBB investment risks. The Exempt CIU Abdul Rahman Al Baker, executive regulations, “will enable regional rules provide the framework for hedge director, of financial institutions access to such instruments,” he adds. funds and other higher risk alternative investment vehicles to be legally supervision at the central bank. domiciled and/or sold in Bahrain, At the core of the CBB’s Bahrain has also notched up a which “traditionally have been regulatory drive is its six volume number of firsts in Islamic finance. domiciled elsewhere,” explains Al CBB Rulebook, which has been In 2001, Bahrain became the first Baker, adding“We see this as a big added to in increments since 2004 and collectively provides the country in the world to develop and growth market given the growing demand for regionally-focused momentum for Bahrain’s financial implement regulations specific to investments, particularly from services sector to develop and the Islamic banking industry, high net worth individuals and offer a new generation of followed in 2005, by the first-ever regional institutions, who are investible products. These have comprehensive regulatory becoming increasingly included the streamlining of the framework specific to Islamic sophisticated in their authorisation and commercial understanding of the financial registration process for mutual insurance and reinsurance (takaful risks arising from these new types funds; and the creation in 2004 of and retakaful) companies. of transactions. Special provisions a new corporate vehicle—the sohave also been included for called Special Purpose Vehicle (SPV)—that was better suited to The new framework updates schemes that comply with Islamic mutual funds than the corporate regulations governing mutual funds principles.” By April 2007, nearly 2,300 funds vehicles previously available. In 2006, and introduces the first-ever rules a new investment business rulebook allowing CIUs targeting professional were authorised by the CBB, of which was issued, creating a comprehensive investors. It will permit exempt 102 were locally domiciled funds—by and up-to-date framework for schemes subject only to limited far and away the largest concentration investment business licensees: one regulation (such as hedge funds), but of locally domiciled funds in the GCC. better adapted to activities such as which may only be sold to a high net In recent years, various initiatives have asset management, funds worth institutional and investor base. been undertaken to facilitate the administration and custody services. Specifically, the new framework continued development of this sector. Key milestones include Bahrain’s first covers three types of CIU: retail CIUs, The industry plays a significant role in national economy, ever Trust Law, introduced last year which are subject to restrictions on the Bahrain’s which has opened up new concentration and types of assets in accounting for 27.6% of GDP in 2005, opportunities for wealth preservation which they can invest to protect retail surpassing the oil sector, and creating in a region which has the world’s investors and so-called Expert CIUs, over 1,500 jobs in 2006, representing a highest concentration of high net which are subject to a minimum year-on-year increase of over 18%. worth individuals and family $10,000 investment rule, and may only “Frankly we are now the hub,”says Al businesses, with an estimated be sold to ‘expert’investors (who have at Baker, “this latest round of regulation collective wealth in excess of $1.3trn least $100,000 to invest) which are will deepen the market significantly, and which also will encourage the knowledgeable of the risks involved in particularly as there is no tax in establishment of real estate investing a broader range of assets Bahrain. That means no withholding investment trusts (REITs) and private (including real estate and commodities) tax, no tax on capital growth: it is all and are therefore subject to fewer risk adding up to a very attractive regime saving schemes. for investors.” Similarly, a new regulatory concentration requirements.
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Bahrain has also notched up a number of firsts in Islamic finance. In 2001, Bahrain became the first country in the world to develop and implement regulations specific to the Islamic banking industry, followed in 2005, by the firstever comprehensive regulatory framework specific to Islamic insurance and reinsurance (takaful and retakaful) companies. The regulatory initiatives have been supplemented by the central bank’s work in developing and issuing Islamic bonds (sukuk), “We were the first to securitise government bonds and issue in Sukuk form,” explains Al Baker, “we have always kept to the motto that not only do we need to be good, we need to be fast in developing new products.”In Bahrain, the Islamic fund industry has been growing at an annual pace exceeding 20% with Islamic funds currently representing some $1bn in assets, out of the $9bn plus invested in CBB-registered funds. Within this broad picture, the outlook for alternative asset management in the region also looks positive. The GCC’s insurance industry, too, is set for exponential growth in the coming years and the introduction of the CBB’s Insurance Rulebook in 2005 has attracted a number of firms that have establish their Middle East hubs for Islamic insurance (takaful) in Bahrain. “The entry into the takaful arena of firms such as American Insurance Group (AIG), Hannover Re, Allianz and ACE Group (UK), sets the stage for growth of the Islamic insurance sector,” thinks Al Baker. In this regard, the CBB has licensed the region’s first captive insurance
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International Islamic Financial Market (IIFM). Among the projects currently being advanced are the development of a master agreement for Islamic derivatives, standardised contracts and documentation as well as market practices for Sukuk, a master agreement for Islamic Treasury Murabaha contracts and an Islamic capital market platform. The next steps also include efforts to attract overseas stock exchanges to open offices in the country and Al Baker notes there have been expressions of interest from “leading US exchanges, such as the Chicago Abdul Rahman Al Baker, executive director, of financial Mercantile Exchange and institutions supervision at the Central Bank of Bahrain. NASDAQ to establish an Photograph kindly supplied by the CBB June 2007 presence in the region. Today, a stock exchange company, Tabreed Captive Insurance operates like any other company,” he Company, by Tabreed, a UAE-based notes. Fortune favours the brave, thinks Al Baker who says that the CBB district cooling firm. Bahrain continues to maintain its will continue to “nurture growth, three decade long leadership with a providing a strong, business-friendly critical mass of 151 banking regulatory framework, which complies institutions boasting assets of $19bn. with international best practice, and The Royal Bank of Scotland, Coutts & ensuring an environment conducive to Co, European Islamic Investment product innovation. Moreover we are Bank Plc, Dexia Asset Management, open to business to everyone. We do EFG International and American not limit ourselves to the narrow Express Private Bank are among region. It is no use restricting yourself prominent new additions to Bahrain’s to a certain area.” “It has been a fast moving period,” banking community. Having established a lead early on concedes Al Baker, “however, look through pioneering efforts in the area how far we have come. In the old a financial institution of Islamic banking regulation and days, Islamic debt issuance, the CBB is now establishing in Bahrain was either a providing valuable thought leadership bank or an asset management firm. in ensuring the sound and continued Now you can be both a bank and an growth of the Islamic banking asset management firm active in a industry as well as the development of broad range of financial instruments, Islamic capital and money markets, either as a provider or as an investor: through the Bahrain-based or both. It is a huge leap.”
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Regional Review ASIA: FUND PROFILE: CIMB-PRINCIPAL
N ASIA’S FAST GROWING economies, there is a definite requirement not only to do well, but also to be seen to do well. Fast forward then CIMB-Principal, which was moved to increase the size of its Global Asset Spectra Fund in early June. Originally launched in November of last year, the fund sold down over 270m investment units. It has now been increased by a further 100m units. The move comes at a time when Asian investors are opting for a more diverse investment portfolio mix, upon which CIMB-Principal continues to capitalise. CIMB-Principal chief executive Noripah Kamso explains that the fund was and remains particularly popular because “it enables investors in four major asset classes, namely equities, commodities, property and fixed income across international developed markets”. Its fund of fund structure adopts an asset allocation strategy which allows the fund to maximise potential returns at different points of the economic cycle by switching into different asset classes at different stages over the medium to long term.“Funds are selected from the fund families of three credible global fund management houses: Franklin Templeton Investments, Schroders Investment Management and Principal Global Investors. This enables it to potentially deliver superior riskadjusted returns compared to investing in a single asset class,” says Noripah Kamso, chief executive of CIMBPrincipal. The fund was recently declared ‘Best Offshore Fund 2006’ by Asia Asset Management, an independent Hong Kong-based research and publishing firm. The success of the Global Asset Spectra Fund mirrors that of CIMBPrincipal’s Global Titans Fund, which was launched in July 2005, as the first “global fund in Malaysia to afford local investors access to US, Europe and
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FAST FORWARD GROWTH Noripah Kamso, chief executive of CIMB-Principal. Photograph kindly supplied by CIMB-Principal, June 2007.
Increased liberalisation in Malaysia’s fund management sector and the growing tendency of Asian asset management firms to diversify their investment approaches have been firmly leveraged by CIMB-Principal Asset Management Berhad (CIMBPrincipal). A joint venture between Southeast Asian investment banking group, the CIMB Group and the Principal Financial Group, a Fortune 500 diversified global financial services group, CIMB-Principle has assets under management of some $4.5bn and is the largest asset manager in the country.
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proved very popular with investors Japan equity markets,” says For the rest of this year, CIMBwho remain conservative, whether Kamso. The success of both funds Principal is also ASEAN bound. it is a bull or bear market. By indicates that, “Malaysian investors are placing significant “We are establishing operations in combining three asset classes into four different proportions, the fund importance on diversification. Singapore and are looking at is able to optimise potential profit.” Investors no longer base their acquisitions in Indonesia, The fund “will close for new investments on diversification says Kamso. investments in early July, or earlier across asset classes alone, but also if the fund is fully subscribed,” she across geographical markets,” she real estate investment trusts (REITs) out explains.“This is the latest addition to adds. In May this year, the asset manager of Singapore and Hong Kong, as well as our suite of 15 Islamic funds, out of a launched six money market funds for Australia’s Westfield Group, the world’s total of 53 funds managed under the CIMB Group. the corporate and institutional market. largest public property company. Like other Malaysian asset Kamso acknowledges a The CIMB-Principal Treasury Management Funds 1, 2 and 3 are diversification of the firm’s portfolio managers, CIMB-Principal has also conventional funds, while CIMB range that serves both retail and leveraged new market opportunities by the increasing Islamic Kausar Treasury Management institutional clients. “Malaysia is provided Funds 1, 2 and 3 are Shari’a compliant blessed with a high savings rate, liberalisation of the Malaysian asset equivalents. These latter funds were averaging at 33% of gross national management sector. Kamso explains designed for investors with “extremely product (GNP) during the 1990s and, that the Malaysia’s Securities conservative investment policy on average, 35% since 2000. Our Commission, with the support of the mandates [and are] suitable for sinking savings rate is higher than those of the Malaysian government, has introduced funds, working capital and revenue US, Germany and Japan,” she says. several measures to catalyse the accounts with high liquidity Although most of Malaysia’s savers development of the local fund requirements,” explains Kamso. The gravitate towards bank deposits, management industry. Global and funds provide companies with a fund Kamso thinks the domestic market is regional fund managers can now set “with a higher credit rating than the still ripe for growth and that local asset up operations in Malaysia. They have company’s own,” she adds. managers must create trust and been given the flexibility to source Additionally, corporations will be “able confidence in the asset management funds from within and outside the to benefit from the tax-friendly nature sector. At the end of 2005, the amount country, in a move intended to of the unit trust investment structure”. of provident and pension fund assets enhance the diversity of the fund Later the same month, CIMB- managed externally accounted for only management business and to facilitate Principal also launched its retail CIMB 2.6% or Ringgit6.4bn of total assets, the entry of foreign fund management Islamic Structured Growth Fund, which according to the Malaysian Securities expertise, including foreign Islamic management companies. or fund invests in a 3-year ‘Best Performer’ Commission, while only 1% Asset Management, Shari’a-compliant structured products Ringgit900m of insurance funds were Aberdeen to be issued by CIMB Investment Bank outsourced. “To tap this potential, Nomura, UBS and BNP Paribas have Berhad and distributed by CIMB Bank industry players must work towards established fund operations and CSFB, and CIMB Wealth Advisors Berhad. The shifting investors’ perception of fund CLSA, Macquarie Bank, JPMorgan and fund will invest in three distinct asset management from just being an UBS have recently set up stock broking classes. The Shari’a-compliant equity alternative investment, to one of a operations in the country. The government said in the 2007 basket will track the performance of the preferred option,”says Kamso. Kamso, has it that the CIMB Islamic Budget that local and foreign fund Dow Jones Islamic Market Titans 100 Index on a series of quarterly Structured Growth Fund is a “smart managers managing foreign funds in observation dates over three years. The alternative to fixed deposits”, with the accordance with Shari’a principles can commodities basket will track the Fund “capturing the best-performing claim income tax exemption on the comprising of management fees earned.“With this tax performance of West Texas combination Intermediate (WTI) light sweet crude international equity, property and incentive, fund managers in Malaysia oil, zinc and copper, while the property commodity asset classes. Products will intensify efforts to attract more basket will track the performance of offering principal protection have foreign funds to be managed out of
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Malaysia, noted YBhg Dato’ Zarinah these entities, which is rated at least important and relevant tool in the Anwar, chairman of the Malaysian single A, will be deemed to be ASEAN growth story and gives investors instantly Securities Commission in a special approved under a new (soon to be international industry address in November last year. released) Practice Note. A Sukuk diversified, cost efficient exposure to the CIMB-Principal’s Islamic Structured approved under this framework may ASEAN top five markets”. The Growth Fund is part of “our efforts to be offered offshore, and to benchmark index provided total returns support the government’s initiative to sophisticated investors onshore. of 110.61% over the last 5-year period deepen the Islamic investment Additionally, the new framework will and 22.70% returns over the last 12management industry. We particularly allow the use of international month period. The combined GDP of appreciate the support given with the documentation, based on the laws of the ASEAN-5 nations accounts for 91% 10-year tax exemption on revenue for England or the US. Credit ratings by of ASEAN gross domestic product. The ETF is targeted “at buy and hold fund houses who manufacture Islamic international credit rating agencies will products for offshore investors. also be acceptable. The moves, “will and cash equitisation (excess cash Offshore foreign investors, particularly introduce international standards and resulting from restructuring of cash those from Gulf Cooperation Council practices as benchmarks in the Sukuk allocations). It is not targeted at hedge (GCC) countries, are also seeking out issuance process, saving costs for funds,” explains Kamso. “The ETF shows that the time has come to Islamic investment products with invest in ASEAN, there is still an capital protection,”notes Kamso. opportunity to get in now before Separately, guidelines for Islamic “The cross over into quasi politics, the herd. Additionally, Vietnam real estate investment trusts came last year with the launch of may be included in the mix at a (REITs) have been introduced as the first FTSE/ASEAN 40 Exchange later date.” The ETF listed with well as tax incentives for REITs. Overall, the guidelines covering Traded Fund (ETF) on the Singapore $31m under administration at launch, by January this year the REITs have been liberalised to stock exchange ( SGX). total had reached $140m. The ETF allow the acquisition of foreign was so successful in local terms assets to enable managers to that it even gained an honourable diversify asset allocations and mention in the annals of the ASEAN enhance investment yield. The international issuers,”notes Kamso. In many emerging markets, key financing ministers meeting in Chang measures are intended to put Malaysia in the forefront of Islamic REITs. “The financial institutions often play a strong Mai in early February. The finance Ninth Malaysia Plan will continue to political, as well as financial role. In this ministers discussed how the region be a significant factor for the regard, CIMB-Principal is no different. could build on the success of the construction and property sectors, The crossover into quasi politics, came benchmark index and the ETF in while firm crude palm oil (CPO) prices last year with the launch of the first promoting inward investment into the will benefit the earnings of plantation FTSE/ASEAN 40 Exchange Traded ASEAN zone. ASEAN is peddling hard to establish companies. We expect the banking Fund (ETF) on the Singapore stock sector to be a proxy for the Ninth exchange ( SGX). The FTSE/ASEAN 40 itself as a viable investment destination, Malaysian Plan and for strong property ETF is the world’s first ASEAN ETF that on a par with India, China, Russia and offers investors a convenient way to Brazil. While it appears strange for demand,”states Kamso. Additionally, non-ringgit Sukuk can access the growing ASEAN economies. ASEAN ministers to talk in this regard, now be issued. The Securities The fund tracks the FTSE/ASEAN 40 in the ETF space in particular, few offer Commission is also working on the Index, which comprises the 40 top regional exposure. For the rest of this year, CIMBintroduction of a facilitative framework stocks by market capitalisation and for the issuance of foreign currency adjusted for free-float across Indonesia, Principal is also ASEAN bound. “We denominated Sukuk by multilateral Malaysia, Philippines, Singapore and are establishing operations in development banks, multilateral Thailand. The ETF is managed by Singapore and are looking at financial institutions, sovereigns and CIMB-Principal Asset Management acquisitions in Indonesia, says quasi sovereigns as well as local or Berhad. The fund advisor is Barclays Kamso, adding: “We see huge foreign multinational corporations. A Global Investors and the market maker potential in the region and in these non-ringgit Sukuk issued by any of is Citigroup. Says Kamso, “It is an two countries in particular.”
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THE TWO FACES OF
GAZPROM: VICTIM OR VILLAIN?
OAO Gazprom Chief Alexei Miller, left, speaks with Russian President Vladimir Putin during talks with Kazakh and Turkmen officials in Turkmenbashi, Turkmenistan, May 12th 2007. The leaders of Russia, Turkmenistan and Kazakhstan reached a landmark pipeline deal that will strengthen Moscow's control over Central Asia's energy export routes. Photograph by Sergei Guneyev, supplied by Associated Press/RIA Novosti/PA Photos, June 2007.
GAZPROM Old habits, it seems, die hard. Perhaps it is a sign of the times that Cold War rhetoric still colours foreign perceptions of Gazprom. In terms of its international image, is Gazprom more sinned against than sinner? Is Russia’s energy major a pawn in some so-far unstated plan by Russia to dominate the 21st century’s energy politics? Alternatively, is it simply an energy company, albeit a huge one, trying to establish a safe foothold in the global energy markets? Francesca Carnevale reports. T THE RUSSIAN Economic Forum in April in London, Richard Lambert, director general of the Confederation of British Industry (CBI) noted that, “What Russia does really matters.” Lambert, like many attendees at the Forum noted growing insecurity on the part of foreign investors in Russia because of what he described as the apparent: “politicisation of business decisions and growing economic nationalism”. A pertinent question resounded around the conference hall. “Is the expertise of Western companies in the energy sector welcome [sic]?”
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Gazprom’s chief executive officer (CEO), Sergei Miller, never had the opportunity to answer Lambert’s question. Miller, like a good number of Russia’s industrial illuminati, was confined to country by a peremptory presidential edict. Vladimir Putin had only to rail against a high-profile conference on investment in Russia being held outside the country for almost all its industry chiefs to stay at home. It was left to Chris Finlayson, country chairman of Shell in Russia, to put the political and investment equation in a pragmatic context. “What is required is clarity in the law
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about what is acceptable and we can work in that context,” notes Finlayson. No matter any particular limitations imposed, clarity about the intent and purpose of the government on foreign investment in strategic sectors, such as energy is imperative, thinks Finlayson. “Russia is the strategic growth region of the future,” he notes. He should know. Shell is the largest investor in exploration in Russia, with a number of joint venture agreements in the country with Gazprom,“sharing investments and risk,”he says. In an increasingly multi-polar world, natural gas, or ‘blue gold’ in industry jargon, has become a formidable economic weapon, giving some countries and their para-statal energy giants, considerable political and diplomatic clout. Some countries manage to enjoy their bounty, with no ideological strings attached (by design or otherwise). Others do not. Among these latter countries, the images of Russia, Iran and Algeria appears to carry immense political baggage. If you think that is over-stating the case, compare and contrast these states with Qatar. This particular country boasts the world’s third largest proven gas reserves. Like them, it has established a qualified foreign investment climate, both direct and indirect, which has helped finance and exploits its Qatargas liquid natural gas (LNG) and gas to liquid (GTL) developments, worth a combined $140bn in actual and planned project and downstream investments. However, the ease, innovation and speed with which Qatar has established a strong supply beachhead in the global gas market is a benchmark that the other three suppliers can only look at in envy. It never gets bad press. That any gas producers are drubbed in print is surprising in itself. Within the overarching energy sector, gas is the least controversial element. Gas (unlike oil) complies with the constraints on carbon emissions defined by the Kyoto Protocol. Its proven reserves and supply is more abundant than oil, and says Qatargas, with existing technology and proper management, may last as many as 200 years, compared with estimates of 40 years or so for crude. Demand too, looks likely to be undiminished, as China, Japan, the US and Europe continue to secure long term supply contracts, either by land or sea. Gazprom is only beginning to find its feet as the Eurasian continent’s leading supplier of natural gas (both upstream and downstream).Yet it is constantly fighting a public relations battle over its actions and intentions. Right now, the firm is not too worried and the reason is straightforward. Gross sales revenue from Europe increased by 45% last year, compared with 2005 and by September 2006, as prices rose to $225.5 per 1,000bcm, yet the volume of gas supplied increased by only 3% to 118.8bcm, according to a recent Natexis Bleichroeder/Raffeissen Centrobank analyst report. Equally significantly, gas supplies to the CIS states rose by 28% to 75.5bcm by September 2006, with export revenues up an impressive 83% to roughly $6.7bn as Gazprom managed to increase prices for gas supplies by an average 43% in the first nine months of last year. Without too much effort, up to now, between January and September 2006, total revenue for the Gazprom group surpassed market
estimates and surged 80%. [Included in that figure was the consolidation of Gazprom Neft into the firm’s IFRS results.] On the surface then, it all looks rosy and things look to be moving in Gazprom’s way. In broader terms, by April this year, Gazprom knocked back Microsoft as the world’s thirdlargest company by market value. Microsoft was valued at about $248bn, Gazprom at $272bn and rising. Gazprom is now the world’s biggest natural gas company by output and reserves, accounting for an approximate 16% of the total, employs more than 330,000 people and supplies more than 8% of Russia’s GDP. The Russian state owns 51% of it all. Look in depth however at the structure of Gazprom’s business and note that there are some thorns among the blooms. Three elements make up Gazprom’s gas supply business. Domestic supply is the first. Gazprom supplies 70% of the domestic market, supplies are heavily underpriced and the company actually loses money in its home market. Anna Yudina, research analysts at Raffeisen Centrobank in Moscow, explains that this situation is not irretrievable.“Inevitably, the government has to raise prices, at least for the industrial sector. In this scenario, Gazprom should return to profit in the domestic market within two to three years,”she says. Exports make up the second element. This is an area where the firm has to work hard to diversify sources and supply, even in the midst of plenty. Gazprom’s export markets stretch across the transcontinental divide, with it’s Siberian and in particular Sakhalin output, servicing now China and Japan. Equally, Russia has been a trusted European supplier since the 1960s, in particular it has enjoyed close relations with Germany and Italy. Today, Russia is responsible for 50% of Europe’s gas imports. [It also supplies, by the way, some 30% of the uranium for Europe’s nuclear plants.] However, “Diversification is critical,” thinks Yudina. The company, she says is depleting its reserve base and it requires significant foreign investment to add to its own investment dollars to better exploit existing reserves, build new pipelines and supporting infrastructure, and prospect and develop new fields. Getting there might be problematic, as Gazprom cannot achieve these aims alone. Additionally, “the government, as Gazprom’s main shareholder, wants to retain strategic control. Up to now it cannot decide whether it wants to cede partial control of these investments either,”says Yudina. A pragmatic solution has to be found. According to Edinburgh-based Wood Mackenzie Consultants Gazprom’s annual production will grow no more than 1% a year until the end of 2010. Gazprom’s three major fields, comprising Medvezhye, Urengoi and Yamburg are all in decline, and its newest big development, the Zapolyarnoye field, peaked in 2005, producing 100bcm of natural gas that year. Even the International Energy Agency, has noted that the firm has not invested enough in new fields. Gazprom is even an importer of gas, buying about 55bcm a year from Kazakhstan, Turkmenistan and Uzbekistan, equivalent to around 10% of its own production. Although foreign firms are anxious to leverage Russia’s gas
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Herein lies at least story, there is notable one rub with its ambivalence on the part customers. What the EU of potential investors. wants is for Gazprom to That is because of the bring gas to the EU’s recent experience of BP, external borders, where which has a stake in the the gas will be bought TNK-BP joint venture, by EU partners who will which has explored and then distribute it inside developed the Kovykta Europe. This would field. At the time of going mean the end of longto press, BP is waiting on term Gazprom a decision by Russia’s contracts with Ministry of Natural European energy Resources whether to giants. This is contrary strip the operator of its Belarusian Prime Minister Sergei Sidorsky, left, and Gazprom chief Alexei Miller to the wishes of both licence, because it claims seen during a news conference at the headquarters of Russia's natural gas President Putin, who is the venture has not met monopoly Gazprom in Moscow, December 31st 2006. Belarus and Russia's concerned with the agreed production natural gas monopoly signed a five-year contract for gas supplies, just hours strategic leverage targets. BP says that is before Russia had threatened to cut off supplies in a price dispute. Under the provided by Gazprom because Gazprom refuses agreement, Belarus will pay $100 per 1,000 cubic meters a reduction from the and his close ally CEO to sanction an export $105 that Gazprom had wanted. Photograph by Mikhail Metzel, supplied by Miller, who pipeline that would Associated Press/PA Photos, June 2007. concentrates on the supply gas to TNK-BP’s customers. A solution will be found, suggests deputy economic end of the business. Both would like to see a Gazprom CEO Alexander Medvedev—most likely, say stronger integration of Gazprom’s supply and distribution analysts, one that will give Gazprom a substantial stake in the networks into the European Union as a whole. To a degree, the ambivalence that Gazprom encounters in overall project. The third element in Gazprom’s business is diversification. the West is a result of the inability of the European Union to Downstream, Gazprom has adopted a strategy of snapping define a common energy policy and for some countries to up gas distribution assets across Europe, as it seeks to extract press ahead with direct supply contracts without apparent value by controlling the flow of gas from the well head to concern for near neighbours. Germany, for one, has managed consumers. The United Kingdom provides a useful to secure long term supply agreements, through direct microcosm of its overall strategy. Most recently, in early June, pipelines, while others, such as Poland and the Baltic States, the company hinted that an acquisition of a UK gas supplier have been entirely by-passed. Germany’s BASF is currently in joint venture with energy is imminent, leading analysts to suggest that the diversified Centrica group could be a target. In recent days Gazprom has major E.ON and Gazprom in a consortium building the denied it will bid for a UK utility, such as Centrica or Scottish $4.8bn Northern European Gas Pipeline, under the Baltic Sea. and Southern Energy (SSE) plc. Instead, the company says Gazprom has a controlling 51% of shares, with E.ON and the firm is pressing ahead with organic growth in the country. BASF holding 24.5% each. Klaus Mangold, chairman of the Even so, shares in both distributors rose after a surprise German Committee on Eastern European Economic announcement by Gazprom’s deputy chief executive Relations, says that in future, European investors will be Alexander Medvedev at a press conference in Malaysia that looking for important qualifications in their investment and the company was close to closing a deal to increase its market supply discussions with the Russians. “Importantly, these include safeguarding current investments, a maximum level of presence in Britain. Philip Dewhurst, a spokesman for Gazprom Marketing openness and clarification on the role of foreign direct and Trading, the firm’s UK sales unit in Cheshire, did not investment in strategic industries. I believe the next ten years return any of our calls, to deny or confirm the statement, but will be about the modernisation of Russia; but for this to really managed to tell the UK mainstream press that no big deals succeed we need the articulation of shared goals,”he says. Before the Russian-Ukrainian gas supply crisis of this year were planned. In the UK, Gazprom supplies gas to industrial clients and commercial users such as department store chain and last, there had never been a geopolitical spat over gas on BHS. It has a so far miniscule percentage of the UK’s small the continent. That spat was interpreted by some analysts and medium-sized business market (at just over 1%), having that the West had entered an era of pipeline power, where bought a small northeast England gas distribution company. geopolitical leverage is intimately linked to pipeline routes. However, say those same newspaper reports, Gazprom These take on further significance they say, as Gazprom’s hopes to raise this to 10%. Without a substantial acquisition trans-continental reach means that its can leverage both however, it looks unlikely that Gazprom could easily build sides of the landmass. A pipeline moving eastwards from Siberia that prioritises China and Japan, also provides a useful market share organically.
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GAZPROM: VICTIM OR VILLAIN?
counterpoint to the raft of pipelines supplying the CIS states, assets matching Shtokman’s reserves in amount and quality, the UK, Germany and southern Europe. The European claimed Gazprom. The approach to Shtokman is resonant The field will be Union worries then about the use of gas as a political weapon, plus the lack of transparency and the ‘undemocratic’ developed with the use of state-of-the-art technological processes in the Russian gas and electricity sectors. As a developments, including for LNG production. However, that counterbalance, the EU is actively trying to explore deals with will have to come from outside.“Authoritative international both Kazakhstan and Turkmenistan and with Iran, bypassing companies will be invited as project contractors for these Russia via the South Caucasus and the Caspian Sea. A key purposes. Meeting project deadlines and costs is a project in this regard is the proposed trans-Caspian pipeline prerequisite for prospective contract awards. This decision is that could in effect break Russia’s monopoly on the transit of an additional guarantee of the Russian gas supply to Europe security in the long-term and proof that the European market Central Asian gas. A similar view carries particular currency in Russia’s is of dominating significance for Gazprom,” said Alexey hinterlands, of Georgia, Ukraine, and Moldova (the so-called Miller, at the time. More pertinently perhaps, Gazprom does GUM countries). Russia’s daily Nezavissimaia Gazeta was not have any experience of deepwater oil drilling. With high gas and oil prices, the Kremlin can apply its moved to denounce the formation of “a new international organisation whose goals are entry into NATO and geopolitical strategy with a liberal hand. Its actions are adherence to European structures”. The alliance was formed supported by $200bn-plus in foreign reserves, a rising by a group of concerned countries reeling from the budget surplus and a 7% annual gross domestic product imposition by Russia of commercial restrictions on milk and (GDP) growth. “What that means is that Gazprom will meat imports from Ukraine, wine from both Georgia and invariably suffer from political spin from both sides. In the Kremlin it is viewed as a Moldova, and mineral water Investors remain ambivalent about Gazprom geopolitical tool, in the from Georgia. Local West its image is filtered internet blogs have it that 14 through negative press,” the message from Russia is 12 notes the analyst. that if you want to join the 10 The outlook for 2007 for EU and NATO, expect 8 Gazprom remains positive, higher oil and gas prices. It 6 thinks the analyst, is a view that a number of 4 underpinned by expected Russian and European 2 strong further rises in analysts reject out of hand. 0 export gas prices, and While Gazprom further contributions from managed to increase the its oil subsidiary Sibneft, price paid for gas by CIS Gazprom Share Price in USD improving the group’s free countries by 43%, it cash flow generation ability. remains well below prices Source: FTSE Group, data as at 31 May 2007. charged to European buyers, says a research analyst in This has remained modest as capital expenditure (notably on London; in that sense, Gazprom has had something of an gas transport) has strongly increased. In December, 2005, unfortunate rap he says. “Belorussia and the Ukraine have Gazprom received the $7bn cash payment from Rosneftegaz now agreed price increases, acceptable to both sides, but they for its treasury stocks, which helped to refinance a portion of are still below market rates paid elsewhere. It has been its debt drawn down following the Sibneft acquisition. As a difficult for them, because they have had very cheap supplies result, Gazprom has managed to limit increases in year end for so long. Gazprom has also shown a willingness to parent debt to about $23bn (closer to $28bn to $30bn including subsidiary debt). “All in all, it has definitely reciprocate and has increased transit fees,”he adds. In part, that may be related to its distribution policy. A improved as a company,”notes the analyst. At the end of May, Gazprom approved a 44% increase in preference for pipeline deliveries was underscored in October of last year, when Gazprom’s management committee its 2007 investment program to $29.4bn, a significant upgrade decided that pipeline gas deliveries from the Shtokman field of its initial budget of $8.9bn for the year. Gazprom will also to the European market, via the Nord Stream gas pipeline, cut down its budget income by 11.2% to R2.277trn (about would take priority over LNG shipments and that Gazprom $88bn) in 2007 against an earlier approved amount. The will develop the field on its own. The Shtokman gas and natural gas monopoly says the changes in its investment condensate field is located offshore in the central part of the programme and budget are related to the purchase of stakes Russian sector of the Barents Sea. Gazprom had considered in Sakhalin Energy, the operator of the Sakhalin II oil and gas giving foreign companies a 49.9% stake in the project, even project, Belarusian pipeline operator Beltransgaz and identifying a short list of companies that included Hydro and Mosenergo, Russia’s largest territorial generating company. Statoil of Norway, France’s Total, as well as Chevron and Most recently, Gazprom and Austrian group OMV have ConocoPhillips. All have extensive experience of deepwater signed a memorandum to control jointly the Austrian natural exploration. International companies however failed to offer gas distribution centre in Baumgarten in North Austria.
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HARLAN CASTLE: THE MID MARKET FORTRESS HILE GIANTS LIKE Kohlberg, Kravis & Roberts, Blackstone and Texas Pacific pursue ever larger transactions that grab the headlines, New Yorkbased private equity shop Castle Harlan has quietly prospered in the middle market. Now investing $1.2bn raised for Castle Harlan Partners IV in 2003, the firm thrives on buyouts valued between $100m to $750m, mostly private companies that not only meet Castle Harlan’s stringent investment criteria but where the firm also sees opportunities to enhance growth in revenue and cash flow. Founder and chief executive officer John Castle, an industry pioneer, has participated in the evolution of institutional private equity funds for more than 40 years. He started out at investment bank Donaldson, Lufkin & Jenrette (DLJ), where he headed up all of DLJ’s private equity activities, including the Sprout Group, from the late 1960s. Castle retained his ties to those activities even after he became president and chief executive of DLJ in 1979. He left in 1986 to set up Castle Harlan in partnership with Leonard Harlan, a former DLJ colleague who had branched out into real estate. At a time when private equity deals often focused on asset stripping, Castle took a different tack. He wanted to
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Castle Harlan founder and chief executive officer John Castle, an industry pioneer, has participated in the evolution of institutional private equity funds for more than 40 years. He started out at investment bank Donaldson, Lufkin & Jenrette (DLJ), where he headed up all of DLJ’s private equity activities, including the Sprout Group, from the late 1960s. Castle retained his ties to those activities even after he became president and chief executive of DLJ in 1979. He left in 1986 to set up Castle Harlan in partnership with Leonard Harlan, a former DLJ colleague who had branched out into real estate. Photograph kindly supplied by Castle Harlan, June 2007.
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THE RISE OF MIDDLE MARKET PRIVATE EQUITY
According to an April 2007 study published by Mergermarket, midmarket deals with enterprise value lying between €25m to €250m continue to be a significant component of overall global mergers and acquisitions (M&A) activity. Yet so much of the latest hype around the private equity sector has been harnessed by top end buyout firms. Neil O’Hara highlights the achievements and strategy of Castle Harlan, a top-rated US mid-market house and discovers how private equity works outside the limelight.
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build great businesses. That principle infuses Castle before the general partner can share in the profits of the Harlan’s investment approach to this day, according to fund. The general partner will then receive a 20% carried William Preullage, a managing director who joined the interest, although some successful firms receive between firm in 1997 from the merger and acquisitions group at 25% and 30%. Sometimes Castle Harlan’s affiliates play a more active Merrill Lynch.“We look for companies with strong market position, proven management teams that we can help role as executives or directors of portfolio companies. For grow their businesses, and attractive free cash flow example, Ernie Danner, the one-time chief financial officer characteristics,” he says. The price has to be right, of (CFO) of INDSPEC, a specialty chemical manufacturer that delivered a five-fold return course. Although Castle to Castle Harlan over 28 Harlan does participate in months ending in April auctions, it maintains price 1996, later became CFO of discipline and often emerges Universal Compression, a the winner only when it has leading maker of special insight into how it compressors for the natural can boost a company’s gas industry that Castle value. Of the 48 core Harlan bought in 1998 and transactions (excluding boltthen took public in April on acquisitions) Castle 2001. Tom Cook, the former Harlan has made over 20 CEO of Truck Components, years, Justin Wender, the another successful Castle firm’s president, estimates Harlan investment in the that half resulted from mid-1990s, now sits on the auctions. The rest came from board of three current proprietary sources, portfolio companies. including people who have The network extends worked with Castle Harlan further through Castle in the past, business Harlan Australian brokers, investment banks Mezzanine Partners or industry knowledge (CHAMP), a joint venture gleaned from existing formed in 1999 between portfolio companies. Castle Harlan and Many of the 19 investment Australian Mezzanine professionals at Castle Harlan Investments Pty. Ltd., a have long histories in the leading local private equity private equity industry.“I’m a firm. In addition to making relative neophyte with 14 investments in Australia, years here,” says Wender— CHAMP provides insights only half-joking—who joined and due diligence on in 1993 after an earlier stint in corporate finance at Merrill Justin Wender, Castle Harlan’s president. Many of the 19 investment Castle Harlan targets that Lynch. Castle Harlon draws professionals at Castle Harlan have long histories in the private have operations in the on its extensive experience to equity industry.“I'm a relative neophyte with 14 years here,” says country, and vice versa for provide strategic direction to Wender—only half-joking—who joined in 1993 after an earlier stint CHAMP’s US operations. Over the years, Castle portfolio companies—14 of in corporate finance at Merrill Lynch. The deep bench draws on its them at the moment—as well extensive experience to provide strategic direction to portfolio Harlan has developed as helping identify potential companies—14 of them at the moment—as well as helping identify expertise in the restaurant problems and solutions. potential problems and solutions. Photograph kindly supplied by industry to the point where has become a Besides its internal Castle Harlan, June 2007. it competitive advantage. “It resources, Castle Harlan can tap a network of more than three dozen former portfolio is not our only game in the house,” says Castle, “But I company executives and other affiliates. These people suspect we see essentially every restaurant deal that comes invest alongside Castle Harlan through a separate fund, up in the United States. The firm has even owned two contributing their expertise in lieu of a management fee. restaurant companies—the Morton’s high-end steak Castle Harlan still earns a 20% carried interest on the houses and McCormick & Schmick’s, an upscale fish money. Carried interest is a share in the profits of a private chain—twice, at different times and in different equity fund. Typically, a fund must return the capital given partnerships. In the current portfolio, Castle Harlan drew to it by limited partners plus any preferential rate of return on its network for the chairman of restaurant operator
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Castle Harlan was not Perkins & Marie Callender’s trying to second-guess him. when it brought in the The questions Pruellage former CEO of Morton’s Sometimes Castle Harlan’s and Castle asked showed Restaurant Group, Allan affiliates play a more active role as they just wanted to Bernstein, who has advised executives or directors of portfolio understand the issues and Castle Harlan on almost all companies. For example, Ernie offer help where they could. its investments in Management and Castle restaurant companies. Danner, the one-time chief financial Harlan soon developed a The firm has made officer (CFO) of INDSPEC, a mutual respect that several successful specialty chemical manufacturer encouraged managers to air investments in the energy that delivered a five-fold return to any problems that arose. “It services business, too. In Castle Harlan over 28 months was a great combination of addition to Universal people and talent and Compression, Castle ending in April 1996, later became resources. I never took it as Harlan owned Statia CFO of Universal Compression, a a threat. It was meant to Terminals, a leading oil leading maker of compressors for help the business gain storage and transhipment the natural gas industry that Castle value,”Kaplan says,“I would operator with facilities in Harlan bought in 1998 and then work for Castle Harlan Nova Scotia and the took public in April 2001. Tom Cook, again in a heartbeat.” Caribbean. It bought the Such a ringing company in 1996, took it the former CEO of Truck endorsement underscores public in 1999 and sold out Components, another successful the strength of Castle to Kaneb Pipe Line Castle Harlan investment in the midHarlan’s “friends of the Partners in 2001. In 1990s, now sits on the board of firm” network. It also another energy-related three current portfolio companies. validates Castle Harlan’s play, the firm acquired collegial approach to its RathGibson, a manufacturer investment portfolio, of stainless steel tubing grounded in a Monday whose largest customer is the oil industry. Castle Harlan bought the company in morning meeting at which all the investment professionals December 2005 from Liberty Partners, another private get together to review the current portfolio and any equity outfit, and in April agreed to sell it to DLJ opportunities the firm is considering. The investment process can take anywhere from four to 18 months and, Merchant Bank. Pruellage, who led the home team for the RathGibson after extensive research and evaluation, the firm insists on deal, says the company met all of Castle Harlan’s basic a consensus decision to proceed with each purchase. “It’s criteria. It was a market leader with a diverse customer base important that everyone owns every deal,” Wender says, (chemicals, food and pharmaceuticals manufacturers as “You can not sit around and point fingers if you could have well as energy), a platform that could be leveraged with killed it and did not.” For all its many successes, Castle Harlan has had the odd bolt-on acquisitions and solid free cash flow. In the course of due diligence, Castle Harlan developed a good investment go sour. Wender recalls a CD retailer it bought relationship with the management, which helped bring the in the 1990s just before the switch from records to CDs lost deal to fruition. After the purchase, Castle Harlan momentum, the advent of Amazon forever altered the strengthened the management team by bringing in a new distribution of music and big box electronics retailers CFO and a new vice president of operations to run started selling CDs as loss leaders to build traffic in their RathGibson’s New Jersey plant. Boosted by growth in stores.“For anyone except for a couple of very large players international markets and a small acquisition, revenues it was a disaster,” he says. The company went bankrupt, a fate most of its competitors shared. and earnings jumped 50% in a year. Cases where the business changes so much that Harley Kaplan, CEO of RathGibson, says Castle Harlan provides a different kind of oversight than other private nothing can be salvaged are rare, however. More equity firms he has known. The backbone of Castle typically, if a company fails to live up to expectations Harlan’s approach is a monthly face to face meeting with Castle Harlan will figure out where the problem lies—in the management of each portfolio company to review marketing, operations or a new product, for example— progress toward strategic goals and address any problems and then draw on its resources to try to turn things that come up. At first, Kaplan found the idea intrusive; around. The firm takes a long term view provided it can years earlier, he had abandoned the public company world still see a path to create future value. “We have to focus on how much is environmental and how much is our to get away from petty micro-management. After a couple of meetings, however, he realised that execution,”Wender says.
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Once a potential target is identified, Castle Harlan assembles a team that will see the investment all the way through from due diligence before the purchase to the closing, the monitoring phase and on to the final exit. Right from the outset, Castle Harlan keeps an eye on what it wants the business to look like when it comes time to sell out. The firm imposes detailed financial reporting requirements on portfolio companies that drill down to show the profitability of each product line and its potential for cash generation. “It forces people to understand their business,” Wender says, “They often have a sense for it but haven’t done the analysis to get an objective answer.” Castle Harlan tries to identify the major risks facing each company and hedge the exposure wherever possible. For instance, when the firm bought money manager Delaware Management in 1988, it also bought out-of-the-money put options on the S&P500 to protect against any decline in asset-based revenues that would occur if the equity market traded down. Under Castle Harlan’s ownership, Delaware prospered: its assets grew from $16.6bn to $35bn by the time it was sold in 1995. The due diligence process sometimes throws up concerns that affect the price Castle Harlan is willing to pay for a company. After the purchase, the firm looks for solutions that will enhance its expected return. If a company has a contingent environmental liability, for example, Castle Harlan seeks to dispel the William Preullage, a managing director who joined Castle Harlan in 1997 from the uncertainty so that a future buyer will pay a merger and acquisitions group at Merrill Lynch. "We look for companies with strong higher multiple of earnings. If parts of a market position, proven management teams that we can help grow their businesses, business are particularly attractive to potential and attractive free cash flow characteristics," he says. Photograph kindly supplied by strategic buyers, the firm tries to focus growth Castle Harlan, June 2007. on those areas to make the company more valuable. As Wender points out, it is good to build a him, as did Castle’s ability to“replicate himself”so that the firm business, and if it results in someone paying a premium it is does not rest on his shoulders alone. The returns on Castle Harlan Partners IV (the first fund in which Hunter’s clients good for Castle Harlan and its investors, too. Those investors are mostly pension funds, along with invested) have far exceeded his expectations.“They know who some endowments and a few wealthy individuals. Brian they are, they know their sweet spot and they have their deal Hunter, managing partner, CEO and chief investment flow in that sweet spot where people come to them,”he says. Castle is sceptical of private equity firms that have left officer of Strategic Capital Allocation Group LLC, a Boston-based investment consulting firm that has the middle market in search of bigger deals. Castle Harlan introduced several institutional clients to Castle Harlan, does not lack for opportunities. After all; thousands of says the firm is one of only a handful of private equity firms companies have between $100m and $3.5bn in annual that meet its forensic due diligence standards for what it revenue, while the largest players must compete for deals in the rarefied air of the Fortune 500.“People go to bigger takes to be successful in today’s market. On short notice, Hunter asked for details of every deal funds because they prefer the economics. Bigger funds Castle Harlan had ever done—then found a thick book mean bigger fees,”says Castle, who has no desire to follow waiting for him the next morning. The principals walked him suit, “We find a lot of transactions where there is very through the failures as well as the successes; what had gone limited competition.”It is a proven formula that is likely to wrong and what they had done. Their openness impressed ensure the firm’s continued success.
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ASIAN TRANSITION MANAGEMENT:
Roundtable
Participants:
Supported by:
Left to right back row: PAUL SACHS, Mercer Sentinel Group FRAN THOMPSON, managing director Asia, FTSE Group (Observer) SCOTT LOTHIAN, head of manager research – Asia Ex-Japan, Watson Wyatt Investment Consulting JUSTIN BALOGH, senior managing director and head of transition management, State Street Global Markets, Asia Pacific FRANCESCA CARNEVALE, editor, FTSE Global Markets STUART LECKIE, Chairman, Stirling Finance and The Hong Kong Retirement Schemes Association (Observer) Left to right front row: FIONA ELLIOTT, Mercer Sentinel Group (Singapore) (Observer) BRIDGET SO, Hospital Authority Provident Fund, Hong Kong JOHNNY HENG, head of global equities trading, Government of Singapore Investment Corporation MICHAEL JACKETT-SIMPSON, director pension and investment services, Citi
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ASIAN TRANSITION MANAGEMENT ROUNDTABLE
KEY BUSINESS TRENDS FRANCESCA CARNEVALE, EDITOR, FTSE GLOBAL MARKETS: Justin, what are the key business drivers in Asia
of transition management? JUSTIN BALOGH, SENIOR MANAGING DIRECTOR AND HEAD OF TRANSITION MANAGEMENT, STATE STREET GLOBAL MARKETS, ASIA PACIFIC: Transition
management began to evolve in the Asia Pacific region about seven or eight years ago, lagging first North America and then Europe in the uptake of the product. There are a number of elements, some unique to Asia, that now contribute to the growth of the product, and which have been particularly influential over the last twelve to eighteen months. In the developed markets of Japan, Australia, Singapore and Hong Kong institutional investors are changing their approaches to asset allocations—though changes in managers still tend to be driven by issues of performance, as well as changes in investment strategies. In the emerging markets of Asia, many institutional investors—particularly in the public sector—are shifting asset weightings away from locally-domiciled investments towards global equity and global fixed income allocations. Institutional investors in countries such as China, Korea, Taiwan, Malaysia, and Thailand are substantially growing investments into offshore indices. These shifts are driving a lot of activity in the transition management business in this part of the world and represents a change from what was driving mandates perhaps four or five years ago. Then it was all about the shift between passive and active strategies. JOHNNY HENG, HEAD OF GLOBAL EQUITIES TRADING AT GOVERNMENT OF SINGAPORE INVESTMENT CORPORATION (GIC): Particularly in this part of the world,
where funds had traditionally more domestic-based investments, the changes we now see among our peers are in the direction of multi-asset class investments. Investors now go into areas that were untapped in the past. I see funds now getting involved in both active management within traditional asset classes, as well as a burgeoning interest in new asset classes, outside of traditional geographies. SCOTT LOTHIAN, HEAD OF MANAGER RESEARCH— ASIA EX-JAPAN, WATSON WYATT INVESTMENT CONSULTING. We are very heavily involved with a
number of beneficial owners right around the region and we help them to diversify their asset base, as Johnny and Justin have noted. Either we help them move their investments overseas, or into different types of asset classes, or different types of investment. We advise many of our clients to use transition management when there is a large project: either involving changing managers, or moving into different asset classes. Moreover, we also use transition managers to help build portfolios for a wide range of different types of assets, including alternatives— building a hedge fund portfolio for example; or a real estate investment trust (REIT) portfolio. With this increase in different underlying instruments being utilised, the onus is
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on transition managers and consultants to work together to help clients through the process of implementing new strategies.
FACTORS INFLUENCING THE CHOICE OF TRANSITION MANAGER FRANCESCA: Bridget, what are the characteristics in a transition manager that you look for? BRIDGET SO, HONG KONG HOSPITAL PROVIDENT FUND: We like to deal with transition managers that fully
understand our objectives. Obviously, we look for excellence in execution: trading capability, risks controls and an ability to time the process and implement a good overall strategy. We also look for reasonable costings and a willingness to compete on price. Once we have all these elements, we feel comfortable going to our trustees and explaining our selection criteria and strategies. FRANCESCA: Paul, is there a particular Asian approach to transition management appearing? PAUL SACHS, MERCER SENTINEL® GROUP (A SUBSIDIARY OF MERCER INVESTMENT CONSULTING, INC.): I would say not. Asian clients are looking for the exact
same things as their sophisticated peers around the globe. Our view is that it is a global business and perhaps transition managers need to have a global perspective. If you look at the leading providers in the market, they are global organisations. Moreover, there are issues of scale and barriers to entry to consider. Firms have to have certain minimum requirements to participate well in this space. Bridget mentioned execution and risk controls. A third element is project management skills. Transition managers bring these three essential skills to the party. Additionally, transition managers really need to have a global perspective. JUSTIN: The core elements of the product are common to transition management elsewhere. However, there are some unique elements in the countries in which we operate that put some burden of flexibility on providers. For example, how we deliver transition management in Japan differs from Australia. So that type of unique country element does play a role, but the core characteristics of good transition management apply equally in Asia as they do in North America and in Europe. PAUL: A transition done in Japan is different from one done in London in so far as they are different markets. I don’t know that it varies based on the location of the client, but instead depends on where the client’s assets are invested. There will be the same challenges doing an emerging markets transition, or dealing with Singaporean securities, irrespective of where the client owner is based. JUSTIN: A transition manager needs a skill set to be able to handle a broad set of instruments, but there are varied structural operating models. For example, in Japan, a broker-dealer approach to transition management cannot take fiduciary ownership of the portfolio, as an investment manager approach would be able to do in other markets. The broker-dealer must take a trade order, from an
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appointed fiduciary to execute the transition management event. That is a function of the local regulatory environment. Therefore, while the instruments traded may be common to global transitions, the local country domicile can have structural implications. SCOTT: Certainly more Asian investors are looking internationally. Equally, more of our clients (around the world) appear to be investing in the same types of assets. Looking at the range of different transition management providers globally, there is not necessarily a clear business model that works better than any other does. Increasingly however, we find that performance seems to be largely dependent on the personnel located in different jurisdictions. For example, transition manager X might have a very strong team, say, in Japan and maybe London, but not as strong in the United States. We do see a wide disparity of capabilities, even within the same organisation. Local institutions need to keep an eye on the team that is really managing their project. JUSTIN: A key differentiating factor is the investment that providers make in their team and the personnel they have assembled. A client should closely examine the intellectual capital that providers have brought together. Clearly, trade execution is an important element in transition management. However, are the teams staffed with professionals that understand the core concepts of portfolio management; for example handling currency risk, market exposure risk, and duration risk on bond portfolios? These are all key concepts that deal with managing an implementation shortfall result. Therefore, a careful examination of a transition providers’ team, checking biographies, interviewing people, is a very important part of the due diligence process. FRANCESCA: Johnny and Bridget, when it comes to sending out requests for proposals (RFPs) and analysing the responses, how much is your decision based on a true understanding of the range and quality of services provided by transition managers? How do you balance that with cost considerations, which seem to lie at the heart of many decisions in transition management? BRIDGET: The quality of services is very important. It ranks very highly on our selection list. We have to be certain that the transition manager can manage the project properly. We need to know how much expertise they have, if they have relevant expertise in managing transitions between different asset classes or geographies, and whether they can provide an accurate estimation of cost. These are important criteria for us. I also have to say we don’t want too many shocks during the process, and so I think that communication at all stages of the project is also important. MICHAEL JACKETT-SIMPSON, DIRECTOR, PENSION AND INVESTMENT SERVICES, CITI: Bridget’s comment
about not wanting shocks is crucial. As a transition manager, we see this as one of our key roles and responsibilities, that is, the avoidance of nasty surprises. Our job is to listen to the client, to understand the client’s
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objectives and basically, to execute in accordance with achieving those objectives. As long as the transition strategy is clearly articulated to the client, the strategy goes to plan and there are no unexpected outcomes, we would argue we had done a good job. JOHNNY: The first thing we do when examining RFPs is to reflect on the kind of mandate we are giving out. If it is a complicated mandate involving multi-asset classes, obviously the ability of the transition manager to have not only execution ability, but also access to the relevant markets is very important. For example, we know of somebody who wanted to do a transition that involved Singaporean bonds, but there are not a lot of transition managers that have direct access to that asset class. Therefore, the ability to sift through that type of information, and the transition manager’s relationship with good dealers in the local market, are important elements. Beyond that, because we erroneously look at cost as an important issue, but in fact it is only one issue, and it should not be an important issue. FRANCESCA: Do you think that you are typical? Many transition managers express their frustration at the way in which clients make decisions based entirely on cost. There are clients who opt for a guaranteed implementation shortfall, or a no-fee transition. JOHNNY: I don’t think we are typical. We do not have too many strings that bind us to those kinds of decisions. I can
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management service understand why it is provider. However, I am sometimes convenient and interested to understand often-times appears when you speak of appropriate to opt for qualitative measures of explicit costs. It comes actual trade execution, with numbers and it is easier to justify if things go how does that necessarily manifest itself in a wrong. However, it is in itself a measure of shortfall. transition result? Ultimately we provide a We exercise flexibility, pre-trade estimate. We say undertake proper due diligence, and we like to the result is going to cost the client a given amount, think that the transition managers we use are able and as you say, all things being equal, if we meet the to comply with the trading strategy and we mandates at hand. That is deliver the client that why pricing is never a result, then you can primary consideration for consider that we have us and why we almost always never go into done a good job. competitive bidding. If it is MICHAEL: We don’t an agency-style transition, necessarily see cost estimates are mere implementation shortfall promises. If the promises as the be-all and end-all of are not met, then you have measuring the success of a to look at the reasons why transition, though it is they are not met. certainly a key component. Competitive pricing is In our view, it is like trying meaningful only in cases to research your fund where it is principally manager: there are many driven, because you qualitative components JOHNNY HENG, head of global equities trading at Government of commit somebody to a that go into working out Singapore Investment Corporation (GIC) price. We also get the who you think over the transition manager involved at a very early stage, because long term will deliver alpha, and that involves looking at the there is no competitive bidding involved and therefore the people, the process, and the infrastructure on offer, for levels of collaboration are a lot higher. We have a group of example. With respect to the execution process, we don’t see transition managers we do use regularly, but we use them this as rigidly sticking to a plan derived solely from the based on our sense of where their strengths lie. numbers of the pre-trade report. Our job is to leverage our MICHAEL: Execution performance is something you can experience base of restructuring assets, to devise multiple quantitatively measure, to work out whether a transition implementation strategies and to communicate the trademanager has met performance targets versus agreed offs to clients. It is in the use of our experience, in benchmarks. Typical benchmarks include implementation consultation with the client, which leads to development of shortfall, close, open and VWAP; and these are easily the best strategy. We think it is more than just numbers. quantifiable and understandable measures. More SCOTT: You can get too hung up on execution and trading. importantly though, is the transition manager’s quality of What we are talking about here is a project that is a execution. This is harder to quantify, as it is subjective. In concentrated risk event. It may be a series of concentrated essence, quality is driven by the strategy the transition risk events, but essentially you have a project in which manager chooses. Therefore, it is important that the client there are lots of different parties involved: custodians, understands how the manager develops the strategy and consultants, clients, different managers and transition ultimately implements it. The element of experience— managers. It is the transition manager’s role to make it having worked in this business for a reasonable period of work, to manage the project from A to C. In terms of time as opposed to being a new entrant—is an area where assessing a transition as it is going on, and afterwards, we we see key differentiation of the transition management make a point of polling (often informally) all the parties providers. involved. That gives you rounded, qualitative feedback, both during the transition and afterwards. It has become a JUSTIN: Clearly, we are measured on a quantitative basis. Implementation shortfall is an industry standard. I agree very important part of understanding how well a transition there are qualitative factors to being an overall transition manager has done that project.
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NO COST OR GUARANTEED-PRICE TRANSITIONS FRANCESCA: I am concerned that some beneficial owners are
being offered transitions on a guaranteed performance basis. PAUL: We all have heard of providers who come and say,“I
will do your transition for no cost, with no commission”. That just means it is not disclosed. There is no such thing as a free lunch, so then the question is,“What is the true cost?” Was there some pre-hedging done? The fact that you cannot measure the impact does not mean that the impact did not happen. It just happened when you were not watching, because it happened before your securities traded. JUSTIN: In some segments of the market, there may be a utility derived from principal trading. Nevertheless, let us be clear, the way that expert institutional investors, staffed by portfolio managers use principal trading, could be very different from the average pension client’s exposure to the use of principal trading in transitions. For example, when principal trading is typically used by fund managers, the assets to be traded are not disclosed to the provider a week or more in advance like they can often be in transition management assignments. The use of principal trading can be very different, between how the asset management industry normally uses it and how it is used in a transition. Moreover, principal trading is a risk transfer but let’s be frank, it is also a potential wealth transfer if mis-used. A pension client may have no insight into this. Therefore, there is no miracle that points to a principal trading provider of transition management being able to execute an event more cheaply, simply because of risk transfer. PAUL: Principal trading has all the cost that agency trading has, and you have to pay a premium for risk and for use of capital. So now the question is: every good has utility, but at what price? So if an agency transition costs me 10 basis points (bps) with plus or minus 30bps of opportunity risk around that, maybe I wouldn’t pay 35bps of principal, but 13bps might be very attractive, because paying 3bps of premium to take 30bps of risk off the table would be pretty nice. JUSTIN: That may be what you see quoted. There may be an undisclosed element of wealth transfer that the client might not be aware of. That is a risk for people managing the interests of pension beneficiaries. They may not be expert in the practices of the operating market and there are varying degrees of experience around the client base that we deal with. PAUL: I think it then goes back to having a framework for evaluation. If you are not familiar with the nuances of transition management, having someone who can help you understand those nuances and put things on an equal footing will help clients to differentiate between transition managers and select the most suitable one for their transition. MICHAEL: Typically we trade agency for the vast majority of client transitions. Having said that, the use of principal capabilities does tend to get a very bad rap in the industry. Used appropriately, that is, so that it does not impact
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negatively the transition portfolio, and if properly disclosed to the client, use of a transition manager’s balance sheet can be a good thing. FRANCESCA: Has transition management become too complex a product for its own good? BRIDGET: Actually, at times I cannot deny that the field is overrun by jargon that is not that easy to absorb. It is not uncommon to get consultants involved in explaining things if we have any concerns. We also welcome transition managers to brief us on strategies that might be employed if there are complex assets to be transferred in or out of the portfolio. They might also tell us that the process might take longer, or there is an illiquid tail that might not easily be traded out. As long as we are kept closely informed at all stages, these issues are acceptable. However, as time goes by, we gain more experience of different aspects.
COMPLEX TRANSITIONS AND ILLIQUID TAILS FRANCESCA: In a plain vanilla transition, it is easy to be a
good transition manager. What happens though, when a substantial portion of a portfolio is illiquid (say, with a small cap portfolio) and difficult to trade away, what then? MICHAEL: That is when a transition manager can really differentiate their transition strategy and the way they
SCOTT LOTHIAN, head of manager research – Asia Ex-Japan, Watson Wyatt Investment Consulting
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approach the assignment. Most transition managers are part of big global firms, with large pools of liquidity. However, it is the manner in which those firms access those pools of liquidity that really is the key issue. With a small cap portfolio, if you go out and incorrectly solicit liquidity from the market, you may see an instant adverse impact on the transitioning portfolios performance, thus resulting in unnecessary cost being incurred. It is about the way you approach the problem. It comes back to the experience you bring to the table and the strategy that you choose. PAUL: If the assets in a portfolio are not liquid, it certainly increases the complexity. Johnny mentioned a noncompetitive process using principal trading. When you do principal trading, you are transferring risk immediately. When you transfer risk you are going to pay a risk premium. Now there are plenty of people around the table here who will argue that agency trading costs less, but to Johnny’s point, there is utility provided by principal trading. So we think in evaluating transitions and transition managers, you need to have a framework by which you can benchmark and evaluate that utility. If, for example, you are looking at an agency transition, you are not going to give out your own portfolio because you don’t want to create information leakage that will impair your prices. You would use a masked process. Alternatively, if you are doing a principal transaction, it is possible to run competitive principal bidding on a blind auction basis, so that the losers are not able to go out and transact against you. The situation with the small cap portfolio you mentioned is that there are two costs you need to worry about: one is impact - the longer you take the trade the less impact you get. The other is opportunity risk: the longer you take to trade, the greater the opportunity risk. It is important to have a rational framework for benchmarking your costs, deciding your trade-offs, and picking the best alternative. It all starts with the framework and finishes with price/risk discovery. Nothing wins like price discovery (and here I am not only talking cost, but also talking risk). It is important to realise only 25% of the total cost of a transition is explicit. Everybody focuses on the explicit cost because they can get a handle on it. However, importantly, it is the other 75%, the implicit costs that you cannot see, that are going to drive your experience.
WHAT IS BEST EXECUTION? SCOTT: We spend a lot of time with clients and quite often it is a three-way conversation, with the transition manager involved. We are trusted advisors and a lot of the transition management game is about trust as well, which is why we see lots of repeat business. Best execution is part of the jargon, banded around a lot. We tend not to put much stock by it. Sometimes it is enshrined in local legislation: a trade might have to be done in a defined period of time or in a certain way. It is more important for us that transition managers do what they say they are going to do. FRANCESCA: Are consultants gatekeepers now: protecting clients and defining best execution?
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PAUL: Consultants bring to the table considerably more
than just helping with the assessment of best execution. The problem with best execution is that there is no definition. If there are ten people in a room, there are twelve definitions. Independent of whether the transition manager is acting as a broker/dealer or as an investment advisor, both have a certain standard of fiduciary obligation to seek the best outcome for their clients. However, there are many definitions that fall within the broad range, but may not optimise. Certainly, all transition managers have an obligation to seek the best possible outcome. As you will note, I have not defined best execution, but that is one of the issues. As an industry, in the last three or four years consultants have increased market knowledge and awareness about transitions and transition management. I was telling a story at a conference a year and a half ago, when I talked about giving transition advice in 2001. At that point, my team and I had studied RFPs and, on that basis, provided advice. I am sorry to say that, if you base advice purely on RFPs, there is a distinct limit to your knowledge. To do a good job, you need to go onsite, to perform research and due diligence, in order to know your transition manager thoroughly. You need to know the captains, the lieutenants, the sergeants and the privates, otherwise you are not going to be able to comment knowledgeably on the nine or ten dimensions that relate to whether a transition manager is a good fit for a client’s mandate. You also need to assess the performance of the transition manager at the end of the transition. JUSTIN: Experience is important as is the quality of the people. In any industry the quality of people is very important. Scott talked about trust. Paul talked about fiduciary best interest of clients. This is another concept that is really under discussion right now and a catchword around the product. An institutional investor or pension fund wouldn’t tolerate a hint of conflict of interest, from either an external asset manager or a custodial provider or an asset consultant. We have seen examples where there have been conflicts of interest exposed in the practices of asset managers and they have had their mandates terminated immediately. I don’t see therefore why these standards should not fully extend to the transition product. No conflict of interest is a minimum standard that any transition management service provider should bring to this discussion, which them puts them on an equal footing to the client’s other outsourced relationships.
THE T-CHARTER FRANCESCA: Is it important to you all to have a formal
treaty or document that sets out what clients should expect in terms of best execution and service provision, such as the T-Charter? BRIDGET: The terms and required services together with the confidentiality agreement are surely addressed on our formal transition management document. We do take on trust that transition managers work honestly in the
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preservation of the value of the assets in a transiting portfolio. Transition managers should meet basic performance standards and work in a transparent manner. For example, if there are any failed trades, they tells us exactly what is going on and how they intend to do about it, While we do not expect them to follow a black and white tick box of standards, we expect assets to be executed on a best effort basis. JOHNNY: The entire process is so complex that having a set of rules to follow could well be wishful thinking. When the T-Charter came out, it was consistent with FSA standards and it was useful in raising awareness and developing a common understanding of a framework that we could be guided by as opposed to having a set of rules that set out a one size only set of rules into which the business has to fit. Given the complexity of any given transition, I think a set of generally accepted principals that we can use as a guide would be more useful than a firm set of rules. MICHAEL: I agree, it is better not to be too prescriptive to the minutia. If you do not have consensus, there is always going to be debate and that can be time-wasting. Fundamentally, clients want trust, they want communication, and they want professional service. I don’t think you need to be prescriptive to the nth degree. SCOTT: To the extent that it helps in increasing transparency, increasing awareness of various terms and disclosure then that is a great thing. However, no two transitions are the same and to try to box things in might be going too far, but the spirit is definitely excellent. JUSTIN: Interestingly though, it does flush out a couple of key points. When the issue of pre-hedging was brought up in the T-Charter, for instance, at least one or two banks immediately pulled out of signing it. This is indicative of where certain providers place their business models, and how important that practice is to their underlying revenue stream. PAUL: Another possible interpretation is that a global organisation trading on a proprietary basis may find it difficult to represent in London that they are not short or long in that security in Sydney or Tokyo. That might not be greed so much as the inability to make a full and honest representation that constrains some of those parties. Johnny’s point is good, prescription can constrain things and Bridget’s highlighting of transparency is valid. If the TCharter helps us agree a set of common terms and provide transparency, then we achieve the result we are looking for. Fiduciary responsibilities in some circumstances may be necessary, but it is not sufficient.You are not done, because you use the word ‘fiduciary’. I have also seen transition managers charge a premium for fiduciary – so every good has a value, but at what price? JUSTIN: I agree with a lot of what you say, but we are dealing with a segment of financial services industry that requires the very highest standards of care. We are dealing with people’s beneficiary and retirement savings. As I said, clients demand that duty of care from all their other service providers, how can they not expect the same from a transition manager? You make a good point Paul, just
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because you say you are a fiduciary doesn’t get you to the table, but I think not saying that you are should exclude you from that table. PAUL: There are ways to use a fiduciary to obtain principal bids. In the spirit of the T-Charter, (that is, transparency) if I am seeking principal bids, then I understand that the people I am soliciting bids from have diametrically opposed interests. They are not fiduciaries. More for the dealer is less for the client. Johnny as a sophisticated investment professional can evaluate that. Your point is: if the client is not as knowledgeable about trading, they should not be doing that, they should be looking to a fiduciary. SCOTT: It is acting like a fiduciary, which is the important part. You wouldn’t want to appoint a transition manager that does not act like a fiduciary, not necessarily only in the legal sense—it should be a given. MICHAEL: Principal execution almost certainly gets a bad rap. If used properly and the client is fully aware, then balance sheet gives you flexibility in a transition that you may not actually have if the balance sheet was not put on the line. At Citi we operate as a fiduciary as defined by Employee Retirement Income Security Act (ERISA) laws, we are one of the few investment bank transition managers that can operate in this capacity. FRANCESCA: Isn’t there a difference between principal activity where you utilise your balance sheet and prehedging? Moreover, pre-hedging is pre-hedging whether the client knows about it or not, so what makes it right in some circumstances and not others? JOHNNY: It is all about timing. Pre-hedging in itself if you look at it as front-running is bad, but if with the knowledge of the client you make aware that you need to pre-hedge for a variety of reasons and especially if the client is aware of pricing, it is more acceptable. It is not right to use a broad brush and say pre-hedging is evil. At times, pre-hedging might be necessary to help in the entire process. If the process is transparent and the client knows what is happening, it is more acceptable, but I agree it is a taboo. For the sponsor, as long as it is a taboo and there is always a question mark as to
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its rightness, no matter how PAUL: Once the event has much transparency there is, occurred there is no and so perhaps the best redress, usually, unless thing is to avoid it. By and there has been general large we have gone on the malfeasance. For example, path of avoiding it totally; in the last six months, we on the basis that it is almost determined in a post trade always impossible to justify analysis situation that a that you have pre-hedged transition manager had for a good reason. When we made a mistake in the do something wrong, it is transition. They had to always hard to justify it well. write a six figure check to You know how the fix it. A prospect asked us argument goes: I had to kill recently what leverage somebody for a bigger they had to extract cause. concessions in unsatisfactory situations, MICHAEL: I am not because they were not advocating pre-hedging, going to have another but rather the use of transition in the next few balance sheet to provide years. Working with a flexibility for example consultant who passes out flexibility to complete billions of dollars of trading in some illiquid transitions per quarter and securities to allow the new has a systematic approach fund manager to begin to it, keeping track of how managing the assets transition managers do, sooner. Then perhaps it PAUL SACHS, vice president, Mercer Sentinel Group can help. With regard to may be the right strategy for the investment bank to put their balance sheet on the measurement, implementation shortfall is easy to calculate because you can do it on publicly available prices, and it line, but that is very different from pre-hedging. captures all the costs and it is the industry standard. The bad thing about it is, it does not tell you whether your INCOMPLETE TRANSITIONS transition manager has done a good job or not, therefore we believe you have to do an attribution analysis. Say FRANCESCA: As a client Johnny, what redress do you have someone says a transition will cost 15bps plus or minus if a transition is not completed to your satisfaction? 30bps, for a small cap portfolio, for example. Then the JOHNNY: We have been quite fortunate in that it has not happened to us, but I would imagine that if you agree to manager comes in at 53bp—and I have seen this happen— something on an agency basis, it also means best efforts. In and done a great job in a very, very difficult market. I have the spirit of that, in the worst case, there will be no second also had situations where a manager has proudly transition. You cannot go back and ask the transition announced it only cost 8bps. Then you undertake the manager to make good all that has gone wrong, because as attribution analysis and you point out that according to the I said earlier, all cost estimates are mere promises. That is it, markets it should have cost only 2bps. If you don’t do that there is no contractual obligation, the only contractual analysis, you simply do not know what is attributable to obligation that there is are the explicit commission costs market and what is attributable to the actions of the and like Paul said, it is the 75% of implicit costs that goes transition manager. unseen, and even if you find that, you cannot seek redress. MICHAEL: The same transition executed on different days Therefore, I think, the only carrot you can wield is to have can have very different implementation shortfall outcomes. no second transition manager again. Now is that reflective of whether your transition manager has done a good or bad job? I think it is debatable which of FRANCESCA: Is that punishment enough? JUSTIN: Certainly. Let’s face it, transition mandates don’t these applies to the outcome of a particular transition; luck come around every three days or so consistently from the sometimes plays its part. If the strategy and the approach same single client. Clients take on these events on a less are clearly articulated, the timeline and the key steps frequent basis than normal ongoing trading relationships followed, then does deviation from the expected result for investment managers. The stick is indeed a powerful necessarily mean it is a poor result? Maybe, maybe not. one. It is much like investment management mandates. There may be legitimate reasons for the deviation that are Poor performance will ultimately be met with termination beyond the control of the transition manager; that is, market volatility or movements. Looking behind the of the mandate.
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numbers and having a true understanding of the drivers of the result is crucial. JUSTIN: A good transition manager should be able to do exactly that. The manager should be able to provide the attribution on what factors came from the market and what came from spread or timing costs. That is really the insight that an experienced transition manager should be able to give.
CLIENT APPROACHES FRANCESCA: Johnny what do you think of the relative roles of consultants and transition managers in communicating the transition process to you? JOHNNY: We don’t use consultants. Otherwise it depends on the complexity of the transition, which can vary from a straightforward hiring or firing of a manager that just needs a straightforward transition from one legacy to one target portfolio. In these cases, during trading, communication is minimal. Communication takes place pre and post trading, getting all the custodial work done. The greatest interaction takes place when there are multi-asset class transitions, where the qualitative factors are important, where the transition manager can provide valuable insight in the behavioural patterns of different asset classes in that transition period. In this case, communication helps pace the transition. However, we are a little bit different to a traditional client, because sometimes we are actively involved in a transition process. We feel that we can work closely with transition managers. We have our own trading team and so we can work more closely with them and tend to use them only for more sophisticated transitions. Basic transitions we handle ourselves. FRANCESCA: Paul, is it a good thing that, in some cases, the buy-side can take the product into their own hands? PAUL: I am perfectly fine with it. It is appropriate for the buy side to take matters into their own hands if they have trading expertise in-house. That allows a team like Johnny’s to evaluate trading opportunities and to pass judgement on whether a principal bid or agency bid makes sense. The vast majority of institutional investors have fiduciaries managing their money. As such they won’t have that direct trading expertise. Transition management in that case is a skill that they need to rent on an occasional basis. They turn to qualified transition managers with key core competencies of project management, execution skills and risk controls. JOHNNY: I think I do see value in the role of consultants, because there is clearly a diverse group of investors out there. Transition management is methodical, there is a fixed set of processes, and even when we use transition managers, we feel we can add value to the trading process. Sometimes we don’t want to take care of things outside of that. Consultants come in handy in beauty parades and for an investor that rarely uses transition management. If you don’t have too many transitions to provide, then any stick you may have is not effective. A consultant however may
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undertake bulk purchases, and by virtue of that they can wield a stick on behalf of a client much more effectively. In so far there is a varying degree of sophistication and size of investors; consultants are there to play a role. BRIDGET: We are not in a position to monitor trades through our internal systems. We have used consultants in the past and now we undertake assessments internally, but it involves communication with custodian banks, transition managers and target and legacy portfolio managers. It is really a dialogue. Before a transition we look for the establishment of a proper framework, run down schedules to define everyone’s responsibilities and we hope it all falls through nicely and we can envisage the outcome. MICHAEL: Different clients want to do different things. We are perfectly comfortable with that and respect this. Some of the more sophisticated funds will want to do it themselves. Certainly a key ingredient under this circumstance would be the presence of capital markets expertise. Not all have it. The one thing I would say about transition management is that execution is really step seven out of ten steps. If there is one key ingredient in the success of a transition, it is almost certainly the correct execution of the planning and strategy phase that sets up the transition for a good outcome. We are seeing a small percentage of our clients doing their own transitions, the advent of algorithmic trading and direct market access is allowing clients in the right position to do so. The common feedback we get these days is that the more complex the transition, the more likely they need the services of an expert. JUSTIN: The landscape and nature of transition management in Asia over the last three years has really changed. We see this throughout the countries represented in the region where we do business. We see more overlay mandates, we see extended timeframe transitions where they go on for three or four months and maybe in the interim we are asked to manage the portfolio for the
MICHAEL JACKETT-SIMPSON, director, pension and investment services, Citi and SCOTT LOTHIAN.
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award to the winner, but three weeks later they realise they cannot establish a contract with the selected manager. Therefore, they go to the runner up, and the same happens. Finally, they go to the second runner up. In that instance, they delayed a small cap transition by about two months, which can be a very expensive proposition. When you have a panel, it gives an investor significant flexibility. The first time we saw panels developed it was by large investors who used qualifications to exclude providers, by applying severe minimum qualifications: it was an exclusionary process. If you are going to have a panel, you should construct it in a fashion that helps you to differentiate Left to right: PAUL SACHS, JUSTIN BALOGH and FRANCESCA CARNEVALE among the survivors and to design the clients. We see significant growth in multi-asset class panel so that it supports your needs as an investor. Even trades and the use of derivatives and in particular fixed panel design has evolved over the past few years. income as an asset class, which has grown dramatically. FRANCESCA: How important are consultants in that Interestingly, a lot of the asset managers that we have come process for you Bridget? to know through the transition process have come back to BRIDGET: It is fairly important. They have a whole panel of use us for transition management for their own, in-house experts who know much more about the various activities. That is an area that is growing as well, but the specialisations of transition managers, so it would give us majority of mandates still come from those institutions that more qualitative advice to consider. We tend to have a are outsourcing the product. There is an increase in transition about once every fifteen to eighteen months and sophistication also. have tried a few transition managers over the years. We have been lucky that we have not had any unhappy SCOTT: It really does vary in Asia. There is a diversity of governance levels in institutions and while some are experiences, so we tend to go back to the same service making their first steps in the international investment providers again and again. arena, others are up to the likes of Johnny and his team. We FRANCESCA: Is there a strong loyalty factor that transition see an institutional investor appointing a consultant as a managers can count on? means of enhancing their governance. Whether that is in JUSTIN: Yes, we have a good mix of clients that have used selecting a manager, or as a decision-making framework, or us for a long time and that use us exclusively and also finding a transition manager, we tailor our approach to lots relative newcomers to the product, who prefer to have a of different types of clients. As Michael noted, it is at least panel at their disposal. I would say the client base splits 90% preparation. By the time it comes to transition day, the around 50-50 of those that use us only and those that work should pretty much be done. A slip on execution utilise a panel. might cost a couple of basis points, but a slip up on project MICHAEL: Yes, we feel that our high degree of repeat management costs a couple of percentage points and that business is testament to the way our clients view us. is a huge difference. FRANCESCA: Are you loyal to your transition managers Johnny? PAUL: The use by larger investors of a panel of transition managers is on the uptake here and elsewhere. We think JOHNNY: We again have a fairly unique advantage, in that this has tremendous advantages for the investors. The we have relationships with quite a number of firms in traditional model involved the simultaneous selection of various areas and we are connected at the highest levels. investment manager and transition manager. It placed They have a strong desire to make sure that the total huge demands on staff resources at a point in time. In that relationship works. We are blessed to be in a situation environment, I would argue that transition management where we have a relationship across multiple business suffered from a lack of attention or due diligence because segments with our service providers. Everything falls in of that time pressure. When you establish a panel, you get place, so we are blessed. If we were to go into using to perform better due diligence on them, vet them, and get panels, then we would have to get more involved in pre them contracted. Unfortunately, I have seen a sponsor and post trade process management. I think the key is independently select a transition manager with hundreds having a panel, but not too long a panel, if you don’t have of million of dollars of small cap to trade. They give the enough transitions.
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MARKET OPPORTUNITIES & CHALLENGES JUSTIN: There continue to be significant opportunities in
the Asia-Pacific region and we look forward to being part of the landscape for many years to come. It is an exciting region, perhaps more so than any other, by the sheer diversity of the client set and diversity of the countries in which we operate and do business. What that means for service providers is that they need to prepare and resource themselves for that growth in business and that is certainly our focus. One challenge for us, is to ensure that we have the right people in place to meet this growth in business. The constant evolution and improvement of transition management means we have to continue to invest in the systems and processes that we use to deliver the product. The nature of the product is also changing. There is more activity around alternative investments, more multi-asset class trades and more complexity. There will increasingly be a clear separation between those houses that are preparing for these challenges, and those firms that offer transition management on a part-time basis, as an extension of their trading desks. I think that is a factor that will be important for clients to consider. Is a provider clearly set up to provide a dedicated product? FRANCESCA: You have a huge and fast growing region to manage, how do you service it effectively? JUSTIN: That really goes to the heart of the matter on resources. Can providers demonstrate that they are putting experienced people in key locations? We are represented with dedicated staff in Tokyo, Sydney and Singapore between which we cover the region’s client base. We recognise these markets and all those in-between require good coverage that is close at hand. That has been a key part of our growth strategy. The competitive environment is different in each of the pockets around Asia. Australia is saturated with transition managers, overwhelmingly so. However, I think you are seeing a top tier of providers that are capturing the lion’s share of the business. In other markets in the region, there are only a handful of providers. There are pocket points where there are real opportunities of being a first mover, which is a reality that perhaps is much rarer in markets such as North America or Europe, given their stages of development. PAUL: We are staffing up quite dynamically on our Mercer Sentinel team, focusing on implementation and governance issues to address the opportunity. We focus on the mid and back office operations, like transitions. We are thrilled on the uptake of transition management. However, a problem for everybody around transition management is the fact there is a lack of a scientific method in the business. The truth is, you can’t run a controlled experiment; run the transition one way and then run it another way. We are not blessed with that. Consequently, people look for a definition of savings and in that case look for something with basis points and a decimal following it. That is a challenge for the transition management industry. We can
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say there are savings in using a transition manager versus not using a transition manager. Further, we can assert there are material savings in using a competitive process and an evaluation framework over hiring a random transition manager. However, there is no statistical way to quantify that to a precise level numerically. Transitions involve cost, risk, and fit. We think evaluating providers can add value all around that process. Helping people to appreciate that is one of our greatest challenges. SCOTT: I see a lot more transition managers calling us over the last ten years. Ten years ago there were maybe about ten transition managers in Europe. Today there are over 40. In Asia while there are only half a dozen credible and serious candidates, there are many more coming to market. It is a function of the market being as hot as it is and investment banks are trying to get that extra deal flow going and are hiring all over the place. That is going to be a big challenge. FRANCESCA: You say there are 40 or so transition managers in Europe, but some of those houses undertake portfolio rebalancing and claim that as transitions. Is that the same in Asia? SCOTT: I would say so. I would say, for want of a better term, that there are some real jokers out there, who I think will not be there any more if the market turns. It is as simple as that. This is where experience counts. MICHAEL: For us the challenge revolves around managing the business and specifically managing it for the long term. Being one of the pioneers of the business in Asia, we hope to be able to continue to shape the industry. Ultimately transition management is a client business, managing relationships, understanding client requirements and using our resources to provide solutions, will continue to be crucial. There is a tremendous amount of growth and diversity in the Asian markets and trying to invest strategically is crucial: be it in headcount or technology.
MICHAEL JACKETT-SIMPSON
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FRANCESCA: As alternative trading venues spring up, are
clients keen that you can access the right dark pools of liquidity? MICHAEL: Clients do want more and varied venues to access liquidity, either via electronic means or alternatives to the traditional exchanges. As a transition manager, having access to those markets is key. Realistically, all the big firms probably have access to similar markets, its in the way liquidity is accessed that is important. Soliciting liquidity incorrectly can negatively impact the value of the securities you are buying or selling. We at Citi operate in a broad range of markets on a daily basis across the globe, this provides us with the know-how and expertise to correctly access these markets. You need to be considered and structured in your approach into those markets. FRANCESCA: Johnny, you have the best of all worlds, dipping in and out of various markets and transitions at will. What are the challenges you face going forward? JOHNNY: I think that in the next few years more people will be throwing their hat into the ring and there will be a lot of wannabees offering transition services. We might struggle to work out in the coming melee who is the best provider? It will get worse before it gets better, because especially in the equity business, it will become more transaction-based. Investment banks will increasingly try to use transition management to draw trading volume through their business and internalise order flow. This is why it will be harder for occasional users of transition services to determine which institutions will be worth dealing with. A second challenge is that in Asia, as more state owned agencies and pension funds branch out and include cross border assets into their portfolio, is to find the right transition managers who can help that process of moving away from domestically oriented investments and take up a more internationally focused strategy. These agencies are not really equipped to do it themselves and they will rely on transition managers. Finally, what defines a good transition management process? That is evolving, whether we measure it by best execution or other matters, I hope to see the industry reach an understanding of what can be considered a successful transition management project. BRIDGET: Our trustees are sensitive to the performance of our scheme. As asset allocation strategies are becoming more complex and increasingly involve derivatives, we will require systems and processes that allow us to constantly monitor and evaluate our exposure and the performance of our portfolios. That in turn highlights the role of transition managers in protecting the value of a portfolio in transition and we will be looking at ways to develop our evaluation processes so that they can cope with these changes. PAUL: When you start to talk multi-asset class, the analytics of defining a successful transition get to be significantly more complex. I still think that the framework of implementation shortfall is the right framework on a grand scale. However, there is significant effort involved in working out what is going on between equities and fixed
BRIDGET SO and JOHNNY HENG
income. Are there challenges for transition management in fixed income? Yes. As we talk around equities: they have distinct advantages: centralised price discovery and standardised execution, which makes measurement an easy process. Whereas if you look at fixed income, a quarter million of a bond, versus five million of a bond is not the same thing and, by the way, getting a price is another issue. That is a challenge going forward for investors and we are all working on it. MICHAEL: We have completed more fixed income transitions in the last nine months than in the previous three years collectively. Fixed income wasn’t associated with transition management, but it is now. In the Asia region, it will be almost certainly be multi-asset class transitions, given the high weighting to fixed income assets that institutions hold and the progressive move to international assets, underscores the need to invest. We have just recruited local fixed income bond managers, for example. Fixed income can definitely be more complicated and harder for clients to understand. JOHNNY: Increasingly, the one thing that keeps me awake at night would be how to deal with the less transparent asset classes, such as commodities and alternative investments and fixed income even. If what we are doing in equities bothers us, what we will be doing in these other asset classes will bother us a lot more. SCOTT: Things will continue to get more complex. When you look back, very few providers have merged systems for fixed income and equities. Fixed income tends to happen on this system and equities on another. Only very few providers can truly manage multi-asset classes on a single platform. FRANCESCA: Thank you all for a very interesting discussion.
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Photograph kindly supplied by istockphoto.com, June 2007.
What now for the scope and definition of the global custody market? The market is still reeling from the mergers announced earlier this year— namely between State Street and IBT, and Bank of New York and Mellon. One merger was expected perhaps, but not two and not one of such magnitude. While some service providers see consolidation as an opportunity; others shudder at the impact, wondering how they will compete with the new custody titans. More pertinently, what will the fallout mean for clients? Lynn Strongin Dodds goes in search of some answers. N THE AFTERMATH of the announcement of the State Street/IBT and the Mellon/Bank of New York mergers, it is clear that in the sector of global custody, a new world order is emerging. Few market watchers had expected Bank of New York to make another attempt for the Mellon Corporation after being thwarted eight years ago. It is a reality now though, and in the aftermath of the merger announcement, the global custodian community is reassessing its reach and market strategies. In some ways, there are reasons to be worried. The top four houses are charging ahead of the competition and a merged Mellon/Bank of New York, if size is anything to go by, itself looks like a hard to beat and powerful force. It is now the world’s largest global custodian with over $18.6trn under custody and administration. JP Morgan is next in line with $14.7trn under custody, followed by State Street Corp,
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THE NEW WORLD ORDER with $12.3trn, according to figures from FT Mandate Research, a UK based group. Citigroup, for now, rests in fourth place with $10.4trn, though it recently acquired the fund administration operations of Bysis’s global alternative fund administration business. Just how far these titans have now separated themselves from the rest is best described by the fifth ranking position, held by HSBC Securities Services with $457.1bn in assets under custody. The remaining top ten include BNP Paribas Securities Services, Northern Trust, Société Generale Securities Services and CACEIS Investor Services (owned jointly by Crédit Agricole and Natexis). To all intents and purposes a yawning chasm has opened up between the top four houses and the rest of the top ten, highlighting the new concentration of business in today’s global custody market. The global titans say their objective is to offer an even broader and more comprehensive product range to cope with today’s multi-asset and multigeography asset managers. Over the short term this state of affairs is unlikely to change. It seems then that the global custody industry is fragmenting into three sets.The titans, which claim extensive depth and breadth of product offering, a high competitive middle market and at the tail end, a group of smaller niche players that offer particular expertise in, for example, hedge fund or private equity administration, and which will remain highly vulnerable to both the high end and middle market players anxious to sweep up additional market share. The question is whether the titans will continue to cast around
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for acquisition targets among the top ten players, or as Citigroup has done, at the smaller, specialist end. Jeff Holland, partner with BBH, agrees, adding,“The key in this business is to be able to anticipate a client’s needs. It is not just about what is sexy at the moment, but what will be important in the future. The focus must be on the overall asset allocation, how that will change over time and the service requirements [the client] will have.” The market is split on the outcome. Some participants have it that the top ten houses will be whittled down to five, in a grouping that will continue to be dominated by the current three US groups, which include Mellon/Bank of New York, JPMorgan and State Street. These commentators think that the Mellon/Bank of New York merger is just the tip of the consolidation iceberg. There has been activity in the past, such as State Street’s purchase of Deutsche Bank’s custody operations, Northern Trust’s purchase of Baring Financial Service Group, as well as the deals struck between RBC and Dexia, and ABN Amro and Mellon. However, the pace is now expected to accelerate. Those for consolidation point out that it was on the heels of the Mellon/Bank of New York deal that State Street announced its intentions to buy Investors Financial Services Corp., a provider of accounting, back-office and investment-advisory services to asset managers, in a $4.5bn stock swap. They also envision a number of European majors emerging including perhaps BNP Paribas or Société Générale, and with specialists, such as Brown Brothers Harriman (BBH), populating the rest of the market. Francis Jackson, head of new business development and client management at JPMorgan Worldwide Securities Services in Europe, Middle East and Africa, holds that, “There definitely will be further polarisation in the market. The larger players will only grow more aggressively but there will be room for the pure niche firms. It is the firms in the middle market which have assets of under $10trn [that] will struggle. They will have to work for every penny and if there is a downturn, they will seriously have to question how much money they can spend to stay in the business.”
There are several external and internal reasons driving the trend, say commentators. First, there seems to be no escape from the takeover waves that are now sweeping across the globe. In Europe, the ABN Amro saga is currently being played out with Barclay’s and a consortium led by RBS wrangling over the fate of the Dutch bank. Most latter is Unicredito’s relatively friction free purchase of smaller rival Capitalia for over $29bn. In other word, virtually every financial institution seems to be in play right now, with a sure impact on those institutions that have an asset servicing arm. As Patrick Centanni, head of State Street’s product and technology solutions team, says,“We are seeing mergers and acquisitions happening at different speeds in different markets from banks to investment managers to multinational corporations. Everyone is looking to create leverage and synergies, and gain consistency in their operating models.This process will have a knock on effect on the custody business and create opportunities for providers.”(please refer to box: BNPP SS makes its play.) Of course, there is an equal and opposite view. Bigger is not always necessarily better, goes the argument, and creating such large organisations is never an easy task. Teething problems are bound to occur, with disgruntled clients casting around for a highly personalised service. As Penny Biggs head of global business development, corporate and institutional services at Northern Trust, notes, “Clients do not like turmoil. If there is upheaval, clients will take the opportunity to look around and see who else is out there. If they do not see that the acquisition is in their best interests then they might move on to another provider.” Moreover, it is also too early to assess what impact the merger with Bank of New York will have on Mellon’s joint ventures with ABN AMRO and CIBC. The fine detail in the merger is confidential right now, but insiders say both institutions are aware of the dangers, as any stumble could be costly. Tim Keaney, senior executive vice president and head of global investor services at BNY stresses that,”we are particularly focused on keeping client service levels high. Exceptional service [sic] leads not only to retention but also expansion of these relationships and [in turn] to revenue growth.”
Francis Jackson, head of new business development and client management at JPMorgan Worldwide Securities Services in Europe, Middle East and Africa, holds that, “There definitely will be further polarisation in the market. The larger players will only grow more aggressively but there will be room for the pure niche firms. It is the firms in the middle market which have assets of under $10trn [that] will struggle. They will have to work for every penny and if there is a downturn, they will seriously have to question how much money they can spend to stay in the business.” Photograph kindly supplied by JPMorgan, June 2007.
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©2007 Northern Trust Corporation. Northern Trust is authorised and regulated in the UK by the Financial Services Authority.
CROSS-BORDER POOLING
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Keeping track of multiple pension funds isn’t easy. Especially when those funds are in the hands of several different managers in several different countries. That’s why Northern Trust pioneered Cross-Border Pooling. You get increased governance and control by pulling all your plans together into one fully managed solution that reduces costs and gives you potentially better returns. The point is to make your job simpler. So you’ll have more time, and fewer balls (and reports, and time zones) to juggle. If you’d like to know how we can help, call Penelope Biggs on +44 (0)20 7982 2200 or visit northerntrust.com.
Asset Management | Asset Servicing | Wealth Management
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BNPP SS MAKES ITS PLAY In April, BNP Paribas Securities Services (BNPP SS), the wholly owned subsidiary of the BNP Paribas banking group, agreed to buy RBS International Securities Services (Holdings) ltd, a 70:30 joint venture between Royal Bank of Scotland and Bank of New York. The deal gives BNPP SS outlets in the offshore markets of Jersey, Guernsey and the Isle of Man for global custody, fund administration, and corporate trust services to both institutions and private wealth clients. The transaction is the latest in a round of acquisitions and investments in organic growth designed to propel BNPP SS higher up the securities services league. Dominance in Europe is the first stage; the next is Asia and the US. How far can BNPP SS go? Is it the European investment services provider to watch in 2007?
I
N AN INFORMAL lunch with Tony Solway, head of BNP Paribas Securities Services in London last year at the Fund Forum meeting in Monaco, Solway predicted that 2007 would be a turning point for the bank. “Always something of a dark horse, there is a clear and purposeful approach in the bank’s focus,” he said last year. “The investment services business will take people by surprise in the speed that it will build market share and client reach.” It is a view that Jacques-Philippe Marson, chief executive officer of BNPP SS has in mind. “Consolidation in the securities services industry continues and this transaction reflects our strategy of external growth via selected acquisitions and partnerships,” he notes, “RBS International Securities Services stood out as an attractive opportunity to reinforce our position in the buoyant UK offshore market, and further answer clients’ growing needs in this arena.” It was a unique opportunity to establish a presence in all three markets at the same time, he adds. BNPP SS already has operations in Jersey, which it assumed when it acquired AMP’s international fund administration business Cogent in 2002. “We were asked whether we had any intention of concentrating the business in one location. We said no. It was the specificities of the locations that also made the deal attractive,” notes Marson. “It all fits perfectly. We are close to the market, close to the client and it allows us to provide services to both US and Asian clients that are looking for a specific offshore element.” As soon as the deal was announced, BNPP SS stressed that it was offering positions to all staff within RBS International Securities Services. BNPP SS now takes on an additional $44bn of assets under custody, and $9bn under administration as well as 176 employees in the three locations. The transaction adds to BNPP SS’s existing operations involving 4,400 staff in 18 countries, servicing 700 clients including, claims the bank “eight of the world’s top ten investment
managers, and a global custody network covering 90 markets”. BNPP SS already has €3.6trn of assets under custody as of December 31st 2006, and €623bn of assets under administration. Three issues define the transaction, explains Marson. It puts in place further pieces in a strategy “of being everywhere in Europe. Right now, we are focusing on our geographic expansion in the northern hemisphere.” Second, “the deal is significant, as it expands our reach into the private wealth and institutional trust business,” he says. Third, it provides the bank with operations in the increasingly important offshore markets of the Isle of Man, Jersey and Guernsey, which adds to the bank’s diverse franchise in providing investment services to the alternative funds sectors: predominantly for hedge funds, but also real estate and private equity. Marson explains that BNPP SS sees enormous growth potential in the alternatives sector. As a proportion of the estimated $2.1trn in assets managed by hedge funds around the world, increasing amounts are administrated by third parties. He points out that back in 2003 “only $60bn was held by administrators, that rose significantly by 2005 to around $360bn and we expect that figure to top $1trn by 2010,” he says. Additionally, the offshore element provides a useful counterpoint to the securities services provider’s operations in Dublin and Luxembourg. “Both centres have obviously grown in significance as UCITs 3 legislation and local regulations have supported the expansion of hedge fund services and fund administration in these centres. However, both countries are firmly in the European Union, where regulation of the hedge fund sector is likely to become more stringent in the near future. Our presence in these offshore centres will mean we can provide a faster and more flexible option to our hedge fund clients.” In this vein, only a few weeks prior to the RBS International Securities Services deal, BNPP SS bought Exelbank, a subsidiary of Banco Sabadell.
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Exelbank provides custody and settlement related services to Spanish and international financial institutions, depositary bank services to mutual and pension funds and outsourcing services related to investment operations and private banking. Excelbank has been a player in the Spanish market for over 40 years, enjoying a franchise which gave it €18bn in assets under custody, serving more than “150 funds managed by some 25 separate asset managers,” explains Marson. He motions however, that the play in Spain was different, as “we were already a strong player in the market. Nonetheless, it will add scale to our operations and strengthen our presence in the country.” In particular, the BNPP SS has been keen to develop its franchise in the alternative sector, an attractive proposition in Spain, which has a small yet burgeoning alternative investment sector. The recent authorisation of domestic, onshore hedge funds in Spain—known as fondos de inversión libre—has created a new market for servicing alternative assets in Spain. In December last year, BNPP SS’s Madrid
office was appointed as depository bank and fund administrator by Algebra Partners, the first independent hedge fund manager in Spain to be accredited by the CNMV, the Spanish securities market regulator. BNPP SS is providing complete portfolio servicing for the firm’s Cygnus fund. Additionally, the bank is also reported to be providing a customised ‘white label’ client reporting solution for Algebra’s own investor clients. The next step in Marson’s global plan is to build on operations in the United States, where it is building its fund administration franchise out of its offices in King of Prussia, in Pennsylvania. Elsewhere, expansion is also in sight. BNPP SS will open an office in Singapore in the second half of this year, and expand its business in the Middle East, where the bank recently gained approval from both the DIFC and the Central Bank of Bahrain to expand its trust and securities services business in the region. “We will concentrate on growing our client base as well as creating opportunities to further cross-sell BNP Paribas products in all locations,” Marson concludes.
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James Hockley, a principal in the operations practice at Investit, a UK based investment consultancy, says,“Is whether the top players can meet all the needs of their clients for all their investment vehicles and in all their geographical regions? What we are seeing in Europe is that the largest asset managers are choosing multiple providers for their custody, fund administration and specialist mandates. This could be anywhere from three to six depending on the specific product ranges and expertise [required].” Photograph kindly supplied by Investit, June 2007.
Moreover, as if to introduce balance in the system, clients themselves are changing the way that they use global custody services. An important question for clients to ponder, says James Hockley, a principal in the operations practice at Investit, a UK based investment consultancy, “Is whether the top players can meet all the needs of their clients for all their investment vehicles and in all their geographical regions? What we are seeing in Europe is that the largest asset managers are choosing multiple providers for their custody, fund administration and specialist mandates. This could be anywhere from three to six depending on the specific product ranges and expertise [required].” The same issue applies to domestic custody banks in Europe that so far have enjoyed a somewhat privileged status. The continental European market has always been a hard nut to crack for global firms, as local asset managers and beneficial owners tend to turn to local providers rather than the global players. Their grip on the market is could be beginning to slip, though, and might erode completely as tax and regulatory harmonisation is rolled out across the European Union. Equally as important, asset management groups have radically changed their blueprint due to regulation and the need to generate returns for an ageing population. Although different countries are going at their own pace, the changes have been universal. Equities and bonds no
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longer rule the portfolio composition. These instruments still play an important part but they now have to share space with a host of alternative assets such as private equity, hedge funds, real estate, commodities and currencies. Asset managers have also cast their nets into wider geographical pools and are looking for opportunities in emerging markets in Asia and emerging Europe. Liability driven investment (LDI) strategies have further complicated the mix. LDI strategies that require derivatives, structured products and ever more complex strategies are becoming increasingly popular. This has led to a degree of convergence with the traditional long only and hedge fund managers borrowing strategies from each other. For example, in the past year, 130/30 funds, which enables managers to short 30% of the portfolio, have become wildly popular. JPMorgan’s Jackson also points to the ‘retailisation’of the fund industry as another significant change. “In the past four years, fund manufacturers are producing investment products to meet a wider variety of needs. They are not only thinking of institutions but also of individuals.” Add all these factors together, and global custodians have had no choice but to change their game plan and re-brand themselves as asset service providers. It is no longer just about the custody but those value added services, and it is now high level executives in the asset management firms who are comparing and contrasting the different providers. As Centanni of State Street, notes,“In the past decisions about global custody were typically made by the operations and information technology groups of fund management organisations. Today, these decisions are being made at the senior management and board levels. The basic custody and fund accounting systems and their resultant capabilities are the guts of the services, but clients want different specialist services wrapped around the core.” The list of these value added services seems endless but some of the key products fund managers all over the globe expect include securities lending, fund accounting, transfer agency, performance and measurement services, risk management, middle office administration, alternative investment solutions plus advisory services supporting clients diverse investment strategies. They also have to be able to offer so called ‘component’ outsourcing. Investit’s Hockley, notes,“Today, fund managers are looking at every floor of their operations to see where they can add value and what can be outsourced. I think the days of the end to end lift are coming to an end. Instead, fund managers are outsourcing different pieces along the chain.” Given the evolutionary nature of the business, it is no wonder that the larger groups are looking to accumulate critical mass. As Keaney notes, “The bigger funds are getting bigger and they want to do business with fewer providers on a global stage. We have an interesting mix of clients and they are all growing their assets under management. They are diversifying, launching new funds, using derivatives and moving into new locations such as Asia. They expect us to be there and one of the reasons for
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the merger is to allow us to push the boundaries of our value chain to meet all their needs. It is to tie the business much more closely with the investment process.” Nadine Chakar, chief executive of ABN AMRO Mellon Global Securities Services, adds, “Although scale is not the be all and end all, it is very important if you want to offer the full gamut of services and to handle the growing complexity of the business. There are a lot of firms today that will have to make a decision about the direction they want to take. The Mellon/Bank of New York merger gives us first mover advantage. We have been able to choose our partner and have not been forced to make a knee jerk reaction.” Although it is difficult to predict the next big merger, there is no doubt that all the players are trying to move in
the same direction by covering all the product bases. At one time technology was the differentiator but today, all clients expect the nuts and bolts of their providers to be the latest state of the art equipment. The biggest challenge in the industry has been building or adapting platforms that were accustomed to processing equities and fixed income, to the new more complex instruments. Over-the-counter (OTC) derivatives can be particularly tricky as their valuations derive from sophisticated pricing models. As volumes expand, the need to confirm transactions with great accuracy and speed grows, as does the possibility of valuation errors that can occur while booking trades. Sebastien Danloy, global head of sales for investor services at Société Générale Securities Services (SGSS), “The technology that was built 30 years ago cannot cope with the
FUND POOLING: THE NEXT LEVEL At one time, fund pooling was entirely a story about pension funds. Now other funds are utilising pooling vehicles. Although the product is achieving a wider audience fund pooling remains a discrete business. Until recently, the impact of withholding tax (WHT) presented the main barrier to the establishment of a substantive cross-border pension pooling business. However, those obstacles now seem very surmountable.
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ULTINATIONAL PENSION PLANS looking to increase governance and risk management processes for their assets, “are building global pension platforms enabling them to execute global strategies. Once in search of tax efficiencies, these days pension funds use cross-border pension pooling to aggregate assets, gain efficient oversight and economies of scale,” explains Aaron Overy, pooling consultant, at Northern Trust, which currently supports $20bn in assets in cross-border pooling platforms. “A cross border tax-transparent pooling vehicle is a key component of these robust global investment platforms,” he adds. Overy says that until recently, the withholding tax (WHT) consequences of pooling presented the chief barrier to cross-border pension pooling. “In the UK, Netherlands, Switzerland and Canada, for example, pension plans that invest directly in US equities pay no WHT, based on double-taxation treaties with the US. Those same plans will pay 15% to 30% tax on dividends if invested through most pooling vehicles. The solution to this problem is to approach tax authorities in a number of different countries to provide formal confirmation of tax transparency,” he says. Pooling vehicles also require new methods for custody and fund administration. In other pooled vehicles, all investors pay the same rate of withholding tax. With a taxtransparent vehicle, different rates of WHT apply to different investors. “Moreover, the vehicle is also tax transparent with respect to capital gains. Accurate calculation of capital gains at the investor level is
particularly important in those countries where pension plans pay capital gains taxes. Some countries (Germany, for example) have stringent regulatory reporting requirements that require detailed tax reporting at the investor level. Securities lending for taxtransparent vehicles requires a special methodology,” explains Overy. Considering all these different demands, Northern Trust created a proprietary system and methodology, which is under patent, and which the bank says is suited to the administration of taxtransparent vehicles. “The key is to record detailed information at the investor level that can then be used to meet the demands of local tax and regulatory authorities,” says Overy. Asset pooling by pension funds was ready to take off some two years ago, when Unilever set up Univest, a vehicle to pool its separate pension funds inside a Luxembourg based Fonds commun de placement (FCP), involving some $2.3bn of assets; 14 managers and 22 separate asset management mandates. Northern Trust structured the pooling vehicle and provides custody, fund administration and management company services to Univest. Kerry White, first vice president and head of multinational business development for ABN AMRO Mellon Global Securities Services, maintains that demand for pooling services “has not waned over the last 24 months, but the individuals who require the product have changed. A key development is the take-up of the product by the asset management space and there is keen interest on the part of
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new developments. You need to have the right systems across every product range but the most important thing is to have a platform that is scaleable, customisable and flexible to handle specific requirements.” Rob Wright, chief operating officer of RBC Dexia adds, “There is an expectation that you will have the right technology. The key difference, however, is how you integrate that technology into the investment processes of your clients. Technology is now seen as an enabler, but one of the key differentiators between providers today is the ability to deliver top-notch, high quality service.” This may sound obvious and clichéd, but the importance of the relationship and the calibre of the people on board cannot be underestimated.“In today’s more complex world, asset service providers are expected to be comfortable
talking to the top brass of fund management companies and not just the IT people. They need to understand how the asset management business works and what is driving the strategies in order to work constructively across their clients’ firms to develop the right solutions to meet their requirements,”adds Hockley. As a result, for the past couple of years, global custodians have been looking to recruit from the ranks of the front office or graduates who are from a more numerate background. Chakar sums it up, “We all can settle trades, do corporate actions, add colour to our websites, etc. However, technology is just a tool. It is an intensely people business and today we are competing with the investment banks for talented people who understand the fund management business.”
insurers.” ABN AMRO Mellon offers two types of pooling services: opaque and tax-transparent: the former directed at unit trusts and SICAVs, “which are utilised for limited partnership purposes as well as the pension fund pooling,” and the latter to meet the multi-jurisdictional needs of institutional investors, including pension funds. A salient issue says White is that it is more difficult for pension funds with disparities in performance results to achieve effective pooling due to implementation costs. “There simply isn’t the volume of development dollars that is available in the asset management and insurance spaces,” she notes. Nonetheless, she thinks that on the pension’s front it remains a large company game. “Big bucks follow big bucks,” she adds. Multinational pension funds are managing scarce skills and resources, with limited asset class exposure, sometimes too narrowly invested, trying to ensure consistency of investment strategy and implementation in a cost efficient manner, agrees Northern Trust’s Overy. For the time being, asset pooling remains the preserve of a “small concentration of suppliers,” notes White. “It is very technical. We need to be sure, particularly when we talk to pension funds, that we can provide a solution that works for them.” According to White, the business is in a rapid evolutionary phase. “There is a significant ripple effect running through the market. Ultimately, the take up of tax-transparent pooling won’t involve a large number of pension funds. I can see asset management firms and insurers taking up the product more readily.” White sees this process already beginning. “We are now talking to fund managers and are in detailed discussions with a number of managers that are anxious to avail themselves of the economies of scale involved. The advantages of managing assets in a central pool are becoming an increasing preoccupation of the financial world this year.” It is certainly true of Belgium, which has been
marketing its cross-border pension’s vehicle aggressively in Europe recently. The Organisation for Financing Pensions (OFP), a legal entity designed to accommodate pension funds, established earlier this year, is targeting companies looking to consolidate their pension schemes on a pan-European basis. The entity was established to create a specific juridical structure only applicable to pension funds and to try to attract foreign pension funds to Belgium, as well as incorporating the European directive concerning crossborder pension funds into local legislation. It was also intended to build on Brussel’s position as the European Union’s administrative capital. Until this year, pension funds in Belgium were incorporated as non-profitmaking companies, which paid an asset tax of 0.17%. The OFP has no such requirements, meaning that capital gains will not be taxed, and nor will there be a withholding tax on dividends. Funds using the OPF are also allowed to apply a discount rate of 6% when calculating the level of accrued benefit liabilities, which essentially allows a fund to cover given liabilities with correspondingly fewer assets. Although a bold initiative, it is not entirely certain the Belgians will succeed. “Belgium is not alone. The Netherlands is pushing to retain its position as a centre of pensions excellence, starting with the tax-transparent FGR vehicle,” notes Overy. Both White and Overy envisage the business coalescing in Dublin and Luxembourg. White notes, “Dublin and Luxembourg have too well established cultures of excellence when it comes to fund administration. They will be hard to topple.” Both experts think that the next phase of development is entirely technology driven: thereby underscoring the dominance of existing pooling expertise in the two capitals. “It is likely,” explains Overy, “that existing platforms will evolve to a self-select platform. It will be an open architecture approach, where the client has complete control and where they will be able to measure their performance against their peers. It is an exciting development.”
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ISSUER PROFILE: THE UK’S DMO
LOW KEY: HIGH TOUCH Robert Stheeman, chief executive of the UK’s Debt Management Office. Photograph kindly supplied by the DMO, June 2007.
The Debt Management Office (DMO), the specialist debt issuance agency attached to the Treasury is noted for its willingness to develop the range of its debt offerings. Among the first of the European sovereign debt agencies to build liquidity in the long bond market, the agency has now started a feasibility study on the possible issuance of Islamic bonds in the near future. Francesca Carnevale talks to Robert Stheeman, the DMO’s chief executive, about the agency’s issuance calendar for the remainder of the 2007 fiscal year.
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OULD THE UK’s DMO really issue Islamic bonds? It’s a possibility. A feasibility study is underway by the agency on the usefulness to government and the market of an Islamic issuance programme.“We would need to understand fully the consequences of any such issuance,” says Robert Stheeman, the DMO’s chief executive, adding that ,“Ed Balls, Economic Secretary to the Treasury, has been interested in seeing the market for Islamic instruments develop. However, realistically, we are unlikely to see the results of our study much before the publication of the prebudget report (which is usually published in the autumn.)”
C
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The (DMO) was established in April 1998, with a remit to market instruments, avoiding any action that might carry out the Government’s debt management policy of undermine the functioning of the sterling money markets minimising financing costs over the long term.“The DMO or conflict with the operational requirements of the Bank of is legally and constitutionally part of HM Treasury (HMT), England.“The variation in the forecast of Exchequer flows but as an executive agency, it operates at arm’s length from means however that there is usually a need to fine tune the ministers. It is a“good thing,”notes Stheeman.“We are part flows and this is done through bilateral dealing on a daily of HMT, with no separate legal status and the Treasury basis,”notes Stheeman,“mainly in the secured markets. To take account of shorter-term cash inflows and outflows, provides the DMO with umbrella coverage”. The UK’s Chancellor of the Exchequer determines the arrangements have been put in place with the Bank of policy and financial framework within which the DMO England and settlement banks designed to cope with late operates,“but delegates to us operational decisions on debt changes in the forecast for the day.” With the complex set of and cash management, and requirements detailing its day-to-day management of daily cash and debt raising the office,” explains operations, it is no wonder Stheeman. In April each The UK’s return to the ultra- long that to the outsider, the year the DMO publishes its term gilt market back in 2005 has DMO appears somewhat business plan, which sets low-key. “We are rather out a series of long-term highlighted efforts by leading happy with our low profile,” targets for the year derived European sovereign issuers to lockexplains Stheeman. “With from the DMO’s strategic in low interest rates at a time when around £60bn in fund objectives.” The DMO was pension funds and insurers are raising planned for this year, “set up as an executive clamouring for long-term assets. and the £1trn in turnover agency,” he adds.“Our Second, it has subsequently been a we will handle this year, we framework document is prefer to adopt a low, low updated every three to four substantial element in the UK’s fund profile and are generally years and sets out the annual fund raising calendar. wary of any precise role of the agency Pension funds have largely been in pronouncements. It must be and our institutional favour of the ultra-long dated bonds. so, as we deal with a governance arrangements.” Defined benefit pension schemes, in fundamental element of the Three years into its country’s financial operations, the DMO took particular, are being driven by plumbing.” over full responsibility for ageing maturity profiles and The UK’s return to the the Exchequer’s cash legislation, which encourages them ultra- long term gilt market management, from the to match their assets against their back in 2005 has Bank of England. The liabilities and demand for long-dated highlighted efforts by DMO’s cash management bonds continues to outweigh supply. leading European sovereign activities and remit are issuers to lock-in low published annually in HM interest rates at a time Treasury’s Debt and Reserves when pension funds and Management Report. Stheeman explains that the agency’s cash management insurers are clamouring for long-term assets. Second, it objective “is to ensure that sufficient funds are always has subsequently been a substantial element in the UK’s available to meet any net daily central government cash fund annual fund raising calendar. Pension funds have shortfall and, on any day there is a net cash surplus to largely been in favour of the ultra-long dated bonds. ensure that this is used to best advantage.”The DMO’s role Defined benefit pension schemes, in particular, are being is to arrange for funding and for placing net cash positions, driven by ageing maturity profiles and legislation, which primarily by carrying out,“market operations in the light of encourages them to match their assets against their forecasts provided by HMT of daily net cash flows into or liabilities and demand for long-dated bonds continues to out of the National Loans Fund (NLF). The DMO’s role is outweigh supply. In part, the changes in the make-up of investors buying to minimise the cost of offsetting the Government’s net cash flows.” The Exchequer’s cash flow has a regular up UK government debt are also contributing to the seasonal and monthly pattern; but it is also subject to consideration of alternative debt structures from the DMO. considerable uncertainty, associated largely with Insurance companies and pension funds still account for unpredictability in the timing of some tax and expenditure the biggest portion of buyers of UK debt. Five years ago flows. The DMO’s approach is to rough tune the seasonal however, that portion accounted for some 68% to 70% of pattern of flows mainly through weekly issuance of the market. Now it accounts for just over 60%. According Treasury bills and bilateral dealing in a range of money to the DMO the percentage of foreign buyers of UK
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government bonds have doubled since 2003. “We were looking at a foreign investor base of some 16% four or five years ago,”notes Stheeman,“and now the percentage tops 30%, with most of this portion held offshore.” Stheeman does not claim to have a detailed breakdown of buyers of UK debt,“anecdotal evidence tells us that the Middle East and a large chunk of Asian central banks have been enthusiastic purchasers of debt,” he says. “Interestingly, it appears that Sterling has become a kind of reserve currency once more. We have also indirectly benefited from the Euro. We used to compete with three or four European currency blocs, now we have only one. Remember that the US dollar, the Japanese Yen, the Euro and Sterling account for 98% of the world’s combined currency reserves.” The DMO has long preferred the auction process to syndications. “It is a transparent and predictable way of issuing debt,” explains Steve Whiting, the DMO’s policy advisor, continuing,“while maintaining a level playing field for primary dealers and at the same time delivering value for money for the government.” “Auctions fit the bill,” says Stheeman. Whiting and Stheeman explain that, “There are good reasons for syndications, but it raises competitive factors. We would have to choose a lead manager, and it might suggest we were favouring or giving status to a small group of banks. We treat all the gilt-edged markets makers (GEMMs) in an equal and transparent fashion. It is very important to us that we take this approach.” “Ultimately, the auctioning of bonds provides the market with the best mechanism for setting a pricing at which investors want to buy our debt,” continues Stheeman. He explains that the preparation prior to an issue is detailed. The DMO puts out as much information as possible into the market well in advance. The agency provides an annual borrowing programme, an annual auction calendar and consults regularly with market participants. “The serious point being that we are not interested in an inflated order book that you might get under a syndication. You get all this hype about this issue being oversubscribed, but debt issuance and auctions is a repeat game. In the 50-year index linked syndicated issue, for instance, we went out of our way to inform the market that we did not want an inflated order book.” “Liquidity is important, and it is something we have focused on very carefully. We had to be sure that whatever we introduced was sustainable,”he says. That requirement comes into focus strongly as Stheeman outlines the structure of the UK’s fund raising requirement, worth a combined £58.4bn this year, “which has a very big skew towards the long end,”he adds. The UK’s nominal issuance is divided into three buckets. From zero to seven years (called shorts), from seven to 15 years (referred to as medium term debt) and long-term debt, ranging from 15 years upwards. “Clearly strong demand for long dated and index linked issues has not changed for a while and I suspect this situation will remain
over the medium term. Ministers have stated, in the budget and elsewhere, that they support this skew to long term issues and index linked gilts,”says Stheeman. There are two reasons for this. “We have a highly developed pension fund industry that needs assets to match liabilities,” he adds. Historically, UK pension funds and insurance companies have been by far the largest buyers of gilts, in particular index-linked gilts. This trend is likely to continue especially as more schemes try to address their matching shortfalls. However many schemes have liabilities with maturities longer than that of the longestdated gilts. Index-linked gilts, for example, extend to 2055, with only a limited number of issues available (and, reportedly, most of the UK’s pension schemes have liabilities that extend well beyond that date). A shortage of long-dated sterling bonds has, in the meantime, encouraged banks and other financial institutions to offer products such as inflation swaps to help retirement funds hedge exposure to future liabilities. However, it is nowhere near enough to help. Further, the implementation of international accounting standards as well as more constraining regulations is forcing life insurance companies and pension funds to better match their liabilities. By marking-to-market larger parts of their balance sheets, these institutions are motivated to reduce their duration mismatches if they want to reduce the risk of high volatility in their financial results. The UK market is a powerful indicator of the potential impact this trend towards longer dated investments can have on the bond market. In the UK, the changes in regulation forcing pension funds to better match the duration of their liabilities has resulted in a strong increase of the bond portfolio weight in the asset allocation to the detriment of equities. Since 2001, the UK institutional investors have been net sellers of equities and net buyers of bonds. The impact of the regulation change has been strong performance of long dated gilts and ultimately an inversion of the yield curve. Second, says Stheeman, is it cheap for us to issue longer dated debt. He points out that the yield on a 10 year £2.5bn issue on the 24th of May this year offered a yield of 5.17%. “Compare that with the yield on 50 year issuance, which is closer to 4.32%,” he says. Thirty year bond yields by comparison range between 4.95% and 4.98%. The upshot is that further ultra-long dated bonds will continue to dominate the UK issue calendar. Just how far the UK sovereign debt market has been skewed by long dated bonds is that back in March 2003, the average maturity of UK debt was 11.22 years and by the end of December 2006, that had been stretched considerably to 13.91 years. Issuance of UK debt, barring any unforeseen circumstances that might change the outlook, after the peak in issue volume reached in 2006-2007, is set to marginally decline in 2008 and beyond.“There is also a big drop in redemptions, which drive the gross borrowing requirements, in 2008,” notes Stheeman. Some £29.9bn worth of gilts was redeemed last year, and in 2008 this figure is scheduled to drop to just above £17bn.
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Asia’s high yield market plays for high stakes
Competition from the loan and equity markets has not only stalled the development of Asia’s bond market, it has also helped to loosen the covenant packages that investors in high-yield bonds demand. However, while some US investors have pushed back, it seems like bond investors from Asia and Europe are willing to accept the weaker terms on offer. Richard Jory reports.
NVESTORS HAVE GOOD memories, which is why they are still cautious when approaching the Asian high-yield bond market. The reluctance stems from US investors, many of whom presumably remember Asia Pulp & Paper (APP), an Indonesia company that went bust during the Asian financial crisis of 1997 and poured scorn on buyers of its billions of dollars of high-yield debt. The default damaged the development of Asia’s high-yield bond market and stalled its revival, already hampered by the region’s love of the equities and convertible bonds as well as the plentiful supply of cheap bank loans. Asian companies still prefer to raise equity, and loans continue to be governed by relationship lending, and are therefore cheap. “Most Asian corporate loans do not have long tenors, they tend to be extendible: usually one-year and extendible twice to three years, and the average life is seven months,” says Patrick O’Brien, managing director in debt capital markets at UBS.“Given the very short average life of the loan book and the relatively low loan deposit ratios across the region, there is a constant fight to find assets. Banks have been substantial take and hold buyers of corporate bonds, which also helps to keep spreads tight.” Because of this, the high-yield market has continued its slow development as corporates in China, Hong Kong and Indonesia seek longer tenors. Indonesian companies were early to adopt the highyield bond market with its strong covenant provisions and have subsequently found it difficult to convince the more aggressive emerging markets bond investors to buy their bonds without covenant packages. “They established a precedent with covenant packages that high-yield investors needed, and in many cases now find it difficult to either remove them or sell new issues without covenants,” says Chris Tuffey, London-based head of EM origination at
I
The number of new issuers rated non-investment grade in Asia exceeded those rated investment grade in 2006, as it did in 2005, according to ratings agency Standard & Poor’s. The opposite was true in 2003 and 2004.“In recent years, investors have increasingly accepted lower-grade Asian names, in line with the global trend of investors seeking higher yields,” said S&P. Photograph by Racha Ramesh, supplied by Dreamstime.com, June 2007.
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LOWER GRADE BONDS MARK ASIAN BOND
GAME ON:
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Credit Suisse. Indonesian companies are likely to remain firm fixtures of the market as domestic interest rates continue to make external financing look very cheap. For Chinese companies, austerity measures imposed by the government have made international (rather than domestic) funding attractive.
Accepting lower grade names The number of new issuers rated non-investment grade in Asia exceeded those rated investment grade in 2006, as it did in 2005, according to ratings agency Standard & Poor’s (S&P). The opposite was true in 2003 and 2004.“In recent years, investors have increasingly accepted lower-grade Asian names; in line with the global trend of investors seeking higher yields,” reported S&P. “On a weighted average basis, 59.6% of new issuers in Asia for the 10 years to 2006 were assigned non-investment-grade ratings.” The demand from investors—which now include international emerging markets hedge funds and asset managers as well as regional private banks—remains strong for corporate bonds.“A couple of years ago the level of credit competence was low, but it has improved as a result of the large number of more sophisticated players including hedge funds setting up in Singapore and Hong Kong,” says O’Brien. The strength of investor demand, as well as generally strong international and regional economic growth, has led to a weakening in covenants packages attached to the bonds. The principal concern lies with debt carve out provisions. “We are seeing the classic cycle, from a technical view, with spreads tightening, speculative grade debt increasing and covenants getting lighter,”says John Bailey, S&P managing director based in Hong Kong. The ability to carve out debt—which allows companies to decide which of its subsidiaries are excluded from any individual liability to repay new borrowings—leaves investors exposed to an increase in leverage at the excluded subsidiaries. Covenants that include limitations on leverage would not apply to these companies, reducing the control that the bond investors have. “Asian issuers have been very spoilt—often issuing investment grade style covenants (that is, no/lite covenants) although they are not investment grade,”adds O’Brien. “At this stage of the default cycle, the market is starting to price covenants and we are seeing a loosening of the operating and financial restrictions that are usually found in high-yield bonds,” said Bailey. Despite that, the default outlook is relatively benign after only two defaults in the last two years, China’s Ocean Grand in 2006 and Malaysia’s Megasteel in 2005. “Given the benign default environment currently, fairly strong corporate fundamentals, and an expectation of continued economic growth, we do not expect to see a pick up in default rates in the near term. Default rates are very low in Asia and lower than in the US,” said Bailey. “But, medium-term, in say two years, we could see an increase in volatility and default rates. The
hardest thing is measuring the length of the default cycle and how high it will bounce back up.”
Standard structure The standard Asian high-yield bond is unsecured, although will often include an interest in shares of operating subsidiaries. There is a limited availability of upstream guarantees, which in China are banned by law. As a result, Chinese high-yield deals tend to include funding to the holding company secured by shares in the operating subsidiaries. More sophisticated structures, incorporating second lien, mezzanine and payment in kind (PIK) debt are generally the preserve of leveraged buyout (LBO) deals. With so few LBOs in Asia, there has been little scope to incorporate these structural complexities. However, bankers expect the LBO market to develop. “We think there are a lot of financial institutions setting up shop to get into that market,”said Bailey.“Absolute debt levels have gone up, but have been offset by significant increases in cash flow levels. But if the LBO market takes hold and companies’ risk appetite increases, we could see debt leverage become more aggressive.” Australia is expected to increase LBO activity, despite the failure to get Qantas’ LBO off the ground. There is also scope in Australia for the corporate high-yield market to develop as its deposit base and domestic bond market remain too small to meet the country’s financing needs— the same imbalance applies in South Korea. Whether an increase in LBO and M&A activity would lead to an increase in bond activity is, however, a moot point. “You would think M&A would drive primary bond issuance growth, but there is a lot of bank finance involved,” says O’Brien. “Private equity in Asia is tying in bank rather than bond financing, like the European model. Either way, in Asia-Pacific, there is not so much bond market acquisition financing.” The market for international bond issuance from Asia has stalled at $33bn to $42bn for years, with around 20% of that amount raised by sovereign issuers, principally the Philippines. Any expansion is contained by the rapid development of domestic markets and the continued reliance on generally short-term loan financing. The regular amount of international bond issuance is in stark contrast to the $39bn raised in local markets from 805 issues completed so far this year, according to Bloomberg. International bond issuance, ex-Japan, so far this year stands at $30.8bn from 67 issues, with that figure falling to $17bn and 39 issues when issuance from Australia is stripped out. Loan volumes for the same period are at $39.72bn from 141 issues. Proving, yet again, that Asia is a region that relies most on equity issuance, there has been $31.3bn of equity raised from 258 issues this year, twice the amount raised in the bond markets. It is notable that, while Asian bond debt is increasingly owned by Asian investors, Asian equity is being snapped up by non-Asian investors.
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A number of companies are using the bond markets to test investor appetite for other deals, particularly equity, which is a red-hot market. Paulo Eduardo de Souza Sampaio, CEO of the National Association of Financial Market Institutions (ANDIMA), says that this new round of bond issuers: “is not used to using capital markets and has decided to issue corporate bonds as a first step. They reason that if they generate a good history of payments, they can come to the equity market and carry out an initial public offering (IPO)”. Photograph by Theodor38, supplied by Dreamstime.com, June 2007.
In May, Brazilian made it one step closer to having a fully-fledged corporate bond market with the decision by agencies Fitch Ratings and Standard & Poor’s to upgrade the sovereign ceiling rating to one notch below investment grade. In no small part, that reflects the government’s retreat from the dollar markets and a general reduction in sovereign debt levels and reduced political risk. That is precisely what is needed to create the space and confidence for corporate issuance, which is starting to take off ahead of the country achieving investment grade. The continuation of, and possible acceleration in, the decline in interest rates will fast-track the process. John Rumsey reports from São Paulo.
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BRAZIL BUILDS CORPORATE BOND PIPELINE
Brazilian corporates exploit opening of debt markets
TANDARD & POOR’S decision to raise the foreign currency ceiling from BB to BB+ and the local currency ceiling two notches to A-3 from B were widely anticipated in Brazil. The decision to retain the positive outlook on the foreign rating means that Brazil is now poised on the cusp of investment grade. The upgrade was attributed partly to president Luiz Inácio Lula da Silva’s hard work to reduce fiscal and external vulnerabilities, a strong macroeconomic framework, inflation targeting and exchange rate policies and the government’s reduced overall debt burden. Fitch Ratings, which raised its ratings slightly earlier, also by one notch to BB+ from BB with a neutral outlook, cited similar reasons. The accumulation of foreign reserves, which at that stage had reached $36bn, will protect Brazil from external shocks, says Shelly Shetty, a senior director in Fitch Ratings’ sovereign ratings group.
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Market developments
historically high interest rate and inflation environment. Brazil’s debt markets have long been dominated by the The second is to fund some of the huge growth in M&A government. The marked transformation of its debt profile activity; and finally investments in organic growth and reflects a big rise in global liquidity and a big drop in working capital continue to be drivers. A number of companies are using the bond markets to political risk in the country as well as a conscious decision to go local. At the end of 2002, the government had 38% in test investor appetite for other deals, particularly equity, dollar-linked instruments. That is simply gone. The stock of which is a red-hot market. Paulo Eduardo de Souza fixed-rate debt has risen to some 35% now from 2% at the Sampaio, CEO of the National Association of Financial end of 2002 and the Treasury has been testing out a greater Market Institutions (ANDIMA), says that this new round of bond issuers: “is not used to using capital markets and has range of fixed-rate and inflation-linked debt instruments. decided to issue corporate The reduction in issuance bonds as a first step. They and the move to local Pace-setting firms have been reason that if they generate currency in key points significant issuers in the last one a good history of payments, across the yield curve has and a half years and include giants they can come to the equity helped banks get a feel for market and carry out an how to price corporates such as Companhia Vale do Rio initial public offering tapping the debt market. Doce (CVRD), Petrobras, (IPO)”. Some companies are not Votorantim, Arcelor and Gerdau. Leasing companies, which even waiting for the advent That should provide more are used by banks to raise of investment grade. confidence. “The trend is obvious: capital for real estate Roberto Padovani, senior transactions and investment Latin America investment you’ll see more and more clients funds, dominated the strategist at WestLB AG, move to higher-yield products. They market last year. They sees the corporate issuance are already increasing the risk in accounted for 67% of being much more reliant on their portfolios and we are tapping issuance or R$50bn out of a interest rate falls. “In Brazil, this niche through credit-linked total of R$73.5bn, according agencies are not considered products,” notes Demósthenes to Sampaio. Income tax in that important in evaluating the fund industry is market risk,”he believes. Madureira de Pinho Neto, vice determined in part by the Padovani sees the president, and head of Unibanco maturity of the assets in corporate bond market Asset Management. portfolios and banks issue really taking off as interest long-term debentures of five rates come to more reasonable levels. Brazil’s benchmark Selic rate has been to 10 years to alter their profile and minimise their tax falling steadily and now stands at 12.5%, with the latest 25 burden. All the major commercial banks were active in this basis point cut taking place in April. Padovani expects the area, he notes. In addition to the leasing companies, pace of cuts to be more aggressive going forward and sees mining companies raised R$5.5bn and energy and the monetary policy committee of the Central Bank telecoms accounted for R$4.6bn. The rate of corporate issuance has been at a slightly (otherwise known as Copom) cutting rates by 50 basis points (bps) at their next meeting on June 5th and 6th. He slower pace this year with R$3.1bn issued as of mid-May, points to the very strong appreciation of the real which says Sampaio, adding that he expects the rate to accelerate penetrated the two to a dollar level in May and low levels and beat totals posted last year. He notes that the of inflation, which came in at 3.1% last year, as providing Comissão de Valores Mobiliários (CVM) is studying further scope for the Copom to accelerate cuts. Not only companies’ proposals for R$6.8bn of planned issuance, of that, rate cuts play to a wider audience. Brazil’s Central which R$5.1bn will come from leasing companies. The Bank has been regularly censured by the Ministry of difference this year is that companies from underFinance for what it sees as an overly-cautious approach to represented sectors are coming to market, such as car rate cutting. Padovani estimates by the middle of next year, rental firm Localiza, which has raised R$200m. The interest rates will have fallen to a point that makes agrobusiness industry, which is very much in vogue, should corporate issuance attractive with real rates of some 6%. If be one of the main areas for issuance, with sugar, beef, soy and biodiesel all being likely candidates. he is right, we are just reaching the tipping point. It helps, of course, that the demand picture is also There are three principal reasons for corporates to tap the debt market, bankers say. The first is the desire to improving. Issuance is coming at a time of huge refinance more expensive debt and improve the profile of international and growing domestic demand for higher it, through longer tenors and shorter coupons, for example. yields and diversification. The Brazilian institutional fund Brazilian companies are looking for an optimal capital industry is slowly diversifying, according to Demósthenes structuring and are under-leveraged because of the Madureira de Pinho Neto, vice president, and head of
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Unibanco Asset Management. He notes that in the last three years, there has been an institutional move away from government paper to credit. He acknowledges that for now the exposure to corporate credit is still limited, but he believes that the trend is clear and accelerating. Pension fund clients are already getting used to corporate debt through exposure to Brazil’s most creditworthy companies, which have pierced the sovereign ceiling. Pace-setting firms have been significant issuers in the last one and a half years and include giants such as Companhia Vale do Rio Doce (CVRD), Petrobras, Votorantim, Arcelor and Gerdau. That should provide more confidence.“The trend is obvious: you’ll see more and more clients move to higher-yield products. They are already increasing the risk in their portfolios and we are tapping this niche through credit-linked products,”he notes. Local currency debentures are slowly taking companies away from the dollar market, says Alexandre Bettamio, head of investment bank UBS-Pactual.“The market is there and it is getting cheaper and easier to place deals.”He cautions that compared to equity markets, debenture issuance is still small beer but believes that it will grow strongly. The local market is getting deeper and becoming longer and most companies would prefer to issue in reals than dollars, he reasons. Once investors believe that the current macroeconomic stability will continue, it becomes easier to raise debt, he notes. UBSPactual was responsible for book-running a 10-year, R$300 million issue by Banco Safra and a 10-year, $300m note programme for airline TAM.“There was a lot of demand for both the bond issues,”according to Bettamio. The bank also participated in part of CVRD’s take-out through the bond market of its $18bn syndicated loan.
Obstacles to Overcome One of the difficulties for investors is the lack of attention investment banks are paying to all but the largest companies that are looking to issue. For now, that means there is limited amount of corporate research in Brazil. Still, even here there are signs of change as banks are hiring research teams. Some of the local banks, including Banco Itaú, UBS-Pactual, Unibanco, Banco do Brasil and Bradesco already produce bond market reports and foreign banks are getting up to speed. ABN AMRO, for one, hired in the research area last year. Still, the feverish capital markets in Brazil are making talent a scarce and exceptionally expensive commodity for banks. Not only that but the big foreign investment banks are still very focused on the booming equity capital markets where fees are much higher than for the debt market. The market is so strong there that they are not averse to poaching or transferring internally fixed-income analysts into their equity team. One of the other remaining hurdles is the stimulation of a secondary bond market. This has started to develop in government markets but liquidity in the corporate market is threadbare. Most issues are snapped up by buy-and-hold investors, typically pension and insurance funds that use bonds to match liabilities. That has made obtaining
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meaningful data on pricing difficult as even large bond issues tend to be relatively illiquid. More importantly, there is little standardisation of covenants in the key debenture market. Each issue comes with its own conditions with wide differences between amortisation terms, seniority and structure. That makes it much more difficult and time-consuming for researchers to compare issues. Moves to standardise contracts have not met with success. The latest initiative might just: Last year, a group including ANDIMA; ANBID, the National Association of Investment Banks; and Bovespa put together a contract template for corporate issuers, which has already been tested out although it’s too early to predict results for now. There are other initiatives to encourage trading. ANDIMA is working to create price transparency, says Sampaio. It started producing daily prices for government bonds in 2002. Last year, it started publishing twice a day and is starting to issue prices after trades have actually happened. The next and last stage will be to investigate any unusual trades to keep the market clean, says Sampaio. BNDES, the Brazilian National Development Bank, has a R$2bn programme designed to enhance secondary markets. Most of the funds are directed to buying issues in the primary market and selling them with as much price transparency as possible. Revenues will be used to expand the scheme and since its launch in September, BNDES has disbursed over R$1bn. The idea is to list prices on CETIP.net and through the stock exchange, Bovespa, which would encourage participation, including from foreigners. The bank has bought issues include by corporates including Lupatech, Ambev, and firms in the electronics, toll road, real estate and banking sector. Even if the secondary market does make strides, there is one other key disincentive foreign investors—the government’s 15% withholding tax. This tax was repealed in February last year for foreigners investing in local government debt and foreign cash has enabled the government to extend its yield curve in local currency. However, despite talk, there has been no move to extend that to corporate debt markets. With the very strong real, the government is seen as unlikely to make this a priority as further foreign inflows would exacerbate the appreciation of the currency against the dollar. That is damaging as foreign funds tend to be willing to hold longer-dated paper and are typically more active traders. The rapid emergence of the equity markets, the reduced role of the government in debt markets, improved ratings, massive global liquidity and falling rates all point the way for much stronger corporate debt markets in Brazil. Already, companies are using the markets to restructure their debt profiles and get investors used to them, often in the hope of going on to tap equity markets. It’s going to take three other planks to really get the market going. Two are on their way: an investment grade rating and lower interest rates. The trickiest part is now to open up trading and allow a deep secondary market to develop in bond securities.
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LBOs POWER US DEBT ISSUEANCE
DEBT END? Fueled by an unprecedented level of LBO activity and a seemingly endless supply of foreign investment capital, conditions for corporate-bond issuance have never seemed better. Still, some say the powerful debt market is ripe for a fall—except no one can say just when. From Boston, Dave Simons reports.
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Globally, debt issuance increased 3% to $1.73trn during the first quarter (Q1) of this year, according to Dealogic, as companies seeking M&A financing continued the torrid pace of corporate-bond sales. Global issuance of corporate bonds was up 22% to a record $700.54bn in Q1, including $626.3bn of high-grade debt and $74.3bn of junk-rated debt. Illustration by Dimensionsdesign, supplied by Dreamstime.com, June 2007.
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HESE ARE HEADY times for the US corporate credit market, with cash positions high, default rates low, and a historically large number of mergersand-acquisitions (M&A) and leveraged buy outs (LBO) engineered by insatiable privateequity interests. Responding to unwavering demand for debt, corporations continue to flood the market with new bond issuances, sending yields to their lowest levels in years. During the first quarter, the spread on the average corporate bond stood at just under 1%, or nearly a point and a half lower than the average spread from five years ago, according to Credit Suisse Group data. The exceedingly low borrowing rates have allowed companies to refinance mountains of old debt, in the process saving billions over the next several years. Things have been so good for so long, in fact, that no measure of uncertainty—be it the pullback in Asian equities or the unwinding of sub prime lending—has been able to halt the corporate-credit momentum. But like all rallies with a hint of irrational exuberance, this one has begun to attract its share of naysayers. Speaking at the Reuters Hedge Funds and Private Equity Summit in New York this past May, Steven Rattner, managing principal of Quadrangle Group LLC, gave voice to the growing apprehension over the corporate-debt environment. “There are a great many extremely talented private-equity guys who know how to see value, add value, engineer deals, and so on,” remarked Rattner. “However,
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none of us should confuse whatever talents we all have with Wood, vice president and credit analyst with Canso the unbelievably strong tail wind we have coming from the Investment Council Ltd. Mason-Wood and other experts debt markets…certainly the largest deals that we’re seeing point to the increased role of ‘covenant lite’ (Cov-lite) loans, go by right now would be impossible in any normal debt highly flexible financing arrangements that carry few of the market. Of all the bubbles that have existed in recent times, traditional protections afforded to lenders. Cov-lite loans the bubble in the credit markets today is, in my opinion, one currently account for 37% of all corporate loans, up from just of the greatest. It is beyond any rational measure in terms of 1% only two years ago. “Just as equity sponsors have pushed the envelope on both the amounts of leverage, the costs of the leverage and purchase price multiples, so have lenders done with the covenants associated with the leverage.” “We are growing extremely negative on credit markets, leverage and the pricing on that leverage,” remarks Jerome which we see as in a bubble,” concurs Tim Bond, head of Egan, senior vice president at TCW/Crescent Mezzanine, a asset allocation at Barclays Capital in London, in a recent Los Angeles-based mezzanine provider. There are signs research note. According to Bond, part of the impetus for that some semblance of sanity has crept back into the the massive re-leveraging by US companies is an effort to marketplace as a result of such high-stakes wheeling and dealing. In May, Standard & substitute earnings-perPoor’s indicated that highshare growth for bona fide yield loans to leveraged earnings growth. Others, buyout (LBO) mavens such however, are not quite ready “Just as equity sponsors have as Kohlberg Kravis Roberts to close the door on the pushed the envelope on purchase & Co. and Thomas H. Lee corporate bond bonanza just price multiples, so have lenders Partners LP have fallen by yet. They point to a number done with leverage and the pricing as much as 33% since the of bullish factors, in start of the year. particular the abundance of on that leverage,” remarks Jerome Such speculation cannot liquidity that continues to Egan, senior vice president at go unpunished by market prop up the market. TCW/Crescent Mezzanine, a Los forces, asserts Mason-Wood. According to information Angeles-based mezzanine provider. “Loan losses will inevitably specialist Thomson Financial There are signs that some increase and corporate bond (itself in a merger process spreads will widen as the with Reuters) compared to semblance of sanity has crept back weak new issues of the past the last major M&A cycle of into the marketplace as a result of few years run into problems. 1999 to 2000, more than such high-stakes wheeling and As losses increase in twice as many strategic dealing. In May, Standard & Poor’s portfolios, investors will stop acquisitions have been indicated that high-yield loans to funding speculative issuers funded with cash this time leveraged buyout (LBO) mavens that need new money to around. By leveraging, survive. A tightening in companies increase such as Kohlberg Kravis Roberts & credit standards will follow shareholder value and create Co. and Thomas H. Lee Partners LP and feed into the illiquidity t a x - a d v a n t a g e d have fallen by as much as 33% of credit markets. The opportunities through since the start of the year. financial innovations that deductible debt interest, say are lauded today will be rued proponents. as their increased leverage Critics, however, worry that and market pricing add to lenders have become much too eager to arrange financing, and often for companies with the credit downturn. While it is taking longer than a shaky track record. Investors can snap up the high-yield anticipated for corporate bonds to weaken and credit spreads bonds of Broomfield, Colorado-based communications firm to widen, the odds are against lower quality bonds.” In its recent credit-market forecast, the Securities Industry Level 3 Communications (currently yielding an eye-popping 8.75%), the most recent issuances the result of a massive and Financial Markets Association (SIFMA) called for a debt-restructuring plan.The catch? Level 3 has zero earnings moderation in corporate-bond issuance for the balance of and a nearly 50% share dilution since late 2005. 2007 compared to the record levels set during the previous Fundamentals, however, have increasingly taken a back seat year, or $889bn versus $1.04trn. Despite the pullback, activity in the current bond-picking environment. Over the past 12 remains historically above average and 17 percent higher months, junk-rated issues have jumped nearly 30%, well than in 2005, powered by mergers and acquisitions (M&A) outpacing investment-grade corporate bonds, according to and LBOs, as well as share buybacks and corporate redata firm Dealogic. “The issues currently being shopped investment, according to SIFMA. Credit spreads are expected reflect the advanced stage of the credit cycle. We are seeing to hold even or perhaps tighten slightly, though could widen very speculative lending at present,” says Heather Mason- by year’s end given an easing in corporate profit growth.
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ssuance of new securities in the US capital markets rose 13% in Q1 this year to $1.8trn, says the Securities Industry and Financial Markets Association’s (SIFMA’s) current Research Report. Merger and acquisition (M&A) and leveraged buyout financing and a flat yield curve have driven corporate bond issuance to a record $308bn, up 23.6% from the same period last year. In addition, increased bond refunding activity has pushed up municipal issuance by 50.8% to $112.8bn on the same period in 2006, also setting a record in the first quarter. Total equity underwriting reached $61.4bn on 202 deals in the quarter, 42.6% higher than the first quarter of 2006. “Looking forward, we see continued favourable market conditions. Weakness in the housing sector appears to be contained. The interest rate environment is stable, the economy continues to grow, and corporate profit growth is still on track. In addition, a healthy stock market and positive corporate credit trends will support continued growth in securities issuance,” thinks Michael Decker, senior managing director for research and public policy at SIFMA. Net new corporate bond sales rose as gross issuance exceeded redemptions by a wide margin in the first quarter, with refinancing at about a third of
high yield issuance, the lowest level in 25 years. By contrast, high-yield financing for mergers and acquisitions and leveraged buyouts are on pace to account for the largest share of total high-yield issuance in 18 years. Ample market liquidity and sustained profit growth will continue to provide the foundation for corporate financial strength and supportive credit conditions, the SIFMA report states. SIFMA also expects corporate bond issuance to end the year at a level comparable to 2006’s record of $1trn. Record municipal bond issuance in the quarter was driven by a higher refunding volume, which rebounded from late-2006 levels and accounted for nearly half of the total long-term issuance. Local and state government financing of general government operations, education, transportation and infrastructure projects will continue to lead municipal issuers to the capital markets. In addition, SIFMA thinks that in some regions the softer housing market may lead to increased issuer demand for municipal bond mortgage financing programs to enhance housing affordability. Mortgage-related securities issuance recovered in the first quarter to total $552.1bn, the highest level since the second quarter of 2005 suggesting the sector—particularly securities backed by conforming mortgage loans— are beginning to regain strength. At this point, SIFMA maintains that subprime sector weakness appears to be fairly well contained.
Globally, debt issuance increased 3% to $1.73trn during the first quarter (Q1) of this year, according to Dealogic, as companies seeking M&A financing continued the torrid pace of corporate-bond sales. Global issuance of corporate bonds was up 22% to a record $700.54bn in Q1, including $626.3bn of high-grade debt and $74.3bn of junk-rated debt. Who is doing all the buying? For the most part, overseas investors, who purchased over $400bn in US company debt last year. While foreign ownership of long-term treasury and agency notes has fallen, corporate bond purchases continue to rise, with significant amounts of capital streaming in from China, South Korea and other AsiaPacific locales, as well as higher-yield seeking investors from the Gulf nations. Some worry that the corporate markets could pay dearly if foreign capital suddenly heads to the exits, but Jay Bryson, global economist for Wachovia, see no reason to fear thus far.“Of course, all foreign investors could bolt for the door at the same time. In that event, a major financial crisis would ensue. But why would foreign investors flee US capital markets en masse? After all, the US financial markets are the broadest, most liquid and most transparent capital markets in the world. In our view, it would take an unprecedented shock to trigger a mass exodus of foreign investors and/or central banks. Moreover, the miniscule net income payments the US remits to the
rest of the world make the probability of a self-fulfilling balance-of-payments crisis appear rather low.” The driving force behind the current corporate-debt runup has been the massive increase in M&A activity: Last year alone saw an estimated 33,000 mergers and buyouts totaling nearly $4trn, with private equity accounting for one-third of all of the M&A activity. For lenders and PE leaders alike, no deal seems too outrageous. Citigroup, a leading underwriter of debt-related agreements, along with UBS, was purportedly set to front $15bn on behalf of private-equity specialists The Blackstone Group and Reliance Group in their attempted bid to procure India’s communications firm Hutchison Essar. (Blackstone, which ultimately settled on Alliance Data Systems for a cool $6.7bn, recently announced plans for a public offering valued at $33.6bn, the largest IPO of the year thus far.) In April, private equity firm Apollo Management completed its $8.5bn buyout of real-estate group Realogy, with JPMorgan Chase and Credit Suisse financing the lion’s share of the deal. Apollo has suggested that it too may soon go public. “Frankly, we in the private-equity business [sic] are all feasting off of the imprudence of our lenders, it is as simple as that,” admitted Quadrangle Group’s Rattner.“We are essentially accessing amounts of capital at costs that make absolutely no economic sense
M&A AND LBO TRANSACTIONS DRIVE CORPORATE BOND ISSUES TO RECORD LEVELS
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from a lender’s point of view. In effect, they are subsidizing our transactions and our equity and are allowing us to do deals that wouldn’t have made any sense otherwise.” Some analysts point to the not-so-coincidental link between the mortgage-debt market and that of corporate credit.“In conjunction with what has transpired in housing, interest rates seem high enough to be choking off much of the real economy but nowhere near high enough to choke off financial speculation that is not only happening at an insane pace, but is increasingly being financed by foreign capital flows into corporate bonds,”says Mike Shedlock of SitkaPacific Capital Management. Mark Kiesel of PIMCO Investments makes an even stronger case for the potentially cataclysmic affect on corporate credit as a result of the declining housing market. “Consumers leveraged rising housing prices and easy credit availability using their home as an ATM,”says Kiesel. “Mortgage equity withdrawal (MEW) soared, allowing consumer spending to grow faster than income growth over the past several years. Today, mortgage equity withdrawal appears tapped. Consumers have been accessing their homes as bank accounts, but housing prices are now falling in many areas, and credit is becoming more difficult to obtain. The slowdown in MEW has been remarkably swift. Thanks to rising housing prices, consumers have been able to grow spending significantly faster than income growth, through unprecedented
increases in mortgage equity withdrawal. In fact, the growth in mortgage debt parallels the growth in corporate profit. As a result, corporate profits, and thus economic growth, are highly dependent on housing prices. As housing prices turn negative, corporate profit growth will eventually follow.” The fact that business investment appears to be lagging last year’s torrid pace is somewhat unsettling, though not necessarily a harbinger of doom, says Teri Mason, associate director, fixed-income research for Boston-based Loomis, Sayles & Company.“Key to the performance of investment grade corporates will be corporate profits. We are assuming corporate profit growth may be less robust in coming quarters, but still strong enough to support the market; however, valuations offer little cushion for a significant economic slowdown or higher volatility in financial markets. Our expectations are for occasional bouts of spread widening that could limit the return potential for bond market indices in 2007,”he adds. Bill Conway, co-founder of private-equity leader Carlyle Group, recently issued a warning that “there is so much liquidity in the world financial systems that lenders are making very risky credit decisions.”Still, what will it take to derail the corporate-debt machine at long last, and when will it happen? As S&P analyst Steven Miller observes,“If you tried to call the end…you would be really poor waiting for it.”
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Paul Spendiff Tel:44 [0] 20 7680 5153 Fax:44 [0] 20 7680 5155 Email:paul.spendiff@berlinguer.com
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Asset owners have more opportunity than ever before to select the benchmark that most accurately reflects the asset allocation and the relevant opportunity set. Photograph supplied by Istockphoto.com, June 2007.
BENCHMARKS: MARKET INDICATORS, OR TRADING VEHICLES? What constitutes best practice in global equity benchmarking? It is a singular question, prompted these days by index providers, to extend the global coverage of their indices, and by others entering the global benchmarking arena for the first time. MSCI has proposed changes to its index methodology. Equally, Russell and Dow Jones Wilshire have also extended the scope of their products. Lillian Goldthwaite, head of equities at FTSE Group, discusses the implications of change. HERE ARE DIVERSE views on the best way to construct a global benchmark and several things that need to be considered when doing so. A global universe can be split in many ways, including country lines, market cap lines and sectors. Equally, when a trustee or plan sponsor reviews its benchmark, it has to take into account varied factors. Market coverage is an obvious starting point. Is an index that included greater granularity (that is, one that differentiates multinational companies from those that focus on domestic markets) useful? Alternately, should investors be looking more closely at custom indices, ones that exclude certain stocks, or limit exposure to certain countries? Trustees might also need to consider adopting socially responsible investment principles—for example by using a socially responsible investment index, such as FTSE4Good. Then again, should investors be looking to non-market cap weighted indices, for example by using FTSE GWA or FTSE RAFI? Additionally, trustees can look at alternative asset classes, such as hedge fund indices or property indices, which have increased their coverage and diversity greatly in recent years. Other factors to consider include the ability to weight by factors other than market capitalisation, such as dividends or sales, or to include equitised property, such as REITs within the overall global equity framework.
T
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A big debate is evolving around the use of global benchmarks. The trend with global benchmarking has been to increase coverage and give greater choice to investors. While this trend has generally been welcomed in the investment community, it has raised several points about the value of benchmarks to investors. In the race for market coverage, are index providers significantly improving the representation of the investable opportunity set and is it being made more relevant to investors? Are standards being sacrificed with regard to minimum cap size, liquidity and country criteria as index providers strive to cover the market? How important is an Emerging Markets micro cap to the investment equation? A benchmark is designed to be an accurate reflection of the market it represents. These days however, the extent to which a benchmark should be a consistent market measure versus a trading vehicle managed for turnover, is under the spotlight. It could be argued that benchmarks are turning into a vehicle for investment, rather than accurately reflecting the market they are supposed to represent. Is this a problem and should the investment community be more concerned about benchmarks being reflective? These developments sit within the context of a broader industry trend toward more integrated and sophisticated global benchmarking. With more choice than ever, it is crucial that asset owners and consultants give careful consideration to questions such as those above, as well as to the process of identifying the best “fit” benchmark to implement specific asset allocation and investment strategies. Now is a critical time for consultants and asset owners to review their options for global equity benchmarks. Although the industry is moving as a whole to the provision of integrated global benchmarks, there remains a degree of difference in approach to capturing the investable universe. These differences can be significant, yet are neither widely understood nor widely examined in the marketplace,
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THE FTSE I WANT TO INVEST MORE INTELLIGENTLY INDEX FTSE. It’s how the world says index. Because investors always want superior returns, FTSE has developed a range of investment strategy indices that are designed to offer an enhanced risk / return profile. Alongside traditional indices, we offer indices that use alternative weighting criteria, which include sales, cash flow, book value and dividends, instead of market capitalisation. www.ftse.com/invest_intelligent © FTSE International Limited (‘FTSE’) 2007. All rights reserved. FTSE ® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.
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THE SEARCH FOR BEST PRACTICE
with the result that a core set of benchmarks have become entrenched as choice amongst different investor groups. Plan sponsors are becoming more and more willing to broaden their mandates outside their home market, and then beyond Developed Large and Mid Cap equities to Small Cap equities and to Emerging Markets. As a result, the existing set of benchmarks have become less reflective measures of overall asset allocation objectives. By giving greater consideration to benchmark selection, plan sponsors could benefit from selecting benchmarks that are a better match to their investment strategy, thereby enhancing their risk control. FTSE supports MSCI’s moves to make its global benchmark indices closer to its own in terms of coverage. However, it may be that MSCI has failed to fully seize this opportunity, for three reasons.The first is decreased coverage. The change from a bottom-up industry level approach to a top-down methodology which targets 99% coverage has effectively removed the overlap between the MSCI standard and Small Cap indices. Inevitably, it has resulted in an overall decline in constituents and market cap across Large/Mid Cap indices for developed and emerging markets. The MSCI All Countries World Index for Large/Mid Caps will lose 451 constituents, with EAFE losing 192 stocks and $12bn in market cap. Second, representation is less accurate. Although MSCI’s coverage has been expanded, the methodology places a premium on turnover management through the use of large buffer zones and between 5% to 10% limits on name changes at reconstitution.This is fundamentally at odds with accurate and timely representation of the global opportunity set.Third, there is a lack of transparency. In order to reconcile the two aims of market coverage and turnover management, MSCI’s rule set is at all times complex and may leave too much room for discretion, making it difficult for managers to predict changes or replicate the index easily. Moreover, once the key decision is taken to diversify away from domestic markets, a raft of additional factors needs to be considered by the plan sponsor, and this could lead to them thinking again about which benchmark to use. Most global index providers subdivide their global indices according to the development status of constituent markets. An active decision needs to be taken on whether to invest in just Developed, or in both Developed and Emerging Markets; and the decision should not be the result only of following the most popular benchmark. FTSE and other providers make available a wide range of index subdivisions to enable the benchmark to closely match the investment mandate.
However, FTSE’s subdivision of Emerging into Advanced and Secondary allows greater choice for investors. Many plan sponsors and asset owners have found that it is more sensible to use separate specialist managers for Developed and Emerging Markets due to the differences in risk profile and liquidity. A mismatch between the mandate and the benchmark neither favours the plan sponsor nor the fund manager, as it allows too much scope for risk to be adopted by the manager, or allows for unfair criticism of managers by plan sponsors. Where this is potentially the case, plan sponsors can turn to index providers for the creation of a specific, customised benchmark that more accurately matches the mandate to the fund manager. This suits the needs of both the manager and investor. A number of mandates now have ethical or beliefbased tilts that prohibit investing in tobacco or similar stocks, or avoid certain countries or companies investing in those countries. It is important that these exclusions are incorporated into the benchmarks used for performance measurement, and this is done via the creation of customised benchmarks. Plan sponsors often set such mandates and many have commissioned FTSE to create custom indices that remove all excluded stocks in their mandates from the standard FTSE Global Equity Index offering. Fund management products related to these indices are delivered and supported in exactly the same way as the standard index products, making the use of these customised benchmarks as easy as using a standard product. FTSE currently calculates several benchmark indices, and customisation options include: • Compliance with specific regulatory requirements • Country exposure limits • Individual company size limits • Removal or overweighting of sectors and countries • Specific capitalisation limits, i.e. all companies smaller or larger than a specified size • Companies with current or forecast dividend yields above a specified level • Indices which are tax adjusted to particular situations • Implementation of a currency hedge within the index Best practice indexing can now deliver all of these options. Asset owners have more opportunity than ever before to select the benchmark that most accurately reflects the asset allocation and the relevant opportunity set. Equally important, they can also choose a provider whose overall index approach suits their preferences for benchmark transparency, construction and maintenance.
MSCI Standard Index
MSCI Enhanced Index
#Secs Mkt Cap (USDbn)
#Secs Mkt Cap (USDbn)
All Caps 4,892 Large / Mid Cap 2,769 Small Cap – Developed 2,123 Small Cap – Emerging Small Cap – All Countries
28,281 26,995 1,286
8,036 2,318 4,528 1,190 5,718
31,496 27,318 3,857 320 4,178
Change #Secs Mkt Cap (USDbn)
3,144 451 2,405 1,190 3,595
3,214 322 2,571 320 2,892
FTSE GEIS #Secs Mkt Cap (USDbn)
8,077 2,929 4,282 866 5,148
32,837 28,791 3,785 260 4,045
Source: MSCI Barra Consultation On An Updated Methodology, A Transition Plan Proposal, 2007, FTSE Group, data as of 30 September 2006
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Investing in the equity markets via
Equity Long/Short Equity Long/Short has allowed investors to participate in the upside during positive years and mitigate the losses in negative years. This dynamic has enabled Equity Long/Short portfolios to generate superior risk-adjusted returns and experience smaller capital drawdowns over a normal market cycle. Laurence Russian, principal at ABS Investment Management maintains that while Equity Long/Short has its own risks and impediments, the strategy offers a more consistent method of investing in the equity markets and should be considered as an equity replacement for a portion of any equity allocation. T HAS BECOME broadly accepted, at least over the past few decades, that anyone building an investment portfolio with a time horizon of greater than ten years should have a core weighting in the equity markets. It has also become common practice among individuals to invest a substantial portion of their savings in equities, even if their time horizon is less than ten years. Studies and asset allocation models vary, but it is a widely accepted belief that most portfolios, should maintain a long-term weighting of between 40-60% in equities. While a diversified asset allocation should provide longterm benefits for institutional and high net worth investors, equity investing involves a significant degree of market timing risks which are not adequately measured by most investors. The term â&#x20AC;&#x153;market timingâ&#x20AC;?has a negative connotation within the finance community, but it remains extremely important for investors looking to generate absolute returns.
I
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The ability of Equity Long/Short strategies to protect capital in prolonged bear markets makes market timing much less of an issue for strategic asset allocation decisions. Consider the following: Chart 1: Cumulative Returns (October 2004 to September 2006) and Table 1: Timing Extremely Important for Long Only Investors, clearly shows that the timing of an investment has a significant impact on future returns for long-only investors. Note the range of three-year returns for the S&P 500 since 1994 is significantly wider in comparison to Equity Long/Short strategies, with nearly all of the dispersion on the downside. Therefore, long-only investors need to either accept the risk of significantly lower returns if the markets fall after the initial investment date or, make the correct top-down market calls on when to invest. In either case, the ability of Equity Long/Short strategies to protect capital during down periods renders market timing or time horizon decisions less relevant. In looking at the S&P 500 Index and other major market indices over the past 100 years, depending on the rolling time period selected, an investor could have made or lost a significant amount of money if they had invested in these markets. It is during bear markets, however, where longonly equity investors suffer from the effects of compounding. As shown in Table 1a: The Compounding Effect, the power of compounding adds significance to avoiding large drawdowns. TABLES 2 to 6 show sample Equity Long/Short returns versus equity indices over several distinct time periods. While the data only goes back to 1994, it demonstrates a very clear picture of the risk-reward characteristics of each investment. Due to the nature of compounding and the
EQUITY LONG/SHORT INVESTING
Photograph by Isobel Poulin, supplied by Dreamstime.com, June 2007.
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6
5
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EQUITY LONG/SHORT INVESTING
Equity Long/Short strategy’s ability to protect capital in extended to hedge funds, as the vast majority of Equity down periods, the strategy has produced a superior risk- Long/Short strategies do not manage to an index. adjusted return (as well as absolute return) through a Therefore, the ability of hedge funds to provide active variety of market environments. After looking at the management (including the ability to short securities and historical data above, it is natural to ask,“How or why can vary exposure) should result in higher risk-adjusted returns Equity Long/Short produce a superior risk-adjusted return and fewer drawdowns over long time horizons in spite of in comparison to long-only equity in both “bull”and “bear” their higher fee structure. Flexible portfolio management is a second major factor, market environments?” There are two broad reasons for this phenomenon. The which allows Equity Long/Short portfolios to generate first is that a substantial talent has migrated out of long- superior risk-adjusted returns. The Equity Long/Short only firms into Equity Long/Short institutions that offer strategy gives investors access to both amplified alpha greater financial incentives (with compensation directly and flexible beta. Alpha is defined as the excess return linked to performance) and which encourage an generated or detracted from stock selection, after entrepreneurial work-style. The second is that, in turn, this stripping out the portion of the return attributed to beta encourages flexible portfolio management adaptable to a or market exposure. We define beta as a portfolio’s net flexible market offering Beta exposure and unconstrained exposure (sensitivity) to the underlying market. stock selection (an alpha strategy), as investment managers Depending on the style of the Equity Long/Short Fund in question, the alpha component should range from 0% exercise increased judgment in the investment process. Over the past ten years, the application of Equity (market timer) to 100% (market-neutral) of the Long/Short strategies, and the hedge fund industry in performance attribution, with beta comprising the rest. general, have grown considerably. This growth will likely While the potential for increased alpha and the nature of continue and ultimately change the structural asset flexible beta are the two factors driving superior riskallocation among institutional portfolios. Additionally, this adjusted returns, they are also the two principal growth will continue to be driven by factors related to both investment risks in most Equity Long/Short strategies. The impact of alpha (commonly referred to as “stock supply and demand. Demand is being led by institutions and high net worth individuals looking for diversification selection”) is frequently magnified in Equity Long/Short as as well as improved risk-adjusted returns and supply is compared to long-only portfolios, as it normally stems driven by talented investment professionals continuing to from both the long and short side of the portfolio. Also, as migrate to the hedge fund structure as it typically offers Equity Long/Short is often less concerned with index higher financial prospects and more investment flexibility. weightings and other portfolio constraints, position Overall, this structure also encourages a more concentration as well as residual sector and factor risks, entrepreneurial atmosphere and allows investment either explicitly taken or implicitly embedded in the stock professionals the chance to prove their skills and, if selection, play a larger role. This non-systematic risk, which is likely to translate into successful, be rewarded accordingly. Another factor that has influenced hedge fund growth is positive return or alpha, is part of what investors are paying the differentiation between what we refer to as “active for when investing in the Equity Long/Short strategy. managers”(i.e. hedge funds) and “semi-passive managers” Flexible portfolio management manifests itself primarily in (i.e. the majority of mutual funds/long-only accounts). As periods of negative returns or heightened volatility. The professional investors realise that they can obtain a better ability to shift exposure and change from aggressive to risk-adjusted return from a truly active manager, they will defensive stocks allows funds to capture the upside of an become less inclined to invest with semi-passive managers, upward trending market while protecting capital in down whose portfolio construction is closely tied to the chosen periods. In our experience managing multi-manager Equity Long/Short portfolios, we benchmark (index). A 2006 have witnessed higher working paper by Martijn Chart 1: Cumulative Returns (Oct 1994-Sept 2006) correlation (and volatility) Cremers and Antii 400 to underlying equity Petajisto of Yale entitled 350 markets in rising markets Active and Passive Positions 300 250 and lower correlation in by Mutual Funds, published ABS Portfolio 200 falling markets (as the by the International Center Max Drawdown: -8.02% 150 following tables for Finance, Yale School of 100 S&P 500 Max Drawdown: demonstrate). Management, shows that 50 -46.28% As underlying market equity mutual funds that 0 -50 volatility increases, closely track an index typically in a falling market significantly underenvironment, many Equity perform those that provide ABS Portfolio S&P 500 Long/Short managers more active management. become more defensive, This argument can be Source: ABS Investment Management, June 2007.
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shrinking their fund’s gross and net exposure, subsequently decreasing volatility. In some cases, when Equity Long/Short managers believe they are in a benign market environment, they will tend to increase both their gross and net long exposure. When they believe they are entering a more difficult or “risky” environment, they will often decrease gross and net market exposure with the aim of protecting capital. In addition, as a fund decreases exposure, either by reducing gross exposure or increasing shorts, the portfolio raises its exposure to cash as short selling generates a short interest rebate. While the historical risk-adjusted returns of Equity Long/Short strategies in both bull and bear market environments presented above are alluring, one must question whether the next ten years will be anything like the past ten years.
Table 1: Timing of Initial Investment Extremely Important for Long-Only Investors Oct 1994-Sept 2006
S&P 500
MSCI Dev. CSFB-Tremont World Index
Equity L/S 31.97
Maximum 3-Year Annualised Return
30.07
21.27
Minimum 3-Year Annualised Return
-17.28
-19.44
-4.77
Range of Returns
47.35
40.70
36.74
Table 1a: The Compounding Effect Initial Loss ¦ Return needed -10%
Worst Equity
Worst S&P
to recover loss
L/S Drawdown
Drawdown
11.11%
Date Range:
Date Range:
-20%
25.00%
Mar 00 - Jul 02
Sept 00-Sept 02
The risks of Equity Long/Short investing
-30%
42.86%
Return: -15.05%
Return: -46.28%
For potential investors contemplating Equity Long/Short strategies and hedge funds in general, the primary concern is transparency. In the ultra-competitive hedge fund world, many managers do not disclose their positions in order to protect their competitive advantage. Our approach at ABS has always been to collect information on a fund’s portfolio on a monthly basis to understand and monitor its various risks (dollar and beta-adjusted exposures, market cap, sector and country concentration on both the long and short sides of the portfolio). By monitoring this type of information, we are able to determine the quality of returns generated and the risks, both realised and unrealised, the manager has taken. This also allows us to detect changes in style or strategy, commonly referred to as “style drift”, which is a common concern among institutional investors. While transparency from Equity Long/Short will likely remain less comprehensive than equity long-only vehicles, the characteristics of the instruments commonly utilized in the strategy (i.e., liquid securities, independent pricing, and low leverage) make transparency a less significant issue as compared to other hedge fund strategies. Outside of transparency, potential hedge fund investors also remain skeptical of the incentive-based fee structure. While incentive fees attract the most talented investment professionals to the industry, it has an unfortunate side effect of attracting opportunistic managers looking to take advantage of the free optionality embedded in the performance fee structure. For such opportunists, it may encourage excessive risk-taking in the hopes of “one good year” and the corresponding fees earned. Unfortunately, the only way to distinguish between the talented and opportunistic fund managers is constant monitoring and experience. At ABS, our experience selecting hedge fund managers has several benefits, including a substantial reference list, a detailed database of meeting logs from years past, and the experience of investing alongside managers who have a substantial portion of their net worth in their funds. Additionally, the ABS monitoring process focuses on making multiple contacts with portfolio
-40%
66.67%
-50%
100.000%
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Recovery:17 months Recovery: 50 months and counting
Table 2: 12-Year Risk/Return Comparison (Oct 1994-Sept 2006) S&P 500
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S 13.13
Annualised Annual Return
9.24
6.77
Annualised Standard Deviation
14.55
13.68
10.24
Maximum Drawdown
-46.28
-48.44
-15.05
0.36
0.20
0.89
Annualised Sharpe Ratio (rfr=4.0)
Table 3: “Bull Market 1” Environment Risk/Return (Oct 1994-Mar 2000) S&P 500
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S 23.16
Annualised Annual Return
23.82
16.24
Annualised Standard Deviation
14.34
13.13
12.43
Maximum Drawdown
-15.57
-13.69
-11.43
1.29
0.83
1.44
Annualised Sharpe Ratio (rfr=5.3)
Table 4: “Bear Market 1” Environment Risk/Return (Apr 2000-Dec 2002) S&P 500
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S -3.68
Annualised Annual Return
-17.61
-19.37
Annualised Standard Deviation
18.31
16.74
8.51
Maximum Drawdown
-46.28
-48.44
-11.53
-1.15
-1.37
-0.84
Annualised Sharpe Ratio (rfr=4.2)
Source: ABS Investment Management, June 2007.
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managers throughout the year to determine their level of focus, motivation, and business viability. Going forward, the most glaring future impediment to Equity Long/Short investing is capacity—too much money searching for too few “great” hedge fund managers.Truly talented investment professionals are a limited resource.The best hedge fund managers exhibit the right balance of skills, judgment, experience, and focus, combined with a passion for investing. There are countless hedge funds formed each year, but only a limited number will succeed at out-performing their peers and delivering a consistently superior riskadjusted return. With the hedge fund landscape becoming more crowded and competitive, the manager selection process will be even more important.
Table 6: “Bull Market 2” Environment Risk/Return (AJan 2003-Apr 2006) S&P 500
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S 14.50
Annualised Annual Return
12.71
17.95
Annualised Standard Deviation
8.70
9.51
5.36
Maximum Drawdown
-4.54
-5.49
-2.67
Annualised Sharpe Ratio (rfr=2.1)
1.21
1.66
2.30
ABS G7 Portfolio represents the historical performmance of a hedged equity portfolio for the period October 1994 to August 2006 in which no other persons that the princials of ABS Investment Management LLC played a significant role in achieving the performance results of such portfolio.
Table 7: “Bull Market 1” Environment (Oct 1994-Mar 2000)
The outlook The “spread” or “out-performance” of risk-adjusted returns of Equity Long/Short Hedge Funds versus long-only equity accounts should narrow as the ratio of money in long-only decreases compared to the money in hedge funds and more specifically Equity Long/Short. Hedge Fund Research Inc. estimates that the total assets under management for hedge funds have nearly doubled since the beginning of 2003 to $1.23trn. Equity Long/Short funds comprise nearly 30% of that universe, and despite the relative popularity of low volatility strategies in recent years, Equity Long/Short remains the largest hedge fund strategy group. With that said, Equity Long/Short is a very broad strategy. Expectations should depend on investment styles and sub-strategies, that is: exposure biases (beta, market cap, growth versus value, or special situations) as well as trading-orientation (buy and hold versus short-term trading). We broadly estimate that investors should expect to participate in 60% to 70% of the upside and 20% to 30% of the downside of the markets over a normal market cycle. For large investors, a customised multi-manager portfolio (fund of hedge funds) is the ideal way to build an investment portfolio where the expected return and volatility distributions are fairly well defined, based on the client’s specific objectives and constraints. A well-constructed portfolio of quality Equity Long/Short managers will continue to produce a superior risk-adjusted return when compared to any relevant equity index (or long-only accounts) over a normal market cycle. For the reasons discussed above, most specifically, (1) the compounding effect, (2) talent migration into Equity Long/Short, (3) flexible portfolio management, and (4) superior riskadjusted returns, institutional investors and high net worth individuals should and will consider the Equity Long/Short strategy not only as a category within the alternative investments, but also as a viable equity replacement.
CSFB-Tremont Equity L/S S&P 500
0.58
MSCI Dev. World Index
0.63 S&P 500
Annualised Standard Deviation
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S
13.13
12.43
14.34
The ABS G7 Portfolio is based on an actual Equuity Long/Short multi-manager portfolio managed exclusively by the ABS teamm from October 1994 through September 2006. The history of the portfolio is as follows: October 1994-August 1998 garantia Fund of Funds Series B Equity. September 1998-December 2002* CSAM Fund of Fuunds B2 - G7 Equity Hedge. January 2003-September 20006 (current) ABS Offshore SPC Equity Portfolio. Each portfolio track record is net of all management and performance fees. The Garantia and CSAM track records are based on a 1.5% management fee and 10% performance fee, while the ABS track record is based on a 1% management fee and 10% performance fee. *Note that from August 2002 to December 2002, the team transitioned from CSAM to ABS, and was not responsible for any canges to the portfolio or its performance. Source: ABS
Table 8: “Bear Market” Environment (Apr 2000-Dec 2002) CSFB-Tremont Equity L/S S&P 500
0.47
MSCI Dev. World Index
0.52 S&P 500
Annualised Standard Deviation
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S
16.74
8.51
18.31
Table 9: “Bull Market” Environment (Jan 2003-Apr-2006) CSFB-Tremont Equity L/S S&P 500
0.74
MSCI Dev. World Index
0.85 S&P 500
Annualised Standard Deviation
8.70
MSCI Dev.
CSFB-Tremont
World Index
Equity L/S
9.51
5.36
Source: ABS Investment Management, June 2007.
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Top 10 Equities By Total Balance—showing the scale of activity in these equities
Top 10 Equites By Change in Balance (Total Balance > 10m)
Rank Stock description Change on Previous Mth (%) 1 DaimlerChrysler AG 54.66 2 Roche Holding AG -17.45 3 Novartis AG -19.75 4 Total SA 0.21 5 HSBC Holdings PLC -62.39 6 Nestle SA 26.46 7 AXA SA 2.61 8 Banco Bilbao Vizcaya Argentaria SA 22.44 9 RWE AG 14.20 10 BNP Paribas -0.70
Rank Stock description 1 Kier Group Plc 2 Willis Group Holdings Ltd 3 Bovis Homes Group PLC 4 Laird Group Plc 5 Commvault Systems Inc 6 First Data Corp 7 FMC Corp 8 Dow Chemical Co/The 9 United Dominion Realty Trust Inc 10 Dean Foods Co
Top 10 Corporate Bonds By Total Balance—illustrating the scale of activity in these bonds
Top 10 Corp By Change in Balance (Total Balance > 10m)
Rank Stock description Change on Previous Mth (%) 1 European Investment Bank (6% 07-Dec-2028) 5.71 2 Hipototta Plc (3.181% 30-Sep-2048) -0.54 3 European Investment Bank (5.625% 07-Jun-2032) -8.89 4 Kreditanstalt fuer Wiederaufbau (3.5% 17-Apr-2009) -0.62 5 European Investment Bank (4% 15-Oct-2037) 4.22 6 Freddie Mac Gold Pool (4.5% 01-May-2036) -0.32 7 Freddie Mac Gold Pool (4.5% 01-Oct-2035) -0.14 8 General Motors Corp (8.375% 15-Jul-2033) -5.45 9 European Investment Bank (5.5% 15-Apr-2025) -10.97 10 Kreditanstalt fuer Wiederaufbau (3% 15-Nov-2007) -3.59
Rank Stock description Change on Previous Mth (%) 1 European Investment Bank (4.125% 15-Apr-2024) 2859.66 2 Ayt Cedulas Cajas Global (3.5% 14-Mar-2016) 769.07 3 Eurohypo AG (4.5% 21-Jan-2013) 578.39 4 AyT Ced Cajas Fondo d T'zacion de Activos (4% 07-04-14) 488.83 5 European Investment Bank (3.75% 24-Nov-2010) 366.15 6 Beazer Homes USA Inc (6.875% 15-Jul-2015) 357.84 7 Deutsche Genossenschafts-Hypobk (5.5% 01-04-10) 319.51 8 Bank Nederlandse Gemeenten (5.125% 20-Oct-2011) 301.80 9 Beazer Homes USA Inc (8.375% 15-Apr-2012) 284.43 10 Banco Sabadell SA (4.25% 24-Jan-2017) 255.28
Change on Previous Mth (%) 490.00 465.29 448.36 284.26 281.25 258.37 253.94 253.69 235.07 232.20
SECURITIES LENDING DATA
A SNAPSHOT VIEW OF THE SECURITIES LENDING MARKET AS OF APRIL 1 2007
The amount of security out on loan as a percentage of the amount available is another indicator of popular stocks. Data from Performance Explorer Lenders by Data Explorers.
Top 10 Equities By Utilisation and Balance
Top 10 Corp Bonds By Utilisation then Balance
Rank Stock description Change on Previous Mth (%) 1 TC Pipelines LP 0.00 2 Cosmo Securities Co Ltd -3.68 3 First Capital Realty Inc not available 4 Frontline Ltd 3.04 5 3D Systems Corp 12.82 6 National Bank Of Canada (5.85% Undated) -1.57 7 Parkervision Inc 11.75 8 Sakata Seed Corp -0.32 9 American Superconductor Corp 0.98 10 WCI Communities Inc 28.61
Rank Stock description Change on Previous Mth (%) 1 Freddie Mac Gold Pool (4.5% 01-May-2036) 2 Fannie Mae REMICS (6% 25-Mar-2037) 3 Bayerische Landesbank (4.785% 23-Jun-2009) 4 Freddie Mac Gold Pool (5.5% 01-Feb-2037) 5 Structured Adjust Rate Mtg Loan Trust(5.955% 25-06-36) 6 Freddie Mac Gold Pool (5.5% 01-Feb-2036) 7 GE Capital UK Funding (5.28656% 01-Aug-2011) 8 Ctywid MtgTrust(4.72% 9-01-34) (SEDOL:12669EG67) 9 Ctywide MtgTrust(4.72% 19-01-34) (SEDOL:12669E3D6) 10 Freddie Mac REMICS (5.5% 15-Sep-2031)
The following tables detail the top securities by fee within two bands of total balance out on loan. Equity by Fee: more than $10m but less than $100m
Equity by Fee: more than $100m
Rank Stock description 1 Hufvudstaden AB 2 Neurochem Inc 3 Home Solutions of America Inc 4 Imergent Inc 5 Midway Games Inc 6 Cell Therapeutics Inc 7 Eurotunnel SA 8 Sulphco Inc 9 Parkervision Inc 10 Medis Technologies Ltd
Rank Stock description 1 Dean Foods Co 2 NYSE Group Inc 3 Fairfax Financial Holdings Ltd 4 Elisa OYJ 5 OKO Bank plc 6 Fortum Oyj 7 Zoltek Cos Inc 8 Tietoenator Oyj 9 Pre-Paid Legal Services Inc 10 La-Z-Boy Inc
Corporate Bonds by fee: more than $10m but less than $100m
Corporate bonds by Fee: more than $100m
Rank Stock description 1 Dura Operating Corp (8.625% 15-Apr-2012) 2 Georgia Gulf Corp (10.75% 15-Oct-2016) 3 Northwest Airlines Corp (10% 01-Feb-2009) 4 DJ TRAC-X NA (6.05% 25-Mar-2009) 5 Calpine Corp (7.75% 15-Apr-2009) 6 Hawaiian Telcom Communications Inc (12.5% 01-May-2015) 7 Technical Olympic USA Inc (10.375% 01-Jul-2012) 8 MagnaChip Semiconductor Finance Co (8% 15-Dec-2014) 9 Movie Gallery Inc (11% 01-May-2012) 10 WCI Communities Inc (9.125% 01-May-2012)
Rank Stock description 1 Delta Air Lines Inc (8.3% 15-Dec-2029) 2 Argentina Govt International Bond (8.28% 31-Dec-2033) 3 Beazer Homes USA Inc (8.125% 15-Jun-2016) 4 General Motors Corp (8.375% 15-Jul-2033) 5 Sherwood Copper Corp (5% 31-Mar-2012) 6 Turkey Govt International Bond (11.875% 15-Jan-2030) 7 K Hovnanian Enterprises Inc (8.625% 15-Jan-2017) 8 Gaz Capital for Gazprom (8.625% 28-Apr-2034) 9 General Motors Corp (7.125% 15-Jul-2013) 10 France Telecom SA (1.6% 01-Jan-2009) Source: Data Explorers, 2007. All figures kindly compiled by Data Explorers, June 2007.
As of May 2nd, there were 208,111 securities available for lending, worth a combined $13,350bn, 35,540 securities were out on loan, worth just over $3.5trn.
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
91
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MARKET DATA BY FTSE RESEARCH
FT SE
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd Page 94
FTSE Global Equity Index Series – Global
31 May 2006 to 31 May 2007
FTSE All Cap Regional Indices (USD) 170
160
FTSE Global AC
150
FTSE Developed Europe AC
140
130
FTSE Japan AC
120
FTSE Asia Pacific AC ex Japan
110
100
FTSE Middle East & Africa AC
90
FTSE Emerging Europe AC
80
FTSE Latin America AC
FTSE North America AC
FTSE All Cap (AC) Regional Indices – Capital Returns (USD) 70
60
50
40
30
20
10
0
FTSE Developed All Cap Country Indices – Capital Returns
60
50
40
30
Dollar Value
20
Local Currency Value
10
0
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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FT SE
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd
%
%
Overall Index Return (USD)
FTSE Global AC Index FTSE Global LC Index FTSE Global MC Index FTSE Global SC Index FTSE All-World Index FTSE Asia Pacific AC ex Japan Index FTSE Latin America AC Index FTSE All Emerging Europe AC Index FTSE Developed Europe AC Index FTSE Middle East & Africa AC Index FTSE North Americas AC Index FTSE Japan AC Index
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
11/6/07 22:08 Page 95
FTSE All-Emerging Country All Cap Indices – Capital Returns 110
100
90
80
70
60
50
40
Dollar Value
30
20
Local Currency Value
10 0
-10
FTSE Global All Cap Sector Indices – Returns (USD)
70
60
50
40
30
Capital
20
Total Return
10
0
No. of Consts Value 2 M (%)
8,030 1,199 1,672 5,159 2,871 1,838 204 113 1,650 203 2,669 1,353
441.06 416.91 609.86 557.97 261.36 597.06 1187.85 882.48 517.27 704.34 378.25 414.66
7.3 7.2 7.0 7.7 7.2 10.6 16.3 -1.7 7.1 5.5 8.1 -0.5 6 M (%) 12 M (%)
12.2 11.2 13.4 15.4 11.7 18.7 32.6 3.1 15.0 19.7 10.2 4.1
24.3 23.0 25.0 27.0 23.9 37.5 64.3 20.9 31.1 27.9 21.1 3.0 YTD (%) Actual DIv Yld (%)
9.8 8.8 11.6 13.3 9.3 14.2 23.6 -0.4 11.2 13.0 9.2 2.1
2.00 2.18 1.63 1.42 2.09 2.45 2.37 1.81 2.61 2.73 1.64 1.14
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap
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MARKET DATA BY FTSE RESEARCH
O il
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd Page 96
FTSE Global Equity Index Series – Developed ex US
31 May 2006 to 31 May 2007
150 150
FTSE Developed Regional Indices – Large/Mid Cap (USD)
140 140
FTSE Developed (LC/MC)
130 130
FTSE Developed Europe (LC/MC)
120 120
FTSE Developed Asia Pacific (LC/MC)
110 110
FTSE All-Emerging (LC/MC)
100 100
FTSE Developed ex US (LC/MC)
90
FTSE US (LC/MC)
80
FTSE Developed Asia Pacific ex Japan (LC/MC)
FTSE Developed Regional Indices – Capital Returns (USD) 40
30
20
10
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FTSE Developed ex US Sector Indices (LC/MC) – Returns (USD)
60
50
40
30
20
Capital
10
Total Return
0
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd
11/6/07
22:08
Page 97
No. of Consts
Value
2 M (%)
FTSE Developed ex US Index (LC/MC) 1,334 FTSE USA Index (LC/MC) 686 FTSE Developed Index (LC/MC) 2,020 FTSE All-Emerging Index (LC/MC) 851 FTSE Developed Europe Index (LC/MC) 505 FTSE Developed Asia Pacific Index (LC/MC) 771 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 288 FTSE Developed ex US AC Index 3,867 FTSE Developed ex US LC Index 568 FTSE Developed ex US MC Index 1,672 FTSE Developed ex US SC Index 5,159
299.22 635.35 251.19 505.64 305.82 260.52 485.20 508.27 463.54 625.57 686.60
6.3 7.5 6.9 10.6 7.3 2.2 6.9 6.2 6.4 5.7 5.7
Overall Index Return (USD)
6 M (%) 12 M (%)
12.9 9.3 11.1 18.1 14.4 9.0 19.0 13.5 12.5 15.2 17.1
24.7 20.6 22.7 37.4 29.9 13.9 38.5 25.4 23.9 29.2 29.9
YTD (%) Actual Div Yld (%)
9.9 8.0 9.0 12.9 10.9 6.0 13.9 10.2 9.5 11.5 12.9
2.41 1.73 2.08 2.19 2.74 1.78 3.02 2.31 2.53 1.63 1.42
FTSE Global Equity Index Series – Asia Pacific 31 May 2006 to 31 May 2007
FTSE Asia Pacific All-Cap (AC) Regional Indices (USD) 140
FTSE Global AC
130
FTSE Developed Asia Pacific (LC/MC)
120
FTSE Developed Asia Pacific ex Japan (LC/MC)
110
FTSE Asia Pacific (LC/MC) FTSE All-Emerging Asia Pacific AC
100 90
FTSE Japan (LC/MC) 7
7
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30
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F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
95
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd
11/6/07
22:08
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70 60 50 40
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MARKET DATA BY FTSE RESEARCH
FTSE Asia Pacific All Cap Sector Indices – Returns (USD)
Overall Index Return (USD) No. of Consts
Value
2 M (%)
FTSE Global AC Index 8,030 FTSE Asia Pacific AC Index 3,191 FTSE Asia Pacific Index (LC/MC) 1,289 FTSE Asia Pacific LC Index 532 FTSE Asia Pacific MC Index 757 FTSE Asia Pacific SC Index 1,902 FTSE Developed Asia Pacific ex Japan Index (LC/MC) 288 FTSE Developed Asia Pacific Index (LC/MC) 771 FTSE All-Emerging Asia Pacific Index (LC/MC) 518 FTSE Japan Index (LC/MC) 483
441.06 492.93 279.47 472.62 544.33 566.94 485.20 260.52 356.09 156.30
7.3 5.1 4.8 4.6 5.5 7.9 6.9 2.2 12.7 -0.2
6 M (%) 12 M (%)
12.2 11.3 10.8 10.5 12.5 15.6 19.0 9.0 16.1 4.4
24.3 18.6 18.6 19.0 17.1 18.4 38.5 13.9 34.1 4.3
YTD (%) Actual DIv Yld (%)
9.8 8.2 7.6 7.1 10.3 13.1 13.9 6.0 12.2 2.3
2.00 1.83 1.85 1.90 1.65 1.68 3.02 1.78 2.05 1.13
FTSE Global Equity Index Series – Europe 31 May 2006 to 31 May 2007
European Indices (EUR) 130
FTSE Global AC FTSE Developed Europe ex UK LC/MC
120
FTSEurofirst 300 110
FTSE Developed Europe AC FTSEurofirst 100
100
FTSE Eurobloc AC FTSEurofirst 80 7 ay
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Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap
96
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd
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FTSE Europe All Cap Indices – Capital Return (EUR) 40
30
% 20
10
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Overall Index Return (EUR) FTSE Global AC Index FTSE Europe AC Index FTSE Europe LC Index FTSE Europe MC Index FTSE Europe SC Index FTSE Developed Europe AC Index FTSE All-Emerging Europe AC Index FTSE Eurobloc AC Index FTSE Developed Europe ex UK AC Index FTSEurofirst 300 Index FTSEurofirst 80 Index FTSEurofirst 100 Index
No. of Consts
Value
2 M (%)
8,030 1,763 242 327 1,194 1,650 113 847 1,178 300 80 100
377.43 446.28 472.35 604.92 655.53 442.64 755.17 476.99 480.75 1611.45 5761.54 5081.00
6.1 5.7 6.3 5.6 4.7 6.0 -2.7 7.1 6.7 6.3 7.7 6.7
6 M (%) 12 M (%)
10.5 12.9 11.9 16.5 17.7 13.3 1.6 16.0 15.3 12.5 14.5 11.1
18.7 24.9 22.2 33.1 34.1 25.2 15.4 29.0 28.4 23.3 26.1 19.7
YTD (%) Actual Div Yld (%)
7.6 8.6 8.2 11.0 11.4 9.0 -2.4 11.4 10.6 8.6 10.6 8.0
2.00 2.59 2.85 1.99 1.73 2.61 1.81 2.63 2.54 2.80 3.07 3.13
Key: AC = All Cap, LC = Large Cap, MC = Mid Cap, SC = Small Cap, LC/MC = Large and Mid Cap
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
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Sm
0
35
e O nt, O S e il & rv G ic a es s & Pro Di du st ce Co ri r ns Ch but s tr em ion uc El Ae ti ec ic o ro n a tr sp & Mi ls on a ic c M ni & Ge e & ate ng El ne D ri a e In ctr ral efe ls In du ica Ins nc du str l E ut e r q i st al u ia ria E ip ls l T ng me r in n S an ee t Au upp spo rin to or rta g m t S ti ob e on ile rvi s ce & s Fo Be Pa o Ho d ver rts us Pro ag He eh du es al Le old cer t is G s Ph h C Pe ure oo ar are m E rs G ds ac q on o eu uip al od tic m G s al en T oo s t Fo & & ob ds od B S ac & iote erv co Dr ch ice u n s Ge ug olo Fi ne Re gy xe ra tai d l R le Li et rs M ne T ai ob Te ra ile lec ve M lers Te om l & ed le m Le ia co u is G m nic ur Te So as m a e ch ftw , W un tio no ar a ic ns t at lo e er gy & & Ele ion C Ha o M ct s m u rd p lt rici w ut iut ty ar e ili e r S tie & e s Eq rvi ui ce No pm s nl en ife t Li In Ban Eq fe su k s ui I ns ran ty In G R urr ce ve e e an st ne al ce m ra Es en l F ta t I in te ns an tr cia um l en ts
ui pm
Eq
11/6/07
FT Al SE l-S A ha IM re
FT SE
FT SE
FT SE
FT SE
0
25
il
%
FT SE
0
10
O
MARKET DATA BY FTSE RESEARCH
FT SE
MARKET REPORTS 20.qxd:MARKET REPORTS 20.qxd Page 100
FTSE UK Index Series
31 May 2006 to 31 May 2007
FTSE UK Index Series (GBP)
FTSE techMARK
FTSE All-Share Sector Indices – Returns (GBP)
60
50
40
30
20
Capital
10
Total Return
0
-10
40
FTSE UK Indices – Capital Return (GBP)
30
20
10
0
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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Overall Index Return (GBP) No. of Consts
FTSE 100 Index FTSE 250 Index FTSE 350 Index FTSE SmallCap Index FTSE All-Share Index FTSE Fledgling Index FTSE AIM Index FTSE techMARK 100 Index
Value 2 M (%) 6 M (%) 12 M (%)
100 6621.45 250 12111.08 350 3493.13 331 4180.45 681 3438.70 240 4776.06 1,178 1212.76 100 1735.02
5.0 3.6 4.8 4.2 4.7 4.5 5.8 8.1
9.5 13.5 10.1 14.5 10.2 14.0 19.0 21.0
YTD (%)
Actual Div Yld (%)
Net Cover
P/E Ratio
6.4 8.3 6.7 7.0 6.7 8.8 15.0 14.7
2.91 1.92 2.76 1.64 2.72 1.68 0.42 1.26
2.77 2.77 2.77 1.53 2.74 -0.41 0.41 -
12.41 18.76 13.08 39.72 13.39 0.00 574.33 -
15.7 30.3 17.7 22.1 17.9 25.1 8.1 26.5
FTSE Xinhua Index Series 31 May 2006 to 31 May 2007
FTSE Xinhua Index Series (CNY/HKD) 280
FTSE/Xinhua China 25 (HKD)
240
FTSE Xinhua All-Share (CNY) FTSE Xinhua Small Cap (CNY)
200
FTSE/Xinhua China A50 (CNY) 160
FTSE Xinhua 600 (CNY) 120
ay
-0
7
7 M
Ap
M
r-0
7 ar -0
07
7
Fe b-
-0 Ja n
6 c-0 De
06 No v-
06 Oc t-
06 Se
gAu
p-
06
6 l-0 Ju
06 Ju n-
M
ay
-0
6
80
FTSE Xinhua Index Series Index Name
Consts
FTSE/Xinhua 25 Index (HKD) FTSE/Xinhua China 50 Index (CNY) FTSE Xinhua All-Share Index (CNY) FTSE Xinhua 600 Index (CNY) FTSE Xinhua Small Cap Index (CNY) FTSE Xinhua China Bond Total Return Index (CNY)
25 50 1,031 600 431 30
Value 2 M (%) 6 M (%) 12 M (%) YTD (%)
16849.14 14241.25 9334.34 9940.48 7236.31 94.17
7.8 26.6 41.6 40.9 46.8 -2.3
20.5 96.5 136.3 131.5 175.5 -2.3
54.1 169.6 190.0 186.4 213.7 -1.1
Actual Div Yld (%)
1.5 54.7 104.1 97.3 167.5 -2.1
1.72 0.57 0.53 0.58 0.25 3.62
FTSE Hedge Index Series FTSE Hedge Management Styles (USD) – 5-Year Performance 150
FTSE Hedge
140
FTSE Hedge Directional
130
FTSE Hedge Event Driven
120
FTSE Hedge Non-Directional
110 100
-0 7 ay M
v06 No
-0 6 ay M
v05 No
-0 5 ay M
v04 No
-0 4 ay M
v03 No
-0 3 ay M
v02 No
M
ay
-0 2
90
Based upon indicative index values as at 30 March 2007, 30 April 2007 and 31 May 2007
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
99
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MARKET DATA BY FTSE RESEARCH
FTSE Hedge – Management Styles & Strategies (NAV Terms) Index Level*
FTSE Hedge Index Directional Equity Hedge Commodity Trading Association (CTA) / Managed Futures Global Macro Event Driven Merger Arbitrage Distressed & Opportunities Non-directional Convertible Arbitrage Equity Arbitrage Fixed Income Relative Value
2M (%)
5685.23 2.4 3476.47 3.7 2600.20 3.1 2185.23 8.6 1961.14 1.0 3728.11 2.9 2291.76 -1.3 2656.61 6.3 3097.53 -0.7 2001.87 -3.7 2143.54 0.6 2090.45 1.0
6 M 12 M (%) (%)
YTD Ann Return (%) 5-Year (%)
4.9 5.9 9.9 5.4 -1.8 8.7 5.0 11.7 0.1 -2.6 1.5 2.8
3.6 3.8 8.0 2.0 -2.8 7.9 5.0 10.3 -0.4 -3.2 1.0 2.6
6.4 8.1 16.5 4.4 -1.1 12.8 9.0 15.6 0.1 -2.0 2.0 2.4
Volatility 3-Year (%)
5.4 7.0 8.0 10.3 3.4 6.3 3.0 9.1 2.2 4.1 2.7 1.4
2.9 4.8 5.5 9.5 5.7 3.0 3.6 4.4 1.5 3.4 2.4 1.4
* Based upon indicative index values as at 30 March 2007, 30 April 2007 and 31 May 2007
FTSE EPRA/NAREIT Global Real Estate Index Series FTSE EPRA/NAREIT Global Real Estate Index Series – 5-Year Performance (Total Return Basis) 350 300
EPRA/NAREIT Global Index (USD)
250
EPRA/NAREIT North America Index (USD)
200
EPRA/NAREIT Europe Index (EUR)
150
EPRA/NAREIT Euro Zone Index (EUR) EPRA/NAREIT Asia Index (USD)
100
ay -0 7 M
6 No v
-0
6 ay -0 M
5 -0 No v
M
ay -0
5
4 v0 No
4 ay -0 M
03 vNo
3 M
ay
-0
02 No v-
M
ay -0
2
50
FTSE EPRA/NAREIT Global Real Estate Indices (Total Return) Index Name
EPRA/NAREIT Global Index (USD) EPRA/NAREIT North America Index Index (USD) EPRA/NAREIT Europe Index (EUR) EPRA/NAREIT Euro Zone Index (EUR) EPRA/NAREIT Asia Index (USD)
100
Consts
Value
2 M (%)
313 127 101 48 85
3872.19 4337.90 3801.83 4276.88 3087.04
1.6 0.6 -3.3 -1.5 5.2
6 M (%) 12 M (%)
10.9 2.9 7.3 15.4 23.5
40.2 31.9 33.0 41.3 51.5
YTD (%)
Actual Div Yld (%)
7.9 4.6 -1.4 6.4 17.0
2.98 3.70 2.20 2.39 2.62
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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FTSE Bond Indices FTSE Bond Indices – 5-Year Performance (Total Return Basis) FTSE Eurozone Government Bond Index (EUR) FTSE Euro Corporates Bond Index (EUR) FTSE USA Goverment Bond Index (USD) FTSE Pfandbrief Index (EUR) FTSE Gilts Index Linked All-Stocks Index (GBP) FTSE Japan Government Bond Index (JPY)
170 160 150 140 130 120 110 100 90
ay -0 7 M
06 No v-
ay -0 6 M
05 No v-
ay -0 5 M
No v04
ay -0 4 M
No v03
ay -0 3 M
No v02
M
ay -0 2
80
FTSE Euro Emerging Markets Bond Index (EUR) FTSE Gilts Fixed All-Stocks Index (GBP)
FTSE Bond Indices (Total Return) Index Name
Consts
Value
2 M (%)
240 410 34 328 12 29 134 244
151.60 175.56 214.90 142.53 2027.76 1911.49 154.00 110.91
-2.1 -1.5 -0.4 -1.8 -1.5 -1.2 0.2 -0.4
FTSE Eurozone Government Index (EUR) FTSE Pfandbrief Index (EUR) FTSE Euro Emerging Markets Index (EUR) FTSE Euro Corporates Index (EUR) FTSE Gilts Index Linked All Stocks Index (GBP) FTSE Gilts Fixed All-Stocks Index (GBP) FTSE USA Government Index (USD) FTSE Japan Government Index (JPY)
6 M (%) 12 M (%)
-3.1 -1.9 0.2 -1.9 -3.6 -3.1 0.8 0.3
0.2 0.7 4.0 0.8 1.9 0.0 6.1 2.0
Annual Redemption YTD (%) Yld (%)
-1.9 -1.0 0.3 -1.1 -2.0 -1.9 1.6 0.2
4.56 4.66 5.31 4.96 1.86* 4.91 5.06 1.67
* Based on 0% inflation
FTSE GWA Index Series FTSE GWA Index Series – 5-Year Performance (Total Return Basis) 300
FTSE GWA Developed Index (USD) FTSE GWA Developed ex US Index (USD) FTSE GWA Developed ex Japan Index (USD) FTSE GWA Developed Europe Index (EUR) FTSE GWA UK Index (GBP)
250
200
150
100
7 M
ay
-0
06 No
v-
6 M
ay
-0
05 vNo
5 M
ay
-0
4 No
v0
4 M
ay
-0
3 v0 No
3 M
ay
-0
02 vNo
M
ay
-0
2
50
FTSE GWA Indices (Total Return) Index Name
FTSE GWA Developed Index (USD) FTSE GWA Developed ex US Index (USD) FTSE GWA Developed ex Japan Index (USD) FTSE GWA Developed Europe Index (EUR) FTSE GWA UK Index (GBP)
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
Consts
Value
2 M (%)
2020 1334 1537 505 686
4538.45 4992.15 4553.68 4615.50 4251.91
7.9 7.6 8.8 8.0 5.5
6 M (%) 12 M (%)
13.2 15.2 14.0 14.9 11.4
27.0 29.5 29.5 28.8 21.6
YTD (%)
Actual Div Yld (%)
10.5 11.7 11.2 10.5 7.6
2.25 2.58 2.36 2.93 2.93
101
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FTSE RAFI Index Series – 5-Year Performance (Total Return Basis) 250
FTSE RAFI US 1000 Index (USD) FTSE RAFI Developed ex US 1000 Index (USD)
200
FTSE RAFI Kaigai 1000 Index (USD) 150
FTSE RAFI Europe Index (EUR) FTSE RAFI Eurozone Index (GBP)
100
7 M
M
No
ay -0
v06
6 ay -0
v05
5 M
No
vNo
ay -0
04
4 ay -0
03 v-
M
M
No
3 ay -0
02 vNo
ay -0
2
50
M
MARKET DATA BY FTSE RESEARCH
FTSE RAFI Index Series
FTSE RAFI Indices (Total Return) Index Name
FTSE RAFI US 1000 Index (USD) FTSE RAFI Developed ex US 1000 Index (USD) FTSE RAFI Kaigai 1000 Index (USD) FTSE RAFI Europe Index (EUR) FTSE RAFI Eurozone Index (EUR)
Consts
Value
2 M (%)
998 1012 1015 473 271
6657.87 7494.07 6552.11 6906.06 7195.47
7.7 7.0 8.6 8.0 9.4
6 M (%) 12 M (%)
11.7 15.9 14.7 16.2 19.1
25.0 30.0 30.4 30.6 34.8
YTD (%)
Actual Div Yld (%)
9.6 12.2 11.7 11.8 14.4
2.03 2.56 2.51 2.92 2.86
FTSE LATIBEX Index Series 31 December 2003 to 31 March 2007
FTSE LATIBEX Index Series – Performance (EUR Terms) 400
FTSE LATIBEX All-Share Index
350
FTSE LATIBEX TOP Index
300 250
FTSE LATIBEX Brasil Index
200
FTSE Latin America Index
150
FTSE Brazil Index
100
ar M 07 ay -0 7
M
6 c-0 De
p06 Se
06 nJu
6 ar -0 M
5 c-0 De
p05 Se
n05 Ju
ar -0 5 M
4 c-0 De
04
p04 Se
nJu
M ar -0 4
De
c-0
3
50
FTSE LATIBEX Indices (EUR Terms) Index Name
FTSE LATIBEX All Share Index FTSE LATIBEX TOP Index FTSE LATIBEX Brasil Index FTSE Latin America Index FTSE Brazil Index
102
Value
2 M (%)
6 M (%)
12 M (%)
YTD (%)
2910.80 4719.20 10882.80 672.87 589.66
18.5 17.3 18.7 14.9 16.7
34.9 34.5 37.3 30.0 33.2
55.9 56.5 53.3 55.5 51.4
25.6 24.9 26.5 20.7 22.8
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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FTSE UK Commercial Property Index Series FTSE UK Commercial Property Index Series – Total Return Performance 30 June 2006 to 31 May 2007 120
FTSE All UK Property Index
115
FTSE UK Retail Property Index
110
FTSE UK Office Property Index
105
FTSE UK Industrial Property Index
100
-0 7 M ay
Ap r-0 7
7 M
ar -0
-0 7 Fe b
7 Ja n0
6 De c-0
v06 No
6 Oc
t-0
-0 6 Se p
Au
g06
Ju l-0 6
Ju n
-0 6
95
FTSE UK Commercial Property Indices (GBP Terms) Index Name
FTSE All UK Property Index FTSE UK Retail Property Index FTSE UK Office Property Index FTSE UK Industrial Property Index
Value
2 M (%)
6 M (%)
YTD (%)
5637.37 5594.25 5685.11 5685.11
0.6 0.9 0.9 0.9
5.3 3.2 8.1 8.1
3.3 1.9 6.0 6.0
YTD (%)
Annual Volatility (%)
5.3 8.8 11.7
2.3 4.1 5.7
FTSE Private Banking Index Series 120
Low Risk 115
Medium Risk
110
High Risk
105
100
7 ay -0 M
ar -0 7 M
6 c-0 De
p06 Se
n06 Ju
ar -0 6 M
De c
-0 5
95
FTSE Private Banking Index Series (USD Terms) Index Value (31 Dec 2005=100)
3 M (%)
107.89 113.72 118.15
1.3 3.4 4.9
USD Low Risk USD Medium Risk USD High Risk
6 M (%) 12 M (%)
2.3 5.1 7.0
6.5 10.7 13.7
FTSE Research Team contact details Andy Harvell Head of Research andy.harvell@ftse.com +44 20 7866 8986
Andreas Elia Research Analyst andreas.elia@ftse.com +44 20 7866 8013
F T S E G L O B A L M A R K E T S • J U LY / A U G U S T 2 0 0 7
Kamila Lewandowski Research Analyst kamila.lewandowski@ftse.com +44 20 7866 1877
Sandra Jim Research Manager, Asia Pacific sandra.jim@ftse.com +(852) 223 0-5814
103
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CALENDAR
Index Reviews July – October 2007 Date
Index Series
Review Type
Effective Data Cut-off (Close of business)
1-Jul 11-Jul 12-Jul Mid July Mid July
TOPIX New Index Series FTSE Xinhua Index Series TSEC Taiwan 50 PSI 20 OMX H25
27-Jul 20-Jul 20-Jul 30-Jul
16-Jun 18-Jun 29-Jun 31-May
10-Aug 15-Aug 28-Aug
Hang Seng MSCI Standard Index Series FTSE Global Equity Index Series (incl. FTSE All-World) FTSE Goldmines Index Series ATX CAC 40 S&P / TSX SMI Index Family Nikkei 225 DAX S&P MIB S&P / ASX Indices NZSX 50 FTSE UK Index Series FTSE/JSE Africa Index Series FTSE Asiatop/Asian Sectors FTSE Global Equity Index Series (incl. FTSE All-World) FTSE techMARK 100 FTSEurofirst 80 & 100 FTSEurofirst 300 FTSE Euromid FTSE eTX FTSE Multinational FTSE Global 100 FTSE EPRA/NAREIT Global Real Estate Index Series FTSE4Good Index Series NASDAQ 100 S&P MIB DJ STOXX DJ STOXX DJ STOXX Blue-Chip S&P US Indices S&P Europe 350 / S&P Euro S&P Topix 150 S&P Latin 40 S&P Asia 50 S&P Global 1200 S&P Global 100 Russell US Indices FTSE Xinhua Index Series TSEC Taiwan 50 OMX H25 FTSE / ATHEX 20
Semi-annual review Annual Review Quarterly & annual review Semi-annual review Semi-annual review - consituents, Quarterly review - shares in issue Quarterly review Quarterly review
31-Jul 7-Sep 31-Aug
30-Jun 29-Jun 31-Oct
Annual Review / Japan Quarterly review Semi-annual review / number of shares Annual review of free float & Quarterly Review Quarterly review - constiuents, shares & IWF Semi-annual review Annual review Quarterly review/ Ordinary adjustment Semi-annual constiuents review Quarterly review - shares, S&P / ASX 300 consituents Quarterly review Quarterly review Quarterly review Semi-annual review
21-Sep 21-Sep 28-Sep 21-Sep 21-Sep 30-Sep Late Sept/Early Oct 21-Sep 24-Sep 21-Sep 28-Sep 21-Sep 21-Sep 21-Sep
29-Jun 24-Aug 31-Aug 31-Aug 31-Aug 30-Jun
Annual review / Developed Europe Quarterly review Annual Review Quarterly review Quarterly review Quarterly review Annual review Quarterly review
21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep
29-Jun 31-Aug 31-Aug 31-Aug 31-Aug 31-Aug 29-Jun 31-Aug
Quarterly review Semi-annual review Quarterly review / Shares adjustment Quarterly review - shares & IWF Quarterly review Style Review Annual review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - shares & IWF Quarterly review - IPO additions only Quarterly review Quarterly review Quarterly review - share in issue Semi-annual review
21-Sep 21-Sep 21-Sep 24-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 21-Sep 30-Sep 20-Oct 19-Oct 31-Oct 30-Nov
7-Sep 31-Aug 31-Aug 17-Sep 14-Aug 1-Sep 1-Sep
29-Aug Early Sep Early Sep Early Sep 1-Sep 4-Sep 5-Sep 7-Sep 7-Sep 10-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 12-Sep 13-Sep 14-Sep 18-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 19-Sep 21-Sep 11-Oct 11-Oct Mid Oct Mid Oct
31-Aug 17-Sep 31-Aug 11-Sep 3-Sep 31-Aug
31-Aug 15-Sep 28-Sep 28-Sep
Sources: Berlinguer, FTSE, JP Morgan, Standard & Poors, STOXX
104
J U LY / A U G U S T 2 0 0 7 • F T S E G L O B A L M A R K E T S
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THE FTSE I WANT THE WORLD INDEX FTSE. It’s how the world says index. Global markets grow more complex and interconnected every day.To stay abreast, you need a comprehensive index that can slice and dice markets the way you do. The FTSE Global Equity Index Series was the first benchmark to cover the world seamlessly with a single consistent and transparent methodology. Because FTSE indices are independently verified by a panel of market practitioners, you can be sure that they will always be in line with investors’ needs. Wherever you invest, FTSE gives you the clearest view of how you are doing. www.ftse.com/invest_world © FTSE International Limited (‘FTSE’) 2007. All rights reserved. FTSE ® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE under licence.
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