Investment Harvard College
Magazine Winter 2010
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oney M f ing? o g r r e o l m o pE eC e h e t s K i s rket a Green M g ity in u g q r e E e m ivat r P Can E t ies a n a k p o o m er L ck Co e h Anoth C nk a l B g in Bounc
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vard Colleg Table of Contents features
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Environmental Goals and Carbon Trading
Green is the Color of Money Anita Panchmatia Emerging Markets
Can Emerging Markets Keep Emerging? Marc Steinberg
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Private Equity
Another Look at Private Equity Matthew Lee SPACs
Bouncing Blank Check Companies Jonathan Greenstein
Inside Scope
Investing Today
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Global Shipping
Back to Business: World Trade in the Wake of the Great Recession Maxwell Young Real Estate
Analyzing a Commercial Real Estate Bubble Matthew Cohen
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Hedge Funds
What the Aftermath of the Financial Crisis and Recent Financial Scandal Means for the Hedge Fund Industry Karl Wichorek Derivatives Trading
Recessionary Trading: Credit Default Swaps and Capital Structure Arbitrage Ike Greenstein Fundamental Analysis
An Argument for Returning to the Fundamentals Sarah Wang
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Investment Harvard College
Winter 2010
The Harvard College Investment Magazine (HCIM) is a semi-annual publication devoted to presenting the significant and current topics of investment and finance. Blending professional articles, interviews, and academic research, the magazine offers a comprehensive array of commentary to the investment field, serving as a platform of intellectual exchange between the professionals and the Harvard academic community. ADVER TISING advertise@harvardinvestmentmagazine.com
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COPYRIGHT 2010 (ISSN: 1548-0038) HARVARD COLLEGE INVESTMENT MAGAZINE. No material appearing in this publication may be reproduced without written consent of the publisher. The opinions expressed in this magazine are those of the contributors and not necessarily shared by the editors. All editorial rights reserved.
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estmentMa Letter from the Editors Dear Reader, Welcome to another issue of The Harvard College Investment Magazine. In this Winter 2010 issue we are excited to bring you analyses of some of the most relevant and interesting developments in the world of investing today. With the worst of the 2008-2009 crisis behind us, there is much to cover both in looking back at what happened and in looking forward to a new world of finance reshaped by the lessons of the eventful recent past. In this issue, our writers review the causes and effects of the crisis and what they mean for various aspects of the new financial landscape. The real estate bubble and use of financial derivatives are explored for their roles in the crisis. We analyze how the world of high-finance, particularly the hedge fund and private equity industries, may come back from the recession. In addition, given the worldwide scope of the crisis, we investigate the prospects for emerging markets and the global shipping industry. And, in perhaps our most forward-looking piece, the impact of the market for carbon emissions on global warming is scrutinized. Moreover, to provide perspective over a broader time horizon, we have added new online magazine display capabilities to facilitate viewing the HCIM archives on our revamped website at www.harvardinvestmentmagazine.com. We hope you enjoy enhanced access to issues back to our first issue over five years ago, in 2004. Finally, on the behalf of all of the Harvard College Investment Magazine, including our dedicated editorial and business staffs, our talented designers, and our Emeritus Board, we hope you enjoy this issue. Sincerely, Jonathan Greenstein and Matthew Lee Editors-in-Chief
WINTER 2010
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is the color of
How Environmental Goals Gave Rise t
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hat is common to a chicken farmer in Thailand, a trader in London, and the most powerful man in the world? All three are oiling the wheels of the carbon economy. At the end of 2009 world leaders met in Copenhagen for the UN Climate Change Conference to review the international protocol that has given rise to the carbon market. Even in the carbon market’s nascent form, the World Bank valued 2008 market transactions at over $120 billion. Decisions made in Copenhagen could ultimately see that increase fifteen-fold by 2020 according to carbon data specialist, New Carbon Finance. The consequences however go beyond the financial markets. The successful application of international protocols could prevent an environmental Armageddon.
The Basic
Science
The Greenhouse Effects
The Earth is naturally blanketed by greenhouse gases. These have warmed the world by an average of 0.74 degrees Celsius over the past 100 years according to the UN scientific body, the Intergovernmental Panel on Climate Change (IPCC). Excess emissions of greenhouse gases enhance the natural greenhouse effect – the IPCC predicts that if emissions continue to rise at their current rate, the average world temperature will rise by three degrees Celsius in the next 100 years. The consequences would be catastrophic. Droughts, cyclones, forest fires, crop failures and clean water scarcity are all cited as potential consequences in the IPCC’s Fourth Assessment Report. And these are just the tip of the (melting) iceberg. When gases are ranked according to their contribution to the greenhouse effect, carbon dioxide (CO2) emerges as the lead contributor, according to the American Meteorological Society. Thus ‘greenhouse gases’ are commonly used interchangeably with ‘carbon’. There is more than a 90% probability that the human activity emitting greenhouse gases is causing climate change,
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according to the IPCC. Faced with these statistics, global leaders have adopted an environment international treaty with the goal of stabilising greenhouse gas concentrations in the atmosphere. The Politic
s
The Kyoto Protocol
The UN Framework Convention on Climate Change (UNFCCC) treaty gave rise to the Kyoto Protocol, an international rule adopted in a December 1997 meeting in Kyoto, Japan. Industrialized countries party to the Protocol committed to reduce their greenhouse gas (‘carbon’) emissions by an average of 5.2% compared with 1990 emissions, in the period 2008-2012. To enable countries to meet their emissions targets, the Kyoto Protocol set out an emission trading scheme based on a ‘cap-and-trade system’. Industrialized countries can also meet part of their obligation by investing in projects that reduce carbon emissions in developing countries, under a mechanism defined in the Protocol. Thus, issues of global warming and sustainable development are addressed. WINTER 2010
to a $120 Billion Carbon Market The System
Cap-and-Trade
The emissions targets defined under the Kyoto Protocol are expressed as a quota: the level of permitted emissions, or ‘assigned amounts.’ Those amounts are divided into ‘assigned amount units’ (AAUs). For the five year compliance period of the Protocol, nations that emit less than their quota will be able to sell AAUs – effectively their excess emission capacity – to countries that exceed their quota. The quota is a cap on the aggregate sources of carbon production. The AAUs create a unit of trade that enables those sources to distribute that pollution load. Hence, the system is called capand-trade, and its market implementation is the carbon market. From an economic perspective, the carbon market directs participants to the lowest cost solution to comply with pollution regulation. Countries can choose to either reduce emissions internally, or to buy and sell AAUs in the carbon market. For example, Greece could invest in carbon reduction technology that reduces its output at an equivalent cost of $5 per unit of emission. One unit of emission on the carbon market, an AAU, may cost $8. By reducing its carbon emissions further than required in the
Protocol, Greece may profit by expending a cost of $5 per unit and selling the excess capacity in the market at $8 per unit. Similarly, France, for example, could invest in carbon reduction technology that reduces its output at an equivalent cost of $10 per unit of emission. If the cost of one AAU in the market is $8, France can make a $2 saving per unit that it purchases in the market instead of reducing emissions internally. In economic terms, this saving represents the gains from trade – the expense that France would have incurred if it had to reduce its emissions without trading. The carbon market exploits the differences in the cost of reducing carbon emissions for each participant. Efficient allocations arise from trading: participants benefit either from the sale of excess capacity, or from the purchase of AAUs at a discount to internal investment costs. Environmental benefits arise from the cap, which is reduced over time. The cap is fundamental: it creates market scarcity by creating a shortage of AAUs relative to the requirements of market participants. In defining the cap, the government is innately intertwined with the market.
By Anita Panchmatia Clean Development Mechanism And the Thai chicken farmer? The Kyoto Protocol defines the Clean Development Mechanism (CDM) that allows industrialized countries to “claim emissions units for financing projects that reduce greenhouse gas emissions in developing countries.” Chicken manure generates hundreds of tons of methane. The Thai farmer cannot afford the technology to capture that methane. The farmer can however engage a carbon trading company that can issue certificates quantifying the methane and pay that farmer for each certificate. Thus the farmer can install a methanecapture kit that he would not have otherwise installed, generating power for his locale. The carbon trading firm can sell the certificates, at a premium, to carbon brokers and ultimately to carbon market participants. Those participants can use the certificates, also known as Certified Emission Reductions (CERs), to meet their obligations under the Kyoto Protocol. Projects generating CERs vary from building wind farms in Mongolia to paying Brazilian landowners to preserve their rainforest. CERs represent an offset of emissions, a carbon credit, derived from ‘clean’ technology while AAUs trade emissions under a market cap.
The carbon market exploits the differences in the cost of reducing carbon emissions for each participant. WINTER 2010
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The system
Advantages
Carbon trading represents the successful application of economic theory to business practice: the ‘invisible hand’ guides market participants to reduce the highest emitting gases with the lowest cost outlay. The market rewards participants that over-reduce their emissions by providing a revenue stream from the sale of excess emission capacity. As demand for emission units increases, so will the units’ market price, acting as a catalyst for participants to innovate their domestic carbon reduction technology. Financial pressure motivates environmental change.
T h e Ma r k e
By pricing the environmental externality – greenhouse gases – market participants have a clearer understanding of the cost of their actions. Under the CDM, investments can be effectively directed towards lowercarbon activities. These investments spark competition in, and provide a financial incentive for, sustainable development. They also facilitate a transfer of wealth from industrialized to developing countries. The system offers market participants prized flexibility: the flexibility to take a common but differentiated approach to solving the pollution problem.
ts
Kyoto and EU ETS
The Kyoto Protocol Emissions Trading Scheme and European Union Emissions Trading Scheme (EU ETS) implement the cap-and-trade system described above. There is an overlap in infrastructure, participants, and products in both markets Participants in the Kyoto Protocol emissions trading scheme trade units that are each equal to one ton of carbon dioxide-equivalent emission (tCO2e). Market participants are restricted to countries that have ratified the Kyoto Protocol. All participants must maintain a reserve of units to ensure that they do not oversell their capacity and miss their targets. Registry systems are defined under the Protocol to track the transfer of AAUs between participants (through emissions trading) or the addition of credits to a participant’s holdings (through CERs, or other units generated through eco projects). The same registries facilitate trade ‘settlement:’ the transfer of units from the account of one market participant to another. An International Transaction Log provides market oversight,
consistently the biggest market contributor, comprising almost three quarters of the value transacted on the carbon market in 2008. The EU ETS is the first mandatory CO2 emissions trading scheme in the world, and the largest multi-national scheme. When it launched in January 2005, all EU member states were participants, allocating units to the most energy-intensive industries. Thus 12,000 of the EU’s largest CO2 emitters, from power plants, to construction companies to cement manufacturers, were given EU Allowance units (EUAs) equal to the value of the carbon that they were permitted to emit. EU ETS accounts for 50% of EU greenhouse gas emissions, and is credited for reducing that load by about 100 million tons of CO2, according to CNN’s September 2008 analysis. This was achieved primarily by shifting energy production from coal to gas power plants, and by improving the thermal efficiency of boilers in coal plants. The governments of the EU member states set and track compliance with market caps. The European Commission oversees the market. Trading may occur on Europe’s biggest climate exchange, the European Climate Exchange, ECX. Two types of carbon credits are traded on ECX: EUAs and CERs. The ‘physical’ commodity, carbon gas, is traded via financial derivatives. ECX develops and markets these derivatives; they are traded using the technology of ICE Futures Europe. ECX offices are located in London, the ‘center of the carbon finance market,’ according to market consultancy Point Carbon. Carbon units are generally more expensive under the EU ETS than the Kyoto Protocol emissions trading scheme, reflecting the higher cost of reducing carbon emissions in industrialized countries. In addition to the cost of carbon reduction technology, the carbon market is also driven by fuel and power markets, the weather, the future supply of offset credits, and, most notably, government policy.
The EU ETS is the first mandatory CO2 emissions trading scheme in the world, and the largest multi-national scheme. verifying registry transaction in real-time to ensure compliance with the rules defined under the Kyoto Protocol. At the end of the Protocol commitment period, the emission unit holdings for each participant will be compared with that participant’s targets over the commitment period and compliance with the Protocol will be assessed. The market trading credits from eco projects (the ‘CDM market’) comprised 27% of the $120 billion traded in the carbon markets in 2008, according to the World Bank. This is a 5% increase from 2007, when the carbon market was half the size. The EU ETS is
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T h e Ma r k e
ts
Trends
The recent economic recession saw a decline in 2008 carbon market prices, as with other markets. Demand for steel, housing, and cement declined, causing reduced economic output and a fall in commodity prices. Carbon market participants emitted lower emissions than expected, resulting in a low demand for carbon units. In fact, in September 2008, the EUA market experienced a sell-off by participants who realized the value of their excess capacity and used the markets to raise cheap cash, according to the World Bank. The sell-off was exacerbated by the fact that allowances are granted for free under the EU ETS. By contrast, the market for financial products that manages exposure to fluctuating prices and trade volumes grew five-fold between 2007 and 2008, based on ECX options trade volumes. The CER market weakened considerably throughout 2008. This is likely due to financing for eco projects being more difficult to secure in the recession environment and financial institutions being more focused on tightly managing their exposure to counterparties, including carbon project developers. The CER market slowdown could also be attributed to uncertainty around post-2012 policy and the end of the Kyoto Protocol commitment period.
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Two main criticisms are levelled at the carbon markets: that they are inefficient and that they are poorly policed. The System
Criticisms
Two main criticisms are levelled at the carbon markets: that they are inefficient and that they are poorly policed. The two countries with the largest carbon dioxide emissions, the United States and China, have not ratified the Kyoto Protocol. This raises questions as to how effective nations that are subject to cap-and-trade systems will be in meeting global environmental objectives. International pressure could be applied to influence countries that cause ‘leakage’ from the carbon economy, but policy is difficult to define. Should goods from those countries be taxed? What if those goods were produced only for export to carbon market participants? Opponents also comment on the inefficiency of the cap-and-trade system, arguing that it enables polluters to buy their way out of carbon emissions quotas. Thus resources are diverted away from long-term technological innovation and low-cost solutions are locked in. Market participants may condemn the uncertainty
around the long term cost of complying with legislation, introduced by a cap that fixes the quantity of carbon emissions while allowing prices to fluctuate. It may be preferable to introduce a tax that effectively fixes the unit price as emissions vary. Market inefficiencies may also arise as countries introduce their own cap-andtrade systems, as is the case in several states in the United States. Carbon units are developed that are not interchangeable, or ‘fungible’ with units in other carbon markets. This may give rise to market instability, illiquidity, and pricing difficulties. While new products and competition are good, consolidation under a universal architecture will reduce market complexity. The importance of policing the market can be broadly categorized into proper measurement, reporting and regulation. Measuring carbon emissions is difficult, sometimes requiring sensors to be inserted into chimney
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stacks, and other times relying on theoretical calculations. Without equivalent units and measurement techniques across market participants, market inventories can quickly become inconsistent. This issue plays to the concerns of Jim Hansen, director of the NASA Goddard Space Flight Center, who told the Financial Times that “carbon trading rules are too complex and they create an entirely new class of lobbyists and fat cats.” The World Bank has already identified issues around emissions reporting, stating that “the exact cap (amount of allowances in circulation) for 2008 is not known with accuracy.” Without accurate reporting, the market cap will be difficult to define and the value of carbon units, undermined. The EU ETS market virtually collapsed in 2006 as too many carbon units were distributed, according to CNN. Units per country were allocated based on previous carbon emission levels (‘grandfathering’); as levels had since decreased, there was an over-supply of units in the market. Some countries are now auctioning units to increase their scarcity. The first auction of Britain’s CO2 units, in November 2008, was four times over-subscribed and raised GBP 54 million, according to The Times. The carbon market can be difficult to regulate – should regulation take the form of fines or sanctions? How much would this cost to administer? Accusations of gaming have already arisen in the CDM market. Companies are claiming carbon credits for renewable energy projects that they would normally undertake, according to the Financial Times. This undermines the CDM principle of ‘additionality’ where emission reductions must be generated by project activities additional to those that would otherwise occur. Complexities also
arise when defining the length of commitment periods and the choice of the benchmark year. Louisiana State University economist, Joseph Mason, underscores the significance of carbon market regulation as he stated in the Wall Street Journal: “Managing a carbon permit market will be far more complex than managing the money supply, which indeed is already tremendously complex, leading to cyclical booms and busts.”
C arbon tr
ading
The Future
The United States is back at the table, the World Bank announced in its 2009 report. June saw a pivotal climate change bill pass through the U.S. House of Representatives. The Waxman-Markey bill, formally titled the Clean Energy and Security Act, is a legislative proposal to establish a national renewable energy standard and an economy-wide cap-and-trade system. The draft bill requires U.S. economy-wide emissions to be 3% below 2005 levels by 2012, and 17% below 2005 levels by 2020. Any decision may be announced at the UN Climate Change Conference in Copenhagen and will impact everyone, from the Thai chicken farmer to the London trader. And as for the most powerful man in the world? President Obama was rousing in his March 2009 speech: “We have a choice to make... We can let climate change continue to go unchecked, or we can help stop it. We can let the jobs of tomorrow be created abroad, or we can create those jobs right here in America and lay the foundation for lasting prosperity.”
References 1. The World Bank (May 2009), State and Trends of the Carbon Market 2009 (http://web.worldbank.org/ WBSITE/EXTERNAL/TOPICS/ENVIRONMENT/EXTCAR BONFINANCE/0,,contentMDK:21844884~menuPK:5 221277~pagePK:64168445~piPK:64168309~theSite PK:4125853,00.html)
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2. Energy and the Environment. Whitehouse.gov. Retrieved October 2009. (http://www.whitehouse.gov/ issues/energy-and-environment/) 3. Emissions Trading Mechanisms. Unfcc.int. Retrieved October 2009. (http://unfccc.int/kyoto_protocol/ mechanisms/emissions_trading/items/2731.php) 4. Emissions trading. Wikipedia.org. Retrieved October 2009. (http://en.wikipedia.org/wiki/Carbon_emissions_trading) 5. Intergovernmental Panel on Climate Change, IPCC Fourth Assessment Report: Climate Change 2007. (http://www.ipcc.ch/publications_and_data/publications_and_data_reports.htm#1) 6. November 30th 2008, The Fool’s Gold of Carbon Trading: A huge new market designed to solve global warming seems doomed to failure, The Financial Times. 7. ECX Products. Ecx.eu. Retrieved October 2009. (http://www.ecx.eu/ECX-Products) WINTER 2010
Can Em erg i n g M ar ke t s K eep
Emergi ng ? By Marc Steinberg
A
ny first-year economics course will invariably include a discussion of the theory of convergence, whereby less developed economies tend to grow at a much faster rate than their wealthier counterparts. Hoping to capitalize on this fundamental tenet of macroeconomics, investors have over the past two decades shifted their funds into lesser developed nations with faster GDP growth rates. Inflows to emerging markets have risen from
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roughly $10 billion in 2003 to more than $60 billion in 2009. Having been met with unprecedented success in recent years, equity investments in emerging markets have proven to be enormously lucrative for those who are willing to accept more volatility in their portfolio. But can emerging markets continue to realize such rapid economic gains even as they become more and more developed? Over the past two years, the global
economy has fallen victim to a widespread and devastating economic downturn. While many nations have suffered tremendous financial setbacks, emerging markets are poised to emerge from this recession relatively quickly and continue to grow at a pace that far outstrips that of their developed counterparts. For example, emerging market economies in Asia such as China, India, and South Korea are predicted to grow by more than 5 percent in 2009 - a marked im-
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provement over the developed economies of the G7 which are predicted to shrink by more than 3.5 percent. The recent global financial crisis will only help to accelerate the fundamental transformation of emerging economies from export-dependent nations to value-added, domestically-driven producers. Many of the world’s emerging markets, particularly those in Asia, have in the past developed primarily as exporters due to labor arbitrage and growing demand abroad. Recently, however, demand for these goods has shifted inward insofar as the economic growth of many emerging nations is now being driven largely by fixed investment and domestic consumption with some developing nations having even become net importers, including India and Turkey. This transition has allowed for emerging markets to experience economic growth despite the significant reduction in exports induced by the financial crisis. Chi-
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na’s economy, for example, has continued to grow despite the recent financial crisis largely because its year-over-year fixed asset investment has risen 34% in the first half of 2009. Moreover, this fundamental shift inward will allow emerging markets to realize the full potential of developing nation consumers, who now account for more than 80% of the world’s population. Thus, even if the economies of many developed countries begin to stagnate and consequently dampen overall demand for exports from emerging markets, developing nations will be able to sustain their economies from within instead of relying so heavily upon the economic prosperity of other developed nations. The future success of emerging markets will be driven by the newfound domestic demand as a consequence of further industrialization. In fact, not only are emerging market industrial corporations, such as telecommunications giants ZTE Corporation and Orascom Telecom, serving as viable eq-
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uity investments, but they are also providing the foundation necessary for a rapid increase in domestic demand. For example, research has demonstrated that a 10% increase in mobile phone penetration is associated with an increase of 0.6 % in economic growth while the same penetration growth in high speed internet access yields a 1.3 percent increase in GDP growth. As emerging markets continue to develop technologically and industrially, they are simultaneously facilitating their own economic growth. From a valuation perspective, many emerging markets represent a far better value buy than their developed counterparts. At the end of September 2009, the P/E ratio of the MSCI Emerging Markets Index was just under 14 times, a value well below the MSCI World’s P/E ratio of over 25 times. Moreover, several emerging markets are now trading at single-digit P/E ratios such as Pakistan and Russia whose P/E ratios were measured at 9.3 times and 6 times WINTER 2010
respectively as of summer 2009. In the past, many investors were induced to steer clear of the highly profitable emerging markets because of their high level of volatility. Due to unstable governments as well as uncertain economic and monetary policies, emerging markets had previously been highly susceptible to external market shocks. In recent years, however, developing nations have established highly robust and stable economies due to largely
from one year to the next and these heavily indebted countries had no choice but to default. Consequently, to make investments in emerging markets worthwhile, the returns on investment must compensate for additional portfolio variance. In spite of recent economic downturns, however, emerging markets have proven to be a profitable asset over time. For example, while investments in developed markets as measured by the MSCI World Index are, after 10 years
markets due to the possibility of substantial short-term losses, the long-term returns of emerging markets remain unrivaled by similarly-timed equity investments in developed nations. Moreover, the transitioning nature of emerging markets makes them better equipped to flourish in the wake of the current financial crisis. As demand shifts inward, emerging markets will be able to realize the benefits of economic convergence which have been profiting foreign investors
Even if the economies of many developed countries begin to stagnate and consequently dampen overall demand for exports from emerging markets, developing nations will be able to sustain their economies from within instead of relying so heavily upon the economic prosperity of other developed nations. positive current account balances and tremendous quantities of foreign-exchange reserves, such as China’s $1.9 trillion in foreign reserves. Decreased dependence on demand from the developed world as well as prodigious capital reserves have equipped emerging nations with the resources necessary to weather financial setbacks. Such decreased risk is manifested in the fact that the Vanguard Emerging Markets Stock Index, which purchases all stocks listed under the MSCI Emerging Markets index, has a 10-year beta of only 1.27. This relatively safe value sits comfortably below the historic beta value of the Morningstar Small Blend category which is comprised solely of American stocks. Despite the aforementioned reductions in the volatility of emerging markets, there are still several risks inherent in these relatively underdeveloped nations including, inter alia, political instability, currency fluctuations and export dependency. Several emerging market economies in the past, including South Korea, Malaysia, Russia, and Argentina, collapsed when foreign investors stopped lending funds out of the fear that these nations would be unable to repay their debts. In doing so, they precluded such nations from carrying their obligations over WINTER 2010
hardly reaching their initial levels, investments in emerging markets, as measured by the MSCI Emerging Markets Index, have in fact doubled. Moreover, although the MSCI World has increased a mere 5.2% from December 31, 1998 to May 31, 2009, the MSCI Emerging Markets had returned a resounding 236.2% over the same period. Although myopic tendencies continue to induce many investors to avoid emerging
for decades while simultaneously reducing the risks associated with dependence upon foreign demand for exports. Although it is unlikely that such investments will continue to see the double-digit annualized returns, the fundamental changes to developing countries have established a legitimate foundation for the long-term growth and profitability of emerging market investments.
References: http://www.economist.com/opinion/displaystory.cfm?story_id=14214001 http://www.tradingeconomics.com/Economics/Balance-Of-Trade.aspx?Symbol=INR http://www.finfacts.ie/irishfinancenews/article_1017260.shtml http://www.franklintempleton.com/share/pdf/lit/TLEM_COMM_1009.pdf http://economictimes.indiatimes.com/News/News-By-Industry/Telecom/Emergingmarket-firms-turn-giants-in-telecom-sector/articleshow/5094092.cms?curpg=2 http://www.financialadvisory.com/article/16-06-2009/p-e-ratios-of-emergingmarkets http://bespokeinvest.typepad.com/bespoke/2009/06/country-pe-ratios.html http://www.google.com/finance?client=ob&q=MUTF:VEIEX http://www.usatoday.com/money/perfi/columnist/waggon/2006-06-15-risks_x.htm http://blog.foreignpolicy.com/posts/2009/03/27/good_analogy_alert_the_us_and_ collapsing_emerging_market_economies http://www.schroders.com/staticfiles/Schroders/Sites/Europe/Switzerland/schroders-emerging-markets-presentation.pdf
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Another Look at
Private Equity
“The recent headline PE deals that have occurred…consisted of far less leverage—and thus far more equity—than the iconic deals of the past.”
B
efore the recent financial crisis private equity had some star power on the Harvard campus, helping to drive routine double-digit returns in the endowment and attracting many recent grads with the promise of adrenaline-pumping deal-making and large salaries. But as big banks started layoffs and the Harvard endowment took a 27% plunge over the past fiscal year, private equity (PE) lost quite a bit of its luster. It was one of the worst-performing assets in the endowment, with the value of externally managed PE holdings falling 31.6% and becoming stubbornly illiquid. The industry screeched to a halt, with depressed asset prices, closed debt markets, and an overall dearth of M&A activity. Now, with economic recovery in sight, PE activity is beginning to rise again. But even so, the future of private equity seems destined to be much different than what was envisioned just a few years ago.
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A role in the world At the height of the crisis, many aspects of the modern finance—from derivatives to bonus-heavy compensation structures-were called into question (with varying degrees of justification), and their roles in the financial system were often presented as misguided or even pernicious. In this skeptical environment, the private equity industry, known by many only for being barbarians at the gate of good companies and for having execs who can commission Rod Stewart for their birthday parties, was not spared. Many have thus asked, just what is the role of private equity anyway? At a guest lecture at Yale in April 2008, Stephen Schwarzman, a graduate of Yale undergrad and Harvard Business School and known for founding The Blackstone Group, provided a high-level look at the industry’s value as an investment vehicle. Mr.
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By Matthew Lee Schwarzman explained that private equity shops can sign confidentiality agreements to access confidential information from potential acquisition targets to determine their value, something that would not be possible in the public markets due to restrictions on inside information. Then, through modifications and improvements, PE shops attempt to increase the value of their portfolio companies to earn a high return. Moreover, returns are magnified for PE funds through their use of leverage, historically 3-to-1. The results have been impressive: 31% beforefees and 23% after-fees is the Blackstone PE record according to Mr. Schwarzman. Of course to be a good investment vehicle, private equity must at least in theory contribute to the value of the companies that they buy and sell. Some of the possible benefits to companies of private equity ownership are discussed in a recent article in the Journal of Economic Perspectives by acWINTER 2010
ademics Steven Kaplan and Per Stromberg. They note that private equity owners often require the management of profile companies to accept compensation packages that are designed to incentivize performance, often through management equity ownership in the company. The expected result is management that is more focused on improving the company long-term rather than appeasing fickle public market investors quarter-by-quarter. Moreover, Kaplan and Stromberg suggest, the high leverage put on portfolio companies effectively earmarks cash flows for debt servicing, preventing the potential principle-agent problem in public companies of management wasting rather than returning cash to shareholders. Finally, the active involvement and expertise of the private equity owners is designed to translate into superior improvement in the operations of portfolio companies, increasing productivity as well as future value. WINTER 2010
Hammered in the crisis
Signs of recovery
Whatever fundamental value-add the private equity industry is supposed to provide seemed to evaporate in the midst of the financial crisis as credit froze and appetite for IPOs or M&A deals disappeared—simultaneously making it nearly impossible to use leverage to make new investments or to exit matured investments. According to Dealogic, PE deals in the first half of 2009 totaled just $24 billion, down from $131 billion in 2008 and the massive $528 billion in 2007. In addition to the dearth of new deal activity were tremendous losses from past deals. The “above-the-fold” news items on the implosions of Linens ‘n Things, Chrysler, and Washington Mutual were what put PE in the headlines rather than mega-deals, and each collapsed investment translated into billions of dollars worth of losses for their private equity backers.
The reopening of credit and equity markets and return of normalcy to the economy has also led to renewed activity in private equity. A recent Economist article highlighted announcements by mega-funds of planned IPO exits from a number of their investments, including KKR’s Dollar General. In October 2009, Mr. Schwarzman suggested up to eight IPOs of Blackstone portfolio companies may be hitting the market in the near future. The return of cash from these exits is undoubtedly happy news for investors after the illiquidity of the previous year. The fact that such activity is again possible is a promising sign for the industry and the economy as a whole. The performance of the big buy-out firms themselves have also improved since early 2009. Shares in NYSE-listed Blackstone has recovered considerably from
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its financial crisis low of $3.55 to trade in the mid-teens in recent months. Similarly, shares in Fortress Investment Group have recovered from a 52-week low of $0.77 to trade in the $4 to $5 range. These results are still a far cry from the $31 per share IPO price of Blackstone or the $35 opening-day price of Fortress in 2007, but it may just be enough to indicate that the worst is over for the industry. In October 2009, KKR completed a reversemerger with one of its Euronext-quoted funds to become publicly-traded. This move precedes the mega- fund’s expected IPO in the U.S. which was originally announced in 2007 but was delayed because of the financial crisis. According to a Reuters source, U.S. listing may come as early as spring 2010.
A changed game Recovery from the lows, however, does not mean things will return to the 2006-2007 days. The future of private equity promises to look very different. For one, the size and structure of deals has already changed. The tremendous amount of capital commitments investors made to various PE funds during the boom, totaling more than $500 billion of callable capital still available for new investments, is no doubt a source of comfort to the industry. But while this hoard is staggering, the availability of cheap credit is just as important as committed capital for an industry whose outsized returns depend on leverage. That cheap credit has not come back—and there are worries it may never (or at least not for some time). As a result, the recent headline PE deals that have occurred, such as the $2.7 billion Blackstone purchase of the Anheuser-Busch theme parks and the $2 billion Silver Lake purchase of Skype from eBay, consisted of far less leverage— and thus far more equity—than the iconic deals of the past. With politics and government seemingly pushing for a larger role in the finance industry, private equity may have something to worry about. The favorable tax-treatment of carried interest (taxed at 15% rather than the typical income tax rate of 35%) has long been controversial. Although Washington seems to be busy with the situation in Afghanistan and healthcare reform, the issue—with its large ramifications for the private equity industry—is unlikely to have
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gone away for long. The location of activity seems also likely to be different, with many more deals potentially happening in Asia. Activity in Asia this year has picked up impressively, from the perspective of both exits and new investments. Mega-fund TPG is realizing returns from investments such as Myer, a department-store in Australia, and Shenzhen Development Bank, a financial institution in China. New investments such as the $1.8 billion acquisition of South Korea’s
PE deals in the first half of 2009 totaled just $24 billion, down from $131 billion in 2008 and the massive $528 billion in 2007.
Oriental Brewery by KKR in May 2009 are an impressive sign of activity in the region.
An enduring industry The final question Mr. Schwarzman fielded at the Yale lecture was on the evolution of private equity: “Private equity is an enduring asset class because it basically makes really great returns. It attracts very talented people. It reallocates capital around the globe. It goes where there’s opportunity and it improves companies by investing more capital in these businesses. So, there’s an enduring place for private equity.” Admittedly, when he said this it was still April 2008, before the worst of the crisis when the world of finance fell apart. But now with that storm past and the economy picking back up, it does seem that private equity— changed, yes, and perhaps tamed—still has a place in the future of the finance industry.
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References “Blackstone CEO Sees Up To 8 IPOs In ‘near Future’.” CBSNews 14 Oct 2009. Web. 1 Nov 2009. <http://www.cbsnews.com/ stories/2009/10/14/ap/business/ main5383330.shtml>. “Back on the catwalk.” Economist 01 Oct 2009. Web. 1 Nov 2009. <http://www.economist.com/ businessfinance/displaystory. cfm?story_id=14558593>. Davies, Megan. “KKR completes deal with fund.” Reuters 01 Oct 2009. Web. 1 Nov 2009. <http://www.reuters.com/article/companyNews/ idUKLNE59001420091001>. Halperin, Alex. “Investors Storm Fortress IPO.” BusinessWeek 09 Feb 2007. Web. 1 Nov 2009. <http://www.businessweek. com/investor/content/feb2007/ pi20070209_895342.htm>. Kaplan, Steven, and Per Stromberg. “Leveraged Buyouts and Private Equity.” Journal of Economic Perspectives. 23(2009): 121-146. “Private equity makes a comeback.” Economist 28 Jul 2009. Web. 1 Nov 2009. <http://www.economist. com/businessfinance/displaystory. cfm?story_id=14116441>. Schwarzman, Stephen. “Financial Markets: Lecture 20.” ECON 252: Financial Markets. Yale University. New Haven, CT. 11 Apr 2008. Lecture. <http://oyc.yale.edu/ economics/financial-markets/ content/transcripts/transcript20-guest-lecture-by-stephenschwarzman>. “Sticking-plasters of the universe.” Economist 29 Oct 2009. Web. 1 Nov 2009. <http://www.economist.com/businessfinance/displaystory.cfm?story_id=14753850>. Zhu, Peter. “Harvard Endowment, Largest in Higher Education, Plummets by 27%.” Harvard Crimson 10 Sep 2009. Web. 1 Nov 2009. <http://www.thecrimson.com/ article.aspx?ref=528856>.
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Bouncing Blank Check Companies By Jonathan Greenstein
S
pecial Purpose Acquisition Companies (SPACs) were all the rage a couple of years ago, a must-have accessory for celebrity financiers such as Ronald Perelman, Tom Hicks, and Nelson Peltz, what the NYSE and Nasdaq clamored to list, and the mechanism responsible for bringing popular companies such as Jamba Juice and American Apparel to public markets. However, they now stand on much more uncertain ground as the credit crunch and market volatility of the recent recession have given cause for a reevaluation of their fundamental structure and the incentives it provides.
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What is a SPAC?
SPACs are a type of investment vehicle first introduced in the early 1990s that are best thought of as blank-check companies, publicly traded buyout firms, or “a poor man’s private equity.” In their initial form, before the SEC got involved and promulgated Rule 419 of the Securities Act, blankcheck companies had many detractors as they were involved in a number of frauds. A SPAC is a shell company, without a defined business plan or operations, which is set up solely for the purpose of buying an unspecified company with the capital raised from
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its issue of stock and warrants to the public. The capital is deposited into a trust until an acquisition is finalized and the company signs a letter of intent for an acquisition to be made within 12 to 24 months; if no acquisition is finalized before the deadline, the SPAC is liquidated and the money returned to the investors (plus interest, but subtracting start-up costs and underwriting fees). If the acquisition fails – a proposed acquisition typically requires 80% shareholder approval – the SPAC managers forfeit the traditional 20% ownership stake they obtain in the postacquisition company, along with their personal investment. If a purchase does goes through, the acquired company becomes publicly listed. As is immediately evident, the incentives to simply complete any deal are tremendous. For investors, SPACs on the surface offer significant downside protection through the ability to vote down an acquisition, while most of the risk is held by the SPAC managers. Additionally, their public nature provides the benefit of Year liquidity and easy exit from in- 2008 vestments. They also provide more 2007 transparency relative to private equity as they are public compa- 2006 nies falling under SEC disclosure 2005 requirements. Despite this theory 2004 though that suggests SPACs are a vehicle through which regular in- 2003 vestors can gain access to exclusive Total private-equity style investments, in reality, hedge funds have provided the bulk of the investor base as the SPACs are sold as a stock and warrant unit that splits, giving hedge funds different options on how to handle the securities given their investment strategies. For the target company in an acquisition, agreeing to be bought by a SPAC represents a quicker and cheaper mechanism through which to become a publicly traded company. Instead of having to pay listing fees, the target is paid to list its shares and the company can escape the scrutiny that a traditional public offering brings. This ‘reverse-merger’ style transaction has been used by Jamba Juice, American Apparel, and the major European hedge fund, GLG Partners, to achieve public listings.
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would thrive. These blank-check companies were thought to be able to offer viable balThough the SPAC financing model has ance sheet assistance to troubled companies been around for nearly two decades now, or legitimate exit opportunities for private it was not until 2004 that it gained real equity firms looking to realize returns. For popularity, providing an intriguing vehicle example, in June 2008, private equity firm through which to benefit from the mergers Apollo Global Management agreed to sell and acquisitions boom. SPACs found ready Hughes Telematics, an automotive GPS buyers in the hedge funds that were full of supplier, to the Polaris Acquisition Corcash and looking for new places to invest poration for $700 million. However, these types of deals panned out far less than expected as they fell prey to the same fundamental buyer-seller valuation spread that widens in recessionary times. Further, even SPACs use leverage to assist in buying companies, and thus similarly faced problems stemming from financing issues because of the recession’s credit crunch. As the large number of SPACs issued in 2007 approach their acquisition deadlines, around 30 had been forced to liquidate as of October 2009, many of which were sunk by shareholders’ disapproving purchases. Apart from the general # of SPACs Issued Average Deal Size (Million) market related problems explained above, much of the difficulty asso17 $226.0 ciated with obtaining the requisite 66 $183.2 shareholder approval can be attrib37 $91.5 uted to the fact that the major set of investors in SPACs is hedge funds. 28 $75.5 As hedge funds were hit with re12 $40.4 demptions during the market’s col1 $24.2 lapse, liquidating SPACs and getting their hands on precious cash 161 $136.3 became more appealing than the Data from SPACanalytics.com prospect of holding on long-term. their money. According to SPAC Analytics, Hedge funds can also take significant blockat the peak in 2007, 66 blank-check com- ing positions, forcing management to pay panies were created with around $12 billion premiums to repurchase the hedge fund’s in cash to spend, a figure representing over shares in order to secure the acquisitiona quarter of all IPO’s in that year. They pro- approving threshold. In 2008, 21 acquisiliferated to such a point that the New York tion proposals were rejected, while only nine Stock Exchange and Nasdaq reversed their were approved. Some high-profile SPACs regulatory stances forbidding blank-check have successfully closed in the 11th hour companies and began pursing the listings though, in large part due to their founders’ acquisition companies to profit from the in- well-connected status in the financial world. creased listings, officially removing SPACs For example, the SPAC launched by Tom from the shadier domain of penny-stock Hicks obtained shareholder approval for a roughly $600 million acquisition of Denand over-the-counter brokers. There was the belief that in times of ver-based oil and gas company right before market downturns and the consequent diffi- its liquidation deadline. cult IPO market, SPACs, with all their cash on hand and downside protections offered,
From Boom Times to Deadlines
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Casting the Recession’s Light on the Real SPAC Winners Popular sentiment holds that SPACs are great as they offer to the public the upside of being able to partake in a private equitylike investment, with the additional benefit of eliminating private equity’s traditional lock-up period and giving the investor a choice of whether he approves of the transaction. However, what the economic downturn and current scramble to meet deadlines have revealed is that there are mechanisms that SPAC managers can employ to push withholding shareholders to vote in favor of a deal – these mechanisms standing on top of the fact that the nay vote entitles the shareholder to an amount slightly less than the original investment. As Kelly Hollman of the Investment Dealers’ Digest explains, one is the use of forward sales contracts, whereby the acquisition company gives a shareholder a payment of the trust amount and a small premium to the liquidation value of the stock in exchange for an approving vote. Additionally, SPAC managers have also used short-term loans from the target company to finance repurchases of shares from potentially disapproving investors. The downside of course is that if the transaction ultimately gets approved, the new company may be left having too little float. Looking more broadly at the success of SPACs, as of the end of October 2009, only 83 of the total 161 SPAC issued since 2003 completed an acquisition, with 54 so far having liquidated. More significantly perhaps in evincing the skill and diversification differences between private equity and SPAC management teams is the fact that the 83 acquired companies, according to SPAC Analytics, have an annualized return of -20.9% (compared to a benchmark of -7.0% for the Russell 2000). These returns beg the question of where any realized upside is for investors once the implicit put option of partaking in the transaction is eliminated. The claim can be made that empirically then, the real winners are the bankers who, no matter what happens with regard to an acquisition, collect the underwriting fees, which at around 10% of the offering are higher than the fees charged for traditional IPOs. This has lead to a push to get more of the money raised in the IPO into the trust
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in order to limit the maximum downside for investors. Though SPACs used to be an area dominated by smaller underwriters such as Morgan Joseph and Ladenburg Thalmann, in the boom, bulge-brackets including Citigroup, UBS, and Deutsche Bank jumped in for a piece of this highly lucrative action.
The Road Ahead for SPACs
“
SPACs are likely to reemerge as the markets pick up again, though in a different form than was seen a couple of years
At the peak in 2007, 66 blank-check companies were created with around $12 billion in cash to spend, a figure representing over a quarter of all IPO’s in that year.
’’
ago. Given the greater difficulty of completing larger acquisitions, as evidenced by the problems the SPACs formed in 2007 are currently having, it is likely that going forward SPACs will be smaller, seeking to raise $100 million or less. These smaller issues will be easier for shareholders to evaluate in the current market atmosphere and would also avoid competition from most big private equity firms. Though this reasoning seems to tie the fortunes of SPACs generally to market trends, what the recent ordeal for SPACs has shown is that they certainly are not a buttress in recessionary times, thus dampening the overly-optimistic view managers, investors, and targets had towards them in 2007. There is also the need for future SPACs to attract more fundamental, long-term investors such as mutual and pension funds, to overcome, among other things, the incentive problem of having short-term capital from
hedge funds. The critical obstacle SPACs face though in accomplishing such an end is the fact that there is really nothing to fundamentally analyze in a SPAC; it is a shell company holding a lot of cash. Goldman’s foray into the space in 2007 represents a move in this direction as it structured the SPAC it underwrote to reduce the typical 20% equity stake in the acquired company allocated to the SPAC management team to 7.5%. The intended effect was to attract a more stable investor base and make acquisition targets more inclined to agree to a takeover by reducing the dilution that acquisition targets and SPAC investors face because of the large amount of stock held by the management team, as well as to give management a stronger incentive to find a deal that would actually create fundamental value. Though the Goldman underwritten offering was ultimately withdrawn, because of the relative lack of regulation governing SPAC structures, it signals efforts that can be taken moving forward to revitalize blank-check companies. References Jenny Anderson, “Crave Huge Risk? This Investment May Be for You.” New York Times, September 23, 2005. Lynn Cowan, “After the Fall.” Wall Street Journal, May 30, 2008. DealBook Blog. “Wall Street’s New Status Symbol: the SPAC.” New York Times, December 7, 2007. Kelly Holman, “SPAC Market Wobbles.” IDDMagazine, May 1, 2009. Peter Lattman, “Yes, Risk is Back Now, with SPACs.” Wall Street Journal, September 29, 2009. Colleen O’Connor, “Increased Competition Tightens SPAC Structures.” IDDMagazine, February 6, 2006. Andrew Sorkin, “$300 Million to Burn, With a Catch.” New York Times, February 12, 2008. “Summary of SPACs.” Available online at: www.spacanalytics.com, October 2009. “The SPAC Report: Third-Quarter Review.” Available online at: www. dealflowmedia.com, October 2009.
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Back to Business: World Trade in the Wake of the
Great Recession By Maxwell Young
Receding recession
T
he world economy has finally stepped back from the precipice it first reached in 2007. Economic growth has returned, with 3.5% GDP growth in the third quarter of 2009, credit conditions have loosened due to government support, and academia is confident that the recession has nearly or actually ended â&#x20AC;&#x201C; confident enough that the last 18 months finally have a name: The Great Recession. 18
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As dismal a label as The Great Recession is, it cannot but bring to mind its “big brother” the Great Depression, whose specter haunted the darkest days of the past year. Yet even with consumer sentiment, economic indicators, and global stock markets at multi-decade lows, piece after piece of news assured us that the Great Recession and the Great Depression were not truly comparable – that while Federal Reserve Chairman Ben Bernanke’s deep knowledge of the latter would help cushion the former, there were many factors that made a repeat of the Depression extremely unlikely. Rapid passage of government stimulus, unprecedented monetary easing, supranational institutions and agreements forming an international financial framework, all prevented the bottom from falling out of the international economy. One of the most hyperbolic comparisons to the Great Depression dealt with the infamous Smoot-Hawley Tariff of 1930, which contributed to sending global trade spiraling downwards. Yet even today, in a new era of trade liberalization and globalization, trade has deteriorated; trade volume growth began to shrink (although it was still positive) in 2007, according to World Bank statistics. In 2009, global trade is forecasted to fall by 10%. How has the global shipping industry – that most tied to international trade – reacted to the crisis?
Getting back up The financial and housing sectors have with good reason received the most attention in the fallout from the Great Recession, yet all sectors of the economy are feeling the effects. Wildly fluctuating credit conditions have impacted some more than others; industries comparatively unaffected by such conditions have received less attention than those teetering on the brink of collapse. One such unwatched sector is global shipping, for which credit conditions are a lesser consideration next to the fall in commodity prices and collapsing GDP growth. Examining the industry is made easier by a simple division; the freight and air shippers in one category, their maritime counterparts in the other. The thesis is the same for both, however; hurt by the Great Recession, these companies look ready for a comeback as global trade rebounds. WINTER 2010
On the beaches, in the air The global freight and air shipping sector consists of many companies, several of whom are known in most of the developed world and increasingly in the developing as well: FedEx, UPS, Deutsche Post (better know in the United States through its subsidiary DHL) and TNT NV. These companies together employ over 1.3 million people, with combined revenues of over $150
“
These companies together employ over 1.3 million people, with combined revenues of over $150 billion per year, appropriately large figures for companies that can deliver around the globe.
”
billion per year, appropriately large figures for companies that can deliver around the globe. From humble bases as deliverers of small parcels and letters, these companies and others like them have expanded into major multinational corporations – indeed, what can be more multinational than the very companies that dispatch freight around the globe? With millions of deliveries daily, it is easy to see how a diminution of world trade affects these road and air haulers. Furthermore, the performance of these companies is highly correlated with GDP growth. Declining world trade and recessionary conditions (the first of which arguably contributes to the second) were among the two worst things that could happen to these companies.
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The financial and housing sectors were at the epicenter of the Great Recession, but it seems that world trade was not unduly battered by the shockwaves.
Oceanic traders Maritime shippers are obscure compared to the ubiquity of ground and air shipping companies – the average citizen, after all, is far more likely to order, say, a few shirts from overseas, rather than send several metric tons of iron ore to grandmother. The world merchant fleet has over a billion deadweight tons of capacity, which demonstrates the sheer volume ocean-going shippers transport. This vast number, however, is currently part of the industry’s problem rather than a symbol of its excellent performance. Leaving that for the moment, the most often used measure of global shipping conditions is the well-known Baltic Dry Index (BDI). The BDI tracks the daily cost of shipping dry bulk cargo (e.g. metal ores or coal) across various shipping routes around the world; accordingly it is influenced by commodity and fuel prices among other things. It follows that as well as being a simple measuring tool for tracking shipping costs, it also provides a good overview of the health of the oceanic shipping companies. Indeed, with oil and commodity prices reaching often record-breaking levels in the months before the market collapse, the BDI was reaching similar heights; from around 4500 in the beginning of 2007 to all-time high of almost 12,000 in May of 2008. Shipping being so lucrative at these levels, companies put in orders for more ships. At
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the time it made perfect sense, but it was not to last. From the peak in May, the BDI dropped precipitously as the catalysts for the Great Recession unfolded, falling below 1000 by October of 2008. One year later, it has only just crested 3,000, barely a quarter of its level less than 18 months earlier. And yet the back-ordered ships, purchased at the height of commodity prices, are now arriving at a time when not only are they unneeded – demand having shrunk so much – but credit conditions have made financing them difficult. Is this the perfect storm for ocean-going shippers?
To trade’s possible increase All this being said, global shipping companies have come through the Great Recession rather well – no major global shipping company has been in danger compared to, say, many of the top global financial firms. Admittedly difficulties remain, but now that world trade seems to have bottomed, the future is looking up, perhaps providing an excellent entrance point for shipping stocks. This is not to say that the industry as a whole is poised to shine – each sector has its share of dogs and deserves further research. But global shippers are certainly coming off a bottom in terms of factors that contribute to their success – GDP growth is going from negative to positive, commodity prices are recovering, and trade volumes seem set to return to their previous course.
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This is by no means definite, of course; Americans, long seen as the center of global consumption, are saving more, while China, though still hungry for commodities, has its appetite driven by government stimulus as much as by private demand. And of course some economists are still calling for a “Wshaped” recovery, meaning that we have yet to see the second trough of the Great Recession. But looking at long-term, secular growth patterns it seems unlikely toasts to “trade’s increase” can go unanswered – billions of consumers in emerging markets will be adding to global demand in the decades to come, requiring products and materials from around the globe. The financial and housing sectors were at the epicenter of the Great Recession, but it seems that world trade was not unduly battered by the shockwaves. The Great Recession was no Depression after all.
References http://www.wto.org/english/res_e/ statis_e/its2008_e/its2008_e.pdf pg. 7 http://www.economist.com/displaystory.cfm?story_id=E1_TQDRNJVD 10-Ks and Yahoo Finance http://shipchartering.blogspot. com/2009/02/world-shippingtonnage-capacity-hits.html WINTER 2010
Analyzing a
Commercial Real Estate
Bubble By Matthew Cohen
D
espite official data from the Bureau of Economic Analysis indicating that the recession is over, the question on many investors’ minds is how long the current positive economic growth can last. The BEA’s data indicates that U.S. GDP rose 3.5% in the third quarter of 2009 – the first quarter of positive growth since 2007. However, this growth is dubious in the sense that motor vehicle sales (think cash-for-clunkers) and the government’s stimulus accounted for nearly all of this growth. Without the government propping things up, GDP may well have remained negative, as consumer confidence remained solemn during this quarter. To make the news even dourer, a commercial real estate bust has the ability to reverse this recent growth, and even to bring a return to the uncertainty that defined the residential real estate bust and credit crunch earlier this year. This article explores the potential commercial real estate bust; first, by looking at the underlying financial instruments that led to this situation, and second, by examining different perspectives as to the severity of the consequences.
Explaining the Residential Bubble By most accounts, the same funda-
mentals that led to the residential real estate bubble have contributed to the current commercial real estate situation. In the case of the residential real estate bust, an underlying cause of the bubble and subsequent bust is said to have been easy credit, extended by the banks searching for ever higher returns. The now-defunct legend that real estate prices would rise indefinitely led banks to look to extend real estate loans to nearly anyone that would ask.1 At the time, the aggressive risk-taking appeared to be prudent, as any bank not engaging in the risk would be missing out on the returns. Another business that many investment banks got into at the time was the packaging of mortgage-backed securities to third party investors. Instead of simply getting homeowners’ monthly payments on their mortgages, banks reasoned it would be profitable if they could tie together different several mortgage payments and sell them off, creating a securitized asset (similar to a bond with its periodic payments and face value). Ideally, these securitized mortgages could have had some benefits: regional recessions would no longer inhibit a potential homebuyer from getting financing and the increased pool of capital (international
According to a report by the Federal Reserve Bank of New York, “By 2006 non-agency origination of $1.480 trillion was more than 45% larger than agency origination, and non-agency issuance of $1.033 trillion was 14% larger than agency issuance of $905 billion.” WINTER 2010
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liquidity now included) likely reduced the cost of funds to U.S. homebuyers. The problem with this scheme was that things quickly got out of hand, as proper regulation began to diminish. According to a report by the Federal Reserve Bank of New York, “By 2006 non-agency origination of $1.480 trillion was more than 45% larger than agency origination, and non-agency issuance of $1.033 trillion was 14% larger than agency issuance of $905 billion.”2 The
bination of supply constraints and sharply rising land and construction costs helped to keep new supply largely in check.”3 Despite this fact, the demand side of the commercial real estate equation is without a doubt hurting due to the recession (spurred by the residential real estate sector’s collapse and the subsequent credit crunch). A good deal of outstanding commercial real estate loans are maturing this year, leading to a fear of a major fallout. The reason why a major liqui-
The lax regulations put into place on October 30 less harmful short term, but the trade-off is less main issue with the lack of regulation was that prime borrowers, also known as Aaarated, were thrown together into securities with high risk borrowers, also known as C-rated or sub-prime. Securities are judged on the basis of their ratings. These ratings are established by rating agencies such as Moody’s and Standard and Poor’s. As the agencies are paid by the investment banks whose mortgage-backed securities they are rating, the agencies have a perverse incentive to give higher ratings than are actually deserved. Thus, mortgage-backed securities with risky payment streams included were given Aaa ratings undeservedly. It was the mortgage-backed securities, along with the overextension of credit that caused the house of cards to tumble when unworthy creditors began defaulting on their loans.
Problems Facing Commercial Real Estate The commercial market for real estate is said to be poised to suffer from a similar catastrophic malaise. There are key differences between the two situations, however. As noted by David Lynn, “The silver lining in today’s environment is a general lack of oversupply in most markets. New construction in nearly every sector has been below long-term trends, though some markets are struggling with oversupply problems. While ample financing was made available for development projects in recent years, the com-
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dation of distressed commercial assets has not yet been fully seen has manifold reasons. First of all, unlike the monthly payments of residential mortgages, commercial loans are paid in 3, 5, 7, or 10 year intervals. Thus, there is a delay in the ultimate pain that is expected to ensue. Also, unlike the residential real estate market, investors in commercial assets are usually pension funds or institutional investors with some capital in reserves. However, this delay does not mean a catastrophe has necessarily been completely avoided. According to Neil Gussis of the BSC group, a commercial real estate advisory firm, approximately half a trillion dollars of debt will be coming to a head over the next several years. The percentage of loans that would be underwater would be anywhere from 2/3 to ¾ of existing loans, Gussis estimates. For the sake of preventing massive loan defaults, on October 30th, 2009, banks, thrift, and credit-union regulators laid out plans to allow more lenient capital reserve requirements. Mr. Gussis believes that these more lax regulations will lessen the chances of yet another financial blood bath. “In this way, borrowers will be able to keep financing in place in properties they’ve already won financing for. If you’re in a situation where a borrower has wherewithal and the property is still cash-flowing, the banks shouldn’t be forced to blow a loan out of the water just because the leverage might be higher than the allowable leverage.” However, there are WINTER 2010
several concerns with this ease in regulation from the banks. Three of these main concerns are mentioned in the Wall Street Journal article “Banks Hasten to Adopt New Loan Rules” by Lingling Wei and Peter Grant. The first of these concerns is that having troubled loans on their balance sheets will make banks wary of lending. A second concern is that these measures will slow the recovery; instead, some say that a 1990’s style immediate mark-to-market ap-
Zell also appears to believe that the lack of oversupply will buoy a recovery. In an October 2009 interview with Bloomberg Television, Mr. Zell posited the following: “This is a demand recession and I suggest to you that as the economy improves, it’s very likely that these buildings that are currently suffering vacancies will be full. That’s the good news. The bad is, they’ll be full at 30% lower rates.” Before putting too much stock into this reassurance though it is interesting
0, 2009 leave the possibility for a robust growth in the future. proach would be more efficient and poise markets for a speedy recovery. There is also the concern that fewer real estate transactions could occur due to these new regulations, resulting in a deadweight loss.4 However, regardless of the financial theory advocated in regard to the capital reserve regulations, there is a possibility that a market collapse will occur if a steep drop in demand for commercial space continues due to the recession. Neither Treasury Secretary Tim Geithner nor real-estate tycoon Sam Zell, however, believes this will occur. When asked whether he thought the impending commercial real estate loan situation could set off yet another (or continuation of the) recession, Geithner replied by saying “I don’t think so. That’s a problem the economy can manage through even though it’s going to be still exceptionally difficult.”
References: 1 Chris Isidore, “Liar Loans: Mortgage Loans Beyond Subprime.” CNNMoney, March 19, 2007. 2 Adam B. Aschcraft and Til Schuerman, “Understanding the Securitization of Subprime Mortgage Credit.” Federal Reserve Bank of New York, December 4, 2007.
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to note that Mr. Zell failed to recognize the severity of the general recession in the first place. In an April 2008 visit to Harvard Mr. Zell expressed his belief to students that “There was a significant slowdown in economic growth during the first quarter but we’ll recover during the remainder of the year.” Hopefully, this time around Mr. Zell, Mr. Geithner, and the rest of the financial community will get things right. One corrective measure could include a mark-tomarket re-evaluation of existing loans in order to clear the market of toxicity in one swift move. The lax regulations put into place on October 30, 2009 leave the possibility for a less harmful short term, but the trade-off is less robust growth in the future. Sometimes it is worth ripping off the bandaid instead of slowly peeling it off; right now may be one of those times.
3 David Lynn, “Real Estate Downturn of the Early ‘90s Differs from Today’s Crash in Important Ways.” National Real Estate Investor, November 2, 2009. 4 Lingling Wei and Peter Grant. “Banks Hasten to Adopt New Loan Rules.” Wall Street Journal, November 12, 2009.
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What the Aftermath of the Financial Crisis and Recent Financial Scandals Means for By Karl Wichorek
O
ver the past few quarters, scandals and the financial crisis have shaken the hedge fund industry. There have been incredible implosions in the hedge fund industry, including the recent shut down of Atticus Capital in August 2009, a fund which once managed $20 billion at its peak in 2007 and closed with only $3.5 billion. There has also been a wave of scandal within the hedge fund industry. The news of insider trading at The Galleon Group and Bernie Madoff â&#x20AC;&#x2122;s unveiled Ponzi scheme has shocked both retail and institutional investors alike. This has caused a number of problems for hedge fund managers; investors who have recently experienced or seen the crisis and scandals are requiring more information about fund strategies and holdings, are more reluctant to give money, and are demanding more liquidity. By examining the concerns of investors, we can sketch a rough picture of what the hedge fund industry might look like in the future. Knowing what strategies hedge funds use to make their money will be one of the primary concerns that investors are going to have as a result of the financial crisis. This
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is a result of both investment bank failures and recent insider trading scandals. Much of the discussion on the causes of the financial crisis has centered on the use of complicated financial instruments that very few people understood. For example, George Soros, a renowned trader, has called for the end of the credit default swap, claiming that it creates an asymmetric risk-reward profile. This argument usually revolves around the notion that nobody truly understood the complicated financial products they were trading and therefore did not know how to price them accurately. When actual returns from these products started deviating from their optimistic valuations, it was discovered that these instruments were incredibly overvalued. Thus, there is now a fear among investors that their money managers might be trading financial products or engaging in complicated financial trades that could end up losing a substantial amount of money. The scandals created by insider trading have also increased investor skepticism towards the financial models employed by hedge fund managers. Galleonâ&#x20AC;&#x2122;s founder, Raj Rajaratnam, was recently indicted for WINTER 2010
the hedge fund industry insider trading. Unfortunately, this is not the only such case. Investors were shocked to find out that Bernie Madoff, the former chairman of the NASDAQ stock exchange, had been running a Ponzi scheme rather than a legitimate investment fund. Naturally, investors want to prevent either scenario from happening with their money. The only way to be 100% sure that this will not happen is if an investor knows exactly what a manager does and how he or she does it. This is not problematic at most researchoriented hedge funds as their strategy and execution is straightforward; they research different markets for undervalued or overvalued opportunities and then execute trades designed to capitalize on those opportunities. Quantitative hedge funds, on the other hand, develop extremely complicated and unique mathematical formulas that execute trades based on any number of patterns. These funds make their money because they do not reveal their formulas to anyone. Yet in order for investors to be confident they are avoiding a Ponzi scheme they have to know how managers are making money. The main problem that this invesWINTER 2010
tor skepticism generates is one of capital availability. According to a hedge fund intelligence report released by Credit Suisse Tremont, a research branch of Credit Suisse, there was a net outflow from the hedge fund industry in Q3 2009 that amounted to $400 million.1 Even with news of a V-shaped recovery in the US and a strong global economic recovery, investors are still reluctant to entrust hedge fund managers with their money. This could cause significant liquidity problems for managers in the future, as fearful investors ask for their money back, invest less, or refrain from investing at all. As the Credit Suisse Tremont report shows, this is starting to happen in the hedge fund industry. This increased desire for liquidity means that many mid-size hedge funds with $250-$750 million in assets under management (AUM) might not be able to survive. Bigger hedge funds have a larger amount of capital that typically comes from a more diverse investor base, thus they can better withstand redemption demands. Smaller hedge funds are adept at maintaining good relationships with their investors and man-
aging investorsâ&#x20AC;&#x2122; concerns due to the fact that they typically have a smaller capital base. The increased demand for liquidity may make it significantly harder for mid-size hedge funds to survive compared to small hedge funds and large hedge funds. The implosion of many investment banks and the resulting financial crisis were also catalysts for the liquidation of many hedge funds. One of the last things an investor wants happening to his or her money right now is another financial crisis. Strategically, mid-sized hedge funds are in the worst position to withstand the shock of another financial crisis. Smaller hedge funds typically specialize in one or two areas of expertise and are therefore well informed of the potential risks in their portfolio. Larger hedge funds are by nature less exposed to any one risk as they tend to have a wider and more diverse investment portfolio. In the case of large hedge funds and small hedge funds, the risk another financial crisis poses can be better managed than at a mid-sized fund. The data published by hedge fund tracking company IEHI, Inc. shows that the majority of funds that have
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The majority of funds that have imploded since the financial crisis managed between $250 and $750 million. imploded since the financial crisis managed between $250 and $750 million.2 Clearly, an increased demand for liquidity from investors and the financial crisis have hurt mid-sized hedge funds. The final question is how the increased demand for liquidity will affect the hedge fund industry as a whole. Based on the fact that investors are going to demand more information and liquidity from managers and that it is going to be harder for mid-sized hedge funds to survive, the industry is likely to see an increase in the number of large hedge funds, a decrease in the number of mid-size hedge
”
funds, and a potential expansion of the number of smaller, specialized hedge funds. Mid-sized hedge funds will either acquire smaller hedge funds by absorbing them into a fund of funds structure or they will be purchased by larger hedge funds looking to expand their capital base. For example, the investment firm P. Schoenfeld Asset Management announced in March 2009 that it was trying to acquire at least three hedge funds with AUM between $200 and $400 million.3 The number of smaller hedge funds that will emerge is uncertain though. Midsized hedge funds could try decreasing their AUM and focusing on one or two areas of expertise, or they could try to increase their AUM by being acquired or acquiring other companies. Thus, it is unclear as to how the financial crisis and recent scandals will affect smaller hedge funds. However, what can be postulated is that larger hedge funds are likely to get bigger and mid-sized hedge funds are likely to decrease in number. References: 1. Credit Suisse Tremont Hedge Index. “Q3 2009 Hedge Fund Update: On the Road to Recovery.” October 2009. Available at: http://www.hedgeconnection.com/blog/wp-content/ uploads/2009/10/CS_Tremont_ Q3_2009_Market_Update_Final.pdf. 2. The Hedge Fund Implode-O-Meter. List available at: http://hf-implode. com/index.html#lists. 3. FinAlternatives. “P. Schoenfeld Looks to Buy Hedge Funds.” March 24, 2009. Available at: http://www.finalternatives.com/node/7344
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Recessionary Trading: Credit Default Swaps and Capital Structure Arbitrage
By Ike Greenstein
I
n the attempt to explain the recent financial crisis, credit default swaps (CDS) have taken a primary focus, leading many to advocate for greater government involvement with this financial tool. This article will review the role of CDSâ&#x20AC;&#x2122;s in the recession, how the related trading strategy, capital structure arbitrage, which links the equity and debt markets, was impacted, and why regulation may be necessary.
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CDS’s and the Crisis CDS’s lie in the general category of derivatives that face little to no regulation, a status solidified by the Commodities Futures Modernization Act of 2000. In a CDS transaction, the bondholder will pay another party to cover a notional value of the bond in the case of a default as insurance, thereby minimizing his exposure. The pricing on the CDS instrument is determined by the probability of default on the initial bond. If there is a “credit event,” such as bankruptcy and a default on the debt, the third party covers the predetermined amount to the bondholder. The proliferation of CDS’s involves players who otherwise have no position in the original credit transaction, resulting in a highly complex web of investors that caused a fear that the collapse of one party would, through a domino effect, lead to a global financial collapse. This comes across in the “too big to fail” theory explaining why the US government felt it necessary to step in and bail out certain companies, including major CDS market players AIG and Bear Stearns. Additionally, the bailouts have been so large, as economist Randall Wray explains, because “there are many dollars of bets for each $1
28
of securitized debt . . . [the] government has to spend many times more than defaults on mortgages to cover losses on bonds, and still more to cover CDS losses.”
Trading Strategies with CDS’s Capital structure arbitrage is a trading strategy in capital markets that links debt and equity in the form of CDS’s and shares of stock. An investment firm will look at a company’s share value in comparison with the spread on a CDS. This strategy indicates a link between a company’s debt default risk and its equity price. The assumption is that the two should go in opposite directions, showing a negative correlation. Consider a company whose outlook is positive. In this case, its share value should increase, representing the strength of the company. Additionally, the company’s strength reflects that it is less likely to default, and consequently, its CDS spread should come down. There are many ways that trading CDS’s occurs. Among these methods is treating CDS’s in the same fashion as a stock. That is, it is bought and sold without taking into consideration hedging the trades. An analysis of the CDS market done by economists Burkhard Raunig and Martin Scheicher
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shows that there is less risk in trading CDS’s than in trading equity. Using a measure that determines the percentage of the notional value considered at risk, Raunig and Scheicher found the percentage of equity at risk to be more than twenty times that of CDS’s, when dealing with short holding periods and higher grade bonds. According to their study, the ratio converges for longer holding periods and debt with lower credit grades, but is always greater than one. Another way to trade CDS’s is the following method of capital structure arbitrage. This method looks at the relationship of share value and CDS spreads and uses hedging. According to economist Fan Yu, using a model that is similar to Merton’s model for derivative pricing, an investor can determine whether the market spread for a CDS matches the model spread. If, for example, the market spread is much larger than the model spread, the investor will go short on CDS’s, predicting that it will converge to the model spread. To hedge this bet, the relationship between CDS and share value would predict that share value will increase, and so the investor also goes short on the equity, to cover his bases. The success of the above strategy depends on the correlation between equity and debt, the volatility of the two, and the notional amount of each WINTER 2010
involved in the transaction. Yu performed a comprehensive study on the relationship between equity and the CDS’s and looked at the success of the above capital structure arbitrage method. For holding periods of 180 days, Yu’s study found the mean return was positive and to be around one or two percent. With unregulated derivatives and small returns, leveraging therefore plays a big role. Without any requirement for holding capital against the CDS’s, the ability to leverage and multiply the returns on arbitrage allows investors to capitalize on these small returns. However, this leveraging presents a big problem. A situation with no leverage may simply transfer risk. However, as Wray explains, with leverage, “global CDS’s reached $60 trillion, and total credit derivatives were at least ten times bigger. These assets linked balance sheets all over the world, so that defaults in one small market could snowball across the globe.”
The Direction of Regulation Politicians therefore have recognized the need for regulation of derivatives as it represents a market that had been estimated in the hundreds of trillions of dollars going completely unregulated. As President WINTER 2010
Obama has said, as quoted in a September 15 New York Times article, “those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.” According to a September 24 New York Times article, Treasury Secretary Tim Geithner has also emphasized that the legislation would be intended to curb the ‘too big to fail’ policy of bailing out the nation’s largest institutions. Similarly, both Representative Barney Frank, head of the Financial Services Committee, and Senator Chris Dodd, head of the Senate Banking Committee, have recognized the need for legislation to increase regulation. The next question becomes who will properly regulate the firms. There has been an uncertainty between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Under the proposal, for some companies the SEC would regulate an option to buy shares at a later date while the CFTC would regulate CDS’s. As such, a September 23 Wall Street Journal article quotes SEC Chairman Mary Shapiro as saying that the current proposition “encourages the migration of activities from traditional regulated markets.” However, according to an October 1 New York Times article, some see Federal HARVARD COLLEGE INVESTMENT MAGAZINE
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Reserve Chairman Ben Bernanke and the Fed as the more natural governing body to oversee the derivatives market. Through all this, the banks continue to fight regulation, and, at a time of people’s dissatisfaction with big government, actually passing this proposed legislation has taken considerable time.. Thus, while the final product remains to be seen, it is certain that these previously unregulated markets will ultimately face stronger oversight, particularly with regard to leveraging and holding capital.
References Andrews, Edmund L. “Bernanke, in Nod to Critics, Suggests Board of Regulators.” New York Times, 1 October 2009. Labaton, Stephen. “An Overhaul of Financial Rules Is Taking Shape.” New York Times, 2 June 2009 Labaton, Stephen and Jeff Zeleny. “Trying to Rekindle a Fire: For Obama, a Window Is Closing.” New York Times, 15 September 2009. Labaton, Stephen. “A Modified Bill Inches Regulatory Plan Ahead.” New York Times, 24 September 2009. Lynch, Sarah. “SEC Seeks More CreditSwaps Power.” Wall Street Journal, 23 September 2009.
Raunig, Burkhard and Martin Scheicher. “A Value at Risk Analysis of Credit Default Swaps.” Working Paper Series, November 2008. Wray, L. Randall. “The rise and fall of money manger capitalism: a Minskian approach.” Cambridge Journal of Economics, 8 May 2009. Wallison, Peter J. “Credit-Default Swaps Are Not to Blame.” Critical Review, 1 June 2009. Yu, Fan. “How Profitable Is Capital Structure Arbitrage?” Financial Analysts Journal, Vol. 62 No. 5.
The Harvard College Investment Magazine would like to thank the
Harvard Undergraduate Council for their grant in support of this issue.
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An Argument for Returning to the
Fundamentals W
ith the nadir of the financial crisis behind us, the best way to go forward may be, in part, to turn back to the fundamentals. At Berkshire Hathaway’s (NYSE: BRK) 2009 annual shareholder meeting, an event attracting over 35,000 people to Omaha, Nebraska and affectionately known as the “Woodstock for Capitalists,” Berkshire Chairman and CEO, and high-profile advocate of value investing, Warren Buffett told the crowd, “There’s so much that’s false and nutty in modern investing practice and modern investment banking. If you just reduced the nonsense, that’s a goal you should reasonably hope for.”1 Advocating for a return to analysis of company fundamentals, Buffett went on to describe what makes a good investor, “If you are in the investment business and you have a high IQ, sell 30 points to the next person. You do not have to be a genius at all, but you do have to have some peace about your decisions.”2 Since the rally began in March 2009, stories about the “return of risk appetite” have abounded and expectations for a reWINTER 2010
By Sarah Wang
bound have already purportedly been priced into the markets. With investor sentiment seemingly renewed, prominent money manager Howard Marks of Oaktree Capital has noted that two critical issues should remain at the top of investors’ minds: risk and complexity.3 This article will explain what investors find so problematic with these two issues in light of the crisis and how taking account of these factors and ultimately returning to value investing may help to weather future storms. Investing’s Pre-Crisis Conventional WisMisunderstanding Risk and a Penchant for Complexity dom:
What many prominent investors are grappling with now in the wake of the crisis is the notion that although risk is obviously a concept that all investors must be concerned with, the high tolerance for risk that has prevailed recently suggests a fundamental misunderstanding of risk itself (which, as will be discussed shortly, is entwined with the notion of an increasing penchant
for mathematical sophistication). As Marks explains, while it is true that investors cannot expect to make money without taking risk, risk taking is not sure to make investors money. Though the notion that if risky investments always produced high returns, they would not be risky, is highly intuitive, it has not been borne out in how investors in reality have approached risk. The risk tolerance that has been seen is in fact somewhat paradoxical to successful investing. When investors are not afraid of risk, they accept risk without being compensated for doing so and risk compensation disappears. This leads to prospective return premiums being unusually low for the respective risk to which they were attached, and in turn, reinforces a misunderstanding of the true risk levels. During the crisis, this effect played out with an increasing attraction to ever riskier deals, more complex structures, and a greater use of leverage to compensate for the reduced premiums.4 The recent shakeup however has seemed to finally awaken some investors to the serious consideration of risks in the portfolio. Wealthy investors
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Rather than solely relying on the higher mathematics of future projects and discounts, investors should return to looking at the underlying factors that affect a company’s actual business and future earnings potential, including its management, industry and secular macroeconomic trends, its competitive edge, and its relation with the government.
are finally beginning to communicate their fears and are sizing up their biggest risks, as well as implementing processes to identify threats beforehand, such as those currently stemming from liquidity, concentration, and inflation concerns.5 The greater embrace of risk goes hand in hand with the willingness to invest in increasingly complicated instruments, even though these instruments touted risk mitigation as a key selling point. As Buffett has noted, “The more symbols quants could work into their writing the more they were revered.”6 In the run-up to the crisis, blackbox quant funds, highly levered mortgage securities dependent on computer models, and alchemical portable alpha all touted high-touch risk management yet glossed over their true risks, and were all embraced by investors.7 Unfortunately, as former Federal Reserve Chairman Alan Greenspan has explained: “It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.”8 As with risk, investors should be quick to consider the downsides of complex financial instruments and very careful in evaluating the upside potential of higher mathematical investing. Back to the Fundamentals As we look back at the causes of the crisis and ahead to how investors might better conduct themselves in the future, Buffett’s simple advice of “if you need to use a computer or a calculator to make the cal-
32
culations, you shouldn’t buy it”9 may hold the key. Rather than solely relying on the higher mathematics of future projects and discounts, investors should return to looking at the underlying factors that affect a company’s actual business and future earnings potential, including its management, industry and secular macroeconomic trends, its competitive edge, and its relation with the government. As the basic theory originally put forth by Benjamin Graham and David Dodd may have been overlooked in light of the recent ease with risk and penchant for complexity, value investing involves simply buying securities that appear underpriced by some form of fundamental analysis.10 These discounted fundamentals can include companies’ book values or dividend yields, with the more modern model of calculating value being the discounted cash flow model. This value investment strategy would include buying low price-to-earnings stocks, low price-to-book value stocks, or low price-tocash-flow stocks. Though there is the inevitable “markets go up and markets go down” reality associated with value investing,11 what the crisis has revealed is that the efficient markets hypothesis that had underpinning modern portfolio theory is subject to far more irrationality in reality. This fact consequently creates tremendous opportunity for a disciplined investor to find stocks that are selling at a discount to a company’s intrinsic value.12 Cutting through the nonsense and going back to the fundamental principles of investing may ultimately be the truest and most sound method amongst all that is “false and nutty.”
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’’
Reference 1 Koprowski, Gene J. “Buffett: Much Investing Thought False, Nutty.” May 4, 2009. Available at: http:// moneynews.newsmax.com/ streettalk/buffett_investing_ quants/2009/05/04/210530.html. 2 Thompson, James. “10 pearls from Warren Buffett’s annual shareholder meeting.” May 4, 2009. Available at: http://www.smartcompany. com.au/wealth/200090504.html. 3 See generally: Marks, Howard. “So Much That’s False and Nutty.” Memos to Oaktree Clients. July 9, 2009. Available at: http://www. oaktreecapital.com/MemoTree/SoMuchThatsFalseNutty_07_08_09. pdf. 4 Marks, Howard. 5 Coyle, Thomas. “Ultra-wealthy Families Recalculate Risk.” The Wall Street Journal. November, 24 2009. 6 Koprowski, Gene. 7 Marks, Howard. 8 Greenspan, Alan. “The Fed Didn’t Cause the Housing Bubble.” The Wall Street Journal. March 11, 2009. 9 Sorkin, Andrew. “A Back to Basics Weekend with Warren Buffett.” The New York Times. May 5, 2009. 10 Graham, Benjamin and Dodd, David. Security Analysis. McGraw-Hill (New York) 2004. 11 Sorkin, Andrew. 12 Kotkin, Stephen. “A Bear Saw around the Corner.” The New York Times. January 4, 2009.
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Decoupling and the Developing World Dubai: The Unexpected
The ETF Revolution A Case for Open Source Software
Interview with Shorebank Executives Interview with NAVSTAR Advisors
Notable Previous Interviews Jeff Bezos Warren Buffett Mohammed El-Erian Ken Griffin
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