Investors say leverage critical to toxic fund

Date: Thursday, February 26, 2009
Author: Jennifer Ablan and Megan Davies, Reuters.com

A growing number of hedge funds, private equity firms and money managers are calling for five to 10 times leverage before considering any part of the "public-private partnership" to take troubled mortgage-related assets off the balance sheets of banks.

Billionaire investor Wilbur Ross and Jeffrey Gundlach, the widely followed mortgage debt specialist at Trust Company of the West, have told Reuters a reasonable amount of low-cost funding is necessary to attract them to such a joint fund.

"If you want private capital and if you only did it on two or three times leverage, I don't think that that is realistic for the size and scale of what the government wants to achieve," Ross said in an interview.

U.S. Treasury Secretary Timothy Geithner is aiming to unfreeze credit markets by way of a new program that would combine public and private capital in a fund that would buy troubled bank assets of up to $1 trillion.

On Monday, the Financial Times said authorities could provide $6 of loans for every $1 in equity capital deployed by the private investors joining the public-private investment fund, citing some people involved in the process.

Gundlach said even $5 of loans for every $1 in equity capital "sounds about right."

Hedge funds and private equity managers take a more aggressive stance.

Ron D'Vari, chief executive of NewOak Capital and former head of structured finance at BlackRock, said it will take five to 10 times leverage to get the 20-plus percent returns that would interest the private equity investors.

"I think given the level of risk, we along with most private equity firms require that much for leveraged return," he said. "Inside five times, the assets have to be discounted further by as much as 15 percent to 30 percent more to make it work."

The root concern among money managers, hedge funds and of course taxpayers will be how to price the assets purchased for the joint public- and private-investment fund.

If the troubled debt and loans are priced too low, it could result in a vicious spiral where banks could be required to post devastating losses that deplete their capital and make it even more difficult for them to increase lending.

Conversely, if they are priced too high, banks will receive a windfall at the expense of taxpayers, who would swallow the losses if the government could not recoup what it paid.

Many banks are reluctant to go through another wave of write-downs on the value of collateralized debt obligations, leveraged loans, credit-card receivables, mortgage bonds and other distressed assets on their books to bring them in line with transactions of similar securities taking place, resulting in wild variations on their value.

Howard Newman, president and chief executive officer of Pine Brook Road Partners, LLC, a private equity fund investing in financial services and energy, said investors have to have a clear understanding of what the risks are and how they can be priced.

The government may come to the conclusion that no rational investor will bear the risks, he said. Alternatively, the government can make the risks bearable, and then it becomes an exercise in gain-sharing, he said.

"Profit and loss sharing is fine, but I am only interested if I know with absolute precision what I am buying and what price I am buying it at," said Gundlach of TCW.

All told, Federal Reserve Chairman Ben Bernanke on Tuesday defended Geithner's public-private partnership, saying that the plan is to strengthen the banks to the point that their profitability would improve enough to attract private capital.

"I certainly could imagine private equity funds being very actively involved -- they're sitting on huge amounts of capital and have been beefing up their capabilities in terms of doing bank (related investments)," said Josh Lerner, a professor specializing in private equity at Harvard Business School. "But they're clearly aware these are treacherous waters."

(Additional reporting by Al Yoon; Editing by Leslie Adler)