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Hedging Against Hedges: Big Investors Grow Wary

Date: Wednesday, November 4, 2009
Author: New York Times

Less than two years ago, anything considered an alternative investment seemed to have an automatic cachet.

Investors were shoving one another aside to get into the top hedge funds and private equity offerings. Venture capitalists were raising money with ease to invest in companies, even if their ideas were merely interesting, not tested.

But the collapse of the financial markets last fall showed the investments’ limits, The New York Times’s Paul Sullivan writes in his Wealth Matters column.

Investors suddenly realized that they could not get access to the money they had put in or sell their investments for anywhere close to what they were worth on paper. Seemingly overnight, investors began to reassess the tradeoff between the promise of high returns that did not always materialize and limited access to their money.

“Clients are concerned about liquidity, lock-up periods and fees,” said Rob Francais, chief executive of Aspiriant, a high-net-worth advisory firm.

In other words, the very things that had made hedge funds, private equity and venture capital so exclusive are now a cause for concern. This new caution has led, at best, to greater discernment among the wealthy. But at worst, it has fostered an ostrich mentality.

“If they can’t understand it, they’ll pass,” said Joe Curtin, head of portfolio analytics and consulting at U.S. Trust Bank of America Private Wealth Management. “That’s a significant departure. If the strategy can’t be explained in conversational terms, they’re not going to do it.”

Like so many other things this year, learning such a seemingly simple lesson has been costly. And the wealthy have not been the only ones to find it out the hard way. Two of the biggest buyers of private equity in 2008, for example, were public pension funds, which bought 26.6 percent of all private equity, and corporate pension funds (14.2 percent), according to Dow Jones Private Equity Analyst. This means the retirement plans of many workers had exposure to the same securities that have so frightened sophisticated individual investors.

Yet billions of dollars in alternative investments are out there, with new funds still trying to raise money. So how are investors looking at assets that hurt them so badly last year?

HEDGE FUNDS Recent reports on the Galleon Group — a hedge fund that is being wound down after insider trading charges — have not improved confidence in the asset class.

“The bloom is off the rose, but not so much because of the bad performance,” said Sol Waksman, president of BarclayHedge, which has tracked hedge funds since 1985. “In reality, the performance was bad but it was still much better than equities. Not letting people redeem their money hurt them more. The Madoff scandal hurt terribly. And the news with Galleon is certainly not helping.”

One alternative some investors are looking at is funds of hedge funds. With stakes in many hedge funds, these funds provide greater diversification, but they still have lock-up periods and their returns have been lagging. For the first three quarters of this year, they are up 9.1 percent, according to data from BarclayHedge. Direct investments in hedge funds were up 19.2 percent for the same period — not much better than that 17.03 percent gain the Standard & Poor’s 500 posted.

“You can’t expect a Ferrari with a fund of funds,” said Jacob Schutt, a principal at Parallel Advisors in San Francisco. “But they should also have protected the downside a year ago.”

The three areas receiving the most money in August were focused on distressed securities, fixed income and strategies that exploited irregularities in pricing.

Still, assets in the hedge fund industry are down 44 percent from their July 2008 high. Mr. Curtin said he did not see any reason for optimism over the next year, predicting that hedge fund returns would trail equities.

PRIVATE EQUITY The problem with private equity investments is one of expectations: clients are not getting a return in the time they expected.

“These funds in the past said they were going to make distributions after two years, but now they’re not doing it,” said Theodore Beringer, managing director of the Beringer Group, a family office adviser.

Just as bad, companies that were supposed to be taken public after two or three rounds of fund-raising are now on their sixth or seventh round with no end in sight. In many cases, this is a function of the equity and debt markets, but investors are still miffed.

New money put into private equity funds was down 59 percent in the first three quarters, according to Private Equity Analyst. The $79 billion raised so far this year more closely resembles 2005, when $97 billion was raised, than the recent boom years.

There is a realization that the days of funds buying a company, loading it up with debt and selling it to another fund may be over for the foreseeable future. Instead, Mr. Curtin said, there has been a move back to “traditional private equity,” which he defined as managing a company over a longer period before taking it public. This requires investors to rethink their returns and whether tying up their money in a fund is worth it.

Earlier in the year, when university endowments began looking for buyers for their private equity stakes, analysts thought this was a precursor to a more robust market for existing private equity. But research by Private Equity Analyst found that sellers were not as eager to sell at steep discounts as buyers had hoped.

That gap may be closing, though. Tony Roth, chief strategist for private wealth management at UBS, said several funds were raising money to buy private equity on the secondary market. He said investors may still be able to buy this private equity for 30 to 60 cents on the dollar.

VENTURE CAPITAL The amount of money investors are committing to venture capital continues to fall. It was down 38 percent in the third quarter from the same period last year, according to Dow Jones VentureSource.

The data also showed that investors were shunning historically strong areas. Software companies were at their lowest level of investment since 1996, and health care was down 25 percent.

Edward Harris, head of business development at Apex Learning in Seattle, has worked both sides of the venture capital business in his 20-year career and said investors were particularly cautious now.

“Early-stage companies face the challenge that there is less money out there, and those investors are more demanding,” said Mr. Harris, who used to manage investments at Vulcan, the investment company set up by Microsoft’s co-founder, Paul G. Allen. “They want a larger stake and want to see more tangible signs of progress. It used to be the right idea and the right people could raise a lot of money out of the gate.”

Now, Mr. Harris said, people want to invest in companies that have revenue coming in. Among individual investors, there is less desire to put money into companies that are based on attracting traffic and recouping the investment through ad revenue.

“If you go back to where the market was frothier, investors feared if you didn’t get into an idea early enough you’d miss out on the opportunity because the valuation would spiral out of sight,” he said. “Now it’s, ‘What’s the rush?’ They want to make sure the idea is still going to be there.”

The same can be said for most alternative investments today.