Opportunities in Hedge Funds in 2019

A distinguished panel gathered on October 10, 2019 at the Standard Club to discuss the current environment for hedge fund investments. Kenneth Heinz, president of Hedge Fund Research, Inc. served as the moderator.

The panelists included:

  • Kevin Doonan, Executive Director, Hedge Fund Strategies, GCM Grosvenor
  • Joseph Scoby – Head of Systematic Investing, Magnetar Capital
  • Tristan L. Thomas, CFA – Director of Portfolio Strategy, 50 South Capital

HFR’s Ken Heinz began with some opening remarks, which he dubbed “Whistling Past the Graveyard”. After a rough couple of years, investing in hedge funds in the next 2-3 years will be better, he said. One reason is that hedge funds are currently preparing for macro risks for which many mainstream investors might not be ready. A couple warning signs Heinz noted include a recent huge jump in overnight repo rates, and negative interest rates on a wide swath of global debt. Also, IPO markets are showing weakness, with the large We Work IPO having been pulled recently at the last minute. Impeachment proceedings and a possible Warren presidency (with her populist, anti-corporate message) also suggest more risk on the horizon.

Tristan Thomas started by talking about bond returns. A return of about 8% YTD for the Barclays Aggregate index indicates that a lot of bond returns have been pulled forward. That leaves little return potential ahead for bond investors unless yields go negative. The minuscule amount of yield available leaves bond investors in a quandary. They still need income and cash flow, but aren’t entirely comfortable taking on more risk. With that backdrop, hedge funds can play a role in the portfolio. One symptom of this trend, Thomas noted, is that he has recently been talking more to clients’ fixed income departments, who need help generating yield, instead of the alternative groups he typically speaks with. Another challenge is that the costs of running a hedge fund have gone up.

Heinz asked the panel if they are seeing reduced liquidity in the market. Thomas answered yes. Doonan added that markets are now faster to gap down because of weaker hands and banks are less involved than before. Some securities have better liquidity than before, particularly securities held inside ETFs, but securities outside of ETFs have fared worse with respect to liquidity.

The conversation then shifted to ESG, a fast-growing area of investing that the hedge fund world has been slow to embrace. Thomas opined that the ESG trend is real and here to stay and represents a big opportunity for hedge fund managers to win additional mandates. One challenge managers face is defining exactly what ESG is. Investors each have their own answer on what ESG constitutes, and managers need to be flexible and offer customization in order to capitalize on the opportunity. As for returns, Heinz asked the panel if ESG has an impact. Thomas said that there isn’t quite enough data in the hedge fund space to definitively answer that question. Doonan also said that he believes the implications of focusing on ESG will be huge and may have an even bigger environmental impact than government policy.

The group spoke at length about the growing influence of tech on their investment process. Scoby said that at Magnetar, they often debate whether they are a technology firm or an investment firm (Answer: they aren’t mutually exclusive, so both). To remain competitive, firms must constantly appraise external technology to ensure they are using the best tools available. Doonan said that many asset owners and funds-of-funds use advanced analytical tools to decompose returns to ensure that they aren’t overpaying for beta. Regarding some other more nascent technologies such as blockchain, Doonan said that they have generally stayed away.

Heinz asked how the panel’s investment processes have changed over the past five years. Doonan said that the average hedge fund has not delivered enough return to justify its fee, which has made focusing on specialization and co-investment recurring themes. As far as identifying an attractive strategy for the current market (or alternatively, which should be avoided), Thomas said that in a perfect world, it would be macro, but there are few good macro managers out there. He likes credit-oriented managers and strategies with short books that are delivering alpha. He sees relative value strategies as less interesting right now. Doonan said that his firm generally tries to avoid generalist managers in favor of more niche, specialist strategies, while rates trading strategies look problematic to him.

A lot of the appeal of hedge funds comes when equity markets are challenged, so if the equity beta continues to deliver returns around 10% with lower than norm volatility, hedge funds will be somewhat unattractive. It is very hard to find true alpha, and also difficult to separate skill and luck, which makes advanced analytical tools, careful due diligence, and experienced managers with niche strategies all the more attractive in today’s low rate world.

Distinguished Speaker Series: David Herro, CFA, Harris Associates

Trust and effective communication provide investment teams with the ability to stick with a sound investment philosophy and process during periods when the approach is out of favor with the market. Oakmark’s focus on developing an intrinsic value for companies provides a foundation for portfolio management decisions. He believes that this foundation drives the long-term successful investment returns that the firm has earned for clients.

David Herro, CFA, partner, portfolio manager and chief investment officer of International Equity at Harris Associates, addressed 200 guests at the University Club on Tuesday, October 8th for the sold-out Distinguished Speaker Series luncheon. Herro emphasized the importance of our fiduciary duty, a sound investment philosophy, the difference between a business’s value and its stock price, the opportunities that macro events can create and the importance of managing emotions. These five themes have been central to his long-term success managing the Oakmark International Equity mutual fund.

Herro measures the attractiveness of a business based on the present value of expected free cash flow. Prices below this value create buying opportunities, and above a reason to sell or not buy. He uses a normalization process to determine the required discount rate, instead of using today’s very low rates. The discount rate also varies for countries and companies based on risk assessments. During his presentation, he illustrated times when one of his holdings, Glencore PLC’s stock price movied far from his computation of intrinsic value. He noted that price often responds to current information versus the long-term business value. This volatility provides opportunities for investors. He guides clients to think and act like investors, not traders.

Herro provided several examples of when macro events moved security prices far from intrinsic value. During the European sovereign-debt crisis investors could purchase Italian government bonds with yields near 8.0% that are less than 1% today. Additionally, yields on Greek government bonds moved above 30% in 2012 and are now lower than US Treasury yields. He notes that despite these movements in price, intrinsic values have not changed by these large magnitudes.

Managing emotions requires a strong foundation. The faith to maintain a set of beliefs during the great financials crisis eventually rewarded investors. In contract, a focus on stock price movement created severe anxiety that lead to many poor decisions.

Herro compared today’s difference between the performance of growth and value styles as comparable to the 1995 to 2000 timeframe. He acknowledges that identifying a change in this relative performance is extremely difficult due to a large number of variables with unstable coefficients. However, he believes that the magnitude of the differences strongly favors the value style currently.

Herro noted that we should never forget that our purpose is to earn returns for our clients. Key ingredients to success include a sound approach, acting like an investor vs. a trader, exploiting opportunities created by macro events and managing emotions. These thoughts have served him well and he believes that they will continue to serve our industry well.

Volunteer of the Month: October 2019

Since joining CFA Society Chicago in May 2019, Marina Viergutz, CFA, CAIA has been actively involved on three advisory groups (CFA Women’s Network, Education and Professional Development). She has been vocal in sharing new ideas and suggestions to enhance Society program and events.

Marina has answered the call to serve as a Mentor in the Society’s Mentorship Program, took a co-lead role in planning the Opportunities in Hedge Funds event scheduled for October 10, 2019 and has stepped up to assist in planning the annual Industry Roundtables event scheduled for February 2020.

Marina, thank you for coming onboard and hitting the ground running! The Society is grateful for members like you!

Distinguished Speaker Series: Rob Brown, CEO, Lincoln International

Current drivers of the global M&A market and perspectives on how it may evolve going forward

On September 10th the Distinguished Speaker Series Advisory Group hosted Rob Brown to provide his insight on the M&A market over lunch at the Metropolitan Club. Brown is the CEO of Lincoln International. His firm serves private equity firms, corporations and private businesses around the world, providing advice when selling or buying a business, securing financing solutions, valuing an organization or portfolio, or navigating special situations. Brown has nearly 30 years of experience advising leading private equity groups, privately owned businesses and large public companies on divestitures, acquisitions and other strategic initiatives.

Brown is a recognized advisor and thought leader in the investment banking industry. He is a frequent guest on WBBM’s Noon Business Hour in Chicago, and a speaker and author on mergers and acquisitions-related topics. Brown sits on the board of UNICEF USA and the Dean’s Business Council for the Gies School of Business at the University of Illinois. He is also President of the Board of Regents at Saint Ignatius College Prep in Chicago.

Brown started with an outlook on the M&A market. Global M&A activity has increased year to date in 2019 compared to the same period in 2018. There have been around 230 M&A deals this year verse 200 in 2018. The P/E market has been robust as well. Following several years of growth with an all-time high in 2018, inflows have returned to more moderate levels. Activity in 2019 could be characterized by established P/E platforms getting larger, with new funds facing a more challenging fundraising environment. Despite the fundraising slowdown, a thinner slate of opportunities for capital deployment has mitigated the impact to capital supply, leaving significant dry powder available in private debt funds.

On the lending front, bankers are still providing funds while defaults, the bellwether of a slowing economy, have not increased in a material way. Overall, the continued trade/tariff uncertainty, slowing global growth, Brexit concerns, and mixed signals from key economic indicators about the likelihood and timing of a recession have given lenders a pessimistic view of the market. They are lending but looking for a reason not to!

Brown advised that valuations of businesses have grown to historic highs. This is due to several factors, the most significant being the tax cuts passed in 2017 (reduction of the U.S. corporate tax rate has made the United States a more attractive jurisdiction for inbound M&A activity and has likely increased the value of U.S. domiciled businesses), and the large sums of P/E money raised over the past several years looking to be invested.

Additionally, there is nothing on the horizon which makes Brown think these valuations would change in the next 3-6 months. Overall deal activity is great with high valuations being the norm. Brown advised that now is an excellent time to consider selling a privately held business. The M/A market could be close to its top as the number of private sellers entering the market is high. These entities are usually late to the market.

Brown noted that although the market is richly priced, a recession would not necessarily bring down M&A prices. It is more likely that M&A activity would cease, but as soon as there is an upturn in the market deals would flow again.

Browns kept his prepared remarks relatively short in order to answer audience questions.

Q: Should a recession occur would capital be available, or would the market dry up?

A: M&A firms have committed capital on their books. This capital would not be put into M&A deals, but left as idle, short term investments. The M&A firm will sit on these funds making a nominal rate and wait until the market breaks upward.

Q: How much of the high multiple business valuation is due to any cyclical effects?

A: Modeling of returns has dropped over the past several years. P/E should float based on a measure of public equity plus a spread. As the prices in the public equity market have risen, so to have the multiples for the M&A market.

Q: Is there pressure on the 2 and 20% fee schedule?

A: In 2009 when the market was in disarray the outlook was for a 30% reduction in P/E firms. This outlook turned out to be completely wrong. The overall amount of P/E firms is now greater than in 2009, and with the constant search for returns that will beat the market, the current fee structure is unlikely to change.

Q: What effect will negative interest rates have on the M&A market?

A: Low or negative rates have not affected the cost of capital. Capital has been cheap for an extended period.  Any nominal change in interest rates will have little to no impact.  What is more important is the availability of capital. It is the extension of investors risk appetite that is the greater concern. Investors are stretching beyond their comfort zone, getting riskier with their investments.

Q: What is the state of European M&A?

A: The trade war with China has caused a number of unintended consequences, one of which is that China has refocused its M&A activity away from the U.S. to Europe and Germany in particular. Lincoln’s office in Germany will set an M&A record in deals for 2019.

Investing in the New Space Race

The Educational Advisory group hosted an event on September 12 at the Palmer House Hilton to educate financial professionals, investors, and space enthusiasts on the technologies of space exploration, the geopolitical landscape, and potential winners and losers in the new space race. Attendees learned about how disruptive forces in the space industry will impact other industries and how this translates to investment opportunities.

Moderator, Myles Walton, CFA, managing director and senior analyst at UBS guided the panel discussion utilizing his wealth of experience as an aerospace and defense analyst and work with defense policy and weapons systems. Panelists at the event included:

  • Steven Jorgenson, co-general partner of Starbridge Venture Capital and founding partner of Space Finance group, Quantum Space Products, Space Angels Network and Integrated Space Analytics
  • Mark (M.E.) LaPenna, founder and CEI of Xenesis a pioneer in space-based optical communications technologies
  • Richard Godwin, serial investor and business consultant and director of cutting edge NewSpace and aerospace companies
  • Dr. Joan Johnson-Freese, U.S. Naval War College professor, Charles F. Bolden, Jr. Chair in Science, Space & Technology, former chair of the National Security Affairs Department at the Naval War College and researcher and author

Myles framed the discussion by asking panelists to comment on what they are most optimistic about space exploration space and what they felt were lessons learned. Johnson-Freese highlighted that seeing investment from the commercial side that came to fruition ten years ago is encouraging. This is balanced with the awareness that space projects take a long time and subsequently have a longer investment horizon. Most technology is dual-use for civil and military and because of this geopolitics come into play. Jorgenson is encouraged by the investing opportunities he sees and that companies in this industry are profitable sooner than expected. He asked us to focus on how these companies impact other industries in the economy. LaPenna honed in on data science commenting that long-term there are many ideas that are yet to be recognized or developed. Investors should not follow the herd and look for diamonds in the rough.

Shifting to lessons learned, Jorgenson spoke of previous business models that were developed by engineers and not by business-savvy managers. Business-savvy managers have come in and the management and execution risk has become better helping to define client demand with a path to revenue. Having a mix of government and commercial investors has been key. Johnson-Freese agreed that business-savvy managers have added value and that the US government recognizing innovation in commercial firms is also a big step. Godwin reflected that the work-life balance of the highly driven and intelligent employees in these firms was not sustainable. LaPenna provided a perspective that some approaches may not be realistic and there is no cookie cutter formula for determining an effective business model. For example, space entrepreneur Elon Musk wants to finance privately but his satellite project is estimated to take 15 years to obtain a mass of 750 million users.

There is significant momentum behind non-governmental stimulation for the space industry. But, is this good or bad? All panelists largely saw this as a positive boost to the space industry. However, with unique opportunities come unique challenges. A key threat is space debris. As satellites are increasingly used, who owns the natural debris found in space and more importantly who is responsible if a satellite is damaged? Godwin pointed out that no one is solving this obvious insurance problem. The insurance industry needs involvement and issues caused by debris need prioritization and resolution. Johnson-Freese added that space law is evolving, and another unique issue is forming laws around how to bring back things from space. In examining challenges, a big question is if global connectivity is demanded by space applications. Steven Jorgensen commented that solving spectrum and bandwidth issues is crucial and optical may provide faster connectivity compared to other technologies. Of options available, optical may also be a cost-effective solution.

What does the future look like for governmental space programs and what should investors expect? Part of the answer lies in American culture. NASA is culture and Americans are proud of the space program but are not as keen on funding it with tax dollars because they do not see it as a priority. Space is taught as a history lesson, but the American public is less interested in the underlying mechanics. It is also cheaper to continue using old technology versus testing new technology. New programs are announced but do not come to fruition due to costs and the inability to gain traction. Programs that do go forward have protracted development cycles opposite of how American culture focuses on quick turnaround. This causes political and technical risk. The original space race originated from political tension. Panelists pointed out that if China lands a man on the moon, the US could have increased enthusiasm for space programs.

A theme throughout the program was the role of private investors versus the government for the previously mentioned dual use technology typically used by the defense sector and how this will play out in the future. LaPenna thinks private investment is vital and reminded us that if you look back in the airline industry, many airlines were spurred by private investments from millionaires. He believes if you don’t dream big, you don’t get returns. Richard Godwin believes that it all comes down to survival and that one needs to understand the market from a technical and customer perspective. Godwin also suggested that investors should consider that many of the firms will not likely get to an initial public offering (IPO) stage and will be acquired by the government. Johnson-Freese shared an observation about barriers for commercial firms investing in space. A significant roadblock that hinders commercial firms is working through government requirements such as contracts, security clearances and paperwork. This has impacted product development adversely. On the other hand, venture capitalist firms have been able to make inroads and now have calls with the US Air Force to learn firsthand about requirements. The Air Force in turn can fund projects quickly and is working closely with private industry.

As investors, what should we take away about space investing?

  1. Few funds focus on this small sector where markets are somewhat limited.
  2. There are technological and business challenges such as global connectivity and space law that need to be solved creating investor opportunity.
  3. Private and commercial investment is growing but investment models are in their infancy with large investors filling roles that the government can’t.
  4. Projects and products have protracted multi-year time horizons.
  5. As this sector continues to evolve, there are many needs and products yet to be identified.
  6. The government is working more closely with entrepreneurs and the private sector than in the past.
  7. A catalyst such as another world power reaching a milestone could place an increased emphasis on space investing.

The space industry has an exciting and uncharted future. Buckle up and get ready for a zero-gravity experience.