The Crisis in Global Capital

Tim Price lives at an intersection. Only his intersection doesn’t show up on Google Maps. As the CIO, Global Strategies for one of the world’s largest hedge fund and private equity investors, he has his finger on the pulse of the alpha-generation industry and on his clients’ growing demand for alpha. In other words, he lives at the intersection of supply and demand for alternative investments - an intersection that is becoming one of the busiest in the world.

As a result, his monthly commentaries can be thought of as a traffic report delivered from his own living room window. This month’s commentary illustrates how private equity is as fundamentally disruptive as hedge funds and ETFs.

Price contends that the global economic freight train is rolling down the tracks at full speed - “the best of times”. But certain sub-sectors of the asset management business are being tossed out the train’s window to reduce weight - “the worst of times” (for those sub-sectors at least):

“…with equity markets internationally close to all-time highs and volatility close to all-time lows, now may seem an unusual time to be bemoaning a crisis in global capital. But crisis there is, as traditional markets and investment approaches are being torn apart by competition from more aggressive corporate activists (primarily private equity partnerships and hedge funds) and, perversely, from highly innovative passive structures (specifically, low cost exchange-traded funds). One could be forgiven for thinking that both the listed equity markets, and long-only equity fund managers, were living on borrowed time.”

Price says that the (herein chronicled) trend toward alpha-centric investing is fueled by a misalignment of manager and investor interests in the mutual fund industry. This conflict, he says, is actually a subset of the broader investor-agent conflict that has existed in most large corporations over the past 100 years. Private equity funds, LBO funds, distressed debt funds and activist hedge funds have disrupted this century-old status quo and unlocked value for investors. Now Price suggests that alpha/beta bifurcation in asset management is an instance of this same trend.

“The owner-manager conflict (or agency risk, if you will) arises in other guises in capital markets. It impacts on corporate bond holders, since management has every incentive (“conflict of interest”) to reduce the value of corporate debt obligations. It is also present in fund management between investor and manager.”

How do we rid ourselves of these conflicts? Price quotes Michael Jensen (coincidentally, one of the first to identify that mutual funds produce very little alpha), who in 1989 argued that LBOs, spin-offs, going private deals - basically any transaction that reduced the size (and increase the focus) of corporations - leads to lower agency costs. We would add that smaller organizations that are more focused on niche value propositions have enabled the disaggregation of traditional products and services. And what better “traditional product” to disaggregate than a high-beta mutual fund?

Addendum: This week’s Economist contains an interesting article about the propensity of today’s management to under-invest in new projects. This is chalked up to hurdle rates that are too high given today’s low rate environment. This excessive conservatism appears to be yet another instance of the agency costs Price discusses.

Says the Economist:

“Executives are all too happy to return cash to shareholders by buying back equity. This has the great advantage of boosting earnings per share, one of the key measures watched by investors. In turn, this supports the share price on which (thanks to options) bosses’ pay often depends….In contrast, investment in new plant and equipment may take years to recoup. Given the rapid turnover of management, executives may feel there is little point in planning for the long term, when only their successors will reap the benefits.”

Comments

[saud ibn ab...:]

How will have your analysis failed to include ...."The OTC derivatives market has exceeded $370 trillion and it will not be long before it exceedes that size." Financial News, 20 Nov 2006, pg 41, "Depository trust moves closer to global warehouse dream" by Natasha de Teran. view at www.efinancialnews.com What affects, short term views, would have been mandatory. Consider bankruptcy of Long Term Capital. How are hedge funds following accounting rules for posting $70 trillion in derivatives? email me please

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2007 Jan 12 06:06 PM