The Best Private Equity Funds Show Persistence

There has been endless debate about whether the best mutual and hedge fund managers show real skill in terms of being able to achieve persistent outperformance. A recent paper by the Boston Consulting Group presents evidence that the best private equity funds do show persistent outperformance as shown in the key figure below:



As I argued in yesterday's post it is important to pick good private equity funds as the average fund globally shows high risk but not neccessarily risk-adjusted outperformance compared to public equities. There is plenty more interesting stuff in the paper.

Listed Private Equity Newsletter

LPX is a global index of listed private equity firms and funds. Though I can't find a public source for the fifty stocks composing the LPX50 Index, they do have a monthly newsletter, linked at the left of their homepage which inlcudes the ten largest firms in the index and the top 5 and bottom 5 performers for the month. Going through a bunch of these, one might be able to get most of the index components except the smaller persistently mediocre ones :) The recent performance of the index has been rather poor and it has been volatile over its history. So it is important to pick good stocks, if one can:

UK Listed Private Equity Strongly Outperforms Public Equity

Source. This chart explains why this sector is so interesting :)

U.S. Listed Private Equity

In case you didn't know, there is a U.S. Listed Private Equity ETF. The problem is that many of the companies on the list are not even really private equity firms. For example, Capital Source does provide loans to private equity backed companies but that is just one of its activities. Other companies on the list are private equity management companies such as Blackstone. You are buying a stake in the management firm, not in the private equity portfolio. In other cases, for example, Ares Capital, the firm is mainly making loans, not taking equity. At a quick glance, the following included firms do seem to be genuine private equity investments:

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I'm already a shareholder in MVC. I may look into the remainder of these in a little while.

Interactive Brokers Can't Add Private Equity Stocks

Unfortunately, Interactive Brokers can't add the two private equity stocks I discussed on Tuesday and Wednesday. The reason given for the Lehman Brothers fund is that it is traded in dollars on the Amsterdam exchange. Regarding the Bear Stearns fund, they just stated "we do not offer this segment on the LSE". It's not surprising that volume in these two funds is as low as it is. The following listed private equity funds are available for trading through Interactive Brokers:

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.l indicates a London listed stock and .f a Frankfurt listed stock. I'll report on these funds in the coming days. Please let me know of any others you'd like me to look at.

I got 50 unique pageviews for my post on the Lehman fund and my traffic from New York and London is up significantly in the last few days - usually the cities where I'm most popular are Sydney and Canberra. But I don't know how everyone got here. According to Google Analytics a lot of people searched for Lehman Brothers ticker:



But when I put those keywords into Google (which totally dominates the list of search engines produced by Google Analytics) my blog doesn't come up in the results. So I'm mystified as to how the visitors actually got here.

Bear Stearns Private Equity

I bet you thought that Bear Stearns ceased to exist? This fund, though now managed by J.P. Morgan, retains the Bear Stearns name. Like the Lehman fund I discussed yesterday, it is managed by an American investment bank, listed on a European exchange (in this case London) and its price is quoted in dollars (rather than Euros or Pounds). It also currently trades at a discount, though not as large due to a biannual redemption feature. Whereas the Lehman fund is mostly invested in North America, this fund is invested 60% in Europe, 28% in North America, 9% in Asia, and 3% elsewhere. The two funds nicely complement each other geographically. Like the Lehman fund, the fund is mostly invested in buyout funds, though they have a somewhat higher proportion allocated to venture capital. Again, like the Lehman fund they invest both in private equity funds and direct coinvestments. An unusual characteristic is the fund's desire to buy out other funds of funds that trade at a discount.

The Bear Stearns fund now has a three year track record during which it has recorded very good performance, especially since the start of the credit crunch:



It has returned 18% since the start of the subprime crisis, while Lehman has returned 8%. Lehman was only half invested though at the start of the subprime crisis and seems to have picked up the pace more recently.

The fund is leveraged through the issuance of preference shares. Fees include a base management fee of 1.125% to 1.05% p.a. (depending on fund size) and a 7.5% performance fee above the performance hurdle of 8% NAV growth.

BTW, Interactive Brokers got back to me. They are going to look into including these two tickers in the their database. So if you are interested in investing in Private Equity and have an Interactive Brokers account - and if you either want to trade futures, invest internationally, or just pay low brokerage fees, you should - maybe you'll soon be able to invest via these two funds.

Lehman Brothers Private Equity

Lehman Brothers Private Equity is a closed end fund trading on the Amsterdam/Euronext exchange. It's only a year old. As the chart above shows the NAV has increased since inception in a period of very volatile markets though about half the fund has been allocated to investments since the IPO, which will have smoothed returns. The share price has been all over the place but now is trading at a very substantial discount to NAV. The firm mainly invests in private equity funds. 64% of those funds are managed by managers whose previous funds were in the top quartile of returns. A smaller portion of the fund consists of direct "co-investments" in companies alongside private equity funds. 75% of the firms investments are in North America, 22% in Europe, and 3% in Asia. The majority of investments are of the buyout variety, with smaller amounts allocated to "special situations" and venture capital. There is no debt at the fund level. The firm has an unused credit facility.

I tried to trade it in my Interactive Brokers simulation account but got the message that there is no such ticker symbol and it isn't included in IB's product listing either. So I've sent a "trouble ticket" to IB and e-mailed the company to see if it can be included.

The firm is listed in Amsterdam, I suppose because it is an investment fund that charges a performance fee. The SEC forbids charging performance fees to non-qualified investors. Other governments (including Australia's too) aren't worried about this.

P.S.

I already got a response from the company. They contacted IB and IB told them that the request for a new listing has to come from a client. This morning I added a request for BPLE.L to my so far unprocessed ticket.

Listed Private Equity

I'm researching potential listed private equity investments. Currently I have a little under 7% of net worth allocated to private equity. My main investments are:

Leucadia National (LUK) Though people don't think of Leucadia as a private equity firm - it's usually mistakenly called an "insurance company" or a conglomerate - their model is to invest in or takeover struggling companies, turn them around and resell them, or provide venture finance - for example in helping Fortescue Metals get going - as well as invest in other funds, real estate and infrastructure development etc.

ING Private Equity (IPE.AX) This is a fund of funds, investing in Australasian private equity funds. It currently trades below book value, but recent asset sales have been at above book value.

Allco Equity Partners (AEP.AX) This company has a few large investments. Its biggest investment is in publicly listed IBA Health. But it also has smaller private equity holdings which it intends to eventually sell on. It trades at way below book value. The company hasn't tried to address this issue so far. They have no debt and are not entangled in the Allco Finance house of cards.

MVC Capital (MVC) This is a direct private equity fund with mainly US and some European investments.

MVC seems pretty unique as a US listed private equity fund. Another listed fund is Equus. Many funds and funds of funds are listed in London. The IPEIT website highlights several of them. And then there is a Lehman Brothers fund of funds listed in Amsterdam.

I'm looking to invest in a couple of them. But I can only invest $US4,000-5,000 without falling afoul of the Australian FIF regulations as I already have about $A8,000 invested in a Man managed futures fund. If a fund or stock is not exempt from FIF you must mark it to market each year for tax purposes and pay tax on the unrealised capital gain. This means you lose the long-term capital gains rate concession. While US mutual and listed funds are exempt from the FIF regulations, European ones are not. Under the FIF regulations you can invest up to 10% of your portfolio of foreign stocks and funds of funds which normally would not be exempt from the rules and still be exempt from them.

Anyway, I'll be posting soon some comparison of these European listed funds.

Macquarie Capital Alliance Group to be Privatised

Another Macquarie private equity listed fund to be delisted. This bodes well for my various Australian listed funds that are trading at huge discounts to book value: EBI, AEP, IPE, CAM, and PMC. Though CAM and PMC are more traditional share funds. EBI continues to attract new hedge fund investors. The manager of the fund referenced in the EBI announcement, Andrew Weiss, was a professor of economics at my Alma Mater, Boston University. I remember once I went to look for him for some reason, but never did meet him. Some grad student was sitting in his office. EBI are going to introduce a buyback facility that will come into play whenever the fund trades 10% below book value. The problem with AEP is of course that it was an Allco sponsored fund, so no privatization likely there, though I expect another more serious takeover effort if it continues to trade so cheaply.

How Does the American Economic Association Invest?

The American Economic Association (the World's top academic economics society) has an $18 million dollar potfolio. They're currently invested 85% in stocks and 15% in bonds. 55% of the total is in US equities and 30% in foreign equities. In April 2007 they reduced the bond percentage from 35% to 15%, which mirrors my more recent moves in my own and my Mom's account. But I made this move after the 2007-8 stock market correction not before it. Still their moves out of high-yield corporate bonds and the total bond market into investment grade bonds were well timed. As Mankiw notes it's surprising they don't have any real estate and I'd add any of the alternative assets such as private equity and hedge funds that the best performing university endowments have. Well, I guess they are a bit too strong believers in efficient markets to do anything like that...

MVC Capital

I added MVC Capital to the private equity category. Also added to Newcastle Investments after they released their earnings and again bought XLF, the financial ETF. I was planning on doing more stuff but didn't expect just how strong the market was going to be. So I was looking for a pullback to get positioned and it just didn't happen. Well, it happened soon after the US open and I missed it. Oh well, better to be out of the market wishing you were in, than in the market wishing you were out :)

Next Investment for my Mom

We had a structured note product - managed futures with a capital guarantee. It has now matured and it is time to reinvest some of the money. I'm planning to reinvest the amount we originally invested in this product and transfer the profit to our other broker to be added to our investment with Thomas White. Our manager at UBS sent information on some products we could re-invest in:

1. Man/AHL managed futures - This is a very similar product to the Man fund I have invested in myself. I did some analysis of the data supplied - it's returned 16.5% p.a. since September 2002 with a 4.9% monthly standard deviation. The MSCI returned 17.2% with a standard deviation of 3.1%. So it gives stock like returns but with more volatility. However, it has low correlations with other investments. 0.11 with the MSCI, 0.23 with CREF Bond Market, -0.03 with TIAA Real Estate, zero with the S&P 500. The only strong correlation I found (0.73) was with Superfund Quadriga B another managed futures product. Is there a managed futures beta (systematic risk factor) ? Yes, I like this product :)

2. UBS A&Q Alternative Solution Index Certificates - This provides access to UBS internal hedge funds. A&Q stands for "Alternative and Quantitative" - these are quant driven hedge funds. 75% of the money is in hedge funds, 10% in commodities, 5% in real estate, 5% in private equity, and 5% in cash. Between June 2006 (inception) and the end of February the Certificate returned an annualized 10.46% with a Sharpe ratio of 1.02, which beat the various benchmarks presented (The SPX did 4.91% including dividends). So this product seems to be of good quality.

3. UBS Multi-Strategy Proprietary Index Certificate - This also provides access to UBS internal hedge funds - but these are the O'Connor funds which are not quantitative funds. Both hedge fund products diversify across individual funds and strategies. From May 2004 to October 2004 it returned 6.09% with a Sharpe ratio of 0.68, which is not particularly attractive compared to equities in that period but better than bonds. Interestingly, at the end of October they terminated their U.S. long-short equity program due to underperformance. So maybe returns will improve going forwards?

4. UBS Agribusiness (USD) Strategy Certificate - 80% is invested in agricultural related stocks and 20% in commodities. I wonder if this is a sign of a bubble - selling this stuff to investment bank retail clients? Maybe a little bit in this one? There is no data as it is a new product.

Minimum investment in these products is typically $10k with $1k increments above that. You don't need huge amounts of money to invest in hedge funds, at least outside the U.S.

He suggests investing most in option 2 and less in each of the three others. We're looking at a $US200k investment. I'm going to suggest to weight the Man/AHL fund more highly than the O'Connor funds or the Agribusiness Certificate and give him the benefit of the doubt on the other two.

I'm also looking to replace a bond fund with an equity fund. The bond fund only returned about 3% per year since we bought it in 2003 and we have too many bonds. More on that in another post.

Madame X: Summing Up

Here are all the posts I've written on this topic:

Miscellaneous Funds
U.S. Large Cap
U.S. Mid Cap
U.S. Small Cap Funds
International Stock Funds
Bond Funds
Individual Stocks
Asset Allocation
Portfolio Overview

Overall, the portfolio is OK as a stock-bond portfolio for someone of Madame-X's age. It is reasonably well diversified across US and international stocks and stock capitalization classes and has a reasonable allocation to bonds. It has some good actively managed funds and some poor ones as well as index funds.

I've suggested increasing the international and large cap allocation a bit using new contributions as well as dumping some losing funds and getting a more rational allocation to actively managed and index funds in some cases.

I would also look at diversifying further. This can be hard to do without losing exposure to the stock market - as long as the additional asset classes have good expected returns this shouldn't be a real problem. The other solution is using leverage to gain more than 100% exposure. I invest in a variety of funds and financial firms that I classify as "passive alpha" - these are all investments which I expect to have a lower correlation with standard stock or bond index funds. They include:

• Real estate

• Hedge funds

• Private equity

• Commodities

• Very actively managed stock funds - where the manager makes no attempt to benchmark against an index. Examples are FAIRX and CGMFX. All those readers who think it is impossible to identify a good fund, have a look at these two. I also like Fidelity's Contrafund (which has nothing to do with Nicaragua :)) and Janus' Contrarian Fund.

• Other financial firms - such as Berkshire Hathaway - an insurance conglomerate - or Interactive Brokers - a market maker in the financial markets.

You have a strong exposure to real estate through your condo - though that is just one investment in one market. As real estate prices fall, funds that invest in real estate could become attractive.

Hedge funds are obviously usually out of bounds to retail investors in the U.S. But there are mutual funds that take short positions. I have shares in TFS Capital's Market Neutral Fund. I also have the Hussman Strategic Growth Fund, but I'm not recommending it :).

Private equity is another hard to access asset class. I don't recommend investing in Blackstone. On the other hand, Leucadia National is in effect a private equity company.

Commodities - you have an energy fund - there is also the option to buy ETFs exposed to commodities like gold. I don't have any in my portfolio - my exposure to a resource fund and the Australian Dollar and Australian stock market is sufficient I think. A non-energy mining oriented fund might make sense in addition, but that's very optional I think.

I'd look at 5-10% in any of these categories in the long-term.

Remember - all these suggestions are what I would do but aren't necessarily what you should do. As they always say - seek a second opinion, I am not a qualified/registered investment adviser.

China Trade

I bought some CHN - the China Fund - and CNY - a new RMB ETF. The latter should appreciate against the USD in the long-term as the Yuan is revalued - I'm investing some of the dollars in my Interactive Brokers account into it. The former seems to me to be the best of the various China funds. They have access to Shanghai A shares as well as the ability to invest in private equity in China. But they recently moved money out of the PRC and into the Taiwanese market before the recent fall in the mainland markets. The fund has outperformed both TDF (Templeton Dragon Fund) and GCF (Greater China Fund) and FXI (H shares index ETF). I like what I read about the manager. Clearly, as shown by their recent moves and their portfolio they are not an "index hugger". I also trimmed some risk in XLF, BWLD, and SHLD in this morning's rally. I sold out of SHLD entirely. Likely, I will buy back in again at some point.

U.K. Stock Research - Listed Private Equity

Digital Look is a great source for research on UK stocks. Far better than Yahoo's offering. I haven't invested in the UK yet, but been looking up info on a couple of companies and was recommended to check this site out by a poster on a Yahoo message board.

I was using the site today because of the takeover of a listed Australian private equity fund by the London listed Bear Stearns Private Equity Limited (BPLE). IPE is edging up today, presumably in reaction. BPLE itself looks like an interesting investment. I'll add it to the watchlist. My main concern is the Bear Stearns name. The biggest position is in a Bear Stearns private equity fund (8%).

Shift in Allocation

Things don't look as bad today as yesterday. At this point I've shifted 10% of the portfolio into stocks as well as a little into private equity, since the close of last month and increased beta by 0.14 points:



* Note: Private equity, hedge funds, and real estate are all mutual funds or listed stocks with the characteristics of those asset classes.

This has been achieved by reducing cash and increasing borrowing rather than selling other assets. I'll sell a little on a bounce in the market or if the bounce doesn't materialize. Only when the lows are successfully retested will I get really aggressive and start selling stuff to increase stock exposure.

Leucadia National

I bought some shares in Leucadia National, which has long been on my watchlist. Essentially it is a listed private equity firm. They should find some good opportunities in current market and economic conditions. I'm classifying this as a "passive alpha" investment in the asset class "private equity".

New Private Equity Investment

Yup, another new investment. ING Private Equity Access. I heard about this one from Enough Wealth. He sold 20,000 shares and still holds 80,000. I bought 6000. The stock is a fund of private equity funds. I am also invested in Allco Equity Partners, which is a single fund, though with its recent large investment in IBA it has more money in publicly listed stocks than private equity. My main reason for investing in IPE is that it is selling way below the book value of its investments. At some point hedge funds and private equity will no longer be the pariahs they've become since August and the price to book ratio should rise. I have more private equity investments on my watchlist. I only have 2.3% of my portfolio invested in these two stocks.

The larger question is whether the stockmarket is bottoming here?



Looking at the chart you can see three very similar candles at the end of the current move down and the previous two major moves down. On the other hand, the stochastics do not appear to be bottoming here. The model allows for up to 2 or so days of downside from here. The weekly chart has reached the lower Bollinger Band in a similar way to the 2006 and 2007 lows. However, in 2007 the market declined considerably after bouncing from the BB. There's not yet any good sign of a bottom in the McClellan Summation on a weekly chart. The same goes for the bullish percentage. So I am very cautiously adding these new investments here, putting 1% or less of the portfolio into each. I'm not doing anything radical yet.

Annual Report: Asset Allocation

The table shows our asset allocation at the account and security level at the end of 2007 (before my recent flurry of trades). The split by currency is not perfect - for example the CFS Conservative Fund has foreign (to Australia) investments while Platinum Capital is partially hedged into Australian Dollars. "Passive Alpha" investments obviously have plenty of correlation with the market (I call them "passive alpha" to distinguish them from my own active trading). I include in this category all financial stocks and funds whose performance would be expected to contain significant sources of return which aren't pure stockmarket beta. This includes a fund of hedge funds (EBI), hedgefund like funds (Hussman, TFS, Platinum Capital), real estate funds (Challenger, TIAA, Newcastle), and private equity (Allco). The Clime fund (CAM.AX) is a long-only closed end fund but deliberately does not track market benchmarks and is very focused. My rationale for counting a stock like Interactive Brokers (IBKR) as alpha is that the majority of their income comes from market-making. If this isn't a source of alpha in the financial markets, I don't know what is. There are also fund management companies (Clime and EBB), a bank (HCBK), and insurance companies (Berkshire and Safety). Beta investments are more traditional mutual funds, which can be pure stock plays or diversified or even bonds, which have less stock market beta. We only had one trading position at the end of 2007 - Beazer (a homebuilder) put options. It was doing OK. I only have two non-financial stocks listed under "industrial stocks" - Symbion and FTS. I don't believe that I have an edge in picking individual stocks so I don't do much of it. But investing in a bank stock, for example, is a way of indirectly getting exposure to a financial asset class (loans) that is hard to invest in otherwise. All the other categories of accounts either support our lifestyle or investing (margin loans). By using margin loans we are 98% invested in long-term investments as well as having 6% allocated to trading, while having liquidity for everyday life.

The table doesn't split things down by retirement and non-retirement accounts. 47% of the total is in retirement accounts.

In retrospect, I have been too conservative in my beta investments in the last couple of years, though now it is beginning to pay off to some degree. On the other hand, my passive alpha investments, which had been doing well, took a distinct turn for the worse from the August "quant crisis" onwards. I plan to get more aggressive in my beta investments once there are some clearer signs of a bottom in the stockmarket. I'll also be adding new passive alpha investments and aiming over time to reduce the percentage allocation to Australian Dollars.

Choosing a Superannuation Asset Allocation

I checked out the "product disclosure statement" a.k.a. prospectus for Snork Maiden's superannuation fund a.k.a retirement account. One interesting point is that under the "superannuation choice legislation" you can opt out of the employer sponsored fund for a private provider but then instead of contributing 15.4% of pay (North Americans with employer "matches" will be envious of this number) the employer may only pay the legally required minimum of 9%. The employee can contribute between 2% and 10%. I am supposing the default is 2% - I will find out when I get to see a pay stub. We will stick with 2% for the moment. 17.4% is a very high rate of contribution as it is. Though when I worked in Australia before our required total employer-employee contribution was 21%!

On asset allocation I am thinking to allocate 90% to the default Trustee Choice and 10% to the "Sustainable Option". The sustainable option is managed by AMP and invests in Australian Shares selected according to various ethical and environmental considerations, both positive and negative. The Trustee Choice is allocated:

Australian Shares: 30%
International Shares(hedged) 22%
Long/Short Equities: 5%
Property: 15%
Cash: 2%
Bonds/Fixed Interest: 16%
Market Neutral Strategies: 10%

This is fairly typical of current endowment or pension fund allocations - 52% allocated to equities, and about 15% to each of hedge funds, bonds, and real estate. For those concerned about management fees they are 0.77% on the Trustee Choice plus an average 0.05% in performance fees and 0.51% for the Sustainable Option. No, there are no index fund options, but I expect a chunk of the Australian and International Share exposures are index tracking.

There is an "Aggressive Mix" that cuts out the bonds, slightly reduces the hedge funds, and increases straight equity exposure to 70%, but I prefer to go for more diversification.