Volatility is bad for Hedge Funds !!

Increased allocation to equity long-short strategy during extreme volatile markets is precisely the worst thing to do. Thats where some hedge-funds have made mistake.

Much of the problem this year has come from extreme price movements in different markets. The S&P 500 has moved by 1 percent or more on about half of all trading days this year, according S&P. The last time the percentage hovered at that level was in 1938. Commodities prices have also moved wildly. This year, crude oil has fallen below $90 a barrel twice and jumped to a high of $110 a barrel. U.S. dollar has lost 4.13 percent this year against a trade-weighted basket of currencies tracked !!!

No hedge is perfect. In periods of unusual volatility, hedges are more likely to fail. They are much more likely to outperform in a low-volatility bear market than in a high-volatility messy market. Much of their "black-box" complex algorithamic models start to behave abnormally during volatile markets as they are unable to forecast anything clearly & bad trades happens... I have heard - at times of extreme volatility, some Hedge Funds does wise thing - put algors to rest :)

If Hedge Funds are investing in a relative-value play, then volatility works against them. It's only the noise traders who really make money from volatility, and they're actually a minority in the hedge-fund world. Anyhow, if a Fund hasen't blown up yet, money will keep pouring !!

Recent LBO deal trends

• Average size of LBOs has fallen to under $1 billion from $2.1 billion in 2007.
• Average equity contribution in leveraged buyouts has increased from 33% in 2006-2007 to 42% in 1Q08, which is near levels seen in 2001-2003.
• Difference (in terms of EBITDA multiple) between what sellers willing to sell for and what lenders are willing to finance has increased.
• Leverage/Coverage metrics have improved.
• Average Debt/EBITDA multiple in large corporate LBO loans has decreased from 6.2x in 2007 to 5.1x in 1Q08.
• Average interest coverage ratio in large corporate LBO loans has increased only slightly (due to wider spreads) to 2.2x in 1Q08 from 2.1x in 2007.
• Structures of loans have become more stringent due to significant increase in the use of LIBOR floors, Financial tests, Restricted payments language and no covenant lite loans.

CDOs greed spells financial crisis

The story is familiar- Bear Stearns and many others.... here is a perfect example of CDOs mess....

IKB Deutsche Industriebank AG, a German bank, was bailed-out for €3.5 billion. This is because IKB’s subsidiary- Rhineland Funding Capital is in a financial crisis. The reason is that Rhineland was holding €14 billion debts, most of them are Collateralized debt obligation (CDO).

CDO is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also..... these CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept teh ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!

Coming back...... Rhineland issued commercial papers to get the required money to buy CDO's. Since commercial papers have lower interest rate than CDO, Rhineland earns the differences and became a very profitable vehicle of IKB.

So this is how the cash flows: US investors bought commercial papers from Rhineland, which had very good credits. And Rhineland is paying them at a rate of LIBOR. Rhineland then used the money to buy CDO’s from other US issuers. These debts have higher risk and pay higher interest rate to Rhineland and many are back by MBS’s. So, Rhineland earns profits.

Last few years, the US banks provided more mortgage to homeowners with weak credits (e.g. some even allow the homeowners to have zero down payment) during low interest rates years of 2006. These are called sub-prime mortgages. However, the abilities of these homeowners to pay the mortgage are generally weak. As a result, when there is a slight economic downturn or increase in interest rate, these homeowners have to give up their houses to the bank. But since the housing price has been dropping, even banks are not able to get back the entire mortgage through house auctions. So, banks won’t be able to pay the MBS they have issued! And since some CDO’s have MBS as backing, these CDO’s will be default too.

As a results, CDO’s market price drops. Rhineland also has to pay back the money to their commercial paper holders as it is of shorter terms. But Rhineland cannot do so because the price of the CDO’s it’s holding is dropping. And they cannot issue more commercial paper neither because now everyone believe that Rhineland is holding risky CDO’s backed by sub-prime mortgage. So, Rhineland is in financial crisis.

Since parent has to back its subsidiary, IKB is in financial crisis too. Similarly, many other hedge funds and investment banks in the world have engaged in the CDO’s or MBS’s involving sub-prime mortgages. And similar was Bear Stearns story - fallout of Bear's hedge funds that actively traded CDOs!!!

Today, the world is blaming complex CDO products for the financial woes of the 2007 credit crunch. Credit rating agencies failed to value these products using their risk and recovery models. Some institutions buying CDOs even lacked the understanding to monitor credit performance and estimate its expected cash flows. As many CDO products are held on a mark to market basis, the steep fall in the credit markets and declining liquidity in CDOs led to substantial write-downs in 2007-08.

Levels of asset classification for fair valuations

FAS 157 divide Banks/PE's/Hedge Funds assets into three “levels”, according to the freedom with with which they can be bought or sold.

Level 1 assets have quoted prices in active markets such as US government bonds or gold bullion, thus valued at mark-to-market.

Level 2 asset - these assets are not as fully marketable as level one, but still sufficiently tradeable to have a definite value. Known as mark-to-model, these are estimates based on observable inputs. generally banks have their own valuation models (e.g. price multiple model & further complex ones)

Level 3 assets – usually artificial financial instruments – are the problem. They do not have quoted prices in active markets. They have to be valued by reference to the bank’s own models. Level 3 consists of unobservable inputs, its what market participants would use to price the asset or liability (including risk), using the best information available.

Another problem arises when the investment is a greenfield project (no revenues generated), and no market comparible exists as hardly greenfield projects may get listed on bowsers. There we have to rely on company's projection - however good or bad - a model is hard be build around this!!

According to industry analysts, the holdings of level 3 assets are substantial. Lehman has $22 billion; Bear Stearns $20 billion; JP Morgan Chase $60 billion, Goldman Sachs $72 billion. Even these figures may be understated, since the banks have themselves decided whether assets belong to level three or the more acceptable level two. Thus any jolt to economy may cause huge write-off trigger for Investment Banks/PE's and Hedge Funds.

Fair value nightmare - FAS 157 could cause huge write-offs !!

It’s haunting the private equity industry: the value of an otherwise healthy PE/LBO deal may be written down to zero now!!!

Its bacause of "FAS 157 - fair value" and it has come at the worst-possible time. Investment firms might have to declare that they invested into worthless equity during the LBO boom. Effective November 15, 2007, the Financial Standards Accounting Board mandates that assets be measured at "fair value", described as "the price that would be received to sell an asset now". Most PE's wouldn’t dream of selling an asset until they felt both the asset and the exit path were as strong as possible. But FAS 157’s fair value approach requires them to imagine selling their portfolio items each quarter, and to identify the factors that would play into the value. Generally PE's/LBO's are generally conservative when it comes to valuations & they prefer to keep the investment at cost (anyhow auditors need a real good reason to okay a write-up).

The trouble is, these buyout deals took place at huge premiums just over a year ago, and now the markets have fallen dramatically. If you value these companies based on public comparible companies - the fair value of your investment is probably zero!! Lets take an exapmle: in the roaring first half of 2007, a buyout firm buys XXX for $1 billion. The company has EBITDA of $100 million, they agrees to pay a 10x multiple – at the high end of a range of multiples in the sector. The deal involves say $300 million equity and $700 million debt, in line with the average 7 times EBITDA debt multiple banks generally offer.

Then things change. Assuming no debt is yet paid down, the public market for XXX, and now the median multiple is now around 8 times EBITDA (using bloomberg/ Capital IQ etc). This means XXX is valued at $800 million (even still XXX earnings are steady at $100 million) - which values the equity in the deal at $100 million – a 66% decline from cost.

Things worsen - still assuming no debt has been paid down, the economy forsees recession, XXX sees a slight decline in earnings and EBITDA is now $85 million. Still trading in the lowered range of 8 times EBITDA, the fair value of XXX is $680 million now. In other words, "Dear investor - Greetings: the portfolio company is worth less than its debt and your equity is (for now) worthless" !!!

Perhaps with certain auditors refusing to sign off on numbers that they feel are unrealistically high, we may see a tussle between the Investment Banks/PE's and auditors (widely hated objects :)) … FAS 157 is here to stay!!

Its easy to understand U.S. when you've "been there-done that" ......

Its a month since i am in U.S. now and will be here for another one month or so.... understanding U.S. economy becomes much easier when its "being there-done that".... i am on a company project and work for its subsidiary that is into direct capital lending to small private companies in U.S. (gosh, hot stuff & i have seen things closely!!!) ..... veterans says its the most interesting markets since last 5 years or so.... credit crisis, distress fed rate cuts, bailouts, Bear Stearns fire sale, UBS writing off billions .... markets are not not only cautious, but confused! i could feel the heat....

i have been working on some good posts now... it relates to current scenario where these financial firms face many issue - valuations of investments, raising new capital, compliance, auditors etc...

i promise to post some useful articles in next few days...
cheers