Alternative investments in the 'new normal': Part II

AsianInvestor published the first of a two-part series yesterday based on a letter we received from Jurng Chuljoong, chief performance officer at Korea Post.

In it he outlines his outlook on alternative investments, which institutional investors are turning to more and more given low returns in traditional asset classes. These are his personal views and do not necessarily reflect those of Korea Post.

At present Korea Post has 5% allocated to alternatives within its $62 billion postal savings unit, and also 5% to the asset class in its $32 billion postal insurance bureau.

This allocation the government-controlled entity has pledged to raise. Here, in the second part of the series, Jurng discusses his views on private equity, special situations, alternative energy, venture capital and hedge funds.

PE portfolio rebalancing
A scrupulous approach is needed to cultivate value out of this ever-bloated asset class. My suggestion is to stay focused on niche strategies such as mezzanine or secondary rather than mega-sized buy-out funds. Cash yield for mezzanine deals has increased, while the upside potential in converting to equity remains. Expected returns of this type of fund are as high as pure equity funds invested pre-crisis. Also it offers the additional benefit of downside protection relative to exposed risk. Outstanding managers in this field are often part of large-scale firms as mezzanine investment opportunities are found in deal-flow-like buyouts. These managers within a multi-business firm have access to proprietary information on companies invested in and fees can be saved via economies of scale.

On the other hand, asset management companies that focus on buyout funds may allocate their inferior resources to mezzanine funds. Furthermore, potential conflict of interest exists as they subordinate the interest of mezzanine funds to mega buyout deals to generate huge transaction or other fees. Mezzanine investments to small business incapable of receiving any sort of loan often turn out to be a hazardous choice, so it’s necessary to concentrate on investments for large corporations.

Direct investment via various capital structures such as RCPS, CPS and CB is recommended also. We can increase our strike rate by focusing on familiar industries rather than covering a wide spectrum of businesses. It is better to stabilise the portfolio by securing cash yield before striving to get capital gains.

Secondary PEs
Due to regulations such as Basel III, there is huge demand for liquidating assets by global investment banks and rebalancing of PE portfolios by pension funds, continuing to create investment opportunities, although not as many as in 2008-09. But direct investment in secondary deals is not recommended given the low efficiency of covering a range of small deals. Most top-tier managers from this field may be found in mid to large-sized fund of PE. These managers possess superior accessibility to underlying portfolios and can accurately evaluate them. They can also easily communicate with GPs and resolve legal issues pertaining to asset transfers. Especially if they have an investment banking background, they will be able to expedite the deal process where speed is the name of the game.

While secondary investments can demonstrate early appreciation of net asset value, in the long run they may incur other losses as contingencies (committed capital) get called. Hence one must be prudent, especially when purchasing GPs that went through major employee turnover.

Emerging economies
Supported by commodities, some EM countries such as Indonesia and Malaysia provide affluent upside as well as downside protection. We can detour around China, suppressed by ever-low price-earnings ratios in IPOs by taking advantage of neighbouring countries in which growth depends on China. However, populist campaigns such as that mounted over Argentina’s recent nationalisation of YPF can jeopardise exit plans, while good GPs with long-term track record are hard to find. We think a good choice is to be to co-invested with strategic investors in your region or country or to cooperate with large local companies rather than go with global players for direct investment.

Buy-out PEs
Due to the present financial crisis, mega deals are harder to consummate and have become a lot less viable. Moreover, leverage is no longer available, and therefore multiple effects cannot be attained. This means the source of return has shifted to value improvement, from price increase. Consequently, mid-size buyout funds that enable concentrated management on portfolio companies are deemed to be more suitable than larger scale ones. However, midsize funds with track record are scarce, so effort is needed when searching for nimble managers.

Special situations
Debtor in Possession (DIP) financing is a unique system designed to protect creditors to bankrupt companies. Only a small number of sophisticated credit houses are adept at protecting the principal against the worst-case scenario. The best managers typically possess a deep bench of professionals with conservative nature cultivated over various economic cycles.

Alternative energy
Europe has served as a strong sponsor of renewable energy for quite a long time. Ironically, this propensity is now an impediment for its proliferation after fiscal constraints were imposed in that region. Also, replacement cost for existing facilities is even lower due to the evolution of technology and competition among vendors after the arrival of Chinese players. Still, this asset class should be on our watch list for opportunities coming from price fluctuation because of the sell-off of distressed owners.

Venture capital
As witnessed by the recent IPO hype of Facebook, the market pays a high price to new ventures and anticipates they will change the industrial and economic landscape, creating value. However, this buzz remains a US-centric phenomenon and is not accessible to foreign investors, especially in the early or seeding stage. Only a handful of top-tier venture capital firms consistently generate returns that fit the risk.

Hedge funds
Commonly it’s believed you can reduce overall portfolio volatility while raising return profile when investing in hedge funds that show low correlation to core and traditional assets. However, as seen by the recent financial crisis, the actual hedging effect was rather limited, and despite the high portion of leverage, during stock market recovery it generated a relatively low rate of return, disappointing many. But it is notable that the market environment has altered, making it a lot more difficult for hedge funds to generate enough returns to justify high management fees.

Most importantly, it is arduous to use leverage and systematic risk remains, which makes it difficult for hedge funds to perform at usual. Hence a new approach is needed other than strategies such as long/short, relative value and event-driven, which have been reliant on high leverage. It is better to increase exposure on funds such as CTA and volatility trading which not only can generate returns under systemic shock, but also can be complementary to a core portfolio. Also, considering structural issues that remain to pose a threat to the global economy, assigning sentinel role in tactical asset allocation within a global macro strategy is recommended.