Our Global Trend Watchlist for Private Equity

In today’s global landscape we see trends that hold a variety of unfolding opportunities and risks—and often they are the converse of each other. At Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”), close attention is paid to these big-picture trends as we work to source investments and systematically de-risk our portfolio companies.

A Reduction In Global Trade

Even before the last US presidential election, we were seeing a clear decline in global trade over the past several years. This trend clearly benefits companies with ample domestic markets and more reliance on local supply chains. That profile fits many firms in the US, the world’s biggest market, and others in Indonesia and India. What we might call “deglobalization” could also lead some companies, especially those with strong pricing power, to spin off some of their units, creating separate entities that could present new investment opportunities.

Increased Global Defense Spending

KKR is looking closely at this area today, especially in Europe and the US, with a particular focus on cybersecurity.

The Rise of The United States of Asia

We’re seeing a big uptick in inter-Asia exports based on trade deals and proximity. Infrastructure is a particularly interesting facet of that trade, and one where we see strong growth potential.

To view the article in its entirety, click here.

How to Potentially Enhance Equity Performance in a Climate of Uncertainty

As challenging as the investment landscape has been, we expect it to be even more so going forward. Global growth is slow, and the returns we have seen in recent years have been pulled forward by quantitative easing and the low interest-rate environment. Over the next ten years, returns are likely to be lower across all asset classes than they were during the past ten years.

In that context, we offer three themes investors can potentially utilize to enhance the returns of their equity portfolios. These themes underscore the reasons we believe private equity can be a useful component of investor portfolios in this kind of climate.

To view the article in its entirety, click here.

A Different Liquidity Trap

Liquidity has its dangers. The evidence is fairly clear that humans (and that category includes most investors) tend to make economic decisions that are not in their best interest. Liquidity, as it turns out, can enable this irrational behavior.

Let me back up. Behavioral finance is a young science that uses psychology to understand irrational thinking. A well-known experiment in the field gives a good illustration of the phenomenon. Imagine you could save $7 on a $25 pen by traveling 15 minutes away to a discount store. When asked, most people say they would be willing to do that. But they would not be willing to travel 15 minutes to the same discount store to save $7 on a $488 suit.

“What’s going on here?” asks Dan Ariely in his bestseller, Predictably Irrational. Saving $7 should mean the same to the consumer regardless of the item being purchased. The problem, he says, is relativity. Wrongly, most of us see a $7 savings on a $25 pen as somehow worth more than a $7 savings on the $488 suit. Yet, the return on investment of the time spent is the same, having nothing to do with what is being purchased.

It’s not just social scientists who are poring over evidence of our irrational behavior. Dalbar, the Boston firm that evaluates the financial services industry, has been studying money flows in and out of mutual funds for 30 years, and concludes that investors can be their own worst enemy. They tend to make bad decisions at critical points, in both up and down markets. The worst case was October 2008 when equity investors lost 24.21% while the S&P 500 Index lost 16.80%. The second biggest underperformance gap took place in March 2000, when the S&P surged 9.78% but investors took home only 3.72%.

Dalbar’s studies show a substantial spread between returns of funds and the returns of the investors in those funds, primarily related to timing of investments.  Philip Maymin of New York University and Gregg Fisher of the investment management firm Gerstein Fisher, wrote a more academic piece a few years back that reached similar conclusions. Their title says it all: “Past Performance is Indicative of Future Beliefs.”

Which brings me back to the subject of liquidity. The ability to convert any asset into cash immediately and easily sounds like a perfect goal for investors. In 2008, the opposite happened as liquidity decreased for every asset except cash and short-term Treasury bills. The experience was not easily forgotten. In fact, behavioral finance tells us that investors remember losses more vividly than gains, even if their gains are greater. Investors reasonably concluded that step one in avoiding similar losses required staying liquid.

It’s no surprise that liquid alternative mutual funds experienced a 22% annual growth in assets (excluding commodity funds) between 2010 and 2014, versus 12% for mutual fund industry overall.  Investors were also looking for potentially higher, risk-adjusted returns, of course, but that goal had to include liquidity.

As the above referenced studies suggest, though, the liquidity “trap” can come at a cost, behaviorally speaking. The ease with which the average mutual fund investor has been able to buy and sell securities does not always turn out to be an advantage.

Does that mean investors should protect themselves from themselves by allocating assets to illiquid investments?  It’s a question more will be asking as private equity, considered one of the least liquid of investment alternatives, makes its way to the retail market.

Traditionally, private equity has been available to institutional investors or high net worth individuals—accredited investors–who could meet the high minimums and who could afford to lock up a portion of their assets for years. Private equity mutual funds now coming to market (full disclosure: our firm, Altegris, offers one) give a broader group of investors access with characteristics similar to mutual funds.  But, importantly, they do not offer daily liquidity. Thus managers of these private equity funds can ignore the market’s demand for instant performance and untimely withdrawals.  They can focus intensely on investments that generally take more time and potentially more effort to work.

Of course, private equity funds haven’t marketed themselves as a safeguard against irrational behavior. It’s their track record that has attracted university endowments, foundations, pension funds and wealthy investors. To wit, in the 25 years through September 2015, the Cambridge U.S. Private Equity index returned 13.4% annually compared with 9.9% for the Standard & Poor’s 500 index, according to Cambridge Associates.

We have just passed the seven-year anniversary of the bull market, making this the third longest rally in history.  When the rally ends, behavioral finance studies suggest many investors, trapped by the ability to sell, will sell at the bottom and fail to get back in as the market recovers. We have already seen that in the increased volatility experienced over the last 12 months. Illiquidity might prevent you from doing just that.

This requires a very close look at what one’s liquidity requirements really are, which, of course, depends on one’s investment goals. That 3.5% illiquidity premium, as measured by the performance of the Cambridge Associates Index vs. the S&P 500, can compound into some large numbers for a child’s education or a different kind of retirement if it is maintained.

Of course, past performance is no guarantee of future results. This applies to both the liquid and illiquid markets. The odds are that we are in for a five to ten-year period of a “Warren Buffet market,” with lower GDP results, lower equity returns and greater dispersion. As Buffett recently observed, investors should be on the lookout any time the market value exceeds the value of GDP.

With a potentially lower return from the traditional markets, meeting an investor’s financial goals today does require a fresh look at allocations and some real discussions about the liquidity trap.


A version of this article was originally published on ThinkAdvisor here: http://www.thinkadvisor.com/2016/05/25/a-different-liquidity-trap

South America, PE, and the Fed

Watch Friday’s Employment Numbers

Last Friday, July 30th, I was invited back to Bloomberg Market Makers with hosts Matt Miller and Scarlet Fu. Katia Porzecanski, who follows the emerging markets, and Tracy Alloway, executive markets editor, joined the sessions. As usual the producers provide some topics a day or so before the appearances to prime the discussions. The questions were “What are you watching in South America?” “Hedge funds and Private Equity assets—what kind of strategies are you looking at?” and “What’s up with the Fed?” As in the past, below are the notes I sent to the producers in preparation for the segment.


South America: I’m watching three countries: Brazil, Argentina, and Mexico.

I don’t think we are close to a turning point on the negative GDP in Brazil. This is important as Brazil is critical to the rest of South America and accidents can happen on the corporate credit side and within the government. They don’t have a lot of levers.

Argentina, may look like a disaster, but is moving closer to an election which will bring in one of a couple of logical, policy oriented candidates, and Argentina will begin its every two decades cycle of recovery. I think the issue on their sovereign debt will get resolved. But, coming out of it may be a change in the covenants of sovereign debt in the future. For example, the ability to hold out from what a majority of creditors agree to on a settlement is likely to vanish.  This makes sovereign debt more expensive but hastens returns to the capital markets for renegers.  In addition, Argentina has phenomenal Shale-based hydrocarbon reserves, which it will be able to exploit once there are adults in the government.  A big part of the shale reserves are in the same area where Argentina’s conventional gas reserves existed. The gathering facilities and movement of the resources are already in place. This could happen quickly and economically.  Unfortunately, in the process, some of the best fishing areas in the Neuquén Province (where I used to fish!) may be destroyed. I hope not. Economically, shale extraction is a big plus. Let’s understand this will add significantly to global energy supply, and put more pressure on prices.

Mexico is, as I said on air, a shining star. The natural growth rate is 2 ½-3%. If Telecom and Energy reform happens, another 1 ½% would be added to the rate. Henry McVey, KKR’s Global Macro Head, discussed this recently on our webinar, “Investing in an Idiosyncratic World.”  Mexico could become one of the faster growing economies in the world with sustainable demographics. Energy reform there would also add to global oil and gas supply. I am pretty optimistic for Mexico.

In general, I like the Americas for opportunities—long and short. Canada is a little problematic right now given the oil patch and commodity producers may have a problem. If global growth picks up at some point, there is a cycle yet to come.


Hedge Funds and Private Equity: In general, given the market environment I expect over the next several years, I am in favor of active managers—non-benchmark-huggers, whether that is long-only or hedge funds that can generate alpha on both sides of the market.

Today, the best Private Equity firms have the most active managers among all managers. That’s because these managers can do more analysis and have more companies to choose from (than those operating in the public markets) in making their decisions. In addition, they are typically heavily involved after the investment is made and do not have to worry about specific quarterly earnings. There is truly an illiquidity premium, which could very well be widening.

I am more nervous about the Venture portion of Private Equity. It is reminiscent of the Dotcom Era. (BTW, when I first typed “dotcom,” spellcheck changed it to “sitcom.” In retrospect, that may have been appropriate.) My guess is that, as always, the top quartile performers in that space will remain at the top. One has to make sure they are investing with a top quartile performer.

I think that the five years after 2008 were hardest for hedge funds, in general.  Now we are entering into a period of low global growth but high dispersion.  One can’t count on beta to meet return requirements, and there is risk on the fixed income side—low yields, but principal risk and credit risk if rates rise. I would look for equity hedge fund managers that run a lower net long position most of the time, fixed income absolute return or long/short managers that fundamentally analyze credits. I also think while one can own real estate, I would like to have a hedger there, as well. The macro strategies may start working and uncorrelated strategies like managed futures do belong in a portfolio. I would actually like to create the core of a portfolio around all the alternative strategies and active management strategies that have been on the periphery for the last several years. On the edges, I would play around with passive strategies, hopefully moving in and out at the right time.


The Fed: In response to the Fed’s news this week, I think the Fed is saying that they will be data driven, but they really want to start raising rates. I would be surprised if the raise actually takes place before the Fed’s dots and the future’s markets get a little closer to each other. Right now the differences are more than a quarter point apart on where rates will be in December. When will the increase happen? If the employment number surprises on the upside next Friday that may move the dots and the market closer to each other and push the odds up on a September increase.

It could surprise. I would bet it will. Why? July is actually a lay-off month, with plant shutdowns and other changes. Unseasonally adjusted, the employment numbers go down by about a million people; seasonally adjusted ends up as a positive number. The unemployment claims, the job openings numbers, and anecdotal info say that there aren’t as many layoffs taking place. Companies are having trouble finding qualified workers and hanging on to the ones they’ve got and perhaps, they are starting to raise wages on the margin. I can’t make heads or tails of the seasonal adjustment factors, which always seem to be adjusted themselves.  If someone gave me some odds on a bet on the number, I think it could just as easily be 275,000 to 300,000 seasonally adjusted, but certainly above the 218,000 consensus estimate. I’ve never met a seasonally adjusted worker, but this could be a surprising month. If the number doesn’t surprise to the upside, then it’s December. Whatever and whenever it is, it really depends on what happens from there in terms of the size and how often the rates continue to rise. I have even said that maybe the first rise or subsequent increases are at 1/8 of a point instead of ¼.

As an added bonus, as I mentioned, Executive Markets Editor Tracy Alloway joined us in a second segment. At 6:30 am that morning Tracy sent over the three topics of the day that we would be discussing: the emerging markets pain, bad month for commodities, and a good month for Italian bonds. We did cover those topics as well. This link takes one to the Bloomberg clip.

Tracy pointed out that the emerging markets as a group experienced major currency declines in the month and some are actually raising rates. My view was that they should be focusing on growth and raising rates was not the way to do it. It was also a bad month for commodities with many blaming the dollar. There are many causes for low commodity prices—slower global growth and the strength of the dollar don’t help. My view is that lower commodity prices may stay that way because of the oversupply and low prices of oil/energy. Energy is a major input to mining and refining costs. As those costs fall the marginal cost of production may fall enough for extraction and refining to make a contribution to overhead, thus keeping the supply higher than it otherwise might be and prices lower. If mining assets actually change hands at wholesale prices (a coal property was described as selling for a dollar), that also lowers the bar on what the price of the commodity needs to be to produce a return on investment. That will certainly be happening in the energy space, and may occur elsewhere.

I didn’t have much to say about Italian bonds other than QE in Europe is likely to continue pushing yields lower than they otherwise might be. Investors are following the money.

Life may not turn out to be quite that simple. I do believe we will see significant dispersion in economic results, sector results and individual company results over the next few years. Active management will have its day. Pay Attention.

Our survey shows the role of alternatives in portfolios is likely to increase—But the language needs to change.

We asked Prosek Partners to conduct a survey of a random selection of attendees at our SIC15 held in May. The topic, of course, was the Role of Alternatives in Future Portfolios. 124 of the 649 attendees were asked a series of questions regarding their use of alternatives and some of the issues affecting their decision processes. One has to say that even though this was a random sample of attendees, almost all the attendees were relatively sophisticated institutional and individual investors and advisors, who were there to listen to a variety of observers and analysts of the global markets, economies, and geopolitics. We have commented on some of the observations at the conference, and you will be seeing videos on the Altegris site beginning June 24. These were not novices when it comes to alternative investments. Every attendee interviewed had some participation in alternatives, with different reasons for their use from complements to traditional strategies, substitutes for traditional equity or bond allocations to hedges against volatility.

70% of the advisors, 69% of the private investors and 63% of the institutions expect to have a net increase in their alternative holdings in the second half of 2015. This may reflect the tone of uncertainties expressed by the speakers at the conference regarding where expected market returns may come from and the possible volatility associated with them.  Highest on the list for advisors and private investors are Managed Futures/Global Macro (33%) while institutions put Private Equity (36%) at the top of the list.  Private Equity (25%) and Long/Short Equity (21%) are also high for advisors and private investors while the institutions put Managed futures/Macro (20%) and Long/Short Equity (20%) next on their list. Interestingly, there were also some expected decreases in all categories: Private Equity, Long/Short Equity, Managed Futures/Macro and Alternative Fixed Income with some investors increasing and decreasing the same strategies. I would read into this a fairly active approach to using alternatives in the portfolios with some concerns about the markets in general—in particular, the fixed income markets. This was certainly the anecdotal tone among attendees away from the hard numbers in the survey.

The survey participants were also asked what percent of a portfolio should be in alternatives. 10-25% was the most common range (59%). Interestingly, 15% indicated 25-50% as the range, while 3% indicated the allocation should be above 50%. We have seen certain institutions, endowments in particular, move toward having alternatives as a core of their allocations with more tactical allocations for long only active managers and straight beta plays using ETFs. It is interesting to see suggestions of higher allocations to alternatives coming from advisors and private investors.

Of particular interest to us were a series of questions regarding attributes of importance and concerns in making investments in alternatives. Clarity Regarding Investment Philosophy and Strategy ranked highest (60%) among attributes and second among concerns (24%) with Lack of Education on the Product Offerings (10%) being the third most significant concern. Among concerns, fees (53%, but 80% among Advisors), was the highest. This has been a high concern for the whole time I have been in the industry. And, with some democratization as well as Moore’s Law at work, the universe of strategies that do justify the fees on a net return basis continues to shrink.

Clearly the industry has some work to do explaining the strategies and positioning them appropriately in portfolios. The term “alternatives” may be part of the problem. This is hard for me to say given that it is an integral part of our name. It has come to represent a multitude of strategies within the investment universe and carries with it a tinge of the exotic. Merriam-Webster describes an alternative as: “different from the usual or conventional. Existing or functioning outside the established cultural, social, or economic system.” That makes it a little scary for some—or maybe for most. In truth, most of these alternative strategies are simply investment approaches that carry different degrees of risk, correlation and sometimes, liquidity, within the classic 60/40 stock/bond allocations. Others, such as true managed futures and absolute return strategies, provide uncorrelated return and risk streams to these classic allocations.  The decisions one makes on including such “alternatives” are not too different from deciding how much to allocate between a small-cap growth strategy or large-cap value in equities, or between high yield and investment grade in the bond world. I can remember when a deviation from the center of the classic style boxes was viewed as exotic and “alternative.”  Every strategy carries with it a different risk and return profile, and allocations should adjust according to the specific needs of the investor.  Given an investor’s goals and desired outcomes, it could be that various “alternative” strategies might offer better ways of achieving them. We have a responsibility to add investment clarity to make this a more complete picture as opposed to an exotic one.   The survey provided some surprises, even for us, with some very positive messages given our focus. It also pointed out, even among a sophisticated group of investors, there is work to do. We are Paying Attention.