Friday, August 27, 2010

Risk Arbitrage and Leveraged Buyouts

The current rash of high profile acquisitions has, inevitably, raised speculation about an impending merger boom. This is probably a bit premature. While some of the conditions that would encourage a boom, such as corporate cash levels, borrowing costs and the equity valuations of potential targets are favorable to deal-making, equity volatility and concern about the economic outlook are likely to instill caution in boardrooms, at least for the time being. The value of U.S. deals announced year to date still lags behind the same period of 2009, which was itself a very soft year. While transaction volume outside of the U.S. has been stronger (and risk arbitrage is a global activity), so far this year it has managed to boost global year-to-date activity only marginally over 2009 levels. In part because of the cyclicality of their trade – recent experience is hardly the first merger drought − many of these traders are now ensconced within “event-driven” hedge funds, which have other strategies such as distressed investing or convertible arbitrage that they can pursue if the merger cycle is unfavorable.

These circumstances would suggest that things are improving somewhat for risk arbitrageurs, if not dramatically. However, although it seems unlikely that merger activity could quickly return to the frenetic pace of 2005 - 7, conditions may in fact be improving more rapidly for risk arbitrageurs than the headline statistics would suggest. The reason is that the composition of current deal-flow is more favorable to them than it was during the buyout boom. Risk arbitrageurs are benefiting from the problems of the leveraged buyout funds.

An arbitrage requires at least two tradable legs – one long and one short. When an acquirer is a private entity such as an LBO fund, and thus does not trade, no arbitrage may be possible. This is not always the case – for example, if the target’s debt trades at a discount, and its debt covenants have a change-of-control provision that requires an acquirer to repurchase the debt at par, a risk arbitrage may still be possible (long the debt/short the equity). However, even if such a trade is possible, it is a rather narrow one, because the amount of the relevant debt outstanding is, in almost all cases, a fraction of the deal size. It is difficult to estimate how much of the acquisitive activity during 2005 - 7, when LBO funds dominated the merger market, actually offered trading opportunities to risk arbitrageurs. At a guess, it was only 65% of the value of deals completed.

The acquisition market has changed in the meantime. LBO funds are having difficulty obtaining the amount of leverage that they could readily access during the buyout boom. In a complete reversal of their experience then, in several recent deals they were handily outbid by non-financial purchasers. Trade buyers’ can raise debt far more easily and cheaply than LBO firms in the current environment. Although some of the most powerful LBO firms continue to be able to complete large deals, LBO funds in general are concentrating more of their attention on middle-market transactions. This is a segment that generally offers less compelling opportunities to risk arbitrageurs than large and complex deals, since arbitrage is most attractive to pursue where liquidity is ample.

The opportunities available to risk arbitrageurs are not measured solely in terms of transaction size: the premium that the acquirer ultimately pays for the target is also a crucial metric. Recent experience has also been quite favorable to them in this respect. Contested bids, such as those that feature in several current transactions, can also expand their opportunities, although at some cost in terms of increased risk. Hedge funds that are equipped to exploit these opportunities – whether risk arbitrage specialists or more diversified “event-driven” firms – may not be experiencing a golden age, but this is certainly a productive period for them.

Monday, August 23, 2010

High Frequency Trading and the "Flash Crash"

It requires only a glance at securities industry job sites to see that high frequency trading continues to grow rapidly, even though it is already thought to account for half of U.S. equity volume. The “Flash Crash” of May 6 and subsequent regulatory interest in these activities have attracted media attention to this corner of the markets. The technicalities of market microstructure and the use of computer algorithms, machine learning, etc. in an attempt to exploit it would seem unlikely to capture the public imagination. But the topic has a certain sci-fi glamour, which is enhanced by the perceptions that markets have escaped human understanding, that events such as the one pictured below could easily recur, and that participants in this activity are up to no good. Mystery, the threat of catastrophe and a suspicion of scandal – how could a journalist (or for that matter, a Congressman) resist?
There has been high frequency trading since the first stock exchanges opened in the seventeenth century – computerization has only accelerated its pace. As outlined in a recent IOSCO study, modern transaction speeds do raise concerns about pre-trade risk and compliance controls, but few if any of these are insurmountable. More trenchant criticisms note that high frequency trading, in the context of fragmented markets with multiple venues, each offering a somewhat different microstructure, opens the door to price manipulation and to meltdowns such as the “Flash Crash.” Further, the competition for liquidity among these venues has led to the practice of selling access to flash orders, which many commentators regard as tantamount to permission to front-run other market participants.

Dubious as the practice may be, offering firms access to flash orders is simply the latest in a long line of privileges that exchanges have offered to attract liquidity providers to their platforms. They argue that investors benefit from these, in terms of faster execution and price improvement: for example, the CBOE claims that flash orders saved its customers $3.6 million in a single month. However, if the practice is banned, as the SEC proposes, it is inevitable that exchanges will respond by devising some new trading privilege to attract liquidity providers. This is not just a cynical comment. Providing a venue for liquidity is exchanges’ business, but they are not in a position to provide it themselves, since that would transform them into broker-dealers. So they have no choice, in a competitive environment, but to find ways to attract third party liquidity to their transaction mechanisms. When exchanges argue that they perform a public service by offering privileges that enhance their liquidity, high frequency traders can hardly be blamed for making use of them.

Multiple, competing exchanges with different transaction mechanisms almost certainly do increase the opportunities for market failure, as has been apparent since the mechanics of the Crash of 1987 began to be understood. Whether computerized direct access to these execution venues exacerbates this problem is debatable. It is likely that modern market infrastructure would have prevented or at least greatly ameliorated the 1987 episode. On the other hand, while the causes of the “Flash Crash” remain obscure, it is certain (if only because of their share of transaction volume) that high frequency traders played an important role in it. While the information available to regulators may not, in the end, be sufficient firmly to establish the cause of the “Flash Crash,” this indicates a serious gap in their capabilities that must be filled – the sooner the better.

As the IOSCO paper notes, regulatory authorities are somewhat hampered with regard to the enforcement of rules against market manipulation by some of the ways that high frequency traders may obtain direct electronic access to markets. This is a situation that must be corrected. Since there is reason to suspect that tape-painting and possibly even more highly irregular activity by high frequency traders contributed significantly to the “Flash Crash,” addressing this issue must also be a high regulatory priority. Much of this can be accomplished by enforcing existing rules, provided that regulators are able to obtain the information needed in order to do so. Fortunately, this is essentially the same information they would require to determine the causes of such episodes.

Friday, August 20, 2010

Inflation and Infrastructure

Infrastructure would seem to offer investors a fairly safe refuge from inflation, and on the whole it does. Operators of infrastructure have at least some scope to raise user fees, and can expect to recoup the depreciated cost of maintenance and improvements upon exit from their position. However, some forms of infrastructure may offer more certain inflation protection than others. In particular, the ability of public infrastructure to insulate against inflation cannot in all cases be counted upon.

First, a digression on inflation, three measures of which are shown below. The best indicator for the aggregate economy is the GDP deflator. It is not more widely used because it is released with a lag – note that the figures after 2007 are still not final – and because inflation in the total economy is too broad a measure for many purposes. The CPI, although widely used, is an imperfect measure, neglecting interest costs, which account for more of consumers’ budgets than many of the items that are included, and since it calculates on a fixed basket of goods, it ignores the price elasticity of consumer demand. The third indicator is rather obscure, but it is probably the best available gauge of the cost of maintaining infrastructure. It tracks the costs of labor, equipment and materials used in heavy construction − pipelines, roads, bridges, earthworks, pumping plants, transmission lines, etc. Although it covers only the seventeen Western states within the Bureau of Reclamation’s remit, it is unlikely that the picture it creates would differ greatly if it included all fifty. The point of showing these indicators is to draw attention to the fact that different portions of the economy can experience different rates of inflation.
The contracts under which public infrastructure is operated are fixed at the time of purchase or lease, and usually include limits on permissible increases in user fees. These will typically be linked to the CPI, the rate of inflation that is most familiar to most users. Given the political sensitivities involved, operators are often restricted to less than the increase in that Index. As the chart indicates, this can put operators of public infrastructure in a squeeze: since 2003, the Bureau of Reclamation series has risen at twice the rate of the CPI. Operators of infrastructure whose user fees can at best increase no more rapidly than CPI are experiencing deteriorating margins, which the decline in their costs in 2009 did not relieve. In principle these should be recoverable on exit from the position, but given the time horizon of infrastructure investments, that could be a long wait. In the meantime their investors experience less than perfect inflation protection on their cash flow distributions.

In contrast, operators of private infrastructure do not risk such pressures. Although the commercial relationships between providers of private infrastructure and their customers vary, pricing is in almost all cases a matter of regular negotiation. Most of their customer contracts are annual, on a take-or-pay basis. Where contracts are of longer duration, operators are generally in a position to assure themselves that any anticipated cost increases are reflected in the charges they negotiate. Providers of private infrastructure have an obvious negotiating advantage over their customers, most of whom cannot easily turn to other providers, and who therefore also have a strong interest in the maintenance of the facility. In any case, inflation is likely to affect their customers’ revenues positively, reducing their resistance to increases in usage charges provided that they are not egregious. With respect to inflation risks, operators of private infrastructure can be relied upon to take care of themselves (and their investors) to an extent that may not be possible for operators of public infrastructure.

Saturday, August 14, 2010

Alternative Investments and Deflation

My previous post discussed an asset category that is widely regarded as a hedge against inflation, and subsequent efforts will return to investments that help investors preserve purchasing power. However, recent economic news has revived speculation, which has been recurrent for several years, about the possibility of deflation. Some comments on what alternative investments can do to protect investors in a deflationary environment seem to be in order.

It should come as no surprise that the answer is, “Not much.” Few investments benefit from deflation.  Sovereign debt is usually regarded as a safe haven (although not a hedge) against it, but it is unclear that the debt of a nation such as the U.S., which relies so heavily on foreign purchasers to finance it, will offer such protection. Japan's experience over the last decade is not indicative: Japan is able to fund its borrowing from domestic savings. If deflation discourages foreign interest in funding what would remain of U.S. consumption, the Treasury yield curve could become quite steep despite the Fed’s best efforts. In this connection, it is not clear what deflation would do to the value of the dollar, relative to major currencies, to traditional hard currencies such as the Swiss Franc, or to gold.

A deflationary environment would, however, provide rich pickings for short-bias hedge funds and investors in distressed situations. It should also provide opportunity to macro hedge funds. This may sound odd, since the last several years’ revival in the fortunes of macro strategies has to a large extent been tied to commodity price developments. But fundamentally, macro investment exploits economic dislocation and volatility, of which there would be plenty in a deflationary scenario. High frequency trading and arbitrages (other than risk arbitrage, which would probably see its opportunities evaporate) could still be productive if volatility does not become too extreme and if sufficient leverage to make these activities remunerative is still available. Trend-following CTAs should also be able to take advantage of deflation, particularly because it is likely to be accompanied by backwardated markets, while those whose trade discovery is driven by mean-reversion would tend to have a difficult time. Most other hedge fund categories would also struggle.

Direct lenders could expect to see demand increase and competition wither, but default experience would deteriorate, and those whose loans are collateralized could find that their security is less valuable than they had thought. Deflation could plausibly launch a period of considerable prosperity for the life settlement business, with increased supply reducing acquisition costs, thus mitigating some of the J-curve effect that has plagued this investment technique recently.

Real assets could be expected to suffer under deflation − infrastructure, particularly private infrastructure − probably less so than others. Although it is firmly ensconced in the commodity sector, the agricultural economy has a cycle at least partially of its own. It is conceivable that farmland and agricultural commodities could escape the worst effects of deflation, but they cannot be relied upon to do so. The experience of the Great Depression seems to argue against optimism on this score, but U.S. agriculture had already entered depression in 1920 as a result of the post-war retreat of commodity prices: agriculture was probably more of a contributing cause than a consequence of the economy-wide deflation after 1929. The ability of timber investors to forego harvesting and income, while tonnage on the stump continues to grow, would offer a possible safe haven during a deflationary episode, provided that it was not too protracted. Unfortunately, once under way, deflation is stubbornly persistent. If deflation results in a decline in the value of the dollar, this might be expected to bolster other commodity prices, but demand destruction would probably be a greater influence on their price development.

Private equity and real estate would not thrive under deflation. Even if by some chance a private equity position does well despite the environment, neither the IPO market nor trade buyers are likely to offer an attractive exit opportunity. Mezzanine finance would probably be difficult to come by, so even a successful investment may come under stress. In a deflationary environment, lease rates would be under pressure, few buyers for real estate would be available, and refinancing, again, might be difficult to locate. In both cases, funds may also find that committed capital is not available to meet capital calls. The secondary markets for private equity and real estate vehicles are likely to see a considerable increase in supply, offering attractive discounts to funds with liquidity to deploy, but these will only provide a cushion against losses rather than an opportunity if the deflationary episode is lengthy.

By and large, alternative investments tolerate moderate inflation better than they accommodate deflation − which is equally true of conventional investments. However, some of them at least offer the hope that they can offer positive performance during a deflationary episode, which is more than conventional assets other than sovereign debt can offer. More to the point, a portfolio of alternative investments that is positioned to weather a period of deflation need not penalize the investor’s performance too dramatically if, in fact, deflation does not materialize. The same is not true of a conventional portfolio designed to protect against deflation.

Tuesday, August 10, 2010

Investment in Farmland

Investor interest in farmland has increased steadily, motivated by the perception that it offers an attractive yield, solid prospects of capital gain and inflation protection. Recent experience supports this view. Over the period shown in the first chart below, U.S. “dirt values” have increased by a compound 3.7% a year. The series is too short for statistical significance, but for what it’s worth, its standard deviation was 6.6%, which is comparable to corporate bonds. Lease rates on cropland (i.e., land that is not under lower-value pasture) have risen by a compound 2.8% annually over the shorter period shown in the second charrt. Note that these averages mask wide dispersions: average cropland values per acre differ by 28X between largely unirrigated New Mexico and potentially sub-divisible Rhode Island.
The increase in farmland values and lease rates is generally ascribed to commodity price developments. Most investors avoid operating farms, and since most leases renew annually, investors tend to purchase properties used for growing annual crops, so that they do not actually own the biological means of production. For obvious prudential reasons, owners of property under perennials such as trees or grapevines prefer to operate the farms or employ tied agents to do so. Although some leases include a participation feature, most investors avoid such arrangements. So in fact, most investors’ returns have no direct relationship to commodity prices. However, if it has no “higher better use” (i.e., as a subdivision), the price of farmland derives from the value of what it can produce. The rental that it can command is also a function of anticipated commodity prices. So the perception that investors’ returns are largely determined by commodity price developments, with some but not excessive lag, is largely correct.

Whether commodity prices are strong or not, increasing production is the main way that a farm operator can grow its business. Farming has a high fixed cost component, so the pursuit of economies of scale is critical to commercial success, except in a few niches. American agriculture is already among the world’s most productive, so investments in increased intensity offer only diminishing returns. Thus increased scale requires increased acreage. With mortgages cheap, farm balance sheets (as shown below) healthier than they have been in a generation and fairly encouraging prospects for commodity prices, operators’ demand for farmland competes with investors’ interest in acquiring it. Farm operators are, in the nature of the case, advantaged bidders: in effect, investors compete against insiders.  It seems likely from the uptick in farm leverage that they are competing with them quite actively.
This provides additional incentive for investors to look for non-U.S. opportunities, where “dirt value” may not be so firm and where competitive bidders may not have such financial resources. However, investors generally confine themselves to regions where agriculture is fully modern. Farm operators who can still gain scale from increased expenditure on fertilizer or hybrid seed will weigh the cost of doing so against the cost of leasing or purchasing acreage. In those regions, “dirt value” and lease rates are likely to stagnate. Investment in “emerging” farming regions is best left to owner-operators, who have the skill, resources and incentive to increase the productivity of properties that they can buy comparatively cheaply there. It is best avoided by passive investors.

In the U.S. and especially elsewhere, the yields on passive agricultural investment and the potential capital appreciation that it offers remain attractive relative to corporate bonds. But the U.S. case is no longer strongly compelling. The opportunity to buy U.S. farmland at prospective total returns comparable to those available in 1987 is unlikely to recur. Consequently, the inflation-protection argument is crucial in order to make a strong case for farmland investment. That is, price expectations for agricultural commodities must be optimistic to justify investment. Otherwise, investment success in U.S. farmland must rely on opportunistic and very judicious purchase.

There are many reasons to be optimistic about the demand for agricultural commodities over the intermediate- to long-term, but given the relative inefficiency of much of the world’s farming, supply is fairly elastic. Granted, it lags demand by several years. Malthusian arguments in support of farmland investment should therefore be discounted, at least on a twenty-year view. Investors should assume that supply will be able to meet demand within the life of their investment, in the process clawing back any extraordinary gains. Since farmland is a long-tail investment, with substantial transaction costs, it should not be purchased as a short-term speculation. Although there will inevitably be supply interruptions that bolster short-term returns, such as the current Russian drought, investors in an illiquid asset are unwise to assume that they will be able to exploit them. This does not argue against investment in farmland, but given that its returns and apparent risk profile are not extraordinary, it argues very strongly in favor of strict price discipline. For most farmland investors, this means that they must rely on a highly qualified agent to handle the purchase and management of their investments.

Thursday, August 5, 2010

Internal Stress Tests

I argued in my July 31st posting that there are rather obvious reasons why the stress tests that regulatory authorities produce for public dissemination might fall short of the severest stringency. Authorities consequently run the risk that, if their tests that are perceived to be undemanding, they might be discredited and even counterproductive, given that publication of their results is intended as a confidence-building exercise. But of course, they also run the risk that excessively demanding tests could damage confidence. Banking authorities must tread a fine line. The same certainly should not be true of stress tests that firms devise for strictly internal consumption. Here it is self-defeating to set the parameters of stress any lower than the limits of what the firm can withstand, since the purpose of performing the tests is precisely to determine what those limits are.

The Credit Crunch revealed that stress can be extraordinarily complex. Sources of risk that are normally treated as conceptually distinct – market stress, credit stress, liquidity stress, operational stress, etc. – all seemed to manifest themselves simultaneously and in bewildering combinations, making it virtually impossible to separate primary causes from subsidiary effects. The Credit Crunch provided ample evidence, if any evidence were needed, that simple models of stress do not reflect the complex realities of systemic crises.

As in other situations, it is sound advice to “follow the money.” While the disappearance of liquidity is not usually a cause of financial crises, it is their invariable accompaniment. It is also the main proximate cause of financial stress, even illiquidity is only a subsidiary effect of whatever event originally caused the crisis. Consider the chart below, which shows the development of one the of financial system’s many sources of leverage. From the second to the third quarter of 2008, $1.1 trillion in credit was withdrawn from the system. On I.M.F. estimates, this increase exceeds all but twelve nations’ G.D.P. and equals 1.9% of the global economy. Such a massive withdrawal of liquidity cannot have failed to affect every leveraged participant in the system, even though it followed directly upon an even more massive increase from the first quarter to the second. Clearly, it would be impossible to trace all the margin calls, forced liquidations and recourses to standby credit facilities that resulted from such wholesale de-leveraging.

At the level of the individual firm, if it is even moderately complex, it is not possible to create a comprehensive test that addresses all the inter-connected sources of stress that were revealed by the Credit Crunch. Testing for stress at a level of such near-universal crisis requires a number of scenarios that increases by the square of the number of position, creditor and debtor exposures the firm carries. This figure rapidly becomes enormous. However, the firm can reduce it to more manageable size by concentrating its attention on margin calls resulting from haircuts to the values of its positions, the callable portion of its other indebtedness and to the default risk among its debtors. This is still a substantial task, but then the stress revealed during the Credit Crunch was itself very substantial. The firm that can hypothetically stress itself to this extent without reaching the limits of its solvency is in extremely sound shape.

Wednesday, August 4, 2010


Erratum to Alternative Assets and Strategic Allocation

p. 71

Figure 3.6 was erroneously reproduced in Figure 3.7.
Figure 3.7 should appear as follows: