China Inc. is at it Again

China's state investment company made its first big play back in March when it bought a stake in the Blackstone Group for $3 billion. That investment is still underwater, but that hasn't stemmed China's interest in investments outside the world of US Treasury's. Today it was announced that a Chinese government controlled bank and Temasek, Singapore's state-controlled investment arm, have agreed to buy a stake in Barclay's bank. That move will generate the cash that Barclay's needs to purchase ABN Amro. China's advisor on the deal? You guessed it . . . . Blackstone Advisory. Here's the story from Jason Dean at the WSJ:

BEIJING – China Development Bank's planned stake in Barclays PLC could become the largest overseas investment by a Chinese company to date, and underscores the growing role China Inc. is playing the global corporate arena.

China Development Bank, a Chinese-government controlled policy lender, and Temasek Holdings Pte. Ltd., a Singapore government investment agency, will together invest as much as €13.4 billion ($18.54 billion) in Barclays, the British financial group announced Monday.

China Development's stake will be the larger of the two: it will buy up to 2.2 billion euros of new shares in Barclays initially, amounting to a 3.1% stake, Barclays said. China Development will then buy as much as €7.6 billion worth of additional Barclays's shares, if the British bank's bid succeeds for ABN Amro Holding NV – and if the deal wins regulatory approval, Barclays said.

If the whole deal is completed, China Development would spend a total of $13.5 billion for its stake in a newly enlarged Barclays, dwarfing other overseas deals by Chinese institutions.

Earlier this year, China's government agreed to invest $3 billion of the country's foreign-exchange reserves in U.S. private-equity giant Blackstone Group. In October 2005, China National Petroleum Corp. agreed to buy PetroKazakhstan Inc. for $4.18 billion. Earlier that year, Lenovo Group Ltd. bought the personal-computer division of International Business Machines Corp. for $1.25 billion.

Chinese companies have tried for bigger deals before – and failed. In 2005, China's Cnooc Ltd. abandoned an $18.5 billion bid to acquire U.S. oil producer Unocal Corp. after a heated political firestorm that has deterred high-profile deals ever since.

China Development may seem an unlikely investor for Barclays. Set up in 1994 by China's cabinet, its primary mission is to make policy loans to support Chinese government economic policies, such as to big infrastructure projects and to rural enterprises. In its 2006 annual report, China Development states its mission as "strengthening the competitiveness of our economy and improving the living standards of our people."

However, China's government has also been pushing the country's expanded economic activities overseas. China Development's annual report also acknowledged its growing part in this effort, saying: "In answer to the call of the State to encourage domestic enterprises to 'Go Global,' the Bank engages in a wide range of international cooperative activities."

China Development said it had been advised in the deal by Blackstone Advisory, an arm of Blackstone Group.

"Barclays Stake Sale Shows Rising Role of China Inc."
Jason Dean

Blackstone's Struggles Continue

Blackstone is trading 20% below its IPO price. Fortress is back near its 52-week low. Yesterday, hedge fund giant Man Group's brokerage arm -- MF Global -- fell dramatically after its IPO after being priced underneath its offering range. In London, Daniel Loeb's Third Point LLC listed a hedge fund that raised $525 million, which was far short of the $690 million it hoped to raise. The market is bearish on anything that smells of private equity or hedge funds right now, either due to systemic risk stemming from the subprime shakeout, worries about a tax hike on carried interest or just concerns that we have reached a peak in the market.

Blackstone was off another 5% today after a miserable month. The company now trades at a PE of 9.67. Just to bring this in to perspective, Blackstone is now trading cheaper than brokerage firms like Bear Stearns and UBS. I think the market may not know how to value a management company like Blackstone. Remember this is a company that has had virtually uninterrupted growth over the last 20 years. They attract some of the top talent on the street. They sold a sizable stake to China which tells me they should have access to the Chinese market that other firms just won't have. Yet, every day the stock goes down.

The questions then become:

1. At what price does Blackstone become a buy?
2. Will Blackstone's struggles scare off Och-Ziff or KKR?
3. Are investors realizing that non-voting shares in master limited partnerships have far more risk that voting shares in public corporations?

Is the Credit Meltdown Finally Here?

The trickle of disturbing data about the credit market has reached a veritable flood in the last few weeks. We are seeing the subprime meltdown continue as well as problems in the high yield debt market. Here are a few of the highlights from the last week:

1. According to Bloomberg there have been over 20 postponed or restructured financing deals in recent weeks and more on the horizon.
   
2. High yield spreads have widened 27% since June 1st, yet still remain at historic lows. I am inclined to think that once a major LBO collapses we could see spreads widen substantially in the weeks and months ahead.(Hat Tip:Bespoke Investment Group)
3. Cerberus announced today that the tighter credit markets forced them to sweeten their Chrysler financing from 3.25% above LIBOR to 3.75% above LIBOR. I expect similar changes on almost every other major deal (yes First Data, I mean you) still out there . . . of which there are about $200 billion.
4. I'm scared everyday when I go online and check the Markit indices because everyday I am shocked and awed by the declines. Today was no different. The LCDX Index that tracks bank loans is approaching 96 with a spread of 229:

   Time / Date	Price	Spread
   4pm Close (17Jul07)	96.14	229.1
   Midday (17Jul07)	96.60	214.7
   4pm Close (16Jul07)	97.06	200.9
   Midday (16Jul07)	97.42	190.4

5. In the subprime world, investors in the troubled Bear Stearns hedge funds were told today that: "preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for investors in the High-GradeFund as of June 30th." That is scary news.
6. The Markit ABX Index continues a plunge that the WSJ market blog calls a "bloodbath". The BBB index is down to 45 from 97 in January, the A index is at 68 from 100, the AA index is at 88 from 100 and the AAA is at 95 from 100. Clearly every credit quality is getting hurt, not just subprime. But I have to admit this BBB chart is by far the ugliest:

So what is an investor to do?

• If you have a bond portfolio I would recommend two actions: 1) focus on high credit quality, 2) shorten your duration.
  
• If you are very ambitious you can look into buying an ETF or mutual fund that tracks the inverse of the junk bond market. Check out this article from the Wall Street Journal from a fund that was launched 2 years ago.
• You may want to stay away from Blackstone and Fortress for a while in case investors flee quickly out of fear that PE management companies aren't where you want to be if the market dries up.
• Don't ditch your long term asset allocation, but you may want to focus on large cap equities and blue chip stocks for the time being as their borrowing costs will stay lower during a swoon in the credit market.
  

Beckham, Cuban, Whole Foods and More

Here is some light weekend reading.

1. David Beckham has arrived in LA to try to make footb . . . . I mean soccer, as popular here as in the rest of the world. While this is clearly an uphill battle, I think at least among women he may make some headway.
2. Mark Cuban has spoken about buying the Cubs for years, but it looks like he has finally made his move. Unfortunately for him actually landing the team may be an uphill battle. Lets just say his $1.5 million of NBA fines may work against him . . .
   
3. Whole Foods CEO John Mackey bragged about his company for years on the Yahoo Finance message boards. Now the SEC is sniffing around. A word to the wise; never write anything that could some day come around to bite you in the . . . .

Now for the heavy weekend reading (proceed with caution):

1. Barry Ritholtz has been angry with the Federal Reserve for using core inflation instead of headline inflation. I think some of his rants make sense. He is also mad at the people who calculate the unemployment rate -- he seems to think the real number is higher than 4.5%. I tend to agree.
2. Stephen Schwarzman has found a way to pay much less in taxes from the proceeds of Blackstone's IPO. Which may explain why Hillary Clinton wants Schwarzman to pay a higher tax rate on his carried interest . . . . Is this Hillary's strategy to win over big business? (if you really want to understand carried interest, read this)
   
3. This blog post by Brad Setser explains why I am not worried about the amazing reserve growth of BRIC countries, which he estimates will grow by $800bb this year.
   

Blackstone Up, Fortress Down

Blackstone IPO'd today under the ticker symbol BX and was rewarded with a 13% gain on its first day in the market in spite of market forces heading the opposite direction. Investors seemed to shrug off the new tax proposal announced by Congressional leaders that could double the tax on carried interest. All in all the IPO was a success and Stephen Schwarzmann and Pete Peterson both made out handsomely.


An interesting sidenote to today's action was that Fortress Investment Group (FIG) had a terrible day. After opening 2.5% above yesterday's close the stock sagged in mid-morning trading before closing down 6.3% on the day. FIG is now trading close to the level it was at last week when I recommended it. In my mind nothing has really changed, this might just represent a second buying opportunity for FIG at a great price.

The Private Equity Tax Battle Rages On

On the eve of Blackstone's planned IPO a proposed private equity tax law could throw a wrench in CEO Stephen Schwarzman's plans. Private equity firms make their money via an asset based fee and a performance fee. This is typically* expressed as "2-and-20": the 2% fee is on all assets under management and is taxed at ordinary income rates up to 35% and the 20% is a cut of the firm's profits and is taxed at the 15% capital gains rate.

Under pressure to combat increased income inequality and increase tax revenue, Federal lawmakers had been tossing around the idea of raising taxes on private equity firms by re-characterizing "carried interest" as ordinary income. It appears that they have curbed that discussion for now.

However, since Fortress and Blackstone would both be publicly traded partnerships, Congress, led by Charles Grassley and Max Baucus (pictured above), could overturn a 20 year old tax law that taxes publicly traded partnerships at 15%. Instead these publicly traded private equity firms would be taxed at corporate rates of up to 35%. This won't effect private equity firms who stay private but it will certainly influence whether or not they choose to go public.

If such a bill were to pass Congress and avoid a presidential veto it would certainly dampen the valuations private equity firms have been receiving and create massive disincentives to going public. The law, were it to pass, would grandfather in Fortress and Blackstone for a period of 5 years.

Fortress Investment Group (FIG) was off 6.5% today on the news and is off nearly 30% since late March. I think investors may be overly pessimistic on FIG because of this bill. FIG's effective tax rate today is already somewhere near 25% and much of their income is not tax-advantaged. If, as I expect, this bill doesn't pass this might be a great time to pick up a few shares of FIG on sale. Heck even if the bill does pass, FIG is safe for 5 years and even with conservative growth projections and higher taxes, buying FIG at $23.50 with a PE of 21.5 is a steal.


* Some firms charge more, some less.

Go to Article from Marketwatch >>
Go to Article from DealBook >>
Go to Article from Bloomberg >>

Will Banks Cool Private Equity Boom?

Just a week ago I wrote about how many key private equity players were worried about a bubble. The New York Times reported this morning that several banks were cooling on lending to private equity firms to fund buyouts. RBS admitted there are signs that the market is "quite toppish." Mezzanine lender Intermediate Capital also warned that deals were becoming more risky. The warning from Intermediate Capital is not good news considering the fact that they may well be the largest lender to private equity firms. Of course when you are talking about billion dollar deals, banks don't work alone. Usually banks form large syndicates in order to spread the risk around. Be that as it may, as more and more banks become more careful with the risk they take on, they may well pull the punch bowl from the party. I have a feeling that until their is a dramatic default the boom still has some legs.

In the past week investors have punished Merrill Lynch for its role in providing bridge loans for large private equity deals, like the $32 billion deal for First Data. While I am prone to worry about the potential for a deal to blow-up an leave banks and investors up a creek, some, including Dana Cimilluca at the WSJ think that all the words of caution from private equity players and banks alike may actually be a good sign for the M&A boom to continue:

"As we see it, the Merrill scare is a brick in the wall of worry the private-equity industry seems to be facing these days. One executive after another — many of them participants in the buyout boom — is sounding alarm bells about a bubble. The latest is Royal Bank of Scotland CEO Fred Goodwin, who says the private equity market is getting "quite toppish". His comments echo remarks recently from Bank of America chief Ken Lewis. Moody’s Investors Service in a note today questions whether a march upward in long term interest rates could slow the debt issuance behind the buyout and stock repurchase booms. (It doesn’t think so.)

What does this all mean for the big question everyone is asking — how much longer the good times in the deal world will last? Investment types often refer to a chorus of caution as a bullish sign, in part because it keeps investor behavior from becoming too irresponsible. If that’s the case, it could perversely mean the M&A frenzy still has some legs."

While Dana thinks the caution is a good sign, I disagree. As private equity firms and lenders start to wise up to the risks, the cost of debt rises and many of these deals start to crumble. If one major deal falls through it could send an ice cold tremor through the market putting in peril all the other deals that are in the pipeline and crushing the holders of bridge loans that were hoping that their debt would quickly be replaced with junk.

There is one concrete graph to look at that may point to why banks are starting to sour on the deals presented to them. I wrote about this last week as well. That is the rise in the yield of the 10-year treasury. Just last week the yield curve normalized and the 10-year yield is now moving aggressively towards 5% (see graph below/ click to enlarge).


**One last note. Insofar as the rise in the markets this year has been fueled by all the M&A activity, if lending tightens up and the deals slow down the market may well correct sharply. In fact a major credit event could finally restore the volatility to markets that many have been calling for.

Amid Flurry of Deals, Signs of a Top

Today a multitude of deals came to light after the holiday weekend:

1. Tishman and Lehman are buying Archstone-Smith for $12 billion.
   
2. Avaya is selling off pieces to private equity firms.
3. Madison Dearborn is in talks to buy CDW for over $6 billion.
4. URS agreed buy the Washington Group for $2.6 billion.
   

But, even now in the midst of an unequaled private equity frenzy some warning signs are beginning to emerge. Just last week investment bank Goldman Sachs placed a freeze on hiring. Seems odd that amidst record profits and a tons of private equity related fees that Goldman would see fit to "pause" hiring. Many in the private equity world have seen fit to apply the brakes as well. Here are some quotes from the titans in the industry:

1. Timothy Collins, CEO Ripplewood Holdings: Current private equity conditions are a "bubble that could end badly."
2. David Rubenstein, Carlyle Group co-founder: "There hasn't been a failure for five years. We need to prepare people for the reality that some deals will fail," he said. He added: "Greed has taken over. Nobody fears failure."
3. Bill Conway, Carlyle Group co-founder warned his firm's investment professionals about froth in the buyout market and instructed them to be careful in their deal-making.
4. Steven Schwarzman, founder of the Blackstone Group warned that the biggest risk in the private equity market is "high prices."
5. David Bonderman, founder of TPG: "Almost everything can go wrong now. . .Two years ago, we slowed down. Last year we got unskeptical. This year we are more cautious again."

It seems the only one who hasn't slowed down is Henry Kravis, and it doesn't seem like he has any plans to stop. KKR has been a part of $120 billion of deals this year including 5 of the biggest 8. They probably have a blockbuster or two left in them as well. So while I won't be the fool to call the end of the private equity boom, I do believe a fair number of the deals announced this year will not work out quite as well as they were penciled.

China Buys Stake in Blackstone

It was announced today that China will set up a state investment company in order to buy a $3 billion stake in the Blackstone Group, the US private equity firm. The stake will be less than 10% and the planned IPO of Blackstone will proceed unchanged. It has been rumored for quite some time that China was going to diversify away from holding US treasury notes in an attempt to be more aggressive and increase its ROI. However, few expected that China's first major move would be to buy a $3 billion stake of Blackstone. Most expected China to proceed cautiously, investing in blue chips stocks more like a pension fund. If China does have as large a risk appetite as this deal indicates, they could quickly become one of the largest investors in the world.

Today China has $1.2 trillion of foreign exchange assets of which $200-400 billion could be pumped into the new investment company. When China puts these assets to work they have the power to literally move markets the world over. The global liquidity boom is going to get another large shot in the arm. Chances are China will model their investment company after Singapore's state run entity - Temasek holdings. Temasek, which manages roughly $60 billion USD, was started in 1974 and has achieved an impressive investment track record. But, even at $200 billion China's investment arm dwarfs Temasek in size.

While the Blackstone deal may be a bit of a surprise to China observers this isn't a shocking move for Blackstone. Months before the IPO of Fortress Investment Group the company sold a 15% stake to Tokyo-headquartered Nomura holdings. So it makes sense that Blackstone would seek to do the same. The major difference is that 15% of FIG cost Nomura $888 million and <10% of Blackstone will cost China $3 billion.

The most interesting sub-plot in this is the role of Antony Leung. Leung is Hong Kong's former finance secretary, is an independent director of China's largest bank, is the former Asia chairman of JP Morgan and was hired by Blackstone in January to run its China business. It seems fairly clear that Mr. Leung paid immediate dividends for Blackstone in the negotiations leading up to the sale.

Source: China to Take Stake in Blackstone
Kate Linebaugh and Andrew Batson

The Friday Roundup

I have far too much to write about today. So instead of boring you, I encourage you to browse through the articles listed below and click on what interests you:

Hedge Funds

1. Applied Quantitative Research (AQR) is rumored to be considering a public offering. I intend to write a full blog post on what this means for investors so stay tuned.
   
2. UBS is closing its 2 year old hedge fund because of sub-par returns resulting from subprime exposure.
3. Tobias Adrian, an economist at the New York Fed, alluded to LTCM in his analysis of systemic risks in the hedge fund industry. Is more regulation on the horizon?
   
4. An event that should help soften the hedge fund industry's image - the Robin Hood benefit - went off without a hitch. (unfortunately it sounds more like a gaudy display of wealth than a charity benefit)
   

Private Equity

1. The Senate just can't let go of the "carried interest" issue. They see the money PE firms and Hedge Funds are making and they see an easy cure to their budget/AMT issues.
2. Cablevision accepted a big $10.6 billion buyout bid from the Dolan Family.
   

Economy/Fed

1. GDP growth fell to 1.3% in the 1Q2007, below the 1.8% estimate and well below the 2.5% rate of growth in 4Q2006.
   
2. Core Inflation (inflation ex-inflation) for March came in at 2.1% which was a comforting number, though still above the 2% Fed comfort level. CPI data is due out May 15th (expect this to be higher).
   
3. U.S. job growth slowed in April. The unemployment rate rose from 4.4% to 4.5% which should help the Fed leave the fed funds rate stable at 5.25%.
   

Mergers & Acquisitions

1. The Dow Jones drama continues: the Bancroft family is probably a little nervous about what Murdoch will do to their beloved Journal (see below, click to enlarge):
   
2. 
3. Another Huuuge Media deal is "unofficially" in the works: Reuters confirmed they have been approached.
   
4. The New York Post reported that Microsoft is looking at Yahoo! as a potential acquisition target. I don't know how much weight I'd put on this one.
   

Real Estate

1. Goldman Sachs thinks California home prices will weaken further.
2. Some people want to remove housing from GDP. Caroline Baum thinks that is ridiculous.
3. Piggington reminds us why following the Median home price can be a faulty indicator. Rich and I prefer the Case-Shiller Indices.
4. Yet another journalist has come out and "called the bottom" in the housing market. I think articles like this are almost criminal. If people rely on faulty information to make a home purchase they could do a lot of damage to themselves financially before all is said and done. Check out the graph below and let me know if you agree with me that such a call may be a bit immature (click to enlarge):

Bancroft Family Is Holding Out

This afternoon Michael Elefante (pictured, right), a Dow Jones board member and representative of the Bancroft Family Trust, announced that the Bancroft family intends to turn down Rupert Murdoch's $5 billion offer for Dow Jones. This was the move that I anticipated. Any good fiduciary would have told the family to hold out for a better offer. It is my personal belief that the family members are surely aware that if they play their cards right they could get a 20-25% premium on the current offer before all is said and done.

Remember, the Bancroft voting shares are not consolidated into 1 or 2 hands. It is estimated that roughly 20 family members control a significant percentage of voting shares. Though they control 65 % of the company, currently shares representing "slightly more than 50% of the outstanding voting power" will vote against the sale. In other words, even at $5 billion the Bancroft family isn't voting all together. If the right price is reached enough family members will agree, and Dow Jones will be sold. This, if anything is encouraging news for News Corp.

The article I read over at Dealbook mentions the potential for a sweetened News Corp. offer. I think they probably will lob another offer up to the plate, I just don't think they will be the only ones.

Will Rupert Murdoch Finally Get Dow Jones?

After a seemingly interminable wait News Corp. finally offered an unsolicited bid for Dow Jones (DJ), the proud owner of the Wall Street Journal, Barron's, Dow Jones Newswires and MarketWatch.com. The bid, which at $60/share represents a 65% premium to DJ's closing price, led some analysts to call it "rich." While $5 billion is no small offer it may not actually be enough to buy DJ.

To be perfectly honest, though this deal has been rumored for years I originally did not have DJ on my short list of potential takeover targets. I left DJ off largely because Rupert Murdoch has been sniffing around DJ for years and never decided to make an offer. The reason? In order to buy Dow Jones one must essentially get the consent of the Bancroft family. The Bancroft family controls between 60 and 65% of the company. They accomplish this through a dual-share structure, Class A common and Class B voting shares. The family controls roughly 15% of the common and 75% of the Class B shares. The company doesn't exercise their influence quietly either. Of the 14 directors on Dow Jones' board 4 have direct ties to the family and it is assumed that a fair share of the other 10 are sympathetic to the family. Family control over the board may partially explain the miserable performance of DJ stock over the past 10 years; before Murdoch's bid DJ still traded 15% below its stock price from 1997.

The Bancroft family will be reluctant sellers and it is likely they will hold out for a bidding war before they agree to a sale. Now that the company is "in play" it should enjoy plenty of suitors. The Times, the Washington Post and Bloomberg are all listed as potential buyers, though I feel the company is ripe to be taken private. With so many private equity firms sitting on billions of dry powder (Carlyle, Goldman, Blackstone etc.) it would seem unlikely that one of them wouldn't take a stab at DJ. I haven't done thorough due diligence but I would imagine, given the company's sloppy acquisition track record and poor leadership, that somewhere in the $1.8 billion of revenue there is some fat to trim and underneath that some unlocked value. Look for news of a competing bid by early next week. If we don't see a bid it will mean Murdoch was further along than we all thought when DJ released it over the wire.

Private Equity Rankings: Who's the Biggest?

Investment banks use league tables to rank who has the highest dollar volume of deals in debt, equity, syndicated loans and M&A activity. Unfortunately (or fortunately if you are sick of hearing about league tables) there really hasn't been a ranking system to evaluate the private equity industry. Perhaps the closest thing we have are the rankings put out by Private Equity International (PEI). According to PEI, the current rankings of the top 5 private equity firms in the world by funds raised since 2002:

1. Carlyle Group - $32.5 billion (founder David Rubenstein pictured above)
2. Kohlberg Kravis Roberts - $31.1 billion
3. Goldman Sachs - $31 billion
4. Blackstone Group - $28.4 billion
   
5. Texas Pacific Group (TPG) - $23.5 billion

Of course Goldman is currently the only publicly traded firm on this list, with Blackstone threatening to become the second . . .

A Detailed Look: Which Private Equity Firms Are Going Public

When Blackstone announced it was pursuing an IPO, the underwriting group included Morgan Stanley and Citigroup, with smaller roles by Merrill Lynch, Lehman Brothers, Credit Suisse and Deutsche Bank. Many in the industry considered Goldman Sachs' surprising absence from the group a major snub. The theory was that Blackstone and other PE shops were incensed over Goldman's major push into the PE world. Lloyd Blankfein, Goldman's CEO, has flatly denied these rumors insisting that his bank has great relationships with the other PE shops in spite of Goldman's huge new $20 billion buyout fund.

The truth of the matter however may be that there is another reason why Goldman isn't on the Blackstone deal, that reason is Henry Kravis, or perhaps Leon Black, depending on who you talk to. The New York Post reported that Goldman may be working with Kravis of Kravis Roberts & Co. on their IPO plans, or perhaps helping Leon Black of Apollo figure out if an IPO was in their future. Obviously with Goldman working with their competitors Blackstone decided to stay away. Mr. Blankfein makes a good point: "it's impossible for us to be in every piece of business." Of course more and more it seems that Goldman IS in every piece of business, but I digress . . .

So lets update our list of Private Equity Firms Going Public or at least considering it:

1. Ripplewood Holdings: They took one of their funds public in Belgium.
   
2. Goldman Sachs (GS): Okay, okay they aren't just a PE shop, but they do have one of the largest buyout funds, are publicly traded and have a forward PE ratio under 10. In my opinion GS is probably the safest/best play in the area.
   
3. Fortress Investment Group (FIG): IPO'd in early February, has been very volatile.
   
4. Blackstone Group: Closest private equity firm to an IPO. But should you invest?
   
5. Carlyle Group: In "monitoring mode" for an IPO, whatever that means.
   
6. Kravis Roberts & Co.: Probably just rumors . . .
   
7. Apollo Management LP: Considering a partial sale to private investors.
8. TPG Capital (formerly Texas Pacific Group): They aren't talking, but they are watching.
   
9. Thomas H. Lee: Not considering a public offering because of lack of diversification.
   
10. Permira: Firm's largest investor says younger management makes an IPO unlikely.
11. Bain Capital: "Not actively looking at it, but we're always open-minded"
    

What does this all mean? With so much new money flowing in to buyout firms, with the universe of available deals shrinking and with the cost of debt rising, it doesn't seem like the boom in private equity can continue much longer. Each available deal is getting squeezed by competition and costs. Let us not forget that just this year a bidding war drove the cost of Equity Office Properties up by $3 billion!

But, with most of the top funds having billions to employ, the frenzy to snap up whatever deals remain will surely lead to an exciting 2007. I wouldn't be surprised if within the next year we see the largest buyout in history.

Fortress Investment Group's First 10-K

Fortress Investment Group (FIG) filed its first Annual Report this morning. As the first major hedge fund/private equity shop to go public the 10-K will be heavily scrutinized and for many it will be the first real peak inside an otherwise incredibly secretive part of our economy.

Needless to say, FIG has been enormously successful. They have grown their Assets Under Management (AUM) from $1.2 billion on December 31st, 2001 to $35.1 billion on December 31st, 2006. That is a 96.4% compound annual growth rate (CAGR). To handle the growth the firm employed 580 at the end of 2006, up from 400 the year before. With $1.52 billion of revenue that amounts to roughly $2.62 million of revenue per employee. For a comparison consider that Google produces $950K of revenue per employee and Wal-Mart manages just $183K. FIG's revenue mix consists of management fees and incentive income on its private equity funds, hedge funds and its publicly traded alternative investment vehicles which FIG calls "Castles." FIG also generates revenue from interest and dividends from its funds. Below is the PE/Hedge/Castle mix pulled straight off of the report:
The risks inherent in this revenue mix should be obvious. First of all the incentive fees make up a full 60% of the 2006 numbers shown above. This revenue is not guaranteed and is linked entirely to FIG's skill in outperforming its benchmarks. In some sense that portion of FIG's revenue is not entirely unlike investing directly in a FIG fund. In fairness however, the numbers above are only a small part of the story. A full 73% of FIG's revenues are derived from "interest and dividend income" as seen below:

The I&D income increased for a variety of reasons, but it too is linked the underlying performance of FIG's funds. Again the risk here is linked to FIG's underlying investment performance.

What are some other risks mentioned in the report?

1. Key Man Risk: In other words it is the importance of FIG's human capital. If one of the key partners or MD's were to leave, provisions in the funds allow investors to withdraw capital. This is not even to mention the potential damage to returns.
2. Competition: FIG hasn't been the only PE/Hedge firm to rapidly grow their AUM. There are only so many companies/strategies to invest in and it will be harder and harder to generate excess returns in such a competitive market.
3. Litigation and Reputation Risk: When a firm consistently takes on new types of risk and is engaged in sophisticated investing techniques it is only a matter of time before one of their funds loses money. If litigation follows, perhaps combined with a general pock mark on FIG's sterling reputation assets may quickly leave the fold. Remember, most pension funds are at least somewhat sensitive to the reputation of their managers with whom they invest.
4. Difficulty in Valuing Nonliquid Assets: FIG estimates that "as of December 31, 2006, $2.8 billion of investments in our private equity funds, $31.7 million of investments in our hybrid hedge funds and $256.4 million of investments in our liquid hedge funds are valued by internal models with significant unobservable market parameters." For those counting at home that is 10% of FIG's total AUM. If there is a change in the value of these assets this could materially change the performance of the company. In other words, because it has to "mark to market" its illiquid assets the firms numbers will always be estimates which may be revised.

Much of this information wasn't entirely new to the market, but certainly the most recent numbers were. The market seemed to have no problem digesting the 10-K as FIG was up 6% since market close on the 13th of April. This too after rising over 15% in the month leading up to the 13th. This puts the stock up roughly 70% or so from its IPO on February 8th. It is trading at a P/E in the low 40's. As many have predicted, the appetite of investors for exposure to this area of the market is substantial, no wonder Blackstone and Carlyle are both mulling over their options. It certainly seems that this party is not quite over yet.

Alternative Assets Update

There have been a lot of great articles on hedge funds, private equity and commodities recently that I haven't had time to write complete blog posts on. So, if you have a few minutes come take a look. The picture to the right is John Arnold, he is happy because he was on the other side of the Amaranth natural gas bet . . . oh yeah, and he made nearly $2 billion in 2006. He'll probably tell you that running a hedge fund beats working at Enron!

Hedge Funds

1. "Behind the Hedge" is a great New York Magazine article on Hedge Funds, including bios on the "top dogs", "brainiacs", "bad boys", "single hitters", "home run hitters", and "whippersnappers" in the industry.
2. "Top Ten" What did the top hedge fund managers make this year? Let me give you a quick breakdown: Jim Simons and John Arnold edged out the competition by making somewhere between $1.5-2 billion in 2006. Coming in 3-5 were the other biggest names in the industry: Eddie Lampert, T. Boone Pickens and Steve Cohen. All managed to make over $1 billion. Not a bad payday if you ask me.
   
3. In this Bloomberg Article we learn that at the G-7 conference the leaders are calling in hedge fund managers to discuss "risks associated with their growing role in financial markets."
   
4. In this CNN Money Article "Bernanke: Hedge Fund Oversight Working" our Fed Chairman speaks about hedge funds and the positive effects they have on the economy. His comments were well timed before the G-7 conference meets in Canada to discuss hedge funds.
5. "Hedge Funds Still in Regulator's Sites": Perhaps a new administration in the US could encourage tighter regulation of hedge funds.
   

Private Equity Good News

1. From the WSJ article "Big Deals, Yes They're Possible Without Buyout Clubs" we learn that LBO activity is on track to do close to $2 billion of deals this year and is making up nearly 30% of all merger activity. Not too shabby.
2. PE shops raised $44 billion during Q12007. With this much liquidity I expect the buyout binge to continue for some time.
   
3. More good news: Much was made of the fact that Congress was contemplating taxing "carried interest" at income tax rates (35%) rather than capital gains rates (15%). In "The Tax Threat to Private Equity? " we learn that for various reasons this change is unlikely to occur. I can almost hear the collective sigh of the big players in the industry.
   

Private Equity Bad News

1. Bad News for the entire market: "Private Equity Breaks Records, IMF Gets Nervous" - While the level of activity has been high, the systemic risks are not going away. Many are saying that just like Sam Zell selling EOP high, the fact that Blackstone and others are looking to IPO may signal a peak in the PE Market.
   
2. The PE deals are getting more expensive. Or so says Taneesha Kulshrestha in "Downside of PE." The multiples firms are willing to pay for earnings have increased, this could be another sign of a market top.
   
3. The other major threat to PE is how the public perceives it. In "Hedge Funds lack buyout firm skills". The article first rips on hedge funds masquerading as PE shops, but goes on to say that miscommunicating their intent with the public, the employees and the media could lead to a significant backlash.
4. Perhaps Private Equity needs an image makeover. Or so argues Andrew Sorkin in "How to Show that You're No Gordon Gekko."

Commodities

1. "Crude Contract falls 4%" on unwinding of the "Iranian Risk Premium." It just makes you wonder if the Iranian government is placing bets on oil futures before it goes out and captures British soldiers. If I were a dictator in the Middle East looking to make a quick buck, it would seem a sensible strategy to me.
   
2. Jim Rogers foresees the comming commodity boom. He is a little wacky but I think having commodity exposure in your portfolio these days is a must, even if used just as an inflation hedge.
3. Prices at the pump have risen 2-3% since I last blogged about gas prices on March 26th. But, they appear to have leveled off for the time being. I will continue to track this as we approach the summer driving season. Check out the graph below courtesy of SanDiegoGasPrices.com (click to enlarge):