Opinion

Hide and seek

Finance | William Jensen | 1 Jun 2008

William Jensen seeks opportunities from the current malaise.

Waking up to the first blast of the Today programme at six in the morning is an old habit from another era. The editors clearly don’t like the nation to doze contentedly and the catalogue of actual and potential financial disasters is in full swing by 6.15. The temptation to hide under the blankets is often compelling and many private investors have retreated into sovereign paper and cash. For most endowments, this is not an option.

Endowment assets have to work hard to achieve the returns that current spend and long term preservation of capital require. A generation ago, the typical endowment was a balanced equity-fixed interest fund, managed to generate an income stream from dividends and interest. But total return investment has taken over for many UK endowments. One of the arguments in its favour is that it liberates the investment strategy to seek returns from wherever they are to be found, without the constraint that an income requirement imposes. When risk is added to the equation, the objective becomes the pursuit of maximum return for the least risk.

This is achieved by combining asset classes and investment styles. Unquestionably the dynamics of such diversified strategies are more complex than those of the traditional strategy, yet the transition from the latter to the former in the UK has been fairly recent and rapid. For many trustees the learning process is still going on but we are in uncharted markets where short-selling, leverage, counterparty risk and the use of complex multi-variable pricing models are among the many factors at play, of which there is little experience except in benign market conditions.

So, those endowment trustees who cannot afford the luxury of hiding from the complexity and novelty of the investment stew in which they find themselves have to look through the angst-inducing reportage of the Today programme to find the mispriced situations that will be the next engines of endowment growth. Interesting opportunities are appearing from the disarray in structured debt instruments and from the lending-drought induced by banks forced to defend their balance sheets.

The impairment of CDOs (collateralised debt obligations) and MBSs (mortgage backed securities), and the overhang of leveraged loans with bank syndicates has reached the point where informed investors see opportunities to acquire assets which have been marked below realistic default expectations or where there is true distressed selling that forces the seller to accept deeply discounted bids.

Leading hedge fund and private equity managers have been dipping their toes into this market, and the argument in favour of taking these opportunities seriously is that if the thinking behind the prospective default and recovery prospects for the underlying instruments stacks up, the prospective returns will adequately compensate for the present risk. The dangers of being a first mover have, however, been painfully demonstrated by Carlyle Group, whose mortgage bond fund imploded under the strain of margin calls.

Another potentially interesting source of returns arises from the lending strike at the banks. Again, it is specialist managers in the alternative funds sector who are directing investor capital towards businesses needing traditional lines of credit to finance specific projects. Ironically, it is the more traditional forms of commercial banking, which were too dull for investment bankers but may now replace the void that the structured debt market has left in its wake.

So, the constructive side of the “massacre on Wall Street” stories is that new opportunities are emerging, even in the very sectors which precipitated this miserable saga and access is becoming available to those who can live with the long lock-in that most distressed debt funds require.

On the cautious side, trustees must recognise that the perceived recovery potential will be in the context of a global economy which is continuing to weaken and that when these distressed instruments were originated, the credit analysts who priced the risk must have considered that they were being adequately rewarded. There have been many mistakes to learn from but there is no guarantee that anyone has.

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