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An Exhaustive Debate

Un debate exhaustivo — Photo: acques Grießmayer. An Exhaustive Debate

Australia, which is among the largest polluters per capita in the developed world, is exploring ways to reduce its greenhouse gas emissions and has set a target for reducing emissions at 5% below 2000 levels by 2020. One of its current initiatives, the carbon pricing mechanism—often referred to as the carbon tax—requires polluters to pay an amount proportional to the carbon dioxide equivalent emitted during a given year.

However, Prime Minister Tony Abbott, who was elected in September, had made it an election pledge to revoke this controversial tax, which was adopted two years ago. In light of the potential change, the debate over how to achieve the 2020 emissions target is ongoing.

Under the present system, polluters must purchase carbon units up to the level of their emissions. These units were initially set at a rate of roughly US$21 (AU$23) per ton. In mid-2015, the number of units is scheduled to be capped and the applicable rate will thereafter be set by market forces via an auction format. Any excess emissions at this stage will be charged at a 100% premium to the auction price for the period, theoretically increasing the incentive for businesses to reduce pollution.

Proponents of the system argue it is the most cost-effective solution, with the increase in costs eventually being passed onto customers. However, a recent government report showed that during a 12-month period, ending in September, emissions dipped by a disappointing 0.3%, despite the US$6.3 billion cost to industry.

In light of its opposition to the current mechanism, the new government is promoting its alternative Direct Action climate policy. Details have been relatively scant thus far but a central element to the plan is a “reverse auction” mechanism in which a US$1.4 billion fund would be distributed to those firms that can reduce emissions at the lowest cost. Critics argue that under this system, the largest polluters would not be punished for failing to address harmful output and the true cost of reducing emissions would be greater than it is under the present mechanism.

Recent polls show that the public has not yet been won over by either option. General consensus appears to favor removing the carbon tax yet is skeptical on the adequacy of the Direct Action policy as a replacement. Given that 40% of carbon emissions are beyond the scope of the tax and would have little incentive under the proposed Direct Action policy, any resolution is unlikely to be a definitive solution.

As it stands, removing the carbon tax would relieve Australian corporates of a near-term burden, but concerns would still remain. Some say current reduction targets are insufficient, and global climate talks set for next year in Paris may place added pressure on the government to revisit its longer-term emission targets.

Colin Dishington, CA, Research Analyst at Matthews Asia

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.

End to the Reign of Style Boxes?

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From a rigid framework driven by investor demands for strict style adherence, asset managers are enjoying expanding freedoms in managing investment strategies. After a twenty-five year period of intermediaries constricting active managers’ discretion and forcing narrower and narrower parameters in the name of style purity, the grip of style-box logic is slowly loosening. The change is hugely important: prescriptive style management had dictated the control of asset allocation as well as product development & selection for two decades. A new regime is emerging.

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During the “Reign of Style” (1992-2008), asset management product development and relationships with intermediaries and end-investors had been tightly categorized and controlled. Arguably, the alpha potential was squeezed out of many good managers and ETFs elbowed their way in. Within this period, there were two groups: those who fit into a box (so called traditional, long-only asset managers) and those who did everything to hide in the shadows so as not to be trapped (so called hedge funds).

‘Asset Allocation’ and ‘Alternatives’ categories are the real winners since 2008

Since 2008, a new era of asset management has started to settle in. ETFs will continue to fulfill requirements for low tracking error accuracy – head to head competition is not advisable. Asset managers should seek to get themselves out of the box before they are pushed out (either by unsustainable margin compression or dwindling flows).

As if the rising dominance of ETFs were not enough, the greater ranges of freedoms for managers come with another less visible though perhaps more pernicious challenge. Intermediaries, be they institutional consultants, global banks, IFA/RIAs, TAMPs, platforms or online advice models have all jumped into the asset management game in various guises. In many cases, using ETFs as the underlying instruments for broadly applicable asset allocation driven ‘solutions.’

The ways we have historically defined an asset manager relative to an intermediary no longer apply. Asset management, as we had come to know it in the last 25 years, is being redefined. Understanding the blurring of the lines between alternative and traditional is certainly important but, equally significant are the eroding lines between the intermediary selecting and allocating to asset managers and the asset managers themselves.

Asset management companies should not expect a resurgence of the intermediary relationships and distribution models of the past; the future holds a more complex reality. Further, active asset managers must be careful not to suffer from the former generosity of their intermediary captors and remain complacent. Intimidated by the lingering power of the box and the desire to fit within what are perceived to still be the guidelines of intermediaries offering access to their clients’ money, managers’ strategic decision-making may be misguided by the affects of the Stockholm Syndrome.

There are rare few exceptional specialist managers. Self-directed and focused on true exploitable inefficiencies, these managers will continue to thrive – capturing the imaginations and wallets of the albeit more selective group of investors seeking their services. Middle of the road managers are most susceptible to relying on the former paradigms for too long and getting the squeeze. If you stand in the middle of the road for too long, you get run over.

“Box logic” is indeed on the decline but, in this industry, it takes a long time to replace established practices – even when they are clearly no longer best practices. Asset managers of the traditional or newly emerging ‘hybrid’ variety need to understand the context in which they are managing their business today and into the evolving future. Increasingly, investors are relying on asset managers to:

Develop and manage investment products with more embedded asset allocation decisions,
Increase the level of “active share” in the specialized portfolios that they manage,
Provide cheap and efficient exposures when warranted.

Seen above, the “Periodic Table of Worldwide Flows” shows where the money has gone. Understanding the underlying dynamics of the industry and motivations of its players informs us where it is headed.

Propinquity is focusing on the implications of a broad set of changes taking place in the asset management industry. Perhaps above all else, over the long-term these changes reflect a broader thesis about the evolving dynamics of the manufacturing / distribution model and the relationship between investors, intermediaries and asset managers. It is becoming increasingly evident that the later two are in a quiet but ferocious battle for the attention and fee-earning opportunities from the former.

Though they may not be at the very top of the league tables, ‘Asset Allocation’ and ‘Alternatives’ categories are the real winners since 2008. Regardless, when one dives deeper into the numbers, the product trends in fixed income and equities reflect the same logic – more flexibility, unconstrained and global. Growth in these categories is an indication of the longer-term (20 year+) structural changes taking place within the industry. These flows only hint at the developing mindset of industry players and the frameworks for how we think about investing globally.

Where many funds now in Asset Allocation and Alternative eventually get categorized is the task of Morningstar and other ‘categorizers’ who are working hard to figure it out. The categories are being developed nearly as quickly as funds are being launched to fill them. Like hedge funds of old, the funds in these categories are, in many cases, ‘anti-category’ approaches. Arguably, many of the best managers and their funds defy strict categorization.

Notes:
Fund flow data should always be viewed with caution. The data tends to shift with the tides and, even given the best efforts at ‘scrubbing,’ is prone to error and unintentional miscalculations. Categorizations of individual funds change through time as do the position of the funds within defined categories. New categories emerge, existing ones are made obsolete and mergers are common. What might appear as a spike or slip in total AuM and flows may in fact be due to a re-categorization. Of course, not all funds fit neatly into a single category.

Ironically, traditional “hedge funds” are being subjected to increasingly narrower buckets – the risk of ‘style drift’ is squeezing the opportunities of a flexible approach right out. It is ironic that, now subject to higher levels of scrutiny and demands for transparency, many of the 20 year old ‘style analysis’ tools have become part of the toolbox for doing due diligence on LPs. From five categories 15 years ago, hedge fund styles are sliced and diced into 100+ categories and hedge fund alpha as a whole in contracting. See earlier articles for extensive discussions of descriptive vs. prescriptive roles of style and the management of investments.

Article by Roland Meerdter, founder and managing partner of Propinquity Advisors

Runners Stay on Track with Wearable Fitness Technology

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La indumentaria electrónica, industria multimillonaria que además promueve el deporte — CC-BY-SA-2.0, FlickrPhoto: Peter Parkes (Flickr: Nike FuelBand). Runners Stay on Track with Wearable Fitness Technology

The rise of wearable fitness technology is making it easier and more fun for athletes to track and meet their fitness goals. While the health benefits of exercise are well known, it is reasonable to assume that these technologies are also helping to drive increased sports participation. In 2012 the number of US half-marathon finishers increased by 15%, reaching a record number of runners.

Although still in its early stages, the integration of wellness technology into wearable devices is a promising and emerging trend that will lead to the launch of new accessories and will be instrumental to growth in the athletic industry. IMS Research estimates that the wearable technology market will reach USD 6 billion by 2016, with strong growth coming from consumers seeking more data on their personal health and fitness.

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As athletes exercise, wearable technologies, such as “smart” watches or fitness bands can track speed, distance, calories burned and monitor heart rate in order to help improve their workouts. Essentially, these devices allow users to track their progress in real-time and provide a simple integrated approach to collect fitness data. Some products even transmit the data to a third party for real-time analysis and feedback. In addition to the benefits for consumers, coaches at all levels can use the data to develop improved or personalized workouts for their athletes.

The impact and possible applications for these technologies are broad-based and just beginning to be explored. For instance, in the 2012 Major League Soccer All-star game, players were fitted with the Adidas miCoach Elite system and television viewers were allowed to see players’ real-time fitness levels. For athletic companies, fitness tracking technologies are another way to interact with consumers, ultimately leading to better utilization of products and building customer loyalty.

“With the rising popularity of athletic activities such as running, wearable technologies will benefit as a growing number of people seek to track their progress towards reaching their fitness goals”

Wearable technology is not a new concept, but it enters 2014 with strong momentum. It was a major feature at this year’s Consumer Electronics Show. The timing for wearable devices seems appropriate as smartphone penetration has increased rapidly over the years, along with the growing availability of WiFi. Recent watches or bands have more stylish options and better battery life. In 2006 Nike launched the Nike+ partnership with Apple that uses a footwear sensor to collect data on an iPod or smartphone. It has further enhanced its offering with the Nike Fuelband. Adidas launched the miCoach platform in 2010 and expanded the lineup with a Smart Run watch last year. Recently, UnderArmour acquired a digital fitness tracking website called MapMyFitness, which has a user base of 20 million, for USD 150 million.

Lending For a Lifetime: Mexico Issues 100 Year Sterling Bond

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Préstamos para toda la vida: México emite bonos a 100 años en libras esterlinas — Wikimedia CommonsPhoto: Esparta Palma. Lending For a Lifetime: Mexico Issues 100 Year Sterling Bond

Hot on the heels of the successful 100-year bond issued by utility giant EDF in late January (the first of its kind in sterling), Mexico followed suit last week in raising £1bn from investors with a bond maturing in 2114, priced to yield 5.75%*. Typically, these bonds are issued by high quality companies and governments given the long time horizon, and have been supported by demand from investors looking for higher yielding investments and those with long-dated liabilities (the Mexico 100-year bond has a duration of 18 years). The new issue proved popular, attracting a £2.2bn order book for a £1bn bond issue. This is the second time Mexico has raised a 100-year bond, following the USD bond in 2010.

Despite the recent uncertainties and asset price performance in some emerging markets, Mexico stands out as one of the few countries where fundamental reforms are helping to improve the country’s standing, with rating agency Moody’s upgrading Mexico’s debt to ‘A3’ in February. We believe there is a high probability of further rating upgrades as the other agencies follow suit. The EDF 100-year bond has performed very well since its launch earlier this year and while the risks for a utility are very different from those faced by the sovereign, investor take-up has been supportive. While we have a positive view on Mexico versus its emerging market peers, the extremely long-dated nature of these bonds means that investors also need to be wary of the future path of interest rates, and given the long-term nature of the investor base, the limited liquidity in secondary markets.

*Henderson participated in both the Mexico and EDF 100 year issues within a number of our portfolios.

James McAlevey, Head of Interest Rates at Henderson Global Investors

The Gross Recipe Gets Salty

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Bill Gross is not the always affable, mild-mannered, yoga practitioner we have been led to believe he is. He is demanding of his staff, prone to hyper-criticism and a bit of a tyrant. Who would have expected that the King of Bonds was driven by a big ego and a tinge of nastiness?

An article, published in the Wall Street Journal last week, reveals a different view of Mr. Gross than what many readers of his monthly Investment Outlook have come to expect of him. Some of his colleagues and industry commentators are shedding light on a range of behavior that is inconsistent with the persona that Bill Gross himself has so masterfully developed over the last four decades. For those who had come to ‘know’ him through the stories he tells, the recent contradicting reports come as a surprise.

Is this is the new normal Bill Gross?

The catalyst for the WSJ article was the sudden departure of Mohamed El-Erian, the highly-respected former heir-apparent to Mr. Gross. Mr. El-Erian fled PIMCO’s offices in Newport Beach and left a reported $100 million annual salary behind. As power struggles go, this one was ferocious.

For a man overseeing $2 trillion dollars in assets and who is, according to one commentator, the Steve Jobs of bond management, few should be really surprised at what was hiding beneath the mild-mannered style Mr. Gross exudes in public. Indeed, a management consultant who had worked with PIMCO for three years likened the shop’s environment to a ‘pressure cooker’ with Mr. Gross as its Chef. Things have boiled over.

PIMCO is like no other firm in the history of asset management. One might argue that it is all but impossible to reach a level of royalty in this industry and create an enterprise of such scale without dishing out some ‘tough love’ every once in a while. Mr. Gross contends that he can indeed be demanding of others but no more so than he is of himself. Ultimately, its about results: AuM and performance numbers will be the ongoing measure of success.

Beyond the melodrama, these newly surfaced elements of Mr. Gross’s personality are important developments for investors to understand and monitor. Asset management is a people business. Success is dependent on attracting and retaining talented individuals who are able to execute as a team. Managing inter/intra-personal complexities, particularly within large firms, is integral to cohesion and growth. These are elements that investors must both be aware of and focus on. Their realities are often hidden from view.

In The Gross Recipe, an essay on Mr. Gross and the persona he has created through his monthly Investment Outlook, I wrote:

“[W]hat works so well for Mr. Gross is that investor-readers do not know everything about him. There is always something unknown remaining for the reader’s imagination to create for him/her self. Perhaps it is this ‘just enough’ status that, like properly managed Fed monetary policy, is the recipe for success.”

Perhaps now investors know too much.

______________

afterword: It is interesting to compare the public persona of Bill Gross to that of the other claimant of the title “King of Bonds:” Jeffrey Gundlach of Doubleline. Mr. Gundlach’s strongly expressed confidence and ego are similar is some ways with what is now very publicly being discussed about Bill Gross. Alas, it has not hurt Doubleline from being one of the fastest growing asset management companies in recent history.

* If you find this topic interesting and have not done so already, please read the essay, “The Gross Recipe.” It discusses the persona Bill Gross has created through his colorful storytelling in the monthly “Investment Outlook” essays he writes. The current essay is a direct follow up from that articles. See: http://propinquityadvisors.com/distribution/the-gross-recipe

[Thanks to Baldwin Berges for his pictorial contribution of Mr. Gross. See: www.baldwinberges.com & www.bd-insider.com.]

Article by Roland Meerdter, founder and managing partner of Propinquity Advisors

The Renminbi’s New Normal

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El “new normal” del renminbi — Wikimedia CommonsPhoto: Elyyo. The Renminbi's New Normal

The gyrations in Chinese money markets in the last few weeks have caused much alarm in the financial press. The moves in these markets are not only inline, but healthy for an economy looking to increase the role of the market in allocating resources. Those who believe these moves indicate financial stress, or draw parallels between the recent volatility and that which preceded the subprime crisis in the U.S., might be looking through the wrong end of the telescope.

First, let’s put the recent volatility in context. The renminbi (RMB) depreciated 1.4% relative to the U.S. dollar (USD) in February, making it the worst performing currency in Asia. The recent weeks have certainly been one of only a handful of periods of sustained depreciation. Such a historical comparison seems inappropriate, however, especially since the RMB is shifting to a more flexible exchange rate regime. Shouldn’t China’s central bank be managing the currency with an eye toward the future, rather than toward the past? Indeed, the experience of countries that have successfully transitioned from a fixed to a flexible exchange rate regime suggests that it is the job of authorities to foster a sense of two-way risk—meaning the currency could appreciate or depreciate to encourage investors to take both long and short positions. In other words, a successful evolution from a tightly managed currency to a more flexible regime actually seems to necessitate a rise in volatility. Even after the gyrations of recent weeks, the implied volatility of the RMB is still only at about half that of the Singaporean dollar, another managed currency; and about a quarter that of the Japanese yen, which is one of the most freely traded currencies in the world. Again, I believe this is healthy and also necessary in achieving China’s goal of further liberalizing its capital markets. Consider it the new normal.

So why are market participants so surprised? Because being long the RMB—expecting that the currency should appreciate—has been the “no brainer” trade for many years. And for the past few years, people have not been using their brains when buying the RMB. They seem to be forgetting cause and effect. Currency appreciation, in and of itself, is neither a noble nor desirable goal. Managing the value of the currency is merely a means to an end. What might that “end” be?

One such “end” might have been to rein in inflation. An appreciating currency is a handy tool to slow inflation through lower import prices. Assume for a moment that the price of oil is constant at US$100 per barrel. That same barrel of oil would be 20% cheaper with an exchange rate of 6 RMB to the US$1 than 8 RMB/USD. In fact, there is an uncanny correlation between inflation and RMB appreciation ever since Chinese authorities transitioned from a fixed exchange rate to a managed band in 2005:

When wages could not keep pace with inflation, an ever-appreciating currency was necessary to help make imports cheaper, keeping inflation in check. But now that wage growth is surpassing inflation, there is less of a need to appreciate the currency. Indeed, the Chinese economy has arrived at a point where a continually rising RMB is not desirable. Consider the position of Chinese exporters. While the RMB has appreciated 9% relative to the USD in the last three years, it has appreciated an astounding 14% on a trade-weighted basis. In a world of quantitative easing, whereby three of the world’s four largest currency blocks are racing to debase their currencies, the RMB stands at a competitive disadvantage.

And last, but certainly not least, the one-way appreciation of the currency has encouraged risky behavior, which together has heightened systematic risk in the Chinese economy. Among those engaged in one-sided bets are the global hedge funds that have raked in profits by being systematically short on the USD versus the RMB. Chinese companies also need to be weaned from the notion of a one-way appreciation that use offshore subsidiaries to borrow USD at low rates and then repatriate the proceeds disguised as RMB payment for goods that its parent firm invoices. The cash then gets invested in cash wealth management products yielding double digits. As we know, any product that offers a yield substantially higher than prevailing money market rates are neither cash equivalents nor risk-free. Then there are numerous chief financial officers who have told me that they believe issuing a five-year bond at 10% in USD is really only costing them 5% because they think the RMB is going to continue to rise 5% every year. These represent just a sample of individuals and companies with deeply vested interests in a rising RMB. By letting volatility creep into the currency movements, Chinese authorities are sending a wake-up call to those vested interests.

According to a Confucian proverb, bamboo does not break because it bends with the wind. Similarly, more volatility in China’s currency should be welcomed instead of shunned if the country is to fulfill its ambition toward a liberalized economy.

Teresa Kong, CFA, Portfolio Manager at Matthews Asia

Can that Cool App I Created Make Me a Billionaire, Too?

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¿También yo me haré millonario con mi nuevo app? — Jan Koum, Whatsapp co-founder. Can that Cool App I Created Make Me a Billionaire, Too?

Just about everyone is entranced with the recent news out of Silicon Valley about billions of corporate dollars being used for acquisitions. Many of the buyouts we’re hearing about are software companies that were startups just a few years ago. There is almost an 1849 Gold Rush mentality now in California. Who can think of the next software application that can be sold to a big Internet company for billions of dollars? Basement and garage software entrepreneurs work feverishly, hoping their ideas can make it big.

But what do company takeovers and buyouts mean for those of us who invest in the market? The first question is always fundamental. Are we witnessing mergers and takeovers that add value? If most of the M&A activity is being undertaken to improve cash flow growth in the long run, everyone should be better off. Usually, however, this isn’t the case.

While many types of acquisitions can add to shareholder value, many others don’t. Some company transactions are deliberately designed to spread another revenue stream over a fixed cost base. If these transactions are executed well, shareholders stand to benefit from higher margins and higher returns on capital. One example of this might behorizontal integration — buying a similar company in a similar business and keeping the revenues but not duplicating the costs.

Another case might be vertical integration — buying another company along the supply chain to obtain ease of control. Some examples include a manufacturer acquiring a sales company, an energy extractor purchasing a gasoline refinery or an Internet retailer obtaining a money transfer firm to help control the financing aspect of selling goods and services online.

A third type of positive takeover could be carried out for diversification. Just as investors often seek to balance the risk in their portfolios by diversifying their holdings, companies may want do the same by diversifying their business lines. Buying other companies may be able to buffer the effects of the economic cycle, smoothing out earnings as one business does better while another is flagging.

All three of these fall into my category of legitimate or worthwhile motivations for M&A. How do we detect if the reasons to take over a company are not so legitimate?

First, look at the motivation behind the acquisition. When a company exhausts its own organic growth, or stalls in its internal growth, management may be tempted to reach out and buy growth. The academic literature suggests that these growth acquisitions often involve overpayment and widespread destruction of shareholder value. Other companies use acquisitions to take out the competition or to find ways of getting around investing in their own businesses. In these cases, the less than noble outcome is typically that management is enriched, but not shareholders.

Second, consider what companies are paying for their acquisitions. During typical cycles, the price paid to take over another company must involve a premium to get existing shareholders to willingly part with their shares. Again, academic research shows that in many buyouts and takeovers, the buyer pays too much and the result is grief for the shareholders of the acquiring firm. Typically the premium paid is 30% or 40% over the current market price.

These are things to look for when selecting individual companies.

In a broader sense, I like to watch M&A activity for its ability to indicate trouble ahead for the market or to confirm that a market peak is approaching. Looking back over history, we see that market peaks and recessions have frequently been preceded by periods of wild or excessive M&A transactions. Takeovers in these euphoric periods typically reach 7% of the names traded in the public marketplace. Now, takeovers are running at only 3% of publicly traded names.

We are definitely seeing some marquis takeovers and glittery deals, and most of them are taking place in the rapidly changing world of technology. There is a scramble across that sector to chase after global audiences for more advertising revenues.

Despite these high-priced deals, there is not yet a broad-based wave of mergers going on in the rest of the market. In fact, the rate of mergers is at or below historical averages. And on the valuation front, the current premium or buyout price paid for the average non-technology takeover is also below the historical norm.

We are watching this M&A trend, and right now it’s anyone’s guess if the cash-rich giants of Silicon Valley are making wise takeover decisions. But until the mania spreads — and we see high price tags in other sectors of the market, such as energy, consumer discretionary and staples — the time for worry hasn’t yet arrived. Based on historical averages, the M&A indicator is rising, but remains well below the danger threshold for the market as a whole.

Column by James Swanson, MFS Chief Investment Strategist

Argentina through the Eyes of Bonds

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There has been much speculation this year when it comes to the future of the Argentine economy. Many on wide side believe the country is heading towards another major financial crisis while many others believe it is just business as usual.

One of the major investment vehicles in the country is bonds, so what do they have to say about the state of the nation?

Let’s take a look at the development of the BODEN (Bonos Optativos del Estado Nacional) Elective Government Bonds, known by their acronym in Spanish, which are the dollar denominated bonds regulated entirely in Argentina and backed by the Argentine Central Bank.

BODEN RG12 was the bond series launched in 2002 after the financial crisis.

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It carried a coupon payment of 12.50% and was being traded at a median performance of 17.99%, which was an adequate performance in relationship to the dividend payments. When the Government made their last payment in 2012 to investors, everyone praised it as a significant movement away from crisis. About 80% of investors were foreigners, and it surely gave them confidence about the future outlook of Argentina.

The next big test for the BODEN series will be the R015 expiring on October 3rd, 2015.

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The bond has an average performance of 18% after the peso devaluation and it is causing concern in the markets, considering it carries a fixed coupon payment of 7% and a payment date just around the corner.

I will trust the bonds to give us more input this year in the upcoming state of the Argentine economy.

Argentina must make payments on the BODEN bonds in dollars, which in turn must come from the Central Bank reserves. Argentina uses these same reserves to resist downward pressure on the peso, and to pay for imported goods.

As the BODEN is a dollar-denominated instrument however, it demonstrates that contrary to common misrepresentation, Argentina can indeed access international capital markets, at least to some extent. Furthermore, the BODEN’s consistent value and trading value over time shows that international investors and markets continue to seek exposure to Argentina.

Argentina has demonstrated both a commitment to and indeed the prioritization of honoring this commitment; however, their continued ability to do so will depend on the bond closing prices, as well as on reserve levels in the upcoming year.

*BODEN trends and statistics provided by www.puertofinanzas.com

Article by Jonathan Rivas, Managing Partner, DCDB Group

The Opportunity in Private Debt

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Fixed Income investors have heard the same story repeatedly over the past few years: there is no juice in traditional fixed income products, and investors will have to look elsewhere to earn any meaningful yield. We see an opportunity for our clients in private debt, as the risk premium of over 5% above comparable high yield bonds nicely compensates for the illiquidity of this asset class, which is arguably the most common barrier to investing. However, we find that most of our clients hold over 85% of their family portfolio in highly liquid securities (i.e. with less than a week of liquidity). The expansive monetary policies of central banks, coupled with some distortions formed by the 2008-2009 financial crisis, have created a great opportunity to lend to middle market private companies.

Brief Overview of Private Debt

Private debt is often utilized by small and mid-sized companies looking for capital or financing. These firms are known as “middle-market” companies- broadly defined as those firms with EBIDTA of $15mm to $100mm and capital needs of $50mm to $500mm. [1] Because of their size, these middle-market firms have limited access to liquid capital markets, which have high minimum issuance sizes. The average issue size per bond in the iBoxx High Yield Corporate Bond index is currently $855 mm.[2]

There are different types of private debt securities- the most typical are in the form of senior loans (first and second lien); unsecured and subordinated debt; and hybrid instruments (combining senior and subordinated debt). The two principal sources of private debt deals are private companies and private equity sponsors. Private companies may look for funding to make acquisitions, to refinance or for growth capital. Private equity sponsors also look to the private debt markets when a transaction such as leveraged buyout or add-on acquisition occurs, or a company needs refinancing.[3]

Investors in private debt earn returns from two factors: 1) contractual return components and 2) equity upside. The contractual return component is the base of the return stream (consisting of high coupons typically 10-15%), plus up-front commitment fees and sometimes premiums relating to early redemptions. Equity upside can be a source of return in some private debt deals. A private debt investor will usually have the opportunity to make equity co-investments in a deal to enhance returns; or sometimes have warrants which potentially benefit from capital appreciation. Private debt investments are positioned higher in the capital structure than equity, giving investors a priority on cash flows of the company.

To understand the risk/return profile of private debt investments it can be helpful to compare this asset type with high yield bonds and private equity (see Table 1 below). While private debt is illiquid when compared to high yield bonds, when compared to private equity we see two main differences: 1) Private debt has a shorter investment period (usually 3-5 years); and 2) Private debt generates attractive cash flows (today we expect around a 9% current yield).

TABLE 1

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Current Opportunity in Private Debt

We like the attractive yields and risk profile of private debt. Private debt is a highly specialized market. Thus, it requires managers with a strong track records as well as a solid network to gain access to deals. We believe the best way for our clients to invest in private debt is through a high quality third party manager. Over the past few months, we have been looking into different managers in the space, focusing on these core qualities:

Track record through multiple credit cycles. We’re looking for managers with a long track record through different market cycles. There are many funds which boast a 0% default rate- but have only been investing since 2009, a period of low defaults across the board. We want to see a team that has proven itself to invest in difficult market and credit environments.
Access to private equity sponsors/ deal flow. We want to work with managers who have direct access to private equity sponsor and deals. This access is important because it ensures the manager is seeing the best deals first- and has first choice in participating. Managers with good access also avoid paying fees to a middle man – which would otherwise be absorbed by the investors in the fund.
Strong investment process/ due diligence process. We want to see a proven track record as well as a strong investment process. We like to see highly experienced teams with the right firm infrastructure to allow for in-depth due diligences.
Alignment of interests. We are always looking for a meaningful alignment of interests when we invest, in this case a capital commitment to the fund from the fund senior managers and or the firm.
Dividend Distributions. In line with our investment philosophy, we look for managers that pay distributions of around 75% of their gross yields. That means at least 9% current yields with expected gross returns of 13% to 17% per annum.

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Report by Ignacio Pakciarz, CEO and Ilina Dutt, Research Analyst, BigSur Partners. You may access the full report through this link.

[1]Rocaton Insights, “Opportunities in Private Middle Market Lending”, January 2013

[2]iShares, data as of January 31, 2014

[3]ICG, “Introduction to Private Debt,” January 2014

Latam Equities’ Piñata

| For Alicia Miguel | 0 Comentarios

Brazil will take centre stage in June when the FIFA World Cup kicks off. Stadium construction delays and concerns that the country’s poor infrastructure will be unable to cope have led to accusations that the country is ill-prepared for such a big event. Later in the year there will be elections. Dilma Rousseff is predicted to hold on to the Presidency, but an embarrassing World Cup or a renewal of the social unrest that marred last year’s Confederations Cup could quickly change her fortunes.

In general, the business community would welcome political change, but fear of defeat could prompt the current government to resort to populist policies that lead to a further deterioration in the fiscal deficit. One crumb of comfort is that persistently high inflation has put the central bank ahead of the curve in raising interest rates compared to other countries with vulnerable currencies. Hence, although this will ensure economic growth remains muted in 2014, Brazil is further through the adjustment process than most.

In Mexico, last year was characterised by positive reform headlines but disappointing economic activity, resulting in Mexico’s economic growth being below that of Brazil. This makes 2014 critical for two reasons. First, in the face of higher taxes, Mexico has to deliver on expectations for a rebound in growth, through an increase in government spending and aided by continued recovery in the US. Second, the hard work of ironing out the finer details of the reforms, in particular the energy reform, needs to be completed. Success on both these fronts will give investors confidence in a structural improvement in Mexico’s long-term growth rate.

Elsewhere in the region, the peripheral countries of Venezuela and Argentina have created headlines for the wrong reasons already this year, both having effectively devalued their currencies. This has added to the nervousness surrounding exchange rates in Latin America that began last summer with talk of the US Federal Reserve tapering its quantitative easing programme. Although this is painful in the short term, it is happening because growth in the US is on a firmer footing, which will lead to stronger demand for the region’s exports.

Valuations in Latin American equities are approaching very attractive levels: like a Mexican piñata, the more hits they take, the closer we get to a gift in the form of a compelling buying opportunity being opened up.

Nicholas Cowley, Investment Manager, Global Emerging Markets at Henderson Global Investors