a degree of latitude asean infrastructure belt & road ... · elcome to the final issue of...

www.AlphaQ.world

A DEGREE OF LATITUDELow fee hedge fund-like returns

TWIN TURBO RETURNSIncome & capital gains

ALL CHANGEFixed income evolves

ASEAN INFRASTRUCTURE Belt & road initiative

2016 IN REVIEW Looking back & peeking forward

PROFILENew York’s Droit

AlphaQFOR INSTITUTIONAL INVESTORS & ASSET MANAGERSDecember 2016

Meet the MillersThe drivers behind the disrupting couple

www.AlphaQ.world | 2

ED ITOR IAL

AlphaQ December 2016

Managing Editor Beverly Chandler Email: [email protected]

Contributing Editor James Williams Email: [email protected]

Online News Editor Mark Kitchen Email: [email protected]

Deputy Online News Editor Leah Cunningham Email: [email protected]

Graphic Design Siobhan Brownlow Email: [email protected]

Sales Managers Simon Broch Email: [email protected]

Malcolm Dunn Email: [email protected]

Marketing Administrator Marion Fullerton Email: [email protected]

Head of Events Katie Gopal Email: [email protected]

Head of Awards Research Mary Gopalan Email: [email protected]

Chief Operating Officer Oliver Bradley Email: [email protected]

Chairman & Publisher Sunil Gopalan Email: [email protected]

Published by GFM Ltd, Floor One, Liberation Station, St Helier, Jersey JE2 3AS, Channel Islands Tel: +44 (0)1534 719780

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©Copyright 2016 GFM Ltd.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher.

Investment Warning The information provided in this publication should not form the sole basis of any investment decision. No investment decision should be made in relation to any of the information provided other than on the advice of a professional financial advisor. Past performance is no guarantee of future results. The value and income derived from investments can go down as well as up.

Welcome to the final issue of AlphaQ for 2016, and to

paraphrase a popular song: “Oh, what a year!”

Jittery and jumpy was the prediction for markets in

2016 from our straw poll at the beginning of the year. Who knew

exactly how jittery and jumpy that could become with the twin

shocks in the polls this year resulting in us leaving 2016 behind

with the UK leaving Europe and America braced for a Trump

presidency.

We know that our readers can benefit from volatility, whichever

direction it takes, but it has been tough to call over this

extraordinary year. And looking forward, it looks no calmer. Our

cover story features the disrupting Millers, with Gina Miller’s Brexit

challenge being debated by the Supreme Court even as we go to

press, with a result due in January. We ask the Millers, what drives

this desire to get involved and to make a difference.

Our regular columnist, fund manager Randeep Grewal, draws on

history, from King Canute onwards, to try and give us a context for

contentious trade agreements. He reminds us that as an investor,

he tries to consider what the counterparty knows, its experiences

and motivations.

This issue of AlphaQ brings you shareholder activism; a look

at the Belt & Road Initiative and its importance for ASEAN

infrastructure; a fund that aims for hedge fund like returns for low

fees; a fund that seeks to produce both income and capital gains

and a route to profiting from hedge fund redemptions.

Hopefully, you will get a quieter moment at your desk over the

Festive season – do spend it with us.

Happy Holidays,

Beverly Chandler

Managing editor, AlphaQ

Email: [email protected]

EL

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www.AlphaQ.world | 3

CONTENTS

AlphaQ December 2016

Companies featured in this issue:• CVCCreditPartners

• Droit

• EastspringInvestments

• EDHECInfrastructureInstitute

• GoldbergKohn

• InvestecAssetManagement

• LatitudeInvestmentManagement

• M17

• MPI

• PAAMCO

• QuadraCapital

• Ropes&Gray

• RosebrookCapitalPartners

• S&PGlobalRatings

• SchulteRoth&Zabel

• SCM

• SetterCapital

• Vanguard

• WHARDSteward

222016

www.AlphaQ.world

A DEGREE OF LATITUDELow fee hedge fund-like returns

TWIN TURBO RETURNSIncome & capital gains

ALL CHANGEFixed income evolves

ASEAN INFRASTRUCTURE Belt & road initiative

2016 IN REVIEW Looking back & peeking forward

PROFILENew York’s Droit

AlphaQFOR INSTITUTIONAL INVESTORS & ASSET MANAGERSDecember 2016

Meet the MillersThe drivers behind the disrupting couple

NEWS FEATURES

04 A degree of Latitude InterviewwithFreddieLaitonthe

newspinoutofLatitudeInvestmentManagementofferinglowfeehedgefundreturnsandbackedbyOdeyandotherinvestmentgiants

05 Quadra opens its doors Introducingaconcentratedstrategyfrom

Paul-GeorgesMoucanwithhisQuadraGlobalEquityAlphawhichenjoyedasoftlaunchinAugustandisnowopentoall

FEATURES

06 Cover story: Meet the Millers InterviewwithAlanandGinaMillerof

SCMDirectontheirbusiness,theirinvestmentmodelandthatchallengetoBrexit

09 Redemptions offer opportunities Opportunitiesontheriseformanagers

investinginilliquidhedgefundassets.JamesWilliamsinterviewsRosebrookCapitalPartners

12 Analysing the endowment landscape MPIexaminesendowmentperformance,

measuredagainsttheYalemodel

14 Easing the regulatory compliance process

NewYork-basedFintechfirmDroithascreatedADEPT,designedtohelpbothsell-sideandbuy-sideinstitutionsaddresstheissueofregulatorycompliance

16 Tech-Savvy MariaMcGuire,commercialfinance

partnerwithChicagolawfirmGoldbergKohn,writesontechnologyfinance,onissuesthatariseinhelpinglendersstructuretransactionswithtechnologycompaniesandprivateequityfirmswithtech-focusedportfolios

18 What lies ahead? AlphaQ’sannualreviewoftheyearand

peekintothefuture

20 Silk road initiative DonaldKanak,ChairmanofEastspring

Investments,writesontheBelt&RoadInitiativewhichiscrucial,alongwithinternationalco-operation,fortheongoingdevelopmentofinfrastructureintheASEANregion

22 CVC offers twin turbo returns CVC’sAndrewDaviesexplainsthe

benefitsofinvestinginEuropeanseniorsecuredloansintoday’slowyieldenvironment

25 The evolution of activist Investing Accordingtoanewreport,Energyand

ITcompaniesaremostlikelytoattractshareholderactivismwithfourin10respondentsbelievingthatthesesectorsrepresentalotofopportunity

27 All change for fixed income Vanguard’sHeadofFixedIncome,

PaulMalloy,discussesinnovationandevolutioninthefixedincomemarket

30 Cakes and trade RegularcolumnistRandeepGrewalcalls

onthelessonsofhistoryanditstradeagreementsfromKingCanuteonwardstogiveussomecontextontheBrexitdebate

www.AlphaQ.world | 4AlphaQ December 2016

ALPHAQ NEWS FEATURE

between them. “The key marketing message

is that we are targeting something similar to

what hedge funds did in the past, absolute

returns, but we are only charging a 1 per cent

management fee while hedge funds have only

returned investors 1.2 per cent a year over the

last 10 years and charged fees of 2 and 20.”

“We are long only and take a long term view.

And if you know what you are looking for, you

can generate high levels of alpha on your equity

book alone. With risk diversified through other

investments, you can end up with a similar

outcome that any hedge fund would offer.”

Latitude’s high calibre godparents ensure it

is safely ensconced in Mayfair while it grows its

business. “We have 15 high calibre investors

from the industry which gives us lots of support

and comfort. We are growing a business, not

just a fund,” Lait says. “And we are investing

in global large cap long term investments

so liquidity isn’t a constraint. We have daily

liquidity and are hugely scalable.” n

November saw Latitude Investment

Management emerging out of Odey Asset

Management, founded by Freddie Lait who,

along with the support of a further 15 influential

but unnamed ‘high calibre investor’ godparents,

is opening the long-only Latitude Horizon Fund

to institutional investors.

Lait spent six years at Odey trading a similar

concentrated portfolio of stocks which have

high-quality business characteristics and strong,

or improving, industry dynamics. Alongside

this, non-equity investments will be made to

generate uncorrelated returns, reducing risk

without compromising performance. Lait says

that the relative allocation of asset classes will

be determined by analysing cyclical factors with

a long term, capital preservation objective.

Lait says: “The framework is one of absolute

return on a rolling three-year basis in which we

aim to outperform inflation on the one side, and

make cash plus returns on the other through

owning choice bonds, credits and currencies

which reduce the risk in the portfolios.”

The fund aims for cash plus returns with low

downside risk, an equity-like real return with

dampened volatility. The fund has been open

for a matter of weeks and is broadly flat, despite

having not expected the Trump vote. “We were

on the wrong side of the trade,” Lait says. “But

this didn’t affect our portfolio; one of the key

things is that we are not reactionary, but will

scythe through events. We are not trying to

trade hot sectors or short term events.”

Lait believes that the vast number of

investors have become shorter term, effectively

trend-following and event-driven. “I think that’s

the wrong way to do it and it is hard to have

a skill set that is repeatable. You are trading

against machines if you want to play at that

game. It is hard to sit in an office in Mayfair

betting against algorithms running on a server

somewhere.”

Lait’s strong macro views feed into the

bottom up analysis of industry dynamics.

“The vast majority of analysts look at demand

side economics but we feel that is too hard to

forecast,” he says.

He likes industries that are consolidating,

where fewer players are carving up more spoils

Latitude launch offers low fee approach to hedge fund type performance

“It is hard to sit in an office in Mayfair betting against algorithms running on a

server somewhere.”Freddie Lait, Latitude Investment Management


needs little maintenance and the number of

stocks in the universe are not moving that

much because stocks leave due to M&A activity,

or stocks enter because of an IPO.

“Everything is very stable,” Moucan says.

“The beauty of the thing is that it is just

500 names and your small team is meeting

the companies on a regular basis, which is

convenient. We are not using quantitative

analysis, we use a simple template looking at

the growth prospects, the barriers to entry of

the business and the management execution.”

Moucan goes long and short the same 500

stocks, giving as an example, Salvatore Ferragamo.

“We were long based on the growth of the brand

especially in emerging markets but in 2015

Ferragamo was the most exposed to China, so the

most vulnerable and I went short at the time.”

Some of the stock has been in the portfolio

for seven years, since he ran the strategy

at Amundi. Quadra Capital Partners was

founded in 2014 and the team all come from

significant positions in large houses, so it is

a boutique fund management firm that packs

quite a punch. The founding partners have

managed more than USD20 billion in over 100

funds, including more than USD3 billion in

international equity structures.

Moucan says: “In reality, a lot of products are

very much the same and you have to provide

something different, and it’s not just products

but service. We are a small firm and the

capacity of this strategy is the same as it used

to be but our strategy is very consistent which

is key to keeping the clients.” n

ALPHAQ NEWS FEATURE

A family and friends’ soft launch in August

2015 is just the start of greater things for

Paul-Georges Moucan and his Quadra Global

Equity Alpha fund.

He spent most of his career at French asset

manager, Amundi, from 2005 managing a USD2

billion strategy. 2015 found him at Quadra and

applying his long/short global equities strategy

to the Quadra Global Equity Alpha fund.

The soft launch raised EUR16 million and

a further EUR200 million is down the line as

institutional investors rediscover their old

favourite. The friends and family from that

first soft launch year received, as at the end of

September 2016, returns of 8 per cent on a one-

year rolling basis, with volatility of 5.3 per cent.

This return is broadly in line with the strategy’s

performance since its 2005 launch.

The Global Equity Alpha Fund’s portfolio

is extremely concentrated with just 50 stocks

in the portfolio, against a global universe of

10,000. “It is impossible to follow 10,000

stocks,” Moucan says. The strategy is all

encompassing global including emerging

markets, long/short with a directional bias.

Moucan says: “When I set up the strategy

I had to face many questions. If you look

at the classic top down allocation between

countries, there is more and more correlation

and more or less the same pattern with stocks,

and when everything is super correlated, your

stockpicking is useless.”

A thematic approach presented a solution.

“I used all my experience and one of the things

I was experiencing was long-term trends, mega

trends which were very relevant and had a

longer horizon than the others. It was also a

way to avoid the country sector approach.”

The themes are well diversified in Moucan’s

500 stock universe. “I am more positive and just

looking at stocks exposed to my themes,” he

says. “So there is a positive bias towards growth

and I am not fishing in the ocean but in a pond.”

The themes fall into three pillars –

demographics, such as the ageing population,

education, infrastructure, as well as luxury

and lifestyle; innovation – with sub themes of

robotics and automatics, security and safety,

and the third pillar is resource scarcity.

The themes have remained the same since

Moucan invented the process so the framework

Concentrated strategy finds new home

Paul-Georges Moucan, founder of the Quadra Global Equity Alpha fund


felt under attack, Gina is now, of course, most

famous for her recent role as lead claimant

in the legal action against the Prime Minister,

arguing that individual members of the Cabinet

have no legal power via the Royal Prerogative

to trigger Article 50 of the Lisbon Treaty to

leave the EU without prior authorisation of

Parliament and MPs.

As the popular press would have it, Gina

effectively blocked Brexit.

Theresa May’s government duly appealed

and at the time of writing, the outcome of

this remains unclear with a Supreme Court

judgement expected in mid to late January.

Poking a stick into these issues has

engendered personal attacks and threats to

Alan and Gina Miller founded SCM in

2009 under the banner of offering

investors fair fees and access to

transparent investment solutions. 2012 saw

them launch the True and Fair Campaign,

calling for 100 per cent transparency of fees and

holdings, and introduction of a Code of Ethics

for the UK investment and pension industry,

while 2015 saw them take a tilt at charities,

with A Hornet’s Nest, a report that reviewed

UK charitable spending, and found it wanting.

This was followed in 2016 by another damming

charity report in 2016, Lifting the Lid, which

targeted charity shops.

If all this wasn’t enough to engender a great

deal of animosity from the powerful elite who

INTERV IEW

Meet the MillersBeverlyChandlerinterviewsAlanandGinaMiller,who,

whenitcomestochallengingtheinstitutionsthatformedthem,havefearlessform,bothjointlyandseparately


INTERV IEW

them being described as a hedge fund manager

(up there with banker as a term of insult in the

popular press) and former model (ditto).

Alan launched the first UK long/short equity

hedge fund in 1997 which charged the 2 and

20 fees that hedge funds charged at the time,

but he managed all sorts of other money along

the way, starting off in pension funds, managing

parts of the British Telecom and Post Office

pension funds, and then managing pension

funds, investment trusts and unit trusts at

Gartmore, Jupiter and New Star.

The discovery of ETFs gave Alan a chance

to ‘see the light’ on fees, transparency and

diversification, offering a path to achieving low

cost, active investing. The SCM portfolios are

100 per cent invested in ETFs, giving them one

of the longest track records in ETF managed

portfolios, going back seven years.

The firm does not disclose its assets under

management and has no outside shareholders,

but its SCM Long Term Return Portfolio has

achieved a return of 100.9 per cent since

inception in 2009.

“We give investors an efficient, actively

managed portfolio offering, in which we invest

alongside them. This was something we wanted

to put into practice for ourselves and if people

wanted to join us, that was even better.”

Gina adds: “Everything I do is driven by my

belief in conscious capitalism. It’s all about the

principal and ensuring honesty.”

This belief was formalised by the 2012

launch of True and Fair Campaign, which has

not made them many friends in the financial

services world.

Gina says: “As an industry we should be

putting our house in order, but whilst people

talk about this, very few put it into action.

But because we are independent, we are able

to stand up and speak and give investors

their basic rights of knowing how much they

are truly paying and what they are actually

investing in.”

“It’s about principal but also trying to put

something back to help others,” Alan says.

“We are in a lucky position that we can act

on what we believe in. A lot of these industry

practices might be deemed fraudulent in other

industries; we won’t give up until the consumer

is treated with respect by the investment and

pension industry.”

The True and Fair Foundation charity report

followed on as a natural target for the Millers.

the safety of the Millers and their family. What

drives this independently wealthy couple to do

any of it?

Alan describes his initial motivation in

founding SCM as a simple one. “After I retired

from New Star in the summer of 2006, and after

the meltdown in the markets, I was looking

for people to manage our own family wealth.

I wanted to find a reputable organisation that

offered investment in a low cost, transparent

and diversified way and the more I looked, the

more I saw there wasn’t any,” he says.

He describes the standard of service for often

extremely loyal private clients at the time as

providing the worst performance, worst service

and the highest fees. “Clients got the short end

of the stick,” he says.

The high profile pair have endured a toxic

dust of media sparkle which has resulted in

“Everything I do is driven by my belief in conscious capitalism. It’s all about the principal and ensuring honesty.”Gina Miller


INTERV IEW

rule of law,” she says, citing her family life with

a lawyer father who fought for social justice all

his professional life, and her early upbringing

under a British constitution.

But there is no plan to move into politics.

“I will never take a role in politics,” she says.

“There is still a lot to do in financial services

and the charity sector.”

Alan agrees: “We are very pleased that a

huge number of the issues we have highlighted

in investment management have been properly

addressed for the first time. It is the mark of

a sea change by the regulator whereby the

numerous, shoddy industry practises have been

exposed for what they are.”

Gina concludes: “We are of course proud that

our children can see that as two individuals,

their parents have achieved a huge amount.” n

“It doesn’t matter what the industry is, there

must be more scrutiny in the social contract

with individuals,” Gina says. “It’s supposed

to be the sector of angels, where people don’t

ask questions or delve too deeply? But why

shouldn’t you – it’s perfectly legitimate to ask

where a generous donor’s money is going?”

November’s publication by the FCA of

its Asset Management Market Study interim

findings, which was heavily critical of the

investment industry, has been welcomed by

the couple.

“The FCA report represents everything we

have been fighting for,” Alan says. “All these

years we have highlighted closet indexing,

securities lending, research commissions,

conflicts of interest re consultants and advisers,

cartel-like behaviour and misleading fund

and industry statistics. This FCA report has

vindicated our work, and their numbers back

our numbers.”

The pair have been targeted by fund

management trade bodies and firms, in what

Alan describes as an attack of “amateurish

shoddy propaganda”.

“But this report has made it all worthwhile

and consumers will be better off now that the

regulators are addressing these issues,” he says.

It was the same motivation that saw

Gina bring her legal action challenging the

government’s right to trigger Article 50.

“It was the same reason I do everything,”

she says. “Transparency, accountability

and scrutiny. We have a process of law and

Parliamentary sovereignty and only Parliament

can grant rights and only Parliament can take

away rights. The government cannot bypass

Parliament. This was the elephant in the room

that no one else appeared to be prepared

to confront.”

Gina expresses herself as very disappointed

that the government appealed the case. “The

government should not be appealing, but

drafting the bill,” she says.

And now, this daughter of the Attorney

General in Guyana, which was a British colony

until 1966, has the support of Scotland and

Wales and a letter of support from Northern

Ireland. “My legal team and I are confident that

we will win as this case is about the letter of the

law,” she says.

This foray into high profile legal action does

not come as a surprise to her. “I always thought

it would be possible that I would fight for the

“It is the mark of a sea change by the regulator whereby the numerous, shoddy industry practises have been exposed for what they are.”Alan Miller


around USD80 billion for the year, which is a

record since 2009. In addition, there have been

a high number of share suspensions, which we

really haven’t seen since 2009.”

Between 2008 and 2009, following the

financial crisis, there was a tremendous amount

of side pocket supply, since when supply

has monotonically decreased and the reason

is simple: side pockets have been remitting

redemption proceeds back to the holders and

there have been no new side pockets produced,

says Lawrence.

“Even though supply has been falling, there

has still been a tremendous supply/demand

imbalance over that period of time. At any given

time there has probably been approximately

USD2 billion of dry powder; however, to put

that into context, there were USD300 billion of

suspended redemptions in 2009.”

A recent report by secondary market

broker Setter Capital found that hedge

fund secondaries were down 13.1

per cent this year to USD410 million as side

pocket supply continues to evaporate. But one

hedge fund manager that expects to see more

opportunities going forward as investors lose

confidence in hedge fund performance, is New

York-based Rosebrook Capital Partners.

Rosebrook profits when hedge funds suffer

poor performance and investors try to exit

through the back door as quickly as possible.

Rosebrook’s Chief Executive Officer, Andrew

Lawrence, concedes that while the amount

of side pocket supply has been falling over

the last six years, since the end of 2015,

“we have entered into a new cycle of hedge

fund redemption pressure and subsequent

suspensions. Net redemptions are now at

SECONDARY MARKET

Redemptions offer opportunitiesJamesWilliamsinterviewsAndrewLawrenceofRosebrookCapitalPartners,afirmwhichfindsopportunitiesinhedgefundredemptions


SECONDARY MARKET

That redemptions are now coming back to

the fore, which could in turn lead to far greater

numbers of side pockets, is the product of a

number of factors. The most obvious of which is

performance.

If one looks at the broad hedge fund index

over five years they’ve generated low single

digit returns and all the while the S&P 500 has

nearly doubled in size (1,219 in 2012 compared

to 2,204 at the time of writing). This has led to

negative investor sentiment.

“We’ve been operating in a world of complete

alpha deficit for the last five years, for the most

part. And US investors in particular have been

throwing in the towel.

“The most florid expression of dissatisfaction

I heard recently came from the chairman of a

US pension fund who said, ‘I think we should

drive up to the petrol station with these hedge

fund managers, tell them to get something to

eat, and drive off’,” Lawrence remarks candidly.

In his view, the more interesting question

is, ‘Why do hedge fund returns disappoint?’

The people who cannot generate returns now

are the very same people who were making

great returns prior to the financial crisis. These

managers are not stupid. They haven’t suddenly

lost their ability to trade.

“My strong conviction is the reason why no

one can generate alpha anymore is because

global policy makers, in particular central

bankers, are intervening so consistently and

regularly in the capital markets, buying up

corporate bonds (ECB) or equities (BoJ), that

prices at the margin are no longer being set by

economic actors.

“What we are experiencing here is a massive

capital allocation problem. Inefficiencies of a

substantial magnitude are being introduced by

these policy makers and it’s no surprise to me

that my hedge fund peers are crying into their

whisky at the bar,” says Lawrence.

To some extent the ship has already sailed.

Performance has been so bad for so long that

the momentum has created this new wave of

redemptions. When one looks at debt: GDP in

the US, tepid GDP growth, income inequality,

etc, Lawrence believes the likelihood that

governments are going to become less involved

in the markets is “very low”.

“To me the problem is structural not cyclical.

It’s probably not going away and it explains why

hedge funds like Perry Capital, who have been

trading for 28 years, have decided to close. If

Rosebrook’s modus operandi is to buy share

classes that have no redemption privileges; i.e.

redemptions that existed previously but have

since been suspended. It buys illiquid assets from

investors who have become forced sellers, which

are being managed to realisation by the fund

manager. As this can be a lengthy process given

that these are hard to sell assets, some investors

need to expedite the process and find a quick

solution. This is where Rosebrook steps in.

“We’re not interested in buying gated shares

where there’s ongoing investment or taking

respective manager risk; although we’re buying

hedge funds, Rosebrook is essentially an asset

purchasing business,” explains Lawrence. “All

the funds that we buy have a fixed pool of

assets that are being managed to liquidation.

“The fact is, the number of potential

problems that people could have in this

business by holding stuff they didn’t expect

to hold are manifold. The important point,

from our perspective, is that these problems

are more than just, ‘Geez, I thought I had

something liquid and it’s illiquid’. It could be

a mandate or charter problem, a regulatory

problem, a problem on the board of directors;

there are lots of issues that could prompt

investors to redeem.”

Rosebrook makes it abundantly clear to

forced sellers that pick up the phone that they

should only proceed to sell if they have no other

option. This is because an investor can only

expect to be offered a price way below the value

of the asset, as this is how Rosebrook makes its

money. Based on the cost of capital it is willing

to put to work, Lawrence aims to target more

than a 20 per cent internal rate of return.

A new report by the Office of Financial

Research (OFR) shows that there has

been an uptick in the use of side pockets

and redemption suspensions among fund

managers on the back of market volatility.

Recent examples include Claren Road Asset

Management, Third Avenue Management and

Stone Lion Capital Partners. Last December,

Third Avenue prevented investors from

redeeming in its USD788 million credit fund

by moving some of its assets into a liquidating

trust, giving Third Avenue the ability to sell the

assets over time and avoid a fire sale.

This is typically why redemption suspensions

occur as the last thing a manager wants to do

is liquidate positions and negatively impact the

performance of their fund.

Andrew Lawrence, CEO at Rosebrook Capital Partners


SECONDARY MARKET

All of this turmoil works to Rosebrook’s

advantage. When assessing an opportunity, the

strategy of the hedge fund is not important as

Rosebrook takes no ongoing investment risk.

What is more important is the nature of the

assets; oftentimes assets held in side pockets

have nothing to do with the strategy. The

types of assets that Rosebrook buys include:

underlying private equity assets; private

debt; public debt; public equity; real estate;

intellectual property rights; natural resources

and litigation claims.

“We are sensitive to the assets we buy. The

sources of the returns we make are two-fold:

firstly, the return attributed to the purchase

discount and secondly the return attributable to

the return on the underlying assets.

“Usually the return on the underlying

assets is zero. They should have some return

associated with them, but everybody knows

they are for sale so most of the return actually

derives from the purchase discount. One of

our primary goals is portfolio diversification

because we don’t want to introduce any other

unsystematic risk into the portfolio. Our returns

are pure alpha, derived from the purchase

discount,” confirms Lawrence.

Before agreeing an asset purchase with

an investor, Rosebrook will look to check

that the underlying assets in the fund

meet its investment criteria and portfolio

construction goals and that the vehicle they

are in is sound.

“We don’t want a side pocket vehicle with

explicit or contingent liability, a law suit

attached, etc. We also seek out what the

manager’s motivations are for realising the

assets and remitting the proceeds back to

us. There is unlikely to ever be a complete

alignment of interests, but we want to be as

closely aligned as possible.

“Often, our alignment with the manager is

greater than the outgoing investor. All of our

investment vehicles tend to have a five-year

life cycle. Our requirements are therefore

much more aligned with the manager as they

try to work their way out of illiquid assets,”

remarks Lawrence.

Currently, Rosebrook has a strong preference

for US assets and US-denominated assets close

to the top of the credit stack. This is in contrast

to previous years when “we would have taken

periphery risk lower down the capital stack,”

says Lawrence. n

Perry Capital have decided they can no longer

make money that’s a problem,” warns Lawrence.

To demonstrate just how bad things have

become, Lawrence co-hosts a bi-monthly

dinner. These dinners include a diverse bunch

of hedge fund managers, policy makers, a

certain theme is explored and then, at the

end of the evening, everyone around the

table shares their thoughts on interesting

opportunities they see in the marketplace.

“These dinners have been happening for 15

or 20 years. The last couple of years no one has

had any good ideas. All anybody wants to talk

about is whether Janet Yellen’s foot will be on the

accelerator or the brake. Trying to guess that is

not a very effective use of hedge fund capital.

“We can talk about abstract capital

inefficiencies, but it what boils down to is

the only way to make money today is to

bet on what the central banks will do. It

shouldn’t therefore be a surprise that alpha has

disappeared from the market,” says Lawrence.

A second reason for the recent wave in

redemptions is because there is a wholesale

pension crisis. Due to the baby boomer

demographics in the G7 economies, pension

plans like CalPERS went from positive to

negative cash flows in 2015 and the US Social

Security System went negative six years ago;

nine years ahead of schedule.

This is worrying because pension plans

are the biggest investors in hedge funds; they

account for roughly USD1 trillion of the USD3

trillion in AUM.

“After the financial crisis, policy makers

saved the banks but ended up destroying the

pension plans, which you could argue are bigger

(and more systemically important) than the

banks. The unfunded liabilities of pension plans

have gone through the roof.

“I would say the approximate cause of almost

all focused redemption pressure on hedge funds

is performance. No manager is going to suspend a

redemption right until you make the redemption

request and the trigger for this, by and large,

is poor performance. This five-year period of

underperformance is creating very focused

redemption pressures,” suggests Lawrence.

He thinks this is part of the zeitgeist; it’s not

just that investors are fed up with returns, they

are upset by how rich hedge fund managers

are. It feeds in to the same anti-establishment

populist sentiment that has led to Brexit, the

Trump election victory and so on.


ENDOWMENTS

Dispersion of 2016 Results

With limited data and only general

information about their actual

allocations, it can be difficult to

identify the causes of the wide

dispersion in the returns of

endowments in 2016. Note the large

spread between the highest and lowest

performing endowments in FY2016

in the chart below (we added some

additional schools to our previous

analysis).

Aside from Yale, which had the best

FY2016 performance, only two other

schools in this group scored positive

returns: Princeton and MIT.

Have they adopted the ‘Yale model’

or are there other strategy insights that

can be identified through a quantitative

analysis? Comparing asset allocations

can be misleading because the actual

allocations may differ substantially

from what is reporting and proxies

for asset classes can vary between

endowment portfolios. In addition,

various asset management products

used by endowments have wide

mandates, like hedge funds, that often

make large and unforeseen bets that

can substantially alter the effective

asset allocation of an endowment

portfolio. With limited transparency on

some of these funds, the effective asset

class exposure information may not be

entirely accessible to the endowments

themselves.

Looking at the correlations of

publicly available annual endowment

returns to measure the similarities of

endowments’ investment ‘styles’ is,

in our opinion, not the best approach

as endowment portfolios vary over

time when asset managers adopt

new strategies and reshuffle funds.

In addition, correlations themselves

could be misleading as similarity of

co-movements between endowment

returns in the past may have little

relation to their allocations: some asset

classes move together at times and then

diverge for an extended period of time.

To better understand the similarities

in endowment investment ‘styles’, we

used MPI’s proprietary ‘common style’

Analysing the endowment landscape

SeanRyan,SeniorResearchAnalystatinvestmentresearchandtechnologyfirm,MarkovProcessesInternational(MPI)examineswhetherendowmentshaveadoptedtheYalemodel

-4

-3

-2

-1

0

1

2

3

4

Harvard

Yale

DartmouthUPenn

Brown

Princeton

Cornell

Columbia

Stanford

MIT

Bowdoin

Duke

UNC

CaliforniaAVG

3.40

-2.00 -1.90

-1.40-1.10

0.80

-3.30

-0.90-0.40

0.80

-1.40

-2.60

-2.00

-3.40

Major endowment performance 2016 – total return (%)

Source: MPI Analytics

http://markovprocesses.com/blog/2016/10/ivy-league-endowments-2016-performance-review/


ENDOWMENTS

technique. Common style measures the

similarity in factor exposures (betas

to individual factors) between two

portfolios. To calculate this statistic,

we first identify a list of factors to help

explain the endowment portfolios. We

then measure the degree to which each

endowment has similar factor exposures

to the others endowment portfolios.

For example, if one portfolio had 60

per cent equity and 40 per cent fixed

income, and the other had 50 per cent

equity, 30 per cent fixed income and

20 per cent real estate, their common

exposures would be : 50 per cent equity

plus 30 per cent fixed income = a

common style of 80 per cent.

In the chart above, we see the

Common Style Matrix for 15 selected

endowments based on the latest factor

exposure results from our FY2016

analysis . This heat map shows the

highest common factor exposures as

dark orange and the least common as

light blue. One immediate takeaway is

that both MIT and Princeton have the

highest common style with Yale: 77

per cent and 78 per cent respectively.

The same does not hold true for

the lowest performing endowments.

Only a few specific factor exposures

were responsible for most of the

gains this year, Private Equity, Real

Estate, US Equity and Bonds, while

more exposures drove losses. We can

also see that USD10 billion UPenn

endowment investment model differs

substantially from the Ivy ‘pack’

and is closer to smaller endowments

(something we also observed in our

FY2015 study), while the USD7 billion

Duke endowment is even further

away from the rest of the schools in

the study. While it’s always true that

a quantitative analysis such as this is

subject to the factors selected (or not

selected), the time period used and the

credibility of the results, when done

properly, it can yield key insights and

information that correlation analysis

and limited holdings cannot. n

Top endowment common style 2016

Yale

Har

vard

Dar

tmou

th

UPe

nn

Bro

wn

Prin

ceto

n

Cor

nell

Col

umbi

a

Sta

nfor

d

MIT

Bow

doin

Duk

e

UN

C

Cal

iforn

ia

AVG

Yale 100 67 61 37 60 78 40 63 66 77 61 50 61 35

Harvard 67 100 70 46 81 63 66 70 80 71 65 57 65 51

Dartmouth 61 70 100 68 71 63 74 69 66 67 77 38 78 59

UPenn 37 46 68 100 60 41 66 61 45 41 58 31 66 71

Brown 60 81 71 60 100 51 63 60 68 64 65 52 78 65

Princeton 78 63 63 41 51 100 41 71 74 82 73 54 48 39

Cornell 40 66 74 66 63 41 100 64 65 43 51 29 62 55

Columbia 63 70 69 61 60 71 64 100 74 63 63 48 50 48

Stanford 66 80 66 45 68 74 65 74 100 64 60 62 50 46

MIT 77 71 67 41 64 82 43 63 64 100 76 45 59 40

Bowdoin 61 65 77 58 65 73 51 63 60 76 100 42 62 54

Duke 50 57 38 31 52 54 29 48 62 45 42 100 32 37

UNC 61 65 78 66 78 48 62 50 50 59 62 32 100 67

California

AVG35 51 59 71 65 39 55 48 46 40 54 37 67 100

Average 58 66 66 53 64 60 55 62 63 61 62 44 60 51



http://markovprocesses.com/blog/2015/11/mpi-dsa-unlocks-top-endowment-performance-1/


REGULATORY COMPL IANCE

Such is the level of interest in Droit, it

has received USD16 million of Series

A investment capital from Goldman

Sachs, Pivot Investment Partners (a venture-

focused investment firm) and Wells Fargo, in

addition to DRW, a principal trading firm. The

Series A capital will provide growth capital to

accelerate the deployment of Droit’s real-time

decision-making engine, which provides point-

of-execution compliance for sales and trading

systems within financial institutions.

The platform ensures that every transaction

is executed across jurisdictional guidelines

on a timely basis by producing thousands

of automated trading decisions per second.

Combining finance and computational law,

ADEPT also establishes that clients are current

with regulations and market microstructure

across their entities, counterparties and

geographies.

Droit’s mission is to provide clients with

robust, enterprise infrastructure to facilitate

compliant and optimal trading of derivatives

across asset classes, regulators, CCPs and

execution platforms.

Commenting on the latest funding

announcement, Brock Arnason, head of Product

and co-founder of Droit (along with CEO

Satya Pemmaraju), says: “If you look at the

participants in the round, one is a VC firm, two

are major sell-side institutions and one is a buy-

side institution, so we have strategic investors

(on both sides of the street) who are using our

product and who believe in us as a company.

This funding will give us the growth capital

to seize the market opportunity we see over

the next few years.”

Droit aims to become the industry standard

for complex, real-time, regulatory decision

making. The platform is designed to help

institutions address three key questions – Who

can you trade with; What can you trade with

them and where can you trade with them in

order to ‘trade right’? Since it first went live

in February 2014, it has implemented more

than 12 global regulatory regimes, with a MiFID

2 solution scheduled before the end of 2016;

indeed, this represents a significant part of the

market opportunity Arnason refers to above.

MiFID II is going to have a high impact on

people’s business models in all parts of sales,

trading and even middle- and back-office work

flows, in both sell-side and buy-side institutions

in Europe, and those transacting with financial

institutions in Europe.

“Coming up with a solution for point-of-trade

regulatory compliance was essential as the

clock is ticking,” comments Arnason. “MiFID

II is set to be introduced in just over a year

and people are scrambling to come up with a

solution.

“Another part of the market opportunity

set we see is the introduction of BCBS-IOSCO

bilateral margin rules. Global uncleared

derivative margin mandates are now being

phased in. These started in September and the

European rules are scheduled to commence

in January 2017. The second wave is set to

commence in March 2017. Institutions are

looking for solutions that can support both

point-of-trade and post-trade and identify trades

that are subject to these mandates so as to

understand what the margin implications will

be for cleared versus uncleared trades.”

Easing regulatory compliance

JamesWilliamsprofilesDroit,aNewYork-basedfinancialtechnologycompanywhoseplatform,ADEPT,hasbeenengineeredtohelpboth

sell-sideandbuy-sideinstitutionsaddresstheincreasinglycomplexissueofregulatorycompliance

Brock Arnason, head of Product and co-founder of Droit


REGULATORY COMPL IANCE

you can go back and see exactly why certain

decisions were made, you can look at how

rules have changed over time and how that has

affected the portfolio.”

“We basically saw the need for a centralised

service that people could plug into their trading

process, their middle- and back-office process,

to drive compliance.”

Droit’s special sauce is the process of

systematising myriad regulatory rules, having

a method to tie them back to the regulations,

having a visual record of the decision trees with

the facts and rules at the time, and having a

robust audit record that people can go back to

check the decisions made.

“We aren’t lawyers. We don’t make legal

representations, but what we do provide is

referenceable rules that have been guided in deep

partnership with many of our clients and form a

kind of consensus reference across institutions.

Legal and compliance departments at our clients

review those rules and if they have a different

interpretation of them their version of the rules

can be modified accordingly in the system.

“We insist, and our clients insist, that legal

and compliance can review the implementation

of those rules to understand them and, if

necessary, customise them. So the system is

very flexible,” adds Arnason.

Over the last couple of years, Droit has

refined the ADEPT platform in response

to client feedback and continued market

evolution. The firm’s vision of becoming a

centralised place using a process of taking rules

and making them computationally executable,

in addition to having a robust audit record, was

core to what the Droit team believed financial

institutions were, and still are, looking for.

“We have built out our MiFID II offering as

the rules become final, and we will be going

live with our first customer before the end

of this year. We are building out our team in

London and implementing MiFID II across

numerous institutions,” says Arnason. He

notes that the MiFID II integration process can

range anywhere from four to six months. Droit

wants to understand exactly who they will be

integrating during that time so that they can

plan to have the right service levels in place.

“We are also looking at opportunities around

transaction reporting and providing services on

eligibility for global reporting processes, which

is another important area for our clients,”

concludes Arnason. n

There are already a lot of global clearing

mandates in place (Japan, Korea, Europe)

for cleared OTC instruments. This regulation

will now impose margin rules on uncleared

OTC trades. In effect, the escape hatch that

institutions could use to do business in a less

expensive way has now been blocked. It is now

going to be more expensive to hold uncleared

trades versus those that are cleared. It will,

says Arnason, change the way people run their

businesses and manage their portfolios.

The Droit team are all former derivatives

traders with Arnason and Pemmaraju having

known each other since working in Chicago in

the 1990s at Swiss Bank. Prior to establishing

Droit, Arnason was working in fixed income at

Morgan Stanley running the Matrix platform

and was heavily involved in the Dodd-

Frank implementation from an operational

requirement perspective.

“I started thinking about the ideal solution

for Dodd-Frank we would like to implement

[at Morgan Stanley]. At the same time, Satya

was running the funding desks for fixed income

at UBS and was seeing things from a slightly

different front-office perspective; namely

funding and clearing implications.

“We went live in February 2014 and the rest,

as they say, is history.”

Following the ’08 financial crash, most

of the major global economies agreed to

address and implement a broad set of themes

centred around transparency, control and risk

management around the trading process. Via

regulations such as EMIR this has, over time,

led to more controls being applied in the pre-

trade space, whilst post-trade reporting and

portfolio management has also become more

controlled. Business conduct controls, clearing

mandates, electronic execution mandates,

transaction reporting, bilateral margining, risk

management – these are all areas that global

regulation now touches upon and of which

financial institutions have to get a handle.

“We created a product in order

to systematise the process of taking

these regulatory rules and transforming them

into what we call computational law,” explains

Arnason. “The idea being that you take a

source text, implement a process where you

can annotate that text and directly link it to

decision trees and efficiently execute the trades.

Every time you come to a decision you store

a rich audit record. From that audit record,


For years, a limited number of lenders

specialised in working with technology

companies and private equity sponsors

with technology-focused portfolios. Today,

those lenders face dramatically increased

competition. Software and technology may

still be an industry of its own, but in recent

years, software and technology companies have

entered almost every sector of the economy;

there seems to be a software application for

every activity or process, and private equity

firms and lenders have followed the changing

landscape, increasing their focus on software

and technology companies. As competition

among lenders has increased, in order to secure

transactions with these borrowers, lenders

must demonstrate a thorough understanding

of the specific needs and challenges faced by

technology companies in the current market.

Successful lenders in this sector recognise

that in the software industry, even more so

than in other more traditional businesses areas,

access to capital is critical to growth and,

ultimately, survival. If software companies are

not continuously investing in their products

internally or acquiring new technology through

third-party acquisitions, they risk being left

behind by fierce competition. We can all

identify technology companies that once led

their fields but did not adequately respond to

the demands of innovation and languished as

a result. Once product and service offerings

F INTECH

Tech-savvyMariaMcGuire,commercialfinancepartnerwithChicagolawfirm

GoldbergKohn,writesontechnologyfinanceandissuesthatariseinhelpinglendersstructuretransactionswithtechnologycompaniesand

privateequityfirmswithtech-focusedportfolios


F INTECH

diligence of the borrower’s intellectual property,

including evaluation of borrowers’ internal

practices regarding creation and development of

their products, the effectiveness of steps taken

by the borrows to protect their own interests,

as well as a keen review of license agreements

such as licenses of intellectual property owned

by a third party and licensed to the company

for use in its products sold to the end-user.

In order to secure deals with technology

companies and private equity firms with

technology-focused portfolios, lenders must

demonstrate a deep understanding of their

clients’ need to grow continuously, the value of

their revenue stream and that the lenders have

the relationships and can make introductions

to further advance the success of their

borrowers. n

are outdated, it takes time and even greater

investment to attempt a comeback, introducing

additional risk to lenders and equity investors.

Lenders must demonstrate willingness and

ability to support their borrowers in their quest

to remain competitive and to grow. Software

and technology companies, often more than

other borrowers, are acutely focused on and

implement delayed draw term loan facilities,

incremental credit facilities and permitted

acquisitions.

Technology companies and private equity

firms with portfolios focused on technology

and software want partners with extensive

experience in and knowledge of their industry.

They focus on how their lender may assist

them in developing new relationships and

connections that benefit the business. In order

to win transactions with these borrowers,

lenders must demonstrate their capabilities

in these areas. The right partner can provide

resources to position a company to go to

the next level, either by attracting a top-

tier investor or purchaser, or through an

IPO. Technology companies look for more

intangibles from their lenders than many other

companies looking for cash-flow or asset-based

credit facilities.

Technology borrowers also look for lenders

who understand that financial metrics used

in other business sectors might not be the

right metrics for them. For example, lenders

to software companies must recognise that

valuations based on EBITDA might not be

appropriate and a valuation based on another

metric, such as recurring revenue, might

provide a more accurate indicator of financial

performance. More and more software

companies have adopted recurring revenue

models, and lenders who fully understand

and have the requisite experience with and

knowledge to accurately evaluate recurring

revenue find this to be an invaluable selling

point with their borrowers. For companies

in transition, they are also familiar with the

process and understand the value of migrating

from a software licensing model to a Software-

as-a-Service model and the effect on revenue

and cost recognition.

Finally, like all lenders, lenders to technology

and software companies must understand their

collateral and take appropriate steps to protect

and secure their interests. They must engage

counsel able to perform the necessary due

“Lenders to technology and software companies must understand their collateral and take appropriate steps to protect and secure their interests.”Maria McGuire, Goldberg Kohn


Alexis Hombrecher, Partner and Portfolio Manager at emerging market currencies specialist manager WHARD Steward, outlines his big picture thoughts on EM for the rest of 2016 and the coming year.“We saw large outflows out of EM right

after the US election in both local and

hard currency (3.5 billion hard and 2.5 billion local and 0.7

billion blended according to data from Citi). The question is

whether this will continue for the rest of the year or whether

these were panic outflows. More recent data on local

currency ETFs is showing that outflows are slowing down

dramatically. We would see that as a good sign for EM going

forward and would expect to see inflows in early 2017.

“We expect EM and G4 markets to continue to de-couple

going forward. This will provide opportunities in EM markets

as G4 will no longer drive EM.

“Many players expect a stronger US Dollar as the new

administration plans increased spending on US infrastructure

and possibly tougher trade deals with other countries.

The question is whether this has already been priced now

or whether we are likely to see further weakening of EM

currencies against the US Dollar.”

Fergus Wheeler, finance partner at Ropes & Gray in London focuses on European credit funds and their outlook for 2017.“Continued low growth environment

going into 2017 will maintain the

tension created by investors seeking

increased yield and pumping billions

into the credit fund market, and the fact that there are

few proprietary opportunities for European credit funds to

successfully deploy capital, relative to their US counterparts.

“The supply and demand imbalance affecting credit

funds in Europe will continue to be exacerbated by the

large number of banks in Europe still willing to lend, with

borrowers taking advantage of very favourable market

conditions through pricing and flexible documentation.

Trying to maintain discipline will be difficult, even for the

most cautious investors.

“While certain macro-factors caused by Brexit, the US

elections and the European leveraged lending guidelines may

create a more favourable fund lending environment through

dislocation in the markets and political and economic

uncertainty, in order for credit funds to maximise their hit

rate in 2017, diversification and creativity will be key.

2016 REV IEW

What lies ahead?AlphaQcontributorsandthoughtprovokersassesstheyearthathasgone

andtakeacautiouspeekintothenextone


2016 REV IEW

“We expect to see funds deploying more bifurcated

strategies, targeting both lower return 5 per cent-plus yields

allowing them to compete more effectively with traditional

bank lenders, and higher return special situations type

transactions and investments in riskier credits, sectors and

more geographically diverse regions.

“In addition, funds are likely to focus attention on

creative ways to source deals. With the credit fund

community being more established in the market after a very

successful 2016, there is likely to be an increase sponsorless

deals in 2017 as CFOs become more familiar with the range

of products on offer, and funds recognise the on-going need

to source interesting proprietary deals.”

S&P Global Ratings has published a report on the evolving prudential regulatory frameworks in Europe, and their application to private infrastructure debt and equity, with Frédéric Blanc-Brude, Director of the EDHEC Infrastructure Institute, examining Solvency II.

“The prudential framework set in place by the

European Commission – now states that qualifying

infrastructure investments will form a distinct asset

category and will benefit from a unique reward profile

which will lead to a lower capital charge for infrastructure

investment.

“Important advances in infrastructure risk have been

made under the Solvency II framework, but much calibration

work remains to be done in 2017, and beyond, to allow

insurers to invest more in infrastructure.

“The future of infrastructure investing rests on the

development of full-scale investment solutions – as opposed

to individual projects – that combine the different aspects

of private infrastructure projects to optimise diversification

benefits, liquidity, performance, and duration.

“Such solutions, if well-designed, documented, and

sufficiently transparent, could be ‘standard-formula’

compatible, meaning even small insurers could gain

exposure to the characteristics of private infrastructure debt

and equity.”

Simon Brazier, Co-Head of Quality at Investec Asset Management writes on the outlook for UK alpha in 2017.“At a glance:

• Understanding the long-term

consequences of a Trump presidency

remains unclear;

• We continue to focus on high quality

companies, able to grow their cashflows and re-invest at

rates of return meaningfully above their cost of capital;

• High valuations, uncertainty surrounding Brexit, the US

presidency and European elections all remain key risks

for 2017;

• We still believe there are opportunities to find returns in

UK equities, but stock selection will be key.”

Judith Posnikoff, Managing Director and Co-founder of PAAMCO, comments on the 2017 hedge fund outlook.“While next year’s market direction

remains unclear, we expect:

• Higher volatility (i.e, spikes in volatility

versus a consistently higher level);

• Widespread dispersion, which will lead to trading

opportunities for hedge funds and the re-emergence

of some strategies such as emerging markets and

commodities;

• Possible liquidity issue concerns;

• Less trend and more reversion;

• Renewed focus on hedge funds and what they can do

for an institutional portfolio – expect to see them crop

up in other areas of the portfolio rather than just in the

alternatives bucket;

• Little to no duration – a positive in a rising rate

environment;

• Re-emergence of some previously out-of-favour strategies

• Less reliance on beta.”

Markus Matuszek, a founding Partner and CIO of M17, a global fundamental value equities long/short fund, comments on the outlook for investing in 2017.“Our outlook is cautiously positive:

in the US, Trump behaves within

well-anticipated behavioural patterns

– some call it ‘The art of the deal’. We believe the Trump-

induced rally will continue until 20 January before reality

kicks in. In Europe, volatility around elections and problems

in Greece, Italy and Spain (public debt and banks) will

dictate much of 2017. In Asia, all eyes are on China with

its issues around foreign reserves, a debt-induced housing

bubble and a banking sector which becomes riskier.

Monetary policies and the expectation of an end of QE

at some point will add to this picture, so that we believe

the end of the 30-year bull bond market will come to an

end, resulting in a widening dispersion of EPS growth

and valuation.

“Investors will have to get used to the ‘old rule’ of risk-

adjusted returns – or put more simply – to take more risk for

a higher expected return and to manage risk through asset

allocation and other tools. Not everything will kick in at once

in 2017, but we believe this outlook captures what will be

the general direction.” n


ASEAN INFRASTRUCTURE

The Belt & Road Initiative, announced by

President Xi Jinping in 2013, is a drive

to build infrastructure connecting China

and the other 64 Silk Road countries of ASEAN,

South and Central Asia and the Middle East.

The initiative is well-recognised as a welcome

stimulus to global growth, and helping countries

face the challenges of poor physical and social

infrastructure. What is less discussed, but

equally important, is Belt & Road’s potential to

address the massive and urgent need to create

hundreds of millions of jobs across the region to

absorb a dramatic surge in working population,

especially the young adult population.

Unaddressed, a growing jobs’ gap could lead

to political fragility, the rise of new fanatical

movements and new economic and conflict-

driven refugee crises that would dwarf what the

world, especially Europe, has faced recently.

The low level of physical and social

infrastructure in emerging economies is well-

documented. Most of the United Nations’ 17

Sustainable Development Goals are related to,

if not dependent on, improving infrastructure,

ranging from clean energy, water and sanitation,

to health, education and sustainable cities.

Accelerating infrastructure investment to close

the gaps in those areas is a priority of numerous

global public organisations.

What is not often as explicitly addressed,

however, are the links between infrastructure

and sustainable creation of jobs, and between

jobs and stability. Concerns about job loss or

the lack of economic security are a source of

political stress that is creating an unpredictable

new normal in politics today, especially

in Europe and America. In poor, emerging

countries, joblessness, particularly among

rapidly growing young working populations, can

contribute to instability. In 2010, just before the

Arab Spring, surveys found that of 11 issues,

including political and religious controversy,

‘employment’ ranked first in importance in all

six Arab countries with annual PPP per capita

incomes under USD15,000.

Nowhere will the job creation challenge be

more acute than in the 39 Silk Road countries

whose work forces are expanding. Those 39

countries (across ASEAN, South Asia and the

Middle East) face perhaps the greatest short

term job creation challenge in world history.

Whereas China itself and many European

countries face ageing demographics, between

2015 and 2030 the working population of the

growing 39 Silk Road countries will increase by

a startling 382 million. To employ 382 million

new workers requires creating more new jobs

than the total working population of the EU 28

(or two times the current working population in

the US) in 15 years!

Better infrastructure in those countries is

critical for creating employment, not only in

construction, but also to foster more efficient

trade and higher productivity. Without more

jobs, the potential for anti-globalisation or even

instability and increased pressure for massive

outward migration will be very real – soon.

The job creation potential in infrastructure

has been well established. Studies in the US

suggest that every USD1 billion investment in

Asia demographicsCountries 2015 working

population in

millions

Increase in

Millions

(2015-30)

China 929 -49

EuropeanSilkRoad 209 -30

India 737 175

GrowingSouthAsia,excluding

India(5countries)

211 68

GrowingASEAN(9countries) 328 61

GrowingCentralAsiaandMiddle

East,excludingIndia(24countries)

283 78

Growing39SilkRoadcountries 1,559 382

Silk road initiativeDonaldKanak,ChairmanofEastspringInvestments,writesonthekeyimportanceoftheBelt&RoadInitiativecombinedwithinternationalco-operationintheessentialdevelopmentofinfrastructureinAsia

Donald Kanak, Chairman of Eastspring Investments


ASEAN INFRASTRUCTURE

infrastructure will result in 13,000-

22,000 jobs created. The job creation

potential will be even greater in

developing countries, and many jobs

can be created while simultaneously

greening the economy. The renewable

energy sector in China employs one

million people, while India expects

to generate 900,000 jobs by 2025 in

biomass gasification.

In Brazil, biofuels have produced

about 1.3 million jobs in rural areas,

while recycling and waste management

employs an estimated 500,000

people. Research has also shown that

investment in social infrastructure (eg.

education, health) yields substantially

more employment than one limited

to physical infrastructure, and can

provide vital contributions to the

process of productivity change, income

growth, and specialisation of the

economy.

To accelerate job creation via

infrastructure requires urgent and

effective leadership on two fronts.

First, a surge in developing country

institution building is required. Better

institutions are needed not only to

provide a stable foundation for society,

but are especially critical for financing

and operating infrastructure projects,

which have long time horizons.

Financial institutions, governance,

reliable policy and enforceable

contracts are essential to expand the

pipeline of investable projects and

inspire confidence in the reliability of

long-term investments.

The other urgent requirement is a

massive mobilisation of investment

funds. McKinsey estimates that USD49

trillion will be needed to finance

global infrastructure from 2015 to

2030, over USD6 trillion of that in

emerging Asia excluding China. That

gap cannot be closed without finding

ways to ‘crowd in’ private finance,

including the large pools of pension

and insurance funds in developed

countries. Global assets under

management, which represent a part

of insurance and pension funds, total

at USD71 trillion today. That capital,

however, cannot flow without better

mechanisms to reduce risk. Long-

term fiduciary investors like pension

funds and insurance companies

are subject to macroprudential

regulation and increasingly stringent

solvency requirements. Matching

those requirements to infrastructure

investments in emerging markets is

difficult, but recent efforts by the IFC,

ADB, EIB and others to create public-

private mechanisms that share and

reduce risks show promise.

Belt & Road institutions such as the

AIIB as well as the Silk Road Fund have

the potential to bring both additional

capacity and new approaches to public-

private investment partnerships. The

AIIB, from which the US and Japan

remain as holdouts, now has over 45

countries as shareholders with more

countries applying to join. With that

broad base and as a new institution,

the AIIB has the opportunity to

innovate and to adopt the ‘crowding in’

of private capital as a key strategy to

leverage additional funding and direct

it to the right projects. Public-private

partnerships in turn bring expertise

and attract more responsible long-term

business sector investment--and create

jobs.

Global businesses are seeing the

need and potential for sales, profits

and job creation via Belt & Road

infrastructure. General Electric

expects to receive over USD2 billion

of orders from Chinese engineering,

procurement and construction

companies this year “as a direct result

of the Belt and Road Initiative”, and

GE’s Vice Chairman John Rice called

Belt & Road “a multi-win strategy”.

Honeywell has 23 branches and over

32,000 local staff along the Silk Road

countries, and China CEO Stephen

Shang says Honeywell is fully prepared

to contribute further to the initiative.

Philips Lighting’s CEO Eric Rondolat

sees many opportunities to ship

products to countries along the Belt &

Road Initiative over the next decade,

with much of the demand coming

from infrastructure, public services

and manufacturing projects, as well as

domestic use. Maersk Linehas recently

become a co-investor with their

Chinese partners on projects along the

Belt and Road Initiative.

The Belt & Road Initiative deserves

more appreciation and support on the

global stage. Continued public-private

partnership around infrastructure has

the potential both to increase global

growth, and create millions of jobs in

the most demographically-challenged

countries. Applying a more urgent

attitude towards infrastructure and

job creation in emerging markets may

be the best way to preserve the global

trading system, promote stability

and avoid a tsunami of economic

emigration far greater than Europe is

facing today. n

Footnotes1. As of 26 Oct 2016, 48 countries have ratified

the Articles of Agreement (AOA) of the AIIB2. Zogby Research Services reported in 2011

(the year of the Arab Spring) that employment outranked in importance all other issues including corruption, education, civil rights, etc., in all six Arab countries with annual per capita incomes under USD15,000. PPP GDP per capita figures from the World Bank

3. The US Council of Economic Advisers (CEA) within the Executive Office of the President estimated that every USD1 billion in Federal highway and transit investment funded by the American Jobs Act would support 13,000 jobs for one year http://www.whitehouse.gov/blog/2011/09/09/american-jobs-act-state-state

4. Standard & Poors estimates investing USD1.3 billion in infrastructure in the US would add at least 29,000 jobs in construction alone and USD2 billion to economic growth while reducing the deficit by USD200 million

5. Job creation potential estimated stated by the UK Department for International Development 2011 report “Green Jobs in a Low Carbon Economy”

6. UK Women’s Budget Group: www.weforum.org/agenda/2016/04/can-investing-in-social-infrastructure-jump-start-economies

Don Kanak is the Chairman of Eastspring Investments, the Asia investment organisation of Prudential plc. He was Chairman of Prudential Corporation Asia, and from 1992 to January 2006, served in a number of senior positions at American International Group (AIG), ultimately as Executive Vice Chairman and Chief Operating Officer of AIG.

In 2011-12, Don chaired the World Economic Forum’s Global Agenda Council on Insurance and Asset Management and is currently a member of its Council on Southeast Asia. He is also a member of the Council on Foreign Relations. Don is a Senior Fellow of the Harvard Law School Program on International Financial Systems.

He is a Trustee of WWF-Hong Kong, and serves on the National Council of WWF-US.

https://www.weforum.org/agenda/2016/04/can-investing-in-social-infrastructure-jump-start-economies




SECURED LOANS

The CVC Credit Partners European

Opportunities Fund offers a unique

proposition, aimed at a wide range of

investors who are seeking an income as well

as the opportunity to generate capital gains; a

twin-engine source of returns.

With yields having collapsed close to zero

in the lower risk areas of the market, CVC

Credit Partners provides an alternative source

of income by buying up senior secured loans

across the first lien of the capital structure.

“The Fund provides investors with exposure

to a strong income stream by investing in

floating rate senior secured investments

across large liquid capital structures that offer

a target 5 per cent income per annum. This

is a similar dividend yield achieved in many

large-cap stocks, the difference being you are

not investing in the senior secured part of the

capital structure, but rather the equity, meaning

you are in the highest and most secure part of

the risk spectrum.

“In addition, through the strategy, we

are also seeking to generate circa 3 to 5 per

cent in capital gains by opportunistically

purchasing debt instruments at a discount to

its redemption value prior to maturity. In short,

we are actively acquiring a pool of collateral

that is not only delivering a stable cash income

but also capital gains to deliver a target return

range of 8 to 10 per cent over the medium to

long term, with an average 50 per cent loan

to value,” explains Andrew Davies, Senior

Managing Director and Portfolio Manager, CVC

Credit Partners.

Davies and his team look at two segments in

the portfolio. One is performing credit, which

is the cash income component, and the second

is what Davies refers to as “opportunistic

investments”. These are stressed and distressed

investments identified by the team whereby a

future event such as refinancing will positively

impact the value of those investments.

The fund, which launched on 25 June

2013 and operates as a Jersey closed-ended

investment company limited by shares, holds

around 50 per cent in performing credit and

50 per cent in opportunistic credit focusing, as

the name implies, on the European corporate

credit market. The reason for this, says Davies,

is that because the strategy has been designed

to deliver income (the 5 per cent dividend that

it pays out) it needs access to a stable source of

income, which comes from the performing part

of the portfolio.

Although some of the opportunistic credit

positions also pay cash, this happens on a less

frequent basis.

“The portfolio’s composition is characterised

by a proportion of the portfolio delivering high

cash income from low volatile secured assets

across a performing book and a segment of

the portfolio seeking to generate income and

additional capital upside from the more volatile

opportunistic part of the book. Put together, we

aim to deliver a stable 5 per cent cash return

and 3 to 5 per cent capital growth,” says Davies.

“The majority of what we do in the

performing portfolio is in the broadly

syndicated institutional market. These are large

new issue primary deals that are coming into

the marketplace. We also trade assets in the

secondary market.”

The opportunistic, non-performing credit

positions in the portfolio are purchased in the

secondary market.

CVC offers twin turbo returns

Yieldproductsarehardtocomebytoday,whatwithinvestmentgradecorporatecreditspreadstighteningandgovernmentbondsoffering

preciouslittlechanceofgeneratinganymeaningfulincome.JamesWilliamsexploresanothersolution


SECURED LOANS

a shift of bank held assets into the European

institutional market, similar to what was seen in

the US institutional market 15 years ago.

“In our view, these assets are mispriced

because it was relationship-led lending. A bank

would typically lend to a corporate in such a

way as to generate additional fees deriving from

M&A events, other financing events, revolving

ancillary lines of credit, etc. So the debt was

often priced lower than institutions would want

to hold it at.”

On the opportunistic side, it is even more

prominent that there is a regulatory-driven

push to divest non-performing corporate assets:

anything from shipping, car loans, credit

cards. Prior to the financial crash, banks built

huge amounts of such assets that are still

sitting on their balance sheets and continue to

underperform.

These impose a significant amount of risk-

weighted capital requirements on banks’

balance sheets.

The amount of capital they need to hold is

very high and, if it is trading at a discounted

value, it impairs the amount of capital that

banks can generate, so they are disposing these

assets into the institutional market.

“The two opportunities are being driven

primarily by the same regulation that applies

to risk-weighted assets. In our view, the

performing credit market is going to grow

because the banks are no longer going to

participate as they once did, and on the

opportunistic side the volume of assets is

also growing as the banks are forced to deal

with capital requirements and raise capital,”

comments Davies.

With respect to where CVC Credit Partners

are seeking out these opportunities – 85 per

cent of which are floating rate instruments

providing an effective inflation hedge – they

would appear to be legion. This is because the

banks are no longer thematically disposing

of single industries or single corporates.

Historically, a distressed name would occur in a

single region or industry and that would be the

focus of the entire market.

Now, because it is a regulatory push, banks

are being forced to divest across all geographies

and industries they have exposure to.

“In our view, this creates a more favourable

portfolio proposition because we don’t just

have to focus on single industries or sectors.

We haven’t had to over-expose ourselves to any

For funds like CVC Credit Partners European

Opportunities, the regulatory changes that

are underway make for a once in a lifetime

opportunity set as European banks are having

to reduce their balance sheet capacity to risk-

weighted assets. Corporate credit, and loans in

particular, of levered businesses, fall squarely in

the cross hairs.

“In the past, European banks would hold

performing corporate credit loans – they used

to represent almost three quarters of the buying

universe,” explains Davies. “That legacy is now

being reduced as banks take these assets off

their balance sheet and price them into the

institutional market. There continues to be

“It’s not often you can take advantage of a regulatory push for performing and non‑performing credit.”Andrew Davies, CVC Credit Partners


SECURED LOANS

Another path to unlock value could be

for a corporate to go through a restructuring

event, where CVC would seek to influence an

outcome to the benefit of its position within the

capital structure.

“A possible outcome here is for a

restructuring to position a corporate so that

it can return to profitability and as such try

and grow its way out of its problems by putting

the balance sheet into a better financing

capacity,” continues Davies. “The cash flows

they generate are used to service debt which is

too high and therefore prevents the company

from growing. They go to the bond holder or

the loan holders like CVC who would agree to

convert a proportion of their debt into equity

to help operating liquidity for a period of

time. Another option could be to extend the

maturity of the loan, and if certain milestones

are not met during that extended period, then

we would take control and seek to recover

our investment.

“There are many ways a restructuring can

assist a corporate’s balance sheet.”

The principal of being able to allocate to both

performing and non-performing credit is that

it allows the investor to get exposure to upside

from CVC’s credit picking expertise. Where

investment grade corporate and government

bond yields are today, if there is any stress

within the markets they can’t really go much

tighter. If anything they will go wider (when

rates rise).

“That ability for us to price the yield profile

of the opportunistic segment of the market,

whose yields are not moved by general market

sentiment, allows us to add downside protection

in the portfolio as well,” emphasises Davies. He

offers the following concluding thought: “Every

corporate issuer now is in full refinancing mode

given where European credit spreads are today.

They want to refinance as much as they can to

reduce their cost of capital. In the high yield

market we are seeing 7-year and 10-year deals

yielding 4 to 7 per cent. The downside risk in

fixed income and high yield today is that if and

when yields widen out, an investor’s mark-to-

market will be material.”

A fund that is able to generate two unique

drivers of returns across the most secure part of

a corporate’s capital structure could provide a

welcome solution to investors that are worried

about how to protect parts of their fixed income

portfolio from future rate moves. n

single sector because the flow of assets today

is cutting across a wide number of industries.

Over the last 12 to 18 months the flow of assets

from bank portfolios have included asset-heavy

portfolios: infrastructure-led financing where

the growth model (i.e. toll roads in Spain) has

not been realised. We’ve seen a lot of these

long-term assets coming into the market in the

last few years.

“This strategy does not trade in

infrastructure assets – but the flow of disposals

have included these type of investments.

“Over the past decade, we’ve been tracking

all European corporate issuers and watching

how the product mix has evolved. We are

monitoring more than EUR60 billion of

corporate balance sheets. So the opportunity

set is significant. It’s just a case of deciding

when we want to engage and timing the

opportunistic part of the strategy in such a

way that we achieve the capital appreciation,”

explains Davies.

During Q3 this year, total loan volume

was EUR18.4 billion, up 10 per cent on the

previous quarter of EUR16.7 billion. This has

put 2016’s YTD total loan volume ahead of the

same period last year, at EUR49.0 billion versus

EUR48.7 billion. This comeback in annual

new issue volume was largely due to a surge in

opportunistic transactions, with refinancings

and dividend recaps up by 99 per cent and 115

per cent respectively on Q2 2016.

“The debt market is continuing to grow

as corporates look for non-bank financing.

I don’t think European banks will retreat to

the same extent as in the US, but regulation

is pushing them to reduce the amount of risk

they carry on their balance sheets. It’s not often

you can take advantage of a regulatory push

for performing and non-performing credit,”

remarks Davies.

The Fund invests just over half (57 per cent)

of the portfolio in single B-rated credit. The

lifecycle of most of these corporate credits is

five to seven years. In the performing part of

the portfolio there are no refinancing concerns.

These are companies that can easily facilitate

financing on their balance sheet. However, in

the opportunistic part of the portfolio, “the view

is we would like these corporates to refinance

either through creating liquidity or because

we believe by doing so it will improve the

performance of the debt before it reaches its

maturity date,” says Davies.


ACT IV IST INVEST ING

The report, published in

conjunction with Activist Insight

and FTI Consulting, found

that nearly two-thirds of respondents

(who consisted of economic activist

funds with combined assets under

management of USD153 billion) expect

the volume of shareholder activism

campaigns to ‘somewhat increase’ over

the next 12 months.

As for the type of activism

campaigns, corporate governance and

M&A campaigns are expected to see a

significant increase, with operational

activism expected to somewhat

increase.

In 2014 and 2015, activists running

majority slates became a norm, with

nearly one-third of proxy contests

seeing a majority slate proposed by

activists. A significant percentage of

respondents expect even more majority

slates to be a cornerstone of activist

campaigns through 2017.

Two thirds of respondents see

the biggest opportunity in small-cap

companies. This is in sharp contrast

to large-cap companies, with 33 per

cent of respondents predicting little

opportunity in this part of the market,

going forward.

As The Wall Street Journal

reported on 14 November 2016,

through October this year activists

have launched just 14 campaigns at

companies with a market capitalisation

greater than USD10 billion, down from

26 over the same period last year,

according to data tracker FactSet.

At the same time, they launched

campaigns at 202 companies worth

less than USD1 billion, suggesting

that activism is moving away from the

mega corporates as hedge funds look to

shake things up at the smaller end of

the market.

“With respect to true activism,

I personally saw less of it this year

[within the large-cap space],” says

Eleazer Klein, Partner, Schulte Roth &

Zabel. “I think we can expect that the

campaigns of large-cap companies will

happen but I’m not expecting major

growth in that area for a number of

reasons.

“One is that it has always been a

hard area to make change because of

a diverse shareholder base. Second,

there are limitations in terms of who

can go after these companies by virtue

of the fact there aren’t many players

who have the capital available to take

sizeable positions to make change.

“Nonetheless, it is an area that is

not immune to criticism to the extent

that inefficiencies are identified.”

Another reason for the lower number

of large-cap campaigns is because a

number of investments made last year

are still being absorbed by some of the

more prominent activist players. Also, in

2016 the performance of some activist

hedge funds has been challenged.

The fact that prominent fund

managers such as William Ackman’s

Pershing Square Capital Management

LP were hit by losses of 25.6 per cent

this year through 31 March, primarily

due to holding a stake in Valeant

Pharmaceuticals International Inc,

could be another reason why large-caps

are likely to be less of a focus.

“The fact that the markets have

performed well is another factor for

large-cap companies being subject to

less criticism; any inefficiencies they

might have get masked by market

performance,” proffers Klein.

Those picking up the baton

and taking the fight to corporate

management groups are most likely to

be hedge funds, according to 84 per

cent of the report’s respondents. Less

than 25 per cent predict pension funds

getting involved.

Klein points out that in the US there

has been a whole raft of interesting

campaigns this year.

One notable campaign involved

United Airlines which, back in April

2016, decided to add two new board

members in a settlement with activists.

The evolution of activist investing

EnergyandITcompaniesaremostlikelytoattractshareholderactivismwithfourin10respondentsbelievingthatthesetwosectorsrepresent

alotofopportunity,accordingtoarecentSchulteRoth&ZabelreportentitledShareholder Activism Insight

Eleazer Klein

https://www.srz.com/images/content/1/4/v2/145073/SRZ-2016-Shareholder-Activism-Insight-Report.pdf


ACT IV IST INVEST ING

recognition of what activism is and we continue to

see this build year after year,” adds Klein.

One aspect of activist campaigns that is

expected to increase over the next 12 months is

the use of precatory proposals. This was seen,

for example, when Carl Icahn pushed eBay for

a PayPal spin-off. It suggests that not only do

activist funds realise that fighting a successful

campaign need not necessarily require an

aggressive proxy fight, but also that corporates

themselves are wising up to the need to settle,

even if, as in the eBay example, the precatory

proposal did not lead to a vote.

Klein explains that a precatory proposal is

special to US activist campaigns: “One of the

rules allows shareholders to put non-binding

proposals on the ballot or the proxy card of a

company. There are limits, but as long as they

are not ordinary course business issues then the

shareholders are allowed, generally, to weigh in

on what they feel a company should be doing

and wish to put pressure on the company by

having a public vote.

“For example, if you think a company should

spin off a certain business division you could

try to get a precatory proposal put on the

proxy card so that shareholders can express

their views. As said, this is non-binding, so the

company doesn’t have to listen to it, but the

advantage is it is very cost-effective.”

In the report, some 58 per cent of

respondents expect to see an increase in

precatory proposals over the next 12 months.

As a final observation, traditionally, activist

campaigns tended to be seasonal. The bulk of

the action would take place at the start of the

year through to springtime when companies

typically held their annual meetings. This is

no longer the case. It’s become a year-round

activity. “We are living through it. There is

no down time anymore. We are working on

campaigns all the time,” confirms Klein.

“Overall, returns in activist funds were not

as good last year as in 2014 and that always

puts pressure on inflows and the ability for

activist managers to put capital to work and

find investment opportunities. There’s no doubt,

though, that activism is still a growing area,”

says Klein.

As the report itself pronounces, “Not only

should we expect activism to continue to thrive,

we should expect it to become an ever-present

activity in the marketplace seeking to unlock

value and hold managements accountable.” n

PAR Capital Management and Altimeter Capital

Management pushed for change because they

felt, among other performance issues, United

Airlines did not have enough directors with

aviation expertise.

“That was a very interesting one in terms

of an industry that has been subject to

underperformance and criticism by long-term

investors. They are what we call ‘occasional

activists’. People who don’t pursue this as a

business model but are frustrated and realise

there are more tools available to them to drive

change than in the past. In Europe, you’ve

seen Rolls Royce and other campaigns that you

wouldn’t have seen a few years ago,” says Klein.

The Rolls Royce deal involved agreeing to

give activist investor ValueAct a board seat in

return for a promise that it would not publicly

lobby for a break-up of the aero-engine group,

nor take its stake above 12.5 per cent, reported

the Financial Times at the time.

Unsurprisingly, the US remains the most

dominant market and represents the largest

investment opportunity. Some 97 per cent of

respondents think there is either some or a lot

of opportunity there. “It is a slow build outside

of North America. That said, there are more

integrated campaigns starting to emerge in

Europe,” says Klein.

Indeed, 84 per cent of respondents saw some

or significant opportunity in the UK. Asked

whether Brexit could be a factor going forward,

Klein responds: “You would think that Brexit

will create tension in more companies as they

have to deal with issues and those with greater

inefficiencies will tend to be identified through

that process; that is where companies that

don’t have good governance, good management,

good vision get shaken out and can’t protect

themselves against market performance.

“The theory is that events like Brexit create

more activism opportunities, but the truth is

no one really knows. No one can say for sure

whether it will create more M&A opportunities

or reduce them.”

Despite being culturally more accepted in

the US, Klein believes that attitudes among

European corporates and shareholders towards

activism are changing.

“Every year you are seeing more recognition,

more identification of company issues that present

activist opportunities for investors, but it is a

slow process. The number of campaigns is rising

steadily. There is more traction underway and a


Corporate bond markets have grown

significantly over the last few years. In

2015, approximately USD575 billion

of all US investment-grade corporate bonds

were traded on MarketAxess alone. This has

happened in tandem with dealers reducing

their market making activities, and while at

first glance it might appear that fixed income

markets are less liquid and more fragmented,

there is no clear evidence that this is having the

deleterious impact that some predicted.

If anything, the growth of electronic trading

platforms and fixed income ETFs have shown

the resiliency and capacity for the marketplace

to adapt, innovate and continue to evolve in

response to market regulation and technology,

bringing buyers and sellers together in ways

that were not previously possible.

In a recent white paper published by

Vanguard entitled Innovation and evolution in

the fixed income market, they point out that

electronic trading has become increasingly

important in fixed income markets, enabling

greater use of automated, computer-driven

algorithm-based trading. This has allowed

a more diverse set of participants to enter

the market, introducing new sources of

liquidity, increasing competition, and reducing

transaction costs.

Moreover, innovation in open-ended

investment vehicles “has generally boosted

market liquidity because two of these vehicles

F IXED INCOME

All change for fixed income

JamesWilliamstalkstoPaulMalloy,headofFixedIncome,Europe,atVanguardoninnovationinthebondmarkets


F IXED INCOME

(exchange-traded funds and target

asset allocation funds) have provided

stabilising effects,” states Vanguard.

“One of the things that we’ve

learned from the financial crisis is

that it’s good to ask questions and

understand different market dynamics,

and look a little deeper. Banks’ balance

sheets used for fixed income trading

are lower and the cost of capital is

rising because of increased regulation.

It’s therefore healthy to ask, ‘What does

this mean?’

“Different institutions have different

opinions; this white paper was a chance

to share ours,” says Paul Malloy, Head of

Fixed Income, Europe at Vanguard and

one of the paper’s authors.

Part of the concern regulators

and other market players have over

perceived liquidity issues is linked to

the transformation that some parts

of the fixed income market have

undergone. The value of corporate

bond inventory held by dealers globally

has fallen considerably from its

2008 peak. Dodd-Frank and Basel III

regulations have reduced systemic risk

in the banking system and shored up

Tier 1 capital ratios but in the process

it has increased the cost of making

markets. Dealers are still providing

liquidity, just less of it because they

cannot absorb the risk of doing so.

“Markets have a history of evolving

and electronic trading platforms are

now the next natural stage of that

evolution,” says Malloy. “I think

markets have always had an amazing

ability to adapt and show resiliency.

Traditional market makers are reducing

the amount of leverage, but electronic

trading platforms are becoming more

prevalent. Buyers and sellers of fixed

income ETFs are trading more cost-

efficiently on the secondary market as

opposed to investing in a wider array of

smaller fixed income funds.”

Both of which are important

liquidity channels. Just as happened

in the equity markets, fixed income

markets now have a wider array of

liquidity providers. In addition to the

broker-dealers, there are principal

trading firms (high-frequency traders),

buy-side firms including hedge funds

and mutual fund houses that are

actively participating as buyers and

sellers, and what Vanguard refers to

as liquidity’s ‘behind the scenes’ allies:

ETFs and target-date retirement funds.

The latter are contrarian by design,

often buying investments that have

declined in value and selling those

that have risen. This is the complete

opposite to speculative investors, who

focus on buying winners and selling

losers. Target-date funds, therefore,

can provide stability, particularly when

market swings are considerable and

stress levels start to rise.

What the above shows is that fixed

income market liquidity has become

a richer tapestry, with a variety of

actors participating at different times

and levels of frequency. This has

made liquidity more fragmented,

but it means that a severe shock is

less likely to cause a run on liquidity

thanks to the evolving structure of the

marketplace.

“It is very unlikely for the entire

fixed income market to say that

everyone is going to leave and run for

the door at the same time. The market

has a diverse set of investors with

different needs; insurance companies,

pension funds, liability matchers.

There are so many diverse needs that

they are unlikely to be doing the same

thing at the same time,” comments

Malloy, when asked how electronic

platforms might respond to a severe

market dislocation.

The main protocols being used on

electronic platforms include: Request

for Quote (RFQ); Central Limit Order

Book (CLOB), and All-to-All.

On Central Limit Order Books,

active bids and offers are stored

and then executed in priority order.

Typically, quotes are transparent to

participants in the interdealer market

on a pre-trade basis. BrokerTec and

eSpeed are two examples of CLOB

systems, often used for trading highly

liquid securities such as US Treasuries.

All-to-all is a more recent trading

protocol that allows buyers and sellers

to interact directly with one another.

As the Vanguard paper highlights, this

is an important distinction because

most electronic trading platforms

match dealers to dealers and to clients.

Because so-called end clients are

participating equally, and directly, with

one another, costs are low and liquidity

is highly accessible.

MarketAxess offers an all-to-all

trading protocol, which it calls Open

Trading. While the majority of trade

flow in US IG corporate bonds is still

done via RFQ, Open Trading now

accounts for more than 10 per cent

of total volume: this figure climbs to

nearly 25 per cent of trade volume for

US High Yield corporates.

Using Open Trading, an investor

can be both a price taker and a price

maker, responding to someone else’s

enquiry. If a large asset manager is

looking to sell a block of bonds, hedge

funds have the ability to bid for those

bonds and trade directly with the asset

manager, whereas in the past they

would have had to deal with the dealer.

“It’s more difficult for banks to

hold large positions. Block trades are

increasingly now being brokered in

the market. For example, on Open

Trading, two hedge funds, or a hedge

fund and an asset manager can come

together and transfer that risk between

themselves,” says Richard Schiffman,

Open Trading Product Manager at

MarketAxess.

Open Trading is the next step in the

evolution of the trading protocol, going

Paul Malloy


beyond the dealer community to allow

investors to trade with anyone active in

the market. “Now, investors can choose

to trade with over 1,000 different

participants,” explains Schiffman. He

adds that “we’ve seen a doubling in

trade activity on Open Trading among

hedge funds over the last year”.

Electronic trading is changing the

way that trades are executed. In short,

they are encouraging participants

to rely less on block trades and

instead execute smaller positions on

a more frequent basis. “Banks are not

warehousing the risks to the same

degree that they were previously. They

are doing a smaller portion of trades on

their balance sheets. We’ve definitely

seen more frequent smaller trades

being done as opposed to bigger block

trades with banks holding them on their

balance sheets and working out of them

over multiple days,” confirms Malloy.

The amount of liquidity in fixed

income is likely to remain ‘lumpy’

for the foreseeable future as trading

protocols evolve. Investment grade

government bonds are highly liquid but

corporate bonds are a complex miasma

of issuers, and subsequently trade less

frequently on platforms. The same is

true of high yield bonds. Over time, as

more of these instruments are traded,

the more liquidity will grow.

“Trading corporate bonds is

harder than trading government

bonds and FX just because there is

less standardisation. But that doesn’t

make it impossible to trade these

bonds electronically, just more of a

challenge,” says Malloy. He thinks that

the growth of fixed income ETFs will

be a major part of the liquidity profile

for two reasons.

“Fixed income ETFs on exchange

provide better price transparency for

buyers and sellers to determine where

the market ‘is at’. Also, buyers and

sellers can cross flows (using ETFs)

without ever having to go directly into

the primary bond market. Our research

shows that nearly 80 per cent of an

ETF’s volume will occur without needing

to go into the underlying market to

complete the trade, which means

participants are finding each other more

cost-effectively than the transaction

cost of the underlying market.”

Market regulation and better

capitalised banks are leading to a safer

more sustainable financial system.

That comes with some trade-offs and

markets adapting. Hollyer points out

in the paper that there is no clear sign

of bid-ask spreads being significantly

different because of declines in

inventory and turnover. In fact, bid-

ask spreads on corporate bonds are

narrower today than they were when

dealer inventories were at all-time

highs during the financial crisis.

‘Liquidity goes through cycles,”

remarks Malloy. “We’re just in one of

those cycles right now where liquidity

remains lower than it was in 2007.

However, one could argue that 2007

was not a good reference point to

begin with given that some banks were

highly levered and there was very low

market volatility.

“Diversity is always a welcome

development. You never want to rely

on one avenue (or protocol) for trade

execution. The market is evolving

away from this and that is why you

get a bit of a dip in the liquidity profile

until you figure out all these different

sources of liquidity and get them in a

better position.”

With respect to whether electronic

platforms are creating too much

fragmentation (and thinning liquidity),

Malloy states that going forward, “while

we would encourage against there being

too many platforms and too much

fragmentation, it is a natural starting

point towards reaching a good solution”.

Limiting trading fragmentation is

one of five suggested principals that

Vanguard believes will help ensure that

fixed income markets across the globe

continue to evolve in the best interests

of shareholders.

Having lots of people in the market

with diverse needs is really the essence

of liquidity; executing what you want,

when you want without impacting

price by interacting with myriad buyers

and sellers who can find each other

with ease.

“From that standpoint, having lots

of platforms in the marketplace is good.

It is just that nobody wants to go to

40 different platforms, with 100,000

users on each. Far better to have more

users aggregated on a smaller number

of platforms. I believe the marketplace

will find the right equilibrium, in terms

of determining the right number of

platforms,” opines Malloy.

Reduced fragmentation will also

create more intense price competition.

Other suggested principals include:

provision of greater price transparency;

further development of all-to-all

networks; integrate trading and order

management systems, and protect

against information leakage.

On this last point, Malloy concludes:

“Anyone using electronic platforms

has to have a responsibility to protect

against information leakage and get

the best execution for the client, and

that best execution should be enough

to keep all players in the market acting

in a responsible way. I believe it is

necessary to protect against things like

information leakage as platforms evolve

to support market participants.”

These changes taking place in fixed

income are closing the doors to some

and opening the doors for others.

Technology, greater transparency and

a more diverse mix of buyers and

sellers coming together on electronic

platforms is evidence that liquidity

remains robust and that the market is

evolving to adapt to this new reality. n

F IXED INCOME

Richard Schiffman


COMMENT

2016 was clearly a year which shook

a few assumptions – who would have

thought that Leicester City would win a

major trophy? There were also some political

surprises with Brexit and the election of Trump.

In both these cases one of the consequences

appears to be the rejection of current

international trading arrangements.

Before discussing this further, I thought

it would be interesting to have a quick

review of a number of trading arrangements

through history.

Canute

Sciant omnes habitantes orbem vanam et

frivolam regum esse potentiam, nec regis

quempiam nomine dignum praeter eum, cuius

nutui coelum terra mare legibus obediunt

aeternis – Henry of Huntingdon, Historia

Anglorum c1129

King Canute (or Cnut the Great as he is

known in Denmark) (c995-12 Nov 1035),

son of Sweyn Forkbeard and Sigrid the

Haughty, grandson of Harald Bluetooth and

great grandson of ‘Gorm the Old’ was King of

England, Norway, Denmark and part of Sweden

in what was known as the North Sea Empire.

Every English schoolchild knows him as the

deluded king who ordered the waves to retreat.

However, the original description of the event

by Henry of Huntingdon in the twelfth century

makes clear that the King was in full control of

his faculties and merely undertook the exercise

to demonstrate to his obsequious and adulatory

courtiers that even a King cannot defy the laws

of nature (the above extract, spoken after the

waves had reached his feet, translates as ‘Let

all men know how empty and worthless is the

power of Kings, for there is none worthy of the

name, but He whom heaven, earth and sea obey

by eternal laws’).

Henry of Huntingdon described the incident

Cakes and tradeInhisregularcolumnforAlphaQ,RandeepGrewalwritesonthesurprisinglyappositesubjectofhistoricaltradingarrangements


COMMENT

Indian textile workshops and the power of the

East India Company transformed India from a

provider of textiles to a source of raw cotton,

with cloth being manufactured in the mills of

Lancashire and Yorkshire.

Navigation, Molasses, Sugar and Stamp

Acts

The mercantilist focus by Britain led to the

Navigation acts starting in 1651 which sought

to maintain all the benefits of trade within the

Empire. Related acts included the Molasses

Act of 1733 and the Sugar Act of 1764, which

sought to maintain preferential status for

commodities sourced within the Empire. As will

be noted in the previous paragraph however

the Empire was not a true free trade zone –

else why not import manufactured textiles

from India?

‘An act for granting to Their Majesties

several duties on Vellum, Parchment and

Paper for four years, towards carrying on the

war against France.’ – Stamp Duty Act 1694

Stamp Duty was first introduced in the UK

in 1694 under William and Mary to fund a war

against France. The Sugar Act of 1764 and the

Stamp Act of 1765 helped build up resentment

in the American Colonies ultimately leading to

the American War of Independence.

Cotton

Originally, Britain imported cotton from India.

However over time Britain also imported cotton

from the US, but that supply was disrupted by

the American Civil War. This led to purchases

from Egypt and massive investment in Egypt

to expand its production. At the end of the

American Civil War in 1865, British (and

French) traders returned to cheap American

imports leading to the consequent bankruptcy

of Egypt and its subsequent occupation by the

British Empire.

Opium wars

Chinese tea and cotton undercut that produced

in the British Empire. Mercantilism led to

the Opium Wars (1839-1842 and 1856-1860)

through which Britain gained trading access to

China. The Chinese were obliged to allow in

opium on British ships whether they liked it

or not. It has been estimated that up to 10 per

cent of the Chinese population became hooked

on the drug as a result. The Qing Dynasty was

also considerably weakened as a result.

of the waves as one of three examples of

Canute’s ‘graceful and magnificent’ behaviour.

The other two examples were the negotiation

of reduced (or zero) tolls for traders from his

empire along trade routes through Gaul and

all the way to Rome, and the marriage of his

daughter Gunhilda of Denmark to Henry, the

son of Holy Roman Emperor Conrad II. Henry

would in time become Henry III, Holy Roman

Emperor (though Gunhilda died before his

coronation).

Thus, even a thousand years ago, the

leadership of England was focused on reduced

tariff access to Europe; and political alliances

that were often sealed by marriage.

The Hansa

In 1157, the merchants of the Hansa (trade

guilds) in Cologne persuaded King Henry II

of England to allow them to trade tariff free

in London and at fairs throughout England.

By 1266 Henry III had granted merchants

of Lübeck and Hamburg (and from 1282

those from Cologne) a charter for operations

in London. From these merchant guilds

and market towns across Northern Europe

developed the Hanseatic League which at its

zenith waged its own battles, but also enforced

safe trade by fighting pirates.

The influence of the Hanseatic League was

not just on the international plane; in England

they provided financial support to the Yorkist

side in the War of the Roses. Notwithstanding

this, tensions occurred because the Hansa

refused to offer reciprocal trading privileges to

English merchants and finally, in 1597, Queen

Elizabeth I expelled the League from London.

In London, the current day Cannon Street

Station stands on the site of the Steelyard

– which was a Hanseatic League warehouse

and enclave on the then shoreline of the

Thames. Hans Holbein the Younger painted a

number of portraits of Hanseatic merchants

stationed there.

The East India Company

On 31 Dec 1600 the East India Company was

given a Royal charter by Queen Elizabeth I

to trade with the ‘East Indies’. Over time the

company would come to rule India with its own

private armies until it was in effect nationalised

in 1858 by the British Crown. At its peak, up to

half of global trade flowed through the company.

Within the British Empire, high tariffs against


COMMENT

Revolution). No amount of planning or

preparation can allow for the unexpected

(how would English history have changed

if Canute had not died in 1035, and if his

daughter had not died before her husband

became Holy Roman Emperor?);

• Trade and taxation are often intimate bed

fellows;

• There are periodic swings between

mercantilism and free trade;

• The public consciousness regarding historical

industrial might and trading success,

certainly in Britain, forgets that the trade

arrangements of the British Empire were

often made under duress (eg the Opium

Wars) or on inequitable terms (cotton and

textile trading with India).

Cakes and eating them

Boris Johnson, one of the leaders of the Brexit

campaign and current foreign secretary,

famously claimed that Brexit would allow

Britain to ‘have the cake and eat it’. So far,

he has failed to explain how this miraculous

cake will exist in two places at once – perhaps

it is a quantum cake? Any serious student of

Adam Smith would actually question the size

of cake post Brexit and whether it will lead

to unrest. Perhaps Boris was unconsciously

echoing another famous appreciator of cakes –

Marie Antoinette.

Investors and Canute

As an investor, I often find myself trying to

distinguish between ‘aspirations’ and reality.

Presentations and projections, whether for

economies or companies are often wrapped in

flowery language.

Canute, facing similar flowery language from

his courtiers, showed that even as King he was

subject to the laws of nature. For investors

the nearest to ‘eternal laws’ are Adam Smith’s

‘invisible hand’ and the concept that free trade

benefits all.

Furthermore, many commentators on post-

Brexit trade tend to consider future trade

arrangements only from their own perspective.

As an investor, I always try to consider what

the counterparty knows, its experiences and its

motivation. For example, the Chinese describe

the period from 1839 to 1949 as ‘The Century

of Humiliation’. Their view of historic ‘trade’

cakes might be more in line with eating cakes

from the oven of Alfred the Great. n

Adam Smith and the Eden Treaty

Adam Smith’s Wealth of Nations, first published

in 1776, strongly influenced William Pitt the

Younger to seek a trade treaty between Britain

and France – the two leading mercantilist

nations of the period; and thus the ‘Eden

Treaty’ was signed.

Despite being inspired by free trade

principles, the British forgot the most

fundamental tenet of any long-term deal – it

must be equitable to both sides. The entry

of cheap British textiles into France and the

resultant commercial crisis are claimed by

some authors, together with the failure of

the French harvest of 1788-89, to have been

two of the proximate causes of the French

Revolution.

Cobden-Chevalier Treaty

A subsequent trade treaty, the Cobden-

Chevalier Treaty between Britain and France,

lasted from 1860 to 1892 when protectionist

elements in France led to the passing of the

Méline tariff.

This was not the first time that trade

between France and Britain had been impacted

by mercantilism. Under Jean-Baptiste Colbert

(29 Aug 1619-6 Sep 1683; finance minister

(1665-1683) under King Louis XIV), France

had previously swung to blatant protectionism.

Ironically, though Colbert brought the French

economy back from bankruptcy it continued to

be impoverished due to the King’s propensity to

spend on war.

These days Colbert is perhaps best known

for providing the motto of finance ministers

everywhere: ‘The art of taxation consists in

so plucking the goose as to obtain the largest

amount of feathers with the least possible

amount of hissing.’

Lessons from history

The objective of this short gallop through trade

treaties is to act as a reminder that over the

last thousand years or so international trade

has been of great importance to the rulers

of Britain. There appears to be a number of

clear lessons:

• Trade treaties that are considered unfair by

one party or the other do not last (eg. the

Eden treaty);

• A badly designed treaty or related tariff

can lead to unexpected consequences (the

American War of Independence, the French

Randeep Grewal is a portfolio manager for the Trium Multi-Strategy Fund. This article is written in a personal capacity; the views and opinions are those of the author and do not necessarily reflect those of Trium.

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