alphaq december 2016 - institutional asset manager · alphaq december 2016 companies featured in...

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]

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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]

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www.AlphaQ.world | 3

CONTENTS

AlphaQ December 2016

Companies featured in this issue:• CVC Credit Partners

• Droit

• Eastspring Investments

• EDHEC Infrastructure Institute

• Goldberg Kohn

• Investec Asset Management

• Latitude Investment Management

• M17

• MPI

• PAAMCO

• Quadra Capital

• Ropes & Gray

• Rosebrook Capital Partners

• S&P Global Ratings

• Schulte Roth & Zabel

• SCM

• Setter Capital

• Vanguard

• WHARD Steward

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 Interview with Freddie Lait on the

new spin out of Latitude Investment Management offering low fee hedge fund returns and backed by Odey and other investment giants

05 Quadra opens its doors Introducing a concentrated strategy from

Paul-Georges Moucan with his Quadra Global Equity Alpha which enjoyed a soft launch in August and is now open to all

FEATURES

06 Cover story: Meet the Millers Interview with Alan and Gina Miller of

SCM Direct on their business, their investment model and that challenge to Brexit

09 Redemptions offer opportunities Opportunities on the rise for managers

investing in illiquid hedge fund assets. James Williams interviews Rosebrook Capital Partners

12 Analysing the endowment landscape MPI examines endowment performance,

measured against the Yale model

14 Easing the regulatory compliance process

New York-based Fintech firm Droit has created ADEPT, designed to help both sell-side and buy-side institutions address the issue of regulatory compliance

16 Tech-Savvy Maria McGuire, commercial finance

partner with Chicago law firm Goldberg Kohn, writes on technology finance, on issues that arise in helping lenders structure transactions with technology companies and private equity firms with tech-focused portfolios

18 What lies ahead? AlphaQ’s annual review of the year and

peek into the future

20 Silk road initiative Donald Kanak, Chairman of Eastspring

Investments, writes on the Belt & Road Initiative which is crucial, along with international co-operation, for the ongoing development of infrastructure in the ASEAN region

22 CVC offers twin turbo returns CVC’s Andrew Davies explains the

benefits of investing in European senior secured loans in today’s low yield environment

25 The evolution of activist Investing According to a new report, Energy and

IT companies are most likely to attract shareholder activism with four in 10 respondents believing that these sectors represent a lot of opportunity

27 All change for fixed income Vanguard’s Head of Fixed Income,

Paul Malloy, discusses innovation and evolution in the fixed income market

30 Cakes and trade Regular columnist Randeep Grewal calls

on the lessons of history and its trade agreements from King Canute onwards to give us some context on the Brexit debate

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 MillersBeverly Chandler interviews Alan and Gina Miller, who,

when it comes to challenging the institutions that formed them, have fearless form, both jointly and separately


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 opportunitiesJames Williams interviews Andrew Lawrence of Rosebrook Capital Partners, a firm which finds opportunities in hedge fund redemptions


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 ResultsWith 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

Sean Ryan, Senior Research Analyst at investment research and technology firm, Markov Processes International (MPI) examines whether endowments have adopted the Yale model

-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


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


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

James Williams profiles Droit, a New York-based financial technology company whose platform, ADEPT, has been engineered to help both

sell-side and buy-side institutions address the increasingly complex issue of regulatory compliance

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-savvyMaria McGuire, commercial finance partner with Chicago law firm

Goldberg Kohn, writes on technology finance and issues that arise in helping lenders structure transactions with technology companies and

private equity firms with tech-focused portfolios


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?AlphaQ contributors and thought provokers assess the year that has gone

and take a cautious peek into the next one


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

European Silk Road 209 -30

India 737 175

Growing South Asia, excluding

India (5 countries)

211 68

Growing ASEAN (9 countries) 328 61

Growing Central Asia and Middle

East, excluding India (24 countries)

283 78

Growing 39 Silk Road countries 1,559 382

Silk road initiativeDonald Kanak, Chairman of Eastspring Investments, writes on the key importance of the Belt & Road Initiative combined with international co-operation in the essential development of infrastructure in Asia

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.


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

Yield products are hard to come by today, what with investment grade corporate credit spreads tightening and government bonds offering

precious little chance of generating any meaningful income. James Williams explores another solution


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

Energy and IT companies are most likely to attract shareholder activism with four in 10 respondents believing that these two sectors represent

a lot of opportunity, according to a recent Schulte Roth & Zabel report entitled Shareholder Activism Insight

Eleazer Klein


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

James Williams talks to Paul Malloy, head of Fixed Income, Europe, at Vanguard on innovation in the bond markets


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.

CanuteSciant 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 tradeIn his regular column for AlphaQ, Randeep Grewal writes on the surprisingly apposite subject of historical trading arrangements


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 ActsThe 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.

CottonOriginally, 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 warsChinese 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 HansaIn 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 CompanyOn 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 themBoris 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 CanuteAs 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 TreatyAdam 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 TreatyA 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 historyThe 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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