Maneerut Anulomsombat, Senior Associate – Investment Banking, The Quant Group. [email protected]

Maneerut is a Senior Associate Director at The Quant Group – Investment Banking, she graduated magna cum laude in Industrial Engineering from Chulalongkorn University and an MBA from Stanford University.

May 2008 Smackdown - The Fight for Financial Hegemony

Last night I switched on the cable and World Wrestling Championship was on. I’ve never really watched wrestling before but for the five minutes that I did, it seemed like the fight was between two greasy large muscular male slamming their heads at each other surrealistically and theatrically slapstick. Amidst this fight another large muscular male came out from backstage, jumped into the ring and dropped-kick one wrestler who fell off the stage then turned around and slammed the other wrestler while the referee bounced around the ring ineffectively. Apparently this is a common scene on “Smackdown”.

I don’t know what it is exactly but this made me think about the fights for the hegemony in global deal-making between the three giants: Private Equity Funds (PE), Hedge Funds (HF), and Sovereign Wealth Funds (SWF). And while the authorities and senate banking committees don’t always wear striped black and white referee shirts, they seem to be bouncing around not quite certain what to do as well.

And here's how the giants compare by size. The Asset Under Management (AUM) of PE by the end of year 2007 was around US$1.16 trillion. The AUM of SWFs rose from US$500 Million in 1990 to US$3.3 trillion in 2007, overshadowing the US$1.7 trillion of AUM thought to be managed by HFs in year 2007 (up from $490 billion in year 2000).

Private Equity Funds

PEs, the smallest amongst them, however, have gotten a larger share of the headlines. This is largly due to their role in corporate takeovers.

In Year 2006, PEs accounted for about one-third of US M&A and almost 20% in Europe by deal value. In 1989, the takeover of RJR Nabisco by KKR held the record as the largest Leveraged BuyOut (LBO) for more than 15 years. The record was broken in 2006 by the HCA LBO for $33 billion by three Private Equity firms Bain Capital, KKR and Merrill Lynch.

Several mega deals poured out after the HCA LBO such as Equity Office for $39 billion by The Blackstone Group and then TXU for $45 billion by KKR and TPG Capital including Goldman Sachs, Citigroup and Morgan Stanley. Soonafter Ontario's Pension Funds, Proividence Equity Partners, and AIG [check facts] clubbed what is still the largest LBO to date of BCE (the holding company to Bell Canada) at US$49 billion.

Since the back half of 2007, deals have slowed across the board amidst ubiquitous credit-defaults in response to the collapse of the US sub-prime market. As well, 2008 has so far been slow.

Carlyle's senior partner, David Rubenstein, voiced that PEs will likely see lower returns in the years to come as it wrestles with a tougher debt market. The Cov- Lite (uncollateralized with limited covenants) debt market has completely dried up for LBO financings.

Hedge Funds

Hedge Funds differ from their Private Equity brethrens in that they apply multii- faceted active trading strategies and much of their fabric involve public market securities, commodities, and currencies and therefore not limited to equity of the private kind. HFs are more apt to employ quick flips while PEs have more dfinitive holding periods typically 4-6 years and are more concerned on corporate governance and the ability to control the companies.

The Hedge Funds have been expanding rapidly in the past couple of years, with more than 10,000 funds managing some US$1.87 trillion in assets by early 2008. Though deal sizes or positions held by Hedge Funds may not be as big as those of SWFs and PEs, their aggregate trades in a year are manifolds larger than PEs'. In 2006, HF trades account for 30% - 60% of trading volumes in US and UK equity and debt markets.

In the past year, Hedge Funds in aggregate have lost multiple of billion dollars in large part triggered by the subprime crisis. Bear Stearns began with the wind-downs of their two hedge funds (Bear Stearns High-Grade Structured Credit Fund and Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund) and finally folded itself into J.P. Morgan.

Och-Ziff experienced declines in value in all of their four funds in the first quarter of 2008.

Sovereign Wealth Funds

Recently the SWFs have played an integral role in the world’s financial system. Their Sources are fortified by petrodollars and trade surpluses largely beneficiaries of rising commodity prices. Their Uses have been instrumental in saving banks, hedge funds and private equity firms from insolvency. A back-of- an-envelop calculation stacks more than US$70 billion injected into these struggling financial institutions in the past year alone.

SWFs are not immune to losses either. Blackstone’s shares were down about 46% since the IPO last year, leaving CIC with a paper loss of $1.37 Billion as the stock market’s close at the middle of March (11th March). SWFs' investments in banks such as Citigroup, UBS, Merrill Lynch, Morgan Stanley amongst them have been critiqued that they might have been made on not-so-favorable terms to the SWFs.

Because of their status of government ownership, SWFs have been accused of having political motives beyond their investment returns and thus closer scrutiny that resulted in many instances deal-breakers.

Friends or Foes?

If hedge funds were like brothers to private equity funds then SWFs have been the parents to both. Before they made investments directly, SWFs used to instead just invest through the PEs and HFs. Now all three compete directly in the marketplace.

However, looking long-term, the SWFs could become a potential threat for Private Equity Funds and Hedge Funds. SWFs’ investments in financial-services

Page 2 firms may be motivated not just by the investment returns, but in large by the desire to learn how those general partnerships are operated. If SWFs can fully build their own investment expertise, then there is no point for them to invest in Private Equity Funds and Hedge Funds. They can do deals by themselves and keep the annual and incentive fees.

Better way to control the game?

Private Equity and Hedge Funds are currently being regulated by the SEC of each domicile country. The problem is that many of these funds are incorporated offshore and the fund operations are therefore not subjected to the SEC scrutiny.

Ideas have been kicked around to have supranational institutions such as the IMF and OECD regulate the SWFs.

Though it is clear to all policy-makers that they should do something to control the investments made by these three giants, there is no clarity in the rules of engagement save for warm fuzzy words like "transparency" and "governance". Leverage perhaps is an obvious area that should be curbed. In many of these hedge fund muti-strategies, the idea is to "lock-in" small spreads and work with large trading capital. It is not uncommon that a billion dollar bet only produce two to three million dollars. So the trick is use leverage with the bet - may be 20, 50, or even 100 times the capital. If the bet, however, goes wrong, the result can be destabilizing to the global capital markets.

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