Oxstones Investment Club™By Devin Banerjee, Bloomberg,
“I am a musician, and the monkey is a businessman. He doesn’t tell me what to play, and I don’t tell him what to do with his money.”
David Bonderman, co-founder of private-equity firm TPG Capital, is doing his best French accent for the Beverly Hills crowd, parroting a blind organ grinder confronted by Peter Sellers’s Inspector Clouseau character in the 1975 film “The Return of the Pink Panther.” The audience, gathered in April for the Milken Institute Global Conference, erupts in laughter. So does Leon Black, founder of Apollo Global Management (APO) LLC, who is seated next to Bonderman.
Bonderman’s message is clear, Bloomberg Markets magazine will report in its September issue. Like the film’s monkey and organ grinder, alternative-asset managers and their investors depend on each other. Bonderman, 71, and Black, 63, pioneers in unconventional investments, can do business only when they raise money from clients, and the clients are increasingly relying on the $5.7 trillion universe of alternatives to meet their goals.
TPG and Apollo are among the leaders in the two categories — private equity and real estate — that top Bloomberg Markets’ second annual ranking of alternative investments.
Private-equity firms’ buying and selling of companies produced average returns of 14.9 percent annually over the three years ended on Dec. 31 and 20.6 percent for the year ended on the same date, according to data compiled by Cambridge Associates LLC. And many of the deals alternatives giant Blackstone Group LP (BX) and big private-equity firms such as Apollo and TPG have brought home involved real estate.
Property Titan
Blackstone’s property unit manages more than $80 billion in assets, with properties as varied as industrial warehouses in the U.S., office parks in India, retail locations in Turkey and Hilton Worldwide Holdings Inc. (HLT), which operates more than 4,100 hotels with 685,000 rooms. Among Hilton’s properties is the fabled Waldorf Astoria hotel in New York, whose guests have included Winston Churchill, U.S. presidents and a host of other world leaders.
McLean, Virginia–based Hilton, the behemoth lodging company started in 1925 by Conrad Hilton, is a symbol of the real estate recovery. Soon after Blackstone took it private in 2007 for $26 billion, distress in credit markets deepened and international travel shrank as the global recession took hold. With its investment marked down 70 percent in 2009, Blackstone took action, restructuring the company’s loans, buying back debt and opening new hotels around the world.
$11.5 Billion Profit
As occupancy rates have rebounded and room pricing has crept higher, the $6.5 billion in cash Blackstone and its clients plowed into the transaction had grown to more than $18 billion as of mid-July, making it the most profitable private-equity real estate deal ever. Since its new public offering in December, Hilton stock was up 21 percent, valuing the company at $23.8 billion. Blackstone still owns 66 percent.
To find the best-performing unconventional investments, Bloomberg Markets searched Bloomberg indexes comprising real estate investment trusts, commodities, hedge funds and funds of funds. Bloomberg’s Rankings team also drew on outside indexes to identify the top-performing private-equity funds and collectibles, including vintage cars, wine, stamps and contemporary art.
The best bets ranged from the porcine to the sublime: from lean hogs to antique cars to paintings by French-American artist Marcel Duchamp, which returned 93.8 percent annualized over three years and 465 percent over one. Other winners were various vintages of Chateau Pavie in Bordeaux and a 1954 Mercedes-Benz race car.
Hedge Funds Falter
As a group, alternatives struggled to beat the Standard & Poor’s 500 Index (SPX), which returned 14.6 percent annualized over the three years ended on March 31 and 21.7 percent for the year ended on that date. Among the worst-performing alternatives were global commodities, which declined 3.4 percent over the three years, and hedge funds, which gained 1.9 percent on average, according to data compiled by Bloomberg. Funds of hedge funds lost 1.9 percent. A $2.8 trillion industry, hedge funds have now underperformed the S&P 500 for more than five years.
“Returns have been anemic, and I think that’s going to be more of an issue for the hedge-fund space,” says Jim Dondero, president of Highland Capital Management LP in Dallas. “Hedge-fund returns have been less than mutual fund returns for almost a decade.”
Among non-exotic alternative investments, real estate investment trusts followed private equity with a 10.7 percent three-year return.
$1 Trillion in REITs
REITs are agglomerations of property sold like stocks. They own more than $1 trillion of property in the U.S. and raised a record $77 billion last year, up from $73 billion in 2012, according to the National Association of Real Estate Investment Trusts, or NAREIT. One category of REIT that soared was operators of self-storage units, with Salt Lake City–based Extra Space Storage Inc. (EXR) the top performer, returning 36.7 percent over three years.
Despite average or lackluster returns, investors are still pouring money into alternatives, led by rich individuals, pension funds, endowments, family offices and sovereign wealth funds. It took more than 20 years for the world’s largest alternatives managers to build their assets to a collective $420 billion, which happened in 2009, according to Goldman Sachs Group Inc. It took just four years to double that figure to $835 billion. Chris Geczy, a finance professor at the University of Pennsylvania’s Wharton School, says institutions should continue to allocate a portion of their money to alternatives.
Diversification
“I would argue that the percentage for almost everyone should be larger than 10 percent,” he says. “Making these sorts of moves could have a benefit in terms of enhanced diversification.”
Investors are particularly drawn to real estate. In a May survey by researcher Preqin Ltd., 82 percent of asset managers said client appetite for real estate investments grew in the prior year. Two-thirds said they planned to plow more capital into property in the 12 months after May than they did in the previous 12 months. Real estate investments were dragged down by the subprime mortgage meltdown that set off the financial crisis, with housing prices in the U.S. plummeting 35 percent from their 2006 peak to the 2012 trough, according to an S&P/Case-Shiller index that covers 20 cities. With increased demand and a lack of new supply, the index has since gained 26 percent as of mid-July.
‘Quick and Easy’
“We’ve had a lot of quick and easy gains, given the fact that values fell so dramatically,” says Michael Hudgins, a real estate strategist at JPMorgan Chase & Co. in New York.
For U.S. investors, the biggest attraction of REITs is their dividends. REITs, in exchange for paying little to no corporate income tax, are required by the Internal Revenue Service to pay out at least 90 percent of their taxable earnings to shareholders.
“You get a pretty attractive dividend yield, and, on top of that, in an economic expansion you’re going to get growth in that dividend stream,” says David Wharmby, a managing director at Hartford, Connecticut–based Cornerstone Real Estate Advisers LLC.
The dividend yield of the FTSE NAREIT All Equity REITs Index was 4.43 percent at the end of 2013.
What worries some analysts is that REITs are returning to their pre-2008 habit of funding purchases with debt. Taking advantage of Federal Reserve benchmark interest rates near zero, REITs borrowed 40 percent of their investment funds in 2013, according to NAREIT. Issuance of commercial mortgage-backed securities doubled to $80 billion in that year.
Debt Finance
“I’m hearing more companies funding their activity purely with debt and counting on cash-flow growth to handle their deleveraging over time,” says J. Scott Craig, a fund manager at investment firm Eaton Vance Corp. in Boston. “I don’t think that’s a healthy development.”
From 2009 through 2011, it was commodities — metals in particular — that helped make the alternative markets sing, as China filled its warehouses with copper, zinc, aluminum and steel to support its building boom. With China’s growth slowing, demand for metals has waned and so have returns to investors. At the same time, steady global growth has eroded gold’s allure as a haven and suppressed its once highflying price, with returns from gold investments down 3.6 percent for the three years ended on March 31 and 19.5 percent for one year.
“There is not much interest in gold as U.S. economic conditions improve,” says George Gero, precious-metals strategist at RBC Capital Markets LLC in New York.
Commodities Fall
Globally, commodities investors on average lost money during the three years ended on March 31 and eked out a 1.1 percent gain in the one-year period, according to the S&P GSCI Total Return Index. The outlook isn’t improving: Commodities are poised to fall 5.5 percent in the year ending in June 2015, Jeffrey Currie, head of commodities research at New York–based Goldman Sachs, wrote in a June 23 report.
“We see significant downside for agriculture and precious metals,” he wrote. Notwithstanding the turmoil in Iraq, one of the world’s largest oil producers, Currie doesn’t predict a sharp rise in petroleum prices either.
Investors in some agricultural commodities have done well in the past three years — and none better than those who put their money into pigs. Contracts to buy and sell lean hogs, the source of the majority of pork in the U.S., delivered a 56.3 percent return in the year ended on March 31, with gains driven by a drop in supply as a diarrhea-causing virus killed pigs in at least 27 states. Over the three-year period, lean hogs produced an annualized return of 11.5 percent.
Antique Cars
Wealthy investors who missed the spike in pig prices could have profited from investing in classic cars. The Historic Automobile Group International TOP index ended 2013 at an all-time high, with 21 percent gains for one year and 40.7 percent over the three years ended on March 31. Big sales in the past year included a record-setting $29.5 million for a 1954 Mercedes-Benz W196 Grand Prix race car and $10 million–plus price tags for a slew of Ferraris from the 1950s and 1960s. Bonhams, the British auction house where the hammer fell to conclude bidding on the Mercedes, says it went to an unidentified private buyer bidding by telephone. The silver racer was driven by Formula One legend Juan Manuel Fangio, who died in 1995.
“If he were here today, Fangio would shake his head and smile his slow smile” at the car’s price, says Doug Nye, a racing historian in England. “He was a humble man.”
Wine Loses Value
Among other exotic alternatives, rare coins rolled out gains of 13.2 percent over three years. One 1583 British gold piece appreciated 22.9 percent. Stamps produced single-digit percentage gains, and collectible wine on average lost value, including a 9.6 percent decline in the three years ended on March 31.
Investors fortunate enough to hold on to bottles of wine from Chateau Pavie in the Bordeaux region of France, however, saw gains as high as 24.1 percent in the three years. During a June auction in The Bowery Hotel in New York, the 1982 vintage of Chateau Mouton Rothschild, from Bordeaux, sold for more than $1,000 a bottle. A single bottle of Henri Jayer Echezeaux, from Burgundy, sold for $4,014.
On a larger scale, no alternative investment category is more vigorous than private equity. Wealthy families and institutions poured $454 billion into private-equity funds in 2013, and public pension funds are still well below their 7.8 percent average target asset allocation to the industry, according to data provider Preqin.
Rush Into PE
“I’ve never seen so many investors enter the private-equity space,” says Antoine Drean, chairman of Triago SA, a Paris-based group that helps private-equity firms raise money. “We are seeing a lot of appetite.”
Much of that investment is cash recycled after payouts. Distributions to limited partners in buyout funds totaled more than $1 trillion from 2011 to 2013, according to Preqin, as firms took advantage of rising stock markets to sell their companies, a process known as exiting. For publicly traded private-equity firms, money earned from exits has flowed through to stockholders as dividends, fueling a surge in share prices.
Blackstone shares more than doubled from 2011 to 2013, and in December 2013 surpassed the $31-per-share IPO price for the first time since 2007, when the firm went public. Black’s Apollo, which went public in 2011 at $19, closed out 2013 above $31.
“The exit environment is incredibly robust, and that’s been the key driver of performance since 2011,” says Adam Goldman, co-founder of Red Rocks Capital LLC, which manages $1.5 billion in publicly listed private-equity vehicles.
Dry Powder
The same forces propelling markets are also raising prices for companies private-equity firms want to buy. Dry powder — buyout money that has yet to be deployed — stood at a record $1.16 trillion as of June 30, according to Preqin.
“Prices are very high,” Black said at the Milken Conference. “It’s still not a robust environment for private equity. We are continuing to sell more than we are buying.”
The combination of too much dry powder and a great deal of demand has created a dilemma for executives such as Blackstone President Tony James, whose firm manages a total of $279 billion in alternative investments. He says Blackstone has been turning away money because the New York-based firm can’t find prudent ways to spend it.
“It tears us up to see all that unsatisfied demand go to our competitors,” James said on a July conference call with media and investors.
It’s a conundrum that few observers would have predicted when the engine of finance was flying apart five years ago.
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