The plight of permanent capital

Permanent capital vehicles have been touted as a solution for alternative asset managers seeking stable long-term financing. However, the market has all but closed to new business, prompting deal sponsors to rethink the way these vehicles are structured and marketed. Rachel Wolcott investigates

Alternative investment managers thought their prayers had been answered. When some firms started listing closed-end funds to access so-called permanent capital, which allows them to extend the duration of their funding to near perpetuity, it looked like a solution they all could use. It isn't.

While several alternative managers have successfully raised funds through the equity capital markets, other well-known players have had deals fail in the initial public offering (IPO) process. Permanent capital vehicles have become more difficult to market, and there hasn't been as much success attracting institutional investors as was originally hoped. This has forced bankers to concede that they may have to rethink the concept.

"Opportunities exist, but we need to put on our thinking caps and develop ways to structure these vehicles to make them more attractive to institutions," says Craig Coben, managing director in European equity capital markets at Merrill Lynch in London. "A lot of the vehicles that have gone out have met with resistance from institutions because the deals were more of the same and there haven't been any innovations."

The market has more or less ground to a standstill, prompting bankers to look for ways to address some of the structural issues that have hampered performance and discouraged investors - for instance, fee structure and cash or investment drag (where the funds that have been raised cannot be invested quickly enough). Distribution is another issue, and new investors are being sought beyond the high-net-worth clients most vehicles have so far targeted.

Closed-end funds are not a new product. Unit trusts have existed in the UK for more than 100 years. Real estate and private equity vehicles have been listed for some time, and more recently, hedge funds and structured credit investors have looked to carve out parts of their businesses and then list them through IPOs. As alternative asset managers have realised the potential of closed-end funds to deliver permanent capital, interest in the asset class has swelled. Approximately 19 vehicles have been listed over the past two years (see box).

The attraction of listing is that it allows managers to lock in capital, without being forced to liquidate positions because of investor redemptions. For alternative investment managers looking to put on longer-term trades in illiquid assets - such as private equity or real estate investments and, increasingly, infrastructure players - permanent capital is a better way of matching assets and liabilities.

Tapping into institutional investor money is another reason alternative managers are using listed funds. Their transparency and potential liquidity can make closed-end funds a convenient asset allocation tool for institutional investors, say bankers. But, with the exception of firms such as KKR Private Equity Investors (KKR PEI), few institutional investors have looked at permanent capital vehicles. Of those that have, many have been hedge funds - not the buy-and-hold investors issuers wanted to reach.

Some banks are using their high-net-worth client networks to distribute deals - but that segment is becoming saturated with the product, say market participants. "More of these deals are being brought to market and investors have a lot more choice," says Ed Matthews, managing director in UK corporate broking at Lehman Brothers in London. "As a consequence, investors can be a lot choosier about where they put their money."

Given the number of vehicles already listed, many investors would need to either sell a position in an existing vehicle or allocate new cash to the strategy in order to buy into a new deal, says Matthews. However, it's not just the number of new listed funds that has dampened the market. Investors have identified some structural problems that affect these vehicles - in particular, the lack of secondary market liquidity, investment drag and fee structure - which has caused many of them to trade at a discount to net asset value (NAV).

Nonetheless, there are some hugely successful permanent capital vehicles in the market. Foremost among these are London-based Cheyne Capital's Queen's Walk, which launched in December 2005, raising EUR406 million. The fund invests in first-loss pieces of asset-backed securities (ABSs) - primarily in the residential mortgage-backed securities (RMBSs) sector. Since launch, Queen's Walk has increased its target dividend by 20% and posted a 12.6% increase in net income for the third quarter of this year.

Two fund-of-hedge-funds vehicles have also performed well, despite recent adverse market conditions. In July, New York-based Goldman Sachs Asset Management's Goldman Sachs Opportunities fund raised $507 million, while Zurich-based CMA Group's CMA Global Hedge raised $402 million. Both these deals benefited from being able to distribute through high-net-worth investor networks.

There have also been successful IPOs from London-based Wharton Asset Management's Trio Finance, which raised $100 million for real estate investments in May, and London-based Washington Square Investment Management, which raised EUR50 million in April through its Carador fund - a vehicle that invests in collateralised debt obligation (CDO) equity (Risk May 2006, page 8).

However, several deals have fared less well and are now trading at discount, while others never made it to market. London-based Cambridge Place Investment Management's permanent capital vehicle Caliber Global Investment completed its IPO in June 2005 and raised an additional $100 million in May this year, as well as securing another $250 million in new funding, according to the fund's third-quarter trading statement. However, the fund, which debuted at just over $10 a share, is now trading at $8.20, a 31% drop from its high of $12.05 in August last year.

Caliber's third-quarter results state that the fund, which invests in ABSs with a focus on RMBSs, sold a number of investments that resulted in a net loss on investments of $1.27 million. According to the earnings statement, the majority of losses stemmed from the sale of a single sub-investment-grade RMBS secured on second-lien mortgages.

But not all Caliber's problems have been due to portfolio performance. Market participants say the $100 million secondary offering barely scraped through because of lack of investor interest. What really caused problems, however, was when Cambridge Place tried to raise more cash through another vehicle, called Crownstone.

That deal, which was supposed to go public in June through Morgan Stanley, Goldman Sachs, Citigroup and Deutsche Bank, intended to invest EUR1.28 billion in a portfolio of European real estate, comprised primarily of commercial properties. The deal was not completed.

"When Cambridge Place announced Crownstone, Caliber was trading at a premium to NAV, and when they pulled Crownstone it was trading at a 10% discount to NAV," observes a senior equity capital markets banker. "The market was furious at those banks for bringing Crownstone to market." Cambridge Place declined to be interviewed for this article.

Crownstone is far from the only permanent capital vehicle to fall flat. Other real estate offerings have failed to find an audience, including at least three seeking to invest in eastern European and Russian real estate. Structured credit vehicles from Faxtor Securities, Gulf Bank International, Mezzvest and Cairn Capital have all stalled. Private equity house Blackstone was forced to pull a deal, while Apollo's private equity listing was ultimately completed on a private basis.

Market participants say the investor base for listed private equity has been saturated by New York-based private equity behemoth KKR's first fund, KKR PEI, which had its IPO in May this year, raising a massive $4.8 billion. The fund is now trading at a 5.5% discount to NAV, weighed down by investment drag and fee structure.

London-based investment bank Cazenove initiated its coverage of KKR PEI in July, labelling it 'under-perform'. Cazenove cites a number of factors as potentially contributing to the fund's under-performance, including fees, cash drag, high current prices for new investments and potential conflicts of interests between KKR and KKR PEI. For example, KKR could keep the best investments for itself, or the fund might be encouraged to invest in other KKR funds for which it would pay fees. In its July 11 report, Cazenove points out that, under the current fee structure, the fund's NAV could fall overall, yet KKR PEI could still pay performance fees to KKR on some of its categories of investments. The fund traded at $22.74 when Risk went to press, down 9% from $25 when it listed in May. KKR declined to comment for this article.

Prodesse, launched by US-based registered investment adviser Fidac, is another fund that has experienced difficulties. Strategy-related performance problems caused by US interest rate policies have weighed on this vehicle, prompting its management team to take steps to shore up its investor base. The fund listed on the London Stock Exchange in April 2005 at $10 and raised $268 million to invest in US agency mortgage-backed securities. In November 2005, Prodesse converted its listing to be quoted in sterling. As of August 15, its stock was trading at 362.50 pence. Fidac charges a 0.2% management fee a year of the value of the gross assets of the company.

"If you look through the various cycles we've been through in the past 12 years, you'll see our returns. If you look in the short term, they haven't been too good," admits Ron Kazel, New York-based director at Prodesse. "The fund's been trading at or near NAV, sometimes at as much as a 10% discount but probably more at a 5% discount. I think over time, Prodesse will be valued on its income stream. The dividends that have been paid out so far have been reduced, and that's affected the share price performance."

Kazel emphasises that Prodesse's performance has been adversely affected by a flattening yield curve in the US and an aggressive rate rising stance by the US Federal Reserve: "We are very much an income strategy, so people who hold on to our strategy through multiple interest rate cycles are going to see the full power of our returns."

When originally marketing Prodesse, Fidac targeted income-orientated institutional investors and the high-net-worth segment. What they ended up with was a little different. "We had a lot of hedge funds and short-term investors that looked at the near-term performance of Fidac and thought this was a cheap way for them to play it," says Kazel. "Then the market for our strategy changed, so that premium compressed along with our dividend. We had these more aggressive, short-term investors who weren't getting the returns they expected."

Now Kazel is concentrating on shifting the Prodesse investor base to long-term investors, including blue chip UK-based money managers and mutual funds, through ongoing marketing. The fund has also repurchased 1,725,000 of its shares in the second quarter of this year. Prodesse is being marketed as a counter-cyclical strategy to other equities and as a fixed-income surrogate. While this approach has had some success, investors are giving mixed feedback.

"Investors must have a strong view on the direction of the US economy and the way interest rates are going in order to elect to invest in Prodesse," says Kazel. "With interest rate policy being volatile, our performance is directly affected. Some investors are on the same page and realise this may take a little bit longer."

Washington Square Investment Management, which launched its Carador fund in April, has taken a unique approach to the listing process. It began by raising a comparatively small amount - EUR50 million - that it could quickly invest in CDO equity positions. The fund has already reduced the target time for investing from between nine and 12 months to six months.

"If I had a target to raise EUR200 million with Carador, that's a (sizeable) amount to invest in the CDO equity market," says Miguel Ramos, managing partner at Washington Square. "It's more efficient to do reopenings and raise EUR50 million or EUR100 million, so that basically you are investing quicker and you are giving investors more visibility about investments and a more efficient ramp-up."

On the negative side, a smaller size means the fund has less liquidity in the secondary market, but Ramos emphasises that the vehicle should be viewed as a medium- to long-term strategy. In any case, Ramos reports that there has been some secondary market liquidity, albeit sporadic, and the fund is beginning to see more institutional interest. The fund launched at EUR1 a share and was trading at the same price at press time, having experienced minimal volatility.

Carador's management has been active in the marketing process to ensure the fund was sold to long-term real-money accounts that would bring some stability to the fund. In the marketing phase, Ramos approached pension funds, insurance companies, family offices and a few banks.

"We took the process in our own hands. We got support from the sponsor bank, but we wanted to talk to investors directly to find out their motivations and concerns," says Ramos. "In some cases, it took six months working with an investor to get them to invest, but the end result is we have a very stable investor base and good insight into their processes and rationale for investing."

CMA Global Hedge was one of the last deals to get completed. This vehicle was sold mainly to high-net-worth investors through EFG International, a global private banking group based in Zurich. Sabby Mionis, chief executive of CMA Global Hedge, views the vehicle as a way for retail investors to access funds of hedge funds.

"We believe this is the way hedge funds will come to retail investors in the future," says Mionis. "It's easy for institutional investors and very high-net-worth individuals to access hedge funds, but the future is with retail, mass affluent investors. This vehicle, with its low minimums and liquidity, helps European investors get into funds of hedge funds."

Launched in July, CMA Global Hedge has already invested 85% of its assets in 34 hedge funds, and the balance is likely to be invested within the next two months. The fund charges slightly lower fees than the typical fund of hedge funds - 1.25% and a 5% performance fee, rather than the usual 1.5-1.75% management fee and 10-20% performance fee.

Another feature that distinguishes CMA Global Hedge from other funds of hedge funds is that Mionis and his partner Angelos Metaxa have each invested $20 million to align their interests with their investors. The fund is also using 100% leverage to boost returns. As of August 15, the euro-denominated version of the fund was trading slightly down from the EUR10 IPO price at EUR9.65.

Funds of hedge funds appear to be well suited to the closed-end fund format, especially when managers are able to deploy their assets quickly and reduce fees. However, not all managers have this ability. Issues such as cash drag, high fees and the challenge of finding the right investor base have bankers wondering whether permanent capital vehicles are feasible for all their clients that want to use them.

"We don't have a mature investor constituency for permanent capital vehicles," says Merrill's Coben. "We banks have to put our thinking caps on and develop better structures, and investors need to take a more long-term and discriminating view of these instruments."

Expectations for permanent capital vehicles have therefore been greatly lowered. With a number of deals failing to launch and others floundering in the secondary markets, it seems permanent capital vehicles only have a future among the best managers offering investment strategies suited to the format. Based on the success of Goldman Sachs Asset Management and KKR, having a brand name also helps.

Nonetheless, there are still a number of permanent capital vehicles in the pipeline, including deals from London-based hedge fund Rab Capital and Morgan Stanley's asset management arm. The kinds of deals that meet success will set the tone for the size and scope of the market in future. Unless asset managers and their bankers find a way to overcome the problems that have taken the shine off this market segment, permanent capital vehicles will remain an option only for the few.

SIZE OF THE CLOSED-END FUND MARKET

- Hedge funds. Currently approximately 30 vehicles representing almost $7 billion in market capitalisation globally, of which almost $4 billion is London listed and almost $3 billion is Swiss listed.

- Private equity and infrastructure. Sixty listed private equity funds representing a total of approximately EUR56 billion market cap globally. Australia's Macquarie alone has A$18 billion ($13.8 billion) in listed infrastructure funds.

- Structured credit and mortgage Reits. More than 45 mortgage Reits and structured credit vehicles globally with more than $45 billion market cap, of which $3 billion is listed in Europe.

- Real estate investment trusts. $468 billion listed globally.