Hedge, private equity funds head for rocks

-- James Saft is a Reuters columnist. The opinions expressed are his own --

LONDON (Reuters) - That whole "make money in any market" thing isn't necessarily working out to the advantage of the hedge fund and private equity industries.

And it's not just them: a forced deleveraging and potential global recession mean the whole range of alternative investments, including real estate and commodities, are very vulnerable and should do substantially worse than plain vanilla stocks and bonds.

The common denominators are dependence on borrowings and high sensitivity to the overall rate of economic growth. If we have, as now seems more likely, an extended recession combined with a sustained sell-off of assets by highly indebted holders, the suffering in the alternative community will be profound.

"We are going through a massive never-seen-before deleveraging across the financial system which will push us into a total meltdown; we already have a partial meltdown," said Jan Loeys, head of global asset allocation at JP Morgan Securities in London.

"Hedge funds are getting hurt -- they are leveraged organizations like the banks. Private equity is going through their own funding problems -- they don't get runs on private equity like the banks but you'll see a large number of private equity deals go bankrupt."

In the event of a deep recession Loeys sees a blended portfolio of private equity, hedge funds, real estate shares and commodities losing eight percent in the coming year, against a one percent positive return for a typical mixture of equity, bonds and cash.

The growth of alternative investments has been phenomenal in recent years, and highly correlated with the overall growth of debt in the global economy. It has produced some outsized returns for investors, huge paydays for practitioners and been a big source of revenue for banks and the entities formerly known as investment banks. More than $5.6 trillion is committed to alternative strategies, according to JP Morgan estimates, a growth of more than 50 percent in a little over two years. But that is now coming unstuck.

Hedge funds are down 12 percent thus far this year, according to JP Morgan, and though transparent data is not available for private equity, if anything returns will have been worse. Real estate is obviously a disaster and commodities, which were flying high at midyear, are now 4 percent down in 2008. The key is the great deleveraging now underway.

The bursting of a debt bubble has had three very important consequences for alternatives. First, borrowing is hard to do and more expensive. The more you need it, the worse off you will be. Second, everyone is trying to sell assets at the same time. This drives prices down and murders forced sellers. Third, the real economy is taking the strain. That is hurting demand for commodities, real estate and the things and services provided by companies owned by private equity.

WHAT IS THE MODEL?

The leverage hedge funds depend upon to magnify returns -- indeed to make many strategies viable -- is harder to come by and more expensive.

And, stung by a truly awful year, hedge fund investors are asking for their money back at an extremely uncomfortable time. Quarter ends, such as the one just past, represent one of the few times that hedge fund investors can get their funds out. If a lot of investors ask for their money at the same time, as many predict, hedge funds all become sellers into a market with very few bidders.

Since 1995 returns in private equity have outperformed public equity by 4 percent a year, according to Cambridge Associates. There is disagreement about why that happened: private equity types maintain their management was adding value, but surely the combination of huge borrowings and a rising asset market, driven by the same huge leverage, was the prime driver.

Now of course leveraged money is expensive and scarce and the initial public offering market, the preferred means of selling on private equity investments, is moribund.

But what is truly scary is not the rate of return private equity may make on new deals -- that may work out well enough if prices are low -- but the risks to existing ones.