Friday, November 1, 2013

The Federal Reserve Is Thinking Deeply About its Portfolio: Are Public Funds?


The Federal Reserve Is Thinking Deeply About its Portfolio: Are Public Funds?

I have some questions for public fund CIOs who are pushing their funds into alternative investments because they’re worried that their bond portfolios are going to perform poorly as interest rates rise.  Before I get to the questions, let me stipulate that you’re not allowed to ask your alternative managers the questions because you know how they’ll answer them even before I pose them.  No matter the question, alternative managers are going to tell you that they can make money.  At a 1.5% or 2% management fee along with the potential for 20% profits, who wouldn’t reassure clients so that the capital commitments continue to flow to alternative managers?
 
Due Diligence List (1999)
Here is the big question.  How do you think your hedge funds, private equity, and real estate managers are going to perform as the Federal Reserve normalizes its balance sheet over the next 5 to 7 years and raises interest rates?  To give you an idea of how the investment environment might change, I suggest you read “The Federal Reserve’s Balance Sheet and Earnings: A primer and projections”[1] by Carpenter, Ihrig, Klee, Quinn, and Boote, who are economists at the Federal Reserve. 

The economists lay out a series of scenarios by which the Federal Reserve shrinks its balance sheet of treasury and mortgage backed securities from $4 trillion to about $2 trillion, while fed funds (short-term rates) rise from nil to 4% to 6%, and the ten-year treasury climbs from 2.5% to 5% to 7%.  Obviously, the interest rates forecast is only a guess, but the fact remains that by one means or another the Fed balance sheet will go on a diet.   Since the Fed is continuing to buy about $85 billion worth of bonds per month, its balance sheet might grow by another $0.5 trillion before the Fed’s purchases come to an end.

I’d suggest you and your head of private equity ponder the following.  For the past thirty years, which is nearly the entire history of private equity, interest rates have generally declined.  Thus, leverage has been kind to PE with a couple of relatively brief exceptions.  In addition, declining rates have enabled many PE managers to repeatedly refinance their portfolio companies before exiting.  What are your returns going to look like if interest rates are rising?  What kind of exit multiples do you think your managers will generate if subsequent owners find their financing costs rising?  Do you think PE firms can wring out enough operating improvement in their companies to overcome rising rates?  Are you sure you really want to make a largely irrevocable 8 to 10 year commitment to PE?  These questions need to be posed with your head of real estate as well.

It’s time to call your head of hedge fund strategies into a meeting.  Obviously, some hedge fund strategies, such as distressed debt, don’t use much leverage.  However, what’s going to happen to the ability of your hedge fund managers to leverage their portfolios?  What are the higher costs of borrowing going to do to their returns?  What are higher rates going to do to the cost of hedging, whether it’s a short book of equities or credit?  If the hedge fund manager is some type of market timer, you might want to ponder whether your manager will be able to unwind his positions before the investment environment shifts.

The road ahead for conventional fixed income isn’t going to be easy.  As interest rates rise, bond portfolios are going to be buffeted and are likely to put a drag on the returns generated by public pension plans.  The minutes of investment committees from North Carolina to California reflect this concern.  However, there’s not much discussion around the expected behavior of alternative investments as the Fed eventually shifts course. 

Financial markets are hugely powerful and drive the vast majority of returns in every asset class.  For thirty years lower interest rates underpinned the rise in the value of financial assets from private equity to hedge funds.  This era is coming to a close.  The Federal Reserve is thinking deeply about its extraordinarily large portfolio. Public funds need to do the same thing, especially as they continue to shift into alternative investments.



[1] http://www.federalreserve.gov/pubs/feds/2013/201301/revision/201301pap.pdf

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