Friday, July 31, 2015

Carlyle Co-Founders Warn on Frothy Valuations, Hedge Fund Underperformance

Carlyle co-founder Bill Conway stated in their recent Q2 earnings call:

The question on everyone's mind is probably why aren't you investing more money? We invested $1.6 billion in our carry funds from the second quarter; we are slightly more than half of that amount outside United States. So far this year we have invested about $3.1 billion. Let me put this investment pace into perspective. Over the past eight years we have invested about $79 billion in our carry funds averaging almost $10 billion per year, which is approximately what we invested in 2014. Our annual investments have ranged from high of $14.5 billion in 2007 to a low of $5 billion in 2009.

There are several factors driving this year's cautious investment pace. Most importantly we think prices in many assets classes are high. Our caution is further driven by uncertainties in Greece, fluctuations in the Chinese stock markets, continued high levels of leverage and a significant movement in energy prices. Also, with corporations struggling to find growth, they have turned to M&A to meet revenue targets while private equity activity has remained relatively muted. 

We believe current conditions will service catalysts for the next round of buying opportunities and while we cannot predict when all these opportunities will present themselves, the breadth of our platform and our dry powder positions us to take advantage when the time comes.
Conway recall the warning signs leading to the 2008 financial crisis.  Carlyle lost their hedge fund Blue Wave Partners due to poor returns and redemptions  Here's what Carlyle chiefs said about hedge funds in the recent analyst call:

Unfortunately, our significant hedge funds were down about 4.3% in the quarter.  

However, management fees from our hedged fund in investment solutions businesses are in total down about $19 million from Q2 of last year due to net redemptions and foreign exchange.

The decrease in distributable earnings primarily reflects a $19 million decline in fee related earnings as a result of lower management fees of $10 million from our hedge fund partnerships and $9 million in higher fund raising expenses associated with raising our second energy mezzanine fund which is not yet commenced management fees.

And our significant hedge funds largely remain below the high water marks and therefore are not contributing any meaningful group performance fees in 2015 as they did in the first half of 2014.

JP Morgan analyst Ken Worthington mined this concern:

Just on the hedge funds, the AUM decline this quarter and seems poised maybe to decline further in coming quarters. I guess first as you see it what are the issues? Obviously there have been some performance problems but is there maybe a greater issue with regard to either oversight or ownership structure or even management selection of purpose. Two, is there something that US managers need to or maybe are able to address here and then three, how do you return that the hedge fund specific operation kind of back to growth? Thanks.
 Conway replied:

I think that the -- it has been volatile and tough environment generally for investing. Sometimes I look at them and I wondered how it can be so low based upon all the volatility I see in the market. I don't think there is any kind of systematic problem with regard to our oversight or the job of the people running the hedge funds are doing or governance or anything like that. Obviously the hedge funds particularly Claren Road; they had a tough time in the first half of this year. But they do have a long track record of strong risk adjusted returns, very a proven team that's been doing the job, same people that when we initially acquired 55% of the business. We are working closely with them to sustain and restore the confidence that their investors have had with them for more than a decade, hopefully we and they will be able to do that. But I don't see it as a systematic problem or anything like that.
Carlyle's hedge funds made the wrong bets in all the volatility. Blue Wave Partners and Carlyle Capital Corporation were the canary in the coal mine that became the Fall 2008 financial crisis.  A hedge fund advisor recently suggested investors redeem their Claren Road investments.

FinAlternatives reported on a Carlyle commodity hedge fund that's virtually disappeared due to high redemptions

The founders of Carlyle’s Vermillion Asset Management hedge fund unit have left the firm amid steep losses and investor redemptions in its flagship commodities fund.

Chris Nygaard and Drew Gilbert, who founded Vermillion in 2005 and sold 55% of it to Carlyle in 2012, parted ways with Carlyle at the end of June, according to The Wall Street Journal

The firm’s Viridian commodity hedge fund, which trades oil, metals, and agricultural products, lost 23% in 2014, which touched off a wave of redemptions that brought assets in the fund from nearly $2 billion to under $50 million.

When asked how to grow Carlyle's hedge fund business Conway replied:

The best and the most -- the best way to grow is to have the hedge fund perform. Hedge funds perform, they can grow themselves. People want to be in their funds. I mean hedge fund like Claren Road it had some redemptions. A year ago they were turning money away. I think they turned away $1 billion a year ago because of -- they just didn't feel that they had the market conditions or the right opportunities to put that money to work. And so these things can turn pretty quickly in terms of what might happen. But the things that were causing to turn are performance. You perform, people are happy; they give your more money. You don't perform, the opposite happens. 
Will there be another Carlyle Group hedge fund run?  Investors may want to add cash like Carlyle to position themselves for the next round of buying opportunities.   

Update 8-1-15:  After shrinking a $1.7 billion hedge fund to less than $50 million, Carlyle chiefs dangled a new pot of gold for investors.  “We are successfully repositioning our commodities business, particularly in commodities finance, to capture an enormous global opportunity.”