It's not denial. I'm just selective about the reality that I accept.
Bill Watterson, author of Calvin and Hobbes cartoon series
Further, down markets present problems that require expertise many current fund managers do not have because they were set up to take advantage of the long bull market in credit and assets. Many private-equity and hedge fund managers were experts at financial engineering, deal structuring and bull market-oriented exit strategies such as the quick flip, but they are not as experienced or nearly as capable when it comes to workouts, distressed situations, minimizing losses and slowly recovering value in a bear market environment.
This lack of capacity to deal with problems has been made even worse by managers as they try to cut overhead costs by reducing staff because they are not making new investments. Many investment managers are now trying to handle hundreds of millions or even billions of dollars of distressed real estate and corporate buyouts with only a skeleton staff. This is nearly impossible to do correctly and is clearly not in the best interests of the limited partners in these funds. Another operational problem facing managers is that they often have several different funds with completely different sets of problems that they are trying to manage at the same time with limited staffing and internal expertise. The problems with a real estate fund are completely different than the problems with a corporate-buyout fund or a credit strategies fund. In the current environment, managers are focused on their survival and not likely to pay close attention to the unique problems facing each of their multiple funds with completely different strategies in different asset classes. Human nature will lead managers to focus on what makes money for them, which at this point is raising a new fund because the carried interest in the old funds is wiped out and does not have any realistic chance of ever being worth anything. Unfortunately again, for their current limited partners, none of this behavior by the manager is going to help them maximize recovery of their investment in the current funds that are distressed.
Many limited partners are very frustrated with the performance of their investment managers, but they are reluctant to do anything that would create a hostile situation and try to remove the manager by force. However, a change of management doesn't need to be hostile. Limited partners can raise these operational issues facing managers and suggest that supplementing their expertise and staffing with either a co-manager or a subadviser would benefit all parties.
The limited partners could feel that there is an independent group with new expertise looking out for their interests, and the existing manager will be relieved of some of the work and responsibility for dealing with the problem funds. In some cases, the current manager may want to exit entirely to pursue other opportunities and would welcome handing off the responsibility of liquidating a troubled investment fund to another group that is acceptable to the limited partners. Limited partners need to start thinking more creatively and strategically if they expect to receive any significant liquidity from their investments in illiquid hedge funds and private equity in the short term. In the long term, it may be many years before the value of private equity and hedge fund investments start to recover any significant value. Hoping that the real estate or corporate buyout market recovers in two years, even if the economy turns around, is not realistic. The last down cycle lasted more than six years, and our current economic situation is even worse.
Some of these investments could never recover value because there was just too much leverage involved. Limited partners need a plan to either change or supplement existing management in these troubled funds if they want to be assured of having the best chance to recover value from their investments. This would also create an orderly transition between the current management structure and a new one that is focused specifically on recovering value for investors rather than maximizing profit and minimizing costs for the fund manager.
As far as publicly traded fund managers such as Blackstone, Och-Ziff Capital Management Group ( OZM) and Fortress, their stock prices already tell the story of what is happening to their businesses. Although their executives talk publicly about how this is a great environment for them to make new investments and they will be back stronger than ever in a few years, the evidence does not exist to support those statements. These companies should not be public at all, and will probably be taken private again by the principals at fire-sale prices at the bottom of this bear market. As a public shareholder of this business, you are really just making a bet on the return of expansionary credit and asset appreciation. You can make this bet in many other ways without paying the hefty fees that these managers charge their investors or being diluted by the enormous compensation that they pay their executives. Investors are better off buying an S&P or Russell index ETF such as the S&P 500 Depositary Receipts ( SPY), which holds shares in AT&T ( T), Exxon Mobil ( XOM) and Procter & Gamble ( PG). Another choice is the iShares Russell 2000 ( IWM) ETF, which holds shares in Waste Connections ( WCN) and Myriad Genetics ( MYGN). If you believe the real estate markets will recover, you may even consider the REIT index ETF such as iShares Dow Jones US Real Estate ( IYR), which owns shares in Vornado Realty Trust ( VNO) and Equity Residential ( EQR).