Global Investor 1.15, May 2015 Expert know-how for Credit Suisse investment clients INVESTMENT STRATEGY & RESEARCH

Illiquid assets

Unwrapping alternative returns

Roger Ibbotson Are investors rewarded or penalized for holding illiquid stocks? Sven-Christian Kindt Exploring the upside of new illiquid ­alternatives. Alexander Ineichen Hedge funds overcome recent challenges. Carol Franklin Trees ­represent a growth opportunity for the patient investor.

Important information and disclosures are found in the Disclosure appendix Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Credit Suisse may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For a discussion of the risks of investing in the s­ ecurities mentioned in this report, please refer to the following Internet link: https://research.credit-suisse.com/riskdisclosure

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Photos: Martin Stollenwerk, Gerry Amstutz

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Responsible for coordinating the focus themes in this issue: Oliver Adler is Head of Economic ­Research at Credit Suisse Private Banking and Wealth Management. He has a ­B achelor’s degree from the ­L ondon School of Economics, as well as a Master in International Affairs and a PhD in ­Economics from Columbia University in New York. Markus Stierli is Head of Fundamental ­Micro Themes Research at Credit Suisse Private Banking and Wealth Management. His team focuses on long-term investment strategies, including sustainable ­investment and global megatrends. ­Before joining the bank in 2010, he taught at the University of Zurich. He previously worked at UBS Investment Bank. He holds a PhD in International Relations from the University of Zurich.

Standard financial theory tells investors to carefully assess the tradeoff between return and risk. Liquidity is a third key consideration. This Global Investor (GI) is about the liquidity and illiquidity of individual assets and overall financial markets. Just as risk and return are uncertain before the fact, so is liquidity. Some assets may appear highly liquid, only for their liquidity to suddenly vanish. Moreover, changes in liquidity often correlate with shifts in risk. As our article on fixed income (page 62) points out, some more exotic bonds become very hard to sell just as their perceived risk increases, and when less liquid assets are pooled in typical (open-end) funds, such difficulties can be amplified (see page 24). This does not imply at all that we would advise against investing in illiquid assets. In fact, assets that eventually generate high returns are very often highly illiquid. Those who invested in Apple, Google or Microsoft when they were small (unlisted!) ventures run out of “garages” garnered huge returns. Apart from private equity, this GI covers a broad range of other more or less illiquid assets – ranging from forests to farmland to infrastructure, and from real estate, the most common of illiquid assets, to the most exotic “passion” investments. We also look at the pros and cons of investing in hedge funds, which are not necessarily particularly illiquid, but where the sources of return are often harder to identify than those of other more visible illiquid assets. Adrian Orr, CEO of the New Zealand Superannuation Fund, known for its innovative investment philosophy, points out (page 26) that even investors with long horizons should gauge the liquidity of their overall portfolio carefully: investments in illiquid assets should be balanced by some that can be easily sold. This rule is of even greater importance for private investors whose investment horizon is ­typically shorter and where the potential for a drastic change in ­p ersonal circumstance (and thus need for liquidity) is that much more pronounced. The temptation of abandoning such caution seems particularly high at a time when both nominal and real expected returns on the most liquid of assets are so meager. Conversely, investors should avoid overpaying for liquidity: Professor Ibbotson (page 10) argues that investors tend to overrate (and thus overpay for) the ­b enefits of owning large cap stocks. The fact that these assets can be traded in almost any circumstance may not only render them more expensive but also prone to excessive price gyrations. In sum: make sure that the analysis of risk and return is complemented with a careful review and “stress test” of the liquidity of assets and ­investment vehicles. Giles Keating, Head of Research and Deputy Global CIO

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THE ALLURE OF ­LIQUIDITY – CURSE OR BLESSING? TEXT MARKUS STIERLI Head of Fundamental Micro Themes Research ILLUSTRATION FRIDA BÜNZLI

What do we know about liquidity? A particular focus of this Global Investor is on market liquidity. By this we mean the presence – or absence – of the ability to sell (liquidate) an asset quickly, without impacting the market price significantly, and without institutional constraints.

Measuring market liquidity For many asset classes, bid-ask spreads are a convenient and straightforward way to measure market liquidity, with declining (tightening) spreads indicating greater liquidity, and vice versa. The spread is simply the cost that you would incur if you were to sell an asset on the market and immediately purchase it back. But, as we will discuss throughout this Global Investor, the concept of market liquidity is more complex than that. To start with, the bid-ask spread is not easy to measure for many assets, such as real estate. Moreover, market liquidity typically varies dramatically

across the cycle. Some assets are highly liquid in the upswing or the top of the cycle, but become less liquid in a downswing. Lastly, instruments matter. For example, closed-end funds can deviate from the value of the underlying ­a ssets, which is bad in some ways, but may also help protect long-term investors. Some vehicles, such as private ­e quity funds and hedge funds, may impose so-called “gates” on their investors to limit redemptions.

Liquidity has many meanings In the wake of the financial crisis, the liquidity of the f inancial system became ­ synonymous with its “lifeblood.” Large injections of liquidity by central banks (the ultimate creators of liquidity) were necessary to save those who “bled”; the provision of liquidity to safeguard the economy has remained paramount ever since. In this context, macroeconomic liquidity does

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kets, as we learn from Yale’s R ­ oger Ibbotson (see page 10), lower turnover stocks actually proved more resilient (and less volatile) during the financial crisis in 2008 than their highly liquid peers.

Bringing it all together not really refer to the availability of cash in the economy, but rather to the smooth functioning of financial markets and thus the economy as a whole. To a financial firm, liquidity refers to the ability to meet its debt obligations without becoming insolvent. While cash holdings (a liquid balance sheet) provide a buffer against losses, the ability to convert assets into cash to meet current and future cash flows – its funding liquidity – can prove critical for survival in the event of stress. Therefore, funding liquidity is now a key r­ egulatory imperative. Nevertheless, central banks ultimately will always need to act as a backstop to commercial banks; as the role of commercial banks is typically to invest clients’ liquidity (deposits) in less liquid assets, they would structurally not have sufficient liquidity to withstand a bank run.

On premiums and risk Investors and firms share a common problem: liquidity risk premiums are hard to gauge, both across different types of assets and over time. Liquidity does not manifest itself in standard measures of risk, such as price volatility. In fact, in normal times, illiquid investments are not necessarily more volatile than liquid ones. Of course, price volatility may simply be hidden because illiquid investments are priced at lower intervals – turnover is itself a definition of liquidity. However, even in ­equity mar-

While the different concepts of liquidity are often treated in isolation, it is essential to try to understand how they interact. We know that liquidity black holes wiped out entire ­markets, such as the junk bond market in the mid-1990 s, and the subprime mortgage ­market more recently. We understand that the deterioration of balance sheets forced banks to cease lending, resulting in a vicious liquidity squeeze that required significant policy intervention to restore confidence so that the financial system could fulfill its most basic purpose. The most challenging part of the liquidity discussion is that it depends heavily on circumstances. The financial crisis was such a profound event that it still has a significant impact on investors’ attitudes toward illiquid investments. Consequently, entire asset classes are being shunned, sometimes unjustifiably, and genuine opportunities will be exited prematurely or missed altogether. In other cases, investors may actually end up paying too much for liquidity. If history has taught us one thing about liquidity, it is that it is often self-fulfilling, and at times a mirage.

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Contents Global Investor 1.15

10

42

Liquidity has its price. But, says Roger Ibbotson, with equities the popular choice has a premium that may be too high.

With dairy farming interests, and over 20 years in asset management, Griff Williams knows plenty about farmland investment.

16

44

Psychology and (il)liquidity

Liquidity trends in illiquid ­alternatives

Amid rising interest in less liquid alternatives, Sven-Christian Kindt points out the reward for sacrificing unneeded liquidity.

18

On doing your homework

If you’ve first done your research, says ­ lexander Ineichen, hedge funds may A bring higher end returns with less volatility.

21

Liquidity – a key to hedge fund performance

It’s a key factor. Marina Stoop examines the role that liquidity plays in hedge funds and for their investors.

24

Open-end versus closed-end funds

The right investment, say Giles Keating and Lars Kalbreier, is a function of the ­underlying asset type and the kind of fund.

26

Attractively consistent

At the helm of the New Zealand Superannuation Fund, Adrian Orr talks about ­patience, opportunity and very long horizons.

30

Talking teak She has branched out. Carol Franklin has a diverse background including language, insurance and plantation ownership.

39

Institutional investment in ­t imberland

It’s not easy going green. Gregory Fleming explains why institutional investors see timberland as a growth opportunity.

Farmland – a fertile investment

Ins and outs of real estate

It’s an illiquid asset, but real estate is ­attracting growing interest. Philippe Kaufmann offers his insights and advice.

48

Infrastructure on the rise

Institutional investors are flocking toward infrastructure. Robert Parker explains why building for the future is a big deal today.

52

Looking beyond liquidity Felix Baumgartner and Patrick Schwyzer reflect on client perspectives of the illiquid asset landscape.

56

In passion we trust

Art, antiques and collectibles: Art Market Research and Development looks at a different kind of alternative investment.

58

From illiquid assets to profitable investments

The European Central Bank is working to restore the European securitization ­market, report Christine Schmid and Carla Antunes da Silva.

62

No exit?

There’s lower and more volatile liquidity in the corporate bond markets. Jan Hannappel outlines the causes and the implications. Disclaimer > Page 65

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Photos: Robert Falcetti

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Roger Ibbotson, founder, chairman and CIO of Zebra Capital Management.

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Liquidity premium

Psychology and (il)liquidity Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend to pay up too much for it while underestimating the extra returns from holding illiquid assets. The o­ verpricing of liquidity seems to be greater in equities than in bonds, in part because in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics. INTERVIEW BY OLIVER ADLER Head of Economic Research, JOSÉ ANTONIO BLANCO Head Global MACS, SID BROWNE CIO and Head of Research Liquid Alternatives

Sid Browne: Economic theory states that there should be a premium available for ­accepting illiquidity. You’ve studied premiums – and associated risks – attached to both illiquid and liquid assets. What can you tell us about your findings in general within a portfolio context? How should institutional and private investors invest? Roger Ibbotson: Let me start off by ­saying that the stocks that I study are actually publicly traded stocks. They may be less liquid than the most liquid stocks, but they’re all liquid stocks. There’s a strong theoretical reason why you’d expect less liquid stocks, in fact less liquid assets of any type, to be lower valued. People want liquidity, and they’re willing to pay for it. They pay a higher price for the most liquid assets, and therefore the less liquid assets sell at a discount. That discount means that, for the same

cash flows, you pay a lower price and ­sub­sequently you get higher returns. Now, what’s especially interesting in liquid markets is that giving up a little bit of liquid­­ity actually can have a surprisingly big impact – by buying stocks that trade every hour, say, as opposed to every minute. José Antonio Blanco: From an investor’s perspective, could you call the effect you’ve just described a risk premium, or is it instead the result of market inefficiency in the sense that investors focus on certain companies and disregard the rest? Roger Ibbotson: It could be both. You can create a risk factor from a liquidity premium. But I am rather thinking of ­something I call a “popularity” premium, which I’ve expanded on in recent papers. The stocks that trade the most are the most popular. And those are the ones

where there is mispricing because they get to be “too” popular, as measured for example by their heavy trading. Interestingly, our measures of stocks that trade less show lower volatility. So these stocks don’t really seem more risky. Therefore I don’t really like calling the extra return a risk premium. Sid Browne: What about in the event of a squeeze, when all of a sudden you want liquidity and rush to sell your illiquid stocks? Isn’t there that flight-to-quality risk? Roger Ibbotson: There could be the risk of having to sell quickly. In actual experience, though, for example in 2008 when you had a kind of a liquidity crisis, it was the most ­liquid stocks that were sold and dropped the most. So even in a financial c­ risis, the less liquid stocks do relatively well compared to the more liquid stocks. Now it is true that it is more difficult to sell the less liquid, and >

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people chose not to sell them. But it is still a fact that their prices fell much less than those of more ­liquid stocks. Sid Browne: So would it make sense to have a very large exposure in your portfolio to these types of stocks? Roger Ibbotson: If you’re a day trader, you don’t want to buy these kinds of stocks because they’re going to have higher trading costs. It really depends on your horizon. If you have a longer horizon, then buying less liquid stocks can make sense. Oliver Adler: Could you discuss the p­ arallels in the bond market, or segments of the bond market, in terms of what those liquidity or illiquidity premiums would look like there? Roger Ibbotson: Well, first of all, bond markets are in the fortunate position of ­having yields to maturity that you can actually see. You know that if the bond doesn’t default, you’re going to get a specific return in that particular currency. And you know it in advance. In the equity market, you can’t see the forward returns in the same way. You only see the result. And since returns themselves are very volatile, it’s hard to discern what the result really is. Moreover, the return measures differ strongly over different periods. That’s why we can debate which ­ of these premiums really exist and how high they are. This is quite different in bond ­markets where maturities are normally fixed. Oliver Adler: Would you say that the stock market gives rise to more irrational behavior in some sense than the bond market? Roger Ibbotson: I’m sure there is irrational behavior in the bond market, too. But yes, there is behavior in the equity market where essentially people are attracted to stocks that trade a lot. And they’ll pay more for them, just as you would do with brands in the consumer market. Consequently, the return structure is going to be different among the less popular and the more popular, and that leads to mispricing. Of course, you’re also going to see mispricings in the bond market, but they may be smaller there and they’re more visible and thus easier to take advantage of. Sid Browne: You’re saying that something could be more popular in the equity market than it would be in the bond market. So Apple stock, for example, could go “hot” and very, very liquid, but the debt, because it’s traded less and because it is a discounted flow of more certain

“What’s especially interesting in liquid markets is that giving up a little bit of liquidity actually can have a ­surprisingly big impact.” Roger Ibbotson

cash payments, would actually not be impacted by this popularity phenomenon. Roger Ibbotson: It could be affected, but it would not be affected by as much because you can see the pricing exactly in a yield spread. And so you know exactly what you’re paying for. José Antonio Blanco: Are you saying that we have more serious information issues in the equity than in the bond market? If you compare two bonds, it’s relatively easy to find the one that is paying too much, or too little. Whereas, for a stock, you might look at the past, but the future is much more difficult to assert. So, as an investor, you tend to grab things that are a bit easier to recognize, like brand names, along the lines “if something is popular, it’s probably better.” Roger Ibbotson: Yes. In the equity ­markets, you can tell stories about the stock. And the stories can be very interesting. And you can pay a lot for stories. That’s why, for e­ xample, value tends to have higher returns than growth. Growth gets highly priced b­ ecause growth ­c ompanies have much more interesting ­s tories than value companies. In the bond market, all these same phenomena may ­exist, but there is more information. It’s much more mathematical. The spreads are visible. Oliver Adler: How about areas like private equity, or hedge funds, where you need a lot of knowledge and can’t easily tell stories? Might it therefore be fair to say that mispricing phenomena occur less frequently here? Roger Ibbotson: Well, mispricing can be pretty frequent in private equity as well because there’s actually less information for the buyer. You need more specialized expertise to understand the specific stocks. Also, in private equity, the presumption is that the private equity manager not only identifies undervalued stocks, but actually changes the company in some way to make it more valuable, perhaps by getting tax benefits, restructuring management or altering incentives. So there are potentially more possibilities for profit if you’re really good at doing that. Hedge funds typically buy publically traded equities or bonds – more or less liquid securities. When you invest in a hedge fund, you are essentially buying the manager who is buying liquid securities. continued on page 14  >

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How Moody’s measures liquidity stress

I

n periods of market stress, investor scrutiny often moves onto lower-rated financial instruments that have been issued with a premium yield level attached. ­C oncerns about the ability of issuers to meet ongoing cash obligations for coupon payments can lead to investor flight from speculative bonds, just at the moment when those issuers most need to shore up their finances to remain in business. Classic examples might be riskier consumer finance companies, smaller oil and gas firms, and heavily leveraged property ­d evelopers. If the stress period persists, such issuers are often unable to raise suffi­c ient short-term debt to maintain their trading ­a ctivities and, if undercapitalized, they may even fail. Defaults in this riskier zone can prove contagious, both because of the effect on other parties exposed to a given sector or deal, and due to the psychological effect on the gener­ al investing public. A vicious illiquidity circle can develop, as occurred in real estate loans in 2008–2009, and may require government intervention and ultimately debt write-downs. Liquidity, a key element of credit analysis

In order to provide additional transparency in its existing liquidity assessment process and arm investors willing to hold speculative-­grade debt against falling foul of rapid shifts in market sentiment, the rating agency Moody’s began assigning Speculative Grade Liquidity

(SGL) ratings in 2002. Loss of access to fund­ ing remains a risk criterion in any assessment. Defining speculative-grade liquidity risk as “the capacity to meet obligations,” SGL s describe an issuer’s intrinsic liquidity posi­tion on a scale of 1 (very good) to 4 (weak). Assignment of a rating is carried out under detailed criteria for measuring a company’s ability to meet its cash obligations through cash, cash flow, committed sources of external cash, and potentially available options for raising emergency cash through asset sales. SGL s are a measure of issuers’ intrinsic liquidity risk – meaning Moody’s assumes companies do not have the ability to amend covenants in bank facilities or raise new cash that is not already committed. Such conditions are not typical in normal market environments, but can occur in periods of economic and credit market stress when companies need liquidity support the most to avoid default. Because Moody’s factors market access and the ability to amend covenants into its longterm ratings, the assumptions utilized in analyzing liquidity are more stringent. One proviso that Moody’s noted from the outset is that liquidity assessments focus on corporate capacity to meet obligations. Willingness to default remains a management issue that is not factored into SGL ratings, but is separately evaluated as part of the longterm ratings analysis. Ratings are dynamic and may be modified ad hoc, as with bond ratings.

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To date, Moody’s assigns SGL ratings to US and Canadian issuers alone, although the framework is used in most other regions as well. Moody’s maintains SGL ratings on ­a ppro­x imately 840 issuers, with USD 1.8 trillion in rated debt. Index summarizes the market conditions

Moody’s also created the Liquidity Stress ­I ndex (LSI) to provide a broad indication of speculative-grade liquidity. The LSI is the percentage of SGL issuers with the weakest (SGL-4) rating. Changes in corporate earn­ ings, borrowing costs and ease of new debt issuance are critical drivers of changes in the LSI over time. Credit cycles tend to lead the economic cycle because willingness to lever­ age into expanding economic activity has to occur before the activity itself gets underway in the real economy. Speculative-grade companies do not have access to the commercial paper markets, so they are generally unable to quickly raise new financing in crisis moments. Measuring their riskiness essentially boils down to gauging the free cash flow from operations, cash on hand, and committed financing from other sources such as revolving credit facilities (the latter is not part of the SGL analysis.) More than 12 years after the introduction of SGL s, the track record now includes both extended periods of more-than-ample liquidity and phases of unprecedented risk and market stress. The LSI’s long-term average value since inception is 6.8%, with a record high reading of 20.9% in March 2009 at the height of the financial crisis in the US. The lowest level reached by the index was 2.8% in April 2013, with default and illiquidity risks exceptionally low. At the start of 2015, the index was still very benign at 3.7%, indicating a below-average forecast of the default rate of speculative-grade companies in the course of this year. Higher risks from falling oil prices were balanced against the steady earnings gains from US consumer spending. 

Article by John Puchalla, Senior Vice President, Corporate Finance Group at Moody’s Co-Author Gregory Fleming Senior Analyst + 41 44 334 78 93 [email protected]

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Oliver Adler: What sorts of issues come up in terms of liquidity and premiums with some of the more obscure asset classes, like infrastructure, or the not-so-obscure ones, like real estate? Roger Ibbotson: Well, of course, something like real estate is by its nature very illiquid. But there are structures that you can buy, like REITs (real estate investment trusts), that make it more liquid. If you put real estate into a structure that makes it more liquid, it tends to be more highly valued. A REIT is a more expensive way to buy real estate, but of course it has the benefit of being liquid. On the other hand, if by buying real estate you actually get involved in managing it, it’s a much more complicated thing. That’s more like private equity. All of these things are less liquid, and they all should have illiquidity premiums. I suspect that a lot of the return from real estate comes from its illiquidity premium. Oliver Adler: Given that the different asset classes seem to have different characteristics, how do you deal with the liquidity issue when you put everything together into a portfolio? Roger Ibbotson: People need a certain amount of liquidity. If you’re going to have a lot of illiquid assets, you also need some liquid assets to meet your liquidity needs. On the one hand, people should not pay for liquidity they don’t need. On the other hand, they may need more liquidity than they think. There’s a danger in going into too many illiquid assets, like real estate and infrastructure and private equity. Some of the universities, for example, did get into a bit of a squeeze in the financial crisis. They could not get very good prices for their private equity investments. One of the ­b enefits of the kinds of stocks I’ve been talking about is that they can easily be sold in any crisis without paying much of a discount at all. Oliver Adler: But might it be possible to argue that illiquid assets could help to put a break on investors’ impulses to sell at the wrong time and save them from making mistakes? Roger Ibbotson: That’s an interesting argument. And, of course, there is evidence that overall stock market trends go in the opposite direction of what retail investors do: retail tends to sell after the crash and buy after the rise. So if retail investors were somehow prevented from overtrading, they

might perform better. But the truth is that people want liquidity even though it sometimes leads them to take the wrong actions. José Antonio Blanco: Once you know what your liquidity needs are, is there a fair reward for real illiquidity? Or could you also achieve a higher return by structuring liquid assets, for example by exploiting anomalies or special effects, as you’ve described (I don’t want to call it risk premiums)? In other words, do you think the illiquidity premium is overestimated? Roger Ibbotson: I think one aspect of what you are speaking about is the ability to achieve “alpha” (a measure of outperformance relative to some asset class or benchmark). To get a lot of alpha, you may need to do a lot of trading. People are ­overconfident, of course, of their ability to achieve alpha. But the more you believe you can create alpha, the more you want liquidity because it is the lower-cost assets that may allow you to achieve alpha. In contrast, if you have long horizons, then you’re the natural type of investor to go after illiquidity premiums. The fact is, though, many people believe they can ­create alpha – some legi­t imately, and others who just think they can – and they will pay up for it. I don’t see that going away. So, the market will tend to pay too much for liquidity, and conversely underestimate the illiquidity premium. 

Roger Ibbotson

The founder of Zebra Capital Management in 2001, Roger Ibbotson is also ­Professor in the Practice Emeritus of Finance at the Yale School of ­M anagement. He has written numerous books and articles, including “Stocks, Bonds, Bills and Inflation” with Rex ­Sinquefield (updated annually), which serves as a standard reference for ­information on capital market returns.

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Private equity in emerging markets

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1 The untapped potential of emerging markets Emerging markets make up:

39%

of global output

18%

of global stock market capitalization

14%

Markus Stierli Fundamental Micro Themes Research +41 44 334 88 57 [email protected]

of global private equity fund-raising

11%

Nikhil Gupta Fundamental Micro Themes Research +91 22 6607 3707 [email protected]

of global private equity investments

2

3

4

Global opportunity

High expectations

The promise of venture capital

At USD 29 billion, emerging market private equity fund-raising has been concentrated in emerging Asia, but growth has been the fastest in Africa.

In the USA , private equity achieved annual returns of around 16% over 2009 – 2014. Only 39% of ­limited partners surveyed expect that the USA will be able to sustain that level in 2015. 57% of limited partners expect emerging market private equity portfolios to achieve net returns of 16% or greater in 2015. Historical annual returns for emerging market private equity were around 13% over 2009 – 2014. Emerging market equities only returned around 4% over the same period. In comparison, US private equity trailed US equity markets in terms of returns.

Emerging market private equity investments ­i ncreased by 60% in value between 2009 and 2014. In the same period, venture capital investment value increased sevenfold, now making up more than 20% of total private equity investments in emerging markets. Technology investments ­h ave more than tripled in the same period.

USD 29 bn

+97%*

USD 4 bn

+327%*

Emerging market private equity by strategy, USD bn 40 33.8

30 20.8

20 10 0

2009 * 2014 vs 2009

5 Data sources used for the article: Datastream, Emerging Market Private Equity Association, Preqin

2014

 Buyout   Growth   PIPE   Venture capital

6

7

Not all markets are equal

In search of exit

Moving up the value chain

Private equity investments expanded rapidly in China, Brazil and Nigeria, shrank slightly in India and collapsed dramatically in Russia and South A ­ frica between 2009 and 2014.

Asian venture capital investments have started to find viable exits through IPO routes. The ­aggregate value of venture capital exits quadrupled over 2013 – 2014 to reach USD 38 billion.

African private equity is moving up the value chain, away from extractive industries.

Private equity capital invested in key emerging markets, USD bn

Number of Asian venture capital exits

15.7

8% 5% 2.7

6.9 China 5.5

4 India

0.6

1.5 Brazil

0.1 Nigeria

2

1.5

0.1 Russia 2009   2014

0.3 South Africa

7% 22% 3%

2007

454

Financials

253

415

Telecoms

126

242

Consumer goods

63

119

Oil and gas

539

42

Basic materials

458

40%

145 exits 50%

USD 9 bn

PE investments in 2009 , USD mn

2014

83 exits 65%

PE investments in 2014 , USD mn

USD 38 bn

Aggregate exit value  Trade sale   IPO  Write-off   Sale to GP

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Investors are increasingly showing appetite to commit to less-liquid alternatives. This includes investment opportunities in areas such as private equity, private debt and real assets. According to a recent study, shifting from liquid assets in which the primary investment return results from the market’s (or benchmark’s) movements to less liquid investments in which the primary source of the return is due to a fund manager’s skill at navigating an investment to a successful outcome typically results in a median return premium of 20%–27% over a fund’s life, and more than 3% per year. This illiquidity premium can be further enhanced by investing with the best-performing managers. These managers typically generate top-quartile investment returns and outperform the median performance benchmark by as much as 20 percentage points. Despite the opportunity to enhance overall portfolio returns (while reducing exposure to daily market volatility), individual investors tend to be under-allocated to illiquid alternatives relative to institutional investors. One oft-cited reason is the restriction on withdrawals of ten years or longer before fully returning capital and profits to investors. However, the recent growth of shorter duration and yield-producing investment strategies, such as direct lending to small and mediumsized enterprises, coupled with the emergence of a secondary market for early liquidity, may result in greater comfort with and more appropriate allocations to illiquid alternatives. AUTHOR SVEN-CHRISTIAN KINDT

Head Private Equity Origination & Due Diligence, Credit Suisse

Photo: Biwa Studio / G etty Images

Liquidity trends in illiquid alternatives

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The illiquidity premium

The manager premium

Individual investor allocation

The term “liquidity” refers to the ease with which an asset can be converted into cash. Assets or securities that can be easily bought and sold, such as bonds and publically traded stocks, are considered liquid. Private equity, private debt and real assets, in contrast, are said to be illiquid. Investment returns tend to increase with the degree of illiquidity of the asset. A recent study of nearly 1,400 US buyout and venture capital funds found that the aggregate performance of these funds has consistently exceeded the performance of the S&P 500 by 20% – 27% over a fund’s life, and more than 3% annually.

An increase in illiquidity shifts the primary source of the investment return from movements of the market itself (or beta) to a fund manager’s knowledge or skill at navigating an investment to a successful outcome. Manager skills influence the returns of illiquid alternatives primarily through strategic and/or operational improvements brought to portfolio companies. For example, a manager may be particularly able to increase portfolio company sales, reduce operating expenses, optimize asset utilization or exploit leverage. The potential for upside in illiquid alternatives is therefore driven not only by exposure to a specific illiquid category but also by investing with the best-performing managers. This is evident in the graph below, which shows that the return difference between top and bottom quartile managers can be over 30 percentage points in private equity.

Relative to individuals, many institutional investors with long investment horizons, such as pension plans (with their liabilities for retirees) and endowments (with their ongoing operating budgets), have built up significant allocations to illiquid alternatives, as shown over the last two decades. In 2013, the average US endowment held a portfolio weight of 28% in alternative assets, versus roughly 5% in the early 1990 s. A similar trend is evident among pension plans. In the early 1990 s, pension plans held less than 5% of their portfolios in less liquid alter­ natives; today the figure is close to 20%. Having a long-term investment horizon may give more patient investors an edge in harvesting the ­illiquidity premium. They can be rewarded for ­sacrificing liquidity that they do not need.

Investment returns generally increase with illiquidity Compound gross annual returns in % 18

Venture capital

14

Manager dispersion increases as illiquidity grows

12

Return differential vs median in %

16

Private equity

8 6 4 2

Real estate

Small equity

10

Global government bonds

40

Hedge funds

20

High yield

10 Median –10 Illiquidity estimates

2

28%

19.4%

30

US fixed income Deposits

1

Allocation to alternatives % of investment portfolio

3

4

5

6

Source: Illiquidity estimates taken from “Expected Returns” by Antti Illmanen, 2011. 1994 –2014 return data taken from Bloomberg, Citigroup, Barclays Capital, J. P. Morgan, Bank of America Merrill Lynch, NCREIF, Hedge Fund Research, Cambridge Associates, Russell 2000.

Top decile 2nd quartile 3rd quartile bottom decile

2%

–20 Long-only Long-only Hedge fixed income equity funds

Private ­ equity

Source: Taken from “Patient Capital, Private Opportunity” by The Blackstone Group, Private Wealth Management, 2013. Return data drawn from Lipper, Morningstar, Preqin and Tass.

Pension

Endowments

Individual investor

Source: Allocation data drawn from Cerulli Research, National Association of College and University Business Officers 2013/14 Studies, Pensions & Investments 2013 Annual Plan Sponsor Survey.

Liquidity options

Historically, illiquid investment propositions such as venture capital and private equity funds required ten years or longer before fully returning capital and profits to investors. However, the growth of shorter-duration and yield-producing investment strategies and a secondary market for early liquidity may result in greater comfort with allocations to illiquid alternatives. The strategies outlined below are only a small subset of more liquid options available to the investment community. These, and others, should make it easier for individual investors to sacrifice liquidity that they do not need in order to capture (some of) the illiquidity premium.

Private debt strategies

Secondary strategies

The private debt market has seen strong growth since 2008, primarily driven by direct lending funds. According to alternatives data provider Preqin, over 200 private debt funds have raised in excess of USD 100 billion of new capital commitments in 2013–2014. Private debt is characterized by shorter investment duration relative to venture capital and private equity funds, and in the case of direct lending, funds can be combined with regular yield payouts to investors. The outlook for investing in the direct lending space remains positive due to persistent structural factors preventing middle market companies from accessing the broader traditional credit markets. While credit supply remains tight, demand for middle-market credit remains strong due to the expected deployment of committed, uninvested capital (also referred to as “dry powder”) and the refinancing overhang of middlemarket companies.

The secondary market in illiquid alternatives has been fueled in the recent past by new regulations (e. g. the Volcker Rule), by record amounts of dry powder and by improving economic conditions. A record USD 42 billion of assets have traded on the secondary market in 2014, up from USD 9 billion in 2009. Investors increasingly see secondaries as a viable channel to generate liquidity before fund lockups expire. They are using the secondary market to rebalance their illiquid portfolios, exit poorly performing investments, reduce capital costs or comply with new regulations. In order to increase liquidity for investors, some managers are now proactively offering the possibility of exiting their funds early. For example, in its latest flagship fund, a US buyout manager committed to selling fund stakes twice a year to a preselected group of preferred buyers. Other managers have started to provide interested sellers with a list of potential buyers.

GLOBAL INVESTOR 1.15 

—18

Hedge funds

On doing your homework TEXT BY ALEXANDER INEICHEN

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—19

Photo: Gerry Amstutz

Recent skeptical reports in the press about hedge funds, and a high-profile divestment or two, have prompted speculation that hedge fund returns are in “structural” decline. Not so fast, says Alexander Ineichen. For investors willing to get off the couch, a careful study of hedge funds shows that they actually deliver higher-end returns than US equities do, with less volatility.

M

any seasoned investment professionals argue that liquidity is an illusion. It is something you think you have, and can measure in good times, but it vanishes immediately during a perfect storm. It is a bit like your path toward the emergency exit in a concert hall: under normal circumstances you can run toward the exit within seconds; when fire breaks out, you cannot. Liquidity is something everyone seems to require at the same time. The financial crisis of 2008 is a good example. Markets literally disappeared for a while. So-called market makers would delete their prices on their screens and not pick up the phone, even in markets that were considered liquid prior to the market disturbance. Another example is the more recent decision by the Swiss National Bank to drop its quasi-peg to the euro in January 2015. For a short time, the foreign exchange market – considered as the most liquid market in the world – stopped functioning properly. Hedge funds – a “quasi-liquid,” superior return profile

Alexander Ineichen

Alexander Ineichen started his financial career in derivatives brokerage and origination of risk management products at the Swiss Bank Corporation, UBS Investment Bank and UBS Global Asset Management. In 2009, he founded Ineichen Research and Management AG, a research boutique focusing on absolute returns, risk management and thematic investing.

In his 2000 book “Pioneering Portfolio Management”, David Swenson, the CIO of Yale University’s endowment fund, distinguishes between liquid and illiquid. But, for hedge funds, he creates something in between that he calls “quasi-liquid.” This is a very elegant turn of phrase. Hedge funds are indeed not as liquid as US large-cap stocks, but are also not as illiquid as, say, private equity or real estate. In the last couple of years the gloss has come off hedge funds. Earlier, the high returns had turned a niche product into a flourishing industry. For example, an investment of USD 100 in the S&P 500 ­I ndex at the beginning of 2000 was at USD 89 (–11%) five years later, including full reinvestment of the dividends. The same investment of USD 100 in an average hedge fund portfolio, after all the fees everyone complains about, stood at USD 141 (+ 41%) five years later. This is a big difference. Hedge funds did well in the second part of the last decade too. In the five years to December 2009, a long-only investment in the S&P 500 went from USD 100 to USD 102 (+2%), whereas an investment >

GLOBAL INVESTOR 1.15 

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of USD 100 in the average hedge fund portfolio went to USD 132 (+ 32%). This is still a big difference, but it had gotten smaller. In the five years to December 2014, a USD 100 investment in US equities more than doubled to USD 205 (+105%). However, USD 100 in the average hedge funds portfolio “only” rose to USD 125 (+25%). As an investor, which sequence do you prefer: –11%/+2%/+105% or + 41%/+ 32%/+25%? The second sequence is superior in two ways: higher-end return with less volatility. I like to think of the first sequence of returns as “nature.” That is what you get if you do not apply risk management: moderate overall return with high volatility. Hedge funds can improve this sequence with active risk management. The second sequence does not appear in nature, it is man-made. Hence the fees. Challenges big and small

The biggest challenges hedge funds face today are linked to the smaller managers. First, they find it very difficult to raise capital ­b ecause the financial crisis and the Madoff incident caused private investors to more or less disappear. They are coming back only very slowly. This means the main source of capital comes from institutional investors who have a more sophisticated decision-making process. They expect a hedge fund to have at least USD 100–150 million under management and three years of proven real returns. Furthermore, institutional investors conduct due diligence with their managers, because a lack of it was one of the sources of disappointment in 2008 . Institutional investors also expect various layers of operational excellence, adding to the cost base of hedge fund operators. This means that the barriers for smaller, less-established managers have risen. Finally, regulation has intensified. Large hedge funds can deal with the added bureaucracy more efficiently than smaller managers. But large hedge funds also face challenges, and one of them is related to regulation. The financial crisis, and the regulation wrath that it triggered, resulted in investment banks downsizing their trading operations. Liquidity in many markets went down. Because of the winner-takes-all effect that resulted in large hedge funds getting larger and larger, these growing hedge funds see dwindling liquidity as a challenge. A less liquid market means diminished opportunity and is more prone to gap risk. Are hedge funds a good/bad investment?

I always recommended to everyone willing to listen that they move up the learning curve with respect to risk management, absolute returns and hedge funds. Knowledge beats ignorance every time. An educated investment is better than an uneducated investment. And education compounds. At the end of the day, an investment decision is binary: either a position is established or it is not. This means the various trade-offs, the pros and cons, need to be carefully weighed against each other. This requires an effort, i.e. learning. Whether a nice chap recommends hedge funds is not that relevant for most investors. An investor needs to reach a level of comfort before investing, and a conviction once acquired requires ongoing reconfirmation. Both are a function of learning and effort. The late Peter Bernstein, author of one of the best books on the history of risk, once wrote that “liquidity is a function of laziness.” What he meant is that liquidity is an inverse function of the amount of research required to understand the characteristics of an investment. As he put it: “The less research we are required to perform, the more liquid the instrument.” An investment in US Treasuries re-

“Over the last decade or so, the conceptual arguments for investing in hedge funds have not changed by much. However, the market place has changed.” ALEXANDER INEICHEN

quires less research than an investment in US equities. An investment in US equities requires less research than an investment in hedge funds and so forth. In sum, hedge funds are not for the lazy. Why I want hedge funds in my portfolio

Hedge funds originally marketed themselves as absolute return products that deliver positive performance in any market environment. Now, in the wake of the financial crisis, hedge funds focus on their diversification benefits and risk-adjusted performance. A portfolio of hedge funds does not obviate any alternative or “classical” way of portfolio construction. However, hedge funds have properties that you do not find in other areas of finance. For example, trend-following managers have had a positive return in 17 out of 19 major corrections in the equity market since 1980. This is unique. There is nothing else in finance that has such favorable correlation characteristics. Among other asset classes, measured low correlation more often than not turns into an illusion when it is most needed, somewhat akin to perceived liquidity. Over the last decade or so, the conceptual arguments for investing in hedge funds have not changed much. However, the market place has changed. For example: hedge funds as a group are larger; the largest funds are larger; some trades are more crowded; liquidity in some market areas is lower due to Dodd-Frank; yields are lower and IT is more important. But again, conceptually, an intelligently structured portfolio comprising independent returns and cash flows is as worth considering by every thoughtful and diligent investor as it was in 1949, when the first hedge fund was launched. If you know the future, invest in what goes up the most. If you do not, construct a portfolio where the source of returns and cash flows are well balanced and the risk is actively managed, while not forgetting that perceived liquidity can turn into an illusion. 

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L

iquidity is an important aspect to consider when investing in hedge funds. Liquidity issues have to be managed by both investors as well as hedge fund managers. While it is true that hedge fund liquidity has generally improved for investors since the global financial crisis, hedge funds are still less liquid investments than equities. To use Alexander Ineichen’s term, they can be called “quasi-liquid.” In the following, we take a closer look at the role liquidity plays for hedge funds and their investors. A key conclusion is that illiquidity is not only a drawback, but also a potential source of returns, which still has to be managed.

Hedge Funds

Liquidity – a key to hedge fund performance

Illiquidity as a source of return

Hedge fund returns can be divided into three components: (1) returns from general market performance (also called beta factors), (2) returns from exploiting risk premia, including illiquidity factors (alternative beta), and (3) returns related to manager skills (e.g. in selecting securities and timing entry and exit into an investment, called alpha.) The performance of equity and fixed income markets to which hedge funds have exposure are typical beta drivers. The sensitivity toward these drivers varies across hedge fund strategies. While long/short equity strategies (which belong to the fundamental style, see box) have a relatively high sensitivity to equity market performance, the influence on managed futures (a tactical trading strategy) or fixed income arbitrage (a relative value strategy) may be minor.

Whether it’s related to an investor’s risk tolerance, or a fund manager’s decision on the appropriate trading strategy, the management of liquidity issues is a vital consideration when investing in hedge funds. And while illiquidity can be a source of risk, it can also be a source of additional returns.

Annualized returns

Low liquidity

Low liquidity

decreasing

increasing

Relative value  9.5%

Tactical trading  13.6%

Event driven  17.0%

Directional investing  18.5%

Relative value  11.6%

Tactical trading  11.9%

Event driven  14.6%

Directional investing  15.3%

Relative value  5.8%

Event driven  7.3%

Directional investing  7.4%

Tactical trading  9.1%

Directional investing  –4.6%

Event driven  –2.6%

Relative value  –1.9%

Tactical trading  5.5%

Hedge funds provide advantages

High liquidity

High liquidity

decreasing

increasing

Best trading strategy is a function of market liquidity In periods of low liquidity, tactical trading strategies have performed best. Particularly in an environment of low liquidity, this style stands out as the only one delivering positive returns.  Source: Datastream, Credit Suisse

Generally, it is easy to gain exposure to traditional beta drivers. However, alternative sources of beta may not be as easily accessible through commonly traded instruments. Default risk and illiquidity premiums fall in this type of category, and hedge funds can be one way to access this type of return. For example, the distressed debt strategy in­vests in illiquid, distressed securities that are not commonly accessible to investors. In contrast, mutual funds have more stringent liquidity requirements and are usually restricted to invest at most in low-rated credit, while their structural setup allows hedge funds to take on such credit risk. Moreover, distressed debt hedge funds have a longer time horizon, which allows them to hold on to investments for longer and to wait until the company that issued the distressed security gets back on track. >

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Glossary of liquidity provisions Redemption notice period Minimum period for advance notice prior to redemption. Redemption period Frequency with which investors can withdraw their funds. Lock-up Time period from the initial investment until it is possible to make a first withdrawal. Gates A gate limits withdrawals to a certain percentage of assets under management during any redemption period. Side pockets A provision that allows the manager to keep particularly illiquid holdings in a separate account. There is usually no liquid market for these holdings. It may be difficult to establish the holdings values and may be difficult to sell them. Hence, if an investor places a redemption request, the manager does not need to liquidate positions in a side pocket immediately. Pro rata proceeds of these holdings are only distributed to investors once these holdings have been sold – which can be long after an investor has withdrawn his capital.

Investments in more illiquid securities on the side of hedge fund managers have implications for investors too. Since the forced selling of securities can mean selling at unfavorable prices, hedge fund managers can set up a range of provisions to avoid losses due to this. Liquidity provisions can take the form of redemption restrictions, lock-ups, gates, side pockets or a combination thereof (see glossary at the left hand side). It is no surprise that the strategies investing in the most liquid assets (managed futures and global macro) tend to be the strategies that offer the highest liquidity for investors. As a result of the bad experiences made during the financial crisis, with many investors not fully aware of such provisions, investors now desire a higher degree of liquidity. Consequently, more liquid strategies as well as structures like UCITS (undertakings for the collective investment in transferable securities), which are designed to accommodate this desire, have attracted more inflows. While barriers of withdrawal can protect investors from redeeming funds at the most unfavorable terms, there can also be arguments raised against such policies. Investors may get the impression that hedge funds are using such provisions as an excuse to earn further fee income before their capital is eventually returned. It is thus important that investors are assured that long lock-up periods are well justified – e.g. because the hedge fund

is holding illiquid investments such as overthe-counter-traded distressed debt securities. Generally, investors eager to benefit from illiquidity premia should be prepared to take a longer investment horizon and be willing to accept more stringent liquidity provisions. In any case, it is important that investors clearly understand the fund terms in order to avoid unpleasant surprises later on. Liquidity requirements and return potential

As Alexander Ineichen points out, hedge funds used to be known as an asset class that delivers superior returns at lower volatility. However, our view at this time is that lower expected upside from traditional asset classes (i.e. weaker beta drivers) in combination with structural changes is likely to dampen the return potential of hedge funds. With regard to structural changes, the investor base of hedge funds is increasingly made up of institutional investors, while private investors previously played a larger role. Tougher requirements regarding liquidity and transparency have made it easier for institutional investors to include hedge funds in their portfolios. Further, the shift toward a more institutional investor base has increased the focus on the role of hedge funds in a portfolio context: low correlations with other asset classes and more stable return patterns have become the key differentiating feature rather than the delivery of high returns. With tough-

Hedge Fund Barometer variables: Liquidity Hedge funds thrive when liquidity conditions improve and are exposed to liquidity shocks when conditions tighten.  Source: Credit Suisse/IDC Percentile rank value 1.00 0.90

Liquidity tight

0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10

Liquidity plentiful

0 Jan. 92

Jan. 96

Jan. 00

Jan. 04

 Liquidity composite   13-week moving average composite

Jan. 08

Jan. 12

GLOBAL INVESTOR 1.15 

er regulatory requirements, operating costs have risen, which in turn has left some smaller hedge funds unprofitable. Conversely, institutional investors have been willing to sacrifice high returns for lower risk as long as their needs for liquidity and transparency are fulfilled. For these structural reasons, we think that the return potential of hedge funds has generally decreased. Liquidity drives our hedge fund strategy

The Credit Suisse proprietary Hedge Fund Barometer is our main tool to assess the broad investment environment for hedge funds. The tool is an early warning framework that should help avoid unnecessary risks. Besides volatility, the business cycle and systemic risk, the tool also assesses liquidity conditions. While we have observed a general increase in risk starting in late 2014, tightening liquidity conditions began to draw our attention in early 2015. As the second chart shows, liquidity conditions deteriorated around the turn of the year. While tighter liquidity is generally a concern for hedge funds, some strategies are less affected and can even thrive in such an environment (see first chart). Given the divergences in monetary policies between the main regions and, in particular, the likely approach of rate hikes by the US Fed, we do not expect liquidity conditions to improve materially in the near future. Therefore, we adjusted our hedge fund strategy in early 2015 and began to focus on ­s trategies that are less sensitive to liquidity conditions, e.g. tactical trading strategies. At the same time, our outlook worsened for relative value strategies, particularly those that are active in fixed income investments. These strategies typically apply higher leverage and/or invest in more illiquid securities, and are thus at greater risk when liquidity conditions tighten. In sum, when investing in hedge funds, investors should not just take traditional market drivers into account, but also focus on liquidity considerations. Illiquidity can be a source of risk, but also a source of additional returns for investors. Careful analysis of the role of market liquidity in an investment strategy can help avoid unnecessary risks and lift returns. 

Marina Stoop Cross Asset and Alternative Investments Strategist +41 44 334 60 47 [email protected]

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The different hedge fund styles and how they deal with liquidity Tactical trading strategies are resilient when liquidity is scarce Tactical trading strategies include global macro and managed futures. In this style, managers try to exploit trends in equity, fixed income, ­currency and commodity markets. Analysis of macroeconomic variables rather than corporate transactions or security-specific pricing discrepancies distinguishes tactical trading from other styles. Tactical trading strategies trade in all major markets. However, one ­m ajor difference between managed futures and global macro is that ­m anaged futures focus on trading futures contracts, the most liquid instrument. In contrast, global macro managers have the widest investment universe trading a broad range of different market instruments. Another key aspect of the tactical trading style is that some strategies are purely model driven. Within managed futures, trend-following strategies are probably the best-known example of this strategy. A model generates trading signals upon which trades are executed. Human discretion and emotions are negated, which helps explain why tactical trading strategies are well positioned to navigate through crisis periods. While discretionary managers may rely to some degree on models, they can use their own judgment when making investment decisions, and may be more prone to making irrational decisions in a tough investment environment. Fundamental strategies have various degrees of sensitivity to liquidity Fundamental strategies focus on individual securities, mostly in the equity and fixed income areas. While directional strategies usually build a broader portfolio of more liquid securities and thus deliberately take directional market exposure, event-driven strategies often build a more concentrated portfolio of securities depending on a specific catalyst (event). Directional strategies tend to take positions in more liquid publicly traded securities, while event-driven styles often engage in illiquid securities (e.g. distressed debt, special situations and activist investors with longer holding periods). While liquidity sensitivity depends on the underlying investments, the ­leverage applied is typically lower than in the relative value segment. Relative value strategies depend on a favorable liquidity environment Relative value strategies include fixed income arbitrage, convertible ­a rbitrage and equity market neutral strategies. They aim to exploit pricing inefficiencies between related or unrelated securities and try to avoid ­directional market exposure. Forgoing returns from beta drivers, returns of these strategies would naturally be lower (yet more stable and with very low correlation to movements in major asset classes). Leverage is a way to enhance returns. It can be high, particularly for fixed income strategies where targeted pricing inefficiencies can be small. But this makes the strategy sensitive to liquidity conditions. While these strategies tend to do well as long as markets move in their favor, volatile markets with scarce ­liquidity can mean that positions need to be sold at unfavorable prices – or worse, cannot be sold at all. This left many investors with large losses during the financial crisis. It is thus vital to keep an eye on market liquidity.

GLOBAL INVESTOR 1.15 

1800

1600

—24

Open-end versus closed-end funds Making what turns out to be the right investment decision can hinge upon the underlying asset type, and understanding the fundamental differences between open-end and closed-end funds.

0

–2

In good times

–4

On the upward trend, ­investors see the discount narrowing noticeably for closed-end funds as the economy strengthens.

–6

1400

–8

–10

1200

In times of crisis

–11%

The discount of closedend funds mirrors the development of the overall market. The discount increases as the crisis ­unfolds, but is quick to revert again as recovery begins to take hold.

1000

–12

–14

–16 800

–18

–20

600

01.05

07.05

01.06

07.06

01.07

07.07

01.08

07.08

01.09

07.09

 MSCI World   Average discount 3m MA (rhs)

Average discount to net asset value for US closed-end investment funds Through the worst of the Global Financial Crisis, the average discount on closed-end funds dipped from roughly – 7% to – 11% in January 2008 before rebounding sharply, but briefly – after which it fell to –18% before recovery at the start of 2009.  Source: Bloomberg, Credit Suisse

Discount to NAV in %

+

– Index points

–7%

GLOBAL INVESTOR 1.15 

I

nvestors have many choices when selecting a pooled investment fund: regional versus global, active versus passive, bonds versus equities, famous manager versus start-up, and so on. But one choice can be overlooked: open-end versus closed-end funds. On occasion, this may be the most important issue. As we will show, the practical difference for investment returns may not be great under normal market conditions, but can become significant at times of market stress, especially for funds investing in illiquid assets such as real estate, small caps, or specialized credits. In such cases, a closed-end fund may be the better structure. Key differences

Closed-end funds have a fixed asset pool. This can grow (or shrink) due to good (or bad) investment performance, but normally no extra capital is added from investors or paid out. An existing investor who wants to exit must sell on the open market to another investor who wants to put money in. In contrast, the assets in open-end funds can change because of shifts in market prices as well as due to net inflows or outflows of capital from investors. When net new money comes in, the manager invests in extra underlying assets, while exiting investors sell units back to the fund manager, who disposes of underlying investments to meet net redemptions. Operation under normal market conditions

Investors in open-end funds buy and sell units at a level equal to the underlying asset value (subject to enough liquidity, see below). By contrast, the price of closed-end funds is typically at a premium or discount to the underlying assets, reflecting the balance between the supply from exiting investors versus demand from those entering. Academic studies have argued that a premium might reflect the skill of the manager or the rarity of the underlying assets, while a discount might indicate lack of confidence in the manager. Morningstar data shows that, over the long term, closed-end US funds have on average traded at a slight discount. This tends to deepen when markets go down, while it narrows or moves to a premium when markets go up and investors become more optimistic. Some closed-end funds buy back their own shares to try to narrow the discount, enhancing value for remaining investors. Sometimes, external predators try to gain control and ­liquidate the fund at the market value,

thus effectively eliminating the discount. ­D espite these measures, discounts and premiums rarely disappear completely, perhaps because demand for most closed-end funds is dominated by retail investors who tend to be procyclical. When money flows in or out of open-end funds, the dealing costs are in many cases spread among all investors. The impact of these costs may be negligible in large funds with little movement, but can be a noticeable burden on performance in small, fast-growing funds. Perhaps, more importantly for an open-end fund with specialist strategies in relatively illiquid assets like small-cap or frontier-market stocks, a good performance in the early years when the fund is small may be difficult to replicate later if large amounts of new money are attracted by the good results, but are not easily investible in the same way. So many successful open-end fund managers in specialist areas close their funds for new investments to protect existing investors as they approach capacity limits. If a manager does not do this, there can be style drift, making the track record of a fund manager less relevant. Operation in stressed markets

When markets become stressed, such as during the financial crisis, some assets may become illiquid, while others remain easy to sell. When this happens with an open-end fund, the first investors to exit will tend to receive cash obtained by the manager from sales of the more liquid assets. While this is good for these faster-moving investors, slower-moving investors are left with units in an imbalanced fund that holds mainly illiquid assets that cannot be readily sold and for which the theoretical valuation may fall further than the more balanced portfolio existing before the stress began. Well-known examples in recent years include some frontier-market, real estate and credit funds. Fund managers may have some ability to restrict (“gate”) withdrawals. If this is done early in the stress situation, it in effect temporarily makes the fund closed, protecting remaining investors. But in a worst-case scenario, this closure happens after the faster investors have left, which leaves remaining investors trapped with a pool of illiquid underlying assets that may then eventually be sold as soon as some limited liquidity reappears, which unfortunately is likely to be near the bottom of the market. Clearly, this process simply cannot happen in a closed-end fund. Faster investors who try to exit will likely find few buyers, forcing

—25

the fund price down to a substantial discount to the apparent net asset value. In the middle of the financial crisis in early 2009, the average discount of the largest US -listed closedend funds rose as high as 25%. But the fund manager is not forced into selling the underlying assets to meet withdrawals. Investors who are prepared to hold their nerve through the phase of stress will still own a share in the balanced pool of assets selected by the manager, with a good chance of recovery after the stress has passed, and they will not be forcibly liquidated near the bottom of the market by the selling actions of other investors in the fund. Indeed, after the financial crisis, the average discount narrowed quickly as markets recovered, providing an additional return driver for these funds on top of the rise in price of the underlying assets. Conclusion: Horses for courses

The conclusion is that investors should choose between open-end and closed-end funds largely on the basis of the underlying asset type. For investments in mainstream, liquid markets like developed economy large-cap equities, an established large open-end fund is probably the better choice in most cases. It avoids the fluctuating premiums/discounts of closed-end funds and should be large enough to avoid issues of dealing cost attribution, although it would likely not have leverage capability. In contrast, closed-end funds are likely to be the better choice for underlying assets such as real estate, frontier markets, small caps and low-grade credit, since these are, or are at risk of becoming, illiquid with all the potential issues described above (see article on Swiss real estate funds on page 47 for more details). 

Giles Keating Head of Research and Deputy Global Chief Investment Officer +41 44 332 22 33 [email protected] Lars Kalbreier Head of Mutual Funds & ETFs +41 44 333 23 94 [email protected]

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Liquidity issues in an institutional portfolio context

Attractively ­consistent Patient, yet opportunistic. Those are two key characteristics of the New Zealand Superannuation Fund, whose very long-term investment horizon allows it to pursue contrarian and illiquid strategies if the price is right, all while managing liquidity at the whole-fund level. INTERVIEW BY OLIVER ADLER Head of Economic Research JOSÉ ANTONIO BLANCO Head Global MACS

Oliver Adler: From the point of view of a private client, what’s special about the New Zealand Superannuation Fund (NZ Super Fund), as a national sovereign wealth vehicle? Adrian Orr: We are a “buffer” fund. Our aim is to smooth the increasing financial burdens for future generations. For that reason, we have a very long-term investment horizon: no money will come out of the fund until at least 2031. That provides us great certainty around our investment horizon and our liquidity needs. These “endowments,” as we call them, together with our governance and our ownership (i.e. our control over our capital) allow us a very high level of risk appetite and also the ability to invest in what can be called illiquid assets. Oliver Adler: How do you decide your investment strategies? Adrian Orr: We have a number of investment beliefs against which we continuously test ourselves, for example, that there is some concept of fair value for an asset, and that prices may deviate from fair value, but should also revert to it over time. These beliefs give us the confidence to pursue contrarian strategies, as well as illiquid strategies, if we think the price is right. All potential investments, regardless of asset class, are measured in terms of their attractiveness – either as a diversifier, or as a (mispriced) opportunity – and, more generally, their consistency with our beliefs. Oliver Adler: Isn’t that what the vast majority of funds do? Adrian Orr: Most funds have specific strategic asset allocations (SAA s) to which they are always rebalancing, whereas we are opportunistic: we are continuously shifting from the least attractive to the most attractive asset classes or assets, based on our confidence in our strategies. We are least invested in black-box hedge-fund-type strategies that are purely skill-based. We have low confidence in skill as a basis for adding investment value because we really struggle to be able to assess it, and we also have low confidence in its consistency. José Antonio Blanco: What kind of horizon do you use to estimate the attractiveness of an asset mispricing? How much do you want to have in illiquid assets? And how much in liquid ones? Adrian Orr: We define a long-term investor as someone who has command over the capital. So at any point in time, we >

—27

Photos: Jamie Bowering

GLOBAL INVESTOR 1.15 

Adrian Orr is CEO of the New Zealand Superannuation Fund, which has posted annualized returns between 17% and 25% over the last five years.

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José Antonio Blanco Head Global Multi Asset Class Solutions +41 44 332 59 66 [email protected]

Managing portfolios – a quest for value Credit Suisse Private Banking follows a structured investment approach, which starts by defining a suitable strategic asset allocation (SAA) for its clients and then actively managing the mandate portfolio in a disciplined way around this SAA . However, the SAA is periodically checked and ­a djusted (see interview). Although financial markets in some broad sense tend to be efficient, there are costs to finding relevant information quickly and acting on it appropriately; so price movements in response to events are sometimes neither instantaneous nor always correct. This opens opportunities to improve the return and risk characteristics of portfolios over time by deviating from the strategic allocation in various ways. We therefore manage portfolios actively, generally in all dimensions across asset classes, markets, currencies and individual securities. In our quest to add value, we combine in-house insights with added value provided by other parties as long as their investment style fits with the logic and structure of the mandate portfolios and the requirements of the client. Unless specifically instructed to do otherwise, discretionary portfolios for private clients are predominantly invested in fairly liquid assets, in the sense that we focus on assets that are easy to trade and monitor, although we will take some limited liquidity risk by investing some of the portfolios in asset categories (like high-yield bonds) and strategies (hedge funds, for example) that are less readily tradable and should therefore generate a liquidity premium on top of their other characteristics. Our prudence with regard to illiquid assets is the result of regulatory considerations (some asset categories cannot be offered to private ­investors because they require very specialized know-how and may entail high and unusual risks) and the fact that investments in illiquid assets limit our ability to adapt the portfolios to the changing environment and client needs. These types of assets are therefore best managed separately from the liquid part of the portfolio. 

should have the ability to buy or sell on our own terms. When you apply that definition of a long-term investor, what it means is that we manage our liquidity at the whole-fund level. We want to make sure that we don’t suddenly find ourselves in a situation where we’ve got a fund full of illiquid assets and have to shed assets in a fire-sale. We always want to preserve the ability to buy assets at opportunistically favorable times, for example, when they are poorly priced by the markets. Oliver Adler: How do you price liquidity? Adrian Orr: We have an absolute level of liquidity that we wish to maintain at any point in time for the fund. And we have a pricing schedule for that liquidity as we approach that must-have level. The level for the fund as a whole is established through specific scenario shock analysis, so that we are always in a position to buy assets at the markets’ darkest moment, as opposed to having to sell assets. Having a moving price structure rather than a defined target quantity of specific illiquid assets tends to create the right incentives within the fund. Oliver Adler: Might it mean that, in a market stress period, your liquidity level actually falls? And could that also mean that you may not be able to then invest in the opportunities you had thought you might want to invest in? Adrian Orr: Well, we try to anticipate and pre-empt exactly that. We are thinking: what does this portfolio look like in bad times? And that consideration sets the price or the “hurdle rate” we are prepared to accept for making that investment. In other words, we have a “waterfall” of liquidity, starting from the highest, mostliquid in­ vestments through to the leastliquid asset structures. We have a pricing structure and a management structure for the whole fund that allows us to work our way through that waterfall. By the time you get down to the leastliquid assets, you are in a very, very strange world, one where liquidity would probably be the least of your concerns. José Antonio Blanco: A look at the current structure of your fund shows that the allocation to what might be called less liquid investments is very broad and relatively small (about 20%). Why do you diversify broadly on the illiquid side, while having quite significant chunks on the more liquid side?

GLOBAL INVESTOR 1.15 

Adrian Orr: You have to take your mind out of an SAA framework. We asked ourselves, how could we achieve our purpose in the least-cost, simplest manner? That means going out and buying listed, low-cost liquid assets to create what we call our reference portfolio. It ends up being effectively 80% equity, 20% fixed income, globally diversified. And we think of that reference portfolio as delivering a Treasury bill plus 2.5% return, on average, over 20 years. We then get out of bed every morning and say: how can we outperform that reference portfolio? How can we add value? José Antonio Blanco: Adding value means …? Adrian Orr: Improving the Sharpe ratio, a higher return for the same risk, or the same return for less risk. And that is when we start actively investing. Oliver Adler: If you compared your actual allocations with a typical SAA for a balanced fund, how marked would the deviations be, say, in the main asset classes from any kind of starting or “reference” point? Adrian Orr: The deviation is quite big, and has become more visible since about 2007, when we shifted away from our SAA (we had one once!) and got far more active and more direct in our investment strategies. This is also the period of high growth in the value-add of the fund. So I would compare our strategy style to a growth fund’s, not a balanced fund’s. We have performed exceptionally strongly over the last five years or so, with annualized returns anywhere between 17% and 25%. Oliver Adler: What about illiquid asset classes such as real estate, which is probably very local? Or infrastructure, which everyone is talking about? Adrian Orr: Many of our illiquid assets have entered the portfolio as diversifiers (like timber) or because there was a significant market mispricing, or a specific asset mispricing (like Life Insurance Settlements). Infrastructure has been the real tough one. Infrastructure assets have been very sought after; so we rarely see a mispricing opportunity, and they aren’t as good a diversifier as people claim unless they are true infrastructure. José Antonio Blanco: How do you handle the delicate question of ethical and sustainable investment vis-à-vis illiquid assets?

—29

“We then get out of bed every morning and say: how can we outperform that reference portfolio? How can we add value?” Adrian Orr

Adrian Orr

CEO of the New Zealand Superannuation Fund, which he joined in February 2007, coming from the Reserve Bank of New Zealand where he was Deputy Governor. He has also held the positions of Chief Economist at Westpac Banking Corporation, Chief Manager of the Economics Department of the Reserve Bank of New Zealand and Chief Economist at The National Bank of New Zealand.

Adrian Orr: A big part of our emphasis on consistency is related to environmental and social governance issues. We will not enter into an external manager contract if we cannot get the transparency we need and the behaviors and reporting and performance that we expect. Oliver Adler: Would you agree that the set of opportunities for you has diminished over the last few years generally, if you look across most investable assets? Adrian Orr: Very much so. Our big valueadd came from being able to be a contrar­ ian investor. Now equity prices are broadly at fair value, globally. There are still some opportunities in Europe and Japan, but that’s where we have lower confidence. José Antonio Blanco: In principle, does the current situation favor illiquid assets relative to traded assets? Adrian Orr: I would say the illiquidity premium has declined. There’s so much global capital chasing illiquid assets, that we just think, why bother? Why take on illiquidity and all of the governance challenges that come with direct investing when you’re not being rewarded for it? So we can be patient and await better opportunities over time. 

GLOBAL INVESTOR 1.15 

—30

Talking teak

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—31

Trees are a fixture of the ­ physical landscape, inspiring the human imagination, and their products are a ubiquitous component of everyday life. Small wonder that they also constitute a vehicle for investment. Teak is particularly prized for its beauty, spiritual associations, durability and ease of workmanship. A teak tree ­matures in about 20 years and is fairly easy to grow, though the locations where it thrives pose their own challenges. ­Nonetheless, in the right hands, teak offers an interesting pro­position for the patient ­in­vestor. INTERVIEW BY GISELLE WEISS PHOTOGRAPHY LUCA ZANETTI

GLOBAL INVESTOR 1.15 

—32

Carol Franklin

Chairman of the Board of Forests for Friends and of the Tree Partner Company, she earned her PhD in English literature before assuming a series of management positions at Swiss Re over the course of 20 years. She subsequently became the Executive Director of WWF (World Wide Fund for Nature) Switzerland.

Giselle Weiss: You describe “falling into” the business of growing trees but finding it interesting. Why? Carol Franklin: Investing in trees means you give your money away for 20 years. The concept is difficult to sell in the sense that if you go about it properly, it ­really is illiquid. Most of our competitors say that you will get a first payout after three to five years, and that they will ­reimburse your investment if necessary, which is absolute rubbish. They also tell you that returns are between 9% and 15% a year, which is also rubbish. We ­compare our ­return to what you used to get on a savings account – so something like 6% to 7% per annum, 85% of which comes in after 20 years when the trees are harvested. How does it work? Carol Franklin: The basic concept is that the investor pays all the money up front, on a shareholding basis. In other words, we have enough money for the 20 years it takes for the trees to grow. We buy the land, plant the trees, and maintain them very carefully. If all goes well, we have the first non-commercial thinning after four to five years. Then after eight, 14, and the final harvest after 20 years. Let’s backtrack just a bit. Why trees, as ­o pposed to vineyards or fancy cars or ­P icassos or a nice little chemical start-up? Carol Franklin: I personally have always been interested in ecology. And trees are vital for our survival. They help slow down climate change by capturing CO 2 . They are something that you can see and touch, as opposed to, say, derivatives. Why teak? After 20 years you can sell the wood. There are a lot of beautiful and interesting trees, but they have no international market, whereas there is a functioning international teak market. At the moment, we are s­ elling all our wood to India, which could buy the ­entire worldwide harvest. Recently, the markets of Vietnam and China have been growing, and some of the wood is g ­ oing to these countries to make very nice garden furniture, doors, cabinets, whatever. It would be nice if the US and European markets became stronger again in the near future. Just to be clear, we’re talking about tree plantations, not tropical forests, right? Carol Franklin: Yes. We plant the trees on former cattle land. Plantations are not ecological, although ours are all certified by

FSC (Forest Stewardship ­C ouncil). What

plantations do is to take the pressure off the primary forests, as people no longer have to go and cut trees in the jungle. And the reason for doing it in Panama? Carol Franklin: Teak only grows in ­tropical regions, but you probably wouldn’t want to invest your money in many of the countries along the equator. Panama has a relatively reliable legal system and, due to its narrow shape between two oceans, there is always a port nearby. If you plant in Brazil, for example, and ­p eople do, the nearest port can be 3,000 kilo­meters away. Getting the timber there costs a fortune. Unlike overland transport, sea transport is not very expensive. Panama a­ lso has tax ­incentives for reforestation. Who should invest in a teak plantation? Carol Franklin: It’s not about quick money. So patient money, possibly. People who have an affinity for trees. People who are ecologically minded and who want to do something to save the world. Pension funds would be ideal ­b ecause it’s a longterm asset and pension funds have calculable long-term liabilities. It’s well suited to family offices: traditional families used to have their own woods, and some still do. We have many grand­p arents! They think long-term, and teak is a shorter return than German forests, for example. A German oak takes 100 years to mature. And who should not invest? Carol Franklin: Someone who might need the money in the next 20 years. I’d also never invest more than 10% of my available money in something like this. We’re not listed, which means the investment is even more illiquid. But this also means we are decoupled from the financial markets. So if everything goes down, which it will again of course, at least your trees will continue to grow. And if the wood price happens to be unattractive at any given m ­ oment, we can just let the trees stand and wait. It’s not rice or oranges or ­v ineyards. Could you describe the planting cycle? Carol Franklin: You buy the land. You prepare the land. You plant the trees. You have to get the right soil and the right seedlings. Over the past ten years, seedlings have improved dramatically. B ­ ecause our plantations are ecologically certified, you can’t use certain pesticides and her­ bicides, so you have to keep the grass and shrubs down with the machete.

GLOBAL INVESTOR 1.15 

“There are a lot of beautiful and ­interesting trees, but they have no inter­ national market, ­whereas there is a functioning international teak ­market.” Carol Franklin

As the trees grow, you cut the branches to avoid knots in the wood. You usually plant between 800 and 1,100 trees per hectare, with the trees spaced about 3 meters apart. After four years, you thin the trees to give them enough room and light to grow and become tall, strong and straight trees. And you continue to thin as the trees grow? Carol Franklin: Yes. The next thinning is usually after eight years. This is the first commercial thinning and the wood is used for doorframes, tongue-and-groove walls, indoor floorboards or furniture. As we now get more money than we pay for the thinning, we can use the proceeds for the maintenance. So in the cash plan this is income, but we do not distribute it to the shareholders – unlike some companies who use this money to keep their shareholders happy and have to look for additional income for maintenance. There’s another

thinning at 14 years, and the final harvest at 20, but it could be 18 or 22, depending on the growth of the trees and the state of the market. Aren’t the trees vulnerable to weather or natural enemies? Carol Franklin: For the first four or five years, you have to be careful about fire. So we have fire breaks, usually roads. And we have people living in the plantation to watch. Panama has no hurricanes. We do have local windhoses, and sometimes a bunch of young trees will fall over. But you can put them back up and they continue to grow. There’s also a type of fungus, but it’s fairly limited, and we are on the lookout for it. What should investors know or consider ­b efore they make such an investment? Carol Franklin: The main thing is that they should realize that the money is out of their portfolio for 20 to 24 years. And they should check us out because you invest in people and not in things. It’s like re-insurance. It seems very technical, but in the end, you underwrite the underwriter. Do you worry about climate change? Carol Franklin: Well, there are general concerns about the unpredictability of the rains. And, naturally, if the tropics were to become colder, that would be an issue. But on a day-to-day basis, I think political risks tend to be higher than natural risks. Panama is probably more stable than some of the other c­ ountries in the tropics. Do people come to see the trees? Carol Franklin: We organize investors’ trips including visits around Panama – to the canal, an indigenous village, the old fortress near Colón and our sheep and goat farm. We have quite a few people who just want to have a look and not invest, or who want to get a feel for who we are before they invest. We’re happy with that. If you were starting over, would you do this again? Carol Franklin: My first experience with this type of investment was actually sitting on the board of a company that failed. It’s a long story. My husband and I made it our business to rescue it – now called Forests for Friends – which was a huge gamble and the odds were against us. But if we hadn’t accepted the challenge, two-and-a-half thousand people would have lost their money. We succeeded, and that effort, as well as starting The Tree Partner Company, has changed my life. 

—33

GLOBAL INVESTOR 1.15 

—34

3

1

2

GLOBAL INVESTOR 1.15 

2

Tree Partner

Province Darién Shareholders’ investment 2014: CHF 4,207,407

1 The Tree Partner Company comprises two teak plantations totaling 170 hectares, located within three hours driving distance of Panama City. 2, 3 Engineers periodically gather statistics on how well the trees are growing. The first commercial thinning occurs at about eight to ten years, when the tree trunks measure 40 centimeters circumference minimum.

—35

GLOBAL INVESTOR 1.15 

—36

4

5

6

GLOBAL INVESTOR 1.15 

7

4 Trees cut from the first thinning will be made, for example, into door frames. 5 Panama’s proximity to ports is a huge advantage in terms of cost. 6 Harvest takes place around 20 years after the planting, when the entire plantation is felled, or “clear-cut.” 7 The plantations provide jobs and learning opportunities to the local communities. 8 The fruit of 10 years’ labor: the wood from thinnings is collected at the entrance to the plantation, then loaded into 12-meter containers and shipped, primarily to India.

—37

GLOBAL INVESTOR 1.15 

—38

8

GLOBAL INVESTOR 1.15 

Institutional investment in timberland

L

and devoted to investible timber worldwide amounts to 165 million hectares (408 million acres), roughly equivalent to the land area of Alaska. Institution­a l investors now own timberland in Argentina, Australia, Brazil, Canada, Chile, New Zealand, South Africa, the United States and Uruguay. Just under half of these assets (by area) are in North America. There is much less harvestable timberland worldwide than forested land. In Australia, only 1% of forested land is developed as timber plantations. Broadly defined institutions, such as the military, universities and even royalty, have held exclusive property rights in forests for centuries. Interest in timber assets by purely financial institutions developed in the 1980 s in response to both the growth of institutionally managed retirement accounts seeking diversification, and a wave of forest divestments by large forest-product companies. Institutions enter into forestry

In the first two decades of investment by institutions outside the wood-products industry, activity was confined to large university endowment funds. US timber companies using GAAP accounting had to pay tax on forest owned – even when it was not being logged, thus incentivizing them to sell such plantations to US tax-free pension funds. Preferential tax treatments for real estate investment trusts ( REITs) also encouraged corporate divestment. During a period of strong equity market returns and declining inflation, the motivation for institutional investment was limited to those with a long time horizon for returns and an unusually broad mandate on alternative investments, enabling direct holdings of unlisted assets. This led the same institutions

interested in pioneering private equity to explore the scope for investing in timberland, as a component of natural resource portfolios. Front-runners were the endowment managers for Yale and Harvard Universities. Yale alone holds three million acres of forests. Harvard’s Head of Alternative Assets, Andy Wiltshire, worked in the New Zealand forests sector early in his career, and drove the 2004 purchase of a 408,000 -acre New Zealand timber estate by the Harvard Management Company. Kaingaroa Forest was the largest commercial forest property on the country’s North Island. A 30% share of this huge forestry block was divested two years ago to the Canadian Public Sector Pension Investment Board with an additional stake taken up by the New Zealand Superannuation Fund. Broadening of interest from private institutional to public institutional investment is thus well underway. Timber has appealed to observers noting long-run real annual returns of 10%–15% on intensively managed, short-rotation plantations. Seeing the very positive returns from timber and its low volatility, sovereign wealth funds and large public pension funds have been acquiring exposure to commercial forest assets. Corporate pension plans now own around 10% of the asset class. Based on measured returns on investment, timber is not positively correlated with other assets. But, because the timber price is responsive to house-building cycles, the run-up to the credit crisis in 2008 saw timberland prices climb and then drop sharply. The sluggish recovery in US housing led to a multiyear opportunity for pension funds to acquire timberland assets at reasonable valuations, and most have entered the market

—39

through vehicles known as “ TIMOs” – timber investment management organizations. These intermediate investment funds make exposure to timberland simpler for non-specialist institutions, but the larger pools of capital often prefer purchasing the assets directly. Returns for institutions that acquired undervalued holdings have been strong, initially driven by a lower discount rate boosting long-duration assets like timber, and recently supported by better wood demand. Current market situation and outlook

The US housing market has traditionally led timber demand and is now in a gradual recovery. The Australia-New Zealand region has enjoyed resilient building activity that is expected to continue, driven by immigration. In China and India, continuing urbanization and construction means these markets are still growing. Chinese plantations cannot meet demand and are under some pressure to be converted into development land. Increasing institutional investment is a safe prediction due to low current allocations within alternative asset portfolios and since wood usage follows wealth development. Thus, there is growing orientation toward the Southern Hemisphere. Recent surveys indicate that investor interest in emergingmarket forests is primarily European, and that smaller-scale investors favor emergingmarket timberlands. Sustainability is a criti­ cal concern – particularly with indigenous hardwood trees – but a wide range of tools are at hand, including forest and manager certification, NGO oversight and replanting requirements.  Gregory Fleming Senior Analyst + 41 44 334 78 93 [email protected]

Find additional details on our map on pages 40–41

GLOBAL INVESTOR 1.15 

—40

Farming and forestry investment Timberland is the investment term for China d pulp to harvestable forests, as is farmland for agriculture n d wo o ber a m u l th of investment. Both types of investments act wo r 4 b n D as portfolio diversifiers, satisfy investors’ S sU or t xp desire for “real” assets and have e da na emotional and social resonance. Ca por t s U S D 2 .6 But they do require patience. E U28 ex  b n w

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Tree products include hardwoods such as mahogany (used for ­f urniture) and softwoods such as pine (used for building and ­p aper production). Woodchips may be sourced from either, though softwood is a cheaper source. South-East Asia produces 90% of the world’s ­n atural ­r ubber. 

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GLOBAL INVESTOR 1.15 

NZ timber destinations

NCREIF Timberland TR Index

Logs constitute New Zealand’s third-largest export industry. New Zealand is also now the world’s leading log exporter (as of 2012) and the biggest supplier of softwood logs to China (as of 2013). JAS: Standard units. Source: UN Comtrade, New Zealand MPI

Returns as measured by a diversified index of ­t imberland investments. Timber serves as a good diversifier, remaining stable during the financial crisis of 2008 as shown in the index. 

Volume (million JAS)

Index

16

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14 The U SA im por t

—41

Source: Bloomberg, Credit Suisse/IDC

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Soybeans Dairy products Meat Paper and paperboard Cotton Lumber Wood pulp

Mature, intermediate and emerging timberland investment regions

Excellent climate for ­a griculture, total annual ­r ainfall

With most US forestry assets already in institutional ownership, investor interest has turned to non-US markets, e.g. Asia. In Europe, forests are generally in private hands.

Agricultural productivity is greatest in the world’s temperate zones. Nonetheless, other regions, such as South America and Africa, where water is still plentiful, are drawing investor interest.

 Mature  Intermediate  Emerging

475–4974 millimeters rain

Selected international agri-trade flows in USD

tra

Investing in farmland means ­investing in rural land along with specific crop and livestock ­a ssets. Crops may be row crops like soybeans or permanent fruit and nut crops.

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Find more information in the articles on pages 39 and 42

NEW ZEALAND

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GLOBAL INVESTOR 1.15 

—42

Harvesting yields from agriculture

Farmland  – a fertile investment

One doesn’t often think of institutional investors and farmland in the same breath. Yet, global population growth and the accompanying demands on our food supply have made agriculture an asset class worth considering. But bridging the worlds of farming and financial services requires rather specific expertise. INTERVIEW BY GREGORY FLEMING Senior Analyst

2014

2055

2014 2055

Food demand is set to grow by over 60% as the world becomes wealthier

Find additional details on our map on page 40

Global population is expected to increase by some 50%

Gregory Fleming: Griff, you have moved from a traditional investment career in pensions and investment funds into advising on and structuring of farmland investments. What motivated this move? Griff Williams: A desire to make agriculture investment accessible to institutional investors. Agriculture is an asset class that delivers real benefits to savings and retirement portfolios, but lamentably, it is very difficult to access it in a pure-play format. It is also an asset class that requires specific expertise that generally does not reside in the financial services sector. As a farmer who has spent over 20 years in the asset management sector, I am blending the two worlds to deliver this objective. What kind of investor considers farmland? Griff Williams: Investors seeking exposure to assets that benefit from long-term secular themes such as population growth, changing dietary habits, growing middle classes, water and conservation management. Farms offer a hedge against inflation, combined with an income yield. At the same time, investors need to be able to trust the farm managers, or at least the partner selecting them. No one really wants to have to go down to the farm and check what’s happening there in person. Is agriculture sufficiently exposed to the modern, services-based economy to offer good returns? Griff Williams: The global population is expected to increase by 50%, to more than nine billion in the next 40 years, while food demand is set to grow by over 60% as the world becomes wealthier. Shifts in diet preferences toward protein foods are well-attested in enriching societies, and this will increase the demand for land resources. So investors can potentially benefit from value-added gains in food or crop quality, but also from the very limited expected increase in the world’s available arable land. The investment time frame is important in illiquid assets. What is the best time frame for taking a stake in farming? Griff Williams: Farming lacks the thrills of daily commentaries on network television. The farmer is almost the archetype of a patient investor, and non-farmers also need some patience. Much depends on the mode of investment, but an investment ­horizon of five to ten years or a longer-term, strategic allocation is reasonable. For investors preferring the fund route to a direct investment, between three and five years is

GLOBAL INVESTOR 1.15 

the shortest time frame to see results, but that renders the investment rather prone to the fortunes of just a few growing or production seasons. Capital gains on farmland are also likely to accrue more reliably over longer horizons. What kind of return can investors expect? Griff Williams: A good internal rate of return would be around 12% to 15% per ­a nnum. This is likely to be split between a cash yield on the farm products of 6% to 8% and a similar appreciation in the capital value of the farmland, as it is improved. Would you say that any one kind of crop or product is superior, from an investor’s point of view? Griff Williams: I have looked at opportunities in dairy, livestock, cotton, sugarcane and fruit, soya, grains, and other rotational crops. Each has unique and demanding characteristics that require very solid experience on behalf of the farm managers. ­Investors may have an affinity with a particular farm product, which is legitimate, but it shouldn’t bias the objective judgment of their returns and risk levels across the cycle. All the farm products benefit from intractable global demographic trends, but within this rising demand trend, some crops are considerably more volatile. Alternatively, some are more demanding – for instance, dairying requires much more investment and stock management than sheep farming. What approach should investors take? Griff Williams: Maximizing sustainable yield and minimizing environmental risks means that it is critical to partner with real farm operators. The skills the investor should try to access are centered on rural productivity, rather than on land speculation or investment vehicles that mainly back trades in the agricultural futures markets. These markets have quite distinct returns time frames and performance drivers from the farmland itself. What are the special characteristics of investing in farmland globally? Griff Williams: The key point is that ­agriculture, in many countries, remains a politically defined investment universe. ­C ertain governments restrict direct farm ownership to residents, while others link subsidy payments to the farm’s output. A set of agricultural economies, however, has liberalized its farming sector to reflect global market prices, and these countries have seen substantial efficiency gains. New ­Zealand is the classic example here, ditching

—43

“Maximizing sustainable yield and minimizing environmental risks means that it is critical to partner with real farm operators.” Griff Williams

Griff Williams

The New Zealand national comes from a farming family on the North Island, where he continues to have dairy farming interests. At Milltrust he is responsible for designing and co-managing the ­globally diversified agricultural strategy with special focus on Australia and New Zealand. Prior to Milltrust, he was Head of Europe and Interim CEO of Itaú Asset Management.

farm subsidies virtually overnight in the ­mid-1980 s. The New Zealand dairy sector is now the most efficient in the world, and few farmers would seek a return to government involvement in the price-setting process. Australia has also largely cut out farm ­support. Other countries, such as the USA , have more recently and gently modified farming subsidies. The 2014 US Farm Bill took the positive, though modest, step of lowering direct payments and replacing them with crop insurance provisions. Globally, rich-country transfer payments to the agriculture sector have been a major obstacle to free trade agreements. It’s important to stress that agriculture can survive and thrive in a high-income country, without state price support. Finding those liberalized land opportunities, and conducting the vital due diligence on legal systems, security of title, environmental and marketing systems, does require a broad range of skills. Have you identified some best-practice markets, or does it vary from farm to farm? Griff Williams: The set of undistorted farm product opportunities is quite small, in country terms. The best operating environments are seen across Australasia and in selected Latin American countries such as Uruguay, Paraguay and Brazil. Once a number of farmers in a given country adopt the best technologies and practices, the pressure on the other farmers builds up rapidly. This is as true of yield-enhancement ­techniques as it is of sustainable farming ­practices. Still, there are enough underper­forming farms in countries with sufficiently good investment conditions to provide ­opportunities for a portfolio approach. 

GLOBAL INVESTOR 1.15 

—44

Trends in real estate investment

Ins and outs of real estate

Photo: Gregor Schuster/Getty Images

As an illiquid asset, real estate takes time to sell and the length of the selling period can vary heavily. For indirect investments in particular, there may be regulatory frameworks and the possibility of pooling properties that moderate the negative effects, but there will still be a certain risk of illiquidity due to the inherent hetero­geneous characteristic of real estate. However, investors with a sufficiently long time horizon can cope with these risks and are compensated by a potentially higher return compared to more liquid assets.

GLOBAL INVESTOR 1.15 

Hints for investors 1 / Adopt a long investment ­horizon. Transaction costs are best absorbed by having a long i­nvestment horizon. 2 / Mind the leverage. Sufficient own funds help to avoid fire sales as price and liquidity cycles can be long. 3 / Know your product. Legis­lation is very different for distinct types of real estate funds and country-dependent. Some setups are more exposed to ­liquidity problems. 4 / Take your time. Avoid making your decision to buy or sell too quickly. This could turn out to be very costly. 5 / Add real estate to your ­p ort­folio. Do not be frightened of i­lliquidity. Real estate is a good d ­ iversifier in portfolios.

01_Allocation to property in UHNWI investment portfolios

W

hen talking about illiquid assets, real estate is at the forefront as it belongs to the most prominent of illiquid assets. In developed markets, real estate is the most important wealth contributor in household portfolios and adds up to enormous amounts of wealth. It is not surprising that regulators and central banks pay a lot of attention to real estate markets. Residential real estate accounts ­ for ­almost 30% of net worth in portfolios of ultrahigh-net-worth individuals (UHNWIs) (see Figure 1), and pension funds also have a substantial share of their allocation in real estate (see Figure 2). Causes of illiquidity of real estate assets

The illiquidity feature of real estate results from a combination of several characteristics. To begin with, real estate assets are always tied to a certain location. The combination of a particular location and a specific object quality creates a unique tangible asset. Consequently, every building requires a one-off analysis and, on a microlevel, prices can even differ heavily on the basis of, for example, exposure to noise or view. All this is reflected in the valuation of a property: there is no true

02_Asset allocation of Swiss p ­ ension funds as of September 2014

While residential property (main residence and any second homes) makes up almost 30% of the total net worth of UHNWI s, real estate also plays an important role when it comes to making investments. On average, property accounts for 24% of UHNWI investment portfolios. In over 40% of all cases, this share has even ­increased in recent years. 

Swiss pension funds traditionally have a sub­ stantial allocation to real estate. As of September 2014, almost 20% of their funds were invested in real estate. This number typically decreases to some degree when equity markets are doing ­p articularly well and therefore make up a larger part of the asset allocation. 

Source: Knight Frank, The Wealth Report 2014

Source: Credit Suisse Swiss Pension Fund Index, Q3 2014

7.0%

in percent 35

19.7%

30 25 33.7%

4.9%

20 15 10 5

31.3%

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tra

las

ia

a e ia al st rica rica IS A s i a /C A f r i c G l o b u r o p e E a e e E dl h A m n A m ss d u i R ti rt M a o L N

 Liquidity   Bonds   Equities   Alternative investments   Real estate   Mortgages   Rest

or objective price. Target prices depend on the type of valuation model used and on investorspecific preferences. Finding a price becomes even more difficult when there is only limited data available on similar transactions and if assets have rare characteristics. This often makes price negotiations time-consuming, and adds to illiquidity. Determining a fair price is especially important when one considers the large size of the transaction. Several other real estate characteristics contribute to illiquidity, mostly from a cost perspective. For example, the design and, to some degree, the location of a building predetermine its suitability for certain activities. The conversion of a big department store into many small retail units is relatively costly, and regulation must also be taken into account. Changing the use of a property from a legal point of view, such as the conversion of apartments into shops and vice versa, may be difficult or even impossible. Investors must bear this in mind and should therefore have a clear strategy when investing in real estate. Other costs include legal expenses and taxes at the transaction stage. In total, there are five steps in the acquisition of a commercial building (see Figure 3). At each step, different types of costs occur. Purchasing a commercial real estate building typically needs a ­negotiation time of about three months, plus several months to conclude the transaction. One last reason for the illiquidity of real estate is simply the state of the market, which can dry up quickly in periods of excess demand (when nobody wants to sell a property) or, more seriously, in a situation of weak demand. Investors are facing difficult decisions

1.2%

2.1%

—45

The main question for investors is whether it is worth accepting this disadvantage from a risk-return perspective. This depends on the time horizon. As high transaction costs associated with illiquidity are fixed costs, it makes sense to hold such an asset for a longer period. Therefore, pension funds and other institutional or private investors with a long time horizon are typical real estate investors. In addition, these investors need to accept that their real estate positions may not be 100% liquid at any time. For wealthy investors, these constraints are easier to cope with (a fact that is reflected in the higher real estate allocations of UHNWI s, see Figure 1). For these investors, it makes sense to accept the illiquidity and be compensated for it. For example, the historical average premium to the intrinsic net asset value (NAV ) for listed >

GLOBAL INVESTOR 1.15 

—46

03_Real estate transaction process A typical transaction process for commercial real estate consists of five steps and may last up to six months. Expenses, such as search or transaction costs, may incur at each step. Steps 2, 3 and 4 could run simultaneously. Due diligence thus makes up most of the time and costs.  Source: Credit Suisse

Research – Search costs – 2–4 weeks

Swiss real estate funds has been 7% since January 1990. Direct real estate investors can avoid this premium. In addition, although direct real estate cannot be traded on a daily basis, this may be a good thing from a behavioral finance perspective. Most investors tend to underestimate transaction costs and in turn reduce their performance by trading too often. Since the real estate transaction process takes time, investors are automatically prevented from excessive trading. Implications of illiquidity on markets

Preliminary check and non-binding offer – Agency costs – 1–2 weeks

Negotiation and final offer – Negotiation costs – 2–4 weeks

Due diligence – Market, legal, tax, technical and environmental due diligence – 1– 3 months

Closing – Additional costs (transfer taxes) – 1–2 weeks

In the case of illiquid assets, the problem­ is that investor interests do not necessarily align with market conditions. While it may be highly rational for an investor to buy or sell a property, too many investors acting in the same manner at the same time can reduce the liquidity of the whole market. In the end, investors behave in a pro-cyclical manner because they take more extreme positions and trade more often when liquidity is high and revise their ideas if liquidity drops. From a long-term perspective – and this is the horizon of most direct real estate investors – this is irrational. Theoretically, there should be a similar number of transactions in each stage of the cycle. But this is clearly not the case. Between the peak in Q1 2007 and Q1 2009, quarterly commercial real estate transactions in the USA fell by 91% in terms of volume, and they increased by 691% by Q3 2014. Illiquidity is often amplified in abnormal market situations. Moreover, not all real estate segments are affected by illiquidity in the same way. Down markets trigger a flight-­ to-quality effect. Most investors will focus on core properties in prime locations of favored cities such as London or New York – if they are still buying real estate assets at all. Negative consequences are not a given

Weeks 0

1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Investment solutions to meet the illiquidity challenge are very different from country to country, but generally adhere to the same simple idea: pool some properties, securitize them and distribute the shares. Then create a market for these shares. This can be a stock exchange or not. In either case, the shares can be traded more or less continuously and the properties are thus effectively more liquid. Sometimes, a market maker is needed to make the market fully liquid. This not only applies to properties but also to mortgages that are backed by properties. The legal structure of such transactions can be very differ­ent depending on the number of owners and

GLOBAL INVESTOR 1.15 

properties. For all these structures, trust is of key importance, which implies a certain degree of transparency when it comes to valuation for instance. Sometimes illiquidity conflicts with certain investment goals. For example, one concept is to reduce liquidity slightly by increasing transaction costs in order to curb speculation. This may help to lock out investors that have a very short time horizon and are prone to selling assets when the first headwinds occur. Limits to liquidity

Even if liquidity is enhanced by pooling properties, there is still no guarantee that this will work all the time. Sometimes pooling properties only results in “pseudoliquidity,” which works when markets are rising (see also “Open-end versus closed-end funds”, page 24). In contrast, in times of falling markets, the number of potential sellers surpasses the number of potential buyers. This can also happen for complex real estate-related financial instruments such as residential and commercial mortgage-backed securities ( RMBS  /CMBS) as investors learned in the aftermath of the financial crisis. Confidence could not be restored on short notice. The risk of moving from a liquid to an illiquid market environment depends on the legal framework, as seen in the case of German openend real estate funds. The announcement of possible regulatory changes to the corresponding legal framework triggered massive redemptions by investors who wanted to retrieve their capital before the new regulation was introduced. In contrast, listed fund structures with a fixed capital base such as in Switzerland are less exposed to such risks. Selling real estate may become easier

As long as properties are tied to specific locations, real estate will face liquidity issues. But we believe that real estate properties will become a priority for investors in the coming decades. First, real estate still does not have the appropriate or optimal weight in many asset allocations. Second, interest rates may stay at low levels for an extended period of time, which makes real estate returns attractive and should help to improve liquidity from the seller’s perspective. 

Philippe Kaufmann Head of Global Real Estate Research +41 44 334 32 89 [email protected]

—47

Beat Schwab Head Real Estate Investment Management Switzerland + 41 44 333 92 42 [email protected]

Swiss real estate funds: Liquidity and diversification Real estate funds are an interesting alternative to investing into physical real estate as they typically offer investors access to diversified real estate portfolios that are managed by experienced real estate professionals. However, the way the product structure deals with in- and outflows of investor liquidity can impact the funds’ returns. Generally, one can distinguish between open-end and closed-end funds. As described in the article by Giles Keating and Lars Kalbreier (see page 24 for more details), these two contrasting structures have both advantages and disadvantages in times of market stress. Swiss real estate funds aim to create a structure that captures advantages from both types, while limiting the disadvantages by having a semi-open-ended structure. This means that funds are opened up to investors during periods of capital-raising activity, but that shares of the funds are otherwise exchanged between investors on secondary markets (with the majority of funds being listed on the SIX Swiss Exchange). Whenever there is strong investor appetite for real estate funds, any excess demand on the secondary market leads to an increase in unit prices and vice versa. However, this excess liquidity does not flow directly into the product and, as such, can neither impact the underlying portfolio nor potentially affect operations, as it is fully absorbed by supply and demand on the secondary market. Typically, this often leads to fund units either trading above (agio) or below (disagio) par to the net asset value of the underlying real estate portfolios. If true investment opportunities arise in target markets, the funds can be reopened for subscription of fresh capital for newly issued units, which can then be put to work. This structure thus enables controlled and healthy organic growth, while also providing a certain degree of liquidity to investors. We also advise real estate investors to diversify internationally. Since real estate market cycles tend to vary between different countries, adding international real estate to a domestic portfolio can significantly enhance the risk-return profile of a real estate portfolio. There are several Swiss real estate funds with an international focus. While such products are denominated in Swiss francs and foreign currencies are mainly hedged, we believe the approach of globally diversified real estate portfolios offers value to investors beyond Switzerland.

GLOBAL INVESTOR 1.15 

—48

Taking a long-term view

Infrastructure on the rise Source: Preqin

Transport sectors

Telecommunications and technology

Energy

Social infrastructure

Resources and waste

2014 282 bn of  USD infrastructure assets

 90% of surveyed investors plan

to invest at least USD 50 mn e ach over the y ear 2015

25% of surveyed investors plan

to invest over USD 4  00  mn  ach over the y ear 2015 e

Illustration: -VICTOR-/Getty Images

2007 94 bn of

USD infrastructure assets

GLOBAL INVESTOR 1.15 

Largely due to the current low interest rate ­environment, institutional investors such as insurers and pension funds are increasingly moving toward allocation into longer-term illiquid assets, in particular into infrastructure as an asset class. This trend has been a significant one. In fact, global infrastructure assets under m ­ anagement have seen a 300% increase over the past seven years. ­Investors are increasingly putting their money into the transport, tele­communications, ­ technology, energy and r­esources s­ ectors, and backing the large-scale construction projects these sectors require. While not without risk, such investment is s­ upported by ­governments and supranationals alike.

—49

T

here is clear evidence that insurers and pension funds with long maturity liabilities are increasing their asset allo­ cation to infrastructure as an asset class. Other categories of ­investors are larger family offices and sovereign wealth funds. The investment case is that infrastructure projects or businesses offer long-term yields that are theoretically fairly stable and normally can provide inflation protection. Typically, investors are ­t aking a s­ even- to ten-year view on the risk / r eward of investing in infrastructure assets, but frequently the time horizons can be ­c onsiderably longer. According to Preqin, global infrastructure­ assets under management in unlisted funds are at a record high of USD 282 billion, having increased threefold since 2007. Of the investors surveyed by Preqin, 25% plan to invest over USD 400 million each over the next year in infrastructure, and 90% plan to invest at least USD 50 million. Preqin estimates that “dry powder”, i. e. uncalled capital already committed, could be USD 107 billion, while insurance companies are planning to increase their asset ­a llocation to infrastructure to 3%. Infrastructure: The different components

Infrastructure covers a range of differing assets, but can be broadly disaggregated into the transport sectors, telecommunications and technology, energy, social infrastructure, and resources and waste management. Examples in the transport sector will include the ­c onstruction of new railways / mass transit systems and trains, ports and shipping, airports, roads, bridges and tunnels. Telecommunications and technology investments range from relatively simple, such as ­m obile phone masts and fiber-optic cable, to complex projects, such as server or other tech cluster farms. The energy sector is very broad, but will include conventional assets such as pipelines, storage facilities, refineries, support infrastructure for oil and gas fields, the nuclear sector, energy transmission systems and a­ lternative energy assets. There has been significant investment in alternatives such as on- and offshore wind farms, hydroelectric systems, solar and biomass plants. Social investments are typically defined as the construction and maintenance of schools, universities, hospitals and prisons. Although there is some overlap with the ­e nergy sector, resources and waste management infrastructure includes water management systems, sewerage, waste collection and the ­r ecycling sector. Typical infrastructure investment vehicles

In an unlisted fund, it is normal for the general partners to manage the infrastructure assets and to appoint management teams as ­relevant to the day-to-day management of individual assets or projects. Limited partners will have made an initial capital commitment, and capital will be called as and when funds are invested. There is typically an initial investment period, and if the general partner has not invested funds prior to the maturity of this investment period, then capital ­c ommitments are waived or the limited partners can vote on granting an extension. There will be clear guidelines on the fund’s turnover, on investment concentration, leverage, planned repayments to limited partners, and how, if necessary, the limited partners can vote on a change in asset manager or general partner. Leverage has to be carefully monitored since funding can be at the fund level or more normally embedded in the actual projects or assets being ­invested in. Leverage levels will typically be higher than what is n­ ormally found in the private equity industry on the assumption that cash flows have a lower degree of volatility than that in private equity. Sources of >

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—50

performance will be cash flows from projects, the improvement or upgrading in infrastructure assets with new management, leverage and over the long term the disposal of assets to new investors.

1

Investor demand: Existing assets versus greenfield projects

The infrastructure industry is dominated by investment in existing infrastructure with a focus by general partners to improve the cash flows from existing assets, to improve the financing structures, to upgrade assets and to sell on what were originally purchased as ­u ndervalued assets. In some cases, publicly listed infrastructure ­c ompanies will be taken private with a view that management change can be more easily effected in a private structure. One key problem is that although 70% of infrastructure requirements are estimated to be in greenfield projects, investor demand is primarily for existing assets. The rationale for this reluctance lies in the fact that investors do not want to carry the initial construction period risk where cash flows will be negative, and where investors have limited direct control over issues such as cost overruns, construction failures, environmental risks, supplier failures, etc. Greenfield project risks are typically carried out by companies with a long history of involvement in the construction of infrastructure, and they may be supported by government, bank or supranational institution guarantees. In emerging economies, many projects have only taken place backed by, for example, guarantees from the Asian Development or the Inter-­ American Development Bank. In Europe, the European Investment Bank has played a key role, not just in ­f inancing projects, but by providing ­guarantees.

2

Financing

Financing can be divided into a variety of constituent elements – ­including equity – typically with pension funds and insurance companies acting as limited partners in unlisted funds, companies involved in the infrastructure sectors providing equity, bank financing, the developing infrastructure bond market and the provision of guarantees from banks, governments or supranational institutions. Given the ­long-term and illiquid nature of the assets, it is generally agreed that it is ­inappropriate to have infrastructure assets in mutual funds where short-term liquidity is provided to investors. If retail investors want to access the infrastructure industry, the most appropriate route is to purchase the equity or bonds of infrastructure construction and maintenance companies.

3

Infrastructure bonds

Apart from equity investing on the part of long-term investors, there is a clear recognition among investors that the infrastructure bond market requires further development. Historically, infrastructure was financed either by bank lending or by bond issues made by supranational institutions, governments, or companies involved in the construction or maintenance of projects. Investor risk was limited to a direct credit risk on the ­issuer without any recourse to the project assets. With banks deleveraging and reducing maturity mismatch risk by ­focusing on floating-rate rather than fixed-rate assets and reducing proprietary positions, bank financing for infrastructure will decrease on trend, and therefore lead to greater reliance on access to funding from investors and the bond markets. Since investors are reluctant to act as equity providers in greenfield projects, they likewise will not be providers of longer-term financing for new projects. They will, however, be active participants in bond issues made by existing infrastruc-

1 Workers laying railway track in northwest China. 2 Pipeline pipes at the ready with oil rig in background. 3 Bales of paper ready for recycling.

GLOBAL INVESTOR 1.15 

ture management companies such as train operators, pipeline managers, etc., while they will also purchase bonds where there are credit guarantees either by government, supranational institutions or banks.

Photos: Imaginechina, Lowell Georgia, Anna Clopet/Corbis

Risks

While the current low interest rate environment encourages increased allocation into longer-term illiquid assets such as infrastructure, it is important to focus on the risk factors in the industry and highlight some examples where investor losses have been generated. For new projects, the obvious key risk is that projects are either not completed or have serious delays and /o  r cost overruns. Recent examples include escalating costs of building new nuclear plants, projected overruns in high-speed train lines and toll road tunneling projects. Political risk has to be carefully assessed; there have been a number of instances, notably in mining projects in higher-risk emerging markets, where a change of government has led to contracts /c  oncessions being cancelled and assets sequestered. Another example of political risk is the possible change in government subsidies and / or support. A number of alternative energy projects and notably wind farms have faced deteriorating economics as government subsidies have been withdrawn, and likewise social infrastructure projects, which might be in the form of a public / private partnership, can suffer from reduced government funding. Environmental issues are critical, notably in the transport, energy and waste management sectors. Examples of problems have been the imposition of environmental fines on projects and infrastructure assets and projected cash flows being delayed because of disputes over environmental issues. Certainty of cash flows is ­o bviously important, but in a number of cases, cash flow projections have been too optimistic. One example has been in toll roads where they have competed with toll-free roads and traffic has not switched to the toll roads, with a mediocre outcome for revenues and cash flows. Another risk is the threat from new technology. For example, in telecommunications, the future viability of mobile masts has to be questioned, while initially the excessive installation of fiber-optic ­c abling led to major losses. Market price movements can change the economic viability of infrastructure. At present, the sharp decline in oil prices is challenging a number of alternative energies, and investment in oil and gas fracking is becoming less attractive. Financial risks involve the threat of higher interest rates and /o  r wider credit spreads. Increased financing costs will challenge the economics of infrastructure, make alternative asset classes more attractive and could delay projects if refinancing needs are not met. Other market-related risks can be changes in foreign exchange rates where hedging longer-term assets can be problematic, shifts in yield curves (which might affect swap pricing where swaps have been used to hedge borrowing risks) and the use of excessive leverage. In 2008–09, a number of infrastructure funds had to be restructured since reduced cash flows could not meet increased borrowing costs and /o  r refinancing could not be successfully achieved. The final risk is that, in “easy” markets backed by quantitative easing, valuations may become stretched and there is some initial evidence of this occurring with current transactions in the ports and trains sectors being effected at values significantly higher than those that took place over the last five years. Government policies

In the recent G20 communiques, the G20 stated “we are working to facilitate long-term financing from institutional investors and to

—51

encourage market sources of finance, including transparent securitization, particularly for small and medium enterprises and we endorse the multiyear program to lift quality public and private infrastructure investment.” It is obvious that at the level of individual governments and also the IMF, OECD and EU, accelerating infrastructure projects is a clear macropolicy objective. S & P has estimated that infra­s tructure financing needs worldwide could total USD 3.4 trillion annually until 2030. For governments, infrastructure investment is clearly attractive given the initial positive impact on employment and the longer-term multiplier effect on the economy. Trends

There are a number of clear trends in the infrastructure sector. First, new investment from investors such as pension funds that need ­long-term assets and do not need liquidity will increase significantly. Second, investment in infrastructure will have the support of governments and supranational institutions given the strong economic ­m ultiplier effects. Third, the environment for investing in greenfield projects / s tart-ups will remain challenging and will require project and credit support. Fourth, investors will focus on areas where there is inflation protection, minimal systemic risk, and where leverage and financial risk is intelligently managed. Finally, the flow of equity capital will be matched by the development of the infrastructure bond market as an alternative to bank financing. 

Robert Parker Senior Advisor +44 20 7883 9864 [email protected]

GLOBAL INVESTOR 1.15 

—52

Advising on illiquid assets

Looking beyond liquidity Global Investor asked two Credit Suisse wealth managers to describe the illiquid asset landscape from the point of view of investors. Do clients feel it is worth trading liquidity for a­ dditional returns? How much of their portfolios do clients allocate to illiquid assets? Are some assets more popular than others? And how does culture affect asset choices? INTERVIEW BY MANUEL MOSER Senior Financial Editor, Credit Suisse

Manuel Moser: What does a typical client’s portfolio allocation look like? Felix Baumgartner: My perception is that “this” client is invested approximately 40% to 50% in equities and 30% in cash. The cash tends to come from fixed income. In other words, when a bond expires, the money goes into the cash portion of the ­account owing to the lack of opportunities in fixed income. Now, clients are a bit ­worried about staying in cash, and consequently they’re looking for other opportunities, including ­illiquid assets. Are some investors more open to illiquid assets than others? Patrick Schwyzer: There are different ways of characterizing investor preferences: by geography, by what stage investors are in in their lifecycle, by their background and by the country they live in. For example, the USA is certainly more open to illiquid ­a sset investment. Switzerland not so much. There are a number of reasons for the difference, one of which could be that in the USA , people have to administer their own pension money. That means thinking through the range of investments for the best yield and return, whereas in Switzerland we still delegate the entire business of pensions to outside parties or the companies’ ­p ension scheme. What about preferences for various kinds of illiquid assets, such as real estate or hedge funds? Felix Baumgartner: The order of ­pre­ference that we observe is: real estate, then hedge funds, followed by private equity. ­Traditional Swiss investors, in particular, look for real estate in Switzerland. But there is not much left here. It’s all been bought up. Some traditional investors still like gold, which is not an illiquid asset, of course, but still very volatile. How satisfied are clients with the ­r eturns on their investments in illiquid assets? Felix Baumgartner: I’d say they’re ­satisfied with real estate, and with hedge funds. Private equity could be the next boom in the coming years because it offers a long-term investment, diversification and good returns. But clients are too little invested in it at present to reap the benefits. For Swiss-based investors, I would estimate that private equity currently represents only about 1% or 2% of their portfolio. Patrick Schwyzer: I would say it’s more like 0.5%! >

—53

Photos: Luca Zanetti

GLOBAL INVESTOR 1.15 

Patrick Schwyzer (left) and Felix Baumgartner from Private Banking & Wealth Management, Credit Suisse, take a moment to exchange viewpoints.

GLOBAL INVESTOR 1.15 

—54

What additional return would a client ­t ypically expect in private equity versus ­traded equity, after fees? Patrick Schwyzer: It’s difficult to price the illiquidity premium. Research shows that private equity does create a positive outperformance over the classic equity market in the long run. For example in a traditional buyout private equity fund, a client would be looking for annual double-digit returns over the lifetime of the fund. How realistic are those returns? Patrick Schwyzer: What’s key in private equity is to invest in what we call top-­quartile performers. So you tend to go with managers who have proven that they can achieve the double-digit return in any particular strategy. Needless to say that expertise and knowledge of the private equity universe are key in identifying such managers. Where would you rank expectations for hedge funds compared with cash, bonds, equity or private equity? Patrick Schwyzer: Again, it’s difficult because hedge funds are not a homogeneous asset class. We group hedge funds into four different styles, so to speak. And every style has its own risk/return ­profile. For an equity long-short manager, for example, a rule of thumb is that you ­participate in two-thirds of the upside and one-third of the downside compared to traditional equity. There’s no such thing as a free lunch, as you know. There are other styles, e.g. managed futures, strategies that tend to be uncorrelated to an ­e quity market. Keep in mind that any broad hedge fund index is just the amalgamation of all these different styles. Nobody assumes that hedge funds are fully liquid. But what about bonds? The financial industry is reporting big rushes into high yields and very high-risk bonds. Do you see a risk that clients may have bought things that they thought were liquid, but that may end up not being liquid? Patrick Schwyzer: Education is key. ­A bsolutely key. This is one of the lessons of the financial crisis of 2008. Sometimes a product behaves just like it is designed to, but a different perception was linked to the product and therefore caused irritation with clients. An explanatory discussion with a specialist typically helps in such situations. Also, secondary market liquidity can be ­provided for alternative solutions. While this generates liquidity, it is not inherent in the

“What I see in most discussions is that clients want to understand the thought process and how we do things.” Patrick Schwyzer

Patrick Schwyzer

is a Managing Director of Credit Suisse in the Private Banking & Wealth Management division, Zurich, and Head of Alternative Investments for Private Banking clients Switzerland and EMEA . He was previously with GAM Global Asset Management London. He graduated from the University of St. Gallen with a special focus on Finance and Capital Markets.

Felix Baumgartner

is a Managing Director of Credit Suisse in the Private Banking & Wealth Management Division, Zurich, and Co-Head Premium Clients Switzerland. He was previously a Director at Credit Suisse First Boston in Global Foreign Exchange (GFX ) and a member of the GFX management team. He is a graduate of the Zurich and the London Business School.

GLOBAL INVESTOR 1.15 

product, and the liquidity provider will t­ ypically buy at a discount to the actual net asset value of the product. Are entrepreneurs more likely than other ­investors to favor illiquid assets? Felix Baumgartner: It’s a good question. As owners of their own company, they’re more open to illiquid investments. They probably have 80% of their total wealth invested in the company, and they’re com­ fortable with that because they know what is going on with it. Of course, if they already have 80% invested in their company, it makes no sense to put the rest in illiquid ­a ssets as well. So we would tend to advise them to maybe put 5% in private equity, if they really want that, and keep the rest in cash or in liquid assets. How much do clients want to know before they decide on an illiquid investment? Patrick Schwyzer: What I see in most discussions is that clients want to understand the thought process and how we do things. They want to understand how we come to the selection of a particular ­manager, be it in the private equity or the hedge fund space. They don’t really want to receive the full package on the due diligence report and go through it themselves. That’s exactly why they come to us. In terms of cycles, is it fair to say that ­investor appetite is back where it was ­b efore the financial crisis? Felix Baumgartner: Absolutely. Investors are looking for opportunities. Clients, and especially Swiss clients, often want to leverage their portfolio, also the illiquid parts. It’s analogous to taking out a mortgage on real estate. And banks are increasingly amenable to offering credit (assessed on the basis of loan to value, or LTV ) on ­illiquid assets. We clearly limit the risk in the interests of both the client and the bank. Patrick Schwyzer: Another cycle-­related example: before the 2008 financial crisis, there was a lot of movement into the socalled fund of hedge funds space, particularly in Switzerland. After the crisis, those private investors left that space. And now we see them coming back, as ­providers ­b egin to offer a selection of ­c arefully vetted single-manager hedge fund products or ­advisory services. Has the rise of family offices played a big role in increasing the allocation to illiquid assets? Patrick Schwyzer: It depends on the type of family office. The smaller ones that

literally are a family of two or three people have one investment specialist who needs to cover everything from bonds to alternatives. In that case, they’re looking to us to help them put together their own portfolio of hedge funds. Bigger family offices typically employ their own private equity specialist or hedge fund specialist, but like to talk to us as a “sparring partner.” Felix Baumgartner: Investment behavior and interest can also change dramatically. We’ve seen that over the last one or two years. Some family offices that previously invested only in traded equities with no ­a llocation in private equity because of ­worries over illiquidity, decided to go into it within the space of three or six months.

—55

Are fees an issue for clients? Patrick Schwyzer: Certainly, pre-2008, the predominant means of investing in hedge funds for the private sector was fund of hedge funds. And there you had a double layer of fees: the underlying managers who on average were going to charge you a 2% management fee and a 20% performance fee; and the additional level on the fund of hedge funds where the manager would pick and choose those funds. We have seen a clear trend toward single funds, which has removed one of the fee layers. The second layer is also under pressure. It comes down to performance. Good ­p erformance is clearly needed to justify the fee levels. 

“The order of preference that we observe is: real estate, then hedge funds, followed by private equity.” Felix Baumgartner

GLOBAL INVESTOR 1.15 

—56

Market overview Indexes compare each sector’s growth over a ten-year period, using the central 80% of data and a 14 -month moving average (14MMA ).

AMRD 2003 = 1000

    

12,000 10,000

Chinese Contemporary Art AMRD Contemporary 100 Jewelry  Classic Cars  Watches

8,000 6,000 4,000 2,000

06

07

08

09

10

11

12

13

14

In passion we trust

The idea of objects of desire as investments of passion took off in the UK in the late 1970s with the publication of “Alternative Investment.” As an investment analyst in the City of London, the late Robin Duthy noticed that, while conventional investments were intensely studied for past performance and future potential, no systematic analysis of the markets for art, antiques and collectibles had been undertaken. Working with the late Sir Roy Allen at the London School of Economics, he devised a sophisticated methodology of trimming and smoothing mechanisms, which eliminated seasonal and other distortions. It is important to remember that when the ­media reports eye-catching prices for collectibles sold at auction, the prices paid by the buyer will be substantially higher than the cash received by the seller; transaction costs in these ­markets (e. g. auctioneers’ or agents’ commissions) can be sobering, reflecting the price paid to overcome the illiquidity inherent in trading high-value idiosyncratic items.

AUTHOR ART MARKET RESEARCH & DEVELOPMENT (AMRD)

Photo: malerapaso /  G etty Images   Sources: Art Market Research & Development (AMRD)

05

GLOBAL INVESTOR 1.15 

“All successful buying must be based on confidence, whether in a dealer or in oneself, and the only basis for confidence in oneself is knowledge.” Robin Duthy “Alternative Investment” – Founder of Art Market Research

Drawing attention: The rise of Chinese contemporary art In 2007, art collector Howard Farber sold Wang Guangyi’s ­“ Great Criticism: Coca-Cola (1993)” for USD 1.59 million at Philips, having claimed to have paid just USD 25,000 ten years earlier. The painting was sold in late 2007 as the market neared its peak for 63 times the reported acquisition cost. After 2005, the auction market for ­Chinese ­contemporary art entered a phase of rapid development. Two years later, Charles Saatchi was noted for selling off some of his younger German artists collection in order to fund his ­interest in Chinese contemporary art. The painting ­“1998.8.30 ” by Lijun sold at S ­ otheby’s Hong Kong in 2010 for over USD 1.2 million. Last year, his ­“ Publication 2 No. 4” sold for over USD 7.6 million. AMRD’s methodology enables comparison with other a­ rt sectors, for example, as represented by the AMRD Contemporary 100, a leading benchmark. Set against an overview of sales of contemporary artists across the globe, the i­ndex reveals that sales of top Chinese contemporary artists have been outperforming the competition for the last five years.

Watches Growth by brand from January 2004 to December 2014 using the central 80% of data from the AMRD Watch Index, calculated on a 14MMA basis. The index was rebalanced to 1000 in 2003 . 2,000 1,800 1,600 1,400 1,200 1,000 800 01.04

01.06

01.08

01.10

01.12

01.14

 Patek Philippe   Cartier   Rolex

Some watches ticking upward Classic Cars Ten years of market growth on a 14MMA basis shows F ­ errari outperforming Maserati by 55% and Triumph by 84%. The Classic Car Index was rebalanced to 1000 in 2003 . 17,000 15,000 13,000 11,000 9,000 7,000 5,000 3,000 1,000 01.04

01.06

01.08

01.10

01.12

01.14

 Ferrari 1959–1982   Maserati 1958–1982   Triumph 1946–1977

Chinese Contemporary Art versus Contemporary 100 The index, calculated on a 14MMA basis, shows that the Chinese contemporary ­s ector has grown 29% in the last 14 months and is back to where it was in early 2007. 12,000 10,000 8,000 6,000 4,000 2,000

01.05    

01.08

01.11

01.14

Chinese Contemporary Art top 25% AMRD Contemporary 100 top 25% Chinese Contemporary Art bottom 25% AMRD Contemporary 100 bottom 25%

Pearls are a girl’s best friend

Investment vehicles: Italian classics in pole position Most of us past a certain age are likely to have owned and subsequently lost a prized possession that has gone on to become a valued collectible. It seems that a combination of rekindling one’s youth and the empty nester’s disposable income enables enthusiasts to purchase rare items, and this is nowhere more obvious than in the ­c lassic car market. Prices for some classic cars are going through the roof, and it is the I­talians that continue to lead the market. Ferrari’s 1959 –1982 models have seen a 1,350% increase in the last ten years. Maseratis produced between 1958 and 1982 have also seen some a­ ction in the last six months, having ­increased in value by over 23%. The 1946 –1977 era ­B ritish Triumphs have almost flatlined in comparison, but have ­c ontinued to rise slowly, with a compound growth rate of 3.9% over the last ten years.

—57

Luxury items tend to be one of the first things to suffer during tough economic times. The last financial crisis was no exception, with the highend watch market taking a steep plunge. The Swiss watch market is especially sensitive to ­e conomic depressions, regularly having to target new m ­ oney. High-end wrist watches are generally a poor ­e conomic investment. People buy them for their beauty, but not b­ ecause they think the watches will hold or increase their value. Yet Patek Philippe, Rolex and some Cartier watches can be exceptions, as they have shown solid v­ alue retention. A person buying a new Rolex or Patek Philippe watch today has a reasonable chance of losing little or no money on selling it in a few years. There is a healthy auction market for v­ intage R ­ olex and Patek Philippe watches, and a few rare models do fetch very high prices at auction, such as the sale of a Patek Philippe 1933 “Henry Graves Jr. Supercomplication” pocket watch, which sold in 2014 at Sotheby’s in Geneva for CHF 23.2 million ( USD 24 million). This set a new record for any timepiece ever sold at auction.

Jewelry has performed extremely well in recent years, with the emphasis being on signed pieces, colored gemstones, and pearls in particular. Names like Cartier, Van Cleef & Arpels or Boucheron are sought after as such a source usually ensures good quality d­ esign and manufacture, as well as having a s­ ignature and normally a unique number. This emphasis on signed pieces is a reaction to the large quantity of unsigned and r­ ecently made pieces on the market imitating ­v intage European pieces. Pearls have increased in value more than any other gemstones. Historically, the world’s best pearls were collected along the Persian Gulf especially around what is now Bahrain by breath-hold divers until oil exploration in the 1930 s disrupted the ­oyster beds. The fact that no more natural pearls are being harvested, combined with strong interest from the Gulf States, which value the acquisition of heritage objects, has forced pearl jewelry prices up to unprecedented levels – ­increasing by 405% in the last ten years. With world records being set every year, the finest jewels and gemstones continue to be objects of desire, having the advantages of displaying wealth, w ­ earability, portability and scarcity value.

Jewelry AMRD Pearl Jewelry Index vs AMRD General ­J ewelry Index on a 14MMA basis over ten years. The index was rebalanced to 1000 in 2003 . 5,000 4,000 3,000 2,000 1,000 01.04

01.06

01.08

01.10

 Jewelry (general)   Pearls

01.12

01.14

GLOBAL INVESTOR 1.15 

—58

European securitization

From illiquid assets to profitable investments

Illustrations: Frida Bünzli

To foster economic growth, the European Central Bank needs to revive the securitization market. This market is currently down to 25% of precrisis volumes or only 14% of US issuance in 2013. Improved transparency, the clearing of bank balance sheets and improved regulatory rules are expected to provide a catalyst for the securitization market going into the second half of 2015, offering attractive yield opportunities for investors.

GLOBAL INVESTOR 1.15 

I

n the aftermath of the financial crisis, the European securitization market collapsed. New issuance in European securitization decreased by more than 75% compared to volumes in 2008 and has not recovered since then. Primary market activity in 2013 was below EUR 200 billion, corresponding to only 14% of US issuance over the same time period (see Figure 1). The lack of a functioning securitization market is a major disadvantage for European banks, the economy and investors. Regulatory-forced deleveraging and its negative impact on lending and economic growth could have been better mitigated, in our view. For the European Central Bank (ECB) to be successful in fostering economic growth, the current pool of assets for Quantitative Easing (QE) might prove to be too narrow, so that the issuance of securitized investment products based on high-quality assets – so-called Qualifying Securitization (QS) – needs to pick up in order to broaden the ECB’s investment base. As the ECB is pressuring interest rates and yields into negative territory, banks are in need of margin expansion. If structured correctly, this can be achieved by QS and align the banks’ need to earn profits with the ECB’s need for economic growth and the investors’ need for attractive yield opportunities. To make the securitization market grow in Europe, it must become economically attractive for banks. So far, the maths have not quite worked out, mainly due to regulatory rules with respect to securitization that result in a lack of “capital relief” for the banks (see box on the risk capital treatment of different loans and securitizations on p. 61). Given their need to remain exposed to the part of the securitized a­ ssets with the highest risk, to which a risk weight of 1,250% is applied, the transaction simply lacks economic appeal for the banks.

—59

ECB as an asset-backed securities buyer

In 2014, the ECB released details of its asset-backed securities ( ABS) purchase program, which was followed by the release of a legal act enabling implementation of the purchase program with actual purchases having started. The ECB has appointed four executing asset managers for the purchase program. The asset managers will conduct the purchases on behalf of the Eurosystem and undertake price checks and due diligence prior to approving the transactions. The program will involve the purchase of senior tranches and guaranteed mezzanine tranches of loans originated in the euro area. Greek and Cypriot ABS will also be included in the purchase, albeit with tighter provisions. The combined size of the ABS purchase program and covered bond purchase program will reach EUR 1 trillion. Several other measures have also been taken in the meantime to facilitate the development of the securitization market in Europe. Among them, we would highlight the changes to Solvency II >

Turning an illiquid asset into an investment opportunity takes time

The ECB is in the middle of a multiyear process to regain investors’ and market trust, as well as to foster economic growth. In our view, the basis for regaining investor trust – including the ECB as an investor – was provided by the comprehensive asset quality review (AQR) and the stress test carried out by the ECB and the European Banking Authority (EBA). In October 2014, following a yearlong analysis of over a million pieces of data, the ECB and EBA published the much-awaited results of the AQR and stress test. The AQR exercise covered 130 banks within the Eurozone’s 18 countries, with total assets of EUR 22.0 trillion accounting for around 82% of total banking assets under the European Single Supervisory Mechanism (SSM ). The EBA stress tests covered 123 banks across 22 of the 28 EU countries, including banks from the UK and the Nordic region. Overall, 25 of the 130 banks failed, with an identified capital shortfall of EUR 24.6 billion. More specifically, 13 banks were identified to face capital shortfalls totaling EUR 9.5 billion. We believe that the ECB/EBA announcement struck the right balance between being too harsh and being too lenient, notably highlighting areas of vulnerability for some of the examined banks. Despite not forcing them to take immediate action, the ECB made it very clear that the adjustments would become part of its ongoing supervision of capital requirements as it continues to forge ahead with the agenda of improving the quality of European banks’ balance sheets. More importantly, we believe that the process toward a European Banking Union has significantly contributed to increased disclosure and transparency, which is building the basis for a greater investor attraction toward banking assets.

01_Primary market activity of European and US asset-backed securities New issuance of asset-backed securities (ABS) remains subdued in Europe compared to the US. The European market is, however, forecast to pick up during the course of the year following the launch of the ECB’s purchase program.  Source: AFME, Credit Suisse  in EUR bn 2,500

100%

2,000

80%

1,500

60%

1,000

40%

500

20%

0

0% 2006

2007

2008

2009

2010

2011

2012

 Total European ABS placed  Total US ABS placed  European ABS placed in % of US ABS placed (rhs)

2013

2014

GLOBAL INVESTOR 1.15 

—60

How does securitization work? The following illustrations show how loans can be turned into tradable securities:

1

When a bank grants a mortgage to a borrower, the bank earns an interest income.

2

The bank then bundles a number of home loans – both risky and less risky – into a pool of mortgages.

3

The bank places these pools of mortgages into a trust. The trust then sells bonds, which are secured by the mortgages.

4

The return and the risk of the bonds depend on the riskiness of the mortgages which secure the bonds. To create different risk categories of bonds, the bank divides the mortgages into risk groups called tranches. Rating agencies such as Standard & Poor’s or Moody’s then often rate the tranches to reflect the risk of default. The bank is required by regulation to keep a tranche of the highest risk category.

5

The newly created bonds are sold to private and institutional investors and even central banks. Thus, the bank has earned a fee for originating mortgages, but sold the risk and rewards of these mortgages to investors through the process of converting them into tradable securities (bonds).

GLOBAL INVESTOR 1.15 

r­egulatory rules for insurance companies, which made the capital charges less onerous for high-quality securitization. Further, rules on the Liquidity Coverage Ratio (LCR) for banks have also allowed some high quality securitization to qualify under certain criteria. However, there is still considerable debate on whether the existing rules on securitization still make the capital treatment too onerous for the issuing banks and this is an area that needs to see some change to help revive the European securitization market. Securitization market with significant volume

We believe that the data published by the EBA and ECB on banks’ risk exposures and risk-weighted assets should allow the market to better understand and quantify the eligible securities. From an issuer’s point of view, we conclude that there are currently situations where an unsecuritized portfolio may require less capital than a securitized portfolio (see adjacent box). As a result, the loan portfolio to be securitized might contain a higher proportion of assets with a higher risk weight attached to it. Thus, we believe that securitization may take place in regard to high-quality small and medium enterprise (SME) loans due to the higher risk weights applied. This is precisely the area where the ECB is trying to unlock the funding gridlock. With securitization accounting far from clear under International Financial Reporting Standards ( IFRS) and a likely piecemeal approach to capital relief, we have tried to estimate the potential size of qualifying securitization assets for Europe. Depending on the range of assets taken into account, we have adjusted the data for asset encumbrance and estimate that the market could range from a minimum of EUR 1 trillion (including mainly SME loans) to EUR 2.4 trillion (including lower risk-weighted asset categories such as securitized or collateralized lending). From the asset breakdown, we predict that securitization is more likely to reopen bank funding channels for SME s and corporate lending as we would expect the capital relief to transmit into lower sustainable funding costs in these sectors. We therefore believe that securitization can play a key role in serving the macroeconomic policy objectives of the ECB to foster economic growth. Given the completion of the AQR and the launch of the ABS purchase program, we believe that these are supportive steps toward a fully fledged securitization market throughout 2015. In turn, we continue to believe this will provide a positive backdrop for the Eurozone by releasing capital pressure from banks’ balance sheets, reducing the cost of borrowing for SME clients and providing lending to the economy. In an environment of very low yields, investors (including the ECB) will gain access to higher-yielding assets, which we expect to be attractively priced at the beginning to reopen the securitization market. 

Christine Schmid Head of Global Equity & Credit Research + 41 44 334 56 43 [email protected]

Carla Antunes da Silva Head of European Banks Investment Banking Equity Research + 44 20 7883 0500 [email protected]

—61

The risk capital treatment of different forms of loans and securitizations In this box we compare the capital requirement for a securitized portfolio (leaving 5% on the book as per retention rules) with that of the underlying loan portfolio. In the analysis, we have assumed that the bank uses the standardized approach for the calculation of risk-weighted assets.

A Capital requirements for typical loan portfolios We take three types of loan portfolios and apply the risk weights under the standardized approach. We take a secured residential mortgage, a commercial mortgage and an unsecured corporate loan, and present our capital charge analysis below: 1 RESIDENTIAL MORTGAGE – RISK WEIGHT = 35%

CAPITAL REQUIREMENT = 0.08 × 35 = 2.4%

2 COMMERCIAL MORTGAGE – RISK WEIGHT = 100%

CAPITAL REQUIREMENT = 0.08 × 100 = 8%

3 UNSECURED CORPORATE LOAN – RISK WEIGHT = 150%

CAPITAL REQUIREMENT = 0.08 × 150 = 12%

B Capital requirement for a typical securitization For a bank that keeps 5% of the portfolio on its books, the maximum capital charge would be as follows: 1 RISK WEIGHT = 5 × 12.5 = 62.5 2 CAPITAL REQUIREMENT = 0.08 × 62.5 = 5% We can see that a bank does not always gain capital relief from securitization. For residential mortgages, for example, the capital requirement is greater for the securitized asset than for the underlying loan portfolio. This difference in capital treatment might encourage securitization of high risk assets, i.e. on a risk-based measure, a higher risk-weighted SME asset would generate more capital relief for a bank than a lower risk-weighted residential mortgage. Regulators thus have to address the risk weight ­a pplied to securitization of assets more closely ­c ompared to the underlying risk of the assets.

GLOBAL INVESTOR 1.15 

—62

Illiquidity in corporate bond markets

No exit? The efforts of regulators to strengthen the financial system have led to both lower and more volatile liquidity in the corporate bond markets. As a result, investors could potentially find ­themselves in a situation where no one will buy. To properly ­manage expectations, and to be able to plan ahead, investors need to understand this new landscape and what it means.

S

ince the financial crisis in 2008, regulators have tightened rules on financial institutions to improve the stability of the financial system. Banks and dealers have subsequently strengthened their financial profiles and scaled back risky capital market activities. This structural change is especially important to bond markets as they depend on intermediaries willing to warehouse risk and facilitate trading activity. As a number of studies by governing institutions suggest, liquidity in bond markets has decreased since 2008: investors now find it harder to enter and exit positions or are incurring higher transaction costs. This could increase the risk of more severe price swings. In an extreme scenario, investors might find themselves trapped as nobody is willing to buy. Here, we take a closer look at this structural change in bond markets and how it interacts with current ­market conditions, and analyze what investors can expect. Corporate bond markets

Compared to equities, the fixed income ­market relies more on dealers and over-the-­ counter structures, which makes it more decentralized and dependent on functioning

intermediaries. Further, the market for cor­ porate debt is much more fragmented than the market for equities as companies usually offer very few classes of equity, but a large number of different debt instruments. Within the bond market, different classes of debt exhibit different liquidity characteristics. The market for government bonds is perceived as more liquid compared to the market for corporate bonds, partly due to the different structures of securities issued. Governments issue in larger lots, have fewer maturities and usually do not add exotic features to their debt. The corporate bond market is much more fragmented and thus shallower. Moreover, in the corporate bond market, different risk segments exhibit different liquidity traits. Investment-grade debt is usually more liquid, while high-yield and emerging-market debt are perceived as less liquid. Declining liquidity raises awareness

A number of recent publications by regulatory institutions and think tanks suggest ­liquidity in bond markets has changed. In ­N ovember 2014, a paper published by the Bank for International Settlements on marketmaking activities found that liquidity in debt markets has shown a diverging trend since the

financial crisis in 2008/2009: global market activity is concentrated more in the most ­liquid securities like sovereign bonds, and less in riskier securities such as corporate bonds. According to the paper, this trend suggests an increased fragility of the latter. As data availability is limited, the International Capital Market Association, a self-regulatory organization, conducted a series of interviews with market participants to analyze the topic from a market view. The study, titled “The Current State and Future Evolution of the European Investment Grade Corporate Bond Secondary Market,” finds that liquidity in secondary European corporate bond markets has declined; interviewees described the decline ranging from “significantly” to “completely.” Another survey of large banks published by the European Central Bank (ECB) in January 2015 focused on Euro-denominated markets and arrived at similar results. More banks reported that their market-making activities for credit securities had decreased during 2014 rather than increased, and a further decrease is expected in 2015. The study also found that participants’ confidence in their ability to a­ ct as market makers in turbulent times had ­diminished in 2014 compared to 2013. Regulatory tightening a driver

We believe that the decline in corporate bond market liquidity can be attributed to an increase in regulation in the financial sector. This matches with the ECB survey results mentioned above, as banks most often cited regulation and balance sheet capacity as reasons for a decline in market-making activities. The financial crisis in 2008 revealed a number of shortcomings of financial regulation. Since then, governing institutions have been actively improving and tightening the regulatory framework, thus leading to a reduction of market-making and trading activities by banks. The Basel regulations for banks have increased the amount of equity banks need to hold against their risky positions. This makes market-making activities, which require sizable balance sheet capacity, less profitable. Additionally, the newly introduced Liquidity Coverage Ratio and Leverage Ratio are steering banks toward holding more liquid securities, reducing high-volume/lowmargin business such as trading activities, and limiting their reliance on short-term funding. Moreover, banks have cut proprietary trading in view of, for example, the Volcker Rule in the USA . Proprietary trading has been a source of liquidity, especially during

GLOBAL INVESTOR 1.15 

volatile markets. As a result, banks and dealers have reduced their fixed income trading activities since 2008 as well as their ability to warehouse risk and facilitate capital market activities. Conditions affecting structural changes

The structural change stemming from financial regulation comes at a time of historically low interest rates fueled by quantitative easing programs adopted by central banks around the globe. On the one hand, we believe that this accommodative stance has reduced market uncertainty and thus eased investors’ concerns about liquidity. On the other hand, low interest rates have increased the corporate debt markets as companies take advantage of the lower funding costs. In Figure 1, we show the increasing gap between primary dealers’ inventory and the size of the US corporate debt market. Moreover, investors’ moti­ vation to drop low-yielding government debt and pile into higher risk and most often less liquid securities has also risen due to monetary policy, in our view. This in turn adds to liquidity concerns again (see Figures 2 and 3). Liquidity most relevant in times of stress

So far, the decline in bond market liquidity has not caused much of a headache for investors as corporate bonds are in good demand. However, it is quite easy to imagine a scenario of many investors exiting at the same time with no one willing to buy or provide market-making activities. In this case, liquidity would evaporate quickly, leaving investors high and dry. The modest decrease in liquidity in the last few years might therefore not be a good indicator of what to expect during turbulent times or in case demand for corporate bonds falls. This could, for example, occur when interest rates increase from their historic lows. We believe the asset management industry is particularly exposed to a sudden drop in corporate bond market liquidity. Investors’ expectations of their ability to redeem mutual fund shares or sell ETFs (exchangetraded funds) on a daily basis could reveal the low liquidity of the underlying bonds bundled into these funds. In case of a pronounced outflow from funds, many asset managers could be forced to sell into dry markets and incur significant losses. The Bank of England’s Financial Stability Report, published in June 2014, aims at extracting the liquidity premium inherent in bond prices by comparing credit derivatives and actual bond prices. The analysis found that

the liquidity premium increased in European investment grade issues from approximately 50 basis points in 2007 to 200 basis points the following year. For European high-yield issues, the rise was even more extreme, from approximately 100 basis points to almost 1,200 basis points during the same period. This suggests that, in times of crises, investors chase liquidity and also quality. Furthermore, according to the study, the liquidity premium is fairly low at the moment. To us, this raises concerns that current market prices influenced by low volatility and low interest rates do not compensate investors enough for the ongoing decline in liquidity and a potential hike in turbulent times. Implications for investors

We believe that investors need to recognize the structural change toward lower liquidity as well as the volatile nature of liquidity, especially buyers of higher-yielding corporate bonds. Certainly, liquidity is more relevant in turbulent market times, but we think investors should plan ahead and assess to what degree they rely on markets. If holding fixed income securities to maturity is an option, investors can shrug off liquidity concerns. If not, investors should analyze each case to see if they are rewarded for the risk of not being able to sell at their convenience. Investors are not alone. Supervisory institutions are increasingly aware of the structural changes in bond markets. A policy response to cushion abrupt movements is not unlikely, in our view. In the long term, we believe that the gap left behind by banks will be filled or that banks will adjust their trading activities to cater to their clients more specif­ ically. As traded corporate debt is a substantial part of the financial system, new forms of trading are evolving quickly. Electronic platforms that rely on peer-to-peer trading instead of dealers already exist and are likely to grow. Another approach would be to standardize the corporate bond market more to reduce complexity and simplify trading and market making. A combination of both seems pragmatic to us as electronic trading requires standardized units to flourish. In the meantime, a closer look at how much an investor relies on liquidity when a security is purchased will help to avoid most of the concerns. 

—63

01_Corporate debt market up A growing gap between primary dealers’ inventory and the size of the US corporate debt market is fueling liquidity concerns. Source: Credit Suisse, Federal Reserve, SIFMA

Federal Reserve data

SIFMA data

8,000

250

7,000

200

6,000 5,000

150

4,000 100

3,000 2,000

50

1,000 0

0 2001

2004

2007

2010

2013

 Outstanding corporate debt USD bn (US) (left-hand axis)   Primary dealer inventory USD bn (US) ­(right-hand axis)

02_Turnover ratio down The turnover ratio of corporate debt is much lower than the ratio of Treasuries and the total debt market. The turnover ratio of the US debt market has decreased on average by more than 30% since 2007.  Source: Credit Suisse, SIFMA in % 14 12 10 8 6 4 2 0 2007

2009

2011

2013

 US Treasuries   US total debt   US corporate debt

03_Outstanding US bond ­market debt US debt markets have increased 14-fold from 1980 to 2013.  Source: Credit Suisse, SIFMA USD bn 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0

Jan Hannappel Equity and Credit Research Analyst – European and US Banks +41 44 334 29 59 [email protected]

1980

1990

2000

 Municipal   Treasury   Mortgage-related  Corporate debt   Federal Agency securities   Money markets   Asset-backed

2013

GLOBAL INVESTOR 1.15 

—64

Authors

Nikhil Gupta

Robert Parker

Fundamental Micro Themes Research........................... [email protected].................................. +91 22 6607 3707......................................................

Senior Advisor Credit Suisse......................................... [email protected].................................. +44 20 7883 9864.....................................................

Nikhil Gupta joined Credit Suisse Private Banking and Wealth Management in 2011, and is currently part of the Fundamental Micro Research team. Before joining Credit Suisse, he worked for a management consulting firm for four years. He has an MBA from the Indian School of Business, Hyderabad.  > Page 15

Robert Parker is a Senior Advisor to Credit Suisse in ­Investment Strategy & Research. He has worked in the ­a sset management industry for 42 years and joined Credit Suisse in 1982 as a founder of CSFB Investment ­M anagement. He chairs the Asset Management and ­Investors Council and is a board member of the International Capital Markets Association. He has a BA and MA in Economics from Cambridge University.  > Pages 48–51

Jan Hannappel Equity and Credit Research Analyst – European and US banks.............................................................. [email protected]................................. +41 44 334 29 59....................................................... Jan Hannappel is a Research Analyst in Global Equity and Credit Research at Credit Suisse, focusing on European and US banks. Before joining Credit Suisse in 2014, he was a corporate finance analyst. Jan Hannappel holds an MA in Accounting and Finance from the University of St. Gallen.  > Pages 62–63

Oliver Adler

Lars Kalbreier

Head of Economic Research......................................... [email protected]...................................... +41 44 333 09 61.......................................................

Head of Mutual Funds & ETFs....................................... [email protected]................................... +41 44 333 23 94.......................................................

Oliver Adler is Head of Economic Research at Credit Suisse Private Banking and Wealth Management. He has a Bachelor’s degree from the London School of Economics and an MA in International Affairs and a PhD in Economics from Columbia University in New York. 

Lars Kalbreier, CFA , is a Managing Director and global Head of Mutual Funds & ETFs. In this role he is responsible for the fund selection and advisory process. Before taking the current role, Lars headed Global Equities & Alterna­t ives Research and was a member of the bank’s I­nvestment Committee. He is a member of the investment committee of Corpus Christi College, Cambridge.  > Pages 24–25

> Pages 10 –12, 14, 26–29

Carla Antunes da Silva Head of European Banks, Equity Research.................... [email protected].......................... +44 20 7883 0500..................................................... Carla Antunes da Silva is Head of the European Banks at Credit Suisse Investment Banking and has covered the European banking sector for 15 years. Previously, she was Associate Director of Research and lead analyst on UK banks at JPM . She started at Deutsche Bank in 1996 , covering Iberian banks. She was consistently ranked a top analyst in the space. She has an MA in PPE from the University of Oxford and an MS c in Management from the LSE .  > Pages 58– 61

José Antonio Blanco Head of Global Multi Asset Class Solutions................... +41 44 332 59 66....................................................... [email protected].................................. José Antonio Blanco is Head of the Global Multi-Asset Class Solutions unit and a voting member of the Investment Committee. He holds a degree in economics and a PhD in applied econometrics from the University of Z ­ urich. Mr. Blanco is a member of the Executive ­C ommittee of the Swiss Financial Analysts Association (SFAA ) and the Swiss Society for Financial Market ­Research.  > Pages 10 –12, 14, 26–29

Gregory Fleming Senior Analyst............................................................. [email protected]............................... +41 44 334 78 93....................................................... Gregory Fleming joined Credit Suisse in 2006 as a senior analyst for the Investment Decision Cockpit and Investment Committee. Previously, he worked in portfolio strategy for Westpac and Grosvenor Financial Services Group, and for the International T ­ extile ­M anufacturers Federation as a global economist. He holds an MA with Distinction in Economic History from the University of Canterbury, New Zealand.  > Pages 13, 38–39, 42–43

Philippe Kaufmann Head of Global Real Estate Research............................ [email protected]........................ +41 44 334 32 89....................................................... Philippe Kaufmann is Head of Global Real Estate R ­ esearch at Credit Suisse Private Banking and Wealth Manage­ment, where he also worked for Swiss Real Estate Research for six years. Before joining Credit Suisse in 2007, he worked for a policy consulting firm and an economic research company. He holds an MA in Economics from the Univer­sity of Fribourg, Switzerland.  > Pages 44–47

Christine Schmid Head of Global Equity & Credit Research........................ [email protected].............................. +41 44 334 56 43....................................................... Christine Schmid is Head of Global Equity & Credit Research at Credit Suisse Private Banking and Wealth Management. She has covered financials for 15 years and coordinates the global financial view. She holds an MA in Economics from the University of Zurich, and is a CFA charterholder.  > Pages 58–61

Beat Schwab Head of Real Estate Investment Management Switzerland [email protected]................................... +41 44 333 92 42....................................................... Beat Schwab has been Head of Real Estate Investment Management Switzerland since November 2012. From 2006 to 2012 he was CEO of the real estate services group Wincasa AG . During his career he held various position in the construction industry and real estate markets. Mr. Schwab holds a PhD in Economics from the University of Bern and an MBA from Columbia University.  > Page 47

Markus Stierli Head of Fundamental Micro Themes Research............ [email protected]............................... +41 44 334 88 57....................................................... Markus Stierli is Head of Fundamental Micro Themes ­Research at Credit Suisse Private Banking and Wealth Management, based in Zurich. He holds a PhD in ­International Relations from the University of Zurich and is a Chartered Alternative Investment Analyst.  > Pages 04–08, 15

Giles Keating

Marina Stoop

Head of Research and Deputy Global Chief Investment Officer........................................................ [email protected]................................... +41 44 332 22 33.......................................................

Cross Asset and Alternative Investments Strategist........ [email protected]................................... +41 44 334 60 47.......................................................

Giles Keating is Global Head of Research for Private Banking and Wealth Management, Deputy Global Chief Investment Officer and the Investment Committee’s Vice Chair. He joined Credit Suisse in 1986. He was ­a Research Fellow at the London Business School and has ­d egrees from the London School of Economics and ­O xford where he is Honorary Fellow. He chairs Tech4All and techfortrade, charities that use technology to reduce ­p overty.  > Pages 03, 24–25

Sven-Christian Kindt Head of Private Equity Origination & Due Diligence......... [email protected]......................... +41 44 334 53 88....................................................... Sven-Christian Kindt is Head of Private Equity Origination & Due Diligence at Credit Suisse Private Banking and Wealth Management. Before joining Credit Suisse in 2008 , he worked for Bain & Company and A.T. Kearney in London. He holds degrees from ESCP Europe and the University of Michigan’s Ross School of Business.  > Pages 16–17

Marina Stoop is the Head of Risk and Flow Analysis within the Cross Asset Strategy and Alternative ­Investments team. She is responsible for providing input to the Investment Committee on financial market risks,­ ­liquidity and flow. Marina Stoop joined Credit Suisse in 2010 after graduating from ETH Zurich with an MA in Science.  > Pages 21–23

Risk warning

Ever y investment involves risk, especially with regard to fluctuations in value and return. If an investment is denominated in a currency other than your base currency, changes in the rate of exchange may have an adverse effect on value, price or income. For a discussion of the risks of investing in the securities mentioned in this report, please refer to the following Internet link: https://research.credit-suisse.com/riskdisclosure This repor t may include information on investments that involve special risks. You should seek the advice of your independent financial advisor prior to taking any investment decisions based on this report or for any necessary explanation of its contents. Further information is also available in the information brochure “Special Risks in Securities Trading” available from the Swiss Bankers Association. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is affected by changes in spot or forward interest and exchange rates, economic indicators, the financial standing of any issuer or reference issuer, etc., that may have a positive or adverse effect on the income from or price of such securities or financial instruments. By purchasing securities or financial instruments, you may incur a loss or a loss in excess of the principal as a result of fluctuations in market prices or other financial indices, etc. Investors in securities such as ADR s, the values of which are influenced by currency volatility, effectively assume this risk. Commission rates for brokerage transactions will be as per the rates agreed between CS and the investor. For transactions conducted on a principal-to-principal basis between CS and the investor, the purchase or sale price will be the total consideration. Transactions conducted on a principal-to-principal basis, including over-the-counter derivative transactions, will be quoted as a purchase/bid price or sell/offer price, in which case a difference or spread may exist. Charges in relation to transactions will be agreed upon prior to transactions, in line with relevant laws and regulations. Please read the pre-contract documentation, etc., carefully for an explanation of risks and commissions, etc., of the relevant securities or financial instruments prior to purchase Structured securities are complex instruments, typically involve a high degree of risk and are intended for sale only to sophisticated investors who are capable of understanding and assuming the risks involved. The market value of any structured security may be affected by changes in economic, financial and political factors (including, but not limited to, spot and forward interest and exchange rates), time to maturity, market conditions and volatility, and the credit quality of any issuer or reference issuer. Any investor interested in purchasing a structured product should conduct their own investigation and ana lysis of the product and consult with their own professional advisers as to the risks involved in making such a purchase. Some investments discussed in this repor t have a high level of volatilit y. High volatilit y investments may experience sudden and large falls in their value causing losses when that investment is realized. Those losses may equal your original investment. Indeed, in the case of some investments the potential losses may exceed the amount of initial investment, in such circumstances you may be required to pay more money to suppor t those losses. Income yields from investments may fluctuate and, in consequence, initial capital paid to make the investment may be used as par t of that income yield. Some investments may not be readily realizable and it may be difficult to sell or realize those investments, similarly it may prove dif ficult for you to obtain reliable information about the value, or risks, to which such an investment is exposed. Please contact your Relationship ­M anager if you have any questions. Past performance is not an indicator of future performance. Performance can be affected by commissions, fees or other charges as well as exchange rate fluctuations. Financial market risks Historical returns and financial market scenarios are no guarantee of future performance. The price and value of investments mentioned and any income that might accrue could fall or rise or fluctuate. Past performance is not a guide to future performance. If an investment is denominated in a currency other than your base currency, changes in the rate of exchange may have an adverse effect on value, price or income. You should consult with such advisor(s) as you consider necessary to assist you in making these determinations.

lated. Hedge funds are not limited to any particular investment discipline or trading strategy, and seek to profit in all kinds of markets by using leverage, derivatives, and complex speculative investment strategies that may increase the risk of investment loss. Commodity transactions carry a high degree of risk and may not be suitable for many private investors. The extent of loss due to market movements can be substantial or even result in a total loss. Investors in real estate are exposed to liquidity, foreign currency and other risks, including cyclical risk, rental and local market risk as well as environmental risk, and changes to the legal situation. Interest rate and credit risks The retention of value of a bond is dependent on the creditwor thiness of the Issuer and/ or Guarantor (as applicable), which may change over the term of the bond. In the event of default by the Issuer and/or Guarantor of the bond, the bond or any income derived from it is not guaranteed and you may get back none of, or less than, what was originally invested.

Disclosures The information and opinions expressed in this repor t (other than ar ticle contributions by Investment Strategists) were produced by the Research depar tment of the Private Banking & Wealth Management division of CS as of the date of writing and are subject to change without notice. Views expressed in respect of a par ticular security in this repor t may be different from, or inconsistent with, the obser vations and views of the Credit Suisse Research depar tment of Investment Banking division due to the differences in evaluation criteria. Article contributions by Investment Strategists are not research reports. Investment Strategists are not part of the CS Research department. CS has policies in place designed to ensure the independence of CS Research Department including policies relating to restrictions on trading of relevant securities prior to distribution of research reports. These policies do not apply to Investment Strategists. CS accepts no liability for loss arising from the use of the material presented in this report, except that this exclusion of liability does not apply to the extent that liability arises under specific statutes or regulations applicable to CS . This report is not to be relied upon in substitution for the exercise of independent judgment. CS may have issued, and may in the future issue, a trading idea regarding this security. Trading ideas are short term trading opportunities based on market events and catalysts, while company recommendations reflect investment recommendations based on expected total return over a 6 to 12 -month period as defined in the disclosure section. Because trading ideas and company recommendations reflect different assumptions and analytical methods, trading ideas may differ from the company recommendations. In addition, CS may have issued, and may in the future issue, other reports that are inconsistent with, and reach different conclusions from, the information presented in this report. Those reports reflect the different assumptions, views and analytical methods of the analysts who prepared them and CS is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report.

Analyst certification The analysts identified in this report hereby certify that views about the companies and their securities discussed in this report accurately reflect their personal views about all of the subject companies and securities. The analysts also certify that no part of their compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report. Knowledge Process Outsourcing ( KPO) Analysts mentioned in this report are employed by Credit Suisse Business Analytics (India) Private Limited. Important disclosures CS policy is to publish research reports, as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein. CS policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. The Credit Suisse Code of Conduct to which all employees are obliged to adhere, is ­a ccessible via the website at: https://www.credit-suisse.com/governance/doc/code_of_conduct_en.pdf

Investments may have no public market or only a restricted secondary market. Where a secondary market exists, it is not possible to predict the price at which investments will trade in the market or whether such market will be liquid or illiquid.

For more detail, please refer to the information on independence of financial research, which can be found at: https://www.credit-suisse.com/legal/pb_research/independence_en.pdf

Emerging markets Where this report relates to emerging markets, you should be aware that there are uncertainties and risks associated with investments and transactions in various types of investments of, or related or linked to, issuers and obligors incorporated, based or principally engaged in business in emerging markets countries. Investments related to emerging markets countries may be considered speculative, and their prices will be much more volatile than those in the more developed countries of the world. Investments in emerging markets investments should be made only by sophisticated investors or experienced professionals who have independent knowledge of the relevant markets, are able to consider and weigh the various risks presented by such investments, and have the financial resources necessary to bear the substantial risk of loss of investment in such investments. It is your responsibility to manage the risks which arise as a result of investing in emerging markets investments and the allocation of assets in your portfolio. You should seek advice from your own advisers with regard to the various risks and factors to be considered when investing in an emerging markets investment.

The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including CS ’s total revenues, a portion of which is generated by Credit Suisse Investment Banking business.

Alternative investments Hedge funds are not subject to the numerous investor protection regulations that apply to regulated authorized collective investments and hedge fund managers are largely unregu-

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