Accessible Tourism
TRAVEL IMPACT NEWSWIRE โ Edition 43 (2009) โ Tuesday, 14 July 2009
Executive Editor: Imtiaz Muqbil.
1. FUNDS FLOOD ASIA & MIDEAST, SEEK โPRODUCTIVEโ PARKING SPACE
Trillions of dollars have landed up in the investment coffers of the Middle East and Asia and will most likely land up in real estate, land, commodities, emerging markets and other such areas still considered to be โproductive investmentsโ in todayโs economic climate. Looking beyond the gloom and doom, a study by the McKinsey Global Institute (MGI, the economics research arm of the consultancy firm McKinsey & Company) sees that as being one of the major results of the global financial crisis and all the shifts and changes it is triggering worldwide. Indeed, one of its primary conclusions is that the traditional big boys, hedge funds and private equity, are heading for some lean times and will be out-gunned by Middle East petrodollar investors and Asian sovereign i nvestors.
Of tremendous importance to the travel & tourism industry as it pursues its fair share of financing and investment options in a highly competitive environment, the study entitled โThe New Power Brokers: How Oil, Asia, Hedge Funds, And Private Equity Are Faring In The Financial Crisisโ was released publicly last week. It provides some keen historic perspectives on the rise and fall of the power brokers, assesses how the global economic and financial crisis has affected them and whether it will alter their future course. Designed โto provide global business leaders and policy makers with a base to better understand some of the most important trends shaping global financial markets today,โ it will need to be closely studied by travel & tourism industry as it ponders its own future.
In a foreword to the study, MGI Chairman Lenny Mendonca sought to underscore its credibility with the comment: โAs with all MGI projects, this research is independent and has not been commissioned or sponsored in any way by any business, government, or other institution.โ The study contains warnings for Asia about the new challenges and risks, as well as the chance it has to learn from, and avoid a repetition of, past mistakes. Between the lines, it clearly outlines all the reasons why the house came tumbling down due to risky behaviour by the money managers, poor government regulation and oversight, lack of transparency, too much herd mentality, and a curiously unquestioning attitude towards โmarket forcesโ and those who drive them.
Says the study, โThe global financial and economic crisis has altered the paths of four influential groups of investors oil exporters, Asian governments, hedge funds, and private equity firms. In a 2007 report, we (McKinsey Global Institute) labeled these four the "new power brokers" because their growing wealth and clout reflected a dispersion of financial power away from traditional institutions in Western developed economies and toward new players and other parts of the world? But the crisis has raised questions about the power brokersโ future growth and influence.โ
Historical context
Providing some historical context, the study says that all four โpower brokers were fundamental contributors to the global financial industry and capital markets boom from 2002 through 2007. Oil investors and Asian governments provided huge sums of new capital to global capital markets. The influence of hedge funds and private equity funds grew as leverage enabled them to account for a large share of trading volumes and M&A transactions, respectively. The power brokers fueled and benefited from the boom, and from each other.โ
It notes, โThe power brokersโ rapid rise before 2008 was fueled by a boom in the global economy, trade, the financial industry, and oil prices. And the power brokers did not just benefit from the boom they were an integral part of the dynamics at play. Credit was ample and cheap, helping drive the growth of hedge funds and private equity. Easy credit also encouraged US consumers to go on a borrowing and spending binge, boosting their purchases of Asian exports and gas-guzzling trucks and SUVs.
โSoaring Asian exports fueled rapid economic growth in that region, adding to global energy demand and pushing up oil prices. Asian and oil exportersโ trade surpluses turned into swelling capital flows that poured into global financial markets. This helped lower US interest rates even more, spurring further consumption and financial leverage, and prompting institutional investors to seek higher returns in vehicles such as hedge funds and private equity. The growth of the power brokers was mutually reinforcing.
โThese dynamics, however, contributed to the increasingly large global financial imbalances that fed the financial crisis. At the time of this writing, it remains unknown how the crisis will be resolved, when global GDP growth will resume, or how the economic landscape may change in the process.โ According to the report, the power brokersโ collective assets were estimated at $12 trillion at the end of 2008, roughly the same as 2007. It says, โWhile this was better than the sharp declines in wealth of most institutional investors, there is no denying that the crisis has abruptly halted the power brokersโ rapid ascent.โ
Future growth projections
The study projects the power brokersโ future growth based on โfour proprietary global macroeconomic scenariosโ developed by McKinsey & Company and Oxford Economics. These depict different trajectories for GDP growth, oil prices and production, Asian trade surpluses, and financial market recovery. Says the study, โIn our conservative base-case scenario, which assumes the global recession lasts through mid-2010, assets in hedge funds and private equity buyout funds (will) decline in 2009 before slowly growing again. In contrast, oil exportersโ and Asian sovereign investorsโ foreign financial assets (will) continue to grow in coming years, and indeed reach higher levels than we foresaw in our original 2007 research. For policymakers and business leaders, this presents a serious challenge: how to ensure that this surplus capital is invested in productive opportunities that will raise living s tandards, rather than contribute to future asset bubbles.โ
The study says that oil exporters and Asian sovereign investors have fared better than private equity and hedge funds. โSoaring oil prices in the first half of 2008 created a windfall for petrodollar investors-though falling financial markets erased much of the gain in the second half of the year. Asian sovereign investorsโ assets increased despite a sharp falloff in the regionโs trade surpluses at the end of the year. This growth was due entirely to China, whose assets now exceed $2 trillion. In 2008, oil investors and Asian governments combined provided the worldโs financial markets with roughly $4.5 billion per day in new capital-up from $2.5 billion in 2007. We project the assets of both will continue to grow in coming years, although at a slower rate than in the past.โ
Ready to jump at new opportunities
It maintains that Asian sovereign investors will remain significant power brokers in global financial markets. At the same time, the study says, oil investors are expected to be particularly active. โSince the financial crisis deepened in September 2008, many oil investors have moved to the sidelines, conserved cash, and focused on supporting domestic companies and banks. Some petrodollar sovereign wealth funds have announced that they are reviewing their investment strategies, although most will retain their long-term investment horizon.
โOnce the financial crisis subsides and recovery begins, they will be ready to jump at new opportunities. Early evidence suggests the petrodollar investors will make more investments in real estate and land, commodities, and emerging markets. The crisis has also heightened their focus on building the organizational capabilities of sovereign wealth vehicles, in part by creating a greater flow of talent from abroad. In the Middle East, there will also be more focus on foreign investments that will have the added benefit of helping promote local economic development.โ
Although the โfuture is less clearโ for hedge funds and private equity buyout funds, the study projects that โthe best funds in each industry will survive and perhaps even thrive. Although projections for their future growth are lower now than they were a year ago at the market peak, both will remain significant forces in global financial markets.โ It adds, โNow the financial crisis and global economic recession have cast great uncertainty over their future growth and roles. Their paths have diverged: oil and Asian investors remain important sources of capital and will continue to grow; hedge funds and private equity buyout funds have stalled, but they certainly will not disappear.โ
2. THE FOUR โPOWER BROKERSโ AND THE โPOWERโ THEY COMMAND
The MGI study identifies the four โpower brokersโ thus:
Petrodollar investors had $5.0 trillion in foreign financial assets at the end of 2008. Their wealth has soared along with oil prices, which rose from just $23 per barrel in 2002 to above $145 in July 2008. The group includes investors in the six states of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates); other oil exporters in the Middle East and North Africa; and Norway, Russia, Venezuela, Nigeria, and Indonesia. The investors include central banks, sovereign wealth funds (SWFs), companies, and wealthy individuals. Government investment vehicles control 65 percent of total foreign assets. Oil investorsโ investment styles are diverse, ranging from conservative and passive to more risk-seeking and active. By country, the three largest petrodollar investors are Russia, with $1.1 trillion in foreign financial assets at the end of 2008; the United Arab Emirates, with $710 billion to $980 billion; and Norway, with $860 billion.
Asian sovereign investors held $4.8 trillion in foreign financial assets at the end of 2008. This group includes central banks and sovereign wealth funds. Their foreign assets have grown rapidly over the last decade because of their countriesโ rising trade surpluses combined with government monetary policies aimed at preventing significant appreciation of their currencies. Central banks manage 90 percent of the groupโs foreign assets, and they invest mainly in low-risk, dollar-denominated assets as well as euro and yen assets. By country, the largest investors are China, with more than $2 trillion in foreign financial assets at the end of 2008, and Japan, with a bit more than $1 trillion.
Hedge funds had $1.4 trillion in assets under management at the end of 2008. Hedge funds and private equity firms are financial intermediaries that invest the money of wealthy individuals and institutional investors, such as pension funds, foundations, endowments, insurance companies, and, increasingly, SWFs. The term "hedge fund" covers a diverse set of lightly regulated investment vehicles that differ in their investment strategies, time horizon, liquidity, and use of leverage. They differ from mutual funds in several ways, including their investor base, use of leverage, fee structure, ability to take long and short positions, and lack of constraints on using derivatives and other types of financial instruments. Because hedge funds are not required to register with investment authorities or report on their activities, there is significant opacity around the industry. By most estimates, it incl uded more than 7,500 funds at its peak, although the 200 largest hedge funds control more than 70 percent of assets under management.
Private equity has long been virtually synonymous with leveraged buyout funds (LBOs). Buyout assets under management, measured in the standard way as the cumulative sum of the past five years of fundraising, reached $1.25 trillion in 2008, making this the smallest of the four power brokers. However, assets managed by the broader private equity industry which includes buyout and venture capital, distressed debt, infrastructure, real estate, and other types of investment funds totaled $2.9 trillion. A private equity buyout fund typically generates returns by acquiring a publicly traded company, restructuring it to improve performance, and selling it several years later.
3. KEY QUOTES FROM THE McKINSEY GLOBAL INSTITUTE STUDY
Investors that were least exposed to global equities fared the best. Among the largest oil-exporters, Russia may have had the least exposure to global equity markets. Its central bank and sovereign wealth funds-the Reserve Fund and National Wealth Fund-invest exclusively in sovereign bonds and cash, and thus their losses in 2008 were minimal. Similarly, the Saudi Arabian Monetary Authority (SAMA) invests mainly in fixed-income securities, although it has some equity exposure as well. Despite modest losses on its portfolio, SAMA increased its assets from $350 billion to $390 billion in 2008 due to a substantial influx of new capital in the first half of the year.
In recent months, managers of several petrodollar sovereign wealth funds have discussed plans to broaden their investment strategies to include more real estate, commodities, and activity in emerging markets. The focus on real estate reflects the current opportunities to snap up many properties at depressed prices.
In addition to investing in real estate, some oil exporters particularly in the Middle East, where arable land is in short supply have stepped up investments in agricultural land for food production and biofuels. For instance, the United Arab Emirates has secured 400,000 hectares of farmland in Sudan, while Saudi Arabia is leasing land in Ethiopia to grow grains. A survey of press reports since 2006 by the International Food Policy Research Institute found eight signed deals involving investors from oil-exporting countries securing farmland in developing countries.
Some petrodollar investors are interested in commodities investments as a way to secure future supplies of raw materials and as a hedge against the risk of higher global inflation. โฆโฆ..Petrodollar investors also are looking to emerging markets, especially in Asia, for long-term growth opportunities.
Gulf infrastructure and construction projects
Collectively, GCC has planned $1.4 trillion in spending on infrastructure and construction projects from 2009 to 2015. This includes Saudi Arabiaโs plans to build several entirely new cities as economic hubs and to expand its petrochemical industry. Abu Dhabi is building new cultural institutions, such as a branch of the Louvre Museum, and aims to build the worldโs first carbon-neutral city. GCC states are investing in alternative energy projects and research.
In aggregate, petrodollar countries have spent more than $280 billion of their wealth to support their currencies, provide liquidity to banks, and aid local companies and investors. This aid proved vital to helping contain the damage from the global financial and economic crisis, although it also reduced the countriesโ foreign assets.
Despite the economic downturn, petrodollar foreign assets will continue to climb over the next five years in all scenarios that we consider. Even with oil prices far below their 2008 peak, petroleum exporters will nonetheless enjoy rising revenue for the foreseeable future because of the increasing energy demand from China and other emerging markets. Future growth in petrodollar foreign assets will depend on three factors: the value of oil produced, the quantity of oil revenue invested abroad, and investment returns.
The only power brokers which gained
The global financial and economic crisis is hitting Asian countries through two primary channels. Turmoil in capital markets has caused a record outflow of foreign capital from the region, while the recession in the United States and Europe is dampening demand for Asiaโs exports. Nonetheless, Asian sovereign investors the regionโs central banks and sovereign wealth funds saw their collective foreign financial assets grow by $400 billion in 2008, reaching $4.8 trillion by year-end. Although this growth rate was far slower than in the past, Asian governments were the only one of the power brokers to record any gains last year.
The overall growth in Asian sovereign investorsโ assets was driven almost entirely by China, whose foreign wealth surpassed $2 trillion. Across the rest of Asia, the story was bleaker. Japanโs and Taiwanโs foreign assets grew just slightly, while the foreign wealth of most other Asian governments declined.
Asian sovereign investorsโ assets will continue to grow, albeit at a slower rate than in the past. In the base-case scenario, their assets grow half as fast in the next five years as they did from 2002 through 2007, reaching $7.5 trillion by 2013. Still, their assets would be one-quarter the size of global pension funds at that time. Chinaโs government-owned foreign assets alone could double over the next five years, despite a declining current account surplus.
Asian sovereign investorsโ foreign assets grew to $4.8 trillion by the end of 2008, up from $4.4 trillion in 2007. While this 9 percent growth is impressive against the backdrop of the global economic crisis, it is substantially slower than the 21 percent compound annual growth rate seen between 2002 and 2007. As in recent years, large current account surpluses in China and Japan drove the growth in foreign assets in 2008. Asian economies had a combined current account surplus of $642 billion last year. Total foreign assets did not grow by quite this much because foreign investors withdrew a net of $150 billion from the region in 2008, and some Asian governments drew down their wealth to finance spending in response to the financial crisis. Nevertheless, Asian sovereign investorsโ assets have doubled in just five years.
Growing dilemma for China
To generate higher returns through more diversified investment strategies, some Asian countries have created sovereign wealth funds. These funds remain far smaller than the regionโs central banks, with total assets of just $640 billion, of which $490 billion is invested in foreign currency assets. However, several are major foreign investors and among the worldโs largest sovereign wealth funds.
The (financial and economic) crisis has highlighted a growing dilemma for China: how to maintain export growth without continuing to amass dollar-denominated assets. Chinaโs efforts to avoid rapid appreciation of its currency have resulted in rapidly growing foreign reserves, most of which are invested in dollar-denominated assets. This leaves China vulnerable to economic and financial turmoil in the United States. Researchers for the International Monetary Fund (IMF) and other institutions estimate that the Peopleโs Bank of China holds between 65 percent and 70 percent of its reserves in dollar-denominated assets 10 In 2008, China increased its holdings of US securities by nearly $600 billion, surpassing Japan as the worldโs largest foreign holder of US Treasuries and bringing its total dollar assets to around $1.4 trillion.
Replacing the dollar
Replacing the dollar with a different global reserve currency is a long-term goal at best. The dollar has emerged as the worldโs primary reserve currency because of the deep and liquid financial markets for dollar assets, the strong productivity growth and innovation in the US economy, and the stable and generally effective legal and regulatory institutions in the United States. The financial crisis has undoubtedly shaken these foundations. Yet the eurozone and Japan have been weakened by the crisis as well, and the prospects for their quick recovery are even more remote.
An alternative solution for China would be to avoid further reserve accumulation through policy changes. This could be achieved by allowing more rapid appreciation of its currency, the renminbi, or by allowing more foreign investment by corporations and private citizens. Since 2000, China has allowed a 17 percent nominal appreciation of the renminbi versus the dollar. During the crisis, however, policy makers have been reluctant to allow further appreciation, as Chinese exporters are already suffering from declining demand. The government is encouraging Chinese corporations to invest overseas. In May, the central bankโs State Administration of Foreign Exchange issued draft rules to make it easier for companies to raise dollars in China to invest abroad.
The IMF has estimated that by the end of 2008, Asian central banks together held at least $2.6 trillion, or 60 percent of their total foreign reserves, in dollar-denominated assets. To diversify currency risk, Asian central banks, especially Chinaโs, have increased investments in euro- and yen-denominated assets over the past several years. While we do not foresee wholesale rebalancing of current portfolios, our interviews suggest that Asian sovereign investors, particularly sovereign wealth funds, likely will use incremental new investments to gain exposure to other currencies. Asian central banks may also seek to channel more reserves into different vehicles that pursue more diverse investments.
More Asian growth forecast
Asian governmentsโ foreign assets will continue to grow over the next five years in all scenarios, although more slowly than in the past. Despite a substantial decline in Chinaโs current account surplus over the next five years, the projected surpluses in the region will drive further accumulation of central bank reserve assets, absent substantial policy changes. In the base-case scenario, Asian sovereign investorsโ assets collectively grow to $7.5 trillion by 2013. China will continue to be the largest source of growth, with sovereign foreign assets doubling in size to $4 trillion. Policy changes to allow more rapid appreciation of Asian currencies or to encourage more foreign investment from households and corporations could substantially alter this projection, however, and curtail further accumulation of foreign exchange reserves.
The global financial and economic crisis has brought renewed scrutiny of the huge global imbalances in savings and consumption across countries. In the years before the crisis, US consumption became an increasingly important source of global GDP growth, accounting for nearly three-quarters of US GDP growth and more than one-third of private consumption growth worldwide. The US personal saving rate has fallen steadily since 1980, turning negative in 2005 as households consumed more than they earned. In Asia, the reverse situation is true. In China, for instance, consumption accounts for just 36 percent of GDP growth one of the lowest shares in the world while its national saving rate hovers near 50 percent. The financial crisis has prompted a reversal in these trends. The US consumer is now saving more and spending less, while Chinese policy makers are searching for ways to ensure that domestic consumption becomes a larger part of future growth.
Changes in Asian monetary policy?
These projections assume there will be no major changes in Asian monetary policy that could substantially reduce the accumulation of foreign reserves. Changes in exchange rate policies that allow more currency appreciation, or changes in foreign investment policies that enable more private investment abroad from households and companies, could slow foreign reserve accumulation sharply in coming years, making our projections of sovereign asset growth too high.
Chinaโs policy makers might consider such policies, given their concern about exposure to the dollar. One option would be to encourage more Chinese foreign investments directly in companies and in publicly listed shares abroad. Such investments totaled just $53 billion in 2008. Yet if they increased at a much faster rate than in the past, such as reaching $330 billion per year in 2013, Chinaโs central bank foreign reserves would grow to $3 trillion rather than $4 trillion by that time. Encouraging more investments in foreign debt securities could have a similar effect. This would allow the government to curb its growing exposure to dollar assets while creating more diversified portfolios of financial assets for households and businesses.
The hedge fund industry hit an inflection point in 2008. Since 2000, hundreds of billions of dollars flowed into hedge funds as a growing number of investors around the world sought higher returns in an alternative asset class. New funds sprouted to meet the growing demand, and the size of established funds multiplied. With interest rates low and capital plentiful, hedge funds added leverage to their assets to gain unprecedented influence in global capital markets. Their total assets under management soared to an all-time high of $1.9 trillion in the second quarter of 2008 nearly four times their value in 2000.
But the breakdown of global credit and capital markets in September 2008 sparked a dramatic reversal of fortune. Liquidity dried up and investors fled to cash and other safe assets. Several major prime brokers that provided financing and other services for hedge funds curtailed their lending dramatically, while one major player-Lehman Brothers-went bankrupt, disrupting the fundsโ operations. Many hedge fund trading strategies suddenly became unworkable.
Hedge funds hit by shakeout
The financial turmoil in late 2008 wreaked havoc on hedge fundsโ performance and their businesses. Although the industryโs assets under management soared in the first half of the year, peaking at nearly $2 trillion, they declined by a quarter in the second half of the year. An industry shakeout has ensued, with a record number of hedge funds closing. One fund manager we interviewed called this "the dot-com bust" for hedge funds. But just as the dot-com bust hardly spelled the end of Internet business, the challenges of the past 18 months will not cause the collapse of the hedge fund industry.
For the first time in hedge fund history, investors made major net withdrawals in 2008. The net asset outflow totaled $183 billion from the peak in the second quarter through the fourth quarter, and an additional $103 billion was withdrawn by investors in the first quarter of 2009. This is equivalent to about half of the net new money that flowed into hedge funds since 2003.
Hedge fundsโ influence in capital markets grew during the financial bubble of 2002 through 2007, in part because of the leverage they employ. But the escalation of the financial crisis in 2008 tightened credit sharply. We estimate that total investable assets of the hedge fund industry consisting of assets under management, borrowing, and leverage gained through derivatives fell from $6.6 trillion at the industryโs peak after the first half of 2008 to $2.4 trillion by the end of the first quarter of 2009. This could, however, bode well for the hedge funds that survive, since the competition for "alpha," or uncorrelated returns, has been thinned.
Hedge funds shakeout not yet over
More hedge funds may close in 2009 because their assets under management have fallen far below their peak, or "high-water mark." Using a database with 1,000 hedge funds, we found that 30 percent-representing 35 percent of assets under management-will not regain their peak for at least two years if they continue to earn their past average returns. Most of these funds will not earn the 20 percent or more performance fees over this period, so managers may choose to shut down these funds rather than operate solely for the 2 percent management fee. Some of these managers, however, may start new funds. For hedge funds with strong track records, investors may be willing to renegotiate more favorable performance fee structures to increase incentives. But newer funds with a shorter history of performance, or those that have not performed well, could become casualties of the industry shakeout.
One lesson vividly illustrated by the financial crisis was the extent to which many investors and fund managers ignored or discounted liquidity risk. Hedge fundsโ liquidity profiles vary widely. A fundโs "liquidity period" is the time it takes to liquidate its assets. Some hedge funds have liquidity periods of a month or less; others measure liquidity periods in quarters or years. In principle, the liquidity period should be less than the redemption period, so managers have plenty of time to raise sufficient cash to satisfy redemption requests. However, the opposite situation has become very common, with investments shifting toward more illiquid assets but with redemption policies staying the same. Many fund managers were forced to limit redemption requests at the end of 2008 either because they didnโt have sufficient liquid positions to satisfy all requests or because they did not want to s ell into a falling market.
More regulation of hedge funds sought
Although hedge funds were not at the heart of the financial crisis, many policy makers argue that their size and activities can affect the financial system and that their lack of transparency blocks an accurate assessment of their risks. So both international bodies and several national governments are considering proposals to regulate hedge funds more closely in a variety of ways. While the details have not yet been worked out, some changes may be enacted. A more mature industry may emerge.
The global financial crisis has thrown into reverse the forces that had fueled the growth and success of leveraged buyout (LBO) funds in recent years. From 2002 through 2007, rising equity markets and cheap credit helped buyout firms generate high returns, while the ensuing flood of investor capital boosted buyout assets under management more than threefold. But now, with credit tight and equity markets far below their peaks, buyout funds are struggling. Funding for the "megadeals" (greater than $3 billion) that accounted for most buyouts has disappeared. Many companies acquired at the top of the market are performing poorly. And new fundraising has dried up as private equity investors assess their portfolio losses and face large capital commitments to the industry.
Buyout funds struggling
From 2002 through 2007, rising equity markets and cheap credit helped buyout firms generate high returns, while the ensuing flood of investor capital boosted buyout assets under management more than threefold. But now, with credit tight and equity markets far below their peaks, buyout funds are struggling. Funding for the "megadeals" (greater than $3 billion) that accounted for most buyouts has disappeared. Many companies acquired at the top of the market are performing poorly. And new fundraising has dried up as private equity investors assess their portfolio losses and face large capital commitments to the industry.
These conditions create significant challenges for the private equity industry. Over the next few years, private equity firms will look for opportunities in other forms of investment, including distressed debt and infrastructure funds, and to other regions, such as Asia. The buyout industry will likely go through a shakeout, marked by the exit of the firms that had relied heavily on leverage and rising equity markets to generate returns. The firms that do endure will be skilled managers that fundamentally improve company operations, or that have unique industry insight.
Values of most portfolio companies have almost certainly fallen sharply as global equity indices have declined by half. Accounting for this, assets in the buyout industry today may be worth less than $900 billion. New fundraising in 2009 is also down sharply, and many private equity investors called limited partners are struggling to fulfill their capital commitments. Furthermore, it is unclear how buyout funds will deploy their current unspent capital now that credit for the largest buyouts the LBOs that accounted for most deal volume in recent years-has dried up.
Shift in bargaining power
With credit tight, the ability of buyout funds to deliver strong returns to their investors will depend more than ever on their approach to managing their portfolio companies. Firms will need to differentiate themselves through unique industry insights that give them an advantage in choosing or strategically managing companies, or through strong operational skills in turning around the business and improving profitability. Firms that lack these skills, and which have relied on leverage and financial engineering to generate returns, will likely fail. This process could be a healthy development.
As buyout industry returns fall during this difficult economic environment, the industryโs relative bargaining power is likely to shift to investors. In recent years, during the boom, private equity general managers could name their price and command unprecedented fees and freedom to operate. Going forward, the new value proposition to investors may involve alternatives to the traditional fee structure of "2 and 20," or a 2 percent management fee and 20 percent of fund performance. Our interviews suggest some management fee adjustments have already occurred.
With credit markets frozen and megadeals not an option, buyout fund managers will look for other ways to deploy capital over the next few years. Although there will be plenty of opportunities in mid-market and smaller buyouts, these deals are unlikely to absorb the LBO fundsโ $535 billion of dry powder. Some managers are therefore looking beyond buyouts to other opportunities. One is distressed debt. Notable examples include Goldman Sachs shifting two-thirds of its uninvested capital ($6 billion) to distressed debt and TPG shifting $2.3 billion of the uninvested capital in its buyout fund to distressed debt. Other private equity funds are providing "debtor-in-possession" (DIP) financing for companies in bankruptcy.
More disclosure rules coming up
Policy makers in the United States, United Kingdom, and European Commission (EC) are considering whether to impose new registration and reporting requirements on alternative investment vehicles, including private equity funds. The EC, for example, recently proposed new registration and disclosure rules and minimum capital requirements for private equity firms and hedge funds managing more than โฌ100 million in assets. Firms would be permitted to offer their services to European investors only if they have an office in the European Union (EU) and have registered with EU regulators. If enacted, such rules would increase overhead costs, and thus favor the larger private equity firms.
Additionally, policy makers are considering possible limits on the leverage used by the largest alternative investment funds, including private equity. Leverage limits could come through the discretionary powers of a new "systemic risk regulator." The EU and United States are considering creating such bodies, with powers that could include requiring banks or investment funds to increase capital or decrease leverage if deemed necessary to ensure financial market stability. The largest private equity firms would almost certainly fall under the purview of such a regulator. Still, it is unclear how such limits would affect private equity firms. Although they often use as much as 70 percent debt in buyouts, the leverage ratios of banks are much higher.
The financial crisis will accelerate the evolution of the private equity industry. Buyout funds that survive will have strong skills in operational improvement and active management. Investors will gain more power relative to fund managers, at least for the next few years, and may put pressure on fees. For now, private equity firms will continue to look beyond buyout for investment opportunities. In the long term, when buyouts resume, fund managersโ focus will return to mid-market deals rather than the megadeals of recent years. In our base-case scenario, assets under management of leveraged buyout funds remain flat at $1 trillion through 2013, under the assumption that megadeals do not recover. Over the same period, however, total private equity industry assets under management grow slightly, reaching $3.4 trillion in 2013.
4. IMPLICATIONS FOR ASIA AND THE TRAVEL & TOURISM INDUSTRY
An important factor attracting investment in the travel & tourism industry over the last two decades was the fact that travel graduated from being a luxury to a necessity, from the realm of discretionary spending to a regular part of the annual family or corporate budget. Annual holidays, gap years, retirement and motivational travel were among the factors that helped create this critical mass movement.
Today, however, all that has changed. Thanks to various crises (financial, geopolitical, health, natural disasters, etc) travel & tourism risks moving back from the โmustโ to the โmaybeโ category. If confidence in travel has been sapped, the industry will need to generate a whole new set of strategies to restore that. This will mean a whole new game-plan. Some thoughts:
The Asia Pacific travel & tourism industry will need to build its case to attract investments, not just in picking up its distressed inventory and distressed debts but in productive and innovative assets that will deliver long-term value. This will require the industry to develop a clear long-term vision for its collective future based on strong leadership and new strategic objectives. Strong investments in airports, convention centres, railway stations, cruise ships and even the small & medium sized enterprises are to be welcomed, but only if the industry can get its act together and prove that it is worthy of attracting investments over other sectors like agriculture, telecommunications and health. Inviting representatives of sovereign wealth investors from Asia and the Middle East to industry events will be well worth it.
Industry conferences will need to take a more sceptical approach towards the โparty-line.โ In the years of the 2002-2007 boom, many conferences were dominated by people who not only put excessive faith in โmarket forcesโ but also were also instrumental in creating the bubbles of which they became the main victims, taking many millions of people down with them. Those who sought to question their โconventional wisdomsโ were considered to be pessimistic doom-sayers. The World Travel & Tourism Councilโs annual summits are a case in point. Clearly, the time has come for industry conferences to move away from mutual admiration clubs of people preaching to the converted to rigorous and healthy debate forums at which views can be challenged and confronted. A healthy check-and-balance mechanism is good for the system, and the financial crisis has proved it.
Governments will need to ensure that such large foreign investment flows do not become opportunities for nationalists to feed xenophobia. Although โattracting foreign investmentโ has been a mantra of globalisation, many countries are wary, rightly, about their economies and businesses being taken over or crushed by cash-rich foreigners. Governments, especially in the least developed countries, will need to ensure that strict limits are placed on how much money can flow into key sectors in order not to disrupt the equilibrium. The public will need to be convinced that short-term gain can lead to long-term pain, and that slow but steady can win the race.
The private sector should welcome strong regulation, stringent enforcement, and public scrutiny. One of the biggest casualties of the economic crisis has been the credibility of the private sector, especially the large corporations which once upon a time were presenting them as oracles of expertise and wisdom. This โTrust me, Iโm from Lehman Brothersโ attitude needs to go. Cronyism, corruption and nepotism is not the exclusive domain of the public sector. The private sector is probably worse, and it needs to come out of denial of this.
Public and private sectors, and both the finance and travel & tourism sectors, will need to beware one of the most dangerous trends taking place. As the McKinsey study makes clear, dozens of fund managers affected by the crisis are now moving to jobs in Asia and the Middle East. Ensuring that they do not create similar problems will be of critical importance. They will need to undergo proper background checks, and their advice taken with some caution. Their fees and bonuses will need to be tailored to specific performance clauses, and they will need to pay a price for mistakes. Unless these check and balance mechanisms are put in place in advance, there is an even chance that history will repeat itself, and that Asia will again pay the price of listening to faulty advice.
By:
When: 7/2/2014
