Vertical Pulse

Go Alternative!

In times of rocky equity and bond markets, institutional investors and high net worth individuals will increasingly turn to "alternative assets" to beat traditional investment returns. In a study of 790 individuals by Barclays Wealth, "Some 15% of respondents said they planned to invest in private equity funds, up from 11% over the past three years, while 21% said they expected to invest in hedge funds, up from 20%. But fewer than half of the respondents expressed confidence in their knowledge of such investment vehicles, with hedge funds and private equity the least understood. Just 27% understood the former 36% the latter." This is Money, a British financial website, covered the study's findings.

Troubled times in the U.K. and U.S. markets are most evident by the study's other findings. "The survey shows that fewer people expect to invest in equities in the next three years, 48%, compared with the past three years, 64%. Investors also plan to cut back their bond exposure, with just 20% saying they will put money into fixed interest in the next three years, down from 26%."

As most of you know private equity funds, hedge funds, venture capital funds, REITs, and other investment vehicles are popular money managers that are considered part of the alternative investment class. Such vehicles, in order to produce "absolute returns," invest in among other things: commodities, oil and gas, infrastructure, real estate, structured finance, and private companies.

IncreMental Advantage will be hosting an "Alternative Investment Due Diligence" conference in Chicago on April 9 to help people better understand the alternative investment universe. In the following weeks visit www.incrementaladvantage.com for more information.

In other news, Forbes ran a story that quoted George Littell, partner at Groppe, Long & Littell, that oil prices will be falling to around $60 per barrel in about two months. His reason, in March 2006 Saudi Arabian "petrocrats thought demand would slacken at the same time that oil production rose from outside the (OPEC) nations." They are only now increasing oil production to bring prices to around $60 per barrel. Also, China's growing demand for oil is overrated for causing prices to increase. "Forty-percent of that country's oil is burned in so-called stationary uses like electric plants ... which will be shifted to less expensive fuels if oil prices stay high. Most industrialized countries made that shift decades ago."

The Taylor Rule

The Oct. 20 edition of The Economist included a special report entitled, "Only Human," which examines the ongoing credit crunch and how it relates to central banks and the world economy. Much attention is given to inflation and how central banks' battle with it produced the sub-prime mess, which gave birth to the credit crunch and liquidity dry spell. One of the report's articles discusses one of the policy follies during Alan Greenspan's rule at the Federal Reserve when the central bank cut rates from 6.5% in early 2001 all the way to 1% by mid-2003. During that time some questioned if the central bank's monetary policy was too loose?

The federal fund rate did help produce large amounts of liquidity in the global market - creating the recent private equity boom and excessive bank lending. When reviewing that time in recent Federal Reserve history various bankers and economists have been prompted to argue over details of how to measure inflation, which dictates central banks' rate decisions. The Economist report discusses one interesting policy that economists use to measure the stance of monetary policy, the "Taylor rule." One that the Federal Reserve did not employ, at least according to its inventor, John Taylor, the Stanford University economist.

"The rule is a guide to what interest rates should be, depending on the amount of slack in the economy and the inflation rate," The Economist reports. "It says that if there is no output gap (ie, if GDP is in line with the economy's capacity) and inflation is equal to the central bank's target, then interest rates should be at a neutral level, causing the economy neither to accelerate nor to slow down. If an output gap opens up, so that GDP outstrips long-run capacity, or inflation rises above target, rates should be above neutral. If there is slack in the economy or inflation dips, policy should be eased." The authors note that the Taylor rule is only a "rough guide."

At a recent central bankers' conference in Jackson Hole, Wyoming, Mr. Taylor said if the Fed had followed the rule, rates in 2002 would have been going up, not down. Also, by the time rates started to rise, the gap between the actual rate and that indicated by the Taylor rule was 3-percentage points. The gap was closed only last year.

The "Only Human" report makes for an interesting read and can be found here.

Commercial Real Estate Slowdown

The American commercial real estate market is undoubtedly cooling, with the notable exception of New York City. Shares in property companies took a battering over the summer, making the sector the worst performer in the American market in May, June and July, according to an Economist article. However, some experts are uncertain that it will crash in a similar manner as the residential market. "Commercial-property investors are not as dependent as their home-buying counterparts on borrowed money; the average gearing of the REITs (one) invests in is just 31%. As a result, tighter lending standards have not had the dramatic consequences that they have had in the residential sector," The Economist article states.

Retail space vacancies have inched up in the third quarter, prompting concern about a slowdown in consumer spending and economic activity. "The retail sector has been a pillar of the commercial real-estate industry -- and the overall economy -- for the last seven years, riding out economic downturns on steady consumer spending strengthened by soaring housing prices and easy credit," a Wall Street Journal story states. U.S. strip-mall vacancies increased in the third quarter to about a 5½-year high.

Rent growth also slowed a bit in the third quarter. "Although rent growth remained healthy in the third quarter, up 2.4% to $24.17 per square foot from $23.61 in the second quarter, it was off the pace set in the first six months of the year, when rents grew an average 3% per quarter," another Wall Street Journal story found. "The vacancy rate hit its lowest level in six years, dropping to 12.5% in the third quarter from 12.7% in the second quarter, though the pace of absorption -- the change in the total amount of space leased nationwide -- slowed. Absorption totaled 14.8 million square feet in the third quarter compared to 17.3 million in the second."

Of course these trends in real estate have not been uniform across the nation. For instance, where the housing market has really struggled, such as Southern California and Florida, retail space vacancy has increased the most. According to The Wall Street Journal, vacancies have also risen and rent growth slowed in weak housing markets such as Miami, Tampa, Phoenix, Orange County, Calif., and San Bernardino/Riverside, Calif. However, the interior of the country has not experienced much of a slowdown in the retail or rental markets.

These are some of the issues discussed at IncreMental Advantage's real estate conferences. For more information, please visit www.incrementaladvantage.com.

Chinese Real Estate

Emerging markets have been playing a bigger role in investors' portfolios for several years now. Not only are the stocks and bonds of most companies domiciled in emerging markets highly sought after, but real estate is a hot commodity in Asia and East Europe. Let's focus on China, since the media and investors give it the most attention out of the emerging market scene.

In March, the National People's Congress approved a major piece of legislation that enforces private property rights. Though the law has many shortcomings, it will definitely mean land value will rise in the coming years. Good news for investors who act timely. Also, the Chinese government is tightening its industrial land policy in order to pursue a more "sustainable" path of economic growth. China's state-controlled press reported that some of the reform measures' goals is to restrict the appropriation of farmland for development purposes, prevent economic overheating, and establish a system of minimum prices for industrial land use rights.

Writing for Real Estate Forum in September, Andrew Ness reported that these policies are "serving to establish a more transparent framework for industrial land sales, which allows international investors to compete on more equal terms with local players. This, in turn, is giving developers, large-scale manufacturers and third-party logistics companies more confidence in acquiring land." Land values have increased also. In Beijing industrial land has increased by 22%, while rates in Shanghai grew by 24%, between the first quarters of 2006 and 2007, he added. Second- and third-tier cities will feel the impact of this land reform law as industrial bases look to relocate to the cheaper fringes of urban areas.

"Over the longer term, the adoption of the new measures will act to significantly increase the total costs of industrial real estate in China," wrote Mr. Ness, who is the Hong Kong-based executive director of CB Richard Ellis Research Asia.

As far as March's private property rights enforcement law is concerned, The Economist pointed out there is plenty of shortcomings in the law: It does not give peasants marketable ownership rights to the land they farm; it does not let peasants use their land as security on which they could borrow and invest to boost productivity; and it does not clear up who owns what. However, The Economist notes, "a revolution (is) waiting to happen (in China)—or perhaps two. One is the bourgeois revolution led by the emerging property-owning middle class that the new law will help. The other is the potential for the simmering resentment in the countryside to boil over, perhaps in frustration at the law's shortcomings. Property rights are at the root of both—which is why the dozing NPC delegates may have started a process this month (March) that will one day change their country completely."

These are some of the issues that are discussed at IncreMental Advantage's real estate conferences. For more information, please visit www.incrementaladvantage.com.

Some Considerations For Starting Or Growing A Business

I'm sure as many business owners and CEOs can tell you, starting and growing a business is extremely difficult. It can be so overwhelming that business owners often turn to consultants or venture capitalists to assist in fund raising and operational expertise. Obviously a lot of planning has to go into business strategy, corporate culture, budgeting, competition, marketing, intellectual property, target costumers, law, costs, and location. I would like to focus on the last two.

Something that business development pros and venture capitalists may overlook from time to time is the impact of government regulatory costs on small businesses. It is something that owners should pay attention to. In September 2005, the U.S. Small Business Administration's Office of Advocacy reported that "research shows that small business continue to bear a disproportionate share of the federal regulatory burden ... the cost per employee for firms fewer than 20 employees is $7,647." Companies with 20 to 499 employees had a per employee cost of $5,411 while companies with 500 or more employees had a per employee cost of $5,282.

The study measured economic, workplace, environmental, and tax compliance regulations. "Environmental and tax compliance regulations appear to be the main cost drivers in determining the severity of the disproportionate impact on small firms. Compliance with environmental regulations costs 363% more in small firms than in large firms. The cost of tax compliance is 67% higher in small firms than the cost in large firms," the study points out. It went on to report that economic regulation impacted large firms more than small- to mid-sized firms. The authors conclude that regulation of international trade, which falls into the economic regulation category, contributed to the higher cost for large firms by virtue of their potential international reach.

The way things are going in Washington these days those costs will only rise. Small business owners should lobby their Congressional representatives to mitigate the cost impact of these laws.

Location, location, location. Another important aspect of growing one's business is location selection. Business 2.0 researched 10 major urban locations that have just about hit rock bottom because of the housing crisis, which may offer opportunities for investors. Dallas; Indianapolis; New Orleans*; Atlanta; Montgomery, AL; Mobile, AL; Memphis, TENN; Austin, TX; Houston; and St. Louis made the list. While the story focused on residential real estate deals business owners should take into consideration the low real estate prices and the pool of educated, skilled workers these locations offer.

Business owners along with their consultants and VCs should also consider the tax climate before expanding into certain locations. According to the Tax Foundation, Wyoming, South Dakota, Alaska, Nevada, Florida, Texas, New Hampshire, Montana, Delaware, and Oregon have the top 10 business tax environments, in that order. The 10 least competitive tax jurisdictions, beginning with the worst, are Rhode Island, Ohio, New Jersey, New York, Vermont, California, Nebraska, Iowa, Maine, and Minnesota.

Decouple From The U.S.

Any literate American knows that the best investment opportunities lie in the developing markets where annual GDP growth rates vary anywhere from 6% to even 20%. Much better than North America, Japan, or Western Europe. The buzz word for today is "decoupling." That is, foreign markets are no longer catching colds when the U.S. sneezes. "It's increasingly clear that the U.S. isn't any longer the sole engine of global growth -- that other economies have, in effect, decoupled from it," a Wall Street Journal story reports today. The story went on to report that Europe, China, South Korea, and other foreign economies are doing well and growing their middle classes. "For U.S. investors looking to cut exposure to a weaker U.S. economy, the key is to find companies that benefit from global growth and avoid those that are domestically focused or have big exposures to the housing market," the WSJ story continues.

"Despite my current views on the death of New York, I just cannot believe this will ever be the case. It has infrastructure, distribution and lots and lots of customers. Where it suffers is brain drain. All its best bankers are in London," opines Fintag.com, a blogger who also manages a hedge fund.

Along with supposed brain drain, the U.S. dollar continues to plummet. This bodes well for some, but overall its not good news for U.S. consumers who will have to pay more for imports, commodities, and oil. As a result, expect a slowdown in consumer spending, which accounts for 70% of U.S. GDP. As the dollar falls some Middle Eastern nations may look to "unpeg" their currencies to the dollar while also diversifying their exchange reserves into other foreign currencies and assets. Perhaps, oil being priced in Euros is not too far behind. "Qatar's $50bn sovereign wealth fund has trimmed its exposure to the dollar to around 40% of its portfolio, down from 99% two years ago, reported Reuters. About 40% of the Qatar Investment Authority's portfolio was invested in euros and another 20% in currencies including sterling," reports ameinfo.com.

The U.S. looks to be less appealing long term as well. Consider the political atmosphere. A lash back against free trade, impending higher taxes, increase in regulation codes, and out-of-control government spending will probably curtail a lot of the growth the U.S. might experience once the housing crisis is over. The constant propaganda (oops, I mean advertising) that moveon.org, environmental organizations, politicians (i.e. Vermont Senator Bernie Sanders), and other interest groups have poured on the American people have taken its toll. Most voters are convinced that open market policies, which are responsible for 200 years of growth, are now bad ideas.

Time to start thinking about a residence in the Caribbean.

Apartment REITs On The Rise?

The Wall Street Journal reported today that the nation's apartment-vacancy rate dropped 0.2 percentage point in the third quarter, while rents increased a healthy 1.4%, according to a study published by research firm Reis Inc. "Apartment owners in high-price cities such as San Francisco and New York seem to be benefiting from renters who are getting locked out of the for-sale market because of the lack of so-called jumbo mortgages ... The stocks of apartment-owning REITs have a lot going for them. Nearly two million rental households have entered the market in the past two years, including buyers who have shied away from the for-sale housing market and those who defaulted on home mortgages," the WSJ reports.

Most sources in the story expressed interest in apartment-REITs, which have experienced recent gains in the stock market. However, the biggest threats to the investment vehicles are an economic slowdown, which would reduce demand, and the "shadow market." Speculators who got caught with unsold houses and condos began putting them on the market as rentals (shadow market). Such new competition drives down rent rates.

According to Bricks & Mortar Capital LLC, REITs have had a good run this decade. REITs made gains of 26.4% in 2000; 13.9% in 2001; 3.8% in 2002; 37.1% in 2003; 31.6% in 2004; 12.2% in 2005; and 35.1% in 2006. A story in September's Real Estate Southern California, a Real Estate Media publication, reports that REITs, as an asset class, have retreated by roughly 20% in 2007.

In a supplement to Real Estate Southern California, an article appeared that certain lenders were still giving out loans to apartment complex owners and investors to upgrade their facilities. Apartment REITs can access commercial-mortgage loans from Fannie Mae and Freddie Mac, where property owners in other sectors can't, and are thus more exposed to the recent credit crunch. "One way of applying the 'find value by adding value' mantra is to identify an under-performing property with below-market occupancy and/or with under-market rents, correct its shortcomings through better management and physical rehabilitation and create a higher-valued, better-cash-flowing property through the process," the article states.

The authors went on to report select lenders still offer 18- to 24-month bridge loans that are taken out with conventional 30-year term, 30-year amortization products.

These are some of the issues that are discussed at IncreMental Advantage's real estate conferences. For more information, please visit www.incrementaladvantage.com.

Activist Investing On The Rise

According to Brighton House Associates (BHA), there has been "considerable" growth in activist hedge funds from a reported eight activist events in 1994 to 141 and 127 instances of activism in 2005 and 2006, respectively, which used data from a recent study conducted by Robin Greenwood and Michael Schor of Harvard University. "The due-diligence period is longer for activist hedge funds so that they can study and find ways to unlock value in the firm, and because the positions are meant to realize gains via a turnaround in the company, they are typically made for the long-term and are less liquid than other hedge fund strategies," the BHA article states.

The financial service firm also found that "not all the firms that become targets of hedge funds are distressed, or have poor operations, have free cash flow issues and poor manager performance." Sometimes distressed hedge fund investors use a "hybrid" strategy, which utilizes a private equity fund buyout approach. A large number of activist investors commonly buy a 1% to 10% stake in a company to sway internal decisions. The media has caught onto a recent trend where activist hedge fund managers will team up and acquire large stakes in a company.

A BHA poll that was given to consultants, family offices, private banks, wealthy individuals, fund of funds, and others found that hedge funds prompted the most interest among investors who are looking to allocate money into the alternative asset classes. The five most popular strategies, in order, included equity long/short, statistical arbitrage, global macro, emerging markets, and market neutral.

Investors should be weary though that some hedge funds do mis-categorize their strategies. In this summer's Morningstar Advisor, its returns-based categorization differed from that obtained by self-categorization for nearly 50% of the funds it examined. Self-proclaimed net long funds were found to have the most discrepancies with strategy-based benchmarks.

"We regressed hedge funds' returns against not just the corresponding months' S&P 500's returns, but also against the one-month lags of the S&P's returns. Using this autoagressive model, 48% of funds self-selecting into the wrong category. Again, the culprits were net long funds touted as (equity long/short)," the Morningstar story states. To elaborate, 43% of all funds reviewed, were wrongly self-categorized; of which 17% were net long; 50% were net short; 56% were neutral; and 78% were long/short.

"The ideal approach would be a direct examination of the portfolio's holdings. In the absence of such information, a returns-based approach and conversations with managers should prove an acceptable alternative," Morningstar Advisor suggests to investors when doing their due diligence.

These are some of the issues that will be discussed at IncreMental Advantage's Jan. 22 Hedge Fund Strategies conference in NYC. For more information please visit www.incrementaladvantage.com.