THIRD QUARTER 2008

The third quarter represented a sea change in the global capital markets, translating into a dramatic decline in activity in the private capital sectors.  Lack of available financing was a material driver of the slowdown.  A recent Barron’s article commented on the fact that private capital and hedge fund investments declined along with the public markets.¹  They chided endowment managers, stating private equity funds have not provided diversification benefits in this down market.  While certainly all assets suffered, we note hedge fund returns are down roughly half that of the public markets, smaller deals continue to transact, and many private energy investments continue to pump out cash flow—pun intended.  Not all private equity investments are large or leveraged and few of our real assets exposures are predicated on public market prices.  As such, we would argue that given the long view, carefully selected alternative investments (by strategy and by manager) should continue to provide strong portfolio benefits. 

Through June 30, performance of private capital strategies was fairly flat, although we expect valuation adjustments and losses to hit portfolios in the coming quarters.  Buyouts and real estate strategies will be hit the hardest.  On the whole, we anticipate the downswing to be muted relative to public markets and permanent impairment to vary greatly by manager.

The most dramatic short-term impact of the public market decline on private capital is what is often called the “denominator effect.”  Investors with mature private capital portfolios that were at or near target allocations suddenly appear heavily over-allocated to illiquid investments.  Liquidity concerns are real as capital calls continue, while distributions from most sectors are likely to be limited near term.  Short of predicting a quick rebound (unlikely), adjustments to a planned commitment schedule are needed.  Not surprisingly, many funds currently in the market appear to be pushing off a final close into 2009.  Recognizing the mismatch between modeling commitments to private funds based on a fluctuating total portfolio value, our Focus Topic this quarter suggests some tweaks to the model that should insulate a private capital program from public market fluctuations.  We also comment on the Financial Accounting Standards (FAS) 157 fair market accounting standards put in place in 2008 and the increased volatility we expect from broad application of this standard.