Developed Countries

Special Report

Dear Client, This week, we are sending you a Special Report written by my colleague Juan Correa on the topic of carry trades. In this report, Juan builds on our previous work on the subject. He analyses the role of interest rates, spot fluctuations, and volatility in determining the risk profile of carry trade returns. He also provides suggestions to improve the return skew created by the occasional sharp drawdowns suffered by carry trades. I trust you will find this report interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature While the great financial crisis claimed many victims in its wake, none better embodies the promise and perils of carry strategies than John Devaney. The Florida-based fund manager was able to amass a great fortune by using cheap leverage to finance the purchase of high-yielding MBS; a popular and very profitable strategy during the U.S. housing bubble. Eventually, he paid tribute to the pillar of his success by naming his 62-meter yacht "Positive Carry", - as a reminder of the great riches that could be achieved by simply borrowing at low yields to invest at higher ones. But just as his success was great, so was his downfall. When the housing bubble popped, Mr. Devaney's fund found itself unable to meet its margin calls, causing it to shut down. Ultimately, every single penny of investors' money was lost, while Mr. Devaney had to liquidate millions in personal assets; the yacht "Positive Carry" being one of them.1 Of course, bonds have not been the only asset class where carry strategies have been popular. Foreign exchange in particular has historically been the market of choice for investors looking to take advantage of positive carry. Specifically, the seminal 1984 paper, "Forward and Spot Exchange Rates", where Eugene Fama made the empirical observation that uncovered interest rate parity (UIP) does not hold2 (Chart 1), officially formalized the idea that carry in currency markets was a factor that could be systematically exploited. Chart 1The Forward Premium Puzzle So where do FX carry strategies stand in reality? Is carry really a market inefficiency that can be taken advantage of in almost arbitrage-like fashion? Or is it more like playing Russian roulette? A strategy that is deceptively profitable, but one that in the long run will wipe out an investor's capital. Table 1The Mechanics Of The Carry Strategy Index To answer these questions, we analyze the properties of carry strategies by constructing a Carry Strategy Index as follows:3 Ranking the 10 countries in the G10 according to their 3-month interest rate. Using the 3-month rate implied by forward rates.4 Going long 3 crosses that have the following criteria: With 1/3 of the portfolio, long the currency from the country with the highest interest rate vs. Short the currency from the country with the lowest interest rate. With 1/3 of the portfolio, long the currency from the country with the second highest interest rate vs. Short the currency from the country with the second lowest interest rate. With 1/3 of the portfolio, long the currency from the country with the third highest interest rate vs. Short the currency from the country with the third lowest interest rate. Rebalance every three months. (For clarity Table 1 shows an example of the strategy at work) We did not take into account collateral return, as this component can vary depending on the home currency of the investor. While not taking into account collateral returns penalizes the profitability of the strategy, this method allows our Carry Strategy Index to be comparable across investors in the G10. Observations On Carry Returns Chart 2 shows our Carry Strategy Index, along with a breakdown of the strategy's two components: the spot component and the interest rate component. The Carry Strategy Index obtained an annualized rate of return of 4.1% from the beginning of the sample in March 1989 to the end in mid-September 2018, with an annualized daily standard deviation of 9.3%. Moreover, while many investors often laud carry strategies as an opportunity to earn a double whammy of positive carry and positive spot return, most of the sample return was attributable to the interest rate component, as the spot component earned a paltry -0.23% annualized sample return, while it was also responsible for all the risk. Which currencies does the Carry Strategy Index favor? Overall, the AUD and the NZD are overwhelmingly carry currencies while the CHF and the JPY tend to be funding currencies most of the time (Chart 3). Chart 2Carry Throughout The Years Chart 3The Usual Suspects: NZD, AUD, JPY & CHF The amount earned on yield differentials was not consistent over time. The best period for our carry index went from 1995 to 2008, where a relatively high level of carry earned remained stable for more than a decade (Chart 4 - top two panels). Meanwhile the convergence of G10 interest rates to near zero in the wake of the great financial crisis reduced the return from the interest rate component to an annualized rate of roughly 3%. Remarkably, while the return offered by the interest rate component decreased, the implied volatility of currencies stayed relatively constant (Chart 4 - third panel), suggesting that the ex-ante return-to-volatility ratio of these strategies has actually decreased since 2008 (Chart 4 - bottom panel). Although the return for the Carry Strategy Index across the sample is attractive, carry investors are unlikely to implement their position over such a long horizon. It is therefore important to recognize that while the interest rate component tends to be relatively stable through multi year periods, the spot component can make the total return of the carry strategy vary wildly across sub-periods (Chart 5). This sub-period performance is likely more relevant for portfolio managers, as these periods reflect with greater accuracy the length of the horizon used to evaluate them. Interestingly, the annualized returns for longer holding periods are more attractive, while carry returns also become more disentangled from spot returns the longer the time horizon becomes. Chart 4Risk Versus Return In ##br##Carry Strategy Index Chart 5The Spot Component Is The Main Driver Of ##br##Carry Returns On Realistic Time Horizons Bottom Line: Our Carry Strategy Index was overwhelmingly long AUD and NZD, while being short JPY and CHF. Moreover, the interest rate component decreased significantly after G10 central bank rates converged to the zero bound, without a corresponding decrease in volatility, resulting in a deteriorating return-to-volatility ratio. Finally, while spot returns had a very small contribution to the sample return, they are a crucial driver for total return in more realistic time horizons, particularly shorter ones. Structural Determinants Of Carry: Is There Really A Puzzle? Many investors have grown disillusioned with carry trades in recent years, as the spot component of the strategy has become much more mediocre than in the past. This general disenchantment with carry trades has only grown stronger, with recent research showing that since 2008 the relationship between rate differentials and spot returns has flipped from positive to negative.5 So where have the good old days gone? A deeper look at the data suggests that the strong positive relationship between spot returns and rate differentials might have been a temporary phenomenon. In fact, the correlation between rate differentials and spot returns can vary widely from year to year (Chart 6). Thus, while the period after 2008 has shown a decrease in correlation, it is not a particularly unique sub-sample, as there have been other periods in history where there has been a negative correlation between rate differentials and spot returns. In fact, the Fama puzzle is not quite a puzzle if one remembers that UIP is not an arbitrage condition like CIP (Covered Interest Rate Parity). Two currencies could very well offer different rates of return so long as they also offer different levels of risk.6 We can see evidence of this by looking at the characteristics of typical carry currencies vs the characteristics of typical funding currencies. Carry currencies tend to have large current account deficits, negative net international investment positions, and are highly levered to the global economic cycle (Chart 7). Not only does this mean they are correlated to other assets, but it also means they are more prone to sudden pullbacks when global liquidity dries up. Funding currencies on the other hand have the opposite characteristics, being typically safe havens that act as hedges against other assets (Chart 7). Chart 6No Stable Correlation Between Interest Rates ##br##And Currency Returns Chart 7No Puzzle: Yield Differentials Are ##br##Just Risk Differentials Does this mean that carry trades will regain their former glory? It is hard to tell. One reason to remain cautious on the long-term outlook for carry trades has been the trade rebalancing that has taken place since the financial crisis (Chart 8). Technically, a rebalancing in the G10 space implies that the risk differential between countries should be decreasing. However, this also means that the return differential has also decreased, which means that the low interest rate component of the Carry Strategy Index at present might be justified. As mentioned previously, the interest rate component is the ultimate driver of carry returns over long horizons (Chart 9). Therefore, carry investors should keep in mind that as imbalances are fixed, risk and yield differentials will narrow, implying that the long-term return of carry strategies will stay low by historical standards. Chart 8Decreasing Risk Differentials##br## In The G10... Chart 9...Imply A Reduced Long-Term Rate Of Return ##br##For Carry Trades Bottom Line: UIP is not an arbitrage condition, which explains why the correlation between spot returns and rate differentials has historically been highly unstable. Instead, rate differentials are often reflective of risk differentials between countries. Rebalancing within the G10 has likely reduced these risk differentials, and consequently carry returns. Cyclical Determinants Of Carry: The Role Of The U.S. Dollar While occasionally there are other currencies that become either funding or carry currencies, this tends to be a rare phenomenon. In fact, the ranking within the G10 rate distribution for any given country tends to remain stable throughout the years. There is only one glaring exception: the United States (Chart 10A and Chart 10B). Chart 10ASince The Mid 1990s Most Countries Remain ##br##Relatively Fixed In The Interest Rate Distribution (I) Chart 10BSince The Mid 1990s Most Countries Remain ##br##Relatively Fixed In The Interest Rate Distribution (II) The first half of the 1990s was the only time where there was significant interest rate migration for multiple countries. Since then, the U.S. is the only country whose interest rate has migrated significantly across the distribution. This is because it has become the de facto global price-maker of monetary policy. After all, the U.S. is the G10 country whose inflation dynamics are least sensitive to currency movements. Therefore, the Federal Reserve is less concerned with its interest rate differential relative to other G10 economies than other central banks. This allows the Fed to reposition U.S. rates within the G10 distribution according to its own business cycle (Chart 11). On the other hand, the central banks in the rest of the G10 are much more concerned with the way that currency fluctuations can potentially amplify the effect of monetary policy tightening or easing. This makes them much more prone to holding their place in the distribution, and following the rest of the pack accordingly as the business cycle progresses. Additionally, the U.S. economy tends to be less affected by the global business cycle than other economies in the G10. As a result, while other countries might move in unison, the U.S. can follow its own dynamics. The current business cycle is an exaggerated example of this phenomenon. Understanding this dynamic is crucial for carry trades, as the U.S. dollar is the only chameleon currency that can constantly shift from funding currency to carry currency and vice-versa. Chart 12 shows that returns from carry strategies suffer whenever U.S. rates are at the top of the distribution. By the same token, when the U.S. dollar becomes a funding currency, the return in our Carry Strategy Index increase significantly. Chart 11U.S.: Global Price Maker ##br##Of Monetary Policy Chart 12Carry Strategies Suffer When The##br## USD Is A Carry Currency Why does this relationship exist? External debt for the world in general and emerging markets in particular is denominated in U.S. dollars. Whenever U.S. rates rise, external debt servicing increases, causing the return of investment in emerging markets, commodity producers and other cyclical plays highly sensitive to U.S. dollar borrowing costs to deteriorate. Moreover, the high rates in the U.S. make cyclical plays like Australia or New Zealand relatively less attractive to global investors. This creates a dangerous environment for carry trades, given that the possibility of a risk-off event - where funding currencies can rally - becomes increasingly likely. Bottom Line: The U.S. dollar is the only currency that can consistently change from carry to funding currency. When the USD is a funding currency, overall carry returns are attractive. Conversely, when the USD is a carry currency, overall carry returns become poor. Tactical Determinants Of Carry: Fighting Against Negative Skew It is important to recognize that volatility is not the only risk that carry investors are exposed to. One of the most agreed upon hypotheses put forward is that carry strategies offer a positive return in exchange for exposure to negative skew in returns, or what is commonly known as the "Peso Problem". Essentially, when they work, carry strategies generate consistent small positive returns; however, they are subject to infrequent yet violent drawdowns. Hence, the return distribution is not normally distributed, but instead has a heavy left tail7 (Chart 13). Chart 13Negative Skew In Carry Strategy Index Why does skew matter? Carry trades are generally accompanied by leverage to amplify the return earned. However, the negative skew can become extremely dangerous at high levels of leverage, as it can lead to margin calls. In selloffs, investors who are not able to meet their margin calls are forced to quickly liquidate their positions, generating downward pressure on prices, and causing even more margin calls. This dynamic causes vicious cycles in carry trades, where losses can pile up very quickly.8 Chart 14Vega-M: An Enhanced Carry Strategy However, we can use the reflexive relationship between risk aversion and carry returns and turn it to our advantage. If we know that once it rises, volatility will create further downward price pressure, which in turn generates further volatility, then we can use the momentum in volatility to determine entry and exit points into carry trades. To take advantage of the above we created a strategy as follows: Long the Carry Strategy Index at day t if at day t-1 the 20-day moving average of the CVIX is below the 200-day moving average.9 Remain uninvested (earn 0% return) at day t if at day t-1 the 20-day moving average of the CVIX is above the 200-day moving average. We call this strategy the Vega-M Carry Index. Our Vega-M Carry Index manages to outperform the Carry Strategy Index within our sample, while also displaying significantly less volatility (Chart 14 - top panel). The Vega-M Carry Index also manages to closely track the interest rate component of the strategy, while eliminating some of the spot risk (Chart 14 - bottom panel). The Vega-M Carry Index also exhibits a much tighter return profile than the Carry Strategy Index (Chart 15 - top panel). Furthermore, while kurtosis in the Vega-M Index is still high, skew for the Vega-M Carry Index is actually positive (Chart 15 - bottom panel). This reduction in negative skew has important implications for investors using leverage. Chart 16 shows how the Vega-M Carry Index allows for a greater use of leverage, as the reduced negative skew eliminated margin calls, which means investors are not stopped out. This allows investors to have much better performance at high levels of leverage. Bottom Line: Given the reflexive relationship between volatility and carry trades, investors can use volatility momentum to generate buy/sell signals. Carry investors should remain invested when the volatility momentum is negative, while they should close their positions when momentum is positive. Chart 15Vega-M: More Compact Return Distribution And No Negative Skew Chart 16Vega-M: Better Performance When Using Margin Investment Implications With the above points considered, we have made a list of the three rules of thumb for carry investors to use: On a structural basis, the long-term rate of return of carry strategies will be determined by the interest rate differential. In general, this differential is a compensation for risk differentials between countries Cyclically, carry trades will deliver poorer returns whenever the U.S. dollar is a carry currency (at the end of the cycle), and will deliver better returns when the U.S. dollar is a funding currency (at the beginning of the cycle). Tactically, investors can use the momentum in volatility as a signal to enter or exit carry trades. Negative volatility momentum can be used as a long signal, while investors should exit their carry positions when volatility momentum becomes positive. While we have divided our rules into investment horizons, carry investors should use all rules in conjunction. The interest rate differential and the projected risk differential between countries can be used to establish an expected long-term rate of return to benchmark against. The position of U.S. rates within the distribution can be used to determine whether a high or low level of leverage is appropriate. Finally, the momentum in volatility can be used to assess entry or exit points from carry trades. What are all these signals telling us right now? The annualized rate of return of the interest rate component in carry strategies will likely remain low. This means that the long-term rate of return of carry strategies will remain at the low end of its historical distribution. Inflationary forces in the U.S. will continue to be greater than in the rest of the world. Thus, U.S. rates will remain at the top of the distribution, which means that leverage on carry strategies should be maintained at a minimum The momentum in volatility continue to be positive. This means investors should hold off from entering into carry trades, and instead wait for a better entry point. Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com 1 Story, Louise. "Hedge Fund Manager Describes Rock Bottom." The New York Times, The New York Times, 10 July 2008, www.nytimes.com/2008/07/10/business/10fund.html. 2 Please see Fama, E.F. (1984) "Forward And Spot Exchange Rates" Journal of Monetary Economics, 14(3), 319-338 3 We use a multi-currency strategy, as academic research has shown that this method outperforms single currency strategies. For more details, please see "Multiple Currencies Investment Strategy To Take Advantage Of The Forward Bias," Haas School of Business, University of California Berkeley, BA 285/E285 International Finance, Student Project. 4 Carry strategies in the FX markets are normally implemented through buying (selling) forward rates with a forward discount (premium) 5 Please see Bussiere, M., Chinn, M., Ferrara, L.,& Heipertz, J. (2018) "The New Fama Puzzle" NBER Working Papers 6 The UIP theory makes the assumption that economic agents are risk neutral. Given this is not the case in reality, much work has been done to try to explain deviations from UIP with currency risk premiums. For more information please see Menkhoff, L., Sarno, L. , Schmeling, M. and Schrimpf, A. (2012), "Carry Trades and Global Foreign Exchange Volatility". The Journal of Finance, 67: 681-718. 7 This makes the Sharpe ratio deceptive as a measure of risk-reward for carry strategies, as this measure does not account for skew. 8 For a more detailed description about the relationship between unexpected jumps in volatility and carry returns please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 9 We use 20-day and 200-day moving averages given that moving averages using these types of ranges tend to best capture the momentum in financial markets. For more details about momentum strategies please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies in Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Neutral The battle of the titans of the U.S. media sector for control of Sky PLC was resolved over the weekend, with Comcast emerging victorious, besting 21st Century Fox's bid for the pay-TV firm. While increasing global diversification and a larger distribution channel are good things, we are somewhat skeptical of the victory for two reasons. First, the battle was settled in a blind auction and Comcast's £17.28 offer beat Fox's £15.67 effort by 10% and their own previous £12.50, made in February, by 38%. This could imply some vastly greater synergies identified over the past 7 months and more than Fox, which already owned 39% of Sky. However, it more likely is an extremely expensive tactic to block Disney, who has already pledged to buy Fox's existing stake, which doesn't bode well for the durability of the goodwill acquired. Our second hesitation with this deal is related to its composition, namely all-cash. We estimate an incremental U.S. $47 billion of net debt added to Comcast's balance sheet but analysts estimate Sky will generate only U.S. $3.8 billion of EBITDA next year, suggesting the index's deleveraging is reversing course. This increased risk has clearly been reflected by Comcast investors, who have wiped 6.5% off the stock's market cap. Bottom Line: We think this deal may be the strategic best case for Comcast but is tremendously expensive. Given that it has already been reflected in the stocks, our neutral recommendation remains unchanged.

Highlights The risk of unplanned oil-production outages is rising. One or more such events will severely test OPEC 2.0's spare capacity in a supply-constrained market (Chart of the Week).1 As things now stand, OPEC 2.0 spare capacity - if it is available - and a likely U.S. SPR release of 500k b/d in 1Q19 will not cover expected production losses, if markets are hit with another unplanned outage from Libya or Iraq.2 Demand destruction via higher prices will have to balance markets. Oil markets are tightening (Chart 2). Falling supply and stable demand will produce a 1mm b/d physical deficit into 1H19, forcing continued OECD inventory draws (Chart 3). The dominant scenario in our forecast includes a supply shock arising from lost Iranian and Venezuelan exports, which triggers price-induced demand destruction. We raised the odds of Brent prices hitting $100/bbl by 1Q19, and our 2019 forecast to $95/bbl on the back of these factors. Unplanned outages would lift prices higher. Energy: Overweight. The long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls we recommended last week are up an average 33.8%, as of Tuesday's close. Base Metals: Neutral. Our foreign-exchange strategists expect the USD to correct further. This will be bullish for copper, which is up ~ 10% since Sept. 11. Precious Metals: Neutral. The USD correction will support gold in the short term. Technically, gold appears to be forming a pennant, which could be short-term bullish. Ags/Softs: Underweight. Corn prices are benefiting from strong exports, according to USDA data. Accumulated exports for the current crop year are up 27% vs last year in the week ending Sept. 13. Chart of the WeekUnplanned Oil-Production Outage Risks Up, OPEC 2.0's Spare Capacity Down Chart 2Physical Oil Deficit Returns##BR##To Oil Market Next Year Chart 3Fundamentals Support##BR##Strong Prices Feature Oil markets are approaching a moment of truth. OPEC 2.0's spare capacity likely will be put to the test in 1Q19, as Iranian export volumes continue to fall, and other threats to production - Venezuelan losses, and increasing sectarian tension in Iraq and Libya - come to the fore. As the Chart of the Week demonstrates, spare capacity in the traditional OPEC states is low and falling: The U.S. EIA's most recent estimate of OPEC spare capacity is 1.7mm b/d this year and 1.3mm next year, well below the 2.3mm b/d average of 2008 - 2017. For its part, Russia - the other putative leader of OPEC 2.0 - likely only has ~ 200k b/d of spare capacity to ramp. On a relative basis, OPEC spare capacity is even more stretched: This year, the EIA expects it to average 1.7% of global demand. By next year, it is expected to fall to 1.3%, or ~ 1.3mm b/d. This will be lower than the spare capacity reported for 2008 (1.6%), when OPEC (mostly KSA) found itself struggling to meet surging EM demand, and well below the 2.6% average for 2008 - 2017. Spare capacity is very close to levels last seen in 2016, when low prices resulted in supply destruction. In the wake of the oil-price rout of 2014 - 16, capex collapsed as did maintenance spending needed to keep production steady y/y. This can be seen in the relentless decline in OPEC production ex GCC and the stagnation in other states unable to grow output (Chart 4 and Chart 5). Indeed, as prices hit their nadir in 1Q16, sovereign wealth funds (SWFs) in OPEC and non-OPEC states were being liquidated to cover gaping holes in producers' fiscal accounts. This partly explains the growing incidence of unplanned outages, and our contention OPEC spare-capacity claims are highly suspect (Chart of the Week). Chart 4OPEC 2.0's Core Producers Would Be Taxed to Replace Lost Exports Chart 5Outside Of A Very Few Regions, Oil Production Has Struggled U.S. Remains Adamant On Shutting Down Iran's Exports The Trump administration's goal is to reduce Iranian oil exports to zero via the sanctions it will impose beginning November 4 from ~ 2.5mm b/d back in April, when the U.S. sanctions were announced. However, as the EIA data indicates, achieving this goal would leave markets seriously short oil. Indeed, the Washington-based Center for International Strategic Studies (CSIS) noted in late August, "realistically, there is simply not enough readily available spare oil production capacity in the world to replace the loss of all Iranian barrels (some 2.4 mm b/d), coupled with the potential for further reductions in Venezuela, Libya, Nigeria, and elsewhere."3 Our modeling includes 1.25mm b/d of lost Iranian and Venezuelan exports, continued y/y losses in non-core OPEC (Chart 4), constrained U.S. production growth, and stagnate supply growth outside a handful of states able to lift their output (Chart 5). We do not believe OPEC 2.0 spare capacity is sufficient to cover these losses and one or two additional unplanned outages in Iraq or Libya, or anywhere for that matter. In addition, a 500k b/d release of U.S. SPR after the price goes above $90/bbl in 1Q19 will contain the supply shock we expect slightly, but will not completely reverse it. We have long believed KSA's ability to maintain production above 10.5mm b/d for an extended period is suspect, despite its claims it can ramp to its capacity of 12mm b/d.4 We are carrying KSA's current production at 10.4mm b/d in our balances estimates, roughly the level it self-reported to OPEC last month. To be clear, we are not saying KSA's production cannot be increased - perhaps to 10.7mm b/d - but we are dubious it can get to its claimed 12mm b/d capacity, or that it can sustain 10.7mm b/d indefinitely. It is important to note any short-term increase in OPEC 2.0's production will come out of spare capacity available to meet unplanned outages, or deeper-than-expected Venezuelan losses next year. Lastly, unplanned outages in a market already stretched by tighter supply will accelerate the rate of demand destruction via higher prices. This also would accelerate the arrival of a U.S. recession brought about by an oil-price shock, all else equal.5 Iran's Hand Is Strengthening You'd never know it from the declarations of President Trump and U.S. Treasury Secretary Steve Mnuchin - both of whom are adamant in their professed desire to see Iranian oil exports fall to zero - but the U.S. has been attempting to engage Iran in treaty discussions to limit the country's ballistic-missile capabilities and nuclear-development program.6 Not surprisingly, Iranian officials have shown no interest in such discussions. This is a remarkable turn of events, but not unexpected. At some point, it likely became apparent to the Trump administration the global oil markets are on a trajectory for significantly higher prices, as our analysis and forecasts indicate. It also likely is apparent to administration officials that oil prices - and gasoline prices, in particular, which matter most to U.S. voters - will be surging just as the 2020 presidential campaign gets underway next summer. Along with our colleague Marko Papic, who runs BCA's Geopolitical Strategy, we believe that, from a game-theoretic perspective, the approach from the U.S. actually strengthens Iran's hand. Given its history with the previous round of sanctions, and the economic hardships they imposed, the government in Iran likely believes it can ride out 12 to 18 months of renewed sanctions. It is not unrealistic to entertain the possibility Iranian politicians take the bet that sharply higher gasoline prices in the U.S. by 2H19 will give Democrats in U.S. presidential and congressional races - which kick off next summer - a powerful issue with which to campaign against President Trump and the GOP. Bottom Line: There is a non-trivial chance that OPEC 2.0 spare capacity will prove insufficient to cover the losses in Iranian and Venezuelan exports we foresee in the very near term. Should this prove to be the case, the odds that Brent crude oil prices exceed our $95/bbl forecast for next year are high. We believe Iran's political hand could be strengthened, if it rebuffs overtures by the Trump administration to negotiate a treaty to replace the executive agreement with former U.S. president Obama that limited its nuclear program. We recommended getting long Brent call spreads last week to position for the higher prices we are forecasting for next year. Specifically, we recommended getting long April, May and June 2019 Brent calls struck at $85/bbl vs short $90/bbl calls. As of Tuesday's close, these positions were up 33.8% on average vs their opening levels last Thursday. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Upside Risks Dominate BCA's Oil Price Forecast," published by BCA Research's Commodity & Energy Strategy October 26, 2017, and "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. Both are available at ces.bcaresearch.com. 2 OPEC 2.0 is the name we coined for the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which was formed in November 2016, following the price collapse brought on by OPEC's market-share war launched in November 2014. Please see last week's Commodity & Energy Strategy lead article, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. In that article we note that, in addition to the highly visible export losses in Iran due to U.S. sanctions and continued deterioration in Venezuelan production, the EIA reduced its estimate of U.S. production growth by 201k b/d in 2019, and the IEA reduced its estimate of Brazilian output this year by 260k b/d. 3 Please see "Whither the Oil Market? Headlines and Tariffs and Bears, Oh My..." published by csis.org August 29, 2018. We are closely following a just-proposed workaround to U.S. sanctions on Iranian oil exports made by the High Representative of the EU, Federica Mogherini, at the UN General Assembly meeting in New York on Tuesday. Ms. Mogherini proposed setting up a special-purpose vehicle that would allow importers in the EU, China and Russia to continue purchasing Iranian oil crude. The SPV would transact in euros, yuan, and roubles, so as to avoid processing transactions through the Society for Worldwide Interbank Financial Telecommunication SWIFT system in Brussels. The SWIFT system is dominated by USD transactions, and the U.S. Treasury has high visibility into transactions made using the system, given USD-denominated transaction like oil purchases and sales must ultimately be cleared through a U.S. bank or intermediary. Iran already takes yuan for its oil, and this mechanism would allow it to purchase goods and services denominated in these currencies. If technical details of the proposed system can be worked out, the SPV could facilitate increased Iranian exports under the U.S. sanctions regime. This would cause us to lower our estimate of lost exports from that country from our baseline assumption of 1.25mm b/d. Please see "Why India Will Struggle to Join Iran's Sanctions Busters," published by bloomberg.com on September 26, 2018. 4 We are not the only ones dubious of KSA's ability to ramp production. Please see "Can Saudi Arabia pump much more oil," published by reuters.com July 1, 2018. 5 In our House view, a recession in the U.S. does not arrive until 2H20. We have argued an oil-supply shock, particularly during a Fed tightening cycle, typically presages a recession in the 6 - 18 months following the shock. Please see Commodity & Energy Strategy lead article, "Odds of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. 6 Please see "U.S. seeking to negotiate a treaty with Iran," published September 19, 2018, by reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

  Neutral As we highlighted in yesterday’s Daily Insight, we are firmly housing market bulls. However, we are concerned that too much euphoria is priced into home improvement retail (HIR) equities. Three reasons underlie our softening EPS stance for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (second panel). Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (third panel). Finally, select industry operating metrics suggest that the easy profits are behind HIR. An inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone and is already having an impact on earnings estimates. (bottom panel). Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin; please see our Weekly Report for more details. Bottom Line: We downgraded exposure to neutral on Monday and crystalized gains of 13.3% in the S&P HIR index since inception. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.  

Special Report

Highlights Investors have piled into private equity (PE) in recent years, pushing assets under management (AUM) up to an all-time high of $3 trillion. However, there are increasing concerns about the outlook for the asset class over the next few years. In this report, we look at the fundraising and deal environment for PE, analyze historical risk-adjusted returns in comparison to traditional assets, and suggest how investors can optimize their PE allocation. Private equity and its two major sub-categories, buyouts and growth capital, have generated annualized returns of 13.4%, 13.7%, and 15.0% respectively over the past 32 years, significantly beating the returns from global equities and small-cap stocks of 8.4% and 9.1%. But the current environment is tougher. Dry powder (funds raised but not yet invested) exceeds $1 trillion. PE managers face increased competition from other investors and from companies with large cash balances looking to make acquisitions. Funds raised at the peak of bull markets have a higher probability of underperforming. The next two vintage years (2018 and 2019) face headwinds to making good returns, because of high entry valuations and a rising cost of borrowing. Manager selection is critical for a successful private-equity program. Top-quartile PE funds have outperformed second-quartile funds by as much as 8% a year over the past two decades. Feature Introduction The private equity (PE) market has grown more than five-fold since 2000, lifting assets under management from $577 billion to $2.97 trillion. However, its share of the private investment market has declined from 82% to 58% (Chart 1). Private equity and venture capital investing is said to date back to 1901 when J.P. Morgan purchased Carnegie Steel Co from Andrew Carnegie and Henry Philips for $480 million. The industry has evolved significantly over the years, and now encompasses a wide range of sub-strategies, offering investors a spectrum of exposures with very different risk/return profiles. Chart 1Private Equity Is A $3 Trillion Market Compared to public equity, private equity investing is harder because of: 1) long-term illiquidity, whereas public equities can be bought and sold quickly, 2) limited information on target companies, 3) the lack of a clear price discovery function, meaning that pricing in private markets depends heavily on negotiations, 4) less separation between ownership and control - finance providers in PE tend to be managers too. The PE space has matured over the years, and this is clearly seen in the compression of returns. However, many investors remain bullish on this asset class because of its historically attractive risk-adjusted return, and ability to diversify traditional portfolios. As of mid-2017, the median net return of the PE holdings of public pensions globally over the previous 10 years was 8.5% compared to 4.2% for public equities, 4.5% for real estate, and 5.2% for fixed income.1 In this report, we analyze in detail the PE market, with an overview of the fundraising cycle, deal environment, and exit channels. We include in-depth analysis of historical returns from the private equity market in aggregate, and from its two largest sub-categories, buyouts and growth capital. We end by listing the key risks for limited partners (LPs - the investors in PE funds), and include a brief note on private-equity secondary investing. Our key conclusions are: Private equity, including buyouts and growth capital, has had exceptionally good returns over the past three decades, but has been on a structural downtrend as competition has increased. Buyout funds generate a negative skew and moderate kurtosis, whereas growth capital tends to have a larger kurtosis and positive skew. Funds raised at the peak of bull markets have a greater probability of underperforming given their higher entry valuations. This is likely to be the case for funds raised over the next 18 months. The current economic cycle has produced fewer home-run deals - in 2002-2005, 35% of deals produced returns of 3x invested capital, but this fell to 20% in the 2010-2013 period. Megacap buyout funds produce the best returns, but this comes with significantly higher volatility pushing down the risk-adjusted return. These larger funds experience larger negative skew and kurtosis driven by greater use of leverage. Entry valuations of investments made by PE funds have been steadily rising, and so has leverage: the median debt/EBITDA has reached 5.5x. As multiples keep rising, general partners (GPs - the fund managers) have to make up the difference with equity infusion. Top-quartile managers have significantly outperformed. Third-quartile managers struggled even to outperform global equities, and fourth quartile managers failed to preserve their initial capital. The secondary PE market is growing. It provides access to mature portfolio assets deeper into their distributions phase, which reduces the duration of the LP's investment. Fundraising, Deals, And Exits Private equity investing consists of many different sub-categories (Chart 2) that differ in value creation techniques and the maturity of target companies. Buyouts and growth capital are over 90% of the total. Buyouts2 invest in established companies, usually with the intention of improving operations and financials. There is usually substantial use of leverage. Growth capital3 takes significant minority positions in profitable yet still maturing companies mostly without the use of leverage. Secondary funds acquire stakes in PE funds from other LPs. Co-investment funds make minority investments alongside a buyout, recapitalization, or any other non-controlling investment. Turnaround funds aim to revitalize companies that face operational difficulties. Chart 2Buyouts & Growth Capital Are 90% Of PE Private-equity firms raised $701 billion in 2017, making the past five years the strongest period for fundraising in history, with a total of $3.2 trillion (Chart 3). Additionally, more than two-thirds of the funds which closed in 2017 met or exceeded their target amounts, and 39% took less than a year to close. The last time fundraising peaked was in 2008, right in the middle of the last recession. However, since 2009, fundraising for buyouts has dropped from 85% to 70% of the aggregate for private equity, with growth capital picking up the slack, rising from 8% to 21%. As fundraising has gotten stronger, PE firms have been raising larger funds.4 These megafunds (with AUM greater than $5 billion) raised $174 billion in 2017, or 58% of that year's total buyout volume, a steep increase from $90 billion in 2016. For investment institutions with large amounts of capital to deploy, megafunds are an attractive and efficient outlet. Another reason for the very strong fundraising environment has been quick follow-up funds, where GPs race to launch new funds before predecessor funds have matured. Historically GPs have waited an average of 62 months between closing one fund and starting the next, but this has come down to 40 months in the past five years. With fundraising so strong, GPs are under pressure to deploy this capital wisely. Global PE deal volume increased by 14% in 2017, surpassing $1.2 trillion (Chart 4). But global deal count has been on the decline since 2015. Along with larger funds being raised, the average deal size in the private market has been rising steadily since the Global Financial Crisis (GFC). Despite increasing deal activity, the sheer volume of fundraising in recent years has led to massive accumulation of dry powder,5 which currently stands at $1.03 trillion. After 2008, dry powder as a percentage of AUM (Chart 5) was on a downward trend because of increased acquisition activity due to attractive valuations following the GFC. But this bottomed in 2012 at 29% and had risen to 35% at the end of 2017. If this level of dry powder accumulation continues, GPs will be forced to reduce hurdle rates and deploy capital into less attractive deals. Chart 3$3.2 Trillion Raised in 5 Years Chart 4Rising Deal Size Chart 5Harder To Find Attractive Deals Another reason for dry powder accumulation is increasing competition for deals both within the private equity market, and from external sources. The number of private equity funds is at an all-time high of 7,775.6 The external competition comes largely from corporate buyers with large cash balances looking for inorganic growth. Corporations have two advantages over PE firms: 1) potential built-in synergies when it comes to integrating the target, giving them the ability to pay a higher price, and 2) a lower cost of capital. An increasing number of corporations have been setting up corporate venture-capital units (Chart 6) to focus on acquisition-led growth. In 2017, there were 38,479 companies bought and sold globally for a total value of $3.3 trillion. But, private equity's share of this market was just 13% by deal value and 8% by deal count (Chart 7). Looking forward, PE funds are likely to act more aggressively and take a larger share of the market, as they did in 2006-2007. In order to increase their share of global deal activity, private-equity funds need to look at more strategic ways to pick up assets: Chart 6Corporations Setting Up VCs Chart 7Buyouts Only A Tiny Player In Global M&A Zombie Assets: Assets (portfolio companies) belonging to funds that last raised initial capital between 2003 and 2008 but have not executed a deal since 2015. Currently there are over 100 such companies that are possible targets for takeover in 2018-2019. Carve-Outs: Over the past few years, one in five deals in the U.S. has come from corporations disposing of non-core assets.7 This provides a steady deal flow for buyout and turnaround funds. Public To Private: As multiples in private markets converge with those in public markets, more and more publicly listed companies are being taken private, and this market has doubled since 2016 (Chart 8). Additionally, lenders have become more comfortable about financing these high-value transactions. Buy & Build/Add-Ons: Purchasing cheaper small assets and adding them to existing large established platform companies. This in turn transforms a group of smaller companies at lesser multiples into a larger corporation with a premium valuation. Add-ons made up one-third of deals a decade ago, but that has now reached 50%. But, since such deals are smaller in terms of dollar value, they make up less than 25% of the total deal volume. Finally, PE firms have also been increasing the holding period of the assets in their portfolio. The median holding period before the GFC was four years, and this has now increased to over five years (Chart 9). Additionally, private equity firms exited 40% of all deals in fewer than three years, but now these quick-flips have fallen to only 20%. This is partly a response to increased competition: GPs are skeptical about finding new attractive deals, and this forces them to hold onto assets for as long as possible. Additionally, the new U.S. tax code has increased from one to three years the threshold period for carry to be treated as capital gain with a lower tax rate, rather than taxed as ordinary income. With fundraising on fire but deal activity struggling to keep pace, the final pillar for a successful private equity program is the exit environment. Global PE-backed exits have been flat for the past two years at around $500 billion, with the deal count between 2,500 and 3,000 (Chart 10). The rise in exit activity in 2015 was fuelled by PE firms looking to exit portfolio companies acquired before the financial crisis. By 2017, the dynamic had changed since more than 80% of exits that year were companies acquired in 2009 or later. Finally, dividend recapitalizations8 reached $42 billion in 2017, but these are heavily dependent on an accommodative debt market and positive environment for high-yield bonds. With rising rates, dividend recapitalization, and other forms of special dividends or distributions that require borrowing, become harder to execute. Chart 8Public-To-Private Activity Chart 9Longer Holding Periods Chart 10Global PE Exits Are Healthy Historical Returns Before we look at the past risk-return profile of investing in this asset class, a note on the data used in this report. All return data are based on the Cambridge Associates Private Investment Benchmarks.9 We are satisfied with the methodology used and the format in which the returns are presented. The provider has taken sufficient steps to minimize survivorship bias. For more details on the data methodology, please see the Appendix. What can investors expect in terms of risk-return exposure from this asset class? Looking at Table 1, private equity and its sub-strategies have comfortably outperformed global equities, with lower volatility, over the past 32 years. Even after statistically adjusting returns for stale pricing,10 volatility for aggregate private equity and buyouts remains lower than for global equities and small-cap stocks. On the other hand, growth capital has had realized volatility greater than that of global equities, but with a significantly higher return; it is still the more attractive investment on a risk-adjusted basis. However, the significantly lower realized volatility of PE in aggregate, and buyout funds in particular, compared to growth capital makes them more attractive investments. Additionally, venture capital experienced volatility of close to 42%, more than double that of small-cap stocks, making it very unattractive from a risk-adjusted perspective. Table 1Risk-Return Spectrum However, comparing the performance of PE with that of publicly traded assets could be misleading given the uncertain timing of cash inflows and outflows from private equity programs. Therefore, we also show the Public Market Equivalent11 (PME) to adjust public-market indices for uncertain cash flow streams. Looking at Tables 2-4, we can see that private equity still outperforms equity indices on a PME basis over different time frames. Table 2Private Equity PME Analysis Table 3Buyout PME Analysis Table 4Growth Capital PME Analysis Another unique characteristic of private-market returns is the J-curve effect where investments in private markets take time to bear fruit, and fees are initially based on committed capital rather than invested capital. In addition, the biggest cash flows will be received towards the end, so the returns for the first few years can be misleading. IRR will remain negative until the point when distributions at least match contributions (the payback point). Given the non-linear return distribution of alternative assets such as PE and venture capital, risk analysis is not complete without skewness and kurtosis. Investing in buyout funds generates a negative skew and a moderate level of kurtosis, which means that investors can expect more stable, predictable returns, closer to a normal distribution. However, growth capital tends to have larger kurtosis and positive skew, thereby a higher probability of large upside gains. Since buyout capital structures tend to be more heavily geared, there is a higher skew towards negative returns driven by the leverage effect. Venture capital exhibits a return distribution similar to growth capital, where a few portfolio companies produce large positive returns given the start-up nature of its targets. PE returns remain attractive but, as with other alternative asset classes, performance has been on a downward trend (Chart 11) driven by increased competition. In the 1980s and 1990s, buyout firms exploited the poor performance of large U.S. conglomerates by acquiring underperforming divisions and using leverage. In the early 2000s, funds took advantage of the stock market rise, fuelled by low rates and levered returns. Within the structural downtrend in returns, PE has had a cyclical profile just like public equities. During bull markets there are more exits at higher valuations, and larger distributions to LPs. However, funds raised in bull markets have a higher probability of underperforming given their higher entry valuations. Looking forward, funds from recent vintages that are halfway through their life are likely to be able to take advantage of current tailwinds to build value and exit at the top. However, funds raised in the next two years will have to deal with high entry valuations and a possible increase in the cost of borrowing. There have been fewer write-offs and deals with capital impairments in the post-2009 period than in the years after the 2001 recession. However, the current economic cycle has produced fewer of the home-run deals that really drive PE performance. For example, in 2002-2005, 35% of deals produced returns of 3x invested capital or better, and more than 50% generated multiples of 2x or better. For the period 2010-2013, the equivalent percentages were 20% and 42% respectively. Looking at Chart 12, we can see that PE, buyout, and growth capital funds outperformed global equities and small-cap equities during recessions and equity bear markets. Chart 11Private Vs. Public Equity Chart 12Recession & Bear Markets Return persistence is the ability of top-performing manager to repeat the strong performance in their follow-up funds. In the PE industry, some large firms have proved able to repeat top-ranked performance time after time across multiple funds. We believe this is likely a function of their network of contacts that gives them access to proprietary deal flows. However, there are three factors that may be creating a spurious correlation here: 1) GPs tend to raise new funds 2-5 years into the life of an existing fund, thus creating overlapping structures of successive funds that are exposed to similar market environments, 2) investments in some portfolio companies are split between successive funds which induces a spurious patterns of performance persistence, 3) much of the top-quartile performance persistence came during periods of low competition. There is also a relationship between holding period and performance, whereby funds that hold onto portfolio companies for longer have lower performance, while quick-flips perform better. Funds have an incentive to exit successful investments earlier to show a good track record, and to extend the holding period of unsuccessful ones hoping for a better outcome. There is an intrinsic cyclicality in this relationship: in bear markets when valuations are low, funds will hold off from selling their assets in the hope of a better time to sell. Table 5 show the average returns LPs can expect from investing in companies with a specific sector focus. But, this comes with a large amount of idiosyncratic firm- and sector-specific risk; this tends to have a larger impact on buyouts than on venture capital which is already very industry focused. Geographic diversification gives investors access to different economic cycles and levels of market maturity across the globe. In the last recession, PE performance was very poor in some regions, while not that bad in others. There has been a clear cyclical pattern for U.S. versus ex-U.S. performance over the past 30 years, closely linked to the relative growth rates in the underlying economies (Chart 13). Table 5Returns By Sector Exposure Chart 14 shows that from Q3 1998 to Q4 2000 relative performance between buyout and growth capital funds tended to move along with the interest-rate trajectory - the former benefits from falling rates which lower the cost of borrowing. Additionally, looking at median net IRR for funds by vintage year, we see that buyouts outperformed growth capital in 17 out of the 21 years (Chart 15). This was driven by stronger distributions to buyout fund LPs. Additionally; it was achieved with a fairly similar standard deviation of fund performance across vintage years. Within the buyout space, the median U.S.-focused buyout fund outperformed its ex-U.S. counterpart only in 2004-2012. Chart 13U.S. Vs. Rest Of The World Chart 14Impact Of Rising Rates Chart 15Buyouts Vs Growth Capital Finally, when allocating to private-equity and especially buyout funds, investors have a choice between different deal sizes (small to megacap). Looking at Table 6, it is clear that megacap buyout funds have been able to produce the best returns, but this came with significantly higher volatility, pushing down risk-adjusted returns. Additionally, these megacap deals have a larger negative skew and kurtosis - investors should expect a higher probability of large negative returns. Looking at performance in recessions, one can find a relationship between the nature of the downturn and the performance of different buyout deal sizes. For example, during the 2001 recession, the smallest deal sizes produced the worst performance because smaller-cap tech stocks suffered in the aftermath of the dotcom bust. During the 2007-2009 recession, the worst hit were larger buyout deals because of the damage done to the credit market. An analysis of PE would not be complete without a discussion of valuations. The average deal size has risen by 25% since 2009: two-thirds of this increase is due to rising multiples, and the remaining one-third is organic (Chart 16). Median EV/EBITDA has risen from 5.6x in 2009 to 10.7x in 2017. Leverage levels have been rising alongside multiples, and so lenders will be more hesitant to offer debt financing for deals. GPs will have to to make up the funding shortage with equity infusion, and this leads to a decrease in IRR. Additionally, covenant-lite loans have been increasing since 2012 and are now 75% of overall loan volume in the U.S. The percentage of listed companies globally valued at more than 11x EV/EBITDA rose from 20% in 2012 to 54% in 2016. Table 6Size Matters Chart 16Private Equity Is Expensive Lastly, return dispersion is much larger for private-market investments compared to public markets, because of the more active nature of the investment process. If an LP had consistently picked only top-quartile managers from 2000, they would have outperformed second-quartile managers by an impressive 7.7% (Chart 17) a year. Top-quartile managers generated these higher returns with only a trivial increase in volatility, thereby producing far superior risk-adjusted returns. Additionally, skewness and kurtosis measures show no significant deterioration (Table 7). Third-quartile managers struggled even to outperform global equities, and fourth-quartile managers failed even to preserve initial capital. Therefore, manager selection is critical to building a successful private-equity program. Over the past decade, there has been clear compression in fees charged by private equity firms (Chart 18). Management fees tend to differ significantly between the smallest and largest funds; but they are fairly consistent at about 1.975% for funds with AUM between $100 million and $1.9 billion. Chart 17Manager Selection Is Critical Table 7Large Dispersion Chart 18Fee Compression? Risks In Private Equity Chart 19Strong Distributions The long-term investment horizon, illiquid nature, and unique structure of PE bring logistical challenges and unique risks. Given the erratic nature of capital draw-downs by GPs, some LPs might be unable to service capital calls which leads to their defaulting on their obligations. In this case, investors are exposed to funding risk and could lose their entire investment in the fund and all the capital already paid in. LPs tend to use distributions from a mature fund to finance capital calls of younger funds. But this may not be feasible in a slowdown when exits dry up and distributions slow, forcing LPs to raise additional capital from external sources12 for commitments. Many investors run an over-commitment strategy to avoid being under-exposed to their strategic allocation. The strong equity bull market has increased overall portfolio values, meaning that LPs have received large distributions, which have been double contributions since 2013 (Chart 19). Therefore, the net asset value (NAV) of PE holdings has not grown, and allocations even contracted in 2017, forcing LPs to keep plowing gains back into their programs to maintain the target allocation. Investors also face significant liquidity risk. GPs could be forced to sell portfolio companies in the secondary market at a discount to NAV, given the illiquid nature of the market. The secondary market tends to be very cyclical and is likely to experience a deal drought, as seen during the last financial crisis. Market risk is the impact of volatile markets on the quarterly changes in NAV of the portfolio. Capital risk relates to the realization value of the private-equity investments. There is a risk of a private-equity investment going bust and losing all its value. Holding a portfolio of funds exposed to many different companies can reduce this risk and generate a statistical distribution skewed towards positive returns. Additionally, diversification over multiple vintage years should create a right-skewed distribution that minimizes long-term capital risk. A Note On Private Equity Secondaries Chart 20Secondaries: Faster Return But Smaller Upside The secondary market for LPs' private-equity investments is growing. Direct secondaries are the sale of an interest in a direct PE investment or portfolio of direct PE investments to a new third-party investor. A secondaries fund is a PE fund raised by a fund-of-funds manager to acquire limited partnership interests in private equity from the original LPs. Secondary investing is no longer looked at as a source of liquidity for distressed investors, but as a differentiated investment strategy and a regular portfolio management tool to rebalance fund exposures and lock in realized gains. The secondary penetration rate (the percentage of total NAV across all PE strategies that trades in the secondary market) is still less than 2%13 but, as the secondary market continues to expand, investors may see a broader spectrum of assets on sale. Many investors look at the secondary market solely for opportunistic investments, making commitments only during or immediately following periods of market distress. Intuitively this makes sense, as secondary buyers should be able to negotiate steeper discounts during periods of elevated uncertainty and tight liquidity. However, there are many reasons to have a dedicated allocation: It Mitigates The J-Curve: Mature secondary investments cut off several years from the typical term of a PE fund because a good portion of the investment period is already completed. This generates immediate returns from the mature private-equity program. Many fund-of-funds managers will combine secondary interests with their primary portfolios to mitigate the J-curve. Less Blind Pool Risk: In private equity, LPs commit capital to a portfolio that is yet to be built. Secondary investing significantly reduces this risk because portfolios acquired are generally more than 50% invested and have less unfunded commitments. This provides investors with an actual portfolio of companies to evaluate. It Diversifies A Private-Equity Program: An allocation to secondaries can provide instant exposure to a highly diversified portfolio of mature private-equity interests. Lower Probability Of Poor Performance: The potential upside for secondary funds is not as high as that of primary funds, but the former produce poor returns much less frequently (Chart 20). Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Source: Bain Global Private Equity Report 2018. 2 Buyouts refers to deals in which a PE fund borrows a significant amount to acquire a target company or companies, which tend to be larger-cap private or publicly listed corporations. 3 Investments in mature companies with proven business models that are looking for capital to expand or restructure operations, enter new markets, or finance a major acquisition. 4 Apollo Investment Fund IX with an AUM of $24.7 billion raised in 2016-2017 is the largest buyout fund raised in history. 5 The amount of capital that has been committed to a private equity fund, but not yet deployed. 6 Source: Pitchbook. 7 The largest global buyout was the $17.9 billion carve-out of Toshiba Memory Corp in 2018. 8 Whereby a company owned by a private-equity fund issues debt in order to pay a dividend to the fund. 9https://www.cambridgeassociates.com/private-investment-benchmarks/ 10 To de-smooth returns, we used a first-order autoregressive model as shown by Rt = A0 + At Rt-1 + e, where At is the auto-regressive coefficient, and A0 is the intercept term. However, statistical methods do not always satisfactorily solve the problem of underestimated volatility for appraised asset values. 11 PME replicates the timing and size of private equity cash flows (purchases and sales) as if they had been invested in public equities. It is the dollar-weighted return that could have been achieved if funds had been invested in the index whenever a capital contribution was made and divested when the GP paid out a distribution. 12 In the Global Financial Crisis, Harvard Management Co issued a bond of more than $1 billion and considered selling a private equity stake of $1.5 billion at a 40%-50% discount to fund its capital calls. 13 Source: Preqin Ltd. Appendix: A Note On Data Sources And Definitions The performance indices all use quarterly unaudited, and annual audited fund financial statements produced by the GPs for their LPs. Partnership financial statements and narratives are the primary source of information concerning cash flows and ending residual/net asset values for both partnerships and portfolio company investments. The data providers' goal is to have a complete record of the quarterly cash flows and NAVs for all funds in the benchmark. All performance is calculated net of fees, expenses, and carried interest. Cambridge Associates (CA) uses two types of return calculation in its indices: Since Inception IRR: This calculates a discount rate which makes the NPV of an investment equal to zero. It is based on cash-on-cash returns over equal periods modified for the residual value of the partnership's equity or portfolio company's NAV. The residual value attributed to each respective group being measured is incorporated as its ending value. Transactions are accounted for on a quarterly basis, and annualized values are used for reporting purposes. End-To-End/Horizon IRR: A money-weighted return similar to the Since Inception IRR, except that it measures performance between two points in time. The calculation incorporates the beginning NAV, interim cash flows, and the ending NAV. All interim cash flows are recorded on the mid-period date of the quarter. With regards to avoiding survivorship bias, CA requires the complete set of financial statements from the fund's inception to the most current reporting date. When an active fund stops providing financial statements, CA reaches out to the manager to encourage them to continue to submit data. CA may, during this communication period, roll forward the fund's last reported quarter's NAV for several quarters. When CA is convinced that the manager will not resume reporting, the fund's entire performance history is removed from the database. Survivorship bias can affect all investment manager databases, including those of public asset managers. But the illiquid nature of private investments can actually help limit this impact, since the private investment partnerships owning illiquid assets will continue to exist and be legally required to report to the LPs even after the original manager ceases to exit. Over the past nine years the number of fund managers that stopped reporting to the database before liquidation averaged per year 0.7% of the total number of funds, and 0.6% of total NAV in the database. During that period the overall number of funds in the database increased by an average of 8% per year. Public Market Equivalent (PME): A private-to-public comparison that seeks to replicate private-investment performance under public-market conditions. The public index is recalculated as if shares were purchased and sold according to the private fund's cash flow schedule, with distributions calculated in the same proportion as the private fund. The PME NAV is a function of PME cash flows and public index returns. The PME attempts to evaluate the return that would have been earned had the dollars been deployed in the public markets instead of in private investments.