Christopher Ecclestone, Principal
Hallgarten & Company
In the real estate world, the mantra is “position, position, position”. The same may be said for hedge funds based in Latin America. Proximity to the real action gives local managers an advantage over funds managed at a distance. We would not have said this in the mid-1990s when Latin America was an intense focus of investor interest in major financial centres and there was a proliferation of emerging markets mutual funds. It was perceived that the best perspective was achieved from a distance (on high?) looking towards the region from the northern hemisphere where one could observe matters without all the baggage that local investors and naysayers brought to the process.
History ultimately came along to mug this school of thought, firstly in the mid-1990s Tequila Crisis and then later on with the traumas of the globalised emerging market crisis of 1998 (ironically triggered elsewhere in Thailand and Russia) and then with the Argentina crisis of late-2001. The people on the ground had been right and those “at a distance” had been caught wrong-footed. It was out of these debacles that the local hedge fund industry arose, paralleling the rest of the world in what came to be known as the “Decade of the Hedge Fund”.
One can get too glib though on this subject for in reality, the Latin “Decade of the Hedge Fund” was really more like half a decade (2003-2008) and it was overwhelming Brazil with little more than a token, sprouting of hedge fund structures in other countries in the region. Nevertheless, it can still be said that non-local LatAm hedge funds were almost as scarce. This is surprising for if there is one industry that likes jumping on a bandwagon, it is the hedge fund industry. Largely, the outside players stayed away from region-specific funds, and the dabbling in the larger markets of the continent was by the very largest momentum funds from Greenwich, who shovelled money in and out of Brazil and Mexico, powered by the yen-carry trade. As we all know, practice came to grief in late-2008. Being closer to the action may have saved the locally-based funds from annihilation as they were smaller and could trade more nimbly, but still, when the elevator cable is cut, all those in the elevator go down.
So the storm has now largely passed and the questions arise as to whether the locally-based funds will recover, whether they will retain their advantages over non-locally managed funds and how they might do this.
For us, the main advantages that locally-based funds have are:
Closer to the political and economic action/intelligence.
Able to play in smaller or less visible names.
Able to tailor their structures to the tax “needs” of their local clientele.
Better able to avoid the tax dragnet that is now being swept by the US and Europe through offshore havens.
Better poised to tap the rising tide of local savings in the region.
Curiously, they have been relatively scandal-free, thus far, in an industry which has had more than its share of traumas in recent years.
We shall address some of these advantages. Firstly, it is undeniable that the local managers are closer to the action and have better intelligence sources. It has now been 18 years since Wall Street “discovered” LatAm and if anything, the learning curve appears to be more of a parabola than anything else. In 1991, it was exotic and unknown with bets being placed upon hunches (and some filtered local gossip). By the mid-1990s, there was an intense study of the region as everyone piled into the analytical game. By 1998, this wave had passed and the interest since then has been cherry-picking of stories that provide some excitement. This led to a situation where the distant observer could not see the wood for the trees. The debacle of 2008 showed that the momentum players from afar did not know what they were doing, particularly in Mexico and Brazil. This was a “faith-based” investment style. The local funds may have played the same stock stories but generally knew the dangers, gossip and flaws of a particular corporate name and steeled themselves to dive overboard. This was a game of chicken, in which they hoped that their nimbleness would help them escape before the bigger momentum funds even knew there was a problem. The locals also rarely read the baby food served up by the foreign correspondents in the region as news.
They had all the local sources at their disposal and, for better or worse, knew the real story of the political world and were cognizant of the latest corruption scandal or its perpetrators.
This closeness to the action also meant that they were privy to the up-and-coming stories, whereas those dependent upon street research were usually only getting into nascent go-go stories after they had “got up and gone”. The boom in Brazilian REITs in 2007 was a particularly poignant example as was the very poor quality MercadoLibre that was dished up as an Argentine ADR and later plunged in value when its true value was divined by the marketplace. Likewise, the Grupo Clarin listing in London promptly went over a cliff when it was realised that it was on the wrong side of the government of the day in Argentina. If anything, ADR trading by local hedge funds was a means of trading against the foreign tendency, a variation on “taking candy from babies”. The foreign investors were obsessed by their liquidity and jurisdiction mantras and clung to their ADR ciphers even when they were one of the worst ways of accessing the real economy in the markets they professed to be interested in.
If we need a reason for the spectacular success of the hedge fund model in the LatAm markets where they have sprung up, we need to look no further than their “tax efficiency” for local HNWs. Hiding funds from the government has made LatAm economies what they are today. Light-fingered governments have been countered by the tight-fisted wealthy. Hedge funds have become the latest tool in this battle. It is possibly that Mexico and Argentina have the most history at hiding the wealth of the HNWs that hedge funds have not taken off there in their onshore version. In Brazil though, a combination of some savvy regulation and a certain realism in dealing with the problem of evasion meant that it was better for the Brazilian economy to have local money stashed in local hedge funds than having it whisked away to Switzerland to be recycled into Madoff-style investment scams.
Likewise, the latest crackdown on offshore havens by Western governments makes life somewhat tougher for LatAm HNWs who live in fear of having their assets exposed to public view even if they are not avoiding the taxes of the jurisdictions that are conducting these witch-hunts. Onshore solutions (read home-grown hedge fund industries) for the tens of billions of flight capital would mobilise capital for domestic advancement (and infrastructure) much the same as has occurred in Asia.
The hedge fund industry around the world has only had a few windows of connection between the savings pools of the masses and that of the hedge funds. Primarily, this has been the participation of public employee retirement schemes in allocating a rising percentage of AUM to “alternative investment” categories. LatAm is way behind on this score. In Mexico, the public equities market has been held back by the failure to even approve equity investments for pension funds, let alone anything so exotic as a hedge fund. However, if locally-based hedge funds were empowered to collect investments from individuals who were not HNWs or from pension funds, then there could be an exponential democratisation of the hedge fund industry in the region.
Finally, legislation to create and supervise hedge funds in the region has been relatively light-touch thus far. Brazil again has the best legislation and should serve as a model for the rest of the region. As usual though ridiculous, nationalist pride considerations have held back others from following this lead. As a result, the others have been retarded in their growth in this category and have missed out on developing the skill sets that come from having a nascent industry and from the retained (dare we say “trapped”) investment funds that can be mobilised from the general evolution of local capital markets.
Thus, in conclusion, we would posit that locally-based hedge funds have a “smarts” advantage over the foreign-based funds. Certainly, they do not have the ability to mobilise the type of money that Greenwich can, but then again, the region does not need brainless money flooding in and out in tsunami tides as we saw in Brazil and Mexico in 2007 and the first part of 2008. Like any tsunami, they do more damage than good. Governments can harvest the industry for good or dissipate themselves in struggling against the sheer Darwinian destiny of hedge funds. It is probably better to join them than fight them.