Chinese Investments in U.S. Real Estate – Challenges, Opportunities and Policy Recommendations

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As the world’s second largest economy, China’s influence on the global economy is expanding at a furious pace, thanks in part to the surge in outward foreign investment. In the United States, China is now a major source of foreign investment with capital flowing into virtually every industry and market. For many Chinese firms and individuals, the United States is a prime destination for their investments because the prospects for stable returns are high.

Policy makers, business leaders, and the general public in the United States still do not have a comprehensive understanding of the patterns and implications of Chinese investment in the United States. While foreign investment has been a critical piece of this country’s economic success, the recent boom of Chinese capital flowing into the United States has stoked fears of job loss and disruptions to local and regional economies and markets, and even threats to national security.

Chinese investment into U.S. real estate, in both the commercial and residential sectors, stirs up these misgivings and sparks debate about the domestic costs of these investments. Concerns range from anxieties over the potential inflationary effects of deep-pocketed firms and investors in the residential real estate market to more pronounced anxieties over property acquisitions that can endanger national security. The reality, as this landmark study makes clear, is much more complex.

Chinese investment around the world surged in the past decade, expanding from an early focus on natural resource extraction and energy in developing countries to broader industries and advanced products and services in developed markets. In 2014, Chinese outward FDI flows totaled $116 billion, and approximately $18.1 billion flowed into the United States. In 2015, Chinese outward FDI flows totaled $118 billion, and Chinese foreign direct investment flows into the United States increased to $22.3 billion. Still, China accounts for less than 10% of all foreign direct investment in the United States.

Chinese direct investment in U.S. real estate was negligible until 2010 but has since grown dramatically and visibly. In 2015, China ranked third in U.S. commercial real estate acquisition volume, trailing only Canada and Singapore and tied with Norway. Chinese developers are building multi-billion-dollar projects in several major cities. A Chinese insurance firm bought the prized Waldorf Astoria hotel in New York City in 2015 and struck a $6.5 billion deal for Strategic Hotels & Resorts in early 2016. Chinese investors dominate an immigrant investor program known as EB-5, and in 2015, China overtook Canada as the biggest foreign buyer of U.S. homes.

This anecdotal portrait reveals the rapid and widespread entry of Chinese investors, both firms and individuals, into the U.S. real estate market, but it also underscores how real estate differs from other investment sectors. It defies the traditional definition of foreign direct investment – ownership of at least a 10% stake in a U.S. company – with a broad range of entry points. Buying a home, for example, does not have an analogue in the technology industry but is critical in painting a full picture of Chinese capital flows into the U.S. real estate market. Furthermore, in addition to the unique channels of real estate development and EB-5 capital, Chinese investors are also increasing investment in portfolios of U.S. assets through real estate investment trusts and private equity funds.

These real estate investments come on top of China’s position as the biggest holder of mortgage-backed securities issued by U.S. government-sponsored enterprises such as Fannie Mae and Freddie Mac. Like U.S. Treasuries, these bonds are important investments for Chinese government finances, because they allow for recirculation of dollars gained by the trade imbalance, and for the U.S. housing market, because they help ensure liquidity and mortgage rate stability. Chinese banks have also become major sources of debt capital in the U.S. real estate market, primarily for U.S. firms. To fully understand the role of Chinese capital in the U.S. real estate market, it is vital to look beyond direct investment. More than any foreign investor other than Canada, China stands out for the breadth, depth, and speed of its participation in the U.S. real estate market.

Our findings are that from a modest base in 2010, China was the source in aggregate of at least $350 billion in U.S. real estate holdings and investments by the end of 2015. This figure includes the direct purchase of real property and indirect investment through the purchase of agency mortgage backed securities and provision of debt financing, among other channels. In addition, we estimate that Chinese entities managing U.S. real estate operations and individual investment through vehicles including the EB-5 program may have created or sustained 200,000 jobs. For commercial and residential real estate, China has been an important source of capital as the U.S. economy recovered from the recent financial crisis and Great Recession.

Chinese investment in U.S. real estate is a recent development with considerable growth potential. While it is not as politically sensitive and does not directly impact national security as does Chinese investment in U.S. technology or telecommunications, real estate affects more people and communities and involves policy makers at multiple levels.

This report aims to objectively present the following:

  • Sources of Chinese capital flowing into U.S. real estate;
  • Motivations and drivers for various Chinese investors;
  • Benefits and impediments posed by this wave of investment;
  • Analysis and projections of the sustainability of Chinese investment in commercial and residential property;
  • Recommendations for U.S. and Chinese investors, policy makers, and stakeholders to keep investment channels open.

Combining information from public records, reports, and trade groups – based in part on gathering of data and interviews with industry sources – this report assembles a unique information set, providing the first comprehensive analysis and understanding of Chinese inbound investment into all facets of U.S. real estate.

This reported investment data are not perfect, a result of the combination of the particulars of real estate investment avenues and the ability of government and third-party sources to accurately measure capital flows. Furthermore, a significant portion of investment from offshore locations, including China, comes in the form of minority interests in projects sponsored by U.S. entities and is not directly traceable to the capital country of origin.

Our study is focused on investment from mainland China, but the flow of capital through intermediary destinations sometimes necessitates the inclusion of capital from Hong Kong, Macau, or Taiwan. Moreover, the task is complicated by the multiple channels for investment, ranging from purchases of homes and apartments to business investment in commercial assets to development and construction, as well as through provision of debt to both residential and commercial property investors. The myriad ways in which to record real estate ownership can also obscure the true country of origin of the buyer. With this in mind, this report presents the data as minimum investment volumes. While acknowledging these data limitations, we have made every effort to compile data and insight that provide a more complete reflection of actual Chinese investment activity across the entire spectrum of the U.S. real estate market than previously published. This includes enhancing investment volumes reported publicly as well as confirming the reported data via industry participants.

The investment flow has come into the United States through several channels:

  • Residential property: Between 2010 and 2015, Chinese buyers spent at least $93 billion on homes, including condominiums, for occupancy and investment. Spending rose at an annual rate of 20% and provided important demand in many local markets hit hard by the housing crisis. Chinese buyers paid substantially more, on average, per home than other international buyers because of their concentration in prime neighborhoods in California and New York.
  • Commercial property: Between 2010 and 2015, Chinese investors acquired at least $17.1 billion of existing office towers, hotels, and other commercial buildings, representing an annual growth rate of 70%. Half of that investment came in 2015 alone. The buyers were mainly large Chinese companies, including real estate firms and institutional investors.
  • Development: By the end of 2015, Chinese-funded projects under construction or planned totaled at least $15 billion. These range from multi-billion-dollar mixed-use projects in Los Angeles and the San Francisco Bay Area to smaller-scale developments in secondary markets. These investors include Chinese developers, builders, and construction companies, some of which have set up U.S. offices, creating local jobs for ongoing operations beyond the construction phase.
  • EB-5 visa program: Since 2010, Chinese nationals have been the most numerous investors in the EB-5 U.S. visa program. The program enables a foreign national who invests at least $500,000 in projects that create a minimum of 10 jobs to receive a U.S. visa and, on completion of the project, a green card for permanent residency status. Detailed data on these investments and the actual number of jobs created are not generally available. But based on the minimum investment and job creation requirements, and assuming all investments are successful, Rosen Consulting Group estimates that since 2010, nearly 20,000 Chinese EB-5 investors have generated at least $9.5 billion of investment capital and contributed to the creation of 200,000 jobs.
  • Residential mortgage-backed securities (RMBS): Chinese government entities began purchasing U.S. government agency-backed RMBS in the early 2000s to diversify beyond U.S. Treasuries. As of June 30, 2015, China held $207.9 billion in agency-backed mortgage bonds, more than any other country, according to preliminary U.S. Department of the Treasury data. These holdings contribute to enhanced liquidity in the U.S. housing finance market.
  • Real estate loans: In recent years, Chinese banks increased activity in lending for real estate acquisitions, recapitalizations, and construction and development. The banks have amassed at least $8 billion in loans and have become a major source of funding for large commercial real estate projects. This loan portfolio extends beyond Chinese investors and projects with Chinese partners, as leading Chinese banks are active competitors with U.S. and international banks and private sources of capital in the commercial property market. Residential mortgage lending by Chinese banks in the United States is more limited, but growing.

OUTLOOK

We believe China’s economic turbulence will create a short-term speed bump for real estate investment overseas, including in the United States. In the near term, a 6- to 24-month temporary period of increased capital controls is likely – either formally via policy announcements or informally through administrative processing – until the Chinese currency can be re-aligned with that of global partners. However, this does not mean investment will cease during this period. Furthermore, the long-term investment drivers remain: strong U.S. demand for capital; a widening and deepening pool of Chinese investors, many of whom have not ventured into U.S. real estate; increasing global appetite by Chinese developers and construction companies; a $1.6-trillion insurance industry that has become active overseas but invested just a fraction of funds available for real estate projects; and new Chinese investment vehicles, such as private equity funds, which have only recently become a factor in the U.S. market.

We project that Chinese direct investment across existing U.S. commercial real estate assets and residential purchases, excluding new development projects, could total at least $218 billion, cumulatively, from 2016 through 2020. In the short term, capital controls will likely slow individual purchases of U.S. homes, the biggest component of Chinese real estate investment, and slow the growth rate of commercial property acquisitions. Chinese-backed development projects are likely to remain a substantial component of the commercial real estate market even as the economic cycle in the United States slows the overall pace of new development announcements. Beyond 2020, Chinese investment in U.S. real estate could accelerate further.

RECOMMENDATIONS

These large capital flows, accelerating substantially in a short period of time, do not come without challenges in both countries.

In the United States, several policy areas will need attention in the next several years:

  1. Rationalization of taxes affecting foreign investment: The Foreign Investment in Real Property Tax Act (FIRPTA), while perhaps well intentioned at inception, is an onerous structure that creates an impediment to international investors in real estate. Every effort should be made so that there is a level field for taxes on foreign investors regardless of their domicile.
  2. Continuation of the EB-5 program: While the program was extended through the summer of 2016, renewal is by no means a certainty. It has been a successful bridge builder, bringing capital into the marketplace, growing or retaining jobs in the United States, and allowing Chinese citizens and families access to visas and residency. The EB-5 program will likely undergo reform, but it should not be altered so dramatically as to cut off access to international capital and immigration, including those from China.
  3. Continued implementation of existing security policy: Offshore investors are understandably screened for security risks and legitimacy of capital sources. So far, such concerns have not been an impediment to investment in U.S. property, as it has been in technology platforms, manufacturing firms, or natural resources extraction and processing. Any proposal to restrict U.S. government occupancy, including those of certain government contractors, in foreign-owned buildings – as is being discussed in congressional circles – should be carefully monitored.

On the Chinese side, the issues that deserve attention include the following:

  1. Continued development of legal and financial rules to encourage private sector investment in overseas property: Chinese companies and individuals can benefit themselves and the Chinese economy by diversifying assets globally. It is critical that China develop a robust domestic legal framework for foreign investment, as many countries expect reciprocal treatment of foreign investors. Likewise, reforms that reduce bureaucratic bottlenecks and expedite outward investment should continue.
  2. Enhanced transparency in capital ownership: The United States and other global financial centers are increasingly monitoring the identities of foreign investors and business operations. While China is not the only country that raises concerns, Chinese businesses historically have been less open regarding origination of capital and ties to government or military officials. Continuing progress toward the transparency required by international agencies – many of which are welcoming China as a significant participant – will be an important step.
  3. Avoidance of capital controls: China’s economic growth rate has slowed, and its currency is re-aligning with that of other major economies. Chinese concern over capital outflows is understandable, but a hard capital-control regime could negatively impact the financial institutions the government nurtured over the past two decades.

China is a powerhouse the US cannot discount. Prosperity and free flow of capital between the 2 nations is the only way to go.

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Turning around the US Economy:- My Top Recommendations for President elect Trump

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The people have finally spoken. Donald J. Trump has won and will be our next President for the next four years … and if things are done right, maybe the next eight too.

It is not going to be easy given the mess he inherited from President Obama which basically sums up as below.

  1. Total US debt, including private and business debt, is today $67 trillion, or just under 400% of GDP.
  2. We have 95 million people not in the labor force; 15 million of them not employed. That’s twice the number officially unemployed.
  3. We have almost 2 million prison inmates, 43 million people living in poverty, 43 million receiving food stamps, 57 million Medicare enrollees, 73 million Medicaid recipients and 31 million still without health insurance.
  4. The US federal government debt will be slightly north of $20 trillion before Obama leaves office in January. Local and state debt is another $3 trillion. That is a total of more than $23 trillion of government debt and a debt-to-GDP ratio of somewhat over 121%. That debt has risen roughly $10 trillion under Obama, in just eight years. This US debt total does not even take into account the over $100 trillion of unfunded liabilities at local, state, and federal levels that are going to have to be paid for at some point.

Bottom Line:  We are still witnessing a disaster in the making. The more we increase our debt, the more difficult it is going to be to grow our way out of our problem with the debt.

Something like $5.5 trillion is “intergovernmental debt.” And even if we did dismiss this internal debt, the government’s debt-to-GDP ratio would still be almost 100% when you include state and local debt….And after eight years of the slowest economic recovery in history, we are growing our debt dramatically faster than we are growing our country—even when we include inflation. Go figure.

My recommendations for President elect Trump

Cutting corporate and individual taxes, effecting significant regulatory rollback and fixing the Affordable Care Act may help stimulate growth but will not be a sufficient condition to stimulate growth. Significant regulatory rollback will help. It is also necessary but not sufficient.

Some more serious actions should include but not limited to:

  1. Reinstituting first and foremost the Glass-Steagall Act because Wall Street cannot be trusted to manage their risk properly. This would separate true banking activities from the high risk gambling that brought the economic system to its knees. Privatizing the profits and socializing the losses is unacceptable.
  2. Appointing the right next four people out of the seven governors to the Board of Governors of the Federal Reserve. People coming from the business world; neither economists nor academics please. Also having a Federal Reserve that is more neutral in its policy making and that realizes that the role of the Fed should be to provide liquidity in times of major crisis not to fine tune the economy, will do much to balance out the future.
  3. Putting the value of the dollar relative to the currencies of other countries under the purview of the Treasury Department, not the Fed. Too much power to the Fed already.
  4. Having the currency of the US backed by hard assets. A basket of gold, silver, platinum, uranium, and some other limited hard commodities would back the USD. If politicians attempted to spend too much, the price of this basket would reflect their inflationary schemes immediately.
  5. Directing to have the FASB to make all banks and financial corporations value their assets at their true market value. An orderly bankruptcy of all insolvent financial firms involving the sell-off of their legitimate assets to well-run risk adverse banks that didn’t screw up should ensue. Bondholders and stockholders would realize their losses for awful investment decisions. The economic system would be purged of its bad debt.
  6. Having the Social Security System completely overhauled. Anyone 50 or older would get exactly what they were promised. The age for collecting Social Security would be gradually raised to 72 over the next 15 years. Those between 25 and 50 would be given the option to opt out of Social Security. They would be given their contributions to invest as they see fit if they opt out. Anyone entering the workforce today would not pay in or receive any benefits. The wage limit for Social Security would be eliminated and the tax rate would be reduced from 6.2% to 3%.
  7. Dismantling Obamacare in its entirety and converting it from a government program to a private market based program. The Federal mandates, rules and regulations would be eliminated. Senior citizens would be given healthcare vouchers which they would be free to use with any insurance company or doctor based on price and quality. Insurance companies would compete for business on a national basis. Doctors would compete for business. The GAO would have their budget doubled and they would audit Medicare fraud & Medicaid fraud and prosecute the criminals without impunity.
  8. Repealing the healthcare bill. Insurance companies would be allowed to compete with each other on a national basis. Tort reform would be implemented so that doctors could do their jobs without fear of being destroyed by slimy personal injury lawyers. Doctors would need to post their costs for various procedures. Here again, price and quality would drive the healthcare market.
  9. Dismantling completely the entitlement state.  The criteria for collecting welfare, SSDI, food stamps and unemployment benefits would be made much stricter. Unemployed people collecting government payments would be required to clean up parks, volunteer at community charity organizations, pick up trash along highways, fix and paint houses in their neighborhoods and generally keep busy in a productive manner for society.
  10. We must make a serious effort to have a balanced budget and to fund healthcare and Social Security. I would propose some form of a value-added tax (VAT) that would specifically pay for Social Security and healthcare. I would also propose that we eliminate Social Security funding from both the individual and business side of the equation and take those costs from the VAT.
  11. We also need to get rid of the shackles on growth and get the incentive structure right with the proper tax mix. Then American entrepreneurs can probably get us out of the hole we’re in without it getting too much deeper. With the amazing new technologies that are coming along, we can probably get to a point where we can in fact grow our way out of our debt problem over the next 10 to 15 years.
  12. It is one thing to talk about unfair trade agreements—and we have certainly signed a few. But we also need to recognize that some 11.5 million jobs in the US are dependent upon exports (about 40% of which are services). If we drop our corporate tax to 15% and work on reducing the regulatory burden, I think we will be pleasantly surprised by how many jobs are created just by those steps alone.

As a conclusion, let me be very clear. If we don’t get the debt and deficit under control—and by that I mean that at a minimum we bring the annual increase in the national debt to below the level of nominal GDP growth—we will simply postpone an inevitable crisis. We have $100 trillion of unfunded liabilities that are going to come due in the next few decades. We have to get the entitlement problem figured out and we must do it without blowing out the debt. If we don’t, I am afraid we will have a financial crisis that will rival the Great Depression and maybe worse.

We’re in a world where most major economies are also in trouble. If the US starts printing again money merely to service its debt because people don’t buy its debt, then I foresee total global debt in the $500 trillion range and global GDP topping $100 trillion. A total global economic disaster.

I have tremendous faith in President elect Trump and his team and just hope all those prescriptions will not go unheeded although they certainly go far, long-term, in fixing a system which is quite dysfunctional and broken.

“Draining the swamp” of our present economic morass will certainly require drastic action tantamount to a real revolution in both thought and practice.

The Old Order has gotten us into this mess, and cannot, or is unwilling, to get us out. It is past time for them to go.

Nothing much in a positive, productive sense can be accomplished under our government, as presently constituted, as it has devolved into a Fascistic, crony-corporatist construct.

Until those who govern are forced to experience outcomes consistent with those experienced by the governed, I am afraid the Republic will drift ever further away from the establishment principles envisioned by those rebellious Founding Fathers, who were intoxicated upon the fumes of liberty, fraternity, and equality of opportunity.

God bless our new President elect Trump and the United States of America…. Time to roll up our sleeves and start making America great again.

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To all those wide-eyed millennials looking for a break

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It breaks my heart to see millions of millennials still chasing rainbows and hoping that the US government or a cartoon character such as Berne Sanders or crooked Hillary Clinton were ever going to change their lives.

Maybe it is time to grow up folks and grow some too and realize that no one is going to take care of you other than yourself if you want to build anything meaningful in your life….whether nailing a big corporate job or creating your own empire. NO ONE. So get used to it, life is not fair and this will never change.

Ever since the paleolithic era we’ve been fighting over scarce resources. Whether this was food, shelter or trendy sabretooth skirts.

Times have changed – but the essence remains the same; it’s resources we’re after.

Money mainly.

In the old days, we used to have a trading system where hunters would trade their catch with fishers for example. This is an equal exchange of value of differently skilled people.

The same concept still applies today. Money simply has made trading your entire life easier.

This system allows us to tap into the expertise of others. The more difficult the task, the more money they get.

Being able to do what others cannot is what makes you “valuable”.

Anyone can sell shoes, anyone can run behind a dumpster truck, anyone can sell fast-food. But not everyone knows how to build a house, lay electrical wiring or perform an open-heart-surgery. The more difficult and in-demand your skills are – the higher your value will rise.

If you want more income – You have to deserve it first.

How?

By building up difficult skills that are high in demand based on your strengths….Nothing else will do it

This means that the barrier of entry for competitors will be high (less competition) and you work in a field where your skills are highly valued.

Additionally, building on strength gives you an “edge” on others….Sounds sweet right?

So what are strengths? Have you ever asked yourselves this question?

Strengths are the things we naturally excel at – the things that come “naturally” to us.

How Do I Find My Strengths?

You find strength through self-analysis

The best way I’ve found to do this is by keeping a journal of my life in which I’m able to spot different trends. Over time you’ll be able to hone down on what you’re really good at.

Here are three ways to discover your strengths:

1. Self-Assessment

Here are some questions you should ask yourself when looking for your personal strengths:

  • In what did I grow up around? Competence can arise from early practice, what types of activities were you involved in as a child?
  • What do strangers compliment me on? You/your direct surroundings often notice your natural strengths faster than you do. Just ask around.
  • What did I want to become as a child? What were the underlying trends?
  • What have I been doing the last 10 years? Competence comes from doing a certain thing for a long period of time.
  • What can I effortlessly talk about without losing drive? An interesting topic is most likely something you’re highly skilled at or highly interested in.
  • What are the things I effortlessly excel at? What activities come easy for you?
  • In what areas do I learn quickly? Some skills are perfectly suited to our temperament and therefore we’re able to pick these up much faster than others.
  • Who do I envy/admire? Jealousy is a nasty but beautiful emotion as it shows us what we truly want. The same goes for admiration.

2. Reading

Furthermore, a great book that will help you find more strengths is Managing Oneself by Peter F. Drucker

Read the summary and define for yourself:

  • Am I a reader or a listener?
  • How do I learn best?
  • Do I work well with others or do I perform better alone?
  • Do I produce results as decision maker or as an adviser?
  • Do I perform well under stress or do I need a structured environment?

Alright – what’s next?

3. Personality Tests

A great way to explore further is by doing some personality tests (although they are often too general – it’s quite likely that they’ll give you some more career-indicators)

Here are the ones I recommend:

  • MBTI-test
  • DISC-assessment
  • Enneagram

Learn more about each type by simply Googling the results you’ve gotten.

Put all of these answers in a separate word-sheet and try to determine for yourself the answer to this question;

How can I combine my skills (based on strength) and my interests to solve a need for other people?

Going Deeper

In our current information society it might be not enough to be simply highly skilled in only one particular field. The combination of different, highly valued skills is also often what elevates your value.

Here’s some other tips to prepare for the future:

Enjoy the power and beauty of your youth. Oh, never mind. You will not understand the power and beauty of your youth until they’ve faded. But trust me, in 20 years, you’ll look back at photos of yourself and recall in a way you can’t grasp now how much possibility lay before you and how fabulous you really looked.

Don’t worry about the future. Or worry, but know that worrying is as effective as trying to solve an algebra equation by chewing bubble gum. The real troubles in your life are apt to be things that never crossed your worried mind, the kind that blindside you at 4 p.m. on some idle Tuesday.

Be Impeccable With Your Word. Speak with integrity. Say only what you mean. Avoid using the word to speak against yourself or to gossip about others. Use the power of your word in the direction of truth and love.

Don’t Take Anything Personally. Nothing others do is because of you. What others say and do is a projection of their own reality, their own dream. When you are immune to the opinions and actions of others, you won’t be the victim of needless suffering.

Don’t Make Assumptions. Find the courage to ask questions and to express what you really want. Communicate with others as clearly as you can to avoid misunderstandings, sadness and drama. With just this one agreement, you can completely transform your life.

Always Do Your Best. Your best is going to change from moment to moment; it will be different when you are healthy as opposed to sick. Under any circumstance, simply do your best, and you will avoid self-judgment, self-abuse and regret.

Keep track of global trends. Where is the world going and how can I prepare for this? Especially the technological boom is very prominent – stay ahead of the robots!

Work for yourself. Everyone will need to become an entrepreneur in the future

The world is your oyster …. Just because the past didn’t turn out like you wanted it to, doesn’t mean the future can’t be better than you ever imagined.

Essence

The world is an inherently competitive place. You’ll need an edge to become indispensable & the only way to become indispensable is to excel at things others cannot do.

Of course competence at a skill will lead to enjoying the activity more – enjoying it more means you’ll be doing it more which in turn makes you more competent.

It’s an endless loop.

Eventually you’ll start to LOVE it and it’ll become your “passion”. So don’t go searching for something until it “feels just right” but create it by building on strengths. Don’t waste time and energy on an endless passion-chase.

Note: Strengths are solely performance indicators (not unchangeable truths). So don’t obsess about them. You can still “be whoever you want to be”, but you won’t perform optimally if you build your life on weakness. It can be stretched – just not indefinitely.

So tell me; what are your strengths?

I hope this personal analysis is timely for you. There’s so much wasted time & energy (and frustration) in fields where we just don’t have a natural advantage in. And the world is simply too much of a competitive place not to use this.

Now that you know the basics, go for the kill and never look back.

The BEST revenge is “OBSCENE WEALTH”.

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BREAKSIT

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That’s what I call the Brexit vote – “Breaksit.” It breaks stereotypes, it cuts across demographics, it astounds the pundits, and it breaks the unity of a pseudo-government called the European Union. It breaks preconceptions. Brexit was a rebellion by the people of England against an overbearing, uncontrollable, unaccountable socialist bureaucracy without adequate checks and balances. England will be free of this octopus with its insidious tentacles that destroy national sovereignty and upend traditional social order. I was convinced, before the vote, that England would vote to Brexit. So few of the political pundits agreed with me, but I was sure it would happen. I was also sure that the stock markets would (temporarily) tank.

For the investor, this is an extremely good buying opportunity. For the 401K and IRA owner, it is a time of confusion and stress. “How could I lose so much money in one day?” you ask. Just hold on. The market will be back. If your investments were sound, they still are sound. The companies in which you invested will survive, and will continue to prosper. If your investments were risky, they remain risky, and the companies may fail – or may succeed beyond your wildest expectations. That’s the nature of risk. I’m going to ride the roller coaster, and look for opportunities at the bottom.

England will do well. There will be a “period of adjustment” because it was linked so intimately to the European economic system, but Europe will still need English products, and England will still need European products, and so a new trade agreement will be reached. Similarly for the US: Our economy is intimately meshed with the English economy and also with the European economy. Our trade agreements with Europe will remain, and we will quickly reach new trade agreements with England. Trade and economics will return to normal.

Scotland may or may not decide to separate from the United Kingdom and re-join the European Union. Even if they do, H.M. Elizabeth II will still be Queen of Scotland. If Scotland splits, Scotland will no longer be united with England in a common government (almost federal), but Scotland will still have H.M. Elizabeth II, as Head of State for Scotland, just as Canada still has H.M. Elizabeth II as Head of State. Northern Ireland will be in a similar quandary: whether or not to leave the United Kingdom and unite with Ireland so as to be a part of the European Union. Both Scotland and Northern Ireland need to determine whether their economic systems are more tied to England’s or to Europe’s.

We all shall all wait and see what will happen. Only the Shadow knows.

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The Symbiosis of Institutional Investors and Activist Hedge Funds

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Second quarter 2016 has waxed brutally for hedge funds in the realm of regulatory compliance. The Securities and Exchange Commission (SEC) has called on investigative authority over hedge funds such as RD Legal Capital LLC and Platinum Partners LP for full disclosure of investment vehicles and practices. Of late, Visium Asset Management has joined the growing list of hedge funds flagged for insider-trading. The Wall Street Journal recently cited SEC’s Director Andrew Ceresney as stating hedge fund “Valuation [to be] one of the core issues.”

As we pointed out in our prior article Hedge Fund Performance and Regulation hedge funds historically had greater leeway in choosing how to value and categorize the portfolio’s underlying investments, drawing on the Securities Act of 1933’s Regulation D safe harbor rules. We also stated that regulatory compliance dictates from the SEC should remain constant, and not increase as hedge funds are above all performance driven. There is deep reasoning behind support for hedge funds, especially activist hedge funds, in the investment world – reasoning that laymen may not understand, but which focuses on the benefits institutional investors derive from seemingly mutually exclusive activist hedge fund activity.

Activist hedge funds exhibit corporate control activism, which according to L. Bebchuk, A.Brav, and W. Jiang, Harvard Law Review authors of The Long-Term Effects of Hedge Fund Activism, can be categorized via three strategies. First, as shareholders of a potential acquirer company, the strategy involves taking high stakes in a target company to ensure full acquisition over competition. Second, as shareholders of a potential target, hedge funds may use blocking strategies to benefit target shareholders. Third, hedge funds have themselves taken aggressive positions in a portfolio of companies solely in order to become activist, rather than diversifying and becoming involved when companies are exhibiting non-performance. Although not widely publicized, traditional institutional investors such as large pension and mutual funds engage in shareholder activism mainly through SEC Rule 14a-8, forcing inclusion of shareholder proposals in the proxy statements of vested public companies.

Marcel Kahan and Edward B. Rock of University of Pennsylvania Law Review do a superb job of explaining the constraints of institutional investor activism and the ensuing need for hedge fund activism via Hedge Funds in Corporate Governance and Corporate Control. We examine the most poignant points:

Pension Funds

  • Governance changes through shareholder proposals have largely been a practice of public pension funds due to the sheer asset size and scope. We have seen a surge of shareholder engagement from pension funds from 2015 to present, with the plunge in global economic and business climates. However, while proxy contests from pension funds aid in activism, the activism is more post-event reactive to company performance than pre-event business structuring. As the authors put it, pension funds traditionally handle only the “motherhood and apple pie issues” of shareholder engagement.
  • Pension funds have political constraints that inhibit an aggressively proactive approach to shareholder activism. Many pension fund trustees tend to overlap between private and public sector duties such as “gubernatorial appointees or elected politicians.” Such positions may lead to a bias towards political establishment dictates as opposed to actively working with company Boards to ensure optimal investment returns. The authors cite CalPERS as a prime example of such constraints, as historically the pension fund has held a strong pro-union position and has widely held union representatives on the Board.

Mutual Funds

  • Mutual Funds are generally retail investors.  The authors state that only TIAA-CREF has held what can be considered as an activist position in the industry. Mutual funds tend to take even a more passive position than pension funds in shareholder engagement.  Specifically, the necessary semiannual filing of all amounts and values of securities renders it difficult for mutual funds to take aggressive “pre-emptive strike” positions in a portfolio of companies.
  • SEC guidelines clearly stipulate the percentage of assets that all mutual funds can have in illiquid investments. In addition, mutual funds have requirements to redeem shares on short notice. These requirements put mutual funds in a passive shareholder engagement position.
  • Diversified mutual funds have major regulatory barriers and expenses that inhibit assertive activism. Unlike hedge funds, mutual funds for the most part do not charge performance based fees, and so depend on feed based on a fixed percentage of the of the mutual fund’s assets under management. Since activist investor proxy contests are costly, we find that most index mutual fund management would prefer to take a reactive position.
  • Most mutual funds have conflict of relationships due to affiliations with other non-activist financial institutions such as insurance companies and conservative pension funds. Many mutual funds have corporate pension plans as core business, and may not want to practice aggressive shareholder activism so as to not jeopardize client preferences.

Shareholder proposals from both pension and mutual funds are more a corporate governance wish list from shareholders, and fall more under the category of broad shareholder engagement than the activism partaken by activist hedge funds. Mutual and pension funds do not use the leverage that activist hedge funds employ to take the necessary positions for pre-emptive strikes to change company financial and operating structures.  As the authors rightly state, “hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position and become active.”  Hedge funds have become almost synonymous with activism. However, Kahan and Rock point out that only US$50 billion of the US$3 trillion global hedge fund assets under management are structured for shareholder activism. The point being that hedge funds are not solely formed to be activist investors. Yet, the small number of hedge funds that are activists truly pack a punch in active corporate governance.

The Columbia Law School’s Blue Sky blog’s article, Hedge Fund Activism: A Guide for the Perplexed has a bit of a mixed review when it comes to the activist hedge fund outlook. While there is an acknowledgement of activist hedge fund influence on company performance, the article takes an almost tongue in cheek approach to the effectiveness of activism, stating that  “institutional investors and knee-jerk academics…both believe that activists are doing the Lord’s work” as the champion of shareholder engagement, but in actuality hedge funds are by and large self-interested. From the points offered by Kathan and Rock on the limits of institutional investors to actively engage in pre-emptive structuring of companies to bolster shareholder interests, the industry must avow to the need for activist hedge fund activity, whether the motives are self-interested or otherwise. Regulatory dictates of the hedge fund industry may bring about transparency in valuations and curb insider-trading in the short term, which can be beneficial. However, a plethora of punitive regulatory barriers can seriously hinder effective shareholder engagement and corporate governance that may only be achieved through hedge fund activism.

REFERENCES

  • Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.
  • Coffee, John C. Jr. 2016. “Hedge Fund Activism: A Guide for the Perplexed.”  The Columbia Law School Blue Sky Blog.
  • Copeland, Rob et al. 2016. “Scrutiny of Funds Grows.” The Wall Street Journal. Print Edition.
  • Kahan, Marcel, et al. 2007. “Hedge Funds in Corporate Governance and Corporate Control.”  University of Pennsylvania Law Review. Pages 1029 – 1069.

 

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