Equities Fixed Income Hedge Funds Private Equity and Real Estate Sustainable Investing

Equities

We follow a philosophy that low-turnover, concentrated portfolios derived from sound bottom-up fundamental research provide an opportunity for attractive performance results over time. We have a culture and firm equity ownership structure that help us attract and retain professionals who share those beliefs, and we follow a repeatable investment process that helps us stay true to our philosophy.

We construct balanced portfolios for private clients, nonprofits and institutions depending on the needs of the client. We can be 100% open architecture, using third-party managers only, or we can put together a mix of internal and external strategies, whatever is in the client's best interest.

Fixed Income

We follow a philosophy that fixed income strategies built from a foundation of stability coupled with fundamental credit research can seek to generate alpha and control risk. We have a culture and firm equity ownership structure that attract and retain professionals who share those beliefs, and we follow a repeatable investment process that helps us stay true to our philosophy.

We construct balanced portfolios for private clients, nonprofits and institutions depending on the needs of the client. We can be 100% open architecture, using third-party managers only, or we can put together a mix of internal and external strategies, whatever is in the client's best interest. Meet the Investment Solutions Group.

Hedge Funds

Hedge Funds

The Investment Solutions Group is an investment-management team within Brown Advisory that specializes in asset allocation, manager selection, hedge funds and other alternative investment strategies. Dedicated to open-architecture solutions, our team has established a strong track record of identifying high-quality, third-party investment managers across the hedge fund, long-only and private equity universes. We leverage this expertise to help clients assemble portfolios that we believe best fit their needs and goals, offering clients a range of solutions from complete portfolio management to fulfillment of specific hedge-fund and alternative-asset mandates.

Founded in June 2002, the Investment Solutions Group now manages in excess of $3.4 billion for clients (data as of January 31, 2017) in a combination of managed accounts, advisory relationships and fund-of-fund offerings.

Private Equity and Real Estate

Private Equity and Real Estate

Brown Advisory has incorporated private equity and real estate investments in client portfolios since our founding. Today, we can provide that exposure in three distinct ways.

Feeder Funds and Multimanager Funds
We introduce clients to investment opportunities in early- and late-stage venture capital and buyout funds, as well as select real estate funds. We also construct these feeder funds into multimanager funds through our Private Equity Partners (PEP) and Real Estate Partners (REP) vehicles to make private equity investing as easy as possible for our clients.

Customized Private Equity Portfolios
For most clients, private equity is one component of a balanced portfolio that we manage. Other clients, however, come to us specifically for custom-built private equity and real estate portfolios.

For more information on private equity please click here or contact Jacob Hodes at 410-537-5315 or [email protected].

Sustainable Investing

Sustainable Investing Strategies

  • Multi-Manager Strategies
  • For clients seeking an open-architecture solution, we have access to several of the premier sustainable managers in the industry - all vetted by internal research.
  • Private Equity
  • Our private equity team is focused on evaluating the growing universe of private impact investments to identify standout opportunities that target various issues of particular concern to our clients. To date, we have placed assets in investments targeting a variety of impact themes such as community impact, microfinance, education technology, sustainable real estate, water initiatives and others.*
  • *Many alternative investments by regulation may only be sold to Accredited Investors (institutions with at least $5 million in assets) or Qualified Purchasers (institutions with at least $25 million in investments).

Customized Portfolios

This diverse assortment of solutions will meet many clients’ sustainability objectives; however, we understand the continued evolution of this space and seek to be able to react quickly to client needs.

For clients with unique missions, value-aligned investing programs, or who simply wish to ensure that they do not own certain controversial companies or have access to certain industries, we offer the following customized options:

Additional Screening: To the extent we have reliable data and can build rules into our compliance systems, we can add specific screens to a separate account to restrict companies (e.g. oil and gas providers) or industries (e.g. tobacco or weaponry).

Customized and Thematic Portfolios: Within a separate account, we can work together to solve for a sustainability need. From a universe of securities researched from both the bottom-up and for their ESG profile, we can assemble a custom portfolio of securities designed to meet many specific sustainable goals or outcomes.

COMPOUND INTEREST | BEWARE THE TRAP

Late in an economic cycle, investors in corporate bonds tend to snap up securities that offer a comparatively high yield but understate the risks of default. Here are our thoughts on how to avoid such “value traps.”

From telecommunications companies in 2000, to homebuilders in 2007, to coal mining companies in 2014, recent history offers plenty of cautionary tales for high-yield investors. Securities that on the surface offer compelling yields at times when such yields are rare can be as tempting as the song of the Sirens in Homer’s Odyssey. But the shoreline of the fixed-income market is strewn with the wreckage of investors lured to their destruction by these value traps. We think Odysseus had the right idea when he tied himself to the mast of his ship to resist the Sirens’ song. In our view, the most effective way to avoid value traps is to tether ourselves to a disciplined approach that steers us clear from temptation.

Understanding the Cycle

The trap often appears when the economy is at the end of its cycle and nearing a downturn. Bond market volatility and default rates are low and memories of the last recession have faded. Value is comparatively hard to find, with most bonds offering very little risk-adjusted return. Overleveraged companies confronting overcapacity usually offer investors the highest yields. At such times, it is easy for bond investors to be seduced by higher-yielding bonds that veil excessive risk.

The plunge by the economy from peak into recession may be caused by the burst of a credit bubble pumped up by years of debt-driven consumption, or by overcapacity in a large, highly leveraged industry. While the end of a cycle is often marked by a distinct event, the underlying signs of a peak are usually similar. Revenue growth begins to slow. Profit margins flag, as companies that have invested in personnel and capital based on projections of sustained growth confront slowing demand and tougher competition. Default rates may begin to rise in certain segments of the economy because of lax lending standards and overextension among high-risk borrowers. Return on investment falls, as companies contend with a dearth of high-return opportunities and distribute cash to shareholders rather than invest in new capacity.

While the U.S. economy shows some of these signs of entering the late stage of a cycle, there are not enough indications to suggest that a recession is imminent. Still, discretion is essential today when sizing up high-yield bonds. For several months, we have been very cautious about securities sold by companies in the commodity sector, including oil, gas, metals and mining. Many of these companies borrowed heavily to fund acquisitions or capital projects based on overly optimistic forecasts for growth. Revenues and earnings are generally weakening or falling outright. We are also wary about parts of the U.S. economy exposed to trade with emerging market countries that confront a slowdown.

The mispricing of some high-risk bonds may become clearer before the end of 2015. Fed policy makers on September 17 reiterated their expectation to raise the main interest rate sometime this year for the first time since 2006. An increase in the benchmark rate may help expose underlying weaknesses in some of the riskiest bonds.

We seek to avoid the temptation of value traps by sticking to a disciplined evaluation process that excludes securities whose prices understate default risk. Here are two essential elements of the approach that we pursue for our clients.

Determine Free Cash Flow

In bond investing, it is difficult to overstate the importance of gauging how much cash a company generates after accounting for capital expenditures such as equipment or buildings. This requires constructing a financial profile based on an analysis of a company’s business model, industry, management, capital structure, covenants and financial statements.

Using such a model, an analyst can stress-test a company, estimating how its cash flow would change under various economic conditions. For the highest-quality bonds among speculative-grade securities, the general rule of thumb is that free cash flow should not fall below 10% of company debt.

A company’s free cash flow acts as a shock absorber during a downturn. The effectiveness of the shock absorber tends to be low when a company faces high fixed costs and/or high fixed charges such as interest expenses and capital spending. Such costs eat away at free cash flow and profits during an economic slump. A weak capital structure increases the odds that a company would fail to pay off bondholders.

U.S. auto suppliers last decade illustrated the hazards of disregarding free cash flow. Prior to the financial crisis, these companies took on excessive amounts of debt to finance leveraged buyouts and acquisitions. Their intensely competitive industry requires high capital investment to adapt to new car and truck models. Even in good times, auto suppliers generate meager free cash and reap a low profit margin. When the Great Recession struck in late 2007, earnings evaporated and many companies could not pay off debt.

An evaporation of free cash flow undermined coal producers such as Alpha Natural Resources and Arch Coal during the past two years. Both companies took on heavy debt to buy out rivals early this decade based on an optimistic forecast for the price of coal. Beginning in December 2013, the companies attracted investors with bond yields exceeding Treasuries by about 6 percentage points, compared with a 4.5-percentage-point spread for the J.P. Morgan U.S. High Yield Index. Since then, the price for coal used in steelmaking and other metallurgy has fallen to an 11-year low, partly because of declining demand from China.

Alpha Natural Resources filed in August for bankruptcy protection, and its unsecured bonds now sell for 3 cents on the dollar. Arch Coal’s unsecured bonds sell for 10 cents on the dollar—it is trying to buy time until coal prices rebound, but it faces stiff lender opposition to a plan to swap current debt for securities that stretch out repayment. A stress test of the two companies’ business models would have revealed that they would not generate sufficient free cash flow at a depressed coal price.

Measure the Loan-to-Value Ratio

A clear comparison of a company’s total debt to its underlying value reveals the extent of a firm’s “equity cushion” during a downturn and whether it could be sold for more than the value of its debt.

The most common tool for measuring a company’s value is to look at the stock prices of the company and its competitors as a multiple of their respective earnings. It is especially helpful to look at how previous economic downturns impaired those multiples. There are other ways to assess value: investors can research what competing companies and private equity sponsors have paid for similar businesses, or estimate the present value of a company’s expected cash flow, or add up the value of each of the components of a company in a “sum-of-the-parts” analysis.

Finally, investors can establish a bedrock valuation by researching the price assigned to similar companies after bankruptcy and a restructuring. If any of these analyses reveal that the loan-to-value ratio of an investment exceeds 100%, an investor should anticipate that a default would result in a loss.

The collapse last year of Energy Futures Holdings Corp., an electric utility, is a glaring example of the danger of mismeasuring the loan-to-value ratio. In 2007, at the peak of a leveraged buyout spree, Kohlberg Kravis Roberts, Texas Pacific Group and Goldman Sachs Capital Partners purchased the company—then called TXU Corp.—for $45 billion. They financed the deal with $40 billion in debt, which at the time represented a loan-to-value ratio of nearly 90%. The buyers were counting on an increase in the price of natural gas to boost the competitiveness of the company’s coal-fired power plants. Instead, the price of natural gas from 2007 until the end of 2008 plunged by about 56% to less than $5 per thousand cubic feet. Energy Futures Holdings Corp. filed for bankruptcy protection in April 2014. Afterward, its unsecured debt sold for less than 10 cents on the dollar.

We also shield our clients against losses during the late stages of an economic cycle by determining the amount of debt maturities a company has to meet in the next three years, or ensuring that a company has adequate liquidity in the form of cash and lines of credit in order to meet its fixed charges. Moreover, we research how much cash management plans to return to shareholders and the amount remaining to service debt. Or, we choose to invest at the “top” of the capital structure, gaining a priority claim on cash flow and, in some cases, a secured interest in a company’s assets.

Successful investing in corporate bonds late in an economic cycle does not require Homeric heroism. But it helps to resist the temptation of high yields and to size up securities with some of the same persistence and sharp-eyed wisdom that helped Odysseus prevail in his 10-year voyage home.

 

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. The J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the U.S. dollar domestic high yield corporate debt market.


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