KICÆs Scott Kalb still keen on Merrill Lynch stake

The CIO of the Korea Investment Corporation explains why the Merrill Lynch deal will work out, as well as his views on hedge fund fees and other topics.

Scott Kalb joined the Korea Investment Corporation in April as its chief investment officer, replacing Guan Ong, who had stepped down last year after leading the KIC's investment strategy in its first three years. The full Q&A with Kalb will appear in the September edition of AsianInvestor magazine. Below are some excerpts from the discussion.

KIC now manages about $30 billion; will this keep growing?

Kalb: The balance sheet of Korea is strong. During the Asian financial crisis, Korea's forex reserves fell to $10 billion. Today they're around $250-275 billion. That's a 25x increase in 12 years. I think the international community underestimates Korea. There's been a late realisation about where Korea is on the global economic stage. This country learned the lesson that you don't go into a crisis with a weak balance sheet, and is now in a position to use the current global turmoil to improve its business position in many sectors.

I expect another $3 billion to be injected by the end of the year. We had been managing about 15% of Korean foreign exchange reserves, them those reserves are growing faster than expected. It's up to the government, and last year FX reserves declined everywhere in the world.

Your first deal in private equity was with Partners Group. Why?

They're a secondary private-equity specialist in Switzerland. Our data shows us that 30-50% of deals in the private-equity markets now are secondary.

What other alternative asset classes are you looking at?

We want to do more in private equity, real estate and hedge funds. In all cases we would work with external managers. We're also interested in commodities. We may outsource this as well, but we can also manage commodity exposures internally, via swaps or indices.

How quickly do you expand into all of these areas?

Opportunistically. We expect to build a diversified portfolio in all of these areas but we must avoid a check-the-box mentality. Right now in private equity, the best opportunities -- in strategies run by the best people -- are in secondary markets. Next year it will be something else. Over time you build a diversified exposure.

Hedge-fund and private-equity managers have been criticised for fees and other issues. What's your take?

Fees, transparency and liquidity are real problems, especially on the hedge-fund side. Let's start with transparency. I was in the hedge-fund world for 10 years. A lot of hedge funds will tell you they don't want to show you the portfolio because their strategy is proprietary. What a load of bunk. This may be true for a handful of individuals, but the majority of funds have more beta in their portfolio than they'd like you to know about. The other excuse is that they didn't invest in the infrastructure, because it's costly to deliver information to their LPs -- in which case they're just lazy.

What's the problem with fees?

Asymmetric risk sharing. It's wrong for LPs to have to pay up front for an unrealised gain, and end up holding all the risk. Sure, GPs may be co-investors, and they may have to hit high-water marks, but that's no protection for an investor. We've still paid the GP up front. Of course managers should be paid for generating alpha, but fee structures should be spread out so that LPs pay over time. That way if the fund's value declines, the manager doesn't collect that portion of the fee.

The cleanest thing for long-term investors is a long-term lock up. I don't necessarily care about monthly liquidity. It's a problem when a long-term strategy creates a liquidity mismatch -- and often without the hurdle rate that you would get in a real private-equity fund.

Are fees coming down?

They are a bit, but the market right now consists of either the great big survivors -- who don't feel the need to accommodate such requests right now -- and a lot of people who are struggling. We need to see big institutional investors pull together and unite. That'll get attention. And I think some hedge funds would be willing to lower fees in return for more stability -- there's a lot of resentment among those who performed well but got used like ATMs when others were gating.

KIC's strategic investment in Merrill Lynch in early 2008 has caused a lot of grief -- what do you do with it?

There was a point when the KIC was concerned Merrill wouldn't survive. Either it was so weakened it would die, be nationalised and sold -- or it would survive and prosper. The stock has moved up fourfold since it reached that tremulous point.

Do you sell?

Even if it just recovers in line with the US economy, the stock should double from here. This year will see a lot of Bank of America-Merrill Lynch write-offs, but this will gradually normalise. The bank booked record revenues in the first quarter of 2009. Even if those revenues stabilise, once the bad debts go away, it should see a huge lift in earnings. Today the stock is trading at $14, or 4x earnings. By 2011 or 2012, it should rise to normal multiples; 10x wouldn't be unreasonable. The stock today remains at depressed levels. We talk to the management every week. We're not throwing in the towel on the US economy.

Has the Merrill stake put KIC off other strategic investments?

No. Strategic investments sit outside of the asset-allocation model, and cannot be diversified through traditional asset-allocation expansion. They can only be diversified by building a portfolio of other strategic investments. We are spending time with the government on guidelines and plans for KIC. There is interest in this as a business for us, so watch this space.

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