MetLife Searches Beyond LBO Funds Amid Signs of Peak

If MetLife Inc. is any guide, it’s time to search beyond leveraged buyouts for investment returns.

The biggest U.S. life insurer plans to devote more to hedge funds, startup companies, and even timber to spruce up $330 billion in holdings dominated by bonds yielding about 6 percent. What New York-based MetLife won’t do is boost the share of assets dedicated to leveraged buyouts after gains from LBO funds were almost double the company’s expectations in the first quarter.

``We want people to understand that we’re over-earning, if you will, in that asset class today,’’ Chief Financial Officer William Wheeler said of LBOs at an investor conference last week. ``Even though times are great, we like this asset class, and things are going very well, it will not last forever.’‘
MetLife, an investor in the first fund arranged by buyout firm Blackstone Group LP in 1987, beat analysts’ first-quarter earnings estimates by 10 percent mainly because of the LBO funds that make up the majority of its $4.4 billion in so-called alternative investments. Since then, the borrowing costs that fueled $1.6 trillion of LBOs over the past three years have reached a seven-month high.

``At what point does the increase in financing costs bring an end to the private-equity party? Who knows, we may be at the beginning of that now,’’ said Michael Stafford, a director at Conning & Co. in Hartford, Connecticut, a unit of Swiss Reinsurance Co. that manages $70 billion in assets for insurers.
Rising Rates
U.S. life and property-casualty insurers had $33.7 billion in private-equity and hedge-fund assets at the end of 2006, 34 percent more than in 2005, according to the National Association of Insurance Commissioners in Kansas City, Missouri, which compiles data only from their domestic units. Overall invested assets rose 7 percent to $6.4 trillion during the year, reported A.M. Best Co., a rating company based in Oldwick, New Jersey.
This month’s increase in U.S. Treasury yields, a benchmark for rates on everything from residential mortgages to corporate bonds, has raised concerns about the buying power of funds that typically borrow two-thirds of what they pay for their targets.

Bond sales for LBOs of companies including US Foodservice, a unit of Royal Ahold NV being bought by Kohlberg Kravis Roberts & Co. and Clayton Dubilier & Rice Inc., have been postponed because investors are demanding higher yields to buy the debt. Shares of Blackstone, manager of the world’s No. 2 buyout fund, have fallen four of five days since its initial public offering last week.

While insurers typically put more than half their assets in low-risk, fixed-income securities, companies such as MetLife and American International Group Inc. have benefited disproportionately from alternative investments that make up less than 3 percent of their portfolios.

AIG Investments

``It’s been a very favorable economic environment for selling assets,’’ said Robert Thompson, who oversees $23.4 billion in private-equity and hedge funds at the asset management unit of AIG, the world’s largest insurer. ``A number of the investment decisions we’ve made in the past absolutely bore fruit.’‘

AIG beat some analysts’ first-quarter earnings estimates by 13 cents a share, primarily because pretax income from Thompson’s portfolio more than doubled to $1.2 billion, growing six times faster than overall investment income. At 21 percent, the annualized rate of return from those assets outperformed the New York-based company’s 10 percent to 15 percent long-term forecast.

``If we think the opportunities out there are less attractive, we’ll slow down our pace,’’ AIG Chief Investment Officer Win Neuger said in an interview this week. ``To me, the universe of opportunities is still significant.’‘

Blackstone Stake

Neuger said it’s difficult to time the market.
``If I’m making a commitment to a private-equity fund today, that money is going to be invested over the next three to five years,’’ he said. ``It doesn’t really matter whether I think the market right now is peaking out. It really matters what I think is going to happen over the next three to five years.’‘
AIG has been investing in private equity since 1980. Between its own funds and partnerships, it has stakes in energy, health and infrastructure companies in the U.S., Europe, Asia and Latin America.

Among its most lucrative bets was the $150 million it spent in 1998 for 7 percent of New York-based Blackstone, founded by Stephen Schwarzman and Peter G. Peterson. In connection with the offering, AIG was to receive 48.8 million partnership units, according to a regulatory filing from Blackstone. At yesterday’s closing share price, that was worth $1.45 billion.

30 Percent Returns

MetLife’s alternative investments returned almost 30 percent on an annualized basis in the first quarter, higher than the company’s long-range forecast of ``high-teens,’’ according to CIO Steve Kandarian.

He plans to diversify away from LBOs by using hedge funds and timber to double the portfolio to 2.5 percent of total assets within four years, he said at a conference June 25. Hedge funds are private pools of capital that allow managers to participate substantially in the gains of the money invested.
Riskier, higher-yielding investments have become more appealing to insurers in the relatively low-interest-rate environment. Corporate bond yields have averaged 5.18 percent for the past five years, compared with 6.89 percent for the five years before that, according to Merrill Lynch & Co.‘s broadest corporate index.

As interest rates rise, LBOs will become less attractive and fixed-income will regain its allure, said MetLife’s Wheeler. Insurers keep the bulk of their assets in bonds because credit- rating companies require more volatile, speculative investments to be backed by larger capital cushions earmarked for unexpected claims.

Transition Period

``The transition period will be difficult, I suspect,’’ said Thomas Russo, a partner at Lancaster, Pennsylvania-based Gardner Russo & Gardner, who helps manage $3.5 billion and held 2.6 million shares of AIG as of March.
``Private-equity returns are built on a series of sales. If sale prices are going down because of higher borrowing costs, you would think that would show up in lower prices paid for assets sold, which would drive down private-equity returns,’’ he said.

Yields on the high-risk, or junk, bonds that firms typically use to finance LBOs averaged 8.11 percent yesterday, the most since November and up from the low this year of 7.58 percent in February, according to Merrill’s broadest junk bond index.
The extra yield, or spread, investors demand to own junk bonds instead of Treasuries has widened 42 basis points to 2.83 percentage points since hitting a record low on June 5, Merrill data shows. Junk bonds are defined as those rated below BBB- at Standard & Poor’s and Baa3 at Moody’s Investors Service. A basis point is .01 percentage point.

Hartford’s View

Last year, private-equity funds that were six years old, or about halfway through their expected lifespan, had an average 11.8 percent internal rate of return, according to data compiled by London-based Private Equity Intelligence Ltd. The Standard & Poor’s 500 Index, the benchmark U.S. stock index, climbed 14 percent in the same period. Investors record gains from LBO funds when assets are sold to another company or in an IPO for a profit. Along the way, they also may get dividends.
Hartford Financial Services Group Inc., the sixth-largest U.S. insurer, is still optimistic enough about the LBO market to increase its investments.
Private-equity and hedge-fund investments represent 1.2 percent of the Hartford-based company’s $122.9 billion in holdings, and within a year it plans to increase that allocation to 2 percent, mostly with LBO funds. The portfolio returned an annualized 20 percent in the first quarter, more than triple that of its bond holdings, according to William Meaney, managing director of Hartford’s investment management arm.
`Big Sector Calls’

``The expected returns from private equity we still feel will look attractive relative to what we’ve seen in the credit markets,’’ Meaney said in an interview.
MetLife’s Kandarian said the company’s decision to cap LBO investments may end up being noteworthy, just like when the insurer sold bonds of General Motors Corp. and Ford Motor Co. a month before they were downgraded in 2005, or got out of its riskiest subprime debt holdings in 2004.
These are the ``big sector calls that served us well in the last couple of years,’’ he said.