Exclusive Interview with KKR Prisma's Girish Reddy

By Ethan Coy

I’d first like to discuss your experience at Cornell. I understand you were one of the first recipients of a scholarship which allowed you to attend Cornell in exchange for working twenty hours a week. What about your Cornell experience motivated you to remain involved with Cornell and take on your new role as a member of the Board of Trustees?

Reddy: Receiving a scholarship to attend Cornell gave me the ability to pursue a track that was very uncommon back when I was a student. By completing a joint degree between the business school and the engineering school I was able to discover my professional passion. I was also lucky to be at the right place at the right time. Wall Street was rapidly becoming more quantitative in the 1970s and my engineering background put me in a strong position to use my skill set to carve out a niche and find a company to sponsor me for a work visa in the United States. That proved to be my key to professional and personal development.

Andrew Rudd, a PhD in Operations Research who taught derivatives in the Johnson School, got me into quantitative finance on the investment management side. The genesis of my entry into finance was a little bit by accident and a little bit as beneficiary of the industry trend at that time. In essence, the scholarship gave me the opportunity to discover my passion for quantitative finance and benefit from a world-class education at Cornell.

From curbing inflation, to creating a national sales tax, to amending the bankruptcy code, India, for all its faults, seems to be managing its economy quite well. Where do you see opportunities for improvement in India and are there areas of the Indian economy where foreign investors should be looking to allocate capital?

Reddy: I have not invested much in India so I am not as familiar with it as someone who actively tracks and invests in the Indian markets. I do think, however, that the general trend is encouraging. In the past, investors have been hesitant to dip into Indian markets because of a lack of transparency in regulatory processes, archaic laws, and disputes over taxation. The current government in India seems to be very inclined to devise a transparent framework in order to encourage international investment. In terms of growth potential, I think India offers immense opportunities due to its youthful demographic: around 40% of all Indians are under 25. That in itself creates an unprecedented demand for goods and services within the country, thus making Indian companies less reliant on exports to fuel growth. This is particularly good for mid-cap companies looking to cater to the domestic market. These companies have benefited hugely from an improvement in living standards which has fueled demand for automobiles, scooters, TVs, washing machines, and much more. There’s definitely been a lot of progress over the years, but many challenges remain. I think political interference, which is a problem in every country, is more of an issue in India. So is corruption. Fortunately, the government is taking concrete steps to address these concerns. The recent demonetization is a big step toward wiping out corruption in India. It’s likely to create public angst and possibly a slowdown in economic growth because of the prevalence of corrupt money, but I think it's a step in the right direction.

Since growth in India is still fueled by banks and bank loans, access to capital is not as easily available as it should be for an economy of that size. There are no established bond markets and bankruptcy laws are vague, I think the next stage should be the issuance of corporate bonds. We cannot rely exclusively on bank loans because they have their limitations.

It’s also worth pointing out that the savings rate in India is very high. For most investors with fixed income, the only choice today is your bank or your company’s life insurance policies. Indians are looking, however, for avenues in which to invest other than just bank deposits.

President-Elect Trump has indicated the desire to stimulate the economy via his infrastructure plan, which largely will be funded by private investors. What role will large institutional investors such as KKR have in such a plan and will President Trump be able to raise the amount of money he plans to?

Reddy: We are still in the very early stages and it is not clear to me the direction the President-Elect wants to take. He clearly has identified infrastructure development as his top priority because it’s a business he knows, and he is hoping to have a public-private partnership. But the details are unknown. There is a huge appetite among pension plans and sovereign wealth funds for long-dated assets that have some income, and for infrastructure projects which tend to have the longest duration. A simple example is a toll road or gas pipeline. KKR is involved in the infrastructure and energy space. These projects have a fair amount of demand, and we could get involved in a public-private partnership, but it’s too early to say. It’s certainly a very important priority for the President-Elect, but the question remains whether Congress will approve it given its resistance in the past to public spending on infrastructure projects.

Bank stocks have surged since Trump’s election as the market anticipates regulation to be rolled back under the new administration. What does this mean for firms such as KKR which have filled the void in lending that banks left after the adoption of Dodd-Frank?

Reddy: I think the need for capital is still very deep and access to capital doesn’t have to come exclusively from banks. Whether some of these regulations will go away or not is unclear, but I think the need for capital remains. Different pockets of capital are important and I believe banks should not be the only source. Pension funds and endowments give us capital to invest, and these institutions have long horizons. Moreover, they don’t typically use leverage, and certainly providing capital for long-term opportunities in an unleveraged manner is one way to make the system much more stable.

Hedge funds have drawn criticism since the financial crisis for their inability to manage risk and earn superior returns. What would you attribute this to, and are central banks one of the main reasons hedge funds can’t generate alpha?

Reddy: The ensemble of central bank policy changes over the past few years has had a very detrimental effect on the investment world. Highly unpredictable and sudden shifts in ideologies and approaches have generated a lot of uncertainty. In particular, fundamental macroeconomic changes have made it much more difficult for hedge funds, which tend to be more micro and fundamentals focused. That’s been the biggest challenge, particularly over the last 18 months with all the talk in the U.S. about raising interest rates. On the other hand, the Bank of Japan decided to go with negative rates and because nobody was expecting such a move, it had a huge impact on financial institutions, insurance companies, and banks, which are the engines of economic growth. The uncertainty that prevailed following these decisions made it very difficult for hedge funds to add alpha in an environment where technical factors overshadow fundamental factors. Over the last six to nine months, however, as monetary and fiscal policies around the world have evolved, the markets seem to have absorbed these changes much better than they did earlier. Consequently, hedge funds have started to do well in the current environment.

Another challenge in the current market is the mix of phenomena like indexation, growth in ETFs, and decline in market liquidity. One trend is thus more cyclical in nature -- that the market now has a better idea how to operate. The second is probably more of a structural trend that hedge funds still need to adapt to. It’s the fact bank regulation, low rates, and capital needs have created some very exciting idiosyncratic and uncorrelated opportunities around the world. We have shifted our portfolios from more traditional alpha sources into these new opportunities.

After co-heading equity derivatives at Goldman Sachs, what made you decide to move into the hedge fund world and what advice would you give our readers interested in working for a hedge fund?

Reddy: When I was at Goldman Sachs I interacted a lot with the hedge funds in developing their strategies, particularly when they wanted to use derivatives to influence their views of the market. Europe was much more open to using derivatives than the U.S. market. So when I left trading, I really wanted to go back to the investment world where I started. One of the attractive features of the hedge fund industry to me was that this industry was at the cutting edge of research and was attracting the best talent. I felt I would continue to learn by being involved in an industry that cuts across asset classes and geographies. I came very much from an equity derivative background, so the opportunity to learn about macro and credit or fixed income strategies was very exciting. The hedge fund solutions industry gave me an opening to deal with all these strategies and I genuinely felt that if we structured the product correctly, we could fill a very important need. I think people should focus more on the characteristics that hedge funds provide, and whether they’re really appealing.

In terms of what people should do to get into hedge funds, remember that they represent an array of strategies and should not be looked at as a single bucket. You’ve got equity, macro, distressed credit, and relative value, so your ability to learn the nuances of the field should be your driver. But also focus on what your value-added is. Going back to my own experience, having a quantitative background when derivatives were starting to evolve allowed me to immerse myself in that space. It’s not just about passion; you’ve got to have the skill set to truly make it work.

As AI transforms the economy and drives many jobs into extinction, how can Cornell adapt, and what are your aspirations for Cornell Tech?

Reddy: I think we are in the very early stages of AI. Our new president is the ultimate expert; Martha’s knowledge and background is very exciting for Cornell. AI’s scope is so vast that we are just scratching the surface. It cuts across robotics, manufacturing, data analysis, medicine, and finance. I think our industry has done a very poor job in leveraging that technology relative to other industries. Indeed, we’ve barely progressed over the past fifty years. We’ve just followed the same path with the same attitude and same approach, oblivious to the fact that disruption in any industry doesn’t come from inside, it comes from outside.

In terms of Cornell Tech, I think our ability to provide business and technology in a single place is a huge advantage, and that we need to leverage that asset aggressively. So far, I think the programs of Cornell MBA and Cornell Tech have been geared toward entrepreneurs, which is good inasmuch as entrepreneurs need to understand marketing, finance, and business. But I think a lot more can be accomplished by incorporating AI, including cloud computing, into other fields of management like finance, marketing, and strategy. I am very excited that Cornell Tech sits at the center of all these fields.

I just set up a chair at Cornell at the Tech Business School for a professor of practice, about which I am quite excited. Mukti Khaire, the professor of practice, is focused on entrepreneurship and trying to bring together and effectively leverage both technology and finance.

Lastly, what does Girish Reddy do for fun?

Reddy: I have a variety of personal buckets. Obviously, my professional life is a big part of what I do. Philanthropy, particularly with an educational focus, has always given me enjoyment and satisfaction. Above all, though, I cherish my family, friends, travel, and golf. Balancing these is always a challenge – but one I’m only too happy to face.

Hidden Giant: The Secret Success of Vista Equity Partners

By Jeremie Mutolo

The performance and success of a private equity firm is difficult to evaluate. Does a firm that effectively raises large funds from numerous wealthy investors fare better than a firm that can double or triple their investors’ money? If asked what the industry performers were over the past several years, the names of more notorious asset management and PE shops come to mind, with the likes of Blackstone, KKR, and The Carlyle Group presumably landing on the list. Even less prominent or sector-specific private equity firms such as Berkshire Partners and Silver Lake Management would gain honorable mention. Very few, however, recognize the middle-market firm based in San Francisco, which at the end of 2014 was crowned the top-performing private equity firm in the world.

Founded and headed by Robert Smith ‘85, a Cornell College of Engineering alumni, Vista Equity Partners has quietly outperformed its competitors over the past several years, yet fails to fully capture the respect of the finance industry. The private equity firm mainly focuses its investments on software, data, and technology companies valued between $25 million and $3 billion, investing a modest $20 to $700 million per transaction. A quick glance at their news section will show that in just the second half of this year alone, Vista Equity has taken part in several acquisitions, totaling roughly $2.15 billion. What’s even more impressive is the performance of their recently closed 2007 buyout fund, Fund III, which, according to Pitchbook.com, has an internal rate of return of 28.24 percent, with Buyouts Magazine reports an even higher IRR.

The success of Vista Equity Partners speaks to the idea of specialization, something that has become a lost art among financial firms. Vista Equity’s focus on software, data and technology-based companies allows them to develop a niche and garner industry experience handling such companies, providing them with the knowledge necessary to ensure maximum returns for their investors. Investors realize the importance of such “niche” investing, so much so that according to the Wall Street Journal, Vista Equity Partners was able to handily surpass its $8 billion dollar goal for its newest tech buyout fund, Fund VI. If the fund is able to close above $10 billion, it will make it one of the largest tech-focused PE funds in recent memory, a record currently held by Silver Lake. This is not the first time that VEP has seen this level of excess investment; their previous two funds, Fund IV and Fund V both exceeded their respective asking amounts. Despite this, Smith remains confident that an abundance in capital should prove to “have no effect on the firm’s performance or strategy”, according to PEHub.

    Mr. Smith’s business acumen is also another facet of VEP’s success, with Smith spending six years at Goldman Sachs focused solely on technology M&A. He handled deals with tech giants such as Apple, Yahoo!, and eBay before forming Vista Equity Partners in 2001. The fundamental reason behind the success of VEP, however, lies in their disciplined investment philosophy. VEP’s ability to strategically identify, acquire, and merge companies through a series of “small” deals is what allows the firm to consistently draw wealthy investors. The recent merger of Fiverun, Marketlive and Shopatron to form the cloud-based retail platform Kibo speaks to the innovative vision of Smith and the firm.

Vista Equity Partners’ success comes at a time when a great number of tech companies are choosing to take their companies private, or remain private entirely. The past few years have been notoriously brutal to technology IPOs, with roughly 50 percent of the tech companies that have become publicly available trading below their IPO price. The decision to go private will vary from company to company, but many enjoy the freedom to focus on remodeling from the inside without fretting over meeting shareholder expectations or maintaining regulation requirements. Toronto-based financial service firm Canaccord Genuity began tracking 95 business software companies that had an IPO and found that 78 percent of them had been acquired, showing just how uncompromising the public market have been. Additionally, tech companies have accounted for 46 percent of buyouts this year, with the private equity industry spending more than $15 billion targeting these types of companies and somewhere of $300 to $400 billion in excess cash reserves readily available to be used, with some firms suggesting an even larger amount of “dry powder”. The poor market environment for tech IPOs presents an opportunity for VPE to feast on companies seeking to make an exit, especially with their proven track record and ease of raising funds. Combined with venture capital funds experiencing “the highest investment rate in 15 years”, according to the Wall Street Journal, the environment is ripe for firms like Vista Equity Partners to be successful in acquiring and renovating these companies.

Source: Allison Griswold, Atlas; Dealogic

But the tech IPO drought that heavily marked the first half of the year is beginning to reverse, as several tech companies have recently gone public, including Twilio and Nuantix. Investors are slowly clamoring for more “unicorns” to become publicly traded, suggesting a broader trend of tech IPOs starting to emerge once again. This bodes badly for a company that makes its money by taking companies private.

Or does it? Widely popular tech companies such as Dropbox and Snapchat are speculated to be going public in the next few years, while Spotify and Uber are mulling over the decision with financial advisors. Demand for these companies to go public is immense, and a favorable market reaction to these highly valued companies will provide a lucrative exit strategy for companies in VEP’s portfolio. If investor fervor is as advertised, Vista Equity Partners finds itself in a great position to reap the rewards.

As companies and the overall economy becomes more reliant on software, private equity firms will begin to aim their sights on the same tech companies Vista Equity Partners has spent years investing in. The bidding war VEP had earlier this year while trying to acquire the event-management software company Cvent speaks to the greater competition the firm will face moving forward. But the discipline and enterprise, traits commonly found in Cornell graduates, of Robert F. Smith will keep Vista Equity Partners performing at the top for years to come.

Emptying the Endowment

By Hamish Macdiarmid

In a much-publicized report, Cornell University revealed that it had lost $280 million in its endowment funds because of the fact that interest rates have steadily been decreasing over the past 16 years. In fact, as economists are quick to point out, interest rates are at their lowest rate in 5,000 years which caught many companies and universities off guard, with their investment strategies ensuring that they lost money playing the markets. Institutions paying a fixed percentage to banks whilst relying on a payout based on the floating percentages used by the banks ensured that as interest rates decreased, universities like Cornell were putting in more than they were getting on returns. As institutions invest in interest rate swaps, a fixed interest rate is paid to their bank while the bank will in turn pay a variable rate on the debt issued by the institution. The variable rates have been lower than the fixed for 16 years, causing schools lose money.

For the uninitiated, an interest rate swap is an over-the-counter trade where two parties agree to exchange future interest payments for a second payment. The amount is agreed upon by the two parties, and it is often a method used by institutions such as Cornell to combat investment losses, manage their credit risks, and earn further income via speculation on the interest rate markets. However, it did not turn out to be the most beneficial investment for Cornell. In fact, their financial report from 2015 stated: “The University experienced an operating loss of $25 million this year; over $20 million of this loss is due to interest expense associated with unattached interest rate swaps, which have no associated debt. The University has a multi-year plan to gradually terminate these unattached swaps.”

Think of this as a borrowing a mortgage at a fixed rate of interest for 10 years or 30 years, which can be a useful tool to mitigate losses caused by variable rates. Interest rates are meant to ensure that risk is managed more effectively whilst generating income for the institution, but in this case 80% of the losses which Cornell experienced were directly due to this investment.

The Endowment of Cornell University decided to borrow money at a fixed interest rate of 4% in 2007-2008. Shortly afterwards interest rates dropped to record lows, close to zero percent, particularly for variable rate loans. Unfortunately for Cornell and the other Ivy League Universities who also experienced significant losses, they were all stuck with borrowing money at the higher rate of interest. It seems that the reported loss of $280 million was calculated by adding up the interest that Cornell University would have paid if they had taken out a lower cost variable rate loan rather than a fixed rate loan.

Cornell was somewhat prudent in taking out a long-term fixed rate loan. Imagine if they had decided on taking a variable rate loan, and if short term interest rates had risen to 10% because of rising inflation - Cornell would have lost a lot more money. So what Cornell did was sensible, and protected their downside risk. Whilst articles which covered the loss in a negative light saw it as a mistake on the University’s part, in reality, they protected their investments at a time when major financial markets were in dire straits.

So why did Cornell decide to borrow so much money – and what did they do with it? With an endowment of $6 billion in equity, Cornell should not be borrowing money at all. They should just be investing their cash, without any leverage or borrowing. So what, then, did they do with the money? As the representative for the College of Arts and Sciences in the Student Assembly, I know from first-hand experience that Cornell does not disclose much of what they do with their financials. For example, the university does not disclose what is specifically done with the budget for the College of Arts & Sciences.

Furthermore, it appears that the university intends to cut back on financial aid in order to save money, as confirmed by a faculty source close to the Provost, Michael I. Kotlikoff, who chooses to remain anonymous. They said “The University is proposing reducing unrestricted funds, which includes making financial aid ‘more efficient,’ which actually means reducing financial aid to some extent.” Provost Kotlikoff has already enacted a similar policy with International Students, ensuring that those from less affluent backgrounds would face a more stringent process to enter into Cornell University. Cornell could have used the extra money to invest into campus infrastructure; for example, in response to a contentious student petition, the University could have used the money to provide free hygiene products such as tampons in school bathrooms. The University estimates that such a plan would cost $20 million: while this may appear quite a large sum of money, relative to the total endowment it miniscule, and small compared to the loss that Cornell suffered.

In spite of their losses, if Cornell had openly invested in a project that made a return of more than the 4% cost of borrowing, then that would be a good use of the borrowed funds and would generate a profit, not a loss. For example, suppose the University buys a piece of real estate, borrowing at about 2.5% fixed rate, and investing the funds at 9% per annum rental return. While they could borrow at a lower 1% variable rate, the University would not because they are still making money, and wants the security of knowing that the cost of borrowing will not suddenly increase.

These convoluted financial disclosures beg the question: why is more information not easily available? For example, Harvard has been more open than Cornell about their loss of $1 billion on similar interest rate swaps. Harvard confirms that it borrowed funds for a major new science facility expected to cost several billion. In evaluating this investment, the main issues are did the campus expansion take place; was it a success; and did it produce an overall positive return for Harvard? Another key point is that they had to pay a lot of money to break the swap early—presumably Cornell had to do the same—which is usually a bad idea. Once the swap is in place it is typically better just to let it run to maturity and expire naturally.

All told, is the loss reasonable in the current financial environment? Cornell’s misfortune is not due to the plotting of evil banks or incompetent investment managers. All financial institutions lost a fortune in the financial crash, and today they are suffering due to the same issue of abnormally low interest rates. Banks’ return on equity are now about 5 or 6%, versus 20 or 30% in 2007, and banks like Deutsche Bank are verging on collapse today. In this respect Cornell did well to survive with their endowment intact, and despite their losses, the University is in a position where it is able to take advantage of the lack of competition once the sluggish growth in the economy has picked up sufficiently.