The European Commission (EC) has given AIG Global Investment Group the green light to acquire 65% of Bulgarian Telecommunications Co. (BTC), the Eastern European country’s largest landline telecommunications operator, for $1.47 billion. AIG Global Investment Group is the private-equity investment arm of American International Group Inc. (NYSE: AIG).

The EC ruled that the acquisition, the largest private takeover in the country to date, would not hinder competition in the region because AIG doesn’t have a telecom operation in the Europe Economic Area. 

Formerly a state-owned venture, BTC was sold to Iceland’s Novator Holdings and Boston’s Viva Ventures, part of Advent International Corp.

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Hedge funds and private-equity funds are both a sucker’s bet. As an investor, the best thing you can do to profit from these “alternative” investments is to avoid them altogether.

While I realize this isn’t a widely held viewpoint, it is one that’s gaining support. Just ask “perma-bear” Jeremy Grantham, the Boston-based money manager who supervises $150 billion in investments for Grantham, Mayo, Van Otterloo & Co. LLC. In an interview published earlier this week, the 68-year-old industry veteran predicted that the spiraling credit crunch could cause half of all existing hedge funds to close within five years.

Hedge funds “are piling on risks of different kinds and presenting it as out performance,” Grantham told Bloomberg News. “In a weak world [made weaker by a credit crunch], they pay the price of all the risk they’ve taken …they melt down.”

Indeed, the meltdown has already started.

Two hedge funds operated by investment bank Bear Stearns – wiped out when they made a big bet on the now-highly troubled sub prime mortgage market – filed for bankruptcy protection yesterday (Wednesday), while the assets of a third were frozen by the company (for a more-detailed report on Bear Stearns’ hedge fund woes, click here).

In today’s global capital markets, havoc can be wreaked in a flash. On Monday, Hedge fund Sowood Capital – which managed an unspecified portion of Harvard University’s $30 billion endowment – revealed it would shut down after a month in which lousy bond-market bets vaporized half its assets. In less than four weeks, Sowood reportedly saw its assets plunge from $3 billion to about $1.5 billion. To save what was left, the firm sold out to Citadel Investments Group, a hedge fund operator that manages assets of about $14 billion. It was Citadel that stepped in to rescue the energy portfolio of failed hedged fund Amaranth Advisors last year.

The Basics: Hedge Funds Math

If your broker hasn’t tried to talk you into investing in hedge funds, yet – and you have more than $1 million in “investable” assets – don’t worry, he soon will. After all, this is now a $2.4 trillion investment pool, and as you’ll soon see, your broker has a huge incentive to bring you into the fold.

He’ll probably call them “uncorrelated assets,” and will explain that their returns have very little to do with the general performance of the major U.S. stock indexes. For that reason alone – to “protect” a portion of your assets from any domestic-market nastiness – you really had to become a hedge fund investor.

But no matter what your broker might try and tell you about the hedge funds he’d like you to invest in, the reality is this: Since this type of fund is so profitable for the management group that runs them because of the hefty fees they’re able to charge, it should also be clear that they are quite profitable for the brokers who sell them. So you needn’t worry that you might be missing out on a truly exciting investment opportunity.

The term “hedge fund,” itself, is really quite a misnomer: Unlike an options-oriented “hedging” strategy that a company or a sophisticated individual investor will employ to protect their investments against a market downturn, hedge funds really don’t offer the same counter-balancing bets.

The truth is that the term “hedge fund” is used as a kind of loophole. It distinguishes them from such retail offerings as mutual funds, which are open to most all retail investors, which are therefore heavily regulated as a result. Hedge funds are only open to qualified, or “accredited” investors, most of them wealthy. Thanks to this limited potential audience, hedge funds are largely free of direct oversight by regulatory authorities, and can operate in a great deal of secrecy. They are free to charge large performance fees, and can utilize strategies that are much more complex and often take on much greater risk than the mutual funds most retail investors are familiar with.

But the biggest secret of all – and one that your broker almost definitely won’t reveal to you – is that the average hedge fund return isn’t very exciting: It was just under 12% in 2006, and was only 4.5% in the four months to April 2007, according to one report. By comparison, the Standard & Poor’s 500 Index returned 15.8% for all last year, and was up 5.1% in the first four months of this year.

However, due to a factor known as “survivorship bias,” the “real” hedge-fund results are probably actually much worse than most research shows. You see, hedge funds that disappear during the year – logically speaking, the worst-performers of the lot – are taken out of the results, a fact that very likely skews the results and makes them appear much better than they actually are.

Barclays Capital has calculated that hedge fund returns are overstated by as much as 2.4% per year, which takes the forecasted 12% return all the way down to 9.6%. Now go in and subtract the 2% management fee and a 20% performance fee (20% of the 9.6% average hedge fund return), and you’re down to 5.7%.

Now get this: Because of the way those management performance fees are calculated – that 20% management fee isn’t refunded on losers – even the average annual return of 5.7% that we’ve cited here is far too high.

Look at it this way. Let’s say that you’ve made equal investments in three hedge funds that as a group have generated an average annual return of 9.6%. But one fund returned 50%, the second 28.8%, and the third lost 50% of its principal value (the average of which is 9.6%). You might just think that the management fee on an equal investment in all three funds would be 20% of the 9.6% average return, or 1.92% (20% x 9.6% return = 1.92% performance fee for the fund managers). But it doesn’t work that way.

Instead, your management-fee charge for your investment in the three funds would look more like this. You’d pay 20% of (50%/3 funds) plus 20% of (28.8%/3 funds), or 5.25%. And that knocks your net overall return down to 2.35% – quite a difference from the 12% that you foolishly might have been anticipating.

To pretty it up and make it look all the more attractive, brokers will often quote you the so-called “top-quartile” investment return. That’s the return made by the top 25% of all funds. If you invested at random, you would have had a 25% chance of achieving this performance. The broker may even compare this top quartile figure to the top quartile return generated by conventional mutual funds.

This is the stockbroker’s version of a “carny” trick. He does this because hedge funds invest in such a wide variety of different things that their returns have more “dispersion” than stock funds – in plain English, they’re riskier – so that the top quartile is further above the median for hedge funds than for stock funds.

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The Problem With Private Equity

As an alternative to a “hedge fund” your broker may try to get you to invest in a “private equity fund.” These don’t invest all over the place, like hedge funds, but instead buy whole companies, “improve” their operations and sell them again. Private equity funds have one advantage over hedge funds and two disadvantages. The advantage is you have a rough idea of what they are doing: Their strategy isn’t secreted away in a so-called “black box” that’s filled with incomprehensible, pseudo-mathematical jargon.

One disadvantage is that to return a profit they must either sell the company they’ve bought on the stock market via an Initial Public Offering (IPO) of stock, or to other companies whose shares are listed on the stock exchange. That means that these funds are also not really “uncorrelated” investments, as they so often claim private equity funds to be. And in a bad market – such as the downturn of 2001-2002 – they can do appallingly badly.

The other disadvantage is that, as well as benefiting from the same “20% for us if we win, nothing for you if we lose” fee structure of hedge funds, private-equity fund managers are rewarded with performance bonuses that are based on the value they’ve added to the companies they’ve acquired with the intention of later selling.

To assess this, the fund managers hire “tame” accountants as business-valuation consultants, and then ask these advisors to estimate the company’s value. Since the accountant’s fee is based on the value of the company, he’s got a real incentive to make and justify a very high estimated value. Management gets paid its performance bonus based on that estimate. So even if the company ends up selling for a lot less – even at a breakeven price, or still worse a loss – management has already been paid. So even when private-equity-fund investors don’t receive any money, the fund’s managers still win.

As an avid Red Sox fan, I have been heartened by the team’s renaissance in recent years, a turnaround fueled by the untold billions of their new principal owner, John Henry, a hedge fund mogul who bought the team in 2002. He’s rich like New York Yankees owner George Steinbrenner. But because Henry made his fortune via hedge funds – while “The Boss” inherited his (thanks to a shipbuilding company) – we BoSox fans like to think that John is smarter than George.

But there’s one flaw in that logic. As the title to Fred Schwed’s 1940 investment classic asked: “Where are the customers’ yachts?”

Since December 2004, two months after the Red Sox exorcised the “Curse of the Bambino” and won their first World Series since 1918, Henry’s funds are down more than 35%. What’s more, over the last decade you would have done better buying an index fund or investing in Treasury bonds than investing in Henry’s funds. For this service, Henry charges the usual hedge fund fees of 2% of assets under management, plus 20% of the profits – indeed he is sometimes credited with inventing that typical hedge fund fee structure.

This is, of course, bad news for the Red Sox: Brett Arends, of TheStreet.com, recently said that Henry’s assets under management had declined from $2.9 billion to $1.4 billion, so there may well be no more $103 million Japanese pitchers in the team’s future. However it’s even worse news for Henry’s investors, particularly those who bought in 2004, when performance really started to decay.

In short, hedge funds and private equity funds are both a mug’s game and should be avoided.

 If you want “uncorrelated assets” you should look at some top-quality stocks from some of the Asian markets that are still trading at very reasonable levels: Such countries as Japan, Korea and Taiwan haven’t seen their indices streak into record territories, and are not trading at the same pricey levels as their U.S. rival.

It’s true that their returns are not completely uncorrelated with the U.S. markets, because today’s global money market is just one gigantic muddy pool. But my very detailed research shows that at least the domestic economic situations in these three countries – as well as the political factors that affect them – are very different than those facing the United States.

As for private equity funds, they are a good investment only in the depths of the most-terrible markets – like in the late 1970s and early 1980s, when stocks were so disdained that Business Week magazine actually carried its now-famous cover story, “The Death of Equities.” It’s during those periods that you’ll find lots of companies available at very cheap prices. But, of course, we are nowhere near that state at present.

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Just two days after Dubai Aerospace Enterprise offered to buy Auckland International Airport in New Zealand for as much $2.1 billion, the government-run aviation investment group announced a week ago that it is scouting airport projects in Europe.

Only three months ago, Dubai Aerospace Enterprise, or DAE, agreed to pay $1.8 billion for two U.S. aviation-maintenance companies owned by The Carlyle Group, the noted Beltway buyout firm. DAE’s goal: To build a $15 billion global aerospace enterprise that will link established markets with their newly emergent counterparts, and to streamline travel both into and out of Dubai, which is establishing itself as the epicenter of the Middle East.

These latest deals also position Dubai at another epicenter: State-run equity funds, and “strategically focused” financing funds – two of the newest trends in the private-equity and venture capital realms.

Private Equity: The “Dot-Com” of the Present

The term “private equity” has been one of the major buzzwords of the past two years, assuming a position of importance like that of the term “dot-com” in the late 1990s, or LBO (leveraged buyout) in the late 1980s. And private equity has been as crucial to market’s record-breaking run this year as its brethren were to the major market surges of their time.

According to one market researcher, the announced private-equity transactions for this year’s first half already exceed the dollar value of deals for all of 2006: $330.3 billion through the end of June this year, compared with $329.4 billion for all last year. And though 2007 is only half over, the $555.5 billion in mergers-and-acquisition deals announced in the first six months of this year is only a third less than the $847.5 billion in deals announced for all last year.

Even during a stretch of admittedly tepid earnings, with money flows this powerful, it is no surprise that stocks have posted one record after another. Think of it this way: It took the benchmark Dow Jones Industrial Average more than two years to pierce the 11,000 level. After that, it took only eight months to surge from 11,000 to 12,000, six months to move from 12,000 to 13,000, and then only three months to make the jump from 13,000 up through the 14,000 level.

While market surges of this magnitude – and even better elsewhere in the world – stock market profits have literally poured into shareholders’ brokerage accounts the world over, an overseas export boom has flooded the coffers of national governments in China, Russia and the Middle East with foreign-currency reserves beyond anything they’d ever need to run their countries. In pursuit of larger returns – and for other reasons, as well – many governments have established state-run venture funds as a vehicle to deploy some of these currency assets.

But, as is often the case when governments try to make a splash in a private-sector venture, these state enterprises are rather late to the party, as a myriad of problems are increasingly manifesting themselves in the private-equity and venture-capital markets. That party isn’t over, by any means, but the competitive stakes are clearly escalating. For insights on the problems state-run funds face, and what those issues mean for investor, click here

In response, some of the leading funds are adopting a more-focused approach – a move that in industry lexicon is known as “getting strategic.” With a strategic – or highly focused – approach, a fund has the rare opportunity to add marketplace heft at the same time as it spotlights substantial cost-cutting opportunities, which will boost profits for itself and its shareholders. It does so by combining two or more firms that operate in similar, or highly complementary, businesses, which adds market share, boosts its product coverage, and increases sale opportunities. And, because it allows for the combining of such functional operations as human resources, finance, public relations, and others, the parent company can streamline these units and reduce overhead costs in kind.

As an example, consider the newly public Blackstone Group (NYSE: BX). With its recent proposed purchase of DJO Inc. (NYSE: DJO), the maker of orthopedic sports-medicine products. After it completes the $1.6 billion buyout of DJO, Blackstone will merge it with its own ReAble Therapeutics, another orthopedic-device company, and one that it acquired last year.

Other buyout firms are looking to do similar things: For instance, the private-equity firm Apollo Management last month agreed to buy specialty-chemical producer Huntsman Corp. (NYSE: HUN) which it intends to combine with its existing Hexion Specialty Chemicals business unit.

Now Dubai is following suit. And it’s focusing on the aerospace and airline sectors. Earlier this summer – in a deal that new French President Nicholas Sarkozy helped engineer – Dubai International Capital, a unit of the government-owned Dubai Holding, ponied up $850 million to purchase a 3.1% strategic stake in the European Aeronautic Defence and Space Co. NV, or EADS (EPA: EAD.PA), the troubled parent of European airliner-maker Airbus SAS.

Dubai’s announcement a week ago that it’s scouting airport projects in Europe was essentially that – an announced plan, but one that’s largely bereft of specifics, with officials not saying where, or when, this would get done. Even so, Dubai’s DAE officials made sure to underscore the venture’s commitment during interviews with the global business-news media. “There will be something in Europe,” Sheikh Ahmed bin Saeed al-Maktoum, a member of Dubai’s ruling family and chairman of DAE, told Bloomberg News a week ago. 

In Auckland, however, much has been said and written about DAE’s proposed purchased of AIA, the international airport located at strategic halfway points between Dubai and North, Central and South Americas. AIA directors unanimously approved DAE’s bid. But in an eerie reminder of a Dubai-fund debacle involving U.S. port management a little over a year ago, Auckland’s local government and some national political parties are opposed to overseas control of New Zealand’s largest airport, which receives 70% of the country’s incoming international flights.

Businesses that touch on national security may be one area where state-run equity funds from a foreign market may find their efforts blunted time and again. For this New Zealand deal to go through, 75% of AIA shareholders need to approve the sale. And Auckland and Manukau city councils together own 22.8% of AIA’s shares. The mayor of Manukau said he opposed the proposal and said he will work with Auckland’s City Council to defeat it.

Shareholders will vote on DAE’s proposal in November.

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Dubai’s Shifting Economy

DAE’s airport proposals and projects tell a larger story about Dubai. The emirate’s economy was built on the oil industry in the early 1970s. And now oil and natural gas account for less than 3% of its revenues, USA Today reported.

Now, the Emirate’s revenues are primarily garnered by its Jebel Ali Free Zone, an economic zone with lucrative business and tax incentives. Increasingly, however, the Emirates are evolving into a tourism destination.

A typical Dubai vacation (or business trip) can include indoor skiing, sand dune cruising, swimming in the Persian Gulf and shopping during the heralded month-long, citywide Dubai Shopping Festival.

Instead of oil, the economy shifted its focus to services, and real-estate prices cycled higher, in kind. The value of its real estate is today evident in Dubai’s enormous skyscrapers and hotels. Earlier this month, Dubai grabbed headlines by proclaiming that the Burj Dubai is officially the world’s tallest skyscraper — and it’s not even completed yet. Add to that Dubai’s proclamation that it has the world’s only “7-star” hotel, and you’ll see the image of inviting opulence that the country is trying – brashly – to cultivate.

But to nurture this vision of a global destination for international tourists and globe-trotting business types, Dubai city needs to make itself much more accessible. And that’s where the worldwide airport network comes into play. Indeed, unlike other funds that “get strategic,” Dubai is approaching this both as a business, and as a means to an end – a business double-play that’s virtually certain to make it a winner with one or both of its strategic mandates.

The New Zealand Herald reported that the DAE sees AIA as the first of many airports that will eventually serve as network hubs for worldwide travelers, while also acting as a jumping-off point that serves newly capitalist markets in such countries as China and India.

Why Auckland, and not Sydney or Melbourne? Because Australian laws forbid foreign control of major airports.

A key beneficiary in all this is Emirates, the Dubai-based and government-owned airline that is currently the eighth-largest international passenger carrier, with 20 million a year. Emirates’ five-year plan is to expand its fleet by 157 planes, and to double the number of its destinations.

By capitalizing on the two latest trends in the private-equity sector – government support in the form of a state-run fund, as well as a carefully chosen strategic focus – it certainly seems to face favorable odds. “You will see in the future we have plans to serve New Zealand from Far East points in our longer-term plans,” Gary Chapman, head of Emirates’ ground-services company, Dnata, told the New Zealand Herald. “That will happen. There is always the possibility of going beyond, going east, beyond New Zealand, to the Americas.”

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