Invariably, our stories prompt people to throw roses at us in praise. However, some readers wrote in after a story about the new hedge fund firm Orchard Capital Partners, which was founded in 2009 by Stu Wilson and Teall Edds, formerly of Stark Investments. The story concerned Orchard's poaching of star Citi prime broker Michael Mills.
Some people queried whether Stark had shut down its funds and transferred them to the newly founded Orchard Capital Partners because the Stark vehicles were a long way below high-water marks. That, they said, was the issue we should be focusing on, and not the establishment of the new firm.
So, we put those points to Teall Edds of Orchard Capital Partners, and asked him if they were true or not.
He says that these comments reflect misunderstandings and require correction. In fact, the two funds that transferred from Stark to Orchard were at or above their high-water marks at the time of transfer. Centar Investments was Stark's Asian fund dedicated to illiquid credit strategies. The management of the fund came across to Orchard at the end of last year, along with the management of the multi-strategy Stark Bosera China Opportunities Fund, since renamed Orchard Makira Fund.
Most attention has been paid to the better-known Centar, which was down 0.89% in 2008 and was up 4.45% in 2009. Through January 2010, Centar was up about 37% since its 2006 launch despite volatile credit markets.
The following is a Q&A with Teall Edds in which the hedging strategy is fleshed out.
Has your strategy been hedged properly or did it drag down performance?
Teall Edds: Hedging is a wonderful thing. It gives portfolio managers the opportunity to protect their overall portfolio while pursuing specific investment strategies. The construction of the Centar portfolio needed to address the inherent strengths and weaknesses of the mandated credit strategy. The strategy is about capital preservation through deal structuring and collateral to guard against idiosyncratic borrower risks, rather similar to how a commercial bank puts together its loan structures.
But beyond that, portfolio hedging is critical for a fund like ours, such that you can generate hedge gains at times in which the mark to market of your overall asset portfolio is adversely impacted by systemic disruptions such as those we saw in 2008.
Didn't 2008/2009 wreck structured deals?
At times like 2008/2009, you are inevitably going to lose on some investments. Even on stronger investments, the mark to market is going to get crushed, even if there is nothing wrong with the underlying credit. Illiquid credit got hit amongst the hardest of all asset classes in this crisis.
The way we would think about hedging a portfolio like Centar is not necessarily by hedging the recovery value of the assets, because that is what your deal structures should do. Instead you're thinking about hedging the mark to market movement of the overall portfolio. One way we did that was by owning equity index puts. When those options were purchased, they were all out of the money. There was a time in 2007 and early 2008 when vols were cheap enough that you could find 50 or 75 strike puts at very affordable pricing. Equity index puts help cover the potential impact of systemic tail risk. Centar could afford to buy puts over time by using a portion of the carry from the credit book. Buying equity vol works well because credit and equity can be highly correlated in this part of the world.
Secondly, the collateral packages on many deals in the region include equity, and therefore equity indices tend to have a high correlation to the value of collateral assets across Centar's portfolio.
What credit protection did you source?
The credit protection market is not all that deep in Asia. We find that sovereign credit default swaps are the most obvious direct credit proxy hedge for a portfolio like Centar, so we generally carry sovereign CDS as a base hedging instrument.
For the credit market, you're really looking to manage the impact of liquidity flows into and out of the region. In markets such as Indonesia, Philippines and Korea, the pricing of sovereign risk tends to be correlated with the corporate credit and liquidity environment, but it can be difficult to monetise the explosion of mark to market gains from CDS amid a gapping market. So we really need to diversify the instruments we use for hedging.
What other instruments can be used for hedging credit?
The better overall hedge for Centar is index equity puts, which provide good gamma-inducing tail risk hedges that mitigate the adverse impact of a big equity market fall. One tends to get much better liquidity from equity puts than from CDS when you need to adjust your hedge profile.
We constructed our hedge book by utilising scenario analysis. We had assumed that as if certain equity markets were down 60%, we should expect a 40-50% decline in the mark to market value of many assets in Centar's illiquid credit book. So when some equity markets were down 70%, it was possible to make some money back on the hedges. As the market falls, you're dynamically hedging the book, rolling down (and out) some puts and taking some cash into the fund
What advantage does this give you?
Those equity hedges gave us correlated mark-to-market gains at a time when the credit book was getting hit, as positions were being marked down by the market to quite distressed levels. Sure, some issuers defaulted as the credit crisis worsened, but the bigger problem was that even the better credit names had limited buyers at that time, hence painful asset mark-downs. There's quite a bit of basis risk between the assets and the hedges, but remember that we're talking about hedging systemic risk in an environment in which many asset classes become highly correlated.
The other thing that worked out well for us was that, in late 2008, we identified cheaper hedge protection from currencies. Equity volatility became prohibitively expensive in the second half of 2008 - when many equity vols tripled - but currency puts were still trading at very cheap vol levels in several regional countries. Historically, currency volatility has been a great hedge for a big blow-out in the market.
Were you trying to also profit from FX plays?
We didn't necessarily take a view on the currencies themselves, nor did we have significant direct local currency exposure. We simply recognised that currency puts were cheap enough to construct an effective tail risk hedge in the event that macro conditions continued to worsen.
How are valuations now?
The mark-to-market values of many illiquid assets have been creeping up slowly, but are still at levels not too far above what they were in March 2009. With Centar, we were able to dramatically reduce our hedges, and now have a book that we believe has excellent value. The put options bought our investors capital preservation. Centar didn't have to sell assets at a time when nobody wanted them. The hedges earned us holding power. Of course, we had the luxury that this was not a strategy that required much leverage.
How did the Centar transfer from Stark to Orchard work?
It went smoothly. We received unanimous consent from Centar's investors to permit the fund transfer. The fund was renamed Centar Select and, in the interest of fairness to investors, Centar's assets were side-pocketed. Cash distributions are now being paid pro-rata to investors from the realisations of asset harvests over time. To date, this process has actually accelerated cash distributions to investors. There is no timeline requirement to distribute cash, but we are aiming to generate returns and release cash on a pace that serves the best collective interests of Centar's investors.
All new investments into the Centar strategy are undertaken in Orchard Centar, the newly established successor fund. A number of Centar Select's investors have been reinvesting their cash distributions into Orchard Centar, and others have simply taken their liquidity back. Orchard Centar has received quite a lot of interest from new investors since we opened it last month.
What are your connections with Stark nowadays?
Orchard Capital Partners is operated independently. We are a sub-adviser to Stark Investments for its remaining Asian illiquid assets. We have a strong relationship and have many good friends there.