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Solent Capital: holding firm in a time of crisis |
Solent Capital was set up in 2003 by Geoff Smailes, Jonathan Laredo and Tim Gledhill, who had worked together at Bankers Trust in the 1990s before moving on to senior positions in structured credit and fixed income at, respectively, Credit Suisse, JPMorgan and Merrill Lynch. Solent has two lines of activity – CDO management and structured credit fund management, with two credit hedge funds.
Solent’s Credit Opportunities fund has $330 million in assets under management. It has produced annual net returns since inception of about 14%, with volatility of about 8.8%. In 2006, the fund delivered a 24% return. It is a relative value fund that specializes in credit derivatives at the liquid end of the market and uses credit indices, tranches and options of the credit indices to generate value. "We might look, for example, at the value of different tranches on credit indices in US, Europe and Asia over various timeframes, see how they are trading relative to each other and understand why they are priced differently," says Raymond O’Leary, a partner at Solent. "We would short one and go long another, depending on how we view that relationship."
It’s a niche space. Credit hedge funds tend to comprise high-yield stockpickers, macro managers and then relative value players. In the last category, along with Solent, there are an estimated 15 funds in Europe and perhaps 30 in the US. "The complexity of the strategy has kept the space from becoming too crowded," says Laredo. "The opportunities are not self-evident, and the transactions themselves can be difficult to understand." Laredo says this deters some investors. "Marketing the fund is a challenge as it requires more explaining than, say, a long/short fund, but we try to be as transparent with investors as possible and talk through the risk in some detail."
The credit crunch has hit returns for 2007 but the fund is still up 4.86%. "July and August was painful for us," says Laredo. "We had seen people getting concerned about the US housing market, and we thought there would be a flight to quality, and had taken risk out of the books. What in fact happened was that as the ABS CP market dried up, panic ensued and banks that had been long safer assets were forced to sell off quickly. Lower-yielding names and less risky tranches were experiencing adjustments two or three times greater than those of riskier assets. As a result our performance was poor for those two months."
Consistent with its risk management methodology, Solent reduced exposure and increased cash in the fund even when this resulted in realizing some mark-to-market losses on positions.
Laredo expects the markets to remain dislocated over the next three to four months. "Banks are the principal market makers in credit and until the current balance sheet overhang has worked through the system, we can expect the market to be driven by technical factors and supply/demand as opposed to fundamentals," he says.
Laredo says he believes now is an opportune time to set up a fund to invest in structured credit where assets are trading at distressed prices. Solent has launched a fund to do just that.
Laredo says: "Over the past five years corporates and governments have issued less debt but the markets for credit have grown in size and the number of investors has also increased. The principal driver of that growth has been the securitization market, including CDOs. The sub-prime and ensuing liquidity crises have left banks with large unsold positions in leveraged loans commitments, exposure to super-senior positions in CDOs and potential exposure to structured off-balance-sheet vehicles such as conduits and SIVs. Until they clean up their balance sheets (by selling positions and perhaps issuing more capital) they will find it difficult to write new debt or make markets in structured assets. As a result, any holder of the assets who is liquidity constrained will eventually be forced to sell, and investors whose mandates constrain them by rating or volatility will eventually capitulate as the rating agencies continue to downgrade assets and the downward spiral of prices continues.
"Taking advantage of the opportunity requires both term capital and the analytical systems to be able to value complex securities at an individual mortgage or loan level. We believe it will take between 18 and 36 months for this to play out. For successful well-prepared investors there are rich pickings to be had."