| Harold Ornberg and his team lead a new breed of hedge fund |
LAST YEAR BOUTIQUE hedge fund Orn Capital created a European distressed-debt hedge fund, the only one active that is purely dedicated to Europe. The fund is Orn Capital’s third, and fund of funds managers are singing its praises. Other funds include its core merger arbitrage strategy and a value event (long/short equity) fund.
Swede Harald Orneberg created Orn Capital in 1999. Since then, the total size of assets under management has grown to $324.5 million. Orneberg, now aged 40, resigned as vice-president in equity risk arbitrage at Salomon Smith Barney in London four years ago and started Orn initially as an account manager on behalf of hedge fund Paloma Partners.
By March 2000 Orneberg had created an $80 million offshore merger arbitrage fund and it was run alongside the managed account until the end of 2001. “I was fortunate enough to launch the merger arbitrage strategy at a time when there was an extraordinary level of activity and positive investor reception to the strategy,” says Orneberg. He hired Australian Lindsay Jones to the merger arbitrage fund from McKinsey in April 2001. He later employed another Swede, Fredrik Ervanius, and in February 2002 they created a European value event fund.
Orneberg is always on the look-out for people with ideas, ability and enthusiasm to join his team and to add new funds. So when Richard Barnes and Gordon Webb approached him about setting up a distressed-debt fund he was happy to discuss the possibility. “Gordon and Richard knew the [distressed debt] strategy very well, but they didn’t know hedge funds,” says Orneberg. He met them in February 2002 and in August arranged an investment of $25 million by HVB in the new Orn European distressed debt fund. “We’ve witnessed in the US quite often distressed funds combined with merger arbitrage. They’re both event strategies but they tend to be counter-cyclical to each other,” says Orneberg.
Webb and Barnes have a long history of working together and vast experience of companies in distress. Before they joined Orn they had been working together at Bank Austria in London where Barnes was CEO. Webb was in the workout area where he managed the bank’s problem loans and also invested in the asset class.
Boring is good The two new fund managers are well into their fifties and so by far the oldest at Orn Capital, dispelling the myth that hedge fund managers are always young and crazy punters. One fund of funds manager who regards the fund as very savvy, says: “They’re a bit boring, but boring is good in this case.”
The Orn European distressed fund invests 80% in western Europe, almost always in the senior end of the capital structure and in bank loans and corporate bonds. “We invest in distressed senior claims, either in bonds or bank debt. Where the company has high-yield issues, we invest in the bank debt as it’s senior to the high-yield issue,” says Webb. The fund doesn’t invest in high-yield bonds where they are subordinated.
Launched in August 2002, by the end of April the fund had been built up to e31.4 million. Although this is small, it has been an extremely difficult fund raising environment. As with all three of Orn’s funds, minimum investment is $1 million. The target net return to investors for the fund overall is 15% plus. It is also subdivided into the different risk categories: 12% plus for lower-risk investments and 20% plus for higher-risk ones.
The fund has made a lot of money from its dealings with Marconi. This time last year Marconi’s bonds were trading at around 30p. They sank steadily in price from April last year through the launch of Orn’s distressed fund in August until around September when they fell to just over 12p. “We watched them at all times and worked on the information we had and decided that at this price it was potentially interesting,” says Webb. The two fund managers were able to source some bank debt and bought into it at around 14p. “We were one of, if not the first non-bank financial institution to join the bank group,” says Webb. As of the middle of May, the bank debt was trading at around 35p, because of market recovery in the telecom sector and in Marconi itself. “We are particularly pleased with that trade,” he says. “We correctly identified the value in Marconi.” They closed most of the position in the middle of May.
Webb and Barnes also bought some of the senior bank debt in the “when issued” market. That is, at the beginning of May they agreed a deal whereby a trader would sell them the senior Marconi debt at an agreed price when it was issued. “That’s risen substantially in the last three weeks,” says Webb. The deal was completed in late May. “We bought it at 85, it rose to 96 and it’s now at 92. We bought it at the beginning of May,” says Webb. “We made a large amount of money on Marconi.”
The two men have also dabbled in capital structure arbitrage. “We have, in the past, bought bank debt without the confidential information and shorted the subordinated bond,” says Webb.
The managers are also looking into opportunities in credit derivatives. “We haven’t yet used, but might use, the credit default swap market to take positions in the distressed market,” says Webb.
The core strategy for Orn Capital remains the one that Orneberg initially launched in December 1999. At the end of 2001 the European merger arbitrage fund had assets of about $135 million and had almost doubled by the end of 2002 to reach about $265 million. This fund dwarfs both of Orn’s other funds, the value event and distressed debt, with $273 million in assets.
Orneberg claims that he decided to leave Salomon Smith Barney in London, where he was a vice-president in equity risk arbitrage, for lifestyle reasons. Working at a hedge fund “is a healthy life: up early and to bed early. There’s minimum confrontation because you deal with brokers who smile on the phone,” says Orneberg. Before SSB he worked at private-equity firm Industri Kapital. He believes that life at a hedge fund is less stressful than private equity. “You do 20 to 30 bargains on a daily basis so stress is in smaller chunks. It’s more like a gentle shower of stress rather than a once-a-year bath in stress,” he says.
Jones describes working with Orneberg as “an intense experience”. He adds: “He has the classic traits of an entrepreneur: driven, action orientated. He’s got perspective and sees the big picture.”
Jones joined after four years as a strategy consultant at management consulting firm McKinsey where he helped to build and launch an e-commerce business in the financial service industry. Before that he was at Australian investment bank Macquarie Bank in Sydney.
The merger arbitrage fund focuses on announced mergers and acquisitions where one of the two companies must be in western Europe or one of a small number of Commonwealth markets.
The merger fund’s goal over a business cycle, usually three to five years, is to deliver 10% to 15% per annum in returns to investors. In 2000 net returns for the year were 13.5%. In 2001 they were 8%, in 2002 0.5% and this year to April 1.42%. Last year was a tough environment for making money for everyone. Stocks were volatile and the M&A market dried up. But, Jones says: “In the US, in particular, average returns in risk [merger] arbitrage were negative several percent last year, while returns in Europe were probably flat or slightly negative.” However, they performed much better than the stock market, which was down 25%.
The Autostrade play One of the deals the fund made money out of last year was the leveraged buy-out of Italian motorway operator Autostrade. The consortium bidding for it announced in November last year its intention to offer e9.50 a share. This price was considered by the market to be on the cheap side. The transaction was over e10 billion and so its success rested on the willingness of several banks to lend the consortium capital. That, in turn, was reliant on the banks’ comfort with income projections for Autostrade. Throughout the transaction there was much uncertainty about the projections and, therefore, whether the consortium would be able to raise the funds.
In February, the bid was increased to e10 a share to encourage the support of institutional investors in the company as the deal needed two-thirds of shareholders to accept it. In the end the transaction closed on time in late February with an improved price. “We bought the shares at prices lower than that [e10 per share],” says Jones. “Depending on where the rumours were the stock was trading from e8.90 up to about e9.80. But, at no stage during the transaction did it trade at e10 until the improved price came through.”
The team also executed a related trade involving Autostrade options. “We were able to look at selling options because there was some uncertainty and some time value of that uncertainty,” says Jones. The fund sold options in December and January for a premium: a form of covered buy (shares) and write (call) options trade. Jones explains: “You were basically taking advantage of the rumours and the uncertainty that the banks might pull out,” says Jones. “At different times we sold options with strike prices e9.50 and also e10 which was a way to eke out a bit more return.”
The annualized return on the money invested for the straight trade where the fund bought the target stock and held it was around 8% to 9%. There were additional returns from the options trades.
The outlook for the merger arbitrage strategy this year is positive, says Jones. “Sentiment is improving, especially in Europe,” he says. “We’re more optimistic and there’s definitely a pick-up in opportunities which will flow through to returns.”
When Orn Capital’s finances grew rapidly after great years with its merger arbitrage fund in 2000 and 2001, Orneberg decided to create a new fund. In October 2001, he hired Ervanius, who had been director of corporate finance at UBS Warburg for around 18 months. Previously he had been an investment professional at Merrill Lynch Investment Managers for four years.
The two created Orn’s European value event fund, which focuses on stocks in the EU, the Nordic region and Switzerland, with a market capitalization of between e0.4 billion and e4 billion. For the purpose of the fund, value is defined as non-TMT, non-biotech and non-pharmaceutical stocks. Managers of such funds must avoid the value trap whereby cheap-looking stocks are bought but never gain value and so don’t provide any return. The managers therefore look for a catalyst, such as M&A activity, likely to drive up a share price.
In the first six months the fund reached a size of e5 million. At the end of April it was close to e13 million. It’s typical for the fund to be evenly matched between long and short positions and in April it held 17 long positions and 18 short.
On target for the year The fund’s annual return target is 15% with a maximum volatility of 7%. Net return this year to the end of April was 3.58%. If Ervanius and the team continue to make similar returns for the rest of the year, the fund’s first full calendar year, they should come close to meeting their target. In the past nine months the fund has only had one down month. Ervanius says: “I think this is quite unique in European long/short.” In March this year the monthly net return was -1.07. “This was primarily due to two short positions where other investors with short positions got nervous ahead of the Iraqi war and covered their positions. This meant that the stocks went up a lot, which was costly for us,” he adds.
The biggest down month since the launch of the fund was June last year when the net monthly return was -4.97. This was primarily due to the fund’s gross exposure of 130% in combination with a 23% net long exposure. “That on its own, because the market area where we invested [value, mid-caps] was down by 10%, means we lost 2.99% just because of exposure,” says Ervanius. On top of that, the fund had three different long positions with two characteristics in common: they were difficult to value and had a management credibility issue, positions that were slightly more risky than the usual value stock. “We spent a very long time analyzing these three stocks and were comfortable with the issues,” says Ervanius. However, as the market started to become increasingly risk averse in May, difficult to value mid caps with management issues were the first to be sold. “After June, we tightened up the portfolio construction rules in order to avoid this ever happening again,” he adds.
In April, investments in Dutch retailer Vendex and French bottle manufacturer Sidel were the main contributors to returns. Sidel, after being taken over by Tetra Pak, contributed 50bp and Vendex on the back of strong sales performance added 111bp.
Ervanius and his team screen for interesting opportunities in the market, looking, for example, for high free cashflow to market cap, high level of fixed assets to market cap and low sector relative valuation. In September this picked up Danske Traelast, a DIY and building materials group. This was trading at only four times the free cashflow that Orn expected it to produce in 2003. It had nearly the equivalent of its market cap in property on balance sheet. The company was, at the time of investment, 30% owned by Codan, a Danish subsidiary of UK insurer Royal & Sun Alliance. “Our assumption was that they [Codan] would be looking to sell and that they could realize much higher value than the DKr101 that they were trading at when we started to look at it,” says Ervanius. “We then spoke to a number of private-equity firms to get a feel for the appetite and we met the company’s CEO three times in six months.” In October last year Ervanius built up a big position in Danske Traelast. In February, Codan announced that it was looking for a buyer and the share price went from DKr120 to DKr145. There was a bid from a financial buyer in April and the deal completed in May at DKr171. Ervanius closed out in April, generating a total return of 185bp.
The value event fund also expects to make money from shorting Royal Caribbean Cruise Lines, the second-largest cruise operator in the world. In addition to the difficult environment for the travel industry, the cruise operator’s balance sheet is stretched, with a very high debt to equity ratio. It is currently 60% leveraged and Ervanius expects it to increase to 70% this year, mainly due to an 18% increase in capacity for 2003. “We expected first-quarter results to be very bad,” says Ervanius. He also expects first-half results to be bad. “There’s at least 30% downside in the stock price. The company could go bust or at least be forced by its banks to do a rights issue,” he adds. If the cruise operator does a rights issue it’s likely to be at a discount, allowing Ervanius to cover his position, buying the shares at a lower price than at which he shorted them.
The outlook for the value event strategy is positive, Ervanius reckons. He feels there is huge potential on both the long and the short side. “There are lots of mispriced companies out there,” he says. He explains that some are dirt-cheap but still have good cashflow and others are starved of new money because equity markets haven’t been open to rights issues for two years. They will either go bust or be forced to make a dilutive rights issue, which make a good short case. “There will be a flood of rights issues when the market opens. The pipeline for IPOs and rights issues is very significant.”
Orneberg plans to continue to increase the number of funds at Orn Capital. He says: “This year we have the capacity to add two or three more funds if we meet the right teams.” Employing talented professionals who are used to a high income and exceptional bonuses brings challenges. Orneberg says: “One pitfall is thinking you can run a hedge fund with less than $200 million in assets. You can run it with $30 to $40 million for 18 months if you’re a single manager but that’s as long as the team will suffer working too hard and being paid too little.” He reckons that a manager working on a $35 million fund is making less than a prop trader. Only when the fund reaches $100 million will there be any change in pay.
