Interview with BlueMountain Capital
Hat Tip to International Pymp for sending this to me. Very insightful interview with BlueMountain, a great long/short credit fund:
BlueMountain Capital Management was one of just nine managers on the receiving end of 38% of all new money put into hedge funds this year, according to a report earlier this month from Bloomberg News. The multi-strategy, long-short credit house launched by Stephen Siderow and Andrew Feldstein in 2003 with $300 million now manages about $7 billion—about $5.3 billion in hedge funds and $1.7 billion in collateralized loan obligations. FINalternatives Senior Reporter Mary Campbell spoke to Siderow recently about credit market opportunities, ratings-constrained investors and how a version of "the Paulson trade" saw BlueMountain through the financial crisis.
What opportunities did you see in credit markets that inspired you to launch BlueMountain?
The driving theme is that the credit markets present an incredibly rich and persistent opportunity set because of the very layered and constrained nature of many of the market participants. It’s a very large market, larger than the equity markets, but with a lot of diversity across individual issuers and instruments types in which many investors are heavily constrained. Those constraints range across factors like ratings, industry sectors, credit quality and liquidity. For example, consider a typical intermediate-term investment-grade bond fund. The manager of this fund is constrained by duration (medium-term only, not short- or longer-dated), credit quality (investment-grade only, not high-yield) and instrument type (bonds only, not credit default swaps or loans). But that creates persistent mispricings and opportunities for us who take a relative-value investment approach in credit.
You launched in 2003 with no idea what was coming in 2008. Talk about how the crisis and its aftermath have affected your business?
It’s funny, I’ll give ourselves a little bit of credit: Andrew and the investment team did anticipate some of the events of 2008; specifically, we saw the growing bubble in the synthetic securitization market—synthetic collateralized debt obligations—happening in ’05, ’06 and ’07. I can show you investor letters that we sent that used analogies like "a spring being wound tighter and tighter" as we described the effect of ratings-oriented buyers’ demand for triple-A and double-A and single-A structured products which compressed credit spreads and drove senior risk tranches far too tight (and the prices far too high).
We saw a great relative-value opportunity to short the senior tranches of risk while at the same time being long the unrated and cheaply priced equity risk of those structured credit products. In a way, we had a version of the Paulson trade from 2005-2007 but in corporate credit. Now, we never claimed to be smart enough to predict when that leveraged unwind was going to happen, but it’s something that we thought was certainly going to happen at some point and we wanted to be positioned in a way to take advantage of it.
We certainly had other things that didn’t work as well in ’08. Our fundamental positioning was defensive with more longs in senior secured loans and most shorts in unsecured debt via CDS. So while cash loans dramatically underperformed CDS—another version of the leverage unwind—on balance, the portfolio withstood the crisis pretty well and was well-positioned for 2009.
Would it be fair to say you were suspicious of the triple-A and double-A ratings on structured products at that time?
I would not say suspicious; I think we were skeptical. We are unconstrained by ratings and therefore, we look for actual value in the underlying securities regardless of rating. We are, however, aware that a lot of other investors are ratings-constrained and those constraints present opportunities. That was one of the opportunities—the ratings-constrained investors were forced to buy the rated tranches, making them expensive in our view, and unrated tranches had little demand because ratings-based investors couldn’t buy them, and we thought they were cheap.
That dynamic continues today. We still find individual corporate securities—loans or bonds—that we think are cheap, in part, because they have a rating that isn’t justified by the fundamentals. Often, credits are bought more than they should be, because they have a higher rating than they deserve, or they’re sold when they shouldn’t be, because they have a lower rating than they deserve.
Are you seeing an increase in demand for long/short credit from pension funds?
Certainly. Our experience at BlueMountain is that the bulk of our inflows over the last couple of years have come from pension funds—a mix of U.S. public, Canadian public, and European public and corporate. Our assets have been growing fairly steadily and the growth has been driven predominantly by pension funds.
In fact, our asset base overall has shifted. If we’d had this conversation in ’07 or early ’08, we were probably 60% funds of funds and maybe 30% pensions and 10% principals and others. Now it’s probably been inverted, with 60% direct pension investors, about 30% funds of funds and about 10% principals and others.
That’s reflective of that change in the investor base and the demand for long/short credit investments from pension funds. I think what’s driving that trend is a recognition that well-executed long/short credit investing offers a very nice risk/reward profile. Typically, if you’re successful, you’re able to participate in a lot of the upside of the market but protect on the downside.
I’d say that many pension funds, through their need for duration, have a pretty sizeable existing long-only credit book—they already own a whole bunch of bonds and loans as part of their duration-matched long-only portfolios. And there are a few reasons they are now deploying capital into long-short credit strategies. One is that they want to diversify the long-only credit book or bond book. Another reason is the desire for higher returns. Many investors are disappointed with returns from equities and are taking a portion of capital from their equity portfolios and putting it into "alternatives" like long-short credit. Finally, long-short credit is often part of a diversified "alternatives bucket," and we see allocations from that too.
Would you say pension funds are becoming more sophisticated investors?
Yes. And they’re doing it, depending on which ones and which regions, in a few ways. Some pensions are building internal teams with the capabilities. For example, I think many of the larger Canadian pension funds are well-resourced in terms of staff to be able to access hedge funds directly. They are becoming very sophisticated investors with respect to alternatives.
Others have acquired the expertise by working with third-party consultants, like Cardano in the U.K., a very sophisticated advisor that has been growing its business to pension funds. Albourne has also been growing quite rapidly, providing that advice. You also have the more traditional guys building out their capabilities and offerings—the Mercers of the world, for example, building teams of specialists who can focus on alternatives or hedge funds, and offering that as part of the service to their pension clients.
And don’t count the funds of funds out, because that’s where pensions outsource the expertise directly. I think that’s a business where you see scaled players like Grovesnor as the winners and the more modest-sized guys having trouble and consolidating.
You said BlueMountain manages about $1.5 billion in consolidated loan obligations. What can you tell me about this side of the business?
We invest in CLOs in two ways. BlueMountain Capital is a CLO manager and we currently manage four CLOs; this summer we completed the transaction for our fourth. Our portfolio managers, Charles Kobayashi, Derek Smith and Bryce Markus, run these portfolios along with our fundamental research team, led by Peter Greatrex. In those cases, BlueMountain Capital Management is the manager of those CLOs. The BlueMountain Credit Alternatives Fund and some other funds that we run own some of the equity of those transactions. We also have third-party equity investors in all those transactions and large numbers of debt investors—people who bought the debt securities issued by those CLOs.
We do expect to be in the market with another transaction in the first half of 2012. Broadly, we like loans as an asset class. We think that both on an absolute basis and relative to unsecured debt, it is an inexpensive asset class right now. The equity tranches of CLOs, what we are buying now, offer a great way to get term financing of these loan assets.
The other thing that we do in the CLO space is to purchase CLO equity tranches and CLO debt securities of transactions managed by others in the secondary market. We think that, in the right structure and with the right underlying loans, CLO equity offers compelling risk-adjusted returns. We have a lot of confidence in our ability to understand not just the structure, and the manager but, critically, the underlying assets, the individual loans in the structure and the companies to whom those loans are made. Our 18-person fundamental research team models and takes a view on the creditworthiness of those individual companies. These views play a big role in how we think about investing in CLO equity and debt tranches.
What opportunities do you see in the current credit market?
One, the technically driven volatility—which I think everyone recognizes is driven by the euro crisis and the U.S. debt crisis and banking crisis—provides opportunities for fundamentally driven long/short credit investing. Obviously, when things are moving not because of the fundamental creditworthiness of the borrower or the underlying business, but because of these technical factors, companies rally and sell off without good reason. That creates a lot of very good relative value opportunities. We see 10, 15, sometimes 20 points of mispricing, both on the long and the short side of individual debt securities which are multiples of the levels in ’05 and ’06.
The second opportunity I’d mention is loans to high-yield companies that are secured, first-lien loans. We consider these as cheap compared to other unsecured assets of the same or other companies. This has been driven by several technical factors, including the retreat from loan mutual funds by retail investors. The Federal Reserve’s announcement that they’re not going to raise interest rates for the next couple of years has made loans less attractive to some investors. But we think that on a risk-adjusted basis, particularly when you start thinking about the recovery levels of different securities in default, loans look attractive because very often they’re trading at levels lower than their ultimate recovery in default.
The third opportunity is the dispositions of assets from banks. We all know about the regulatory changes that are increasing the capital charges for banks on different kinds of assets. There are a number of those kinds of assets that will be coughed up in the near term. One type is the structured credit portfolios of bank intermediaries.
We just announced a transaction we’re going to do with Crédit Agricole, where BlueMountain is effectively going to take the risk of their synthetic CDO portfolio. That’s the kind of opportunity that we’re seeing—as banks are looking to shed assets and reduce risk they are willing to sell and we think there’s good opportunity there.
Lastly, we’re excited about a more technical opportunity – credit index arbitrage. The CDX and the iTraxx credit default swap indices are extremely liquid and among the most traded credit instruments in the market. Since this is an OTC market, not surprisingly, there is oftentimes a gap, that is, a basis, between the market price the index versus and the market price of each of the 100 or 125 single names that make up the index. Once you put these arbitrage trades on, they are riskless to default because you’ve got longs and shorts completely matched, company by company. Of course, you are subject to mark-to-market moves from the difference in price between the index and the single names and we hold plenty of cash against the trade. What’s interesting about the credit index arbitrage opportunity is that it’s very much driven by market volatility. We’ve more than doubled the size of our index arbitrage book from pre-summer until now because the recent dramatic moves in the credit markets.
Across all of these themes, we expect continued opportunities for the foreseeable future because we don’t think the volatility is going to go away any time soon.