Brownstone Partners

Long/short credit performance sees Brownstone rise in rankings

Originally published in the May/June 2009 issue

When a team of former Bear Stearns credit analysts decided to set up their own event driven long/short credit hedge fund the pitch to potential investors was straightforward. Allocate with us and we will take you through the credit cycle, generating absolute returns regardless of how the market performs. That approach has seen the Brownstone Partners Catalyst Master Fund generate a net annualised return of 10.15% since inception in July 2004. During that time the fund’s assets have grown to $370 million. Now that the credit market is front and centre with investors, the fund is attracting attention, not least because it recently featured in 82nd place in Barron’s list of the 100 top performing hedge funds over the three years to end-2008.

“The key to our approach, which is very relevant at this point in the cycle, is that we developed the strategy to provide full directional flexibility through the business cycle,” says Oren M. Cohen, co-founder, portfolio manager and head of research with New York-based Brownstone Asset Management LP. “The genesis was really our belief, through our experience, that not a lot of credit managers had a flexible approach to generate returns through the credit cycle.”

Cohen is careful to emphasise that this is not a message tailored to the current environment. He, co-founder Douglas Lowey and subsequent partner Curt Schade, who joined Brownstone in 2006, all worked at Bear Stearns in the mid-1990s. During that period and later they all saw how a high yield hedge fund could provide absolute returns by combining painstaking research with the nimbleness to trade around the broader credit cycle. “When it’s time to be short, we’ll swing this portfolio short,” Cohen says. “That’s how we not only stayed out of trouble last year, but generated good positive returns in a very down market. We think that that discipline will also help us outperform in what everyone is now looking to as the big long opportunity in credit because we are disciplined to recognize the pitfalls on the downside.”

Net exposures adjusted
Each of the three principals has 20 years’ experience in high yield credit markets, enough to have ridden through several business cycles. The portfolio swung from 30% net long at the end of 2006 to 65% net short during the 2008 downturn, but is currently market-neutral and is growing its long book opportunistically. The fund is targeting surviving high yield credits on the long side – those that will avoid defaults – and is playing deeply distressed credits on both the long and short sides.

The fund’s 58.3% cumulate performance from inception to 31 March 2009 compares well with the –0.1% return over the same period in the Credit Suisse High Yield Domestic Index, not to mention the 23% fall in the S&P 500. Volatility, as measured by the standard deviation on an annualised monthly basis, is just 3.2% and the Sharpe Ratio is 2.08.

Brownstone’s approach to credit investing has two key focuses. One is the position the fund will have as a lender or bond holder in a company’s credit structure, the other is the coupon percentage payout which rises and falls with fluctuations in the value of a bond’s price. During the middle of the decade, bond market volatility shrunk to record lows and at the beginning of 2007 most bonds were trading above par. This meant low yields for bond holders. At the same time, Brownstone’s portfolio mangers were acutely aware that 2007 was looking quite toppy for the recovery part of the cycle. Indeed, despite the business cycle being five years into an upswing, bonds were trading above par despite real signs of economic weakness developing. “We developed a conviction not to be long bonds any more,” Cohen says. “The only trade was down and we shorted bonds. That’s how we look at credit. It’s from a macro basis, understanding where we are in the cycle and then on the micro basis picking individual credits with catalysts that will generate absolute total returns.”

Brownstone’s main focus is on event driven trades. Research targets a company or industry-wide situation to find any positive or negative catalyst that can generate significant price movements in the bonds. Such catalysts might typically involve consolidation, pricing dislocations or new competitors entering a market. The company’s capital structure is dissected to determine what spot in it maximises the risk/return opportunity. “Risk is part of the equation,” Cohen says. “We don’t just want to maximise the return. It has to be a risk adjusted return. In some cases the bank debt might have a lower return but a lot lower risk so that is a better place to be than an unsecured bond. It’s always case by case. Find the trade first and then figure out in what part of the capital structure you want to express the view.”

US gaming sector shorted
One illustration of Brownstone’s approach, and one of its bigger trades going into 2008, was to short the US gaming sector. “The reason we thought we were early to the trade, ahead of the pack, is that even the bears who believed we were going into recession in 2007 – and we were in that camp – thought that the gaming sector was recession resistant based on past cycles,” Cohen says. “Our understanding of the gaming industry led us to believe that in the current cycle, gaming was much more prone to consumer weakness than in past cycles. Why? Because 10 or 15 years ago you had two choices: you went to Vegas or Atlantic City.”

It meant that the gaming industry held up relatively well in the early 1990s and earlier recessions. By 2007, however, the gaming industry had diversified, spreading out across 35 different states and had become dependent on convention and family business. “It became much more consumer discretionary and much more reliant on hospitality revenues from hotels and restaurants – not just pure gaming revenues,” Cohen says. “As late as early 2008, sell-side analysts were still preaching this recession resistant theme. Then it all fell apart.”

“This is always the evidence of a toppy market when the high yield market finances start-up ventures,” Cohen says. “We shorted the bonds of a native-American casino start-up in the 90s and rode them all the way down into the high 30s. The operation has just opened. There is no proof whether it will succeed or fail, but it was highly speculative and overpriced in a bull market.”

Winning plays in cable television operator Charter Communications and branded consumer products manufacturer SoloCup also illustrate Brownstone’s approach. With Charter, which is now being reorganised, the fund invested in second lien notes in what Cohen acknowledges was a complicated capital structure. “We were pretty high up in the structure and believed even with the restructuring these notes would continue to pay a coupon,” he says, adding that “it got carried down with the crisis last year.” Since then, the notes have recovered considerably and continue to pay a 10 7/8% coupon.

With SoloCup, the play took longer. Brownstone invested in 2005 when the company was suffering from being over-levered. The fund liked management’s plans to rationalise the business and cut costs; this allowed it to substantially reduce the leverage before the recession. Now there is a possibility that the bonds, currently trading around 80, will pay out at par if the private equity sponsor sells the company. “In the meantime we’re comfortable that the credit is a survivor and that it is a very attractively priced bond,” Cohen says.

Portfolio averages 40 positions
On average, the portfolio holds around 40 positions. Since shorts in bonds mean the fund is paying negative carry on coupons, the holding time for such positions is usually limited to three to six months. The duration of a long position, however, can vary much more. If a specific event is isolated the catalyst could play out in a few weeks. Cohen cites the example of a credit being marked down in price on a misinterpreted news item. “If we think we have an edge on that situation and (the price reaction) should have gone the other way, we’ll put on a trade just to close the gap with that mis-understanding,” he says. “It happens more often than you think.”

Ideally the managers seek to hold long positions for over a year to generate substantial gains. But it can also depend on the point in the cycle. “In the current environment,” Cohen says, “if we see a recovery phase emerging you would expect core positions in the long book to carry over for a couple of years as you ride into the recovery phase.”

On the current outlook, Cohen expresses mild discomfort at remaining bearish and believing that the recession will be longer than the stock market is anticipating. “We think this is the end of a long business cycle, a 25 year cycle that built up a lot of excesses in the global economy. You don’t turn that around over night. We do think that takes a couple of years to work out. It’s going to feel like a recession going into next year.”

But that bearishness on the economy may already be fully priced into certain segments of the high yield market. In consequence, high coupons may offer an incentive to get in early and can offset what maybe a relatively minimal downside. “If I can buy a bond at 70 cents with a 10% coupon, even if my timing is somewhat off, I’ve got a break-even trade if the bond goes down 10 points,” Cohen says. In that scenario, the downside is close to zero and there is potentially pretty good upside. “That’s how we look at each situation,” he says.

All of this requires intensive credit research as well as stress testing both models and capital structures. The aim is to identify companies that can generate plenty of liquidity in the current environment and meet their financing obligations. “Our task right now is to separate the survivors from the restructurings,” Cohen says. “A good point to make is that even if you believe defaults rise to the level of 25%, which would be quite high by historic standards, that still means 75% of the universe survives. There is ample opportunity to identify surviving credits without taking too much risk.”

Clearly, risk adversity is paramount since memories of 2008 are still seared in investors’ minds. Anecdotal evidence suggests that substantial sums of money are on the sidelines as investors remain wary about equities. The opportunity for Brownstone and other credit funds is substantial. “The big question is how long and deep the recession will be and what this means for credit versus equity,” Cohen says. “It is a decent time to be entering our space because a lot of damage has been done. The equity market needs growth to propel stock prices; we just need a bottoming out and some sign that the economy is not going down significantly more. Then it can bump along the bottom. Even very slow growth is fine for high yield credits with high yields that will survive, that will not have to restructure. So there are pretty good opportunities today even without significant growth in the economy.”