Cheyne Capital Management

Healing credit markets offer reservoir of opportunity

Originally published in the October 2010 issue

The post-2008 period has witnessed a sharp economic downturn give way to an environment of anaemic growth propped up by record low interest rates. Difficulties in financial markets linger against a backdrop of tight credit conditions and periodic shocks affecting sovereign borrowers, particularly in Europe. Hedge fund performance rebounded and then stalled during the second and third quarters.

Successfully navigating the post-2008 minefield offers challenges to the investment managers at Cheyne Capital Management in a way that founders Jonathan Lourie and Stuart Fiertz couldn’t have foreseen when they set up the firm in 2000. Then the focus was to build on a successful approach to convertible bond and credit investing which originated in their development of Morgan Stanley’s convertible bond management practice. Though Cheyne continues to manage money in convertibles, it is now more focused on opportunities in investment grade corporate bonds as well as European Event Driven and Real Estate Debt. From its origins, Cheyne has focused on credit investing, and worked to be a pioneer in diversified European alternative asset management. To that end, Cheyne has raised some $1.5 billion of fresh capital in new products since early 2009 while delivering best-of-breed performance (see Fig.1 & Fig.2).



Meeting Lourie, Fiertz and members of their team means a walk into history with a modern perspective. Cheyne is housed in Lord Beaverbrook’s St James mansion where legend has it that the Express newspapers magnate smoked cigars with Churchill in the drawing room overlooking Green Park and Buckingham Palace during WW II. The proximity to history puts into perspective our own recent financial crisis which, in turn, presents clear investment possibilities. Lord Foster fit Cheyne’s cutting edge trading operations into the historic mansion – his iconic helical glass staircase symbolises the link between past and future.

“The real story is that post-2008 there is opportunity in the credit markets which provide for attractive returns without resorting to leverage,” says Lourie in his famous drawing room office. “We think the risk/reward in the credit sectors is more definable and more visible than it has been for a very long time.”

Convertible bond returns were high during the 1990s and provided investors with attractive risk/reward characteristics. Cheyne was always oriented to understanding the underlying credit of converts, not merely the equity component. When convertibles became less attractive as volatility dried up in 2002-2003, Cheyne got creative, but kept the core focus on credit and bottom-up fundamental analysis. New products saw the firm bring in new dedicated investment teams. John Weiss and David Peacock joined from Goldman Sachs in 2001 to invest in investment grade credit, followed later by Simon Davies and Shamez Alibhai and their teams who joined to invest in event driven and real estate debt, respectively. The belief was that harnessing expertise and fundamental research would provide an investible edge.

“We think real estate debt offers the same opportunities convertibles once did to roll up your sleeves and take a bottom up approach,” says Lourie. “Risk reward is very favourable. Risk can be calculated and the reward is substantial. There is historical mis-pricing in real estate debt,” he says, noting that event driven is being fuelled by high levels of cash on company balance sheets and rising takeover activity. “The post 2008 dislocation is an aberration and offers big rewards.”

Now over 80% of assets (see Fig.3) are in corporate credit, real estate-backed securities and event driven. Cheyne aims to match each opportunity with an investor set rather than offer a multi-strategy flagship fund drawing in different asset classes. The aim is to help investors allocate to specific and transparent risk profiles and avoid the style drift that can affect a multi-strategy fund.


Cheyne emerged from the 2008 credit crisis intact.Its use of term finance structures in investment grade credit allowed it to avoid being forced to sell positions when spreads blew out to 2000 basis points. In early 2009, the firm named fixed income specialist Chris Goekjian as chief investment officer. Goekjian had extensive relevant senior experience in the credit markets having run Credit Suisse’s global fixed income business. The move underlined Cheyne’s evolution into a credit focused business and signalled where it expected opportunities to be plentiful in coming years (see Fig.4). The role Goekjian plays is both hands-on and strategic: he oversees asset management teams and risk management, and looks at new investment areas and products.


Corporate credit
In terms of AUM, corporate credit is currently Cheyne’s biggest area with gross assets surpassing $50 billion. Under Weiss and Peacock, the team’s defaults have been a miserly 34 bps in total over nine years, compared with a Moody’s figure of over 200 bps. Using credit default swaps, the positions are primarily long, investment grade credit, and can be leveraged or unleveraged with target returns of 20% plus. Migration from the market has left spreads at historically high levels. The main European investment grade index is pricing in five year cumulative default rates of around 9% compared with a worst ever outcome since the early 1970s of just over 2.4%.

“It is pricing in potential risk which is far higher than we perceive, particularly if you think corporates are currently running with the most cash-rich balance sheets we have seen in a long, long time,” says Weiss. “In Europe, investment grade companies are running at decade-high levels of profitability. This is not an environment that is going to create high levels of defaults; quite the opposite. So you are getting very, very good value for investment grade and that underpins the strategy. The thing we do differently is that if we do use leverage, it’s term-financed.”

A common approach is for Cheyne to set up customised accounts for clients with appropriate terms and financing. The liability matching strategy and term financing helped their levered strategies avoid the fate of other credit hedge funds that got closed out during the credit crisis due to using margin finance. Not needing to cut and run, Cheyne managed its portfolio positions and hung on for a rebound in performance.

In the aftermath of 2008, Cheyne continued to focus on credit fundamentals and signals from other asset markets, with a view to spotting transition risk early. Its analysts, who combine a wide range of experience in ratings agencies, commercial banks, equity analysis and accounting, visit companies to scrutinise the motivation of managers as well as analyse track records with bond holders and creditors. Close analysis, for example, of US mortgage lending, led the group to beat a very early retreat from financials and dodge the defaults and losses that subsequently beset the sector.

The attraction of credit as an asset class, Cheyne believes, will continue to grow as retiring Baby Boomers shift from low yielding government debt to higher yielding corporate debt. Because sovereign credits won’t yield enough, investment grade corporate credit will be in increasing demand to fund pension liabilities. “This is a very safe play and one where you can get a return,” Weiss says, noting that using term finance to buy investment grade is a better play than, say, lower rated corporate credit where refinancing risk is higher and some companies are over leveraged.

“We are a solution driven business,” says Weiss. “A lot of our clients have particular goals or portfolios they are not able to manage effectively and we respond to those sorts of opportunities. Our general approach on investment grade is going to be the same for the foreseeable future. As the long side becomes less interesting in two to three years time we will emphasize more our relative value trading, but long opportunities are still there given the continuing big dislocation in credit.”


Event driven
The Cheyne European Event Driven Fund, launched in October 2009, has clocked up twelve months of sequentially positive performance against a volatile backdrop since launch. Simon Davies, Michel Massoud and their team manage a total of over $1 billion of gross assets including in event driven credit and loans. Initially, the new fund focused mainly on credit restructurings but since April the focus has shifted to more exposure in merger and acquisition equities as the pick-up in M&A activity has accelerated. In the event driven spectrum Davies concentrates on transactions with hard catalysts.

“In this environment the harder and nearer term the catalyst the less beta risk you have,” says Davies. “In a non-directional, quite volatile market we think this is pretty attractive. In European M&A there is a massive amount of strategic US interest in European companies. Big industrial companies that looked at acquisitions didn’t move. But now when they look in dollar terms, these assets look cheap because of sterling and euro devaluation and low valuations,” he says, citing News Corporation’s move on affiliate BSkyB and other bids. “There is a real trend of non-European companies moving into Europe and we think that is going to continue. Quite often these situations can become competitive and that is the real home run for an arbitrageur. The environment has been great for us over the last six months and we think it is going to get better.”

The Fund has a European mid-cap focus, meaning companies with market capitalisations up to $2 billion. The mid-cap focus will minimise crowding with the London arms of US event driven funds that target bigger merger deals. In the mid-cap area there are just a handful of other players and deal flow in Europe is running close to one a day or every other day. Davies thinks this is sustainable for the foreseeable future but doesn’t see (or want) a turbocharged M&A boom. He is keen on the UK market for its clean timelines and well understood bid process using either a tender offer or a scheme of arrangement. This means the predictability of deals completing in Britain is greater than in Europe. What’s more, company restructuring and fiscal retrenchment is further advanced in the UK than in Europe, leaving corporates more enabled to boost growth through mergers.

“Our approach is straightforward in the M&A business,” says Davies. “You have a deal on the table. You do all the exhaustive analysis on the risk of a deal breaking. If a position is on our book we believe a deal will close. The issue is how much do you want to pay for an option on someone else bidding higher?” In the bid battle over Sperian, eventually won by Honeywell, the downside was 1.5% with an upside of over 60% after the US conglomerate waded in. “That optionality was way too cheap,” Davies says. “Ideally, we want to find optionality but not have to pay for it.”

Real estate debt
After the collapse of Lehman Brothers and the freezing of the credit markets, opportunities in real estate debt markets emerged quickly. The subsequent indiscriminate sell off of the asset class made it timely for Cheyne to launch its Real Estate Debt Fund in August 2009 focusing on senior high quality assets in the UK and Northern Europe. Before 2008, real estate debt was packaged in residential and commercial mortgage backed securities. Investors bought the paper for its yield premium, secure in the knowledge that the rating agencies had rated it‘AAA’. Outsourcing this credit research to agencies would eventually cost investors dearly. When credit markets imploded few had the technical ability to differentiate good credit risks from bad ones.

With 10 years of experience in real estate debt, Alibhai and his team had that ability. The fund (Fig.2) is up 25% in a year and has AUM of $650 million. The size of the market is upwards of $250 billion in credit and loans with the latter expected to come to market as refinancings rise over the next three to four years. The fund runs a tailored strategy letting investors decide on the level of risk (40% loan to value (LTV), 60% LTV and 75% LTV or high grade, barbell and deep value). Having gathered loan level UK residential mortgage market data since 2004 Cheyne can take a fundamental view of how well borrowers are performing. For example, in a securitization vehicle called Granite, originally set up by Northern Rock, the fund bought mortgage backed securities for between 66 and 72 pence on the pound, a price that reflected a greater than 50% fall in UK house prices. The positions were sold at an average price of 89 pence after several months, locking in an annualized return of around 50%.

“We will trade the portfolio but the strategy isn’t based on a tactical trading strategy or momentum,” says Alibhai. “It is based on fundamental value. We monetize investments in the portfolio when we find the returns no longer merit the risk, or when we find better opportunities.”

UCITS funds
Cheyne has set up a UCITS umbrella in Ireland and made its convertibles strategy the first share class to be offered. Like other hedge funds, the aim is to target a set of investors who haven’t been able to invest in the existing offshore funds. The convertibles strategy was the first UCITS set up because its focus on fundamentals and very low leverage meant it required little modification to fit the UCITS requirements.

“The way we run the convertibles strategy fits in neatly,” says Goekjian. “Some of the other asset classes would have to be changed in terms of how they manage their portfolios to fit into a UCITS wrapper due to liquidity requirements, leverage requirements and so on. We are looking at each asset class to have a UCITS conforming fund but we don’t have a specific timetable.” Merger arbitrage is seen fitting easily within UCITS, while credit strategies are judged to pose more challenges. This is related mainly to the difficult of defining counter party exposure on a credit instrument or a derivative.

On the horizon
Cheyne anticipates that changing markets will continue to throw up opportunities. Lourie and Fiertz intend to refine the expertise the firm has developed in credit and some related event strategies, but they are agnostic about how this may be applied in future.

Goekjian is the key point man for evaluating new strategies and portfolio management teams that pitch the firm. But there is little mystery in how Cheyne could expand as its development over the years makes plain.

“In general terms,” Lourie says, “if the risk/reward can be matched by pedigree and experience of different market cycles we will look at different asset classes, but they will be contiguous to the areas we are already in.”

Cheyne expresses quiet confidence that the impact of the so-called Volcker rule requiring banks to withdraw from some investing activities will offer up opportunities. Not least it means there will be much more talent coming out of investment banks for Goekjian to ponder as the firm expands existing teams or launches new products.

“To a certain extent you would expect many of the strategies we run, and none more than merger arbitrage and the real estate debt product, to experience less competition from the proprietary trading desks ofbanks,” says Fiertz. “There used to be extremely fierce competition from over-leveraged banks. Today they have diminished their prop desks and the capital associated with it. There is an opportunity for hedge funds to capture those returns.”

A decade on from its formation Cheyne continues to develop strategies that offer investors attractive opportunities. Lourie is confident that the long-term close client relationships that date back over ten years give Cheyne an advantage in continuing to grow its business. It is thus well placed for a new phase of growth and to enhance its standing as one of Europe’s alternative investment leaders.

“At Cheyne, in addition to the focus on strong performance, there is a commitment to IT, infrastructure and compliance in an industry where the regulatory environment has become much more stringent,” says Lourie. “It raises the barrier to entry in the asset management industry and confers an advantage to firms that have made that investment.”