Finisterre Capital

BILL McINTOSH

The revolution in global financial markets spurred by the credit crunch has turned sovereign debt markets upside down. With US sovereign debt downgraded and other western countries facing downgrades as they choke on severe debt imbalances, the emerging economic world has never looked stronger in comparison. The timing is thus opportune for Finisterre Capital.

Finisterre’s funds tap opportunities in a variety of asset classes, including sovereign debt, local currency debt, foreign exchange, corporate credit and special situations. It has also just seeded the Finisterre Equity Fund to round out its product range.

Finisterre enjoyed mixed fortunes in 2011. Its $900m Finisterre Global Opportunity Fund fell 5.96% in the 12 months to December, though its $585 million Finisterre Sovereign Debt Fund was up 10.35% for the same period. Meanwhile, the $245 million Finisterre Credit Fund was down 4.06.%. Still, the case for absolute return investing in emerging market credit looks set to remain strong.

“This is an asset class that anyone can see is probably in better shape than in the developed markets,” says Paul Crean, Finisterre’s chief investment officer, in an interview at the firm’s Old Burlington Street headquarters in Mayfair. “Emerging markets will continue to be a strong source of growth for the global economy, while on the investment side there are big institutions with virtually no exposure. That is why there is going to be an ongoing allocation into this space.”

A quick look at the numbers shows that Finisterre’s target market looks attractive. The US public sector pension market is a $4 trillion pool but it has only 0.5% of that sum invested in emerging market debt. In the UK, the proportion is 0.2% of assets, while it is less than 1% among Japanese pension funds. The timing for a long/short manager like Finisterre is also good given the two decade rally in bond prices that has benefited long only funds.

Liquid emerging market credits
The Sovereign Debt Fund, the firm’s first fund, launched in 2003, trades only the most liquid assets issued in emerging markets, including Russia, Brazil, China, South Korea, Poland, Hungary, the Ukraine and the Middle East. Currently, the largest long exposures are to external debt in Russia and Qatar, while the biggest short exposures are to external debt in the Ukraine and FX in Hungary. The primary investment thesis is to get long of credits that are cheap or fundamentally moving in the right direction and get short of credits that are either expensive or deteriorating.

“We are actually set up very defensively in the market,” Crean says. “I think Greece is going to default and there are more shocks to come. We are long of higher rated credits in the Middle East where spreads widened earlier because of the Arab Spring but the fundamental ability to repay investors is clear. We are short of the lower rated single B type credits where the spreads don’t reflect the risk you are actually running in investing in that country.”

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A long play on Qatar
One key long play was Qatar Diar, the real estate arm of the Qatar government. Though rated double ‘A’ and wholly guaranteed by the Qatar state, the unit’s debt traded at a 220 basis point spread to US treasuries, which was a pick-up to Philippine and Indonesian sovereign credits, even though Qatar Diar is about eight notches better rated. A mid-2011 restructuring at the real estate developer and worries about the Arab Spring spreading to Qatar negatively impacted Qatar Diar’s debt. But, according to Crean, this ignored Qatar’s continuing high teen percentage growth rate and rising demand from Japan for Qatari gas to replace energy generation from lost nuclear output. What’s more, with per capita GDP surpassing $100,000, Qatar’s general prosperity contrasts with the relative poverty of many other Arab states.

A play in the short book was Ukrainian external debt. Though single ‘B’ rated, the east European state continues to fail on many levels, notably in dragging its feet on implementing recommendations from the International Monetary Fund. The country’s political chaos has seen its ex-prime minister jailed while the IMF is playing hardball over demanding reforms in exchange for the release of additional credit. Yet despite these factors, Ukrainian sovereign debt was trading at similar spreads to Italian government debt as recently as last summer – around 500 basis points over the 10-year US treasury.

“Should you be pricing the Ukraine and Italy at more or less the same level?” asks Crean. “I would argue not. The Ukraine has no history of complying or of putting coherent policies together.” Crean says it was the long only money chasing yields among weaker sovereign credits – including, among others, those of the Ukraine, Argentina and Venezuela – that created the mispricing of credits. “The history of crisis tells you weaker credits get hit harder,” he says, noting that spreads on Ukrainian debt ballooned to over 2500 in 2008. That level likely won’t be hit again, but Crean was adamant that spreads last summer were just too tight.

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Shifting exposure rapidly
The prospectus limits the Sovereign Debt Fund's gross exposure to 400%; net exposure can range from 50% net short to 250% net long. The managers can switch net exposure quickly, shifting from net long to net short in the course of a day.

“The thesis of the fund is to stay in only the most liquid assets,” says Crean. “We have some quite long-term, sticky views but we will trade around them.” A key reason for Finisterre’s trading stance is to give portfolio managers the opportunity to gauge liquidity in real trading conditions. “I think you need to constantly test that liquidity,” says Crean, adding that the Sovereign Debt Fund has probably generated higher turnover recently because it trades in a risk on/risk off environment directed by news flow.

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Equally clear is that growing fears about sovereign credit quality has meant that fixed income markets have begun to display high levels of volatility more commonly observed in equity markets. The iTraxx Europe Crossover index of sub-investment grade credit default swaps has undergone wild swings in recent months, trading at around 400 in early August before hitting 740 later in the month. It then came into 650 before going out to hit 800. Typically, fixed income investors build a portfolio of long positions to tap into daily carry. When markets get into trouble, they turn to hedging it through liquid benchmarks like the iTraxx as best they can.

“Fundamentally that is the wrong way to look at markets,” says Crean. “You must be convinced on what you want as your longs and what you want as your shorts. Our portfolio reflects fundamental views on both sides.” An enduring focus on the long side for Finisterre comes from its bullish stance on oil. Earlier in 2011, it expressed this by getting long of Russian credit and the ruble. More recently, the Fund has gone long of Middle East credits that the managers believe are fundamentally cheap.

Global Opportunities and Credit
The Finisterre Global Opportunities Fund, set up in April 2006, is a multi-strategy fund investing in emerging markets. Whereas the sovereign fund concentrates on four highly liquid buckets – external sovereign debt; FX markets; the most liquid local rates markets and FX volatility – Global Opportunities has a much broader mandate. It could, for example, look to acquire quasi sovereign credits such as Gazprom as well as other corporate bonds. It can run bigger exposure to rates and FX than the sovereign debt fund and also has the capability to invest 30% of NAV in emerging market-focused equity long/short opportunities.

The Finisterre Credit Fund, set up in July 2007, invests in emerging market corporate and financial sector credit. Post the 1997-98 Asian credit contagion, sovereigns have been careful to avoid fiscal deficits, leaving room for greater corporate issuance. In 2010, for example, emerging market corporate issuance was estimated at $205 billion, or more than double the $83 billion issued by emerging market sovereigns. The ratio of issuance levels in 2011 was broadly similar.

Among emerging market companies, borrowing to fund expansion is continuing. Many of these companies are more profitable than developed market competitors and often have less leverage. Even with such advantages some emerging market companies still have higher spreads than developed market peers. Conversely some companies are over-levered or moving in the wrong direction. Given this backdrop it is possible to get well paid for taking corporate credit risk with emerging market companies, while using a long/short approach to maximize opportunities on both sides of the portfolio.

Principal Financial acquires 51%
In mid-2011, Finisterre concluded a transaction that saw Principal Global Investors (PGI), part of Principal Financial Group with $330 billion in AUM, acquire a 51% interest. PGI, which runs a multi-boutique model, acquired a 20% stake that re-insurer XL Capital bought in 2007 when Finisterre was looking to expand the business. To that stake PGI added another 31% interest acquired from the existing partnership, providing the majority position needed to consolidate Finisterre into its financial results. For PGI, which until the Finisterre deal had invested in long only and US asset managers, the logic was straightforward. It wanted to gain exposure to active investment management and be able to offer emerging market funds to institutional investors.

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With the 2007 XL Capital investment, Finisterre got locked-up capital, that helped the firm double assets to near $800 million just a year later. Then the credit crunch intervened and the firm lost assets as its liquidity profile let investors cash out quickly. Yet just as assets flew out the door in late 2008 and 2009, they flowed back in during the recovery as Finisterre’s track record and increasingly in-demand emerging market investment focus attracted new investors. This boosted assets to nearly $1.8 billion by the end of 2011 when Finisterre launched a new emerging market long/short equity fund, thus broadening its offering to investors.

Strategic synergies
The relationship with the new controlling shareholder brings Finisterre important synergies. Though the investment management function remains autonomous, PGI has a very large distribution network which will help Finisterre market to Asian, Australian and Middle East investors which will expand on the hedge fund’s existing European and US networks.

Crean relates a story from a recent business trip where he secured a meeting with China Investment Corp., the country’s leading sovereign wealth fund. “Finisterre would never have got this meeting as a standalone hedge fund,” he says. “But the PGI relationship opens doors and it is a critical factor in Finisterre’s continued growth.”

With Finisterre employees holding a 49% interest, the alignment of incentives to grow the business is clear. The principals have agreed five-year contracts with PGI and have put 50% of the proceeds from the sale back into Finisterre funds with a five-year lock-up.

“The multi-boutique model is one we really like,” says Crean. “It provides an excellent combination of autonomy for the manager on the investment side with the help of a large parent on the infrastructure and support side. PGI take a very hands-off approach which allows the entrepreneurial spirit of a smaller company to breathe within a much larger organization.”

What’s more, PGI offers Finisterre additional attributes beyond a distribution platform. The boutique model means that PGI runs resources centrally that can be shared by affiliated partners when needed. One clear example of this is on compliance, legal and regulatory matters where PGI runs global teams that operate in London, New York, Asia and elsewhere.

If the convenience of a global compliance and legal resource is something independent asset managers might well dream of, more beneficial still is PGI’s experience with fund structuring. Though Finisterre doesn’t run UCITS products, the link-up with PGI means that the experience is readily available for the hedge fund manager to develop onshore and other products as investor demand and market opportunities dictate. The PGI stake also makes Finisterre a better credit.

A new wave of growth
Crean is confident about the opportunities for alternative funds to ride a new wave of growth. In broad terms, this is about total return strategies gaining investor custom. “I do think that over the next five to 10 years that there will be products developed that will tempt some institutional money out of passive index investing,” Crean says. “I want to be ready to have a look at that space with PGI, which has a lot of structuring capability, so that we can develop products.” He sees this becoming an increasingly important factor over two or three years as investors shift into the middle ground between passive and alternative investing.

“Part of the opportunity is that there is this huge pool of assets that is long only, indexed and passive,” Crean says. “But it is failing to generate sufficient returns to match its liabilities. A lot of the pension fund money won’t go all the way into alternatives but does need to get higher returns. There is this gap in the middle that is slowly going to get filled over the next decade. Perhaps that is the opportunity for unconstrained mandates … to take most of the upside but provide protection from the downside when it comes.”

But the solutions investors are looking for go beyond that. Here Crean is keen to tap PGI’s expertise on structuring so that pension funds can generate returns of 6-8%. With equity markets dropping again in 2011, Crean says pension funds “are crying out for products that can help solve problems.” Even if pension funds can’t allocate to offshore funds, it seems that a new breed of alternatives managers like Finisterre will provide solutions that can work for these investors.