Andrew St. Pierre, president of multistrategy real estate investor Merestone Partners (pictured), argues that the huge overhang of US commercial real estate debt coming due over the next two to three years will place enormous pressures on banks –especially the regional banking system.
GFM: What is the background to your company and fund?
ASP: Merestone Partners was conceived as a joint venture between a Boston real estate family office, the General Investment and Development Companies, and the management team of the fund. Merestone follows a multistrategy approach to investing in real estate through the publicly-traded securities issued by companies that are themselves directly invested in real estate or that have embedded real estate exposure that renders them sensitive to trends in the market.
The fund was launched in January of 2006 with myself as president. Portfolio manager and senior analyst John Garofalo joined the team in 2007 and William Cullinan joined in early 2009 from the client service group of Fidelity’s prime brokerage unit to head business development. Currently we manage about USD29m in assets.
GFM: Who are your key service providers?
ASP: Merestone’s auditor is Atlanta-based Gifford, Hillegass & Ingwersen and legal counsel is WilmerHale in Boston. The accountant and administrator is Partnership Financial Accounting, also in Atlanta, and the fund’s prime broker is NorthPoint Trading Partners, with custody and clearing performed by Goldman Sachs.
GFM: How and where do you distribute the funds?
ASP: At present, we are investing for our sponsor and joint venture partner, GID. We are in the middle of our first significant push to accumulate outside assets and are targeting high net worth and managed wealth players as well as smaller institutions and family offices – places where the size ticket they can write to move their needle is not disproportionately large given our size.
But we will – and regularly do – speak to anybody who might one day be interested in working with us as we grow. Our job is quite simply to develop long-term relationships with truly like-minded investors, and the more people whose radar screen we can get on and stay on, the better job we do over the long haul in terms of building scale.
GFM: What is your investment process?
ASP: Our value-based approach involves a fundamental, cash flow-based analysis on each company we look at – either from the equity side or debt side, and often both. We look for fundamentally under- or over-valued stories where our modelling can give us insight not available on the Street.
From there, if we can, we will fashion the trade according to the part of the capital structure we feel is best suited to achieving our goals. Many of our strategies often have multiple legs involving different securities issued by the same company, but from different parts of their capital structure.
This strategy recognises and applies a certain amount of top-down macro-analysis. We are focused on the public area of real estate investing – primarily in North America but with the ability to be substantially global should our growth allow those skill sets to be added to the team. We invest in real estate investment trusts, real estate operating companies, homebuilders, home supply companies, home furnishing retailers, insurers, mortgage lenders, real estate brokerage or management firms, and sectors such as restaurants, retail, gaming and infrastructure that have embedded real estate exposure.
We use very little leverage – ours is a valuation play to find mispriced assets so that we are not paying up for that leverage. We are ecumenical as to where we take our exposure in the capital stack and our investments will often feature positive cost-of-carry characteristics that allow us to collect substantial income as we wait for our thesis to play out.
Some trades will mimic pairs trade strategies while others take on aspects of capital structure arbitrage. We truly try to be open and flexible in order to create a portfolio that can plausibly claim to be multistrategy. We will construct trades using equities, preferreds and debt, and will hedge using the same if it is feasible. We also trade US Treasuries, Treasury Inflation Protected Securities, options on stocks and exchange-traded funds in the attempt to balance our exposures to certain trades.
GFM: How do you generate ideas for your funds?
ASP: It is a dynamic process that is not much list-oriented. We read an awful lot and talk about markets and companies with a wide range of players in the real estate world. When we find interesting possibilities we will do a quick and dirty analysis just to see if the fundamental premise holds water or can be explained away as a fluke. If not, John and I engage in verbal Mortal Kombat in an attempt to dislodge the other from their position before a full-blown model is built and various scenarios evaluated. Only after we convince each other will a trade appear in the portfolio.
The research process normally starts with an internal idea derived from our views on trends in valuation in a certain area of the market that drives us to search for stories in that area. Normally, these areas of interest are dislocated to one degree or another due to economic trends or industry issues.
Once an idea is identified, a quick financial analysis, most often cash-flow based, is done in order to determine if the fundamental premise of the trade is validated or negated by the underlying financial condition of the company. Often times, when focused on the debt side of our companies, a liquidation analysis is created to assess the viability of a company and the extent to which it can sustain the safety of the bonds.
This fundamental work is then used to ascribe a risk/return projection to the proposed trade, which will then drive the decision to create any hedges. Normally, the areas we focus on at any given time are at least partly defined by our empirical views on the economy, trends in liquidity or interest rates, or other economic factors that help create the themes we are attempting to exploit.
GFM: What is your approach to managing risk?
ASP: For the most part, and to the extent that the portfolio is hedged, it is done at the security level, although there have been occasions where a thematic strategy has been hedged to a certain degree. Generally, the portfolio is not hedged overall except to the extent that short positions and cash may reflect management’s assessment of either market directionality or valuation.
GFM: How has your recent performance compared with your expectations and track record?
ASP: We are pleased that our core deeply discounted fixed-income positions continue to tighten their spreads, pay their coupons and accrete to maturity. They allow us the luxury of being a bit sceptical of the recent strength in the market, which we don’t see as widespread or based on undervaluation – at least in the sectors we focus on.
That said, we are fully aware of the explosive rallies in financials, Reits and homebuilders, and we admit that we rue the fact that as fundamental investors, we were not believers in their essential under-valuations as sectors. Simply put, we are not momentum traders and we expect a pull-back from these levels as the realities of expansive government spending and no real progress on job creation finally hit the market’s consciousness.
GFM: What opportunities are you looking at right now?
ASP: We look to get short in Reits and financials, as well as Treasuries, if 10-year yields again approach our targeted yield levels.
GFM: What events do you expect to see in your sector in the year ahead?
ASP: We think real estate is in for a long recovery at a subdued pace. There is an awful lot of commercial real estate debt coming due over the next two to three years, and not a lot of players writing those loans. It is going to place enormous pressures on banks – and especially the regional banking system.
GFM: How will these developments affect your own portfolio?
ASP: We will continue to be short regional banks and for the most part will not look to play the long equity trade for a while yet.
GFM: Are investors’ expectations shifting between capital preservation and growth? If so, how do you deal with this?
ASP: As individuals they may seem at this point far more interested in investing in bonds than the stock market. Whether this translates into more modest return mandates and tighter risk controls on the part of institutions remains to be seen. But you never lose money taking the short side of investors’ memories and the prevalence of greed over a balance of risk and return. Were things to return to a more traditional risk-return equation, our strategy of value preservation and common sense portfolio construction would put us in the catbird seat.
GFM: What differentiates you from other managers in your sector?
ASP: First, we define real estate as any company that has significant exposure to real estate or to trends in real estate markets. This allows us to identify many situations where a company may have embedded real estate value or has a big part of its operating business exposed to the real estate markets, so we have a far broader mandate than a traditional long-only Reit manager.
Second, we are able to move across the capital stack to take our exposures in the most efficient way possible, and where fear and volatility may have pushed valuations to the point where they become illogical or at least historically cheap.
Third, we try to do this at all times with the real goal of providing a high level of liquidity, which outside of Reit portfolios really doesn’t exist in the real estate world.
GFM: How do you view the environment for fundraising in 2009? How does this affect your funds?
ASP: The fund raising environment right now is difficult and very, very competitive. We hear this time and again from managers across a number of disciplines, and it is mirrored in our own efforts to broaden our investor base. For us it simply delays our surmounting the “chicken or egg” problem of reaching larger institutional capital pools.
However, we are having good, productive meetings and our sense is that though the fund-raising cycle has become dramatically elongated, investors are once again trying to be creative in trying to find returns that can be rationalised against risk and liquidity.
GFM: Do you have any plans for other product launches in the near future?
ASP: Not until we feel we have Merestone well established with a group of truly like-minded investors.