Edward Horner outlines the investment process and stringent risk management procedures driving Eden Rock's investments in asset based lending strategies.
Edward Horner first gained experience of the financial markets aged 18 while working on the London International Financial Futures Exchange for Alpha Financial Futures Ltd. After graduating from Newcastle University with an honours degree, he joined Merrill Lynch International Bank Ltd. He became the youngest Financial Consultant in the London office of the International Private Client Group and was made a partner of the largest team in Europe, where he advised clients with combined assets in excess of USD 2 billion on their global investment portfolios, comprising both traditional and alternative asset classes. Edward resigned from Merrill Lynch in 2001 to establish Eden Rock Capital Management with Santo Volpe and James Matthews. Mayfair-based Eden Rock now numbers 17 and has allocated assets in excess of USD 800 million.
HW: What is the background to the fund?
EH: The Eden Rock Structured Finance Fund (ERSFF) is a fund of asset based lending funds. The goal of the fund is to achieve a superior investment return on a risk-adjusted basis with little correlation to the major equity and fixed income markets. The fund employs leverage on a variable basis of up to 150 per cent. The target annual return is 10-15% with a target volatility of less than 3. The minimum investment is USD 100,000 or currency equivalent and there is no lock-up. ERSFF was launched on November 2 2004. Including some leverage, the current size of the offshore fund is USD 360,000,000 and the US onshore fund is USD 370,000,000.
The Funds Investment Advisor is Eden Rock Capital Management (ERCM). ERCM has a seven member Investment Committee, listed as follows:
Michael Staveley - Chief Investment Officer
Santo Volpe - Chairman
James Matthews - Chief Executive Officer
Edward Horner - Managing Director
David Moore - Head of Management
James Beaumont - Senior Analyst
Andrew Kinsey-Quick - Senior Analyst
HW: How and where do you distribute the fund? What is your current and targeted client base?
EH: The Fund is distributed via a variety of channels, primarily within the financial centres of Europe, as well as throughout the Middle East. The in-house marketing team at Eden Rock is in direct contact with target investors and several third party marketing firms also represent the Fund. The Fund has been approved by the due diligence committee of a number of Private Banks and so is distributed via their networks. A number of fund of funds have opted to gain exposure to the asset based lending space via an investment in ERSFF. The net performance of the Fund, coupled with the uncorrelated nature of the returns, makes ERSFF a viable investment for other fund of funds. Going forward the aim is to further diversify the client base by continuing to attract more institutional investors.
HW: What is the investment process of your fund?
EH: The investment process is carried out in a rigorous qualitative and quantitative procedure. Once the team has identified an attractive potential investment the decision whether or not to proceed is made based on a number of criteria - strategy, structure, on-site inspection (qualitative), volatility and correlation (quantitative). After the decision to proceed is made, the due diligence commences with an examination of the fund's documentation - financial accounts, offering documents, due diligence questionnaires, compliance manuals, etc. This is followed by an on-site visit to observe the front, middle and back office procedures and records of the fund manager. full report is then produced and submitted to the Investment Committee for approval.
Portfolio construction is primarily a qualitative process. Every week the Investment Committee 'refines' its view of which strategies to emphasize given the near-term likely market behaviour. The strategic emphasis is then balanced according to the diversification factors of the portfolio. The aim is to be diversified in the number of managers, strategy, expected volatility, expected correlation and liquidity. The portfolio is also analyzed quantitatively. Periodically, an optimization process is carried out in order to maximize the 'quality' of the expected return of the overall portfolio. A balance of optimal factors is sought based on certain risk/reward ratios and statistical measures.
The qualitative aspect of risk management is primarily based on regular communication with the manager focusing on capacity issues, style drift, staff turnover, key-man risk, counter party issues, etc. Ongoing risk management is achieved quantitatively by examining the statistical properties of 'behavioural changes' in the pattern of returns of a particular investment. Investment returns are analyzed with respect to changes in their statistical properties with respect to in-house customized benchmarks. The goal is to have a quantitative indication that a drawdown represents a behavioural change in the excess return of an investment; thus, a warning signal. Not only are factors considered such as downside sigma, indicating a change in risk, but also changes in style are flagged by quantifying deviation around customized benchmarks. Expected performance is compared to actual performance given the market environment.
HW: How do you generate ideas for your fund?
EH: Eden Rock monitors an extensive universe of managers using all the conventional sources - such as manager databases, prime brokers, third party intermediaries, etc. However, in the asset based lending space in particular, we tend to rely on market contacts for investment ideas. Asset based lending funds are typically relatively small in size and therefore capacity constrained. As a result, ABL funds tend to be less 'visible' than most hedge funds. Due to our presence in the space - we tend to get more or less first look at emerging asset based lending funds and we make it our business to stay abreast of developments within the sector.
HW: What is your approach to managing risk?
EH: Risk has to be viewed in a quite specific way when managing a portfolio of asset based lending funds. The risks that apply to more conventional hedge fund strategies are not always relevant to asset based lending, largely due to the absence of marketable securities. When making an investment in an asset based lending fund - one is effectively gaining exposure to a pool of private, off-market loans that are collateralized by some form of asset, whether it be a physical asset, or some form of receivable.
Therefore the risks that are particularly pertinent to the strategy can be broken down in to four main categories:
- Legal Risk
- Loan to Value Risk
- Pricing Risk
1. Legal Risk
During the due diligence process, a great deal of emphasis is placed on verifying the documentation surrounding each loan. We need to ensure that, in the event of a default, the manager is able to seize control of the collateral securing the loan and make the loan good. If there is some form of legal oversight in the loan documentation then the asset may become tied up in a dispute thus negatively impacting the fund. It is also essential that we are fully aware of the prevailing bankruptcy remoteness laws in the various jurisdictions in which our managers operate.
2. Loan to Value Risk
We need to ensure that the value of assets used to collateralize loans is sufficient to cover the cost of the loan in the event of a default. This is only achieved by monitoring loan to value (LTV) ratios carefully. LTV ratios vary by strategy - but typically a loan will not exceed 70% of the value of collateral.
3. Pricing Risk
There is typically no mark to market with asset based lending managers - so the pricing methodology employed by managers has to be fully understood and monitored. Our pricing analyst is a qualified accountant and ex auditor for Ernst & Young. It is his role to perform regular on-site audit of the managers in which we invest.
Fraud is perhaps the greatest risk associated with any type of hedge fund investing, but with asset based lending this risk is arguably heightened as some managers in the ABL space do not have conventional, 'Wall Street' backgrounds. We mitigate this risk by spending a great deal of time with managers prior and subsequent to investing. We also engage the services of external agencies to carry out in depth background checks as a matter of course.
To further protect the Fund against this risk, Eden Rock has structured an insurance policy with an A.M. Best A- (Excellent) rated insurer that protects the fund against fraud at the sub fund level.
Overall - we feel the best way to mitigate risk in this fund is via diversification. Providing we can obtain transparency to the underlying loan level, so that we can ensure there is limited overlap between collateral type, counterparty, structure of loan, duration of loan, industry and geography - then we feel, to a certain degree, the more underlying funds - the better. The Fund is currently allocated to 32 underlying managers and the intention is to grow that number to 45-50 over the next 12-18 months. Of course, future allocations will have to pass all aspects of Eden Rocks extensive due diligence process. To date - we have rejected more ABL funds than we have invested in.
HW: How/against what do you benchmark the performance of your fund?
EH: There is no obvious benchmark for the Fund. The Fund is constructed to produce annual returns in the 10-15% range with very low volatility - regardless of prevailing market conditions.
HW: Has your performance been as per budget and expectations? Do you expect your performance or style to change going forward?
EH: Performance has been as expected since inception. The annualized return since inception is +11.22%, with no down months to date and volatility of 0.99%. The Fund has also demonstrated minimal correlation to equity and bond markets, as well as the major hedge fund indices.
HW: What opportunities are you looking at right now?
EH: We are currently conducting final due diligence on a ship financing fund, a property bridge loan fund and also an inventory lending fund. There are a number of other asset based lending funds that we are carrying out preliminary research on.
HW: What events do you expect to see in your sector in the year ahead?
We expect to see interest in the space continue to gather pace, which will lead to further capacity constraints amongst existing managers and inevitably some downward pressure on performance in some strategies. However, we envisage these challenges will be more than offset by an ever increasing number of emerging asset based lending managers.
HW: How will these changes/future events impact on your own portfolio?
EH: We need to continue to only invest in managers who are experienced and specialists in their field and who are disciplined when it comes to accepting inflows of capital. The emergence of new asset based lending, at an ever increasing rate, represents a particularly exciting opportunity for Eden Rock. Due to our experience of the sector, we are able to get comfortable with managers perhaps sooner than some of our peers. One of our greatest challenges going forwards will be to continue to identify and validate talented manager's early and secure capacity with those managers. Eden Rock has a proven track record of doing just that and the Firm is now better resourced than ever to continue along these lines.
HW: What differentiates you from other managers in your sector?
EH: Asset based lending has been the largest strategy allocation of the Firm since inception. To my knowledge, Eden Rock was the first to launch a fund of funds dedicated to the asset based lending space and now in excess of 80% of the firms assets are invested in the strategy, so it is clear that asset based lending is the focus of the Firm. We are confident that we know the universe of ABL managers intricately and I suspect we are one of the largest investors in the space.
HW: Do you have any plans for similar/other product launches in the near future?
EH: Our near term plan is to consolidate our position within the asset based lending space. We will continue to evaluate opportunities to launch further, specialist products as and when we identify opportunities to do so.
(Edward Horner was Interviewed on 13 April 2006)