HEDGE FUNDS - Comeback Kid
After several years of struggling to beat the market Maverick Capital’s Lee Ainslie is once again on top of his game, trying to disprove the skeptics who questioned his firm’s seemingly old-fashioned strategy.
ONE UNSEASONABLY WARM AFTERnoon in late October, a crowd of 200 people gathered in the auditorium of the smartly renovated Morgan Library & Museum in New York for the annual partners’ meeting of Maverick Capital. The guests, among them representatives from several of the most prestigious foundations and endowments in the U.S., had come to hear about their money. And Lee Ainslie III, managing partner of the $11 billion hedge fund firm, had good news to share.
Maverick’s main fund was up 24 percent for the year, more than triple the return of the Standard & Poor’s 500 index, Ainslie told the audience, which included Sam Wyly, the wealthy Texan who co-founded Maverick 14 years ago. Maverick did particularly well shorting the shares of subprime mortgage lenders, capitalizing on the collapse of the subprime market that had caused so much pain for many hedge fund managers and investment banks.
When Ainslie, 43, finished discussing his firm’s performance, he turned over the podium to partner Steven Galbraith, a former chief investment officer for Morgan Stanley, to talk about the current investment environment.
“I would argue that we are beginning a period of long-short nirvana,” Galbraith, 44, told Maverick’s investors, a further 200 of whom were participating in the meeting over the Internet. “My guess is that we’ve seen the bottom and we’ve got the best ahead of us.”
If he’s right, it’s about time.
From 2003 to 2006, during a bull market when many managers were making so much money they hardly knew what to do with it, Maverick struggled. Its flagship Maverick Fund was up, on average, just 7.8 percent a year, managing to beat the S&P 500 only once, in 2004. Some investors worried that Maverick had lost its edge and gotten too big for its brand of long-short equity investing, which dates back more than a half-century to hedge fund pioneer Alfred Winslow Jones. Maverick looked, at best, old-fashioned and, at worst, completely outmoded. Many firms that had started out like Maverick, doing purely long-short equity investing, had invested more globally, expanded into other strategies and embraced more-modern instruments, from derivatives to exchange-traded funds.
“Some long-short equity funds have been making macro calls,” Ainslie told Institutional Investor this spring, in the first of a series of interviews spanning more than six months. “But that is not our job.”
Ainslie’s job — pure and simple — is to pick stocks. In his model, market risk is replaced by stock-picking risk. Investors bet on the ability of the firm’s analysts, Ainslie among them, to identify stocks that will go up and those that will go down. They also count on Ainslie’s portfolio management skills to determine which ideas are the best. They are not betting on market momentum.
Early Maverick investors were rewarded handsomely for their faith in Ainslie — who got his start as an analyst for legendary Tiger Management Corp. founder Julian Robertson Jr. — and his seemingly old-fashioned method of investing. With an average net annualized return of 21.4 percent from 1995 to 2002, Maverick Fund was one of the world’s best-performing hedge funds, beating the S&P 500 index by nearly 12 percentage points a year. Maverick’s long-short strategy really shone after the tech stock bubble burst. From 2000 to 2002, it beat the S&P 500 by an average of 26 percentage points a year. Institutions, new to hedge fund investing, flocked to the firm. Its assets soared to $7.5 billion by the end of 2001, placing it No. 3 in II’s inaugural Hedge Fund 100 ranking of the world’s biggest hedge fund firms in May 2002.
But Ainslie’s strategy stopped working in 2003, when the world’s equity markets bounced back. Maverick missed many of the markets’ highest fliers on the long side. The availability of cheap credit made matters worse, as the best candidates to short — struggling companies with broken business models or bad management — often became buyout targets of private equity firms.
As Maverick struggled, quantitative funds making macro calls were doing very well. In 2005, for example, Goldman Sachs Asset Management’s Global Alpha fund and Renaissance Technologies Corp.’s Medallion fund were both up about 30 percent, easily beating the S&P 500, which rose 4.9 percent. D.E. Shaw Group’s macro strategy returned 16.7 percent that year. Taking risk was a good thing.
Even funds that stuck to long-short equity, including some managed by former Tiger employees, put up impressive numbers. Lone Pine Capital’s Lone Cypress fund, run by onetime Tiger consumer analyst Stephen Mandel Jr., was up 32.5 percent in 2005. Viking Global Equities, managed by the ex-Tiger triumvirate of Andreas Halvorsen, Brian Olson and David Ott, rose 21.2 percent; Blue Ridge Capital, managed by John Griffin, another prolific stock picker from Tiger, returned 24.5 percent. Maverick Fund, meanwhile, was up just 0.3 percent — its worst year ever.
At the end of 2005, the firm had more than $11 billion in assets, good enough for No. 16 on the Hedge Fund 100 ranking. The next year Maverick experienced its first major redemptions, losing more than 10 percent of its capital base, which shrank to less than $10 billion. Some longtime Maverick institutional investors — including University of Texas Investment Management Co. — considered pulling their money. On this year’s list, the firm was No. 40, with $9.6 billion in assets.
No one was more devastated by the dip in performance than Ainslie, who had left New York in 1993 after three years at Tiger and moved to Dallas to launch Maverick’s hedge fund. “Oddly, our disappointing results in 2003 did not concern me too much,” he says, because investors were bidding up the prices of unprofitable companies that didn’t fit his approach, which relies on extensive fundamental research. “But in 2005 I was very concerned because it was clear that we should have generated much stronger returns in what was a more rational environment.”
Maverick needed to make changes. In early 2006, Ainslie, Galbraith and the rest of the senior investment team concluded that the firm’s stock-picking process was fine, but that it needed, among other things, to think more about its portfolio as a whole, rather than focus so much on its industry-sector investments, and to grow its international presence. Yet they never wavered in their core belief that Maverick’s long-short investment approach was the right one. In fact, they had already begun trying to diversify the business by launching new funds that fed off the same idea pool as the existing strategies.
“At Maverick they love what they do, and they want to do it well,” says Denise Hitchens, head of due diligence at London-based family office Kedge Capital, a Maverick investor. “They wanted to figure out what was going wrong.”
INTROSPECTION AND SELF-ANALYSIS are key traits of Lee Ainslie — and, by extension, of Maverick. In his 2005 year-end investment letter, which begins with a quote from 19th-century British author Samuel Smiles about learning from failure, Ainslie wrote, “Our security selection was terrible — our shorts were actually up more than our longs for only the second time in our history.”
Ainslie’s own history began in Alexandria, Virginia. There he attended the private Episcopal High School, where his father was headmaster and where he formed some exceptional ties. Ainslie’s contemporaries at EHS included Winston Holt, who would eventually head client relations at Tiger and later take a similar role at Maverick, and Lee Hobson, who would also join Tiger before becoming one of Ainslie’s first hires at Maverick.
Julian Robertson is also an EHS alumnus. Ainslie, who has a BS in engineering from the University of Virginia, met Robertson while studying for his MBA at the University of North Carolina, the Tiger founder’s alma mater. Ainslie worked on a project with the UNC board of trustees, of which Robertson was a member, and the two would talk about stocks. In 1990, after graduation, Ainslie joined Tiger as an analyst. The firm had $700 million in assets and eight investment professionals.
Ainslie fit the Tiger mold. He was young, smart and athletic. (Robertson prized jocks’ competitiveness.) “Most of Julian’s analysts were barely shaving,” says Ted Caldwell, founder of Lookout Mountain Capital, a money management firm based in Lookout Mountain, Tennessee, and an early hedge fund investor.
At Tiger, Ainslie worked closely with Mandel, who would leave the firm in 1998 to found Lone Pine. “Steve is one of the finest analysts ever to set foot on the planet,” says Robertson. “I think Lee got a lot out of that relationship.”
Tiger began as a pure fundamental long-short equity shop, but by the time Ainslie arrived, Robertson had started to add other strategies. In the early 1990s global macro was king, and managers like George Soros were minting money by making big bets on bonds and currencies. At Tiger large macro bets came to dominate performance — much of its 73 percent return in 1993 was from shorting European currencies.
Adding global macro strategies helped Tiger grow. But as Robertson moved more of his firm’s assets into bonds and currencies, several of his star equity analysts left to run their own businesses. Ainslie was among the first of the so-called Tiger cubs to leave, moving to Dallas in August 1993 to manage the stock investments for a hedge fund firm being started by entrepreneur Sam Wyly. The Wyly brothers, Sam and Charles, made their fortune founding several companies, including Michaels Stores and Sterling Software. In 1990 they formed First Dallas, a private limited partnership and the predecessor fund to Maverick. After a couple of years of impressive returns — the partnership was up more than 100 percent in 1991, thanks in part to a well-timed wager on junk bonds by Sam Wyly, who managed the portfolio himself — they decided to open it up to outside investors and recruited Ainslie.
Wyly bet on everything from French interest rates to emerging-markets debt. Ainslie’s vision for the new firm — christened Maverick Capital on October 1, 1993 — was very different. To his mind, hedge funds are meant to be a relatively conservative investment vehicle, created to both preserve and grow capital, as practiced by Jones and by Tiger in its early days. By March 1995 the Wylys had given Ainslie complete authority over all investing-related activities. The next year Maverick Fund was up 46.8 percent, after fees, even though its net market exposure — its longs minus its shorts — averaged about 45 percent. The firm, which began with $21 million in seed money from the Wyly family, had grown to more than $700 million by the start of 1997.
Maverick consumer sector head Brian Zied remembers just how unique Ainslie’s vision was at the time. “Early in 1998, Lee invited me to lunch,” recalls Zied, 38, who was working as a retail analyst for Leon Cooperman at Omega Advisors in New York. “I was very impressed with the way Lee thought about building a business and his approach to investing. Most hedge funds were taking huge risk to generate returns, such as macro risk in Russia, and I just thought that was a really bad idea.”
Zied, who began his career as an investment banker at Bear, Stearns & Co. in 1991 before moving to Omega in 1995, was right. Many hedge funds, including Omega, took a hit when Russia defaulted on its government bonds in August 1998. None suffered a worse fate than Long-Term Capital Management, which lost $4.6 billion and had to be bailed out by a consortium of investment banks organized by the Federal Reserve Bank of New York. The average hedge fund was up 2.6 percent in 1998, according to Chicago-based Hedge Fund Research. In the midst of the maelstrom, Maverick returned 22.3 percent.
Ainslie’s old employer wasn’t so fortunate. After reaching a then-record $21 billion in assets in July 1998, Tiger lost $600 million during the Russian debt crisis. That began an 18-month downward spiral that would see its assets shrink to less than $7 billion. In 1999, Robertson began talking to Ainslie about taking over the Tiger portfolios or combining the two firms. After months of discussion, the two agreed that it would be difficult to come up with a solution that would satisfy both firms’ investors.
“We talked about it, and discussions went fairly far,” Robertson recalls. “But it is hard when you have something like that to say how close it came to happening.”
Merging with Tiger would have transformed Maverick overnight into the world’s biggest hedge fund firm and changed it from a long-short equity specialist into a multistrategy manager. After serious consideration, Ainslie and his senior investment team decided not to take their firm in that direction. Although Ainslie recognized the advantages of diversification, he didn’t think becoming a multistrategy firm was in the best interest of his investors.
“I’m not sure I would be able to add value consistently in a wide variety of investment opportunities,” Ainslie says. “I do, however, have significant confidence in our ability to add value consistently in long-short equity investments, and there is a lot to be said for staying focused.”
During Maverick’s first decade in business, Ainslie managed the difficult balancing act of centralizing authority around himself as portfolio manager and delegating responsibility to the senior members of his investment team. Early on he organized the now 161-person firm so that no single professional is responsible for covering, on average, more than five stocks in the portfolio. The firm’s investment universe is divided into six industry sectors — health care, consumer, financials, industrials, media and telecommunications, and technology — each run by a sector head who oversees several analysts. Maverick also has specialists in specific geographic regions, including Japan and Latin America. Ainslie and Galbraith are responsible for portfolio construction and sector weightings.
Unlike Tiger, where analysts often had to fight with Robertson to get their investment ideas into the portfolio, Maverick has a more collegial environment. “The thing that Lee didn’t adopt — the part that most managers who came out of Tiger didn’t adopt — was the strong hand,” says Lookout Mountain’s Caldwell. “Julian was a much better team builder than he was a manager.”
Ainslie, who became majority owner of Maverick on January 1, 1997, has rarely had a problem managing his team. “I have very fond memories of Maverick,” says Robert Bishop, who headed up the industrials sector from 1998 to 2002 before leaving to become CIO of Soros Asset Management. “Operationally and culturally, the firm stood out.” Bishop had first met Ainslie in 1992, when they were both analysts at Tiger. In 1998, Ainslie convinced Bishop, who was working as a portfolio manager at Kingdon Capital Management, to join Maverick, which by then had opened a small New York office. (In 2000, Ainslie and other members of the Dallas investment operation moved to New York.) “We were a unique group of people,” Bishop says. “Lee is very good at knowing who he wants to bring in and working to get that person.”
INVESTING THE MAVERICK WAY is a painstaking endeavor. Ainslie and his team try to identify the best and worst companies in each of the sectors in which they invest, performing detailed, on-the-ground research by talking to each company’s management, suppliers, competitors and customers. They use the intelligence they gather to build their financial forecasts, which they then compare against those of Wall Street analysts to find stocks that are either under- or overvalued.
“We expect to know more about a company than any other noninsider,” says Ainslie.
As of March 2000 only one investment professional had ever left Maverick. That would soon change. In February 2001, Duke Buchan III, a former Merrill Lynch & Co. investment banker who had overseen the financials sector at Maverick since 1997, left to start his own firm, Hunter Global Investors. In January 2002, Bishop departed for Soros, and consumer products and Latin America sector head Lee Hobson left in spring 2003 to launch Dallas-based Highside Capital Management. Maverick had also gone through two technology sector heads by the end of 2002.
Ainslie quickly brought in new talent, hiring investment banker Gunnar Overstrom from Morgan Stanley to replace Buchan and commodity and cyclical industries expert David Snyder to take over from Bishop. (Bishop helped recruit Snyder, who had been working as a portfolio manager at Zweig-DiMenna Associates in New York.) But it took Ainslie more than 18 months to find a new technology sector head — former Tiger analyst Andrew Warford, who had been managing a technology portfolio at Viking in Greenwich, Connecticut. Still, 2003 was one of the firm’s worst years. Maverick Fund was up just 4.6 percent, compared with the S&P 500’s 28.7 percent return.
“Lee Hobson had left, I had left, Lee [Ainslie] was doing technology on his own,” says Bishop, who today runs his own hedge fund firm, New Canaan, Connecticut–based Impala Asset Management. “I think that is one reason that year was so hard for Maverick.”
Turnover was only part of the problem. Low-quality, high-momentum stocks were leading the bull market, making it difficult for pure fundamental long-short investors like Maverick. “Operation enduring bubble” was the phrase Lone Pine’s Mandel coined to describe 2003. “Stocks went up — virtually all stocks — regardless of fundamentals, valuation, accounting practices, competitive positioning, quality of management, financial viability, earnings momentum and every other factor that we consider critical,” Ainslie wrote in his year-end investor letter.
Maverick’s traditional areas of strength, technology and health care in particular, were also becoming tougher. “The business of investing in health care has changed significantly,” says Steven Kapp, 47, sector head since 1996. “Probably the biggest change was Regulation FD.” (The Securities and Exchange Commission implemented Reg FD in 2000 to prohibit public company officials from disclosing material information to any one investor without first making it available to everyone.) “We used to have much more enlightened conversations with people,” Kapp adds.
Increasingly, other hedge funds are using the same research methods as Maverick’s. “We were one of the first hedge funds to use data from IMS,” says Kapp, referring to the London-based company that collects and analyzes information from hospitals, doctors and pharmacies. “Looking at this data gave you an edge.” Now most health care investors use IMS information.
Shorting presents its own unique set of problems. Ainslie says that is why Maverick’s core funds have always had a long bias. Short-sellers, he explains, face several inherent challenges, not least of which is the long-term upward trend of the market and the potential for unlimited losses when a short goes against them. Cheap credit and the boom in private equity deals made shorting all the more difficult, as troubled companies that were potentially good shorts became targets of buyout speculation, which drove up their prices.
By 2003, Ainslie felt he was stretched too thin. Bringing in Galbraith to help focus on the portfolio day to day was an acknowledgment that Maverick had grown too big for one person to oversee.
As former CIO of a global investment bank, Galbraith brought a fresh perspective to Maverick. He had lived in the U.K. and spent considerable time in Hong Kong and Latin America, and has a more macro view of the world than does Ainslie. He is used to thinking about the impact that economic forces have on individual companies and industries. Although only one year separates him and Ainslie, the gray-haired Galbraith looks the part of the older, seasoned Wall Street executive. “I’m one of the old men,” jokes Galbraith, one of the few investment professionals at Maverick who regularly wears a suit and tie.
Although Maverick managed to beat the S&P 500 in 2004 — it was up 14.6 percent, versus a 10.9 percent rise in the index — the next year it was barely in the black, up 0.3 percent. Some investors and market participants started wondering if Maverick and Ainslie had lost their touch.
“From our perspective Maverick at the time had gotten too big,” says Caroline Gillespie, a managing director of Commonfund Asset Management Co., a money management and fund of hedge funds firm that specializes in investing for foundations and endowments, and a longtime Maverick investor. “They have grown big, and they have hired a lot of people,” agrees Michael Hennessey, co-founder of Morgan Creek Capital in Chapel Hill, North Carolina, which manages $7 billion mostly for high-net-worth individuals and small institutions.
Size wasn’t the only problem. One of Maverick’s biggest failings was that it had not been sufficiently international and had missed much of the huge run-up in European markets from 2003 to 2005. Although Maverick has always had an international component — Hobson had been very good at investing in Latin America — it was never a truly integral part of what the firm did. Galbraith in particular recognized that Maverick needed to become more global. He got up at the 2006 partners’ meeting and admonished his own firm for not moving more quickly.
“I said, ‘We have the same level of international investment we did when it was Lee Ainslie and the pizza delivery guy,’” Galbraith recalls.
EARLIER THIS DECADE, Maverick was a favorite among the initial wave of institutional investors looking to invest in hedge funds. They included the Knight Foundation and the endowments of UNC, Duke University, the University of Texas and the University of Virginia. Maverick also had been a staple among funds of hedge funds offered by firms like Commonfund, Lookout Mountain and Morgan Creek. But by 2006 some of these investors had started scaling back their commitments to Maverick, often after becoming concerned about the affect that the firm’s size was having on performance.
The partners at Maverick have always carefully studied the question of growth. Ainslie closed Maverick Fund to new money from all but strategic investors in 1997. A year later he offered a levered version of the same fund for those looking to take on more risk. The firm was also early to implement staggered redemption fees as a means to control growth and reward long-term investors. Today, investors locking money into Maverick’s main fund for one year pay a 2 percent management fee and 20 percent performance fee. Three-year lockups carry a 1.75 percent management fee and 17.5 percent performance fee, and a five-year lockup charges 1.5 percent and 15 percent.
In 2002, Maverick started a fund of hedge funds called Maverick Stable to enable Ainslie and his partners to diversify their own investments. The fund, managed by former Maverick media and telecom analyst Bates Brown, was opened to outside investors in 2005. That year Maverick launched two market-neutral funds as well as a long-only strategy and a 150/50 fund (now 130/30), all of which rely on the same investment research as Maverick Fund.
For Ainslie, who sets high standards for himself and is always looking for ways to improve, the firm’s investment performance in 2005 was especially frustrating. At Maverick he has always emphasized hard work and dedication and discouraged complacency.
“At times it felt like we were zigging when we should have been zagging,” says health care sector head Kapp, who has known Ainslie since they were classmates at UNC. “We had put on too many investment positions and lost some focus.”
In December 2005, Ainslie brought together Maverick’s senior partners, including the six sector heads and Galbraith, and asked them to answer, in writing, two questions: If they ran Maverick, what would they change? And, if they were to start their own firm today, what would they do differently?
Ainslie reconvened the group the following month to consider the answers and come up with a plan of action. Most of the senior team thought Maverick’s fundamental long-short equity investment strategy was sound. The problem, as they saw it, was that the firm needed to improve its focus. In particular, the sector heads needed to be bolder and cut back on their number of positions.
“The number of positions they had in their books had drifted up,” recalls Commonfund’s Gillespie. “They had a lot of extraneous stuff in the book. No one individual position looked like it was doing damage, but when you added them all up, they had an impact on returns.”
In total, Ainslie and his team outlined 11 changes to improve Maverick’s performance, including promoting better communication between sector heads and reducing the number of investments in the portfolio by almost 20 percent, from about 220 to 180. And a key commitment was to make Maverick more international. During the past two years, the firm has opened, or significantly expanded, offices in London, Shanghai and Taipei.
A sharpened Maverick showed better results. Maverick Fund ended 2006 up 12.4 percent, powered by a 5.8 percent gain in the fourth quarter, thanks to good calls in the media and telecom, industrials and financials sectors. Though the fund did not beat the S&P 500, it was at least on the right track.
“Smart people don’t get stupid overnight,” says Gillespie. “Smart people stay smart and they make some errors. There was always a sense that Maverick would go through the process of self-examination and sort out their issues.”
Although this year Maverick has done well in every sector — especially media and telecom, which is led by senior partner Michael Pausic — Ainslie and his team needed something big to show that what they do still makes sense. The volatility that ripped the markets this summer, which took down some macro and quantitative managers by 20 percent or more, did precisely that. While many hedge funds — including Goldman’s vaunted Global Alpha — were scrambling to get out of losing positions, Maverick was enjoying the results of its hard work.
In particular, the fund reaped the rewards of shorts that financials sector head Overstrom began researching in 2004. Overstrom and his team believed that the shares of subprime lenders, which offer loans to borrowers with little or no credit and then repackage them for sale to Wall Street, were ripe for a fall after in some cases doubling or tripling in price in 2003.
“Folks that were long were giddy,” recalls Overstrom, who watched from the sidelines in 2004 as other investors enjoyed a 70 percent run-up in the shares of home lenders.
For Maverick the craziness of the subprime market was in full display on February 5, 2005, when Ameriquest Mortgage Co., an Orange, California–based mortgage lender, paid $15 million to sponsor the halftime show at the Super Bowl. Not long thereafter, Maverick put on its first subprime short. It wasn’t until early this year, however, that the firm started to ramp up the position, after the financials team returned from a home lenders conference in Las Vegas. There they spoke to executives from several small West Coast lenders, who told them that their companies had stopped issuing subprime mortgages because Wall Street was no longer willing to buy them.
“That was pretty important information,” says Overstrom, whose team was convinced that one of the major Wall Street firms had begun to pull financing. “The pieces were starting to fit together.”
Going into the first-quarter earnings season, Maverick had large short positions in two major lenders. At one point the financials team’s bet against the subprime market accounted for 16 percent of Maverick Fund’s net assets. “We were willing to be in very illiquid positions,” says Overstrom. “If we were wrong, getting out would have been costly.” Maverick wasn’t wrong. So successful was the firm’s subprime bet that Ainslie had Michael Lyons, a managing director in the financials group, give a presentation on the investment at the annual partners’ meeting. Maverick’s conservative approach to investing, which emphasizes both capital preservation and growth, seems ideally suited for today’s volatile times, as evidenced by its 31 percent return for the 12 months through mid-October, with roughly half the volatility of the broader market. The firm’s 130/30 fund was up 22.9 percent, more than three times the return of the S&P 500 index.
Ainslie wrapped up the meeting with a Q&A session. After a handful of polite inquiries, the audience was largely silent.
“Are there any other questions?” asked Ainslie. “I can’t believe I am getting away so easily this year.”
As the limited partners made their way upstairs into the library’s newly constructed steel-and-glass conservatory for a wine tasting hosted by Maverick, they appeared satisfied with what they had heard. The wines were organized by country, and in a typical Ainslie touch, the New Zealand selection included a sauvignon blanc from a vineyard owned by Julian Robertson. For Maverick, 2007 looks to be a successful vintage.
Says Ainslie, “We are getting back to a level of returns that we can be proud of.”