MICHAEL BURRY PREFERS NOT TO DISCUSS THE FUND MANAGERS WHO HAVE invested with him. But when it comes to Chalkstream Capital Group and its CIO, Andrew Tsai, the California physicist-turned-hedge-fund-manager, who earned a fortune shorting the U.S. subprime market, makes an exception. “I found Andrew and his team to be highly intelligent, very engaged and very well informed as to their understanding of the space,” says Burry, who wasn’t always on the very best of terms with all his investors. Today, Burry manages only his own money.
Tsai needs to be exceptional. Chalkstream’s small client base consists almost entirely of hedge fund executives and partners at major banks and asset managers who have entrusted the New York–based firm with their personal capital. As some of the world’s top investors, they have high expectations — none more so than Tsai’s business partner, Peter Muller, a former proprietary trader at Morgan Stanley who left the bank last year and launched quantitative hedge fund firm PDT Partners.
Muller and Tsai founded Chalkstream in 2003 as a family office to run Muller’s money. From the start, though, they planned to attract like-minded capital and create a bespoke firm catering to sophisticated investors. The pair found clients who could stomach relatively high risk and volatility in exchange for the potential payoff from bold bets on unique opportunities. “We want to traffic in areas where there is not a lot of capital chasing for returns,” says Tsai in an interview at Chalkstream’s Midtown Manhattan offices in the Random House Tower, an address the firm shares with PDT.
Tsai and his 12-member team have caught some of the most interesting and profitable trades of the past decade. Despite Chalkstream’s impressive pedigree and investor base, however, its overall returns have yet to truly impress. But the firm is confident that it can hit a home run with its biggest bet yet: on Japan, the graveyard of many a brave fund. If Tsai succeeds, Chalkstream will have lived up to its promise.
With $700 million in assets and a dozen significant outside clients, Chalkstream is a hybrid of family office and fund of hedge funds. When it isn’t developing its own investment ideas, it looks for one-of-a-kind managers like Burry and his former firm Scion Capital. Chalkstream’s fund-of-hedge-funds portfolio consists of 15 to 20 managers, and it keeps a second, less-liquid portfolio for major tactical — though not necessarily directional — bets and private-equity-type opportunities. The mix can vary, but the firm typically splits its assets about 60-40 between the two. Chalkstream charges an annual 1 percent management fee and 10 percent performance fee on the hedge fund portfolio, and a 15 percent private-equity-like performance fee for the illiquid portfolio.
The firm’s philosophy sets it apart from institutional investors and funds of hedge funds that focus on asset allocation and avoid market timing. Chalkstream tries to stay out of step with stocks and bonds — its clients have enough exposure to both — and makes large calls that would spook more-traditional investors. “We think traditional asset allocation is very dangerous,” Tsai says, “since people are allocating on the past, not the future. We are not in the business of filling buckets; we are in the business of finding opportunities.”
Besides shorting subprime mortgages in 2007, Chalkstream profited from 2009’s run-up in Brazilian commercial real estate and the 2010 subprime rally. To really thrive, though, the firm must grow its assets. With that in mind, Tsai and Muller want to start attracting institutional capital. They’re keen to lure some big fish: corporate pension funds and other institutions that might see their shop as an idea generator as well as an investment opportunity.
But even a sophisticated hybrid firm like Chalkstream faces the same headwinds as other hedge fund advisory businesses. Many investors are unwilling to pay the double layer of fees, the cost of doing business and the barriers to entry are rising, and few managers are posting extraordinary returns. Investors may admire Chalkstream, but privately some admit to disappointment with its performance. Through the end of 2012, it had returned an annualized 5.6 percent net of fees since inception in 2003, compared with 50 basis points for the HFRI Fund of Funds Composite index, but Chalkstream was stung hard in 2008, when its hedge fund portfolio finished the year down 44 percent. (The firm declined to comment on performance.)
Although Chalkstream quickly bounced back, the 2008 stumble also raised questions about the team’s ability to time its best ideas given its relatively early exit from the subprime trade. These are questions that the firm hopes to silence with the new Japan investment.
That trade has an equity and a credit component. Known for its deep-dive investment process, the team has been researching the Japanese market for at least six years, led by partner and investment analyst Rishi Shah, who has visited the Land of the Rising Sun alone and with Tsai. In Tsai’s view the current Japanese economy shares some structural similarities with the U.S. subprime market before 2007. As proof of its conviction, Chalkstream is raising its first-ever stand-alone fund for the investment.
“I look at what they are doing in Japan right now, and I really like their thesis,” says longtime Chalkstream investor Arjun Divecha, chairman and head of emerging markets at $106 billion, Boston-based money manager GMO (formerly Grantham, Mayo, Van Otterloo & Co.). “What is exciting to me is the way they are going about it.” For more than two decades, Japan has proved a terrible place to invest, Divecha notes, but Tsai and company “have found a can opener to open the can that has real potential,” he says.
Tsai, 41, was born in St. Louis; his family had moved there from Taiwan so his father could earn a Ph.D. in engineering. The younger Tsai graduated from the Wharton School of the University of Pennsylvania in 1993 with a BS in economics; he wrote his senior thesis on how to set up a hedge fund.
After interning with broker-dealer Susquehanna International Group, working as an open-outcry trader on the floor of the Chicago Mercantile Exchange, Tsai joined Lehman Brothers Holdings’ fixed-income trading desk in New York. In 1997 he left Lehman to become CIO of New York–based Integrity Capital Management, a quantitative hedge fund he launched with four other partners, including two former Goldman Sachs Asset Management executives. At Integrity, Tsai got to know Chalkstream co-founder Muller, an investor in the fund. “I was just really impressed by how he thought, how he conducted business, his character and his passion,” says Muller, whose PDT Partners manages more than $2 billion in assets.
Integrity closed its doors in 1999, a victim of the crash that brought down its much larger rival Long-Term Capital Management. Tsai joined the tech boom, becoming president of Urbanfetch, a start-up with offices in New York and London that let customers order whatever they wanted online and receive it by messenger. By 2003, Urbanfetch, like many other dot-coms, had folded. Tsai was working in London as CEO and director of Global Name Registry, an Internet infrastructure company backed by U.S. private equity firm Carlyle Group, when Muller came knocking.
Now 49, Muller grew up in Philadelphia and New Jersey and majored in math at Princeton University. After college he moved to the San Francisco Bay Area and took a job as a researcher and programmer at pioneering quantitative research firm Barra. In 1992 he moved to Morgan Stanley, where he built up its famed proprietary quantitative trading business, PDT — although the bank never broke out returns, this unit was known to be highly profitable — and quickly established a reputation in the close-knit quant community.
“I think the first time I ever spoke to Pete, he called me up to yell at me,” says Clifford Asness, founding and managing principal of $70 billion, Greenwich, Connecticut–based quantitative alternative-investment firm AQR Capital Management. Muller had gotten wind that AQR might be interviewing someone from PDT, and he was not happy. The two quickly put the matter behind them and became friends, but Asness says Muller remains “quietly one of the most competitive guys you’ll ever meet.”
While at Morgan Stanley, Muller started investing his own money with hedge fund managers. “I realized that trying to pick good funds, keep track of how they were doing and figure out how to allocate was just as challenging an investment business as running a hedge fund,” he says. “If I was going to do it, I wanted to do it well, and I didn’t have time or inclination to run another business myself.”
Muller decided to launch a family office and put Tsai in charge, but he knew he would have to be open to accepting other people’s money. “I didn’t have enough capital to afford Andrew and a world-class team,” says the skilled pianist and songwriter, who has performed at numerous venues in New York City. “So the idea was that over time if we were successful and we liked doing it, we would bring in outside investors.”
The firm started with a modest $200 million, sharing windowless Madison Avenue offices with a hedge fund. Its name reflects Tsai’s interest in fly-fishing, a hobby he picked up in the U.K. Tsai ran Chalkstream’s day-to-day operations while Muller chaired the five-person investor committee.
Robert Stavis was an early investor in Chalkstream. Now a partner with Larchmont, New York–based venture capital firm Bessemer Venture Partners, Stavis spent many years as a fixed-income arbitrage proprietary trader before retiring and investing his own money. A member of Chalkstream’s investor committee, he says he’s impressed by “what they are trying to do, which is not be just an index of alternatives but to have a thoughtful view on any part of the investment cycle and to try and articulate that by finding themes and investing in those themes.”
GMO’s Divecha also got in early. Divecha, who is based in Berkeley, California, met Muller when they both worked at Barra. When Muller came to him with the idea for Chalkstream, Divecha was intrigued. “What I particularly like is their choice of interesting investment theses,” he says. “It is really the quality of the thinking and the analysis.”
While Chalkstream was gathering investors, Tsai and his team began putting money to work. In 2003, after thoroughly kicking the tires, its hedge fund portfolio allocated to Burry and his Cupertino, California–based Scion. “I was looking for investors who would do a lot of due diligence up front and understand the people and the process by which we invest,” Burry says. At about the same time, Chalkstream started looking at two small hedge funds in Japan, whose names it won’t disclose. These funds seek to unlock returns at small and midsize Japanese companies by working with management to make governance and operational changes.
Two years later Burry turned his attention to the U.S. mortgage market. In an effort chronicled by Michael Lewis’s 2010 bestseller The Big Short, he sought investors to take advantage of the opportunity he saw there. Chalkstream was one. As the bottom fell out of the subprime market in 2007, the handful of hedge funds and other investors that had shorted it won big. Burry executed his subprime trade through credit default swaps. Chalkstream gained 26.2 percent that year, compared with 10.39 percent for the HFRI Fund of Funds Composite.
Although subprime kept making money in 2008, the risk also spiked. It was unclear whether regulators would interfere with the market — as they would by stopping traders from shorting bank stocks later that year — or how long the profits would keep rolling in. In early 2008, Burry closed his firm, returning investors’ capital, and left the asset management business. For him, making money off so much suffering as people lost their homes was deeply unsettling. “It was terrifying,” Burry recalls. “It felt like I had a front-row seat to a jetliner crash.”
For Chalkstream the global economic collapse of 2008 was humbling. U.S. equity markets plunged roughly 40 percent that year, while the average fund of hedge funds was down 21.37 percent. Chalkstream’s big loss mainly stemmed from its overuse of leverage and a lack of transparency in some of its underlying hedge funds that meant the firm didn’t hedge risk as well as it should have. The special investment fund fared better than the hedge fund portfolio, falling 24.8 percent. “Last year we did not execute the cardinal rule of investing: preserve capital,” Tsai told investors in an apologetic year-end letter. “The last four months of the year were a shock both for the magnitude and the speed of our losses.” Still, Chalkstream didn’t see a single redemption in 2008. In fact, two of its major investors boosted their allocations. The firm rewarded this loyalty by returning 33.3 percent in 2009, versus 19.98 percent for the overall hedge fund market and 11.47 for funds of hedge funds.
Chalkstream improved position-level transparency in its hedge fund portfolio, began doing more in-house hedging and stopped using leverage at the portfolio level. Investor committee member Stavis thinks the changes made a big difference.
Tsai wants Chalkstream to blend the best of the hedge fund industry’s institutionalization with the more entrepreneurial spirit of hedge funds’ original era, which lasted until the end of the 1990s. “We invested in technology and systems much earlier in the life cycle” than most family offices, he says. “We’ve spent almost ten years building up our risk analytics.” This allows Chalkstream to execute even complex trading strategies in-house, an advantage it will need for the credit portion of its new Japan strategy.
Chalkstream is open to new capital, but Tsai insists that it has no plans to become an asset gatherer. The firm wants to keep its asset base small enough that it can stay nimble but still make enough money to keep and develop new talent. That includes COO Balkir Zihnali, who monitors Chalkstream’s hedge fund and direct investments. Born and raised in Turkey, Zihnali worked as a forensic accountant for PricewaterhouseCoopers in Eastern Europe before earning his MBA in finance from New York University’s Leonard N. Stern School of Business and moving into the hedge fund industry. He joined Chalkstream on Tsai’s invitation in 2009. “It feels like the classic fund-of-funds model is broken,” Zihnali says. “I wanted to go to a more hybrid opportunity.”
If Zihnali is key to executing the Japan strategy, partner Shah built that strategy with Tsai. Before Shah came on board in 2006, he was an analyst for Greenwich-based property investment firm Starwood Capital Group. Some mutual friends introduced him to Tsai, who explained how Chalkstream was going to short the U.S. mortgage market through credit default swaps. “It was a perfect hedge,” says Shah, who started on Japan shortly after he arrived.
Japan’s economy has been contracting since the 1980s, but many investors have mistakenly believed they could unlock value in some of its companies. Extracting good returns from these supposedly undervalued corporations has proved difficult over the years, and plenty of hopefuls have lost money in the so-called Japanese value trap. Life has been even worse for foreign activist investors who came to Japan seeking to force change on its companies, only to fail. In the small to midcap range, though, Chalkstream has found opportunities. A significant subset of those companies are currently trading below the value of the cash on their cash-heavy balance sheets. Chalkstream is convinced that in some cases it can unlock value by working with management.
For this equity trade to work, on-the-ground experience and know-how are crucial, Tsai says. Chalkstream has invested with the two Japan-based hedge funds that it has gotten to know well over the past six years. Its due diligence on each firm was so extensive that Tsai and his staff accompanied investment team members to meetings with company management, bringing along their own translator.
On the credit side Chalkstream seeks to capitalize on a structural peculiarity of the Japanese corporate bond market and on the country’s debt-burdened sovereign balance sheet. Japan has an aging population, and retail and institutional investors have flocked to name-brand corporate credit such as that of Mitsubishi UFJ Financial Group and Sony Corp., so the nation is deeply invested in its blue-chip companies. This has created a supply-demand imbalance: A company’s debt doesn’t always trade on its fundamentals, and thanks to strong appetite for corporate bonds, a struggling enterprise can still be valued above par.
Until recently, Japan hadn’t let its corporations default. But given its own deficit and the general scarcity of capital worldwide, it can’t keep bailing them out, Tsai explains. As a result, some will fail. That’s already starting to happen: Last year computer chip manufacturer Elpida Memory filed for bankruptcy protection and consumer electronics maker Sharp Corp. came close to the brink. Chalkstream is buying credit default swaps on Japanese corporations that it regards as vulnerable. Owing to demand for corporate credit from the Japanese retirement market, as well as the widespread assumption that the government will never allow large-cap casualties, such insurance contracts are still relatively cheap.
What makes Chalkstream’s Japan trade distinctive is its structure. The firm stands to make money in a bad economy through CDSs or in a good one through equities. In fact, Tsai is confident that both sides will do well. He stresses that this is not a macro or directional strategy.
The Japan play is Chalkstream’s ideal target: a blind spot in the market, an opportunity “created by some dislocation or confusion,” Tsai says. It’s too early to tell if the Japanese fund will thrive, but it looks promising. Launched last October, it returned 5.6 percent for its first three months.
The 2008 economic collapse and its aftermath shook investor confidence in the old ways of doing business. Institutions have been questioning their fundamental assumptions, putting everything from manager selection to asset allocation up for review. If Chalkstream can prove it has found a better way, the firm may find itself standing at the headwaters of a new approach to money management, reeling in some of those big ones.
