Maurice Salem is by his own admission something of a bond bore, happiest in the world of prepayment risk, negative convexity, reverse repurchase agreements and other bond market arcana.This obsession has served Salem, the 35-year-old founder and managing director of Wharton Asset Management, and his investors well. From offices in Upper Brook Street, hard by the U.S. Embassy in London’s swank Mayfair, he has been running family and outside money in a range of private offshore funds since 1993. Salem launched Wharton’s first publicly available investment fund, Y2K Finance, in September 1999.
The $1.45 billion hedge fund’s results are certainly eye-catching. Between September 1999 and May 2005, it has produced cumulative returns of 131 percent, net of fees. Y2K has not recorded a single negative month: It sports an average 12-month return of 16.75 percent and a standard deviation of a mere 2.84 percent. These returns have been extracted from some pretty dull instruments -- asset-backed securities, 54 percent of which are triple- and double-A rated -- through a rare financial sophistication.
Even more noteworthy, Wharton emerged unscathed when the ratings downgrades of automakers Ford Motor Co. and General Motors Corp. by Standard & Poor’s on May 5 roiled credit markets, affecting instruments ranging from investment-grade, high-yield and emerging-markets securities to, most markedly, complex structured products like credit default swaps. The ructions wounded several high-profile hedge funds, including London-based GLG Partners’ Credit Fund, which lost 14.5 percent in May.
Wharton sailed through the crisis, thanks to its single-minded focus on ABSs: bankruptcy-remote special-purpose vehicles that provide investors with comfort about default risk even as their complexity offers a yield pickup over equivalently rated securities. Wharton manages $6.7 billion in the asset class, 75 percent of which is in U.S. securities. In addition to its Y2K hedge fund, the firm also manages $5.25 billion in ABS collateral in three collateralized debt obligations and invests in property and private equity deals for the Salem family and their friends.
“We have never really thought of ourselves as a hedge fund,” says Salem. “The opportunity could be in hedge funds or CDOs or wherever we believe we have a specialist expertise that differentiates what we do from the hundreds of other managers out there.”
The ambitious Salem would like to push Y2K’s assets up to $2 billion while expanding its investor base among funds of hedge funds and other wealth managers. The original investors in Y2K were chiefly the proprietary trading desks of big banks. Wharton charges a 2 percent management fee plus 20 percent of all gains over its hurdle of one-month average LIBOR. The minimum investment is $5 million.
Salem would also like to continue to ramp up the CDO business, on which Wharton earns management fees and holds equity pieces in two of its three deals, aiming for big capital gains. “There is no reason we shouldn’t be managing $10 billion in a few years,” he says. “We have the right track record, and this is a market niche that we can fill.”
Many observers concur. “Maurice’s team is one of the smartest groups we have dealt with. A lot of what they do has been highly innovative,” says Richard Pereira, vice president in the asset finance group of Nomura International in London. Y2K was one of the first European hedge funds to buy ABSs. And Wharton’s H2 Finance CDO, launched in March 2004 with $1.8 billion in assets, was the first of its type, a cash CDO backed by repurchase agreements.
Like most bond fund managers, Wharton is unabashed in its embrace of leverage, the erstwhile bogeyman of market worrywarts. On average the firm gears up the Y2K hedge fund between 14 and 18 times its assets, utilizing the abundant financing of the repo market, where bonds are pledged as collateral with other banks in return for cash, or vice versa. (When cash is pledged for bonds, it is known as a reverse repo.) Salem limits the fund to a maximum leverage of 20 times, though banks would offer more against such highly rated collateral.
Of course, leverage carries risk, even in the collateralized repo market. The chief hazard: a lack of liquidity caused by investor panic in the midst of a market meltdown. “There is a danger in using repo to finance leverage,” says David Rosa, a structured-finance analyst at credit rating agency Moody’s Investors Service in London. “A market dislocation could infect the repo markets and the ability of a fund to finance its positions. That said, repos are the lifeblood of markets, so any disruption in the repo market would be set against the background of broad market crisis.”
Wharton has done its best to minimize those risks. For Y2K the firm uses extended-term repos. Whereas most dealers use repos for short periods -- overnight or perhaps out to one week -- Wharton typically uses repos with a maturity of up to six months, which can buy time in a market crisis. The firm has gone to greater lengths to secure triple-A ratings on its CDOs, turning to a so-called evergreen repo, which effectively employs a put option to extend the repo a further six months, buying even more time. Salem has also arranged a E250 million ($301 million) committed bank credit line to back up the repo facility. Providing additional stability, the CDO assets typically have a maturity of about five and a half years, while the liabilities -- the investor payouts -- stretch out in different tranches over eight years. Wharton holds the management contract for the life of the CDO.
“The main risks for hedge funds are liquidity and potentially large investor redemptions. CDOs work for us because we are terming the trade; we are terming the assets, the investors and the liabilities,” explains Salem.
Y2K was early to the asset-backed repo trade, which made Wharton a valued account for the repo desks and bond traders of big banks. “There was very little repo of ABSs going on, and none by funds,” says Salem. Other funds have since moved into the arena, including London-based firms BlueBay Asset Management, which has $2 billion in a range of fixed-income hedge funds, and Cambridge Place Investment Management, which manages $4.7 billion in funds and CDOs.
Though Y2K has $1.45 billion in assets, turnover of the underlying cash ABSs runs closer to $30 billion a year. The repo market provides cheap financing for all this activity. Wharton funds positions at close to LIBOR, a rate usually reserved for big banks dealing among themselves. That aggressive funding approach has boosted Y2K’s returns and helped Wharton move into managing CDOs, because the ability to fund cheaply makes the H2 structure work.
Since the beginning of 2004, Wharton has raised a little more than $5 billion for three CDOs. The first, H2 Finance, is composed of European ABSs and is financed by repos. The second, G Square Finance, is made up of U.S. securities and has assets of $1.25 billion. It was launched in November 2004; notes were issued to fund 10 percent of the assets, with Wharton holding an equity piece worth $11.25 million. The remainder of the the CDO was financed through a senior swap provided by Citigroup. The third CDO, the Delta CDO Series 2005-1, is the first managed synthetic CDO done by a European manager; it was launched in April with $2.2 billion of assets.
This collection of CDOs puts Wharton in pretty heady company. The biggest CDO managers are among the savviest of traditional bond investors: in the U.S., BlackRock, Bridgewater Associates, Pacific Investment Management Co. and TCW Group; in Europe, AXA Investment Managers and Prudential M&G.
Among hedge funds Wharton is following a trail blazed by the Clinton Group in the U.S. Since 2000, Clinton has launched eight CDOs, five mezzanine-grade ABS deals totaling $2.4 billion at time of issue, two synthetic investment-grade corporate bond structures totaling $2 billion at issue and a high-grade ABS deal valued at $1.5 billion at issue. By contrast, the firm runs $1.54 billion in hedge fund assets.
BORN IN LEBANON, SALEM MOVED WITH HIS FAMILY in 1975, at the onset of that country’s civil war, to Belgium and was sent off to Carmel College, a U.K. boarding school, in 1981. The son of a merchant who made money trading tobacco in West Africa, Salem studied economics and French literature at the University of London. He put in a short stint in the graduate training program at Edmond Safra’s Republic Bank (now part of HSBC Holdings) in London before joining Swiss Bank Corp. in 1990. With his fluent French, he quickly rose to become head of the French government bond sales and trading desk, then one of the biggest in the firm.
In 1993, at age 23, he left Swiss Bank to set up Wharton. He chose the name because his family had bought Bala Cynwyd, Pennsylvaniabased Wharton Econometrics Forecasting Associates a year earlier. Wharton’s first private fund, called Carmen, invested in global fixed income with a macro style. At the same time, Salem’s younger brother, Gaby, began investing the money of family and friends by buying up property and making private equity deals through a fund called Genesis.
Wharton has since done a number of deals in conjunction with private equity firms. For a short time it was among the owners of Belfast City Airport, which was sold to TBI in 1996. With Mercury Private Equity it was one of the backers of G2 Estates, the management buyout group that took Greycoat Properties private in 1999. And this year it backed Lehman Brothers Real Estate Partners’ acquisition of Fastighets AB Tornet, Sweden’s third-biggest property company.
For six years Salem was content for Wharton to manage his and his family’s money. Then in 1999 he decided to launch Y2K and offer it to the public. “It wasn’t an easy decision; we weren’t used to having to answer to outsiders,” he says. “But it was the right decision. Y2K was the first ABS hedge fund in Europe, and its performance has put the business in the public eye, which has had many benefits.”
At its core Y2K generates returns by leveraging spread trades. Salem estimates that half of Y2K’s returns come from cheap funding and leverage and the remainder from securities selection. “We don’t use prime brokers,” he says. “We deal directly with banks. We have worked very hard to develop these relationships with the banks. It is those relationships and the funding we can get that makes Y2K work.”
That nimble financing also undergirds the CDO business. CDOs typically fund the securities in their portfolios by issuing notes to the public, explains Juan Carlos Martorell, senior vice president and head of structured-products analysis at S&P in London. H2 has issued notes in four tranches, raising E140 million. Wharton bought E15 million of unrated equity notes, the so-called first-loss piece.
But the bulk of the portfolio is funded through repos. Says Martorell: “In effect, Wharton has created a mismatch between the maturity of the asset portfolio, which is typically five years, and the short-term repo liabilities. That creates a market-value risk that is unusual in a CDO.”
Moody’s Rosa says H2 is a hybrid of a CDO and a structured investment vehicle. For the rating agencies, this makes analysis that much more difficult. A traditional CDO is assessed according to the investment policy of the manager and the credit risk of the assets. To assess H2, the rating agencies also have to take into account how the manager funds the portfolio. Moody’s biggest concern has been a possible dislocation in the repo markets. If Wharton were unable to fund in the repo markets, it would be forced to sell the asset portfolio to pay back its borrowed cash.
“What kills funds is being forced to liquidate positions in a very short period of time, generally when everyone else is also rushing to the exit because there is a market problem,” says Salem. “The evergreen means that we won’t have to do that.”
Though H2 took more than six months from conception to pricing, the effort was well worth it, says Salem. Although investors in the Y2K hedge fund can take their money out with 30 days’ notice, CDO investors are locked into H2 until maturity. The senior notes mature in 2009; the subordinated notes and equity mature in 2011.
“We would do this trade every day if we could,” admits Salem. “It’s a great trade for us. From a business point of view, we have certainty of assets. But one of the reasons we can raise the money is because we have a track record to show investors. We also buy the equity, the first-loss piece of the transaction.” Known in the trade as “skin in the game,” buying the equity notes is a good way for managers to reassure investors that their interests are aligned.
It is testimony to Wharton’s expertise that no other manager has reverse-engineered the H2 Finance structure. Other managers could do it. But Wharton has a huge advantage when doing these transactions: It is a seasoned player in the repo markets and has existing repo lines with banks, and it is able to obtain very attractive rates of financing. “There are plenty of managers with experience running asset-backed securities, but very few that have funding experience,” says Nomura’s Pereira.
The problem for Wharton is that even with its ability to fund at rates close to LIBOR, there is no arbitrage when spreads on ABSs are as tight as they are now. Investors have piled into floating-rate assets, and spreads have compressed, particularly in Europe. CDOs of triple-A-rated ABSs are now 12 basis points tighter than the 2003 average, and spreads on triple-A-rated covered bonds are as tight as 15 to 18 basis points over LIBOR, compared with the high 20s at the start of the year and as wide as 55 basis points in 2000.
That is why Wharton’s second CDO, G Square, is buying dollar-based assets. “We can’t afford to put the trade on in Europe at the moment because the current spread environment is difficult,” says Salem. “If and when this changes and spreads widen, we will be ready.”
G Square doesn’t use repos. Its funding comes from a total-return swap with Citibank. Wharton delivers the ABSs to Citibank, and Citibank pays the interest and principal on each security on payment date. For providing the swap, Wharton pays Citibank LIBOR plus an undisclosed spread. In effect, instead of using a repo, Wharton receives term funding from Citibank.
To handle all of this activity, Wharton has been growing. The firm’s professional staff has more than doubled, to 15, in the past three years. Among the hires are head of structured products Paul Cook, who joined in September 2003 from UBS, where he was head of syndicate and trading; Stefan Loreti, who was a senior analyst at Abbey National; and Simon Burton, a BlueBay CDO manager.
In October, Katie Maher joined Wharton as head of risk. She is a former forensic accountant from Deloitte & Touche who was most recently seconded to the U.K.'s Financial Services Authority, dealing with the inappropriate selling of split capital investment trusts.
“It seems I have fallen into an institution,” Salem muses. “But I still think we can move fast. We can ramp a CDO deal fast, and I would like to maintain a slightly maverick edge.”
