This content is from: Portfolio

West Meets East

Pacific Alliance Group delivers consistently strong returns by scouring Asia for mispriced assets and other opportunities.

Chris Gradel is a romantic at heart — at least when it comes to office buildings. For the past seven years, the co-founder, managing partner and chief investment officer of Hong Kong–based Pacific Alliance Group has been operating his growing hedge fund empire from St. John’s Building, an unremarkable 22-story rectangle of glass and steel in the city’s Central business district that is overshadowed by much newer and taller towers. As other hedge fund managers in Hong Kong have flocked to such glitzy buildings as the 62-story Cheung Kong Center, whose tenants include U.S. multistrategy giant Eton Park Capital Management, Gradel has stuck with St. John’s, where he started his firm in July 2002 with just $10 million in assets and a lone secretary, subletting a single room.

"We have a slight sentimental attachment," says Gradel, 37, whose firm now occupies three floors, has $3 billion in assets under management and employs 120 people spread among its original Hong Kong headquarters and posher digs in Beijing, Shanghai and Tokyo. "We also don’t like following the crowd in anything that we do."

No one can accuse the Ulster-born it of following the crowd. Unlike most of the big multistrategy shops and smaller hedge fund managers that have rushed into Asia this decade and made largely long-only bets on its promise of rapid economic growth, especially in China, Gradel and his team at Pacific Alliance have placed a decidedly directionless wager on the region. Although they are generally bullish on Asia’s long-term prospects, it doesn’t matter to them whether markets there go up or down. In true hedge fund fashion, they scour their world for mispriced securities, identifying innovative ways to arbitrage them or catalysts to unlock their value. During its short lifetime, Pacific Alliance has invested in everything from listed closed-end country funds trading at deep discounts and nontradable Chinese C shares to asset-backed loans and distressed debt.

The approach seems to be working: Gradel’s flagship $1.45 billion Pacific Alliance Asia Opportunity Fund has a net annualized return of 27.71 percent since its inception through May of this year. That’s more than twice the 12.24 percent annualized return for the Eurekahedge Asia ex-Japan hedge fund index during the same period and a whopping five times the 5.14 percent return for the MSCI AC Far East ex-Japan index. Pacific Alliance’s performance during the recent turbulence has been even more impressive. For all of 2008 the Asia Opportunity Fund was up 7.64 percent, trouncing the Eurekahedge index, which fell 26.45 percent, and the MSCI index, which plummeted 54.48 percent.

"Anybody who was up last year was doing something right," says Robin Eggar, head of communications and public affairs at Winton Capital, a $15 billion London-based hedge fund firm. "These guys [at Pacific Alliance] were smart to have found a niche where the holes were obvious, and they exploited it while others stood by idly."

Gradel has profited by operating away from the crowd. But the real secret to his success has been his knack for identifying talent — a skill he developed as captain of boats for his college rowing club at Oxford University — and his decision early on to emphasize local expertise in building his team. Pacific Alliance’s investment process depends on it, as Gradel and his fellow portfolio managers and analysts do their own on-the-ground research to generate investments; they don’t want to rely on bankers or other intermediaries for ideas.

"That was critically important last year, when many hedge funds lost a lot on poorly structured syndicated investments okered by the banks," Gradel notes.

All of Pacific Alliance’s 32 hedge fund investment professionals have extensive experience in Asia. Some, like managing director Ian Zheng, Gradel’s first hire, grew up and went to school there. Others, like COO Derek Crane, a it, have spent most of their careers in the region. The combination of homegrown and imported talent has helped Gradel — who studied economics and engineering at Oxford before getting a more practical business education in the employ of American industrialist Robert Pritzker — navigate the often murky world of Asian markets.

Gradel himself has spent most of his adult life in Asia. He first came to China in the mid-’90s to run a factory that Pritzker’s company, the Marmon Group, was purchasing from the Chinese government. In 1999 he moved to Hong Kong as a consultant for McKinsey & Co. It was there, two years later, that he met Horst Geicke, a former president of the German Chamber of Commerce in Hong Kong, who owned trading and manufacturing businesses in China and Vietnam. The two hit it off, and Geicke provided half of the seed capital for Pacific Alliance. In return he got one-third ownership of the management company and the title of nonexecutive chairman (both of which he retains today).

The other $5 million came from Millennium Management, the now nearly $12 billion New York–based multistrategy giant run by Israel Englander, where Gradel worked for three months in 1999 before starting his job at McKinsey. Millennium went on to invest as much as $150 million with Pacific Alliance and to own 20 percent of its management company before Gradel bought back half its stake in 2007 and the rest this year.

Under Gradel’s leadership, Pacific Alliance blossomed almost overnight into a major player in Asian markets, dealing in hedge funds, private equity and real estate. With $1.45 billion in hedge fund assets as of April 1, it is the seventh-biggest hedge fund firm headquartered in the region, according to Alpha ’s latest Asia 25 ranking, up from No. 12 a year ago and No. 19 in 2007. Working closely with managing directors Zheng and Eddie Hui, Gradel oversees the firm’s hedge fund investments, the majority of which are in China.

"I spend practically all my time on the hedge fund," he says. "I manage the fund."

Entrusting the firm’s other investment activities to members of his team has allowed Gradel to focus his energies on the hedge fund. Managing partners Allan Liu and Rachel Chiang head up Pacific Alliance’s 50-person private equity group, which has invested a total of $1 billion in 34 deals , including China’s first leveraged buyout. Patrick Boot, a managing director who Gradel recruited in 2007, is in charge of the firm’s $300 million in Chinese real estate investments. Pacific Alliance also owns 55 percent of VinaCapital Group, which Geicke and Gradel co-founded in 2003 with Don Lam to invest in real estate, private equity and other ventures in Vietnam. VinaCapital CEO Lam manages the firm’s now $1.7 billion in assets largely independently from Pacific Alliance.

Gradel has had his headaches. In September 2006 his firm successfully listed on London’s AIM exchange a $275 million closed-end fund that follows the same investment strategy as the flagship hedge fund. The Pacific Alliance Asia Opportunity Fund Limited (not to be confused with the limited partnership of the same name) soared by 60.86 percent in 2007, lifting its assets to $407 million, but last year it suffered an 18.31 percent loss, while the more diversified hedge fund made money. Following a recent vote by shareholders, Gradel wrapped the closed-end fund back inside the limited partnership.

Growing up in Northern Ireland, Chris Gradel got a firsthand view at a young age of the repercussions of political conflict. His parents had moved from Germany to Ballymena, a loyalist stronghold, in 1970, the year before he was born, and Gradel remembers watching from the school playground as dense smoke occasionally rose over the small industrial town, signaling that the Irish Republican Army had just set off a car bomb. In 1977 an IRA terrorist oke into his house and tried to kill his father, who ran an Irish subsidiary of a German company. "I slept through the whole thing," says Gradel, who lived in Northern Ireland until the age of 15, when his father changed jobs and moved the family to Loughborough in the Midlands region of England.

Gradel’s own fighting instinct showed itself at Oxford, where, as an undergraduate, he took up rowing for New College, one of the 38 schools that make up the university. "When I started I had no idea that rowing takes so much time and involves such tremendous pain," says Gradel, who manned all eight oars — at one time or another — for the eight-man crew and was named captain of boats his senior year by the New College Boat Club in recognition of his leadership and competitive spirit.

He graduated from Oxford in 1994 with an honors degree in engineering, economics and management. Given his résumé he could have easily gotten a job with a top bank or company in the U.K., but he chose to work for Pritzker, whom he had met when Pritzker was a visiting lecturer at Oxford. Pritzker had built Chicago-based Marmon Group into one of the largest privately held companies in the U.S. and offered to launch Gradel’s career by throwing the young man into the deep end.

"Bob said, ‘Before you run any of my businesses, you have to spend a year on the factory floor to see for yourself how it works,’" Gradel recalls.

Gradel soon found himself in Cedar Bluff, a 1,000-person town in rural Virginia, working for a company that made coal-mining equipment. One of his first jobs was to count all the bolts on each type of machine in the factory. "It was mind numbing," says Gradel, who recalls thinking at the time, "So this is why I got a degree from Oxford."

After a year Pritzker sent him to China, which was auctioning off old state-owned factories to all comers, including Westerners. Gradel was put in charge of a plant that Marmon was buying from the government — a ramshackle operation that made conveyor belts for coal mines. The plant was located in Tangshan, a city of 3 million people about 100 miles east of Beijing. Gradel — who at the time didn’t speak any Chinese — spent six months there, modernizing the operation and improving safety procedures. He also got officials from the city and the local Communist Party to approve Marmon’s request to build two new factories on green-field sites.

"That was terrific experience," says Gradel, who went on to spend six months in Tianjin and two years in Beijing working for Marmon. "I gained an understanding of the motivations of people in government and the restrictions under which they operate. I also learned that confrontation is not going to work in China."

In late 1998, Gradel told Pritzker (who by then was getting on in years; he would retire in 2002) that he was leaving Marmon, and he accepted an offer from McKinsey to join its Hong Kong office. Before starting his new job in spring 1999, Gradel headed to New York at the invitation of Robert Knapp, a classmate of his at Oxford, who was managing a portfolio for Millennium. Gradel worked at Millennium for three months, learning the basics of arbitrage from Knapp, who was impressed by how quickly his friend picked up the subtleties of hedge fund investing.

"I had thought Chris was unusual the day he accepted a job to work for a coal-mining company," says Knapp, who rowed with Gradel for three years at Oxford. "Chris is really good at finding out what is going on."

By the time he arrived at McKinsey, Gradel knew he had little interest in a consulting career. Still, he says, his three years at the firm taught him discipline and trained him to analyze companies. He also widened his circle. Among those he met in early 2001 was Hong Kong resident Geicke, a German-born entrepreneur and owner of a family manufacturing business. "Chris is extremely ight, very clear and straight," Geicke says. "He has always had a sense of what will work." By spring 2002, Gradel was eager to leave McKinsey and set up his own investment shop. He approached Knapp and Geicke.

Knapp flew to Hong Kong to learn more. Gradel suggested that they go to Shanghai, China’s foremost commercial city, with its famous waterfront, the Bund, and crowds of people, so Knapp could see the opportunity for himself. Stunned by the sheer electricity of Shanghai, Knapp agreed that China had great investment potential. On his return to New York, Knapp proposed to his colleagues that they offer Gradel seed financing. "The go-ahead came from Millennium and from Horst on the same day," Gradel recalls.

Pacific Alliance launched that July, investing in exchange-traded closed-end country funds selling, in some cases, at a 40 to 50 percent discount to their net asset value, and then taking activist positions to close the discounts. The next year, Gradel expanded his portfolio into distressed debt and other securities, looking for market dislocations that had created mispricings. By 2005, Pacific Alliance was managing $300 million and had 12 hedge fund staffers. That year, when China announced stock market reforms that would convert nontradable C shares held by state-owned companies into publicly traded A ones, Gradel instructed his team to buy as many as possible. "Having a large investment team on the ground, with each member having his own significant network, we were able to quickly cast a wide net when searching for C shares," he explains. "The money we made was a function of how many people we could muster."

Pacific Alliance earned about 300 percent in 2006 on the C shares trade (the Asia Opportunity Fund was up 45.6 percent overall that year). By the middle of 2007, however, the C shares had all been converted into publicly traded ones, the discounts on closed-end funds were largely gone and distressed-debt investments were drying up, as most of the world was still awash in credit and equity markets were flying high.

That fall, Gradel took the entire company — by then spread among Beijing, Hong Kong and Shanghai — to the luxurious Grand Hyatt Tokyo in the fashionable Roppongi district for two days of formal and informal meetings. On the second day, he gathered all the investment professionals in a private conference room to talk about what they were seeing in the markets. The general view was that Chinese equities, which had hit an all-time high in October 2007, were overvalued and that Asian markets in general were overpriced. After everyone spoke Gradel asked people to vote by a show of hands on what the firm should do.

"Overall, the vote was about 70–30 in favor of caution," says managing director Hui, who has 20 years of experience in Hong Kong. "When we got back to Hong Kong, Chris and I immediately began the process of reworking the portfolio, getting out of anything to do with equities where we could. That is how we escaped the crash in 2008."

Last year Gradel and his team focused on making loans in China, where credit was virtually nonexistent, as the government had been attempting to slow the economy’s then–double-digit economic growth. "We saw asset- and share-backed lending as an attractive opportunity to weather the storm," Gradel explains.

The bulk of the investments were short-term idge loans made to property developers like Beijing-based Zhonghong Group. In April 2008, Pacific Alliance provided $92 million in financing for the company to complete a shopping mall in a well-established residential area of Beijing. Zhonghong, which is paying a 32 percent annual interest rate on the 18-month loan, put up the mall as collateral and by the beginning of this year was using rental proceeds to pay back interest and principal.

At their height, idge loans accounted for nearly 70 percent of Pacific Alliance’s hedge fund portfolio, helping Gradel to preserve and grow his investors’ capital in 2008. This year he expects asset-backed lending to fall to 25 percent of hedge fund assets, as the loans roll off and companies that borrowed from Pacific Alliance refinance them with cheaper bank loans, thanks to the government’s 4 trillion–yuan ($584 billion) stimulus package. Gradel is redirecting that money into closed-end funds, which are once again trading at sizable discounts, and oader distressed opportunities driven by financial deleveraging, hedge fund redemptions and the capital flow out of Asia.

Late last year, Gradel caught a morning flight from Hong Kong to Tokyo. Although he had never done much business in Japan, he liked what he was being told about a certain deal there. Staying at the Grand Hyatt Tokyo, Gradel met with Katsuya Takanashi, chairman and CEO of Secured Capital Japan Co., a publicly traded real estate management company with $5.7 billion in assets. Secured Capital has a great investment track record, but it was struggling to refinance an existing convertible bond. Such were the times. With the system in default, perfectly creditworthy companies were unable to obtain financing.

Pacific Alliance invested $30 million in a convertible bond that gives the firm as much as a 40 percent stake in Secured Capital, which is listed on the main board of the Tokyo Stock Exchange.

"It was a terrific deal for Chris," notes Jon-Paul Toppino, president and CIO of SCJ Investment Management Co., a subsidiary of Secured Capital that manages several Japanese real estate funds.

"The investment was attractive financially but also strategically, as it gives us a foothold in the Japanese market," Gradel says. "Secured Capital has a distressed-debt-servicing team, which will give us more depth when looking at Japanese distressed-debt opportunities."

Gradel inked the deal with Secured Capital in late March, just as he was getting ready to open an office in Tokyo. In June he hired Anthony Miller to run the Japanese operation. Miller, who had been president of New York–based multistrategy fund Ramius’s RCG Japan unit, had okered the Secured Capital deal with Pacific Alliance. He was already a member of the firm’s four-person investment committee, which approves all loans and other structured deals and includes Gradel, COO Crane and chief credit officer Philip Skevington.

Pacific Alliance’s entrée into Japan is the latest example of Gradel’s investment style. The Oxford graduate has no crystal ball, he says, but is inclined to be opportunity-driven. That, in part, is what has drawn him to Asia, where markets are less efficient and transparent and where every few years capital rushes in and then just as quickly rushes out.

Asked where he expects Pacific Alliance to be in a decade, Gradel responds: "Certainly, I do not want to gobble up the rest of the world. I don’t have that amount of ambition." Nor will he need it. Asia appears to present a world of opportunity perfectly suited to his investment style.

Related Content