Opportunities in illiquidity

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Investing in the subordinated slices of structured finance deals is not for the faint-hearted. Arielle Weliky talks to Joe Parish, co-founder of Structured Equity Capital Partners, one of a new breed of funds focused on this illiquid sector

In the past few years, the pages of Risk have been peppered with stories describing how senior equity and credit derivatives traders have quit their jobs on the dealing desk in favour of life as a hedge fund manager. The tale is not so common among asset securitisation specialists, but Joe Parish and Scott Shannon are bucking the trend. The duo co-founded Structured Equity Capital Partners (Sequity Capital) – a new hedge fund in North Carolina that will invest in the equity and mezzanine slices of structured finance deals – in the first quarter of 2003.

Before starting Sequity, Parish and Shannon worked at Wachovia Securities in Charlotte, North Carolina, where they had helped build the asset securitisation group from scratch in 1990. “The business at Wachovia had naturally matured from origination and structuring to focus on sales and distribution,” Parish says. It was those pioneering days of the early to mid-1990s that Parish particularly enjoyed, and with Sequity he says he’s regaining that sense of entrepreneurship.

Sequity is currently in its start-up phase, and has a target size of around $200 million – a figure that Parish believes will probably be reached within a few years. Sequity is shooting for an internal rate of return of between 14% and 19% with a standard deviation of 5%. The fund will invest in asset-backed securities and collateralised debt obligations at the lower end of the capital structure – from triple-B all the way down to equity slices.

Consumer targets

The fund manager’s strategy starts with targeting the consumer, real estate, corporate and diversified credit sectors of the structured finance market. Sequity then looks at the fundamentals of each sector to determine the weighting for each. After the sector weights are assigned, relative weights for individual asset classes within each sector are established. At the asset level it is targeting assets with a gross return of 15%; it then analyses the volatility of returns, expected credit risk, default risk and loss severity. The target values for these factors differ with the specific asset, says Parish. “Quantitatively we are looking at the financial health of an issuer, track record, performance, risk management,” says Parish. Following the quantitative assessment, Sequity qualitatively assesses management’s capabilities, integrity, philosophy, strategic objectives and focus.

Once an investment is made, Sequity uses an expected credit performance scenario to track performance. “We formulate a base credit performance and use that to track the investment,” says Parish. The scenario includes values for cumulative default rates, loss severity and analysing the shape of the credit curve.

Sequity will use derivatives, initially mainly traditional interest rate hedging products. “Credit default swaps are [potentially] an important tool for us,” Parish says. However, for the private and less liquid deals Sequity will invest in, the default swaps market is far from developed. “We are awaiting the emergence of a new class of hedging instruments,” he adds.

Part of Sequity’s edge, according to Parish, is its focus on direct origination and structuring. It will target specific sectors of the market, specific asset classes and specific issuers. “All our investments will earn us a liquidity premium,” says Parish. “We are targeting sectors that don’t have an active secondary market. In some sectors there is [significant] structuring premium too, such as the private corporate credit.”

For most institutional investors, Sequity’s strategy will appear quite alien, and Parish says he is spending a lot of time educating potential clients. Some investors will undoubtedly be put off by the relative illiquidity of the asset class and the longer investment horizon. But for other investors, the diversification benefit of the innovative strategy should be appealing.

Parish and Shannon’s pedigree should also assuage any concerns about investing in a novel hedge fund strategy. Their group at Wachovia managed portfolios of corporate and structured debt for institutional investors, and on a proprietary basis. For example, Risk understands that one large commercial paper conduit created in 1995 at Wachovia to fund a diversified portfolio of asset-backed debt was one of the best-performing asset-backed commercial paper conduits during the duo’s time at the firm. It had assets of more than $20 billion, with an investor base including more than 300 institutions. Over the same period, Wachovia lead-managed more than $50 billion worth of securities, according to market sources.

Transparency is another concern weighing on investors’ minds. Compared with many hedge funds, Sequity’s strategy tends to be buy-and-hold. “We are basically holding a book of risk, and we are happy to disseminate a lot of information about it to investors,” Parish claims.

Its buy-side application of techniques developed by banks’ structured finance groups makes Sequity something of a rarity. Parish doesn’t expect this to last. “We will soon reach a time when structured equity will be considered a new investment class within alternative investments,” he says.

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