Areca Value Discovery Fund: Ayaltis

Winner: Best diversified fund of hedge funds over one year

Specialising in subprime financial crisis cast-offs could be seen as an inspired strategy choice. For Ayaltis, a specialised fund of hedge funds (FoHF) adviser with a focus on fixed income and credit opportunities with a macro bias, it has been a recipe for strong performance.

Areca Value Discovery Fund, launched in December 2008, invests primarily in mispriced and dislocated investment opportunities created from the subprime and credit crisis. It does this through 15 to 25 underlying managers.

[Pictured: Son Nguyen, partner and head of marketing, Ayaltis]

Net cumulative performance since inception is a healthy 36% (at end October 2012) with an annualised return since inception of just over 8% with volatility of 4.73%.

The Areca Value Discovery Fund invests in managers that capture dislocated relative value, event-driven and distressed opportunities. The fund, with almost $300 million of assets under management, is one of three FoHFs run by Ayaltis.

The rationale for creating the FoHF was an early belief that global deleveraging would present unique opportunities. Market uncertainty creates mis-pricings and readjustments, reasoned Ayaltis. They expected this cycle to last for a few years as governments continue to struggle with massive debts and corporates continue to deleverage.

The core part of the portfolio invests in funds with asymmetric return profiles, such as relative-value fixed income, event-driven and distressed credit. Relative-value credit currently makes up around 30% of the fund’s allocation, with 14% in relative-value fixed income.

The portfolio’s satellite exposure comes from global macro strategies that aim to take advantage of macro dislocation, market momentum and liquidity.

By geography, exposure is largely to the US. This is “absolutely and ruthlessly deliberate”, says the chief investment officer (CIO) of Ayaltis, Ernesto Prado, formerly CIO of Peak Partners and previously responsible for fixed income and global macro strategies at Harcourt Investment Consulting.

“It’s not because the US is in better shape than other countries, fiscally and financially, it’s just because the US has enough paper and green ink and a well-functioning printing machine to pay back the dollars they owe on the bonds they issued to borrow,” explains Prado. “In Europe the printing press is broken.”

European markets are not accelerating and Prado doubts they will any time soon. Despite this gloomy outlook, around 30% of the fund’s exposure is to Europe.

At present, only 5% of the fund’s portfolio is invested in emerging markets. If the situation in Europe deteriorates further, Prado says this area will become correlated with the developed markets.

“The moment you have panic that is big enough to make people fear counterparty risk, everything correlates.” At that point he will invest in emerging markets because they will be cheap.

Ayaltis looks for managers with an understanding of the way in which company and country balance sheets are structured. This involves knowledge of the relationship between the equity and fixed income parts of the balance sheet and the ability to offer fixed income-like protection with equity upside.

Managers should be “masters of the universe in hedging techniques for the risks they are undertaking”, says Prado.

The allocation to relative value is not how many hedge fund managers and investors would understand the term, where a fund seeks to capture the relative values between stocks or financial instruments.

The FoHF invests instead in a second type of relative-value manager. Prado explains these with reference to the Berkshire Hathaway stake in Goldman Sachs after the collapse of Lehman Brothers. The company’s chairman and CEO, Warren Buffet, structured a deal to pay $5 billion in exchange for preferred shares in the bank. He also demanded a coupon, Prado says, that was much higher than would usually be
demanded from an AA rated company.

Managers that can structure this type of deal are what he is looking for. “We aim to select managers who are experts in debt restructuring, distress restructuring and generally balance sheet behaviour,” says Prado.

These are managers with the ability to structure unlimited upside and limited downside investments in corporations, structured products or sovereigns that find themselves in the wrong corner of the over-indebtedness equation. These are “structures that actually deliver strong returns with a strong seniority protection for your principal, similar to the one Warren Buffet engineered while in addition getting the equity upside for free, if one can manage to get it”.

These types of relative-value deals are preferred “as opposed to gambling long- or short-biased in any risk asset class in the hope the markets will rally or go down next week, which we absolutely cannot know and for which we don’t trust anyone who pretends to know it”.

The credit part of the fund’s relative-value exposure is mainly to mortgage-backed securities and other structured products.

The fund’s second-biggest exposure (23%) is to global macro. The starting point for this allocation is, once more, balance sheets. This time, however, it is a country that is under the microscope.

In normal circumstances, a country should be able to produce wealth after clearing its debts. “But, if it doesn’t achieve that, it is going to be having the most massive balance-sheet hangovers, as is the case today,” explains Prado.

The violent effects of this are being felt through yield curves and the foreign exchange markets. “That’s what we call macro. But I would still say it is relative value, deep event-driven credit, because sovereign countries have always been credit, not risk-free, as the wide world is only beginning to understand.”

Managers in this part of the portfolio find opportunities as countries deleverage.
Prado says it is also important to look for managers running uncorrelated strategies. “We assess if we are in either a cycle when everything is growing, credit is unlimited and we have growth,” says Prado.

“We have a certain bias to a certain type of asset class and structures. Or we believe the opposite side of the equation, that it’s a very fragile situation where everybody is over-indebted, meaning all balance sheets are over-indebted, which is the case right now, which is an extremely dangerous case. At this stage, we’re going to have a very different profile.”

That top-down macro assessment influences which strategies the fund goes into. When “everything is really ugly”, the fund goes into relative-value positions in fixed income. If things settle, the emphasis shifts to strategies that can take advantage of valuation differences between fixed income and equities.

Ensuring that the manager has the same worldview as Ayaltis is the starting point for pre-investment interest. “We do a lot of work to develop confidence that the manager is an absolute god in hedging itself, by the virtue of how they can structure trades à la Warren Buffett. You have a little bit of an indication – or as much of an indication that you can have – that the trader is going to be protecting your wealth.”

Continual top-down macro analysis of the portfolio ensures the fund is investing with the right types of managers and in the right asset classes.

After investment, monitoring is done to ensure the manager is keeping on top of the opportunity set. “Then we monitor the end of cycle for signs that would make us decide not to retain a manager anymore, despite his top skills, because all the opportunity set has been captured now the cycle is turning. Even if we respect the ability of that manager to trade every environment, we would get out because we would prefer to be in an environment that is going to be printing returns.”

Despite being five years on from the collapse of Lehman, Prado believes there is a future for the fund when – or if – markets normalise again. When that happens, he will switch to investing in managers that focus more on relative-value opportunities in equities.

This is not something Prado expects in the short term. “The fairy is not going to show up tomorrow to forgive the debt of Greece, the debt of Spain, the debt of Italy, the debt of France, the debt of Germany even, the debt of the US or the debt of Japan. There is no way in the world that we’re out of this very quickly.”

Fund facts
Name of fund: Areca Value Discovery Fund
Management company: Ayaltis
Portfolio managers: Ernesto Prado and Son Nguyen
Contact details: Lavaterstrasse 101, 8002 Zürich, Switzerland ([phone])
Assets under management: $290 million (at November 1, 2012)
Launched: December 2008
Net cumulative performance since inception: 36.09% (at end October 2012)
Annualised return since inception: 8.19%
Annualised volatility since inception: 4.73%
Sharpe ratio: 1.17 (RF 2.5%) or 1.69 (RF 0%)
Strategies covered: diversified, relative value
Share classes: US dollar, euro, Swiss franc
Number of underlying managers: 20
Administrator: Banque Privée Edmond de Rothschild
Prime broker/custodian: Banque Privée Edmond de Rothschild
Auditor: Ernst & Young
Legal counsel: NautaDutilh
Domicile: Luxembourg
Listing: Luxembourg Stock Exchange
Minimum investment: $200,000, Sfr200,000, €125,000
Management fee: 1.5%
Performance fee: 10%
Redemption terms: quarterly plus 45 days notice

2011
Shortlist: Best performing diversified FoHF over one year