Finding Investment Pearls

Using dislocations and drawdown funds, Colin Ambrose, CIO of UJA of New York is seeking alpha in China.

Art by Dadu Shin

In December 2009, Colin Ambrose became the first CIO of UJA-Federation of New York, a philanthropic organization that unites the Jewish community towards national and international causes. He was tasked with establishing an investment office, hiring a team, and creating a sustainable governance structure and processes for managing the institution’s endowment and pension assets. One of his main priorities has been to continually seek and find managers pursuing unique strategies. His goal is to locate promising uncorrelated investments each year for his $1 billion endowment and $400 million pension plan.

CIO: What are some interesting new (or old) opportunities for niche global investing?

Ambrose: After the global financial crisis, capital providers exited certain niche segments of the market. We looked for an experienced manager who could source and structure short-duration private credit deals that were too small or complex for traditional lenders. We invested with a manager who focused on originating loans to companies specializing in niche segments such as consumer leasing, credit card originations, commercial equipment leasing, and merchant cash advance loans. This investment provides us with exposure to first lien, self-amortizing, performing assets.
Another compelling investment is capitalizing on dislocations in Asian public equity markets. Asian markets are inefficient and prone to bouts of market panic and euphoria. Companies with strong fundamentals and solid growth prospects often decline severely during risk-off episodes. We invested with a Hong Kong based equity manager in a drawdown fund that takes advantage of market dislocations to invest in a concentrated portfolio of cash flow generating companies with clear growth potential.
Other niche areas which we have looked at are dedicated strategies to take advantage of the change in CMBS B-piece retention rules and opportunities in the TruPS CDO market.

CIO: Can you go into more detail on that?

Ambrose: The Dodd-Frank risk retention rules strives to incentivize stronger underwriting standards by mandating that issuers and B-piece buyers retain a greater portion of bonds for a longer period of time. This mandated change should affect supply-demand dynamics and the overall illiquidity premium for B-piece investments. This represents a potentially interesting opportunity.
TruPS CDOs are hybrid securities typically issued by small banks or insurance companies with both preferred stock and subordinated debt-like features. The TruPS CDO market is a quirky, niche market ripe with inefficiencies that represents an interesting fixed income relative value opportunity for discriminating investors.

CIO: How do you capitalize on the dislocations?

Ambrose: In China specifically, there’s a lot of risk on, risk off, and huge retracements in the public equity market. And you can get whipsawed enormously if you’re not careful. It was fortuitous timing that we found a manager looking to raise an opportunistic drawdown fund that can capitalize on periods of market volatility and call capital to take advantage of extreme dislocations. We committed to this fund that focuses on investing in a concentrated portfolio of public stocks in greater China. The terms are LP friendly with a strong alignment of interests. The manager only calls capital when needed, and we only pay fees on called capital and the incentive is taken on the back end over a preferred return hurdle
As the fund is able to exit and harvest gains, it will return our capital.

CIO: You use a drawdown approach?

Ambrose: I think a drawdown vehicle that’s only used for true dislocations is the best way to play dispersions in Asia. We prefer to commit money when there are dislocations rather than invest $20, 30 million, and if there’s no dislocation – you end up with a beta play to China, rather than a dislocation play.

CIO: How long is it locked up for?

Ambrose: It’s a three-year investment period, and then a two-year harvest period after that. So it’s about a five-year lock on capital. It’s a longer-duration strategy requiring patience and it’s not for everybody. The intermediate story of China over a five-year period’s not very long term, but it’s certainly longer than many investors think today.

CIO: How did you choose a manager for the Asian markets?

Ambrose: It was somebody who is local to Asia, located in Hong Kong, who’s been doing this for a long time, who has a coherent investment philosophy and a repeatable process, who does deep fundamental research and is patient. We look for all of these things in a manager, whether it’s in Asia or elsewhere. And it’s somebody who we’ve been able to track for several years.
Asia is a totally different market than it was five years ago, yet you were able to put your trust in a person. What led you to do that?
We have a long-term outlook on this space. We’re going with an individual who’s proven over the years that they can generate strong performance in Asia. And we think that that’s likely to persist, based on the repeatability of their process, the rigor in which they underwrite cash flows and their focus on high-growth potential companies. And, again, this is an opportunistic dislocation play, and we think that Asia is likely to continue to have episodic periods of risk on, risk off. We think that provides attraction entry points, and when there’s euphoria in the Asian markets, attractive exit points.

CIO: What made you decide to move in this direction?

Ambrose: We looked for ways to position the portfolio to capitalize on opportunities in a low expected return environment. In today’s volatile, uncertain environment we think that cash flow- generating strategies are compelling investments. This led us to seek to assemble a diversified collection of idiosyncratic coupon-paying investments.

CIO: How do you choose your managers?

Ambrose: I’m looking for true alignment of interest, so fees that make sense for both sides, terms that make sense for both sides. Not just charging premium terms because they can get it, so if there’s a longer lock up, say, a three-year lock up, that the incentive is crystallized after three years, but not taken on an annual basis. And, in terms of whether they’re ethical people, we spend a lot of time doing reference checks, not just what the manager provides for us, but triangulating through our networks.

CIO: What are the advantages of being a small fund?

Ambrose: As a small team with a small Investment Committee, we are nimble and can efficiently make investment decisions without a lot of red tape. Our small size also is an advantage when trying to secure an allocation to an oversubscribed or capacity-constrained fund. It’s easier for a manager to accommodate our small bite size, while still meaningful to us, than carve out a large allocation for a bigger investor.

CIO: When you were first starting out, was there difficulty determining between the beta plays and the dislocation plays?

Ambrose: The world’s gotten a little bit more complex, and in a low-return environment with less alpha, I think you have to be more thoughtful and creative. Market beta alone is unlikely to help us meet our return objective, yet we don’t want to take on more risk to stretch for return. So where are you going to get your alpha to meet your return threshold? One of the ways that we think of doing it is through opportunistic allocations – either tactically to market dislocations, or to invest in some sort of complexity that most people are not able to invest in, or with a longer time horizon.

CIO: What are your opinions outside of Asia?

Ambrose: Outside of Asia, we have invested more in global emerging markets in rather than country-specific allocations. It’s a function of the bandwidth of a small investment team: We’re not local on the ground in those areas to allocate to country-specific opportunities, particularly dislocations like in Greece, where it would take a while for us to get comfortable with that situation. We do not have the bandwidth to analyze that appropriately. So, the niche investments that we generally do are more domestically-oriented opportunities that we can get comfortable with, such as private credit.

CIO: And your thoughts on the new Trump administration?

Ambrose: I think with the new administration, there’s likely to be continued uncertainty and volatility in the market. And that’s great, because there should be more dispersion of returns, which should help active management, and our portfolio is managed actively. The consensus was that if Trump won, it would be bad for markets, and we’ve certainly seen—other than in the initial pullback – the market has liked the idea of a Trump presidency. I’m not in the game of predicting what will happen with his policies. I’m not sure what policies he’s going to put forward, and what the effects are going to be. I do think that there’s more disagreement on the impact of his presidency. Disagreement is good for the market, creating more dispersion in returns.

CIO: Are you seeing any trends?

Ambrose: In a low-return world, we have seen increasing pressure on hedge fund managers to lower their fees. Several funds have lowered their fees and reduced their lock ups. Movement toward a better alignment of interest on terms is a positive development for the hedge fund industry.

CIO: Anything people commonly overlook?

Ambrose: I think people tend to get excited about an opportunity and neglect to ask the most important question: What if I’m wrong? When looking at niche strategies, always focus on the consequences of being wrong. Make sure you can survive a bad outcome, because there inevitably will be bad outcomes.

CIO: Advice to those who are new at this?

Ambrose: My advice is to ask your managers where they are seeing market dislocations and inefficiencies. Many times, they will cite one-off situations that are short-lived and not appropriate for a dedicated allocation. I’d recommend focusing on opportunities that have some persistence and are likely to play out over time as opposed to a quick trade.

CIO: What alerts you to something that might be a good opportunity?

Ambrose: It’s important to have the discipline to evaluate a lot of different ideas. If you see a wide range of ideas, then when you see something that’s truly differentiated and an excellent idea, it stands out a lot more. When you’re only looking at a few ideas, it’s hard to have a relative value perspective of the merits of each.
The other thing is the duration of the opportunity. We try to avoid one-off trades. We’re looking to invest in discreet opportunities that can play out over the lifecycle of a fund. We want to be confident that the opportunity is going to be there, and not something that just may happen. So, therefore, we’ve avoided being early to make dedicated allocations to areas that may evolve, but are still uncertain. For instance, many funds were raised to capitalize on the potential for a large European distressed cycle based on the pressure on European banks to restructure their balance sheets. We already have capital allocated to multi-strategy managers who can opportunistically invest in distressed assets in Europe. We chose to be more patient and wait for our managers to alert us to these opportunities, rather than invest in a dedicated vehicle that starts the clock ticking on an opportunity set that may or may not happen.