Waterfall Asset Management

Transcription

1 Investment Due Diligence Report Waterfall Asset Management Master Custodial Account Report written by the NEPC Hedge Fund Research Team as of May 2014 Product Rating: Neutral 900 Veterans Blvd. Ste. 340 Redwood City, CA TEL: CAMBRIDGE ATLANTA CHARLOTTE CHICAGO DETROIT LAS VEGAS SAN FRANCISCO 1

2 Firm Waterfall Asset Management was founded in November 2004 by Thomas Capasse (Principal) and Jack Ross (Principal). Prior to founding Waterfall, Mr. Capasse and Mr. Ross worked together at Merrill Lynch where they founded the ABS Group in the early 1980s. While at Merrill Lynch, they conducted many of the first ABS issuances across a diverse spectrum of sectors including subprime residential mortgagebacked securities (RMBS) and small balance commercial (SBC) loans. The Firm is currently 63% employee owned (51% Principals, 12% key employees). Dyal Capital Partners ( Dyal ), a subsidiary of Neuberger Berman which takes minority investment stakes in alternative asset managers, owns the remaining 37%. Waterfall is headquartered in New York City and currently has 48 employees, including 21 investment professionals. Investment professionals average 12 years of investment experience and over four years at Waterfall. Waterfall manages $3 billion of assets across two primary strategies, ABS and NPLs, through two commingled funds, 14 separately managed accounts/funds-of-one, and one private Real Estate Investment Trust (REIT). Waterfall Eden ( Eden ) was launched in March 2005 to focus on investing in high yield ABS through the secondary market and through primary new issuance. Waterfall Victoria ( Victoria ) was launched in July 2007 to focus on NPLs. Waterfall Sutherland ( Sutherland ) was launched in November 2011, as a spin out from within Victoria, to focus solely on SBC NPLs. In November 2013, Sutherland was converted into a private REIT. Investment Thesis Waterfall feels that asset backed securities and whole-loan NPLs offer compelling risk-adjusted returns given the structural complexity of the products, lack of sophisticated market participants, and a supply/demand imbalance in the market driven by regulatory reform. Broadly speaking, recent financial regulations (Basel III and Dodd Frank/Volcker Rule) have resulted in significant bank disintermediation that has impacted both the primary and secondary markets for loans and asset backed securities. On the supply side, lending standards for banks have become stricter. This has led to growth in the specialty finance/lending space. Specialty lenders have increasingly tapped the ABS markets via securitization as a funding source for growing its business. Waterfall aims to take advantage of this market dynamic in two ways. First, by using its strong securitization and structuring background, Waterfall will partner with specialty finance companies and negotiate terms in new issue ABS. Second, Waterfall aims to drive the lending and new issue process through purchasing interests in specialty finance companies directly. In addition, more 2

3 onerous capital requirements have also impacted the market on the supply side. Banks are faced with increased capital charges for holding risky assets, including ABS and certain loans, and have been selling off assets into the secondary market. Waterfall aims to purchase securities that are mispriced as a result of the stressed/distressed selling. On the demand side, there are fewer sophisticated market participants that trade in the ABS market. As part of the Volcker Rule, banks were required to close down proprietary trading desks which had historically been large buyers of ABS. Hedge funds have largely replaced banks in this capacity. Waterfall seeks to take advantage of the reduction in market participants through fundamental security selection and active trading. Positives Experienced team: Founding Principals, Tom Capesse and Jack Ross have deep experience in the structured securities space having been investing in ABS and NPLs for over 30 years. Mr. Capesse and Mr. Ross pioneered ABS issuance of many sectors and have a strong understanding for the underwriting process behind developing these complex securities. This fundamental credit analysis strength is beneficial when sourcing secondary market opportunities. Breadth of capabilities: Waterfall has capabilities across the spectrum of ABS and NPL investing, including more esoteric securities and structures. Furthermore, the team has demonstrated a strong understanding of the lending/origination and securitization process. Flexible mandate: The MCA proposal offers Waterfall the flexibility to invest across the best risk-adjusted opportunities that it uncovers in the secondary markets or develop through primary issuance in high yield ABS, NPL, and specialty finance companies. Discretion: Waterfall will provide 30 days notice in advance of any direct investment, for client approval. Issues Possible conflicts of interest: As part of the MCA, Waterfall will make direct investments in two styles. First, the account can make direct private-equity style investments in specialty finance companies, including debt servicers and lenders\originators. These companies will be operated to generate new issue loans and structured securities which may be purchased by other Waterfall funds (Eden, Victoria or Sutherland), or sold into the market. Second, the account can also make direct investments in loan pools (performing or non-performing) or large portions of directly negotiated new issue ABS tranches. Both types of 3

4 direct investments give Waterfall an edge that can potentially benefit its other funds through the use of MCA capital. This represents a potential conflict of interest. This type of potential conflict exists with many multi-product investment managers, and is mitigated by the manager's allocation policies. The SBCERA MCA agreements recognize this possibility Limited direct investment track record: Waterfall has demonstrated strength in understanding complex structured securities and the lending/origination and securitization processes. The team has partnered with, and made direct investments in some specialty finance companies and servicers within Waterfall funds; however, the track record is limited in both scope and length. Waterfall has done seven direct private equity deals within its funds. Investment Strategy Summary Waterfall focuses on two primary strategies, asset-backed securities and nonperforming loans. Waterfall Eden was launched in March 2005, targeting high-yield asset-backed securities. Eden seeks to generate attractive risk-adjusted returns through a combination of high current yield and capital appreciation. The team continuously analyzes the full spectrum of the ABS marketplace, ranging from RMBS, CMBS, Consumer ABS, CLOS and even more esoteric ABS (timeshares, aircraft leases, etc), in search of mispriced opportunities. Eden invests in ABS through both the secondary market and through the primary new issuance market. Primary new issuance has been a growing component of the strategy over recent years as Waterfall has been able to partner with specialty finance companies to negotiate stronger terms than available in the secondary market. The portfolio is constructed in a core-satellite framework. Around 20% to 30% of the portfolio is concentrated in best ideas sectors that Waterfall views as offering an attractive risk/return profile, driven by technicals or fundamentals, which also offer scalability. The remaining 70% to 80% is diversified across the breadth of ABS sectors. The portfolio is actively traded, and sector allocations are frequently rotated within the portfolio as relative value opportunities shift. 4

5 Waterfall Victoria was launched in July 2007, targeting NPLs, residential and smallbalance commercial (SBC) mortgage loans being sold by distressed sellers as part of the post-crisis deleveraging process. Victoria generates returns primarily through capital appreciation, driven by loan workouts and servicing partnerships, and liquidations. Current income is a growing component of the strategy as Victoria has been increasing investments in performing new issue SBC loans, through the suballocation to Sutherland, as well as current portfolio positions transitioning from non-performing to re-performing. Sutherland was launched in October 2011 as a spin-out of the SBC loan portfolio from within Victoria, as an effort to attract dedicated investors and lay the foundation for issuing a private REIT. Victoria retained an ownership interest in Sutherland to maintain portfolio exposure to SBC loan assets. The portfolio comprises performing, sub-performing, and non-performing SBC loans and other real estate-related debt investments sourced through secondary markets or generated in the primary market. Within Sutherland, Waterfall owns Coldwell Banker Commercial Alliance, an SBC property brokerage, and ReadyCap Commercial, an SBC lender. These entities generate new SBC loans which are a growing portion of the Sutherland portfolio. In November 2013, Waterfall converted Sutherland Fund into a private REIT. Investor LP shares were converted into REIT shares including those held by Victoria. The proceeds of the REIT conversion and public offering were used to acquire CIT Group s Small Business Lending unit. In addition to the pool of Small Business Administration (SBA) 7(a) loans acquired through the deal ($636 million unpaid balance of which 81% were performing), Sutherland received CIT s servicing portfolio ($823 million unpaid principal balance), the non-bank SBA license and the firm s office in New Jersey, along with a staff of 50. The license, if approved, will allow ReadyCap Commercial to originate commercial loans through the SBA 7(a) loan program which can be securitized and sold into the secondary market or retained by Waterfall funds. The MCA is structured to take advantage of the opportunities that Waterfall identifies in the ABS and NPL markets that are being driven by bank disintermediation. The account will be able to invest through Waterfall funds and through direct investments. At origination, the account will have roughly 25% of the capital invested in Victoria and 25% of the capital invested in Sutherland, which are legacy investments. The remaining 50% of account capital will be available for direct investments and/or investments in current or new Waterfall funds. Over time, the account complexion can shift as there are no concentration limits or investment guidelines. Direct investments will be made in one of two styles. First, the account can make direct private-equity style investments in specialty finance companies, including debt servicers and lenders\originators. These companies will be operated to generate new issue loans and structured securities which may be purchased by other Waterfall funds (Eden, Victoria or Sutherland), or sold into the market. 5

6 Second, the account can also make direct investments in loan pools (performing or non-performing) or large portions of directly negotiated new issue ABS tranches. Team Waterfall has 48 employees; 21 of which are investment professionals. Tom Capasse and Jack Ross are the principals and they are ultimately responsible for all investment decisions across strategies. Mr. Capasse and Mr. Ross are supported by three senior portfolio managers, Tom Buttacavoli, Brian Rubello and Patrick Lo. Mr. Buttacavoli is the portfolio manager for the loans strategy and leads a team of 10 investment professionals. Mr. Rubello and Mr. Lo are the senior portfolio managers for the ABS strategy and lead a team of five investment professionals. In addition to the deep investment team, Waterfall has a dedicated risk management team of seven professionals managed by Carole Mortensen. 6

7 Biographies Tom Capasse, Principal Managed principal finance groups at Greenwich Capital, Nomura Securities and Macquarie Securities With Jack Ross, was a pioneer in the development of the securitization market and founding member and manager of Merrill Lynch s industry leading ABS Group ( ) Began career as a fixed income analyst at Dean Witter and Bank of Boston B.A. from Bowdoin College Jack Ross, Principal Founded Licent Capital, a specialty broker/dealer for intellectual property securitization At Merrill Lynch, managed ABS and Real Estate Finance Groups At Drexel Burnham Lambert, completed early ABS transactions M.B.A. from The Wharton School and a B.S. from the University of Buffalo Tom Buttacavoli, Managing Director Portfolio Manager Structured Finance Analyst specializing in intellectual property securitization at Licent Capital Strategic Planning Analyst at BNY Capital Markets Financial Analyst within Merrill Lynch s Partnership Finance Group B.S. in Finance from New York University s Stern School of Business Brian Rebello, Managing Director Portfolio Manager Portfolio Manager, Aberdeen Asset Management Vice President/Senior Credit Analyst, Deutsche Asset Management Senior Consultant, KPMG Consulting M.B.A. from Miami University and B.S. in Chemical Engineering from the National Institute of Technology, India; CFA designation holder Patrick Lo, Managing Director Portfolio Manager Analyst focusing on the origination, structuring and financing of various classes of ABS at Citigroup Capital Markets B.S. in Finance from Massachusetts Institute of Technology 7

8 Terms Management fee: 1.25% Incentive fee: 20% subject to 6% hard hurdle *Fees are paid at the account level. Investments in Waterfall funds are subject to standard fund fees. Direct investments are subject to MCA fees. Aggregated to the account level, Waterfall takes fee netting risk. Expenses: Not disclosed Term: Not disclosed *NEPC has not received or reviewed the full MCA documentation outlining the terms of the account agreed to by the client and Waterfall. Operations Administrator: Not disclosed Auditor: Not disclosed Legal Counsel: Not disclosed 8

9 Performance Summary Since inception in March 2005 through March 2014, Eden has generated strong risk-adjusted returns (9.5% annualized return with 5.1% standard deviation for a Sharpe ratio of 1.1). Comparatively, over the same time period, the ML High Yield index exhibited 8.3% annualized return with 10.8% annualized standard deviation for a Sharpe ratio of 0.5. Strategy peers, as reflected by the HFRI Relative Value Fixed Income-Asset Backed Index, exhibited 9.1% annualized return with 3.2% annualized standard deviation for a Sharpe ratio of 1.7 over the period. Eden experienced a substantial drawdown of 21.97% from June 2007 to October 2009 and recovered over the following 13 months. During this period, investor liquidity demands outstripped Waterfall s capabilities and Eden decided to sidepocket illiquid/impaired assets, which represented approximately 30% of fund assets, in November The plan to sidepocket assets was voted on and approved by a majority of fund limited partners. Investors were given a pro-rata share of the sidepocketed assets and the option to redeem or remain in the fund. If an investor elected to redeem, they would receive payouts on a quarterly basis over two years. Today, the side-pocketed assets have been fully liquidated and investors that elected to redeem have been fully paid out. Investors that remained in the fund, and new investors after November 2009, were now subject to an investor level gate to better match investor liquidity with the liquidity profile of fund investments. Since inception in July 2007 through January 2014, Victoria has generated strong risk-adjusted returns (8.8% annualized return with 2.3% standard deviation for a Sharpe ratio of 2.2), while experiencing minimal drawdowns. Comparatively, over the same time period, the ML High Yield index exhibited 8.7% annualized return with 12.5% annualized standard deviation for a Sharpe ratio of 0.5. Strategy peers, as reflected by the HFRI Relative Value Fixed Income-Asset Backed Index, exhibited 9.6% annualized return with 3.7% annualized standard deviation for a Sharpe ratio of 1.6 over the period. 9

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12 Disclaimers and Disclosures This memo provides a summary of documentation and information received by NEPC from Waterfall through phone calls and meetings. NEPC has not reviewed the formal MCA documentation outlining the terms of the account agreed to by the client and Waterfall. NEPC has reviewed a draft term sheet only (included below). NEPC has identified several positive attributes, as well as several issues related to this mandate that should be considered. Past performance is no guarantee of future results. Information on market indices was provided by sources external to NEPC, and other data used to prepare this report was obtained directly from the investment manager(s). While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within. This report may contain confidential or proprietary information and may not be copied or redistributed to any party not legally entitled to receive it. In addition, it is important that investors understand the following characteristics of non-traditional investment strategies including hedge funds, real estate and private equity: 1. Performance can be volatile and investors could lose all or a substantial portion of their investment 2. Leverage and other speculative practices may increase the risk of loss 3. Past performance may be revised due to the revaluation of investments 4. These investments can be illiquid, and investors may be subject to lock-ups or lengthy redemption terms 5. A secondary market may not be available for all funds, and any sales that occur may take place at a discount to value 6. These funds are not subject to the same regulatory requirements as registered investment vehicles 7. Managers may not be required to provide periodic pricing or valuation information to investors 8. These funds may have complex tax structures and delays in distributing important tax information 9. These funds often charge high fees 10.Investment agreements often give the manager authority to trade in securities, markets or currencies that are not within the manager s realm of expertise or contemplated investment strategy 12