In Depth

Stillwater Sees Sizzling Deal Flow With Hot Strategies

Jan 19 2007 | 12:06pm ET

If having a diversified portfolio and product line are the ingredients for a successful hedge fund, then New York-based Stillwater Capital Partners is cooking. Stillwater sports an asset-backed lending hedge fund, an asset-backed fund of funds, and a multi-strategy fund of funds. All three vehicles posted double-digit returns last year, 11.10%, 11.81% and 15.02% respectively (net of fees), with low volatility. The firm also manages a private equity real estate fund.

Managing director Jonathan Kanterman attributes the funds’ steady returns to low correlation to the equity and/or fixed income markets. “A lot of hedge funds say they’re uncorrelated to the market, but I think we’re one of the few who truly are market-neutral, in the sense that we don’t invest in the stock or bond markets,” he says.

Bridging The Opportunities

The Stillwater Asset Backed Fund is a bridge-lending fund that makes short-term bridge loans in real estate, law firms and insurance. The fund is fully collateralized, and will not kick in more than 70% loan-to-value. So, if a real estate developer wants to borrow money for a property that Stillwater appraises for $10 million, then it would lend the developer no more than $7 million.

The typical borrower is not sub-prime, nor one with bad credit, according to Kanterman, but a developer who finds himself in a time crunch, with perhaps only two weeks to close on a property. “We’re faster than the bank and will send two or three people out on a Sunday to the property to start the underwriting and the appraisal,” says Kanterman.

That is not to say that Stillwater is competing with traditional lenders on deals. Banks often refer business to the firm, knowing it can close more quickly and bridge the loan until they can finish their due diligence, according to Kanterman, and six months later the firm is out of the picture. “Over 80% of the time we’re getting taken out by traditional financing,” he says.

Other sources of deal flow for the fund include leads from lending trade publications, mortgage brokers and Stillwater’s own in-house underwriters. The firm closes on about four deals each month from the roughly 100 that appears on its radar, Kanterman says.

To mitigate property risk, Kanterman adds that the firm ensures the owner has title insurance along with “every other type of insurance,” including for floods and hurricanes, depending on the region. Also, in valuing a property, the firm always gets two appraisals: one from an independent appraiser and one from his underwriting team.

Chasing Lawyers

The fund also lends money to personal injury law firms that are contingency fee-based and need a line of credit to keep operations running in between settlements. Stillwater’s credit is secured by every case that the firm has, as well as personal guaranties from the firm’s partners.

“If the law firm is looking at $30 million in gross settlements over the next year, that represents about $10 million in fees for the firm. We’ll lend about $2 million in a line of credit. Historically, most firms don’t fully draw down on the credit line and usually utilize about 50% of it,” says Kanterman.

The possibility of fraud is reduced because firms are only borrowing about 20% of their next 12 month’s revenue, according to Kanterman, who is further comforted by the fact that firms run the risk of being disbarred or losing their license in the event of a fraud, a deterrent if ever there was one.

In addition, the fund is engaged in insurance premium financing, where it lends capital to high net-worth individuals who are taking out life insurance policies. Kanterman says the firm utilizes three estate planning law firms who are its source of deal flow in this space.

“They bring us the type of borrower we’re most comfortable with, which is a 78-year-old high net-worth individual.  They may already have $20 million in life insurance and be taking out an additional $5 million life insurance policy through a major carrier. We will lend that individual the premium payments for two years and at the end of two years he repays the loan plus interest.” 

If the borrower does not pay back the loan at the end of two years, then Stillwater takes back the policy and, through its strategic partners, sells the policy on the secondary market, recouping its principle plus interest. The firm charges a 14% interest on the insurance premium loans and an average of 16% interest in all three lending categories.

Hands-On Experience

Stillwater’s asset-backed fund of funds features the same low volatility, low correlation steady returns as its sister hedge fund. Seventy-five percent of the underlying managers in the fund of fund’s portfolio are asset-backed lenders with the balance is in more liquid asset-backed securities. The vehicle does not invest in the firm’s hedge fund because it was “cleaner and simpler” for Stillwater not to invest in itself. “If our hedge fund wasn’t doing well, at what point do you fire yourself?” asks Kanterman.

The advantage for Stillwater and its investors in running a fund of funds alongside a hedge fund with a similar strategy is the quality of due diligence on underlying managers.

“There are certain questions that we can ask, such as, ‘Do you have title insurance?’, ‘Can we see your loan documents?’, ‘How do you value the collateral?’, ‘Do you have fire and flood insurance?’ All of these things hit closer to home when you have been involved in it and done it,” Kanterman says.

On the flip side, what Stillwater requires from its underlying managers also translates into running a better in-house hedge fund. Asset-backed lending is not a traditional strategy in the sense that there is a prime broker, custodian and an administrator, Kanterman explains. When underlying managers balk at giving Stillwater access to its loan book, the firm hires a third-party asset verifier in the form of a law firm, accountant or auditor.

“There’s no pricing or future value of anything; it’s just realized interest on a monthly basis. Two years ago, we realized we weren’t doing that for our own clients and so we engaged our auditor to independently do that,” says Kanterman. 

Wanted: Creativity

The New Finance Fund, which currently invests in 40 managers, interviews several hundred managers per year, according to Jack Doueck, co-founder and managing principal, who is keen on a manager’s creative niche within the asset-backed lending space. “If they have some kind of specialty and expertise then we’re interested,” he says.

“When I went into the hedge fund business 16 years ago, I think there was under $100 billion in the industry, today it is over $1.5 trillion. What that means is that unless you’re very creative and smart, you’re just never going to make the returns.”

And what is Stillwater looking for in terms of creativity? Well, consider that the fund of funds is currently invested in one European manager who is lending money on different types of collateral including airline equipment, and another Brazilian shop, which lends money to cattle ranchers on individual heads of cattle.

“Part of the loan is backed by the Brazilian government and he gets paid by the slaughterhouse,” says Doueck. “These were ex-JPMorgan bankers with great pedigrees and they found a niche in the marketplace where they can charge 18-20%. They hedge out currency risks and they’re taking cattle, which is a commodity with insurance and protection against disease, and which sounds like a funny business, and have built a finance structure around it.”

Unwanted: Greed

Doueck says the fund of funds is not necessarily looking for a three-year track record and will invest early in the underlying manager if he or she has a good pedigree, experience and investment thesis. However, the firm will not tolerate asset gatherers disguised as portfolio managers.

“A lot of times we run across a manager who is really smart but he has structured his product in a greedy fashion where it doesn’t leave a great taste in our mouths,” says Doueck. “If they make a bridge loan, the fund gets an interest coupon but then they also charge points for that loan. In an ideal world, the points should go into the hedge fund and we should all participate. Some managers take those points and put them into a separate deal-origination entity that they own.”

“We’ve also had managers that said they were hard closing at a certain level and didn’t, and that can be a violation of trust,” says Kanterman. “Above and beyond the checks and balances and due diligence, you want to have trust in your managers.”

Adding another layer to an already desirable cake, Stillwater this month launched an offshore ABS fund of funds for its European clients who wanted a more traditional asset-backed product, complete with a prime broker and a custodian. Half of the capital comes from institutions and family offices and the other half from high-net worth individuals, according to Doueck, who says the firm doesn’t have many large institutional clients, such as pension funds, because of capacity constraints.

The firm currently manages some $700 million in total asset under management for over 350 clients. “We’re looking to bring in more endowment and foundation money this year,” Doueck adds.

By Hung Tran


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