New York-based hedge fund Cross River Partners focuses on small- and micro-cap companies, combining a concentrated "core" long book, with a smaller holding of best new ideas and a short book. It's a strategy the $35 million firm has employed successfully for 11 years, generating double-digit annualized returns. Cross River founder and managing partner Rich Murphy spoke recently with FINalternatives senior reporter Mary Campbell about the firm's private equity-like approach to investing, the attractions of small cap companies and a recent Cross River success story.
Tell me about Cross River Partners.
Cross River Partners was founded in 2002 with the idea of creating a small micro-cap fund that took concentrated positions in unique names, giving our limited partner a chance to own companies that are extraordinarily unique. Keep in mind that these are names that are not broadly held by any of our peers in the hedge fund community. Currently, our AUM is $35 million. We started with roughly $3 million in 2002; we’ve raised a little over $7 million total. The rest has come through appreciation.
What do you like about small- and micro-cap companies?
The obvious answer is that they are under-followed, and so you get a lot of price discrepancy. We try to buy stocks for 50 cents on the dollar or less, and the small- and micro-cap space is where a lot of those opportunities are. As you can imagine, funds with more assets can't play in this world efficiently; that's a key advantage we have over our competitors.
The second reason is you can understand the business much better. These businesses tend to be one or two revenue line-type companies, so you can really dig in and understand what is driving the stock. If you told me to analyze IBM, with 100,000 people working there, I could spend years, but I can really make a difference in the small-cap space and bring value to our limited partners.
Cross River runs a very concentrated portfolio—how many positions do you usually hold?
Right now, because of capital restrictions, we hold 10 to 12 positions. And then we have a short book, in which puts play a key role. I call it 8x8: We tend to roll out eight puts that go out about eight months which act as protection against any black swan events. But what drives our performance is that core portfolio of 10 to 12 stocks.
What criteria do you use in selecting companies?
We're generalists: Valuation drives most of our decisions and our process is proprietary. We screen for ideas, and that universe is typically around 400 names when they get past our first screen. Now, we have two other screens, a qualitative screen and a quantitative screen. We look at those ideas that come through that initial screen in those two frameworks. It doesn't take a ton of time, but that's how we generate our ideas.
We build our models internally. I have an investment-banking background so I personally build them. We get to know the businesses from a quantitative standpoint by looking at the margins. We then analyze the company on a ratio basis, and the last step is meeting with management. We meet with management as the final step in our process because we want to talk to management with the model in front of us, and understand what they actually do. We don't want to go in there just getting the regular Wall Street pitch.We feel at the end of our process we really know the companies well and we make a buy/sell decision at that point, and when we do, it's not going to be 2% of the portfolio. Our position size is on average 10%, so if we can't put 10% of the assets in a company, then we're not interested in looking at it.
Are you concerned about holding too big a stake in a given company?
Because our asset size is relatively small, that is not a huge issue for us. We can scale this fund up to $250 million; at that point we would close the fund to new investments. Our sweet spot is the $250 million market-cap range. If you look back historically, that's where we've made most of our money.
Can you give me an example of a Cross River success story?
The most recent success was just sold: Republic Jet. We bought it, like we do a lot of names, when everyone hated it, and the stock at the time I think had gone from $12 or $13 down to $2, $2.50. But it had a core business, fixed-fee lines. If you’re on a flight from JFK to Syracuse, you're likely to be on a fixed-fee flight, and if you're flying American Airlines, they outsource all those small flights. That business is great because it's a fixed fee, so Republic Jet for that matter, which owns Chautauqua, get a fixed fee from American for making that flight. There's no fuel costs, there's no nothing. So we knew we had this gem of a business in the fixed-fee flying arena.
They made a mistake and bought Frontier Airlines, out of Denver. They bought it out of bankruptcy and that caused the stock price to collapse. However, the management team was excellent. Bryan Bedford turned Frontier around, took a lot of the excess costs out through the post-bankruptcy process and now in Q1 of this year, they've announced they're spinning Frontier out and separating Republic Jet from Frontier. We always knew that Republic Jet was worth $9 to $10, just on a cash basis, and Frontier was getting about a negative $8 value we didn't think was warranted.
What you saw in the macro picture was that the airline business was becoming more professional, if you will. They're charging for everything; they're going to charge you for oxygen soon. But to us, that's a great thing, that's a good way to run a business—you should charge for stuff that people will pay for and $3 for an earphone is not going to break the bank for people. I always used to lament that I could fly to L.A. cheaper than I could get a black car service from New York City to my house in Westchester, and that just didn't make sense, so it’s nice to see that the industry is changing.
How involved do you get with the firms in which you invest?
It varies. I've never met a CEO that didn't think his stock was cheap, so I don't necessarily think that talking to management and getting their opinion is of the utmost importance. As many people have said in the past, I'll take a great business over a great management team anytime. That being said, we like to look at margins. We have a company in the marine construction business right now and the margins have been depressed for a variety of reasons. Now, are those margins depressed permanently, like BlackBerry, or is this a cyclical business? That's when we talk to management and they have a lot of insight into the actual industry.
Typically we have two companies that we call private equity in our fund. They don't comprise a huge portion of the fund, but we will take activist roles on those types of names, though we are always fans of the management team. We don't get involved with management teams we don't like or don't think are competent. We'll try to get a board seat, or put people on the board in those instances, but that's not the norm.
What is your typical holding period?
We're long term, but we're driven by target price. For example, Republic Jet had a target price. When our investments hit those target prices—unless something's completely changed—we're out of it.
Your minimum investment is $250,000. What is lock-up?
It's a one-year lock-up and its quarterly out, monthly in. The lock-up is a way to weed out people that we don't want in the fund. We truly view our limited partners as partners. A lot of my money is in the fund—most of my money is in the fund, actually—so the last thing I want is someone putting a bunch of money in the fund and six months later saying he wants to get out. I'd rather not have him in to begin with.
And you say the capacity is $250 million, at that point, would you consider launching a second fund?
Yes, that's the business plan. At $250 million, we would launch a mid-cap fund, which would invest in names around the $750 million market-cap range and that would be something that could go up to about $750 million, making us a billion-dollar firm at that point.
Most people think of $750 million as small-cap, but there's a lot of opportunity in that space. In comparison to our current fund, the returns might be slightly muted, and the volatility would be slightly muted, so institutions would be interested in that—pension funds, funds of hedge funds, endowments. We can certainly execute our current strategy in that world, and we intend to do so.