Q&A: Sizing Up Structured Credit After The Financial Crisis

Apr 24 2014 | 4:40pm ET

Varadero Capital is a hedge fund to watch. The winner of this year's S&P Capital IQ/New Legacy Annual Global Emerging Manager Awards nod for credit shops, the firm focuses on structured credit, and has garnered $650 million in assets since its debut five years ago.

The New York-based firm is led by Fernando Guerrero and composed of his core team from NIBC Credit Management, where he led the North American business. The Varadero team has been together since 2007, and Guerrero recently spoke with FINalternatives Senior Reporter Mary Campbell about his and their outlook on the structured credit space and Wall Street's short memory.

How did you come to found Varadero Capital?

I started my career in finance in Houston, working for a regional bank called Texas Commerce Bank.  At the time, TCB was a Wall Street darling, triple-A rated, powered by the booming Oil Patch economy. I was young and impressionable, and as I watched plummeting oil prices cause the entire Southwest economy to crumble, it made a lasting impression about the fragility of an economy and the resulting market downfall.

When TCB was acquired by Chemical Bank, I was transferred to New York and placed with the asset-backed securities group, where I cut my teeth in a burgeoning market.  I spent 20 years on the sellside, building asset-backed securities and collateralized debt obligation desks at several firms, before moving to the buyside in 2005 to try my hand at managing capital. In retrospect, that move was the first step to building Varadero Capital.

What was the next?

In the first quarter of 2007, as the crisis began to gather steam, I was hired to run the U.S. business of a mid-sized European bank. I had seen the movie before, having spent two decades on the sell-side creating structures to react to credit cycles. My team and I immediately went into crisis management and implemented a plan that, in hindsight, made a material difference to the health and viability of that financial institution. With the support of the bank and its shareholders, we kept the core team together and secured a runway to launch our firm. Today, approximately three-quarters of our team have worked together since 2007—more than seven years, and very interesting ones.

Where do you see opportunities in the structured credit space?

We think of credit as a cyclical market. The way we describe the cycle is like a pendulum swing—at one pole you find mispriced assets, at the other, mispriced liabilities.  The market climate following the credit crisis allowed firms like ours to profit from acquiring mispriced assets from sellers who weren’t as prepared to evaluate the range of potential outcomes. As those assets season and, importantly, as the range of potential outcomes narrows, their “fair value” should become clearer to the market.

This is what generally happens as the pendulum swings from the mispriced assets pole. But that swing inevitably overcorrects, and swings towards mispriced liabilities. And that’s where we see the markets moving today. What this means in practice is that complacency is creeping into the market, and that complacency is making various parts of a securitization capital structure more (and less) attractive.

How do you evaluate a potential investment? What are your criteria?

Our investment process is built around understanding the range of potential downside outcomes for a pool of assets. We evaluate investments with a lens that allows us to examine what we call “left-tailed scenarios.”

We try not to apply value judgments to these scenarios. For one thing, we don’t call them “base,” “bull” and “bear” cases; rather, we select them for their dispersion and label them “A”, “B” and “C.”  These scenarios represent paths that aren’t supposed to happen, like what I experienced in Texas. What we seek to ensure is that scenario A is substantially different from scenarios B and C. That dispersion and those differences help us to understand the impact of stress on the performance of an investment and, in a way, to measure the fundamental riskiness of that investment.

What are the risks and how can they be mitigated?

Structured credit securities are not inherently complicated. At the end of the day, they’re just balance sheets with pools of assets financed by fixed-income liabilities. However, as the market matured from the 1980s to the 1990s and the 2000s, financial engineering added layers of complexity that made these fundamentally simple investments more difficult to evaluate. Securities that are difficult to evaluate appeal to fewer investors and therefore tend to have both a liquidity and a complexity premium associated with them. In times of stress, these premiums can widen, negatively impacting the market price of these securities. We think that the best mitigant for this risk is to understand the character of the assets you own, and how they’re likely to perform under stress.

What, in your opinion, are the most long-lasting effects of the 2008 financial crisis on the structured credit space?

Unfortunately, so many of the changes that came of the financial crisis will be fleeting. Wall Street has always had a short memory. Even regulation will ebb and flow. I think the most important change that came of the crisis was the birth of a new breed of structured credit investor who brings a different mindset to the opportunities and challenges posed by this asset class. Varadero is one of these investors, and I think that one of the long-lasting effects will be the role that we and others like us play in the markets for structured credit.

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