In the hedge fund world, Mequon, Wisconsin, is known as the town where Brian Stark and Michael Roth have built one of the largest and most successful arbitrage partnerships. Before settling in Mequon, the two partners received their legal education at Harvard Law School (class of 1980) and practiced law for a number of years, Brian at Coghill & Goodspeed in Denver, CO and Michael at Covington and Burling in Washington, D.C. Predating his legal education, Brian developed an interest in investing, and published a book, "Special Situation Investing: Hedging, Arbitrage and Liquidation" (Dow Jones-Irwin, 1983). In 1986, Brian began to manage a fund specializing in domestic and international convertible arbitrage. Michael joined him in 1988 and over the next several years, the two managed several accounts. In October 1994, they organized their own investment partnership, Stark Investments, L.P., followed by a companion offshore fund, Shepherd Investments International Ltd., in July 1995. Over almost fifteen years, they have produced very consistent returns, compounding at a net annual rate of over 21% and have expanded their activities into risk arbitrage, capital structure arbitrage, and private placement convertible investments. Today, the firm manages $1.5 billion divided into four products, the original multi-strategy funds, European and Japanese oriented convertible arbitrage funds, and a fund specialized in private convertibles. Brian Stark and Michael Roth spoke with HFN publisher, Antoine Bernheim in early January 2001.
Profile of Brian Stark
Born: November 1, 1954
Education: BA, Brown University; JD, Harvard Law
Family: married to Debra, 2 daughters
Last vacation: The Disney experience
Last book read: Tuesdays with Morrie by Mitch Albom
Hobbies: running and bicycling
Favorite quote: "What lies behind us and what lies before
us are tiny matters compared to what lies within us." (Oliver Wendell Holmes)
How he best describes himself: intense, boring-intensely boring
Profile of Michael Roth
Born: November 4, 1954
Education: BA, University of Wisconsin - Madison; JD, Harvard Law School
Family: married to Cathy, two sons
Last vacation: Disneyland
Last book read: The Greatest Generation by Tom Brokaw
Hobbies: Running; computers; sports
Favorite quote: "The only thing necessary for the triumph of evil is for good men to do nothing." (Edmund Burke)
How he best describes himself: Family-oriented, disciplined, patient, calm, optimistic, tries not to take himself (or life's travails) too seriously, short
Q. Could you describe your investment philosophy?
A. Our approach is framed by the goals we have for our investors. We aim to achieve absolute net returns of 15% to 20%; we want these returns to be uncorrelated to the major equity and debt markets; we want to have a heavy degree of principal protection; and, finally, we want to produce returns that have low volatility. The way to reach these goals is through arbitrage strategies which we approach on a global basis, mainly in the G-7 markets. Convertible arbitrage is our primary strategy, representing typically 70% to 90% of our activity. In addition, we do risk arbitrage, private placement arbitrage and capital structure arbitrage. Each of these other strategies is done on a much more opportunistic basis.
Q. Could you describe your research process and the resources you use?
A. We screen the global universe of convertible and risk arbitrage opportunities using a quantitative approach. We rely on proprietary quantitative models which our team of twenty-two quantitative and IT professionals developed in conjunction with the trading staff to identify securities that are significantly mispriced from a quantitative perspective. Examples of such securities are convertibles where the imbedded option is mispriced or risk arbitrage spreads which are unduly wide on a risk-adjusted basis. We then bring to bear our team's considerable trading experience to determine which of these opportunities are real and which are only apparent. In addition, we have a strong set of relationships with the brokerage community, which are very important in the rather lumpy universe of convertible securities. Being among the first to be called by brokers about trades involving significant blocks of convertibles is critical to performance. Finally, we have a team of several analysts who focus on credit and company analysis for convertibles and deal analysis in the risk arbitrage area. The depth of the research varies with each situation. We may visit companies where we have a particular interest in building a large position.
Q. How do you allocate capital between the various strategies you employ?
A. We believe this to be one of our particular strengths, due to our long-standing experience in the global markets as well as in various arbitrage strategies. As a result, we have the ability and expertise to move capital among geographic markets and among strategies based upon where we see the best opportunities. We try to balance several factors: on the one hand, we are bottom-up, looking for the optimal risk-adjusted opportunities; on the other hand, we have portfolio risk considerations such as diversification by positions, geographic markets and strategies. Our allocation between U.S. and non-U.S. convertibles has shifted back and forth over the years. In 1999, risk arbitrage constituted 15% to 20% of our portfolio while more recently, as attractive risk arbitrage opportunities have decreased, it has declined to only 8% of the portfolio. This allocation process is a result of our weekly portfolio meetings where managers of each particular area present their best trades and least attractive holdings, and we decide as a group where the best opportunities lie.
Q. Could you describe your policies regarding leverage and hedging?
A. We fully hedge our equity exposure and our currency exposure. We are more opportunistic in hedging our interest rate and credit exposures: in Japan, we fully hedge interest rates because rates are low, the cost of hedging is low and the consequences of being under-hedged when interest rates turn would be very costly. In the U.S., the convertible market has been somewhat insensitive to moderate interest rate shifts and we are only partially hedged. On the credit side, a continuous hedge would be costly, but we opportunistically asset swap to sell out the bond component of the portfolio, buy default puts or short high-yield or convertible securities. We approach leverage as a tool, which we manage according to geography, markets and macro-economic conditions. For instance, in Japan, where we are able to sell out most of our credit exposure, thereby setting up essentially a warrant book, our leverage is higher than in the U.S.
Q. The convertible new issue market is increasingly influenced by convertible arbitrageurs. How will that impact the future profitability of your strategy?
A. Convertibles are increasingly being structured to meet the goals and the demands of convertible arbitrageurs; we view that as a positive. Established arb funds are receiving larger allocations of new issues. That is another positive. Investment bankers now see that arbitrageurs can play a very positive role in the marketplace as a source of demand as well as a stabilizing force, because arbitrageurs always go counter to the general trend. When equities are moving up, arbitrageurs are selling into strength and when equities go down they are buyers into weakness. If you look at the entire convertible market, as opposed to just the new issue market, the fact that such a large quantity of product is now in arbitrageurs' hands can be a moderating force in the short-term, which is what happened last year. Arbitrageurs were not under pressure to liquidate because they were hedged, and convertibles held up much better than they have historically in that type of environment. In the long run, however, this increased concentration could have an adverse effect on the convertible market if liquidity was drained from the hedge fund community.
Q. Could you describe how your organization functions?
A. The overall orientation of the firm is one of consensus. People here are team players and are compensated more from overall performance as opposed to individual P&Ls. We try to set the tone for the organization in terms of portfolio management and macro-views, but we have a very talented staff, particularly at the senior level, where there is one senior portfolio manager to oversee each geographic market as well as each strategy. Below the senior portfolio managers are traders with four to five years of experience. We currently have ninety employees spread among trading, quantitative analysis, credit and risk arb analysis, technology, legal and compliance, administration, accounting, settlements and funding, and investor relations and marketing.
Q. What are your goals for the future?
A. We want to continue to incubate and cautiously add additional arbitrage strategies that are complementary on a risk-adjusted basis when and where appropriate. We are currently working on capital structure arbitrage, statistical arbitrage and specialized forms of fixed income arbitrage. There are a lot of synergies in having a large team of credit and risk arb analysts, IT professionals and quantitative analysts. To make optimal use of such talent and keep these individuals challenged, it makes sense to have some cautious growth in mind. We are, however, very sensitive about not going beyond our area of expertise, always remaining focused on arbitrage strategies.