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May 25, 2016  

LP Moves Prompt Changes at Deer Park Road

Mortgage-bond investor Deer Park Road Management is adjusting its product mix in response to redemption pressures and shifting investor demand.

The $1.9 billion firm is unwinding one of its hedge funds, called Burgess Creek, after a large European investor asked to withdraw $50 million, and is transferring most of the remaining investors to its flagship STS Partners Fund. At the same time, it is tweaking the fee and liquidity terms for STS Partners amid sagging performance.

With an annualized return of 24.5% since its 2008 inception, STS has been a bonanza for Deer Park Road. The fund has an unconventional fee structure, with no management fee. Instead, limited partners pay a 60% performance fee on the first 4% of the fund’s profits. The rate drops to a standard 20% of any subsequent profits.

But the fund’s returns aren’t what they once were. STS gained 8.8% last year. While that was well above the industry average, it was the first time the fund’s full-year return was below 23%. Until August, STS hadn’t had a down month for 70 consecutive months. But year-to-date, it is down 2.1% as of April 30.

That helps explain why Deer Park Road is reopening STS to outside investors for the first time in four years and amending the fees and liquidity terms applicable to new investments — including the assets moving over from the now-unwinding Burgess Creek. Newcomers will pay the industry-standard 2% management fee and 20% performance fee. They’ll also be subject to a one-year “soft” lockup, during which they’d have to pay a 5% penalty on any withdrawals. Burgess Creek investors had been used to a monthly redemption schedule.

The changes apparently aren’t sitting well with some investors. Limited partners representing nearly three-quarters of the capital in Burgess Creek have opted to transfer to STS. Most of the rest have asked the manager to liquidate their assets — a process that’s expected to take months, considering that Deer Park Road specializes in illiquid “odd lot” mortgage-backed securities.

“I know that some investors in Burgess Creek didn’t want to wait . . . for their money back, nor did they want distribution in kind, so they planned to move from Burgess to STS and then immediately redeem from STS hoping that they could get out faster when part of the larger fund,” a source said. “They’re not waiting for the lockup to be over. They’d rather pay the redemption fee and get money ASAP.”

But a source close to the Steamboat Springs, Colo., firm said most Burgess Creek investors were eager to transfer to STS and so far have shown no signs of wanting to withdraw. “No one has done that,” he said. “I’d be very surprised at that.”

Still, STS has been hit by redemption requests including $82 million for April and $75 million for May. It is bracing for another $86 million of withdrawals in June and about $50 million in July. The fund had $1.5 billion under management as of March 31.

“It should be noted that while the pace of redemptions has increased somewhat in the near term, this has not presented any change to our portfolio-management strategy,” the firm wrote in an investor letter distributed last month. “Of note: through the first three months of the year, the balance of redemptions, back-fill contributions and cashflow on the portfolio holdings has generated a positive increase of approximately $40 million. While the coming periods account for some incremental increase in outflows, they represent a relatively small portion of the overall fund size and are mitigated by the increase in portfolio cashflows.”

In reopening STS, Deer Park Road hopes to raise $250 million to $500 million — in addition to the assets transferring from Burgess Creek. So far, it has taken in $10 million of fresh capital.

Deer Park Road launched Burgess Creek in 2013 to offer investors a less-volatile version of its STS strategy. While nearly 70% of Burgess Creek’s positions also are held by STS, the balance of its holdings are higher-rated mortgage securities that tend to be more liquid. Through April, Burgess Creek was showing an annualized return of 6.6%. But year-to-date, it was down 4.5%.

In December 2015, a Danish pension began withdrawing its entire $50 million investment from Burgess Creek. At the time, the fund had a little more than $300 million. As a result of the redemption, which was to be executed over six months, other investors would have held increasingly large percentages of the fund. That, coupled with investor demand for STS, was enough for Deer Park Road to pull the plug on Burgess Creek. In doing so, it offered limited partners three exit options: transferring to STS, liquidating their stakes over 12-18 months, or receiving in-kind payments of assets. Only one investor opted for a payment in kind.

The changes to STS’ fee and liquidity terms were designed to make the fund more attractive to pension consultants and other advisors to institutional investors. They have shied away from STS due in part to the perception of a liquidity mismatch between the underlying assets and the fund’s monthly redemption schedule. There also was a concern that without a management fee, the firm might be vulnerable to periods of low or negative returns.

Several sources suggested Deer Park Road may have had an ulterior motive in ushering Burgess Creek investors to STS. Because the funds have similar portfolios, liquidating Burgess Creek could have dented the values of the underlying securities, which in turn would have hurt the performance of STS.

The maneuver also has rekindled skepticism among some observers about the ability of STS to generate such consistently strong returns. “The firm has too perfect of a return profile since its 2008 launch,” one source said.

Deer Park Road is led by founder Michael Craig-Scheckman and chief investment officer Scott Burg. Craig-Scheckman previously was a portfolio manager at Millennium Management. Before joining Deer Park Road, Burg co-founded an asset-valuation shop called Clayton IPS, now known as MountainView IPS. Among MountainView’s clients is Deer Park Road. Scott Gibson, who became head of marketing for Deer Park Road earlier this year, previously worked at MountainView IPS.