Steve Kuhn doesn’t like to boast. Well, maybe he does, just a little. Pine River Capital Management earned an estimated $2 billion in profits in 2012 across its various funds through its subprime mortgage securities play, and the chatty chief of fixed income, who orchestrated the strategy, notes almost in passing that it probably ranks among the top Wall Street trades of all time. That would put Pine River in the company of John Paulson, whose funds made $15 billion in 2007 shorting subprime, and George Soros, who made $1 billion in 1992 shorting the British pound and breaking the Bank of England in the process.
Pine River is not the only hedge fund firm that posted very big gains in 2012. But it has had so much success with its mortgage strategy dating back to 2009 that outsize returns have become an odd sort of image problem — the kind most hedge fund managers would die for. Notwithstanding Kuhn’s boast, Pine River probably has to spend as much time moderating expectations of future profits as it does explaining its methods and operations.
| Pine River founder and CEO Brian Taylor, left, and chief of fixed income Steve Kuhn |
The need to dampen enthusiasm for its reputation as a major profit engine puts Pine River in a very different place from a few years ago, when it was so beaten down after the market collapse that its assets had fallen from $1.3 billion in July 2008 to $612 million in January 2009. Pine River founder and CEO Brian Taylor had to dig into his own pocket to keep the company running smoothly, putting 25 percent of his personal fortune into the firm at the time.
Pine River didn’t stay down for long. Today, Taylor presides over a burgeoning financial empire managing more than $14 billion across a family of hedge funds, separately managed accounts and real estate investment trusts. From the firm’s headquarters in Minnetonka, Minnesota, he oversees eight offices spread from London to Beijing, with about 350 employees. The New York office, the core of Pine River’s trading operation, now occupies an entire floor of a Midtown high-rise.
“In terms of performance success and asset-raising success, I don’t think anyone matches up with what they have done in the past five years,” says Jonathan Havice, chief investment officer of Jeffrey Slocum & Associates, a Minneapolis investment adviser to institutions that has placed money with Pine River.
What is remarkable is not just how quickly Pine River recovered and grew after the slump but how coolly confident Taylor seems to have remained through it all.
“I never had any doubt about survival,” Taylor tells Institutional Investor’s Alpha. “Crisis creates opportunity. You just have to be there to take advantage of it.”
Now, as it positions itself for future growth, Pine River has to contend with those sky-high expectations and the danger of becoming pigeonholed as a one-trick manager with a narrow specialty in mortgage securities. How it handles the next stage in its development is being closely watched by institutional investors, who have played a big part in its growth.
“If they were still out pounding the table, telling us they were going to make 20 percent per year over the next five years, we would be highly skeptical or suspicious of the risk,” Havice says. “But if their guidance is for 10 to 12 percent, we are comfortable with that. That is where their expectations are.”
Taylor is quick to point out that trading mortgage securities, while highly successful for the firm, represents just one aspect of a much broader operation. “Fixed income has been a tremendous opportunity for us and our clients,” he says. “But it is not all that we do. We trade equities; we trade currencies; we trade derivatives; we trade credit.”
Pine River now runs $9 billion spanning ten separate hedge fund investment strategies, trading everything from convertible bonds to Asian securities, as well as about $5 billion in two REITs. The firm describes itself not as a fixed-income or mortgage specialist but rather as a global investment manager with a relative-value focus — primarily hunting for securities with hidden value compared with others in its space and then placing trades to capitalize on the mispricing, often relying on arbitrage-style trades to profit from the spreads.
Havice acknowledges that the firm’s current concentration in mortgages and housing clearly stands out, but he does not view it as an area of concern, partly because the mortgage market is so large, at more than $13 trillion, and in such a state of transition with the retreat of Fannie Mae and Freddie Mac as guarantors that there is likely room for Pine River to maneuver for years to come. As for the firm’s ability to scale up other strategies, Havice says: “Time will tell. I don’t think anyone really knows.”
Still, the mortgage trade served to burnish Pine River’s reputation at a crucial point in its transformation from a small Midwestern hedge fund manager into a global financial company.
The mortgage play is centered in the $4 billion Pine River Fixed Income Fund (previously named the Nisswa Fixed Income Fund), which was launched in 2008 and is the firm’s largest hedge fund. Its big idea was essentially the reverse of the trade that earned Paulson so much money. Starting in late 2006, Paulson bet against the booming market for subprime residential-mortgage-backed securities, and he cashed in when the housing market crashed. After the collapse Pine River invested in cheap RMBSs and profited as the prices rose. The firm’s thesis has been much more nuanced than a simple long bet on mortgage bonds. But the bottom line is that Pine River correctly diagnosed the mispricing in RMBSs and effectively exploited it.
“They have shown themselves to be ahead of the pack,” says Inna White, founder and chief investment officer of New York–based Althea Group, a fund of funds dedicated to credit strategies that invests with Pine River. “They are truly opportunistic.”
The Pine River Fixed Income Fund soared 93 percent in 2009 and has continued to produce remarkably strong results since. It posted net annualized returns of 39.2 percent from inception in February 2008 to the end of April. The fund rose 7.55 percent this year through April. Pine River declined to discuss returns in that fund or in its other hedge funds.
The Fixed Income Fund is now closed to new investors, but the expertise Pine River developed in residential mortgage finance has informed its other strategies, including long-short equity (mortgage trends play a big role in the fate of many financial stocks, for example). The influence of the mortgage strategy is evident in the numbers. Between the Pine River Fixed Income Fund at $4 billion, the Pine River Liquid Mortgage Fund at $1 billion and the two REITs, the firm has about $10 billion, or more than 70 percent of its assets, in mortgage- or housing-related entities. The mortgage play shows up in other Pine River funds as well.
Taylor suggests that focusing on the success of the mortgage trade misses the bigger picture at Pine River, which is developing into a financial firm with diverse talent and interests and a business infrastructure so sturdy that it wows institutional clients. Taylor has put so much emphasis on infrastructure over the years that business operations now account for two thirds of Pine River’s workforce. While the company has 119 investment professionals, it has 154 people involved in business infrastructure and an additional 72 in information technology. “The reason they have grown so fast is that there aren’t that many hedge funds that delivered good returns in the past several years and also had a strong institutional infrastructure,” White says.
GREAT TRADERS DON’T TYPICALLY MAKE GREAT BUSINESS managers. “The guys who sit in front of a computer all day trading tend to be guys who can’t build a business very well,” says Irv Kessler, an early investor in Pine River and now a partner in one of its REITs, Silver Bay Realty Trust Corp. Kessler should know. The veteran hedge fund manager co-founded Minnetonka-based Deephaven Capital Management in 1994. “Very few people really have the ability to be a good trader and to be a good manager,” says Kessler, who left Deephaven in 2002 after the firm was sold to Knight Capital Group. “In fact, that is my own failing. I built a number of businesses that were good, but I got to a point where I didn’t like it. I think Brian thrives on it.”
Although Taylor started out as a trader and portfolio manager, he quickly transformed himself into a savvy business manager after he launched Pine River in 2002. Today the 48-year-old works out of an office in the firm’s Minnesota headquarters and keeps an apartment in New York. His personal office in New York is a glass-walled corner space that overlooks Central Park, but the desk is positioned so Taylor’s back is to the view. There is a small refrigerator stocked with his refreshment of choice, the energy drink Red Bull, which reflects his devotion to physically challenging sports. Along with his three sons, Taylor skis, snowboards, climbs mountains and participates in triathlons.
With his close-cropped brown hair and sinewy build, the CEO looks a little like actor Kevin Costner in character for a role as an FBI agent. Taylor has a patient and methodical way of talking, punctuated by long pauses as he considers his thoughts. He is regarded by colleagues as a math whiz and a tech devotee.
Part of Taylor’s skill is the ability to hire talented and capable managers, then let them hog the spotlight while the CEO retreats to the background. As a result, Kuhn is probably better known than his boss. “Some people like to be front and center,” says Kuhn, whose trademark shiny shaved head is a familiar sight on financial news broadcasts. “I put myself in that category. Brian doesn’t, and he doesn’t mind if I get the attention.”
Taylor has also tried to build loyalty within his management team by handing out partnerships to top lieutenants. Pine River now has 16 partners (two were added in April), each of whom has an equity stake in the firm. The effect has been to dilute Taylor’s own equity in Pine River, which is now about 35 percent. Taylor’s willingness to do this is somewhat unusual in the hedge fund business. “Historically, founders of hedge funds have been reluctant to own less than 50 percent from a governance standpoint,” says Howard Altman, co-CEO and co–managing principal of accounting firm Rothstein Kass and head of the firm’s financial services group. “In some cases, however, we have seen founders relinquish majority control in an effort to create a succession plan.”
Pine River’s CEO is patient in his recruitment, especially if he finds someone whom he perceives as the right fit for a particular job. Taylor says he spent three years wooing James Clark to Pine River. Clark worked at Goldman Sachs Group for 18 years; he was a partner and head of that firm’s risk and portfolio construction. He joined Pine River in April 2012 and is now a partner and co–chief investment officer, sharing that title with Taylor. Clark is co–portfolio manager of the firm’s flagship Pine River Fund with Aaron Yeary, a partner who has been with the firm from the start.
A peek under the hood of the Pine River Fund provides some insight into what the firm is really all about. The multistrategy vehicle, launched in 2002 (six years before the Fixed Income Fund), is an amalgam of the various strategies Pine River pursues. It manages about $2.5 billion.
The Pine River Fund maintains nearly 3,000 positions at a time and averages more than 13,000 trades per month, with the largest allocation, at about 27 percent, in equities. The fund returned 12.11 percent annualized from inception in June 2002 through the end of April 2013. It is up 7.02 percent this year through April.
“Think of this as a multipronged instrument, with convertible bonds, interest rates, credit, stock, a volatility component,” says Yeary. “You are being paid a fee by the marketplace to go in and hedge different components of these securities. We do that day after day, capturing small profits each day. It is a machine that warms my heart. We are making money off turnover and rehedging as opposed to taking big sweeping bets.”
The flagship fund also provides a window into the source of the firm’s investor capital. About 60 percent of the Pine River Fund’s investors are pension funds. Endowments, foundations and other institutions make up a further 8.4 percent, while much of the rest comes from funds of hedge funds, which account for 18.7 percent.
Wooing institutional investors was important to Taylor from the day he launched Pine River. So was his dedication to relative-value investing. Taylor developed his investment style as a graduate student at the University of Chicago Booth School of Business, where he earned his MBA in 1988.
His potential caught the attention of Minneapolis-based Cargill, the privately held agricultural giant that also ran a proprietary global financial trading operation. Cargill gave him a summer internship in its equity derivatives trading group and offered him a job upon graduation. By then Taylor seemed to be fully formed as a trader, investor and investment manager. He had only just arrived at Cargill when some company veterans left to form a new investment company, EBF & Associates. They took two Cargill traders with them: Thomas Siering, who had been with the company for seven years, and Taylor, who had barely warmed his seat.
“Brian and I were the first two professional hires at EBF,” Siering says. “That spoke volumes to what they thought about Brian. They could have had anybody. They took a kid right out of school.” Siering now works for Taylor, having joined Pine River in 2006, and is CEO of Two Harbors Investment Corp., one of the firm’s REITs.
Stories abound about how hardworking Taylor was during his EBF years — one of those first-in-the-morning-last-at-night desk jockeys who seemed driven to succeed. He was managing $775 million for EBF when he left in 2002 to form his own firm.
The early days of Pine River have been well documented: how Taylor launched the fund in a cabin in the Minnesota woods with several EBF colleagues and eventually established roots in the Minneapolis suburb of Minnetonka. The cabin period provided a quaint yarn to spin during the firm’s early days, but Pine River quickly outgrew its homey image. It added the Pine River Asia Fund in 2004 to trade in Asian securities and Pine Edge Value Investors in 2007 to pursue a value investing strategy. Its relative-value orientation drew it to convertible arbitrage, which became an early specialty.
But trouble soon hit. As the events of 2007 and 2008 unfolded, Taylor miscalculated how bad things would get and failed to move to a more defensive portfolio allocation ahead of the bloodbath.
“At that time, some things that happened surprised us, and I made mistakes as CIO,” he says. “I guess I didn’t think policymakers would let things get as out of hand as they did. In hindsight, we could have understood that in a crisis things could have become political and could result in what was not the best outcome for the economy. I always believed that policymakers would come to their senses. I was wrong.”
In the aftermath, hedge fund managers faced a sudden rush of investors trying to pull their money out. Many managers put up gates to prevent a big drain on assets that would force position liquidations at fire-sale prices. Not Taylor, who honored redemption requests. The combination of redemption and trading losses sapped $700 million worth of assets from the firm, bringing the total down to $612 million by January 1, 2009.
“Brian made the decision that the right thing to do was to give people their money back,” Silver Bay’s Kessler says. “I feel that reflects on the type of people you are dealing with. Other funds could have done that but decided to take the easy way out and freeze redemptions.”
The challenges brought on by the market rout didn’t stop Taylor from looking for future investment opportunities. The collapse of the subprime mortgage market had been the proximate cause of the market crash. But those mortgage bonds were still around and dirt cheap — a potential moneymaking opportunity if handled correctly. To analyze and run the strategy, Taylor hired Kuhn in 2008. Kuhn had been a Goldman Sachs portfolio manager in charge of $40 billion worth of mortgage-backed securities who worked out of both New York and Beijing.
The opportunity that Kuhn and his team settled on in 2009 was to exploit the divergence in prepayment views between agency (Fannie Mae and Freddie Mac) and nonagency markets. Investors figured underlying borrowers in agency pools would race to prepay loans, taking advantage of falling loan rates after the Federal Reserve announced it would buy agency mortgages as part of its quantitative easing program. Meanwhile, prime nonagency mortgage bonds were trading as if almost no borrowers would be able to refinance and prepay loans. Kuhn thought both views extreme and placed his bets accordingly. He bought certain agency bonds that would rise in value if prepayment rates slowed and simultaneously bought nonagency bonds designed to rise in value if prepayment rates increased. Both bonds moved in his favor.
As Kuhn began digging into the mortgage situation, he decided he could gain an edge by developing an in-house computer analysis system. It was an expensive proposition that required finding and hiring a team of dedicated computer nerds. During his time in China working for Goldman Sachs, Kuhn had heard about tech companies that operated computer programming and analysis offices in Beijing staffed with Chinese university graduates. The solution had been cost-effective and highly productive for tech companies. Kuhn proposed that Pine River open its own tech office in Beijing to work on mortgage bonds. He anticipated a fight. Instead, Taylor forked over the capital, convinced that Kuhn was onto something. Kuhn’s Beijing team has been bolstering Pine River’s mortgage edge ever since, providing valuable data analysis and helping the firm create a proprietary model for evaluating nonagency mortgage bonds.
The latest twist in the mortgage trade came toward the end of 2011, brought on by a number of large banks and broker-dealers shedding billions in structured credit to adapt to the much tighter regulatory capital regime imposed by the new Basel III global standards on bank accounting. Nonagency bonds in general and subprime bonds in particular fell steeply again as they were dumped on the market. By November 2011 nonagency subprime bond prices were back where they had been in 2009, and Pine River jumped in to take advantage of the new mispricing. By 2012 house prices began to rebound, and so did bond prices.
The other big idea that Pine River launched during this period was its first REIT, Two Harbors. One of the lessons of 2008 was that hedge fund assets can become unstable during periods of stress; people want their money back. A public entity like a mutual fund or REIT is different, with a permanent capital base supported by public markets.
“The appeal of having a permanent capital base certainly wasn’t lost on us,” Two Harbors CEO Siering says. “We are proud of the fact that during the crisis we didn’t gate or suspend a single investor redemption. Nonetheless, people used Pine River as an ATM, and we had a pretty serious drawdown. The allure of having permanent capital was reinforced by that period of time.”
The trick to successfully launching a public vehicle was having some expertise to sell. The mortgage play provided that opening. “We realized that there was a value proposition to taking the hedge fund expertise that Kuhn had built on the private side and bringing that sophistication to the public market,” Siering says.
Launched in 2009 with about $124 million, Two Harbors soared in a few years to its recent size of $4.2 billion trading mortgage-backed securities.
Two Harbors also hopped on board the trend of buying real estate owned (REO) properties — repossessed homes owned by banks as a result of the market crash — and then renting them out to create a profitable cash flow with the intent of ultimately selling the homes at another profit. The entrée to that business came from Kessler, who was running a company called Provident Advisors that was managing REO homes. Two Harbors started buying houses in January 2012, using Provident as its property manager. In short order, Two Harbors owned about 3,400 homes and decided that it had stumbled upon yet another mortgage-related separate business. Two Harbors spun the REO business out into a separate public company, Silver Bay Realty Trust, in December 2012.
Pine River believes the synergy that led to the REITs’ creation can be duplicated in other areas. “The success of Two Harbors and Silver Bay has been the result of the infrastructure of Pine River,” Siering says. “People on Wall Street take what we say very seriously.”
But there are plenty of skeptical analysts on Wall Street who are not yet convinced that Pine River can transfer its past hedge fund success into attractive long-term returns at the REITs, particularly Silver Bay, where Pine River must prove it can profitably manage a far-flung collection of single-family home rentals.
Clearly, Pine River has been fortunate in the way events have played into its mortgage expertise again and again since 2008. But it has also been opportunistic in exploiting those opportunities while pursuing a range of other investment options through its various funds and operations.
And it intends to continue looking for new areas into which it can expand both financially and geographically. The firm recently opened an office in Austin, Texas, run by Kuhn, who had been based in New York. Austin is viewed as an emerging financial center as well as a beachhead from which to seek investment from pension funds throughout the Southwest. Another Minnesota hedge fund firm, Whitebox Advisors, recently opened an office there, run by Paul Twitchell, a longtime friend of Kuhn’s.
As to where Pine River will find its next big investment, Taylor says he is exploring several tempting opportunities. He has talked about starting a mutual fund and launching a vehicle to invest in reinsurance bonds. One institutional investment adviser familiar with Pine River says Taylor may have his eye on a play in catastrophe bonds, which insurance companies sell as a way to lay off homeowner casualty policy risk in places like hurricane-prone Florida.
“At any point in time, we have multiple ideas floating around internally about new products, new strategies,” Taylor says, adding, “There are some new things in the works.”
