That 3.5% loss was Waterstone’s biggest ever on a single position. Yet in 2008, thanks to a healthy number of shorts, trades around Bank of America’s January 2008 acquisition of Countrywide Financial and, most importantly, the lessons Bergerson has learned in prior routs, Waterstone clobbered the average convertible and equity arbitrage hedge fund and most of its multistrat peers, netting 12.07% vs. the 26.03% loss these funds reported as a whole. “One way we made money last year is risk management, and actually hedging is another—the short equity hedge in terms of credit and some short credit,” says Bergerson, whose intense nature and no-nonsense personality can be great, say market participants—unless you’re dealing with him on the other end of a trade. “The converts and credits we shorted went down dramatically and we profited from the short positions, whereas with our longs, on average, we didn’t get hurt too badly on too many positions and had some that made some significant money.”
This year through August, Waterstone’s returns have been even better: The fund has gained 43.16%, nearly 10 percentage points more than the Absolute Return Convertible and Equity Arbitrage Index, which is up 33.63%. The firm’s notable success over the past two years stems from its decision to reverse course on convertibles in mid 2007. As the spread between convertibles and stocks tightened, Bergerson says, he decided that the risks involved in owning a lot of lower quality credits outweighed the rewards. The firm reduced leverage and began shorting credit. “We definitely foresaw the possibility of a credit event happening,” says Martin Kalish, Waterstone’s chief operating and chief financial officer.
Had Waterstone held nothing but its net long convertible positions last year, Bergerson estimates that his fund probably would have lost between 30% and 35%. (Citadel Investment Group’s Kensington Global Strategies, which had a significant convertibles exposure, lost 55% in 2008.) But Waterstone easily offset those losses. In the case of Countrywide, Waterstone bought the company’s bonds, shorted the credit through credit default swaps and shorted its equity. “It was a situation where our long bonds ultimately paid off and the short equity also made us a lot of money,” says Bergerson. The firm benefited from similar plays on PNC Financial’s purchase of National Citicorp, Banco Santander’s acquisition of Sovereign Bancorp and Wells Fargo’s purchase of Wachovia Bancorp. Citigroup’s troubles also proved profitable. After shorting Citi’s preferred securities for most of 2008, Waterstone covered its shorts and went long right before the government bailed it out in November.
Driving Waterstone’s investment decisions is detailed fundamental credit analysis, of course, but also the lessons Bergerson has absorbed in two decades investing in the cyclical convertible and credit markets. “Since I’ve been in the convert market on the buy side since 1992, I’ve learned to kind of trade around the cycles to reposition us ahead of them and build portfolios in the downtimes that pay off in the following years,” says 44-year-old Bergerson, noting that within the past two decades the convertible market has cycled down in 1990, 1994, 1998, 2005 and 2008. That insight didn’t prevent him from losing money on his Lehman bet, but it did help him size the position so as to put little of the portfolio at risk. Since its inception in 2003, Waterstone has averaged an annual return of 16.37% net of fees.
Bergerson’s fund management record goes back to 1999, when he joined the now-defunct Deephaven Capital Management as senior portfolio manager of its U.S. convertibles book, a job he took over from Andy Redleaf, who had left to form Whitebox Advisors.
During Bergerson’s time at the helm of Deephaven’s convertible book, the portfolio rose steadily: up 26.63% in 1999, 22.65% in 2000, 24.80% in 2001 and 16.08% in 2002, according to Waterstone marketing materials. Ironically, while Waterstone and Whitebox are churning out profits this year, Deephaven collapsed under the weight of poor performance and significant redemptions. Its assets were sold to Stark Investment for $7.3 million.
Bergerson and Kalish launched Waterstone in August 2003 with $25 million and quadrupled fund assets within its first two months. Waterstone was formed with a team of seven, including two other recruits from Deephaven—Chris Parks, who handles operations, and Ildiko Hildreth, an analyst. Today, Waterstone employs 18 people, with 10 of its 11-member investment team boasting significant credit experience. “The biggest differentiating factor between us and other convertible shops is that we do a lot more fundamental and credit research,” says Kalish, a New Jersey native who transplanted his family to Minnesota in 2000 to join Deephaven only to be greeted by 80 inches of snow and 37 straight days of subzero temperatures his first winter there. “We do a lot more research and it shows in our returns, based on the alpha we produce,” he says. For the life of the fund its correlation to the Credit Suisse/Tremont Hedge Fund Index is 50%, while its correlation to the Standard & Poor’s 500 Index is negative 5%.
In spite of Waterstone’s strong performance, the firm was not immune from 2008’s market chaos. Bergerson and Kalish decided not to restrict investor withdrawals last year because they had the ability to pay investors back and didn’t think holding on to the capital was necessary. Of course, because of that decision, the firm served as a source of liquidity for cash-starved investors unable to redeem from other funds. In the fourth quarter of 2008 and the first half of this year, Waterstone investors asked for 40% of their assets back. By January, the firm’s assets under management had plunged by 43%—to $665 million, a far cry from its September 2008 peak of $1.17 billion. Those redemptions, however, ultimately proved little more than a minor setback.
Waterstone’s assets have climbed back up to $1.2 billion, helped by big gains and a few hundred million dollars from several institutions, including a sovereign wealth fund and a fund of funds.
In his years of investing, Bergerson has made mistakes, and his willingness to discuss them suggests an openess to learn. In May 2005, for example, an unexpected bid to acquire General Motors sent an already weak convertible market into a downward spiral. At the time, hedge funds represented roughly 80% of convertibles trading and many funds were short GM stock and long its convertible bonds—a traditional arbitrage play.
Billionaire investor Kirk Kerkorian’s surprise bid to add to his stake in GM sent the car maker’s stock soaring at roughly the same time a rating downgrade weakened the company’s bonds. The double punch led to a big sell-off that eventually brought down a number of major convertible players, including Triborough Partners, SAM Advisors and Marin Capital. Caught up in the mess, Waterstone lost 10.29% in 2005—the firm’s only down year since inception in 2003—and investors pulled roughly half the fund’s assets.
Ever aware of that blemish on Waterstone’s track record, Bergerson and his investment team view 2005 as a learning experience that helped them navigate last year’s market so well. “Going through the bad market in 2005, when a lot of assets came out of the strategy itself, definitely helped us prepare and position ourselves appropriately for this downturn, and I think we got it right in 2007 leading into 2008,” Kalish says. He said the experience taught the firm to stick with its convertible and credit expertise and its fundamental trading strategy and also to find out what other convertible firms might be forced to sell because of redemption requests. Still, 2005 wasn’t all bad. When many of Waterstone’s peers were going under, the firm’s traders snapped up a handful of good positions at bargain basement prices—positions that Waterstone continues to hold today. When similar buying opportunities rose in 2008, the firm took up the same strategy.
A critical component of Waterstone’s success in 2008 was its access to financing. In August that year, the firm had quite fortuitously diversified and strengthened its prime brokerage relationships. That month, Waterstone severed its long-time prime brokerage relationship with Goldman Sachs—a seemingly smart move given the bank’s hesistance last fall to finance convertible arbitrage positions. Meanwhile Waterstone added JPMorgan, Scotia Capital and Bank of Montreal to its prime broker fold, which already included Deutsche Bank, Barclays Capital and BNP Paribas. Says Kalish: “The market itself really made us diversify because you didn’t know what was going to happen tomorrow. It wasn’t that we needed six prime brokers, but it let us know that we are able to manage our counterparty risk better.” While many of Waterstone’s peers were more heavily levered in the summer of 2008, Waterstone had borrowed between 2 and 2.5 times equity, below its historical range of 3 to 3.5 times. Since then, the firm has cut its leverage to about 2 times on a gross basis.
“Because they are a proactive partner, there are no surprises or fire drills that make you question how they’re running their business,” says Steve Latham, a director in global prime finance sales for Deutsche Bank’s prime brokerage business. “Waterstone has been open and proactive and that has been critical given recent market activity. Our relationship with Waterstone is a true partnership that is beneficial to both parties.”
Financials have been one of Waterstone’s key interests in recent years, given that as much as half of new convertible issuance in 2008 came from financial companies. The firm shorted the stock and bought the credit of a number of banks it identified as being attractive acquisition targets because of rich deposit bases, branch networks and/or market niches. “We picked companies to be long where there was a franchise value and a reason why somebody would want to buy them if they got into distress,” says Bergerson.
Just as telling, he says Waterstone steered clear of troubled lenders. “We avoided situations like Washington Mutual where there was so much toxic assets or loss potential in their loan portfolio that it would overwhelm the franchise value of the company,” says Bergerson. In Washington Mutual, First Federal Bank, National Citicorp and IndyMac, Waterstone profited by shorting the companies’ stock prior to such events as bankruptcy or recapitalization.
Unlike some funds that got hurt taking concentrated positions in individual names, Waterstone limited losses by restricting its exposure to any individual industry sector to 10% of total assets. The firm regularly stress tests the holdings of each industry sector in its portfolio to confirm that if all of them were to fail, their combined losses would still remain below that 10% limit.
Keith Menzel, a trader who joined Waterstone in 2004, echos Kalish when he says that fundamental credit research distinguishes the firm’s trades. “You have a lot of specialists in volatility arbitrage that don’t really understand companies,” Menzel says. At Waterstone, “there are several eyes that look at every position—generally a trader and an analyst.”
That intense scrutiny allows the firm to make moves it otherwise couldn’t. For instance, Waterstone has occasionally sold bonds it holds directly back to the issuers—instead of offering them in the open market. That approach has led to higher returns because the issuers who did buy back their bonds did so at a slight premium. Menzel says Waterstone benefits from its location in the U.S. flyover zone—Plymouth, Minn., 20 minutes from the Minneapolis city center—because it prevents the firm from buying into Wall Street’s group think. Deutsche Bank’s Latham agrees about Waterstone’s independence: “Shawn is not afraid to run a more fundamental strategy and invests based on his research and convictions, rather than running a more traditional, pure convert arb strategy. He’s a smart, independent investor and this is apparent when you look at his returns.”
Patience has also proved profitable. After insurance company LandAmerica Financial Group filed for bankruptcy last November, insurance regulators forced the group to sell its insurance subsidiary. That deal, done at a steep discount, took a toll on LandAmerica convertibles, of which Waterstone was a holder and had first purchased at $96.69. When the converts traded down, Waterstone marked its position down. But the fund kept on buying. Confident in LandAmerica’s potential, Waterstone increased its stake as the insurer’s bonds traded down to $0.14 on the dollar. The bonds have since inched up to $0.32.
“Our philosophy is about having conviction in our opinions and our ability to stick to our convictions—both positive and negative,” says Ranga Ramamoorthy, an analyst who tracks the banking and financial sectors for Waterstone. Looking ahead, Waterstone expects that the Federal Deposit Insurance Corp. will take over many more banks this year and next, and that this will create attractive investment opportunities if Waterstone is able to identify the strongest candidates—those ultimately likely to be acquired by a third party. Ramamoorthy is keeping an eye on the bank management teams that have not blown up a bank and are young enough to build up their businesses.
A Minneapolis native whose father was a lawyer and mother was the controller for a Minnesota law school, Bergerson attended Columbia University and began his career in finance in 1987 as a credit officer at National Westminster Bank USA in Chicago. He earned a masters of business administration in the evenings at Northwestern University’s Kellogg School of Management in 1992 but, despite graduating with a 4.0 grade point average, passed up several high-profile job offers for an intern level position at Chicago boutique derivatives trading firm O’Connor and Associates—the lowest paying position of his graduating class. It was a choice Bergerson made with the same meticulous thought and planning he applies to his trading activities. Eager to remain in Chicago, and aware of the growth potential of derivatives, Bergerson correctly decided that if he committed himself to five years of hard work to learn the industry, the payoff could ultimately prove much greater than those of the traditional investment banking and corporate finance career paths he had passed over.
Seven years later, in 1999, Bergerson and his wife—a native of Sweden whom he met after losing his passport in Turkey while traveling during the summer after college—decided to return to his hometown, where he took a job with Deephaven. When Deephaven founder Irv Kessler decided to leave the firm in 2001, a year after selling to equity market-maker Knight Capital Group, it was not Bergerson he chose as his replacement. Kessler named Bergerson chief investment officer, but for the chief executive position he tapped Colin Smith, then 37, who was managing Deephaven’s risk arbitrage strategy. Deciding he wanted ownership of his investment activities, Bergerson in early 2003 left Deehaven to form his own firm, recruiting Kalish, then Deephaven’s operating manager, to help.
The differences between Waterstone and many of its peers don’t end with investment strategy. Unlike many hedge fund firms whose offices are adorned with expensive artwork, offer sweeping views and center around large trading floors dotted with computer screens, Waterstone’s headquarters is unassuming and modest in size. Located in a Minneapolis suburb, the firm is lodged on the second floor of a generic-looking office complex where one would sooner expect to find a dentist’s office than a billion-dollar hedge fund. Once inside, there’s no question that serious work is being done. On a Tuesday afternoon in early September, Waterstone’s small trading floor was all but silent as the firm’s analysts and traders tracked the market and their own positions.
As of mid-September, roughly 90% of Waterstone’s portfolio consisted of long positions in convertible bonds, with the majority of its short credit taken through credit default swaps. Short convertible positions represent only 3% of the portfolio, down from roughly 20% last year and as much as 55% in the middle of 2004.
Oddly enough, Lehman’s bankruptcy, which cost Waterstone 3.5% of its assets, indirectly created an opportunity for Waterstone to make that money back—and then some. Before Lehman’s demise, the bank had rehypothecated its proprietary position in the preferred convertibles of Reinsurance Group of America as a way to finance the trade. When Lehman went bankrupt, the lender seized the preferreds as collateral.
Unable to short the stock because of the Securities and Exchange Commission’s temporary ban on shorting financial shares, the lender sold off the position at a distressed level. Waterstone, one of the few convertible shops with dry powder, snapped up the 700,000-share position for $28 million, or $40 per share. Today, the preferreds are trading at $60.62—and have become one of Bergerson’s favorite positions.
Says Bergerson: “Generating alpha is our major theme.”
Photographs by Darin Back
