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| Brendan Rogers (left) and Scott Roth. (Photographs by Wesley Mann) |
By Neil O’Hara The last time most people heard about Severn River Capital Management, a hedge fund founded by two Navy veterans and named after a river that flows into the Chesapeake Bay, it had just about dried up. In late 2005 the Greenwich, Conn., firm notified investors that it planned to abandon its original multistrategy arbitrage focus-an approach that lost 7.68% from July 2004 through March 2006-and instead refocus on long/short equity and debt opportunities in a more concentrated portfolio. Investors, spooked by the thought of style drift and worried the firm wouldn’t be able to shift gears successfully, yanked out their money in droves.
The investor exodus led Scott Roth, Severn River’s founder and managing partner, to return everyone’s money and start over, running the principals’ money alone. It was a brutal comedown for a fund that raised $750 million in just three months before its first closing, at the end of June 2004. The move was hard for Roth on a personal level too: He had to cut back a 35-person team to just four people, letting go of talented staff whose skills were no longer needed.
But Roth had seen the writing on the wall. The margins in convertible arbitrage and merger arbitrage had evaporated, the great rally in distressed from its 2002 lows had played out, and even the trades in the equity of reorganized companies weren’t as profitable as they had been. “The strategies made no sense anymore,” says Roth. “You had to put a ton of leverage on.”
Roth and co-portfolio manager Brendan Rogers figured they could apply their complementary analytical skills-Roth’s honed on Wall Street, Rogers’ in management consulting-to make money placing straightforward bets in equities and credit instead. “There is always something going on,” Roth says. “You don’t have to depend on the broker/dealer for financing, and you are not worried about spread trades that you have to leverage multiple times.”
Since the switch in April 2006, the firm has kept a low profile while rebuilding its assets and track record. Although Severn River dismantled its original master-feeder structure and liquidated its offshore fund at the time, the onshore fund carried on. The core team-Roth, Rogers and Christine Glick, the firm’s chief financial and chief operating officer-knuckled down and quietly began to develop a track record in the new strategy.
Severn River does not fit the conventional mold, as its Greenwich, Conn., offices attest. Eschewing the glitzy glass-and-steel buildings nearby, where hedge fund bigshots AQR Capital Management and others are located, the firm operates from a converted townhouse that now stands all alone. The street door opens immediately to the trading desk-although Severn River doesn’t have any full-time traders-with offices along one side and a conference room at the back.
Roth caught an early break in rebuilding the asset base when an institutional investor who had known him for years stepped in and wrote a $60 million check. The investor had not ponied up money for Severn River at its inception in 2004 for lack of interest in a multistrategy fund, but did have an appetite for long/short-and faith in Roth’s ability to make money.
That faith has proven well-placed. Severn River delivered a 38.7% gain in 2006 for the nine months through December-putting the few continuing investors well above the old high-water mark-and followed up with a 38.3% gain in 2007. The performance was all the more impressive because Severn River was fighting a rising market: It maintained net short exposure during periods when the Standard & Poor’s 500 index rose by 9.5% and 3.5%, respectively. Severn River bucked the trend again in 2008, delivering a positive return of 2.79%, while the benchmark index lost 38.5%. An 11.5% return for 2009 lagged the 23.5% gain for the index, but the firm has kept pace with the benchmark during the turbulent market in 2010-both were up 1% through September.
Severn River now has nine employees and manages $384 million; $114 million of that is in onshore and offshore hedge funds, with the rest in six managed accounts. The portfolios all have identical asset allocations. Interest from tax-exempt North American investors last year prompted the firm to create a new offshore fund, which accounts for 55% of its hedge fund assets.
The successful revival of Severn River came as no surprise to Brian Walsh, managing partner at fund-of-funds manager Saguenay Capital, who has known Roth for many years-Roth worked for Walsh trading convertible bonds when they were both at Veritas from 1998 to 1999.
“Scott is methodical,” says Walsh. “He does a lot of deep homework. He can pull apart a balance sheet as well as anyone, but he will also look at the capital structure to find the best way to play the company.”
Such attention to detail may reflect Roth’s background in the Navy. He graduated from Annapolis in 1987, spent two years learning about nuclear reactors and two years on active service managing the twin reactors aboard the nuclear-powered aircraft carrier USS Carl Vinson. Roth left the Navy in May 1992, earned an MBA at Harvard and landed his first job on Wall Street in 1994 at Goldman Sachs, on the convertible bond desk. In 1997 he left for a brief stint at HBK Capital Management before joining Veritas Capital Management in early 1998, where he ran convertible arbitrage, pairs trading and merger arbitrage portfolios. A year later Roth quit and teamed up with Steven Bloom to form Sagamore Hill Capital Management, a multistrategy hedge fund that grew from $55 million to more than $2 billion by the time Roth left in December 2003. Sagamore Hill eventually shut down in 2006.
Roth never forgot his Navy roots. Nor did his partner, Rogers, another Annapolis graduate and Harvard MBA who spent 10 years as a Navy SEAL and two years at management consultants McKinsey & Company before joining Severn River at its inception in 2004. Both men trained as engineers, gaining skills that enable them to delve into technologies beyond the grasp of most portfolio managers.
Severn River adheres to the military KISS principle (“keep it simple, stupid”), particularly in its revamped long/short strategy. The fund typically has just 20 to 30 positions in its portfolio, including both long and short positions. Unlike most long/short managers, who have a significant net long bias-up to 60% in some cases-Roth and Rogers run their portfolio with close to zero net exposure on average, and it is net short at least as often as it is net long.
Since its metamorphosis, Severn River has generated the majority of its returns from its short book. In the four years through June 2010, the firm’s net return stood at 120%, compared with a 20% loss for the Standard & Poor’s 500 over the same period. But cumulative gross returns on the short book amounted to about 130% versus just 10% on long positions. That’s thanks in part to extremely well-timed bets against financial stocks.
Roth makes no claim to have anticipated how bad the financial crisis would be, but he did recognize that the securitization of credit had become a house of cards. Severn River sold short a raft of financial stocks in 2006 and 2007, including Downey Financial, a major player in option ARMs, a type of adjustable rate mortgage that got many borrowers into deep financial trouble when the housing crisis hit. Downey Financial went belly-up in November 2008. Severn River also shorted Doral Financial, a leading mortgage originator in Puerto Rico that escaped bankruptcy in July 2007 only through a massively dilutive recapitalization, and Corus Bankshares, a specialist in large condominium construction and conversion loans brought down by escalating delinquencies. It eventually bit the dust in June 2010, long after Roth had covered his position.
But Severn River’s rise doesn’t come down to just a one-off lucky call on the financial crisis, either, as the firm’s contrarian performance in 2006 and 2007 shows. “We feel we can generate alpha on the short side,” says Roth. “The shorts we like the most are catalyst driven, event specific, or a business model that doesn’t work.”
A recent example was Blockbuster, the video rental store chain, whose securities Severn River described as “richly valued for a business with declining revenues and high fixed costs” in its letter to investors for the second quarter of 2010. Selling short the common stock offered limited upside, with the price already well under $1.00, and would have been prohibitively expensive given a minimum margin requirement of $2.50 per share. Instead, Severn River sold short the junior and senior bonds, based on its assessment that the likely recovery values would be much lower than market prices in light of the dismal expected recovery ($0.10 per $1) for senior secured debt in the liquidation of Movie Gallery, Blockbuster’s largest direct competitor.
But Roth pursued the analysis one step further. He lives in Greenwich, Conn., where Blockbuster never had an outlet because a local independent video rental store owned the market. When that store closed down earlier this year, Roth talked to the owner, who said the store could no longer make ends meet with three employees and 3,000 square feet of space. “I have no idea how Blockbuster can make it work at 6,000 square feet per store,” says Roth. “Wall Street analysts don’t understand that this year’s profitable store is next year’s loser.” The input gave Roth the confidence to stay short until the payoff: Blockbuster filed for bankruptcy in late September.
Detailed analysis has been a trademark throughout Roth’s career. Walsh recalls that when the easy trade went away in convertible arbitrage-buying cheap volatility embedded in convertible bonds and hedging with options or common stock-Roth didn’t rely on trading the hedges to make money the way most of his competitors did. He chose instead to pore over the prospectuses for new types of convertibles, bonds that had price caps and floors intended to force investors to convert them into equity at specific thresholds. “On more than one occasion, he found anomalies where the investment bankers had made a mistake in how the securities would behave when they hit certain trigger prices,” says Walsh. “He made money because he had done more homework than the Street.”
Another investor cites high-quality research as a key factor in his decision to allocate money to Severn River in 2007. But the investor waited for Severn River to demonstrate that the switch to a long/short strategy worked before jumping in. “Anytime anyone shuts down a fund and launches another in short order you are a bit cynical about what is going on,” he says. “We wanted to make sure that Scott and Brendan had the skill sets to be long/short equity managers.”
Severn River searches for investment ideas among North American stocks that have a market capitalization of at least $250 million and trade at least $6 million worth of shares on average every day.
Rogers says the theoretical universe is about 1,300 companies, but in practice certain sectors are more susceptible to change and the associated stock price volatility that creates investment opportunities: technology and telecommunications stocks, for example. In four years Rogers reckons Severn River has looked at about half the companies in its universe in varying depth. When he spots a potential opportunity, he keeps going back to see what has changed. Roth and Rogers also screen companies for attributes such as balance sheet strength or weakness, revenue trends or dependence on commodity prices as a check on the research they are already doing. “It always generates a name that we have not thought of, a name that is not in the press and well-known to the market,” says Rogers.
Severn River isn’t above being opportunistic, though. A tip from a buy-side analyst who thought the banks in Puerto Rico were attractive prompted Roth to rummage through their financial statements. By the time he finished, he reached the opposite conclusion: Most of the Puerto Rican banks were in deep trouble and overvalued in the market. Severn River sold short several names, including First Bancorp, a bank overly dependent on wholesale funding, which had set aside inadequate reserves against potential losses on its construction and commercial loan book. In the past two years, the FBP share price has slipped from $11 to $0.30; Severn River has remained short all the way down.
It hasn’t been a smooth ride, however. FBP’s share price rallied more than 50% on four separate occasions during the slide to oblivion, and in early 2009 the annual cost of borrowing FBP stock exceeded 100%. Fortunately, the extreme cost lasted less than one month, during which the stock price tumbled more than 40%. “Sometimes a high borrowing cost is an indication that the price is about to break,” says Roth. “You have to be firm in your conviction. It is hard to hold on through a squeeze or rally if you are not very sure.”
The willingness to stick with short positions when the markets are working against them sets Roth and Rogers apart in a long/short equity crowd dominated by managers who look for alpha on the long side and use shorts mostly to hedge. Roth and Rogers treat longs and shorts as independent sources of alpha, while many competitors generate excess returns primarily from long positions and sell short passive vehicles like ETFs and index futures to hedge market risk rather than making directional bets on single stocks to create more alpha. “We don’t run intrasector pairs like Merck versus Pfizer,” says Roth. “We look for individual ideas on both sides of the portfolio.”
The principals clearly enjoy having fewer positions to worry about in the long/short portfolio, a big change from their long/short days. With no more than 30 names, they have the details of every position at their fingertips, something they could never do in a multistrategy book that had at least 500 different positions.
Knowing the story doesn’t mean Severn River is infallible, however. Valuation plays can be particularly frustrating because the absence of a catalyst means a stock can lose money to the point of pain before the manager’s thesis is proven. In early 2010 Severn River shorted Netflix, the video rental company, in the belief that the share price had run far ahead of its intrinsic value. A few weeks later, in the face of relentless share price gains, the fund covered its short at a loss. It was a wise decision; by late September the price had risen more than $100 since the fund closed out at $62.
Severn River also took a hit in 2009 on Palm, the handheld electronics manufacturer. Like many other hedge fund managers, Roth did not believe that the much-heralded Palm Pre smart phone launch in May 2009 would turn the company’s fortunes around, so he bought put options to go short. Just before their expiration, the share price popped up above the strike price, and the puts expired worthless. Unable to borrow stock to maintain its short exposure, Severn River could only watch from the sidelines as the price fell 50% in the ensuing month. “The problem with puts is that if you get the timing wrong, you are out of luck,” says Roth. In the end, Palm did not go bust, but only because Hewlett-Packard stepped in with a rescue bid in April 2010-at a price far below Severn River’s put option strike price.
The government rescue of General Motors dealt another blow to Severn River last year. By contract, the senior debt should have ranked pari passu with pension liabilities in a bankruptcy reorganization-but the government elected to give union pensioners priority at the expense of bondholders. “There are times when you are just wrong,” says Roth. “The White House rewrote bankruptcy law.”
Roth does not dwell on the inevitable setbacks, however. He knows he’s taking calculated risks, and Severn River’s track record demonstrates that he’s right far more often than he’s wrong. “Scott doesn’t fall in love with stocks,” says Walsh. “He doesn’t have an ego that has to be stroked. You can tell him he’s wrong, and if you show him why, he’ll change his mind.”
Risk management is a critical discipline in a portfolio as concentrated as Severn River’s can be. In the early years of its long/ short incarnation, the biggest position could reach 15% of assets, although 5% to 6% is more typical today. The firm doesn’t have sector concentration limits, either, which facilitated its substantial-and successful-bet against financial stocks before the financial crisis hit.
Roth tries to keep the maximum loss on a single position to 5% of capital, however, and he’s obsessed with liquidity as the first line of defense. “Cash and liquidity are underrated in this business,” he says. “Investors say illiquid positions earn an extra 3% return, but then you get November 2008 and they can’t get out to take advantage of the opportunities. We will sit in cash until the opportunities come. They always do.” Roth says Severn River could liquidate 90% of its portfolio in a week and the rest within a month, one reason why its hedge funds have no gates. Severn River keeps a close eye on its gross market exposure too. Although the firm has leeway to invest up to 225% of capital, gross exposure has seldom exceeded 150% and is typically close to or less than 100%. The firm uses Morgan Stanley and Goldman Sachs as prime brokers, but leverage is not crucial to the strategy, and its lines of credit were never cut during the financial crisis.
Severn River charges a 1.5% annual management fee, but its 20% incentive fee vests over two years, which gives investors a chance to claw back half the fee if the firm loses money in year two. The firm made the change in 2009 on its own initiative, not under pressure from investors. And unlike other hedge funds, the clawback isn’t tied to a longer lockup. “We put that in because we think it’s the fair thing to do,” says Roth.
Like any successful small hedge fund, Severn River wants to boost its assets under management-but it is particular about the kind of investors it will take. Roth does not want fast money that will pull out in a heartbeat if Severn River hits a rough patch. “We want people we can develop a relationship with and who really understand us.”
His caution may be a legacy from the multistrategy launch, when he explained to potential investors that it would be harder to make money in arbitrage strategies for the next year or two. Nobody listened-and then they were upset that Severn River lost money. “One investor told us we had to take more risk or he would pull his money and give it to another big multistrategy fund,” Roth recalls. The money did leave-and the other fund suffered a spectacular meltdown not long afterward.
Four years after Severn River transformed itself, Roth and Rogers have shown they know how to make money in good times and bad while keeping net exposure close to zero. That record has proven to Severn River’s investors that the decision Roth and Rogers made years ago to shift the firm’s strategy was the right one and plays to their strengths. “If they think market conditions are stupid they won’t invest,” says Walsh. “They want to do things when they feel there is a real opportunity.”
