Q&A: STS Partners Aims To Build On Recent Success

Feb 9 2015 | 2:04pm ET

STS Partners was one of those rare things in 2014: a hedge fund that produced double-digit returns. The Steamboat Springs, Colorado-based firm, which specializes in distressed asset-backed securities, saw its $1.3 billion STS Partners Fund return over 25% last year, ranking third in Bloomberg's Top 100 hedge funds with over $1 billion. Its second fund, the $270 million Burgess Creek, also generated double-digit returns last year, so it will come as no surprise that the firm is preparing to launch new products in 2015.

To find out more about STS Partners' winning year—and its future plans—FINalternatives recently spoke with Managing Director Will Bashan and Portfolio Manager and CIO Scott Burg.

What is the difference between the Burgess Creek fund and the STS Partners fund (which did very well last year but is closed to new investors)?

Scott BurgScott BurgBurg: Basically, the difference between the two funds is STS is a much more binary, high-yield, higher risk reward type of scenario...When we were looking at the bonds, you'd have to run the bonds to really see what fit where, and we started to see we were passing up all these bonds that have a little bit more credit enhancement; can actually allow more of a fundamental story to take place; have a longer average life, so they'll be outstanding longer; and we're passing these bonds all up. And we finally said, 'This doesn't make any sense,' because while the current yield on these bonds is lower, the total return component is very attractive. These types of bonds within both residential and commercial mortgages are going to be higher up in the capital structure, they're going to be more liquid, have a little bit more transparency, but what we like about them is they allow the fundamentals to play out over a longer period of time.

And one of the things that we're really seeing in terms of the fundamentals is we don't necessarily need housing to be increasing at 4%, 6%, 8% a year. Even in a flat housing environment, these bonds are becoming more and more seasoned—the youngest bonds now are 2007, you're going on eight years of seasoning. So what you're left with is a lot of the bad stuff is being flushed through and a lot of the good stuff is left. That's the thesis or the investment premise behind Burgess.

When last we spoke, in 2013, you used the word "phenomenal" to describe the potential of the asset-backed securities market. Would you still describe it that way?

Burg: I would not repeat the word 'phenomenal.' I think in 2013 I was correct: If you would have put $1 billion in the securities we were talking about in 2013, you would be a happy camper. But what I will say about the opportunities is...we have to be more opportunistic in the areas where we're going. So, over the last18 months, we're finding what we see as gems in a lot of different areas. It's not just mortgage-backed, it also could be commercial real estate, one of the things we've been adding is new-issue structured aircraft, backed by aircraft or even aircraft parts; it could be manufacture housing, could be a franchise deal, it could be a CDO, it could be a derivative...We still see very strong opportunities within structured products, but I think now, not only are you betting on the strong horse but...it's very important what jockey you're picking because we've seen a significant run-up in many of these assets and some of them, we see prices that we just don't think are going to be justified by the cashflow. So while there's areas where we're seeing incredible opportunities, at the same time, you're seeing trades that are making you scratch your head.

What is an example of a 'gem' you discovered in 2014?

Burg: One of the things going into 2014, in our macro view, that was definitely against the herd was our view on interest rates throughout 2014. I don't know if that's just being out in Steamboat [laughs] but our view was that interest rates would not only stay low but the whole curve would compress and flatten....So with that macro view about what was going to happen with interest rates, one of the areas that we found that was very undervalued to that expected scenario was the non-agency, interest-only securities. And so that was our major theme throughout 2014. It was wildly successful: Basically, in these securities in the subprime arena, as interest rates come down or flatten out there's more money that goes in to pay these securities; as interest rates go up, there's less money and they perform more poorly. So this was definitely a trade that we put on through 2014 and continue to put on selectively in 2015, that...has had a lot of value.

Can you see Burgess eventually closing to new investors?

Will BashanWill BashanBashan: Given the strategy and where it is in the capital structure, we could see it closing at some point, but right now that's very far off—it may be $1.5 or $2 billion. But at the end of the day, we approach all our investments and everything we do by letting the market tell us what to do. And so, we don't like to draw a hard line in the sand one way or another, but right now, we're still really excited about the opportunities within Burgess and want to continue to grow the assets.

Do you have any new products planned?

Burg: Yes, there's actually two things that we have on our plate going into 2015. One isn't necessarily different from Burgess, it's going to be a Burgess Creek Irish fund, to allow us to raise money out of Europe and pretty much that whole section of the world. It's going to have a similar strategy to Burgess Creek. The way we're looking at it is that it's a sister fund that allows us access to capital that we otherwise would not be able to get.

The other opportunity that we're becoming more and more excited about is a single-manager (meaning us) mutual fund...How Burgess Creek came into development, it's kind of the same way with the mutual fund, as we are continuously looking at these bonds and we're saying, 'Wow, this is actually really interesting yield, especially given the world and the world's rate of returns right now,' and you go, 'This doesn't necessarily fit Burgess, but jeez, the right investor would absolutely like this type of return.' And at the same time, we're running these bonds anyway, so we're excited to hopefully be launching that in the summer of 2015.

Bashan: We've been a sub-advisor for a '40 Act fund for about two years...and the strategy has performed very, very well. So what we want to do is roll that out—again, we would just be the sub-advisor, we'd partner with a distribution entity—but we would roll out that strategy that we've had going for now two years so there's already a pretty impressive track record.

Is the Irish fund a way of dealing with Europe's Alternative Investment Fund Manager's Directive?

Bashan: We chose as a firm not to be AIFMD compliant, so that effectively shuts us out of the European market. We actually are going to partner with one of our larger investors that's based in New York and London. They will be AIFMD compliant, they're the ones that will be getting the fund up and running, and we'll be a sub-advisor. So it allows us to do what we do, which is manage the money, and not have the burden of AIFMD to deal with.

Did you consider becoming AIFMD compliant?

Bashan: It's certainly a burden, and it's not something we couldn't handle, but we chose not to because, quite honestly, we see so much opportunity in the U.S. market and other markets that it was just hard to justify the resources for that when we still haven't really tapped into a large part of the U.S. market.

Is the mutual fund an attempt to tap into the growing appetite for liquid alternative products?

Bashan: When you look at today's market environment and yields being so low, we think there's a very high demand for this product—which is basically decent yield, protection against rates rising...Plus, we have a pretty good-sized investor base currently, it's not a '40 Act investor base, naturally, but a lot of our investors would love to have us run a more liquid product, so there's a built-in client base or demand that we can satisfy currently if we have a single-manager type product.

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