Scott Johnston, managing partner, and Simina Farcasiu, partner at Belstar Group answer SCI's questions

Scott Johnston

Q: How and when did Belstar Group become involved in the structured credit market?
SJ: Belstar was founded in 2005 with a unique perspective: we believe that diversification is paramount in risk management and so we didn't want to offer cookie-cutter products. Our business has evolved into four different product lines: TALF credit funds; a fund that invests in hard assets, such as timberland; a fund of funds (FoF) on Société Générale's Lyxor platform, around which principal protected notes are structured; and a fund of hedge funds.

The fund of funds was developed specifically to correct what we saw as major inefficiencies in the fund of fund industry. It employs a reduced fee structure, it focuses on smaller hedge funds - which tend to have a statistical advantage worth around 300bp-400bp over larger hedge funds - and captures alternative sources of beta, such as insurance exposure in property/casualty and diversified life, special purpose acquisition companies and short-term asset-based lending. We take a sceptical view of pure arbitrage strategies.

The idea is to identify 'frontier beta', which relies less on manager expertise than on the structure of the investment idea itself. We prefer to have alpha as a bonus on top of a unique beta source.

Many tail risks have become aligned over the last few years, but we're still looking for tail risks that aren't. If you don't do that, we think it's impossible to identify where the correlation risks come from.

The Lyxor platform enables a near-infinite variety of note structures around a fund of funds serving as the engine; for example, a five- or seven-year double-A rated note where the coupon is driven by the return of the underlying FoF portfolio. It's been shown to be a good way for investors to access decent returns - the portfolio lost only 3% last year and, as of this interview, we're up 1.5%.

The platform also offers investors weekly liquidity and the risk control/capital preservation aspects are transparent. We've seen an up-tick in calls coming in about it recently.

Simina Farcasiu

Q: What, in your opinion, has been the most significant development in the fund of funds area in recent years?
SJ: The larger fund of funds typically buy big-name hedge funds, but the liquidity crisis demonstrated that 'size equals safety' isn't always true. In addition, large size acts as a constraint because it means that potentially interesting exposures, ones that are often the province of smaller funds, are often missed. These exposures are often hard to characterise as well, which confounds box-checking consultants.

Q: How has this affected your business?
SJ: The last six to eight months have validated what we've been a proponent of all along. The market has been presented with a unique opportunity to strip everything down and re-evaluate the lazy assumptions of the last cycle.

Q: What are your key areas of focus today?
SF: We launched two new funds in April - the Belstar Credit Fund and the Belstar Altair Credit Fund - with the aim of participating in the ongoing TALF funding rounds [see SCI issue 133]. There are significantly positive policy aspects associated with the TALF programme.

TALF recognises the importance of securitisation technology. The essence of the capital markets is to aggregate and redistribute risk and reduce the costs of intermediation.

The beauty of securitisation is that it enables different risks to be distributed across different appetites through the use of senior and subordinated tranches. In a well-structured securitisation, senior tranches get paid for providing liquidity and subordinated tranches get paid for taking credit risk. But to work properly there has to be a diverse and understandable set of risks backing the bonds, as well as a way for investors and their agents to understand the correlation of the underlying portfolios.

To take a negative example, securitisation technology became perverted by applying it to non-diversifiable asset classes (namely, subordinated tranches of subprime mortgage pools) and the misperception of risk ended up damaging an entire class of investors. Investors did not understand that those particular pools were essentially 100% correlated, and hence that those senior tranches were not protected by risk diversification.

The TALF programme targets traditional ABS structures, which are based on diversifiable risk. These ABS classes offer liquidity alpha to capital providers.

The current TALF opportunities derive from policymakers' attempts to attract capital to senior tranches of diversifiable asset pools. Providers of senior capital are supposed to get paid primarily for taking liquidity risk rather than credit risks. This class of investors is essential to the operation of modern capital markets.

The programme does seem to be working and is helping to unfreeze credit markets. In this respect, we're seeing the beginning of a virtuous cycle.

Attractive returns for providing liquidity will continue for a while, but opportunities will shift as spreads begin tightening and the market's attention will move from one asset class to another as the TALF dollars are redeployed to other liquidity bottlenecks. Consequently, it is necessary to have an approach that is broadly flexible from a top-down perspective, yet specifically analytical from a bottom-up perspective.

Our new TALF-enabled funds are traditional hedge fund structures but corrected to have longer lock-ups and lower fees. Both funds have broadly similar objectives: the critical factor is to be flexible and responsive to the sources of capital that fit the character of the alpha opportunity.

One such important source of capital is investors with high savings rates and comparatively high risk aversion, and whose profile suits them to acting as short-term liquidity providers. Such investors were spooked by the events of the last two years, but are now being gradually attracted back into certain asset classes.

Q: What is your strategy going forward?
SJ: As a boutique, we can come to market with flexibility and speed. When we began, credit didn't hold much interest for us - there was too much complexity risk relative to the available returns. This changed quite rapidly and we have been able to respond.

Transparency is vital and ultimately helps us to be nimble. But generally we'll always be adaptive to what's going on in the market - we've created a platform that can bring new and creative products online swiftly.

SF: We have expanded our core team of experienced individuals, as we identify partners with a common vision and complementary skill-sets to address a broader set of opportunities.

Q: What major developments do you need/expect from the market in the future?
SJ: The next few years will be a great time to be in the alternatives area. Volatility is high, which is highly advantageous.

In volatile environments people inevitably make sub-optimal decisions driven by emotion rather than objectivity. This is a gift to the hedge fund industry.

Borrowing costs are low, which helps, even though leverage levels will be far lower. But, most importantly, much of the competition has been vaporised, particularly if you take into account bank prop desks.

As a result, I expect certain hedge funds to enjoy at least two or three years where they make returns of around 20%, while stocks - for example - continue to go sideways.

SF: However, the market eventually needs to see a reduction in uncertainty if it is to get back on track. Hedge fund alpha is coming at the cost of market beta in a high-uncertainty environment.

About Belstar Group
Belstar Group is a private investment firm providing alternative and real asset investment vehicles to financial institutions and high net-worth individuals globally. The firm's investment strategies seek to maximise returns by leveraging its seasoned management team's knowledge, experience and industry relationships. Founded in 2005 by ceo Daniel Yun, Belstar Group has offices in New York, Dallas, Thailand and South Korea.

CS