Marathon: expand hedge fund role in Europe's capital markets

Meet Marathon, the hedge fund that bought up toxic debts at the request of the US Treasury, and is now increasingly taking care of the distressed assets of European Union banks. Asset managers such as Marathon, which have acted as the sweepers and moppers of the financial system over the past few years, are likely to grow in size and sway if present trends continue.

As European banks are asked to lift their capital levels, non-banks will step in where traditional banks will not and cannot. The scope of the changes is as yet incalculable. The European Central Bank (ECB) does not know if the risks of financial crisis will go up or down as a result: it collects little data on alternative investments. In the long run, regulators may push for more oversight and transparency, long anathema to the taciturn hedge fund industry. The publicity-shy Marathon is only at the start of the race.

The New York-based company was founded in January 1998 by Bruce Richards and Louis Hanover, both previously managing directors at broker Smith Barney. Known as MCAP Global Finance in Europe, Marathon now has about $12 billion of assets under management as of April this year. It invests in distressed high-yielding debt and securitised products. The company is increasingly interested in mortgage-backed securities (MBS), non-performing loans (NPL) and distressed corporate bonds being sold by European banks.

In January, Marathon launched its second such fund investing in these products. Marathon Europe Credit Opportunities Fund II started with $530 million in assets under management and comprises approximately $1 billion at the time of writing. The first fund also manages about $1 billion. The difference between the funds is that the second has no limitations on the proportion of assets bought from European banks.

“We see a ton of opportunities in Europe,” says chief operating officer Andrew Rabinowitz, a former lawyer and auditor who joined Marathon in 2001. As EU banks deleverage under rising pressure from regulators, Marathon will be there to take on their non-core assets. The fund buys these high-yielding assets if it reckons the risk of non-payment is less than the perceived risk and the assets are being auctioned off more cheaply than the fundamentals suggest.

The supply of distressed debt is certainly huge. EU banks hold €2.4 trillion ($3.25 trillion) of non-core assets, of which half are NPLs, according to PwC, which estimates that €500 billion will be sold overall and the remaining debts wound down. But this is not just a story of ailing southern banks jettisoning their bad debts. Far from it. About two-fifths of the debt is on the balance sheets of UK and German institutions.

Moreover, EU banks are disposing of their distressed debt at ever-increasing rates. PwC expects sales of non-core assets to rise from €64 billion last year to about €80 billion this year. The pace has accelerated since mid-2013, according to Marathon, with its pipeline of visible deals coming out of the banks getting larger and larger. The UK was the most active market for deals last year, followed by Germany.

Rabinowitz points to three factors driving the rise in such debt auctions. Banks want to improve their leverage ratios as a result of Basel III regulations and disposing of non-core debt may prove preferable – and less difficult – to raising capital. “Much more deleveraging has to happen in the eurozone because banking assets as a proportion of GDP are 3.5 times that in the US,” he says.

Second, eurozone banks want to improve their liquidity ratios because of an upcoming asset-quality review that the ECB will publish in the summer. The results may well affect a bank’s stock price, debt rating and customer faith in the bank: hence the push to clean up balance sheets. Third, banks may simply want to reduce their exposure to corporate debts in the eurozone periphery, for instance, if they have exposure limits.

Where are the opportunities to buy bank assets? The picture becomes clearer looking at NPLs. Banking sectors in six countries reported NPLs in excess of €100 billion in 2012: the UK, Germany, Spain, Ireland, Italy and France. Greek banks had only €56 billion in NPLs, although this figure is rising year-on-year. Indeed, PwC thinks much of the increase can be attributed to continued debt problems in the eurozone periphery.

Spanish banks, which made up just under a fifth of Europe-wide loan sales in recent years, had about €170 billion of NPLs on their balance sheets in 2012. But competition is intense on the buy side, especially for structured credit and commercial mortgage-backed securities (CMBS), says Kateryna Taousse, a distressed debt portfolio manager at Pacific Alternative Asset Management Company. A reviving Spanish economy and relatively liquid financial markets have attracted investors back to Iberian shores.

Solid demand for EU bank assets may prove a challenge for Marathon’s Europe funds. “Fierce competition [for these assets] comes primarily from a small number of US funds,” says Richard Thompson, chairman of PwC’s European portfolio advisory group. Debt market participants are starting to complain of too many auction bidders. “We have seen price hardening in the past year,” says Thompson.

Competition for such assets is indicative of a number of trends. Bullish investors are shifting their money back into European assets. High-yield debt markets have seen a separate reversal of trend. “Sovereign debts have provided excellent opportunities [for distressed debt investors] in the past,” says Taousse, “but corporate [bonds] have had more interest from investors over the past year.” With more asset managers willing to take a risk on EU distressed debt, the risk premium is reduced, leaving Marathon with fewer rewards for its buys.

A second challenge for Marathon’s Europe funds is lower-than-expected EU inflation. Debtors are more likely to default if inflation is lower than they expected when they issued the debt; deflation – which is present in Greece – increases any debt burden in real terms. A shift in inflation may be problematic for Marathon, whose debt analysis was based on past inflation expectations, rather than current trends. However, alternatively, higher default rates may drive away the fund’s competitors for distressed debt.

It is too early to judge the performance of Marathon’s second Europe fund, launched in January, but the original European credit fund has performed relatively well. It returned 11% last year and 22% in 2012, according to reports. Rival hedge funds in the strategy space returned 14% last year and 10% in 2012, according to the distressed/restructuring index compiled by Hedge Fund Research, a data company.

Following the US model
Rabinowitz has reason to believe that funds such as Marathon will play a bigger role in European capital markets in the future. He cites ECB president Mario Draghi’s remarks that, while about 80% of the EU’s financing needs come from bank loans, about 80% of US financing needs come from capital markets. Rabinowitz says: “Whether it’s implied or expressed, it’s clear in our opinion that [the ECB] wants to move to a more US-like model, where they use capital markets like bond issuance to help with the risks.”

There is clearly room for asset managers to play a bigger role in the EU’s financial markets. But are there risks attached to such a shift? PwC’s Thompson says it’s a difficult question but posits it may be a positive move: “We need more financial institutions to be lending money. Some funds may [be tougher on debtors] but they may be willing to invest more and for longer.” While banks may allow debtors to restructure, asset managers may be less forgiving, he suggests. “This may be more sustainable. It may reduce personal debt.” 

Rabinowitz agrees it could be a positive shift. “By keeping a lot of the financing on [bank] balance sheets, it creates higher risk and higher leverage.” But are there added risks to the financial system if a large cache of distressed debt is passed from a heavily regulated banking industry to a set of so-called ‘shadow’ banks? The consequences of mispriced securitised assets have been seen before. 

Thompson sees no suggestion to doubt the competences of a competitive industry. “These are reputable, well-recognised institutions that are in some way regulated already. There is no suggestion that they do not have capabilities [to price distressed debt].” The current transfer of bad debt from banks to hedge funds and the like is purgative to some extent. As prices come down in debt auctions, they may become more sensibly valued, he says.

In any case, Thompson says it is likely that the European financial system will begin to look more like that of the US in future. This will cause challenges for the ECB, which admits it collects little data on hedge funds, but ironically is pushing for the shift. Alternative investment companies were mentioned in only half a dozen pages of the ECB’s 150-page Financial Stability Report, released in May. 

A spokesman for the ECB says that the regulator plans to intensify its monitoring of the risk transfers involved in NPL disposals but that current sales are “not a concern”. 

“Banks have been deleveraging for some years,” he says. “Asset sales are market prices and are not occurring in a disorderly way, like a fire sale. It is not a forced sale.”

Rabinowitz says that Marathon still sees opportunities in the US, but admits that they are scarcer than they were in 2008 and 2009. Default rates are lower, but private restructurings still abound. Marathon does not “manage to a number” and is not committed to retaining a specific exposure to the US.

Marathon is still proud of its securitised credit fund, which invests mostly in “mispriced” mortgage-backed securities. Half the fund’s invested exposure is to residential mortgage-backed securities (RMBS) and about a third is exposure to CMBS. The fund also has a 9% exposure to collateralised debt obligations and a 6% exposure to whole loans.

After a bad 2011 where the fund returned -4.2%, the fund has been relatively successful over the past two years or so. It returned 30% in 2012, 13% in 2013 and 5.5% for the first four months of this year. Rival hedge funds in the strategy space returned on average 6%, 17%, 10% and 4.4% over the same periods, according to the fixed income asset-backed index compiled by Hedge Fund Research. Investors will have almost doubled their money since April 2010.

Marathon reckons that the US housing market bodes well for holders of distressed mortgage-backed assets. The distressed housing inventory has halved since its peak of 4.3 million in 2009, and is projected to come down to pre-crisis levels. Mortgage delinquencies are at their lowest levels since the crisis, and a spate of house-building and looser credit could be positive, Marathon believes.

How does the fund decide if a home loan security has been mispriced by the market? What data does it tap into at a granular level? “For whole loan portfolios, you can get individual borrower data,” says Rabinowitz. “You can look at how often [homeowners] have managed their monthly payments over the life of the mortgage. So someone may have a Fico credit score which would be considered below prime, but that may be only because they missed three payments by a month or two over the course of nine years.

“We also look at trend lines. What’s happening in that individual zip code? For RMBS you don’t get payment histories for specific houses because of privacy rules, so there we look at zip code-level data. How are these assets performing? How is the economy performing? What are the inventory levels, what’s available for sales, how much has come off the market in terms of rentals and buys? What’s employment, what do wages look like?” 

The analysts will then use this information to get a better idea of the risks attached to the RMBS: how likely homeowner non-payment is and so forth. The fund takes into account the dominance of certain industries in the zip code: for example, whether finance or the automobile industry predominates. Analysts can project, say, industry wage rises or job losses, and use this to project the risk of lending to residents in the area.

Controlling interests
Rabinowitz is most keen to talk about Marathon’s risk controls. “We’re quite proud of our risk systems,” he says. “Risk systems are one of the critical things we have.” Senior executives – including himself and co-founders Richards and Hanover – sit on the firm’s risk management committees.

In 2009, as part of a scheme to clean up the balance sheets of decrepit US banks, the US government launched a public-private investment program (PPIP) for legacy assets. The Treasury ultimately asked nine financial institutions to buy up seemingly toxic assets from US banks at cut-rate prices. In the first round of the selection process, 104 applicants had to be cut down to about 40. “The first thing they looked at was risk systems,” says Rabinowitz, and on these criteria, Marathon went through to the second round, before being selected to be one of the nine.

The message: if the US government can trust Marathon in a crisis, so can investors. Rabinowitz led Marathon through a process where he brought administrative and IT systems in-house. “As we were growing, as the product mix started to diversify, we got into CMBS third-party vendor systems that couldn’t meet all of our needs so we started to do it in-house.”

To mitigate any risks a high-risk asset investor might take, Rabinowitz pushed for triangular reconciliation. “What was key to us was integration with our prime brokers and our administrators.” When most funds reconcile their accounts, they check their books with the prime broker, who checks the books with the administrator – a linear process. As a safeguard, the fund now also checks books with the administrator  – triangular.

“There’s really no room for error,” Rabinowitz stresses. “You want your risk-takers to know the same things as the books, and records to be the same thing as you’re reporting to your clients. You all want to be on the same page. If there’s any [mistakes] there, you’re either misrepresenting things to your clients, you’re not trading the right amount of risk or you have a trade break that you don’t know about.”

Rabinowitz speaks less exuberantly about regulation. The alternative investment fund managers directive (AIFMD) makes fundraising harder, he concedes. “But we continue to see demand in the US and Europe, as well as in the Middle East.” 

The chief operating officer frets most about more transparency, particularly into fund managers’ pay, which AIFMD mandates. “If regulators have more information, that’s good,” he says, but he dislikes multiple disclosure rules in different jurisdictions. “I would prefer not to give information on remuneration,” he says, as there are risks of identity theft, a crime targeted primarily at the wealthy. “I’ve tried to live my life in a discreet manner and so would I prefer the market know what we make as a group? I would prefer that be private confidential information, because of the way we live our lives.”

The hedge fund, on the other hand, is actually less than discreet. It now owns a small town in California – including a hotel, two churches and almost 300 homes. Scotia, which has a population of about 1,000, was originally built in the 1880s by timber producer Pacific Lumber Company (Palco) to house its workers. Marathon lent to Palco at distressed levels, starting in 2006. When it filed for bankruptcy in the summer of 2008, Marathon took possession of the town.

“Our plans are to exit the investment and earn an attractive return for our clients,” says Rabinowitz. “Timber wasn’t in much demand because of the housing crisis in the US, but now timber has picked up as housing has improved.” The town is, in the end, just another asset in Marathon’s portfolio.

It is illustrative that Marathon didn’t simply junk its small-town investment as soon as it could. The origin of the hedge fund’s name tells the investor a little about its philosophy. Co-founders Richards and Hanover came up with the name Marathon when founding the company in 1998, but it’s no classical allusion. “When they were founding the company, their vision was managing risk and managing clients’ money over the long term,” says Rabinowitz, summing up the values of the company. 

“Having a long-term horizon, Marathon is not just sprinting or running a 40-yard dash but has a long-term view,” he says. The firm may do well in European distressed debt markets, if it stays the distance.