Some asset backed loans are better than others

Despite Credit Woes, Asset-backed Loan Funds Enjoy Steady Returns

By David Price
November 21, 2007

With Wall Street’s giants taking billion-dollar write-downs from subprime-linked losses following this summer’s spate of hedge fund closures, mortgage lending has become the black sheep of the investment family. But a small number of hedge funds have carved out a niche for themselves in this market, and the results are eye-opening.

Even at the height of the credit meltdown this summer, the Ambit Bridge Loan Fund was clicking along, turning out roughly the same 1% return it has produced each month since its March 2005 launch. Contrast that with the shellacking many other funds took at the same time and Ambit's strategy of asset-backed lending looks positively stellar.

Ambit originates and services short-term real-estate loans, writing checks for up to $25 million to developers seeking to get commercial projects off the ground. The loans are secured at a maximum of 70% of the property's value. Interest, which is typically 12% to 15% per year, is pre-paid and held in escrow, creating a sure-fire revenue stream to support fund returns. Through the end of October, the domestic Ambit fund and an affiliated offshore fund, Ambit Bridge Loan International, are up 9.84% net this year. Over the past 12 months, both funds were ahead 12.72%.

"During the past few months, our strategies have held up very well," Ambit Managing Director Ben Shoval says, adding that the recent upheaval in the credit markets may actually be working to Ambit's advantage by expanding the pool of potential borrowers.

Meanwhile, Jonathan Kanterman, managing director at hedge fund firm Stillwater Capital Partners, estimates that dealflow for his New York-based firm has tripled in recent months, with traditional bank lenders pulling back as the sub-prime credit crisis spreads. Like Ambit, Stillwater is enjoying significant improvement in the collateral offered by would-be borrowers as well as a favorable swing in the loan terms it can command.

But perhaps most noticeably, Kanterman says, there has been a big jump in investor interest. He explains that in the past, the lack of volatility in ABL fund returns was often a fund’s own worst enemy, because many institutional investors were willing to take on more risk in return for the potential for much bigger returns. Then, the credit and equity markets began to sink, "and all of a sudden, the steady-eddy hedges like us were getting a lot more attention," he says.

Both Ambit and Stillwater are currently open to new investors, and Stillwater also recently partnered with U.K.-based Matrix Group to market a new fund of ABL funds. The firms have weathered the recent financial turmoil relatively unscathed, although Ambit did have a $5 million redemption earlier this year when a pair of limited partners with their own cash needs¬ pulled out of its fund.

Shoval, who managed three funds of hedge funds for several years before locking in on an ABL strategy in 2005, says his investors now include at least one "major" investment bank, a few insurance companies and a family office. Assets under management across both the domestic and offshore funds by the Wilkes-Barre, Pa.-based firm total about $210 million.

According to Gregg Winter, president and founder of Winter & Co. Commercial Real Estate Finance, a commercial mortgage brokerage and advisory firm in New York, hedge funds are a more efficient vehicle to source, originate and service short-term loans, compared with pulling together investors for each deal. He launched the W Financial Mortgage Fund in June 2003 and now manages nearly $30 million, all from accredited individuals. The fund makes close to $80 million in loans, and net returns for investors have been just under 11% per year since inception.

"This is a progression of hard-money lending," Winter says, adding that investors benefit by gaining greater diversification and a more reliable income stream under the hedge fund model. "It's the same philosophy behind investing in a mutual fund—there's a lot less risk in spreading out investments across a portfolio of stocks rather in than a single company." Looking to capitalize on the booming interest in asset-based lending, Winter plans to open up the fund to institutional investors in early 2008.

As with any asset-backed vehicle, the biggest downside risk for ABL funds would be a precipitous decline in the value of the underlying asset. But while residential property values have fallen in many parts of the country, commercial real estate prices have so far held strong. The short time frame, along with the low loan-to-value ratio typical for bridge loans, also provides a substantial financial cushion for fund managers if a borrower falls behind or defaults on a loan. A sudden glut of similar properties on the market could whittle away some of those gains, Kanterman says, although "it's pretty unlikely that the commercial real estate market is going to drop 25% or 30% in only a year or two.”

Because of their stringent due diligence, however, most ABL fund managers say that foreclosures are extremely rare in their business. At Ambit, Shoval said he has only had one loan get into trouble, while Winter says W Financial has yet to experience a single default or foreclosure.

As a rule, ABL funds are also relatively conservative in their own use of leverage. Many, like Ambit, don't borrow at all, although some of its limited partners have levered positions to boost their earnings potential. Winter, on the other hand, said he occasionally will take on debt—either to keep the fund fully deployed or to swing slightly larger deals.

And despite the growing interest by institutions and the resulting tide of new money, Winter said he doesn't anticipate the eventual rise of huge ABL mega-funds. Real estate is a very local business, he explains, making it tough for a firm to expand much beyond the markets it already knows intimately.

"This is a niche strategy, and to do it well, you really have to understand the territory. That's probably going to keep most firms from getting too big or going national," he says. "I'd think it would be difficult to ramp up to $1 billion or more in size.