Like many a good hedge fund manager, Patrick Pat McMahon carries the trading gene deep within his DNA. Described by colleagues as a deeply intuitive trader, Mr. McMahon founded New York-based MKP Capital Management LLC after nine years at Salomon Brothers Inc., where he was managing director in the fixed-income capital markets, ultimately heading the collateralized mortgage obligations trading and structuring desk.
A star athlete in high school, Mr. McMahon remains an extraordinarily disciplined competitor when it comes to managing hedge funds. His longtime co-chief investment officer, Anthony Tony Lembke, said he first witnessed Mr. McMahon's extreme self-control during the market debacle surrounding the collapse of Long-Term Capital Management LP in October 1998. On Columbus Day that year, MKP's investment staff came into the office to move the portfolio to cash, although the market wasn't officially open. In the middle of that ultra-stressful day when portfolio managers were selling off their securities at incredible discounts, Mr. Lembke said he vividly remembers looking over at Mr. McMahon and found him so clear-headed, calm and professional. His business was potentially crumbling and he was much more worried about the rest of us.
That humbling experience permanently altered Mr. McMahon's viewpoint on business risk. His recognition of the problems in the subprime market led the firm to aggressively reduce exposures to outside market and counterparty risks. This focus enabled the firm to successfully navigate through the market turbulence over the past 24 months.
What measures are you taking during this troubled time? Our investment process is devised to make sure we keep the firm secure throughout various distressed periods. Our independent risk group makes sure all investment professionals speak the same risk language. This emphasizes the actual volatility of asset classes, manages to a maximum drawdown, respects stop loss levels and relies on fewer overall themes that emphasize sizing consistent with conviction.
Real price discovery is also paramount in our process. For example, we have transacted actively in many of the sectors that have been in the eye of the storm over the past 24 months. We believe investors should not confuse lower prices with no liquidity. We don't accept the notion that there are no markets, prices or liquidity for various credit securities. There is a big difference between not liking the price and not being able to receive a price. When managers claim there is no liquidity, they are really saying they don't like the price, not that there isn't a fair amount of capital looking to invest in these distressed areas.
Do you see opportunity in the current turmoil? We are in the middle of the largest asset repricing of the last century. We are witnessing what some may call The Great Unwind and are seeing major disconnects between equities and credit, particularly in the structured credit area. The space is realistically pricing in stressed scenarios and the potential for a protracted downturn in global economies.
Although we are discouraging the notion of catching the bottom, we have started to encourage clients to invest. We are encouraging investing with a long-term view and to avoid seeing the current situation as simply a trade. The environment will be one that rewards managers who employ a disciplined and balanced approach, incorporating both long and short risk positions.
Do you anticipate a major restructuring of the hedge fund industry given recent history? The alternative space is going through its first major and real shakeout in its history with no bailouts likely to slow this process. Although the industry is going to shrink, this cleansing will favor managers who operate with an institutional framework. MKP views this as a healthy part of the evolution of the hedge fund industry, weeding out firms that have not invested in a complete infrastructure, real alpha generation process and solid risk management skills.
Furthermore, the fund-of-funds industry will need to evolve a bit more. Overall, (funds of funds) have not outperformed the indexes. Many have been overdiversified, making it more difficult to outperform with their extra layer of fees.
Have your clients been in touch to talk about due diligence post-Madoff? We've been getting a lot of calls.
People get too caught up in trying to figure out how to blame somebody or create the new cop that will be the magic bullet that will solve all problems. I really think it's more about doing serious due diligence on a firm. It goes through various different levels. In the current situation, there are many firms that invested in a (hedge funds of funds) firm that invested in his firm. So investors were only looking at the audited track records of one and didn't process all the way through to (the underlying fund).
In the end, people will realize that there will be no agency and no regulation that trumps your own strong due diligence.
Are you getting more selective about investors you'll accept? We've always strived to identify investors with the same long-term mindset we have. Due diligence is a two-sided coin. We spend a significant amount of time discussing our investment philosophy and risk views with the (entities) we want as investors.
There is no foolproof form that one can fill out to see if an investor is suitable for us. And sometimes it shifts as personnel change and the mandate changes as a result. We try to do a significant amount of work on what type of institution they are. When you sit down with them, you can hear what their investment mentality is. You can ask them about the structure of their investments. ... There are many questions you can ask, but they all lead to a more common-sense approach to due diligence rather than a check-the-box mentality.
What is MKP's advice to its clients these days about the role of hedge funds in their portfolios? We think there is a massive disconnect between equity markets and credit markets. To a lot of people, credit is looking significantly cheaper than equities at this time and since credit securities now have more equity-like characteristics, should that have a greater weight at the expense of equities?
We are having significant conversations with our clients about their asset allocation models; they have called into question whether the same model should be used going forward. The differences between equity and fixed income in a portfolio may not be the same as they were in the past. A lot of the credit-based securities really have equity-like characteristics at this point. ... I think (pension fund executives) need to dig in deeper on where those allocations should go ...
I think absolute-return strategies will become more important than they ever were before. ... Now everyone is waking up and saying (that) down 15% to 20% is good on a relative basis. But that's still down.