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Salida: ‘Back from the abyss'

Date: Saturday, August 15, 2009
Author: Joanna Pachner, Globe and Mail.com

When Salida Capital Corp. beat all other bidders in a charity auction last month to score lunch with Warren Buffett, the $1.68-million (U.S.) win sent a signal to Bay Street: Salida is back.

Little has been heard from the once high-flying hedge fund manager since a catastrophic performance during the market meltdown last year. The eight-year-old company, which had risen fast riding the natural-resource boom, saw its flagship Multi Strategy fund plunge 67 per cent in 2008. What's more, three of its six hedge funds got locked up in the Lehman Brothers bankruptcy, where they remain.

Amid a rapid exodus of key staffers and dwindling assets under management, what had been a spunky success story gave way to rumours of the money manager’s imminent demise.

Yet here was Salida, in early July paying a whack of cash for the right to introduce its most patient and stalwart clients to the Oracle of Omaha, in order to, in the words of president and chief executive officer Courtenay Wolfe, “thank some of the big people who've been our supporters over the years.”

Though Ms. Wolfe insists the auction bid wasn't a marketing tactic, the media spotlight highlighted Salida's recent spectacular performance.

The Multi Strategy fund, which currently has assets of about $85-million, is up 100 per cent to the end of July (recovering about half its losses). Salida's offshore BTR Global Energy Fund has bounced back even better, returning 136 per cent in that period. Few Canadian hedge funds can boast such lofty stats.

If you take 2008 out of the equation – and, boy, wouldn't many funds like to do that – those numbers aren't so unusual for Salida, whose hot streak started almost as soon as the company opened its doors. Five of its six funds averaged 20 per cent in annual gains from the day they launched. Multi Strategy, boasting an 87-per-cent gain in 2006, was named the best fund in that category at the following year's Canadian Investment Awards. Also in 2007, Barron's ranked Salida's Global Opportunity Fund the fourth-best in the world on the basis of a staggering 1,100 per cent return over its six-year life.

By the spring of 2008, Salida was ready to take its business up a notch. Although the company had amassed some $1.3-billion in assets, it remained little known beyond Bay Street.

Cue an ambitious growth strategy: more hedge funds, greater diversification, a high-profile new president, a whole new sales force, a major marketing push.

Just as the firm was about to press Enter on these plans, the entire financial system crashed. As one former Salida insider puts it, “We got caught by a once-in-a-lifetime tsunami.”

Ms. Wolfe says Salida owes its comeback to sticking with its “opportunistic, aggressive and active investment management style,” which means making significant bets on often small resource companies. Seeing triple-digit annual returns again, investors may well write off the second half of 2008 as a blip.

But, as Al Kellett, a Morningstar Canada fund analyst specializing in alternative investments, observes, “The problem with financial markets is that once-in-a-lifetime events happen every four years.”

Who's hedging whom?

The term “hedge fund” is meaningless today. The breadth of products and strategies it covers – from traditional arbitrage to sector-focused stock pickers – ranges from relatively low-risk and low-return funds that carefully hedge their investments and promise to gain whether the market goes up or down, to highly leveraged funds that make big gambles on equities, commodities or derivatives.

These days, many people define hedge funds (rebranded “alternative investments”) by their lucrative fee structure: what's termed the two-and-20, meaning a 2 per cent management fee and 20 per cent of profits.

About 85 per cent of Canadian hedge funds are net-long equity funds, says Bob Thompson, an alternative investment analyst at Canaccord Capital Corp., meaning they hold more stocks than they short and so aren't really hedged. “We don't have a lot of true hedge funds,” he says. “Our funds tend to be more event-driven, concentrated in a few ideas, mainly in the resource space. So hedge funds isn't the right name for them – they're non-traditional equity funds.”

Salida's funds certainly fit that description.

Though officially born in 2001, the company actually emerged out of Banfield Capital International Ltd. Danny Guy, a seasoned oil-and-gas analyst, joined Banfield as portfolio manager in 1998, and three years later, he and Brad White took over the renamed firm when founder Jeff Banfield left following a settlement with the OSC of insider trading allegations. (Salida means “exit” in Spanish.)

The company catered primarily to the wealthy, with most of its business held in funds domiciled offshore in the Cayman Islands.

In 2004, with Salida's assets surpassing $400-million, the founders hired Gary Ostoich, an influential hedge-fund industry lawyer, as president to help with management and operations. That same year, the company launched the Multi Strategy fund as its flagship Canadian fund, with Mr. White as manager, and Mr. Ostoich went about recruiting new talent in an early attempt at diversification.

Salida was becoming known as an aggressive investor in junior resource stocks. The fundamental thesis at the firm was that the developing world's growing middle class wanted the basics of life, and commodities were the most basic of all.

Its managers sometimes took activist stands and would play matchmaker, for instance pointing Yamana Gold toward Viceroy Exploration (Salida had stakes in both). So when, in January, 2005, Mr. Ostoich tapped Jason Russell, formerly of CIBC Wood Gundy, to run the new Global Macro fund, he introduced a very different element into the mix: Mr. Russell methodically traded currencies and commodities, wrote his own computer code, and believed that the only true hedge was liquidity – being able to get out if things turned south.

New hires, big plans

Through the mid-2000s, Salida roared ahead, with some of its funds posting high double-digit gains. “It was a performance-driven shop,” recalls Mr. Russell. “In my mind, I was putting up good returns – 15 per cent, 18 per cent. Relative to my space, I was doing great. Relative to them, I was a pea-shooter.”

Despite its success, Salida's heavy resource exposure made it somewhat one-dimensional and vulnerable to market swings. As well, the principals felt it was time to raise the volume on self-promotion.

In April 2008, the company hired David Fleck as co-president. A high-profile veteran of Big Bank trading floors, Mr. Fleck was most recently co-president of equities at BMO Nesbitt Burns.

Salida also brought in Ms. Wolfe, who had headed sales at Tricycle Asset Management, to ramp up sales and marketing.

“If you looked at [Salida's] returns historically and you looked at the growth of our competitors, our returns were consistently better, but our [asset] growth was dwarfed by their growth,” says Ms. Wolfe. Her plan starting that summer was to aggressively market Salida's funds to institutional investors and wealthy individuals in Canada and the U.S.

She never got the chance.

What had been economic volatility turned into a sudden rout in July, as the oncoming bear market mauled commodities first. Junior resource stocks were particularly punished as investors fled to large-cap stocks they perceived as safer.

Most Salida funds were hit hard, averaging 25-per-cent drops for the month. It was a whipsaw switch. People were stunned. “It was beyond any level of comprehension,” says a former staffer who requested anonymity. “About two weeks into it, it was pretty clear to me that the selloff was not going to reverse quickly. We kept saying to each other in July that it was about survival.”

Over the subsequent four months, as investments of almost every kind plunged, some of the most dramatic collapses happened in the hedge fund world. While, on average, hedge funds outperformed most asset classes, their roughly 20-per-cent loss in 2008 belied the underlying principle that such instruments could deliver profits in any market.

And then there were hedge funds whose losses were stunning. Salida's were among them.

Mr. White tried to stanch the bleeding in Salida's flagship fund by reducing leverage and shifting to larger, easier-to-sell equities while holding on to the fund's core positions. He, as many of his peers, had been shorting financial stocks on the assumption that the sub-prime crisis would continue to hurt them. But in the resource selloff, financial institutions' shares were now outperforming those of miners and oil producers, making his bets wrong on both sides.

Since many of Salida's investments were in small resource companies whose shares no one dared to buy, the managers were “handcuffed,” explains Mr. Kellett.

“Investors are withdrawing their money, and it becomes harder to manoeuvre. You're closing out positions that you might not want to close out. Some of these managers had made tremendous amounts of money riding this resource boom, they really believed in these companies. They didn't want to adjust their exposure.”

To keep redemptions at bay, Salida launched an outreach program to its investors, holding monthly conference calls. It seemed to work: As of early September, 2008, the company reported that “there has been no up-tick in redemption flows whatsoever.” Then, on Sept. 15, Lehman Brothers filed for bankruptcy.

Many people date the full-out financial crisis to the Lehman wreck.

“Unlike with Bear Stearns, where the government said, ‘Common-equity guys, you're wiped out, but we'll guarantee agreements on default swaps,' they didn't do that with Lehman,” says Jim McGovern, former chair of Canada's Alternative Investment Management Association and CEO of Arrow Hedge Partners Inc. in Toronto. “That directly caused the crash.”

The beginning of the end

But it was the subsequent U.S. ban on short-selling major stocks, aimed at protecting the financial sector, that really started hedge funds' collapse, says Mr. McGovern, because the funds no longer had their most trusty tool for hedging investments. The only way to cover those positions for funds like Salida's was to sell commodities, which tend to be illiquid. “You saw an industry get ravaged,” he says.

Salida was right in the centre of a financial hurricane.

“It was almost impossible to react,” recalls a former insider. “If you had any leverage in your funds, you could never get onside, couldn't sell fast enough. Firms like Salida were like deer in headlights.” The atmosphere on the trading floor was electric. People were throwing up from the pressure.

“It was the most stressful period of my business career,” says the insider. “You're trying to understand what's going on, and whether it's sustainable. The market was dropping 200 points a day. Normally, the last bastion of support for a market is the M&A area. You think, if the stocks get cheap, they'll get acquired. But no one could get capital. This was just liquidation.”

Salida employees say that through that summer and fall, there was some disagreement about how to respond to the crisis.

Shifting away from the resource focus was one option. “People did have different theories,” says one former employee, “but when you've been down one track, to reverse course is very difficult.” For many, the decisions were personal because Salida managers had large investments in their funds – historically, 25 per cent of the company's assets came from insiders.

“Understand how truly unbelievable it is to watch your personal portfolio go down $1-million in a week,” says the insider. “These guys definitely participated in their clients' joy and pain.”

For Salida, Lehman's collapse was disastrous for other reasons. Lehman's prime-brokerage arm had catered to hedge funds, handling their trades, providing loans and performing various administrative tasks. Salida used Lehman as prime broker for three of its offshore funds. When the brokerage filed for bankruptcy, those funds' assets were frozen. In a bankruptcy process, hedge funds become unsecured creditors, going to the bottom of the pile. It's still unclear whether Salida investors will get any of their money back.

Salida's years of stellar profits had created a cushion of capital, but by October the firm was deeply wounded. The Multi Strategy fund was down 34 per cent that month, 63 per cent for the year. In a note to investors, the company explained that it had lost money on several M&A transactions, such as its investment in a private coal producer whose sale to OAO Severstal was derailed as Severstal's shares plunged. “We have written down private equities by an average of over 40 per cent for the month, in line with broader illiquid markets,” Salida informed investors.

It was clear that expansion was now out of the question; the focus was survival. Mr. Fleck was gone by October. Mr. Ostoich followed soon after. Mr. Russell, whose Global Macro fund ended 2008 up 20 per cent, the one bright spot amid losses, met with the remaining top staff – Ms. Wolfe, Mr. White and Mr. Guy – and proposed a strategic shift closer to his more risk-averse approach.

“In my mind, things needed to change,” he says. “I wanted to see [Salida] take a more systematic approach. But it was unlikely to happen.” To Mr. Russell – who left last November and has since started his own hedge fund manager, Acorn Global Investment – it was fundamentally a disagreement about risk management.

Perhaps it was impossible for Salida's founders to change their stripes by then. “You live and die by the sword,” says the insider. After an extraordinary run, “they hit a bear market that took them all the way down in three months.”

Signs of a turnaround

Last spring, Salida's offices in midtown Toronto exuded serenity and elegance, with a water wall gently gurgling in the lobby amid an expanse of marble and dark wood. There was no sign that all hell broke loose here only a few months earlier, other than a relative emptiness. The company was down to about 18 staff from 24, and was managing some $300-million in capital, a 75-per-cent drop from its mid-2008 peak. This summer, that's ballooned to about $400-million.

Seated in the posh boardroom, Ms. Wolfe, recently elevated to the post of president and CEO, stressed that 2008 was a temporary setback from which the company was quickly recovering. “We have never been strong in telling our story,” she said, but with signs of a performance turnaround, she intended to change that.

But mid-summer, those signs were indisputable. The BTR Global Energy fund had made the Top 10 in the Barclay Hedge index three months in a row, including the top spot in May. The new offshore Strategic Growth Fund – a successor to Mr. Guy's Global Opportunity fund whose assets remain frozen at Lehman – was up 99 per cent. At the end of July, the total returns since inception for the Multi Strategy and Global Energy funds were 179 per cent and 118 per cent, respectively. Not bad for a firm being written off as a casualty of the market meltdown.

How did Mr. White and Mr. Guy, the two founders who are now Salida's sole portfolio managers, do it? In a word: China.

Salida's investment strategy is based on a fundamental belief that the world is headed into an era of deflation, where hard assets and commodities will fare strongly. The duo has been rebuilding on the foundation of holdings they managed to retain in last year's carnage, using a similar strategy to what worked so well before: buying into companies they expect to get snapped up.

“We believe you have 10 really good ideas a year, and we take significant positions [when we see them],” says Ms. Wolfe, adding that those 10 holdings represent about 50 per cent of the Salida portfolio. “We look for catalyst events or special situations: takeouts or mergers based on consolidation of the resource space.”

As Mr. White explained during a webcast in July, China has been driving this trend in the resource arena, “moving out of dollars and storing them in the ground.” Although the Chinese government was tightening the taps on stimulus lending, its actions in the first half of the year “helped clean up the commodity market.”

“The Chinese are aggressive buyers of energy, commodities and hard assets, and we strongly believe this will continue,” Mr. White said. He pointed out that China is at the table for every oil deal. “We expect their acquisitions to be even more aggressive than the Japanese in the '70 and '80s,” he told investors. “With over $2-trillion (U.S.) in foreign reserves, they're in the right position to do it.”

Canadian companies stand to benefit because Chinese buyers have been shut out of the American resource arena, and Canada is the natural next target. In June, for instance, Sinopec bought TSX-listed Addax Petroleum for $7.2-billion (U.S.). Salida owned a chunk of Addax. Mr. White sees potential for similar deals involving Argentina's YPF S.A. and the Jubilee offshore field in Ghana.

Adjustments to the formula

When someone asked Mr. White during the webcast how Salida would protect itself from another period like early fall of 2008, he said the firm is putting more capital into larger-cap, more liquid stocks.

“There's an ongoing cleanup in the smaller names,” he added. “Our hedges are higher and stronger. And we have less capital deployed, so we can make adjustments much faster. We have a smaller asset base – not that I'm cheering about that.”

And economic troubles are over, he stressed. He calls the state of the U.S. economy “disgusting” and sees a W-shaped market, with more bounces and drops to come.

As for Salida's future, he was conservative. “We have more than adequate capital. We're back from the abyss, but no one should be overly confident. And we're not.”

Ms. Wolfe, the marketing maven, isn't so modest. She says the firm plans to pick up where it left off last summer by adding new funds this fall, reaching out to retail investors and doing more marketing. As for diversification beyond resources as a protection against market swings, that particular part of last year's planned expansion seems to be on the back burner.

“We can't change the events of last year,” says Ms. Wolfe. “The best thing we can do is keep moving. People often get defeated not by the external environment but by stopping moving forward. You can't just all stare at the screen. You can't get paralyzed.”

Canaccord's Mr. Thompson points out that Salida's investing focus has paralleled that of some of the most successful investment managers around, all of whom were sideswiped to various degrees by what happened last year.

“These people – Eric Sprott, Rohit Sehgal, Jim Rogers, Salida – they didn't suddenly get dumb,” says Mr. Thompson.

He notes that at the Berkshire Hathaway annual meeting in early May, Warren Buffett was asked how his money managers made out during the market crash. “He said, 'They did equally or worse than the market. And I'm not worried about it.' He said that 2008 was a year in which you could be right on everything you're doing and your performance would have been as bad as those who were wrong.”

Salida's principals can only hope that when its investors sit down for steaks and a chat with Mr. Buffett some time this year, he repeats that message face to face.

The firm's high-octane, high-risk investing style, essentially unchanged by the events of 2008, may bear little resemblance to Mr. Buffett's buy-and-hold philosophy, but Ms. Wolfe prefers to stress the theme of long-range thinking.

Mr. Buffett has proven, she says, that you can be successful through ups and downs when your trajectory stretches over decades. “We plan to be around and doing this for a long time going forward.” She may be right. Provided another financial tsunami doesn't emerge on the horizon.

An excerpted version of this ran in Friday's Globe and Mail

Special to The Globe and Mail