By Irwin Speizer
Photographs by Joachim Mueller-Ruchholtz
The launch of Lucidus Capital Partners could have come at a better time. Spun out of the London office of Bruce Kovner's Caxton Associates by a pair of traders, Darryl Green and Geoffrey Sherry, it started up in July 2009, pursuing a long/short credit strategy that Green had pioneered with Caxton.
But in its first year as a stand-alone fund, Lucidus posted somewhat lackluster results. Green and Sherry had decided that the markets would continue to sputter through much of 2009 and so stayed largely on the sidelines. Instead, markets rallied. Hedge funds that invested aggressively reaped unusually large rewards in 2009, with some funds reporting returns in excess of 100%. The main Lucidus fund, Green T G2, finished 2009 up 4.57%—a figure that includes trading in the strategy prior to its spin-off in July—which was just about equal to the second-worst year since Green began trading the strategy a decade earlier through an earlier incarnation.
That level of return in a boom year might make it difficult for a new fund to attract capital. Not so for Lucidus, which has been raking in new money since it opened its doors. Launching with $70 million in assets one year ago, Lucidus hit more than $1 billion as of July, placing it in the top ranks of new funds for raising capital.
"It is a testament to their risk control and money management that they can be wrong on the markets and still make money," says Jim Hodge, chief investment officer of Permal Asset Management, the $20 billion fund of funds based in New York that is a Lucidus investor. "Darryl has a big place in our portfolio."
Lucidus has emerged as somewhat of a prototype of the start-up fund that can appeal in the post-market-crash environment to institutional investors who got burned by managers taking risky, leveraged bets. Lucidus seems to devote as much attention to figuring out how it will get out of trades as it does deciding which ones to get into. Green says what investors like in Lucidus is precisely what he had in mind: a highly liquid credit fund with low volatility that aims for average annual returns in the 11% to 14% range. Instead of a hair-raising roller-coaster ride, Lucidus promises to take investors on a Sunday drive in the country, with an investment style that seeks to avoid sharp declines by closing positions early but also doesn't double down in boom times to juice returns.
"We believe our investors are looking for strategies where you can make 12% but where you can sleep at night," Green says. "You don't want the huge downside, where you can lose 10% to 20% of your money."
Among the institutional investors that have joined Lucidus is the UK's Universities Superannuation Scheme, which manages university employee pension funds. Luke Dixon, hedge fund portfolio manager at USS, says Lucidus has a special allure because of its ability to avoid the big swings other funds have experienced over the past few years.
"Boom-bust investing cycles destroy wealth and can cause critical damage to funding ratios and spending programs," Dixon says. "Lucidus is the antidote to this sort of investing, and Green T G2 is a terrific diversifier and long-term performance enhancer."
As for those underwhelming 2009 returns, Dixon says the numbers were more of a positive to him than a turnoff. "If plus 4.5% is your second-worst year ever, investors should not be too disappointed," Dixon says.
And Lucidus can boast that it outperforms benchmarks over the long haul. From inception to the end of 2009, Lucidus returned 130.25%, while the Merrill Lynch High Yield Master II Index rose 91.507% and the Barclays Aggregate Bond Index was up 85.168%.
Part of the Lucidus investment style takes direct aim at the long lockups of distressed credit funds, as well as at funds using various types of complex investments that proved difficult to unwind in the last market rout. In many cases, those funds resorted to gates or other redemption restrictions that kept investors trapped inside funds they sought to exit. Lucidus aims for a portfolio composed of investments that can be liquidated at any moment in no more than three days. By contrast, many credit funds maintain long positions that can sometimes be difficult and painful to liquidate if necessary, particularly funds that invest in distressed credit and seek to influence bankruptcy proceedings.
To keep its traders in line, Lucidus employs hard trading stops that require positions to be closed out whenever prices pass targets set within a fairly narrow range. The system is designed to help protect the fund from large losses if prices fall, but it can also limit potential profits by selling out positions that continue to rise past a profit target.
While the trading system is ultimately run by Green and Sherry, it is policed by chief risk officer Cyril Themar-Noel. Part of his job is to make sure that all the trades and stops are set in such a way that a total liquidation would never result in a loss of more than 3%. "The core philosophy of our risk management and our strategy is that we can get out," Themar-Noel says.
Green has been trading his credit strategy through several different organizational structures for years. At Lucidus, Green and Sherry are majority shareholders of the firm and co-managers of the Green T G2 Fund. Sherry, 45, is the junior member of the duo and credits Green with developing the trading system with its use of hard stops. Sherry works out of Caxton's New York office and serves as senior credit portfolio manager for Lucidus.
The Lucidus name refers to trading results for the strategy back to 1999, when Green launched the first incarnation of the fund as Green T Asset Management with Caxton as a limited partner. During that period the fund had one down year, losing 1.09% in 2004, and recorded its best year in 2006, when it gained 22.03%. The G2 Fund, which began trading in April 2003, recorded an annualized gain of 8.51% from its inception through the end of July 2010, with a Sharpe ratio of 1.380. From July 1, 2006 (which is when Sherry and the New York team started trading the fund along with Green) through this July, it produced an annualized return of 11.44% and a Sharpe ratio of 1.759.
What happened in 2004 highlights the approach Green takes to explain setbacks. His prediction at the start of 2004 was for a market rally, and he placed a series of long credit bets to catch the rise. Instead, the markets turned against him, triggering a series of stops that closed out his positions at losses.
"We got the market wrong at the beginning of 2004," Green says. "We were long, and we liquidated the whole portfolio." The fund was down by 2.7% in January 2004 and lost another 1.04% in February. Green made up much of the loss in the subsequent months so that by the end of the year he was down by 1.09%. "We take our lumps, we get out and we get out early," Green says. "We get out before it is on the front page of the Wall Street Journal."
To make sure Lucidus was set up as a fund that would appeal to institutional investors, the managers paid special attention to back-office functions. By spinning out of Caxton without severing ties with the firm, Lucidus was able to bring with it a full complement of back-office staff, including some shared with other Caxton entities. The result is that Lucidus launched with a full-time staff of 26 and offices in two countries.
"You don't often have a [start-up] with that many people on day one," says Christon Burrows, who runs overseas operations and marketing of the fund from the London office. "We were institutional from the start."
Green, 52, is based in Caxton's London office and serves as co-chief executive officer of Lucidus with Burrows. In an unusual arrangement, Green, Sherry and Burrows all continue to hold jobs at Caxton. Green is CEO of Caxton Europe Asset Management, Sherry is senior credit portfolio manager at Caxton Associates, and Burrows is director and head of business support at Caxton Europe. Green and Sherry also manage a $500 million credit strategy for Caxton that mirrors the G2 fund.
Both Green and Sherry drew on a history of working within large financial organizations as a basis for the structure they put in place at Lucidus. Sherry began working at Morgan Stanley as a junk bond analyst after he graduated from the University of Chicago with a bachelor's degree in political science in 1987. He received his MBA from Harvard University in 1991 and, after a short stint at Wasserstein Perella, landed as a high-yield bond trader at Chemical Bank in 1995, staying on through a series of mergers over the next decade.
In 1998, a couple of years after Chemical Bank merged with Chase Manhattan, Sherry shipped out to London as a high-yield bond salesman pitching European investors. The merger of J.P. Morgan and Chase got Sherry bumped up again to co-head of credit trading in Europe. One of his regular customers in London was Darryl Green, who was trading for his new Green T Fund. In 2002 Sherry moved to New York and became co-head of North American credit trading for J.P. Morgan. He joined Caxton in 2005 as senior credit portfolio manager.
Green was impressed with Sherry's skill as a sell-side trader and began trying to lure him across to the buy side, finally landing him in 2005.
"I thought Geoff was one of the strongest traders in the market at that time," Green says. "I tried to entice him to join us on a couple of occasions before he finally accepted. Our two styles were very similar."
Green, a London native, is protective of his privacy and declined to discuss his personal background. Those who know him describe him as intelligent and focused, and while he is a congenial conversationalist, there is a hint of ego, as with many successful hedge fund managers. He tends toward dress shirts with his monogram on the sleeve, and he spent time off this summer scaling the Alps.
Investors note that Green is generous with his time, making a point of keeping investors informed of fund activities. "I have found Darryl Green to be very accessible, responsive and transparent, and these are not three characteristics attributable to many hedge fund managers," says Dixon.
GREEN developed his expertise in trading during a decade with Paribas Capital Markets, starting out on the proprietary trading desk in 1985 and rising to head of global markets, which included the bond trading, derivatives and foreign exchange divisions. In 1996 he moved to Donaldson, Lufkin & Jenrette International, where he was chief investment officer for the fixed-income division. Green learned and developed his trading skills at Paribas, refined them with what he gleaned from Donaldson and applied them to the trading system he would later employ as a hedge fund manager.
His work at Donaldson and Paribas brought him to the attention of Caxton president Peter D'Angelo, which led to the start of a business relationship that continues today. In 1999 Green and Carol Toliver, a colleague from his Paribas days, decided to launch their own hedge fund firm, Green T Asset Management; Caxton signed on as a limited partner, owning 25%. In 2003 the fund changed its name to the Green T G2 Fund as it underwent some operational modifications to attract a broader range of investors. Green T Asset Management merged with Caxton Europe Asset Management in 2004, bringing the G2 fund under Caxton control.
Green became CEO of the Caxton Europe unit and began courting Sherry in earnest. In 2005 Toliver retired and Sherry signed on to run credit trading in New York for Caxton. He began trading the G2 fund with Green the next year. When Green and Sherry decided to strike out on their own, they spun out G2 last year under the newly formed Lucidus, which takes its name from the Latin word meaning "suffused with light." Green and Sherry together own a majority of the company, with Caxton once again holding a 25% stake.
ONE result of the Lucidus style of investingis that it excludes much of the credit spectrum, including any companies with severely distressed credit. Lucidus trades primarily in the credit of very large and solvent corporations, and its vehicle of choice at the moment is the credit default swap, which it uses for both long and short positions. Lucidus considers the CDS to be the best way to maintain its liquidity goals at the moment, but it has used cash bonds in the past and may use them again in the future if they provide better liquidity. Its portfolio tends to be fairly concentrated in about 30 to 50 company names.
"We only trade liquid products," Sherry says. "As we define it, that means you can get in and out in a relatively efficient, quick manner. That limits what we can trade. And we trade with stop losses. The typical credit hedge fund doesn't do that."
Lucidus is run as more of an active trading operation than most credit funds, which tend to spend most of their time analyzing and picking investments that they then hang on to for longer periods while they wait for an investment thesis to play out. "It is hard to justify spending weeks preparing a 50-page research report on an investment idea if the portfolio manager is going to get rid of the position if he hits a stop loss," Green says.
While those stops can force a position to be closed out at Lucidus, they do not preclude it from quickly reentering the same trade. Lucidus can find itself entering and exiting the same trade more than once before moving on.
For example, in early March this year, the G2 fund sold one-year CDSs on MBIA Inc., the Armonk, N.Y.-based insurance company, at a price of 33 basis points up front, expecting the value of the position to improve based on good performance by the firm. The trade included a stop at the equivalent of 40 points up front. Over the next few weeks, the value of the position improved in Lucidus' favor by about 15 points, which was not yet at the preset profit target. But it was enough for a review of the stop. G2 moved the stop down to a price of about 30 points up front, which is where the position began.
MBIA continued to perform as Lucidus expected, but then a competitor, Ambac, defaulted on some of its loans, triggering a sell-off in credit across the sector. The G2 position in MBIA quickly sank; when it hit the new stop, it was immediately sold off—close to the same price where the position began.
Lucidus monitored the situation for the next week and decided that the original thesis about MBIA was still sound, so it went back and repurchased the CDS position at almost exactly the original up-front price. By mid-April the position gained enough value to reach the profit target. This time G2 sold out at a comfortable gain.
The MBIA trades illustrate several key elements of the Lucidus trading style. It involved a large corporation whose credit Lucidus did not believe would fall into distress, which meant any investment in MBIA credit should remain highly liquid. It began with an analysis of the company and a prediction of where its credit would likely trade over a relatively short period of time. It involved an investment using CDSs and hard stops positioned on the basis of the underlying thesis. And finally, the holding period was relatively short, although it was not limited by a strict time frame.
"We don't have a target holding period," Green says. "We have a target return. We have hit the target in 48 hours, or we might hold for two to four weeks. A distressed-debt guy might hold a position for two to four years. We don't aim for that. A long holding period for us would be three months."
The style and liquid nature of the portfolio sets Lucidus apart from much of the credit field. "Liquid credit trading is a rare niche in an asset class dominated by leveraged, long-biased carry investors. Lucidus is one of very few pure-play liquid credit traders in the industry," Dixon says. Asked to name those he considers direct competitors, Green said he could think of only two: Brian Riano's Claren Road Asset Management and James Caird Asset Management, which was spun out of Moore Capital Management in 2008 by Tim Leslie.
While maintaining liquidity is a major goal of the investment strategy at Lucidus, it is still canny investments that drive profits. For that, Lucidus depends on the analysis and trading savvy of Green and Sherry. A big part of their role is to try to determine overall market trends and decide the appropriate level of risk for the strategy. They are not always correct, as their call for a difficult market in 2009 led to few long plays and diminished returns. Individual company selection for the bets they do make involves a team of four portfolio managers and five research analysts split between New York and London. The two teams are geared toward focusing on their respective geographic areas, although not exclusively.
"Although a very important part of our business model is correctly calling the overall risk paradigm, it is the single name selection within a given paradigm that will often produce the most important P&L for our fund," Sherry says.
One example of how it all works is Dixons Group, an electronics retailer based in the UK that was undergoing a restructuring earlier this year. Green and Sherry were on the lookout for new long-credit investments, and Dixons looked interesting. It was a large company whose credit was actively traded, and while it was experiencing financial stress partly as a result of the weak retail market, it was not in full distress mode.
Members of the Lucidus team tracked and analyzed the progress of the restructuring and decided that the effort was producing good results for Dixons, which would likely be reflected in the company's bottom line and be good news for the company's credit. In March of this year, G2 sold five-year CDSs on Dixons at approximately 630 basis points, with a stop at 670 bps just in case things got worse. The analysis proved correct when Dixons reported upbeat earnings. The CDSs moved in G2's favor, and after three weeks G2 cashed out around its target of 530 bps for a healthy gain.
TRADES like that helped Lucidus notch solid returns through July, putting it on track to reach an annual return for 2009 in the range of its target in the low single digits. That profit level, in turn, would bolster a marketing pitch that some potential investors questioned after the more modest results of 2009. Midway through 2009, Green responded to questions about Lucidus' performance during the boom market by reminding investors of the fund's longer-term average return rate and its demonstrated ability to avoid steep losses.
He also cautioned that the markets might not be able to sustain the 2009 rally for long. "In many conversations I can recall Darryl saying, 'If you believe the market will continue to rally the way it did in the first six months, you should not be putting money with us,'?" says Simon Meadows, head of business development at Lucidus.
What happened late in early 2010 demonstrates the ability of Green and Sherry to quickly revise their outlook in response to market conditions. They reversed their market outlook and pursued a more bullish strategy, placing a series of long bets based on a prediction of a strong credit market rally. Lucidus profited for the first few months of 2010 thanks to nearly 30 long credit positions, including big plays on MBIA and Ford Motor, as well as bets on the credit of retailers (Neiman Marcus, Liz Claiborne, Levi Strauss, Dixons) and airlines (United Airlines, British Airways). Lucidus scaled back short credit positions during this period.
By mid-April many of the Lucidus positions hit their targets and cashed out with gains, just at the moment when the credit outlook started to sour on concerns about the Greek debt crisis and worries about the impact of U.S. financial reform measures. In April Lucidus turned bearish and went from a 55.57% peak net long position on April 6 to 59.66% net short on April 26. The short positions played out quickly and favorably, and by the end of April, the net short position had fallen to 32.68%.
At that point Lucidus turned cautious, waiting for some indication of market direction. The fund scaled back risk so that its gross portfolio exposure, which peaked at 74.76% on April 26, dropped back to 39.41% by the end of the month. When concerns rose in May of a double-dip recession, Lucidus found its cue and piled on short positions, raising the net short bias to 62.7% by May 18.
Those types of quick moves into and out of credit positions resulted in returns of 4.18% through July this year. The performance has no doubt helped Lucidus continue attracting new investors, and the managers are confident they can raise even more money. Much of their investment so far has come from the UK and Europe, and the firm is hoping to bring in new investors from the U.S., Asia and Australia, which they say could double assets to $2 billion.
"We have more to raise, but we are a long way from exhausting our potential," says Meadows.