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Interview with Frank Brochin, General Partner, StoneWater Capital

New York-based StoneWater Capital is founded and run by a group of partners with significant public and private equity investment experience. Founded in 2004, StoneWater Capital is a specialised asset management firm and manages over US$150 million in a global family of long bias fund-of-hedge fund vehicles as well as custom vehicles and other investments.

  1. One of the common themes about the StoneWater Capital partners is that you all have private equity backgrounds. Why get together and form a fund of hedge funds?

    We formed StoneWater Capital in early 2004, as a vehicle for investing our own funds. As former partners of Warburg Pincus, a leading, global private equity firm, we understood the appreciation potential of investing in private markets; at the same time, we sought the liquidity provided by public markets.

    Hence, we set as a primary objective to preserve and grow our capital by investing in public markets through equity managers who think and act like private equity investors. We feel that over long periods of time, such fundamental equity investing-whether in the private or public markets-is the most consistently successful method for safely preserving capital and generating substantial wealth.

    To date, we have raised US$155 million, which includes approximately US$30 million of our own funds. We believe our firm is distinct among fund-of-funds management firms for its dedicated focus on long-term fundamental investing.
  2. Why did you focus on Asia?

    We believe that the emergence of Asia, excluding Japan, presents the most compelling investment opportunity of our time. Just as technology was the driving macro factor of the 1990s, the development of Asia will be the most transformative macro-economic event of this decade. The overall region today resembles Japan in the early 1950s, when the first farsighted investors recognised that it offered a combination of high growth prospects and low valuations that were superior to any other market in the world. From 1950 to 1972, Japan transformed into a developed economy and early investors made more than 50 times their money: we feel that globalisation, both in terms of technology transfer and large foreign capital inflows, is likely to accelerate the transformation of Asia in a shorter time span than recorded in Japan.
  3. As a group you have a couple of products-a US focused fund and an Asian-focused fund; do you take the same approach for both?

    We have the same approach in the US, where we manage three funds. As a firm, our sole focus is on long-term fundamental managers. As former private equity investors, the four of us have a significant competitive advantage in sourcing, engaging, assessing, monitoring and replacing fundamental managers.
  4. How much time do you spend looking at or researching macro economic conditions?

    We are not a macro fund; we make money by picking bottom-up fundamental investors. However, we believe that Asian growth is fuelled by a variety of long-term macro trends that are largely immutable, and will create significant opportunities for our managers and the businesses they invest in. These include: (i) vast first-time infrastructure building due to general development and increased urbanisation; (ii) a burgeoning middle class and resulting growing consumer demand; (iii) favourable demographics, as a large portion of the Asian population is entering its middle-age years, during which they are the most productive from an economic perspective; (iv) credit expansion among both consumers and businesses; and finally (v) pan Asian trade, now exceeding trade with the West for many Asian countries.

    The cumulative effect of all of these factors is that Asian growth today is self-generated; it is no longer export dependent.
  5. We have seen a number of groups launch Asia-focused funds of funds, you have a different approach to most in that you invest solely in long-biased equity managers. Is there a danger that you will lose some diversification benefits and your underlying managers will all go down together in bad months?

    We did a pro-forma analysis of the past five years, which showed that our maximum drawdown would have been less than one fourth of the index maximum drawdown over the same period.

    One reason is that we are ideally structured to deliver both alpha and limited risk: our fund is made of concentrated portfolios of misunderstood and under-researched small- and mid-cap stocks, diversified by industry and country. Since each manager runs a concentrated portfolio, each manager can deliver alpha while having a relatively low correlation with other managers and with the overall market indices.

    Moreover, our managers are exceptional investors who know how to pick stocks that offer stable earnings and compelling valuations, and thus have limited downside, even in declining markets. Our private equity background allows us to distinguish between such exceptional fundamental managers and investors who have merely been lucky to date.
  6. What kind of sectors do you favour?

    We believe that the best strategy for investing in Asia is to build a highly diversified portfolio of stocks that will benefit from the rise of the Asian middle class: we call these consumer-oriented stocks.

    This strategic choice translates into a predominant focus on small- and mid-cap companies, and into a competitive distinction compared to most Asia-oriented mutual funds and hedge funds, which offer a near-exclusive exposure to large-capitalisation stocks. Although larger stocks provide more liquidity, in many cases they provide a volatile earnings stream at fully valued prices. In addition, most large-cap Asian stocks are in highly competitive, international industries, eg, exporters, industrial companies and commodity manufacturers. By contrast, most stocks selected by our fundamental managers will have dominant local market positions, strong operating margins, positive cash flow, limited competition, limited debt, rising P/E multiples, growing liquidity and compelling valuations. This approach should dampen both economic and market volatility.
  7. You reviewed over 200 managers as you carried out your research; what are the criteria you look for?

    We performed a year-long, exhaustive review before launching our initial portfolio. The identification of a handful of superior companies and management teams from a large universe of small- and mid-size companies requires intensive research and balanced judgment by exceptional fundamental managers. Each of our managers has been assessed to possess a first-rate intellect, rigorous analytical discipline and deep knowledge of indigenous business challenges unique to specific industries in each country and local market. Not surprisingly, they have a long exposure to the Asian equity markets, on average 18 years. With two exceptions, all of them are based in Asia.
  8. How receptive have your client base been to the idea of an Asia-only fund of funds?

    Our clients agree with us that investing in Asia today is analogous to investing in the US at the onset of rapid industrial expansion more than a hundred years ago: opportunities abound, but one must be selective. In that context, they appreciate our focus on Asia.
  9. How would you define your approach to risk management?

    We focus on minimising business risk and valuation risk by buying unique companies at compelling prices; we do not focus on minimising volatility. We accomplish this by picking exceptional fundamental managers.

    We then seek to dampen volatility, as compared to minimising it, by making sure that our portfolio is diversified in terms of managers (10+), companies (200+), industries (15+) and countries (10+).
  10. How do you manage the relationship between the liquidity you offer your own investors with the range of liquidity terms that your target managers put in place?

    We are convinced that successful investing in small- and mid-cap public stocks in Asia requires a long-term perspective and a private equity mentality, and we encourage our clients to think and invest for the long term.

    We have a one-year lock-up for our Japan and Asia ex-Japan funds (although liquidity is available during that first year for a 3% fee) and a two-year lock-up on our Indian fund. This matches the underlying liquidity of our managers.
  11. A lot has been written about the recent growth of the Asian hedge fund universe in terms of both assets and funds. What positive and negative effects are you seeing?

    The growth of the Asian hedge fund industry is a long-term positive for providing additional liquidity to smaller stocks and for our strategy. With more interest in Asian markets, we would expect a re-rating of the PE ratios of growing, smaller domestic-oriented stocks.
  12. What is your outlook for the rest of 2005?

    The MSCI Asia ex Japan index has outperformed the US market in each of the last four years; we would not be surprised if the same occurred again in 2005.

    However, we are long-term fundamental investors by training; in fact, the four of us collectively have some 80 years of long-term fundamental investing experience. We are more comfortable predicting the next three to five years rather than the next five months.

    In the next three to five years, I expect that our investors in Asia will benefit from the triple upside of sustained rapid earnings growth, major expansion of price/earnings multiples, and significant currency revaluation. I also expect that our fund will outperform the MSCI Asia ex Japan Index, which should in turn out perform the S&P 500 index.

Contact Details
Frank Brochin
Stonewater Capital LLC
1 212 207 5509