GEM Capital Management Sets Up Off-Shore Arbitrage Fund

This summer the tax-exempt market will see yet another off-shore arbitrage fund launch as more managers are taking advantage of the growth of foreign interest in municipal bonds. GEM Capital Management LLC will follow in the lead of Blue River Funds Asset Management, among others, and set up an off-shore account. The difference this time is that it will be a fund of funds that will focus solely on the municipal arbitrage strategy. GEM president and portfolio manager Keith Pagan, who also wears another hat as managing director for Blue River, said the fund will be open for business this summer. Based in the British Virgin Islands, the fund will carry GEM’s name and is likely to cater specifically to European and Asian financial institutions looking for exposure to the strategy. The term arbitrage is used widely in the market. The general concept is to take advantage of price differences in two different markets. In this case the strategy is to perform a carry trade on a tender-option bond program. Carry trades refer to a strategy of borrowing at the short end at a lower interest rate and financing the purchase on the long end. TOB programs leverage a carry trade various times to enhance returns. In this version of municipal arbitrage, the fund is going long on the municipal curve and short on the taxable curve, which means using the Securities Industries and Financial Markets Association curve or the London Interbank Offered Rate. SIFMA or LIBOR can be used in the floating part of a TOB. Going off shore will allow the fund to attract foreign buyers for several reasons. Pagan said the account will be located in the British Virgin Islands because there is an established infrastructure in place that supports pooled investment funds. Foreigners prefer off-shore because “it protects their identities with respect to U.S. regulators because they don’t want to get co-mingled with U.S. investors with respect to potential withholding requirements, tax, regulatory and privacy issues,” he said. Another popular area for off-shore accounts is the Cayman Islands, which happens to be where Blue River runs what several market participants called the largest off-shore municipal arbitrage account that stands at around $1.3 billion to $1.5 billion, according to sources. Blue River managing director Robert Bigelow did not return calls. Ferenc Sanderson, a research analyst at Lipper Funds who specializes in hedge funds, said that primarily German institutions, as well as Japanese clients, may be looking at munis. “The foreign institutional investors are chasing yield,” he said. “And making sure that it is off shore for them so that it would have a legal structure that they are comfortable with makes sense.”A main question posed by several traditional market participants is the tax issue. Why would a foreign investor want a tax-exempt bond when they do not have to pay domestic taxes? The answer is that these funds can still generate high returns using muni arbitrage just by utilizing the relative slope on the the muni curve. With an off-shore account, there is even more flexibility in this process. An investor with a domestic arb strategy will always avoid bonds that are subject to the alternative minimum tax, while an off-shore account does not because the AMT does not affect them. Another advantage concerns the holding of collateral. This is part of the TOB program, where there needs to be a holdover of a certain amount because the bonds are marked-to-market frequently. For a domestic fund, the collateral must be tax-exempt, for an off-shore account, the manager can purchase treasury bonds and pick up some extra yield that otherwise isn’t possible. Another issue with the fund of funds approach is the natural diversification of allocating assets in several different funds. “A fund of funds will offer diversification of managers and there will be some nuances in investing strategy across those managers, so you might expect to get a less volatile return profile,” Pagan said. “There are almost 50 different muni markets out there and different tax regimes, so each portfolio is truly unique. Different managers will use different leverage factors and hedging instruments with either the SIFMA or LIBOR.” This is not the only way to diversify funds, however, as Chip Norton, managing director of Fortigent’s tax advantaged debt fund, a domestic municipal fund of funds, points out. Fortigent’s strategy of diversification moves beyond the TOB trade and into other alternative investments.“There are a lot of municipal alternative funds out there,” Norton said. “We like to have a lot of different pieces to give our clients the best diversification and we actually diversify away from the TOB trade.” Fortigent’s fund has about 15% allocated to funds using this form of municipal arbitrage, with the rest in other strategies. GEM’s will be entirely in muni arb. The new GEM endeavor has $25 million in verbal commitments. The management fee is between 0.5% and 1.0%, and the performance fee is applied “only after exceeding a rather high hurdle rate,” Pagan wrote in an e-mail. “I don’t recall ever seeing a higher hurdle rate than ours, in any fund of any type.” Sanderson said that performance fees for fund of funds tend to be in the ten percent range. Pagan would not say what anticipated performance was, but did not that last year GEM’s domestic fund of funds returned around 10%.