ASIAHEDGE SEPTEMBER 2008 ISSUE
VENUS CAPITAL MGT INC

The Indian market has evolved from an exotic outpost to a mainstream emerging market, attracting more Asian hedge fund managers along the way, but few have clocked up the 14 years of experience that underlies Venus Capital Management. The Boston-based firm has five funds with an India focus, with two more in the pipeline, all exploiting opportunities in India via a range of risk averse strategies.

The company evolved from a wealth management company into an Indiafocused hedge fund boutique, and its assets have grown steadily as interest in single-country Asian funds has grown. “We launched a long-only India fund in 1996- we couldn’t short then because India had no derivatives market. Single country Asian funds were not that popular then. People wanted a manager who invested across emerging markets, and it was a nightmare selling the fund because India was an exotic country says Vik Mehrotra, fund manager and founder of Venus.

Two crucial changes in India enabled Mehrota to contemplate moving from long-only equity investing to hedge fund strategies- the emergence of the Indian derivatives market and set up of the central depository, which brought a paper based system of settlement in 5 days, to a paperless T+2 settlement. “In 2002, when the derivatives market came we knew that a successful fund manager should be able to control volatility. There’s no doubt this century will belong to China and India, but in both markets if you can’t control the volatility then the short-term can kill your business,” says Mehrotra. Venus has seen last three bear markets in India, while the current new hedge fund managers have seen none. Though, Mehrotra believes that the level of sophistication of the current breed of hedge fund managers will improve gradually. “A bear market, resulting in loss of capital is a very good and fast teacher and the current long only breed of managers will learn quickly”. Most Indian hedge fund managers are looking at mid caps, and in a bear market, volume dies. Some mid caps can be down 40% to 60% but are still not saleable. “2 and 20 is a very good incentive to be long only, in a bull market, says Mehrotra.”

Our clients want to preserve capital and add value. We’ve had five and a half years of extremely stable returns, down only in four out of 68 months.”

The decision to focus on arbitrage came out of the demand from investors for stable returns, and of the firm’s $500 million in assets under management, $320 million is in the Venus Arbitrage Fund. “We have the domain knowledge to do long/short equity but we felt that arbitrage was better because we have seen very vicious bear markets in India and hence wanted market-neutral low-risk strategies,” says Mehrotra.

The investable universe has burgeoned, from 50 single stock futures to approximately 260 in the space of three to four years. “There used to be very few convertible bonds,” says Mehrota. “In the last five years Indian firms have raised $30 billion in 250 different issuances, so the universe of CB’s, ADR’s, GDR’s and single stock futures has grown tremendously.”

“Although Venus’ investment opportunities have expanded, there remain few competitors in the arbitrage space”, says Mehrotra. “Arbitrage is not so crowded. Newcomers have no experience in arbitrage, no track record. There are multi-strategy managers thinking about arbitrage in India but they don’t have the patience or the expertise to do it.

In addition to the Venus Arbitrage Fund, Venus’s 45-strong team of professionals is responsible for the Venus Special Situations, Venus Relative Value and Venus Event Driven funds. All the research for the funds is done out of India, and alpha generating team comprises of 12 analysts based in Delhi and two in Boston. . “We started outsourcing to India in 1996, long before the outsourcing craze,” says Mehrota.

The special situations are described by Mehrotra as a ‘chicken’ way to participate in the market. “You get some beta but not NIFTY times one or two. This fund’s strategy takes out some of the systemic risk and protects on the downside,” he says. “The special situations fund gives investors the chance to capture 40% to 50% of beta downside but 60-70% of upside with 1/3rd the volatility of the Nifty Index.”

India has abundant special situations opportunities, according to Mehrotra. Indian firms are seeking international legal and technical support for spin-offs and acquisitions; and the volume of mergers and acquisitions and private equity deals has been growing. In 2007, $70 billion of M&A activity took place, according to Grant Thornton.

“One example of the fund’s strategy is Reliance Industries, which is due to spin off its retail division next year. “It owns the largest natural gas reserves in India and will start production in the fourth quarter of 2008. This is the catalyst for a very undervalued stock, that has gone from INR 3,200 to INR 2,200,” says Mehrotra.

Another example is Mumbai-based engineering conglomerate Larsen & Toubro, which will benefit from the nuclear power treaty between India and US, due to be approved by the end of this year, says Mehrotra. “India will need 15 to 25 new nuclear plants and L&T will be a beneficiary of that. Its market capitalisation has gone from a high of $32 billion to $18 billion but it has a $20 billion backlog of orders. ” It is estimated that India needs $500 Billion, in the next 15 years, to improve its infrastructure. This inevitable spending is a boon for L&T.

Three new funds have been launched this year and two more will be launched in the coming 12 months. The Venus Index Plus Fund is launching on September 1st 2008 and will be the first open-ended India index fund, tracking the S&P CNX Nifty India Index. The fund will be a flat-fee fund offering daily liquidity for investors to time the market and will be offered in three share classes – 1x Nifty long, 2x Nifty long and 1x Nifty short. “Now we are segregating beta from alpha in certain strategies. When you add value and generate alpha people pay you two-and-20 fees but they shouldn’t have to pay that for beta, which is why we are launching a flat-fee, index-based fund,” says Mehrotra. “Most India managers are not performing Nifty on a risk-adjusted basis, so, why should investors pay hedge fund fees for obtaining Beta?”, asks Mehrotra. The Index fund will outperform Nifty by 200-300 basis points without changing its constituents or weights.

Venus has also launched the Venus Relative Value Fund, which is going to take advantage of cross-country and cross-market price differentials, and will use structured transactions in European and US markets to enhance returns. This year, Venus has also launched the Venus Event Driven Fund, which is going to take higher risks and aim for higher returns but will hedge out the Beta risk using Nifty futures. The event-driven fund will generate positive Alpha.

The Venus Opportunities Fund, a hybrid fund with 70% deep value liquid equities and a 30% illiquid side pocket which will make private equity-type investments, is due for launch in the fourth quarter of 2008. Slated for launch in 2009 is the Venus Real Estate Fund. This will be a tie-up with a local developer and will seek to take advantage of the shortage of homes in India that is expected to continue for many years to come.

“India has extremely strong macro dynamics. Seventy percent of the population is under the age of 40, and commercial real estate is also in short supply. There are a lot of good opportunities but it’s going to slow because real estate has been very hot,” says Mehrotra. “There is going to be an extended cooling-off period and prices will moderate but there will continue to be tremendous opportunities long-term.”

Overall the outlook for India in the short-term remains tough for India managers of all stripes, and Mehrotra is no exception in his cautious view. “We had a five-year liquidity-driven bull market which got over-extended and now we’re paying the price,” he says. “The rest of 2008 will be a washout and the global deleveraging process still has some room to run. India will be a trading market with a negative bias until global institutional investors come back to allocate to emerging markets again.”

Mehrotra expects that Indian GDP growth will slow from 9.5% to 7.5%, and inflation is a big problem for the country. “The government will definitely try to control inflation in a big way because this is an election year and if they lose the battle against inflation they will lose the election. My fear is that they will suck up the liquidity too much and India will have a hard landing”.
“Our outlook is cautious for the next three months so we are taking a market-neutral approach. There is a direct negative correlation between the performance of the Indian stock market and the price of oil, as India’s budget deficit is primarily on account of oil prices.”

Though the short-term outlook is looking bleak for India, Mehrotra says, “In the longer run investors will realize that there are very few economies in the world that are growing at a reduced rate of 7.5% and as India integrates into the global economy, they will be forced to allocate more money to India for investments. There was a time when India used to account for 40% of the global trade and hopefully that time will come back in this century”.

Mehrotra mentions that short-term negativity should be used by the long term investors to their advantage. Venus Capital Management has distinguished itself by controlling short-term volatility while preserving long term gains. Even during the current time of severe retrenchment in the industry when several India funds are down 40-60% this year and their existence is threatened, Venus has plans to beef up its IT infrastructure so that the business model becomes very scalable when investors return to India. Apart from IT, it has also invested in people by hiring new talent . Venus recently added to its Alpha generating team by hiring Tajinder (Natty) Singh, as a Trading Strategist, who was instrumental in managing the proprietary trading desk at Fortis Bank in New York.

“The current retrenchment in the industry is the best time to build your human and physical and knowledge infrastructure but it requires an investment and long term commitment to India, says, Mehrotra.”

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