A look inside three funds we’re backing

Michael Houghton

Lucerne Investment Partners

Interesting things happen when investors get over the idea that equity markets are where all the action is. The truth is, some of the most compelling opportunities are to be found elsewhere.

Our mission here at Lucerne Alternative Investments Fund is to provide active funds management with low correlation to equity markets.

For this wire, I set up a roundtable discussion with three boutique fund managers working in distinct niches: corporate finance, cryptocurrencies, and ASX small caps.

If there's a theme, it's diversity. The common thread is each investor has earned a place in the Lucerne Alternative Investments Fund.

The subtext of the conversation is why funds of funds like ours exist. Some money managers deal only with sophisticated or wholesale investors or require high minimum stakes, for example. Lucerne enables people to access niche opportunities where direct investment is limited.

Our roundtable participants are, in order of appearance:

  • Michael Henshaw, portfolio manager for PURE Asset Management, outlines the problem in equity markets that his company aims to solve for small enterprises
  • Henrik Andersson, chief investment officer for Apollo Capital, discusses the state of play in cryptocurrencies, and the emerging technologies enabling decentralised finance
  • David McNamee, portfolio manager for Altor Funds Management, describes a successful investment that has rewarded his company's search for market inefficiencies and the catalysts that reverse them.

See below for the video of the roundtable and an edited transcript.


A different type of wealth management

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Edited transcript

Michael Houghton

Good afternoon everyone, and thank you for joining us. My name is Michael Houghton. I'm the chair of the Lucerne Alternative Investments Fund, and also a member of the investment committee.

Joining us today are managers that we invest in via LAIF and I'm pleased to introduce to you Michael Henshaw, portfolio manager for PURE Asset Management; Henrik Andersson, chief investment officer for Apollo Capital; and David McNamee, portfolio manager for Altor Funds Management.

First of all, Mike, welcome. Can you give me a one-minute elevator pitch of what you are and what PURE do?

Mike Henshaw

Thank you Michael. Our fund was set up three years ago. We're running $140 million.

We target a 15% return to investors, about half of which is capital growth and half of which should be derived from income, which we pay out quarterly.

What we're trying to do is solve a problem in equity markets. That really is the idea that a lot of smaller companies, which is our target area, struggle to get access to bank debt.

When they're listed, they're very much beholden to their equity price. And as we all know, the equity price and the operational performance can become detached, such that the company is starting to deliver good results or has been delivering good results, but it's not yet reflected in the share price.

If that coincides with a period when the company needs capital, it's very much hamstrung in that that capital can be very dilutive.

And so we've come up with a concept of providing convertible loan notes that are an alternative to an equity raise.

And the attraction for the companies is that they can raise capital effectively at a premium to their share price.

So we charge an interest rate and we have a conversion term that is a significant premium, typically 70 plus percent above the prevailing share price.

Houghton

From what you've described there, you wouldn't be calling yourself a long-only equities fund. How would you see your asset class fitting in investor's portfolio?

Henshaw

We are absolutely focused on hybrid investments but we think of ourselves as an absolute-return fund, in that we only have, at most, 20% of our assets in equity or equity-like instruments and 80% in credit or cash.

So that's delivering us that resilience to the market. But we have potential to receive equity-like returns from that portfolio of equity instruments that we derive from playing the space for hybrid debt.

Houghton

What would you say is one thing investors need to know about your asset class?

Henshaw

As an industry, the convertible loan note industry has had a poor track record in Australia, but in fact they're extremely useful in providing that stop gap between what is debt and what is equity, and allow people to take a much lower risk, but still give themselves access to the upside that small caps can deliver, which is an area of the market that is particularly exciting, in my view.

Houghton

Would you say you are well positioned in the way that you've structured your investments in those companies to better manage downside risk or volatility in your underlying investments?

Henshaw

Obviously, with 80% of the portfolio in either cash or fixed interest, there's an inbuilt resilience to falling equity markets, and three years in, we've never had a credit loss.

We do have the volatility of the equity component of the portfolio or through the convertible note exposure to equity, but that tends to be quite short term.

When the market sold off in February, March last year, the market was down 30% and we were down just a little over 5%. And thereafter, once you've taken that initial hit, the portfolio tends to stabilise quite quickly.

Houghton

Thank you. I'm going to move on to Henrik now from Apollo Capital. Maybe we could begin with the one-minute elevator pitch on your asset class.

Henrik Andersson

At Apollo Capital Management, we run two strategies. We are a focused crypto asset manager — the leading crypto asset manager in the country, we believe. And our first strategy is the long-crypto strategy.

We launched that strategy three and a half, four years ago. It's since then up around five times.

That strategy has a strong focus on something called decentralised finance, or DeFi. That's a new financial infrastructure that is being built using blockchain technology.

We also run a second strategy, which is very different in its risk-return profile. It's a market neutral strategy.

We use something called stable coins in that strategy to generate returns. Our target return for that fund is between 20% and 40% net returns per annum.

Houghton

Where do you see your asset class sitting in an investment portfolio?

Andersson

Crypto asset is an emergent asset class, sitting in perhaps in some portfolios in that alternative investment portion.

We see investors allocating somewhere between 1% and up to 5% of their allocation to something like crypto asset. It is highly volatile, but also has a potential very big upside.

Houghton

What's one thing you'd like investors to know about your asset class?

Andersson

Crypto asset is the best performing asset class the last three years, the last five years, and the last 10 years.

And we see an increased adoption again in Bitcoin as a digital gold, in DeFi, and in the NFT (non-fungible token) market.

And we also see an increased acceleration, I would say, from the interest from institutional investors, trying to get exposure to this new emerging asset class.

Houghton

Obviously it gets reported often when volatility does strike, particularly for Bitcoin, because that is how people see the crypto asset market. How do you manage that downside risk or that volatility in your funds?

Andersson

That's right — the asset class has very high volatility. For the upside, you have to accept some of that volatility.

From the investor standpoint, I think the key is to allocate the smaller portion of your investible assets to something that is as volatile as crypto.

Houghton

Thank you, Henrik. Now to you David. What's the one-minute elevator pitch for Altor Alpha?

David McNamee

The ASX is a unique market globally. We're focused on the small sector of the Australian stock market.

And when you put it in a broad global context, Australia hasn't really had the depth of, say, the venture capital market as, say, Europe or the US.

A lot of emerging companies look to list on the stock market. And if you look at the ASX, it's roughly 2,300, 2,400 listed companies, and about half of those are trading sub $200 million market cap.

So it's a quite a large investment universe where you find some dislocation in terms of asset prices and there are inefficiencies that exist.

We believe in that market. And we're looking to deeply understand what the catalysts are in the businesses.

What's the realistic upside to those investments? The catalysts really drive the share price, moving forward. And as we get close to those catalysts coming through, we look to exit our position.

Houghton

Where would you see your asset class, your fund, sitting in an investor's portfolio?

McNamee

The fund is only very small; we soft closed the fund end of last year. The liquidity constraints are real in the market segment we're operating in.

And with the very nature of dealing in small equities, it is a high-risk proposition, but we still are focused on deeply understanding what the risk-reward is for each of the investments, and they need to stack up.

We're really looking for asymmetric risk-return profiles. If you fill a portfolio full of those, you'll have a really good expected return on the total portfolio.

Houghton

It sounds like you would have some challenges around managing downside risk and volatility, given the size of the companies you're dealing with and, of course, seeking the catalyst to generate the price growth.

McNamee

You can find things — and we do find things — you can buy companies on negative enterprise values or close to cash and not pricing in much of the upside. That's really our sweet spot.

We try and find as many of those as we can. We try not to price in too much blue sky or execution risk from management teams. We try and back big thematics or large tailwinds that are going to drive different sectors. One comes to mind because it's very recent.

We invested in a resource company called Sunstone Metals (ASX:STM). Malcolm Norris, the CEO — I've followed him for a long time. He's found some of the world's largest copper porphyry deposits.

We were actually buying Sunstone from 0.90 cents, which was actually below cash or cash-equivalent backing. Malcolm has subsequently found a large porphyry deposit in Equador just recently.

The share prices were trading above six cents today. Even if he didn't hit on the whole, we thought that our downside was extremely well protected.

The company wasn't burning a lot of capital, had flexibility around what it wanted to do with its balance sheet strength, and had a really strong management team.

Malcolm had a strong track record and he ultimately delivered on finding another copper porphyry deposit and the stock went up six times.

Houghton

What's one thing you would like investors to know about your fund or your asset class?

McNamee

We're seeing some incredible technologies coming through; we're seeing some incredible founders coming through.

There's so many exciting things happening, whether that's in the hydrogen sector, the renewable sector, the mining sector, the technology sector.

Houghton

Thank you very much. I'm now going to ask each of the managers to spend a little time on a couple of questions that are unique to what they do.

I'm going back to you, Mike, and PURE. Probably the most interesting question for me would be how do you source your opportunities?

Henshaw

I wish I had a better answer for you than the one I'm about to give, to be honest. It's quite an organic process.

We started off very much outbound, looking for companies that we thought looked undervalued, needed capital, and our solution would work for them.

We negotiate every transaction that we get involved in. And it's not an ideal starting point for a negotiation, offering someone capital. And so we've really worked on the deal flow that we can generate.

And that is really going out to a number of the different brokers out there — the IR (investor relations) companies, corporate advisors, and building up a network of people in those industries.

A lot of them we know from earlier in our careers. We try and explain to them how for certain companies, our solution is a better outcome for their client than an equity capital raise, which is the default position of a lot of small caps. And what we are trying to offer is a sort of productised alternative.

Houghton

Can you give us an example of a recent opportunity that you participated in and why you liked it?

Henshaw

We've got a lot of exciting companies in the portfolio. But if I had to pick one that's a standout right now, it would be company called XREF (ASX:XF1), which is a HR software company.

XREF has been on the market for some time. It's a reasonably well known small cap. It provides automated reference checking for employees, servicing corporates, SMEs (small to medium enterprises), government departments.

If you think about these companies, they're typically hiring tens or hundreds of people a year and the HR department is making a lot of calls to referees.

XREF is saying is their solution can streamline a lot of that work. Not everyone can have an automated reference check, but certainly for a proportion of the market, it's a very time-savings solution.

The overall industry that operates in is $400 million per annum globally, but it's growing at 20 plus percent and XREF is a dominant provider in the Australian market. And one of the larger providers in the US. It's obviously a highly fragmented market at the moment and it's got a foothold in Europe.

Houghton

Thank you, Mike. Henrik, I'll go to you now. A lot of investors are curious about China's push to ban Bitcoin.

What are your thoughts on what you're seeing generally in the Bitcoin market, and the impact other countries are starting to have with discussions around either issuing their own the version of a cryptocurrency or regulation.

Andersson

China has been banning some parts of the crypto markets all the way back to 2013, eight years ago.

Now, as you say, in May, April this year, they put a ban on Bitcoin mining. Bitcoin mining was fairly big in China. It was estimated around 50% of all Bitcoin mining was taking place in China.

Bitcoin mining is how the Bitcoin blockchain is secured. And when we talked to investors in the past few years, one of the biggest concerns they had is that Bitcoin mining has been concentrated in China.

When China banned Bitcoin mining, obviously the miners shut down in China and the hash rate, which measures the mining power on the Bitcoin network, fell quite dramatically.

Bitcoin's price also took a hit at the time. May was the second worst month for Bitcoin ever. But since then the Bitcoin hash rate is back to where it was before the Bitcoin mining ban in China.

I think that shows how resilient the Bitcoin network is. Now we are seeing Bitcoin mining being moved to Northern Europe, to North America, to US, and Canada.

And long term that's fantastic for the Bitcoin network, because it's becoming more decentralised.

It's not reliant on China anymore. So that's really good long term for the decentralisation of the Bitcoin network.

Houghton

Decentralised finance, or DeFi, is another sector emerging in the blockchain or crypto asset class. Give us a one-minute elevator pitch on what DeFi actually is and who the main players are.

Andersson

We identified DeFi quite early on as the main use case for smart contracts. Those are new financial primitives that are disintermediating legacy financial institutions.

They're more efficient, they're transparent, and they're fair, these networks. And it's basically software replacing a lot of what financial institutions have been doing for a long time.

And you can uniquely do that with blockchain technology. This market that has been growing very quickly for the last 18 months, two years.

There is something called total value locked, which is basically how much money is in these different DeFi protocols.

That metric has come from below $1 billion at the beginning of 2020 to over $200 billion today.

So you can say that market has increased by 200 times in a year and a half. So it's growing very quickly and we have seen a few different verticals within DeFi taken off during this time.

One is the lending markets, where you can permission-less use software to borrow and lend money in crypto assets. Major players there are called AVA and Compound. We've been an investor in AVA for a long time, as an example.

A second vertical within DeFi that has really gained a lot of momentum is something called decentralised exchanges.

We've been an investor in this market for a long time as well. Major players are Uniswap and Curve. Those are crypto assets that we hold in our portfolio.

We believe the next big wave when it comes to DeFi will be something we call on-chain derivatives.

In traditional markets, derivative markets are much larger than the spot markets. We think the same will play out in the DeFi markets.

We've been investing heavily in that space the last year or so. One is called Synthetics, one is called dYdX and the third one is called Perpetual Protocol.

Houghton

Thank you, Henrik. I think we could probably spend another 35 minutes on DeFi alone. It's fascinating how it's playing out.

I'll cross to you now, David. I think the key question is how you identify those micro-cap winners, but equally importantly, how do you identify the time to exit?

McNamee

The entry and the exit is always pretty difficult. There's a number of facets to it. On the investment process side, we're looking for things that show a large upside; that have a strong thematic.

We dive deeply into understanding what are the key things in the company's pipeline, or what are the key catalysts, and what that means from a valuation perspective.

As these things play out, we have a really good understanding as to what the true valuation is. Exiting for us is when that upside isn't as large and there's no catalyst.

Even if the catalyst is coming through, if it's not a three, five, six times your money scenario, that's the point where we are looking to exit.

At that point, people are starting to price in a lot of blue sky, a lot of execution from management teams.

We don't really want to hang around for that. What you often find from a share price perspective is that things bubble along within a range or come back down to earth, which is what's happened with quite a number of investments that we've exited — they've either stagnated or come back down.

Houghton

Can you give an example of one of those special investment opportunities that you have in your portfolio?

McNamee

We got involved with a local company called RedEarth Energy. They basically produce virtual power plants for batteries within the home.

They're also doing some interesting things in the crypto mining space. They build a really smart system that allows consumers to choose what they want to do with the green energy they're collecting off the roofs of their homes.

Consumers can trade energy back into the grid, they can use it to power other systems they might want to run, they can charge their electric vehicles.

It's really putting the power of collecting that green energy back into the power of consumers' hands.

Houghton

Thank you. That brings us to the end of the discussion. Thanks, Mike, Henrik, and David.

It is pleasing for us to have been invested with each of your funds from early days and to have participated in the performance that you've all contributed.

And for those of you wondering how you can get access to these funds, if you're unable to invest directly, you can always invest through the Lucerne Alternative Investments Fund. Again, thank you everybody, and goodbye.



Executive Director
Lucerne Investment Partners

Over a 25-year career, I've worked with ultra-high net worth investors, family offices, and property investors to provide investment advice, portfolio construction, debt structuring and lending. As an experienced finance and investment executive...

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