It didn't take long for Sprott Inc. to figure out its bet on Flatiron Capital Management went bust. In only six months, the asset manager has shut one of the funds, and Flatiron's two co-founders, Steve Duenkler and Parm Kaliarai, have been removed of their asset management duties.
So how did this happen?
Despite a focus on convertible bonds, the Flatiron portfolios also invested in warrants of junior resource companies such as Argonaut Gold Inc. Dundee Precious Metals and New Gold Inc. Historically, these bets paid off, because many of them were hedged. As you'll see from this filing, in September the warrants to buy Dundee Precious Metals were offset by a short position in the stock.
First, Flatiron's managers invested way too much money in Great Basin Gold convertible bonds that went haywire when the company filed for creditor protection. Once they quickly became more or less worthless, the warrants in the rest of the portfolio suddenly comprised a much bigger chunk of the remaining fund value. Put simply, the old managers "increased the concentration in the wrong securities, and then the securities started to get marked down in the last month," Sprott chief executive officer Peter Grosskopf said on a conference call.
While that normally wouldn't be too much of a problem because the warrants were hedged, this fall that hedge was loosened, in hopes of earning more money on certain companies. The decision proved particularly disastrous in November when the Strategic Yield Fund lost 32 per cent of its net asset value.
But there was a double whammy. While the concentration in these warrants grew, the rest of Bay Street figured out what was going on and they started to withdraw their bids on the warrants, preventing Flatiron from selling their positions unless they wanted to unload them for extremely cheap. As Front Street Investment Management chief executive officer Gary Selke put it, there's very little that can be done when the "market smells blood." (Front Street contracted the management of the Strategic Yield Fund to Flatiron.)
Sprott and Front Street are trying to assure the market of two things. They say the interest bearing securities in the portfolios are in decent shape; it was the warrants that were troublesome. They also don't think a distribution cut is necessary for the Strategic Yield Fund right now – but they will reassess that in the near future.
And they're making one thing absolutely clear: "Leverage was not the issue here," Mr. Grosskopf said.
That's a bit discomforting, though, because it means the results stemmed from plain old bad portfolio management.