Second Curve: Hedge Fund on the Edge

Thomas Brown's fund had stellar performance last year. But this year is a different story, thanks to a few big bets on subprime lenders

by Matthew Goldstein

The reversal of fortune at Thomas Brown's Second Curve Capital hedge fund is stunning.

Last year, the New York-based fund was a standout performer, with one of its three investment portfolios posting an eye-popping 68% gain. Over the course of 2006, the value of Second Curve's holdings ballooned to $734 million, up 78%. But this year, the air is coming out of Brown's fund fast and furious, as several big bets on lenders to people with shaky credit histories went bust. Second Curve's three investment portfolios were down almost 30% as of the end of March, say people familiar with the New York-based fund.

April, meanwhile, is proving to be another cruel month for Brown, a widely quoted money manager who often writes about the financial stocks his funds own on his bankstocks.com Web site.

On Apr. 16, shares of First Marblehead (FMD)—Second Curve's second-largest holding—got pummeled, falling 23% to close at $34.60 (see BusinessWeek.com, 4/16/07, "First Marblehead Plummets on Sallie News"). Investors pounded the Boston-based college loan processor on news that JPMorgan Chase (JPM) and Bank of America (BAC) were taking part in a $25 billion buyout of Sallie Mae (SLM), the nation's largest student lender. Both banks are customers of First Marblehead, and some on Wall Street fear the loan processor could lose business once the buyout is completed. Shares of First Marblehead bounced back a bit on Apr. 17, rising nearly 6%.

Loyal Crew?

The next two weeks could be a pivotal time for Brown, whose fund permits investors to redeem their money every six months. Investors in Second Curve have until Apr. 30 to tell Brown whether they intended to redeem all or some of their money when the second quarter ends on June 30.

So far, Brown says he hasn't gotten any redemption requests. The former Wall Street bank analyst is confident his investors will stand behind him and won't look to jump ship. He notes the seven-year-old fund has weathered two other similarly disappointing quarters in the past without incurring mass defections. "People know our style," says Brown. "We have partners who look to give us more money when our performance is down."

Investors stuck with Brown last year—and he raised more money from them for a new fund—even after he was forced to disclose some messy details about his personal life in a public filing with the Securities & Exchange Commission. In registering Second Curve as an investment adviser with the SEC, Brown disclosed that he was charged with assault in February, 2005. The charges "were brought in connection with a pending divorce case," according to the filing.

Bad Timing

Last September, the charges were dismissed and the report of his arrest expunged by a Connecticut state judge, after Brown completed a court-sponsored, family-violence education program, according to the filing and Brown. A court clerk says she can't comment on the matter.

The domestic dispute, however, remains on Second Curve's registration form, even though the hedge fund is no longer officially registered with the SEC. Brown dismisses the incident as stemming from an "outrageous" claim, and says it has never been an issue with his investors. He has asked the SEC to remove the assault charge from his filing, but regulators won't do so unless he re-registers and files an updated form.

If Second Curve is to rebound this year, Brown is going to need investors to show the same kind of faith they put in him during that personal crisis. Of the 17 stocks Second Curve had money in at the end of 2006, all but three are trading lower this year. And that doesn't include its ill-timed investment in Accredited Home Lenders Holding (LEND), a mortgage lender that has been hit hard by the meltdown in the subprime lending market.

In February Second Curve disclosed that it had acquired an 8.5% equity stake in the company, just as the market for mortgages to people with poor credit records began to crumble. Shares of Accredited Home Lenders are down 63% this year. Other big losers for Second Curve include the subprime credit card company Compucredit (CCRT), online lender Netbank (NTBK), and Encore Capital Group (ECPG), a buyer of consumer receivables.

Previous Rebounds

It may be simply a case of spin, but Brown says some of the selling in the stocks Second Curve holds may work to the hedge fund's benefit by year-end. He says the sell-off in many of those names is an opportunity to buy more shares at cheaper prices. Brown, for instance, says Wall Street is "misreading" the Sallie Mae buyout as bad news for First Marblehead, noting the loan-processing firm has ironclad contractual agreements with JPMorgan Chase and Bank of America. In 2006 Brown's faith in First Marblehead was well rewarded, as the stock rose 157%.

Brown stuck with the company, even after scandal claimed the scalp of former First Marblehead chief executive Daniel Meyer in September, 2005. The shares tumbled in the wake of the scandal, which involved allegations of improper gift-giving. But within a few weeks, the stock recovered and took off—and so did Brown's fund. The question now is whether Brown's faith in such stocks will be rewarded once again.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.