What is the Right Way? Offshore or UCITS?
Marcus H. Storr, Head of Hedge Funds, FERI Trust GmbH, Bad Homburg/Germany
Innovation is the Foundation for Systematic Investing
Harold M. de Boer, Managing Director, Transtrend BV, Rotterdam/Netherlands
A Disconnect in Global Markets
Crispin Odey, Founding Partner and Portfolio Manager, Odey Asset Management, London/United Kingdom
Deal Spreads and Flow Are Key
Steven R. Gerbel, Founder and CIO, Chicago Capital Management, Chicago/USA
A Fundamental Approach to Investing
Peter M. Schoenfeld, Founder, CEO & CIO, P. Schoenfeld Asset Management LP, New York/USA
What is the Right Way?
Offshore or UCITS Hedge Funds?
Marcus Storr, Head of Hedge Funds, FERI AG
A few years back, hedge funds and alternative investment funds were a highly unpopular and unfavourable choice for investors in Germany. However, many institutional investors and family offices are now considering investing in absolute return funds and hedge funds. What changed their minds in such a short span of time? Low to negative yields in traditional asset classes have left no choice for investors but to consider alternative investments that provide absolute returns. The investment trend is more towards European-regulated UCITS funds as compared to offshore funds.
Trends in Europe-based hedge funds
Post-financial crisis, the assets under management in Europe-based offshore hedge funds remained unchanged, but the UCITS space witnessed some serious developments with current assets being 10 times what they were back in 2009. Currently, assets under management in both the offshore and UCITS space are almost the same, with several hundred billion invested in each. This behaviour surely signifies that after the financial crisis, European investors are seeking more liquidity and prefer to be in a more regulatory-driven environment. It is highly questionable whether this development is something to get worried about or be happy about. UCITS funds surely provide relatively good liquidity and portfolio transparency, but at the same time they add implicit costs and create complex fund structures. Most importantly, UCITS regulations restrict the investment universe which translates into lower performance of UCITS funds than their offshore counterparts.
Performance tracking error: UCITS versus offshore
Four years back, FERI carried out a detailed quantitative performance and risk analysis of UCITS and offshore funds using data from 2005 to 2011. We found that the performance of UCITS and offshore funds in the Equity Hedge strategy tracked quite closely to each other, but the results were disappointing for other strategies as offshore funds performed better than the UCITS funds, creating a higher tracking error between them.
In August 2016 we updated our previous empirical analysis using a time period from 2005 to 2015. We had a quiet hope in our hearts that the tracking error would have been minimised but the results were even more disappointing, as we almost lost our old friend ‘Equity Hedge’ on the way. The largest tracking error was seen in Relative Value and Event Driven strategies, followed by Tactical Trading and, though to a minor extent, Equity Hedge. These results again support our previous claim that UCITS funds have a relatively restrictive investment universe, which is reflected in their performance when compared to offshore funds.
Perception: only offshore funds have problems
It is often perceived that only offshore funds can gate their funds for investors, but the reality is that, based on their prospectuses, UCITS funds can also gate their funds. Another misperception is that UCITS regulations would save the UCITS funds from any kind of fraudulent losses but the reality is also different.
For example, during the Madoff scandal, UCITS funds were as badly hurt as the offshore funds. UCITS funds offering the strategy were severely affected by the Madoff investment scandal and those UCITS funds stopped redemptions right after the scandal. After fighting the case for four years, investors were only able to recover one-sixth of their investments from those funds.
Both UCITS and offshore hedge funds are useful in their own way. UCITS funds work well in dedicated liquid strategies such as equity long/short, merger arbitrage, CTAs and global macro strategies. On the other hand, offshore funds can be invested across all the strategies.
The final remark from my side is that thorough due diligence and an understanding of the underlying risk factors is the crucial point when investing in either UCITS or offshore hedge funds.
Innovation is the Foundation for Systematic Investing
Harold M. De Boer, Managing Director, Transtrend BV, Rotterdam, Netherlands
Part I – A changing world
I started my career at Transtrend – it was at that moment a research project – in 1989. In 1992, I had a telephone on my desk. Then it grew into a mobile handset, and I was very proud of this, because you could then connect with someone else. Could you imagine something like that in 1992 or 1989? When we were communicating, I wrote a column every week for a newspaper, and I had to send it by fax, and then the journalists over there had to retype the whole thing again. When we were connecting with exchanges, you would look at the homepage, on the Internet; we had brochures being sent by the exchange – only in 1992.
In 2007, in the stock exchange, you still had floor traders. Nowadays in the New York Stock Exchange they have to ask people to walk there for a picture, because otherwise there would be no one. The same goes for cars; there was not even an emission scandal to be worried about! Toxic fumes were just allowed. You paid for your car with cash, now you use a card.
You did your shopping in real shops, or your wife did the shopping; the Internet is where you do it right now. What could you buy at Karlstadt with one mark in 1998 – sorry, 1982? How many things could you buy at Karlstadt? I would say, not a lot. In 2014, the whole chain was bought for one euro. Times are a-changing. And beware, it doesn’t stop here.
Part II – Active Risk
Defining active risk as tracking error
This is very relevant when we talk about active risk in investing. There is the Dutch National Bank; here you have the Bundesbank, which watches over investors, for instance, pension funds and so on, and they have to take active risk into account. It works like this: they say, if there’s a pension fund, you have to do a whole analysis, and you use an index, a stock index or a fixed income index, in your calculation of historical performance and historical risks. Then any deviation from that index, anything you do differently to that, will add an additional risk to the equation; that risk is called active risk.
Your risk gets higher if you deviate from the index that you’ve been calculating with. And that means for a pension fund, many investors are almost obliged to use those kinds of passive investments, getting close to the index. This whole idea is a pure academic truth, and you have to all remember that academic truths are always true only under certain conditions. And one of the conditions here is that the past reflects the current – or, said otherwise, that the world does not change.
Changing composition of equity indices
So there’s a very nice theory about why to use indices and so on, which is completely true if the world does not change, and we just saw that now and then some things change. Not only do people get older, but many other things change too. What’s the consequence of that? Well, if the world changes, look at the S&P 500 at this moment – what are the largest firms in it, market cap-weighted? Number one is Apple, okay, founded in 1976, but how large was it in the index in 1992? Microsoft, founded in 1975; how large was it in 1992? Facebook, founded in 2005. This is the same index, and we were checking the same index – well, there were a lot of changes there.
Evolving activities of index constituents
Let’s bring our focus to Germany and to the DAX. Number two is Siemens – okay, old company, always in there since 1847, but SAP was founded in 1972, and how large was it in 1990? Does anyone know? I don’t think it was a big firm then. Without computers there was not a lot to SAP. Let’s look at Siemens more closely. Their Telegraphen-Bauanstalt used to make electrical telegraphs and telegraph lines – are they still making them? I hope not, because you won’t sell very many. They used to make electrical generators, electrical trams and trolley buses; I walked around Frankfurt and this area, but I didn’t see a lot of these anymore.
And, luckily, Siemens does something else too. They make some other things that don’t look like trolley buses at all, the things that we see around us today. They make draft technologies: wind power, solar and hydro, diagnostics, healthcare technology – that’s what they’re active in now. They built nuclear power plants but stopped this activity in 2011. They were active in IT, but sold that division in 2010.
What is the consequence of all this? If you are passively invested through your indices, and even if you would be constantly invested in exactly the same stocks, you are still running a huge active risk because you are constantly invested in something different than you were thinking, and that you calculated with. If you were invested in Siemens, you changed from being invested in something with nuclear plants to something without nuclear plants. You were invested in IT, and then you were not invested in IT. You were invested in an index without Facebook, and no one even knew what Facebook was, and now you are usually invested in Facebook. That’s the idea, that you would be passively invested, and that you would not have an active risk. But you cannot get away from active risk. There’s no way to get away. Or is there?
Conventional risk measures are unstable
Is this a bad thing? Well, yes. The bad thing is that your foundation of being a passive investor is gone. It also means that a lot of Value at Risk measurement that is based on calculating back with the same things has no validity, because it’s based on the idea that things don’t change, and yet things are changing. So something may still be called an S&P 500, and something may still be called a DAX or anything else – but it’s not the same thing; it’s a changing thing. Is that bad? No, it’s not bad at all, because developments, changes, are the basis of growth, the foundation of prosperity. If there were no changes at all in the world, you would not even gain money with investing; investing is all about changes.
So be aware of that, because change is a thing you’re going through, and if you want to have a share of that prosperity, the outcomes of changes, of developments, what should you do? Well, one, you should participate in the developments. Two, you should not close your eyes to them; don’t say: ‘Well, I’m passive, nothing has changed, I’m still invested in the same thing’ – no.
And you should not want to be the passive victim of developments. Let me give you a few examples of the passive victims of developments.
The dot-com crisis: in the 1990s, we increasingly heard about the Internet bubble, as more and more Internet stocks were admitted to these indices. This had a big impact, and even traditional firms were buying some Internet-based assets. You could measure that the index was absolutely, completely different from before. You could measure – if you just looked at an index (and I look at the MSCI World, so this is a broadly diversified stock index) – the risk index at that moment was two and a half times as large as before. If you calculate it back and say, well, it’s the index, it’s the same index, you are not seeing it. But if you just look at the whole thing you see you are there, and you and everyone who invested there were invested hugely in something other than what they were invested in before: they were hugely invested in IT, in Internet ventures, firms that had never made money.
You can do it, but don’t say ‘I’m passive, I’m not in there,’ – you are, and when the bubble burst, big losses came out of it for anyone invested in it. Why were people invested? Well, there were also some investment managers who said, ‘We’re not going to do it so much,’ but they lacked performance in 1999; they were behind other investors. So investors then said, ‘I want to be invested in the investment firms that are invested in Internet stocks,’ so that’s why they were in there, and people were in there because they were passive, but they were passive in something that was actually active.
In 2007-2008, banks were growing rapidly – they were involved in all kinds of things that they had never been involved in before. Banks were the main part – the Dutch index was very extreme, but many other indices faced the same thing. Banks were doing mortgage-backed securities; they were doing all kinds of collateral debts or obligations. The bank in 2007 was a completely different bank than the bank in 2005, 2003, or 2001; in those indices there were more and more banks. If you calculate risk management, just normal risk management, and you look at the MSCI World, the risk in the MSCI long-only invested stocks, all the stocks in it, in 2007 it was – according to all things that are generally accepted, including looking at correlations that were changing, looking at volatilities and leverage – four and a half times as large as it was in 2004-2005. If someone would have said in 2004-2005, ‘You know what, I’m going to be invested in stocks, and I will leverage twice, then the risk is twice as high,’ – anyone would have said, ‘Your risk is too high, you cannot leverage that thing so much, because you have twice the risk.’ Without the leverage, people had four and a half times that risk in 2007, willingly. The conclusion, the effect of it: there was a crisis, the whole thing came down. Yes, because something is happening in the world, developments are going on, and by being passive you are part of it.
Cap-weighted debt indices
When the Greek debt was rising, if you were invested in fixed income, what you effectively were was a creditor. And an active creditor would go to Greece and say, ‘Greece, you have a problem. Your debts are rising, you seem not to be able to improve your situation; I will stop lending to you, or at least I will ask a higher interest rate for lending to you.’ That’s what an active creditor would havedone.
A passive creditor invested in a passive index that is market cap-weighted would have gone to Greece and said, ‘Greece, I have a problem: because you are becoming a large part of the index, I have to lend more money to you. So please, could you borrow more money from me?’ That’s what a passive investor is doing. And, ultimately, the whole thing comes down, and the passive investor and the ones that are invested in those stocks, and in this case in interest rates, lose.
Should we feel sorry for these people? Should we feel sorry for people who have lost money by having lent to Greece? Should we feel sorry for all those investors in stocks that lost a lot of money in the 2007-2008 collapse because of the credit crisis? Should we feel sorry for the ones that were invested in Internet stocks in 1999 and lost in 2001-2002? No. For two reasons: one is, okay, you can feel sorry for those that had no other way than being invested, for example, they had to be invested and their regulator also had said that the only way to invest is in those passive things. But every professional investor should have done his homework and should have seen that he was so highly invested in Internet stocks – so they were willingly taking that risk.
You could not be an investment advisor, and say in 2007, ‘Well, the risk is not high.’ The risk in stocks on long-only investing in 2007 was four and a half times as high as before. Anyone who is a professional investor could have calculated that and will have calculated that. But what they did do is say, as long as they stay with the index, it’s all right. No. The composer of an index is not doing risk management; you have to do that. The composer of the index is not doing the investment management; you have to do that. So that’s the first reason – they are willingly taking the risk.
Investors must accept responsibility for bubbles
The second reason, and the most important reason, is about why this Greek thing went up so much. Why wasn’t the interest rate going up? Because people were willing to keep lending to Greece. It’s because of those passive investors that kept lending to Greece, that the situation could get so bad. They should have said to the banks, ‘Hey, what you’re doing is very risky here right now – are you sure you want to do this?’ It’s partly the fault of the stakeholders of the bank; it’s the ones that hold the equity. If the ones that hold equity do not correct the bank, then yes, it’s their own fault they lose. Every bubble is caused by the ones that invest in it blindly. They are causing it, so they should not and we should not feel sorry when they lose because of it; we should blame them for creating the problem.
It’s the same thing for Internet stocks. It’s always the investor that is responsible for every bubble. That’s the whole idea of financial markets: investors should correct things, should say, ‘Hey, this is not going well; I should go away from there.’ Investors should say, ‘I do not want to be invested in nuclear power in Germany anymore.’ It should not be dependent on whether Siemens decides to stop doing it. It’s the investor that should decide that; that’s the task of the investor.
Part III – Conclusions
Passive investors are constantly exposed to a huge risk that is not taken into account. It’s assumed that it’s not there – well, it is there. It’s not being measured. You can do all kinds of calculations with an index, and you just suppose it’s right, but it is there: with all these things, you can measure it, and it’s not being managed. Investment management is about managing things, looking after things, making choices.
Active investor choices
If you don’t do it, well, everything is about changes; the world is changing – that’s the essence – and it will keep on doing so. The source of income will be from changes; that will cause all the future price moves. Is China growing? Will the currency become a much bigger part of our whole economy? Will it become comparable whatsoever? These things are going on; you cannot walk away from them by being a passive investor. You are there; you have to measure it, and you have to manage it.
This can only be done with an active investment style, and an activity that should include, for one, actively choosing which developments you want to participate in, and which you do not. Do I want to be largely invested in Internet stocks even though the companies don’t make money? It’s your choice; you do it, yes or no. It’s not a choice of the one making an index; it’s your choice.
How heavily do you want to be exposed to those developments, in risk terms? It’s your choice. Every investment is your choice. It’s your choice how large you want to be exposed. But don’t say later on, ‘Oh, I lost so much because the Internet came down,’ or the credit crisis.
No, it’s your choice as an investor to be invested to that extent on such a development. To do this, to make it possible to express those things in risk terms, you have to be using a non-standard risk measurement that assumes a changing world. Most of the generally accepted risk measurements – and those allowed by the UCITS funds – are not assuming a changing world. Your source of income can only be from a changing world, and you’ll use a risk measurement that assumes no changing world. There’s a misalignment here. You have to use a risk measurement that takes this into account.
Best execution and flash crashes
There are still people who feel sorry about investors losing in a flash crash. Why can someone lose money in a flash crash? Only for one very simple reason: because of being willing to sell at any price. Can you imagine you want to sell your house, and you say, ‘I want to sell it today, at any price.’ Currently, most orders that come into exchanges, buy-and-sell orders, are price insensitive. People may use an algorithmic strategy for doing that, but such a strategy will sell at any price if you do not feed it with a price limit. Most people don’t. They effectively ‘tell’ the strategy it has to be close to the opening, it has to be around the opening, it has to be done in the first ten minutes, it has to be done around settlement, I want to have the settlement price – all those things. But if you say, ‘I want to have the settlement price,’ it means ‘Whatever the settlement price is going to be, I’m going to sell it at that price.’ Those flash crashes only happen because people are willing to sell at such a low price.
On Black Monday 2015, there were ETFs on American stocks, S&P equally weighted, being sold on that Monday more than 20% below the price of the previous day. None of the stocks in those ETFs were that low, and the biggest rise of equity markets in 2015 was during the 10 minutes after that opening of the exchange, because then it went all the way back up. People selling thought they were invested in something that was liquid – yes, you could sell it immediately, but without any idea of price. If you are invested, if you own a house and you want to sell it, the first thing you look at is: at what price am I willing to sell; at what price am I willing to buy?
The whole market equilibrium theory is based on one thing: if the price is lower, more people are willing to buy; if the price is higher, more people are willing to sell. Only then do you get equilibrium. If there are more and more people coming in, in which the order is: ‘I want to sell, and it has to be done within 10 minutes; I want to sell but I’m checking, I’m using an algorithm that is volume-weighted, and I’m not doing more than 1% of the volume’. Yes, it sounds very good, but be aware, if 101 different investors, each with a completely different investment strategy, have decided to sell the same thing,
using exactly the same execution strategy, and they’re all limited to doing not more than 1%, and together they are willing to sell 101%, and if selling constitutes 101% of the volume, you can completely collapse a market. And that’s what’s happening every day. Every day we see markets make such moves – for a few seconds, the price is going up, or the price is going down.
Specifying limit orders
On Eurex two days ago, the two-year Italian bonds opened in an equilibrium, an auction at a price more than double the price of the previous day – for a two-year bond! Someone was there who said, ‘I want to buy,’ – it was only one company, but at more than double the price. You should never do that – if you sell something, you always say, ‘I want to receive this, and I want to pay that.’ You should never invest, you should never be active on a market without bringing a limit. You should never give your money to someone to invest for you who says, ‘We will sell it on the close, or we will sell it around the opening, or we will sell it within five minutes’ – nonsense! Anyone that is trading without having a price limit essentially says, ‘I’m willing to pay whatever price, as long as it’s the price around the time; I’m willing to sell against every price.’ And the people acting like that are the ones that are ruining the market, because they are completely disrupting the whole fundamental model of market equilibrium: that you want to buy, and you want to buy more if the price is lower, and you want to sell more if the price is high. This is what you have to choose. And if the consequence of that is that you are a little bit away from the index, then it’s good.
It all comes down to this very simple thing: active investment means that you are making decisions, and as an investor if you let the investment be done by someone else, he should be doing it, but you have to take the full responsibility for all your investment decisions. There are a lot of things being written about markets not functioning, and around Greek markets not functioning. Markets are not functioning if everyone is investing passively. If you are passive, you see that there’s no other place in society where being passive is good. Suppose you walk on the street and you see a child is crossing the street without watching. Do you grab the child to prevent him from running before a car, or not since you are a ‘passive walker’, walking your most efficient way from A to B? Being active is being responsible. Being passive is being irresponsible, hoping that the market will do the work for you; it will not.
You cannot be a passive investor and you should not want to be a passive investor. But if you really want to be a passive investor, there is only one way you can achieve that: do not invest at all!. Good luck.
Answers to questions from the audience
Question regarding the higher costs of active investments
Passive investors are free riders
There is too much focus on costs disregarding price. Suppose you go to a baker and you want to buy a piece of bread, and then you ask the baker, ‘What is the cost of you selling me this?’ And the baker says, ‘Well, that’s five cents, and the price of the bread is two euro,’ – expensive bread, five cents. And then you ask the baker, ‘Do you have a cheaper one?’ And the baker says, ‘Yes, I have one priced at three euro, with only a one-cent cost.’ Well, let me take that one. That’s what is happening in the market these days. There are a lot of those things saying: well, considering the indices, I’m doing just as well as the other ones.
Suppose you’re on a big ship and the ship is sinking, and you are on a life raft, with 20 other people on that boat, and 10 people can row. You can make a choice and can conclude: the ones that are rowing and the ones that are not rowing end up at the coast at the same moment. So why would I row? It doesn’t help me.
Well, if no one rows, you will not get ashore. So saying that being active doesn’t help you compared to others is not a good reason for being passive, because it means that everyone is irresponsible and nothing will happen. The whole point with functioning markets is founded on there being enough people that are active. And if there are not enough investors that are active, the ones that are passive, the ones that are the parasites that want to profit from the ones that are active, these will lose money too. They still will maybe not do worse than the other ones because everyone is losing, but it all has to do with market functioning: you have to be active, otherwise the market as a whole doesn’t function.
It’s the same with working; in the Netherlands there are people who say, ‘I don’t have to work because then I get social benefits.’ Of course it works, but if everyone would do that, I don’t think there would be social benefits. If you are an investor, do you want to get social benefits, or do you want to earn something? That’s the choice you have to make.
Question: In 2007 the risk in a passive stock index was much higher than in 2005; how large is it right now?
Changing patterns of correlation
How large active risk is, I cannot know; it’s changing constantly, but be aware, you have to measure it, and you don’t measure it by looking at the index. If you are invested in an index, you are invested in a basket of elements, and the correlation between these ingredients is changing almost constantly, and they can change to a large extent now and then, which has been the case because QE had a big impact. It was the case because of these banks becoming bigger and bigger. It was the case because of the IT bubble. But that’s constantly happening: these changes to the correlation are growing, and becoming smaller again.
Question regarding inferior performance after 2008
Increasing correlations between markets post-crisis
There have been a number of things happening since 2008, for instance QE and so forth, which have made a change in the world that has caused markets to become more connected with each other than before. One factor can really dominate almost all markets; that wasn’t the case before. Even in 2007, when people were talking about the credit crisis – everyone said it started in 2008, but everyone that talks about the credit crisis in 2008 is a stock investor. The real credit crisis started in 2007, but it was mainly interest rate markets. During that period it was the case that the fixed income investors and the equity investors were living in completely different worlds: things could happen in one asset class that barely impacted on other asset classes. That is not the case anymore. Also not where it really should be.
What has happened with all kinds of things, like risk management becoming large or leveraging companies, is that markets have become much more directly correlated with each other and have started to react to the same things. I think in May 2012, you saw all kinds of markets coming down. It was a kind of risk-off move, and even commodities were coming down. For instance, corn futures were coming down, while at that same moment it was very dry in the US; there was absolutely no reason for that market to come down.
At such a moment, our means of being largely diversified stopped functioning, and we had to come up with improvements to take account of the fact that markets are getting more disturbed by each other. As they disturb each other, it’s becoming much harder to find real diversification, and the system has to be more robust to still recognise that, yes, okay, this corn market is now doing something, but if we just look at corn, we don’t even see that something is happening there; before, we could see that. So, we had to improve. And we succeeded in improving.
If you look at the first six weeks of this year, there was one comparably big move; a big sell-off, and everything was just one market, essentially. It didn’t matter what you were looking at, stocks or interest rates or the dollar, it was all one big market. But due to the lessons learned in 2012, the improvements we made in response to that, we could cope with this situation much better. And again in June, when during a few days, almost everything was about Brexit. But the system did very well. Without the improvements, that would not have been the case. Before it would, but before, it was easier. Markets changed. So, we had to change as well.
A Disconnect in Global Markets
A summary of current market views
Crispin Odey, Founding Partner and Portfolio Manager, Odey Asset Management, London, UK
In the early Seventies, the trading system built on Bretton Woods started to crack. Thanks to the costs of the Vietnam War, the USA started running a large current account deficit. Production which had happily been running along at 3.5% per annum fell to under 1% and the developed world’s obsession then with full employment meant that wage increases of 6% suddenly became inflation of 6% per annum. By the late Seventies many were predicting the death of capitalism. But just then steps forward Milton Friedman and a world dominated by free market determination of prices and we enter a new 30 years of growth. What cemented the new regime was that in the Anglo Saxon world at least, privatisation of credit was instituted at the same time. As individuals gained access to leverage in a world that was globalising, individuals became richer (thanks to asset price inflation) even if their incomes were constrained by growing international competition. However, by 2005 asset price inflation and the expansion of the balance sheet had created a world in which wage earners could no longer afford the asset prices. The reaction of the authorities since then has been to lower interest rates so as to support asset prices and intervene via QE where appropriate. However, none of these policies has been good for growth. Productivity in the West has now fallen to almost negative rates, investment has stalled and individuals have turned against globalisation. This is a long answer as to why Brexit was always likely to be popular in the UK. It also lies behind Trump’s possible success later this year. Without productivity growth, capitalism becomes unpopular, globalisation becomes unpopular and politicians become unpopular.
The last couple of years has been all about the attempt, especially by central banks, to prevent the deflationary forces from taking hold. We have watched them go way beyond their mandate, but it’s proving less and less effective in promoting growth. Increased credit growth with negative productivity only results in economies effectively eating their capital. Elsewhere when you see the Bank of Japan buying 5% of the stock market with printed money, it seems strange that nationalisation has so quickly been reinstated after ‘privatisations’ were the mantra of the last 30 years. When will central banks realise that monetary policy which holds up asset prices whilst growth disappears actually exacerbates the divide between the Haves, who own the assets, and the Have-nots, who are losing their jobs?
It is always dangerous to fight the Fed and that is what we have been doing this year. The world economic growth continues to disappoint despite the benefit of lower energy costs. Corporate earnings in most parts of the world have continued to fall and now the USA is experiencing falling earnings. My thinking this year was that stock markets would follow earnings. What we did not expect was that markets would re-rate massively into an earnings downturn. Moreover, it still seems to be a re-rating which is not supported by hopes that earnings will soon recover but only by the monetising undertaken by central banks. The quest for yield explains 100% of this year’s performance. Quite apart from the pain that this policy is bringing to pension funds, insurance companies and banks, it has ensured that individuals have been buyers of dividend streams which are not underwritten by earnings streams. There is nothing sustainable about the current status quo.
Already we have seen, since the crisis of ’09, central banks expand cash in the system by around 700%, so that cash now is closer to 100% of GNP up from 13% of GNP, when things were normal. No one will ultimately trust fiat money again, but the fact they have gone so far, means that there is no way back for these guys. We saw that, in the UK, Carney’s reaction to a Brexit result, which immediately took 10% off the trade weighted value of sterling and was the equivalent of a massive monetary expansion anyway, was to lower rates and increase QE. All assets responded to the bubble machine. But next year will be a different one for the UK economy. The balance of payments could show a 10% current account deficit. Inflation could easily be 4%, or if not, real wages will take the equivalent hit. Investment uncertainty will take its toll. Fiat money may meet its nemesis then.
Since it is the central banks who are responsible for the bubbles, it is no surprise that the epicentre of the bubbles lies in the sovereign bond markets. After all, $14 trillion of government bonds now have a negative yield up to 10 years. Whilst world GNP stands at around $75 trillion, M2 now stands close to $83 trillion, the stock markets are close to $75 trillion, bank lending somewhere in the $140 trillion range and government bonds at around $40 trillion. No one is spared.
The bulls on equities argue that sentiment remains negative even as stock markets hit new highs. However, we worry that earnings and prices are going in different directions. Take the UK equity market. Since 2011 the earnings for the FTSE 100 companies have fallen from 500 to 119 currently or nearly 80%, whilst the stock market has risen by around 10%. That would be okay if we were at the beginning of an upcycle but indications point to a peaking in demand for most production. This peaking is coinciding with new capacity coming on stream. No wonder sentiment is a little off-colour.
Investors are being driven to invest further and further from home. Keynes wrote in the Thirties that “people should travel, goods should travel but savings should never travel.” I never understood that remark until now. The developed world has always had a surplus of savings because on the whole capital is protected and labour is not. In the developing world they are always chronically short of capital because labour is protected and capital not. Sadly savings, thanks to QE, are going into a place where the odds of their survival are slim. Who is responsible for these irresponsible policies?
We think that the Republican presidential candidate Donald Trump would do much better if he could only moderate some of his statements. He appeals to a lot of people, who have the feeling that in the past 30 years, their life has got much worse, and they have not had any of the benefit of the glut of money. At the same time, the rich are doing better than ever. That is why Trump likes to criticise the Federal Reserve.
The result of the Brexit referendum was a vote against the political class. Politicians must respond to that. Theresa May’s job will be a difficult one. Leaving the EU will drag on for years. During that time, Europe will change.
It would certainly be simpler to follow the market. But then we would be ignoring the fundamental data. At present, we are selling insurance shares. Interest rates can hardly go any lower. The credit cycle and with it, economic growth, will be more difficult and all asset classes are simply overvalued. At the same time, the insurance industry lacks capital, and the financial regulators would like to see more of it. In the boom years, the dividends paid out were too high. At present, we would only pay 0.5 of book value for insurance companies. However, in reality, the book value is about 2.5. We are not very enthusiastic either about Swiss watchmaker Swatch, or video-on-demand operator Netflix.
Hedge Fund Strategy Focus
Merger arbitrage; deal spreads and flow are key
Steven R. Gerbel, Founder and CIO, Chicago Capital Management, Chicago, USA
Pure, plain vanilla, merger arbitrage
Merger arbitrage is a systematic attempt to profit from publicly announced merger transactions where a definitive agreement has been signed and the financial terms of the merger have been publicly disclosed. This is probably one thing that disturbs me the most about running a merger arb fund; a lot of my competitors claim to run merger arb funds, but they do a lot of things other than merger arbitrage.
Merger arb is simple. A deal is announced. Somebody’s going to buy a company for $50 in cash. There’s a big pop in the stock; it goes up to $49. It is at this point that we start to get involved in the transaction. We start to look at the transaction from various aspects to try and capture that dollar of spread. Then it usually takes three to four months on average for the merger to be completed.
That is merger arbitrage. It’s not glamourous. It’s not an extremely complicated strategy. But it does take a great deal of discipline in order to employ that strategy. The reason why merger arbitrage exists, and why it makes so much sense, is merger arbitrage funds provide liquidity for those investors who don’t want to take the risk that the merger might fall apart by acting in a similar manner as to how a pool of insurance policies might work.
If I can create a large portfolio of positions that are similar to the example I just mentioned, publicly announced deals, I know the terms of each merger.
I can calculate the approximate rate of return I’m going to receive on the investments before I even make them. In my example, I know I’m going to get $50 in cash, with a very high degree of certainty
in 3-4 months.
Taking a bunch of those investments and putting them in a pool makes a great deal of sense. It provides liquidity to the individual whose company might have been sold just a few minutes ago, or a day ago, unexpectedly. Original long-term investors can get out of their large positons. We provide other investors with liquidity at that inflated price that might have changed their lives without having to assume the deal risk of making that last 2% left in the trade.
It just makes a lot of sense for both the buyer and the seller. From the merger arbitrageur’s perspective, this is a trade that can be entered into with a pretty high level of certainty. Approximately 98% of the transactions we invest in are completed. The 1%-2% that fall through are where you have to manage things and where the risk comes in.
Style drift: ‘rumourtage’, SPACs, warrant arbitrage, option hedges, legal arbitrage
What is merger arbitrage not? What are my competitors doing out there that they claim is merger arbitrage and it’s not? They buy and hope. I have a lot of competitors out there that will go into stocks on rumour. I call it “rumourtage.” They’re hoping that there is going to be a deal for $50 cash, when the stock opens earlier in the day at $25. They’ll buy it at $30, $40 a share, on the hope that a deal will be announced. That’s not arbitrage in my mind. That’s fundamental investing, with some good news that occurred, and where you may or may not get lucky and as a result be able to make a great deal of money.
Arbitrage, in my mind, the way we do merger arbitrage, instils a level of certainty, or an extremely high probability that that relationship will work out. When you’re in the buy-and-hope mode, you don’t have that high percentage, that high degree of certainty.
SPACS: A lot of my competitors also invest in these Special Purpose Acquisition Corporations. SPACs are great. SPACs are wonderful. They’re created mostly for entrepreneurs to go out and raise a lot of money. When the entrepreneur finds a company to purchase they use the money in the SPAC as equity to obtain the financing necessary to pay for the acquisition.
Sometimes it happens, sometimes it doesn’t. When it doesn’t happen, the cash is returned. Some of the merger arbitrage players will go out and they’ll invest in these SPACs under the premise that they’re probably not going to get a deal done in the last two, three, four months. The merger arbitrage player is then betting that they’ll get their cash back, and hopefully, they’re buying the stock at below the price at which they’re going to get the cash back. So it makes sense. You can make money doing it. But it’s not merger arbitrage, and that is my point.
Warrant arbitrage: I’m sure you all know what warrants are. Very similar, where they’ll go out and invest in warrants hoping the stock goes up so they can sell their warrants at a premium to where they purchased them.
Stock positions hedged with options: This one drives me nuts. There are some very large merger arbitrage funds out there, one specific publically traded mutual fund comes to mind, that have investments in Google and Yahoo and other things that have absolutely nothing to do with merger arbitrage. That fund has structured warrant positions around their large stock positions that are unrelated to merger arbitrage just to make sure that they don’t lose money on the position. So if you’re running a $5 billion fund and you have a bunch of these positions in your portfolio, and you’re not going to lose money on them because of the way you have your options structured, it creates a very consistent rate of return. Zero. It allows you to continue to collect your management fee.
Legal arbitrage: There are a lot of guys who do merger arbitrage that will go into trades, like the Office Depot-Staples transaction, which you may or may not be familiar with, after the merger had received a tremendous amount of antitrust scrutiny. The arbs would then go to court each day to determine if the merger was going to be completed or not.
In my mind, you’re no longer investing on the premise that the merger will be completed under the original terms in the original timeframe prescribed when the deal was announced. You’re now into attempting to guess if the judge agrees with the companies or the anti-trust regulators.
The issue that comes to mind here is that in a lot of these situations, the hedge fund managers, in my opinion, are much smarter than the government. They understand the topic better than the judge will ever understand it because they’ve followed it for years. The arbs are very educated on this topic. Furthermore, in my opinion, I think the world would be a better place if the hedge fund managers got to decide, as opposed to the judge. But the reality is that the judge, with less education, fewer resources and so forth, in a limited amount of time, has to make this determination. As a result, I feel that these types of trades are kind of like a coin flip, in my mind. There are just too many variables to make an educated guess.
Those are tough cases. A lot of people follow them. I’ve seen what I thought were obvious cases go the wrong way. In such a situation, the probabilities go down drastically that I’m going to be right. They go from me being 98%, 99% sure that the deal’s going to go through when it’s announced when I make my original investment, to being 60%, 65%, maybe 70% sure that my trade is going to go through. And it produces a much less certain outcome. It produces a lot more volatility, and it’s just something that we stay away from.
Then there are the newest, latest and greatest ETFs out there buying the target. Of the new ETFs, there’s one specifically that I’m aware of where they just go out and buy the target. The company that’s being taken over, that’s what they buy. They then simply hope that it goes up. That’s not arbitrage. That’s buying in a selective group and hoping it goes up.
At Chicago Capital Management, we don’t do any of these. I don’t care what merger arb fund you invest in – in the future, I would highly encourage you to ask these questions when you meet with them. If they do invest in any of these methods, because you certainly can make money investing in all of these ways, it’s not arbitrage.
A bond substitute?
So why should you invest in merger arbitrage? Merger arbitrage produces consistent, positive, absolute returns regardless of the market climate. In running merger arbitrage funds for 23, almost 24 years, I’ve been involved with a fund that’s been down only two years. It’s not glamourous. Our strategy produces a consistent rate of return over time, with a very low volatility structure. It’s perfect for those who are maybe looking for an alternative to bonds in this environment, and so forth. But that’s what it produces.
One of my clients, years ago, summed it up really well for me. He’d been invested in the fund for five years. He told me that his organisation gets together every quarter, so that’s 20 meetings in five years. When they get together they talk about the funds that are up the most. They talk about the fund that’s down the most. They talk about the funds that are negative. They talk about the funds that have all the volatility. In five years, 20 meetings, my company’s name had never come up. Never been discussed. Why? Because we’re positive. There isn’t much volatility, really. It’s boring, is how he described me.
That story kind of struck me. There was also an article written about our fund, one year. The title of the article was ‘Boringly Beautiful’. At first, I was kind of taken aback by the term boring. Then I thought, you know, this makes a lot of sense. It’s exactly what we’re trying to create – that consistent, month-after-month profit. Nothing anybody’s going to jump up and down about until you string numerous months of profit together. Sure, once in a while we get an overbid, and we make more than we expected in a transaction, which is great. We’re always open to that. But it really is just a grind-it-out type of strategy, where if you can do it consistently, it can produce long-term, consistent, stable returns.
The volatility of equity markets and the low interest rate environment has prompted many investors to embrace alternative sources of investment returns. That’s what we’re here talking about: the consistent, positive rates of return that can be produced with low correlation and low volatility.
Because if you’re buying a company, the company that was in my example earlier, where you are paying $49 for a stock that is being purchased for $50 in cash – I come in after the deal’s been announced, and I purchase it for $49 dollars. It’s the time value of money. If it’s going to take a hundred days, I’m going to make about a penny a day on that transaction. It’s very consistent.
Sure, some days, it might be down a little bit because somebody’s trying to sell. It might be down a few pennies. Some days it might be up a few pennies, because they got their proxy approved, or they’ve got some antitrust approval or they got some other type of approval that was pertinent to the transaction. But over that three to four month period in an average deal, you’re going to make your dollar. It’s pretty simple.
It’s a strategy that provides a differentiated source of returns. When analysing each deal we focus on the probability that a deal will close, rather than on company performance. This is a big one, which I don’t think a lot of people, a lot of investors, spend enough time on or take into consideration enough.
In my example, if the market goes up or down, I purchased stock at $49 and I’m getting $50 dollars in cash. If the market goes up or down, it’s not going to matter. I’m still going to get my $50 dollars in cash. Sure, it matters if the market crashes. I’ll give you that. Everything changes if the market crashes, or if the market goes down 20%, 30% in those two months. But the majority of the time, it’s going to be a nice, boring, consistent trade, which is going to be in your portfolio, and you’re just going to make your money.
The strategy provides a market-neutral return stream, again, if the market goes up or down, which can be good or bad. There are certainly the years where the market’s up 15%, 20% , and I’m producing 10%, 12%. and my investors are like, hey, why didn’t you make more money? You’ve got to take the good with the bad. We make positive returns when the markets are down, and we do all right when the markets are up. We’re never going to end up 15%,20%, 30% per year. It’s going to be hard to keep up with the S&P.
How should a merger arbitrage portfolio act? As I mentioned earlier there should be very limited volatility from outside forces. What the ECB does. What the Federal Reserve does. What everyone does – if they raise a quarter of a point or not, it doesn’t really matter to this strategy. It’s almost irrelevant in the short term. Over the long term, it does matter. Over the long term, it will change the rate of return that we’re able to make.
Hedging stock for stock deals
No correlation. Another thing that keeps the portfolio from being extremely volatile is that all stock swap transactions should be hedged as much as possible. I mentioned the ETF earlier that I’m aware of that only purchases the long side of merger transactions. It’s going to be volatile. It’s going to go up and down with the market because of that long bias to that portfolio. A fully hedged merger arbitrage fund should not experience this type of volatility.
In contrast, we hedge portfolios as much as possible. So if it’s a stock swap, let’s say I’m getting one share of the company’s stock at $50. We’ll replace the cash with stock. So I’ll buy one share of the target. I’ll short one share of the acquiring company, or whatever the corresponding ratio is. I will lock in that trade. I will lock in that dollar of profit.
Again, if the market goes down, I’m going to make money on my short, and I’m going to lose money on my long. But it’s going to be at the one-for-one ratio. It’s going to offset. So it takes that market volatility out of the trade for that stock transaction.
So if you hedge it as much as possible, if you know the ratio’s one-for-one, you hedge it one-for-one. If we know we’re getting $50 in stock at the end, based on a 20-day pricing period, let’s say, then I will buy the stock at $49. When the 20-day pricing period starts, I’ll short 5% of what I need to short every single day, to lock in that profit, to replicate that ratio of, foreseeably, one. I will short 5% every day and we’ll make that money. The profit will then be locked in.
That is merger arb. I’m not out there saying, oh, I’m not going to short my 5% today, because the stock’s down, and I think it will go up tomorrow. That’s not merger arb. That’s not arbitrage, in general.
My last point here is that cash transactions should not be hedged. Over the years, I’ve had a lot of discussions with investors. Some of them feel I should have an overall macro hedge on cash transactions. I disagree with this philosophy, because what I think should be the macro hedge, and what you think should be the macro hedge, are never going to be the same. When the market goes down, my idea was not as high as your idea, and you were right.
So my theory is that if I don’t hedge, every investor knows exactly where I stand. If the market implodes 25%, 30%, and I’m not hedged, you know that ahead of time, and you can take action when you feel it is necessary or appropriate. You always know where I stand. So that’s why I’ve always taken the position that the cash transaction should not be hedged.
So the volume in 2015 was very good. We saw a lot of deals. In other words, the dollar volume of the deals was up to the $2.5 trillion mark. We had 11,000 M&A transactions announced.
Again, the 11,000 is a little bit of a misnomer, in that there aren’t 11,000 investible transactions. Those are just transactions that occurred and were reported by Bloomberg. Those include all kinds of things. But you get a sense for the deals. 2014 was a good year and 2015 was a good year. Now we’re in 2016, and it’s not going to be as good as the previous two years, but it’s going to be all right.
Corporations seeking M&A for growth
There are certainly plenty of transactions out there for a smaller merger arbitrage fund to invest in. We have lots of choices. We’re not forced into a corner, where there are a few transactions and we have to play them all. We’re not, by any means, a merger arbitrage index at our organisation.
The current M&A environment is unique, to say the least. The corporations out there have cut out pretty much as much fat as they can. The private jets, the enormous salaries and bonuses – they’ve already cut back all those expenses. Now they’re getting to a point where they need to grow.
They need to show some growth. There have been limited opportunities. I feel that a lot of companies, specifically in the US, are struggling to find that growth right now. With cash as low as it is, you have companies issuing debt just to issue debt. I mean, if you can issue debt at negative rates, why not? That is my opinion, if you’re running a company.
So they’ve got tremendous amounts of cash on their balance sheets, and they’re getting pressure now to use that cash, to do something with it. Shareholders are saying, ‘If you’re not going to do something with the cash, return it to me. Give me a dividend.’ In the US, dividends are taxed at a much lower rate than gains. So they say, ‘Give me the cash in a dividend. Let me go do something with it. Ifyou’re not going to use my cash, I’ll use my cash.’
Hostile bids to increase
So you’re seeing more and more pressure for people to do things, for corporations to do things, to engage and get that growth. The easiest way to get the growth is through M&A. Then it gives them a whole set of synergies from the merger that they can then extract costs out of, which they’re good at, because they’ve been doing it for the last four or five years, to improve their profits in that manner. Corporations need a growth path, and increased, unsolicited deal activity is likely.
What I wanted to get into at this point is that there are a lot of companies out there right now that have approached their optimal target. The company they really want to buy. They have approached them, and they’ve tried to make it work, and it hasn’t. Now, we’re starting to see a little more of an aggressive tack from some of those companies. I think in the coming months and years that you will see more hostile deals more aggressively conducted. The targets will be more aggressively sought. I’m hopeful that this will lead to some increased deal flow.
Right now, deal flow continues. The improving market conditions to increase economic growth bodes well for M&A. Improving market conditions – in the sense that if you want to do a deal for stock, right now, a lot of the acquired stocks are at all-time highs, or very close to all-time highs. Their currency is worth as much now as it’s been worth in years making it easier for management teams to pitch deals.
Small US banks ripe targets
Especially in the banking industry, where I do a lot of work, a lot of the old guard banks, such as small community banks in the United States, are targets. We have about 8,000 banks in the United States, believe it or not. Those small community banks, those individuals, those older gentlemen, like my father, have been waiting to sell their bank at an all-time high. That’s their goal. They want to go out at an all-time high. They want to go out at a price that exceeds any trading price their stock has ever traded at, so that they can say they did a good job, and they can retire in happiness.
It’s starting to get close for a lot of these guys. And what do I mean by getting close? They’re getting close because they’re getting old. Their expectations are finally coming down. My father is 82 and still goes to work every day. They need to sell this bank because they just can’t do it anymore. It’s going to start to occur. I think you’ll see a pickup. We have seen quite a few bank mergers in the last five to 10 years, but I think the trend is going to pick up even more.
It’s that activity in the small to mid-size range that is our bread and butter, what I like to play in. When you get into the Office Depot-Staples, or the big medical insurance companies out there that are in the process of merging right now, you get into antitrust, and you get into all kinds of legal issues that make it much harder to get that deal to pass through and to get the regulatory approvals necessary to complete the deal.
In the smaller market cap M&A arena, you’re not going to have much of a problem getting an antitrust approval with 8,000 banks out there. I mean, it’s incredibly likely approvals are going to occur. When there is a merger in the banking industry specifically, very defined metrics are used to determine if an antitrust situation occurs or not. It’s very black and white. It’s not a question of what the market is in the banking industry. It’s a matter of deposit concentrations and things of that nature, which are easy to calculate, very black and white, and you can almost always rest assured that those deals are going to go through.
The final point here is that the cash deals will continue to be the preferred structure. If you can go out and buy a company that is making money, that is profitable, and you can take some expenses and some costs out of that from the synergies, and borrow at ridiculously low rates, in my opinion you don’t have to be very good to make money or to make your merger work. It’s a much different environment than it was, say, 15 years ago or 20 years ago when I got into the business.
Deal spreads are attractive. Four to eight per cent is probably a little aggressive now. But about 3-6% are the cash-on-cash returns we’re finding out there right now. A lot of that is coming from the smaller banking world.
As I mentioned earlier, the firm I run has about $175 million. We’re not a billion-dollar organization. We can invest in those small, little community banks. We can make enough in one of those investments to make half a percent, let’s say, or a quarter of a percent. We can find enough liquidity to do that. A lot of the billion-dollar shops won’t even look at those trades.
So I’m investing in the smaller transactions where there are higher rates of return because there are fewer competitors. There’s less risk because I don’t have to worry as much about the regulatory risks, because one mom-and-pop bank on some corner in Oklahoma in the US merges with another one, and there’s basically no regulatory question there at all in my opinion. I mean, they’re not going to control any market or anything like that.
As I mentioned, approximately 98% of the transactions we would invest in go through. We haven’t been invested in a deal that actually broke while we held it in about four years. We just don’t put ourselves in that situation. We don’t have to.
Now, some would argue that we’re missing out on some opportunities and probably would be better off buying one or two deal breaks and investing in the bigger transactions. The spreads/profits that we would be able to realise would more than make up the amount of money that we would lose in the deals that don’t go through, and I would be better off. That’s arguably true. However, the volatility that would be created from that, and the uncertainty, it’s just not worth it. It’s just not worth it when you’re trying to build a long-term franchise, in my opinion. We’re trying to provide the consistent rate of return for those investors that might be looking to get rid of some of the bond exposure.
So, we have improving valuations, rising confidence about the economy, and the willingness of companies to make deals, without question. We talked about how valuations are going up. The confidence that companies have, you obviously feel better, you’re more likely to do a deal or get involved in a merger transaction when your stock is at an all-time high. Your investors are less likely to question you. It just makes sense.
We’re heavily invested in the financials. It is by far my favourite sector to be invested in.
Many of the foreign investors that we speak with, when they’re looking at a merger arbitrage fund, they’ll always want to know the attribution. They’ll want to know where the return’s coming from, what segment. They always want to know why we’re so heavily invested in the financials.
Small bank deals have lower deal break risk
Imagine your banker. Your family bank or whatever. Your banker is probably, I’m guessing, very conservative. He probably doesn’t take a lot of risk, and so forth. That’s the same attitude bankers use to approach mergers. These guys do a tremendous amount of work on their mergers. They have calculated everything out. They’ve gone through the whole loan portfolio. Many times, I hear on conference calls, we’ve looked at one hundred percent of their loans. We’ve been in their office. We had a team of people in their office for three to four weeks, and we’ve looked at every loan in their portfolio.
There are very few surprises. Loans, in most loan portfolios, don’t go bad overnight. Usually, it takes a year or two. The financial industry, the smaller bank industry, where I spend a lot of time, is very predictable. You really can get a sense as to where that industry is going. If you’re investing in that, in the merger arbitrage sense, it’s a very safe place to be.
In the 24 years I’ve been investing in merger arb, I’ve had two bank deals fall apart. I’ve invested in thousands of these transactions. One broke because the acquirer’s stock imploded in 2007, and the target said, fine, we’ll call off the deal. We’re better off. Their stock went up the day the deal fell apart. So it was a positive.
So again, it goes back to my attempt to create the most safe, consistent, positive rate of return I can possibly create. That’s how I think of merger arbitrage, in general. That’s how it should be done in my opinion.
Probably the single most important thing for when you’re looking at a merger arbitrage fund is the risk management. You don’t want to see huge positions.
Some of the larger funds have a different take than I do on this. I’m sure they would have agreed with me when they were smaller. However, now that they’re larger, they can’t own the smaller trades that I can put in my portfolio, which right now has about 35 positions in it, 35 mergers that we’re invested in. A lot of those are not going to move the rate-of-return needle for the large merger arbitrage funds. The large merger arbitrage firm has to deal with a much smaller segment.
So, if I were you, looking to invest in a merger arbitrage fund, I would look at their portfolio. I wouldn’t want to see any position larger than 15% of their fund. If it is, I would ask some questions. They’re going to tell you that they did great research, and so forth, and that they know everything, and they’re highly competent, and they have a high degree of confidence that this merger will go through, and so forth.
Justifiably, they’re right. Ninety-eight, ninety-nine per cent of deals go through. The problem is that they’re operating in that top echelon, and they’re ignoring the deals that are smaller, because they have to. As a result, their probabilities are actually higher than that or, their probability of being invested in a deal that runs into regulatory problems, or something, is actually significantly higher than the average stats.
A few other metrics for you, when you’re looking at a merger arbitrage fund. The top five positions – they really shouldn’t represent more than 50% of the gross value of the longs. The short positions are there for the stock mergers. If there isn’t a short position, ask if they’ve got some options against their position, to protect them.
You want to avoid the troublesome trades, obviously. You want to stick to the stable trades that are going to produce the absolute rate of returns, and that are going to generate the returns you’re looking for. All right, here’s a typical merger arb spread. This is from a while ago. Virgin Media was bought by Liberty Global. For each share of Virgin Media, you were entitled to 0.258 shares of Liberty A, and 1928 shares of the Class C, and 17 dollars in cash. The transaction was announced on February 5th, and the transaction closed on June 7th.
You can see that, in a perfect world, the spread would be a perfect line to zero. We put it on at $1.40, and we ended up making $1.40 over the timeframe. It annualised out to a 22% rate of return on that trade. That trade also implies some leverage. So it’s mathematical. That’s the point I want to get to. Merger arbitrage is a very neat strategy that works very well over time.
Here’s another one. Ithrew this one in for The Heinz Company. It was bought by Berkshire Hathaway. Again, there’s always some volatility in the spread. There are always some things, like there’s an institutional seller, there’s some news, or whatever. However, at the end of the day, you make the money you expect to make.
In this case, it was $72.50. We bought it around the 72 mark when it went down. The original spread was very tight, because, of course, it was Berkshire Hathaway buying them for cash. There just wasn’t much there as far as due diligence you needed to do on it, if Berkshire Hathaway had the cash to complete this transaction or not.
You got a couple of dividends, so you’re picking up an extra dollar here. So it’s 72 dollars and 50 cents, plus approximately another dollar. A little more than a dollar in dividends. You’re really walking away with $73.50, or a little bit more. Again, over the life of the deal, which for this one was 166 days, it came out to an annualised return of 10%, almost 11%. Without that much risk. So, again, we did pretty well.
So merger arb is a niche strategy. It works extremely well if done correctly. It tends to be very safe. The volatility isn’t there. Things like the election we have going on in the US – or clown show, if Trump wins, or if Clinton wins. Yes, that will affect things a little bit. That will affect which deals get done. If Trump wins, I like to say that he’s going to build a 20-foot wall and in Mexico, Home Depot will probably get bought, because they’re going to start selling 21-foot-tall ladders to get over that wall. They’re going to make a lot of money. You’re going to want to own them.
You know, if Hillary gets elected, you’re going to see a lot of noise in the drug space. If that plays out, there will be a great deal of change. How it plays out will be very interesting. But where there’s great change, there’s great opportunity.
And that’s where the smart CEOs, and so forth, they’re going to go out there and they’re going to do deals. They’re going to pick up and take advantage of those situations, and they’re going to make money. We’re going to be right there with them, doing the arbitrage on their deals, making money with them.
So it works. It’s a low-growth, low-volatility strategy that works. Over time, as long as you have those expectations, all will be fine.
Hedge Fund Strategy and Special Situations
A fundamental approach to investing
Peter M. Schoenfeld, Founder, CEO and CIO, P. Schoenfeld Asset Management LP, New York, USA
Our firm, PSAM, was founded almost 20 years ago. Our roots are very much in the merchant banks, and our team has a real passion for transactions. Our strategies are based on seeking to understand and anticipate the dynamics of how corporations in the market enter into transactions that could lead to major corporate events. Those major corporate events can take many different forms.
Prior to founding PSAM in 1996, I was vice-chairman of Schroder & Co. USA, in charge of their proprietary trading activities, which consisted predominantly of various kinds of arbitrage strategies. I’ve been investing in this space for over 40 years. My entire career has been spent looking at these complex kinds of transactions: restructurings, M&A, distressed credit opportunities, spinoffs, and a whole host of other kinds of exotic situations.
I’ve always had a fascination with trying to understand the game theory under which corporations have battles for corporate control and the way they deal with problems in their capital structure, and ideally, how companies can look to optimise those capital structures as they come out of stressful situations.
In our view, PSAM has a deep bench and a strong investment team (including four portfolio managers) with significant investment experience. All of the PMs have one common interest driving them, and that’s that they share my enthusiasm for analysing complex situations. Nine members of our firm are partners.
As a firm, we think globally. That is a longstanding orientation, and we believe it should allow for us to source a diversified set of ideas on a regular basis. We attempt to distil the sample of global opportunities that we see into a portfolio that we believe provides the best risk-reward opportunities for our investors. Since inception, we’ve maintained an office in both New York and in London. In fact, our London presence dates back to my Schroder days, so I and other members of the current PSAM team have been involved in London since 1986. We’re as comfortable looking at situations in Europe and the rest of the globe as we are in the US.
We generally follow an absolute return strategy, meaning that we are looking to capture a potential spread between the value that we see in the individual companies that are undergoing large corporate events and where they are trading at a specific point in time. In addition, we seek to achieve an attractive return, relative to the risk we are taking, by trying to maintain a bond-like type of volatility. And obviously, we attempt to outperform bonds by a good margin.
We believe our ability to identify opportunities in both equities and credit, across multiple geographies, should help us to source investments through a variety of market conditions. Essentially, we aim to have an evergreen investment approach, which we believe should provide opportunities to put capital to work, no matter where we are in an economic cycle.
The common discipline that runs through all our strategies is transactional analysis and an appreciation for the regulatory environment and tax regimes under which companies operate. For example, even though several companies may be within the EU, each country has a different takeover code. Typically, the antitrust laws are a little bit more uniform in their interpretation, but there are real distinctions that exist. Having the expertise to interpret the nuances of each country on a local basis, I believe, is a distinguishing factor.
What we pride ourselves on is the work we do in attempting to duplicate the work that the companies themselves are doing in trying to reach decisions on whether or not to merge or whether or not to spin off various parts of their business. From our perspective, doing a very deep dive into the possible outcomes and having a scenario analysis as to what the possible outcomes are, is key to having the confidence to build large positions.
We often get involved in friendly and unfriendly takeovers. Sometimes, we are involved in strategic transactions and at other times we examine or participate in financial transactions managed by various private equity and leveraged buyout firms. The merger arb weighting in our portfolio fluctuates with the flow of opportunities and the embedded returns we believe are available in announced transactions. While the headline number for M&A volume is down year-over-year (2015 was a record year for deal volume), the level of activity through the first half of 2016 still exceeded the level of announced activity during the same period in 2014. We expect the flow to continue for large strategic transactions that are primarily equity financed. Unless confidence in the board room shifts to recessionary concerns or capital markets deteriorate more meaningfully, we believe the flow should continue.
Our special situations strategy encompasses investments where companies are working to make changes, but they’re not as all-encompassing as an M&A transaction. In many cases, these events are designed by the companies themselves and can involve anything from a spin-off or a divestiture to significant management, tax or regulatory changes.
At other times, these changes are forced upon the company by institutional holders, hedge funds, activists, and others finding fault with governance issues and how management is behaving.
Stressed and distressed credit
Stressed and distressed credit is also a large focus for our firm. Usually, stress to a company is brought about because of the amount of leverage a company has put on its balance sheet. A business may be extremely attractive, but its balance sheet may need to be addressed and restructured either in or out of bankruptcy.
Investing across the capital structure and on a global basis
This is a hallmark of our investment approach. We believe one of our greatest strengths is the level of collaboration we have between the PMs across our various disciplines.
Typically, at least 50% of the investments we make have a non-US side to them, in the sense that either the transactions are taking place abroad, or they’re cross-border transactions, which are becoming much more popular today. We’re seeing a lot of cross-border activity lately.
We think our style of event driven investing lends itself to outcomes that are less predicated on the market direction and more on outcomes tied to specific events unfolding at a company that could increase shareholder value. A portfolio of idiosyncratic event-driven situations should be characterised by low correlation to market movements.
If you take a step back and look at what has taken place over the past month and in many instances since I arrived in Germany this week: Monsanto has received an improved bid from Bayer, Fresenius has gone out and made some significant transactions themselves, and GE made a bid for SLM Solutions, a 3D printing company. E.On is spinning off Uniper Group, RWE AG is engaged in spin-offs themselves and ThyssenKrupp is in negotiations with Tata. This is just a microcosm of the environment that we are in and why we are so excited about today’s investment opportunities.
Activism, spin-offs and special situations: activity and outlook
In 2015, there were 132 activist campaigns. Most of those are not your high-profile activists. These are really campaigns that are run by institutions that are concerned about compensation issues, or about the basic structure of the board – managements having both CEO and chairman-of-the-board roles. The targets of these campaigns were quite large. The average target market cap was $14 billion.
We have some very quirky laws in the US where you cannot sell a division or you cannot sell a subsidiary without assuming a tax at the corporate level. That’s totally inconsistent with what happens here in Europe, where you are able to sell a division and not be taxed at the corporate level.
In the US, corporations have to go through some intermediate kind of transaction of this nature, where they first have to spin off the company. They have to let that spin age for a period of time before someone can come in and make a bid for that company without incurring a tax at the basic corporate level. It’s a real disadvantage under the US tax code, compared to the flexibility that most companies have elsewhere around the globe. But it is an intermediate transaction that can create, in the special situations category at least, some fairly significant opportunities.
Yahoo: discreet activism
Yahoo Inc. and Alibaba are names we’ve been involved with for a very long period of time, dating back to 2011 when Carol Bartz was still the CEO of Yahoo. The company had terribly underperformed its peers for an extended period of time.
We were originally attracted to Yahoo because of the value we ascribed to the company’s Asian assets (Yahoo owned a 40% stake in Alibaba Group and Yahoo Japan). We also believed there was a path to realise this value in a tax efficient manner. We believed investor fatigue with the perceived lack of progress by the company in realising value of these assets had weighed on the stock for many years.
We had written letters to the board well before other funds surfaced with their own approaches to extract value. We maintained a dialogue with Alibaba all along and they ultimately agreed with us; they came to want these Asian assets pulled out of Yahoo, so they weren’t fully controlled. Alibaba and Yahoo Japan made up nearly 90% of the value of Yahoo for a long period of time.
We were very constructive; working behind the scenes, communicating with the board and their advisors as to what we thought was the proper methodology for the disposition of certain holdings. Ultimately, the company did sell some of Alibaba, very early and for a lower valuation than they could have gotten had they waited. And our knowledge of the company provided an entrée to participate in a pre-IPO private placement of Alibaba. At the time of our original investment in Alibaba, our analysis of the overall e-commerce market in China indicated that the market could triple over a three year period. We were firm believers that the leading e-commerce company in China had price and operating cost ratios that would allow it to maintain its dominant market share in the Consumer to Consumer (C2C) and Business to Consumer (B2C) market segments.
Additionally, we believed an eventual IPO by Alibaba would provide the company a currency to help achieve meaningful growth in new global markets.
We derived additional exposure to Alibaba though an investment in Softbank Group. In addition to owning stakes in Sprint Nextel Corporation at the time and Yahoo Japan, Softbank also owned 32% of Alibaba. We bought shares of Softbank and hedged out some of its public components of the company. We also held hedges in the Tokyo Stock Price Index (TOPIX) against the position. In doing so, we believe we were able to create additional exposure to Alibaba at a meaningful discount to what we believed the company was worth.
Vivendi: public activism
A little over a year ago, we ran a proxy fight against Vivendi. We have been in the security since 2012, when the company owned a variety of entertainment and telecommunications assets and was subject to a credit downgrade. We believed the company’s stock price was trading at a discount due to this holding company structure and because there were no synergies between the media and telecom assets.
Vivendi committed to a number of asset sales in its effort to reshape itself as a smaller company focused on content and media. Over time, Vivendi successfully divested itself of stakes in assets such as Activision Blizzard Inc., Maroc Telecom SA, French phone unit SFR and Global Village Telecom (GVT).
Despite following through on transactions that we believed would unlock value, including the multiple asset sales, reducing debt and committing to returning capital to shareholders, Vivendi shares traded poorly. Beyond the return of capital, we believed the music industry was approaching an inflection point with growth in streaming and subscriptions outpacing the decline in physical sales. We thought Vivendi would benefit from this dynamic via its ownership of the world’s biggest record label, Universal Music Group, which has a stake in streaming operator Spotify and had already realised gains on an investment in Beats.
Our thesis, which we articulated in our white paper on Vivendi, was that Vincent Bollore, who had slowly crept in and taken virtual control of the board, was looking to distribute a modest amount of capital to shareholders after creating a huge cash coffer post asset sales. We didn’t think having $30-plus billion of value in his hands was the right way for this company to operate.
Under French law, if a company attempts to distribute a dividend, it must be ratified by the shareholders. We solicited proxies against his dividend policy, came out and asked for at least an additional $4 to $5 billion of cash to be distributed directly back to shareholders, and for the company to institute a stock buyback programme in addition to the cash distribution over time.
We were going the distance toward the vote. I remember distinctly being out of the office and getting a call from Vincent Bollore asking us how we could settle our differences. In the end, we reached a resolution, which largely went in the direction that we wanted. That was a fairly exciting proxy fight. We received a lot of press here in Europe and, in the end, I think all shareholders came out better, as a result.
The stock initially responded well, however the company has recently underperformed as investors continue to grapple with endorsing the ambitious direction the company is taking through new acquisitions and stake building.
Deutsche Telekom AG (“DT”)
Back in October 2012, MetroPCS Communications, Inc. (“MetroPCS”) announced a merger with T-Mobile USA (“T-Mobile”), a subsidiary of DT. In that merger, MetroPCS shareholders would receive 26% of the combined company and a special dividend of $4.09 per share prior to closing. The surviving entity was to be the already public MetroPCS, and its shareholders would have been enhanced by the addition of the T-Mobile assets, but diluted by 74% of its pro forma stock that would be issued to DT.
We believed the structure of the initial transaction was unfavourable for MetroPCS shareholders. We addressed our concerns over the deal in a letter to the Board of MetroPCS in February 2013, which we then made public. In our letter, we highlighted our dismay at the amount of leverage, what we felt was the above market cost of the interest rate on the intercompany debt and the exchange ratio for the equity split. We filed definitive proxy materials urging MetroPCS shareholders to vote against the initial transaction. In our view, it would have been better for PCS to remain a stand-alone company while examining opportunities to consummate alternative transactions than to accept the package of cash and securities initially offered to MetroPCS stockholders.
In March 2013, we met with proxy advisor Institutional Shareholder Services Inc. (“ISS”) and detailed our concerns over the initial deal structure. Later that month, ISS issued a report recommending shareholders vote against the initial proposed transaction.
One month later, DT announced a sweetened bid for MetroPCS by reducing the debt on the new entity by $3.8 billion, in-line with the $4 billion debt reduction we requested, while also reducing the interest rate on the intercompany loan from DT by 50 basis points. Finally, DT also agreed to extend the lock up period on their shares to 18 months following consummation of the deal closing. Based on this positive development, PSAM withdrew our proxy solicitation campaign opposing the proposed combination and the deal closed at the end of April. The revised terms were nearly identical to those we suggested as a “win/win” solution in our original letter to both boards of directors. We held onto our position in T-Mobile post completion of the transaction. In fact, I believe today, if you were to call up DT, or call up MetroPCS, I think they would agree that we were constructive to the process and T-Mobile has done exceedingly well in the United States in competing with some of the major carriers. Certainly, T-Mobile has far exceeded Sprint, and only has two competitors to speak of in Verizon and AT&T.