Acacia Capital Management

Bringing in-depth due diligence to long/short equity

BILL McINTOSH

The long-term emergence of China from stagnant peasant dictatorship to an economic powerhouse, albeit one directed with exacting discipline by the central government, is only in mid-story. For investors, the difficult task is figuring out how to best get exposure, while ensuring adequate risk protection. A variety of assets reflect the China boom. Some, like real estate in Hong Kong, have been easy for foreigners to acquire and have proven vastly profitable. Others, like so-called ‘red chip’ shares in Shanghai, remain largely off limits to outsiders and have been extremely volatile.

Ryan Weidenmiller, the founder and portfolio manager of Acacia Capital Management, has managed money in venture capital and equities in China since 2002. In a recent interview, he discussed investing in China in light of the current economic backdrop.

Weidenmiller’s track record in venture capital with Susquehanna International Group features bringing a dozen Chinese companies to market in the US through initial public offerings, raising $7 billion. During this time, he concurrently managed a several hundred-million dollar long/short equity fund for Susquehanna.

IPO background
Among the IPOs were Home Inns, the leading budget hotel operator, now with over 1,400 hotels, Giant, a leading online game developer, and Bona, a movie producer and distributor. They underscore Weidenmiller’s expertise in technology and media which, along with consumer, services, basic materials and energy, are the key investment areas for the long/short equity Acacia Master Fund, Ltd.

“The recent deprecation in the RMB is an interesting signal to heed,” says Weidenmiller. “It really does speak to the fact that the wage pressure in China and the export-led nature of the economy have put pressure on the growth trajectory. It is worth paying attention to since it shows China is not a one way bet.”

Indeed, the negatives for China don’t stop there. With Europe its biggest market, a breakup of the single currency could make China something of a negative beta play. All of this is going on against a backdrop of massive investment in infrastructure. So-called fixed asset investment (FAI) has risen dramatically from 40% of GDP in 2003 and now accounts for over 60% of GDP (See Fig. 1).

Transition to consumption
The trick for China is to make the transition over the next two to five years from FAI to an economy more driven by domestic consumption. The level of consumption has actually declined relative to GDP in recent years as FAI has grown. Rebalancing and keeping China stable with slower growth amid heavy debt issuance of local government bonds will be a tricky challenge for the Beijing authorities. Using a global long/short approach is thus sensible. In 2011 and until June of 2012, about 30-80% of the fund’s exposure was in China-based companies. The remainder was in listed stocks offering exposure to technology and China-related themes. Companies that trade in Canada and Australia, for example, are included as resource plays, a type of exposure that began to be increased in 2010 and has since been reduced.

After a number of years pursing venture capital opportunities, Weidenmiller refocused on public markets. From 2006-07 investment poured into China and other emerging markets, leaving a situation, he felt, where too much money was chasing too few venture capital opportunities.

The Acacia strategy aims to bring a venture capital mindset to analysing public companies via obsessive due diligence and finding quality management teams that can execute. Analysts build proprietary DCF models using a bottom up, valuation-driven approach to discover large market dislocations among different possible plays that are then sized and re-sized opportunistically to take advantage of catalysts. The book is typically concentrated, containing some 15-40 positions. It looks for companies that can stay in control in industries that look structurally well placed and offer 25-40% upside.

Current positioning
One sector judged attractive is natural gas. This is due to rampant pollution inflation and declining coal prices in China.  

At the moment, Acacia holds a sizeable cash position as the mangers evaluate new opportunities on the long side. Acacia recently cut a significant amount of their China exposure due to a belief that US-listed Chinese ADRs are fundamentally flawed in their underlying variable interest entity (VIE) structures.

VIE allows Chinese companies to circumvent foreign ownership restrictions in certain industries, such as media or education. The structure allows a local Chinese person or company to hold the license for the restricted industry and pledge revenues to a foreign-owned subsidiary. The contractual nature of the revenue pledge is different from pure equity ownership, which represents a residual claim on the assets after debt and lien holders. The structure has worked well for over a decade, but is now under scrutiny.

Short side
Acacia’s stock shorting is done on a strictly bottom-up basis, looking for companies that are overvalued by 25% or more. Individual stocks, rather than index futures, are preferred.

Being shorted are a number of e-commerce and tech names with high growth expectations built into the model and consequently carrying high valuations. Typically, the catalyst for a short position would be a fall in earnings.  

“E-commerce companies in China have been high-flyers, but the profitability of the business continues to deteriorate, as the barriers to entry are very low,” says Weidenmiller.

Additional shorts include cement manufacturers, glass producers, and property developers on the basis of Weidenmiller’s thesis that China’s fixed asset investment must slow. There are also a few targeted shorts in financial services and solar-power products manufacturers in China.

Historically, the fund has had average net exposure of 20-30% with the gross around 120-130% since inception in December 2008.

Annualised returns from inception in December 2008 to June 2012 are 14.7%.