Audley Capital Advisors

Bumper returns for a more refined form of activism

Originally published in the March 2011 issue

In the 1990s activist fund managers fought many legendary battles, winning more often than losing. Tactics and the managers who deployed them were audacious. The reputations created then have passed into investment history on Wall Street and in the City.

Julian Treger rode that wave either side of the millennium as a co-founder of ActiveValue, the pioneering European activist firm that targeted companies as diverse as Liberty, the retailer, and Pilkington, the glass manufacturer. Activist managers then tended to be forceful with target companies. The aim was to make a lot of noise, get management’s attention and burnish the activist manager’s reputation.

“In the 1990s activism was a new thing,” Treger says in an interview at Audley Capital’s Mayfair boardroom. “You really had to bark a lot – and bite a bit – to be heard. There was a struggle between shareholders and managers. The tendency at the time was for institutional shareholders to sell and go away if there was a problem rather than engage. But during the 1990s there were a series of skirmishes and ultimately those culminated in the Enron scandal.”

The changes post-Enron saw corporate governance get stronger and the need to engage in battles with management correspondingly reduce. Even so, Audley Capital Advisors LLP, founded by Treger and Michael Treichl in late 2005, has prospered mightily. The flagship fund it advises was ranked the top performing event driven fund in Europe for three of the last five years by EuroHedge and was nominated for both Best Event Driven Fund and Fund of the Year in 2010, also by EuroHedge.

The performance of ActiveValue was also strong, returning 17% on a compounded basis during its 1993-2003 lifespan, giving it a 400 basis point outperformance of the equity market over the period. Despite that, Treger began to see how the traditional activist tactic of hostility during the 1990s carried within it the seeds of underperformance. “Because you are an aggressive hostile activist, your fearsome reputation is your main tool and you do things from an investment perspective that are not necessarily always rational in terms of the particular investment even if they are rational in terms of the reputation of the firm,” Treger says.

“Normally in investing you should run your winners and cut your losers. But as an activist if something is going well you feel that that is not what people are paying you to do, so you sell your winners. But if something is not going well you have to stick there and fight because if you are defeated by the management then you have become a declawed lion. You tend to run your losers and cut your winners, which is the opposite of what you normally should do in an investment.”

So, in an effort to develop a more management-friendly brand of activism, Treger teamed up with private equity investor and veteran M&A banker Michael Treichl, who had spent his entire career working with, rather than fighting corporate executives. Together they conceived an investment strategy based on constructive engagement with management teams. It means that Audley always aims to engage with corporate management and establish a communication channel before investing. Among other things, this improves the quality of information available to the portfolio managers.

Targeting value
Audley has a value-driven investment style and uses best practices from a number of different investment disciplines. The firm’s edge is comprised of: attention to detail, a private equity style due diligence, a deep value approach to investing (in the mode of Benjamin Graham), an understanding of macroeconomic trends and several decades of experience. “Friendly activism is quite a skill,” Treger says. Adds co-fund manager Treichl: “You need experience to judge situations and understand what changes can be achieved, where agendas overlap with management.”

“I think if you have a more medium-term time horizon there is also less competition and more opportunity to earn outsize returns,” says Treger. “Obviously you have to make sure you are picking situations where you aren’t going to fall on deaf ears or where there aren’t controlling shareholders who don’t want to cooperate.” According to Treichl, this is a more flexible model: “We are not control freaks. We tend to focus on situations where you can work with other shareholders to bring about corporate changes that we think make sense.”

Audley remains interested in European listed companies that are exposed to BRIC growth. The idea is that it is easier to make money out of China and India, than in the countries themselves. Focusing on the commodities story involves seeing where the resources will come from and then getting funds in early to build positions. The focus extends to BRIC infrastructure plays like OPG Power Ventures, a London-listed power generator based in India.

In late 2010, Audley gained notoriety for his involvement in Walter Energy’s $3.3 billion takeover of Western Coal. A structured financing from funds advised by Audley was instrumental in rescuing Western from insolvency in late 2007. Treger subsequently took a seat on the board. In early 2008, devastating floods swept Australia and the price of coal soared. Audley managed to persuade Western Coal to retain Morgan Stanley to “evaluate strategic options” – investment banking jargon which often means putting a company up for sale. The stock price rocketed to nearly $10 from $0.50. But when financial markets crashed and the sale didn’t get completed, Western Coal plunged to $0.44. But then in the fourth quarter of 2010, again with the help of Audley, a sale was announced at $11.50/share. Since then, the firm has been spending time getting more involved with Chilean silver and gold mining equities and companies such as EBT Mobile, a Chinese mobile services retailer and one of just six Apple Computer Inc. distributors in the country, where Treger expects a float or sale to a trade buyer at some point over the next 12-18 months. In the interim, true to its style, Audley continues to work closely with management to plan for the next stage of growth and the longer-term positioning of the business.


A watershed year
It would be an understatement to say that 2008 was a difficult year for most hedge funds and Treger was no exception. The fund which he advises suffered from a lack of liquidity in the markets and depressed valuations in many of its mid and small cap plays.

“What we said to investors at the end of 2008 was that the fund was fundamentally worth much more than the market value because the market value was very depressed by the panic and illiquidity of a lot of our positions,” Treger recalls. “We told them: ‘If you stick it out for the next three years, we strongly believe the fund will be worth much more then than it is worth now.”

Audley turned out to be right and in the process the firm followed what could be viewed as a text book case of how to communicate with clients. Its investment team updated investors each month about the intrinsic value of the positions and the potential uplift – calculations that showed the portfolio was worth about three times what it was then trading at. In addition to being transparent, the fund cut management and performance fees to 1.5% and 15% (from 2% and 20%) to reflect the fact it was asking investors to stay the course. A side pocket was also set up for the minority of investors who wanted to liquidate, and now many of these investors are choosing to recycle their capital on return to the ongoing fund.

“We couldn’t call the bottom of the market,” says Jolie von Arnim, head of marketing and investor relations. “But we knew December 2008 was certainly not a time when you wanted to start dumping assets. The fund rebounded faster than anyone could have anticipated. Investors became much more confident. The fund has no issues now with liquidity and ultimately it executed on what it promised.”


Special opportunities
Audley is cautiously exploring other niches of the alternative investment world. “What we try to do as a firm is to identify niche opportunities where there are competitive edges where we don’t see investment managers offering the particular expertise where we can differentiate ourselves,” says Treger.

One example is a new partnership in the natural resources arena with Lucio Genovese, an ex-Glencore executive based in Zug, who brings deep mining knowledge and an expansive network. With 25 to 40 investments, this strategy is intended to be more diversified than a typical activist fund. In effect, Treger expects to apply a light form of activism to some of the small cap holdings in the fund, but not to the relatively small stakes it will hold in mid-cap and large cap resource stocks.

Another example is a private equity fund focused on distressed investing in Europe. This venture is at an early stage, but Treichl expects significant opportunities to emerge in this arena during the next two to three: “In 2012-14, there will be a $1.8 trillion bulge in repayments on leveraged loans, 40% of that in Europe.” He adds, “Given the likelihood of some upward movement in interest rates, default rates are bound to increase and that looks to us like an attractive opportunity set.” Both Audley founders have plenty of experience in this field: Treichl was closely involved with the restructuring of Head-Tyrolia-Mares and Treger with Signet, both highly complex but successful transactions.
Distressed is skill-based and very labour intensive so they are considering partnering up with one or two other senior private equity investors with a background in distressed investing. “We are not looking at a debt trading fund,” says Treichl, “That’s a very crowded field, but there are few if any funds focused on special sits in the distressed space in Europe.”

One other niche product involved a joint venture with a convertibles trader to offer a cash enhancement product to a French company. That saw the client get a double digit percentage return instead of the 30 basis points it had been earning.

Insurance opportunities
Treger also sees a niche opportunity in specialised insurance. Audley has helped Caspar Gilroy launch a private equity vehicle based in Guernsey to acquire long tail insurance liabilities, including employer’s liability/workers’ compensation, in order to create finality for the corporate. The first client in Europe was Morrisons, the FTSE 100 supermarket chain. Gilroy had previously purchased one of the largest non-life insurance run-off’s in the London insurance market called Minster Insurance Group (owned with J.P. Morgan). This private equity venture successfully sold an insurance company last year to Berkshire Hathaway’s National Indemnity Company (“NIC”). It also created the world’s first independently rated (AM Best A- rated) prospective retrospective insurer in Europe named Grafton, which NIC backed with a 50% quota share. Gilroy and his team are looking to start a US version of Grafton in the third quarter of 2011. Not only is the strategy very specialised, it also has a different payoff profile than the hedge fund products Audley advises due to the returns being uncorrelated to equity markets.

Experienced team
Audley currently has seven professionals in London focused on investment origination and execution. They come from different backgrounds, including investment banking (M&A, financial sponsors), private equity and distressed. Most are fluent in two or more of the main European languages, and graduates of elite schools like Oxford, Cambridge, Sorbonne and Columbia abound, neatly complementing the founders’ Harvard education.

“The skill sets of this team are very much corporate finance and fundamental value investing,” says von Arnim. “But if we see interesting opportunities which we think are compelling we will partner with an expert who can complement our skill set.”

Investing and risk management
For Audley, the most important part of risk management comes before an investment is made. “Our process is fairly granular, more like in private equity,” says Treichl. “We will spend weeks or months on a project, talking to industry analysts, getting the views of managers we know, bringing in consultants and so forth. We then make our judgement, based on all these different perspectives. That judgement is more important than data room-type diligence which often just gives you a false sense of certainty.”

The firm also believes its investment process benefits from the different backgrounds and experience profiles of its founders. If they can’t agree, the investment is not made. “We may miss out on opportunities because of that,” says Treichl, “but we are also less likely to have train wrecks.”

An important part of Audley’s process is to consult with large institutional shareholders in a company ahead of investing. In some cases, this may extend to determining whether those shareholders would be willing to work with Audley on corporate changes or some form of restructuring, including putting the company up for sale. “We know the long only investors and they understand what we do, so generally we can avoid high-profile campaigns and stay behind the scene, which is much better,” says Treger.

The firm is also in the process of hiring a new head of risk management. One area where risk management is expanding is in the use of dynamic hedging to offset expectations of a bump up in volatility in 2011 and beyond. “There is no doubt risk management has become a much more important part of the broader fund management business in the last couple of years,” says von Arnim. “Our beefing up in that area reflects this.”

Bias to real assets
Treger played retailing and media during the early 1990s after their over-expansion in the late 1980s, but Audley is now biased toward bricks and mortar, and firms that offer fundamental value through exposure to real assets. Treger also thinks real estate may offer some interesting distressed opportunities but not, perhaps, until 2012 after interest rates have increased.

“We avoid the unknowable, the unfixable and the overpriced,” says Treichl, “so we’re going to be very careful about investing directly in markets where we don’t understand the valuations. There are plenty of companies in Europe with proprietary know-how or strong brands that are going to benefit from BRIC growth without getting copied or clobbered on price.”

Treger adds, “Ultimately you want to buy things that are trading at price earning ratios below 10 and EBITDA multiples in the mid single digits or less,” says Treger. “We ideally like to see a potential uplift of 40-50% over two years.”

“I think people who invest in this sort of strategy and philosophy are going to be people who want to make money,” adds Treger. “The financial sector is polarised between the majority who just don’t want to lose money and a minority who really want to make money and are willing to tolerate high levels of volatility in order to make consistently higher returns. Also it is more interesting to us as investors.”

Treger’s take on the market is that it is in a melt-up phase. A 20 year bond bull market is ending and investors are starting to rotate money out of the bond market. Since cash pays next to nothing, investors are being squeezed into equities and other hard assets. Moreover, inflation looks set to soar.

In this environment, Treger says that the Federal Reserve and the Bank of England will eventually raise rates even though they want to create some inflation. “When the rates go up there will be a period of dislocation particularly when investors apply those higher rates on the long end to sovereign wealth debt service payments,” he says.

”We think it is fair weather for the next six to nine months but then there will be this real period of dislocation. That period will accelerate the transfer of power from the west to the east. I think our themes remain intact but there are bumps on the road and we have to be nimble.”