Making Event-Driven Strategies Work in Latin America

The inside view

Ricardo S. Maxit, CIO, Copernico Capital Partners
Originally published in the February 2005 issue

Investors familiar with Latin America have come to accept volatility as an inherent characteristic of the region. This is due to the relatively small size of some of the region's financial markets, and the corresponding lack of liquidity, particularly in times of crisis. It is also a result of the periodic unexpected events, either endogenous or exogenous, that seem to have an inordinate impact on the region's securities prices – witness the Mexican debt crisis of 1982 and the Russian debt crisis of 1998, both of which had an equally devastating impact on Latin American investors at the time.

Why do traditional volatility management techniques fall down?

Traditionally, the way to deal with volatility in Latin America has been simply to avoid the region as a whole, or to try to time the market by investing when the fundamentals appear to be compelling and exiting as things begin to deteriorate. Unfortunately, as many have learned, market timing in Latin America has proven as difficult as it is elsewhere. Quite frequently, the uninitiated tend to invest after the markets have already run up, when the region begins to appear in a favourable light on the front covers of the world's financial press. They exit only after the subsequent crash, often provoked by factors external to the region itself, when the market is at its most illiquid and hence lowest point. This is clearly not a recipe for success. On the other hand, the buy-and hold strategy has frequently failed to produce better results, as the graph below of the Ibovespa in US dollar terms indicates.

Having said all of this, Latin America has been and continues to be a region from which astute investors can extract substantial returns. This is due in large part to the fact that markets in Latin America, at least as compared to more developed markets, are still imperfect in terms of both information flow and the analysis of available information. The result of these two phenomena is miss-pricing of risk. For those that can evaluate risk correctly and structure investments to take advantage of this, the returns are often far greater than they would be in more developed markets.

An example of this is in the area of merger arbitrage. In developed markets, information is so widely disbursed and rapidly acted-upon by such a large number of investors that the spreads in a typical merger arbitrage deal rapidly narrow to the point that currently it is an uninteresting strategy. In Latin America, however, merger arbitrage deals have been so few and far between that they have simply not attracted the attention of the vast majority of investors. As such, when they do occur, few players are in a position to seize the opportunity, or to properly evaluate the risks involved. Consequently, the spreads tend not to be arbitraged out as they would be in more developed markets. For those that are properly structured to take advantage of this, the returns can be quite attractive.

Traditional Methods for Dealing with Volatility

It's getting too crowded in here

In today's competitive marketplace, hedge fund managers are under pressure to produce the kind of double-digit returns to which investors have become accustomed. This has become increasingly difficult to accomplish in a large number of the more traditional strategies which have become over crowded. Many of these strategies are arbitrage related, and as in the example above, depend on initially wide spreads that will close over time, resulting in gains for those investors that are astute enough to spot the opportunity at the outset. In addition to merger arbitrage, this is true for convertible arbitrage, or even for some of the more event-driven strategies like distressed debt investing.

When there were relatively few players in these strategies and a good supply of opportunities, the supply and demand equation was favourable for those with the know-how and technology to produce a good stream of returns. As more and more money has flowed into hedge funds, and in some strategies as the supply of opportunities has diminished (witness the decline in merger and acquisition activity in 2001 and 2002), the equation has reversed.

Confronted with this dilemma, investors desirous of performance have had to seek out managers who tend to be smaller in size, as measured by assets under management, and who can operate in a niche that has not yet become overcrowded. Ideally, these managers also possess some kind of specialized knowledge or expertise and have put in place an infrastructure that is not easy to duplicate, at least not quickly, so that there are additional barriers to entry once it becomes apparent that profits are to be made.

Far from the madding crowd

Event-driven investing in Latin America still has mileage, it is a niche exploited by few managers. As an example, we have been successfully exploiting this niche since 1999, as evidenced by a compound annual rate of return of 12.8%. In fact, in 2003 and 2004, our flagship fund, the Latin American Strategic Fund was up 31.2% and 18.9% respectively, and the more recently-launched Argentina Fund, which is now closed to new investors, was up 38.8% (for 11 months) and 24.4% respectively.

Is such performance sustainable, and how was it achieved? Part of the explanation is the supply/demand equation. While there are many funds in Latin America that focus on the long-only side, either in equities or fixed income, there are very few players that focus on "non-directional" event-driven situations. As Latin American markets have typically been very volatile, the performance of the long only funds can be breathtaking during boom periods, but hair-raising during bad times. There have been a number of these cycles over the past two decades in Latin America. It not only takes a strong stomach to invest in them, but at the end of the ride, the returns are often deceptive, and frequently viewed as not worth the risk. This is even more the case for those investors who tend to come into the market only as a bear market is ending and they inevitably sell, in disgust, at the trough.

A key element of our strategy is risk control. Early on in Copernico's life, our partners discovered the dangers of over concentration of the portfolio. As a result of the events of September 11th, 2001, we suffered our only negative year with a drawdown of 6.7%. While by Latin American standards, this result is not bad, it went beyond the limits of what was acceptable to our partners. As a result, a full revision of Copernico's risk controls was implemented which has since proven effective.

While event driven investing is in theory non-correlated to the general direction of the markets, it is important to hedge against market movements that may have an impact on event driven positions in the short term, i.e., before the catalyst materializes. In the event that the catalyst does not materialize, always a risk in event driven investing, it is important to build in as much protection as possible. The market for hedging has improved dramatically in Latin America over the past decade, and although certainly nowhere near as deep as in developed markets, we regularly takes advantage of all the tools that exist. In terms of protection against completion risk, and other risks inherent in our positions, we rely on diversification, position limits, tight stop-loss controls and many of the tools such as VAR that are commonly used by hedge fund managers anywhere.

Capacity in Latin American event-driven investing

The events on which we have focused thus far are typically corporate situations that will produce a catalyst to re-price a security either up or down. These may include the stocks of companies that are being acquired, bonds that have put or call provisions in the event of a change of control, or shares in companies that are likely to engage in repurchase programs. While admittedly the number of these opportunities in Latin America is more limited than in the more developed markets of US and Europe, so are the number of players than can spot them and have the know-how to successfully exploit them. The big merger arbitrage guys don't look at Latin America and the Latin American funds typically don't know how to do merger arbitrage so when an opportunity comes up, there are very few who can take advantage of it, and that is where the spread comes in.

In order to identify the opportunities, as well as do the homework essential to evaluating the risks involved, we rely on an internal team of 15 people, including six specialist portfolio managers, plus a well-developed network of contacts throughout the region, in New York, and in London. This network of contacts has been built up by the three partners of Copernico, all of whom have been operating in the Latin American markets for over twenty years and have seen the good times as well as the bad. We like to think that one advantage we possess is that we typically do not talk to brokers, but rather to other portfolio managers, both in local markets and in international houses.

A great niche to be in, but will it last?

For the moment we do not see a lot of competition in sight. There are a few players who are very good at this approach with specific Latin American expertise, and it is not a market that lends itself easily to waves of new entrants. The barriers to entry, starting with knowledge of the languages (our partners are fluent in Spanish, Portuguese and English), include local contacts, trading experience in what are frequently somewhat esoteric instruments (e.g. bonds issued by Argentine provincial governments), and a specialized research team capable of analyzing and understanding local contracts, regulations and corporate documents.

Even if other hedge fund managers could put together this expertise, it is unlikely to be worth it for most of them, since the market capacity is relatively limited. We currently have $250 million under management, and feel that it can grow to about $500 million before running into capacity constraints. The Copernico Argentina Fund, which was launched in February 2003 to take advantage of restructuring opportunities in Argentina after the devaluation and debt default, is already closed at $61 million. For the moment, that is all the capital, combined with the allocation to Argentina from our more broad based Latin American Strategic Fund, that we feel the market can handle. Obviously we will re-evaluate this as the situation in Argentina develops and the market changes, but for the moment if we want to keep our returns at or near their historical levels, we prefer to be smaller rather than grow too fast. This is what our investors expect of us and we intend to deliver.

So while many hedge fund mangers are becoming increasingly frustrated with overcrowding in their markets, we expect funds like ours will continue to focus on the relatively sparselypopulated niche represented by event driven opportunities in Latin America. For the moment at least, the returns seem to justify attention.

Copernico is a specialist in event driven and momentum strategies. It was founded in 1999 and currently has US$250m under management. It has 2 funds. It flagship fund is the Copernico Latin America Strategic Fund with US$140m – a multi-strategy vehicle with event driven focus – has had an annualized return of 13% since inception. It was also selected by CSFB Tremont in October 2004 as a constituent of its new Emerging Markets Investable Hedge Fund Index. The Copernico Argentina Fund, with US$61m, has had an annualized return of 33% since inception.