Tages PSAM Credit Fund UCITS

Yield, event catalysts and shorts

Originally published in the November | December 2017 issue

PSAM celebrates its 20th year in 2017 and founder, Peter Schoenfeld, has been investing around corporate events for 40 years, heading up proprietary trading in banks before starting PSAM in 1997

From the outset, PSAM has had offices in London and New York. The firm invests globally, across US, European and Asian markets, and is often involved in deals with a cross-border dimension. PSAM has 45 employees including nine partners. The analytical style and compensation structure of the investment team encourages collaboration and promotes synergies.

PSAM focuses on event driven situations and invests in three main strategies: merger arbitrage, stressed and distressed credit and special situations. They seek out investments that can be impacted by complex and transformational corporate events, such as mergers, spin-offs, bankruptcies, liquidations and insolvencies. Exogenous factors like tax and regulatory changes can sometimes be critical. PSAM dynamically moves capital amongst these sub-strategies in their multi-event portfolios.

PSAM pursues activism to defend its interests as a shareholder or creditor. The firm has the gravitas to win an audience with – and win over – company boards, management and investors. PSAM has been both a discreet and a public activist. For instance, in 2011, PSAM began a private dialogue with Yahoo’s board around realising value from its Alibaba and Yahoo Japan stakes, years before other activists became involved. In 2013, PSAM’s proposed reconfiguration of the Deutsche Telekom AG/MetroPCS merger – articulated in a public proxy fight – proved to be very close to a blueprint for the final deal structure. In 2015, PSAM entered into another proxy fight, publishing a white paper arguing that Vivendi was sitting on too much cash, and attained the aim of Vivendi returning more capital to investors.

In credit, PSAM regularly plays an active role in pursuing in-court and out-of-court restructurings. This is often done via active participation in ad hoc groups of like-minded, similarly situated creditors. In the case of Linn Energy, PSAM and a group of bondholders negotiated a plan of reorganisation whereby existing unsecured debt was converted to equity and the group backstopped an equity rights offering to allow for a reduction in secured debt. At emergence, PSAM and four other funds in the group took seats on the newly formed Board of Directors. Since emerging from Chapter 11 in February 2017, Linn has engaged in an active M&A process whereby it has sold a significant amount of assets, created a joint venture, pursued stock buybacks and engaged in other value-enhancing actions.

Liquid alternatives
PSAM has built out a suite of products ranging from traditional hedge fund strategies, with quarterly liquidity, to more liquid offerings, with weekly dealing. The firm is committed to liquid alternatives. In September 2010, PSAM was one of the first US alternative asset managers to launch a UCITS fund. “Initially this was a tactical move to maintain relationships with European investors who stopped allocating to offshore structures post-crisis,” admits PSAM Partner and Head of Marketing and Investor Relations, Caroline S. Greenwald, who was featured in The Hedge Fund Journal’s 2017 ‘50 Leading Women in Hedge Funds’ survey in association with EY.

The firm’s first UCITS fund, the MS PSAM Global Event UCITS Fund, is a more liquid subset of PSAM’s flagship strategy, whereas the Tages PSAM Credit fund is a new investment strategy for the firm.

For the past 20 years, PSAM’s credit focus has been on stressed and distressed names whereas the Tages PSAM Credit fund invests in high yield and “is expected to have de minimis position overlap with other PSAM strategies,” says PSAM Credit Portfolio Manager, Peter Faulkner.

Tages International Funds UCITS Platform
PSAM is no stranger to UCITS and its MS PSAM Global Event UCITS has received The Hedge Fund Journal’s UCITS Hedge award for Best Performing Event Driven Fund, based on its risk-adjusted returns. For PSAM, Tages was a natural choice to partner with on a UCITS offering (and not only because a fund structure launched in May 2016 was already in place for PSAM to assume management of on 19 June 2017). PSAM has known principals at Tages for 15+ years and have always had a strong personal and business relationship. Tages Capital is amongst the leading seeders, having allocated over $900 million to 19 seed or acceleration deals. Tages Group oversees $18.8 billion of which $2.3 billion is in hedge funds and liquid alternatives, with over $500m in UCITS alternatives. Tages seeded the PSAM strategy and the Tages International Funds UCITS Platform has launched four other UCITS strategies: the Anavon Global Equity Long/Short fund; the Tages Cygnus Europa Event Driven UCITS Fund; the Tages Rotella UCITS Fund (a managed futures strategy); and the Tages Atreaus UCITS Fund (a discretionary macro strategy).

The Tages PSAM Credit UCITS has already obtained UCITS marketing passports in the major markets of Italy, the UK, Switzerland, France and Germany, and may soon add Spain. It can be invested in by both retail and institutional investors. An early bird fee discount (of 1.15% management and 10% performance fees) is offered for the institutional share class. The target is to raise at least €250 million. PSAM has substantial capacity in all of its strategies.

A distinctive perspective on high yield
The Tages PSAM Credit strategy has synergies with other PSAM credit strategies and applies the same fundamental research based approach. When analysing corporate events the team looks at the whole capital structure. PSAM views high yield through the lens of a highly discriminating and rather sceptical distressed investor, which is important when some of today’s high yield names were distressed not so long ago, and might become so again, for instance if they cannot refinance debt. “We look at a number of factors, like free cash flow, business relevance, liquidity, maturity schedules, credit agreements, indentures, covenants, corporate organisation charts to see where debt sits, and use of proceeds when subsidiaries are sold,” explains Faulkner, who joined PSAM in2002 and has been investing in distressed and special situations since 1983, formerly at Mutual Series, Alex Brown & Sons and MJ Whitman. Head of Credit Research, Phil Brown, brings incremental experience to the table. He previously worked for private equity firm Sun Capital Partners and event-driven hedge fund Buckeye Capital Partners. There are four credit analysts, including Senior Analyst Al Moniz, who has primary responsibility for the Tages UCITS fund. Moniz most recently worked at Fore Research and Management in New York for 14 years, where he was a Credit Portfolio Manager, focused primarily on US and European High Yield. During his tenure at Fore, he spent three years at the firm’s London office and focused exclusively on European credit. Before that, Al worked at KPMG Corporate Finance where he focused on middle-market technology M&A advisory.

Why high yield?
PSAM is of the opinion that high yield corporate debt is generally an attractive asset class. “US high yield has generated approximately the same total returns as US equities, with roughly half the volatility, over the past 30 years,” says Faulkner. Examining the worst recent period for both asset classes, the GFC, drawdowns have also been recovered more swiftly: high yield made more in 2009 than it lost in 2008, while US equities did not re-attain their pre-crisis peaks until 2013 (while the Euro Stoxx 50 remains below its 2000 and 2007 peaks). Additionally, high yield mutual funds remained liquid throughout the crisis, with the suspension of dealing by Third Avenue in 2015 looking highly exceptional.

High yield has not thus far proved to be well suited to passive investment strategies, such as index funds or ETFs, which have tended to underperform high yield indices by a large margin, sometimes as much as several percentage points in a year. Most active managers outperform benchmarks in long only credit strategies, including in high yield, according to research studies including PIMCO’s Bonds Are Different: Active Versus Passive Management in 12 Points.

Faulkner acknowledges that the eight-year bull market in credit is a long one, but the notion that it cannot last for longer than a certain number of years is arbitrary. Although yields are stretched – particularly in Europe – the absolute level of yield is historically low; credit spreads – over and above the risk-free rate – remain above the pre-crisis lows touched in 2006 and 2007. “Fundamentals are supportive, with reasonable economic growth, contained inflation and very low default rates outside a few sectors, such as energy in 2015, and retail more recently,” says Faulkner. Technicals are also supportive as Faulkner sees plenty of long term, institutional “real money” being put to work in the high yield market.

Improving upon long-only high yield
Nonetheless, given the relative tightness of spreads, Faulkner wants to have a meaningful short component – and the rising dispersion of returns within the credit market improves the opportunity set for both long and short credit selection. “Retail, healthcare, certain telecom and lower-rated names have been generally weak in late 2017,” Faulkner observes.

PSAM’s strategy carries out fundamental, in-house, greenfield research to identify event-driven catalysts, and selectively hedges and shorts, to the end of providing better risk-adjusted returns than a long only approach, with moderate correlation to, and less downside volatility than, high yield indices. The objective is absolute returns, not relative value, hence the benchmark is a spread over risk free interest rates and not a high yield index. The gross return target is about 4% above a blended benchmark of short term US and European interbank interest rates. Most of the return (about 70-80%) is expected to come from income (i.e. clipping coupons), but price action on long and short positions can be another source of profits. The return target is quite conservative partly because the strategy is subject to a hard cap of 200% gross exposure, and a net exposure range between net short 40% and net long 80%. (Some other credit UCITS funds can employ multiples of this leverage and directional market exposure, and have correspondingly higher risk and return targets).

Names and catalysts
The high yield market is worth $1.4 trillion and encompasses a wide hierarchy of credit ratings. PSAM expects to be mainly invested in the higher rated names, such as “crossover” rated names (on the cusp of investment grade) and “fallen angels” (that were formerly investment grade). As aforementioned, lower-rated high yield names are more likely to be on the radar of other PSAM strategies. One example of an event catalyst is that such issues may be vulnerable to any reduction in the tax deductibility of interest, if the Republicans’ tax reform proposals come to pass, Faulkner reckons.

The high yield asset class contains about 3,000 issuers in the US and Europe, and many thousands of bonds (source Barclays and JP Morgan). PSAM is highly selective in filtering out credits with interesting catalysts, and only expects to be exposed to 20 or 30 issuers at any time. “We are not solely in the top names you see in ETFs and we do not emulate long only index funds – so we can sleep at night. We are in a subset of names with good catalysts and stories attached, as well as being companies whose businesses we like,” points out Faulkner.

Catalysts can include asset sales, earnings reports, de-leveraging, yield to call and industry consolidation – and all of these could be positive or negative for long or short positions. For instance, a takeover bid could be credit-positive if bonds trading below par are then redeemed at par and/or if the new parent is of higher credit quality than the target, whereas it might be credit-negative in some instances of leveraged buy-outs from financial or private equity sponsors.

Events and interest rate risk
In corporate debt, events are also germane to gauging interest rate risk. High yield corporate debt, with typical headline duration of four years, has less interest rate risk than does investment grade corporate debt, around six years. PSAM can hedge interest rate risk as part of the overall hedging program, which looks at beta, correlation and tail risk. But interest rate sensitivity in high yield is somewhat unpredictable as most corporate bonds can turn out to be shorter, or longer, lived than their maturity. Active credit managers can add value by accurately anticipating the timing of prepayments and repayments. Faulkner forages for bonds with event driven catalysts – such as calls, pay-downs, asset sales and mergers – that could lead to a faster return of capital. If all of the catalysts he anticipates do materialise within the expected timeframe, the long book of the Tages PSAM strategy could end up having a target investment period duration of less than one year. Currently, the average holding period on the long book is expected to be six to nine months.

In any case, Faulkner is currently sanguine about interest rate risk. “The Fed and ECB telegraph everything so perfectly that it is in the market price. Only a surprise in rate expectations – such as a more hawkish than expected comment from the Fed or ECB – would cause a major shock,” he judges. Faulkner still attempts to protect the portfolio against a rate rising scenario with hedges and shorts that reduce interest rate sensitivity and Beta.

Europe and US
With no benchmark constraints, Faulkner is completely opportunistic in name selection and geographic weights,but expects to invest mainly in the US and Western Europe (he does not contemplate taking on emerging markets exposure). The US currently represents the lion’s share of exposure for the Tages PSAM credit strategy, but currency risk is not being taken to earn the interest rate differential between Euros and US dollar; US exposure is hedged back to the Euro master class of the fund. This seems prudent as PSAM is not a currency specialist. The US dollar’s 2017 depreciation against the euro has been a multiple of the interest rate difference.

Other PSAM strategies have allocated as much as 70-80% of their credit sleeve to European distressed credit in the wake of the European sovereign crisis in 2011-2012 and the 2002-2003 “crisis of confidence” brought on by WorldCom, Tyco and Adelphia, etc. Currently, Faulkner finds Europe overall is less rich in opportunities than the US but, nonetheless, has provided some worthwhile investments. Europe’s mergers and acquisitions (‘M&A’) bonanza is also throwing up some opportunities.

Telecoms, media and capital structure arbitrage
Telecom industry consolidation, rationalisation and regulatory change are big picture themes that provide a backdrop for many PSAM investments, in both the US and Europe PSAM is investing in multiple companies, across all disciplines. The Tages fund has bought the bonds of certain companies that have an attractive yield, but could offer price appreciation, in the event of consolidation. As the telecom and media industry face disruptors, changing consumer behaviour and new regulations (think net-neutrality and cutting the cord), the playing field, going forward, is changing drastically. “Companies are cutting costs, becoming more efficient and paying down debt and consolidating,” explains Faulkner. The transition from mainframes to the cloud is another multi-year megatrend which “affects a very wide swathe of companies in terms of how information is stored and processed. This is highly disruptive and touches on business process outsourcing, and supply chains. These trends create winners and losers,” says Faulkner.

Capital structure arbitrage trades, with long and short legs, are a growing sub-strategy. These can involve curve, or calendar spread, trades: being short bonds of one maturity and long bonds of another maturity, within the same company, partly to avoid or reduce the negative carry of an outright short. This can be desirable in situations where the timing of a negative catalyst is uncertain. Capital structure trades can be bullish or bearish.

Shorts and hedges
Idiosyncratic shorts face “earnings problems, secular industry changes, may be priced for perfection, and could have exhausted their options for raising money from capital markets,” says Faulkner. Shorts can be predicated on anticipating credit ratings downgrades, or on expectations of leveraged buyouts. “A couple of shorts worked out lately,” he adds.

Some shorts are intended to act more as hedges than profit centres. They include high beta names designed mainly to dampen overall portfolio volatility, as part of a risk management process that involves the Chief Risk Officer. PSAM’s hedges contain “creative ways to protect the portfolio at low cost using bespoke baskets of credit names,” says Faulkner.

Risk management and liquidity
Risk management includes the UCITS rules and PSAM’s own guidelines. Chief Risk Officer, Eitan Leger oversees risk monitoring and risk management. PSAM looks at risk in two ways; investment or event risk and systemic market risk. They attempt to limit the systematic risk by focusing on event situations with identifiable catalysts (or expected catalysts) that they believe will lead to successful conclusions with limited market correlation along with direct hedges. PSAM has implemented a discretionary portfolio overlay program which seeks to limit the residual beta exposure to major equity and credit indices. They stress test the portfolios to identify and quantify sensitivities to various portfolio shocks, including changes in equity markets, interest rates and credit spreads.

Liquidity risk management has many facets. “PSAM as a firm has never gated or side pocketed,” states Faulkner. PSAM has a dedicated trader and multiple counterparty relationships to source liquidity. The PSAM Tages strategy only invests in publicly traded bonds. No more than 10% of an issue will be held, and in practice Faulkner does not expect to come close to that. The sizing of positions is also tailored to local conditions. Though the US high yield market is about three times larger than the European market, it does not follow that US issues are always more liquid than their analogues in Europe. “A $250 million issue in Europe could be more liquid than one of the same size in the US,” according to Faulkner, illustrating the market savvy that this seasoned team brings to the credit markets.