The launch of the Tyrus Capital Event Fund in October 2009 gave a clear demonstration that the European hedge fund industry had finally begun to recover from the travails of the credit crisis that began the year before. The fund and its team, which exited Deephaven Capital when it was acquired by Stark, raised $1.5 billion in the fourth quarter of 2009 before closing at year-end as one of the year’s biggest launches. The success offered proof that the right manager with a coherent strategy and a strong track record could still woo enthusiastic backing from investors.
Now fast forward to July 2010. Founder and chief investment officer Tony Chedraoui is looking forward to bountiful opportunities for the event driven trading style in which Tyrus is an acknowledged leader. This shouldn’t be surprising given an expected rebound in corporate activity from the low levels of recent years. Indeed, the recent uptick in US merger and acquisition (M&A) activity looks likely to spread to Europe eventually. Indeed, it would be surprising if the credit crisis of 2008-09 – an epoch defining event – doesn’t eventually bring about significant deal making and restructuring that will provide opportunities for skilful investment managers like Chedraoui.
To find out how Chedraoui plans to exploit this and to delve into the youthful Lebanese-born hedge fund manager’s trading style, The Hedge Fund Journal visited Tyrus Capital at its offices in Grosvenor Place perched opposite the vast private gardens behind Buckingham Palace. Chedraoui discussed his background, his career progression from investment banker via prop trader to portfolio manager as well as the importance of getting the right balance between conviction and risk management. He also discussed the key precepts that guide his approach to event driven investing.
Chedraoui’s background is unusual, though a pattern of success emerged quickly. He attended the American University in Beirut, where he studied Computer and Communication Engineering, before winning a place at the prestigious Hautes Etudes Commerciales (HEC) in Paris to study for a Masters degree in Finance. His natural ability as an entrepreneur helped to finance his studies; when the nearby ecole polytechnique sold its old network cards, Chedraoui bought the lot, reconfigured them and sold them on at a profit to his fellow students at the HEC. He was also chosen to join the elite team of “Junior Conseil”, the HEC’s own team of consultants, and worked on a number of projects for leading French companies.
While at the HEC, Chedraoui also spent some time on internships with international consulting groups EDS A T Kearney and Andersen Consulting, as well as a spell in venture capital with ABN AMRO Ventures. In 2000 he joined Lehman Brothers in London as an investment banker on the highly regarded Media & Telecom team. Chedraoui’s natural talent was quickly evident and he was rapidly promoted, but he became increasingly fascinated with the world of hedge funds and started reading about some of the great traders and their life stories. Convinced that he would never be happy unless he had tried his own hand at managing money, he considered leaving Lehman, but was instead offered the opportunity to manage some of the bank’s own capital. Chedraoui’s idea was simple: to employ an investment banking approach to investing in event-driven situations.
“First you need to define what event strategies are,” Chedraoui says. “Event can be defined in so many ways. For us an event is something that you can pinpoint. The definition of an event is really a timeline for us. It needs to have an end date. You need to understand how an event finishes.” Once a transaction has been announced, the deal is studied in detail and the time line is constructed around it.
A notion of time
“The advantage of event is the notion of time,” he says. “This is your only advantage over other strategies. You know when the event is going to close and you know, more or less, what the downside is. We use the notion of time to our advantage. This is the only advantage we have. With long/short strategies you don’t know when you are going to make money. Here you know. So the notion of time is crucial.”
The event-driven investment strategy (see Fig.1) pursued by Tyrus is therefore based on specific corporate events that are not dependent on the general economic environment; it seeks to produce returns that are correlated to specific event trades rather than to broader markets. Tyrus focuses on situations with embedded event-driven optionality, with the objective of generating attractive returns with limited downside risk. Before investing, Tyrus studies the timeline of the relevant transaction in detail from a process point of view; this involves investment banking expertise as well as legal expertise. An event usually consists of a number of milestones leading to an outcome; it is very important to analyse every milestone and to build a risk/reward analysis of each step leading from one milestone to the next, as the risk typically changes. This means the fund can be long for one milestone, and then short for the next, or vice versa depending on the date in the event timeline.
This approach to event-driven investing is decisively influenced by Chedraoui’s experience as an investment banker and the application of that experience to the then bank’s prop trading desk, where he generated high returns. “The people I hire as investment professionals are either investment bankers or lawyers because I want people who understand corporate finance transactions, how M&A works and the timeline of that process,” he says. “Different jurisdictions have different regulatory policies so it is very important to understand these in detail when analysing the different dates and milestones that make up an event. Being schooled in investment banking is crucial.”
Bankers understand complications in the transaction process. They also have the tools to understand valuations, both upside and downside, as well as the synergies and dilution shown in pro forma models. “You need to understand pro forma synergies – understand how much can be paid for an asset – since a transaction is usually about the synergies that can be extracted and the net present value of these synergies,” Chedraoui says. “But if you don’t understand these notions and you have never modelled them or modelled a pro forma balance sheet of a company, then when you are formulating your approach it is very difficult.” As a result of this philosophy, Chedraoui has built his team from former top-ranked investment bankers and lawyers. He has applied the same care with the selection of the operations team and believes that the firm’s operational infrastructure is one of the best in the business.
Another essential skill is trading and understanding how markets react to different developments. Chedraoui believes that the way a stock trades and the bid/ask in the market can provide him with useful information.
Corporate finance meets prop desk
In effect, Chedraoui took corporate finance discipline to Lehman’s prop desk and added trading skill before joining Deephaven in mid-2006 to lead the European event-driven strategy. He was given the opportunity to build the team out and to pursue his own philosophy and approach with the capital he was allocated. This was a busy time for event-driven investors in Europe, with regular announcements of large takeovers, and Chedraoui made the most of this bountiful set of opportunities, generating significant returns for Deephaven’s investors in his first few months. He was rewarded in mid-2007 with the launch of his own fund, the Deephaven European Event Fund, which closed to new investment with assets of $500 million. In January 2008, Chedraoui was promoted to head of global event-driven investing at Deephaven, and despite the very difficult environment his new fund returned more than 15% for the year, winning a major award as a result.
Compared with merger arbitrage strategies that run widely diversified portfolios, the book at Tyrus is generally much more concentrated, focusing on 20 to 30 trades with a known downside and a timeline for every trade. Whereas some approaches to merger arbitrage use leverage to juice up returns on small spreads, Tyrus abjures leverage. Chedraoui believes that it is difficult, if not impossible, to calculate the correlation between positions in a merger arbitrage book. Merger arbitrage is inherently a risky strategy, deals typically presenting a small potential upside with a larger possible downside. “In a weak market noone wants this sort of risk reward, and spreads tend to widen together,” he says. “If diversification tempts you to add more merger arbitrage exposure to your book then really you are adding significant risk, which will hurt you in a bad market.” With a more concentrated approach, Tyrus focuses on the large cap equity space and avoids less liquid assets. The benefit of this philosophy was shown when it enabled Chedraoui to reduce the Deephaven European Event Fund’s portfolio to cash within a few weeks and to return 97% of the proceeds to its investors little more than a month after the announcement in early 2009 that Deephaven would be sold.
Risk, reward and timing
Kraft’s ultimately successful bid for Cadbury earlier this year is another pointer to Chedraoui’s approach. He recalls that the process was odd, especially given how the stock moved above 800p in November 2009, well above the 745p per share initial indicative offer from Kraft. To Chedraoui it showed that the market was convinced that either Kraft would pay more – the Cadbury board had indicated that it might recommend an offer at 850p per share – or that there would be a counter bid featuring either Hershey or Ferrero. But doing the pro-forma models showed that neither Hershey nor Ferrero would be likely to be able to secure financing on as favourable terms as Kraft at a time of constrained credit availability. Furthermore, neither Hershey nor Ferrero would benefit from synergies to the same degree as Kraft.
To Tyrus, that left Kraft alone in the frame with no more than an indicative offer, meaning that Cadbury shares had a maximum upside of around 5%, but a downside, if Kraft decided to walk away, of around 30% if it were to return to pre-bid levels. Chedraoui therefore decided not to take a position in the deal, even though a number of other players accumulated large positions. This, and the fact that many other merger spreads narrowed to an annualised return of 5% or less in the first quarter of 2010 at a time of growing concerns over sovereign credit-worthiness made Chedraoui increasingly feel that merger arbitrage was not rewarding investors sufficiently for the risks incurred. He therefore began to cut merger risk in his book aggressively, enabling him to protect his capital in the difficult market conditions seen in May and June of this year.
Building portfolios that make sense
This helps to underline the rationale behind the portfolio construction process (see Fig.2). “If you build a portfolio that makes sense you are in a better position to limit the downside,” he says. “But you need to know your downside on trades and the correlation between them. If you only have merger arbitrage in your book you will find that the correlation will hurt you in a bad market. Instead you must try to build a portfolio that does not consist entirely of merger positions. You need to add other strategies that do not correlate with deal break risk, like restructurings, spin-offs, rights issues and unconditional deals, and better still is to add positions that may benefit if a deal breaks or is restructured.”
Chedraoui does not believe that there is informational edge in event-driven investing. What interests him more is analysing the motivation of the players in the process: the bidder or bidders, the target and the financial sponsor.
He cites the unravelling in 2008 of a number of the leveraged buy-outs launched by private equity firms. “The motivation of the players was a much more important factor,” Chedraoui says. “You have to consider the implications. The buyers don’t want to pay a massive break fee, the target is hoping the bid will go through, and for the banks, finance has become much more expensive and they are pledged to finance at a rate that is suddenly too cheap. The motivations of the players have changed and they will act accordingly if they can.”
If Chedraoui feels that there is a reason why a deal may not be consummated but is trading with a narrow spread, he may look for ways to short the deal, which then also helps to create a robust portfolio. “This is how you hedge your book,” Chedraoui says. “It’s not shorting the market since if you do that you are taking a directional view.”
Chedraoui also firmly believes that event investors should not be trying to make a fixed return each month. “With event-driven investing you have to be patient,” he says. “It is an opportunistic strategy. It does not matter if we make no money in a year, it is just important not to lose it. But when there is an amazing opportunity I want to make money. I will wait for it. We wait for good opportunities and we do only what makes sense to us because we don’t want unnecessary volatility. Does it mean there can be a year when we make no money? Yes, if nothing happens. But we have always found interesting deals.”
A changing financial landscape
Despite the uncertain financial landscape, Chedraoui is optimistic that eurozone volatility and the related sovereign risk issues will eventually either be resolved, or at least priced into markets. Once that happens CEOs, now cowering under tin hats, will emerge to a changed financial environment and begin doing deals to benefit their shareholders. “Look at the US: 2008 was a difficult year, but in 2009 takeover activity picked up quickly. In Europe, 2010 has been the year of crisis, but once the problems are priced in we will see tremendous opportunities.”