Friday, 19 December 2014
Last updated 8 hours ago
Feb 21 2014 | 8:19am ET
Alpha with Asymmetry was the title of a 1998 white paper by Akanthos Capital founder Michael Kao, but it could also be his hedge fund's motto.
Akanthos manages just under $120 million, almost half of it Kao's own money. Assets peaked in 2005 at $750 million before the fund fell victim to redemptions by what Kao termed “over-concentrated investors.”
He described the fund, during in a recent phone interview with FINalternatives, as a “capital structure long/short fund with an event bias.”
“It's a little bit of a mouthful,” he admitted, “but...everybody knows what equity long/short is and if you want to broaden that purview from equities to every part of the capital structure, that would be us.”
Over the past five years, the fund has produced an annualized return of 41.6%. Since inception, the returns are even more impressive—the firm declined to provide the figures, but a source with knowledge of the fund told FINalternatives Akanthos is up 195.9% since 2003.
Last year, the fund returned 34.35%, net of fees, ranking Akanthos among those rare hedge funds to best the S&P 500's 29.6% return in 2013.
“The key was that our exposure to equities was less than 20% net long,” said Kao. Their return—including a 5.14% Q4 gain—came largely from the firm's focus on what he likes to call 'event options.'
“These event-driven equities, even though they take up a small portion of our portfolio, when they work, they really work and can go up multiple times.”
Relative Value Meets Event Driven
It's a strategy Kao, a former commodity derivatives trader, first formalized while running the relative-value business at Canyon Capital, a multi-strategy fund based in Century City, California.
“Certain types of relative-value strategies...have what I call 'positive convexity',” said Kao. “Meaning that if the underlying stock goes up in price, your derivative security becomes increasingly sensitive to the underlying. And, conversely, if the underlying goes down in price, the derivative becomes less sensitive...”
Such strategies, he said, lack explicit catalysts, so his idea was to combine them with event-driven strategies “that are by definition driven by specific catalysts.” But “event-driven strategies...tend to be negatively convex:... if something falls down, you become a lot longer and if something goes up, you wind up becoming shorter.”
Kao's theory, expressed in the earlier-mentioned white paper, was that “through intelligent security selection, if you combine these qualities, the positive and negative convexities tend to self-hedge at a macro level and you should theoretically be able to come up with a very interesting alpha stream.”
Kao built a business around that strategy at Canyon and that business became the cornerstone of Akanthos, which he founded in 2002.
Anatomy Of A Trade
Walking FINalternatives through a 2009 investment in General Growth Properties, a publicly traded real estate trust, Kao illustrated his investment approach—and betrayed a love for asymmetry rivaling that of an '80s hairdresser.
The investment was also a winner for Pershing Square Capital's Bill Ackman but Akanthos, said Kao, “played it in a completely different way than he did and, from a return perspective, we may have actually milked more value on a percentage basis than he did.”
“It's quite a complicated story,” said Kao, with some understatement.
The play, which accounted for one eighth of Akanthos' 270% gain in 2009, began as a convertible arbitrage trade—long the convertible bonds, short the stock—in 2007.
Late that year Kao got worried that GGP was taking on too much debt, so he cut the fund’s position by about 90%, fearing market sentiment would erode the bond floor in the convertible.
Fast forward to September 2008, the height of the financial crisis. GGP by this time had amassed $25 billion of senior secured debt and a $1.5 billion “sliver” of senior unsecured debt, said Kao. To make matters worse, $900 million of that $25 billion secured had to be rolled that month and “there was no credit available at all and even companies in bankruptcy that required DIP [debtor in possession] financing, which is about as secured as you can get, could not get it.”
GGP “went into a death spiral,” said Kao, and was clearly about to file for bankruptcy. But Akanthos viewed the firm as “a company with great assets because, going into September '08, the guys had probably 93% occupancy nationwide, they were the second-largest retail REIT, and they had great assets. They just had too much leverage.”
The convertible bond fell off a cliff in September, said Kao, but convinced that GGP's rental stream was still viable, he decided to buy the firm's distressed bonds—at an average price of 6 cents on the dollar—in the belief they might one day trade at par.
By April of '09, the bonds were trading at 15 cents on the dollar. Kao said he sold some to control risk but was loathe to sell them all. Instead, he sought what he termed a 'cake-and-eat-it-too' solution—some way of “retaining exposure to that right tail while cutting down your dollars at risk.”
So he had another look at GGP's capital structure and decided that the firm's convertible bonds were responding more quickly to the prospect of recovery than were its shares. “So, what we did was re-invest a small portion of the proceeds of each bond sale into the equity, thinking that the equity was lagging and they should have been moving in lockstep.”
By the time the GGP bonds had reached 75 cents on the dollar, Akanthos was completely out of the bonds but had amassed a small equity position. Shares had climbed from $1 to $4, but that represented a market cap of “only a couple hundred million dollars” for a “massive capital structure,” said Kao. Moreover, “the bonds were already at 75, implying that our original thesis of par was a real possibility.”
“Well, here we saw a completely different opportunity. We said, 'What if we shorted the convertible bonds at 75 and went long, dollar for dollar, the equity?' The bet was that if the bonds are really worth par, chances are there's so much value to the enterprise, that the underlying equity market cap could be 5X what it was. In other words, we would only lose about 25 or 30 points on our bond short but we could make 5X our money on the equity long.
“At this point, we did a completely different trade: this was the capital structure trade that we did and it turned out to be a second home run, because in the ensuing months there were three bidders for General Growth...The stock went from $4 to $17...We lost 30 points on our bond short but net, the trade was a huge winner. So, we got out of that trade and sat on the sidelines again.”
While they were on the sidelines, Simon Property withdrew from the bidding for GGP; volatile GGP shares settled back into the $12 range; the bankruptcy reorganization, now in its late stages, saw the bond trading at 105 with little to no correlation to the equity. And here, said Kao, was another opportunity:
“[W]e thought that the equity at $12 now represented a very interesting, event-driven value stock...[Y]ou had three credible buyers establishing real asset value. So we really thought at $12 we had maybe $2 or $3 in downside but on the upside, if an activist guy like Ackman got involved...and was able to really unlock value here and deleverage the company at the same time, the equity upside could be $10 or $15.”
So Akanthos went long the stock. But, wanting to be hedged against the REIT sector, Kao said they “put on a whole bunch of different creative hedges,” including put spreads on GGP's largest competitor SPG as well as convertible arbitrage trades in the REIT space.
Long story short: “During this multi-year period from '07 to '09, if you measured the total P&L that we extracted out of this capital structure in all of these different guises and divided by beginning of period AUM,” said Kao, “we probably extracted 40% at the fund level just from this capital structure. But it was never from just buying something and riding it up, it was always with a view towards re-optimizing for risk-reward.”
From WaMu To Fannie & Freddie
“A lot of people ask us where our ideas come from,” said Kao, “and basically I say, in a way the ideas kind of naturally present themselves as circumstances evolve because we follow capital structures over long periods of time. In some cases, some of our trades have gone on for 10, 12 years, but we are very adept at milking a lot of value out of the capital structure in a lot of different ways.”
Sometimes, of course, these down-the-rabbit-hole trades can backfire, as was the case with Akanthos' 2007 investment in Washington Mutual. Despite their best analysis, their bet was undone by what Kao terms “inconsistent government policy when the government just reached down across multiple capital structures and effected arbitrary outcomes.”
To wit: the decision to strip WaMu's “crown jewel assets”—its $200 billion deposit base and 2,200-branch retail network—and sell it to JPMorgan for a fraction of the price Jamie Dimon had offered for the bank six months earlier.
But Kao put the lessons learned from this loss into a trade that proved to be a big winner for Akanthos. In this case, arbitrary government decisions—specifically, Hank Paulson's decision to put Fannie Mae and Freddie Mac, the secondary mortgage lenders, into conservatorship and to draw an arbitrary line between the senior and subordinated debt and the preferred.
“He basically said everything above the preferred gets an unconditional, explicit government guarantee, that gets par,” said Kao, “but the preferred and everything lower gets wiped out.”
“When that happened, we were actually short a small amount of preferred and we were shocked that on such a small position we made so much money. Once we realized the potential illegality of what the government just did, we covered our short and actively went long.”
Akanthos, along with prominent investors like Bruce Berkowitz' Fairholme Capital and Perry Capital, is betting the government will eventually return the now-profitable Fannie and Freddie to private investors. Currently, all profits from the institutions go to the U.S. Treasury, a situation both Fairholme and Perry are challenging in court.
To date, said Kao, their Fannie/Freddie bet has been “a big home run,” with the securities they bought at 2 cents on the dollar now trading around 34-35 cents on the dollar. “It remains to be seen, however, whether government will do the right thing and restore value to old private capital,” something Kao thinks it must do “if it ever hopes to re-attract new private capital to the mortgage market.”
The View Ahead
While Akanthos may hold between 30 to 40 positions at a given time, its top 10 holdings can represent as much as 30-50% of the portfolio. To sleep at night with that kind of concentration, Kao said he ensures each of his top 10 bets has a different “thematic driver.”
These drivers change over time. Currently, they include the “government” theme, represented by Fannie and Freddie and another theme Kao describes as “equities that look like convertible bonds.”
“We're trying to find equities that are trading at or near or maybe even below the amount of cash that they have on the balance sheet...That, to us, is like buying something that's trading almost like a bond...For instance, we own equity in Radio Shack. Radio Shack is a stock that's trading around $2.60 a share; it's got cash per share north of $3; it's got liquidity of over $6.50 a share. What's even more, short interest is north of 40% of the float, so there's a lot of bad news baked into a stock with that much liquidity. The ample liquidity gives the company time to turn itself around. So, it's almost a bond-like equity in that it's trading near what we hope is a floor valuation but it has multiple event options including a potential short squeeze as well as a real turnaround of the business.”
But generally, at the moment, Kao considers the world to be “a very tricky place to invest.”
“There are a lot of fiscal headwinds that are still the hangover from 2008 and none of the developed countries have really gotten their fiscal houses in order from a balancing-the-budget perspective, so the underlying economic recovery has been very fitful and sluggish, with persistently high unemployment, especially in Europe.”
“But then, at the same time, these fiscal drags have been met with unprecedented amounts of monetary easing...So you've got a juxtaposition of fiscal headwinds with monetary tailwinds [which] creates a very uneven and distorted macro backdrop in which to invest.”
“From a big-picture standpoint, I can't pound the table like I was able to do back in '09 and say, 'You know what, this particular Asset Class A or Asset Class B is an incredible opportunity,' because there's no one asset class or strategy that jumps out at this time. The signals are very distorted. Our positioning, therefore, is to try to focus primarily on idiosyncratic situations...All throughout last year, we've been very hedged on the general equity and credit markets but yet we've been able to beat the overall indices by being involved in these very idiosyncratic, asymmetric situations.”
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