Category: Markets

Fortress Doesn’t Believe in (Possibly Care About) Conflict Checks

“NY Post – SoftBank’s Fortress Investment Group is raising a $400 million fund to sue tech companies over intellectual property infringement…”

Before we get started, I know that Mike Novogratz left his life’s work years ago, but who else am I going to put up there to represent Fortress?

Now, I have to admit I was ready to poke some fun at SoftBank for this one. How can a conglomerate, with telecom, semiconductor and robotics interests allow one of its portfolio companies to be an outright patent troll? How can SoftBank, who has $195B in committed capital for it’s tech-focused investment vehicles, allow Fortress (“FIG”) to shakedown the very companies in which they seek to invest? Well after a while, it hit me: whether purposeful or not, this is probably a great way to hedge a tech-centric private equity portfolio. Outside of proper due diligence, managing FX / rates exposure or structuring capital calls to meet specific milestones, there aren’t many ways to manage the downside risk of making poor investments in the first place – especially when deploying capital into intellectual property-heavy tech industry.

Odds are, you’re investing in a tech company because it claims to have a new technology that can streamline business processes, enhance end-user experiences or is simply a brand new class of product. With new technology comes the prospect of a high adoption rate and, of course, multiples of invested capital. It’s not all glitz and glamour though, and there are real risks to investing in the tech space, more so perhaps than any other industry. The costliest mistake you can make in tech investing is, by a wide margin, not conducting the proper diligence around a target’s intellectual property / patent portfolio. Does the company really own this IP? Are they infringing on someone else’s IP? Who’s line of code is this, truly? Are there any outstanding lawsuits? What about imminent filings? Tons of these lawsuits are filed every day around the world by what are known as “patent trolls” – individuals or funds that buy random portfolios of IP and lawyer up to shakedown other tech companies for infringement. Rarely do the lawsuits reach a decision as they’re usually settled outside of court, which is exactly what the patent troll wanted. It’s a pretty scummy industry, but it’s also pretty lucrative – which is why FIG wants a piece of it. If a respected NYC asset manager raises $400M with the intention of suing nerdy Silicon Valley idealists into oblivion, the nerds will pay up to settle. Cash burn is fine when it serves whatever “mission” the unicorn de jour says it has, not when it’s being wasted on lawyers.

That brings us to the impact of this new FIG vehicle on its parent, SoftBank. Taken at face value, it seems like FIG is raising two birds toward everything SoftBank has built it’s reputation on – investing in and building out new technologies. If you take a forest vs. tree view, though, a successful patent troll investment platform can hedge against IP-related losses SoftBank portfolio companies may incur. Obviously a $400M investment is an irrelevant hedge for a $195B portfolio, but it’s a start. It’s not unthinkable that were this initial foray to be successful, that FIG would double or triple down to target more or larger targets. I also wouldn’t discount the idea of SoftBank seeding a larger IP strategy within FIG were they to succeed with this initial vehicle – that would be something special. This will be an interesting story to follow in the next few years and, no matter what happens, it’ll be a great exercise in thinking outside of the risk management box for SoftBank.

I Say We Bail Out the Hedge Funds, Too

“Bloomberg – At Milken, Hedge Fund Managers Swap Ideas on Staying in Business”

Won’t somebody please think of the fund managers!

I wanted to write a blog about how out of touch this group of millionaires is that they felt it necessary to take to a public forum to complain about how difficult it is for them to make money. Because when you’re blaming your own investors, stating their risk aversion has “sowed the seeds of very mediocre returns and high fees”, you’re not doing yourself any favors.

The truth is, though, they’re partially right. Now before we get into it, it’s important to understand that while the average American probably views fund managers as overpaid leaches, sucking economic value from the public system for their own private gain, they serve an important role in a modern economy. Traditionally, fund managers have offered three key benefits to investors and the market as a whole: (i) they assist institutional investors such as pension funds and insurance companies diversify their portfolios across different sectors and strategies, creating a more predictable return profile to match their long-term liabilities, (ii) they offer other sophisticated investors the opportunity to invest in more illiquid strategies like real estate, commodities and derivatives, and (iii) they provide liquidity to the broader market and enhance price discovery. Historically speaking, hedge funds have been pretty good at generating benchmark-beating, uncorrelated, risk-adjusted returns, and they collected fat fees for doing so. After all, investors were generally beating their benchmarks, even after the funds collected their fees, so nobody cared. Times are different now, though, and that’s where the plight of the hedge fund comes into play.

The rise of passive/index investing has been pretty detrimental to the traditional hedge fund model for a number of reasons, however it’s not just the strategy itself, but the time in which it came to prominence which ended up being the perfect storm for hedge funds. According to EY, the ETF market increased from $700B under management in 2008 to over $4.5T at the end of 2017 – for the people at home, that’s an increase of 543%. What’s more, 2017 alone saw inflows of $464B into passive vehicles. The explosion in passive products and their AUM has either democratized or socialized the markets, depending on who you ask. Either way, they have given all investors the ability to target as broad or narrow an investment strategy as they like, from simply buying the S&P 500 or small cap energy stocks, to shorting the VIX and beyond. As more and more money flows into these products, the asset managers need to go out and buy more stocks to replicate the underlying indices, therefore inflating individual stock prices in the process.

This is the problem for hedge funds. We’ve been on an almost ten year tear after bottoming out in the financial crisis, with the S&P 500 up +259% over that period. When you combine such strong, broad market performance with the explosion in passive capital basically bidding up individual stocks on a daily basis, it is nearly impossible for traditional fund managers to generate any alpha – and ladies and gentleman, if there’s no alpha, there’s no fees to collect for the fund managers. As a result, you’ve seen many large investors wonder out loud why they’re paying fees to managers who can’t beat the market, which has led to an all-out exodus from the hedge fund model. Even behemoth pension funds such as CalPERS are ditching managers for the passive life. Doing away with fund managers in the name of saving money on fees may prove to be penny wise and pound foolish though, as any deep correction in the market would likely be amplified by the fact that so many investors have plowed money into these products. At the end of the day, these guys are called hedge funds. They aim to provide appropriate risk-adjusted (i.e., hedged) returns. If you’re just super long energy stocks through an ETF and there’s another 2015-2016 episode, you’ll wish you had paid some fees and been hedged through an experienced energy fund manager who would’ve had proper risk management systems in place to mitigate downside risk.

Regardless, at this moment the hedge fund model is broken and if they want to survive, they’ll need to adapt. I saw an interesting piece in Bloomberg the other day that encouraged managers to ditch 2/20 and actually pay all their LPs a guaranteed fixed rate over the benchmark returns to manage their assets. Anything generated over that fixed rate would remain with the fund manager. The investors would generate a guaranteed return, similar to a fixed income product, and the manager would retain any alpha generated. It’s an interesting idea, but not likely. It’s good to at least see people thinking outside of the box.

Here’s A World I’m Not Ready to Live In…

“NY Post – Global wine output fell to its lowest level in 60 years in 2017 due to poor weather conditions in the European Union that slashed production in the bloc, an international wine organization said.“

Sound the alarm, folks – we’ve got a crisis-a-brewin’!

According to a newly published report by the OIV on Wednesday, it looks like global wine production dropped -8.6% in 2017 to the lowest level since 1957. That’s 12 years before we even went to the moon, for some context. The culprit was poor growing conditions, more specifically, frost, in the “old world” stalwart regions of Italy, France and Spain. The good news here is that while production has plummeted to 250 hectoliters,  global consumption inched up only slightly to 243 hectoliters in 2017 (that’s about 33.25B bottles of production to satisfy 32.3B bottles of consumption). So like, should we be investing in wine then?

It’s hard to say, really, and it also depends on your risk appetite. The best benchmark to monitor price fluctuations in the secondary fine wine market is the Liv-Ex 100. It used to be free, but with success comes a paywall I suppose (check it on BBG if you have one: LIVX100). Anyway, prices have been relatively subdued in 2018, but that comes on the heels of a 31% run-up in the index since YE 2016. So it would appear that a lot of the impact of last year’s small yield is already baked into the market. That doesn’t mean there aren’t opportunities to make money, though.

Wine is becoming an increasingly, well… liquid asset. Aside from becoming the go to data source for wine markets, Liv-Ex also runs a secondary marketplace where participants all around the world buy and sell fine wine. This also consists of trade settlement / logistics operations which manage payment, delivery and storage in the Liv-Ex bonded warehouse. So if you think you’re able to day trade around the wine markets and make a profit, have at it (it obviously isn’t that liquid yet, so keep an eye out for those elusive arbitrage opportunities).

Outside of trading wine on your prop account, there are many private investment vehicles investing in all facets of the wine industry: real estate, rare wines, you name it. A lot of the managers take nuanced approaches that suit investor appetite, too, like equity vs. debt, or region-specific approaches.

So, there are mechanisms to profit in a market with increasing demand and waning supply, but you want to do it the right way in order to limit your downside. You want to play the macro trend here, especially if you’re going to lock up capital in a private vehicle for 5-10 years. Demographics are changing and with it, tastes in wines. Millennials are now drinking more wine than baby boomers, and it shows in not only sales but in varietal and regional preference as well. While Bordeaux, Piedmont and Burgundy are timeless, the younger crowd has really taken an affinity to new world wines out of Chile, California and Washington (no doubt a function of cheaper prices and increasing quality). Were supply imbalances in the global wine market to become a relatively normal occurrence, I fully expect the new world regions to pick up the slack both in production and, perhaps more importantly, agricultural and distribution technology. That’s where the money will be.

Netflix Likes On-balance Sheet Debt, Too

“Bloomberg – The world’s largest online television network sold $1.9 billion of senior bonds in its largest-ever dollar-denominated offering“

Here’s an unpopular opinion: Netflix really isn’t that great of a product – like, at all. I’ve always felt that their movie catalog was downright awful, filled to the brim with low-budget features that close to zero people have ever heard of. Their television and original series content definitely offers a better selection, but they’ve never been able to convince me to pony up cash on a monthly basis. Alas, the numbers don’t lie – Netflix continues to beat street estimates for new user growth quarter over quarter. So when they announce they’re issuing a bunch of high yield debt to finance new licensing acquisitions and original content production on the back of parabolic customer growth, it shouldn’t surprise anyone. But I’m a cynical numbers guy, so I’m here to poke some holes in everyone’s favorite stock (and one of my least favorite products).

The content industry is very fond of off-balance sheet transactions, and Netflix is no different. The transactions materialize in the form of commitments to purchase content from production houses (Disney, Warner Bros., NBCUniversal, etc.) in the future for a few billion dollars. This ensures that Netflix is able to provide newer content for its audience as tastes change. The weird thing here is how these transactions are accounted for. Netflix amortizes these costs, through COGS adjustments, across the shorter of (i) what they deem to be the length of time viewers will continue to stream that particular show/movie or (ii) ten years, starting on the date that the content becomes available for streaming. As of 12/31/2017, Netflix had amassed $17.7B in content acquisition liabilities, of which $10.2B never makes an appearance in their financial statements as the content isn’t yet available for streaming on the platform.

Once you adjust for the off-balance sheet obligations, Netflix’s total liabilities jump from $15.4B to $25.6B at YE 2017 and $27.5B after this latest bond offering. Normally this wouldn’t be worrisome as your assets and liabilities rise in tandem – or so you thought, until you find this gem they buried in the footnotes of their 10-K:

“…content assets, both licensed and produced, are reviewed in aggregate at the operating segment level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the net realizable value or fair value may be less than amortized cost. To date, the Company has not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost, net realizable value or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off.”

Ah, yes – there’s always the risk that all of those content assets acquired in the off-balance sheet transactions may not really be worth the acquisition cost, in which case there will be sizable charge-offs that will directly impair their free cash flow (which is already running huge losses as they follow the Amazon business model). As the company continues to grow its customer base, it will need to go to market and increase the size of their content acquisitions, which will inevitably lead to a few charge-offs as their content portfolio expands. This isn’t really an issue from a microeconomic standpoint. It has the ability to become a macroeconomic issue though, if content providers decide they want a bigger slice of the Netflix pie and start jacking up rates for licensing, even as Netflix begins to experience some standalone charge-offs. Any rate increases will continue to hit Netflix right in their cash flow statement. This is the point at which they’d need to pass those costs onto consumers, but who is to say they’ll continue to pay up? Netflix has the benefit of being structured like a low-cost gym membership, where customers forget about (or don’t mind) the cheap, recurring charge hitting their account each month. Were those costs to rise, customers may be a little more sensitive as to what they really gain from their membership, and whether or not it’s worth it.

I’m not saying any of this poses a going concern risk for Netflix, either. I do, however, think it does pose downside risk for equity investors, especially if you’re buying at these levels. Institutional investors are well aware of the off-balance sheet transactions and their cash impact, they just haven’t cared because customer growth has acted as a buffer. If there are any hiccups in customer growth or worse, retention, then lookout below as content cost and cash flow profile move up the ladder of importance in valuing the company.

P.S. – If they knock The Irishman out of the park I will disavow everything I just wrote. Can’t lose with Scorsese directing that cast.

Christine Lagarde: Noted ZeroHedge Reader

“CNBC – Global debt is at historic highs and governments should start cutting levels now, the IMF says”

*Sigh*

So, there’s been a lot of debt chatter coming out of the IMF recently. Just yesterday, we had them offer their unsolicited analysis on how the U.S. debt/GDP ratio will be worse than, gasp, Italy’s by 2023.  Today, we have Christine Lagarde, former French finance minister and current head of the IMF, imploring governments around the world to reduce their debt loads now while the getting is good. Don’t get me wrong, if you have the ability to reduce your debt burden in a responsible manner, do it. That said, just telling people debt is too high and that it’s a risk shows either a misunderstanding of the global financial system or an unwillingness to actually explain to people how it works and why we’ve racked up $164T in obligations.

The IMF piece focuses mainly on public sector debt as that has increased the most in the last decade, but we should touch on private debt first. Private, non-financial debt accounts for most of the debt globally, about 63% of it. In the last decade of low rates, households have borrowed to purchase houses, and corporations to fund domestic operations while leaving cash overseas and away from the tax man. In the case of the former, a house is a huge asset that can appreciate in value, be sold or be collateralized. In the case of the latter, the newly raised cash shows as an asset on the balance sheet while the bond appears as a liability, largely canceling each other out minus some interest expense. To the extent the cash is used for capex, that too will appear as an asset on a balance sheet as new equipment, property, investments, etc. In the end, the macro impact of private borrowing is a relative wash (barring credit cards and other consumer lending products, those are poor financial choices).

Let’s jump into public debt though, because that seems to be what’s worrying the IMF the most. They claim that debt/GDP ratios for advanced economies have only been this high once before: WWII. This is very true, but also very misleading. It’s helpful to understand the role government debt plays in a modern, credit-based economy before losing our minds.

Modern economies all have a (i) Government, (ii) Central Bank and (iii) Banking System. There are slight nuances here and there (especially in the Eurozone), but their functionalities are generally the same. Since all three of my readers are here in the U.S., we’ll use our system as a proxy for all developed economies. The Federal Reserve is the arbiter of the dollar. It controls the base money supply, credit availability / expansion, the cost to borrow in dollars, etc. It does this through what is called Open Market Operations (“OMOs”). This means that when the Fed wants to increase the money supply, they create some dollars and use them to buy shorter dated U.S. Government bonds. This pumps dollars into the banking system and reduces short term interest rates with the intent of stimulating the economy, and vice versa when the Fed wants to do the opposite. In a nutshell, the Fed uses the credit of the U.S. Government to conduct monetary policy. It’s no coincidence people say the dollar is backed by the “full faith and credit of the U.S. Government”, it’s a fact. Because of this relationship between the dollar and U.S. Government bonds, the two are more or less accepted universally as collateral in financial transactions (this is true for most other developed nations as well). At this moment, there are trillions upon trillions of dollars worth of government bonds posted as collateral all around the world, reinforcing trust in counterparties to transactions and keeping the system humming along. So while governments would be doing right by their taxpaying citizens to reduce or eliminate fiscal imbalances, a global, coordinated effort to actually pay down outstanding debt would wreak havoc on the financial system as bonds posted for collateral would cease to exist. Not only would there be a need to source new collateral to conduct transactions, the need would be great enough the materially impact interest rates and dollar reserves around the world. There’d be funding shortages, leading to soaring overnight and repo rates. It would be a mess (not cataclysmic, but messy regardless).

What’s also grinding IMF gears is not just the amount of public debt/GDP, but the pace at which it has accelerated over the last decade or so. The concern is understandable, but also a bit misguided. Since the financial crisis, central banks in the developed world have pumped trillions of dollars of liquidity into the financial system through Quantitative Easing (“QE”). This is a monetary policy tool in addition to the standard OMOs we discussed up top, and is used when conventional methods of stimulating the economy aren’t sufficient. The main difference between OMOs and QE is that the latter is more broad in its bond purchases, targeting government agency (Fannie, Freddie, et al.) and longer dated bonds. During and after the crisis, governments around the world, in tandem with their central banks, undertook an effort to recapitalize the global banking system through QE. For example, the U.S. Government would issue bonds directly to banks, who would turn around and sell the bonds to The Fed. At the end of the process, the U.S. Government has more debt, the banks have newly created cash and The Fed owns the bonds. This is where a lot of the incremental debt came from – a decade long effort to recap and stimulate the global economy through QE is directly responsible for the sharp uptick in public sector borrowing.

And that’s not a necessarily a bad thing. The Fed is what’s considered a quasi-government entity, but for all intents and purposes, it functions as part of the U.S. Government. If you think about it along those lines, you have bond issuance showing up as a liability on the U.S. Government’s balance sheet, but as an asset on the Fed’s. What’s more, the U.S. Government is paying interest to The Fed on the bonds, and The Fed turns around and writes a check each year to the Treasury to return the proceeds (minus operating costs). Lastly, The Fed reserves the right to buy and sell those bonds to conduct OMOs in the future, but it can also hold the bonds through maturity if need be, at which point the U.S. Government will either pay the principal to The Fed who will give it back at year end, or simply refinance the bonds in an endless cycle: wash, rinse, repeat. So yes, governments have been borrowing hand over first since the crisis, but when you combine central bank participation alongside how much government debt is owned by public and private retirement vehicles, much of it is actually owed to ourselves.

And that’s my problem with pieces like these. They’re all show and no substance. People read this stuff with the IMF stamp on it and then think they’re making informed decisions on how to invest, vote or spend – but they’re not. The only way modern capitalism works is the expansion of credit, not the contraction of it. Take a lap, Lagarde.

 

 

CLO Market Structures Credit Problems for Itself

“Reuters – US leveraged loan borrowers are increasingly switching to a cheaper short-term Libor rate to reduce interest payments, which is squeezing the returns of some Collateralized Loan Obligation (CLO) investors…”

Here’s an interesting battle brewing in the structured credit world, which was borne out of recent developments in the debt markets that originated on rates desks across the pond. Got it? Good.

So, there is this thing called LIBOR, which stands for London Inter-bank Offered Rate. It’s the rate at which banks around the world are willing to lend money to each other for different short-term maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. The longer the maturity, the higher the rate (for the rest of this blog, any reference to LIBOR means 3-Month LIBOR unless stated otherwise). Pretty simple. This rate is incredibly important because, logically, banks borrow money from each other at any LIBOR, add a few percent onto it (the spread), and then lend that money to retail and commercial clients (think car loans, credit cards, mortgages, corporate loans, revolving credit, etc.).

Some of those commercial clients are companies with poor balance sheets that need to borrow capital to operate, so they’ll tap what’s known as the leveraged loan market to do so. In a leveraged loan transaction, a bank will arrange and structure the loan, then sell pieces of it to other banks or investors to transfer some of the risk in a process known as syndication. Because the company borrowing already has a poor balance sheet, the participating banks view them to be at a higher rate of default and that is factored into the interest rate they charge, which is typically LIBOR + the spread (normally between 200 – 500 basis). Now, the thing with loans tied to LIBOR is that it changes every single day. Because of this feature, banks will usually reset the coupon every month or two in order to reflect whatever the current LIBOR is. It’s for this reason that you’ll see the terms leveraged loan and floating-rate loan used interchangeably. It just means that the interest rate on the loan changes periodically based on where LIBOR is moving (and you should check your credit card – I bet your interest payments are ticking up, as they’re floating-rate as well).

We said before that when a loan is syndicated, other banks and investors buy a piece of it and receive their portion of the interest. We know what a bank is but who are the other investors? CLOs. These are shell companies that go out and buy a bunch of different loans, structure their cash flows into debt tranches and sell them to asset managers, pension funds and insurance companies as investments. The debt tranches are just like bonds, each having a credit rating and an accompanying coupon payment based on the credit risk an investor is taking. There is also something called the equity tranche. Investors here are taking the most risk and only receive interest payments after all of the debt tranches have been paid off. Now, let’s get to the good stuff.

The post-crisis era has been a boon for the leveraged loan and CLO markets. Rates were low, so risky companies were able to borrow and investors were searching anywhere for yield, so demand for CLOs skyrocketed. Alas, the party wasn’t going to last forever, and now we have quite the credit quandary on our hands. 3-Month LIBOR has gone parabolic since about Thanksgiving 2017, which means that loan interest payments are ticking up in lockstep. No worries, though, we have a fix for that. Like we mentioned before, these loans are floating-rate, so their interest rates reset every month or two. Wouldn’t you know it, creditors are resetting these loans at the much cheaper 1-Month LIBOR in order to ease the interest burden on companies and prevent defaults. That seems great, and it is, for the banks and the companies that borrowed. CLOs aren’t enjoying it as much. See, the CLOs issued the debt tranches at fixed coupons which were tied directly to the interest they expected to generate from loans referencing 3-Month LIBOR. However, the underlying loans are now paying less interest as they reference the cheaper 1-Month LIBOR, which has created a mismatch between the CLO’s assets and liabilities. As a result, you have CLO managers trying to renegotiate coupons on tranches they promised to investors to reflect the cheaper rate, but investors are saying, “no thanks”. Can’t really blame them for not willingly accepting a lower return, can you? At the end of the day, these CLOs are taking in less money than they’re paying out, so someone needs to lose.

Raise your hand if you’re thinking “equity tranche”. That’s correct, these guys are gonna get smoked. They only receive what’s left over after the debt tranches are compensated, so any shortfall in funds will erode returns for these guys and impact what investors are willing to pay for an equity tranche in the secondary market – and that will also impact new CLO issuance as investors require more yield for their risk. At the end of the day I don’t think you’ll see any material impacts here, but you’ll most likely see funds write down some positions and perhaps a downtick in new issuance. The structured credit markets have always been fans of ingenuity, though, so I have no doubt they’ll come up with a mechanism to rectify this hiccup as well.

 

Blackstone Doing Its Damnedest to Ruin Blythe Masters’ Legacy

** UPDATE **

The CEO of Solus was on Bloomberg this morning explaining the situation. Great video if the blog below is a bit too arcane to read through.

“Bloomberg – The Great Blackstone Swaps Saga Just Became a Whole Lot Crazier“

Buckle up. This is a doozy, but it’s also one of the more ridiculous stories from the street in the last few years. It’s also a great example of what I alluded to in my very first post, where I opined that financial services has almost completed its transformation into a parody of itself. This may be the story that pushes it over the proverbial goal line.

Credit-default swaps (“CDS”) were invented in the early 90’s by Blythe Masters and her team at J.P. Morgan in response to the Exxon Valdez incident. JPM extended $5B in credit to Exxon for remediation costs after the spill and wanted to hedge the credit risk associated with it. For the uninitiated, investors buy CDS to hedge their long exposure to a company’s bonds, or, in the case below, short the company’s bonds outright and make money if they default. It’s simply an insurance policy against a company defaulting on their obligations.

The CDS market is governed by the International Swaps and Derivatives Association (“ISDA”), which is a self-regulatory committee that has developed the framework for what constitutes a technical default in the CDS market. There are many nuances and mechanisms  in the framework  that make determining whether or not a credit event has occurred more difficult than it should be (we saw this in the Greek sovereign debt debacle of 2012, which was eventually ruled a default after much debate). I don’t want to get into the weeds too much, but there is one mechanism we do have to touch on – that is “cheapest-to-deliver”.

The idea behind CDS is that they protect investors from default generally, not specifically. Meaning, it doesn’t matter which of a company’s bonds actually trigger the default. Once the ISDA committee determines a credit event has occurred, the company is now “in default” and CDS will pay out across the capital structure (equity not included, of course) in what they call a credit auction. The auction consists mainly of banks and investors determining at what prices they would be willing to buy and sell the defaulted bonds, which then sets the recovery and payout amounts. Once the trades clear and a recovery price is determined, the CDS will payout via a cash settlement. The payout will be equal to (1 – recovery %) * CDS notional amount. This is where cheapest-to-deliver comes in. If you are short bonds through CDS, you need to deliver bonds to the bank to settle the trade. Remember, we said CDS protects investors generally and not specifically, meaning if you need to deliver bonds for settlement, all you need to do is go out and source the cheapest one possible for delivery to the bank. For example: If I’m short a company’s bonds, I don’t actually own a particular bond to hedge. I’m purely gambling that they’ll default one day – so when they do, I just need to go out and find the cheapest company bond possible for delivery to maximize the payout. If you have the option to deliver a $20 or $30 bond on a $100 CDS, you deliver the $20 bond every time and take the $80 payout (this is oversimplified for purposes of the blog).

K, now that we have that out of the way we can get into the actual story. A couple of years ago, Blackstone (through their credit entity, GSO) put on a large CDS position against a New Jersey-based homebuilder, Hovnanian. They were betting that the company would default on its debt, triggering the CDS to payout and padding some MD’s pockets. Well, the thing is, that never actually happened and Blackstone decided they were going to do what it took to force a default. They offered to structure a refinance package which would have Hovnanian exchange their current bonds for newly issued ones at longer maturities, lower rates and, hilariously, a higher notional amount of debt on their books (while technically the incremental debt wouldn’t hurt them since the rates are so low and maturity so long, its funny to hear of a company solving their debt problems by adding more debt to its balance sheet). This means that the company says “Hey, we know you had $100 bond from us, but we’re gonna replace that with a new bond that says we owe you $125 now. Oh, and it’ll also be at a much lower rate and take us much longer to pay you back.” That crushes the value of the new bonds in the market, which would work precisely in Blackstone’s favor if the company defaulted and Blackstone was forced to deliver the bonds for settlement in the auction under the “cheapest-to-deliver” mechanism. The only thing left was figuring out how to structure the default. Well, the parties decided that a Hovnanian affiliate would buy back some of the old bonds before the exchange, and there would be a clause in the new bonds that prohibits the Hovnanian (and its affiliates) from making any interest payments on the old bonds prior to maturity, triggering a default – through a subset of bonds that only Hovnanian itself owns! For the avoidance of doubt, Hovnanian was going to halt interest payments it owed to itself in order to trigger the default. That’s just shameless.

Naturally, the banks and hedge funds that were on the hook for CDS payouts were less than excited about this newest feat of financial engineering. One fund, Solus Alternative Asset Management, is taking their grievances to the courts, which is fine (but arduous). However, there’s always been one firm that’s never been afraid to go to the mattresses, who wasn’t going to take this disrespect lightly. One firm who wields so much power in the markets that anyone would be crazy to cross them: Goldman Sachs. Goldman was one of the largest sellers of Hovnanian CDS, and they stand to lose a hefty amount if Blackstone pulls this off. They had been relatively quiet on the matter, until some chatter started popping up last week that Goldman, alongside Solus and Anchorage Capital, had been lining up enough demand for the defaulted bonds in the upcoming credit auction that they would be able to push the price up high enough to materially impact the recovery amount and wipe out most of Blackstone’s potential CDS payout – which makes sense! There should be demand for this company’s debt, they’re in an even better financial position in default than they were beforehand thanks to the refinance package. The value of Hovnanian CDS dropped sharply on the rumors and it appeared that Blackstone had met their match. That’s a veteran move by a market-maker that knows exactly what they’re doing – kudos to GS.

BUT… if you thought that was the end of it, you don’t know how petty money can make people. Hovnanian has now announced it’ll be exchanging an additional $840M worth of bonds at, once again, a higher notional amount, with a 3% coupon and a maturity date of 2047. That, my friends, is the most preposterous thing I have ever seen in my life. That’s almost exactly on par with what it costs the U.S. government to borrow money for thirty years, and these guys just build houses for a living. As you can expect, this will depress Hovnanian bond prices further should they decide to move forward with this newest exchange, once again putting Blackstone in a perfect place to cash in on their CDS position in the upcoming auction. As a result, their position has materially increased in value over the last couple of days.

Truth be told, this is a sad day. Blackstone is making a mockery of, if used properly, a great market mechanism to manage the risk associated with financing growing companies around the world. The CDS market suffered greatly in the post-crisis era of tighter regulations, but this will likely be the straw that breaks the camel’s back. The ability for a company itself to determine if and when it will trigger an unnecessary technical default makes the instruments utterly useless and, if that’s the case, then maybe the CDS should die because Pandora’s Box is now open. Markets do need a way to hedge credit risk, though. There just isn’t a clear alternative in the works yet. In my opinion, the easiest mechanism would be for re/insurers to be paid a nice fee to wrap each individual bond issuance with market standard triggers (just like their regular insurance policies), but that is probably unlikely after what AIG, MBIA and AMBAC did to themselves in the financial crisis. If anyone has any ideas, I’d love to hear them.

Connecticut Striving to Become the Municipal Equivalent of Sears

“Bloomberg – Connecticut and Hartford Get $2 Billion Offer for Properties“

Connecticut is a fiscal disaster. Their decades long episode of legislative ineptitude has put the Nutmeg State in a perilous financial position that most government officials only dream about. As it stands, CT has one of the worst public pension systems in America with an embarrassingly low 44% funding ratio, one of the largest per capita tax burdens in the nation and a shrinking tax base as corporations and citizens flee the state.

You can only operate in that way for so long before markets smell the blood in the water, and it seems like one fund just got its first whiff. Chicago-based Oak Street Real Estate Capital sent a LOI to the state capital last week, offering up to $2B in cash in exchange for certain state-owned properties structured as a leaseback, yielding 7.25%. For anyone unfamiliar with a leaseback, this is when a company sells properties and/or heavy machinery to a buyer and then leases it back for continued use. This is a common way to generate liquidity for cash-strapped companies whose fixed assets are generally worth more than the business itself, like Oak Street’s neighbor, Sears Holdings.

Sears, like Connecticut, is a balance sheet disaster. Eddie Lampert bought Sears years ago through his fund ESL Investments. In a bid to free up cash and provide some short term flexibility, he sold Sears’ best performing properties into a publicly-traded REIT called Seritage Growth Properties. The asset sale was structured as a leaseback, allowing Sears to continue using the properties as retail outlets, generating a healthy rental yield for Seritage shareholders and protecting ESL LPs from the eventual Sears bankruptcy, as they own a healthy chunk of Seritage partnership units as well. The move was savvy financial engineering which, in the face of what will be a well-publicized credit event, Lampert doesn’t get enough praise for. While the move will ultimately benefit ESL’s investors and the ridiculous corporate structure they set up with Sears, it is going to destroy the company, as the now struggling retailer has the added expense of paying rent to its own investors – and that is most likely the same fate that awaits Connecticut if they try to financially engineer their way out of this mess. They couldn’t agree on a simple budget for years, I’d love to see how they navigate the asset-backed lending markets.

 

I’m Shocked That an ICO Promoted by Floyd Mayweather and DJ Khaled Was Fraudulent

“Gizmodo – SEC Charges Founders of Cryptocurrency ICO Promoted by Floyd Mayweather Jr. and DJ Khaled with Fraud“

I’m not even going to comment on Floyd Mayweather or DJ Khaled here, because if you invested a single dollar based on what a guy who can’t read posted on his Instagram, you should get burned. However, whatever you think about cryptocurrencies and their *sigh*, relevance, there is one indisputable fact: they have contributed to the meteoric rise of the ICO.

For anyone unfamiliar, an ICO (Initial Coin Offering) is a new way to raise start-up capital in the crypto space. At a high level, a start-up has an idea for a new payment system and agrees to issue their new currency supporting it to investors in exchange for bitcoin and/or ethereum. They then turn around and use the funds raised to develop the payment system and currency infrastructure. Say for instance, Domino’s wants to develop a system to revolutionize the way we all pay for pizza. You fund their venture with bitcoin and they give you PizzaCoin. If the payment system takes off and the value of PizzaCoin increases, good on you and your investment prowess.

The problem with the process is that it totally skirts the SEC regulatory framework for issuing securities and raising capital – ipso facto: it’s the wild west out here in ICO land. Any start-up in the world can issue its fake currency to any sucker that’s willing to fork over their fake bitcoin purchased with actual dollars. They can market the currency however, and to whomever, they please. This has resulted in numerous fraudulent companies raising millions of dollars from retail investors for their useless currencies. When I say useless, I mean totally useless – kinda like this ICO, the aptly named Useless Ethereum Token which has raised over $125K. What a world.

The worst part is that many unsophisticated investors don’t understand they’re not purchasing an equity interest in the company itself, but merely gambling on the value of the stupid currency they bought. Were one of these currencies to be widely adopted, the company itself would be clipping transaction fees left and right, but the ICO participant experiences none of the upside provided by the increased cash flows. You have investors providing equity capital to build the company and its product, but receiving a 0% equity stake in said company or product. It’s a perversion of the venture capital model, used solely to benefit the founders (equity holders) at the expense of investors bearing literally all of the execution risk.

These companies are extracting real dollars from the economy in order to build equity value for themselves, and leaving investors holding useless assets they created out of thin air. The sad part is that it doesn’t seem investors are catching on to the scheme, because every time one ICO blows up, I wake up the next day and it’s just like:

 

 

Walmart Buying Companies Because Its Competitors Are

Healthcare is an interesting space right now. It seems everyone can feel that change is coming, but nobody actually knows how it’ll materialize. This has resulted in a wave of product announcements and M&A activity from companies that want a piece of the lucrative, yet complex, healthcare pie, and yesterday was no different:

“Bloomberg – Walmart Inc. is in talks with health insurer Humana Inc. for a closer partnership to provide health care to consumers at home and prevent illness, according to a person familiar with the matter.”

News broke last evening that Walmart is in talks with Humana about a much deeper partnership, and possibly an outright acquisition of the insurance company. This is a reactionary deal from Walmart on the heels of the CVS / Aetna transaction, which was a reactionary deal to Amazon entering the space – and that, my friends, is really what this is all about: Jeff Bezos and Amazon’s healthcare ambitions. The Company has announced a healthcare partnership with J.P. Morgan / Berkshire Hathaway, as well as intentions to pursue its own internal initiatives. Amazon has been tight-lipped on their approach, but it is widely assumed they’re going after the pharmaceutical distribution channel, a likely target given Amazon’s logistical and distribution expertise. This would not be welcomed news for companies like Express Scripts (who was acquired by insurer Cigna earlier this month), who manage pharmaceutical benefit plans on behalf of employers by negotiating drug prices with pharmacies and processing claims payments. Amazon would look to put the screws to these middlemen by applying their tried-and-true business model of undercutting on price and over-delivering on service. Amazon will succeed here, as it always does. The issue for pharmacy companies (Walmart, CVS) is to figure out a way to bypass being forced into business with Amazon as they enter the space. Their answer? Buy the insurance companies and handle the middleman activities in-house, building out an entire healthcare network under one roof for their millions of loyal customers. It really isn’t a bad idea and probably one of the best responses to Amazon encroachment I’ve seen. The only hurdles outside of regulatory burden will be sourcing adequately-priced deals and how to pay for them. CVS decided to go the debt route and the markets have been less than pleased. It’ll be interesting to see how it plays out, but I’ve got my chips on Jeff being the most disruptive new entrant into the space.