#ActiveAllocator Research – The typical investment banking M&A process is dull, static and has not evolved much in the past two decades that I have been observing it. What is needed is innovation – sadly conspicuous by absence in a largely secretive world. I have long believed that financial options, modern finance can bring much to investment banking. To illustrate/ amplify my point I show how the time period for closure during announced M&A deals can be hedged using simple put and call options. Happy to provide more esoteric examples and variants too. We describe in a very simple illustration the mechanics of setting up and implementing a hedge.
Step 1: Deciding between Floating vs. Fixed Exchange Ratio Collar
Step 2: Designing a Hedge – Objectives
Step 3: Designing a Hedge – Parameters
Step 4: Designing a Hedge – Deciding on Collar Width
Step 5: Designing a Hedge – Pricing the Hedge (Illustrative)
The coronacrisis may well be a watershed moment – both business mix and key players are likely to change. Development strategies will involve regional and global positioning for flow and advisory business; developing new products and market capabilities as well as going offshore. Meanwhile exchanges further consolidate faster than ever before as the world gets even more networked.
London’s breadth and depth makes it vulnerable to attack from other centers, however, its proven ability to adapt and innovate, history, allied to deep pools of skilled personnel and strong regulator are clear positives.
Financial institutions and markets do not exist in isolation – centers need to focus on non-financial factors too.
Will latest U.S. moves to punish China over disputes on trade, IP, coronavirus origins and recent imposition of national security laws on Hong Kong affect its status as a major regional financial center? Eliminating policy exemptions and treating Hong Kong as part of China is bound to affect existing rules on travel, extradition treaties, investment and export controls as well as trade and financial market regulation.
We studied major financial centers around the world and uncovered some generic critical success factors. People – the availability of good personnel and the flexibility of labor markets: Business Environment – regulation, tax rates, levels of corruption and ease of doing business; Market Access – levels of trading, as well as clustering effects from having many financial services firms together in one center; Infrastructure – the cost and availability of property and transport links; General Competitiveness – to be good at most things.
It is against such and other criteria that Hong Kong’s future competitiveness may be examined.
The offshore world is physically dwarfed and legally separated, but institutionally connected and closely linked. For many smaller economies, this is sometimes seen – incorrectly – as an “easy way” to break into the financial industry. Now, many countries are refusing to let companies registered in offshore tax havens access financial aid from coronavirus bailout packages – Gibraltar, Bahamas, Andorra, Bermuda, British Virgin Islands, Cayman Islands, Panama are increasingly scrutinized. France, Poland, Belgium and Denmark exclude companies from taxpayer-funded relief programs. But Ireland, the UK, Luxembourg and the Netherlands as well as U.S. companies that engaged in corporate inversion transactions are eligible.
Congress allocates $175 billion in relief aid to hospitals and other healthcare providers to cover expenses or lost revenues tied to the COVID-19 pandemic. At least 10 health systems have received $200 million or more in federal COVID-19 relief in the form of reimbursements for providing COVID-19-related care, e.g., building temporary structures, leasing properties, buying supplies, hiring and training additional workers and increasing surge capacity. This has important implications for the health care real estate sector – much of which is owned by REITs.
Despite the coronacrisis and Brexit, New York and London to continue to dominate. Other important regional and specialist centers are increasingly vying. Frankfurt, Singapore and Tokyo will continue to assert role as hubs, with the status of Hong Kong now somewhat challenged. Financial centers have critical mass, transparent, liquid and broad markets alongside the talent required to execute business – these skills and structures can be adapted for new markets.
China to strip Hong Kong of legal autonomy. U.S. to decline certification of autonomy from China which may trigger financial sanctions under Magnitsky Act and other provisions under Hong Kong Human Rights and Democracy Act. This will affect trades, visas, customs, banking and law enforcement and regulation cooperation. Financial centers are always reflections of a wider context, from current market issues, to local financial players, to international investor flows, to the culture and history of the country in which they operate.
After today’s NextGenerationEU announcement I did a back of envelop calculation to contrast the already announced, and proposed stimulus, with the European outlay during 2008. The data shows that European Union 2020 coronacrisis stimulus is twice that it provided in 2008. Infact, it equals the entire global stimulus during 2008 Global Financial Crisis. Still too early to arrive at implications of this huge outlay.
Pandemic Emergency Purchase Program has envelope of €750 billion to buy government and corporate bonds. Complements big bank stimulus package. Eases collateral standards and removes self imposed restrictions on purchases. Next Generation EU of €750 billion as well as targeted reinforcements to the long-term EU budget for 2021-2027 will bring the total financial firepower of the EU budget to €1.85 trillion.This is near equal to the $2,000 billion stimulus provided across the world during the 2008 global financial crisis.
#ActiveAllocator Research- ‘Today, the European Commission has put forward its proposal for a major recovery plan. To ensure the recovery is sustainable, even, inclusive and fair for all Member States, the European Commission is proposing to create a new recovery instrument, Next Generation EU, embedded within a powerful, modern and revamped long-term EU budget. The Commission has also unveiled its adjusted Work Program for 2020, which will prioritize the actions needed to propel Europe’s recovery and resilience.’
We welcome this initiative and await details.
#ActiveAllocator Research- responding to WSJ article today Tue, May 26, B1 ‘European Banks Exposed to Sudden Downturn’. We examined the events affecting the European Banking sector during the 2008 crisis and identified key drivers of recovery. They raised capital, increased liquidity, reduced their U.S. structured credit exposure and relied on the economy to recover to reduce non-performing loans. We opine that they now need to build capital (and cut balance sheets) from recent levels, take account of an increasing level of loan losses, not just from problems emerging to date from the crisis, but over the course of a developing economic down-turn.
While governments have rightly stood behind European banks, these banks are still in a weaker position, relative to their American counterparts, due to past capital policy – with the shock of coronacrisis led events posing risks to damaging market confidence and trust. The effective closure of mainstream sectors of economy is a major issue for banks, and may call for further intervention. In the longer term banking models are likely to change (a reversion to tradition?) under taxpayer-shareholder and regulatory pressure – but reforms need to be introduced at a measured pace for fear of further unbalancing.
As the coronacrisis progresses, we expect companies to separate portions of business. Such actions will be driven by strategic decisions to divest businesses and/or valuation creation opportunities. These may take form of spin-offs, carve-outs or sales. Primary reasons for spin-off include (i) Value creation – both for parent company and new separate public company; (ii) Certainty of execution; (iii) Tax free to parent and its shareholders; (iv) Can be run parallel with other divestiture alternative. These are typically a 6-12-month process that involves carving out a business from the parent (e.g. financials, management). It involves various documentation and filing requirements (e.g. SEC filings, IRS private letter ruling) and may or may not be preceded by an IPO. We provide an overview here.
LATAM Airlines files for bankruptcy today. But I don’t expect a United States Airline – none of the big 4 to follow suit.
I expect the $58 billion in aid for U.S. airlines to stave off bankruptcies. This said 750,000 pilots, flight attendants, baggage handlers, mechanics and others — will soon be among the most at-risk for losing their jobs even though the bailout barred layoffs, involuntary furloughs or pay cuts for employees. After October 1, many of these jobs will disappear.
In examining the outlook for airlines we pored over a dozen filings. Contrary to intuition, it seems that for this sector, labor is largely a “ fixed” cost (partly given union pressures) and not variable – hence a metric to be managed to for larger legacy carriers.
#ActiveAllocator Research – “Those who cannot remember the past are condemned to repeat it”. We examined multiple likely causal reasons that in combination exacerbated the 2008 crisis in the United States. Our analysis removed the “least important” variables and left us with four variables with high explanatory power – decline in home prices, a doubling in oil and higher energy prices, wealth destruction in equity markets and large reduction in credit availability. We do not see this combination of factors during the 2020 coronacrisis.
Hertz files for bankruptcy, a casualty of the coronacrisis in 2020. Anyone remember Budget? Budget filed for bankruptcy, a casualty of the 911 crisis in 2002. Budget listed $4.05 billion of assets and $4.33 billion of liabilities then and had 6,500 car and truck rental locations worldwide. Avis was Hertz’s major rival that acquired it. Here are highlights, reconstructed from history, of that bankruptcy.
Low 2020 EPS and very elevated 2021 consensus growth estimates makes 21x P/E hard to justify.
As the coronavirus pandemic continues to mercilessly unfold, I recommend that large companies recognize and immediately act on significant business risks and stifled growth prospects in the months ahead. To not do so would be willful blindness. Top management in all publicly listed firms now needs to pay special attention to funding and capital structure issues, to ensure adequate liquidity, to manage cash properly and improve capital productivity. Firms should creatively avail of the spectrum of available financing options. To catalyze creative thought, I present these along with their pros and cons in a visual here.
We see a notable increase in bankruptcy filings during the coronavirus pandemic. We describe the typical bankruptcy process in this primer.
A rise in corporate bankruptcies, as well as the pressure felt by companies not in bankruptcy to rid themselves of non-core assets, are expected to result in an increase in private equity opportunities for investment in bankruptcy sales and corporate divestitures. Because management and operational problems typically accompany the financial difficulties experienced by such companies, investments in these companies are difficult to analyze. Federal bankruptcy laws govern how companies go out of business or recover from crippling debt. A bankrupt company, the “debtor,” might use Chapter 11 of the Bankruptcy Code to reorganize its business and try to become profitable again. Management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court. Under Chapter 7, the company stops all operations and goes completely out of business. A trustee is appointed to liquidate (sell) the company’s assets and the money is used to pay off the debt, which may include debts to creditors and investors. The investors who take the least risk are paid first. For example, secured creditors take less risk because the credit that they extend is usually backed by collateral, such as a mortgage or other assets of the company. They know they will get paid first if the company declares bankruptcy. Bondholders have a greater potential for recovering their losses than stockholders, because bonds represent the debt of the company and the company has agreed to pay bondholders interest and to return their principal. Stockholders own the company, and take greater risk. They could make more money if the company does well, but they could lose money if the company does poorly. The owners are last in line to be repaid if the company fails. Bankruptcy laws determine the order of payment. The bankruptcy court may determine that stockholders don’t get anything because the debtor is insolvent – debtor’s solvency is determined by the difference between the value of its assets and its liabilities. Most publicly-held companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 provides a process for rehabilitating the company’s faltering business. Sometimes the company successfully works out a plan to return to profitability; sometimes, in the end, it liquidates. Under Chapter 11 reorganization, a company usually keeps doing business and its stock and bonds may continue to trade in securities markets. The U.S. Trustee, the bankruptcy arm of the Justice Department, will appoint one or more committees to represent the interests of creditors and stockholders in working with the company to develop a plan of reorganization to get out of debt. The plan must be accepted by the creditors, bondholders, and stockholders, and confirmed by the court. However, even if creditors or stockholders vote to reject the plan, the court can disregard the vote and still confirm the plan if it finds that the plan treats creditors and stockholders fairly.
Bloomberg May 23 article “China’s $941 Billion Sovereign Fund Seeks More Resilient Assets”
We expect much greater scrutiny for foreign M&A deals as well as delays especially for direct investments made by Sovereign Wealth Funds, particularly China Investment Corp. We describe the ‘typical’ approval process timeline and outline key considerations in the highly opaque and secretive CFIUS review process.
What is the host country for investor?
Does the acquirer have a good record of compliance?
Does the acquirer have state ownership?
Oil prices rise to $33. Storage crisis easing. Supply curtails to 11.5 million b/d. Fuel demand increases and stockpiles reduce 5 million barrels. States ease lock-down and travel rises. Demand uptick matched with OPEC supply cuts, and U.S. wells shutdown. But gasoline demand is still soft, and outlook is still fragile with low prices discouraging production.
ActiveAllocator Research- An excellent Forbes article points out that the M&A environment has radically altered in the coronacrisis. Among other things, pandemic induced uncertainty increases negotiation period, surfaces newer due diligence issues as well as increases effort to obtain third-party consents. It also delays antitrust and regulatory approvals, makes buyers and their boards of directors much more cautious, shifts more closing risk and indemnity risk to sellers, brings added risks of “buyer’s remorse” and above all raises valuations concerns.
We recommend a collar to hedge the time to closing risk and point out the advantages and disadvantages of fixed vs. floating ratio hedges.
The record of Operational & Investment Due Diligence within private equity, real estate, hedge funds and traditional investing has been dismal through the ages. An after the fact event, it is usually about shutting the barn after the horse has bolted. The function has done very little to insulate investor portfolios from losses. The activity has devolved to fiduciary CYA, designed to protect the wealth management firm, pension or sovereign fund, consultant or product purveyor from liability. In going through a roster of standardized questions, to which are offered standardized answers, it is about dotting the ‘i’ and crossing the ‘t’. One now sees new digital platforms that collate, collect, structure, and offer fund manager data for easy access to prospective investors.
The Capital Allocator is in the business of entering into partnerships with fund sponsors to potentially generate significant returns, mainly through long-term capital appreciation, by making, holding and disposing of privately negotiated equity and related investments.
Such investments are usually made as a passive investor in vehicles directed by a third party fund sponsor; as a result, the investor has only indirect influence over-achieving ultimate investment objectives. We believe that a methodical approach to selecting sponsors—which combines scientific rigor with seasoned subjective judgment— may contribute to creating strong results in a variety of economic environments. We present here a ‘best practices’ framework for selecting financial sponsors. We draw attention to important issues, metrics and considerations deemed worthy of exploration.
What follows does not represent an exhaustive list, of course. Each investment and operational diligence mission inevitably take one down paths that are not common to other missions. One must be prepared for this—and even seek it and relish it. For, it is forays beyond the common and readily available, that enable real insight into the people with whom one entrusts with one’s capital.
What is missing is the capital allocator’s nuanced perspective. We suggest one here.
Download PDF here:
Retail investors who are ineligible to invest in quality hedge funds, in hard to access investment vehicles, either because they do not meet minimum levels of wealth or income standard, or the high subscription amounts often needed to participate in such funds gravitate to liquid alternative investments. The rise of liquid alternative investment funds, packaged in mutual fund formats over the past years, as the fastest growing category of “alternative investments” is now well documented. McKinsey & Company suggest “retail alternatives will be one of the most significant drivers of U.S. retail asset management growth over the next five years, accounting for up to 50 percent of net new retail revenues”.
With liquid alternatives beginning to find increasing traction in institutional portfolios too, the question is – are they an effective substitute for hedge funds and other illiquid structures? Little empirical fact based exists and opinions abound.
Our research at ActiveAllocator.com attempts to answer this question and concludes that they are not.
Retail investors in considering hedge funds immediately encounter a wide variety of strategies, organizations and structures. Indeed, hedge funds, rather than being an asset class, are broadly a collection of governance structures and investing techniques with many common structural features. Unfortunately, from an investor’s perspective, it is often difficult to decipher which structural features are useful, which imply tradeoffs and which are simply undesirable. The dearth of empirical research leaves investors to make intuitive judgments about what features they should favor.
We re-examined a sub-set of provisions governing fund investing- liquidity terms. In contrast to alternative mutual funds, which allow investors to redeem their holdings on a daily basis with little or no advance notice, hedge fund investors are subject to a variety of terms that may restrict their ability to access their capital. All things equal, investors prefer more liquid investments to less liquid investments. Liquidity provides investors with a valuable option – specifically the opportunity to trade in and out of investments in order to rebalance a portfolio, respond to unforeseen cash flow requirements or redeploy capital towards other opportunities.
While the benefits that liquidity offers to investors are clear, the costs associated with greater liquidity are less apparent. We explored two related questions:
•Do investors pay a price – in terms of lower investment returns – for better liquidity? In other words, do funds with more favorable liquidity terms underperform less liquid funds?
•If the answer to the question is yes, then what drives this cost? In other words how can one explain the under-performance of more “liquid” funds?
Our research finds that there has been a substantial performance cost from offering increased liquidity. The under-performance cannot be attributed to fee levels or the strategy pursued by a particular fund. We are unable to attribute the liquidity cost to differences in skill across managers; we do not find strong evidence that less skillful managers (whose performance is weaker) offer more attractive liquidity terms.
Instead, our results indicate that managers who offer more restrictive liquidity terms are able to outperform more liquid managers because they are able to pursue a broader range of attractive trading opportunities.
The notion of putting retail investors in cookie-cutter mass-produced standardized buckets of allocations, referred to as model portfolios, is remnant of antiquated ‘90s thinking. In 2020, during the coronacrisis it is akin to paying a doctor expensive (very typically over 1% of assets) fees for an over-the-counter pain medicine prescription.
Bespoke allocation goes far beyond conventional passive risk and return trade-off found in model portfolios. It personalizes for unique investor preferences including accommodating a desire or aversion to alternative investments, expressing preferences for desired levels of illiquidity, considering different investing horizons, incorporating time varying risk preferences as well imposing constraints on specific asset classes to reflect unique investor circumstances.
Departing from model portfolios has potential to foster greater transparency. Moreover, it raises the quality of discourse an advisor has with her client. It encourages a conversation not on historical, but around forward looking risk- return expectations. It also brings nuance in investment decision making, conspicuous by absence in model portfolios.
Rather than persist with the historical notion of putting clients in coarse model portfolios, a far better approach is to begin by analyzing the forward-looking statistical properties and expected behavior of a client’s existing portfolio. This helps to arrive at the best combination of asset sub-types that improve existing allocations on a variety of chosen metrics.
ActiveAllocator.com lets you create bespoke portfolios in 10 clicks, in 10 minutes and at 1/10th cost.
ActiveAllocator is a digital asset allocation platform with technology-enabled customized advice capabilities. It is the world’s first portal that seamlessly integrates traditional, illiquid and alternative investments within portfolios. It helps investors analyze existing allocations, discover inefficiencies and create bespoke portfolios in minutes.
ActiveAllocator helps you go beyond traditional model portfolios by utilizing disruptive technology driven personalization. Create directional, semi-directional and non-directional market exposures in minutes.
Download white paper authored by Sameer Jain to explain the characteristics of distressed debt.
#ActiveAllocator Research – Distressed Debt. WSJ today, May 19 page B2, reports that 59 distressed debt funds are in the process of raising $67 billion. I have long advocated that opportunistic and distressed debt may have a useful role in investor portfolios. I had authored one of the early white papers explaining the characteristics of distressed debt which whilst dated in the data is still very useful.
Watch video: The updated 2020 opportunity
WSJ article May 18, “Saudi Fund Snaps Up Some U.S. Stock Bargains”. Saudi Arabia’s $300 billion SWF, The Public Investment Fund, in Q1 2020 bought around $500mm equity each in Facebook, Walt Disney, Marriott, Cisco, Citigroup, Bank of America, Boeing, Carnival, Live Nation Entertainment inter-alia.
The U.S. has long been very open to receiving foreign capital in U.S. firms. Now we see a rise in protectionism, trade barriers and inward-looking sentiment seeping into policy and regulation. The number of transactions reviewed by the Committee on Foreign Investment in the United States (CFIUS) has been growing and the fear of foreign state governments buying distressed assets increases. Opposition is no longer just vocal; a lot of activity is taking place behind the scenes in Washington. Constituency interests, too are crowding out traditional policy interests. Any involvement, other than through voting of shares, in substantive decision making of key U.S. companies is likely to be scrutinized. For mergers and acquisitions post CFIUS review, the standard process could now be longer than the typical 45-60 days if the transaction is believed to be a “threat to impair” national security.
This will be especially true for direct investments, more than for portfolio investments. How different SWFs are treated depends in large measure on how transparent they are, national security concerns as well as reciprocity.
ActiveAllocator’s core growth strategy capitalizes on several long-term industry trends that continue to be valid and even stronger in 2020. One being mass-customization. Technology driven mass customization is affecting many customer oriented industries, driving clients to expect highly personalized services uniquely tailored to their specifications. ActiveAllocator allows the “traditional” advisor to provide a modern digital advice experience. Recognizing that the “market of one” is the new norm, we go far beyond broad meaningless categories such as the wide spectrum of “very conservative” to “very aggressive” investors. Rather, our system is designed to drive the individualization of every aspect of asset allocation, down to the level of a single client.
Customers demand personalization without realizing they are demanding it, as they grow accustomed to companies anticipating their needs and offering what they’re looking for – sometimes before they even know what that is. Retailers and travel companies are using predictive tools and algorithms to exceed expectations, yet digital teams at financial firms have been slow to re-engineer websites and apps to enable highly personalized digital experiences. As consumers become more accustomed to personalized services – from online music selection, to customized exercise plans, to personal shopping, to travel – expectations will further rise. Within the financial advice sector, our approach rapidly exposes the fallacy of the “one size fits all” solution approach – such as those embodied in model portfolios and managed accounts.
Personalized service is going to be a key weapon in advisors’ battle, against competition from and disintermediation by, digital advice platforms. Once investors realize that the same managed accounts offered by advisors can be manufactured in minutes by robo-advisors at a fraction of fees, advisor fee compression is but inevitable. In an era when money can be managed effectively, efficiently and cheaply, ActiveAllocator helps advisors move up the value curve. Marrying our cutting edge fact-based, algorithm-driven predictive analytics with the advisor’s special understanding of the client’s unique circumstances drives superior outcomes. We believe that this powerful combination goes far beyond anything offered by emerging digital financial advice platforms, robo advice and digital investment managers.