In their latest episode of the VALUE: After Hours Podcast, Michael Kao, Jake Taylor, and Tobias Carlisle discuss:
- Warren Buffett Prefers Preferred Stock
- Oil/Inflation/USD-Clash of the Titans – Fed vs OPEC+
- Millions Will Lose Jobs
- Generating Alpha With Asymmetry
- When Inflation Gets Out Of Control
- Finding The Fulcrum Security
- After The Recession & The Economic Recovery
- The Shadow Banking Sector
- The Future Of Energy
- Winning Three Legged Trades
- Synthetic Event Options Explained
- From Contango To Backwardation
- Soros’ $500 Million Notional Dollar-Deutsche Mark Options Trade
- The El Paso Convertible Trade That Didn’t Work Out
- Buying Convertible Bonds For 4c On The Dollar
- Working With Gary Cohn At GS
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias: This meeting is streaming live. I am Tobias Carlisle, joined as always by Jake Taylor. This is Value: After Hours. Special guest today, Michael Kao. He’s Urban Kaoboy on Substack. @urbankaoboy on Twitter as well, Michael?
Michael: Yeah. Urban– yep.
Jake: It’s a good name, by the way.
Michael: There are a lot of fakes. There’s only one, the real one.
Tobias: I first saw Michael speak in 2010 at a Value Investing Congress where I thought he gave the absolute stand-up presentation of the two days, which was a capital structure arbitrage. I think it was GM. We’re trying to remember exactly what it was, but I’m going to take everybody through who Michael is through his background, and then we’re going to discuss a little bit of how he views the markets and what he’s seeing at the moment.
How are you, JT? I should check in with you first. We’ve just got back from Omaha. So, we’re buffered it up at the moment.
Jake: Yeah, definitely do a little Berkshire review, probably later in the show.
Michael: I made my journey to value mecca a couple of years ago too. Yeah, it’s fun.
Jake: We had a great time. [crosstalk] Yeah, I’m starting to wonder though, Toby, I think there might be more than 10 people that listen to the show, because we met a lot of people [laughs] in Omaha.
Tobias: We had a really fun turnout. We had just impromptu drinks after the event across the road at the Hilton, and we got a few hundred people, I think, in that little-
Tobias: -outdoor area.
Michael: That’s cool. It’s always fun.
Tobias: Last year, we pirated this little spot upstairs and not realizing that, because it was COVID, it was a much smaller meeting than it usually is. And then, I was walking up the stairs this time to go to that area, and they had a security guard standing there and she said, “This is not the Value: After Hours podcast after party. They didn’t book.” So, I said, “Oh, that’s terrible of them. I’ll go let them know,” and then we headed downstairs.
Jake: [laughs] It worked out just fine. We got to be outside instead. It was a beautiful day.
Michael: It never ceases to amaze me that you’ve got two elderly gentlemen that can command basically, what, 50,000 people for hours and hours and hours and hours. It’s pretty remarkable.
Tobias: With no bathroom breaks.
Michael: [laughs] I know. At their age.
Tobias: And they’re drinking that Coke like it’s water.[laughter]
Tobias: Let me just give a quick shoutout to all of the listeners. Toronto, Phoenix, Kathmandu, Rolling Hills. Guilford in the UK. Doha, Qatar. Egersund, Norway. Madison, how you doing? Aiden, Brussels, Belgium. Kennesaw, Georgia. Cardiff, Wales. Bendigo, what’s up, Australia? Black Hills, South Dakota. Munich. Milton Keynes. London. Katowice, Poland. Tallahassee. Lisbon, Portugal. Wagga Wagga, Australia, how are you? Sterling, Scotland.
Jake: Oh, my God.
Tobias: Victoria, British-Columbia. Altamonte Springs. And John de Grumman says, “Welcome, Mike.” That’s a good place to get going.
Michael: Thank you for having me. Wow, that’s very exciting. That’s very cool. You rattled off places that I’m heading to later this year. [laughs]
Tobias: When I saw you speak in 2010, you were running Akanthos Capital. You’d come out of Canyon. You’re a Goldman Sachs guy. Even before that, you were a university student and you studied– I didn’t know this until I was just– You’re electrical engineering and computer science. So, how did you transition from that into where you currently are?
Michael: Well, yeah, a little bit of background then. I wanted to be a videogame designer growing up. I knew with 100% certainty that that’s what I wanted to do by 9th grade. I was a pretty good coder. I knew four different programming languages by 9th grade and all this stuff. That’s what I went to university for. During my time in college, I did a couple of engineering internships, decided that the life of a coder really wasn’t suited for me, but yet, well, this is my only skill. I know nothing about business.
So, I just made like a last-minute pivot, almost random in a way. I interviewed for this IT position. Both Goldman and Morgan Stanley were interviewing for IT. I remember asking a couple of fraternity brothers, “You know anything about these firms? Are they any good?” They’re like, “Oh, yeah, they’re the top of the top as far as investment banks go.” And I said, “Okay, well, I’m interviewing–”
Anyway, I wound up getting both job offers. I picked Goldman. I got drafted into the J. Aron Group, which was unbeknownst to me at the time. It was the most profitable division of Goldman. I think J. Aron accounted for 30% or 40% of overall Goldman Sachs profitability. This is around 1991 or 1992. Would you believe that 21-year-old me at the time had the naivete and perhaps idiocy to ask the partner in charge of IT for a sit-down? Because I said, “I know nothing about commodities. What I know about Wall Street is stocks. I don’t want this assignment.” She sat me down. She goes, “Let me tell you something. You got handpicked by the most profitable division of the firm. I would take this assignment.” I’m like, “Okay.” [laughs]
So, I wound up taking that gig. I was coding basically the GUI software for the sales traders in the FX group, and the FX options group, specifically. I’ve realized very early on, “You know what? If I wanted to be a coder, I should have just gone to Microsoft or a company where the revenue generators are the coders. But if I’m here at Goldman Sachs and I had already gone through a multi-month training program and I got the vague ideas of, ‘Okay, here are stocks, here are bonds, here are commodities, here FX,’ this is all super exciting stuff to me.’
I just took night classes, and read a ton on my own, and very quickly realized, “You know what? If I’m here at Goldman, I should take a go at least trying to be a revenue generator somehow.” I kept running into these brick walls. I remember during lunches, I go up to Human Resources and say, “Hey, I want to be a trader. How do I be a trader?” They’d tell me to read a bunch of books and send me on these wild goose chases, and a couple of months later, I’d be done. “Go back upstairs.” “Okay, done. Done this.”
Soros’ $500 Million Notional Dollar-Deutsche Mark Options Trade
Anyways, these wild goose chases kept happening, but meanwhile, I was just learning. I didn’t know, but I was actually learning quite a bit. A year into the job, I just rolled out my currency options module. The senior sales guy, his name was John, he calls me out on the desk to bitch at me for all the bugs in my new program. And then, lo and behold, his biggest client, Quantum Fund, calls up. Quantum Fund wants a two-sided market on a $500 million notional dollar-deutsche mark options trade.
Tobias: You got to say Soros with Quantum Fund as well. [crosstalk] generation to [unintelligible [00:07:59] Mike?
Michael: That’s right. This is right after– this is probably, what, less than a year after Soros-
Jake: Broke the bank.
Michael: -earned the reputation. The man who broke the bank of England, right? So, needless to say, when Soros calls, the whole desk goes quiet. He wants a two-sided market. Everybody’s guessing, is he buyers, is he a seller, how do we quote the market, blah, blah, blah. Meanwhile, I’m just trying to get my sales guy, John, to explain to me what the options trade was. So, he sketches it out on a napkin, but he gets it backward and I just corrected him. I said, “I think you got it backwards. I think it’s supposed to be like this.” He’s like, “Yeah, you know what? You’re right.” I thought nothing of the conversation, but two days later, I get a call from Richard.
So, back then, Richard [unintelligible [00:08:47] and Lloyd Blankfein co-ran J. Aron. So. Lloyd ran trading, Richard ran sales. So, they’re the two senior partners there. I get a call from Richard himself, who is actually my boss’s boss’s boss. He’s like, “I hear you have a knack for options and interest in finance. Would you like to interview for a job as analyst position on one of the desks?” And I’m like, “Yeah.” So, that’s basically how I transitioned.
Working With Gary Cohn At GS
I spent a couple of months as a jack of all trades. I was basically precious metals analyst. But the precious metals and base metals desk– By the way, precious metals was run by a partner named Jim Riley, base metals was run by none other than, Gary Cohn. So, it’s a very interesting place to grow up, if you will. Lots of colorful personalities, incredibly intense atmosphere. But there was a small nascent desk called the GSCI desk, which was Goldman Sachs Commodity Index was launched back in 1991. There were two traders on that desk and it was a very nascent product. They were selling structured notes on GSCI. There was a listed futures contract, and Goldman was trying to make a big institutional push for making commodities and investable asset class.
So, in my role as a junior analyst on the desk, if somebody said, “Hey, do this pet project.” It didn’t matter whether or not they were my direct report, I just did it. I did projects for everybody. So, within a couple of months, one of the two traders left to be a sales guy. And all of a sudden, I landed a role as the junior trader, the number two trader on the GSCI desk. Then the next couple of years were super, super interesting because at one point, one of the large pension funds comes in with, I don’t know, 50 basis point allocation to commodities. Then I found myself at this epicenter where I had to make $10,000 up.
So, I put into perspective. GSCI those days was a 10-lot up market, right? It was literally getting picked. Being a market maker in GSCI basically meant that you were getting picked apart by the locals, left and right, the four traders. It was no fun. But when this pension fund came in, my mandate from my bosses were, you stand up to any size they want, any size, because I could always arbitrage the underlying 22 different commodities. So, I was making $10,000 up lot markets, and then arbitraging the 22 underlying commodities. It was unbelievably fun, exhilarating, and incredible learning experience.
Tobias: At some point, you’ve transitioned out of Goldman Sachs to Canyon. How did that come about?
Michael: Yeah, so, I did that for a couple of years and then I realized that, “You know what? I’m doing just technical analysis pretty much. I don’t know a thing about fundamental analysis or finance.” So, I decided to go back to business school. I went to business school in Philly. I did a very impactful internship during my business school years. I got an internship at the Harvard Management Company, the endowment fund. And these were the days when Jack Meyer ran that. There were two-star portfolio managers, John Jacobson and Jeff Larson, and I got to spend a summer with them. In one summer, all of a sudden, my world expanded. I went from technical analysis– And my idea of hedge funds were either CTAs or macro funds. That’s it. I had no idea that there was this massive world of equity long, short, convertible arbitrage, capital structure arbitrage, merger arbitrage.
This was circa 1996, 1997, hedge funds really weren’t a thing. All my classmates were going to investment banking and consulting. I think I might have been the only person that was actively looking for hedge funds. There are two little known shops, one of them being Citadel that had just opened. They had $500 million under management. I actually interviewed with Ken back then, wound up getting a job offer at three different shops that specialize in convert/capital structure arb. I think the offer from Canyon didn’t come in until after I already graduated. It was already during graduation weekend and I thought, “Well, this is pretty cool.” I wanted to be back on the West Coast. My wife is from there.
Basically, since high school, I’ve been living in California. I always consider California my home. Their bread and butter, Canyon started by Josh Friedman and Mitch Julis both super smart guys who I consider to be friends and mentors to this day. They came out of Drexel in that whole Drexel diaspora. And their firm was mainly focused on credit, high yield direct lending bank debt. Again, this is an area obviously convert arb capital structure touches upon credit, but this was pure credit, and I really had no idea about it. But I took a chance and it worked out, because Josh and Mitch–
Generating Alpha With Asymmetry
Long story short, during my years at Canyon, they let me have the ball and run with it. I had this idea of creating a business within a business. I wrote a paper in probably circa 1998, I entitled it alpha with asymmetry. The general thought was that convertible and capital structure arb strategies tend to be long gamma, long optionality. Merger arb strategies and event driven strategies generally tend to have short gamma characteristics. The way I explained that is always that, if you think about a friendly deal where you’ve got a 95% chance of making a dollar, if the deal closes in, that 5% chance of a deal bust, you might lose $10. Well, that awfully sounds like short optionality to me.
So, my thought was, what if I created a business where these two asset classes could be paired and systemically hedge one another. But if you could be very smart and diligent about security selection, you might be able to create alpha with a lot of asymmetry. And so, that was the strategy that I started and ran at Canyon, and then wound up porting over to my own firm in 2002.
Tobias: So, let’s just talk a little bit about Akanthos in a little bit more detail and we’ll go back through what you’ve said. Because this is a value podcast, we might need a little bit more explanation of some of those terms.
Michael: Sure. Sorry, rephrase the question. What was I doing at–?
Tobias: Yeah, tell us a little bit about Akanthos and then we’ll go through those strategies just a little bit more, because for the most part, we’re vanilla long only value here, and we probably need some more explanation of some of those things.
Jake: [unintelligible [00:17:14] terms.
Michael: Yeah. So, look, I think by focusing on– At Canyon, the portfolio that I ran was always very convertible centric. The reason why I chose the convertible asset class to focus on was one. There really was no single analyst at Canyon focused on it, because most people focused there on either senior secured debt or senior unsecured high yield debt. Convertibles are an interesting asset class, because they touch upon credit, obviously. They also touch upon equity valuation, and they obviously also touch upon optionality. That’s very, very appealing to me.
In that period of time also, convertibles as an entire asset class, I would say, were a value asset class, because they were pretty mispriced. I remember giving this pitch to investors all the time that– I wish I had a graphic to show you, but if you think of the proverbial hockey stick of an equity option, now think about it from the standpoint of the Merton real options model. So, if you think about a firm’s equity as a real option on its assets, you can now think of that as, “Okay, the strike price of that option is the amount of debt, because by the accounting identity, equity equals assets minus liabilities.” So, that equity option is basically a call option. I’m going to try to frame it. It’s a call option on the firm’s assets. But debt to the investor standpoint is a short put. So, let’s see. If this is a call option, then a short put looks like this.
Why is that? Because the strike price of that put, by the way, is the amount of assets that are required to make the debt whole at par. When you buy a bond, you have a fixed income upside. You are getting your upside purely by the coupon and the yield. Well, that’s actually akin to the premium that you get from selling an option. But why is it a put option? Well, it’s because that if the assets exceed liabilities by so much and stock goes to the moon, well, the bondholder is just going to get par at the end of the day. But what happens if the underlying company falls into financial distress where the asset value of the firm drops below the par amount of debt outstanding? Well, then your bonds have equity, like, downside, so you are short of put on the firm’s assets.
Finding The Fulcrum Security
So, this is the holistic way that I think about capital structure period, because to me, equities bonds, they are all part of a continuum of value across a firm’s capital structure. Where the fulcrum resides, and what I defined by fulcrum is the fulcrum is that part of the capital structure that has the most asymmetric movement based on a change in the firm’s enterprise value. So, let me say that again. The enterprise value obviously is the equity value, plus the amount of debt in a company’s overall value. If you have a company with no debt, then the market cap equals the enterprise value. You have to also subtract out cash. So, there in that case, the fulcrum security can only be the equity, because that’s it. Change in enterprise value directly manifests and change in equity value.
But what if you have a very highly levered company where most of the enterprise value is the debt value? Well, if the asset value exceeds the liability value, the fulcrum could still very well be the equity. In fact, the attractiveness of buying a levered equity that’s been pounded down by exogenous factors where the company still has strong cash flow, well, you can find very, very asymmetric opportunities in fulcrum equities that way. But during the great financial crisis, for instance, the credit stress was so severe that in many cases the fulcrum securities became subordinated debt in my specialty convertibles.
Tobias: Can I just ask why is that the case, because unlikely to collect on the equity, and so it’s much more likely to fall through into some sort of bankruptcy proceeding in which case you want– [crosstalk]
Michael: Yes, I’ll give you an example. So, probably, my career winning this trade of all time was buying distressed convertibles and general growth properties which was a very, very levered retail REIT that went into bankruptcy in 2008. This was a company that has something like $25 billion of senior secured debt, basically mortgages. And then below that, I can’t remember the exact number now, but let’s say that it was a sliver of senior unsecured debt, I want to say maybe $2 billion or $3 billion worth. A big chunk of that senior unsecured debt was its convertible bonds, and then beneath that you had the equity. Well, at one point in 2006, 2007, asset values were this high.
So, you take the entire debt stack, like I said, you have $25 billion of tiny sliver of senior unsecured and then the equity. Well, the asset value was so high that all the debt was basically worth par, and then you had this massive equity market cap. But the level of credit distress during the great financial crisis was so high. By the way, I still laugh at how people compare this current regional banking crisis as anything close to GFC. It’s just not anywhere close. But at that point– [crosstalk]
Buying Convertible Bonds For 4c On The Dollar
Michael: Yeah. But I don’t think that’s what this is. Anyways, not only had equity been wiped out, even that layer of senior unsecured debt was trading down at four cents on the dollar. I could buy convertible bonds at four cents on the dollar. The reason for that was, in 2008, if you remember, even dip financing, debtor in position financing, which is basically stock. Senior secured financing offered in bankruptcy, even that had dried up. And so, you had very, very levered companies like Circuit City, for instance. They had to liquidate. They had to go into a Chapter 7 liquidation. There was no reorganizing that equity. They literally had to liquidate their inventories and receivables in a vacuum.
So, it was with that backdrop that people priced the securities in the general growth properties, capital structure, similarly. But the variant view that my team and I had at the time was, this is a very different company than a distressed purveyor of TV sets and refrigerators. Properties were basically a properties that still had 90 plus percent occupancy. So, we basically made a very, very strong directional– So, the way we got into that trade to talk to you a little bit about the flavor of what we did at Akanthos was, it started off as a convertible arbitrage trade. We had on some of the convertibles long before they went into financial distress and we were short the equity. At one point during the cratering of the entire capital structure, the equity gets wiped out, but the convertibles themselves go into deep distressed territory. That’s when we essentially covered all our hedges, but massively sized up, as in like, we 10Xed our position in the convertibles at four cents on the dollar, because we said, “You know what–”
So, remember, the debt stack is here, the convertibles are here. The implied equity value went to something like all the way down here. So, when I talk about the fulcrum security, a tiny, tiny movement– Our bet was that any recovery in asset value right here would disproportionately accrue to the fulcrum layer. The fulcrum layer here was definitely the bonds. I remember Bill Ackman at the time, he was very well known for making a contrarian view on the equity. He was buying the equity at a couple of cents per share. But our view was that that was actually a much worse trade than ours, because we wound up buying a senior security at four cents on the dollar. At one point in 2009, when the bonds had gone from 4 cents to 70 cents or 80 cents, now, we were already sitting on a huge amount of gains at that point, but I perceived a different type of trade now. What we then did was, I remember now, I thought that the fulcrum was jumping to the equity layer. At this point, the equity might have 10Xed. The equity might have gone from 30 cents to $3, okay?
Now remember where we are in the cycle. If the equity is worth $3, my convertibles should be worth par. I had already made a huge amount going from 4 cents to say 70 cents. But the thought in my head was, “Well, what if I did this trade? What if I shorted the converts now at 70 cents?” Because I still didn’t know at that time in late 2009, whether or not this recovery was going to hold. So, what if I shorted the bonds at 70 cents and went dollar for dollar long the equity? Why would I do that? Because my perception was that, if this economic recovery was taking hold, then asset values would go back up to here. All I could lose on my convertible bonds would be 30 points, plus accrued interest, whatever. But the equity, if that happened, I would make five or six times on my equity bet. The equity would actually go to probably $20 a share at that point.
Winning Three Legged Trades
So, we completely changed the trade. We went from convert arb down to pure distress. Just balls out long the convertible bond to four cents on a dollar. And then, when the converts went back to 70, we shorted the converts and went dollar for dollar along the stock. Then what happened was, as we all know, the economic recovery did take hold and then before you knew it, there was a bidding war between Brookfield and Simon Property Group for General Growth Properties. My bonds went to par. I lose my 30 cents on the dollar, but my equity went from $3 to, I think it was 17 when we sold the equity. So, that’s what I mean by like, this was my career winning this trade of all time, because there were three different trades that we milked out of the same capital structure over a span of, I want to say, three or four years. We didn’t make money on the convert arb. In fact, we lost a little on the first part of the trade, but on the second two legs of the trade, we absolutely killed it.
Warren Buffett Prefers Preferred Stock
Jake: Michael, what do you think about Buffett? He tended to do a lot more preferreds during that time period than just purely long equities. Does that make sense to you? Was he thinking in fulcrum ways at that point?
Michael: Well, sure. But see, Warren Buffett though has an advantage that most people don’t. He gets sweetheart treatment there. And so, most people can’t go and say, “Hey, I’m going to take a billion in a pref.” I think it’s great. Usually, he does it like a convertible pref. So, that’s exactly the idea. He’s getting the protection of being senior to the equity. He’s getting a very large dividend rate, but he still retains the equity upside. Yeah, that’s exactly what he’s doing. I think we talked about it earlier before we started the recording, but one of my favorite value books, the reason why I like Seth Klarman’s Margin of Safety is that it talks about finding value across the capital structure as a continuum. It doesn’t just focus on equity. Most people, especially the retail crowd, just think of equity. Most of the money I made in my career was actually buying distressed bonds. Yeah, anyways.
The El Paso Convertible Trade That Didn’t Work Out
Tobias: One other trade I’ve heard you talk about was the El Paso in about 2005, El Paso convertibles. Do you want to walk through that one a little bit?
Michael: Yeah. So, that was another interesting setup. I’ll say that this was one of my most interesting trades that never made any money.[laughter]
Michael: It never made any money because I gave up on it. And eventually, the event that I wanted to be exposed never happened. But a long story short, so again, back then, I tended to focus on the convertible the first time I look at a capital structure because again, the convertible informs where I need to go, whether I want to need to focus more on the equity or on the bonds. And so, I remember my analysts at the time said, “Hey, there’s a really interesting convertible with a one-year maturity trades at roughly 90 cents on the dollar, about a 10% yield to put.” So, we discussed it in committee, and we looked at it, we’re like, “Wow, this is a pretty levered company.” It’s a pipeline company, but pretty levered. There was a lot of senior secured debt above the convertible layer.
I said the senior secured debt, I believe was a revolver was yielding just a little bit less than that bond. It was maybe yielding like 8% or so. I said, “Well, I would rather be in the top of the capital stack rather than be in this security that’s artificially held up in dollar price.” The reason why I knew it was artificially held up because of its imminent maturity is that there was a pari passu bond that was a longer dated bond in the capital structure. I think it was maybe even a 30-year maturity bond that was trading around in the mid-1970s. So, the formulation– [crosstalk]
Tobias: When you say it’s artificially held up, it’s because it’s just about two, that’s year away from–? [laughs]
Michael: See, this is what I mean by the short gamma aspect of event arbitrage. Just like a merger arb deal, where the spread is artificially held tight by the high probability of deal closure, the price of a bond that’s about to mature is artificially held up by that event, that by the event of maturity. But what if the shit hits the fan and there is a default event? Well, then that bond that’s about to mature has the farthest to fall. I used to tell my analysts and I’ve tweeted this out on numerous occasions, “The tenor of a bond is irrelevant in bankruptcy.” It’s irrelevant in bankruptcy. And so, that informs our trade formulation.
So, what I did here was, instead of going long that convertible that my analysts recommended to be long, I wound up shorting. I shorted it against that long piece of debt in the same capital structure, trading around the mid-70s. And then I went long, the senior secured revolver. There’s three pieces to the trade. In my mind, what I was forming was, I was forming a synthetic event convertible.
Jake: Like a [unintelligible [00:36:03] almost
Synthetic Event Options Explained
Michael: Well, it’s a synthetic event option. I’ll explain to you what I mean by that. Synthetic convertible bond is what I mean by it. Because in a convert, if you think about it, you’re getting paid to wait, you’re getting paid a coupon, but you have optionality on the upside. Here, I’m getting paid to wait by being long the senior secured paying me 8%. That piece of paper I viewed as bulletproof. The company could go bankrupt, and I’m going to get that 8% because I’m so senior in that capital stack. But if the company went bankrupt, my capital structure arb where I’m short to convert and that long piece of that long bond, those two converge.
Again, what I say in bankruptcy, bankruptcy doesn’t care about tenors. So, that 90 cent on the dollar convert is going to converge down to where that longer piece of debt is trading. Or, it could be the opposite. Maybe there’s a happy medium where the actual asset value justifies 80 cents on a dollar. My long bond goes from 75 cents to 80 cents, and my short bond goes from 90 cents down to cents 80. In either case, I’m covered in bankruptcy. I make money in bankruptcy. But there were also rumors at the time that Chevron-Texaco was looking at acquiring El Paso. Well, then you have to break down your event arbitrage analyst hat and say, “Okay, how do I get screwed or how do I make money here?”
If they were bought for cash, usually, bonds have a change of control put at par on a cash acquisition. So, what that means is if El Paso gets bought for cash, then any bonds with that change of control language snap to par. So, in that case, my 90-cent on the dollar bond snaps to par, I lose 10 cents. But my 78-cent or 75-cent on the dollar bond snaps to par, and I make 25 points. And again, I’m still clipping 8% on my senior secured, so that I’m covered in a cash acquisition.
But what about if it was a stock acquisition? This is what I got most excited about, because in a stock acquisition, the change of control puts– don’t necessarily get triggered in a stock acquisition, but the underlying debt essentially gets assumed by the acquiring company, and it becomes the credit of the acquiring company. Now, El Paso was a very levered credit. I can’t remember the credit rating, but I’m going to say that it was close to a CCC. It might have been like a single B about to get downgraded to C or something like that. It was very levered. But Chevron-Texaco was like either A or AA at the time.
So, here’s what would happen on a stock acquisition. Again, senior secured revolver, nothing happens. I’m still getting my 8%. Well, that would actually trade well above at that point, because that 8% senior secured revolver probably reprices to yield 3% or 4% under a single A credit. Now, the convertible bond is callable and putable at par. Same thing. It can’t go much higher, because it’s callable approval at par. It really can’t go much higher than par. You can lose 10 points on my convertible short, okay? But what about my long bond? A 30-year duration trading at 75 cents on the dollar, if that bond all of a sudden gets rated to single A, it goes up to 130 cents on the dollar. It goes up like 60 points.
So, I loved this trade, but unfortunately, it was a pre-GFC trade, because pre-GFC, I ran my book very differently than post-GFC. Pre-GFC, I liked, in fact, my secret sauce, what my LPs liked most about Akanthos and what we did was that, we were very, very creative in taking disparate pieces of the capital structure, like, I just explained, piecing them together to form a very asymmetric option at really no cost, because I was getting paid here, I was getting paid to wait here, and completely covered in all circumstances, whether it’s bankruptcy, cash takeout, stock takeout, or nothing happens.
Basically, long story short, this turned out to be one where I held it for quite some time, I cooked the coupons, nothing really happened, I wound up just taking it off. But at the time, I viewed my portfolio as a very eclectic collection of these types of payoffs. And then obviously, post-GFC, the reason why that changed was that these trades require the balance sheet of PBs. So, I was able to lever the equity in my portfolio by two and a half to three times, which was actually lowly levered when you– Most convert arbs back then were levering anywhere from four to eight times.
So, we were on the low leverage side. We were on call it like two to two and a half times on average. But that’s also what saved us during GFC, because when the convertible asset class essentially got destroyed and became unrehypothecatable by the PBs, the PBs forced a lot of my brethren out of business by forcing them from a starting point of, say, call it five times leverage down to one in the space of a month in a total vacuum of dearth of bids during the financial crisis. So, it was a very, very challenging time. Dodd-Frank, post-GFC, the prime brokers didn’t have these magnanimous terms on extending balance sheet, so we had to evolve. So, we became much less levered and more directional in our bets.
The Future Of Energy
Tobias: Mike, you’re a family office now and you’ve still got your license, so you’re careful about the way you describe the trades you’ve got on. So, a lot of your public commentary tends to be more macro. Can we just talk to you a little bit about how you feel about– Let me throw some ideas at you. How do you feel about energy?
Michael: Well, energy is the area that I’ve been focused a lot on for a long time, because again, going back to my Akanthos stays back in 2016, we were focused on a lot of the distress in the sector. When oil cratered in 2014, 2015, there was a lot of financial distress. There was a very levered upstream MLP that went bankrupt in 2016. And then we joined a hedge fund group led by Elliot where we were owners of the senior unsecured bonds in this capital structure. We came to an agreement with the second lienholders. We gave the second lienholders the legacy business, and then we recapped the company, added new capital in, bought out the crown jewel assets, hired new management team and basically, formed a new company to harvest this asset.
So, the reason why I still have my investment advisor open is that I essentially have a one-asset fund now that’s in this post-reorg private equity. On my personal balance sheet, it’s a significant bet on the long-term prospects of oil. So, my view on oil macro is very nuanced. I do think that the ingredients for another shale revolution, that period of time where between, call it, 2014 and 2018, I view is very idiosyncratic. You had the confluence of shale coming into its own at a time where a lot of long cycle projects just got turned on, and they basically crushed the prices. So, what that then did was it led to a dearth of long-term investment.
Shale was very, very undisciplined at the time, and the management teams were compensated on just production as opposed to profitability. And so, our model was very, very different. We always decided we would leave capital reallocation decisions to the equity holder and we would distribute out earnings, which is what’s happening now with my company. But the reason why I have a very long-term view on oil is that I think between the dearth of long-term Capex, the non-lasting nature of the shale revolution, I think most of the best locations have been drilled out. I’m not saying that there is a shortage of oil. I think there will be a shortage of cheap oil. When the Permian peaks, probably sometime next year at some point, the world may vary– Of course, ESG, how that’s completely redirected capital spend.
Oil/Inflation/USD-Clash of the Titans – Fed vs OPEC+
At some point, I do think that there is the risk that we have a very sustained period of high commodity prices. Now, I say it’s nuanced because in the short-term, I see lots of deflationary effects. I’ve written at length on Twitter about this, where you’ve got essentially a clash of the titans between the Fed and OPEC+. I personally think that OPEC+ acted way too soon. I jokingly called it a premature emasculation, because– Here, we get into economics a little bit. I really like to think big picture. I respect all the people that do the fundamental barrel counting. I try to synthesize that, but really look at the bigger picture of thinking about supply demand framework and what OPEC+ did I think was to avert short term pain at the expense of long-term gain. Because if you think about where we were before the OPEC+ decision, we had a very backward dated forward curve, which implies a very inelastic supply curve.
From Contango To Backwardation
So, what happens when to prices, when an inelastic supply curve meets a downward demand shock, possibly from Fed hikes and synchronized central bank hikes causing a demand destruction of everything, not just oil? Well, that results in a very, very sharp price drop. That’s exactly what happened. So, I’ve written at length since last year that the signal quality of a forward curve going from contango into backwardation can be significant, because that’s the first time that the market is paying you, what’s called, a convenience yield for spot prices over and above forward prices. It’s unusual for a storable commodity when that happens. So, that’s why there’s signal content when the forward curve first moves from contango to backwardation. But the reverse is much more difficult, because when you have a forward curve that’s already in backwardation, it’s very, very hard to forecast when that downward demand shock happens. And so, I think that caught a lot of people offsides.
So, you had a very inelastic supply curve and then you had a downward demand shift. What OPEC did in its cut was, it shifted the supply curve back up. But there’s a cost to doing so, because going forward, it means that the supply curve is more elastic. There’s that much more spare capacity in the system. So, my view is that when the economic recovery– It’s funny to talk about economic recovery when we haven’t even seen the real recession yet.
After The Recession & The Economic Recovery
Michael: So, I’m thinking already two steps ahead. After the recession and after the economic recovery, when oil prices come back up, now the price move won’t be as parabolic because you’ve got a much more elastic supply curve. So, that’s what’s going through my head. That’s what I mean by my view on oil is still long-term bullish. I still think it’s a mistake for the administration to gut the SPR in the way it has, because I still think that that’s myopic. I don’t think that the shale revolution is going to be repeated anytime soon. So, at some point, when US shale starts to inexorably decline, then that’s the scenario. I’ve referred to in the past that at some point, we might see the supply-demand singularity point where even a recession impacted demand might not be enough to cover the spare capacity in the world. But that scenario I think was now pushed out because of what OPEC did, because OPEC just created a lot more future supply elasticity.
Tobias: You previewed a little bit where I wanted to go. We haven’t gone through the recession yet and we certainly haven’t emerged at the other side. You’re presupposing that we do go through some sort of recession probably attended by some pretty significant stock market collapse. What are you looking at there?
Michael: Well, when you look at the state of valuation in the asset markets, you look at how steep this hiking cycle has been. It’s hard for me to envisage a soft landing here in a way we don’t know what we don’t know. I think that there are lots of icebergs hidden in the surface. I don’t think I alluded to earlier. I don’t think that this is going to be a GFC 2.0. We tend to always focus on the last war, and I think that at least the large banks are extremely well capitalized. Now, regional banks, that’s something different. Unfortunately, I do think that this march towards bigger and bigger money centers at the expense of regionals is somewhat inevitable. Unfortunately, it’s not a great outcome, but I see that happening.
The Shadow Banking Sector
I’m more concerned about the hidden icebergs than the rest of the shadow banking sector. I define shadow banking sector very, very loosely by including hedge funds, private equity, venture capital, insurance companies, pension funds, endowment funds. Any financial intermediary essentially, that’s ultimately in the business of borrowing short and lending long is a shadow bank. I think that, again, the money centers are well protected, but I don’t think we’ve necessarily seen the shoe to drop yet. In that clash of the titans between the Fed and OPEC+, Fed being the central bank for dollars and OPEC+ being the central bank for oil, ultimately, I think the Fed has the upper hand.
The concern I have is that, when you look at core PCE over a long period of time, since the 1990s, since the beginning of my own career, it has been well behaved between, call it, the zero bound and say 2% for decades, which means that during the tequila crisis in 1994, the Fed was able to paper that crisis over with monetary stimulus. Ditto for 1998, ditto for 2000 and 2001, ditto for 2008, ditto for 2020, every single time because of the lack of inflation. This time though, if you look at that chart of core PCE, it’s boom, popped way out and it’s proven to be sticky at around the 5% mark. And so, everybody’s already belly aching about how the Fed needs to cut and that’s definitely priced into the yield curve, but we literally have just gotten into positive real rate territory, just now.
So, I think what I am concerned about for a number of different asset classes is that the recency bias, not of the last one to even five years, but the recency bias of the last several decades has led us to think that at the first whiff of any sort of recession, the Fed is going to tuck tail and run. But this time is different, because just by judging by that long-term chart of the core PCE, it is very, very different. And so, the reaction function, I think, will be different. That’s a scary thing. That’s why it does cloud my short-term view on oil, because I’ve not seen any recessionary backdrop where oil didn’t fall very precipitously. What we’ve seen so far is really not that precipitous, and it just depends on what OPEC does now.
When Inflation Gets Out Of Control
Jake: Just a story from Berkshire. This last weekend, I met a woman who was from Brazil, and I was asking her what was her lived experience of the inflation there for basically all of her lifetime. And she said that, “Right now, it’s back down below 5% in Brazil.” Basically, no one believes it will stay there. So, this is like the other side of the coin from the US PCA experience of– [crosstalk]
Michael: Well, let me tell you my own experience. I just got back from two weeks traveling to Egypt and Jordan. The Egyptian pound, by the way, six months ago was $18 to $1. When went, it was $31 to $1, but the black-market street rate was $42 to $1. And so, listen to this heartbreaking story. My tour guide, the guide that was with us for the five days that were in Egypt, she’s definitely one of the folks that are better off in that economy. She said that a couple of months ago, she sold her used car because she wanted to trade up. But within two weeks of her selling that car, the price of her used car had gone up 50%.
Michael: She not only could no longer afford the trade up, she couldn’t even afford to buy her own car back. She had to beg the buyer of her car to sell it back to her at 25% above what she sold it for.
Michael: That’s how brutal hyperinflation is, especially in a developing economy like that.
Jake: This is what this woman was saying, is one of the outgrowths of that, and it’s a perfect example, is that no one will commit then to long-term contracts because you can’t know what anything is going to be. And so, if you end up, no long– [crosstalk]
Michael: Which exacerbates the inflation.
Millions Will Lose Jobs
Jake: Right. And so, you end up in a very low trust environment at that point, because no one can trust each other longer than six months when the prices are moving that much. I think it’s very expensive to run a society in a low trust environment. I think that’s actually been one of the keys to the US’s success is that we have an extremely high trust environment, and it lowers the friction of doing economic activity between humans.
Michael: Well, that’s why I do think though that the Fed and Jay Powell in particular understands the cost of letting inflation expectations get unanchored, because at the end of the day, and I always have to caveat this by saying I don’t want to sound insensitive about job losses, but when you look at the unemployment rate at 3.4%, and the delta between that 3.4% and what the Fed has jawbone where it would like to see unemployment go, call it 4.6%, that’s not a job loss of 100,000 jobs. That’s a job loss of between one and a half to two million jobs. Why do people need to lose their jobs? Because, unfortunately, the Fed has one tool. It is monetary policy. The one tool that they have is to sledgehammer the economy into submission to lower aggregate demand up for goods and services. The only way to lower aggregate demand for goods and services is to create job losses.
But I have to point out that inflation though is the most regressive tax at all. So, while it’s going to be brutal for the one and a half to two million people that lose their jobs, having inflation run rampant affects 350 million people just in our country, of course. Globally, it’s affecting the entire world. So, it’s not like we’re alone in fighting inflation. I think Europe and England have a much bigger problem on their hands, because they have much higher level of inflation and structural impediments that disallow their central banks to be as aggressive as our Fed, in my opinion.
Jake: What about the fiscal side? It seems like even if Powell wants to be hard, we’re still running trillion-dollar deficits.
Michael: Remember that song by Sammy Hagar, I Can’t Drive 55? I’ve got one foot on the gas and one foot on the brake?
Jake: Yeah. [laughs]
Michael: That’s what’s happening. I also call it the vodka Red Bull economy.
Michael: It can’t be healthy for the heart. When you’re administering a depressant at the same time, you’re administering a stimulant.
Tobias: That’s a real young man’s game, those vodka Red Bulls.
Jake: [laughs] Yes.
Tobias: Jay Powell got a question from Elizabeth Warren where she said, “What would you say to the families, the one or two million families who are going to lose their jobs?” And he gave an answer that was very similar to yours. He said that he’s looking after the hundred million or so other families by raising rates to control the inflation. So, I think that that’s where he’s publicly that’s [crosstalk] he is.
Michael: That’s what I heard in this recent presser. I think, to me, the money phrase that I wrote in my recent Substack was exactly that he said that inflation is actually the most pernicious tax on the people least equipped to afford it.” Look, I think my trip to Egypt is a stark reminder of what happens when inflation gets out of control.
Tobias: Mike, absolutely fascinating. We’re coming up on time here. The two places where people can find you. You’re on Twitter @urbankaoboy, K-A-O-B-O-Y, I should point out to people. I will link it up in the show notes. And your Substack is great as well. It’s Urban Kaoboy as well.
Michael: Yeah, right.
Tobias: This has been a really fantastic, wide-ranging discussion. I really appreciate you providing your insights and [crosstalk]
Michael: Yeah, thank you for taking me down the memory lane.[laughter]
Michael: I didn’t anticipate that, but that was fun. I like that. [laughs]
Tobias: It was good chatting. And we’ll be back next week, folks. I’m not entirely sure who got– We’ve got a great guest– [crosstalk]
Jake: You’ll be here, Toby. I’ll probably be here.
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