Michael Kao didn’t know it at the time, but changes that would soon decimate the convertible-bond market were just getting under way the year he launched Akanthos Capital.
Kao founded the Los Angeles–based hedge fund in 2002 with a focus on three relative-value strategies: capital structure arbitrage, event-driven arbitrage and convertible arbitrage. For the next two years, Akanthos’s returns ranked in the industry’s top quartile and the firm’s assets under management surged to $750 million.
But as Akanthos grew, the convertible arbitrage game was heading toward disaster. Beginning in March 2002, volatility — the main currency of convertible arbitrage — began a long descent that didn’t hit bottom until 2006.
Like other funds focused on the convertible market, Akanthos suffered. The fund managed to make money in 2004, but 2005 was a different matter. Akanthos took a body blow on October 31, 2005, when funds of funds representing 40 percent of its capital delivered redemption notices effective December 31. After much deliberation Kao decided not to invoke the right to suspend redemptions, a standard provision in hedge fund partnership agreements. He realized the decision would make it harder for the fund to capitalize on any near-term market recovery, but he also knew it would give him the credibility to raise fresh capital from investors who might stay the course after the hot money exited.
Kao couldn’t sleep. Yoga didn’t help, and neither did his exercise bicycle. “It was the single most stressful time I have ever had,” he says. Finally, he took up kickboxing, which he still does for an hour three times a week. “Punching something definitely helped,” he jokes.
Akanthos survived, but many other large convertible players were not so lucky. According to Hedge Fund Research, convertible arbitrage strategies lost an average 1.86 percent during the treacherous months of 2005. Since that time the market has rebounded strongly, with industry-wide returns on convertible arbitrage bouncing back to 12.70 percent in 2006. This strong showing continued through the first five months of 2007, in which convertible arbitrage generated returns of 4.30 percent.
But the market emerged from the 2004–’05 turmoil greatly changed. Gone are the swarms of single-strategy funds that once dominated trading. Numerous dedicated convertible arbitrage funds failed in the market collapse, and many more were forced to abandon convertible arbitrage in favor of other strategies. Although the recovery in returns has enticed some bold managers to reenter the market with single-strategy funds, the profile of the typical convertible investor has changed, perhaps for good. Today a growing portion of the convertibles market is made up of funds resembling Akanthos — arbitrage traders who happen to focus on convertibles but look for opportunities in other parts of the capital structure too.
“Single-strategy is a tough way to start out, and it’s a tough way to stay,” says Paul Bucci, senior international convertible portfolio manager at TQA Investors, a Stamford, Connecticut–based manager that, like Akanthos, focuses on relative-value strategies. “In a year like 2005, you need two or three other strategies that work well.”
Some of the world’s biggest hedge funds got their start in convertible arbitrage. Fund managers like Highbridge Capital Management, Citadel Investment Group, HBK Investments and Stark Investments, among others, built their early reputations largely on the basis of the double-digit annual returns they generated with convertible arbitrage strategies through most of the 1990s and early 2000s. By 2004 many of these funds had grown and diversified, shedding the convertible arbitrage label. What the big multistrategy funds did not leave behind, however, was exposure to convertibles. When the bottom fell out of the market in 2004, multistrategy funds that had remained active in convertibles survived
by slashing their exposure.
In convertible arbitrage strategies, investors seek to capitalize on mispricings between a company’s convertible securities and common stock. In a traditional convertible arbitrage trade, an investor purchases the convertible and shorts the underlying common stock in a ratio that eliminates market risk for small price moves in the stock, a so-called delta-neutral hedge. The value of any convertible is determined to a large extent by the value of its embedded call option, which in turn is affected by expectations about future price volatility in the stock. As a result, convertible arbitrageurs rely on volatility as an important source of profit.
When volatility moved toward historical lows in 2004, the market began to experience real trouble and returns began to slip. Investors who had poured assets into convertible funds in prior years began to scale back on their commitments, forcing some managers to sell positions to meet redemptions and driving down prices on convertibles. Things got worse in 2005, when average industry-wide returns on convertible arbitrage strategies dipped into negative territory for the first time since 1994.
Now, with convertible arbitrage returns on the upswing (thanks to a pickup in volatility and an increase in new issues), John McGorty, senior vice president and a portfolio manager at Norwalk, Connecticut–based fund of hedge funds EACM Advisors, says that interest in convertibles has revived among investors. Investors are being drawn into the market in large part by a resurgence in the new-issues market, which is providing fresh arbitrage opportunities. A robust new-issues calendar in the first four months of 2007 has already matched the total for 2005. The big multistrategy firms that left the market in 2004–’05 are back, and their commitments to convertibles have increased along with these funds’ sometimes spectacular growth over the past several years. These returnees are being joined by a growing host of newcomers.
“A week doesn’t go by that we don’t see convertible managers marketing a new vehicle to us,” McGorty says, “whether it’s a classic convertible arb effort or a long volatility profile awaiting a sustained turn in volatility, or a multistrategy construct.”
Many of the new “multistrategy constructs” have more in common with funds like TQA and Akanthos than they do with the Highbridges and Citadels of the world. Indeed, a growing number of fund managers seem to be tapping the demand among investors — particularly funds of hedge funds — for convertible arbitrage vehicles positioned somewhere between the concentrated risk of single-strategy funds and the broad diversification of big multistrategy funds.
When funds of hedge funds exited convertible arbitrage in 2005, many of them planned to get their future exposure through the market’s large multistrategy funds. But Steven Wilson, who runs convertibles at Context Capital Management, a hedge fund manager based in Greenwich, Connecticut, says that strategy hasn’t always worked because multistrategy funds often can’t provide enough exposure to meet the needs of these large investors. By contrast, funds like Akanthos and Context, which focus on convertibles as part of a narrow multistrategy approach, can deliver convertible exposure in the size funds of funds need while avoiding the pitfalls of single-strategy concentration.
The strategies of these managers are perhaps best described as credit- and capital-structure arbitrage, with a heavy emphasis on convertibles. “If you understand converts, you can understand pretty much every part of the capital structure,” says Kao. “Maybe that’s why it has proven to be such a popular jumping-off point for a lot of multistrategy funds.”
For fund managers the most important and obvious benefit of this model is the ability to dial up and down their convertible exposure as market conditions warrant. The big convertibles players that survived the 2004–’05 shakeout were mainly those who found ways to make money in trades driven by credit, corporate events or rising equity valuations.
Credit- and event-driven trades helped Kamunting Street Capital Management survive and even make money in 2005. Founder Allan Teh, who began trading convertibles at Goldman, Sachs & Co. and then ran Tribeca Global Convertible Investments, an in-house hedge fund at Citigroup, launched Kamunting with $600 million in June 2004 — just about the worst time imaginable to start a convertible arbitrage fund. The fund survived the market collapse, had a banner year in 2006 and saw its assets under management swell to nearly $1 billion, mainly from retained earnings rather than additional contributions. This success can be attributed in large part to the fund’s use of an approach described by Teh as “credit-driven and convertiblecentric,” that in many ways resembles the narrow multistrategy structure utilized by Akanthos, Context and TQA.
Teh looks for distressed companies whose equity value far exceeds the principal value of its outstanding convertible bonds. Convertibles make up 65 to 70 percent of Kamunting’s investments, with plays on improving credit trends in nonconvertible debt making up the rest of the book.
“If you own a convert in a company that is ‘money good’ in bankruptcy, you should never lose money,” Teh says. If the company fails, the convertible-bond holder profits from a short equity position and the bonds get paid out at par. If the company recovers, gains on the bonds from improving credit, higher volatility and rising equity value should outweigh losses on the equity hedge.
Teh maintains that convertible bonds’ protections have measurable value the market doesn’t always recognize. “People say converts are trading right at implied volatility in the options markets,” he says, “but options have no dividend protection and no takeover protection, so convertibles should trade higher.” Convertibles often also have more call protection than the options market implies, particularly if the issuer is a shaky credit. Teh cites Ford Motor Co. as an example: Given its tenuous financial position, Ford won’t call its outstanding convertible bonds while it might have to redeem them for cash, he says. Instead, it will wait until the stock trades well above the conversion price so investors have a compelling reason to exercise their conversion right, a delay that Teh says could add 10 percent to the value of the convertible.
At the moment, Teh says he is long debt securities (both convertible and straight) of General Motors Corp. and Ford but short the common stocks of both. He believes the senior and secured debt will pay out at par if the companies go bankrupt, as occurred when auto-parts maker Delphi Corp. declared bankruptcy in 2005, but his hedge implies the bonds would recover only 30 cents on the dollar. “I will probably make more money if GM and Ford file for bankruptcy than if they don’t,” says Teh. “In the meantime, it’s an 8 percent yield on a hedged position in Ford.”
Like Kamunting, Akanthos invests in several areas, all of which play a role in determining the value of convertibles. Kao describes his fund as a value investor in four dimensions: volatility, credit, equity valuation and events — an approach he developed in the 1990s. Kao started out in the early ’90s at Goldman Sachs’ J. Aron division trading the Goldman Sachs Commodity index against the individual components, making macro bets to over- or underweight particular commodities. He soured on directional trading after seeing that even legends like George Soros and Julian Robertson Jr. lose badly from time to time. After a brief spell at Harvard Management Co., Kao joined Canyon Capital Advisors, a multistrategy Beverly Hills, California–based hedge fund firm run by alumni of
Drexel Burnham Lambert that at the time specialized mostly in credit-related strategies. When Canyon hit a rough patch over the Russian debt default in 1998, Kao suggested a relative-value strategy combining convertible, capital structure and event-driven arbitrage under one umbrella. He ran the strategy successfully until 2002, by which time it represented a significant percentage of Canyon’s capital and profits.
Kao carried this strategy over to Akanthos, where his favorite trades combine plays in more than one dimension. A big winner this year has been Phoenix-based Freeport-McMoRan Copper & Gold, in which Akanthos owned a convertible preferred stock. Both credit and volatility looked cheap to Kao, in part because Freeport’s copper and gold mines are concentrated in Indonesia, a country torn by ethnic and religious conflicts that threaten its political stability. Akanthos put on the classic convertible arbitrage trade — long the convertible preferred and short Freeport common stock. Kao expected a big move in the convertible relative to the equity as the market recognized the undervalued credit and volatility components.
He got a pleasant surprise when Freeport agreed to buy Phelps Dodge Corp., a copper mining company also based in Phoenix whose major assets are in the U.S. The acquisition announcement introduced a third dimension to Kao’s trade in the form of the merger arbitrage play. When rumors began that Australian mining giant BHP Billiton might buy Freeport to break up the deal, a skeptical Kao upped his position. “People thought someone was going to buy Freeport-McMoRan, and we felt the opposite,” Kao explains. When the company’s merger with Phelps Dodge closed on schedule in March, Akanthos won big.
These complicated strategies illustrate another advantage that managers say they derive from a narrow, multistrategy, convertible-focused approach — the ability to leverage skills across related relative-value strategies. Context’s Wilson says the ability of a convertible analyst to call upon a risk arbitrage colleague sitting across the desk gives funds modeled in this manner a critical advantage amid today’s frenzied takeover activity.
But realizing such synergies is hardly automatic, as many multistrategy fund managers can attest to. The cross-pollination benefits of a multistrategy approach often fail to materialize because specialized research and trading teams have an incentive to compete internally for capital allocations and trade ideas.
At Akanthos, Kao has tried to eliminate the inherent conflicts of interest that bedevil some big multistrategy firms by insisting that his team work as asset class generalists. Analysts may specialize by sector, but each has to understand the entire capital structure from equity through convertibles to straight bonds and bank debt. He recognizes that asset class specialists will sometimes have an edge over his broad-based research team, but it’s a price he’s willing to pay. “We would rather make that sacrifice and be able to allocate capital objectively across the capital structure than have that process be politicized in favor of the most influential trading desk or research team,” Kao says, adding that this approach paid off in the Freeport-McMoRan/Phelps Dodge saga, when the fund early on grasped the merger arbitrage opportunity and figured out how it meshed with the original convertible arbitrage position.
By simply surviving the 2004–’05 disaster while so many of their single-strategy competitors failed, funds using these convertible-focused, credit and capital structure arbitrage strategies established themselves as an important part of the convertibles market. Now, with many investors still nursing wounds from past investments in single-strategy funds, and funds of funds unable to access adequate levels of exposure through big multistrategy funds, this new breed of convertible fund seems poised for additional growth. In May, Context and TQA — both already big players in U.S. convertible arbitrage — announced that they will merge to create a $1 billion hedge fund manager dedicated to global convertible and capital structure arbitrage, fundamental credit analysis and event-driven strategies.
“We got bruised but we didn’t get knocked out,” says Akanthos’s Kao, summing up the experience of many convertibles market survivors. “We emerged a lot stronger.”
