Distressed bets propelled '09 return, Akanthos Capital eyes traditional convert arb prospects ahead

By Rebecca Melvin

New York, Jan. 7 - While hedge funds in general posted terrific returns in 2009, Akanthos Capital Management had an exceptionally good year due to some interesting convertible trades - some traditional and others "idiosyncratic," the fund's chief executive and portfolio manager said.

Among trades representative of the fund's "capital structure, long-short" strategy was buying General Growth Properties Inc. convertibles when they were priced at practically nothing and going long General Motors Corp. bonds and short Ford Motor Co., the seeming favorite, Akanthos' Michael Kao told Prospect News.

Akanthos notched an incredible 268% return for 2009, compared with about 42% for the HFRX Convertible Arbitrage index. In 2008, Akanthos' loss, negative 54%, was in line with the overall industry, Kao said.

While he is proud of being able to exceed the benchmark by such a large margin in 2009, Kao was also quick to point out: "It's back to ground zero for this year."

Going forward, Akanthos expects great results from more traditional convert arb and a very healthy double-digit return. If specific scenarios play out, like reinstatement of Fannie Mae dividends and a revival of the convertible preferred market, then that return could swell.

Anatomy of an asymmetric bet

General Growth filed for Chapter 11 bankruptcy in April 2009 to reduce and restructure its debt. The initial filing included 158 regional shopping centers owned by the Chicago-based real estate investment trust. Debtor-in-possession financing came from hedge fund Pershing Square Capital Management to the tune of $375 million.

In explaining the trade, Koa referred to Bill Ackman of Pershing Square, who "has been outspoken on the capital structure of GGP. Recognizing that GGP had good assets but a bad capital structure was what drove our trades."

For General Growth, which has about 91% to 93% occupancy and is considered one of the premier commercial real estate portfolios in the United States, the bankruptcy was more about liquidity than solvency, Kao said.

"You can't mark long-lived assets to 0% just because there is no bid," he said.

"We had a small position, heavily hedged, and we may have lost 1% or 2% in the trade. But when the bonds were tracking down to eventually 4.5 cents on the dollar, that's when we moved in. We bought at 11, eight, six and four," Kao said.

Akanthos bought a significant stake when the market started to turn at the beginning of 2009. To control the risk, it sold as low as 15. Then the bonds began to move up; they reached 70, and now they stand at 95 or 96. Akanthos' average exit, or sale, in General Growth was at 50, and the average buy was at six.

Kao said that when his firm started selling, it put sale proceeds back into General Growth equity. "It was 30 cents to $1 to $2," he said. "And given that GGP has a very top-heavy capital structure, with $25 billion of senior secured, it was likely that if the convertibles wound up being worth par, there would be value in equity."

The equity wound up going up to $6 by the time the convertibles were in the mid 70s, and Akanthos fully exited in the 70s in November.

When the equity took a hit to $4 from $6, Akanthos started shorting the converts and went long the equity. Then in December, with this newly configured trade, things really started to get interesting for Akanthos. The stock went to $12, and Akanthos took its largest year-to-date gain with the asymmetric bet.

"We lost on the bond short but ended up tripling the equity position," Kao said. These types of trades are what he called "railroad bond situations," and Kao believes many more of them remain in the convert space going into 2010.

Kao tells the story of Cy Lewis, a lowly Bear Stearns bond trader in the 1930s who bought railroad bonds that had sunk to 5 cents on the dollar after the U.S. government commandeered the railroads to ensure timely delivery of war materials.

Lewis bet about $800,000 of proprietary capital on railroad bonds and later made $17 million, putting Bear Stearns on the map, Kao said.

"Our portfolio is pretty idiosyncratic," said Kao, asserting that the fund is not a pure convert arb but has a capital structure, long-short strategy that expresses bets primarily through converts.

"2008 created multiple railroad bond opportunities in the convert asset class, and that's the way we made money in 2009," he said.

A key to being able to capitalize on such dislocations was being in the middle of the storm and not walking away, Kao said.

"Multi strats like to say they can time the asset class; but being in the center helped," he said.

"We still think it's a good set up; we're still reversed on it," Kao said of General Growth.

Long GM, short Ford

Currently Akanthos is short the new Ford Motor 4.25% convertibles and long General Motors' 5.25% convertibles due 2032. Before the end of the year, the fund was long the GM bonds and short Ford equity.

"This trade goes back to March when Chrysler senior secured creditors were getting shafted by the government in favor of the unions. The convert marketplace then sold off GM, with GM senior unsecured going down to 4 cents on the dollar," Kao said.

"We took a contrarian view, betting that the $27 billion GM senior unsecured creditor class was large and diverse enough to include Main Street holders that the government would revise its offer. As it turns out, the government eventually buckled under the pressure of protests by Main Street holders, and we got a much fairer deal," he said.

Although Ford equity is on a tear, Kao is betting against the company because of the legacy costs that it retains, while GM was able to shed them.

In addition, GM emerged from bankruptcy, but it still doesn't have new equity and won't until the latter part of the year. That means that while Ford is getting a lot of exposure from equity analysts, GM is not.

As for support of the convert position, Kao said the GM convertibles trade at a three-point discount to the straights. "They are the cheapest to deliver. They represent the equity; even here the bonds have a 30% to 40% upside, so we're shorting Ford against it. Ford equity is rich, and we think GM bonds are cheap," he said.

Akanthos covered its short Ford equity position at year-end for tax reasons and shorted Ford convertibles instead.

These trades had very asymmetric risks and rewards early on as outright bets, but now they have appreciated and can be restructured as hedged plays, he said.

Second 'golden age'

Kao thinks that convert arb, which hasn't been overly successful in recent years, is poised for what he calls a "second golden age."

The first golden age was from 1998 to 2004 when there was stable credit but volatile equities, he said. Most funds of funds had 25% allocations in convert arb at that point. But in 2005 there was a mass exodus from the asset class, and now converts look like the ugly step children of high-yield bonds, Kao said.

But just as there was a rebound in 1999 and arb returns were strong, so he suspects that the rebound after 2008 will favor convert arb and traditional high delta, low premium type names.

"From a macro perspective, we're poised for a second golden age of arbitrage," he said. "The Fed and central banks globally are going to be wary of allowing another 2008. They are going to remain easy for a long time.

"In addition, investors are not sure whether this is a huge bear market rally in equities or the beginning of a secular bull [market]. That means a lot of equity volatility will persist.

"Before converts didn't work because credit volatility outstripped equity vol, bond floors were squishy. But now we're entering into a period like 1999 to 2004. And we are bar-belling our book to be half railroad bond situations and dislocated capital structure and half more traditional convert arb."

Returns in 2009 were primarily distressed returns not convert arb returns, but that is about to change, he said.

A lot of investment-grade converts are rich, and the real value is in the sub-investment-grade space. Also you don't have to look any further than Fannie or Freddie Mac preferreds to find opportunity, he said.

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