By Relative Value Group, Deutsche Bank Prime Services
Opportunities for Absolute Return investment in the equity market are increasingly extending beyond some of the traditional ring-fenced strategies developed over the last 20 years. This development is being driven by a desire to increase returns relative to risk assumed. The opportunities being sought are driven by a number of themes. On the positive side increasing globalisation, greater transparency of information, greater linkage of Bond/Equity markets, higher levels of corporate restructuring and increasing liquidity in equity derivative and credit markets (the latter with the Credit Default Swap (CDS)) are all playing their part in creating opportunities for those managers able to identify and exploit them. On the negative side, as returns diminish and systemic risks rise in some of the traditional strategies driven by capacity limitation, managers looking to take advantage of these newer opportunities are assuming a wider array of risks. It will be important for these managers and their end-investors to feel these risks are fully understood and managed effectively if this trend is to continue successfully.
This article by Deutsche Banks Relative Value Group reviews these trends and developments in the Equity & Equity Derivatives markets with a focus on the analytical tools now becoming available and examples to illustrate these developments.
Examples are primarily taken from the Relative Value and Merger Arbitrage areas of investment and principally those in Europe, areas in which the author has specialised over the last 10 years.
In the same way that we have seemingly seen an inexorable growth in assets under management among hedge funds, we have seen that same trend towards globalisation both in daily life and in the investment sphere. From an investment perspective the trend has been seen in terms of
1.Increasing corporate cross-border activity, as evidenced most recently by acquisitions of European companies and assets by US corporates with for example Proctor & Gambles acquisition of Wella but over the last few years in such mega tie-ups as BP/Amoco, Vodaone/Airtouch & Mannesman, and Daimler/Chrysler.
2.Trend towards Global sectorsmost notably Energy and Pharmaceuticals, where risk and return characteristics are increasingly characterised at a sector level rather than at a country/regional level.
3.Greater importance of regional investmentover individual country investment as evidenced in particular in Europe with the success in terms of growth of liquidity of the Euro-STOXX-50 listed derivatives against the individual local country index derivatives.
From an Absolute Return perspective, globalisation has had a significant impact for M&A hedge funds with volumes of deals in Europe for instance now exceeding those in the US. 2002 also saw a significant number of deals in Asia with a number of US acquirers.
Much of the cross-border M&A activity leads to closed-end investment risk arbitrage which concludes on completion (or failure) of a deal. However, the desire in many cross-border international deals to leave listed investable entities has led to a substantial increase in the range of investable open-ended cross-border relative value deals. Particular deals in this regard have been:
(Dual Listed Company structures) between UK and Australian companies (BHP/Billiton (2001), Brambles PLC/UK (2002)), UK and South Africa (Investec, 2002) and just recently a UK/US company, Carnival UK PLC/Corp (2003)
DLC structures allow for separately retained listings of the two combining stocks on each of their original exchanges. This is done through an overlay structure which provides for an agreed attribution of economic earnings between the two companies. A couple of years ago such structures had largely been thought to be anachronistic and no longer appropriate, as evidenced by the effective restructuring of a number of these cross-border structures. The introduction of the Euro in 1999 led to the removal of a number of such structures in Europe, most notably Dexia (France/Belgium) and Fortis (Netherlands/Belgium) but also the desire for establishing a global share was also strong in the removal of the DLC structure in others deals such as Allied Zurich (UK)/Zurich Allied (Switzerland) to create Zurich Financial Services and ABB. However, far from proving redundant, such structures have in the last three years provided bankers with the flexibility to provide cross-border tie-ups which simultaneously allow the investment community to retain ongoing economic exposure in each of the jurisdictions.
For Relative Value/ Absolute Return investors, these structures provide investment opportunities with the two listed non-fungible shares trading at different levels reflecting the different supply/demand dynamics of investors of the two shares, most notably the separate domestic investors. The dynamics of the spread are in reality difficult to determine a priori being substantively driven by relative market sentiment in addition to the more quantitative aspects of relative trading volumes, tax treatment on dividends etc. For a background report on spread drivers we would refer people to a report published by the AustralianFederal Reserve Banki
Taking of stakes in overseas companies and retaining free-float as a listed entity.
This has been of particular note with regard to European/Asian tie-ups, most notably Frances Renault with Japans Nissan but also a number of smaller companies such as Germanys Hochtief, with its listed subsidiary, Leighton Industries in Australia and Dutch-listed ASM International with its listed Hong Kong subsidiary ASM Pacific.
These structures have been of particular interest over the last year as risk premia evidenced in volatility of individual stocks between Europe and Asia have substantially switched – at least pre –SARS – from the traditional Asian premium over Europe to Europe now being perceived in many areas as more risky. As evidenced both with realised volatilities and in risk perception as measured by implied volatility, Asian stocks have looked less risky than many of their European counterparts.
In the context of investment opportunities for relative value funds the relative outperformance of Asia both in return and (lower realised) risk has led to situations where the effective market value (as reflected by market prices) attributed to the residual operations of the European holding entity/parent has actually been negative. Figure 3 illustrates this for Renault relative to its 44% holding in Nissan.
While there is no direct realisation of value in these situations – and in fact they may persist or become more negative over time – they provide clear anomalies and are value investment opportunities for those with a global investment perspective.
While the clearest way to look to extract value in the above situations is to buy the undervalued (European in the above example) and short the overvalued asset (the Asian stock in the same examples), the different attribution of ongoing risk (implied volatility) in the corresponding options market may also lend itself to effecting this in the options market. A sale of puts to effect a long position on the higher volatility (in the above cases European stock) and purchase of puts on the lower volatility (in this case Asian) may well prove to be a better risk adjusted trade if the realised volatilities move more into line.
While the trend for globalisation is clear, anomalies do still appear within this framework as a consequence of local or regional regulatory and consequent investment restrictions. One such is Ryanair the low cost airline operator which is listed on the Irish/UK exchange and also has an ADR, which is listed on NASDAQ and also part of the NASDAQ-100 index. European Union (EU) regulations require that holders of an EU operating license must be controlled by EU nationals. To ensure compliance with this regulation, Ryanair has set a permitted maximum ownership for non-EU investors of 49.9%. To effectively implement this restriction however the company has had to implement investment restrictions firstly on creation of new ADRs (an investment instrument primarily designed for US (ie non-EU) investors) and secondly on the purchase by non-EU nationals of the locally listed share. Such investment restrictions have led to the ADR listing – as the only direct company-issued tool for non-EU investors to invest in the stock – moving to a premium over the local stock. Such a premium over the local share should not of course be justified on strict economic terms but the lack of convertability (fungibility) between the two has led to a spread differential which becomes part of the investable relative value universe.
Balance Sheet management: Greater Linkage of Bond/Equity
A key component over the last 2 years in Europe has been the repairing/restructuring of balance sheets stretched by the high capex and growth seen through much of the late 90s and 2000-2001. This has seen a greater focus on cash flow and balance sheet strength, and consequent greater concentration on the liability side of the balance sheet from equity analysts. From the perspective of Absolute Return investors this has led to a number of areas for potential investment opportunity, over and above the traditional well-established convertible arbitrage and distressed security strategies, most notably:
Relative Valuation anomaliesbetween bonds /corporate credit instruments and equities
investment analysis seeking to provide a quantitative link between bond / equity valuations and their derivatives using company volatility measures.
. Particularly in Europe, the restructuring of the equity side of the balance sheet has often been done through pre-emptive rights issue in which current stockholders can subscribe for new stock. The rights to subscribe for new stock at a particular subscription price are ordinarily listed for a short period during which these effective options very often trade at a discount to their option valuation determined fair value (we explore this further in the section on equity derivatives)
Further development of Convertible structures
. The adaptiveness of the Convertible issuance market to meet corporate and end-investor – increasingly of the Absolute Return variety – has been a key feature of the last few years. This has been manifested of course with the likes of the successful placement of mandatory structures in Europe and Japan or recently variable conversion ratio issues in the US
The highest growth area in the above has undoubtedly been that of the CDS market, which is the largest component (over 40% by a number of estimates) of the credit derivatives market. By way of example of illustrating this, theBritish Bankers Associationiiestimates the market for Credit Derivatives may continue to grow to $5 trillion by the end of 2004 from 2002 year-end estimates of just under $2 trillion and $1.2 trillion at end 2001.
To illustrate the growing interaction of the bond/credit derivative area with the equity area , we highlight as an example the merger earlier this year of US finance company Household International (HI) with international banking group, HSBC.
Once the deal was announced back in November2002, HSBC bonds, CDS and Equity, as illustrated in Figure 5, all converged on their HSBC equivalents but with a spread reflecting the risk of deal completion. Through the period post-announcement and pre-completion, investors could monitor the relative spreads in the three instruments to determine which at any time offered the best exposure in terms of risk and reward for the deal. Movements in the spread of one instrument could well be indicators of likely spread movements or opportunities in the others. An Absolute Return investor monitoring all three spreads was likely to have been a better informed investor in terms of characterisation of risk and investment opportunities than one just monitoring one of the three instruments.
While monitoring of the dynamics between the bond, and more latterly the CDS, and the equity markets has been of increasing importance, the development ofCapital Structuremodels looks to be taking this to a new level. Capital Structure models (and as yet it is probably fair to say there is no deemed unique best model), and their usage in so-calledCapital Structure Arbitrage, seek to determine more direct quantitative relationships between bonds and CDS on the one side and the equity and equity options/derivatives on the other. The models use as minimal inputs to determine a theoretical CDS price for a certain maturity, a stock price, asset volatility, debt per share and a bond recovery rate. For a good introductory guide and illustrative analysis tools we would refer readers to the technical paper on thesiteiii(Lardy, Finkelstein, Khuong & Yang (2000)). Of particular note in Capital Structure Arbitrage are the key inputs of debt recovery rate and asset volatility, for the latter of which equity volatility is largely used as a proxy. Coupled with the recognition that a bond default is likely to lead to a substantive collapse of the share price close to zero, the linkage between equity put options and the structure of their implied volatility skew and bond values or CDS tied to bond default and recovery rates has been a key driver in Credit Structure arbitrage. We expect this area to continue to develop for Absolute Return investors able to comfortably straddle the divide of the bond, credit derivative and the equity/equity derivative markets.
For the Absolute Return investor, the characterisation of potential return and levels of risk is crucial in the analysis of any investment. Greater transparency, whether in the form of access to information on the internet (for example, recently introduced webcasts of European Commission Midday briefings), conference calls, open hearing sessions (as for example recently introduced by the UKs Competition Commission) or market published information has enabled the investor to more confidently look for a wider base of investment opportunities. The introduction of information by Crestco on levels of stock borrowing for the top 350 stocks in the UK – planned for the Summer of 2003 – is one such step towards transparency that should again aid investors.
Hand in hand with greater transparency are the issues of Corporate Governance. In Europe this manifests itself strongly for the Absolute Return investor in the rights of minority and non-voting shareholders. In Europe, the capital structure of firms developed through the years has led to
Controlling holding company structures(sometimes of the Chinese Box form with several layers). We estimate that as much as $135bln of capital is tied up in listed holding company structures alone such as Olivetti/Telecom Italia, Christian Dior/LVMH, Heineken Holding/Heineken
. Non-voting stock is common in Italy and Germany in the form of saving shares and preferred shares, but is also seen in other countries such as Switzerland eg Roche with the non-voting Genussschein and France, the latter with preferred shares . More widespread in Scandinavia and Switzerland is the dual-voting share structure where typically one share class is entitled to more votes – commonly 5 or 10 although with notable exceptions such as Ericsson where the ratio is 1000.
Over the last few years there has been considerable consolidation both of holding companies (eg Ratin/Rentokil, Dordtsche/Royal Dutch) and share classes (SAP Pref/Ord, Banca Intesa Savings/Ord, Holcim Registered /Bearer) which leads one to the sense that these complicated capital structures will eventually disappear over time. For the Absolute Return investor participating in the spreads between a holding company and its listed assets or share class spreads, we would always highlight the investment mantra ofBe the right side of value. That mantra would lead for instance to a bias of looking for opportunities in Germany where the voting share of a particular stock can anomalously trade at a premium to non-voting preferred stock (which still exists for listed companies such as Boss & Henkel). Looking at situations where the non-voting stock trades at a discount are much more susceptible to the risk that the lack of a vote may hurt value in the event of a corporate action, such as a takeover. Even so the bias towards tidying up these share class structures can still lead to investment opportunities of buying such discounted shares, but as with all investments, and even more so here, caveat emptor.
Harmonisation with a European (at least EU) wide takeover code, last rejected by the European Parliament in July, 2001, may well push forward some of the corporate governance issues for minority shares but not to the full extent recommended in the advisory Wise Men report commissioned by theEUiv.
Monitoring, and lobbying, for greater Corporate Governance is part and parcel of the realm of Absolute Return investing, in terms of seeking greater value for shareholders along with the whole investment community. We would expect to see this trend continue and indeed intensify in the coming years.
Equity Derivatives: Growth has led to increased opportunities
Equity Derivatives have long been a tool for the sophisticated Absolute Return investor to better risk control both the overall portfolio and individual situations. This has particularly been the case with regard to US risk arbitrage where usage of options, such as purchase of put options on stocks which are the subject of announced bids, has grown widespread. There have been significant other drivers however in recent years, most particularly in Europe, driving their use by Absolute Return investors, notably.
Greater liquidity. This has particularly been the case in Europe, with the rapid growth of Equity Derivatives both at the pan-European level of contracts such as the Euro STOXX 50 but also at the single stock level
Establishment of Specialist Volatility/Equity Derivative arbitrage funds
. In contrast to the wide extent of convertible arbitrage funds, specialist volatility arbitrage funds have only recently come to the fore. Specialist long volatility funds with their strong negative correlation to many other Absolute Return investment strategies (which have an apparent bias to underperform in periods of high to extreme market volatility) led the way last year but more specialist arbitrage funds incorporating skew, term structure, mean reversion, dispersion and credit driven trading strategies continue to develop
Greater use of derivative elements in special situation events
. The US has of course led the way in embedding effective optionality in merger acquisitions but since Aegons acquisiion of Transamerica in 1999 and Vivendis acquisition of Seagram in 2000, optionality has become more widespread in European deals. This was evidenced first with Telefonicas deal for Endemol (2000) and subsequently in a number of deals such as HSBCs acquisition of CCF (2001) and Scottish & Newcastles deal with Finlands Hartwall (2002), and more latterly intended acquisition of Bulmer (2003). This growth in special situation events is not confined of course to M&A activity but is also apparent in other relative value situations such as cross-border or global cross-holding trades like the Renault/Nissan holding relationship mentioned earlier
. These of course are very cyclical as investment opportunities tending to come at stages of the investment cycle where balance sheets need to be rebuilt. The prevalence of them in Europe over the last 2 years commencing with BTs in 2001 and running through the likes of Cookson, Ericsson and more latterly France Telecom and Allianz have however provided for investment opportunities for Absolute Return funds. The tendency of many holders to sell at least some of their rights entitlement rather than subscribe, at least fully, typically leads these rights to trade at a discount.
Growth of Credit Default Swaps and Capital Structure Arbitrage
. As alluded to earlier in the section on Greater linkage of the Bond & Equity markets, the growth of linking credit instrument valuation to total asset, and equity, volatility has seen substantial incraese I equity derivative activity for names with volatile credit valuations and in particular restructuring or high capex names
By way of illustrating some of the trends, Figures 6 and 7 illustrate two of the types of analysis tools used to identify potential opportunities. Figure 6 shows the spread differences in the EURO-STOXX50 and S&P-100 implied volatilities (3 month maturity), sourced from our web tool, The wide spread differential seen in January and April suggested to some that European risk was being evaluated too high relative to the US and therefore may lower relative to that in the US. Figure 7 shows by contrast to this macro/statistical driven analysis, a rights arbitrage situation with the discount seen over the life of the Ericsson rights issue from August 2002.
Managing the Opportunities afforded: Assessing the Risks and Returns
Previous sections have highlighted some of the latest developments in Absolute Return investing for investors from the equity/equity derivative side of the investment spectrum. Figure 8 schematically illustrates the breadth of interlinked investment areas is developing.
[Figure 8: Absolute Return Investing in the Equity & Equity Derivatives markets: A Development Schematic]
Of course the real key issue in all of this is the drive in the Absolute Return space of investment to increase the alpha return but through control of the risk assumed. Whether the metric for success is to exceed T-Bill returns consistently, optimise Sharpe ratio/ Information Coefficient, control tracking error in index enhancement, or some other, the key component of success lies in managing the risk side of the portfolio to achieve the absolute return. Within this framework, if investment managers are to exploit the wider range of investment opportunities whether under the umbrella of Event Investing, Capital Structure Arbitrage, Volatility Arbitrage or other, then the ability both to spot the Alpha opportunities and control the risk in trying to achieve that Alpha will be crucial. To this effect the author sees two critical developmental elements:
Development of the analytical tools to identify potential Alpha opportunities
With regard to the latter, the risk management and due dilligence process would also of course need to encompass knowledge of derivatives and considerations on the scope for any systemic risks arising from the rapid growth of markets such as the CDS market.
The migration of the stock-picking manager from the long investment community to the long/short hedge fund style has illustrated that consistent absolute returns are not just about the ability to pick winners and losers; the ability to control the risk engendered in running such a portfolio of longs and shorts is a crucial extra element. So the developments highlighted here will need time to mature if some of the long-term consistent returns of well established strategies are to be matched. It will be the task of the broader Absolute Return/Alternative Investment industry to monitor and support this process if the opportunities are to genuinely lead to the consistent high quality of return/risk sought by investors in Absolute Return funds.
Many of the ideas and developments highlighted here are ones likely to provide key issues for Absolute Return investors and managers alike in the coming years in terms of both allocation of capital, and management of that capital. Much of the development of the industry has focussed on ring-fencing individual strategies, leveraging the ability of the individual managers specialist expertise and at the same time reducing style drift. Going forward it may be that style drift will be an inevitable consequence of developments in the industry with ever greater focus on cross-product opportunities. Whichever way the industry develops however the need for ever more sophisticated cross-product analytical tools – and associated risk management – looks set to continue. From the our own experience, the enthusiastic take-up by clients of Deutsche Banks own analytical tools and database information on to this desire within the investment community.
This article was first published in The Capital Guide to Alternative Investment, May 12 2003
iiiLardy, Finkelstein, Khuong & Yang (2000), CreditGrades Technical Document
ivReport of the High Level Group of company law experts on issues related to takeover bids, 10 Jan, 2002