November 25, 2019—Charles Schwab in Talks to Acquire Rival TD Ameritrade to Create $5 Trillion Brokerage Behemoth. Is this the Result of Zero Commissions?
Former Uber CEO Travis Kalanick Sells Nearly $1.5 Billion of Uber Shares as the IPO Lock-Up Expires. Why’s He Selling?
The “Big Short 2.0”: Carl Icahn Bets Big Against Shopping Malls. Will it Pay Off for the Billionaire?
Hedge Fund Legend Louis Bacon Shutters Hedge Fund Moore Capital After a 30-Year Run. Was he the Last of a Dying Breed of Non-Systematic Managers?
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian Klymochko: Welcome investors and podcast listeners to Episode 41 of the Absolute Return Podcast. I am your host Julian Klymochko.
Michael Kesslering: And I am Michael Kesslering.
Julian Klymochko: Today is Friday, November 22, 2019. Back from a trip, this week was in Montreal earlier this week for some client meetings and yesterday in New York. I spoke at a conference there, but it is nice to be back chatting with you guys about some really important market events that happened over the past week.
- We are going to chat about Charles Schwab. They are in talks to acquire rival TD Ameritrade, which would create just a brokerage behemoth with nearly 5 trillion in assets. Is this the result of the battle to zero commissions?
- Former Uber CEO Travis Kalanick, he sold nearly $1.5 billion of Uber shares as the IPO lockup expired. We are going to chat about the lockup IPO dynamics and what investors need to be concerned about when that happens.
- The big short 2.0 Carl Icahn bets against shopping malls and an intricate bet with credit default swaps. Will it pay off for the billionaire?
- Finally, we are going to chat about hedge fund legend Louis Bacon. He shuddered his hedge fund Moore Capital after a 30-year run. Was he the last of a dying breed of non-systematic managers?
Julian Klymochko: So we have a big potential M&A deal on our hands with brokerage firm giant Charles Schwab in preliminary discussions, which are now public, to acquire TD Ameritrade for 26 billion dollars. Now, this combination would create an online discount brokerage behemoth with about 5 trillion in client assets. A merger between the two would allow the companies to cut costs. It is really a play on synergies, so they are looking to cut costs and then the merged entity would be in greater position to sell ancillary services such as wealth management, etc. Since the entire trading commission, business has gone to zero, which was a really interesting dynamic that we chatted about in the past month or two. Charles Schwab moved to zero trading commissions. It was really where the industry was going. They had been steadily dropping over the past couple decades, and with the emergence of Internet online trading in the late 90s and now over the past few years, you had an upstart Robin hood which came out with zero trading commissions and they have had a lot of success in signing up clients. These more established firms really saw the writing on the wall, and Charles Schwab was the first to implement this zero trading commissions. But that really, let the horses out of the barn and their competitors, including TD Ameritrade, really had no choice but to follow. It really hurt TD Ameritrade because they were much more reliant than Schwab on trading commissions. I believe Schwab is that single digit percentage of revenue, roughly 7 percent, but Ameritrade is north of 20 percent.
Michael Kesslering: 26 percent, I believe.
Julian Klymochko: Right, so it really punished their stocks a very clever M&A move by Schwab here was to punish Ameritrade stock and then come in and try to acquire it. Classic move and kudos to them for attempting it. Effectively, they forced their hand on this zero commission trade deal just given Ameritrade’s higher reliance on commissions and where seeing dynamic there. But if you’re TD Ameritrade, what do you do? Right. The competitive dynamics and the entire industry has just really been turned upside down. They really need to consider some sort of strategic alternatives here.
The other thing is there is big implications for a Canadian bank TD because they own a forty three point two percent stake in Ameritrade in addition to their big footprint in U.S. retail banking. But TD shares have underperformed their Canadian peers. The other big Canadian banks since this whole brokerage battle broke out on the trading commission side. So TD share price has increased just one point eight percent compared to average gains of 4.3 percent for the other big six banks since Schwab did drop commissions to zero, which forced TD Ameritrade to follow. In addition to other competitors such as Fidelity, however, got to warn investors on this deal. It is just speculation at this point, so it is not a definitive deal. I remember in the original article, which CNBC broke, I believe. They indicated that they expected a deal to be done and announced by yesterday, but it still has not come out yet. It is a pre-arbitrage speculation at this point. The other thing to keep in mind, that it would be subject to pretty intense antitrust scrutiny, because this is a four to three consolidation, taking four major players down to three. Which the antitrust regulators, whether it be the DOJ or the FTC, typically do not look kindly upon, however, one analogous deal that is kind of making its way through the system right now is T-Mobile and Sprint, and that one looks like it could get the green light. It certainly has gotten approval from the FTC. They are kind of at their last roadblocks there, so it is not against the rules to do a 4 to 3 consolidation, but it does require a significant amount of effort to get through that antitrust scrutiny. Nonetheless, some share action here.
You had shares of Schwab surging about 8 percent, while TD Ameritrade stock rallied more than 20 percent on the news. Then we have this left out party, E-trade. Their stock actually fell by more than 8 percent, reflecting perhaps investors thinking maybe they’ll get acquired. Now, that seems to be off the table, doesn’t it?
Michael Kesslering: Yeah, absolutely. And with regards to the anti-trust issues, I did see some sell side research from I believe it was KBW that had come up with some research showing that the issue isn’t just the three to four. Its other segments that they are involved in, so things such as custody of Ria assets, which, you know, there’s really only three main players. And so that would be taking, you know, a where I believe they had estimated that Charles Schwab was at 50 percent of the market, TD Ameritrade being at around the 13 to 20 percent range with another player that was 25 percent.
Julian Klymochko: Right, so the antitrust regulators would be concerned that if they consolidate market share to 60 percent, then there is less consumer choice leading to potentially higher and anti-competitive pricing for customers.
Michael Kesslering: Absolutely, and which is very interesting, because if you’re thinking about it just from the customer’s standpoint, the only reason that this transaction is coming about is because of trading commissions going down to zero, which is inherently good for customers. But the antitrust regulators, they do have to look at it on a long term basis. If the companies, you know, they diminish one line of their business to then build up significant pricing power in another line, that net isn’t good for consumers. Another interesting thing that I wanted to point out was just in reference to Charles Schwab, the founder of Charles Schwab and former CEO. In early November after they made their announcement that they would stop charging commissions. He went on stage at an impact investing conference to basically let investors know that he had always hated commissions and that, you know, he never liked them then he doesn’t like them now, which I found was very interesting coming from him. As there is likely no one else that has increased their net worth as much as he has by charging commissions.
Julian Klymochko: Perhaps some virtue signalling they’re acting pretty sanctimoniously with the elimination of commissions. But I’m sure that message shouldn’t be taken to heart.
Michael Kesslering: Yeah, absolutely. I mean his net worth is 9.2 billion dollars. The lion’s share of that is due to charging commissions. But you know, strategically from Charles and Charles Schwab, the company, it’s a brilliant strategy. You know, they do something that will yes, it does impact their own revenues, but impacts their competitors more and take advantage of that by acquiring them on it at a depressed level.
Julian Klymochko: Right, so we are going to be watching the newswires closely this weekend, because I find typically these blockbuster deals tend to get wrapped up over a weekend and announced Monday morning or Sunday evening. We do see an abnormally large amount of M&A deals announced for Monday’s open. So that’s something that perhaps will be a definitive deal when we get into the office on Monday.
Julian Klymochko: Wanted to chat about Uber’s co-founder, Travis Kalanick. He actually sold nearly $600 million of Uber shares this week, taking the total tally of his share sales since the IPO lockup expired to nearly one point five billion. And that’s reason because the IPO period just expired November 6, and how that works is when you do an IPO of which Uber did in May. Typically, there is a six-month holding period in which insiders such as Travis Kalanick was famously pushed out as the company’s CEO prior to its IPO.
Insiders like that are forced and they are unable to sell their shares until the six months is up, which happened on November 6 and he is not shy about selling out of his shares. He continues to hold roughly 1.3 billion of shares; he has sold over half of his stake, which is really interesting. He has actually moved on to a new venture called Cloud Kitchens. He has invested pretty heavily into that, so that seems to be where his focus is.
Have some other transactions by insiders. Co-founder Garrett Camp he sold only about $20 million of shares this month, which is a small fraction of his stake. Then, conversely, new CEO Dara Khosrowshahi has bought more than $6 million in shares this week, according to filings. So it’s a really interesting dynamic and we just wanted to chat about how shares react into and after an IPO lock up because it is a really interesting dynamic.
Michael Kesslering: Yeah, and just to be clear on the actual dynamic, the lock-up is an arrangement between the insiders and the IPO underwriters. This is not a regulatory issue; this is strictly a contract between the IPO underwriters. If our listeners will remember, we did discuss when Beyond Meat, their insiders were actually allowed to break that lock up by the underwriters and sell into a secondary offering that was a number of months ago.
Julian Klymochko: Right, I remember another example being GoPro. That was another heavily hyped low float IPO. That absolutely skyrocketed and the founder was able to get out of the lockup by donating it to charity and then selling it at highly inflated values of something really to keep in mind. And we do have a number of examples where that happened or you’ve had negative share price reaction after this IPO expiration.
Michael Kesslering: Absolutely and with regards to the negative price reaction, it’s typically with low float stocks that have also had a lot of positive sentiment during the IPO process. So the first one to point out would be Beyond Meat as they increase their float as a percentage of shares outstanding from 21 percent at the initial IPO. So a very low float IPO to 65 percent at walk-up and with a lockup expiry, there share price actually decreased about 18 percent. Now, it cannot be completely attributable in this situation to just the lockup expiry as sell side analysts were reducing their expectations around the same time, so there a little bit of bleed in there.
Julian Klymochko: I believe they announced quarterly results around that time as well.
Michael Kesslering: Absolutely.
Julian Klymochko: Which actually beat expectations, though.
Michael Kesslering: Yes.
Julian Klymochko: There is a lot of things going on there.
Michael Kesslering: Yeah had the negative sell side reaction as well. Uber, who did not have a very positive IPO as well as Lyft. In those situations, Uber increased their float from 11 percent to 58 percent and the share price actually decreased 1.8 percent on expiry. Lyft they increased their float from 30 percent to 70 percent. So this was a the most dramatic of the examples for increasing the float and their share price decreased about 0.7 9 percent.
Lastly, being Tilray increasing a bit smaller in terms of their forward increase from 13 percent to 21 percent, but the share price decreased about 17 percent on expiry. Now why I wanted to highlight some of these examples is not necessarily, because I believe that there is an anomaly, that you should go short ahead of the expiry. It is more so on the long side and that is because, you know, this really is not an easily explainable trade to make as prior to expiry. Not only are short locates a little bit more difficult, especially if it is a low float stock.
Julian Klymochko: Meaning it is very expensive and difficult to short the stock.
Michael Kesslering: Yes and the cost to borrow is just prohibitively high. So not only do you have to be right, but your thesis really needs to play out in that exact day. The costs of the trade are quite expensive, so it is really interesting if you are along these names to be aware of these lock up expiry, if you are looking to trade out of the name anyway, you know, perhaps using that prior to the lock up expiry, it would be a good solution.
Julian Klymochko: Right, and it is an interesting dynamic because it somewhat explains how some of these low float IPOs reached such overvalued overheated levels. Where this stock just kind of skyrocketed, such as we saw on Tilray and Beyond Meat prior to IPO lockup expiry when the shares are brand new and there isn’t large amount of float, because you don’t have that counter balance of short sellers coming into the market. So it’s a supply and demand issue where you have a lot of demand because it is heavily hyped, but the supply just isn’t there. So what happens? Well that pushes up the price. What that IPO locked up expiry does is it leads to a dramatic increase in supply. Which economics 101 leads to lower prices and as we have seen on a lot of these names, it’s not guaranteed. But we did see it anecdotally Tilray down, what, 90 percent Beyond Meat down 80 percent, so there’s been significant moves after these IPO lockups, so that’s certainly something that IPO investors should be very aware of.
Julian Klymochko: Do we have the big short 2.0? Billionaire Carl Icahn, he bet big against shopping malls through a really interesting trade. He has actually become the largest short seller of shopping mall debt, structuring a bet against shopping malls that could pay out as much as 400 million bucks. Now, this bet tracks the performance of the CMBX Six Index, which tracks the value of 25 commercial mortgage backed securities through a security called credit default swaps, which is a pretty complex thing. But basically it was used, if you saw the movie The Big Short, where you had these hedge funds betting against the residential real estate sector. They bet against subprime mortgages, through these credit default swaps. It is a very similar trade to that however, instead of betting on residential real estate mortgages as they did in the big short one made famous through the big short movie. Here, what Carl Icahn and others are doing, what in what they hope could be the big short 2.0 is they are betting against shopping mall mortgages through these credit default swaps. What this index has, it has significant exposure to loans made in 2012 to malls that have lately been running into difficulties. And it’s no secret what’s been happening at these shopping malls. You have had many of the core tenants running into a lot of problems, basically, the Amazon effect, a lot of shopping is going online.
Specifically these core department store tenants really suffering. Sears went bankrupt, J.C. Penney really struggling. You are seeing it through others such as Macy’s, but thus far, it has not really worked. There had been a hedge fund playing this space, they raise three hundred million bucks, sustained heavily losses, betting against this index. It has not worked thus far; we look at fundamentals of malls. Now they have suffered rising vacancies and falling foot traffic as shoppers migrate online, which has been happening. It has been a long-term trend, but many landlords have continued to service their debt by finding new tenants. Some owners have also been able to modify or secure extensions to their loan. So it’s a really interesting dynamic such that you have lost these main department store tenants and other retailers. But what we’ve seen is one way where they’ve actually recovered that by more experienced based businesses, gyms, etc., things of that nature. So you’ve got to think on this trade now, there’s underlying index has climbed 20 percent year to date, leading to early losses to icon on this bet. Makes you wonder, is he wrong or is he just early?
Michael Kesslering: Yeah, absolutely. So specific to the index. So you had mentioned that it does track the value of 25 CMBX commercial mortgage backed securities and those 25 commercial mortgage backed securities are really referencing 40 malls. When Alder Hill Management, they hedge fund that you had mentioned that had raised money on the basis of this trade back in 2017. Now they were forced to exit this trade earlier this year after two and a half years. But they’re really just, you know, closing their trade while Icahn is putting it on. So quite opportunistic by Icahn, but they made the prediction back in 2017 that 2017 would really be the tipping point. That they were really banking on, that being the correct timing for the trade. And around that time there was a deck circulating that I remember reading through at the previous firm that we were at. At the time I just looked at it decided it was outside of my area of expertise, never really thought about it again. But I remember as well at the time that credit Suisse analysts, we’re talking about the fact that there was a lot of CMBX tourists. And, you know, we’ve talked about merger arb tourists and kind of the dangers inherent in that
Julian Klymochko: By tourists, you mean non-experts?
Michael Kesslering: Yes that we’re looking to get into a trade that’s outside of their expertise. And it was early driving up the prices for credit default swaps and then throw 2018 Alder really ramped up their bets and their expectation was that 25 out of the 40 malls that are tracked by the index would be in default by 2022.
Now, as of today, I believe there is some analysis showing that about roughly three malls have been delinquent on their loans since 2012. This thesis so far has not played out, now that does not mean it still will not play out, but it has not yet. What this really highlights to me, at least is the danger of, number one, the danger of crowded trades as this has become a very crowded trade and the dynamics of the price movement of this index can be swayed similar to what we were just talking about with low-flow IPOS. You can get a lot of interesting price dynamics in what would otherwise be a fairly illiquid index.
Julian Klymochko: Right, so many short sellers who have been burned on this trade now exiting, pushing the price further up.
Michael Kesslering: For the people that remain in the short selling trade. Another one is it really highlights the importance of understanding the instruments that you are using to affect the thesis that you have. Because in this trade, not only do you need to have your thesis on the fundamentals of the mall industry correct, including how the loans are structured and things of that nature on the fundamental side. But you also really need to understand how the instrument, a credit default swap works, like how the different pay out scenarios among the tranches work, the cost of carry of the instrument, which is estimated to be 5 percent per year on the lowest tranches and 3 percent per year annually for the higher tranches.
Julian Klymochko: Right, and by cost of carry you mean the negative return or the payment that the investor needs to make just to hold onto the trade.
Michael Kesslering: Absolutely, so in this scenario, with such a high cost carry, you really need to be right. But you also need to be right in an expedient fashion because your returns are being eaten away every day. So those were just a couple takeaways that that I had from going over this situation.
Julian Klymochko: Right, so if you are making an insurance like a bet, which this trade is, say, you are buying insurance on a house. In order to make it pay off and be economic to you, then you need that house to burn down and in quick fashion or else you, get stuck paying the insurance premiums month in and month out, and it’s just a money losing trade. So Carl Icahn here having a big bet could pay off as much as 400 million if the big short 2.0 actually works, but that is to be seen.
Thus far kind of hedge fund roadkill. Others suffering as it has not worked out in time. And we’ll see if he is successful over the next couple of years. Either way, this trade runs out by 2022, I believe that is how it is structured. So we will know over the next two to three years.
Julian Klymochko: We had another retirement of a hedge fund legend this week with Louis Bacon shuttering his hedge fund Moore Capital after a 30-year run. Now, he founded his firm in 1989 with the $25000 inheritance. And he was one of the really the big major global macro funds of his era. He delivered a net annualized return of seventeen point six percent annualized over the past 30 years, which is over 21000 on a cumulative basis, just crushing the market. But his style is quite a bit different because he popularized trading on a global macro basis, which makes bets on everything from U.S. equities to European bonds to Asian currencies, etc. Interest rates, big sort of overarching economic bets, not micro bets where you are betting on stock price or a certain bond. You are really betting on currencies, interest rates, equity indices, etc.
Now, in the first full year of his fund, he wagered that Saddam Hussein would invade Kuwait, which did happen, and generated him an 86 percent return. Certainly, he started off on the right foot, but he decided now to return client capital. Obviously, after an amazing run. But it’s still going to run it as a family office. So manage internal capital for himself and behalf on other principles looking at returns. They certainly have come down significantly over the past few years. It has been substantially harder to generate those big macro gains, especially as a shoot from the gut fundamental trader. You really seeing those types of investors go away and in their place. The rise of quantitative systematic investors rules base that use a lot of data. You don’t have star managers anymore, you just have algorithms and teams of computer programmers and analysts that set the rules on how prices should move, and they generate returns that way. Got a statement from Bacon here. He stated, “Although this has not been an easy decision, it will allow me the space to step away for significant periods of time when my other interests abound without ongoing weight and responsibility of looking after public investor’s capital.” So certainly, there is a lot of pressure when you are running outside money. Not just that, but the guy is rich enough where he doesn’t need to worry about that anymore.
As of the end of the year last year, they were running 9 billion dollars. The amount of fees that they are earning was significant and he is clearly a billionaire, doesn’t need to manage outside client capital can just turn into a family office. He also acknowledged disappointing results for his main funds in recent years amid challenging trading conditions for his core strategy based on macro movements of currencies, interest rates and other securities globally. He also noted competition for not just talent, but also pressure for lower fees had led to a challenging business model for funds like his. So really going out here, hanging up his gloves and going to run as a family office. It is interesting to know we have seen a number of hedge fund legends hang up the gloves over the past number of years convert to a family office. They have obviously been tremendously successful, more than enough money that anyone could ever want. You had legends like Carl Icahn, Leon Cooperman, George Soros, Stan Druckenmiller and David Tepper kicking out client capital, creating a family office, which is interesting because, you know, clients need summer to put money and it really gives the next generation of hedge fund managers perhaps a shot at those clients.
Michael Kesslering: Yeah, absolutely and in terms of his performance, you know, having a net annualized return of seventeen point six, I believe it was percent since 1989. Now, putting that into perspective, you know, from 1990 to 2010, global macro funds gained 14 percent on average. So quite a healthy return, but during that time, his returns were actually in the 30 percent annualized range then really in the last 10 years or so. But since 2010, global macro funds have basically been flat as well and that’s really similar to what Bacon was realizing as well, was his returns over the last number of years he hasn’t been able to track the index. The interesting aspect of that is back in; I believe it was early 2017. He came out saying that the Trump presidency would be very good for global macro, as in his opinion, it would bring a lot more volatility back to the markets. And that really hasn’t played out because as a global macro manager, what you really rely upon is volatility. That’s how they make their money and especially somebody like him who trades in an area of the market a lot. He does a lot of foreign exchange; he has been described as the best Fx-trader, of all time by some of his peers. He really needs that volatility and he just did not have that in the last number of years. So he’s looking to remove himself from the markets.
Julian Klymochko: Right and there’s a couple dynamics here that I wanted to touch on.
Number one, it shows that generating good returns much easier when you are smaller. Obviously, it’s first year running 25 grand to generate huge returns, ways easier than when you’re running 9 billion dollars, which he is running when he announced the closure. The second thing is markets have been become so much more competitive over the past 30 years that its way, way more difficult because you have so many more smart people that know about the same types of trades that used to make your money. And that competition reduces inefficiencies and makes the overall market more efficient, making it more difficult to generate that outperformance. Lastly, as institutional investors have come in to the hedge fund space over the past number of decades, they have really demanded a lower volatility profile, which has had the effect of reducing returns. You can really only generate those big returns if you are willing to take that risk. And if you do take that risk, your NAV is going to be quite a bit more volatile. Your returns are going to swing around in order to generate those big home run returns.
And that’s it for episode 41 of the Absolute Return Podcast. If you enjoyed today’s episode, please view more at absolutereturnpodcasts.com. Feel free to leave us a review, recommended to your friends and colleagues. Wish you good luck in trading and investing this week and we will chat with you next week. Cheers.
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