April 20, 2020—Private Debt Funds Halt Redemptions as Investors Rush for the Exits and Asset values Plummet. Should Investors be Worried?
Trump’s Art of the Oil Deal. Will it Bring Balance to the Global Oil Market?
A Coronavirus Cure? Remdesivir Shows Promising Results in Clinical Trial.
A Discussion of 5 Reasons Why Merger Arbitrage Is A Must-Own Investment Strategy.
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, ladies and gents, to episode 63 of The Absolute Return Podcast, I’m your host, Julian Klymochko.
Michael Kesslering: And I’m Mike Kesslering.
Julian Klymochko: Today is Friday, April 17, 2020. Another wild week in the markets. We kind of had a couple back-to-back weeks where markets are rallying. We are going to talk about what is going on, what happened this week. Off the top:
- Private debt funds, a number of them in Canada, halted redemptions as investors rushed for the exit and asset values held by these private debt funds, they plummeted. Should investors be worried about this when they are getting their funds gated?
- Trumps art of the oil deal. Will it bring balance to the global market?
- A coronavirus cure. Remdesivir show promising results in a clinical trial.
- Lastly, we are going to touch on a blog post I put out this week. The discussion of the five reasons why a merger arbitrage is a must own investment strategy.
PRIVATE DEBT FUNDS HALT REDEMPTION AS INVESTORS RUSH FOR THE EXITS AND VALUES PLUMMET
Julian Klymochko: But first, we are going to talk about how two of Canada’s largest debt funds froze investor redemptions. Now, this industry parlance is known as gating investors. Where they request to get their money back. You say no because you are uncomfortable with selling or can’t sell and it’s really just a BS thing that investment managers do. Nonetheless, what they are trying to prevent here is really a stampede of investors running for the exits at the same time, which is clearly starting to happen. And a lot of these private debt funds, so by halting redemptions, the fund managers keep the investors’ money locked up against those investors’ wishes. The managers of these funds have halted redemptions in the hope of sidestepping the large losses on investments they would need to sell assets and honour redemptions. And the reason I have such an issue with this is because if we look at the return profiles on a lot of these private debt funds, private mortgage funds, what they’re doing is they’re artificially smoothing returns and making investors oblivious to the underlying risks and the underlying volatility of the assets held by these private asset funds. I looked at the return profile on one of these funds that actually halted redemptions and it goes for six years, nothing but positive monthly returns. That is right, not even a single negative month. Within a six-year timeframe, they claim to Sharpe Ratio above seven. No, correlation to the markets, etc. Then all of a sudden, when bad things happen in the market, when there is some volatility, oh, they cannot honour redemptions. A lot of these funds are eliminating distributions, etc. And you got to think about why, and perhaps this is the reason. It is because the NAV is made up. The underlying asset values and returns that they are telling investors since they are not mark-to-market; they are actually marking to model. Basically saying whatever they want on returns, and that’s why they disclose, or they say that every month their NAV, their returns are positive. It is going up, which is really just pure fiction, so investors really can’t believe that. What they are telling you with this gate, this halting of redemptions, suspension of redemptions. Investors can’t get their money out because in order for these managers to liquidate, they need to recognize very large losses. That is where the market is, that is the true net asset value. I’d estimate just a rough estimate that if these investment managers were to actually honour redemptions, which is the right thing to do for investors, their net asset value would decline by 50 percent, 75 percent or worse. Time and time again, I see absolute nightmares in these private debt and private mortgage funds where investors look at their statement and see steady rising returns. No losses, everything looks great until one day they wake up and it is a calamity. They are bankrupt and the NAV is zero. This comes out of nowhere; I often say that the return profile of these private asset funds sometimes looks like that life of a turkey graph where everything is going swimmingly for the turkey until Thanksgiving. That Turkey’s life goes to zero, it gets slaughtered and you kind of see the same profile on a lot of these private asset funds and they’ve really grown significantly over the past number of years. It is really just old people looking to generate extra income in what they believe is a low risk manner.
But it’s generally not the case that it’s low risk at all. These are typically extremely high-risk strategies, but nonetheless, globally, investors have put more than 550 billion into private debt funds over the past five years. And really what I have beef with here is that managers of private debt and private mortgage funds, they claim low volatility, high returns with low risk and low correlation with traditional asset classes, which clearly is just not the case. I think we are going to see a lot of bad things happen and we’ve seen it in the past where these illiquid funds, You wake up with no warning, the NAV is down significantly, they are winding up, and you get cents back on the dollar. So I really caution investors against private debt funds, whereas they believe that they’re shielded from volatility. But in this scenario, volatility can be your friend, because if you’re invested in a public fund that’s in trouble, maybe it’s down 50, 60 percent, that will get the alarm bells going off saying, hey, something’s wrong here, and that gives you a warning signal to perhaps revisit the investment. Perhaps you want your money out, you redeem, and you sell it so that volatility provides a great warning sign for investors. However, you don’t get that in these private debt funds. Everything looks like it is going perfectly well until it is too late and they are down to zero.
Or perhaps something close like that, and it’s turned into a complete disaster, so I could go on about this all day. But those are my thoughts on these private debt and private mortgage funds. Investors have really been tricked into this and I just think that it is a horrible thing to do to investors. They want their money back, as a manager; you’ve got to sell the assets and the current net asset value. The current price is whatever bid is in the market that reflects true underlying value. What are your thoughts on this disaster of these debt funds halting redemptions?
Michael Kesslering: Quite a few thoughts on this, as it is quite topical right now. Guess, where to start? Really? Like this comes down to like the appeal of this is, for a lot of investors. They just like the yield play and that is whether it be retirees. But even people that are at the accumulation and saving sort of part of their financial journey. The yield is something that is very easy to explain. What isn’t explained to these investors is the underlying liquidity of these assets. And so they are somewhat tricked into believing…theoretically, as long as there is enough creations and people buying into these funds, then as long as there’s more of them than there are of the people redeeming. There really isn’t any issues. It is really only in situations like these that the underlying liquidity matters and that is the point. That is what it really matters for an investment like this.
One of their comments were that they will keep these gating in place until there’s reasonable visibility on the future direction of economy and financial markets, which is such an absurd thing to say.
Julian Klymochko: Laughable.
Michael Kesslering: Yeah, You normally have a crystal ball like that is just an absurd thing to say, but as well, we were talking about this before. But do these managers still take fees while they’re suspended redemptions? Because, that’s a pretty poor look optically when you’re forcing investors to stay in this investment while still taking fees out. As well, some of these private lenders, they really highlight their flexibility and they really take pride in not being traditional lenders. So they highlight their flexibility relative to these traditional lenders, the banks, and really think of themselves as a lender of last resort. They will have anecdotal evidence of the businesses and mortgages that they write and how they are able to provide lending solutions to less, more, I guess, high risk credits.
And really this comes from this ability is it doesn’t really reflect their strength and stability of their capital base because somebody like Warren Buffett can be the lender of last resort because number one the reputational advantage that he has. But as well, he sits on a very large cash pile. He’s not dependent on raising money from outside investors or even keeping money within a fund because he is effectively running a closed end fund realistically. So he has a very stable capital base, whereas these funds, they don’t have a stable capital base. You really can’t be a lender of last resort unless you have an investor base that is very on board with this. And for example, you’ve seen other private equity funds and venture capital funds that run a fund that will have a fixed duration, whether it be 10 years or even you’re having some infinite debt, don’t have a term. So they realistically, you know, they don’t have a defined ending term, but you can still redeem at a certain price where at a at a fundamental base, I don’t agree with gaining these redemptions because really it’s just a manager imposing their view of capital allocation onto an investor and myself as the investor, That is my job is to allocate capital. Somebody else taking that away from you as an investor really isn’t good, and it’s something that investors really should be aware of when looking at funds. And so early at the end of the day, I just fundamentally disagree with gating redemptions and think it’s a really poor practice from the industry.
And that’s not even to get into the volatility smoothing that goes on in these funds where they’re not marking to market really just kind of using very, very rudimentary assumptions to go about their asset value.
Julian Klymochko: Yeah, exactly. So should investors be worried? Definitely. Gating is a horrible, horrible sign. Clearly, the fund structure just does not make sense. You have this asset liability mismatch. If you’re going to offer monthly redemption or whatever the frequency is, you better be damn sure you’re owning assets that you can liquidate in time to honor that redemption or else it’s prone to disaster and blow up risk like we’re seeing right now. So definitely be worried. Stay away from these types of funds, and what you mentioned, what some of these funds are doing, basically having the funds remain gated until they have more insight into the market or what not. Basically, they’re saying, look, we’re not going to disclose the NAV until asset prices go way back up because they’re way down right now and we don’t want to market big losses because then we’ll look bad. So that’s a really, really poor look. Imagine if there’s a draw down and we just say, look, market stuff out there, we’re just going to stop disclosing to you what it’s worth and we’re going to pretend that it’s not down and we’re going to start marking once things recover.
Michael Kesslering: That would not be a great solution.
Julian Klymochko: Exactly. Just have everyone oblivious and that would be fine, right. But I digress. We caution investors on private debt funds and private mortgage funds as this mark-to-model. These returns, mark-to-model returns tend to be artificially smoothed and keep investors oblivious to the true underlying volatility, the true underlying risk, which is significant as we are seeing these days. The underlying net asset value here clearly is highly impaired and substantially lower than what they’re disclosing to investors. So have caution on these and if you got caught up now, wish you luck. We see these lessons learned and investors just keep going back to it, but onto the next topic, which is Trump’s art of the oil deal.
TRUMP ART OF THE OIL DEAL
Julian Klymochko: What happened this week was a deal between OPEC members and other nations that faced significant hurdles. What they are trying to do is curtail oil production in response really to the decimation of demand with respect to the coronavirus pandemic and resulting global economic recession. OPEC members and a number of non-OPEC nations were in that week long discussion to cut production. It hit a snag as Mexico balked at the required production reductions. President Trump stepped in, Brokered a deal with holdout Mexico such that the agreement could be completed so they got a deal done with the help of President Trump.
And what this deal represented was an unprecedented agreement to slash global oil production by nearly 10 percent. That is nearly 10 million barrels per day, which is a ton. This deal caps a tumultuous time for crude prices as they have declined from over $60 per barrel where they started the year, which that price was kind of so-so. A lot, of producers were struggling; especially North American shale oil producers were struggling a $60 per barrel.
However, things have gotten much, much worse with this whole global recession as prices have hit $20 at the time of this crude oil production cut agreement. However, you would have thought a 10 percent cut would have done it. Apparently not, because prices kept going even lower after the deal got struck. They actually hit eighteen dollars today, which was the lowest price in nearly 20 years. Basically no one’s making money, there’s just like a massive supply. Got a comment here from the oil analyst at Morgan Stanley. He stated, quote, “The OPEC+ agreement will not prevent sharp inventory builds in coming months, and near term oil prices in the physical market will likely remain under pressure.” Oil prices were actually down on the news as the market expected as much as 20 million barrels per day production cut. So the market was looking for something higher than this 10 percent production cut. The other thing to keep in mind, there is this massive, massive current oversupply and this production cut deal does not come into effect until May 1st, which leaves a number of weeks for oil producing nations to significantly increase production and really just keep flooding the market for another 2-3 weeks here. What are your thoughts on this unprecedented oil deal and the modest, if I would say disappointing reaction in the oil markets?
Michael Kesslering: Yes, definitely disappointing for oil producers. It was a two-sided issue. There was a supply glut but as well, there is two sides to the market. The main issue is that there was a massive demand drop for oil. So that has not been solved, and that is due to the corona virus and overall economic activity decreasing by such a large rate. Because of this large demand drop and as you had mentioned, that this doesn’t come into effect until May 1st is that there will continue to be large inventory builds. There is some interesting plays in terms of shipping and storage. But, you know, this really isn’t going to fix the issue right now because as I mentioned, this is mainly a demand side issue. As you mentioned, Trump being the broker of this deal. Now, for people who have been following kind of Trump’s commentary on OPEC and oil prices in general, he is really just driven by political motivations. This was driven by fear that these sustained oil prices could hurt his re-election prospects in oil producing states, which traditionally he has controlled in terms of voting Republican. But if there was a prolonged stretch where people are losing their jobs in mass and the view is that Trump has done nothing to help the situation, that obviously could cost him some votes and perhaps swing a couple of those states.
The other aspect of this, so he gets the credit of brokering this deal while also not officially cutting American production, but because of the price movements, you are likely to see some production cuts in the US, but not mandated by the government. That is just the free market doing its own thing in terms of companies have been cutting their CapEx substantially.
Julian Klymochko: Yeah, and the thing about oil production, especially shale oil, declines pretty dramatically. So if they stop drilling, then production falls off a cliff, and I believe that production has already fallen by a few hundred thousand barrels per day in the U.S. And it’s really interesting dynamics because historically presidents would go to Saudi Arabia saying get the oil price down, produce more but now it’s completely flip-flopped such that over the past year or so, the U.S. has become the largest oil producer in the world at about 13 million barrels per day. They have a lot of economies that are reliant on oil production, specifically Texas, which is also one of the largest states and so that’s something to consider and somewhat ironic where they used to want a lower oil price and now the president is fighting for a higher oil price.
Michael Kesslering: Yeah, and just to add some context around the declines in production is with these CapEx reductions, is there’s a certain amount of sustaining CapEx needed for any oil well. But in particular with shale drilling, with its hydraulic fracturing is typically the high pressure nature of those wells results in a really high decline rate. Looking at, you know, 30 or 40 percent. What that means is you need to increase your production by 30 or 40 percent a year just to stay steady. In terms of your base level of production, so it is a really high decline rates in those assets. Without any continued investment into those fields, you will see just natural declines.
A CORONAVIRUS CURE? REMDESIVIR SHOW PROMISING RESULTS IN CLINICAL TRIAL
Julian Klymochko: Yeah, good point on that one. If we want to talk about something that is a lot more positive and can generate hope for investors and we really saw that in the markets today.
The market is up 2 to 3 percent largely on the back of this Remdesivir news out of this Gilead trial. What happened here was it is a potential effective treatment for a COVID-19 that they are currently testing. Early data from a clinical trial indicates that Gilead anti-viral medicine Remdesivir. It is having a beneficial effect on patients where they showed rapid improvements in fever and respiratory symptoms. Some details behind this clinical trial. The University of Chicago enrolled one hundred and twenty five people with COVID-19 into Gilead phase 3 clinical trials and nearly all patients recovered from the disease in less than one week. But unfortunately, two patients died. However, that is significantly better than what could be expected under normal circumstances. After starting the drug, many patients, saw their fevers reduced quickly. Some came off ventilators the very next day after starting this treatment, and most did not need the full course of 10 day of the treatment. Quote here from one of the patients that received the treatment. He indicated that “Remdesivir was a miracle.” He was 57-year-old factory worker.
What exactly is Remdesivir and how do they develop it so quickly? Well, it has actually been around for a while. They initially developed it to fight African Ebola a number of years ago. That was kind of around the 2013 timeframe. Gilead worked with the US Army Medical Research Institute of Infectious Diseases and the U.S. Centres for Disease Control and Prevention. And the way Remdesivir works is it jams the molecular machinery that some viruses use to build their genes as they replicate. So pretty much halts the replication of this virus, and as they are developing it, they were going through clinical trials against Ebola, but then that outbreak really fizzled out. They did not do much more work on it. However, they are basically repurposing a drug, repurposing Ebola, which is another virus and Ebola treatment to work on at COVID-19. And so far, I mean, its early stage. We don’t have full data. This is really just a sneak peek. It was leaked from the trial but I mean, it is looking quite positive, isn’t it?
Michael Kesslering: Yeah, it certainly is. I guess I remain a little bit more cautious in my optimism right now and I will preface that with the fact that both you or I are not experts in this field. Just we are just strictly looking at the numbers, but it definitely looking quite positive and you did see Gilead up 9.4 percent on the news today. That is a positive but I will put it in the context of, two out of the one hundred and thirteen patients with severe symptoms dying does imply a one point eight percent fatality rate as well. I guess the positive is, is that for the people that did not pass away, that they did actually fully recover. It was not just keeping people alive. It was it was helping people fully recover, we will keep in mind that this was one hundred and thirteen patients with severe symptoms. The full study of severe patients contains twenty four hundred patients so this implies that less than 5 percent of the results have been released so far, and my assumption is that these are the most favourable results. It will be interesting to see what the remainder of this study shows, a one hundred and thirteen patients likely isn’t a statistically significant enough sample size. After this, run the full study. It will be interesting to see how that evolves As a human being, being optimistic as possible with this, as this would be an absolutely massive in terms of getting us back to a more normal state of life. As things may not go back to exactly how they work. Maybe in some good ways and maybe in some bad ways as well but, you know. This is one major step in the right direction to continue on a positive note.
Julian Klymochko: Certainly, it provides hope not only for investors, but just in terms of society. And getting back to the way things were. I actually wrote a bit about Remdesivir about a month ago in a blog post, and my thoughts were at the time that investors should be hopeful that you never want to bet against human ingenuity. You’ve got to be confident that we’ll come up with a vaccine. We will come up with effective treatments. There is, you know, tens of billions, if not hundreds of billions of dollars of research dollars being spent. Most health groups globally are strictly focused on COVID-19 and coming up with solutions and we are starting to see the result of that. There is Remdesivir, there’s hydroxychloroquine. There is going to be a number of various treatments coming out that are going to be proven to be effective and over time, I’m quite confident there will be a vaccine as well. That provides hope for investors, and keep that in mind over the long term. This should be something that will be resolved.
On the other side of it, I caution investors, especially if they are looking to try to monetize this or make some sort of investment play on Gilead. You got to be concerned with the stock up 10 percent today because I believe that they’re not looking to commercialize. Not looking to build a business out of this. This would be more of just a thing for them to do for the good of humankind to get this drug out there in the market. I think they are pretty steadfast in their commitment to getting this out in a cost effective way. Not really a money looking business.
Michael Kesslering: Getting their expenses back basically, is what type of situation it would be.
Julian Klymochko: Yes, by not building a business basically and not looking to make a profit centre, so that’s something to keep in mind. I got a quote from Gilead. They indicated in statement. “The totality of the data needed to be analysed in order to draw any conclusions from the trial.” They are really offering a cautious statement, really saying that it is insufficient at this point to make any sort of judgments. The University of Chicago also stated that partial data from an ongoing clinical trial is by definition, incomplete and should never be used to draw conclusions.
Got a quote here from RBC Capital Markets health care analysts. He indicated, “The anecdotal data looks promising on the surface and continues to support some potential for the drug to be active in certain COVID-19 patients. Nonetheless, there are major limitations to contextualizing and interpreting this data.” Other people involved are quite cautious, so far, it is looking good. However, it is early stage, so investors really need to take that caution.
BLOG POST: 5 REASON WHY MERGER ARBITRAGE IS A MUST – OWN INVESTMENT STRATEGY
Julian Klymochko: Last thing we wanted to chat about, I put out a blog post this week, really just a discussion of 5 reasons why merger arbitrage is a must own investment strategy. And we’ve talked a lot about the opportunity set in merger arbitrage and that’s kind of the first reason to want to own it, is the attractive yield. Historically you earn kind of three to five hundred basis points above cash. So earlier this year we saw 4 to 6 percent average annualized yields or annualized returns for the average merger arbitrage spread. In March, we saw that blow out to the low 20 percent range. Now it is kind of in the low teen range, sort of 13 percent annualized, which is a pretty exceptional annualized return vs. a lot of the alternatives out there.
The second reason to consider merger arbitrage is the consistency of its return. We looked at data from JP Morgan that showed from 2009 to 2019 calendar years. It was one of the only asset classes. That booked positive returns on average over every single year and even if you look at the global bond portfolio over those eleven years. Global bonds had three down years. You had three global equity bear markets over that time period as well.
The third reason to consider Merger Arb is its low interest rate exposure. This is basically referring to duration risk. Interest rates are at an all-time low. I think going back hundreds or perhaps thousands of years, interest rates have never been lower. And if you own bonds and interest rates start to go up, bond prices move inversely to interest rates. As interest rates go up, if and when they do, your bonds are going to get hit. Merger Arbitrage is a marvel floating rate exposure that can do well in a rising rate environment.
On the fourth reason, the income or the returns that merger arbitrage produce, they’re largely through capital gains as opposed to interest income commonly found in standard fixed income portfolios. For Canadian investors, these capital gains taxed at half are typically taxed at half the rate as a traditional fixed income type interest payment. There is some pretty significant tax efficiencies for taxable Canadian investors.
Lastly, the fifth reason to consider merger overcharge in your portfolio is basically an unprecedented opportunity where we’ve basically pounded the table in terms of the opportunity set being unprecedented. I referred to it last month as a generational buying opportunity where you are seeing low risks spreads, low risk investments, price to yield. 10 to 15 percent annualized and even trades that you could indicate nearly risk free and north of 5 percent annualized.
So really a list of five reasons to consider merger arbitrage, where obviously big fans of it. Run the strategy, allocating personal dollars to the strategy and really done it for a long time. There is a number of reasons. Why it makes sense to have within the context of a diversified portfolio.
And it’s really a standard strategy in all or most institutional portfolios, and it’s something that I believe should be in every investor portfolio. You are talking about 60/40 equities and bonds. Well, you need to have some alternatives in there, such as merger arbitrage and some other alternative strategies as well. What were your thoughts on it?
Michael Kesslering: Yeah, I am obviously a big proponent of the merger strategy. We have talked about it on the podcast a lot. Over the last month or two, well, a month and a half here, it is really been a generational opportunity in this space. Now, one area that sometimes is comparable in terms of some of the focus on yield, although the underlying dynamics are quite different, is that a preferred shares. How would you compare, if an investor is looking at a preferred share opportunity vs a merger or strategy.
Julian Klymochko: I have a pretty simple rule of thumb investing. And one of these rules is never invest in preferred shares. They are certainly a misnomer. Definitely not preferred in any way, shape or form and here’s why. They present fixed income upside with equity downside and historically the returns have been quite poor. They pretty much provide no protection and a down market.
For example, I read an article today that compared the preferred share index with the equity index. The equity index was down 17 percent through mid-April and the preferred share index was actually down 19 percent. So talk about non-preferred returns where they are actually doing worse than equities. And that the way that preferred shares work, they typically get issued at twenty five dollars per share. You have no upside because if they started going up as interest rates go up, the insurance will just call them and issue new ones at a lower interest rate. So they basically have very little upside, huge downside I’ve seen in restructurings. These get absolutely gutted far worse than the common shares. What I’m talking about there specifically was that of Yellow Pages, which went through a restructuring about 10 years ago.
In addition to that, you’ve got to disclose that we are long yellow pages stock in one of our multifactor funds. Nonetheless, a lot of caution on preferred shares. I would just recommend investors stay far, far away. Don’t touch preferred shares with a 10 foot pole. They turn more often than not into absolute disasters. You get fixed income upside with equity downside, which is really a horrible value proposition for investors. In addition to illiquidity, stay far away. There is really nothing good to be had out of preferred shares if you’re looking to get that yield. Look other places. Look at corporate bonds, government bonds, municipal bonds, even junk bonds, high yield bonds. Look at bank loan funds, levered loan funds, or even alternatives like merger arbitrage or other credit type strategies like that, other yield strategies.
And going back to our earlier discussion, stay away from private debt and private mortgage funds, too. That is kind of a stay away from list. A warning list for investors, preferred shares, private debt funds and private mortgage funds. That is all we got for you today. On The Absolute Return Podcast, if you enjoyed it, please check out more episodes at absolutereturnpodcast.com and definitely follow us on Twitter. Mike, what is your handle?
Michael Kesslering: M_Kesslering.
Julian Klymochko: And you can find me on Twitter. I tweet quite a bit. A lot of insights, a lot of market analysis, etc. I am at Julian Klymochko, K-L-Y-M-O-C-H-K-O, and until next week. We wish you the best of luck in the investing and trading and we will chat with you soon. Cheers.
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