October 13, 2020- Morgan Stanley Continues its Acquisition Spree with $7 Billion Deal for Eaton Vance. Does the White-shoe Wall Street Investment Bank Have More Deals Up its Sleeve?

$80 Billion Fintech Company Square Invests $50 Million into Bitcoin. Are Pension Funds Next?

Busiest Week in SPAC History with Eleven IPOs Raising $5 billion. Why Have SPACs Gone Wild?

Vatican Cardinal Forced to Resign After Getting Caught Trading Forbidden Credit Derivatives. Are Credit Default Swaps a Tool of the Devil?

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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 podcast listeners to episode 91 of The Absolute Return Podcast. I am Julian Klymochko. 

Michael Kesslering: And I’m Mike Kesslering. 

Julian Klymochko: Today is Friday, October 9th, 2020. On Monday, it’s Canadian Thanksgiving. So happy Thanksgiving to all our Canadian listeners. In the US, it is Columbus Day. Bond market’s closed, equity markets open. However, there is no settlement. Nonetheless, I’ll be around. So, feel free to reach out on social media if you want to chat. Have some really cool things to chat about this week. 

    • Big deal in the M&A space as Morgan Stanley continues its acquisitions spree with a $7 billion dollar deal for Eaton Vance, which is pretty shocking for me because this came just three days after they closed their massive $13 billion dollar deal for E-Trade. Now is Morgan Stanley going to continue its M&A spree? We chat about that. 
    • Onto crypto, $80 billion-dollar FinTech company Square, invested 50 million into Bitcoin, or pension funds next? 
    • Crazy week in the SPAC market. In fact, the busiest IPO week for blank checks in the history. We had 11 IPO’s raising $5 billion dollars. Why have SPACs gone wild? 
    • And lastly, we’re going to touch on crazy wild story in the Vatican of all places where a Cardinal was forced to resign after getting caught trading forbidden credit derivatives. Are credit default swaps, tool of the devil? 

MORGAN STANLEY CONTINUES ITS AQUISTION SPREE WITH 7 BILLION DEAL FOR EATON VANCE

Julian Klymochko: Let’s chat about this Morgan Stanley- Eaton Vance deal. $7 billion cash and stock, 50% cash, 50% stock plus a special dividend to be paid out to the target shareholders prior to closing. As I indicated, this one was pretty shocking, unexpected, just given the timing. Morgan Stanley has been on quite the acquisitions spree lately just closed the $13 billion dollar acquisition of E-Trade financial, but from a strategic standpoint, certainly, it makes sense. Under the leadership of CEO, James Gorman, his strategy was really to focus on building the bank’s wealth management division, that was his top priority. He really likes to stable cash flows and revenues instead of investment banking, which is more transactional and trading and those types of less dependable businesses. He likes wealth management because you steadily clip that management fee. 

Some interesting background on this. Eaton Vance actually put themselves up for sale a few months ago and approached Morgan Stanley, typical in M&A it’s the other way around where you’ll have an acquiror reach out to a potential target to see if they’re interested in doing a deal, but not here. it was the target who reached out to the acquiror. At the time, Morgan Stanley said, “hey, we’re interested, but can’t right now. We have a $13 billion deal that we have yet to close, but we’ll take a look at closing this after which happened within three days.” Interesting note from the Target CEO, he indicated that the merger agreement was signed at three or four in the morning. So that gives you a sense of the life of a young investment banker. Got to stay up all night closing these deals. Interesting transaction, large premium, nearly 50%. Morgan Stanley stock was actually up on the news a bit less than 1%. Typically, what we see in an M&A transaction is the acquirors’ stock declining. However, Morgan Stanley stock up a bit,  Eaton Vance stock surging, obviously with the big premium here. Up 48.1% on the day, wanted to touch on the M&A spread, the merger spread. Roughly 2.8% annualized, nothing to write home about not super attractive. I was telling our trading desk specifically that I like this one at a 5% annualized spread, 2.8% annualized. It’s tough to allocate to that, just given the wide spreads that we’re seeing in the SPAC arbitrage market. Nonetheless, this spread pricing in, a 94% odds of success. If we look at the upside compared to the downside, interesting strategic rationale, Morgan Stanley revenue from wealth management has gone from 15% in 2008 to now, North of 50%, they’re going to become a giant in the asset management space. Managing roughly 1.2 trillion in assets. So, it’s certainly a solid deal. Mike, do you think there’s more coming down the pipe for Morgan Stanley?

Michael Kesslering: No, I don’t think so at this point, at least from Morgan Stanley CEO Gorman, he did mention on the deal call it, now they’re done with M&A, and we’ll focus on integrating both E-Trade and then Eaton Vance after the deal closed for that one. But yeah, going into a little bit more of the rationale, let’s start here with Eaton Vance. They had traditionally been a consolidator in the industry with a number of acquisitions of smaller asset managers over the last 10 years. One of their most interesting moves prior was to get into the space of direct and indexing back in 2003, through their subsidiary parametric. Where they actually grew their assets of about $4.7 billion dollars back in 2003 to 300 billion now, which makes up over 50% of their asset base at Eaton Vance, they have about $500 billion dollars’ worth of AUM. But it’s also a really good deal for Eaton CEO, Thomas Faust, where he’s actually the firm’s largest individual shareholder at 3%, as well as some stock options on the side. So, this combined stake actually is worth about $250 million dollars. This represents a little bit of a partial liquidity event for him. In terms of valuation on Morgan Stanley side, they did the deal at about 1.3% of AUM.

Julian Klymochko: Roughly 17 times next year’s earnings.

Michael Kesslering: Yeah, and so not really a particularly high valuation for an asset manager in general. However, this is more of a low growth asset manager. So that seems a little bit more fair. I can see the rationale from Gorman’s side. He actually came up through Morgan Stanley wealth management business. That makes a ton of sense of why his sensibilities really buy more towards the wealth management side, but as well, the other rationale for Morgan Stanley is really just trying to get a rerating on their multiple that they get. They’re currently trading at under 10 times forward earnings. I believe it’s around nine times, where their comp to more as a bank stock. So, they’re really just trying to get more of an asset manager, multiple where companies such as Charles Schwab, they’re trading at like 18 times forward earnings. And Gorman did mention this on the deal call that, yeah, they’re very interested in get a rerating higher. Any CEO would be if asked if they could trade at a higher multiple, but really mentioned that this isn’t likely to happen over the short term. It would be a long-term thing. I think he even mentioned that he would like to see it in his lifetime.

Julian Klymochko: Right, certainly didn’t happen that day with stock up 0.6%.

Michael Kesslering: Yeah, exactly. And so, it’s really just part of a long-term plan to get valued more like an asset manager, get that favourable multiple. And that would be great for investors over the long-term.

Julian Klymochko: Yeah, interesting deal. $7 billion, not too appealing from a merger arbitrage standpoint. And Mike, as you indicated, this is likely it for M&A at Morgan Stanley for a while, but who knows? People say this and things change, but obviously we will monitor this deal. Trade it if the spread widens to a more attractive level in the 5% annualized range. 

$80 BILLION FINTECH COMPANY SQUARE INVESTS $50 MILLION INTO BITCOIN 

Julian Klymochko: One thing that we’ve been talking about quite a bit on the podcast lately is micro strategies. Massive $425 million investment into Bitcoin and their thesis behind that. Well, ever since then, we’ve been discussing who’s next. Are we going to see pension funds? So, we going to see other corporations? Well, we got it this week with fintech giant Square buying $50 million dollars’ worth of Bitcoin to put on its balance sheet. Now a bit different than micro strategy because obviously Square significantly larger. And this investment into Bitcoin is about 1/10th of what micro strategy did. It’s less than 1% of Square assets. So, it doesn’t really move the needle all that much. However, it does have really important signalling value. I have a quote here from the company. They stated that, “We believe that Bitcoin has a potential to be a more ubiquitous currency in the future”. And to note here, we just see increasingly more and more corporations become uncomfortable with the risk of just holding Fiat currency on their balance sheet. And they’re seeking to diversify, especially in an environment of tens of trillions of dollars and money printing, fiscal stimulus, monetary stimulus, that seems never-ending. And we’ll definitely see more of that, but in my opinion, yeah, we’ll probably see more corporations buying into Bitcoin and note, there are only limited amount of Bitcoins out there. Roughly 21 million, but my thesis is that we’re going to start to see some major pension funds and endowments start owning large portions of Bitcoin specifically. And in the future say, it’ll probably take a decade or two until Bitcoin becomes a staple asset, a default to asset and an institutional calibre portfolio. Mike, what are your thoughts on that piece of mind? You think it will happen or are they always going to be kind of gun shy with respect to cryptocurrencies?

Michael Kesslering: Yeah, I don’t think they will be gun shy forever. It really just comes down to Bitcoin still is struggling to gain the legitimacy of other asset classes. And just because they’ve struggled to date that has been on an upward trend, just to look at the amount of people that are aware of Bitcoin. First of all, ever since the last real major bull market in late 2017 and into 2018, pretty much everybody is aware of Bitcoin now. Now that doesn’t mean they know how to use it or trade it or anything like that, but really Square has been kind of an, in terms of larger players, they’ve really helped in normalizing this through their cash app. You can trade Bitcoins; they were very early to that. 

Julian Klymochko: Yeah, it’s a big revenue line for them, isn’t it? 

Michael Kesslering: Yeah, it certainly is. And as well, they’re really helping out with the ecosystem. In terms of the open-source nature, they actually came out with their white paper that explains the whole kind of soup to nuts execution of how they did this. And this has been similar with what they did with their sub-zero cold storage solution. They’ve been very open-source, which is kind of the ethos around cryptocurrency in general.

Julian Klymochko: With zero, it sounds like actually really chilly. Cold storage that doesn’t technically mean that it’s like a low temperature, but with the name of sub-zero, I wouldn’t be surprised if it was, liquid cool.

Michael Kesslering: Yeah, very interesting branding. But so just to delve into it, it was a short white paper, but definitely worth the read for anybody interested in the crypto space, but it really outlines how they bought the Bitcoin and how they did that was through an over the counter exchange with a broker that they used on the cash app. And they basically just negotiated a spread on top of a Bitcoin index and executed using a TWAP. So, a time-weighted average price over a 24-hour period that they mention that it was a relatively high-volume 24-hour period so that they could reduce the risk of large price discrepancies and ensure there was liquidity. But for custody, they also just use their own cold storage solution. They outlined that, so the sub-zero solution, they talked about the insurance and some of the policies that they recommend as best practices and the considerations needed when looking at those policies.

And as well as how they were going to treat it from an accounting perspective as they were going to keep it as a non-current asset and how that would impact their earnings on a go-forward basis.

We strive to be as very transparent with how we do things at Accelerate. And so, I mean that same ethos with Square and exactly how they went about this and really the whole idea with them being so transparent is so that other players in the industry can replicate it, which would be good for their underlying core business, as we’ve just mentioned, you can trade crypto through the cash app. So, a growing industry is very good for them.

Julian Klymochko: Yeah, the other reason that they may have wanted to be transparent as you look at what micro strategy did and how their stock price reacted, clearly investors like this strategy, obviously with Square, it’s a bit more difficult to tell just because the transaction size is more so a drop in the bucket, but nonetheless, I mean, Square stock was up, who knows if it’s on this crypto thing, but certainly it doesn’t hurt these days to be buying Bitcoin on the balance sheet. If you are a technology company specifically, not sure how the market would react, say if you’re a gold company or some sort of manufacturer or something, not really adjacent to the cryptocurrency space, but nonetheless, continue to be constructive on Bitcoin price up over 50% year to date. And if you don’t have exposure to it, I think you should at least consider a small allocation in a well-diversified portfolio. As some of these large corporations are doing, we’re going to continue to see more of it. And I bet perhaps this year or next, we will see reports of a pension or an endowment allocating to Bitcoin as well. 

BUSIEST WEEK IN SPAC HISTORY WITH ELEVEN IPOS RAISING $5 BILLION 

Julian Klymochko: But Mike let’s move on to the SPAC space. Every week we talk probably about a SPAC deal and think, can it get any crazier? And it continues to get even wilder each and every week. What happened this week is we saw an absolute record in IPO issuance. Specifically, the main catalyst was Chamath Palihapitiya. The one we crowned the SPAC master, his Social Capital Hedosophia capped off a record week in SPAC IPO’s by issuing three new special purpose acquisition companies and raising a cumulative $2.1 billion. These are all going to be spent on technology acquisitions. Well after these three, that makes six SPACs for them.

Today’s October 9th, and thus far in October, we’ve seen 22 SPAC IPO’s raising an aggregate $9.5 billion. Now ladies and gents, the all-time record was back in July at $10 billion. We’re not even one-third through October. We’re going to smoke that record this month and we’ll likely beat it by halfway through October. That’s right next week, we’re set to just destroy that record because the amount of S1. I think I saw four S1 filed today, which indicate that those are going to be going public in the near term. I had a question today, just someone on Twitter reached out, what’s the timing from S1 filing to go public transaction? And one real quick one that I saw was Apollo’s recent SPAC, which we do have a position in. From S1 filing to IPO, is only about two weeks. Typically, they’re longer than that, but they can be pretty quickly.

Now I just wanted to touch on SPAC market dynamics. It’s grown to an asset class that is over $80 billion dollars and it cracked that $80 billion dollar market just today. It also cracked more than 200 SPACs outstanding. There are now in fact, 202 with, I believe more than 150 out there looking for deals. So, there’s going to be a lot going on if you’re one of these series D/E type,  VC-backed entities, I’m sure there’s at least a couple dozen SPACs banging on your door, but what’s happened, say, since June is we’ve had the SPAC asset class market cap, basically double from $40-80 billion. You’ve had a huge increase in supply by a hundred percent. However, we have not seen a commensurate increase in capital invested in SPAC arbitrage funds. And the net result is the widening of spreads, far more attractive SPAC arbitrage opportunities. We are capitalizing on this and in the Accelerate Arbitrage Fund, which is the only SPAC focused ETF out there. But I digress, I think it’s a great time to be investing in SPAC arbitrage, tons of supply, not too much demand. It’s a super inefficient market, just because if you look at Apple, Mike, how many sell-side analysts do you think cover Apple? At least.

Michael Kesslering: Yeah, exactly. And plus, and then you include all the buy-side analysts that would be covering it, very large amount.

Julian Klymochko: There’s like no one covering SPACs and its heavily retail-dominated. So, if you pay attention to it, you got good modelling skills, def trading skills. You can really generate some alpha in the asset class. Plus, there’s just so much to do. Tons of good opportunity. I compared it to the slim 2.8% annualized return of the Morgan Stanley-Eaton Vance M&A spread and it’s tough to allocate that when we’re seeing, on the low side in the SPACs arbitrage space, kind of in the 7% annualized and the ones that really hit, you know, you can double your money like Diamond Peak Holdings, which is a holding in the Arbitrage Fund. But Mike, what are your thoughts on this SPAC news? Are we going to peak this month or is it going to keep going? I mean, these S1s don’t stop. They’re not stopping, but we have seen some weakness in pricing. I looked at the data prior to today, 70% of SPAC IPO’s in October, actually broke price. Traded below the IPO issuance price, so certainly buyers are getting gun shy and that may slow down new issuance, unless these issuers start giving better terms, i.e., overfunded trusts while they’re above $10 dollars in the kitty or what we call net asset value, higher warn coverage, or other investor-friendly terms such as that. So, what are your thoughts on this current craziest SPAC market?

Michael Kesslering: Yeah, absolutely. Like you mentioned, it’s the price performance has been fairly lukewarm with recent IPO’s. But yeah, not for Chamath. I mean IPO D, E and F, which all listed today. They all closed at a significant premium credit.

Julian Klymochko: Credit to Chamath there. Like I said, really weak tape for SPAC IPOs, even Apollo trading at a discount, Chris Shumway trading at a discount, TPG trading at NAV. We talked about it, I believe on last week’s podcast, who’s getting premiums these days, biotech and VC, certainly Chamath representing the VC side. And in this really weak tape, he issued $2.1 billion of SPACs, which is like 3% of the market outstanding. And they got bid up, they traded at premiums of about 1.7% to around 7%. So certainly, credit to him. He earned this SPAC master moniker in my opinion.

Michael Kesslering: Yeah. So, Chamath, there’s a ton of hype around him and it’s very well-deserved, but yeah, like you mentioned a lot of high-quality sponsors trading below NAV. But that’s really just great news for folks that don’t participate in IPO. So especially retail investors that don’t typically have access to IPOs. They’re actually able to get these at a discount. The craziness as well, I mean, you have, well Shaq now has a SPAC. That’s with Forest Road Acquisition.

Julian Klymochko: Shaq SPAC is back. 

Michael Kesslering: Exactly, but to the question about, you know, why things have gotten so wild. It’s just simple, it’s a hot market and terms have been heavily weighted towards sponsors. 

Julian Klymochko: The other thing is performance has been great. 

Michael Kesslering: Exactly. And so, if you’re a sponsor looking to file an S1 or has filed your S1, I mean, it’s in your best interest to get these out as quick as possible.

Julian Klymochko: From a sponsor’s perspective, there’s one reason only that people are doing this, and it’s to promote. You look at these Chamath deals, he raised $2.1 billion today, and he gets a 20% promote that he shares between himself and his partners. If successful, that represents like $400 million in his jeans for maybe a year’s work. Where you’re just basically playing middleman. Credit to him because most people don’t have the ability to do that. But great work if you’re available to get it.

Michael Kesslering: Yeah, and for Chamath like, I think he’s one of the highest of the highest quality SPAC sponsors. But as you had mentioned, there’s 150 SPACs out there. So, when you’re looking at these sponsors and the promotes, the 20% promotes, I’m going to put out a wild guess that of those 150, probably about 145 or 140 are going to be renegotiated lower. Because if you’re a company, you’re likely going to be talking to multiple SPACs, you can negotiate down the founder promote and get it to either earn out or just to completely cancel the founder shares.

Julian Klymochko: Yeah, grind them down to something reasonable, like $10 to $20 million dollars, which is still not a bad payday if you can get it.

Michael Kesslering: exactly, it’s something that you see commonly if there’s just mismatches between the amount of companies that are wanting to use SPACs and the amount of SPACs, those dynamics will shift the other direction. So, it’ll be interesting to see how it works out throughout the entire deal process for these SPAC sponsors. But if they are able to keep this leverage, I mean, it will be very profitable for these sponsors

Julian Klymochko: Yeah, certainly. And profitable for the investment banks as well. I think their cut is about 7%, assuming that a deal successfully gets consummated before the deadline. And no one’s complaining about the investment bank fees, just the promote on the sponsor side, meanwhile, the sponsor does most of the work in terms of putting these deals together. Nonetheless, an interesting mechanism to monetize one’s reputation and network to the tune of tens of millions of dollars. Judging by the amount of S1 being filed each day. Typically, three to four, we expect many, many more SPACs IPO’s. I believe we’ll crack a hundred billion dollars in market cap for the asset class by year end. We’ll continue to monitor that, but certainly, October is stacking up to be a record year. 

VATICAN CARDINAL TO RESIGN AFTER GETTING CAUGHT TRADING FORIBBEN CREDIT DERIVATIVES

Julian Klymochko: Before we end the show today, I wanted to touch on a pretty funny story out of the Vatican no less. There’s a potential scandal brewing there, as Cardinal Giovanni Angelo Becciu, I don’t know. Italian religious Cardinal in the Vatican, he was actually forced to resign under allegations of financial misappropriation.

And this is where it gets pretty funny at the heart of the matter is under the Cardinal’s guidance, the Vatican invested some donations that were earmarked for the poor and needy. Took this capital and invested it probably in a limited partnership that traded in structured notes containing credit default swaps linked to the car rental company Hertz. The way that these structured notes slash CDS were structured, the bet was that Hertz would not default on its debt by April, 2020. And in fact, they were successful in the trade, they made money on it. However, Pope Francis was not impressed. Oddly, he came out in 2018 and condemn the use of credit default swaps of all things the Pope was against CDS. Claiming the financial instruments quote, “Encouraged the growth of a finance of chance and of gambling on the failure of others, which is unacceptable from an ethical point of view”, end quote. Interesting thing to hear, obviously, the Cardinal wasn’t executing these trades on his own. He was not dealing in these forbidden credit instruments on his own, but he was aware of the investment in the CDS link notes. These were held directly through an account in Switzerland and made by a third-party consultant on his behalf. However, you know, it seems like he’s perhaps getting ex-communicated from the church trading in a forbidden security, not from a regulatory standpoint, but from surprisingly a religious standpoint. So, are credit default swaps a tool of the devil here. Mike, what are your thoughts?

Michael Kesslering: Yeah, well I mean, I guess I would push back a little bit on Pope Francis, his interpretation of the unacceptable ethically because they’re profiting off the failure of others. 

Julian Klymochko: But in this trade specifically, they’re actually speculating on Hertz, not failing, kind of the opposite. 

Michael Kesslering: Yes, not the exact situation, but his general thoughts on a credit default swaps, but are really just looking at them. We saw in the 2008 crisis, guys like John Paulson made a killing off of CDS.

Julian Klymochko: Greatest trade ever. 

Michael Kesslering: Yeah, but typically I would say probably 98% of the time. That’s not how CDS is used. They’re typically used as a form as hedging instruments. 

Julian Klymochko: Right. 

Michael Kesslering: But so, really just offload your exposure. But really this comes down to these investments. I believe it was a Swiss advisor, which was not named, I don’t believe at least. But that’s who made these investments, as a general rule of thumb as an advisor, it’s probably a pretty good idea to get an idea of what your client’s ethical stance on investments are. Maybe get that outlined a little bit in the (IPS) Investment policy statement, this is just a complete disaster for all involved, but a fairly entertaining story from an outsider’s perspective, strictly from the point of view that I did not expect this to come across my desk this week. We’ve seen crazy things in the SPAC world, did not expect to be talking about the Vatican today.

Julian Klymochko: Yeah, certainly Mike. I don’t know about you. I did go to Sunday School as a child. I do not remember reading in Corinthians about the forbidenness of credit derivatives and other sophisticated credit products. I don’t remember reading in the 10 commandments, “thou shall not speculate on default probability,” but nonetheless, these are looking like the tool of the devil. Credit fund managers you’ve been put on notice. You may be going to hell, unfortunately. So definitely pray, go to confession and you know, pay up for your religious crimes here, but that’s all we got folks this week on The Absolute Return Podcast. If you enjoyed it, definitely check out more absolutereturnpodcasts.com. Follow us on Twitter, Mike, what’s your handle?

Michael Kesslering:  It is @M_Kesslering

Julian Klymochko: And you can find mine @JulianKlymochko, wish you all the best. Hope you have a great Columbus Day, Thanksgiving Day, and we will chat with you soon.

Cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.

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