October 19, 2020—SPAC IPOs Reach Fevered Pitch with October Issuance Breaking $10.5 Billion Record. How Much Can this Market Absorb?

First Citizens to Buy CIT Group in $2.1 Billion Bank Merger. Why are Financial Firms Consolidating? 

Alpha + Beta Outperforms as Mutual Funds Struggle to Keep Up. What is Enhanced Indexing and Why Should Investors Consider It?

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Transcript

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 92 of The Absolute Return Podcast. I am Julian Klymochko. 

Michael Kesslering: And I’m Mike Kesslering. 

Julian Klymochko: Today is Friday, October 16th, 2020, a bit of a slow go of things in the markets this week. Almost considered not having an Absolute Return Podcast this week, but forget that. We’re bringing you what we got, and we do have some news in the SPAC space. 

    • Record breaking issuance brought us above 10.5 billion months to date, halfway through October. And we already surpassed June 10 billion record SPAC IPO. How much more can this market absorb a new SPAC issuance? 
    • We’re going to get into the blank check space in the M&A sector. Some bank deals specifically First Citizens announced the acquisition of CIT Group for $2.1 billion dollars. Why are these financial firms consolidate? 
    • And lastly touching on alpha plus beta performance versus long-only equity mutual funds and the indexed. We want to look at what is enhanced indexing and why should investors consider it?

SPAC IPOS REACH FEVERED PITCH WITH OCTOBER ISSUANCE BREAKING $10.5 BILLION RECORD 

Julian Klymochko: But Mike, let’s start off on blank checks. Everyone’s favourite discussion topic these days, and it’s not surprising because seemingly that’s where all the action is. For example, this week blank check initial public offerings continued at a blazing quick pace. 1 billion of SPAC IPO’s spread out over five new issues this week. Topping the list, we had Peter Thiel back to Bridgetown Holdings, which did a $575 million dollar IPO. This SPAC has focused on technology, financial services and media companies. Surprisingly in Southeast Asia, it’s a fairly specific, but I would caution investors that these SPACs don’t necessarily do a deal in line with their mandate. Earlier this month we did discuss one specific SPAC transaction in which cannabis focus SPAC, did a complete 180 and ended up doing a deal in the space infrastructure sector, which is, you know, quite a bit different than cannabis I’d say, but who knows, perhaps they’re smoking something funky that day, but I digress getting into some of the SPAC issuance this week.

Investors were pretty lukewarm. Earlier in the year. If we’d see, say like a Peter Thiel backed SPAC IPO, we’d expect that to trade significantly above $10 dollars, but this one’s, you know, most of the volume was right around that $10 dollars range. So, investors really lukewarm on new issuance. It’s just, as we’ve discussed in the past, there seems to be quite a bit of oversupply of SPAC coming into the market. And it’s not surprising when we’ve had four months back to back to back to back of $10 billion dollar plus issuance, and October’s has been insane. 10.5 billion within the first 16 days. We still got the back half of the month. Mike, where do you think October is going to end up? I think we’ll see 12-13 bil.

Michael Kesslering: Well, I mean just if this week is any indication, it does look like it’s tapering off a tad. That’s just all relative to the last few months. If you’re looking at literally any other timeframe over the last number of years, this would be fantastic.

Julian Klymochko: I think a billion per month is probably a more normalized level. And now we’re at like 10X that. 

Michael Kesslering: Yeah, exactly. 

Julian Klymochko: At least for October. It looks like we’re going to be way above that.

Michael Kesslering: Going along with that thread this week, as you had mentioned, Julian, there were five SPACs that started trading this week, where two of them are trading below NAV.

Julian Klymochko: One was an overfunded trust too; I believe some of them were 10.15, that Spartacus.

Michael Kesslering: Yeah, so they had already provided some concessions to invest to entice investors, but weren’t able to get it trading up. Then as well, I guess you can compare that to last week where we had 11 list last week, with only four trading below NAV. And with that, you had, as we had discussed the Chamath deals where you have a couple of those that are trading at pretty significant premiums. So, you do have a couple that are a little bit below NAV with those, but some pretty large premiums. And when you’re looking right now, we’ve talked a lot about the upward trend in SPAC sizes. There’s a lot of big deals as you had mentioned this week and over $500 million dollar IPO which is kind of part of the course where we’re barely blinking at $500 million dollars SPACs where even a 500 million or a billion dollars SPAC, they’re going to be looking at target companies in the billion dollars plus range.

Julian Klymochko: Probably $3 billion plus once we get to that. 

Michael Kesslering: Yeah, Exactly. And in terms of the targets, what’s really getting that nice SPAC pop are the VC style targets. Perhaps even pre-revenue or very little revenue, very immature business models that haven’t quite been proven out, but do have great concepts. I guess I would just like to highlight that it does become a little bit harder to get those types of VC level returns if you’re thinking of VC and like the seed series, A style VC returns with an over billion dollar starting valuation where, really some of the expectations for some of these billion plus SPACs should be more along the lines of growth equity. So, the late stage venture capital.

Julian Klymochko: Yeah, and I certainly frame it that way in that many of these SPAC opportunities are more equivalent to a late stage VC type opportunity, which would have, you know, a different risk reward than a seed stage or series A type investor.

Michael Kesslering: Absolutely, and in terms of looking forward, you know, well it keep tapering off next week? I’m a little bit unclear on that. I think we still do have a number of SPACs that are going to be pricing early next week. So, it remains to be seen. This could just be a quick little slowdown and a further round pop with more big-name sponsors. It’s really tough to say right now.

Julian Klymochko: Yeah, we’re still seeing a significant amount of new S-1 filing. Seemingly every day, some days three to four indicative of a healthy amount of new SPAC issuance. And the other dynamic that we’re noticing is that any sponsor, SPAC sponsor that had a reasonably successful SPAC, they’re just banging these things out. I saw DNY Technologies come out with their third. They filed an S-1 after hours on Friday, they have their first one still out there. Hasn’t completed a deal yet. I should note that we are along that one in the Accelerate arbitrage fund, their second one DNY Acquisition II, no deal yet. And they’re already ramping out with the third one. So, we’re seeing plenty of follow on from sponsors, just due to the lucrative nature of these blank checks that they’re launching and not to mention the demand from the market once they announced these deals. So, we definitely see more follow-on transactions from those successful sponsors, just creating effectively a business line where they just keep pumping these things out along the same lines of how private equity firms have follow up funds. I mean, you don’t do one fund and that’s it. You know, you turn it into a business. You’re effectively manufacturing new SPACs here, but that’s about all we got this week on a SPACs news. 

FIRST CITIZEN TO BUY CIT GROUP IN $2.1 BILLION BANK MERGER 

Julian Klymochko: So, let’s get into some M&A, we actually had this year, second largest regional bank merger in which First Citizen Bank shares announced a friendly $2.1 billion dollar acquisition of CIT Group in an all stock merger of equals transaction. They did refer to it as (MOE), merger of equals. But in fact, it did come with an 11% premium to CIT unaffected, sharp price. So, make no mistake here folks. CIT is the target; First Citizen is the acquire.

This deal is creating the 19th largest US Bank based on assets. I believe proforma they’ll have over a hundred billion in assets on the balance sheet and indicative of perhaps despite their claims of merger of equals. It will keep the First Citizen name and ticker and will be run by the First Citizen CEO. So, I was thinking its kind of laughable when they claim merger of equals because that’s more so the acquirer’s strategy to get the target at the lowest premium possible. Have to say a merger of equals. We shouldn’t pay a control premium, but you know, in fact, they’re just buying the company on the cheap, but I digress getting into these strategic rationales here. 

Isn’t this one, like I said, like 50%

Michael Kesslering: GDPS, yeah.  

Julian Klymochko: GDPS which is significant, which is probably why for Citizen share price rallied so hard, but we’ll get into the share price action on these ones. And the other thing is more of a defensive move because these rigid regional banks are really facing pressure from the giants such as the JPMorgan and The Bank of America. Is real tough to compete with those guys. Not only that, but making the environment even more difficult is the persistent low interest rates where it gets more and more difficult to generate that net interest margin when there’s not a lot of spread there, not a lot of flexibility. What are your thoughts on this interesting bank deal, which I’m sure we’ll probably see more of?

Michael Kesslering: Yeah, I guess first of all, you did mention, there was a premium that was paid to CIT Group but it was still trading at a pretty low book value ratio where it was at .43 times. 

Julian Klymochko: Yeah, It’s crazy, .43 times book value. I can’t recall seeing that, but it seems like CIT Group stock just got slammed since Corona and never recovered. I believe they’re probably trading around book value you know, pre-March and then they got crushed in the bear market and just never rebounded.

Michael Kesslering: Yeah, I mean in the regional banking sector, there actually has been a decent amount of consolidation over the past year where this is actually the second largest regional bank deal. Second to the South States, $3.2 billion takeover of CentreState Bank. That actually just closed in June, I believe. But these regional bank mergers do make quite a bit of sense, as you had mentioned, the accretion on earnings.

Julian Klymochko: When you’re paying that low of a multiple, I think. And it’s an all share deal at around eight times earnings, which is crazy when the S&P is trading at what, 21-22 times.

Michael Kesslering: And then you factor in the potential for both revenue and cost synergies, and we always are quite sceptical of revenue synergies, but the banking sector does lend itself to at least the possibility of the revenue synergies, where in this acquisition First Citizens, this will now allow them to cross sell their full banking offering. As I believe CIT clients, they really were only being offered mortgage and deposit products at their branches where they’re able to now just offer a more comprehensive suite of products providing multiple ways to monetize the customer base. And then as well, they have identified 10% worth of noninterest expense savings. And I do believe I saw in the press release that they expected that they were going to lower their costs of funds as well on that net interest side. So, in terms of the stock market reaction, it does make sense that the market does love this deal.

Julian Klymochko: Yeah, talk about the market-loving this deal. Obviously, CIT stock’s going to go up because they did receive a premium, however, it did search nearly 27% on news of the deal. And the shocking part, well, perhaps not shocking. Once we saw the near 50% accretion to EPS and just a stunningly low valuation in which First Citizen is acquiring CIT, but certainly First Citizen shareholders loving this deal. Their stock was actually up double digits, 11.4%, which is a super interesting dynamic because as we see in most deals, especially all share deals. Traditionally, the acquirer’s stock will go down, but one cause of the acquirer’s stock going down is perhaps arbitrageurs going long. The target short, the acquire, probably not on this one. The spread was super tight. I checked; it was less than 1% annualized. So really not worthwhile putting on that spread just because there’s really not much available there in terms of compensation for taking on the risk of this merger arbitrage trade.

Michael Kesslering: I guess unless you thought that there was going to be a competing bid come in, which maybe this is a low enough offer, but at least in my recollection, I can’t remember too many over bids in the regional banking sector.

Julian Klymochko: Yeah, it is pretty rare. But do you have a good point that perhaps some market participants are pricing on some upside optionality on perhaps a CIT overbid, but who knows? We’ll see, continue to monitor this one, see how it plays out. 

ALPHA + BETA OUTPERFORMS AS MUTUAL FUNDS STRUGGLE TO KEEP UP 

Julian Klymochko: Lastly, wanted to touch on the strategy of alpha plus beta. Now, before we get into it, I wanted to discuss what exactly is alpha plus beta. Well, the beta part is just index exposure, you know, a hundred percent long the index and this analysis that we run is based on the Canadian index, specifically the TSX and the alpha component is what we refer to as an index overlay. So, you’re overlaying the index with something that can create some out-performance, whether it’s a tax overlay, some sort of derivatives overlay, but what we refer to an alpha overlay for our strategy is a long short, alpha overlay.

So, it’s a hundred percent index the beta plus a 50 long, 50 short, alpha overlays to enhance effectively the index. So, the story here is this past year’s historic volatility. We just went through Q-1 and investors were just shocked with the dramatic drop. The TSX fell more than 37% in 22 days. And in my opinion, with that tremendous volatility that should have allowed Canadian equity fund managers to stand out from their benchmark, perhaps get some outperformance, one dynamic that we’ve seen over the past while. And we know that most mutual fund managers underperformed, but one excuse was we are in a raging bull market. And many of them had you know, perhaps more cash in the portfolio, which caused them to lag. Well shouldn’t we have seen the opposite effect where most would have outperformed when the market got smoked. Unfortunately, that was not the case while unfortunately for long, only mutual fund guys.

But if you’re an index investor here, then you are laughing because the majority of long, only Canadian equity mutual funds, woefully underperform, the major stock market benchmark over the 12 months ended June 30th, 2020, a stunning 88.4% of Canadian equity mutual funds underperformed, the benchmark S&P/TSX composite index. Nearly 90%, almost 9 out of 10 long only Canadian equity mutual funds outperformed in perhaps an environment in which a performance would have been the easiest. So, for example, and I’m getting these figures from a globe and mail article this week, which flagged me into the data over that timeframe. The average Canadian dividend and income equity fund dropped 8.4% while the TSX 60 fell only 1.4%. So, 700 basis points of underperformance. Meanwhile, the alpha plus beta strategy that we ran was actually up 3.7% of performing the index by 500 basis points. And there’s a real important difference between losing investors’ money and making investors’ money.

There’s one thing to perform on a relative basis, but its nice to say that you’re up when the market’s down and the average Canadian dividend and income equity fund dropped nearly 10%. So, it really just supports the case for enhanced indexing, our strategy, specifically our alpha plus beta enhanced benchmark strategy outperformed significantly, but it did it by mitigating downside risk. And that’s something for investors to consider, especially when we go through a 37% drop in 22 days. So just wanted to go over the woeful performance of long-only Canadian mutual funds, which unfortunately for investors they’ve historically been known as high-cost benchmark huggers. And what we refer to as benchmark hugging is where you seek to match the index very closely, but make some small modifications, you know, overweight this one, a little underweight, that one, a little. Where you’re not trying to stray too far from the index in order to reduce careers, because if you beat it significantly great, you know, you might get a larger bonus, but if you lag significantly, you’ll probably get fired.

And you combine that with the very high cost structure of Canadian equity mutual funds. Many are like 2%, 200 basis points per year. So, you combine benchmark hugging with high fees, and it’s no surprise that the vast majority in nearly all of them outperform significantly. So just wanted to flag that for investors and Mike, you got anything else this week? 

Michael Kesslering: Nope, nothing else from my end. 

Julian Klymochko: All right, well that wraps it up for us this week, ladies and gents, hope you enjoyed the episode. And if you did definitely check out more @absolutereturnpodcasts.com, follow us on Twitter as well. Always dropping insights, research and analysis into the social media sphere. So, Mike, what’s your Twitter handle?

Michael Kesslering: My is M_Kesslering

Julian Klymochko: And you can find me at @JulianKlymochko on the Twitter machine, which you all the best of luck in your trading speculating, hopefully investing and we’ll chat with you next week. 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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