Was the “recognition” of James Pallotta in his nearly 2,000 word tome to investors last week. It was Pallotta's way of apologizing for being so hard on himself and an answer to the old riddle - what's the sound of one hand patting yourself on the back. The full letter is reprinted after the jump, but here are some of the highlights:
To state the obvious, [the 8% loss] would not have been the case had we understood fully the speed and ferocity with which events would unfold. [Once we fix the flux capacitor, everything will be fine. Had we known we were going to lose a ton of money we wouldn’t have lost a ton of money because we would have done things that would have avoided losing money, having already known the things that would lose money.]
Compounding matters, our short book failed us, which was enormously frustrating because historically it has been more volatile than our long book (and, therefore, sized accordingly). [It’s enormously frustrating when the market doesn’t obey historical precedent, or when fund managers don’t obey the first rule of the market which is that it doesn’t obey historical precedent and that future performance cannot be predicated on past results.]
Many of our equity shorts ripped to the upside as VAR-induced forced-covering by quantitative strategies accelerated. [PS – it was the quant’s fault… f’ing computer models.]
We are first and foremost “bottom up” cash flow-obsessed stock pickers. [Jim Cramer without the sound board.]
In the end, it is entirely possible that losses will prove both “wide” and “narrow” in their distribution across the globe (meaning that losses will be widely distributed but will likely hit certain institutions particularly hard). However, a deeper crisis -- spurred by failure (or near failure) of a major financial institution -- must be acknowledged as a possible risk also. [A plague on all your houses, but some houses will be plagued more than others.]
Again, I welcome your calls and visits with our team in Boston, and I wish you the very best. [I just called, to say, I love you. Also, I will take you on a whale sighting excursion. Or we can go to Fenway. Or take a duck tour. Please just come visit. I’m so alone, so very alone.]
August 21, 2007
The Raptor Global Fund Ltd.
Kaya Flamboyan 9
P.O. Box 4774
Curaçao, Netherlands Antilles
Ladies and Gentlemen:
I write to offer my commentary on recent performance for The Raptor Global Fund Ltd. (“Raptor” or the “Fund”) and to discuss our positioning and thinking in the current, volatile phase of the U.S. equity market. As you know, our equity portfolio has suffered an uncharacteristically sharp drawdown in the last two and a half months, leaving the Fund down 8% on the year across its various share classes through August 15, 2007. Among the forces at work here were gross and net-long exposures above historical average. To state the obvious, this would not have been the case had we understood fully the speed and ferocity with which events would unfold. Further, some of our core longs were simply crushed, and, in nearly every case, the magnitude of decline appears disconnected completely both from underlying equity value-creation stories (which have limited, if any, dependence on access to credit markets) and from visible, secure, increasing company cashflow profiles.
Although we had been relatively bullish on private equity-led buyout activity, it would be inaccurate to suggest that event expectation drove any individual equity selection. In our view, our core longs are generally characterized by strong, rising free cash flow at an attractive valuation with significant opportunity for redeployment of excess or under-earning capital. In recent weeks, the apparent attractiveness of companies with this profile to acquirers held our names hostage to perceptions that acquisition activity is dead (though we never depend on it, we disagree; LBO activity is deferred certainly, but strategic buying-interest looms). Further, the adverse price movement in both our long and short names was accelerated and likely greatly exaggerated by the leverage-induced liquidation of enormous positions by quantitative market-neutral equity strategies. The de-levering -- heralded by significant volatility -- has been characterized by indiscriminate selling (often without regard for fundamentals such as cash flow profile, value enhancing forces at work, or price relative to prospective cash flows) and by incredible short coverings in many instances. Because typically these funds were levered five to seven times their capital, more than $200 billion of positions were likely unwound globally in about ten days.
Compounding matters, our short book failed us, which was enormously frustrating because historically it has been more volatile than our long book (and, therefore, sized accordingly). For the first time in the history of our equity strategy, we received virtually no performance contribution from our short book against the backdrop of a precipitous market decline. Many of our equity shorts ripped to the upside as VAR-induced forced-covering by quantitative strategies accelerated. But failure on the short side is attributable not only to the market-neutral de-levering phenomenon but also to exceedingly strong corporate fundamentals, which have limited the number of highly-compelling individual short opportunities. Consequently, we have used more market indices and structured ETFs as hedge positions in the last months. Hedging is difficult with the type of volatility we are seeing, and, while we believe conditions will revert to “normal,” it will take time. Currently, we believe that having more cash is prudent in the short run.
Our response to the drawdown is exactly that expected by our investors and demanded by the Tudor “playbook.” Gross and net exposures have been reduced dramatically and may shrink further. Naturally, this action is evident in performance but is nonetheless necessary for positioning the portfolio to a defensive place in the current volatile environment. Our very longterm performance record is built on the “first principle” that strong compound annual returns are achieved through capital preservation and avoidance of outsized losses (Note that we have weathered one similar drawdown). Thus, exposures will increase materially only when losses have been meaningfully recouped via both a rebound in our (albeit reduced) core longs as well as carefully selected trades with exceptional risk/reward profiles.
We are first and foremost “bottom up” cash flow-obsessed stock pickers. Hence, we will be more discriminating until there is, for better or worse, greater clarity about both the functioning of the capital markets and the path of economic growth. The kind of indiscriminate selling that occurs during periods of financial system stress attended by heightened concern with regard to prospective economic growth should lead to incredible individual equity investment opportunities for our strategy in the coming months.
Market Analysis and Outlook
Looking back, the second quarter had a strong finish propelled by strong corporate earnings, merger and acquisition activity, increasingly benign core inflation data, the related Fed step towards monetary policy “neutrality” during its late March meeting, (arguably) complacency stemming from sustained historically tight corporate credit spreads, and the lack (at that time) of any “contagion” in the corporate credit market of both the collapse of several non-conforming mortgage origination companies and disruption in residential mortgage-backed securities (RMBS). U.S. equities, as measured by the S&P 500 index, rose 6% in the quarter resulting in an equal gain for the first half of the year. The run was sustained in the first half of July with another 3.6% appreciation. Then the bottom fell out.
Largely, the equity market ignored a clear warning (with the benefit of hindsight) in late June with the collapse of two Bear Stearns Asset Management credit hedge funds, which were highly-leveraged and RMBS-focused. Simultaneously and similarly ignored (again, with the benefit of hindsight), the major rating agencies downgraded significant face value of junior nonconforming RMBS securities while substantially raising their cumulative loss forecast on the huge volume of 2005 and 2006 vintage loans.
These developments were just the first dominoes to fall. In a rapid chain reaction, they were followed by the failure of several notable hedge funds, concerns about the pricing of investment bank inventory and lending exposures, complete seizure and breakdown of segments of the credit markets, and nearly unprecedented intervention and liquidity-provision by central banks as overnight rates skyrocketed and lenders and investors briefly lost complete faith in any non sovereign borrower or collateral. In short, a few weeks ago there was a housing problem. Today there is a liquidity and excess leverage problem. Further, at this juncture, believing completely that the credit bubble has burst is not a necessary condition (however difficult to refute) for agreeing that this may have been the “largest margin call ever.”
In addition, beyond general risk aversion, there was a more direct transmission mechanism among mortgage-related debt, corporate debt, and equity markets. We were wary of “exuberance” in leveraged lending, yet we expected this activity to remain brisk as long as economic and corporate profit growths were sustained and corporate credit quality remained constructive. We would have been less sanguine had we understood more fully that the same investors who buy subordinate RMBS and related CDOs are presumably also purchasers of mezzanine CLOs – the largest purchasers of leveraged loans. Describing this circumstance as problematic is a gross understatement when $300 billion in acquisition-related leveraged loans and high-yield bonds (twice as much as one year ago) must find a home in the coming months. Because merger and acquisition activity has been a regularly-demonstrated plus for equity valuations, this sudden inability to finance deals is surely valuation-deflating.
In the coming months, losses totaling billions of dollars are liable to accrue for holders of certain RMBS and related structured products, e.g. CDO, ABCP, etc. The leverage employed in these assets is unknown but likely astronomical. Even the most senior securities (in which any held-to-maturity loss would be remote) will probably be downgraded. These factors coupled with related redemption and margin call activity threaten to keep credit markets under stress for some time. In the end, it is entirely possible that losses will prove both “wide” and “narrow” in their distribution across the globe (meaning that losses will be widely distributed but will likely hit certain institutions particularly hard). However, a deeper crisis -- spurred by failure (or near failure) of a major financial institution -- must be acknowledged as a possible risk also.
In combination, these factors have been a “perfect storm.” Equities have fallen more than 9% from July 19 to August 15, 2007 (to date the low close in this market sell-off). We view this “headline” figure as an understatement of the damage because the average stock is down significantly more. Approximately 55% of the S&P 500 fell 10% plus. Approximately 25% fell in excess of 15%. Figures for the NASDAQ were similar, with 50% down more than 10% and 35% down more than 15%. Further, it remains altogether unclear: a) how the credit market calamity will resolve or b) whether the central bank action will have a lasting palliative effect. While we accept that the Fed will provide liquidity as needed to facilitate the potential for an orderly unwind, our read is that it could likely take the aforementioned failure (or near-failure) of a significant financial institution to motivate meaningful rate-cut action.
Before this current period, our constructive view on equities was a function of what we believed would be an economic scenario with moderate growth and moderating inflation. The consumer, while chastened, was job- and income-growth-resilient. Corporate profit growth and high profitability were moderating but sustained and existed alongside opportunity for corporate managements to create significant equity value through deployment of unprecedented free cash flow, cash balances and capital freed via business portfolio optimization. This circumstance was complemented by the active acquisition appetite of both strategic buyers and massive sovereign wealth accumulated in recent years.
But all bets are off in a recession or a climate characterized by fear of recession. It is now our view that a consumer recession is likely – if not happening already. The last few months have seen a shift towards savings. Further, credit growth, which is vital for GDP growth, is not probable in the near future. Unlike the brief credit market disruptions of 2005 and 2006, the current one will be longer and deeper with the potential to evolve into a credit contraction. The CDO market seems broken outright. Securitization of certain assets is prohibitively expensive or impossible, thereby restricting availability of credit and driving up borrowing costs. The longer present conditions persist, the more potentially damaging to the general economy – rather than only to institutions overly-concentrated and overly-leveraged in these asset classes.
That said, unlike in prior periods, many economies around the globe are humming in unison with domestic and consumer demand as a driving force, which is supportive of their ability to weather this storm (albeit taking more body blows than ever before). Nominal and real interest rates remain low by historic standards, which, when combined with corporate borrowers still under-leveraged position, leaves their borrowing costs low. CLOs arguably have a transparency and structure which should attract capital at some price. And, finally, the sharp decline in the value of corporate loans and high-yield bonds reflects a supply/demand imbalance, not further credit deterioration. Consequently, we believe that corporate debt markets will normalize after a period of months required to deal with the overhang.
As for us, we are bowed but certainly unbroken. Our team is strong and resolute. We have spoken with many of you through this challenging period. As we proceed, please continue to engage us. Members of the team and I remain available to speak with you by telephone or here in the office (preferably before or after U.S. market hours). Time with us may be coordinated through Anna Ponder, our Investor Relations professional, at 203-863-8616 or firstname.lastname@example.org. We released a special NAV report to you on July 30, 2007 to proactively share performance numbers (through Friday, July 27, 2007). We will continue to be candid.
While our long-term record has been good and while we recognize that “it’s a marathon not a sprint,” we are incredibly disappointed in our short-term performance. I hope you find this letter helpful in understanding our thoughts on Raptor’s recent performance and our total commitment to future performance. Again, I welcome your calls and visits with our team in Boston, and I wish you the very best.
Very truly yours,
James J. Pallotta
Tudor Investment Corporation
The Raptor Global Portfolio Ltd