TRADING STRUCTURES IN FOCUS: CAPITAL STRUCTURE ARBITRAGE

Georgetown Hedge Fund Strategies Group

What is Capital Structure Arbitrage?

Taking long or short positions in different parts of a company’s capital structure so as to capture perceived inefficiencies

Long debt/short stock

What is Capital Structure?

Refers to how a company finances its assetsAccordingly, refers to the company’s

liabilities and how they are arranged

Equity

Ownership stake in company

I.e. A company might sell shares in itself to raise money (10% of company for $100M)

Advantages: capital does not have to be paid back

Disadvantages: dilutes ownership, more expensive than debt (to be explained)

Debt

Money borrowed by a company

I.e. A company issues $100M in 10 year bonds, with a 5% coupon has to pay $5M in interest per year, and has to repay full $100M in principal in 10 years

Advantages: cheaper than equity, creates “tax shield”

Disadvantages: principal must be repaid, interest payments must be met

Important Concept: Seniority

In case of bankruptcy:

Debt holders get paid first, and equity holders last

Generally1) Senior secured debt2) Senior unsecured debt3) Unsecured debt4) Preferred stockholders5) Common stockholders

Capital Structure Arbitrage: How it works

One part of the capital structure is out of what with the other parts

Steps 1) isolate mispricing2) enter position (includes establishing

hedge)

Example 1

Company ABC manufacturers cars

Its capital structure consists of the following$500M in equity

100M shares @ $5 each$500M in debt (trading at par)

$200M in senior secured debt company assets as collateral

$300M in unsecured debt

Example 1 Cont’d

Company’s sales start plunging, and as a result

1) Company’s stock falls 10% to $4.50 per share

2) Company’s debt (all tranches) falls 20%

What kind of trade could one put on?

Think about seniority and what would happen in worst case - bankruptcy!

Example 1 Cont’d

Possible trade (assume all purchase prices are immediately after price drop)

1) buy $10M of senior secured debt 2) short $10M of stock

Possible Scenarios: Bankruptcy

1) Senior secured debt will get paid off at par (for a gain of 20%)

2) Stock short hedge will make $10M (100%)

Possible Scenario: Sales Rebound

1) Senior secured debt climbs back to par (20% gain)

2) Stock climbs back to where it was before (-10%)

Total return = 10%

Rationale Behind Trade

1) Senior secured debt would be the first thing to get paid off in case of bankruptcy, so it should not have fallen more than stock price

2) Short stock position hedges bankruptcy risk because the stock would be worth $0 in bankruptcy

More Interesting Example

DEF Corp is a packaged food producer

$1B in equity 100M shares @ $10 each

$1B in debt $300M in senior secured debt $700M in unsecured debt

Active CDS trading on unsecured debt

Company has $500M in tangible assets

Disaster: food poisoning traced to DEF Corp

Company now faces huge drop in sales, potential legal action

Stock plunges 50%Senior secured plunges 5%Unsecured plunges 45%CDS (on unsecured) spread surges 35%

Think of a trade!

Notable Cap Structure Arb Traders: Boaz Weinstein

Former Deutsche Bank Co-Head of Global Credit Trading at age 35! $40M per year in 2006, 2007

Ran $10B prop portfolio for DB “Saba”Made $700 and $800M for DB in 2006, 2007

respectivelyLost $1.8B in 2008

Boaz Weinstein Cont’d

In early 2008, bought the debt of GE, Ford, and other big companies Corporate debt had been hit by early 2008 credit crunch

nothing like what was yet to hit the markets in late 2008!

Had been hedging long debt position with CDS contracts

In September 2008, financial markets fall apartWeinstein’s debt positions get hammered, and CDS

markets freeze (critically needed for hedges)DB risk managers force wind-down = 18% eventual

losses