Varenne Capital Partners

VARENNE CAPITAL PARTNERS

Investment Management Commentary

(January – December 2018)

March 15th, 2019

INTRODUCTION

Varenne Capital’s investment objective is to deliver superior long-term returns with the minimum necessary risk-taking. We strive to achieve this goal by combining complementary investment frameworks – Long Equity, Short Equity, Merger Arbitrage and Tail Risk Hedging – in a single strategy and by relying exclusively on proprietary research. Each framework is the result of years of research and development and comprises original methodologies, formalized processes, a dedicated team of specialized analysts and bespoke information systems. By reading this document we hope you will be convinced that, throughout the cycle, our approach translates into a superior value proposition when compared to traditional long/short or long only investing.

GENERAL PRINCIPLES

We believe in two basic principles: solving equations differently and adding value. Everything we build stems from there and, as far as investment management goes, translates into the following:

Solving equations differently

- We combine investment strategies into a ‘structure’ because it: o is synergistic: Long Equity drives returns throughout the cycle, Short Equity adds idiosyncratic performance, Merger Arbitrage reduces correlation to equity market indexes and contributes to funding Tail Risk Hedging; o copes with changing market and economic conditions in an adaptive portfolio; o allows each team to focus on the most favorable opportunities available and relieves them from the pressure to be ‘in play’ all the time;

o efficiently employs investment vehicles’ balance sheets. While we typically do not resort to significant leverage on Long Equity and Short Equity combined, we benefit from it to fund short term Merger Arbitrage trades and Tail Risk Hedging; o optimizes risk profiles.

- We separate risks from opportunities and deal with them independently. o On opportunities: ▪ Long Equity: most of the long-term returns come from the quality of the businesses that we select in this pocket of the portfolio and the price that we pay for them. We will always try to maximize our Long Equity allocation. ▪ Short Equity: short equity should be idiosyncratic and is meant to generate performance - hedging longs with shorts is at best a very costly proposition leading to sub-par long term returns. ▪ Merger Arbitrage: much like an insurance business, we underwrite risk only if we are adequately compensated and are perfectly happy to stay on the sidelines when our conditions are not met - typically at times of low volatility and strong equity market performance. o On risk and hedging: ▪ Market risk: equity market corrections and bear markets are natural events and should be seen as opportunities for both longs and shorts. In our opinion, an investor is better off accepting market risk within those boundaries and only hedging the residual risk. ▪ Hedging: residual market risk and its root causes can be hedged efficiently through asymmetric risk/reward instruments or trades. Hedging more than that subtracts performance disproportionately and deprives investors of long-term returns.

Adding value

- Research: we believe in 100% proprietary research. We follow a strict ‘brokers are not welcome’ policy and never employ sell-side research.

- Process: for each of the frameworks, our teams add value through proprietary research and a five- step process encompassing universe reduction, idea generation, first-hand analysis, systematic portfolio construction and direct market execution. o Universe reduction: it pays dividends to define safer investment sub-universes where the odds are in the investor’s favor and focus can be put on the best available opportunities. For instance, we limit our Merger Arbitrage activity to announced and friendly deals in order to maximize our team’s hit rate. o Idea generation: we do not believe that receiving the 23rd call of the day from a sales person pitching the same idea adds any value. We generate original investment ideas internally through our databases, scoring systems and screenings that cover more than 60 countries.

o Analysis: first-hand analysis adds value when formalized within a sound investment methodology. The latter ensures recurrence. For each of the frameworks, we have developed specific investment principles and proprietary analytical tools to best implement them. o Portfolio construction: systematic, rule-based, portfolio construction adds value as it forces the teams to formalize decision metrics and to focus on the best available opportunities. It also keeps emotions out of the equation. o Execution: direct market execution reduces costs and enables best execution. No research costs or any other commissions are borne by the investment vehicles.

- Information systems: bespoke information systems are essential at each step of the process as they allow us to manage huge volumes of information and orientate each team’s priorities. We have invested heavily in this area and continue to do so.

None of the above would mean much, though, without a great and talented team. At Varenne, we are fortunate to rely on an highly competent, energetic and committed group of people. We made the choice early on to specialize our teams by investment framework with Long Equity and Short Equity being two different teams probably the best example of this approach.

CAPABILITIES

We operate several investment frameworks within the Long Equity, Short Equity, Merger Arbitrage and Tail Risk Hedging space. We refer internally to those as ‘capabilities’:

Long Equity and Short Equity teams can express their views through individual stock selection or purpose-built baskets based on fundamental and behavioral factors with the aim of optimizing the risk- return profile of the portfolio. Each book is independent with exposures determined by a rule-based portfolio construction model comparing key investment merit metrics. The aim of the model is to maximize long-term returns, reduce correlation to equity market indexes and to adapt portfolio composition to changing market and macroeconomic conditions. Unlike ‘pure player’ single strategy funds, our approach allows investment teams to focus exclusively on the most favorable opportunities and relieves them of the obligation to deploy capital when they do not find ideas that meet or exceed our risk-reward criteria – we are happy to stay on the side-lines on one or more of the frameworks when we believe that to be the most sensible decision. In the following commentary, we will touch on the philosophy of each of the frameworks and review their contribution for the year.

CONTRIBUTION PER INVESTMENT FRAMEWORK

In what turned out to be a challenging year, we are pleased with the overall contribution of the different frameworks:

Long Equity proved resilient throughout the year, Short Equity was marginally negative - but contributed significantly in Q4 - while Merger Arbitrage and Tail Risk Hedging produced consistently positive returns. Tail Risk Hedging’s contribution was all the more satisfactory as it recovered its entire carrying cost before turning positive. Focusing on the Value Active Fund, it is interesting to note how the sub-strategies behaved on a monthly and quarterly basis in adapting to changing market conditions:

Finally, the uncorrelation strategies’ contribution over Q4 reveals how they played a significant role in the period:

LONG EQUITY

Philosophy

The Long Equity team applies private equity techniques to build a core concentrated portfolio of high-quality businesses whose stocks, at the time of buying, trade at a significant discount to our estimate of economic value. After applying granular universe reduction, based on GICS sub-industry classifications, to exclude highly cyclical or financial businesses, the origination team performs weekly fundamental and behavioral screenings on proprietary databases and scoring systems in over 60 markets. The goal is to search global developed and ‘emerged’ geographies for highly cash generative businesses boasting sustainable competitive advantage, superior management teams, autonomous value creation dynamics, high cash generation and, whenever possible, positive net financial positions. The analysis team takes the lead from origination and deploys a filter step aiming at quickly discarding most of the ideas to focus only on a promising few. Only when a lead appears to be interesting does a full-fledged due diligence process begin. The team combines conceptual, high-level analysis with field investigation. This risk, business, financial and industrial analysis includes several company interactions. While no use of sell-side research is made, the team is typically reinforced by the interaction with at least two industry experts providing valuable advice. Upon finalization of all of the due diligence modules, the team determines an Intrinsic Value Estimate (‘IVE’) and assigns an Economic Quality Rating (‘EQR’) to the business under review, based on our proprietary scale illustrated below.

The portfolio construction model draws on both sets of metrics to determine the optimal portfolio composition from all possible combinations of the available watch-list components. Most of the core concentrated Long Equity book is in what we refer to as the industrial portfolio - stakes in highly cash- generative businesses with good to excellent economic quality. Some noteworthy exceptions are turnaround situations or sum-of-the-parts investments which typically have lesser weights and a shorter life span. Traditionally, we make use of this annual letter to review the positions that have made a significant contribution to the latest annual performance.

Main contributors in 2018

Overall, we are pleased with the balance between positive and negative contributors in the core concentrated Long Equity portfolio.

The main negative contributors in the Long Equity book have been the following: Greggs (GB00B63QSB39), Photo-Me (GB0008481250), Novo Nordisk (DK0060534915) and Accenture (IE00B4BNMY34). Photo-Me was the only realized loss at year-end. The largest positive contributors were Ulta Beauty (US90384S3031), LVMH (FR0000121014), Nike (US6541061031), Givaudan (CH0010645932), Vittoria (IT0000062882) and Ross Stores (US7782961038). Below we will discuss some of these investment cases starting, as customary, with negative contributors.

GREGGS (ISIN: GB00B63QSB39 – United Kingdom) It is somewhat ironic to discuss Greggs as a negative contributor as, at the time of writing, the company’s share price is at historical highs. Nevertheless, after a 44.23% annual gain in 2017, Greggs’ stock had a difficult 2018 before fully recovering in Q1 2019.

Source: Bloomberg – Data as at 15 March 2019 We disclosed in our 2017 letter that we took advantage of the combined fall in the UK stock market indexes and in the Pound Sterling that followed the Brexit referendum to initiate a position in Greggs, the largest specialty take-away and ‘food-on-the-go’ chain in the UK. Since opening its first bakery in 1951, Greggs has steadily grown to employ more than 23,000 associates in approximately 1,953 points of sale, as at the end of 2018. The business is unique in that it is not only a retailer, but also an integrated producer thanks to its network of highly automated factories, positioned throughout the UK, allowing Greggs to produce and retail food at lower unitary cost than its competitors. Furthermore, Greggs’ own supply chain and logistics management allows for maximum efficiency and real-time response to what its shops and customers demand without compromising on quality. The ability to produce in bulk and then distribute fresh products with high granularity to its points of sale adds significantly to Greggs’ costing power. The business is led by CEO Roger Whiteside and a team of very experienced executives. Mr. Whiteside has a decades-long track record of success in food distribution as the Director of Marks and Spencer’s Food Division, and as CEO at both Thresher Group and Punch Taverns where he successfully engineered a text-book turnaround. He is also the founder of online supermarket Ocado.

Since assuming the role of CEO in 2013, Mr. Whiteside has accelerated Greggs’ transformation from a traditional bakery model, many of whose products would be consumed in the home, to a ‘food- on-the-go’ specialty chain with meals primarily taken away or available for in-store consumption. Everything from manufacturing, logistics, information systems, product development and shop estate has been repositioned accordingly. As an example, the management team renewed Greggs’ traditional product range to include hot drinks, breakfast deals, hot meals, and more up-market options such as burritos and high-quality coffee and expanded trading hours to fit with the new offering. A healthy food range was added with the aim of increasing the company’s share in the food-on- the-go market and to ensure that Greggs maintains a universal appeal. The highlight for late 2018 was the announcement and subsequent launch of the first vegan sausage roll available on the market. A success from both a technical and marketing standpoint, the vegan sausage roll was an instant hit and propelled Greggs’ comparable sales to an impressive +9.6% in the seven weeks to 16 February 2019 – this testifies to the long journey from their simple bakery days to a sophisticated modern food-on-the-go provider. Under Whiteside’s leadership, Greggs has continued to plan for the future by making significant investments in its systems, industrial processes and refurbishing its shops. A factor in our choice to initiate a position in 2016 was a major £100 million investment program, announced in March 2016, which is set to take full effect in the coming years.

Source: Greggs (Presentation of 2016 interim results and 2017 half-year results) & Varenne Capital Partners The plan aims to streamline and expand Greggs’ manufacturing processes and supply chain – thus removing in advance any potential barriers to the company’s future expansion. Greggs’ 13 production sites will make way for 8 fully automated manufacturing sites and facilitate an accelerated multi-year expansion leading to well in excess of 2,500 points of sales. Greggs’ stock price faced a difficult 2018. They released a warning on their first half sales at a time when investors were nervous about the prospect of anything linked to declining retail footfall. In reality,

9 this warning was simply due to bad weather conditions as the UK was brought to a halt by the extremely rare phenomenon of snowfall in March and April. While the market was unnerved, our team lost no time and flew in to Newcastle. They spent time with the management and operations teams, visited factories and dozens of shops which confirmed the conclusion that the weather was the sole factor to blame for the relative slowdown in sales growth. Fast forward to March 7th 2019, Greggs preliminary result announcement and outlook fully reassured investors with sales growth resuming in the mid-double digits, margins holding up well and the business ready for accelerated shop estate growth. With cash generation at an all-time high and no financial debt on their balance sheet, Greggs has also announced that it will declare a special dividend alongside the forthcoming interim results.

NOVO NORDISK (ISIN: DK0060534915 – Denmark) Another negative contributor for the year was Novo Nordisk but, similarly to Greggs, we would not read too much into this as the position contributed significantly to the portfolios’ performance in 2017, and its share price has fully recovered at the time of writing.

Source: Bloomberg – Data as at 15 March 2019 A Danish pharmaceutical company, Novo Nordisk is the largest global producer of insulin, the main treatment for diabetes - a condition sadly affecting over 425 million people worldwide and forecast to reach 630 million in 2045. The business commands market share of over 45% in terms of volume and enjoys leading positions in the treatment of obesity, growth deficiencies, menopausal conditions and hemophilia (a congenital coagulation disorder). Novo Nordisk employs over 40,000 staff and has a presence in over 190 countries.

With outstanding economics, including ROE of over 70%, Novo Nordisk matches all of our investment criteria we require for longs, including a very strong cash-flow generation enabling ambitious R&D plans while returning cash to shareholders through massive buyback programs. Novo Nordisk has a history of being at the forefront of innovation and, as R&D milestones and news-flow demonstrated, 2018 was no exception.

Source: Novo Nordisk – Q4 2018 Roadshow Presentation

Looking ahead, the company continues to rely on a strong pipeline of innovation, most notably with the FDA-approved, new generation, GLP-1 product, Semaglutide, now ready for regulatory filing in its oral version in the US, the EU and Japan. Given the convenience of tablets over injections and the efficacy of the treatment, oral Semaglutide has the potential to become a game changer in the treatment of diabetes and a blockbuster for Novo Nordisk in the coming years. Moreover, recent clinical trials have confirmed unprecedented results for Semaglutide in the treatment of obesity as it acts on the patients’ satiety hormone. Out of the 1.9 billion currently overweight individuals, the WHO estimates that 650 million adults are obese, equivalent to 10% of the world population. Due to sedentary lifestyles and the spread of Western eating habits to Asian countries, the number of overweight people is predicted to rise to 3.3 billion by 2030.

ULTA BEAUTY (ISIN: US90384S3031 – United States) The most significant positive contributor for the year, Ulta Beauty is also the largest position in the core concentrated portfolio for all the UCITS and AIF funds that we manage. In a down year for the markets, Ulta Beauty’s share price bucked the trend and appreciated by 9.47%.

Source: Bloomberg – Data as at 15 March 2019 Describing Ulta in their own words, the company is “the leading cosmetics and beauty retailer in the United States and the premier beauty destination for cosmetics, fragrance, skin care products, hair care products and salon services bringing together all things beauty, all in one place… it offers a full- service salon in every store featuring hair, skin, brow, and make-up services. Ulta Beauty operates 1,174 retail stores across 50 States and also distributes its products through its website, which includes a collection of tips, tutorials, and social content.” In a way, Ulta is like three companies in one: a leading specialty retailer, a beauty services salon operator and an e-commerce business. Let’s take them one by one and explain why Ulta is such an exceptional business.

Specialty Retailer On the specialty retail side, Ulta is by far the largest player in a segment that, along with the internet, keeps gaining market share at the expense of traditional distribution channels.

Source: Euromonitor International Within Specialty Beauty, and differently from Sephora, the company has a unique market position as a ‘one-stop shop’ where customers can find an assortment of over 500 brands, more than 20,000 products from prestige all the way through mass cosmetics and private labels. At the time of writing, the company has enrolled over 32 million customers in its Ultamate Rewards loyalty program and benefits from a huge amount of consumer data for marketing and engaging with them online and offline. Services At a time when consumers must have a reason to visit any shop, services are an essential component of Ulta Beauty’s differentiation strategy. They make each store a destination in itself and a place to experience new and different products in a way that the internet simply cannot match. They also attract customers who spend more, more frequently and want customized expert advice that goes beyond tutorials. E-commerce On the e-commerce side, one of the things that struck us is that beauty is one of the largest consumer categories in the United States and probably the only one in which Amazon is not very powerful. The simple explanation is that high-end brands do not wish to market through Amazon for fear of engaging in price promotions and losing their exclusive brand image aura. This plays to the advantage of Ulta which may be regarded as the Amazon of cosmetics, a place where shoppers can find everything online and offline as well as use their loyalty program points earned offline and also take advantage of targeted promotions. If we look at Ulta Beauty through the prism of our methodology, we can see that the combination of retail, services and ecommerce translates into a superior business model that delivers over 40% ROE, high double-digit EPS growth and buybacks in the millions of dollars with no debt.

Pricing Power The company enjoys premium prices and benefits from limited competition intensity as high-end brands favor a ‘selective distribution’ model. The focus is on newness, brand and product marketing, service and innovation more than just price. On the internet, high end brands have a limited, unofficial presence on Amazon. Furthermore, Ulta carries exclusive product lines from the likes of Estée Lauder, L’Oréal or LVMH and targets subsets of shoppers with customized e-marketing campaigns that have become an essential showcase and launchpad for major and ‘indie’ brands wanting to reach the right consumer segment. As a case in point, digitally-native brand Kylie Cosmetics launched exclusively in Ulta stores in Q4 18. Services are another source of pricing power as consumers benefit from expert advice resulting in bigger average basket sizes. Current service partnerships include MAC (Estée Lauder) and Benefit Cosmetics (LVMH) in make-up, Dermalogica (Unilever) in skin care and Redken (L’Oréal Professional) in hair care. Costing Power With sales approaching 7 billion dollars, Ulta is the number one cosmetics retailer in the US, followed by Sephora. The business enjoys significant bargaining power in what remains a fragmented market. Management favors large and efficient stores in suburban strip malls or local convenience shopping centers to expensive malls and urban city centers. The average payback period of a store is just 2 years. On the e-commerce side, Ulta Beauty benefits from low costs of customer acquisition thanks to high conversion of digital advertising and repeat business stemming from the Ultamate loyalty program. The sheer size of the business allows for economies of scale and density and is supported by a dedicated national supply chain and a network of e-commerce specialized distribution centers - the last of which, Fresno, started operations in July 2018. The business lends itself well to ecommerce as products are small, relatively high-value units that, unlike apparel, do not get returned frequently. Consumer data collected by Ulta enables efficient online and offline marketing campaigns, including activation of influencers to target Ultamate members and social network users. Our team spent a week in Chicago, home to the company’s headquarters, and was very impressed with the sophistication of Ulta Beauty’s e-marketing capabilities. Management team When it comes to the management team, we are in great hands. Mary N. Dillon is recognized as having one of the best track records in the field of product marketing earned as former Global Marketing Director for McDonalds and Gatorade, to name a few. Mrs. Dillon also sits on Starbucks’ Board of Directors. Mary Dillon has been able to surround herself with outstanding professionals in any domain. In Marketing and Merchandising she hired longtime colleague David Kimbell, Derek Hornsby in Supply Chain management, Shelley Haus joined for Brand Marketing. On the finance side, CFO Scott Settersten, is a company veteran who joined in 2005 after 15 years of extensive experience at PricewaterhouseCoopers.

Value Creation dynamics The business has exciting opportunities to keep growing profitably with 80 new net stores announced for 2019 and a 5-year target of 1,700 stores in the US alone, e-commerce development and potential international expansion. On top of that there is structural single digit growth in the beauty market and still plenty of market share to gain from traditional channels in what remains a very fragmented 130+ billion-dollar market. Economic prospects Our team believes that the business will deliver above average economic performance for years to come and, thanks to fixed-cost leverage, can increase operating margins. With sales growing 16.2% year on year, several hundred million dollars of cash on hand, and cash flow from operations at almost one billion dollars in 2018, Ulta recently announced a 700 million dollar buyback plan for 2019 alone.

LVMH (ISIN: FR0000121014 – France) Once again, LVMH was one of the main contributors to our portfolio’s returns. Posting organic revenue growth of 11% and a record operating profit from recurring operations of more than €10 billion, a 21% growth, the world leader in luxury goods continues to demonstrate solid growth across all regions.

Source: Bloomberg – Data as at 15 March 2019

With dominant positions in high-end wines and spirits (Cognac and Champagne), fashion and leather goods (Louis Vuitton, Fendi, Loro Piana, Céline, Kenzo), perfumes and cosmetics (Dior, Guerlain, Givenchy), watches and jewelry (Bvlgari, Tag Heuer, Hublot, Chaumet), as well as selective retail (Sephora, DFS, Le Bon Marché), the company truly embodies the concept of pricing power.

Moreover, the management team around CEO Bernard Arnault is extremely competent on all levels. We feel privileged to regularly exchange with LVMH teams. Rarely have we been able to invest in companies whose human and financial resources and strategy can compare to those of LVMH in its ability to combine long-term vision with exceptional results. In addition to this, unlike other more cyclical players in the luxury goods space, LVMH has repeatedly demonstrated resilience to economic slowdowns thanks to its geographic diversification and business units such as perfumes and cosmetics distribution, which are typically less affected by business cycles. With Free Cash Flow of €5.5bn (up 16%) and an extremely strong balance sheet, LVMH announced the acquisition of Belmond group on December 14th, 2018, for an enterprise value of $3.2 bn. Belmond owns and operates some of the highest-end luxury hotels in the world such as the Hotel Cipriani in Venice, Copacabana Palace in Rio, Hotel Splendido in Portofino, but also assets like the Simplon-Orient Express. We believe the acquisition can be regarded as vertical integration, a way of acquiring priceless shopping venues for LVMH’s brands and, at the same time, complements LVMH’s relatively small presence in the hospitality industry with Cheval Blanc.

Key portfolio movements during the year

INVESTMENTS During the period under review we initiated positions in Tiffany & Co. (US8865471085) and Booking Holdings (US09857L1089). We have also added to our holdings in Walt Disney Corporation (US2546871060), Accenture (IE00B4BNMY34) and EssilorLuxottica (FR0000121667).

DIVESTMENTS We disposed of the following four positions in 2018 in the Long Equity book: Photo-Me International (GB0008481250), Expedia Group (US30212P3038) and Bauhaus International (KYG1080K1094).

SHORT EQUITY

Philosophy

At Varenne we short for performance and not for hedging. The team seeks companies that have a high probability of facing a capital event - i.e. a recapitalization, a capital restructuring or a bankruptcy/liquidation – within an 18 to 24-month timeframe. They have the option to express their views through idiosyncratic single stock short ideas or bespoke baskets built on fundamental and behavioral factor analysis in over sixty markets.

Short Equity is separate from Long Equity and is equipped with its own methodology, specific processes, proprietary information systems and a dedicated team of analysts.

Contribution in 2018

To reiterate our comments from last year: “in a continuation of the conditions experienced in the second half of 2016, 2017 proved far from conducive to this short strategy as extremely favorable credit conditions allowed even virtually insolvent companies to refinance on very favorable terms. With monetary policies tending towards normalization in 2018, we expect to be in a position to again deploy capital to shorts during the year. Our plan is to start with bespoke diversified baskets first and then, as conditions become more favorable, single stocks”. As always at Varenne, we have the choice to stay on the sidelines if the odds are against us. In the second quarter of 2016, with our short opportunity indicators at historical lows, we made the decision to refrain from engaging in single stocks shorts until normalization of monetary policies or credit conditions occurs. In hindsight, we believe our decision has proven to be correct.

Source: HFRI – Data as at February 2019 17

As the above graph illustrates, short-biased funds could not generate positive performance between Q1 2016 – when we covered our successful short positions on US biotech and on a few shale oil-related single shorts – and Q4 2018. As expected, we re-entered the field in Q2 2018 after Fed Funds crossed the 1.5% threshold. We did it through a basket of companies presenting both unfavorable behavioral and fundamental factors such as problematic Free Cash Flow yield levels. Exposure started at 5% and ramped up to 7.5% at year end. As at January 1st 2019, 49 companies were part of the selection. On average they were burning cash at a pace of 8.8% of their market capitalization, with 21 out of 49 not in a position to pay dividends. Return on net assets was very poor and not enough to service their debt levels, on average 47.1% of their equity capital.

Source: Varenne Capital Partners – S&P ClariFi

Overall, Short Equity posted a slightly negative performance over the year, -0.19%, but proved a significant and increasingly positive contributor in the second half of the year.

Outlook

At the time of writing, monetary policies have undergone a spectacular about-turn and it remains to be seen how fiscal stimulus in both the United States and China will impact consumption and economic activity in general. What is certain is that all of our indicators have clearly reversed course.

Source: Varenne Capital Partners – Data as at March 15 2019

As an example, yield on speculative grade credit only briefly moved above the 7.5% threshold – a rate which we consider to be the minimum level of a functional market – only to fall back again immediately after the Fed’s posture change in January. The implication on our shorts of extremely favorable credit market conditions - discussed in more detail later in the letter - is that we can be right on the analysis but wrong on the outcome as virtually bankrupt businesses will be able to refinance and de-facto avoid default and insolvency. Against this backdrop, we will continue to monitor credit conditions and economic activity in 2019 and, should any of them start to deteriorate, we stand ready to make the most of our research by focusing on idiosyncratic trades in addition to our diversified selection.

MERGER ARBITRAGE

Philosophy

A true “fund within the fund”, our Merger Arbitrage strategy aims at reducing the overall correlation of the portfolio to equity indexes and providing additional returns during bearish market phases. Using dedicated real-time information systems, our team detects new mergers and acquisitions globally and focuses exclusively on announced and friendly deals, the ones that have the most attractive risk-return profiles, only when spreads meet or exceed our minimum profitability thresholds. Owing to correlation between volatility and merger arbitrage spreads, we expect this strategy to contribute the most in agitated market conditions and, all other things being equal, portfolio exposure to increase in the weeks following volatility spikes as it is usually at such times that our minimum profitability requirements are met or exceeded.

Source: Varenne Capital Partners – Value Active Fund Compared to arbitrage ‘pure player’ funds, our portfolio construction model has a major competitive advantage in that we are under no obligation to be ‘in play’ - i.e. to invest - when our criteria are not met. Exposure can vary from 0 to 100%, so we can be expected to stay on the sidelines in periods when conditions are not favorable for the strategy and to be very active in deploying capital in conducive conditions.

Contribution in 2018

As we wrote in last year’s letter, 2017 was one of those periods during which there is probably more risk than potential return in merger arbitrage. As a consequence, our average exposure was one of the lowest in recent years, ranging from approximately 7% on the UCITS portfolios to 14% on the AIFs. Reasons for this were the rare star alignment of a prolonged phase of very low interest rates, extremely low market volatility, aggressive deals supported by cheap and abundant financing exposed to risk of non-event and severe antitrust scrutiny and, as part of a more general chase for yield, enormous capacity in the M&A market.

Source: BarclayHedge – Data as at end 2018

As expected, the situation improved in 2018 and Merger Arbitrage contributed positively to both the returns and the resilience of the portfolio. The ‘normalization’ of US monetary policy led to an increased exposure to US deals in the second half of the year, while a rebound in equity market volatility in Q1 and Q4 lead to a widening of spreads and more opportunities to deploy capital efficiently.

Spreads Widening – Q1 & Q4 2018

Source: Varenne Capital Partners

Beyond the positive contribution of Merger Arbitrage in 2018 of +1.16%, we are truly satisfied with the quality of the performance. Uncorrelation was illustrated by eleven months of positive performance (September’s was negative by 3bps) and the team successfully identified and discarded problematic deals such as NXP Semiconductors (NL0009538784), Akorn (US0097281069), Avista (US05379B1070) and Tribune Media (US8960475031), only to cite a few. Below are the main trades set up by our Merger Arbitrage team throughout the year, as well as their profitability.

WEIGHTED DURATION TARGET BIDDER DEAL TYPE DEAL STATUS ANNUALIZED NET PROFIT (DAYS)

Zodiac France Safran Cash for Stock Very Likely/Quasi-Certain/Mechanical 28 2.62% IGE + XAO France Schneider Electric Cash for Stock Very Likely 58 2.16% Euler Hermes France Allianz Cash for Stock Very Likely 72 2.13% Dalenys Belgium Natixis Cash for Stock Quasi-Certain 83 2.51% Bioverativ USA Sanofi Cash for Stock Very Likely 29 16.89% Refresco Netherlands PAI Partners Cash for Stock Very Likely/Quasi-Certain/Mechanical 35 3.45% Callidus USA SAP Cash for Stock Very Likely 58 4.22% Merrill Lynch Capital III USA Bank of America Cash for Stock Mechanical 30 2.35% Banco BPI Portugal CaixaBank Cash for Stock Quasi-Certain 1 1.34% (non-annualized) Abertis Spain Hochtief Cash for Stock Very Likely 21 6.00% Yoox Italy Cie Financière Richemont Cash for Stock Very Likely/Quasi-Certain/Mechanical 106 3.28% CommerceHub USA Sycamore Cash for Stock Very Likely 12 4.76% Ablynx Belgium Sanofi Cash for Stock Mechanical 28 1.85% Orbital ATK USA Northrop Grupman Cash for Stock Very Likely 193 3.300% DST Systems USA SS&C Tech Cash for Stock Very Likely 20 15.61% Time Warner USA AT&T Mix offer Very Likely 1 1.75% (non-annualized) AuFeminin France TF1 Cash for Stock Very Likely/Quasi-Certain 77 6.59% Snaitech Italy Playtech Cash for Stock Very Likely/Quasi-Certain/Mechanical 31 24.35% CityFibre UK Consortium Cash for Stock Very Likely/Quasi-Certain/Mechanical 39 8.46% Validus USA AIG Cash for Stock Very Likely 28 4.54% ZPG UK Silver Lake Cash for Stock Very Likely/Quasi-Certain/Mechanical 38 3.71% Naturex France Givaudan Cash for Stock Very Likely/Quasi-Certain 57 2.60% British Airways Perp 6.75% UK IAG Cash for Stock Mechanical 48 3.85% Abaxis USA Zoetis Cash for Stock Very Likely 13 8.93% Altamir France Amboise Cash for Stock Mechanical 23 2.55% Vittoria Assicurazioni Italy Vittoria Capital Cash for Stock Very Likely 109 1.27% GFI Informatique France Mannai Cash for Stock Very Likely/Quasi-Certain 95 30.52% (non-annualized) Luxottica Italy Essilor Stock for Stock Very Likely/Quasi-Certain 227 2.88% Pinnacle Foods USA ConAgra Brands Mix offer Very Likely 95 1.91% Syntel USA Atos Cash for Stock Very Likely 67 6.20% Vedanta Resources UK Volcan Investment Cash for Stock Very Likely 30 12.26% esure Group UK Bain Capital Cash for Stock Very Likely 102 2.97% Barclays Bank ADS UK Barclays Bank Cash for Stock Quasi-Certain 44 3.53% Citigroup Perp 5.8% USA Citigroup Cash for Stock Quasi-Certain 10 3.73% K2M Group USA Stryker Corp Cash for Stock Very Likely 31 5.85% CA USA Broadcom Cash for Stock Very Likely 54 7.37% MAN SE Germany Volkswagen DPLTA* Mechanical 19 3.90% Mazor Robotics ADR USA Medtronic Cash for Stock Very Likely 44 5.98% Ansaldo STS SpA Italy Hitachi Cash for Stock Very Likely 16 7.38% Sonic Corp USA Roark Capital Cash for Stock Very Likely 44 6.23% Enercare Canada Brookfield Infrastructure Cash for Stock Very Likely/Quasi-Certain 28 22.25% Mitel Networks Canada Searchlight Capital Partners Cash for Stock Very Likely 75 5.77% LifePoint Health USA Regional Care Hospital Partners Cash for Stock Very Likely 7 7.09% Express Scripts Holding USA Cigna Mix offer Quasi-Certain 93 7.88% Aetna USA CVS Mix offer Very Likely 15 39.00% Beni Stabili Italy Covivio Stock for Stock Mechanical 10 3.37% Dun & Bradstreet USA Consortium Cash for Stock Very Likely 140*** 3.16% Gemalto Netherlands Thales Cash for Stock Very Likely 313*** 2.47% Belmond USA LVMH Cash for Stock Very Likely 131*** 4.59% Navigators USA Hartford Financial Services Cash for Stock Very Likely 82*** 4.38% Red Hat USA IBM Cash for Stock Very Likely 194*** 14.23% Europac Spain DS Smith Cash for Stock Quasi-Certain 35*** 1.04%

Average duration (days): 64** Average annualized net profit (weighted average): 5.21%**

* Domination Profit and Loss Transfer Agreement ** Excluding Banco BPI, Time Warner and GFI Informatique *** Estimated Settlement Date Source: Varenne Capital Partners – Value Active Fund

Outlook

Looking ahead, we see conditions remaining favorable for Merger Arbitrage, at least in terms of deal flow thanks to cheap financing and record amounts of private equity dry powder. Even though January marked the best start to the year since 2000 with $275Bn of deals announced, visibility is still very low at this time and we currently aim for exposure levels slightly below those of 2018 with comparable gross contribution to the overall portfolio performance. Finally, we’ll have to keep a close eye on regulation as global antitrust authorities redefine their practices, notably on cross-border deals against a backdrop of political tensions between the US, China and Europe. This could lead to a shift in practices and additional layers of scrutiny that can be hard to predict – e.g. President Trump’s decisions based on the recommendations of the Committee on Foreign Investment in the United States (CFIUS).

TAIL RISK HEDGING

Introduction

Whereas corrections or bear markets are natural events that often present investors with excellent long and short opportunities, major financial shocks or prolonged economic crises can drive risky assets into hard-to-reverse negative returns. In order to protect against the consequences of extreme events, we implement a ‘Tail Risk Hedging’ strategy. The aim is to identify root causes of risk that cannot be managed within our other frameworks and, whenever possible, isolate them and find appropriate hedges in the form of risk-reward asymmetric instruments or trades. Hedges are built within a maximum annual budget linearly estimated at 1.5%. Within the framework the team typically deploys very long dated (18 months to 5 years) optional strategies and resorts to shorter-term trades from time to time. Assets and instruments include currencies, commodities, interest rates, indexes, credit and equity derivatives.

The team determines different macroeconomic scenarios with the goal of ensuring that portfolios are equipped to fare as well as possible in any one of them. As an example, nine such scenarios are shown in the above matrix. In benign economic conditions, we expect portfolio returns to stem from the quality of the businesses in the Long Equity book, the idiosyncrasies on the Short Equity side and the opportunities that we will have, from time to time, on Merger Arbitrage. In problematic, less likely, scenarios, Long Equity, Short Equity and Merger Arbitrage might not be enough to preserve invested capital. That is why, when our analyses demonstrate that imbalances and risk are building in the global economic or financial system, we can discretionally deploy our hedging budget of up to 1.5%. The following paragraphs outline our macroeconomic views and the hedges currently in place.

Systemic risk

Since Bretton Woods and the end of the gold standard in 1971, global debt has increased at a far more rapid pace than economic growth. Moreover, in preventing the “financial crisis” from blowing into a global depression, the central banks have since pursued ultra-accommodative conventional and unconventional monetary policies, aggravating the risks of instability in the financial system. After many years of asset purchases and low, or negative, interest rates, a desperate quest for yield has led economic agents towards riskier and riskier assets, potentially causing misallocation of capital and mispricing. It is in this potentially meaningful disconnection between prices and fundamentals that the largest financial instability risks reside. Against this backdrop, financial imbalances kept growing in 2018 as the financial system has become chronically addicted to monetary stimulus making any normalization process an extremely difficult one.

Source: Bloomberg – Data as at end of 2018 Given the acceleration in global economic activity and the inflationary impact on asset prices of almost a decade of ultra-loose monetary policies, monetary authorities finally started to act in 2017 for fear of finding themselves materially behind the curve. But, once again much like the taper tantrum of 2011 and the emerging markets scare of 2015/16, central banks faced immediate market backlash in

26 terms of asset price deflation. It did not take long before the Federal Reserve and then other major central banks reversed course and pressed the pause button on normalization. As we noted in our letter last year: “normalization in monetary policies could expose the cascade of financial excesses that started in sovereign bonds and progressively spread to asset classes including investment grade and speculative grade credit, emerging market debt, real estate and finally equity.” If this sounds familiar it is probably because it is just what happened in the second half of 2018 before fear of the consequences led to what we might half-jokingly refer to as the “Powell Put”. To understand how serious the imbalances are, let’s take the example of speculative non-financial debt, which includes various types of non-investment grade credit, such as leveraged loans and high- yield bonds. Corporate High Yield – Default Rate

Source: Standard & Poor’s In recent years, default rates on speculative grade debt have reached record lows while the percentage of speculative rated issuers has increased to a record high of over 50%. The huge availability and cheapness of credit have artificially enhanced short-term corporate solvency. This in turn reduced the perception of risk and led to even more favorable credit terms, in the end allowing even virtually insolvent entities to refinance easily. In this context, the ability to repay debt is itself influenced by the availability of credit in a reflexive relationship: default rates have remained historically low not because borrowers are increasingly capable of paying back interest and principal but because of the market willingness to finance them regardless of the likelihood to pay back. Beyond potentially mispricing credit, these exceptional monetary and credit conditions have been transmitted to private and public equities by vectors including acquisitions and buybacks. 27

Let’s take a look at some hard facts for 2018: • The Leveraged Loans market peaked, eclipsing all previous record highs

Source: LCD S&P Global Market Intelligence – Data as at end of 2018 • After more than doubling in 2017, Collateralized Loans Obligations (“CLOs”) issuance reached again an all-time high

Source: ECB – Varenne Capital Partners

• “Covenant lite” percentage of leveraged loans issuance peaked at about 70% both in the United States and in Europe - versus less than 10% in 2006!

Source: S&P Global Market Intelligence – Data as at November 2018 • Acquisition multiples remaining above the 2007 peak:

Source: S&P Global Market Intelligence – Data as at end of 2018 In summary, pausing on normalization of monetary policies might well seem the only option for central banks around the world, but the impact on asset prices cannot be dismissed as it risks creating major difficulties down the road. The risk is that misallocation of capital and mispricing have been artificially sustaining valuations, providing investors with a false impression of much improved long- term fundamentals. 29

When prices and market conditions influence fundamentals – which they are instead supposed to reflect… – the risk is that, despite a seemingly optimistic outlook, reflexivity is at play and an unsustainable equilibrium is in the making.

One final consideration: when monetary and fiscal authorities around the world are all engaged in sustaining economic activities and reflating assets, it may take much longer than we think to have unsustainable imbalances exposed and resolved. All we know is that they will surface at some point and this is the risk we deal with in the Tail Risk Hedging book.

Hedging policies

As discussed in our previous annual letter, we took advantage of extremely benign market conditions in 2017 to ramp up our hedging. The decision paid dividends in 2018 as the year saw several episodes of market volatility and a correction. Tail Risk Hedging contributed positively to both UCITS and AIFs portfolios during the year.

Source: Varenne Capital Partners – Value Active Fund As with the other strategies, we will discuss the main contributors and then the changes that occurred in the book throughout the year. 30

Main contributors in 2018

Credit Default Swaps (CDSs) on European Subordinated Financial Debt CDSs on European Subordinated Financial Debt was the largest positive contributor to the performance of the Tail Risk Hedging portfolio for the year under review.

Source: Bloomberg – Data as at end of 2018 Our team has for some time sought out instruments with asymmetric risk-reward profiles in order to mitigate the possible negative consequences of credit and/or economic crises and, in summer 2017, initiated a position on Credit Default Swaps on European subordinated financial debt, i.e. junior debt issued by European bank. Subordinated debt absorbs losses immediately after equity but prior to any other instrument in the capital structure. The picture below represents Deutsche Bank’s balance sheet as publicly disclosed.

Source: Deutsche Bank – Annual Report 2018 31

In case of an extended economic crisis or financial shock, financial institutions will have to face losses with a very thin (0.53%) layer of equity and subordinated debt. To better gauge the underlying risk, it suffices to compare it to the more than 23% of the bank’s balance sheet committed in derivatives - despite “netting accounting” adopted after the financial crisis. Because of bond purchases and ultra-loose monetary policies, and after what the market perceived as favorable election outcomes in both the Netherlands and France, investors’ risk perception reached a post-financial crisis low in the summer of 2017. The combination of a better political climate, benign market conditions and a general chase for yield on riskier and riskier assets created an environment where investors were willing to sell protection on subordinated financial debt for less than half the price the market required only a few months before.

iTraxx Sub Fin S26 5 Years (Spread Basis Points)

Source: Bloomberg – Data as at Q3 2017

Throughout the second half of 2017 we took full advantage of this rare window of opportunity to buy CDSs on subordinated financial debt for an annual spread of less than 1%. The team focused first on iTraxx Sub Fin Series 26, shown above, and then on the subsequent Series 27 until January 23rd, 2018.

Source: Markit

We had acquired notional amounts equivalent to roughly 27.5% of net assets on the UCITS and ca. 33.5% on the AIFs portfolios when CDS started to rapidly re-rate, benefiting our portfolios just as the equity market indexes were dislocating.

Source: Bloomberg – Data as at end of 2018

Reasons why CDSs on European Subordinated Financial Debt were re-rated in 2018 include: - Both the Italian election results in April, and Turkey’s currency and economic woes, in July/August, reminded investors of the fragility of the European banking system and modified the market’s perception of risk. - Monetary policy normalization in the US and expectations for normalization in Europe reduced the demand for CDS underwriting.

What happened simply reinforced our conviction that, in a crisis scenario, European financial companies will once again prove to be one of the weakest links in the global financial system and, should such an unfortunate situation occur, subordinated debt bondholders risk suffering disproportionately.

Put on Best: Euro Stoxx 50 and Nikkei 225 The second largest positive contributor to the 2018 performance was a “Put on Best” option on Euro Stoxx 50 and Nikkei 225. The rationale behind this trade is described below. S&P 500 – 3-month Implied Volatility

Source: Varenne Capital Partners

Back in spring 2017, equity markets’ implied volatility regime reached a very low level thus creating extremely favorable conditions to setting up long dated hedges. Our team focused on two notoriously volatile indexes, the Eurostoxx 50 and the Nikkei225. Both are highly sensitive to macroeconomic activity because of the cyclicality of their export-oriented components – think Japanese and German exporters.

The idea of a put option on the best of the two stems from the correlation between the two indexes observed during market crises. Taking the 2007-2009 financial crisis as an example, all other things being equal an investor shorting one index or the other would have ended up with pretty similar results. EuroStoxx 50 & Nikkei 225 (Basis 100)

Source: Varenne Capital Partners Although correlation between the two indexes is typically very high during crisis periods, that is not necessarily the case at other times. Interestingly enough, short term past correlation between two indexes is often extrapolated as a key input for pricing longer dated combined options.

Source: Varenne Capital Partners

On these grounds, in March 2017 our team asked their usual counterparties to provide quotes for 20% out-of-the-money put options on each index in isolation and then asked them to combine them under a best of put option structure.

Premium Put 80% Premium Put 80% Put on Best premium 80% Discount Discount EuroStoxx 50 Nikkei 225 EuroStoxx 50 + Nikkei 225 EuroStoxx 50 Nikkei 225

20 March 2020 7.50% 6.60% 4.06% -45.87% -38.48%

Due to the exceptionally low implied volatility environment we received relatively reasonable quotes at 6.60% and 7.5% as a starting point. Applying the ‘best of put’ structure provided significant additional discounting of 38.5% and 45.9% respectively, which we found compelling. We set up the trade at the very end of Q1 2017 and, as at the date of publishing, notional size as a percentage of net assets is 15% on the UCITS portfolios and 25% on the AIFs. The option’s maturity is March 20, 2020. In 2018 the two indexes once again followed a very similar path, thus validating our thesis and providing a positive contribution to the overall portfolio despite time value decay.

Source: Varenne Capital Partners

Key portfolio movements during the year

Although 2018 was not an as obvious period for setting up hedges as 2017, our team succeeded in identifying and executing two new positions on US credit and Brent oil.

CDX IG Tranche 7-15% (S29) A third positive contributor to the 2018 overall performance, this trade was initiated in Q4 2018. Technically it translates into purchasing protection on the 7-15% loss tranche on the investment grade CDX index series 29. We will try to summarize the rationale behind this in the following paragraphs. For quite some time our team had been looking for a way to hedge US credit tail risk and naturally investigated the high yield space only to find that risk hedging was fairly priced. In 2018 we took another route and explored the investment grade market instead as the response to the financial crisis altered some of its characteristics. In fact, in less than ten years, the search for yield pushed BBB-rated issues to represent roughly 50% of the overall market.

Source: Morgan Stanley, Citigroup

Even more interestingly, in just a few years, investment grade rated issuers’ leverage profile changed dramatically, with close to 25% of them now leveraged more than 4 times EBITDA.

Source: Morgan Stanley – Data as at 7 September 2018

On these grounds, the team focused on the most leveraged components of the CDS index CDX, a static index of 125 US investment grade entities, at inception. Over 50% of the components were in effect rated BBB, half of them in very cyclical businesses. Furthermore, the solvency indicator of the bottom quintile looked deteriorated with a Net Debt to EBITDA ratio of 3.45 and a more worrying Net Debt to Free Cash Flow from operations ratio of 5.5. In the event of a severe economic or financial shock, it is easy to imagine a reduction in operating earnings and cash flow metrics leading to a decline in solvency indicators, spread widening and, for some of the names, downgrade to high yield rating. Without mentioning the potential unsustainability of pension obligations and the risk of outright restructuring for a significant percentage of the index components. While the economic quality of the investment grade portion deteriorated significantly, the perception of risk did not and the CDS levels have remained roughly similar over the last few years thus showing a potential inefficiency and, consequently, a tail risk hedging opportunity.

Source: Varenne Capital Partners – Data as at 9 January 2019 38

Within the CDX index the team has purchased protection in the form of a pay-off on the 7-15% loss tranches of the series 29 of the CDX index expiring December 2022. Differently from a CDS, no notion of recovery applies and, in case of losses amounting to 15% in the index the pay-off would equal 100% of the notional of the trade. As at the time of writing the targets for this trade are 15% of AUM on our non-UCITS funds.

Put Brent Future March 2022 We took advantage of a global bull run in oil price to set up a contrarian long term trade on oil at the beginning of Q4. There were several reasons for that and are summarized below. While OPEC production is in structural state of overcapacity, US shale production continues to increase sharply as a consequence of widespread technical advances which bring down marginal production costs. Also, we believe that Brent, the global oil standard and WTI, the American light sweet standard, are in principle fungible commodities, yet in Q4 2018, Brent commanded a premium over the WTI of a hefty 10$ a barrel despite lower intrinsic quality. We think in the long term the premium will narrow significantly as the US increases WTI exports thanks to new legislation, new pipeline capacity to connect the production basins, new storage infrastructure and the acceleration of the transition to alternative sources. In the case of a significant economic shock, we expect a drop in real and forecasted demand to exert significant pressure on oil prices and, despite OPEC’s efforts, US producers will still be incentivised to sell at marginal extraction cost, i.e. without being able to recover exploration and fixed production costs. The price would decrease dramatically, and, in such a scenario, WTI-Brent convergence should accelerate as the 10-dollar premium would translate into an unsustainable difference in percentage terms and transportation costs for oil would simultaneously lower. On the back of our analysis, we have bought deeply out of the money Put options on March 2022 Brent Futures, at a strike price of $30, in a way trading moneyness for time. A move like this would not be possible on equity, simply because the option would be tied to a reference market level that would risk making it ineffective a few years down the road. The notional target for this trade is, at the time of writing 15% of AUM for the non-UCITS funds that we manage.

Current positions

To summarize, please find underneath an overview of Tail Risk Hedging positions as at the time of publishing.

A FINAL WORD OF THANKS TO GREAT INVESTORS…

We hope you found the above document informative both for the investment decisions that we have made throughout the year and the general philosophy that we employ. We are very fortunate in this business as previous generations of great investors and analysts have shown us the way through their extensive writings. All we need to do is take the time to learn from them and follow their steps. To us they are great references and constant sources of inspiration and learning. Think of George Soros and Warren Buffett. An odd couple by many standards, different in almost every respect, they have one thing in common: each has developed a sound and unwavering investment framework that has guided them in every decision made throughout their very long investment careers. Much like the Chairman of our Supervisory Board, Jean-Marie Eveillard. Having sound and consistent investment principles, and sticking to them in the long run, is the main characteristic trait of the investors whom we admire, those who have been able to deliver results over decades. They epitomize the difference between added value and simple risk taking.

…AND OF ECONOMISTS’ ABILITY TO PREDICT RECESSIONS!

Source: Philadelphia FED – TS Lombard

This document has been prepared for private and confidential use. It does not constitute, and should not be deemed, an offer to buy or sell or a solicitation of an offer to buy or to sell an interest of any kind. All information reported in this document is intended solely for illustration purposes and is subject to change without notice. Attribution and contribution figures are estimated, gross. Readers should be aware that attribution and contribution calculations are indicative and entail significant assumptions and approximations. No representation, warranty or undertaking expressed or implied is given as to the accuracy or completeness of the information contained in this document and no liability is accepted by Varenne Capital Partners, its members, partners or employees for the accuracy or completeness of any such information. This document includes forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those expressed or implied in the forward-looking statements in this document. Past performance is no guarantee of future results and no representation is made that an investor can achieve similar results in the future.

Varenne Capital Partners is authorized and regulated by the Autorité des Marchés Financiers ("AMF"). Varenne Capital Partners, 42 Avenue Montaigne, 75008, Paris, France. [email protected]