MONEY MANAGER INTERVIEW

Following Capital Structures Over Time to Extract Value

MICHAEL KAO, AKANTHOS CAPITAL MANAGEMENT, LLC

MICHAEL KAO is CEO and Portfolio Manager at Akanthos Capital Management, LLC.

Mr. Kao has devised and implemented investment strategies spanning multiple asset

classes and markets since 1992. Prior to forming Akanthos Capital Management, LLC, in

2002, Mr. Kao worked at Canyon Capital Advisors, where he analyzed, devised and

implemented trading strategies in convertible and , merger

arbitrage, standalone and option strategies, and firm-wide portfolio hedges using index options, interest rate instruments, currency options and commodity options. While at Canyon Capital Advisors, he co-founded and lead-managed the firm’s Arbitrage Strategies Group, and co-founded the Canyon Capital Arbitrage

Fund, directing investments for just under $700 million of fund capital in various arbitrage strategies spanning convertible, capital structure and merger arbitrage. Mr. Kao began his investment career at the J. Aron Currencies and Commodities division of Goldman Sachs, engaging in index arbitrage, strategies in over 30 underlying future and options markets, and dynamically hedging and making markets in various commodity-linked derivatives. Mr. Kao is a graduate of the University of California at Berkeley with a B.S. in electrical engineering and computer Science, and the Wharton School of the University of Pennsylvania with an MBA in finance.

SECTOR — GENERAL INVESTING Mr. Kao: One of the early lessons, and one that I (AFJ502) TWST: Please begin with some highlights from adhere to today, is that you always have to have a view on your career, with a view to steps that led you to found everything at all times. It’s something that I encourage my Akanthos Capital Management. analysts at Akanthos to have. Essentially, we have to have a view Mr. Kao: My pre-Akanthos career was but on pretty much everything in our portfolio at all times. eventful, preparing me for the company we have today. I graduated My boss at Goldman was a gentleman by the name of from Berkeley with an engineering degree and went straight to James Riley, who headed precious metals and commodities trading. Wall Street to work for Goldman Sachs. My first job was in the J. Jimmy, as we called him, was one of the best instinctual traders I have Aron Group, which is the currency and commodities division, and ever met. He taught me not the high finance of trading, but the street which led me to trade a product called the Goldman Sachs smarts of trading. That is, the tactics of trading, especially reading Commodity Index. It was a combination of a market-making desk, market sentiment and understanding the dynamics of trading. a derivatives trading desk as well as a proprietary trading desk, From a practical standpoint he also taught me the value of because the Index product was a nascent one at the time. having positive gamma versus negative gamma. Perhaps I should My mandate was to ensure that there was liquidity in digress for a minute and demystify the jargon. Gamma is a piece of the product for any that wanted to invest in jargon that options traders use to describe the rate of change of the commodities. It was essentially a market-making type of role, delta of an option. Delta of an option is basically an option’s and because it was new, in-between times where there was sensitivity to the underlying share price. Therefore the gamma is the institutional flow, we had to find ways to make ourselves rate of change of that rate of change, if you will. It’s a little bit of an relevant. We were encouraged to essentially have proprietary esoteric concept, but basically when you are long optionality — views on all 22 of the underlying commodities at the time. when you are long options — you have a quality called positive 952-7400 (212) Wolfrath permission contact Kenneth reproduction material: For Copyrighted TWST: What did you take away from the experience? gamma. If the underlying stock or commodity goes up, your option MONEY MANAGER INTERVIEW — MICHAEL KAO becomes more and more sensitive. So the lessons I learned at to arbitrage the convertible bond against the stock. Goldman were trading instincts and optionality. Over the years General Motors became more indebted After that I went off to Wharton business school and did a and the fundamentals declined. Now remember, this was the old short stint at Harvard Management Company, working for folks like GM, and the trades we did sort of migrated into where we were Jon Jacobson and Jack Meyer. That was where I was introduced to arbitraging the convert against straight debt, thus underscoring my other asset classes, and that the world of finance is greater than just theory of using the capital structure for maximum effectiveness. pork bellies and orange juice. After business school I landed at TWST: Can you give a specific example of this Canyon Partners, a then-nascent credit fund in Los Angeles. I was one arbitrage trade? of four investment professionals and the first that was hired with a Mr. Kao: Sure. There was a point in time where you derivatives background. I was able to learn credit analysis from two could buy the convertibles for, as I recall, a 14% yield, and you very smart credit guys, Josh Friedman and Mitch Julis, both of whom could short equivalent duration straight debt at a 12% yield. had previously been at Drexel Burnham. Typically a convertible ought to be priced At Canyon, which I joined in 1997, at a premium to straight debt. And if all Highlights I was given fairly free rein and developed my things being equal, if the coupons are the investment philosophy involving being same, if the durations are the same, the Michael Kao discusses his firm’s creative up and down the capital structure. It convertible ought to be priced at a premium, investment philosophy and involved looking for the best bang for the buck because presumably there is some value strategy, which follows capital in the capital structure, and especially that you pay for that underlying equity structures over very long periods identifying the fulcrum security — whether it option. In this case the market was pricing of time to extract as much value be the equity or the preferred, or the debt — the convertible 200 basis points wider than as possible. He says that his firm where you can have the biggest opportunity. At the equivalent duration straight debt. In is a bottom-up hunter of value up Canyon I was doing hybrid trades, combining other words, the market was paying you an and down the capital structures. elements of credit analysis, meaning buying extra 200 basis points to take the option, Mr. Kao uses an example of an bank debt and high-yield convertible bonds, which was a complete inefficiency in the arbitrage trade to represent this and hedging them with option strategies. capital structure that we exploited. philosophy as well as an Then in 1998, I formalized my Once the auto and financial crisis idiosyncratic situation that approach with a white paper that I entitled impacted Wall Street, GM became what I represented a win for his firm. “ with Asymmetry.” I posited that you call a modern-day railroad bond. If you may Companies discussed: General can combine certain strategies, which are recall from your history books, in World War Motors Company (GM); Ford long gamma strategies, and combine them II President Roosevelt commandeered the Motor Co. (F); Federal National with other event-driven types of strategies. railroad system to ensure a reliable supply of Mortgage Association (FNMA) Essentially it involved recognizing that the war material. When he essentially and Federal Home Loan Mortgage price that you pay for an explicit catalyst is nationalized the railroad system, their bonds Corporation (FMCC). sometimes negative optionality, but that collapsed down to five cents on the dollar. It through intelligent security selection you can wasn’t fundamentals that drove the bonds to create an interesting alpha stream. five cents on the dollar; it was a complete This was basically the centerpiece of my investment style random active government interference that caused it. that I started doing at Canyon and built into what I’ll call a relative A little-known trader by the name of Cy Lewis, at a value business. It was those founding principles that I used to start then-unknown firm Bear Stearns, saw, based on liquidation Akanthos, which is what we’re now about. We follow capital analysis, these bonds could be worth par if at the end of the day structures over very long periods of time. One of the things our we are a country based on the rule of contract law. Based on that clients know us for is that we’ll pick over the capital structure every assumption, he made what turned out to be an historic wager that which way until we’ve extracted every bit of value from it, paid off and put Bear Stearns on the map. assuming there is value to be recognized. I called GM a modern-day railroad bond because in the TWST: Can you exemplify your strategy with a spring of 2009, the Administration was doing a similar thing portfolio holding to help illustrate your process? I see that across multiple industries. In autos, specifically, the Chrysler among your top holdings is General Motors. Do you still hold it? senior secured lenders were being bullied into accepting a $0.35 Mr. Kao: In December we closed out our GM (GM) on the dollar settlement. exposure, but that capped off a highly successful 10-year period TWST: How recently did you close out your positions? where we traded GM under almost every possible guise. Ten years Mr. Kao: We exited GM fairly recently, and it worked ago, when I first started Akanthos, we determined that GM out very well. Back in 2009 the Administration was basically presented an unusual opportunity as a result of awarding the autoworkers’ union 100 cents on a dollar, although its having issued three different tranches of convertible bonds. their position was in essence senior unsecured. This was a complete Because of their large size in the convertible market, the bonds were upending of the rules of bankruptcy. And so when that happens, the priced very inefficiently and consistently traded cheap, and so we senior unsecured bonds of General Motors traded down to five viewed the best risk/reward in that capital structure at the time was cents on the dollar. At the time we basically said, “This looks just MONEY MANAGER INTERVIEW — MICHAEL KAO like this whole situation that happened 70 years ago.” To us it Fannie Mae (FNMA) and Freddie Mac (FMCC), things like that. represented a historic buying opportunity. By the end of 2009, as many of these names had run way up, we saw that convertible arbitrage as an asset class was left behind, mainly because of the destruction of fund capital in that space. So we made a pretty “We’re very much a bottom-up hunter of value, if dramatic shift, again from the bottom up, from distressed you will, but again, up and down the capital structures. debt to convertible arbitrage. I always tell people, because we hunt for value from Over the last several years though, as the world has embarked on incessant QE, it’s driven all rates down, the bottom up, it does for the most part tend to put us and so all spread-based strategies have been basically in the right place at the right time.” arbed away, in my opinion. So if you look at our portfolio breakdown, there has been a consistent decline in our spread-based strategies, and the bulk of our exposures now are what I call event-driven or event options — and Our analysis indicated that at the end of the day, if we what I call other relative value, which in many cases are equity- follow a regular Chapter 11 process, that these bonds are to be worth centric types of bets. Convert arb, which has always been closer to 50 cents on the dollar. Hence, during the 2009/2010 point of somewhat of main stay in our portfolio, is actually now in a net time, we were invested in the GM capital structure through the bonds short position, because valuations are so unattractive. as an outright distressed bet. Over time, as the reorganization went on TWST: Given your bottom-up approach, are there any and the bonds traded up as we had predicted, we saw another notable headwinds or tailwinds you can comment on? opportunity and felt that the bonds were lagging Ford (F) equity. Mr. Kao: I believe that post the financial crisis the world The world saw Ford equity as effectively representing the has been sandwiched between two conflicting forces. One is continued last guy in Detroit remaining solvent, but to our mind it was trading fiscal headwinds where all of the developing economies really haven’t at a big premium that perhaps it didn’t deserve, simply because it addressed their fiscal imbalances and keep kicking the can down the avoided bankruptcy. Ironically, Ford couldn’t effect a lot of the road. They have created relatively tight fiscal conditions both in cleansing that GM was able to do. So we established a basis trade, Europe and here, and frankly also in Asia. Structural problems of high where it went almost like an equity long/short. We were shorting entitlement spending and soaring government indebtedness have some Ford equity against GM bonds. When the new GM IPO came essentially continued unabated while taxes also creep higher. That out, our bonds converted into a package of warrant and stocks. So pretty much leaves just the central banks as the only source of any part of our trade became an explicit equity long/short — GM versus economic stimulus. Central banks only have one blunt weapon, which Ford, and part of it became a kind of a warrant arbitrage. is monetary policy. So the central banks have been in overdrive even To bring the saga to a close, in 2012 we decided that we as the fiscal imbalances continue. didn’t want to complicate the trade anymore with the GM-Ford basis, and we decided to play GM purely through the warrant. We 1-Year Daily Chart of General Motors Company consolidated our position into the GM warrants and basically used the warrants as an asymmetric way of playing our long GM thesis. Bottom line, in the past,we had a fairly market-neutral type of trade on in GM. Post 2009, we had a decidedly bullish outlook on GM. And then toward the 2013 year end, as new GM stock crested around 40 bucks, we decided to get out of our entire position. Part of it has to do with my macro hesitancy to be long anything that’s pro-cyclical in this environment. TWST: Can you give us a closer look at your basic investment philosophy and approach? Do you consider macro trends? How do you view the current investment climate? Mr. Kao: We’re very opportunistic in the way we shift around. First of all, we’re not a top-down macro asset allocator. Chart provided by www.BigCharts.com We’re very much a bottom-up hunter of value, if you will, but again, up and down the capital structures. I always tell people, because we hunt for value from the bottom up, it does for the most part tend to The result is a weird confluence of fiscal headwinds with put us in the right place at the right time. extreme monetary tailwinds. And what that does, I think, is push risk Let me give you an example. In 2008, during the financial assets into kind of like this la la land, this fantasyland, while crisis, the most attractive opportunity that we saw was in distressed economic reality is quite a bit lower. debt. And even though we had a pretty eclectic idiosyncratic portfolio, TWST: What’s your view looking ahead? How do see for the most part, most of our bets were variations on distressed debt. it playing out? These ranged from bankrupt GM bonds to the preferred securities of Mr. Kao: I worry that we are in another sort of credit MONEY MANAGER INTERVIEW — MICHAEL KAO bubble, only this time the leverage for the most part has been taken as a very arbitrary situation and much like that railroad bond off of the balance sheets of Corporate America and pushed on to the example that I mentioned earlier. We felt that this was an untenable balance sheets of governments. You could say the same thing in situation. We viewed the U.S. as kind of trapped between a rock and Europe. And I worry that if there is another crisis this time around, a hard place, and that there is no way the country could easily who’s going to bail out the governments? The crisis can become one disband Fannie and Freddie, because let’s face it, nine out of 10 of either an interest rate crisis or a currency crisis. It’s always new mortgages are being originated with the GSE guarantee. something that we don’t necessarily expect, so it concerns me. This In the same breath, though, they cannot be nationalized, is a big macro concern that I have. which would mean adding another $5 trillion of off-balance-sheet liabilities to our $17.5 trillion of national debt. So our view is that these preferred securities trading down at two or three cents on the dollar represented an incredible option on the eventual restructuring and the eventual recognition that “We want to be as idiosyncratic as we can on the micro, this conservatorship is an arbitrary government construct, that is on individual bets, while we want to be relatively and that the rule of law and shareholder rights will defensively positioned on the macro, that is hedged on eventually be respected in this country. things like credit spreads and interest rates.” TWST: And how did this scenario translate into profit? What was your thesis? Mr. Kao: At the end of the day we felt that these preferred securities represented tremendous optionality. We also made the observation that these companies were saddled What it means also, from the standpoint of how we with $188 billion of senior government preferred, which carried a very position ourselves, is that for the last 24 months my investment heavy 10% dividend. And mind you, TARP banks only paid 5%, but mantra to my investors has been, we want to be as idiosyncratic as Fannie and Freddie were kept deliberately in a state of financial limbo, we can on the micro, that is on individual bets, while we want to be because the government sought to siphon off value from them through relatively defensively positioned on the macro, that is hedged on this 10% dividend. We predicted back in 2011, however, that this things like credit spreads and interest rates. In a year like last year company had enough reserves and earnings power that they would be we were able to really deliver on our mantra. able to overcome this dividend and become profitable. We managed to beat the S&P 500 by 500 basis points; we In 2012, when our thesis came true, the Treasury were up 35% net to our investors. But yet our overall allocation to Department came out with another sort of bait and switch. The first equities was less than 20%. We wound up making a lot of money in was the active conservatorship. The second was the so-called Third some of our event options, namely the Fannie Mae and Freddie Amendment where they said, now that you’re profitable, we’re Mac preferred securities. And from an overall perspective, if you going to replace that 10% dividend with a 100% profit sweep. were to ask me how I view our current portfolio, I view it as a pretty Effectively then, this company that just was able to turn the corner eclectic mix of thematically diverse asymmetric payoffs. This is in conservatorship got the rug pulled out from under it again, with why I found it kind of necessary to give you a little bit of my the government starting to sweep all the profit. background with respect to the optionality component, because I view our portfolio as an eclectic mix of option-like payoffs. But the 1-Year Daily Chart of Federal National Mortgage Association option-like payoffs are derived from a lot of different themes. TWST: Can you share with us a recent idiosyncratic situation or asymmetry that has represented a win for you? Mr. Kao: I will tell you one of my largest positions, and also our largest gain last year came from the Fannie Mae and Freddie Mac preferred securities. We’ve been involved in this trade since 2008. Originally in 2007 we basically were one of the very early, I guess, bears on Fannie and Freddie credit. We viewed them as a potential house of cards with the spreads trading too tight. So we owned credit default swaps in the senior and the sub debt. We also had short positions in the preferred, and we also had put spreads in the common stock. But then in the first of week of September of 2008, Hank Paulson put Fannie and Freddie into conservatorship, drawing an Chart provided by www.BigCharts.com arbitrary line between the preferred and the sub-debt. Everything above the preferred line wound up getting an explicit government guarantee. Everything at the preferred line and below was essentially wiped out. This Third Amendment has been the target of multiple No one anticipated that type of arbitrary outcome. We wound up lawsuits. The most vocal plaintiff is Fairholme, whom we know making a lot of money on a very small preferred short position. well and respect. We’re trying to educate people, including the press However, when we thought about it, we viewed it, again, and politicians, that all of these efforts, such as the Johnson-Crapo MONEY MANAGER INTERVIEW — MICHAEL KAO legislation to dismantle Fannie and Freddie, make no economic could be looking at a 50-bagger. So when I’m asked about what I sense whatsoever. The politicians on both sides of the aisle are hell- mean by asymmetry, that’s an extreme example of asymmetry. This bent on destroying Fannie and Freddie, mainly because they need is still currently a very significant position in our portfolio today. a scapegoat to point to for the financial crisis. In fact a lot of the TWST: To conclude, is there any else you’d like things that they are objecting to are the lavish pay packages and the investors to know about your strategy? Any topics we’ve missed? forays into subprime lending, all of which are gone. Mr. Kao: Well, what I have discussed at length is just a The current Fannie and Freddie are fulfilling the mandate few of our involvements. Our strategy revolves around having a lot that they were supposed to, which was to provide a counter-cyclical of different “pokers in the fire,” and emphasizing securities or force to the economy as a lender of last resort when there are no other positions that are meant to zig hopefully when the market zags. Our lenders for home buyers. From that perspective, they have done investment objective, ultimately, is really about trying to achieve exactly that. What the various legislations are trying to do is undo equity-like returns without the correlation to the S&P. We have been Fannie and Freddie, only to rebuild the same thing under this new able to do that in recent years, and hope to continue to do so. entity called the FMIC, which is untested. But the worse part, in my TWST: Thank you. (VSB) opinion, is that in a country like ours, where we are supposed to be holding sacrosanct the rule of law and creditor rights, these politicians MICHAEL KAO are willing to run roughshod and essentially allow nationalization of CEO & Portfolio Manager a company without compensation to its creditors and shareholders. Akanthos Capital Management, LLC TWST: And how did this present opportunity? 21700 Oxnard St. Mr. Kao: Off the back of that thesis we have probably Suite 1730 made so far the best return of my career. Something that we bought Woodland Hills, CA 91367 at two cents on the dollar has gone to 36 cents on the dollar. I have (818) 883-8270 pretty strong conviction that I think at the end of the day in the court (818) 883-8271 — FAX system, we will prevail, and that these preferreds could wind up www.akanthoscapital.com being worth par, which would mean that from our original basis we e-mail:[email protected]