08 Décembre 2014

Fund managers get it wrong sometimes. And we are no different from the others. Bad call, bad timing, adverse newsflow, negative mark-to-market on a position that may – in the end – turn out to be a very profitable trade; you name it. Our view is that investors should focus very much on what happens when such adverse events happen. Because those happen – whatever the process, the experience, the team, etc.

At the end of the day, investment performance is not only about profitable trades, which is the part that managers usually put forward in investment letters and pitches. It is also about hit ratio – being right more often than wrong – and managing adverse events in a consistent and robust manner. We believe that November was a case in point for us. Our long Abengoa position (partly hedged with iTraxx Xover index) went through a set of adverse events driving the 5-yr CDS wider by more than 1,000 bps and the bonds lower by 10 to 35 points. We thought that it would be useful to share this example and to articulate how we coped with it.

The company and its business

Abengoa is an engineering and clean technology company. Its main business is to develop projects (solar plants, electricity grids, etc.) and then sell them. The company has debt both at the corporate level (holding company) and at each project or group of projects level. Once a project is completed, term-financed, tested and commissioned, Abengoa sells all of or part of the equity of the project and reinvests in the development of new projects – a process called “asset rotation”. The company is headquartered in Spain and operates globally (Europe, the US, Latin America).

The position and the situation

At the beginning of November, the Fund was long Abengoa through 5-yr CDS, for 4.9% of the Fund’s NAV (partially hedged with iTraxx Xover index). We did not hold any bond. The investment thesis was based on our expectations of EBITDA growth, deleveraging – via asset disposals and capex stabilization – and a more focused and better understood business model for the group. A number of events and corporate actions supporting this view were recently announced and are expected to continue to materialize.

Abengoa is a large group with a complex capital structure. The very nature of its business requires a diversified access to debt capital markets; from short-term to very long-term funding, from non-recourse secured to corporate unsecured funding, from all currencies and from all sources – banks, money markets, bond investors, convertibles, etc. The company has a track record of sub-optimal investor communication which has created mistrust and skepticism among some market participants and left the group more vulnerable than others to a potential negative newsflow.

On 13 November, the company released its Q3 results. The order book was disappointing and there was a large increase in the bridge debt raised for projects under construction. The latter raised eyebrows in the market as Abengoa classifies such debt as non-recourse and, despite the guarantee granted by the parent company, excludes it from its leverage ratio. Adjusting for this extra layer of debt would add between 2.5x and 3.0x of leverage, bringing the total adjusted recourse net leverage ratio for the group up to between 4.5x and 6.0x – factoring in working capital seasonality. As a result, Abengoa bonds and CDS widened dramatically with the 5-yr CDS traded as high as 1,780 bps.

Our reaction and our view

Our investment team has researched Abengoa since 2010 and in the past 12 months alone, we had 10 meetings with management – 1-on-1 meetings and calls, group meetings, conferences. 1-on-1 calls were arranged with Abengoa’s management on 13 and 14 November. The following week, the team attended a dedicated investors’ call and a physical roadshow in London and had two 1-on-1 meetings with senior management. Those various interactions with management, combined with a number of extra diligences and an in-depth update of our detailed financial and capital structure analysis supported our credit view: (1) Abengoa has a number of high-quality businesses, (2) it carries too much debt, (3) it can set a realistic roadmap to sizeable deleveraging, and (4) it has the liquidity to deliver such plan in a credible manner over the next two years.

With that in mind, we decided to hold on to the 4.9% exposure via the 5-yr CDS (which traded with an implied default probability as high as 75%), as a number of catalysts should help CDS normalize in the short to medium term. Separately, we decided to add short-dated instruments – with maturities of less than 2 years – for 4.8% of the Fund’s NAV with unlevered expected returns in the 10-15% area within 3 to 16 months.

Lessons to be drawn

At through, the position had a -1.8% impact on the Fund’s performance. At November month end, the loss had been reduced to -1.0%. This is a significant drawdown for a single position. It has to be put in perspective with an extreme negative price action on a significant position of the Fund (bonds losing up to 35 points, CDS widening by ca. 1,100 bps intraday).

A knee-jerk reaction ignoring all the tangible facts in our knowledge, our in-depth analysis and the technical situation on the company’s debt instruments would have been to cut our open position and crystallize our loss. We chose not to follow this route as we saw a greatly enhanced risk-reward for the Fund’s investors at the new market levels. Specifically, we complied with our risk management policies and processes and did not add to the position until our investment thesis was fully revisited and updated with the new developments. Upon completion of such review, we focused on restructuring our positions on the name and decided to increase our short-dated exposure to take advantage of the trading dislocation with limited additional market beta.

Overall, the Fund went through a real-life stress test on one of its sizeable idiosyncratic positions while limiting the negative impact on its performance and retaining significant potential upside for the future. The necessary deleveraging of Abengoa’s balance sheet will be a multi-step journey, will take time to play out and bears some execution risk. However after the recent events, it provides our investors with one of the most attractive risk-adjusted opportunities for the months to come, in our view.