How hedge fund boss Bill Ackman dodged a Covid bullet

When Bill Ackman realised coronavirus was about to run rife in the West he knew he had to do something fast to protect the $US10bn ($14bn) of assets managed by Pershing Square, much of it in restaurant brands that were vulnerable to the economic lockdowns he saw coming. Rather than sell stock, he opted to hedge via credit default swaps.

‍

The CEO of activist hedge fund Pershing Square Capital Management had watched the Matt Damon film Contagion and was concerned not only by the asymptomatic spread potential of the virus and the likely resistance of Americans to social distancing and mask wearing, but also the general lack of concern about the virus in the West.

‍

In his keynote discussion at the Sohn Hearts & Minds Conference on Friday, Ackman reveals how the portfolio hedge via credit default swaps proved very profitable — including “75 bagger”.

‍

“I started reading about Wuhan, which was very reminiscent of the film,” Ackman recalls. “The first significant moment was when the Chinese decided to shut the entire city.

‍

“But the way they did it … they basically announced a curfew and a shutdown, effective in 12 hours and I said ‘look everyone is gonna leave’, and then several hours later, the news stories were ‘everyone is leaving’ and then it was reported that five million people had left Wuhan.

‍

“The second very concerning thing was the belief at the time, which turned out to be correct, that it spread when people were asymptomatic, and I thought ­asymptomatic spread is not something we’ve had to deal with … it was just math from there.”

‍

Another alarm bell rang when Pershing Square held its annual investor meeting in London, and while Ackman considered cancelling, “people thought I was crazy, which got me concerned”.

‍

“It was a bit like the boy who cried wolf … you’re running around … no one seems to care.

‍

“Then I started thinking about the economic implications and it was clear that the only way to stop the virus was to shut ... the city, the state, the country.

‍

“And my concern was that Americans don’t behave the same way Chinese do. My theory was the only way to shut this thing down ultimately will be a global economic shutdown and the markets are not trading as if there’s going to be a global economic shutdown, and we own 10 things — three of them are restaurant companies.”

‍

Another “canary in the coal mine” for Ackman was the early impact on Starbucks in China.

‍

“Starbucks has a huge presence in China and so they were experiencing it. So that’s how we first thought (about) the impact, and then we went through the portfolio name by name,” he says.

‍

He knew markets were about to tank, but to sell everything would have been inconsistent with the firm’s philosophy of owning large stakes in companies for long periods.

‍

“Then we started thinking about hedging,” he said.

‍

Having used credit default swaps to build massive notional short positions in the lead-up to the global financial crisis, Ackman decided to use them as a hedge for the entire portfolio.

‍

After calling a rare Sunday night meeting of his investment team on February 23, he laid it out.

‍

“I’d been talking about the virus in the office and people would sort of smile,” Ackman recalls.

‍

“I said, ‘Here’s the way I think about this and this is how it’s gonna play out and here’s how it’s going to play out economically — markets gonna crash, credit markets are gonna crash’, and it was on that call we started talking about hedging possibilities.

‍

“You can short futures, which is bilateral, you can buy puts, which is asymmetric but expensive, and if you get the timing wrong … and to do something of big scale is difficult, and then there’s the credit markets.”

‍

Widow-maker trade

The “widow-maker” trade at the time had been to bet against ever-tightening credit spreads.

‍

“We like stuff that for a long time has only gone one way, it’s bounded by zero … so at 47 pips or whatever I’m like ‘how much tighter can we get?’,” he says.

‍

“The tightest ever was probably 37 for investment-grade credit and that’s when MBIA was writing protection for nothing with the synthetic CDO, so I said OK and the only question was just scale.

‍

“So we decided to put on $US25bn of notional short. I wanted to get it as large as possible but think about how much of a notional bet to hedge the portfolio, and then cost a carry was the other relevant consideration, and at 50 basis points per annum you know it’s not that expensive.

‍

“We had a lot of debate around do we sell Hilton — Hilton stocks gonna go down a lot — do we sell Berkshire Hathaway because, you know, Berkshire is gonna go down a lot, and we said, ‘You know what, let’s just build a bigger hedge’ so the hedge just got bigger and bigger and bigger, and then at a certain point I said, ‘can someone figure out what percentage of the notional market we are short?’

‍

“At which point one of the guys in the team said ‘well we now own CDS on 26 per cent of the investment grade index in the US … and 23 per cent of investment grade index in Europe’, and I said ‘you know what, this is not a long-dated bet, we’re gonna have to get out of this thing and that’s ultimately what led us to say, OK, no more.”

‍

In a little over a week the spreads blew out, so that by February 8 the “trade” was up a cool $US2.6bn.

‍

“So, we were up $US2.6bn, which is kind of fun, but now it’s a bit scary because you’ve got 40 per cent of your portfolio — the whole portfolio got crushed — our portfolio’s down 30 per cent, the CDS thing went from zero to $US2.6bn, and now you got a portfolio in which like 40 per cent of your assets are in this incredibly volatile instrument.

‍

“And then the Friday, the equity markets were up 10 per cent on something Trump — who knows, I don’t even remember what it was — and the trade went down $US800m.

‍

“I said, ‘OK, you know, and we’re sort of sizing and saying well how much, how much more can we make — we could lose $US2.6bn — how much more can we make?

‍

“The spreads went out to where they were in ’09. They would have doubled from there so it’s a two-times return and we can lose 100 per cent, and then equities look like the opposite.

‍

“So great companies we owned that we said are going to survive this and may actually do well as a result of COVID are now trading 30, 40, 50, 60 per cent off.

“And so we just reversed the trade and we did it as quickly as we could.

‍

“It’s like lugging around this massive trade — where every counterparty we dealt with knew what we were going to do, and it’s not like you trade this thing in the dark — it’s not an electronic trade, it’s old fashioned, pick up the phone and you call someone.

‍

“The fun part is I was in a beach house at a makeshift desk, with CNBC on in the family room, and I’m sitting there on my laptop calling traders. So I felt like what it was like to be a trader for the rest of my life — I’m not really a trader but it was cool, and I insisted on trading it alongside my traders just because it was fun.”

‍

Good year ahead

Looking ahead he says 2021 will be a great year for shares and tells investors to “go long”, even though Pfizer’s vaccine breakthrough will trigger complacency and difficulty in containing the virus.

‍

“You’ve got low rates, you’ve got likely stimulus, you could see infrastructure spending, you’ve got still very well capitalised banks, you’ve got access to capital,” Ackman says. “So I think 2021 could be a very, very good year in markets, so go long.

‍

Out of control

“But the northern hemisphere winter will be grim and the coronavirus is out of control.

‍

“The problem is unsophisticated people will take this announcement (Pfizer’s vaccine breakthrough) as, ‘oh, I don’t have to worry’ and you want people to be a bit scared,” he says.

‍

“It would really suck to get sick or die when a month or two later you can have a vaccine.”

‍

But the economy is on track for a “very, very good” recovery.

‍

“You’ve got a more moderate Democrat in the White House, you have the kind of far left of the party that’s been neutered a bit by the results of the election,” Ackman says.

‍

“Trump’s actually done a lot of good. He’s done some harm as well, and he’s done it in a way that I think is far from ideal, but I do think things like corporate tax reform are long-term good for the country, not just for Wall Street, but for the middle class, for the working class, etc.

‍

“It helps make the country more competitive, it helps keep businesses here.”

‍

Ackman says the prospect of no major tax increases in a gridlocked Senate is positive.

‍

“You’ve got something like $US2.5 to $US3 trillion of savings that have built up because people aren’t eating out, they’re not going on vacation, they’re not driving, and by the way, when you keep someone locked down, their next move when they can actually feel safe is gonna be to go on a vacation, to go drinking, to go to dinner, to go to a show.”

‍

This article was originally posted on The Australian here.

Licensed by Copyright Agency. You must not copy this work without permission.