In surveying this year for dramatic alpha-related stories, we have much whence to choose. This was the year in which the Murdoch family announced its intention to sell some of their highest value holdings to Disney. Also, in 2017 the EQT Rice merger (contested, unsuccessfully, by one prominent hedge fund and challenged, but in time accepted, by another) overcame opposition and may end up redefining the natural gas market. In a very different but equally convoluted affair: Dana Gas shook up the whole world of Shariah finance by claiming, as a restructuring ploy, that its bonds were no longer in compliance with the rules of such finance.
Meanwhile, in the finance world’s analog to “Mayberry RFD,” a rural telephone company is spending the holiday season telling Aurelius Capital Management that no, it is not in default thank you for your concern: and calling Aurelius a “rogue noteholder.”
But we’re not going to invoke any of those stories any further. We offer instead, in no particular order, a list of stories that moved us, taking us along with them from Venezuela to Britain and to cyberspace, with a couple of stops in Washington, D.C. along the way.
Venezuela and PDVSA Default
By October of this year even Russ Dallen, a long-time Venezuela bull, founder of the Venezuela Opportunity Fund, was telling clients to buy credit default swaps to hedge against default.
In November Venezuela’s state-owned oil company, Petroleos de Venezuela SA, or PDVSA (the parent corporation of Citgo) defaulted on its debt. On Thursday, November 16, the International Swaps and Derivatives Association ruled that a credit event had occurred, triggering CDS payments.
Is there a legal distinction between Venezuela and PDVSA for such purposes? It is difficult to tell. Mitu Gulati, a law professor at Duke, writing in the Credit Slips blog, has described this as “an exam question on veil piercing.” It is surely relevant that within days of the default the government was firing and arresting Citgo executives, and replacing them with Maduro cronies.
As a headline writer at Foreign Policy concisely described the situation, “Venezuela is so broke it can’t even export oil.” It can’t afford to make the payments necessary to service the ships that would carry its oil into international waters.
Unsurprisingly, given that condition, Venezuela the sovereign state has also defaulted. The law-school exam question would be: are these two distinct defaults or one? Are the creditors of PDVSA bound to seek out Citgo assets for relief, while the creditors of the sovereign state seek out other non-petroleum-related state assets? Or is it all one big pot for the delving hands of both sets of creditors?
SCOTUS upholds the “absolute” in “absolute priority.”
From distressed assets international we now move to distressed assets domestic, those within the purview of the U.S. bankruptcy courts.
Early this year the U.S. Supreme Court issued a decision in Czyzewski v. Jevic Holding Corp., a case that arose because a private equity company, Sun Capital Partners, borrowed money to buy a trucking company, Jevic, in 2006. Two years later there was a global financial crisis underway, and it was about a month after the failure of Bear Stearns that Jevic entered bankruptcy.
Due to the very distressed condition of the Jevic estate, roughly analogous to that of Venezuela’s oil export operations, the bankruptcy court decided that the appropriate move was a structured dismissal, to the disadvantage of certain creditors who would have been entitled to a pay-out under the absolute priority rule. The APR is itself a creation of the bench. It dates to Justice Willian O. Douglas’ opinion for the Supreme Court in Case v. Los Angeles Lumber Products (1939).
And almost eighty years later, that same bench is unwilling to abandon the APR to ad hockery or to water it down. Justice Breyer struck down the efforts at pragmatic exception-allowing behavior by the courts below, saying that he “cannot find in the violation of ordinary priority rules that occurred here any significant offsetting bankruptcy related justification.” This decision doesn’t close down the practice of structured dismissals altogether, but it must strengthen the bargaining position of some of the subordinated debt holders it situations that call for them.
Blockchain is the hot thing
Bitcoin has taken off amazingly (and, for those who worry about bubbles, ominously) this year. Other cryptocurrencies have done likewise.
Meanwhile, blockchain technology, a/k/a distributed ledger tech, or DLT, something that was pioneered by the cryptos but which has a wide range of other applications, is the real hot new thing.
This year for example Deloitte proposed that the Swiss Confederation is in a “special position as a global innovation center” and should make use of that position to turn itself into the world leader of DLT, which would require that it “adapt and issue laws and regulations to promote this new technology.”
Brexit consequences emerge from the London Fogs
In a referendum in June of 2016, “Leave” defeated “Remain” amongst voters of the United Kingdom, and with a healthy turnout of 72.2%.
It wasn’t until March of this year that the government of the UK acted on that ‘Brexit’ decision by invoking Article 50 of the Treaty of the European Union. This means that the actual departure date is in March of next year.
The implications of this ‘Brexit’ have dominated British politics all through the year now ending, and they are an important study for pursuers of alpha.
It emerged in September that the EU has plans to give the European Securities and Markets Authority heightened authority over hedge funds. Those plans have been driven by the concern that hedge funds based in the UK could set up shops on the continent (or in Dublin) and then game disparities in regulations/supervision.
In September a story in the Financial Times quoted an unnamed EU official explaining that “there is a strong case for transparency among supervisors to address concerns around supervisory arbitrage, and that is what we are proposing.” ESMA would get a new executive board which would keep close tabs on the outsourcing arrangements of Eurozone based fund managers.
Relatedly, the plan might turn ESMA into a supervisor of important benchmarks such as the Euribor. When such a move was last seriously discussed, in 2012, Britain resisted giving ESMA such power. But one doesn’t have much leverage over the rules of a club when one is walking out the door of the clubhouse for the last time so ….
Carried Interest Survives Trumpian Tax Reform
As the year ended, both houses of the U.S. Congress had just passed Trump-supported tax reform legislation.
In one respect at least, and in a respect dear to the hearts of hedge funds and related pursuers of alpha, this bill ignores a campaign promise of the President’s to crack down on “carried interest,” the applicability of the capital gains rate to the share of the profits of investment partnerships that go to fund managers as part of their compensation for their managerial labors.
Controversy about this subject has been around for a long time, now and then flaring up with the general public before it does down into glowing embers among wonky tax policy experts.
The presidential campaign last year was one such flare-up. Trump used the issue of carried interest to establish his populist bona fides, and in particular to differentiate himself from Senator Cruz, who he regularly alleged was too close to Wall Street – not the sort who would challenge carried interest at all.
The carried interest procedure, now preserved as if in amber, doesn’t make a lot of sense on its face. Carried interest sure looks like labor income. Many salaried employees of many “Main Street” business also receive performance based rewards, perhaps in the form of a Christmas or year-end bonus. Yet the run-of-the-mill bonus is ordinary income, whereas a partnership-profit carry is capital gains. Since there will always be a market for populism and since the Treasury is always thirsty for revenue, the income will surely arise again. The next time it does, it may well be as a weapon that Trump’s foes will use to challenge his man-of-the-people credentials.