“We never let beta creep into our portfolio,” says BCK Capital’s Wayne Yu
The current environment is playing to the strengths of special situation hedge fund strategies, which seek to generate alpha from announced deals, and as merger spreads widen out, new opportunities are arising.
This is according to Wayne Yu (pictured), the CIO and CEO of BCK Capital Management, which he founded in 2015. Based in Stamford, Connecticut, BCK Capital runs a global market neutral special situations strategy that aims to deliver pure alpha to investors, using a robust risk programme to actively hedge against any exposure to market beta.
Yu says that recent market dislocations have led to a big overall market sell-off. Indeed, March was the worst month for the Dow Jones Industrial Index since 1987.
“Over the last few weeks we’ve seen merger spreads widen out with unprecedented velocity,” says Yu. “Essentially, what happens in these types of situations is initially the first 2 or 3 per cent move down doesn’t do much but when you start to get an acceleration on the downside then stuff starts trading at a beta of 1 and everything moves in the same direction. That can create interesting opportunities, which is exactly what we are seeing now.”
Pure alpha shop
Yu graduated from the University of Chicago School of Law and Harvard College and has always brought a refined legal/regulatory focus to deal analysis. Prior to establishing BCK Capital, Yu worked at Citadel Investment Group for six years where he headed up Citadel’s event-driven business for the Americas. His most recent role was Managing Director at Societe Generale where he ran the bank’s proprietary event-driven trading desk.
At Citadel, the special situations strategy was part of a wider multi-strategy offering but a lot of the portfolio management style Yu uses today originates from his SocGen days.
“At BCK Capital, we can be more nuanced because we’re not trying to impose a risk model on different types of strategies. We only look at special situations in the fund,” explains Yu.
“Our basic philosophy is we are a pure alpha shop. We’ve always been very careful to try to hedge out risk where we don’t have a view; this is something I’ve been doing my whole career. Something like the price of oil is not something we have a view on and so if we were to be invested in an oil company, we’d look to hedge out that risk by shorting other comparable oil companies.”
BCK actively seeks out potential revaluations that might occur as stock ownership moves across different investor groups who each have distinctly different risk/reward expectations.
Fundamentally, the team looks for situations where the risk/reward is mis-priced. If there is litigation associated with a deal that the market is pricing in as 50/50 and BCK Capital thinks it is more of a 75 per cent likelihood, it would look to take advantage.
The current market is ideal for seeking out mis-pricing opportunities and as Yu explains: “The special situations and mergers we invest in tend to be situations that are going to succeed or fail separate from market forces. In general, the things we are involved in have allowed us to consistently make money, even in down markets because we always stick to our knitting. We never let beta creep into our portfolio.”
Three drivers of alpha
In terms of portfolio construction, there are essentially three buckets BCK Capital invests in.
The first one is merger arbitrage (going long or short spreads); last year’s Celgene situation is an example of a long spread position in the portfolio.
“A second bucket is what we call ‘merger-related special situations’. That could be the Sprint/T Mobile litigation, which was related to the merger but more of a litigation play. These are often situations that we find really exciting. That’s what we find really interesting. Hostile deals or situations where you have a competitive dynamic also fall into the merger-related bucket.
“The third bucket includes special situations that have nothing to do with mergers. This could include companies involved in litigation or regulatory issues. Our special situations have a bit of a bias towards regulatory and legal trades. Moreover, we focus on staying away from investments heavily trafficked by other funds in our special situations bucket, as we believe hedge fund concentration can often be a significant source of drag on alpha,” states Yu.
One of the biggest M&A deals in 2019 was the USD54.5 billion merger between oil giants, Occidental and Anadarko, but Yu says that large-scale M&A has been largely unattractive during the last couple of years; at least up until the recent market swoon. “Last year, the Anadarko deal was one, and Cellgene was another good one.”
Even when BCK Capital doesn’t have a view on whether a deal will close or not, it will sometimes express a view on timing.
As Yu explains: “There have been a few litigation situations we’ve been involved in where we didn’t have a strong view on the outcome of the litigation, but had a strong view on the timing, which we thought the market was getting wrong. By using calendar options we monetise that view.
“Another point to make, is in our strategy, we have the flexibility to be short merger spreads.
“We are happy to do this when we think they aren’t efficiently priced. There are some systematic strategies in the market that buy every merger spread on announced deals. Sometimes, what ends up happening is you have something that is pricing 99 per cent likelihood of completion when the real likelihood is closer to 85 per cent; we look to take advantage of those opportunities on the short side.”
At any given time, there are usually five or six short positions on merger spreads in the portfolio.
Although largely discretionary, BCK Capital does have a systematic component, using rules for internal risk controls. “We are constantly asking ourselves, ‘What is the downside risk of this investment?’ If we are short, what is the risk that an acquirer comes along and buys the company? What if there is some surprise to the upside? Conversely, if we are holding a long position, what could hurt the situation?
“We focus on the downside risk first. Then, when we think about how attractive a situation is and how much risk it deserves, there is a discretionary component with respect to position sizing,” he says.
You can’t model litigation
With so many quant funds dominating the industry, Yu’s approach to trading special situations is an example of where brainpower and nuanced analysis of the deal landscape sets it apart. Litigation is complex and doesn’t fit neatly into financial modelling. Wall Street likes to model things but how do you model a litigation that could bankrupt a company?
“Quant funds help to drive some mergers spreads on the long side to unattractive levels, which we can take advantage of,” remarks Yu. “Similarly, it’s hard to program in the right things to predict litigation. There aren’t enough data points, and it relies on the experience of human individuals. It’s also hard to program machines to interpret regulatory changes. Maybe one day with AI it will be possible, but not right now.”
Investors will always want to consider pure alpha strategies, especially in these uncertain times.
Last month, to widen its appeal to investors, BCK Capital launched a higher volatility version of its flagship fund.
“We had a lot of inbound interest in our flagship strategy. However, some investors said while they liked our pure alpha approach they wanted higher returns for higher volatility so we decided to create a 2x volatility version of the exact same strategy,” concludes Yu.
With markets falling sharply, this looks to be a good time to trade on further mis-pricing in the global economy.