Notes from Capital Allocators: Andy Redleaf

• Some historical dates of interest he pointed out

1971: Bretton Woods: Nixon dissolves monetary regime of fixed exchange rates
1972: Listing of currency futures
1973: CBOE and listing of options
1975: De-regulation of trading commission (led to 10x reduction in commission fees)
1982: Stock index futures listed

All of these events bore the ‘fingerprints of Milton Friedman’ and the Chicago Business School who professed the wisdom of crowds and transparency of free decentralized markets in efficiently allocating risk/capital.

The idea of the ‘lone wolf’ or individual having low-cost access to markets and entrepreneurs in a garage being enabled has always been part of the American pioneering ideals. Andy makes interesting comment that ‘its place in the cultural zeitgeist ebbs and flows’.

• From managing their own money to money management

His move from independent market making in options (he remarks that options were primarily retail driven) to money management with Deephaven occurred as option-like instruments such as ‘perks’ and convertible bonds started to gain traction with institutional investors and they could leverage their understanding of options to these markets.

• Markets are ecologies, not fixed systems

Best to be opportunistic/agnostic to find profitable niches remaining adaptive as niches will become crowded as they attract capital.

• Sources of edge

• • “Markets that don’t talk to each other that well”

Market segmentation that can occur for regulatory reasons or differences in customer bases, preferences, horizons. This leads to relative value opportunities as a niche can be carved by taking the steps to intermediate the transition of regimes or straddling regulatory frameworks.

These can be relatively short term (ie several months) trades and can require that there is a mechanism or salesforce who can recycle the risk to a different customer base. Try to avoid the risk of tying up capital owning orphaned securities.

• • • The classic example being ‘cap structure arbitrage’. Ie investment grade bonds which become stressed or the relationship of distressed bonds to equity. “Finance is about governance” — the senior debt investors, subordinated debt investors, equity investors all have different conditions under which they are willing to finance business but in the end, it is all the same business. Relating all the pieces is a niche.

• • Why did he buy a bank?

As a hedge fund he is able to borrow at the amazingly low rates but since its overnight money and market to market, the great rates are attached to poor terms. A manufacturing business, on the other hand, borrows at inferior rates but at locked up terms.

A bank gets the best of both worlds especially at the short end of the curve. The downside is regulatory scrutiny and restrictions. An additional advantage of a bank charter: access to deposits with what he considers to be underpriced deposit insurance and a degree of ‘forebearance’ in the event of bankruptcy. He says these advantages post 2008 under undervalued albeit subtle.

Intends to use the bank to make loans to ‘bankable’ entities that they can identify as being better credits than conventional banks. Better credit analysis of mortgages for example. He says many banks claim they can do this but the idea is fundamentally opposed to their incentive as public entities to grow and consequently make more loans. They either need to lend more cheaply or loosen standards to grow.

He mentions that the best financing rates on the long end of the funding curve is being an insurance company. He comments that Warren Buffet is an above average investor, but the best borrower of all time, using the float from Berkshire’s insurance business to fund the asset purchases. He’s good on the asset side, “phenomenal” on the liability side. This is not the typical narrative or what most people focus on.

• The GFC

Unlike many others, he attributes the 2008 crisis, not to poor incentives (‘originate to distribute’) citing the fact that the banks had plenty of skin in the game and had savings wiped out. He discusses how it was too much leverage exactly as money went from being “information insensitive securities to information sensitive” as people understood banks would fail but didn’t know which ones, forcing them to pull money from all of them. The analogy in commercial banking being run on the bank boosting reserve requirement, forcing deleveraging and a massive contraction in the money supply.

• Current investing challenges

• • Orphaned securities because of a decline in ‘active liquidity’. This, in turn, has led to fewer arbitrageurs willing or able to arbitrage relative values leaving valuation spreads to persist. Corporate America via M&A is left to fulfill this role.
  • Reg FD: shut companies up and served a blow to active managers as information became more level.
  • The growth of passive vs active. Supply of active liquidity has declined, amidst increased demand for passive exacerbating valuation spreads that.
  • Expansion of central bank balance sheets has met little resistance reflecting a global tacit approval for institutional and government ownership (Fannie, Freddie purely public, Maiden Lane owning stocks). These policies seem to be in keeping with the current collective mood.
  • Whitebox funding costs increased by $30mm pa meanwhile they cut their fees by $30mm pa. This has been a direct transfer of wealth from money managers to ‘too big to fail’ or quasi-government businesses. Andy believes ‘the world liked that’. In other words, the zeitgeist that dominated the 1970s and 1980s which championed the entrepreneur has been traveling cyclically lower. Interesting story arc he draws as animal spirits get carried away culminating in GFC and now pendulum swinging the other way.