Financial engineering is the order of the day for many publicly held companies as they pursue stock buybacks and dividend increases to reward shareholders.
Such engineering, often financed with bonds, can boost a company’s share price, but it may also depress its bond prices by adding more debt to the company’s balance sheet. Cohanzick Management of Pleasantville, New York, a $1.7 billion manager of specialty credit strategies, established a hedge fund last year designed to take advantage of that trend. The $21 million Cohanzick Nexus Fund, managed by firm founder David Sherman and principal Bruce Falbaum, shorts bonds of mostly investment-grade companies. About 50 to 60 percent of the bond shorts are accompanied by either a long equity holding in the same company or a call option on its stock. The firm generally has 20 to 60 positions at a given time.
The fund’s rationale is that, with interest rates so low and credit spreads so tight, companies are issuing bonds to pay for acquisitions and financial engineering.
Through April buybacks were on pace to total $1.2 trillion for 2015 as a whole, according to Westport, Connecticut, stock research firm Birinyi Associates. That would easily break the 2007 record of $863 billion. “They are borrowing money to buy back stock and pay dividends,” Sherman says. “For many companies, if they don’t take advantage of financial engineering, activist hedge funds have so much money that they will show up on their doorstep and make this happen.” Sherman considers the equity/option positions a directional hedge: The bulk of the fund’s return comes from the short bond positions, and the equity hedges are meant to add a bit more return.
The idea for the fund arose from Sherman and Falbaum’s success with a short-bond position they took on Dell in late 2012 along with a call option on the Round Rock, Texas–based computer company’s stock. The duo made that move for a client who was interested in shorting corporate bonds. After deploying the strategy successfully with other companies, such as Barrick Gold Corp. and Time Warner, they decided to create the fund.
Sherman and Falbaum divide the fund’s strategy into three facets. The first is identifying deteriorating trends that hurt companies’ business operations. That could mean shorting the bonds of an energy company when oil prices fall. The fund doesn’t generally put equity hedges on these positions because weak operations will likely hurt both a company’s stock and its bonds, Falbaum explains.
The second prong of the Nexus Fund’s strategy is financial engineering. This can include spin-offs and leaving profits overseas to avoid U.S. taxes. “With financial engineering, shareholders win in the short term and may or may not gain in the long term,” Sherman says. “Bondholders lose in the short term and the long term.”
The third category is leveraged expansions. This generally consists of companies adding debt to make acquisitions rather than buying back shares.
The Nexus Fund has shorted bonds and established or is considering an equity hedge for companies such as H&R Block, the Kansas City, Missouri–based tax preparation company, and fast food giant McDonald’s Corp.
H&R Block has a deal, pending regulatory approval, to sell its banking unit to BofI Federal Bank. H&R Block is pursuing the sale in part because as long as it owns the bank, it can’t implement a share buyback and dividend increase without approval from the Federal Reserve Board. “The company has said that once it sells the bank, it will add leverage to buy back stock and pay dividends,” Falbaum says. “Assuming it is successful in selling the bank, it makes sense [for investors] to sell the bonds and buy the stock.” A sale of the bank may ultimately lead to a credit downgrade for the company, he says.
Suffering from deteriorating business conditions as consumers shy away from fast food, McDonald’s is engaging in financial engineering. It announced plans last year to return $18 billion to $20 billion to shareholders through stock buybacks and dividends by the end of 2016. To pay for that, the company will need to issue $10 billion to $13 billion of bonds, doubling its leverage to 2.8 times earnings before interest, taxes, depreciation and amortization, he estimates.
Not surprisingly, Sherman and Falbaum are optimistic about the fund’s prospects, leaning on the idea that rising rates will boost fund performance in coming quarters. Others in the investment community think Sherman and Falbaum might be on to something. Chris Litchfield, a retired hedge fund manager who is now a private investor in Greenwich, Connecticut, notes their strategy is the opposite of a technique commonly used by hedge funds in the 1970s and 1980s, when interest rates were much higher: Back then, the funds were buying companies’ convertible bonds and selling their stocks.
But Martin Fridson, CIO of New York–based money management firm Lehmann Livian Fridson Advisors and a friend of Sherman’s, says it’s not always easy to find the right company. “The key thing is betting on companies doing further financial engineering not already anticipated by the market,” Fridson says. “How many good situations can they find?”
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