Isaac Corre – Event-Driven Investing at Governors Lane (EP.344)

24:04It really is a very, very powerful tool. And we find that when we apply it in situations like that, it's not the same competitive environment as we've seen in the long, short world. As you triage the world of these event -driven equity situations, where do you hone in on your sweet spot so that you know where to apply, say, alternative data in that example? So we certainly look at a lot of the things that drive the old opportunity set, which is activist situations, spinoffs, companies that have gotten themselves into some problem, some legal or regulatory disruption that has changed things. We're always looking for things where corporates are trying to do something to make their business better or are facing something that's made it a lot worse.

24:46And then the nice thing is you get to pull on threads from that. And sometimes that's where things get really interesting. We were involved in a semiconductor company where there was a subject of an activist campaign. And that really gave us a lot of other opportunities to look at other things. How about the credit and distressed world? How have you evolved in how you look for opportunities there? We have always been very focused on the stressed and distressed credit world. I would say that we were not big players in that market over the course of most of our lifespan at Governor's Lane, partially because we thought rates were just too low and spreads were too tight.

25:22We were involved periodically in some of these situations. And one of the things I think about this stress market that was pretty sobering for us was this creditor -on -credit violence that you're seeing now. It used to be that if you were in the same class of creditors, generally you thought that you were going to coordinate together to maximize the outcome for the credit group. That changed. I don't know whether it was because of a dearth of opportunities in distress or whether it's because the sponsors became more willing to play off one creditor against each other. In some situations, such as PCG, it was just such a big opportunity and it became quite a food fight.

25:54I'm optimistic that that will get somewhat less violence if we see a real distress cycle, but the positive distress opportunities has kept us away. I think there's some amount of adverse selection in distress until the last year or two, just because there's so much liquidity. There are very few good businesses with bad balance sheets going into bankruptcy. Now, I'll say this. There are some folks who have done a spectacular job in distress, and I have enormous respect for what they've been able to do. We tend to be more neutral in terms of cyclicality unless it slaps us across the face. We run pretty low beta.

26:27But what we've seen in the last year, I would say, is credit spreads really widened out a lot as rates went up. Part of that was fear of the economy. Part of that was that a lot of folks who are stretching along the risk curve because rates were so low now feel more comfortable in cash. So we've now seen much more opportunity and we've gotten much more involved in both high yield and bank debt. I should say, by the way, that we have from time to time been opportunistically involved in distress, which we bought in distress form as the bankruptcy was coming out. Last year, we got very involved in the high yield market.

26:59We particularly liked 144A securities that were rated triple C. A lot of that is the rating agencies just look at the leverage statistics and tell you what the rating is. But when you go in and really examine these businesses, and remember, because they're 144A securities, you actually have to sign up to get that information. So what you see is that there's some very, very high quality businesses there. Not all of them are businesses that should trade at eight times EBITDA and are levered at seven times. Some of these are 15 times EBITDA businesses that are levered six or seven times. They're not high capex, they're very free cash flow generative, and they have a self -help story.

27:34When you walk through what creates the 144 opportunity set? It's typically an LBO and the private equity firms don't want public filings, but they can't just raise bank debt. So they raise bonds and they use this SEC rule that was for sophisticated investors who can look at these bonds. But as a result of that, the financial statements aren't generally available. You have to go to the company and sign up to get them. And so that market is a little bit more opaque. It's certainly less efficient than the equities market or even the investment grade market where folks can download that data and put it on their platform in a nanosecond.

28:12We think it's just a much more interesting area to play. We're going to take a quick break in the action to tell you about SRS Aquium. Want to make sure your M &A processes aren't stuck in the past? Partner with a company that's been defining the future of dealmaking for nearly two decades instead. When it comes to M &A innovation, SRS Aquium has reshaped the way that deals get done, streamlining processes for maximum efficiency and minimum headaches. Professional shareholder representation, online M &A payments, digital stockholder solicitation, SRS Aquium pioneered each and continues to set the bar for game -changing innovation.

28:57So leave the days of disjointed deal management behind and define your future with SRSAquium, the smartest way to run a deal. Learn more at srsaquium .com. That's S -R -S -A -C -Q -U -I -O -M .com. And now, back to the show. So across these three buckets of themes, how do you bring them together to construct your portfolio? What we try to do is run a concentrated best ideas portfolio. All the investment partners meet every day for anywhere from half an hour to an hour and a half. And we go through what's in the pipeline and what people are working on. What are the best opportunities we see? Do we think that we should be taking up positions or down positions?

29:44And we cross rough between the various themes. And because we all know the portfolio so well, we go through this exercise so regularly, it's a pretty efficient way of making sure that we're getting the money to the best ideas and dynamically adjusting them as market conditions change and as new situations arise. How do you run your short book? Part of what we do when we underwrite a long is how are we going to hedge it? And we hedge at each position level. And we ideally will find individual securities that we want to short against it. If not, we'll use a custom basket or an ETF, or if all else fails, a market hedge.

30:19And the idea of that, one is we want to underwrite our longs in terms of their alpha opportunity, not just we like it, it's a cheap stock, we think it's going to go up. And then also from a portfolio construction perspective, that keeps you pretty balanced. When you roll that all up, you can look at the portfolio. And if you're doing it right, you shouldn't have to make a lot of adjustments in terms of your overall exposures in the portfolio. We do look for factor tilts and if we think how we got more or less beta to the market than we wanted. But ultimately, what we're really trying to do is make sure that the hedging of the portfolio is done at the position level.

30:56We do alpha shorting. And when we do alpha shorting, we buy things long against it for the same reason. It's much cleaner from a portfolio construction perspective. It's also much cleaner from judging the quality of the position and the alpha generation of the position. How have you organized your team to be able to pursue these different themes and then bring it together as best idea portfolio? Pretty much the entire team has pretty good experience across at least credit and equities. And of the five senior members of the team, three have been involved in merger arbitrage a decent amount as well.

31:31So we have a pretty good understanding of each of the themes that we invest in. And so that really helps, that facilitates it. And Bruce Haggerty, who I've worked with since I hired him in 2006 with a brief hiatus when I left Eaton Park and he stayed, he and I have been doing this for a long time. a long time together. It's cliche, we finish each other's sentences and all that. But it really does work in terms of we're both really on top of everything that's going on. And Danny Yusuf and Fennel Gadadra have both done a lot in equities and credit. So we have a pretty good zone defense, if you will, or zone offense, if that's a term for how we look at the whole ecosystem.

32:09How do you align your partners and the people on your team with your objectives so that it all works in terms of decision -making? Well, the compensation structure for the partners is based on the performance of the firm. In 2022, we became really interested in credit. We had a really good equity portfolio. We realized at that point in time, high yield was trading over the beta of 40 or 50 % to the S &P 500. We were going to have to take down some of our exposure to start dialing up our credit exposure. We had a conversation about it. There wasn't a single dissent because everyone knew that what we were really trying to do was make money for the firm.

32:42And if we make money for the firm, we all participate in that. How do you view your competitive landscape? It really has changed a lot. For most of the time that I was investing before, say, the financial crisis, there were just a lot of really large shops that did merger arbitrage in the expansionary market and distressed when there was a contraction and a little bit of equities to top that up. And that all changed. I think it really began to change after the financial crisis. And I think part of it was that we all maybe didn't appreciate how much we were dependent on the rate environment to create these opportunities because we were looking at alternative spread products, off -the -run spreads.

33:22And as rates came down, but spreads compressed, so that entire opportunity set became much more anemic. So I think a lot of folks had to find new ways to apply their skills, and different firms had different levels of success with that. So what's happened is that that competitive environment has changed pretty dramatically. I would say on the credit side, the distressed market is much, much more sophisticated. It's much larger than it used to be. On the equity side, I think it's the opposite. It's a better competitive environment with maybe a somewhat more challenging opportunity set. But as I think we successfully adapted to that opportunity set, it's better to be in a less competitive environment.

33:58How has some of the size of, say, the modern multistrat, think of like pod shops, impacted what you see in the securities that you're looking at? the pod shops in merger arbitrage have become a very, very important player. Some of them do some amount of event -driven equities, but I think it's much, much more constrained because of the market neutrality that they run. But I think the biggest impact, I would say, is in merger arbitrage. And I think that part of the reason spreads are as tight as they are is because the pods really do have very, very dedicated effort to that. And they've done a very, very good job, but it makes it somewhat less interesting for us, at least with the safer, friendly deals.

34:37On the equity side, I think the pods have done just a terrific job in harvesting short -term alpha, calling the quarter and things like that. They're just very, very good at. I think where we can win is more in the intermediate term alpha and with the event dynamic. So that's where we try to spend our time. And I'm sure that they'll get better at what they do and we'll get better at what we do and we'll continue to duke it out. But they've done just a terrific job on the merger ARP side. You've talked about the 144A market. What are some of the other opportunities that you're really excited about?

35:07I would say right now, we're really excited about bank debt. I don't know the duration of this opportunity, but it's very, very attractive right now. Essentially, the bank debt market, leveraged loan market, I should say, has been really dominated by the CLOs. And that algorithm right now is broken. So CLO formation is harder now than it was before. There's less demand for the AAA tranches of CLOs. So what we're seeing, paradoxically is that actually the larger bank debt deals are harder to place and we're getting more concessions in that market. So we've been very active on the capital market side of the bank debt market.

35:43And compared to say friendly merger arbitrage, it just seems like a much, much more attractive opportunity set. So we've been pretty excited. We've been dolling up our exposure there a decent amount. What's an example of one of those larger deals that you've had attracted? We're participating in the transaction that Bausch and Lohm is doing. We think the rating is lower than it should be. It's rated B1 in part because they have this dynamic with their old parent valiant or what is now called Bausch. We think the pricing is really, really attractive on that. What are some of the biggest risks you're thinking about?

36:13There are a lot. There are all the macroeconomic risks. And we try to not be particularly directional on that, but you have to respect that. It's one thing for the economy to slow, but when you have a real recession, everything goes wonky. And we have to constantly monitor for that. As I said, we're not a macro fund. There are loads of people who do that. It's the same thing with oil or other commodity prices. I think at this stage, you have to acknowledge that climate risk is a big part of that and the disruptions from climate risk are real -time concern. Look at the tragic fires in Hawaii. We saw what happened in PG &E.

36:48Obviously, this has a pretty significant impact on PNC insurers and power generation and creates potentially some opportunities on energy transition from our own business, I would say the ones that we have to underwrite on a daily basis, a lot of it is regulatory and policy risk. When I spoke about merger arbitrage, I spoke mostly about the United States, but very few transactions are purely domestic anymore. And the role of foreign regulators in US -based situations is very dramatic. We've seen this with the CMA in the UK, obviously the various Chinese agencies that regulate transactions, they're a very big part of that.

37:23And obviously, China is increasingly a black box. It's very hard to do due diligence there. In fact, they've arrested people for it. So those kinds of risks are the risks that I probably spend the most time on. We're in what appears to be a real paradigm shift in terms of the relationships between countries. The trend towards globalization has clearly slowed dramatically, if not backed up. Those risks matter a lot to the kind of strategies that we run. I'd love to walk me through an example. And the one that's coming into my head is the Activision Microsoft deal where you have US regulatory of the UK and EU.

37:59How did you look at a situation like that and assess it as it went along the process? I wish I had gotten 100 % right. We originally were involved in Activision when Kodik had all of his problems because we felt that there was no way that he would last as a CEO. And we thought there were two ways that that would play out. One was that an activist would show up and the other was that the company would sell itself. We were fortunate that the latter happened. We were surprised where the spread traded. And as we dug into it, we felt pretty comfortable that the US didn't have a winnable claim. We certainly recognized the risk that the US would try to challenge it.

38:35The chair of the FTC, Lina Khan, is very, very transparent in terms of her view of these transactions. So we thought the US was the principal risk, Microsoft was saying all the things that they needed to say, we thought, for the Europeans to approve the transaction. When I started doing merger arbitrage, the European Commission was a non -entity to American arbitrageurs. But since then, they've actually become a very predictable and quite thoughtful regulator. So we felt pretty comfortable that the EU would do the right thing, but would approve the transaction. Maybe I should stop and say, there are essentially two ways that companies can address a concern from regulators.

39:13They can do what's called a structural remedy, which is essentially to sell off part of the business or to hive off some of the business, really sell, in a way that satisfies the regulators that there won't be a competitive problem. And there are nuances around that, whether the buyer will be able to really compete. And then there are behavioral remedies where the company commits not to do certain things. And the European Union is very, very willing to accept behavioral remedies, partially because I think their enforcement mechanisms are a little bit more efficient. So if they see a problem, they can address it, whereas in the U .S., the enforcement mechanisms are a little slower.

39:43And every administration comes in pounding the table that they're not going to take behavioral remedies, and eventually they ease up a little bit. We knew that there was a good chance they would challenge the transaction in the U .S., but we felt very confident that they would lose that challenge. We were not necessarily as concerned about the CMA. And the problem with the CMA is it's a little bit more of a black box. And we really had a rough time getting a sense of where they stood until they issued their policy paper. The work we did was really more about understanding who was on the panel.

40:14Who were the decision makers? What was their worldview? Were they populists? Were they Brexiteers? Or were they folks who thought more like the Europeans? And I think the work we did led us to the conclusion that they were more of the European mindset. Obviously, we were wrong on what was a pretty, I thought, surprising issue, which was the future of cloud -based gaming. I think in hindsight, we recognize now that there was more dialogue between the US and the UK than we had appreciated. And they were probably doing the US's bidding in a certain way, which is surprising. But then they really reversed course when the US lost.

40:49I think once they saw that the US regulators were over their skis legally, and it's still not done, but we feel pretty good that it's going to get done. I think we did the right work. The decision came out. It was a little bit of a surprise, but we've managed to weather it. And how did you trade that position along the way? This was all going on with an extremely volatile market. There was implied beta, as there should be in Activision, because it was probabilistically going to be worth X when Microsoft bought it, or it could be just a stock. And we did a bunch of option trades to manage our risk.

41:22I'm not going to say we got every zig and zag right. We didn't. We never do. The great thing about this business and the hardest thing about this business is a lot of folks who are in our industry, there are people who got 90s and plus on every single one of their tests. And in investing 50s, 55, 60s, pretty good. Now in arbitrage, that's not true. You have to be in the 90s on arbitrage. But still, this was a situation where we realized it was an extremely high beta situation. And I think overall, we did fine, but we probably reduced too much when the CMA said they were going to block the deal.

41:55Every indication was that that appellate process was not a real appellate process and the transaction seemed dead, but then we got re -engaged when it looked more likely to happen. What's an example of a position in your portfolio that you feel really emblematic of how you want Governor's Lane to work? Position that I'm most proud of is Luckin Coffee. It's a Chinese coffee retailer, the aspiring Starbucks of China. And it was a very controversial stock. I guess it was 2019. it turned out that they had committed significant fraud. And the company had a restructuring. It was a Cayman Islands restructuring with a US Chapter 15, where they, we think, cleaned house.

42:39They recapitalized the company. We bought some of their securities, both equity and converts, at the later stage of the bankruptcy. And we did a ton of work on it. And we really thought they had cleaned up the business. And they had not only cleaned up the business from a financial statement an integrity perspective, but they had also gotten the business model to work. They had gotten their ASPs up. Their problem back then was they were just solving for growth. They weren't really solving for the four -wall economics of their stores, and they had shut a bunch of underperforming stores. They had really turned around the business and were growing again.

43:12And they had also made some product introductions, which to this guy who grew up in Milwaukee, Wisconsin sounds revolting, but coconut latte was a huge hit. It was a scary stock. We knew a lot of people who had been burned in the prior iteration of it, and no one wanted to touch it. We bought a decent -sized position when the stock was trading low double digits, high single digits. And we did a lot of the work I was describing, a lot with the alternative data, some surveys. We spoke to franchisees in China about it, and we've sold a decent amount of the way up. What would you like Governor's Lane to become over the next five or 10 years?

43:50I really want to stick to our heritage. I can see the idea of expanding our product offering. Some people want only a merger product or some people want only a credit product or a venture of inequities product. We think about that as something that we'd like to do. But at the end of the day, I think that what's so critical to us is our success as a firm is the culture and making sure that we're always making capital decisions that are optimal. I want to grow responsibly, recognize the fact that the graveyard of hedge funds is filled with hedge funds that did what we did and got too big and to grow with discipline in a way that allows us to continue to maintain the culture that has contributed to our success.

44:35I think we've got some room to run, but if I could be doing what I'm doing now just better in five years from now, that's success. Ten years from now, that's success. Isaac, I want to ask you a couple of closing questions. What's your favorite hobby or activity outside of work and family? I read a lot. I've been trying to teach myself chess, which is really one of the most humbling things I've ever done in my life. And losing to 10 -year -olds online, it's good for the soul, but it is very humbling. But mostly reading. I also try to spend a lot of time on fitness and exercise and yoga and mindfulness and all that kind of stuff.

45:13What's one thing that most people don't know about you that you find particularly interesting? I took a gap year after high school and worked on a kibbutz and farmed turkeys and fixed tractors. And what'd you learn from that? I don't like turkeys. I grew up, my father was an academic. My mother ran a group of healthcare facilities. I really came to respect agriculture and manual labor. There's something about the end of the day after doing that. You just feel like you've really accomplished something. And the people who do it and the people I did it with were incredibly thoughtful people. Someone who grew up around the university, you just forget that there's thoughtfulness and genius and imagination all over the place.

45:59What's your biggest pet peeve? I'll stick to investing. I think people fetishize multiples. And so often you hear people tell you, oh, the multiple is so low. we should be long or the multiple is so high we should be short. And multiples are a very reasonable proxy for the market's estimate of the net present value of the future cash flows of a business. But all a multiple should do at first is make you ask the question, why is the multiple there? Why do we think that's too low? Why do we think it's too high? And just the idea that the multiple is some exogenous thing that the market slaps on a stream of earnings just drives me up a wall.

46:38Which two people have had the biggest impact on your professional life? It's a hard question for me to answer. First of all, I've been doing this for a long time, and I had two very different careers. And I had some great mentors, including Arthur Lyman, in the legal profession. I've had some great mentors, including Eric Mindich, in the investing profession. So I'll quote the Talmud. There's a saying, some rabbi said, that I learned a lot from my teacher, more from my colleagues, and the most from my students. And I feel that way about my career. I've learned a lot from my mentors. I've learned a lot from my colleagues.

47:14But it's the people that I trained who then become my colleagues. Those are the ones who I've really learned from. So whether it's Bruce, Danny, Fennell, those are the folks who really, in the last eight years, have just had an enormous influence on me and have changed things that I thought for 24 years of my investing career. It's really that that has been the biggest influence. What's the best advice you've ever received? When I was launching Governor's Lane, I was talking to actually the wife of a cousin of mine who is a very, very senior person at one of the premier consulting firms. And she said to me, who's going to say no to you in your firm?

47:49And I thought that was a really, really good piece of advice. I had to find people to say no to me and I've succeeded. All right, Isaac, last one. What life lesson have you learned that you wish you knew a lot earlier in life? I think despite what I said about my year as a farm and I think really the importance of physical fitness and recovery to one's life. I grew up in a very, very academic environment. I was taught to read two languages before I was three, but sports were just not something that was on the radar screen. I'll never be an elite athlete. What I realize now is that it's so important for your mind and for your well -being to be active.

48:30And if I could have learned a sport and excelled earlier in life, that would have been great. And I didn't, and I regret that, but I'm doing my best now to make up for it. Isaac, thanks so much for sharing this really insightful look at modern event -driven investing. Thanks for having me. It was a real pleasure, Ted. Thanks for listening to the show. To learn more, hop on our website at CapitalAllocators .com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more.

49:05Have a good one, and see you next time.