The Derivative - The Kaoboy of Convertible Arb with Michael Kao

Episode Date: July 15, 2021

Saddle up everybody, because we’ve got the UrbanKaoboy on this episode, who’s ridden everything from ponies to draft horses to mustangs over his 30+ years in the investment game, doing commodities and derivatives at Goldman in the 90s, risk arb at Canyon Partners, and then opportunistic/value at his own fund Akanthos Cap Mgmt, before hanging up his spurs and focusing on running his own family office. We’re talking with Michael Kao about the credit culture in LA investment firms, trading the Goldman roll in commodities, how corporate debt = short puts and equity = long calls, the trading pits, finding long gamma in a short gamma arb strategy, convertible bonds, arb trade structures, Star Wars, pricing synthetic options, credit spreads blowing out, needing good marginability, Michael Saylor's diamond hands, the potential train wreck that is MSTR's balance sheet, and more. This was a fascinating look into the mind of an opportunistic investor. Chapters: 00:00-02:24=Intro 02:25-13:41=Drexel, LA, and the Goldman Commodity Roll 13:42-36:50=Canyon, Akanthos, and Convertible Arb 36:51-55:45=MSTR, Saylor, and the Capital Structure 55:46-01:01:19=Tokenized Residential Real Estate 01:01:20-01:08:02=Star Wars Fanboy Follow along with Michael Kao on twitter @UrbanKaoboy  And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, and our host Jeff at @AttainCap2 or LinkedIn, and Facebook, and sign-up for our blog digest. And visit our sponsor, the CME Group at www.cmegroup.com to learn more about futures and options. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. If you could pair convert and capital structure ARB strategies, which also have the benefit, in addition to what I said of being long gamma, not reliant on the greater full, but you're also getting paid to wait because part of what's different about convertible ARB versus options ARB is that you're actually positive carry in many cases, in most cases, at least back then.

So if you pair that with certain selected merger AR positions, on a systemic basis, you're kind of protected against these idiosyncratic blow-ups every once in a while, but you might be able to extract a pretty interesting alpha stream. Saddle up, everybody, because we've got the urban cowboy on today. He's ridden everything from ponies to draft horses to Mustangs over his 30-plus years in the investment game, doing commodities and derivatives at Goldman in the 90s, risk garbage Canyon partners, and then opportunistic value at his own fund, a canthos capital management before hanging up his spurs and focusing on running his own family office. We're talking with Michael Cow and diving into his extensive investing experience, Star

Wars fandom, and what he's up to these days. Welcome, Michael. Great. Thanks for having me. Thanks for being here. Appreciate it. Good to meet you. So we were just talking briefly. You're out in L.A.? I spent most of my life in Southern California with a short stint on the East Coast. That period of time I was working for Goldman Sachs and then business school in Philly.

So that was my five years. And then I've been in LA ever since. Tell me the LA investment scene. There are a lot of firms out there. Are they moving out of there? Yeah. So I would characterize LA as a very credit-driven investment scene because of the, the roots of Drexel out here.

So after, after Drexel basically disbanded, there was like a big diaspora out of Drexel. And so, you know, the shop that I went to after, after business school was Canyon founded by twoDrexel guys, Josh Friedman and Mitch Jewelers. But then also in the area, obviously know about Oak Tree, Howard Marks,

and Aries, and Apollo. I mean, so all these guys basically came out of Drexel. So there tends to be an agglomeration of funds with credit slash distressed backgrounds. And Goonlock's out there too, right? What's that? Goonlock's out there too? Yeah, yeah. A lot of credit. Sorry, I cut you off. What were you going to say about distressed?

Yeah, so what I was going to say was that like, you know, when I, when I ended, so my, my career before Canyon was in a completely different area. I was at in the Jay Aaron group of Goldman Sachs trading commodities. I was one of two traders making markets in the then nascent Goldman Sachs commodity index and, um, and making markets on the underlying futures contract, total return swaps and structured notes tied to that derivative. It was the first investable, real investable commodity index. So when I was graduating from business school and looking for job opportunities, you know, most of the, most of the

opportunities that I had were in convertible and capital structure and risk guard. So, you know, had a job offer back then from Citadel when they were starting off another firm called HBK, but I really wanted to be back in LA and so so when I got the job with Canyon ironically I didn't really know where I was going to fit in and I quite frankly I think that my bosses then didn't really know where I was going to fit in because my background was more of a derivatives background I really had no credit expertise. And, you know, they were very, very long on credit expertise and back then weren't as familiar with derivatives. So what I wound up doing at Canyon was kind of carving out my own niche and focusing on the convertible capital structure area because,

you know, that part of the capital structure is very interesting if you think about what a convertible bond is you know it's it's a bond partially it has an embedded option in it to convert into equity so you need to you need to study credit worthiness you need to study equity valuation you need to study equity valuation. You need to study option valuation. So it was a great place to learn a lot about the entire capital structure. Let me backtrack for a second. So back at Goldman. So one, did you know Mike Dolly, the head of the futures business there?

He was on the board with me at NFA. He was a great guy. So anyway. No, no. head of the futures business there he was on the board with me at nfa he was a great guy so anyway no no i was i was i was at goldman from 92 to 95 okay so so you know relatively brief stint and actually my my very first job at at goldman was in electrical engineering computer science. So I joined the IT group and wound up designing the currency option software, which was how I wound up on the trading desk. That's a whole, that's a different, interesting, serendipitous story about how that happened. Yeah. And this has been a common theme like the last five of the last 10 podcasts we've done are all engineering you know majors oh really yeah so

there's a common thread they just see investments and trading in a unique way right i want i wanted to be i wanted to be a video game designer growing up so but i but i guess uh you know running a hedge that's kind of like playing a video game i suppose exactly with live bullets all right um so second thing with the goldman commodity index like a lot of people i've known in my career basically built a business and a career front running that eventually um right i know all about that yeah so was that part of how soon after that did you guys know that was going on and were you doing things to try? Oh, yeah. Oh, yeah. Yeah, yeah, yeah. That was, well, so if you're familiar withid contract and there was enough underlying liquidity in each of the underlying commodities to index we had the pension fund of a major U.S. corporation come in and make just a very small allocation to commodities and they wanted to come in via

the futures contract so I as one of the market makers had to basically stand up and basically offer any amount of liquidity, right. To, to this big pension. And so I then had to go arb, you know, the, the underlying 22 to run commodities. And as you can imagine, you're, there are certain commodities, especially and the softs that are notoriously illiquid and every index roll it became a huge game where we had to figure out okay how do we the locals know exactly what days of the month we're supposed to roll and they're going to be set up to front run us and we needed to figure out okay how do we outwit the locals it was fun it was pretty fun which they're as street smart as it gets so tough to outwit those guys um yeah well especially at institutional size right we're the paper market and so we had to come in next you couldn't go too far out to find parameters that that's exactly right yep um

and what kind of size are we talking like you're slinging thousand lots in the meats or it was oh gosh i if if memory serves this is a while ago now i mean you know i i was making like 10 000 lot up markets yeah um you know and in a index which at that point you know the locals market was maybe like 10 up right yeah so i had to be like you know 10 000 up you know what do you want to do right and they're like we got one we got one on the line goldman's right right i can't remember the sign for goldman so i was in the bond pits uh when i started um so there was Carr and Deutsche. Okay, yeah. Everyone had a symbol, but I can't remember what Goldman's was.

Oh, our trader, his name, he went by Ski. Ski, right. Yeah. But that was the whole game. Yeah, and they were like, okay, Goldman's coming in. Everyone puts their hand in their pockets, right, and just waits. Yeah. Well, I had to, you know, as part of, you know, one of the things that wait yeah well i had to you know as part of you

know one of the things that they make you do as you know when you're one of the low guys on the totem pole coming up the ranks of jay aaron is they make you clerk uh in one of the pits for like you know a month or a couple months so i so i clerked um in the comex gold pit for a little bit and got my you know share of you know just you know being being in the pits and you know just trying to you know acquire some you know sweet street smarts from just watching the open outcry action i mean it's it was pretty cool cool experience i tell people like the amount of paper is what you can imagine like you can imagine these big dudes screaming and yelling but just the amount of paper at the end of the day lining the floor oh it's incredible yeah it's like such needed disruption more than

and physically and physically exhausting yeah just being in there that's why the hours are so short right right um so sorry a little trip down a trading pit memory lane which is always fun so then from there you said enough with this i'm gonna go to business school well it wasn't it wasn't so much enough with it but like um i you know because i studied uh electrical engineering and computer science there weren't a lot of degrees of freedom in that major. I mean, you're studying pretty specialized stuff. And so obviously, I had picked up a lot of knowledge about trading and options and whatnot from being on the job, but I never felt like I

had a formal finance education. So I decided to go back to business school and kind of broad my horizons a little bit. So that's why. Yeah. And then at Canyon, so you started to dive into that. It was mostly convertible bond arms yeah so when i when i when i joined canyon uh canyon was primarily um in you know high yield uh bank debt you know and also they had a direct lending business and you know super super smart uh group um heavy heavy on the fundamental analysis but you think about it was kind of alien to me, because in my world of commodities, right, you do macroeconomic analysis, but most of the trading analysis is technical, right? So I had a totally different skill set. But I think the,

I gravitated towards the one part of the capital structure that I felt was a orphan at that time. This was circa 1997. So relatively inefficient convertible market. And also within Canyon, the organization, it wasn't a well-covered asset class because convertibles tend to be senior unsecured notes. And most of the high-yield analysts focused on stuff that was senior. So I looked at the junkier credits. Sorry, was there alpha was like we can tell better than the next guy the better credit worthiness, right? We're getting overpaid for the actual risk we're taking.

Yeah. Yeah. Yeah, that's right. So you said, all right, I can do that in even a riskier trench. Well, so I wrote a white paper probably around 1998. It was entitled Alpha with Asymmetry. So I came up with this idea that I thought, well, you know, there are certain asset classes or certain strategies that are inherently long gamma, right? So I think of convertible arbitrage, capital structure arbitrage is

inherently long gamma type types of asset classes. And, and the other the other interesting thing, the other interesting dynamic of about these strategies is that they're not reliant upon a greater fool, right for an exit strategy. So as long as you're able to buy implied ball cheaper than actuals, and essentially dynamically hedge, right? You're able to extract the value without necessarily relying on the greater fool. So that was very, very attractive to me. But then I also thought, well, you know, there, there are certain types, you know, back in 1997, 1998, um, there were some risk arm spreads were very, very wide. This is, you know, we're heading into the big telecom internet bubble times, right? And don't forget, 1998 was the period of LTCM.

And when LTCM blew up, you know, they had levered risk ARB positions. And so, you know, so I was also very attracted to playing some of these really, really juicy risk AR arb deals. But I recognize that, you know, risk arb tends to be a short gamma type of strategy, right? So like if you're, if you think about it. Yeah, so like, so if you think about the typical friendly risk arb deal as something that has a 95 chance of uh consummating and in which case you make a buck on the spread but you've got a five percent five percent chance of a deal bust in which case you might lose 10 bucks right yeah that that type of risk reward is very similar to being short ball right at least short

tails right so so it's like but i used to call that merger arm but you're calling it risk merger yeah merger arm merger arm um so but um the the point of my paper though was that this alpha with asymmetry thesis was that you you know, if you could pair convert and capital structure arb strategies, which also have the benefit, in addition to what I said of being long gamma, not reliant on the greater full, but they're also you're also getting paid to wait because, you know, part of what's different about convertible arb versus options arb is that you're actually positive carry, right? In many cases, in most cases, at least back then. So if you pair that with certain selected merger ARB

positions, on a systemic basis, you're kind of protected against these idiosyncratic, you know, blow ups every once in a while but you might be able to extract a a pretty interesting alpha stream so anyways so the point the point of that paper was to basically pitch the partners there uh to let me um run a portfolio like this and um you know they they let me have the ball and run with it. And I wound up kind of carving out a little niche business within Canyon. You know, we started a fund, I think, back in 2000 or 2001 called the Canyon Capital Arbitrage Fund, which was a separate fund to showcase that strategy. And then, you know, when I eventually left in 2002, I always wanted to strike out on my own and, you know, do my own thing. I pursued a strategy mix that was pretty similar, at least initially, and then it evolved over time.

So did your, so A, is that paper still out there? Can we put it in the show notes? That, that, that I can't, that is, that is a proprietary. Okay. Sorry. I thought you meant you put it out into the world as a white paper. No, no, no. It was an internal white paper that I presented as a, yes. Got it. And then two, did your thesis prove true, like through the whole dot com bust and all that? You know, yeah. I mean, you know, during, you know, it's I've learned throughout the years, though, that, you know, a lot of a lot of investment success also happens to be being in the right asset class at the right time. So I'm not going to give myself too much credit and, and say that, Oh yeah, this was all because like, you know,

I had this brilliant thesis. I'm going to say that like, you know, that at that period in time, the convertible asset class was a great place to be. It was a relatively orphaned asset class. There weren't that many sophisticated players in it. And at the same time, you had this lead up into the internet bubble where you had unbelievable actual realized

ball across the board. And yet, if you knew credit analysis and could be in the right credits where the bond floors actually held up in the, in the face of a stock collapse, um, you could make a lot of money. And so, you know, you know, my, my business at the time was really resilient during the dot-com bust. Yeah. Congrats for that. It was a fun place to be. Right, because you'd think that was the mother of all credit risk, right? A lot of firms blew up and didn't have the cash to pay out.

Yeah. and didn't have the cash to pay out? Yeah, I mean, well, so it's interesting because I've now lived through a lot of different credit regimes. And so, you know, 1998 was a different story. But again, I'm going to say I got lucky there because I was just starting my business and I didn't have a lot of capital committed and I didn't have leverage. Right. So I was in a good spot to capitalize on some of the some of the blow ups that were caused in the wake of LTCM. But in 2008, however, you know, I took it on the chin, even though I supposedly had a long ball strategy, right?

The problem in 2008 is that, you know, you had, yeah, you had a big ball event, but it was more the credit ball was probably even higher than equity ball, right? So, so if you think about what a convertible chart looks like, you know, it, you know, if I were to kind of sketch it out, right, it kind of, if you think of a bond, as you know, going back to the sort of Merton real options framework, right, a bond is can be modeled kind of like a short put on assets, right? On the assets of a firm. The equity of a company is kind of like a long call option on the assets of a firm. So a convertible bond, what it looks like, if you were to graph it out, it kind of looks like you're short a put. And the part where it acts like a put is when the company goes into financial distress, and then it starts acting more like a call option as the equity and the firm succeeds, right? 2008 happening the the bond floor that convert arbs bank on to uh hold uh in order to start covering their equity deltas in a stock crash well those bond floors were just they weren't there

in many cases the bonds fell faster than the equity which never it didn't make any sense but it was because you had a you had a credit event that that and that caused the illiquid bonds to gap much more severely than even the equities at that time so you're so you're delta hedging it you're short the equity, but what you're saying is the bonds were whatever, 2, 3x down more than the equities? Oh, yeah. Oh, yeah. Yeah. In many cases. And then in theory, you could dynamically adjust like over time, you know, my strategy evolved because, you know, if you stuck with a traditional convert arm playbook, you typically are long the convertible bond and your short stock and you

dynamically hedge the convertible bond, like you would an option. Right. But there was so much dislocation in and around the financial crisis and afterwards that, you know, we became much more creative in terms of how to play different parts of the capital structure. So in some cases, you know, to even out the implicit put that i'm short but you know in my long convert position i might be short another piece of debt in the capital structure um you know i might be taking on senior subordinate subordinate basis risk by doing that um in some cases uh we would create really interesting synthetic payoffs. So, for instance, in the GM capital structure, I was involved in the General Motors capital structure over a 10-year period, but we played at every length along that curve, initially as a pure convertible ARB

position. And then at a later point, when the stock had cratered, and you know, a lot of the bonds were much more credit sensitive, there came a point in time where you could buy the convertible bonds, I can't remember the exact yield, so I'm just going to use round numbers. Let's say that you could buy the convertible bonds at like a 10% yield, right? There was a situation where you could actually short similar duration straight bonds for like a 9% yield. And think about how crazy that relationship is, right? A convertible should never yield more than the equivalent duration straight bond

because presumably you're willing to pay up for that embedded optionality. But here was a situation where the convertible market was so inefficient and distressed that you could buy a convert that was yielding, say, 100 basis points more than the straight bond. Just because nobody wanted to stock it. Right. So what we did was, in that situation, we basically just shorted the straight bond and basically you have a slightly positive carry position and you have an embedded call option left over.

Yeah, perfect. Although GE kept wandering. positive carry position and you have an embedded call option left over right yeah perfect yeah although ge kept kept yeah yeah yeah well so so eventually general motor so so here's another example so like eventually you know during the financial crisis the obama administration was basically making up a lot of the rules that went along right and so there came a point in time when they were making deals in chrysler's capital structure with the unions uh and but but making the senior secured lenders take a haircut so when that happened senior unsecured convertibles and gm cratered down to something like five or six cents on the dollar, in which case we shifted our strategy again. Now we're thinking, okay, you know what,

now forget about hedging. I mean, these deeply distressed convertible bonds at five or six cents on the dollar represent very, very interesting fulcrum securities, right? So in the case where at the end of the day, if we are a land of laws, eventually if in a more regular sort of restructuring process, these security, like our bonds were treated as peri-pursuit with some of the um the uh the pension obligations um then the the recovery ought to be 50 cents not five cents so it became an outright distress bet so we became very uh just fluid in the way we look at the capital structure. We'd play in equity, we'd play in bonds, we'd play in bank debt in some cases. And we'd be long and short any

parts of the capital structure. And that was once at a, and how do I say it? Acanthos? Yeah. Yeah. Acanthos. Yeah. One of those Acanthos. So that was once you moved yeah, Acanthos, yeah. One of those, Acanthos? So that was once you moved over to Acanthos, so it's still at Canyon. Yeah, yeah, yeah, yeah, yeah. So that, yeah, I mean, you know, I started Acanthos back in 2002. So financial crisis, you know, we had already been in the thick of things for quite a while when the financial crisis happened. And my takeaway is like, don't try this at home, right? Like professional, this is why you need a hedge fund manager, right? This is, yeah, we, I mean, our, our strategy was definitely more, uh, more complex, but you know, back then, you know, I, I would say that, you know, if you, if you spoke to

our investors back then and ask them what sort of was our differentiators that we were very creative in how to structure structure trades right so you know we did a um if you want another trade example i can give you an interesting one i'll i'll label this i'll label this example like the the most interesting trade that never made any money um so there was a company called El Paso, which is a pipeline company. And back then they were very, very levered. And they had a short-dated convertible bond

that was yielding, again, I forget the exact yields, but let's say it was yielding 10% like a one-year put right so most people would just buy that piece of paper at 90 and then with the anticipation that in a year it's gonna you're gonna get par back right but but if you think about that that's kind of like playing a merger arm right because it's a very just it's a very levered credit. And so chances are you're going to get par, you're going to make your 10 points, right? But in that small likelihood where the company defaults,

you could wind up getting hurt, right? Especially when we noticed that there was a very long dated bond that was Perry Pesceau trading in the 70s. And this is like a maybe like a 20, 20 year duration bond trading in the 70s. Right. So and then the the bank debt at the time was yielding, you know, we could we could I think it was like a piece of a revolver that we were looking at that was yielding something like 8 percent and that bank that was super super senior secured solid right no no credit words so we created this really interesting trade i'll call it like a synthetic uh event option what we did was we we went along the bank that just because it was like a super safe 8% piece of carry. But then we shorted the convert at 90, and we went long the long bond at, call it, 70 cents on the dollar and so the so if you think about it right if the company winds up in bankruptcy

in bankruptcy i used to uh tell this to my analyst and in bankruptcy it doesn't matter what a bond's maturity is because bankruptcy is the event that snaps all the maturities to zero. Yeah. Right? So in a bankruptcy, the 90 cent bond that we're short will converge to the 70 cent bond that we're long. So you're protected. You're, you know, that 20 point basis will collapse. Yeah.

Okay. And our 8% senior secured piece of paper is going to be untouched. So we're golden in a bankruptcy, right? But there were rumors that Chevron Texaco was circling, looking to potentially buy this company. And if they bought this company, because this company is already very levered,

it would most likely be a stock for stock transaction. So in a stock for stock transaction so in a stock for stock transaction the the acquiring company just assumes the underlying bonds a little passive right well this is where it got it got it gets really interesting because if we had a change of control our converts that we were short were puttable at par on a change of control so our losses on our short would be capped out at 10 points yeah but our long bond at 70 would all of a sudden become chevron texaco credit and when we modeled what that would mean you could make 60 points on that long bond right and meanwhile our bank debt again would still be slow and steady 8%, right?

So it was a really, really interesting trade, super asymmetric on both sides. But, you know, we held it for a while. I mean, when you put these trades on, part of the reason why this type of trade worked pre-financial crisis and didn't post-financial crisis is, you know, it required good marginability from prime brokers, right? And pre-global financial crisis, we had great marginability on doing stuff like this, not so much post-financial crisis. Because if you just have to put up the funds capital, it's not exciting. It doesn't get people out of bed. It's like three percent or something yeah oh well yeah exactly so like this type of trade you know um you know only makes sense if you have great margin terms because you know and and pre-financial

crisis was you know you could you know these prime brokers um understood that you know you had a trade that basically had there was almost no way you could lose money on the trade. So they gave you very generous margin terms, right? But post-financial crisis, they didn't care whether you had a bulletproof trade like this. They just weren't going to give you the terms. Right. They're like, we don't care. It's a trade. It's risk on our books. That's right. That's right. And what if you were still doing this today, what do you think this current environment is like, like impossible for this kind of thing? Oh, it's much harder, much, much harder.

I mean, well, so, you know, it's weird because the capital markets are pretty messed up. I have a feeling that like for these types of trades, we still wouldn't be getting great marginability. But then you hear about people like Bill Huang getting like 10x on being long mean stocks. It boggles the mind. The other thing I'll say is that – The rumor mill on that one was that when the repo rate went negative or something, they were basically paying him to take on more leverage. It's, it's, it's really, this, this is what a very long period of zero interest rate policy will do, right?

It just winds up distorting financial markets across the board. But what I was going to say about the convertible market specifically is that, you know, this is not the convertible market that i cut my teeth on right now i mean if we want to segue a little bit to what you originally contacted me about which is micro strategy you look at these you look at these converts that he issued right the first one was like a you know 75 basis point coupon and then uh the second one that he issued was basically a zero right and you know, 75 basis point coupon. And then the second one that he issued was basically a zero, right. And, you know, you had, you know, in the early 2000s, you definitely had a bunch of these really, you know, similarly crappy looking converts, I'll say, you know, very low coupon, et cetera.

So it's not entirely different, but this, this micro strategy situation is very, very interesting. I'm not at all involved in Bitcoin or micro strategy, but I viewed it as a case study in the making, let's just say. So let's dive into that a little. So outside of MicroStrategy, and you mentioned it quickly, like that nice thread you did was laying out how the capital structure is like an option. So you touched on that briefly, maybe expand on that a little bit more. And then yeah, the part B is, how is their board allowing what they're what they're doing? And what's that end game and all that gonna look like? Yeah, so, so just to back up a step, right. So I

talked about earlier how, you know, like in the Merton framework of real options, the accounting price being the par amount of bonds outstanding. And then on the flip side of that, the underlying equity of a firm is basically a call option on the firm's assets with the strike price of that call option, again, being the strike price of a par amount of debt outstanding. So if you think about it, again, being the strike price of a par amount of debt outstanding. So if you think about it, right, that's the accounting identity, your equity isn't going to be worth anything until that, that, that par amount of debt is satisfied. Conversely, if the assets of the firm are less than the firm are worth less than the par amount of debt, then your bonds are going to be impaired.

That's why they look like a short put position. So the point I wrote three threads in my strategy. That's just pure capital structure. That's just capital structure in general. But the first thread on microstrategy that I wrote was back in April. And I called it, you know, like microstrategy, a real options analysis. And I basically laid out this framework where I said, look, I mean, he. So this guy, Michael Saylor, you know, prior to any of these Bitcoin transactions, MicroStrategy was a pretty low-growth, steady-eddy SaaS business

worth about a billion dollars or so. But he then issues two tranches of convertibles. The first one being a 0.75% of December, 2025. Uh, that one was struck at, uh, $398 in micro strategy terms. Um, that was a $650 million deal. Uh, and then shortly thereafter um you know so when he did that and announced that he was going to use the proceeds to buy bitcoin that's when his stock goes crazy right and so at one point you know his stock got up to something like 1300 or something right so at that point uh he he taps the convert market again for big size. And this was actually a brilliant issuance because he issued now a zero coupon bond due

December of 20, I think it was 2027, if I'm not mistaken. This time, the strike price is 14 30 14 32 uh on micro strategy stock right and this time uh that the size of that issue was uh 1.05 so between the two converts he issued 1.7 billion of converts and i was arguing that you you know, if you think again, going back to the real option framework, he's now layered these two short put positions, right, into the capital structure. And, you know, I guess if you really want to be technical about it, technically, he, the company, is long to put, the investor is long to put the investor short to put, but I argue in a subsequent thread that, you know, really, um, the, the company's incentives are basically the same as the, as the investors incentives, because let's face it, management cares, management owns stock management is incentivized like a stockholder.

Man management is incentivized to maximize the value of the call option that represents stock. And typically management really doesn't care about creditors so much, right? And also true to form here, and I've seen this over and over again throughout my career is that you know um ceos are eternally ebullient animals they believe that their stocks can only go up and so they issue these convertibles and already fully count the fully converted shares and their and their shares outstanding as if the converts are already converted well wait a second because if the convertible bond doesn't get converted into equity it is debt it is debt that needs to be satisfied at maturity so that was the point of my thread. And so the other point of my thread was that he's

using his existing balance sheet cash plus the cash raised by $1.7 billion in convertible issuance, exchanging the cash, which is a zero vol asset, for a 100 plus vol asset that is Bitcoin.

And furthermore, furthermore, kind of putting himself in this rhetorical trap where he said that like pretty much any free cash flow going forward is going to be used to acquire more Bitcoin, right? So, I mean, it is truly a remarkable thing. And so, but if that weren't enough, right? So, I mean, it is truly a remarkable thing. And so, but if that weren't enough, right, a couple months later, a couple months later, as we know, wait, there's more. He issues a $500 million senior secured note, this time due in 2028. But the difference this time is that this one has, this one has a cash coupon paying six and one eighth percent. Okay. Um, so, so he obviously has exhausted his convertible, uh, his, his convertible, um, issuance capability. capability so now he primed the converts by issuing something that's structurally senior and and um just you know and also it's structurally senior in that this convert is issued out of an

optico um and it's also you know technically senior just by because that this is this is secured by his main business. So I said in this subsequent thread that I wrote that he's now materially elevated the risk of what I call perception to reality risk, where the 6 1⁄ eighth percent coupon eats up about 55% of his existing cash flow. Furthermore, and I have to admit, I have not dug into the bond indenture, but any senior secured piece of paper, even in today's market, has got to have covenants, basic interest coverage and leverage covenants. Yeah. So, you know, a lot of the pushback that I got on my thread is that, well, you're just spreading, you know, FUD that, you know, this guy's got diamond hands.

He's got 72. Crypto hater. Yeah, he's got 72% voting control. He'll never be a for seller. But again, I remind people, I go, look, the debt maturities don't matter if there's an event of default, just like in my El Paso trade, right. Right. So in an event event of default if there ever were one right all these maturities collapsed is zero right so it's a it's a very interesting situation because now he's got cash flow issue basically right potentially but but there's the there's also this perception to reality issue

right so that there in in 2008 the perfect example of the perception to reality issue is what happened to banks, right? Even healthy banks were running out of liquidity because you had a global run on the banking system, right? This is not a bank obviously but i posit that you know right right now he's still in the money on all his bitcoin purchases and with bitcoin at 32 33 000 what have you but what if bitcoin were to go down to mid to low 20s uh below his basis right then you kind of got to wonder if you're one of his corporate customers, okay, am I going to renew that contract? Is this the right provider that I want to stay with?

I mean, does he have his eye on the ball? So I wonder about that. And it's really interesting because his capital strategy, I built a little spreadsheet today to kind of look at this a little bit further. It's remarkable where his stock is trading. I have to say truly,

truly remarkable because he's got the he's trading at a five. His market cap is about five and a half billion. He's got 2.2 billion of debt on top of that. Right. And I think he's got about 83 million of cash uh and then his bitcoin holdings currently are worth about 3.4 billion so if you want to look at what his total enterprise value is if you were to treat his Bitcoin holdings as just cash with no illiquidity discount, well, then his net debt position is negative 1.3, right? Because his Bitcoin position of 3.4 exceeds his debt of 2.2, right? Yeah.

But that's bullshit. I mean, this is like a hundred ball asset that can literally, as we've just found out, in the space of two months, it's cratered 50% because of a couple of errant tweets by Elon Musk. Yeah. So what if you had a situation where some random fud whether it's from elon musk or china cracking down or sends this thing down more um or and what if he had to actually liquidate so what discount do you want to put on that treasury asset that is not cash? So if you put a 20% discount on it, then his total enterprise value is $4.8 billion, which trades at essentially 52 times EBITDA. If you have a real cratering of Bitcoin where it goes to,

you know, say, you know, 11 or 12,000, that's the point at which the wipeout of value of his Bitcoin holdings exceeds the total amount of debt issuance. I calculate that to be around like 11,500. You got a real problem, right? Then you got a real, real problem because it's not clear to me at that point that his existing business business uh would survive at

um and i would even argue that just like right now um it boggles my mind that the his his his business is trading at the valuation that it's trading concerning where it was before all any of the bitcoin transactions and it's all he's cleverer by half right because he's currently winning on all this right the stock's at still at 600 from like 100 or something um so right is well i mean i think is he oh yeah yeah so like a equity the equity market, well, either he's really, really smart or the equity market is really, really stupid or it's maybe some combination of the two, right? Yeah, and you have Tesla. Yeah, I mean, hundreds times EBITDA, right?

So it's like, yeah, I agree with what you're saying, but it's also a piece of like, well, just as you're saying the greater full and someone wants to buy it. Speaking of which, who's buying that, who bought those convertibles, hedge funds institutions. Yeah. I mean, I think that, so the, the convertible market, I have to imagine just like the, you know, I think his senior secured debt issue was many times oversubscribed at six and one eighth. And, you know, people are like, oh, yeah, so he's got like infinite debt capacity. Well, but you know, that's, that's also kind of

bullshit, because having been in this market, right? When you have a hot capital market, it's not uncommon for people to fluff their new issue demand by like 5 to 10x just to get like good allocation to flip, right? So it's not, there's real demand for a senior secure note is not 5x the 500 million. That's bullshit. That's just not right and then how does the zero percent convertible work they're basically just giving you money it's like it's just i'm giving you money for this yeah so so like basically it's i can't remember what um premium it's sold at, but, you know, presumably the people that are buying it are

either outright convertible funds that have to own, they're kind of like index, equity index funds, right? But they have to own, you know, a piece of the convertible or you have ARBs that deem it to be cheap lull. But see, here's the thing about – in convert ARB, right, the notion of implied ball is only as good as what your underlying credit assumption is, right? In options arbitrage, you never have to worry about a bond floor or a credit rating. An option is an option your what your implied ball that you're buying at is is is a hard number but in a convert

that's right but in a convert right you could be buying something that you that seems really really cheap and i trust me i've made this mistake where you think that the underlying credit is like a 650 over credit. And based on 650 over, you're buying a 29 implied when actuals are trading at 55, let's say, right? Well, a lot of times, the reason why you're able to buy that cheap ball is because the credit really isn't 650. It's really like a 900 over credit or a thousand over credit. And you're actually paying to premium to what real ball should be worth. Yeah, that's a pet theory of mine that options are never cheaper, expensive. They're exactly what the market is, right? they're exactly what the market is right they're exactly what the market is pricing that well it's just that it's just that

the convertible security is a much more complex security because there are so many different moving pieces and now in microstrategy you add the 100 volt bitcoin into the equation and yeah it just gets geometric right it's like how do you model that yeah exactly i love it so yeah so it'll it'll be it'll be really really interesting to see what happens i i don't know uh what happens but you know i think i think the point of my threads wasn't necessarily to predict this will happen and this will you know look's got, he's got a fair amount of time on his hands. What he has no control over is, is what Bitcoin price does before maturity. But I think that, you know, he's, he's, he's kind of painted himself into unnecessarily into a rhetorical

corner right by saying that he's going to use pretty much all cash flow to buy additional bitcoin because you know one thing that he could do that would be just heroic right now is that i believe his busted convert so like one of his, his stock price is trading at 560. And so the first convert that was struck around 398 is still about 40% of the money, right? But the other convert that he issued, the billion dollar convert that struck at 1400, that's deeply busted.

It's trading at like, you know, it's 40% of, you know, um, you know, it's, uh, 40% of the, of the strike price. Right. And mind you, mind you, you know, when Bitcoin was at 63,000 micro strategy stock never got past 900 again. So, so that, So that one is a very, very busted piece of paper. And I'm not as up on the current pricing, but a friend of mine told me that those know he he filed for a billion dollar shelf right to potentially tap his equity i mean if i were him and my stock is trading at this ridiculous valuation i'd be tapping that shelf and buying back those bonds at 70 cents on the dollar because it's free money yeah but if But if I'm Michael Saylor, no,

you're not going to do that. I'm going to, I'm going to buy, I'm going to tap that shelf maybe and just buy more Bitcoin and leave myself no room to maneuver. If Bitcoin ever to, were to ever go down, at least that's what he says he's going to do.

I have no idea. Well, maybe that's always in the back. He can always play that right. And Bitcoin keeps going down and that billion dollar convert keeps going or 30 cents he can tap the shelf and but that's not going to be there forever the shelf either right yeah let's move on another thing if you want to talk briefly about what you're doing at smart re you're an advisor on their board or whatnot oh yeah so yeah this is a a pretty interesting it's totally different from anything i've ever done um i'm a board advisor to this company called Smarter, Smart Real Estate. And what he's doing

is he's tokenizing the residential real estate market. And what's really interesting about this business model is that you have a cohort of aging baby boomers that are typically asset rich and cash poor. And, you know, we talked about how, you know, post financial crisis, or maybe we didn't talk about it, but post financial crisis given Dodd-Frank and, you know, just banks reticence to, uh, to lend, especially to do things like cash out refis and reverse mortgages. A lot of baby boomers can't really tap this massive source of equity. Uh, that is, um, that is a big chunk of their net worth. Um, and, um, at the same time, you've got, uh, millennials that are, that are, um, less rich than the boomers as a cohort, but want access to a, a long-term, uh, inflation protected asset class that is us residential real estate market.

And what smarter is business plan is doing is it's basically bridging that gap right it's allowing people to sell a fraction of their home equity without incurring any debt that that equity gets basically tokenized down to dollar increments and uh people can buy so it's a timely business yeah yeah so in theory i could buy i could buy like 50 worth of your home that's right yeah yeah it's pretty it's a very very interesting business model so so that yeah it's like you i could purchase an individual home like that i'd pick out on a map or it's by zip code or something um yeah so he so he's uh he he's he's got um he's already got 8 000 homes uh through his platform uh and he's primarily 75 percent of northern california and 20 excuse me 25 southern california so he's looking to expand but

yeah it's uh it's exciting something something different than uh than what i've been doing but it it does it's um you know i i'm i'm not a crypto hater as much as i am a crypto skeptic in that I've really thought long and hard about, you know, for instance, the first dot-com wave where you had all this initial value accrual to these layer one companies, you know, the global crossings, the level threes of the world, etc. And all these, you know, B2B companies that were touting, you know, network effects, etc. And at the end of the day, the guys that were left standing were the companies that really made use of the reach of the Internet and their ability to garner cash flow, actual cash flows. Right. So if you look at what's happening during the current crypto craze right you've got all this money being aggregated in the tokens themselves and the tokens themselves are really you there's no intrinsic cash flow generation capability even in some of the DeFi tokens these ecosystems are built upon a a sort of

payment in kind characteristic where you're dependent on the flourishing of the ecosystem but the cash flows aren't coming in from without right so so a company like smarter is interesting to me because it is making use of blockchain technology, but to disrupt an existing vertical that happens to be a very, very huge vertical. That has cash. That's right. Huge cash flow. It's just a massive market So that's why I took this assignment on. It's something that is very, very interesting to me. And I'm kind of leery that when all is said and done, the final crucibles of value are going to be in the tokens versus companies that can actually garner cash flows.

Right. Well, it's crazy, right? In one breath, we're saying Saylor's crazy and in the next, investing in a tokenized thing. But that's America, right?

That's the... But it's totally different, right? Yeah, yeah. One is levering up to buy a token and this other situation is you're tokenizing a real asset yeah and making

money on on the on the trading of of that asset i will say it's like the prop firms in chicago got together and we're like hey let's create these token it's just poker chips like they're sitting around the poker table of like let's use matches now let's use marbles now let's use right just to see who's the better trader and they'll trade back and forth so before you go typically we ask uh some favorites but we talked a bit offline in your grade one level five triple A fanboy for Star Wars is that right? yeah I guess you could say that so we're going to we're going to switch

my background first there you go get over here in the million thousand alright and then instead of our normal favorites questions we're going to stick all Star Wars and dig a little deeper. So if you're ready, your favorite original movie.

Oh, episode four. Okay. New Hope. All day? Yep. Not Empire? I mean, I'm a little. You know, I like Empire, but it's New Hope that always,

I always wind up re-watching because I'll tell you what, it's that initial Star Destroyer scene that just blew my mind when I was like six years old. Favorite prequel movies, if you have one? Revenge of the Sith. Revenge of the Sith. Love it. Easily. Favorite of the sith revenge of the sith love it easily favorite of the recent series which all includes and uh rogue one okay all right thank you for including rogue one that would have to be it um how they tie right into the star destroyer scene you mentioned is awesome. Yeah, yeah. I'm not a fan of the

latest three sequels at all. Just retelling it with slightly different, right? It's like, come up with something new. It was just a rehash. Oh, this is a... We could go deep on this one. We'll do another podcast.

Just a minute. Favorite animated series? Star Wars, we're talking, right? Yep. I would have to say The Clone Wars. I'm a Dave Filoni fanboy. See, he actually is a fanboy. Like Kevin Feige is a fanboy for Marvel.

And we need a fanboy running that franchise yeah which they could have done right any of those concepts that he had in clone wars would have been great for the i mean that's what saved the prequels kind of of him coming in and and polishing that up uh that's right favorite non-canon book have you gone into any like thron trilogy stuff like that? It's been actually a very, very long time since I've actually read a Star Wars book, but I do love

those original Timothy Zahn, Heir to the Empire series, but I mean, the Star Wars expanded universe is just so huge I can't even keep up with it. Yeah. Bookshelves here.

Oh, I'm in the Millennium Falcon. But when I was like, I probably read a hundred of them. I mean, it got out of control. You might be a bigger fanboy than me. I don't know. Bad guy or girl? Oh, Boba Fett. Okay.

Oh, for sure. Because I saved up all those proof of purchase action, those proof of purchase Kenner things when I was a kid. Yeah. And I remember getting that Boba Fett action figure before Empire Strikes Back came out. And I'm like, this is the coolest thing ever. I don't know who he is, but I like him.

You saw in my uh in our investors guide to the uh star wars fans guide to the investing i think i equate him to microsoft like looked cool back in the day now kind of looks like a guy in a gray sweatsuit and his death i don't quite agree he could have had a more uh pronounced death no but i think the expanded universe says he survived a certain way exactly well and we just saw him right we just saw him in uh that's right exactly exactly uh favorite good guy or girl oh han solo you're sitting in his seat i'm sitting in his seat never tell me the odds i like that i kind of live i live by that motto right um although he strikes me as like a short gamma guy right yeah yeah i would say that for sure um and uh, creature or alien. That's a tough one because, uh, I love all the aliens. I, I,

I collect a lot of stuff. I have all the, the, the, the bus of the creatures from the cantina. Um, wow. Did you get that? Uh, my son got for Christmas, the Cantina special Lego set? Do you see that? I don't have that. I have a couple big Lego sets. Well, that's a tough one because I like a lot of different creatures. Maybe. I'll tell you mine is Salacious Crumb.

I hate that. I hate that I hate that no no no no no Return of the Jedi was my least favorite of the original mainly because they got too cute with some of these little yeah no I like some of the darker things

I like the Rancor though I mean he was pretty cool thanks so much Michael this was fun. All right. Thanks, Jeff. The Derivative is brought to you by CME Group. CME Group is the world's leading and most diverse futures and options exchange. For more information and educational resources about futures and options, visit cmegroup.com. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel follow us on twitter at rcm alts and visit our website to read our blog or subscribe

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