(upbeat music) - Welcome to Inside the Road, the podcast where we speak to the leading minds in wealth management. I'm your host, David Clark, and this episode I'm speaking with Michael Rosen, the co-founder and chief executive officer of Context Capital. We talk to Michael about founding the firm, what led him in the industry and finance and some of the things that have shaped him is interest in restaurants and founding a couple of restaurants along the way. We talk to him about managing $2.7 billion at the firm managers, with an average return of just over 12% per annum with very low volatility. Most investors in the space tend to think about this as equity-like returns for significantly less risk than equities. Please remember to keep your feedback coming. You can email me at
[email protected]. Please also remember that this is not financial advice and is designed to be informational purpose and entertainment purposes. You are encouraged to listen to the disclaimer at the end of the podcast. Enjoy the episode. Mike Rosen, welcome to Inside the Road. - Thank you for the pleasure to be with you. - Mike, what time and whereabouts are you joining us from today? - I'm joining from San Diego, California on 4 p.m. on Liberty in the U.S. - Fantastic, Mike. As we like to do on the show, perhaps you could kick away by giving an introduction to yourself for the listeners. - Wonderful. I've had two financial services jobs in my whole long career. One was from 1983 to 1996. A partner and I ran a small and then larger mutual fund group, which we sold to Oppenheimer funds in 1996. I stayed at Oppenheimer funds through 2000. And then I was charged with my batteries and went to the court on blue in the UK and cycled around Italy and France, swine country. Only to come back to the States and start another financial services company context. - Fantastic. And what made you start context? - Well, in my prior career, I was an outright investor. Mutual funds don't have the ability to hedge. And we focused exclusively on convertible securities and high yield tax recredits. And although we had great success, the convertible fund I managed was number one over the tenure I ran it versus our competition. It became abundantly clear that the types of companies that issue convertible bonds are not an unbiased representation of corporate America. You know, you don't have meta or Apple or Nvidia. You have a lot of companies that believe that they will join that elite group, but somehow along with increased revenue comes increased SGA and R&D. And ultimately many companies destroy value. So context was really reflection that being an outright investor is like being in a boxing ring with one arm tied behind your back. - And Mike, you mentioned you had a break in between there. And I somehow think that fits when I Google you and I looked on LinkedIn and I can see you've also got some interest in some restaurants that you've found. It says there's a clear entrepreneurial spirit there. Tell us a little bit about that and why you've started those. - Sure. I own a fine dining restaurant in San Diego, Juniper and Ivy. I kept complaining about the food scene in San Diego. You know, they're first. After I moved from New York, I moved from New York in 1998 and I commuted every other week back to the World Trade Center. And I kept complaining to my family about the San Diego restaurant scene. And I had already started context, but at some point my older daughter said, I'm tired of listening to you complain, either open a restaurant or shut up. And I started thinking about risk and reward and I didn't want to have a regret. So Juniper is a fine dining restaurant which also gave birth to a fast casual concept, the crack shot, which is gourmet fried chicken, pastures fried chicken. So it's a, I love food and wine, but it's not quite the same business and it's not as, it's a puzzle, but in a very different way. - My interpretation of restaurants is that they're very easy to start, hard to keep going. I'm lucky enough to live in a suburb in Sydney, Manly where we love the water and surf, but there are some great restaurants and bars, but boy, do they come and go? You know, I can count on one hand, those that I think that have been there for at least 10 years. What have you learnt from that process that you think helped you in the investment world if anything? - You know, I always thought there were some correlates, not the EBITDA or general business success, but one thing you learn, you know, I don't know if you're an amateur cook, we all are amateur cooks, even though I've had some professional training, a home cooks don't understand a meason floss. In a commercial kitchen where you have to do 300 or more covers, it's all about preparation. And I feel the same way about a firm like context, which is a trading firm looking at relationships. We have to have our homework done before the trading day, and we have to be able to react very quickly. You can't do research on the fly, you have to be prepared. So I think, I guess the other similarity, which is very different than most businesses, where if you have a colleague that's an underperformer in many businesses, you don't throw them under the bus because they make you look good. But in a kitchen, one colleague that's not doing their job, can throw the whole kitchen down. And I think that's very similar to the investment world. One mediocre team member really has a drastically difficult impact on the success. - Mike, maybe we can dive into context a little here in that strategy. Perhaps you can start off for the listeners and talk about what is a convertible note and why you choose to invest in them. - Of course, a convertible bond is issued by a public company. They can be private, but we focus on liquid public companies. And I'll give you a typical example. You have a biotech company that gets one product through the FDA. It's going to take longer than they ever imagined. It's going to be more expensive than they ever imagined. They may have burned through a lot of cash, but at some point they get a product approved and maybe the equity market cap goes from 500 million to a billion five. Now they've got one product with a high gross margin, but they've got a sales force, very expensive, and they've got a research development pipeline. So even though they have one high margin project, they're likely not free cash flow positive. They're likely burning cash. So at some point they need additional cash to fund their product development pipeline. And a banker may offer a convertible as an alternative instead of selling equity and experiencing immediate delusion. You can monetize your volatility and most bonds today are five year maturity. So a company issues a five year maturity bond at a premium to where the stock price is currently trading. That is largely a function of interest rates, credit quality, and the underlying volatility. So to them, the banker is going to say, your stocks at 20 will issue a convertible at 27. In five years your stock will be 35. You'll be happy. You'll convert the bonds. Happy story. And that occasionally happens. But also you may run into an instance where three or four years after the bond has issued, the stock is below its issue price. And now the company likely doesn't have the cash to pay it off. They'd have to dramatically cut their product development pipeline which they don't want to do. And that's where I think capital structure investors really shine. In my experience at Oppenheimer Funds, I realized just how siloed equity investors and credit investors can be. They don't talk to each other. Equity investors are very positive people. The glass is always half full or full. And the company is going to execute. And credit investors, we always figured out how we're going to get screwed. And we have a very different mindset. So often when you look at companies that are new to the convertible market, the prospective purchasers of the bond are very concerned about what the hard assets are. How the company will mitigate risk. And so you see a lot of industries, Tesla was a prolific issue.
convertibles in their early days and today lucid and ribion are. And as distressed as, for example, lucid bonds are today, the equity market cap is so much larger than the outstanding debt. So it's a case where if you look across a company's capital structure, there's often a disequilibrium that enables you to structure a trade that has positive convexity or positive expected outcomes over a very broad range of different potential outcomes. So Mike, you're describing here a world where you're straddling both debt and you referred yourself, you said when we look at it and put yourself in that bucket as a sort of credit bond thinker rather than the equity thinker. You're straddling both sides there and the example you gave of a biotechnology company and then some other technology companies which a lot of investors would associate as high growth, high risk trading at a market capitalisation that may not have a lot of real assets in behind it and when the merry go round stops there's not a lot left in your hand to rely on. There's not, you know, in Australia private credit is a huge topic or point at the moment because it's grown exponentially and people are wondering if this is a bubble. Is this convertible area an area where people are exposed to absolute loss? When does it go wrong tragically? Well, context, partners fund is a 2.1 billion dollar fund. We've averaged better than 13% for 15 and a half years. We've never lost more than 1% of Nav on any position. To be clear or to be sure there's enormous credit risk. I mean these are as you point out these are not mature companies, they're not free cash flow positive but the advantage we have is we can short equity against the underlying convertible position and potentially hedge ourselves to where we believe the hard asset recovery value will be. We also have to play psychologist in many respects because company management teams many of them are creditor antagonistic. You know we have a biased for example against energy companies from Texas because the CEO has often started his wildcatters and when things go against them they double down and we like company management teams which are creditor friendly. They realize that we're not a Apollo we're not the big bad private we're not doing alone to own we don't want the keys to the company. If they get into a difficult situation we're happy to work with them and either convert out the bonds for additional equity or restrike our convertibles and extend maturities as long as we can put ourselves in a good position and have a hedgeable security the companies can destroy value and we can make money and I think that bears a lot of examination because of course unless you've owned you know alphabet or Nvidia or handful of other companies people have constantly frustrated with companies that showed great potential and ultimately destroyed value and there are many companies that are you you know I'm not exactly sure in Australia but there's a company called Wayfair I don't know if you know them they're they make I guess relatively inexpensive furniture and they sell through the internet and they have all kinds of technology and tools to cut out the middleman but they've been prolific issuers of convertibles they destroyed a lot of equity value they would have been far better off issuing equity and deluding the equity but they've been very responsible at understanding that you know equities forever but debt can kill you so they've been very amenable and restructured their debt and we like companies where the management becomes concerned about their salary and bonus and things potentially they can restrike their options so anytime a company does a deluded restructuring it's incredible benefit it's incredibly beneficial you may be familiar with option pricing models like black shows or merton the convertible arbitrage architecture generally is based on an option pricing model but the one thing option pricing models don't take into account they they generally assume the equity goes up the convertible or derivative goes up on a specific delta and vice versa but if a company is somewhat distressed and they do something deludive our credit quality of the bond will improve and the bond will appreciate but the equity might continue to decline going to the delusion so any of these models never consider that you can occasionally make money on both sides of the hedge trade so my q alluded to the success of the fund i think it's around 20 years old from what i've read and i think what you mentioned and the track record at a little over 13% compound annual growth rate is obviously very compelling i think you throw into that the very low volatility and lack of correlation of it i want to say you haven't had a 12 month period that's a down period i think you got close in 2022 at 0.2 or 20 basis points up which was good to be able to keep the track record going and the street going what is the source of that return i would imagine that you're getting some of that return from trading some of that from fundamentals can you maybe break that down for the listeners absolutely uh we call them alpha buckets and the first alpha bucket would be trading dislocations and interestingly the opportunity in this segment of our pnl is really been driven by uh post global financial crisis legislation um Dodd frank and vulgar and bozzle have all contributed to a dramatic shrinking of the risk capital that banks are allowed to deploy so if i go back 20 years goldman sacks were was likely running a proprietary book of three or four billion they had 20 traders and salespeople on the desk diddo for Morgan Stanley Deutsche Bank credit swiss at the time um so they if a um if an outright investor a pension a mutual fund an insurance company was interested in buying or selling a convertible bond uh they would call up goldman sacks and say hey i'd like to buy 50 million xyz bonds but goldman doesn't own 50 million they may have 5 million in inventory and since goldman's desk is not there to take dramatic risk they like context have these bonds hedged and there's a price for liquidity and that's how goldman's trading desk was so profitable but now goldman's trading desk runs less capital than context has very severe risk control so we've become a very good partner with the major trading desk in facilitating trading so we always will be a good partner we'll put a price on a bond versus an underlying common stock at any point any day and that contributes to our really rapid uh trading we turn over our portfolio about eight times a year and most of that is reflective of these trading dislocations um another area of pnl which may not seem like its skill-based would be um new issue pnl while convertibles are not like equity ipios where they'll go up 20 30 or 50 percent on average uh when convertible bonds are issued they come one or two or three percent cheap relative to what a model would tell you there were and we are such good trading partners that we get very good allocations we punch above our weight on new issues and we will hedge them and when they become fair value we will get them off of our book so that's a very um profitable endeavor for us and the new issue market has been very uh robust over the last year and we believe robust into the future the third source of pnl would be these uh private exchanges and again these are public companies where context or a bank or an advisor or context in three or four competitors will approach a company and say your bonds were 18 months from maturity
you can't let them get to under one year, you'll get a qualified opinion, and we will help structure a solution that is beneficial to us and dilute it to the company but enables the company to survive. So we do a lot of these corporate restructurings. Those are the three primary areas. Whatever the residual return is would be volatility trading, coupon income, short rebate income, minus finance costs. So that's the way we look at our P&L and broad terms. And was there a fourth or is it the three main buckets? The three buckets, the fourth is kind of a catch all because it's really hard to measure certain aspects. Okay, so that catch also got the dislocation, the new issues and the and the private exchange areas. What sort of trading conditions for a lot of a I think a lot of clients or investors, particularly if they're new into this space, they may not have a good feel for what sort of conditions are conducive to returns and what sort of conditions are difficult for returns. Is there a way to think about that? You would think so. Every January, you know, first when we start a new year, we always joke if you know, if we could make a deal to be up eight or nine percent, given the headwinds, given the risks, would we take it? And we're particularly challenged at determining specifically what is going to be a good year and a bad year. But in general, rising interest rates is a headwind. Now, it was, you know, if they raise rates rise modestly and slowly, not a particular headwind because if bonds on average have five year maturities and we love to own bonds that are two years or 30 months from maturity, our our effective duration is just over three years. So interest rates aren't that big a headwind for us. Low volatility is a headwind, but interestingly, even when the VIX or general market perception or measures of volatility are low, many of our companies have single stock volatilities at 50, 60 or 70. So these are companies where, you know, it's very difficult to to reach consensus for equity managers or fixed income managers on how these companies should be valued. You can think of a company like Airbnb or, you know, SNAP. There are people who think the stocks are going to zero and there are raging bulls and whenever there's that kind of dichotomy, we find opportunity in volatility trading. And Mike, what role, if any, does leverage play in the portfolio? What sort of debt and what sort of leverage do you have against these positions? We do run leverage, I guess, on first glance, it may seem we use a lot of leverage. We're typically one and half to two and a half gross long over capital. Most of our peers are four times or higher. We definitely have more of a credit bent and have more credit exposure. And so we feel it's only appropriate to utilize less leverage. But again, as you noted, our sharp ratio, our sortino ratio, our correlation with both the equity market and the Bloomberg Ag are very low. And how many positions are in the portfolio typically? Typically 150 to 100. But 25 positions are really core holdings. Many of those might be the companies where we're going to do a private exchange. And often times those 25 names will be 40% plus of our exposure. So a lot of the names will have small positions from a trading perspective. And if there's a few outright investors that need liquidity, we'll provide liquidity. If somebody comes into the market, what we'll call a clumsy buyer, and they're interested in getting invested fast, we'll certainly sell bonds at a price that we think we can replace them at. And Mike, if you're on the mythical desert island and you sort of got one opportunity to ring back to the office, what are the three questions you're asking them if you want to know what's going on? I can be more than three or less. What are the couple of things you're asking? You know, you hit one, obviously, where are we from a leverage perspective? We currently from a technical perspective have three prime brokers, Morgan Stanley, JP Morgan, and Jeffries. And we allocate different types of trades to different prime brokers based on financing rates. So, you know, there are occasionally stocks that are hard to borrow. There may be no borrow cost at Morgan Stanley and JP Morgan may want to charge us 4%. But if we reallocate those securities for maximum leverage, then we'll have very different allocations. So, I like to know how levered we are because that drives how many, you know, if there's a break in the market, how aggressive you can be. But you don't always take advantage of that optionality to become more aggressive. For example, in March, COVID, many of our peers not only gave up all their profits from January and February, but many of them found themselves down 12 or 15%. Largely because of leverage, we had taken down our leverage in March, not because we anticipated COVID. But in April, May and June, we thought that the, you know, the var, the value at risk in our portfolio was so high given the global situation that we chose not to. But it's always nice to know that you can pursue opportunities. I also will quickly sort our portfolio into exposure buckets. And, you know, you have to take risk in this business, but you want to take intelligent risk. So that's certainly something we review and, you know, hopefully don't find ourselves in a difficult position. But again, my partner, Charlie Carnegie, who was with context, left context and came back, Charlie serves as our CIO, Charlie in his, you know, years away from context, worked for a number of multi-billion dollar multi-strat funds. And when he joined Bill Ferdig, who is my co-founder and me, we had kind of pioneered this approach to looking at convertible arbitrage from a capital structure perspective. But Charlie certainly came back with better systemized risk management. So a lot of the tools we have in place make it much easier for me to sleep at night. I've met Charlie once and we'd, we'd refer to him in that action as a boomerang. One that comes back, Mike. So you can tell Charlie I said, "Good day." Can you tell me, Mike, have you ever had a hedge or a structural failure in the portfolio? Or a hedge file? When we, yeah, obviously. And if you, you know, when we have success, it's success by a thousand micro victories. Our positions are generally modeled again so that we have positive convexity across the wide range of outcomes. There are outcomes that we think are low probability that occur. And when that happens, we have to determine in a post-mortem or live if the position is still with us, how did we get the probabilities wrong? Or was this just, you know, one, one tail of the distribution? Things happen. But often we miss something. We miss something. If we don't understand why a hedge position is losing money, our first inclination is to reduce that position. We should be able to go back and say, "Ah, we miss this, but it's okay." You know, the other scenarios and the way the position is structured, but we lose. Our batting average is about 70%. We win on 70% of our trades. So that's a lot of losers. And with those losers, can you normally identify
to verify what you missed? - I'd say slightly more often than not, but company, these are living breathing companies. They don't know what their competitors are doing. We certainly sometimes miss a new startup. You could have a company that has a great technology product that you think has a wonderful note and good margins, and then Google starts to give it away. - Sure. - I note, Mike, that I think you have a background in economics and psychology if I read your bio correctly, and a little bit of reading into behavioral economics will point out that things don't always behave the way they're supposed to behave, and trying to understand the end consumer at the end of this can be difficult. So there are certainly circumstances where things don't turn out and nobody really knows why in many cases. Mike, in wrapping up, what do you think the present outlook is and I know you've flagged at the start of each year? What do you think the present outlook is for this type of strategy given the sort of macroeconomic settings we're facing? - I'm not a fan of the macroeconomic, I guess, world that we currently face, but we also face both in high yield and the convertible market debt maturity walls. And a lot of companies issued high yield debt back when the risk free rate was close to zero. So, so-- - So post-COVID. - Interest right, super low, yeah. - Yeah, and as those bonds approach maturity, many of those companies I don't think will be able to structure a high yield bond that will either have covenant setter acceptable to them or a coupon that's acceptable. So we expect a lot of opportunity. We've already seen a broader range of companies issuing convertibles from utilities, some established old economy company. So we're very excited about the transformation of the debt maturity wall and what that foretens for convertible issuance. We also both see opportunity and risk in companies that have their heads in the sand. And we are very, we have quarterly, where more frequent calls with different management teams. And at this stage in the market cycle, if they don't know what time it is, then they're not going to be in our portfolio. - Mike, in terms of the way you see most investors look at this type of asset, I'd imagine it's pretty low correlation versus other asset categories. And if you have investors or endowment type investor longer term, high net worth individuals in that space, how do they tend to think of this investment inside of a portfolio that they're building to endure? - We have very different answers, depending on what investors, we have some foundations. Foundations are very focused on the kind of endowment approach of very diversified low volatility. They view us as equity like returns with far lower risk. Sometimes you have insurance companies that largely have fixed income mandates. And this is a way for them to sneak in some alpha into their portfolios. - Did you set up a little bit? - And our largest single allocations are, single family offices and a few multifamily offices. And I think especially for American investors or gunslingers, but I think some of the Swiss and Asian investors, they just like funds, that manage risk. And they're really concerned about risk and we take risks seriously. - Well Mike, thank you very much for joining us inside the rope. Great to have someone from San Diego on the line we're diversifying out the podcast. Thank you very much. And hey, congratulations on the success of the firm and the success to date. Well done and all the best for the future. Thanks for joining us inside the rope. Thank you for listening to Inside the Rope with David Clark. Be sure to subscribe to this podcast on iTunes. You can connect with David by visiting codercapital.com. Any views expressed in this recording represent the personal opinions of the speaker and do not represent the view of any other party. If this recording contains reference to any financial products that reference does not constitute advice or recommendation and may not be relied upon. Listeners in Australia are encouraged to visit www.moneysmart.gov.au to obtain information regarding financial advice and investments.
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