Money Stuff: Short Squeeze as a Service

If you run a public company and you want to raise money, you can sell stock, but you probably won’t. Many companies feel a certain squeamishness about selling stock, and we have talked a couple of times recently about the “de-equitization” of public companies over the last few decades. Companies mostly buy back stock; they don’t sell it.

One problem with selling stock is the price. If you run a public company, you probably think your stock price is too low. If you sell stock to new shareholders, you are diluting your existing shareholders: You are selling too cheap, transferring some of the company’s existing value to new shareholders at the expense of old ones.

Occasionally, though, a public company will think its stock price is too high: The stock price is above the present value of all the cash flows that management expects the company to have. This is a more pleasant problem: If you sell overpriced stock to new shareholders, that is accretive for your existing shareholders. [1]  But it is still, I think, a problem. You are in some sense ripping off the new shareholders, selling them stock for more than it is worth. You might feel some sense of fiduciary duty to them too, and feel bad about giving them a bad deal. In the big meme-stock wave of 2021, companies were initially nervous about selling stock into meme frenzies: Are you even allowed to sell stock at prices you know are too high? [2]

The ideal, most pleasant solution would be to sell overpriced stock to non-shareholders, people to whom you have no fiduciary responsibilities and whom you don’t mind ripping off. (“I would tax foreigners living abroad” is Monty Python’s ideal tax policy.)

For instance: Your stock is trading at around $100 per share, though you think it’s really worth more like $200. Then magic occurs, and for a little while you have the opportunity to sell stock at $700 per share. If you sold stock at $700 to nice enthusiastic retail investors who love your company, you’d feel bad: They’re overpaying for the stock and will lose a lot of money when the magic ceases and the stock reverts to $100, or perhaps to $200. But what if you sold stock at $700 to evil hedge funds who hate your company? Evil hedge funds who have shorted your stock to bet that it will go down: They’re not shareholders; they’re the opposite of shareholders. Wouldn’t that be nice? You’d get money by selling stock at high prices, which is accretive to your real long-term shareholders. The short-selling hedge funds would lose money by buying the stock at high prices, but you want that. Everybody wins, except the people who should lose. It’s a perfect trade. All you have to do is figure out how to make the magic occur.

Avis Budget Group Inc. figured it out! I mean, by accident; the magic here is less “they did deep research into dusty old spellbooks and found the right incantations to say” and more “an itinerant wizard showed up at their front gate.” But that did happen. Bloomberg’s Jordan Fitzgerald reports:

Avis Budget Group Inc. is set to receive $650 million in cash as part of a settlement agreement with Pentwater Capital Management to resolve a lawsuit regarding short-swing profits, according to a filing.

Shares in the car rental company gained 6.5% in postmarket trading Monday. Payment is subject to court approval, based on the filing.

Earlier this year, Avis surged more than 600% across one month to a record high, after Pentwater Capital disclosed that it had amassed a large stake. But shares fell quicker than they went up, wiping out roughly 70% of that rally in just two days, which Avis leadership attributed to sales action from Pentwater.

We talked about Avis’s rally in April, and then a few weeks later we talked about Pentwater’s sales. The bones of the story are:

1. Avis’s stock traded down from around $130 at the start of the year to around $100 in mid-March.
2. Pentwater had been buying Avis stock for a while; it was a 6.8% shareholder last year. This April, it announced that, between its stock and derivative positions, Pentwater owned a bit more than 50% of Avis’s stock, around 18 million shares. 
3. Another big shareholder — SRS Investment Management, a fund run by an Avis board member — also owned more than 50% of the stock. So more than 100% of the stock was owned by two big insiders. [3]
4. How is this possible? There were a lot of short sellers who were betting against the stock; something like 49% of the float was shorted as of mid-March. Pentwater and SRS owned, roughly speaking, all of the outstanding shares plus some of the shares that had been borrowed and shorted.
5. This was alarming news for short sellers: If all of the stock is owned by a few big insiders, there could be a short squeeze in which stock lenders demand their stock back and short sellers have to buy it back at any price.
6. And so, in fact, Avis’s stock shot up, closing as high as $713.97 on April 21, as short sellers bought back stock.
7. Then Pentwater, over a few days at the height of the short squeeze, sold about 4.3 million shares for about $1.75 billion, an average price of around $400 per share. If you assume that its average purchase price was $100 per share or so, then it made a profit of more than $1 billion on those 4.3 million shares.
8. The stock dropped as Pentwater sold; it ended April at $180.67, and has mostly been in the $145 to $190 range since. (It closed yesterday at $186.28 and was up this morning.)

One somewhat perverse thing to take from this story might be that Pentwater caused Avis’s stock price to drop, from the $700s to the $180s. That is Avis’s takeaway, Fitzgerald notes:

“Given the quantum of shares sold in such a short span of time, our stock price experienced a significant decline,” Avis CEO Brian Choi said on the company earnings call in April. “It seems the only insider active during this period of excess volatility was Pentwater Capital.”

Another, more informative thing to take from this story is that Pentwater caused Avis’s stock price to rise, from the $100s to the $700s. It’s still in the $180s! Avis’s stock price is durably higher than it was before Pentwater’s intervention. Seems weird for Avis to be like “ugh they drove down our stock price.”

But as we also discussed, there is a problem with these trades. The problem is that US securities law — the “short-swing profit rules” of Section 16 — do not allow Pentwater to (1) buy a ton of stock in Avis, (2) sell it a few weeks later at a profit and (3) keep the profit. Once Pentwater became a 10% holder of Avis’s stock, it was an “insider” for purposes of these rules, and it could not keep any profit it made on “short-swing” trades (buying and selling within six months). It could make the profit — it could buy at $100, or $200, and sell at $400, or $700 — but it would have to give up the profit to the company.

Still, you can work with that. Pentwater bought a bunch of stock in the $100 to $200 range, which had the effect of igniting a short squeeze and pushing the stock to $700. Then it sold a bunch of stock in the $400 range, which had the effect of defusing the short squeeze and making, like,  a billion dollars of profit. So far, so good. And then the third stage of the trade is returning the profit to Avis.

But, you know. For one thing, the Section 16 rules are sort of complicated, and Pentwater had an argument that it didn’t actually owe Avis much of its profits. It argued that it bought the stock in some funds and accounts that it managed, and sold the stock out of other funds and accounts that it managed, and you couldn’t “match” most of the buys and sells under the Section 16 rules. When it initially announced its sales, Pentwater said that it was “engaged in discussion with the Issuer and [has] agreed to voluntarily disgorge to the Issuer any short-swing profits realized from these matchable transactions.” But it also said that most of its trades were not matchable transactions: Only about 94,000 shares, in its telling, violated the short-swing profit rules and thus had to give up their profits  — on the order of tens of millions of dollars — to Avis. The rest— on the order of $1 billion of profits — were Pentwater’s to keep. Avis apparently disagreed, but that was a starting point for negotiations.

For another thing, Pentwater’s pitch, in those negotiations, was pretty good. It goes something like this: “Hi. We have created a billion dollars of profit from nothing. We did it by trading your stock, buying it low and selling it high. But we sold it high to short sellers, whom you should hate. This trade cost you nothing: no money, no dilution. And it cost your shareholders nothing: When we sold at $700, it was to evil short sellers who got squeezed, not to your good and loyal long-term shareholders. This is just a free transfer of a billion dollars from your enemies to … well, to us. And you. We’ll give you most of it. But we want a few hundred million dollars as a tip for raising all this free money for you.”

This pitch is not entirely provably true: Who knows who was buying at $700? Every “short squeeze” is some combination of (1) short sellers actually feeling squeezed and being forced to buy back stock and (2) retail traders (and momentum-trading professionals) betting that short sellers will get squeezed and buying stock themselves. But the pitch is probably roughly true and quite appealing. “Short squeeze as a service,” a reader called it in an email to me in April; I think that’s right.

Anyway Avis said in April that it “will go after every last dollar that our shareholders are owed,” and it said yesterday that the $650 million settlement “is subject to court approval,”  which will require a court to find that “the Company has diligently pursued the claims raised in the Section 16(b) Action and that the Settlement Amount is fair, reasonable and adequate.” [4]

Is $650 million every dollar of profit that Pentwater made on this trade? I hope not! It’s a great trade and they deserve to make money from it. Is $650 million a good and fair result for Avis? Absolutely! That’s like 10% of its market capitalization! Avis didn’t even do anything! Pentwater just extracted a billion dollars from short sellers and gave Avis some of it. A perfect financing trade, a non-dilutive sale of overpriced stock to short sellers. I don’t know if Pentwater is going to run this trade for (on?) other companies, or if bankers are going around pitching it to other companies, but they should.

Hahahahaha:

SpaceX was awarded the lowest possible environmental, social and governance rating by index provider MSCI ahead of the company’s record $75bn public float this month.

The triple C assessment means SpaceX has the same score as that awarded to the Russian state on MSCI’s ESG government rating scale in the wake of its 2022 invasion of Ukraine. It leaves SpaceX “lagging its industry based on its high exposure and failure to manage significant ESG risks”, according to MSCI.

The rating issued on June 11, just one day before the initial public offering, came as investors and analysts raised concerns about SpaceX’s governance standards. …

In light of the IPO documentation and other publicly available information, “a poor controversies assessment, a very poor governance assessment and a low overall ESG rating should not surprise anyone”, said Frédéric Ducoulombier, a programme director at the Edhec business school’s Climate Institute. “This is very close to a governance horror story for public-market investors.”

ESG is strange because “E” and “S” are somewhat in the eye of the beholder, but there are pretty mechanical and widely accepted standards for “G.” Is SpaceX a corporate governance horror story? Just, obviously, absolutely yes. I don’t even mean that pejoratively! Maybe being a governance horror story is a good thing! Good corporate governance essentially means making corporate management answerable to shareholders, and that’s not obviously or universally good; shareholders have their own flaws. It is perfectly reasonable, based on historical evidence, to think “giving Elon Musk absolute control of a trillion dollars of public investors’ money, with no meaningful voting rights or enforceable fiduciary duties or any other constraints on Musk’s behavior, will work out well for them financially and entertainment-wise.” A lot of smart people have more or less made that bet, and who am I to second-guess them?

But does SpaceX give Elon Musk absolute control of the company, with no meaningful voting rights for public investors and no enforceable fiduciary duties or any other constraints on Musk’s behavior? Yes. Is that “bad governance,” in the generally accepted meaning of the term? It is the worst. The end, zero out of 10 for G, done. “It would be difficult for a serious ESG data provider, or for a fund applying its own ESG screening, not to identify major governance concerns at SpaceX,” Ducoulombier hilariously told the Financial Times. Duh!

Is SpaceX bad for the environment? I dunno, man; you can write your own little science fiction story for this paragraph. “In the future humanity will depend on massive AI data centers, and by putting them in space where there is abundant solar power, SpaceX will make them environmentally sustainable,” fine, whatever. “By putting lots of junk in space, SpaceX will pollute space, which is part of the environment,” why not. “Probabilistically humanity will do something to destroy the environment of Earth, and by making our species multiplanetary, SpaceX will give us access to the only survivable environment in the year 3026,” okay. “Elon Musk will send rockets to distant solar systems inhabited by superintelligent aliens, and then he will troll the aliens on X, and the aliens will take revenge by destroying the Earth, which will be bad for the environment,” I could see it. Nothing in MSCI’s expertise makes them any better qualified to write this science fiction story than anyone else. 

Is SpaceX bad for society? I mean, rockets are cool, and Elon Musk is Elon Musk, and the main way to answer this question is probably to look at a picture of Elon Musk and see what feelings come up for you. Again, MSCI has no unique access to those feelings.

What should SpaceX’s overall ESG rating be? I do not think there is any particularly good or general way to answer that question, except that obviously the governance score is zero, so there you go.

If you run a hedge fund, and your portfolio goes up by $1 billion in a year, you can charge performance fees on that return. Conventionally those fees are 20% of returns, so you’d get $200 million, which you can use to pay traders and buy yachts and stuff.

If you run a private equity fund, things are different. You do not generally charge performance fees on mark-to-market returns, in part because there’s not much of a market to mark to. If you buy a company in a leveraged buyout for $5 billion, and next year it’s worth $6 billion, how do you know? There’s no public market for its stock; any valuation that you give the company would be subjective and conflicted. Instead, you charge performance fees — generally called “carry” or “carried interest” — when you sell the company: If you buy a company for $5 billion and sell it for $6 billion, then you have $1 billion of gains and collect your $200 million of carry. Instead of collecting fees every year on mark-to-market performance, you wait several years to sell the company and collect the carry all at once.

In a hypothetical steady state, these approaches shake out roughly the same way: If you run a big private equity business, you are constantly buying new companies in new funds and selling old ones from old funds, so you are collecting carry each year. But that’s not guaranteed, and if you have a spell of good mark-to-market performance (your companies keep getting more valuable) but no realizations (you don’t sell them), you won’t collect very much money, and will have trouble paying for upkeep on your yacht.

What you want is a financial product to smooth your lumpy carried interest into something more like a mark-to-market performance fee, and of course that exists. The Financial Times reports:

Private equity executives are increasingly trying to borrow against their future share of profits from successful deals as a deal drought delays payouts. ...

“People would just like some cash to do some other things, whether to meet capital contributions for [newer] funds or buy properties,” said Islay Robinson, founder and chief executive of Enness, which specialises in mortgages for high-net-worth people.

This year he had been closing two to three transactions per month, he added, “significantly more” than in previous years, which he put down to companies sitting in buyout portfolios for longer than previously. ...

Hold periods are now seven years on average, up from five to six historically, according to Bain & Company. This has hurt the sector’s fundraising and prompted many dealmakers to search elsewhere for employment with more predictable compensation. ...

Executives can borrow against carried interest that they are forecast to receive based on a fund’s valuation, including unrealised holdings. Private banks to offer the service include UBS, Citi and Deutsche Bank, a person familiar with the matter said.

Enness said the loans could be secured against the so-called carry alone, meaning that a lender could not seize an executive’s personal assets if the forecast profit share never materialised.

The deep point of private equity — of finance, really — is something like “if you can find any moderately predictable series of future cash flows, you can borrow against it,” so why not your carry?

Private equity firms hire consulting firms to help them do due diligence to decide whether to buy software firms. Everybody is nervous. Who will be disintermediated first by artificial intelligence? Maybe customers will stop buying software from the software firms, because AI allows them to replace that software with their own custom vibecoded applications. Maybe the private equity firms will stop paying the consulting firms for advice, because AI provides better advice. I guess the private equity firms are safe for now, though you could tell some pretty straightforward disintermediation stories for them too, and private equity associates might be nervous that their work can be replaced by AI.

But you could imagine a zero-sum game between the software companies and the consultants, where the consultants have to prove their worth by disproving the worth of the software companies. Here’s a funny Financial Times story:

Bain & Company, one of the world’s leading advisers on dealmaking, is “vibecoding” — using prompts and AI to write code — to rapidly recreate pieces of target companies’ software.

The mock-ups let potential buyers test how difficult the technology would be to reproduce as the cost of building software is rapidly falling, and also understand how the product could evolve. ...

“It’s kind of the difference between seeing something in 2D versus 3D,” said Rebecca Burack, head of Bain’s global private equity practice.

“We are leveraging vibecoding to show what a software company can and can’t do, to understand where it fits in the value chain and to understand whether it is the actual code that is the defensible part of the business or something else,” she said.

I mean, I have never really thought about it before, but I suppose a decent rule of thumb is “if your consultants can recreate the target company from scratch in a few hours, you should pass on the deal.”

Elsewhere in disintermediation, here’s another Financial Times story about replacing lawyers with AI:

An AI law firm that uses technology instead of lawyers to prepare legal claims has won a case in the English courts for the first time, in a sign of artificial intelligence’s potential to disrupt the industry.

Garfield AI, which became the first AI law firm in the UK to receive regulatory approval last year, won the claim over unpaid fees for a freelancer following a three-hour trial at Wandsworth County Court last month.

The case is believed to be the first time a trial has been won using an AI lawyer not only in the UK but globally, according to founder Philip Young, a former London litigator.

Sort of. The English legal system involves solicitors and barristers; the AI replaced the solicitor doing legal analysis and pre-trial work, but the AI still “instructed a human barrister to do the advocacy.” In the American system, you can’t really hire an AI to be your lawyer and a human to present the case in court, so maybe the human lawyers can keep more of the benefits of AI for themselves.

And here’s a Wall Street Journal story about AI in investment banking:

Some investment bankers said clients familiar with AI now expect them to produce slide decks, financial models and other materials more quickly. Certain clients are using AI themselves to generate sharper or more-technical questions, or to compare pitches from different banks. Moreover, lower-cost investment-banking services might push down the fees bankers charge clients.

On the one hand, if you think that the core product of an investment bank is the pitchbook, then banks can never really be disintermediated: Clients are not going to make pitchbooks themselves. On the other hand, (1) the pitchbook is not really the core product of investment banking, or even a product at all, and (2) in any case the clients can reasonably expect AI to make the pitchbooks faster and better.

Last week I made some jokes about a prediction market index, which is just a funny thing to think about. If a stock market index goes up, that means that people think the aggregate present value of future cash flows to public companies is higher than it was yesterday. If a prediction market index goes up, does that mean that people think that events are more likely than they were yesterday? Just in general? What could that mean? “This is pretty stupid,” I wrote, “but on the other hand I bet there will be an absolutely straight-faced launch of a prediction markets index in like two weeks.”

Good news and bad news: Someone did launch a prediction market index, and here it is, but I don’t think it would be fair to call it absolutely straight-faced. The index was down a bit as of this morning, so I suppose things will happen less. 

Citadel: the hedge fund that became an energy giant. Top-Paid CEOs Smash the $200 Million Payday. Apollo Caps Private Credit Fund Again After 17% Request to Exit. Korean Stocks Tumble 10% as Extreme Volatility Rattles Investors. ‘FOMO Really Got Me’: Taiwanese Go Deep Into Debt to Amp 100% Stock Rally. Hedge Fund With $1.5 Billion to Shut as Team Joins ExodusPoint. How ‘Perp Futures’ Are Shaking Up Wall Street. Bust-out fraud. KPMG Australia’s chair and senior partners to depart in wake of audit scandal. The $80 Pie Only a Former McKinsey Consultant Could Dream Up. “Nowadays, though, Pokéheists are no joke.” The New York Post is mad at Bobby Jain.

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