2023 February CAD

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-.95% MTD

-4.33% YTD

"Dyin' ain't much of a livin'."

-The Outlaw Josey Wales

Dear Partners,

For the month of February, The Caravel Capital Fund returned -0.95%.

We telegraphed in late 2022 and in our January 2023 letter that we had become more and more concerned about the impact that rising interest rates would have on G7 economic activity. Unfortunately, we did not correctly identify the link in the chain that would prove to be the weakest. In the past eight weeks, we have learned that a 400% increase in the cost of money to the consumer is negligible compared to the impact it has on the poorly managed banks that chose near-term profits over risk management. Clint Eastwood said it best in "The Outlaw Josey Wales, "Dyin' ain't much of a livin'." In the latter part of February, we realized the consumer was not reacting as fast as central banks were raising rates. We concluded in early March that we were too early to buy bonds, and since we don't have a predilection to any ideas that are not working, we have materially unwound the strategy. In the following hours and days, the current banking crisis emerged, sending bond prices much, much higher. Bad timing.

WHAT HAPPENED?

 In the days (hours, really) after we completed most of our sales, multiple bank failures began to erupt. For over a decade, banks' only options were to lend money at 3% or buy bonds yielding even less. Rapidly rising interest rates caused bond holdings to drop substantially in value. Bank depositors get nervous when they hear their banks are losing money and consider that their savings may be at risk. Then everybody wants their money at once, thus forcing the banks to sell loans at huge losses. When mismanagement is particularly bad, these losses may wipe out more than just shareholders and creditors; the losses can impair the depositors. This can cause a massive panic without government/central bank intervention, which thankfully has occurred quickly. The knock-on effect of these bank failures and subsequent interventions is that interest rate expectations fall. Quickly. In the last fortnight, interest rates fell 20%. When rates go down, bond prices go up, and FAST. We had sold hours before this started. Spilled milk, but it hurts nonetheless. Let's get back to making money.

We want to share a great idea we identified and recently added to our portfolio. We want to do this for several reasons. Most importantly, for our partners to know and understand how we manage their money. Additionally, when we have strong convictions and an investment has a massive upside over the medium term, it helps to share our ideas. We have a motto at Caravel: Analyze, Invest, then Advertise; in that order. A company's stock price doesn't go up by itself; it needs buyers. We regularly share our ideas with the institutional salespeople and traders we speak to daily at investment banks. If, like us, you find this idea compelling, please share it or use it yourself.

ONEX Corp is a Screaming Buy

ONEX is a Canadian financial services company with core businesses of assembling and managing alternative asset portfolios, including private equity and credit.

ONEX Corporation's ("ONEX" or the "Company") subordinate voting shares ("SVS") are materially undervalued, trading at an approximate 50% discount to their net asset value ("NAV"). NAV for this discussion is the tangible value per share of ONEX's cash and investment portfolio, not some hypothetical number. We believe a catalyst is approaching that could substantially reduce or eliminate this discount and generate a 100% return to the current market price.

ONEX's NAV per SVS, as reported on February 24, 2023, was C$131.31. This compares to the SVS' closing price on March 20, 2023, of C$66.20. The $131.31 NAV, as defined by the Company, ascribes zero value to ONEX's 100% owned and operated asset management platforms, which oversee over U$34B (C$46B) in fee-paying capital. We believe this alone is worth USD $6.00 per share (C$8.00). In addition, we calculate ~U$18.00 (C$24.66) per SVS is held in equity investments that have gone public and thus have traded daily at observable prices. We estimate ONEX carries these holdings at ~U$16.20 (C$22.20) for reporting/NAV purposes, reflecting discounts for marketability and trading restrictions. ~U$13.00 (C$17.85) is in cash and equivalents. Finally, the Company has historically generated a 7% markup vs. book value on its private equity investments when they are sold. ONEX currently values these at U$4.8B (C$6.6B) (>C$80/SVS). This means the actual NAV could be closer to C$150 per SVS once factoring in discounts and ascribing a conservative value to the asset management business.

ONEX management realizes that their own shares at these prices are currently the best opportunity out there.

ONEX released Q4 and FY22 results on February 24, 2023. Book value increased from U$90.15 to U$96.95 per SVS (ONEX reports in USD), or +7.5 % year-over-year. For FY22, the Company bought 6,039,668 SVS at an average price of C$ 69.90 through its normal course issuer bid.

If we remove the foreign exchange impact, we calculate about ½ of the U$ 6.80 increase in NAV year-over-year was generated from share buy-backs. ONEX is buying back nearly every share they can (about 35,000 per day on average) without launching a substantial issuer bid. Over the past twelve years (except for six months after the onset of COVID), ONEX's SVS have traded between a 25% discount to NAV and a 20% premium. The average discount between the trading price of the SVS and reported NAV has been less than 15% over this period.

So, what is it that ONEX sees that the market is missing?  Digging Into ONEX’s Private Equity (PE) Portfolio.

Given ONEX’s PE assets account for >60% of NAV, it is worth reviewing where their exposure lies:

*Internally estimated based on public filings. Excludes publicly traded stocks.

We believe the above profile represents a balanced mix of cyclical and defensive industry exposures. We would note that the total return for the S&P industrials, financials, and healthcare sectors for 2022 were -5.1%, -10.7%, & -2.3%, respectively. These sectors account for >60% of ONEX’s PE exposure. Meanwhile, the overall S&P 500 returned -18.3%, and ONEX’s SVS lost 33.9% in 2022. The math says ONEX’s shares have been disproportionately punished relative to its PE investment positioning.

What Do We Mean by "Screaming Buy?"

Source: RBC Equity Research

As you can see above, the last time ONEX traded at a discount of this magnitude (Q1 2020), it doubled over the following twelve months.

Recent Events Provide a Great Entry Point

We have noticed that stocks with PE and Venture Capital exposure have been broadly for sale since Silicon Valley Bank collapsed and other smaller players in the US financial system came under intense scrutiny.  While this scrutiny is certainly warranted, we have confirmed neither ONEX’s investment portfolio nor its operations are exposed to the current situation south of the border. While ONEX’s cost of capital (and that of their peers) may increase marginally going forward, we believe the $11 drop (-14%) from the closing high over the past two weeks is an overreaction by the market. The shares should be bought, not sold.

A Game-Changing Catalyst: CEO Succession and Unwinding of the Multiple Voting Share Structure

1. ONEX has 100,000 Multiple Voting Shares (MVS) outstanding. The MVS are entitled to cast 60% of votes at any shareholder meeting unless such session involves the terms and conditions of the MVS themselves.  They also give the owner the right to elect 60% of ONEX’s board of directors.  100% of the MVS were awarded to ONEX’s CEO and founder, Mr. Gerry Schwartz.
2. At the November 11, 2022, shareholders’ meeting, Mr. Schwartz announced a proposal: he would step down as CEO, and the Company would appoint Bobby LeBlanc as his successor, and the MVS would subsequently be phased out over a five-year sunset period.  As an amendment to the original MVS terms, this proposal needs to be voted on by holders of the SVS. A proxy circular will be mailed for this meeting shortly.  On the Q4 earnings call, Mr. Schwartz expressed the utmost confidence in Mr. LeBlanc, who he touted as the best person to lead ONEX going forward.  Mr. LeBlanc is a qualified and experienced executive, knows ONEX’s business extremely well, and we agree with the CEO and board’s endorsement of him.  We expect Mr. LeBlanc will make the elimination of the SVS discount to NAV his top priority.

Conclusion:

The modernizing of ONEX’s corporate governance and share structure will open the Company up to a new pool of investor capital.  Environmental, Social, and Governance restricted pools of capital are massive.  According to a PwC report, ESG-oriented assets under management (AUM) will “more than double” in the United States to $10.5 trillion; to rise 53% in Europe to $19.6 trillion; and to more than triple in the Asia-Pacific (APAC) region to $3.3 trillion in 2026.

This will improve ONEX’s trading liquidity, exposure, and valuation multiple, in our view.  Shareholders are getting more than a 66 % discount on a balanced private equity and credit portfolio, selected and managed by a top team of professionals.  ONEX’s recent moves to realize value on some of its largest publicly traded holdings, Powerschool (PWSC) and Celestica (CLS), demonstrate management’s understanding of the best way to accrete value to the SVS today.  We expect this trend to continue and are excited to be along for the ride.