2023 May CAD

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-3.19% MTD

-7.55% YTD

“The Market is never wrong, investors are either early or late.”

“The Market is never wrong, investors are either early or late.”

• Jeff Banfield, April 22, 2023

Dear Partners,

For the month of May, the Caravel Capital Fund was down -3.19%, bringing the total net return for 2023 to -7.55%.

It’s hard to imagine the month of May being any worse for the fund with bad luck following us everywhere.  We don’t say that lightly, and to explain it we will detail the specific holdings that caused so much pain below.  The good news is that almost all the positions we will mention have improved materially, excluding the merger deals we have exited, putting the fund +2% for June as we write.

Our market hedges cost us 30 basis points. Despite interest rates rising substantially, the NASDAQ advanced nearly 8%, led by popular semiconductor stocks like NVDA (+36%) and AMD (+32%).  The Artificial Intelligence (or AI) phenomenon has become a mania and like all others, will take some time to work though the market.  The fund’s market hedges are a necessary cost we accept to ensure our clients don’t lay awake on nights when markets are dropping precipitously.

The merger arbitrage book took large losses during May as 3 different mergers broke or materially deteriorated.  As a rule, we exit these trades when market prices don’t reflect the information we know, and we can’t explain why.  The liquidations cost the fund 1.00% in aggregate.

Our largest short position rose 35% in what we saw as a painful short squeeze as other investors covered their short positions.  This cost the fund 0.80%.  We traded around the primary short position which helped dampen losses, and we continue to hold the short position which we have held for almost 2 years.  The position is still very profitable from our initial short price, and we expect to make the money back as the company is ultimately to issue equity and materially dilute current shareholders.  The company has $900 million of debt, $1.1 billion of leases, and it generates about $250 million of EBITDA in a good year. After debt service and lease obligations, the company might generate about $40 million of free cash, and that is with everything going their way this year.  We strongly believe the stock has a good chance of going to $2.00.  Its currently at $4.70.

In what could be our worst luck, we initiated a short position in an office REIT which fundamentally we expect to cut its distribution and likely fall by 50%.  Within two weeks of establishing a position at an average cost of about $13.50, the company announced it would buy back 25% of its stock at $15.50 through a substantial issuer bid (SIB) funded by asset sales.  This announcement only served to deteriorate the company’s balance sheet further, but it gave the stock a short-term bump to ~$15. To underscore our thesis that the company is headed for disaster, the CEO tendered all of his personal shareholdings into the bid, despite its price being ~50% below the company’s stated ‘NAV’.  It’s disgusting, frankly.  The stock’s rally cost the fund 35 basis points, however we managed to add to our position after the announcement and subsequent to the company buying back 25% of its stock at $15.50, the shares have fallen to 12.40 this month, a 52-week low.  This has generated about 55 basis points this month for the fund.  We continue to hold it short, though we have taken profits on half of the position.

We lost a further 60 basis points when a different company sold 20% of its US operation for what was originally thought to be 3 times what we expected.  We naïvely purchased shares as the stock rose 40% in the morning only to learn the initial report of the sale was not entirely forthcoming.  The stock sold off hard over the remainder of the day and gave up nearly all of its initial rally.  We exited the trade and did a tremendous amount of work on what company actually did with the sale.  We personally met with the CEO who happened to be on vacation in the Bahamas a week later and determined in fact the market was being too punitive.  We repurchased the shares late in the month and subsequently we have earned back about 50 basis points this month.  We now hold the position mostly though options thus only exposing the fund to about 15 basis points of risk going forward with the opportunity to earn at least 10 times that.  The company has purchased almost 9 % of its own stock

during the past month and is actively purchasing the shares as we type.  They intend to use the proceeds from their 20% sale of their US subsidiary to purchase an additional 8% of the issued and outstanding shares.  We believe strongly they will purchase these shares and then if the price remains at this level, the company will announce an SIB for upwards of 15% more shares.  This has been a rough investment, but we are firmly of the mind this will produce 1.5% to 2.5% return for the fund over the coming months.

The stock that we had mentioned a few letters ago, Onex Corp cost the fund 30 basis points as a very large seller sold millions of shares down to 60 dollars.  We traded around our core position as best we could during this painful time.  The company however has done a miraculous job since the new CEO took over and has generated almost $1 billion from selling the publicly traded shares it held, signaling to the market they are very serious about creating shareholder value and making big changes in how the company operates.  At the time of writing the stock is trading at $70.  Our exposure to the name is hedged with short positions in the sectors to which their private equity holdings are exposed, as well as short positions in the roughly $800 million dollars worth of publicly traded shares they continue to hold.  We are confident the company will sell these remaining shares in short order and announce a major change in the business which we firmly believe will move the shares up past $100 in short order.  Our holdings are further insulated through the use of options.  In June the trade has generated about +100 basis points for the fund.

We initiated a position in TD Bank preferred shares last month and have added more this month.   The bank has about $25 billion of excess capital that it ended up with when the US Justice Department denied the approval of its purchase of First Horizon Bank in the US (we didn’t own that deal… a small blessing).  During an investor day early this month the CEO stated they will reduce their excess capital by $15 billion through buying back common stock and other securities. The preferred shares we purchased at $20 and $21 will likely be redeemed by the bank at $25 in October (the preferred shares are only redeemable once every five years), thus reducing about $400 million of the banks excess capital.  If the bank does not redeem the preferred shares, the coupon will be reset to about 6.35% after tax, which is above the banks current cost of capital.  We shorted another TD preferred share at $25.00 (par value) as a hedge which has a 6.30% coupon and is nonredeemable for four more years.  We have substantial conviction in this strategy as we fail to see a scenario that works against us.  These don’t come around often enough and we continue to look for more of them.

We have taken a serious look at the remaining merger arbitrage positions we hold and are very comfortable with the quality and return they will produce.  We are fully committed to our craft and continue to do what we know over time generates above market returns with below market risk.  We continue to have about 24% of the funds capital in cash and continue to be short the overall market albeit using options to limit the pain the tech sector is delivering.  The last 12 months have been the most challenging in my previous 30 years.  That should say something.

If you would like to discuss anything at all, we welcome a call or email to discuss our returns with our partners any time.

We thank you for your continued confidence and capital,

Jeff and Glen.