Risk Management = Risky Business

I came across an interesting video on the McKinsey website, in which the recently deceased Peter Bernstein gives a thirteen minute talk on risk in the real world and in the financial markets.

http://www.mckinseyquarterly.com/Organization/Strategic_Organization/Peter_L_Bernstein_on_risk_2211

Risk, in modern portfolio theory, is essentially the volatility of an asset price. This definition of risk is debatable, as Bernstein and most successful investors believe is that risk is uncertainty, in the sense that we do not know what the future holds. Realistically, there are a range of outcomes to any investment situation, and as investors, we do not know where the eventual outcome will lie in that range, what the actual range truly is, and when that outcome will occur. MPT fails in the sense that it says that risk occurs is a nice smooth normal curve. Our experiences in the real world tell us otherwise. We are continually getting 3 and 4 standard deviation events every couple of years - something that should not occur often according to MPT. The reason why there is this discrepancy is because the risk model is wrong. In fact, most risk models and therefore risk management tools are wrong because they attempt to do the impossible - predict the future and insure against it.

Bernstein goes on to say mistakes will be part of the investment process, and that the successful risk mitigation does not depend on determining when a particular risk will come to fruition, nor what type of risk will occur, but in how well we are prepared to deal it. Most risk management tools fail because they ignore their own fallibility, create a sense of security in their users, which eventually leads to these massive failures we read about in the WSJ each morning. Take LTCM for example. LTCM used sophisticated techniques such as fixed income arbitrage, statistical arbitrage, and pairs trading, and it did so in obscure markets such as Russian bonds. While this can, and did lead to good returns for LTCM initially, LTCM relied heavily on its risk models. Models that did not foresee the liquidity crisis in Russia, and did not foresee how LTCM's simple involvement in the game changed other players actions, and therefore the usefulness of their risk model. In short, they were ill prepared to deal with this outcome because their risk models did not, and in fact, could not tell them that this outcome would occur and that it would occur at that point in time. Another prime example is the crash of 1987, in which portfolio insurance was the main culprit. With markets in the midst of crashing, the portfolio insurance (puts) of most large institutional investors kicked in en-masse. This caused major investment funds to aggravate the situation by essentially selling large amounts of stock all at the same time, further pushing the indices down and causing a feedback loop. In this situation, risk management's new creation (portfolio insurance), misled investors once again because it simply could not foresee the actions of other investors, and it did not have the option to correct itself.

What is the lesson from all of this? The lesson is that risk models and risk management tools simply cannot work in every scenario. First off, it is important to understand that you and your decision making process are fallible, and that you will never be 100% correct, nor be able to see all of the potential outcomes - both positive and negative. Therefore, it is important to focus on the worst-case scenarios, and then protect yourself as much as possible in these scenarios, because the worst-case scenarios are the ones that matter the most to your long-term investment success. This involves having a good understanding of probability theory, as pertains to the magnitude of potential losses. Most investors protect against loss by hedging, which is a good option, although it involves you taking a position in another instrument with potentially disastrous outcomes (see LTCM and portfolio insurance). Value investors protect against loss by buying instruments that have limited downside in even the worst-case scenarios. Even though you may not know how one position will work out, when combining several of these positions, the portfolio should have limited downside as a whole. As for the upside, the sky is the limit.

I would also like to point out that it is very refreshing to see somebody of Bernstein's stature bringing up a very simple yet effective concept of risk mitigation. When you do not know or do not understand an investment, then using the "run like hell" approach may simply be the best way to avoid that particular risk. Good players realize when they do or do not have an edge, and pick their shots accordingly.

The state of M&A, Risk, and Risk-Arbitrage in Canada

With the markets bottoming on March 6th, money has finally started flowing away from treasuries and back into risky investments. Initially it was the primary markets in the form of new debt and preferred offerings from banks, insurance companies, and essentially every firm that could access the debt markets. It then cascaded into the secondary markets, as the TSX Composite is now up 33.8% since that day. Now, the M&A market is picking up steam as well, as evidenced by several deals hitting the tape in the last few days, specifically Pluspetrol Resources making a hostile Takeover Bid for Petro Andina Resources on June 18th, and Challenger Energy announcing a merger with Canadian Superior on June 19th. This presents a great opportunity to discuss the current state of M&A, risk, and risk-arbitrage (an investment strategy typically employed by hedge funds and investment bank proprietary trading desks) in Canada.

First off, sector wise, M&A is currently hot in the oil and gas arena, as these two deals comes on the back of CNPC / Verenex in February, Suncor / Petro-Canada and Paramount Energy Trust / Profound Energy in March, and Clean Harbours / Eveready in April. In addition, Canadian Superior and Challenger Energy just announced their intention to merge, literally the day after Pluspetrol's announcement. This recent activity in the O&G sector makes me think that risk is being viewed through a different lens than in 2007 / 2008, and that the O&G sector will be a hotbed of M&A activity in the coming months. CAPP recently issued a presentation that highlighted expectations of a decrease in drilling activity of 22.3% YoY in 2009, and actual YoY comparisons show the active rig count coming in at ~100 in April - much lower than in 2007 / 2008 (http://www.capp.ca/getdoc.aspx?dt=PDF&docID=151585). In fact, it has been significantly lower throughout 2009 relative to the past two years. With WTI and AECO still miles from their highs of ~$140 / bbl and ~$11 / mcf in 2008, the interpretation is that drilling simply does not make much sense in this environment, especially given the volatility in the commodities, and therefore the inability to plan for profitable production growth. With growth not emanating from the drill-bit, firms are being forced to find growth through other means - M&A. This makes sense, especially when one can purchase production (or potential production via exploration companies) on the open market for a song relative to a company's 2008 share prices. Consolidation is a major theme that will continue to play out in 2009, not only in the O&G sector, but throughout the capital markets.

Secondly, appetite for risk is definitely back, as PAR is primarily an oil and natural gas exploration company, which is a much riskier investment relative to a producing company. In addition, PAR is not a domestic play, but has operations located in such risky locales as Colombia, Argentina, and Trinidad and Tobago. Note that the return to foreign country risk is corroborated by the Challenger Energy deal, as it is also an O&G exploration company with operations based solely out of Trinidad and Tobago.

Thirdly, as risk is back, risk-arbitrage is finally making a comeback as well. There are two indicators for this. One, Pluspetrol's Takeover Bid for PAR is hostile, which is something that we have not seen in months. Secondly, the risk-arbitrage community is committing real capital to this deal, as the stock opened at $9.00, a full $0.90 or 11% above the $8.10 deal price. The day's low on PAR on the 18th was $8.75, and 6.3mm shares traded at or above that price - 24 times the 3 month average daily volume! Over one million shares traded the following day as well, and PAR has continued to tick upwards to a high of $9.47 / share on the 19th, settling in at $9.25 at the close of business. What this indicates is that risk-arb investors believe that PAR is cheap at $8.10 / share, and that either Pluspetrol will come in with a higher offer to appease investors or PAR will source a white-knight to save them. Either way, investors are willing to speculate on the prospects of a higher realizable valuation in the future, hence, risk and risk-arb are both back.

In the next blog, I will go through an analysis of the PAR deal, partially because I believe risk-arb is coming back, but also because PAR is a live, hostile risk-arb, and it is therefore potentially extremely lucrative and very exciting.