Magnetar Hedge Fund Strategy

Margin Call is a broker’s demand on investor using a margin to deposit additional money so that the margin account is brought up to the minimum maintenance margin. Occurs when account value drops below maintenance margin.

Collateralized Debt Obligations (CDOS): Structured financial product that pools together cash flow generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

Advantages of CDOs:

1. Designed to offer asset exposure tailed to the risk that investors desire.
2. Provide liquidity as they trade daily on secondary market.
3. Pay slightly higher interest rates than corporate bonds that are similar in ratings.
4. Allows banks to make more loans that its capital would allow as they can sell them to a third party.

Asset Backed Securities (ABS): Security backed by assets such as mortgages, credit card loans and other debt. CDOs is a subset of ABS

Safest to Riskiest: Senior Secured, Senior Subordinated, Convertible Subordinated, Convertible Preferred Stock, Common Equity

Mezzanine Financing: Hybrid of debt and equity financing used to finance the expansion of a company. (All the convertibles are mezzanine financing). Usually provided to borrower quickly with little due diligence and no collateral. Hence higher return.

Advantages of Mezzanine Debt for lender: 

1. Higher interest rate than bank loan – 2 to 3%
2. Possible equity-like returns through warrants with low strike price.
3. Higher priority than equity holder in case of default.
4.  Have some control of the firm (can take part in decision making to protect their interest)

Advantages of Mezzanine Debt for borrowers: 

1. Less cash constrained due to payment in kind, inexpensive way of financing without diluting its ownership
2. Cheaper than common equity
3. Treated as an equity on a company’s balance sheet, allowing them to obtain traditional financing easier.
4. More flexibility as they are able to structure coupon, amortization and covenants to accommodate specific cash flow requirements of the business. Re-negotiable

Disadvantages for borrowers

1. More expensive than traditional or senior debt
2. Interference from lender through debt covenants or restrictions in their operations.

Credit Default Swap: Transfer credit exposure of fixed income products between parties. If the CDO defaults, the seller of the CDS will pay for security premium and interest to the buyer CDS.

Hedge Fund Strategy 1: Relative Bet

This strategy involves taking advantage of relative pricing anomalies that allows hedge fund to reap profit that are market neutral. This is consistent with the objectives of the hedge fund.

(In the case Magnetar realise the mispricing between equity and mezzanine tranche of the collateralized debt obligations; equity tranche offers a much higher yield that mezzanine even though they have similar risk. Hence Magnetar decided to long equity tranche and short mezzanine tranche by buying Credit Default Swaps. Hence if CDO defaults, Magnetar can earn from a huge payoff from the CDS despite equity tranche loss. If CDO does not default, Magnetar can earn payoff from equity tranche which are higher than cost of buying CDS on mezzanine tranche.)