Bill Ackman explains how his hedging strategy cost only a little but yielded gains of $2.6 Billion

Hedge generated $2.6 billion of proceeds

The bottom line is that our hedging strategy worked. While we incurred mark-to-market losses on our portfolio equal to $2.6 billion, we made the same amount on the hedges. Notably, as of our last public report released yesterday, we were flat for the year.

By selling the hedge, we generated $2.6 billion of proceeds, the substantial majority of which we invested in both new and existing investments, which we believe will payoff as markets recover.

Purchase of CDS as a hedge

Based on this analysis and to protect our investors from these potential losses, we purchased a very large notional amount of CDS. We disclosed that we had done so in a press release issued by Pershing Square Holdings, Ltd. on March 3rd, 2020:

“Dear PSH Shareholder, During the past ten days, we have taken steps to protect the portfolio from downward market volatility. We have done so because we believe that efforts to contain the coronavirus are likely to have a substantial negative impact on the U.S. and global economies, and on equity and credit markets. Our approach to address this concern has been to acquire large notional hedges which have asymmetric payoff characteristics; that is, the risk of loss from these hedges is limited, while their potential upside is many multiples of our capital at risk. These hedges will likely mitigate portfolio losses in severe market declines, while also somewhat reduce the portfolio’s upside potential if there is minimal economic or market impact from the virus.”

“Dear PSH Shareholder,

We are reporting our NAV today so that shareholders are informed of the materially positive impact on NAV of various hedges that we previously acquired to protect the portfolio from downward market volatility. As we explained in our March 3, 2020 communication, we have acquired large notional hedges with asymmetric payoff characteristics which will help to mitigate portfolio losses in severe market declines, while reducing the portfolio’s upside potential if markets recover. While recent market declines have caused the market values of our portfolio companies to decline substantially, the increased value of our hedges has more than compensated for these losses as you will note from today’s reported results.”

At the time of the March 9th press release, our CDS contracts had increased in market value from zero to approximately $1.8 billion because of spread widening.

Risk reward ratio

By March 12th, our CDS contracts had increased in value to $2.75 billion, and we began selling. We sold because the risk-reward ratio of holding the contracts at 140 basis points was not nearly as compelling as when spreads were at 50 basis points. Also, our CDS position had become a very large percentage of our portfolio, approaching 40% of our capital as our companies’ stock prices declined.

Furthermore, the deterioration in markets greatly increased the opportunity cost of our owning CDS. In order to make a meaningfully greater profit on CDS, spreads would have to widen further to approximately the levels they briefly achieved during the financial crisis. Had we had been able to sell our entire CDS position on March 12th, we would likely have done so, but because of the very large size of the position, it would take us more time to exit.



What are CDS?

A brief primer on CDS: in simplified form, when you purchase CDS, you are committing to pay a fixed spread on a quarterly basis for a fixed period of time (for the most liquid, on-the-run contracts, the term is five years) times the notional amount of the contract. If spreads widen, the CDS you purchased becomes more valuable as you can sell it and receive the difference between the wider spread – let say 150 basis points per annum for five years – and the spread you committed to pay – let’s say 50 basis points, for the remaining life of the contract. On the other hand, if spreads narrow to 25 basis points, you will lose money because you will be required to pay the difference: 50 - 25 = 25 basis points, times the notional amount of the contract for the remaining life of the contract – to your counterparty when unwind the contract.

This is best understood by a somewhat simplified example: assume you purchase $1 billion notional of CDS on the IG index for 50 basis points. In summary terms, you are committing to pay 50 bps times $1 billion, or $5 million of premium per annum for five years. Assuming you sell the CDS a month after purchase at a spread of 150 basis points, you would receive approximately the present value of the spread, in this case 100 basis points per annum, times the $1 billion notional amount of the contract for the remaining 4 years and 11 months of the contract’s life.

The present value of 100 bps for 4 years and 11 months is a number which is slightly less than the present value factor times 4.92 years times 100 basis points times $1 billion, or approximately $45 million. Since the contract in this example was only outstanding for one month, the total premium paid would be 1/12th of the annual payment of $5 million or approximately $417,000. Therefore, for a total outlay of $417,000, you would make $45 million.

This understates your actual risk, however, because if spreads were to narrow during that month, you would lose substantially more than the premium. That said, if you were confident that spreads would either stay the same over the next month or widen, you would only be risking the premium of $417,000.