Polygon's European Equity Opportunity Fund Down 7% in 2011

This is the January letter from Polygon’s European Equity fund. The firm as a whole manages close to $5billion. While down 7% in 2011, the fund was up 28% in 2010. Below is commentary from the fund manager and more data:

January saw a strong rally, with the US in particular enjoying its best start to a year since 1997. Markets performed well in Europe too (Euro Stoxx 50 +4.3%, DAX +9.5%) and volatil-ity averaged 20.2%, with a low of 18.3% on 20 January. Portfolio performance was positive for the month, with the two main contributors being Exeter and Aperam. As for under-performers, there was no real negative newsflow per se but rather some price reversal ver-sus hedges for stocks that had performed well at the end of 2011 (such as Norma, Galliford Try and F&C Asset Management). In relation to hedging, we remain conservatively hedged at 85-90% of LMV and are optimistic that if the early signs of a return to stock picking con-tinue, we should see some significant stock re-rating versus hedges in the next 3 to 6 months.

In terms of the top portfolio performers for the month, Canadian gold explorer Exeter Re-sources released a long anticipated pre-feasibility study on their Caspiche gold and copper project in Chile. This study provided the market with certainty around capital costs, operating costs and metallurgy, and the share price responded positively. Projected operating costs are better than anticipated and the small oxide starter project looks more viable than in the previ-ous study. The challenge for Exeter is financing their large project which has a very high capital cost to develop. The starter project has the potential to provide cash flows while they seek a partner or sell the larger sulphide project. The shares are still cheap at less than 0.1x P/NAV and an EV per equivalent gold ounce below $10. The company now has a much clearer path forward to production and/or a potential M&A transaction.

Aperam, the Dutch listed stainless steel company, also performed well in January, trading up 43.5%. The long awaited consolidation in the stainless steel sector in Europe began to gather pace with the announced merger of ThyssenKrupp’s stainless steel asset Inoxum with Finland’s Outokumpu. The deal is expected to close by year end and the biggest hurdle is anti-trust as Outokumpu post merger will have a greater than 50% market share in Europe. We believe the EC should view stainless steel as a global market, in which case the size of the combined entity would be less significant from an anti-trust point of view. Outokumpu, the surviving entity, will close plants over the next 3-4 years, taking out around 1.4m tonnes of capacity. This will reduce, in fact almost eliminate, the overcapacity in Europe and the whole sector will benefit as a result. Aperam will enjoy a free ride effect as they will be able to run their plants at higher capacity utilisation than before once the Outo-kumpu / Inoxum plants have been closed. Aperam outperformed Outokumpu by 20% in January as they avoided paying what we and analysts view as a very high price for Inoxum. We hope that Outokumpu will be the market leader going forward, reducing capac-ity when needed to avoid continued pressure on the base price. We sold down our position towards the end of the month, but have still kept a toehold in the stock as the valuation dis-crepancy between Newco Outokumpu and Aperam is still high (Newco Outokumpu at 7x vs Aperam at 5x 2013 EBITDA).
January was quiet on the M&A front, albeit not insignificant for our portfolio as Colfax com-pleted the acquisition of Charter on 13 January. Charter had been our second largest posi-tion overall and the mix-and-match election allowed us to pick up an extra 70 bps of return (our shares got taken out at 995p versus 988p had we opted for the standard terms). Also, on 27 January, Ophir obtained the approvals it needed (Antitrust in Kenya and Tanzania) to proceed with its acquisition of Dominion Petroleum via a Scheme of Arrangement in Ber-muda. We had owned a medium size position in the trade since October (when the deal was announced) and the Court date is set for 1 February.

Equity capital and financing markets, on the other hand, were surprisingly busy in January. Most notably, Repsol (€1,364m sale of treasury stock) and Eutelsat (€981m sale by Abertis) visited the overnight block trade market (we participated in both deals). There was also a significant rights issue in the financials space by Italy’s UniCredit SpA which raised €7.5bn in a 2-for1 deeply discounted rights issue at €1.943 (a 43% discount to TERP). This was an important test of confidence for the European Equity Capital Markets which they passed with flying colours. Positive macro sentiment and a strong rally in European financials (SX7E up 7.61% in January) provided the backdrop to a 70% rally in the UniCredit stock price from its month lows and helped push the deal to a successful conclusion that few would have pre-dicted when the it was announced in Q4 2011. We were able to source stock in what was a hard-to-borrow name and take advantage of some attractive rights arbitrage spreads though-out the rights trading period. Lastly, there was even an IPO for Russian Oilfield operator Rus-petro which managed to raise $250m of primary proceeds via a lisiting in London. But one swallow does not a summer make. We remain sceptical about the European IPO pipeline until such time as 30/50 day average volatility is under 30%. Unlike in the US, where the IPO market has continued to function as a provider of growth capital to companies of all shapes and sizes, there hasn’t been a significant European IPO since Glencore in May 2011.

In terms of sectors, our top 3 net long exposures in declining order of size at the end of the month were in Industrials, Consumer and Materials. Our biggest net sector shorts in declining order of size were in Financials, Telecom and Utilities. In terms of liquidity, at the end of January we could liquidate approximately 60% of the portfolio in 42 trading days or 75% in 75 days (assuming we were selling no more than 15% of the 6 month average daily trading volume).

Dislocation trades (i.e. value names with re-rating catalysts) represented 33.4% of total LMV at the month end (versus 31.1% in the previous month), with M&A accounting for 11.4% of LMV (down from20.2% in December) and Corporate Restructuring representing 47.7% (versus 41.4% at the previous month end). At the month end the Special Sits category accounted for 7.4% of total LMV.