Strong Recovery - Value Regains its Place in the Sun

Camelot Portfolios: Special Market Update and Performance Commentary

by Darren Munn, CEO/CIO

In October, 2020 we published a performance commentary highlighting:

• The tremendous divergence in the market – growth strongly outperforming value & dividend stocks.

• Our belief this trend would reverse at some point.

• The strong performance of our strategies not focused on value/dividends.

• Our plan to improve the performance of the value/dividend-oriented strategies.

We now have another six months (November through April) of performance data to update our progress and the changes in the market. We believe the results show the change in the market we were expecting is in process and our investment plan has produced excellent results!

Progress Update - Perfection is the Goal but not the Expectation

Since we started this process back in the second quarter 2020, we can report significant progress. We believe the absolute and relative performance has been excellent!

• 100% (10 out of 10) of our Core SMA strategies outperformed their benchmark for the trailing 12 months through April 30, 2021 (net of our 50 bps management fee).

• 9 of the 10 outperformed by at least 1000 bps (10%)

• Over the last 12 months, on average 8.00 of our 10 core strategies have outperformed their benchmark each month, which we believe shows consistency.

• Based on the asset levels in our strategies, approximately 90% of our AUM have outperformed their benchmark for the trailing 12 months.

• Premium Stock Dividend has outperformed by 16% over the last 12 months.

• Premium Stock Growth has outperformed by 38% over the last 12 months.

• Opportunities Income has outperformed by 13% over the last 12 months.

• Core Income has outperformed by 20% over the last 12 months.

• The Camelot Event Driven Fund (EVDIX) is 1st percentile in its category for the trailing 1, 3, 5, 10, and 15 year periods (as of April 30, 2021) according to Morningstar!

In October we wrote:

“At the same time, we believe investors have the insatiable desire to “do something” even if the action provides little discernable value. Right now, investors are giving up on some of the high dividend parts of the market. We are not giving up on the high dividend part of the market, but we are going to change our assumptions & our selection process because some things will never change:

• We believe earnings & valuations still matter and will eventually be recognized by the market.

• We believe speculative investing behavior will eventually be punished.

• We believe parts of the market left for dead will adapt & recover.

We are determined to “do something that adds value.”

We believe the results of our strategies prove the strength of our discipline and investment process. Instead of chasing performance in Large Cap Growth & Technology, which many did, we “did something” we believe added value. We will continue to strive to manage our strategies with discipline and excellence.

Market Update

In our last update, we showed 1, 3, and 5 year heat maps showing the strong outperformance of Large Cap & Growth over Small Cap and Value. Here is an update.

Source: Morningstar.com/markets 05/18/2021

The strong outperformance in Small Cap and Value over the last 6 months has completely flipped the 1-year chart and has significantly narrowed the divergence over the past 3-5 years. Even better, the absolute performance is now nicely positive for the Small Cap and Value parts of the market versus the negative numbers shown last time.

Based on valuations and historical precedent, we believe this relative performance shift in the market is likely to persist for an extended period of time, maybe even several years.

But what about absolute returns & risk?

Sometime here in Q2, 2021, the U.S. GDP will recover to where it was pre-COVID. However, the S&P 500 is nearly 30% higher that it was last year when U.S. GDP was at the same level, which seems challenging to reconcile. We believe there are three primary reasons:

1. Corporate earnings growth – margin expansion

2. Lower Interest Rates

3. Quantitative Easing & Stimulus

While we continue to expect very strong earnings growth in 2021, we believe the margin expansion many companies experienced has likely peaked and will be pressured by higher labor and materials costs. As interest rates have already started to recover from the historic lows in 2020, be believe the greater likelihood is for rates to move higher from today’s levels over the next 1-2 years. We also believe the liquidity created by QE and government stimulus will start to taper in the coming months. So the tailwinds to market growth over the last year will all likely dissipate or even reverse over the next few quarters.

We believe this means there is an elevated level of risk in the market, especially in the more speculative & highly valued areas like Technology, SPACs, Electric Vehicles, and other companies that benefited from COVID shutdowns or from the massive influx of liquidity in the system.

We are still finding opportunities in companies that traditionally pay higher dividends and expect continued recovery, both in the level of dividends and market prices. With real yields on Treasuries currently negative, these types of stocks will likely attract investors as their economic recovery takes hold.

This could lead to the opposite scenario from what we saw last year – strong GDP growth but weak market growth; positive returns for Value but negative returns for Growth.

In summary, we believe the market growth over the next 1-2 years will be less exciting than the last 3 years and may struggle to get to double digits. There will likely be extended periods where the market chops around in a range without making much progress as the valuations catch up to market prices. We also believe this choppiness will provide opportunities for our investment process to further prove its’ value.

Conclusion

We believe our performance results indicate the bold action we took last year helped restore and build on the strong, dependable track record we strive to maintain at Camelot. Our Portfolio Manager team is more integrated and collaborative, providing additional opportunities for us to capture in our strategies.

We will work diligently to build on the current momentum as we strive to deliver a great investment experience for the clients you serve. Thank you for the trust you place in us and for the pleasure of serving you.

With Extreme Gratitude,

Darren Munn

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Disclosures:

• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

• Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.

• Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client's investment portfolio.

• Approved – B224

Get Ready for the Taper Tantrum

by Paul Hoffmeister, Chief Economist

• Vaccination numbers keep climbing; economies keep reopening.

• Massive government support and the fading pandemic have contributed to a historic recovery.

• That massive support may start to be unwound during the next year, threatening the equity outlook.

According to USA Facts, approximately 45% of the US population (nearly 150 million Americans) have received at least one Covid-19 vaccine dose; and 30% have been fully vaccinated. At the same time, economies continue to reopen. The most significant news recently came from the European Union, with its plan to welcome foreign tourists next month in time for the summer travel season.

All the while, the Federal Reserve is maintaining its zero interest rate policy (“ZIRP”) and bond buying programs, and the U.S. government has spent nearly $6 trillion, borrowing from the future to support the economy today.

The confluence of massive government support and the fading pandemic has contributed to an 89.2% rally in the S&P 500 from its closing low on March 23, 2020 through last Friday. And year-to-date, not including dividends, the S&P 500 is up 12.7%.

Aside from a new, unstoppable Covid variant, the biggest threat to equity markets may be the unwinding of the extraordinary economic support that we see today. That threat may not be imminent, but it could erupt within the next 12 months or less.

On the fiscal side, we are beginning to see the political limit to the outsized spending. Last week, Democratic Senator Joe Manchin, referring to the White House’s $2 trillion infrastructure proposal, said: "It's a lot of money, a lot of money.. Are we going to be able to be competitive and be able to pay for what we need in the country? We got to figure out what our needs are and maybe make some adjustments… We're at $28.2 trillion now, debt, so you have to be very careful. There's a balance to be had here.”
Note, with Democrats controlling 50 seats in the Senate, Manchin is the political margin, i.e. the critical fulcrum vote that will likely decide policy until the next Congress convenes in January 2023. For their part, Republicans have proposed a $600 billion counter-offer for infrastructure. The easy spending days appear to be over, for now.

On the monetary side, Federal Reserve officials are maintaining their dovish posture. On Monday May 5, Federal Reserve Governor Michelle Bowman said, “Despite the progress to date and the signs of acceleration in the recovery, employment is still considerably short of where it was when the pandemic disrupted the economy and it is well below where it should be, considering the pre-pandemic trend.” This dovetails Chairman Powell’s public statements weeks ago that the economy is not yet out of the woods.
But, the Fed’s median forecast for the unemployment rate is for a decline from 6.1% today to 4.5% by year-end. If that level is reached by December, it will not be far from the 3.8% rate of unemployment that the economy was experiencing just prior to the Covid outbreak and lockdowns.

Perhaps that will be the point where the economy will look to be “out of the woods”. This suggests that during the next 6-9 months, the Federal Reserve will begin to telegraph a monetary unwind – of its bond purchase programs and ZIRP.

Last week gave us a glimpse of what this threat may pose to markets today. Treasury Secretary Yellen said in a video released last Tuesday that interest rates may need to eventually rise to ensure that current fiscal ‘stimulus’ doesn’t overheat the economy. At one point that day, the S&P 500 was down nearly 1.5% from its closing level on Monday.

If such a seemingly innocent remark can cost the market that much, how much would an official departure from the current monetary posture actually cost? 10%? 20%?

Investors should reflect on the market tantrums of 2018 to gauge the risks ahead to assess possibly a worst case scenario. In both February and then the fall of that year, while the Fed was raising interest rates, it began to telegraph even more aggressive rate increases. As a result, we witnessed a nearly 10% and then 20% decline in the S&P 500.

In sum, the ”easy gains” in the equity market are very likely behind us – as the economy and financial markets experienced a historic natural disaster/recovery scenario -- and future gains may be much more difficult to come by. If anything, the risk-reward profile for equity investors today appears to be asymmetrically unfavorable.

Tax Update:

President Biden said last Thursday that he wants to see the corporate tax rate increased to somewhere between 25% and 28%. This is a soft backpedal from the 28% that the White House was initially advocating, and is likely due to pushback from within the Democratic Congressional Caucus. Senator Manchin is now on record, for example, to be in favor of a 25% corporate tax rate.

What’s unclear is where moderate Democrats stand on capital gains and estate taxes. President Biden has proposed raising the capital gains tax rate to the top ordinary income tax rate. Under this proposal, the top income tax rate would be raised to 39.6%, and therefore so would the capital gains tax. Adding the 3.8% Medicare surtax, the top capital gains tax rate would rise to 43.4%. Biden also proposes eliminating the stepped-up basis on estates passed to heirs. The backpedal on the corporate tax and quiet surrounding capital gains and estate taxes suggest that a new tax plan will not pass soon; it’s more likely that the plan will be passed during the fall.

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

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B219 // Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537

Disclosures:
•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
•       Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

How Tax Hikes Will Be Confiscatory

by Thomas Kirchner, CFA

• Confiscatory tax rates of 87% result from elimination of the step-up basis.

• France's “supertax” President was ousted after one term.

• Nonsense academic studies appear to justify tax hikes.

• Offshore tax evasion is largely a myth.

Tax hikes are coming. Key proposals by the White House involve an increase in long-term capital gains rates to income tax levels, an increase in the corporate tax rate, and an elimination of the step-up basis on estates [i]. Taken together, they have the effect of creating a confiscatory tax environment. We look at how such confiscatory tax regimes have failed in other countries in the last decade and discuss some of the academic studies that claim to show massive tax evasion by the wealthy. Finally, we debunk the widely-held belief in offshore tax evasion by the wealthy on a massive scale.

Confiscatory rates justify abolition of the estate tax

A key element of the Administration's tax hike proposal is the elimination of the so-called step-up basis. Under current tax laws, a deceased person pays an estate tax of up to 35% on assets upon death. The heirs then receive what is left, and their tax basis reflects the value of the assets upon receipt. The U.S. differs with this approach from the rest of the world where not the deceased person is taxed, but the heirs on their respective share of the inheritance. Hence, the term “inheritance tax” rather than “estate tax” is used everywhere else.

The problem with the elimination of the step-up basis lies in its combination with the estate tax and the proposed higher tax rates on long-term capital gains, which will lead to overall tax burdens of nearly 90%.

A simplified example illustrates the toxic interaction of these three taxes. Consider an estate worth $100 million that consists of founders' shares in a business, so we can assume a tax basis of zero. Upon the death of the founder, an estate tax of 35% is due. For simplicity, we ignore the current $10 million exemption, which is going to sunset in a couple of years anyway.

After paying the estate tax, the heirs will be left with $65 million. The problem is that most heirs won't have an extra $35 million lying around that they can hand over to the IRS. So, they will be forced to liquidate the estate. With the tax basis of the shares at zero, they will need to pay $52 million in long term capital gains taxes if they are located in high-tax states such as New York or California. Add to that the $35 million in estate tax, and the total tax burden is $87 million, or nearly 90% [ii].

These are confiscatory tax levels. We believe that eliminating the step-up basis is a good reason for the abolition of the estate tax altogether. After all, it leads to a triple taxation of income: corporate taxes are paid on the profits of the business. Capital gains are merely the discounted cash flows of the after-tax corporate earnings, so that capital gains taxes are already a form of double taxation. Taxing such gains again with an estate tax then amounts to triple taxation.

Parallels to the French tax debacle

Former French President Hollande gained infamy for not only stating that he hates rich people, but also for acting this way. In 2012, he introduced a 75% “supertax” on earners over 1 million Euros, who were faced with a total tax burden, including social security, of well over 90% [iii]. He found out the hard way that such confiscatory taxes don't work: many high earners moved to London or Geneva and conducted their business from there; those who stayed behind avoided realizing gains in anticipation of a future repeal.

Actor Gerard Depardieu took the most drastic step of taking on Russian citizenship. While we won't speculate which Hollywood stars might vote with their feet, we note that Senator Warren is trying to prevent this from happening by calling for an increase of the exit tax on the wealthy.

The end result of Hollande's tax hike, derided as “Cuba without the sunshine” by then little-known economic adviser Emmanuel Macron, the current President, was that an estimated 10,000 high income earners left France permanently. Despite this small number of people, income tax receipts fell €16 billion short of projections. Moreover, a mere €200 million per year was raised by the tax, nowhere near enough to offset the drop in tax revenues. Hollande had to rescind the tax two years later [iii][iv].

The confiscatory tax hikes proved to be transitory, as was Hollande, who ended up as a one-term President with approval ratings in the low teens. Permanent, however, was the damage to the French tax base, as few of the tax refugees returned.

Revenue-optimizing tax rates

The proposed tax increase on the highest income earners to 39%, when combined with state and local income taxes, will lead to total tax rates in California and New York of roughly 52%. We believe that this number is no accident. In 2014, Fed researchers published a study [v] that claimed that the peak of the Laffer curve, at which maximum government revenues are achieved, is 52%.

But just because there is a study that shows that 52% is optimal does not mean it really is optimal. After all, the French “supertax” of 75% is close to the theoretical optimum of 73% that none other than economist Emmanuel Saez calculated as optimal. That is the same Emmanuel Saez who rose to fame with his monstrous tome “Capitalism in the 20th Century” a few years earlier, which claimed that rich people were getting so rich that they were becoming a threat to democracy and advocated income tax rates in the range of 54% to 80%. Of course, we know now that while that 73% tax rate may have been optimal in ivory tower theory, in real life it was terribly suboptimal and had to be nixed.

It might be a good bet that the 52% “optimal” rate calculated by the St. Louis Fed researchers will have the same fate as the French “supertax” and turn out to be dramatically suboptimal and revenue-minimizing.

Do the top 1% really evade 20% of their income taxes?

All this talk about tax hikes comes against a background of an academic study [v] purporting to show that the top 1% of earners evade 20% of their income taxes. That claim made headlines a few weeks ago, but its dubious assumptions remained unchallenged.

Uncontested are the raw data: IRS audit data show that as you climb the income ladder the percentage of tax evasion relative to total income declines sharply. In this data, the largest percentage of tax evasion occurs just below the median income group in the 40th percentile, where taxpayers evade 6% of their income (interesting side note: half of that evasion occurs through Schedule C /sole proprietor income).

For the top 0.1% earners, tax evasion is half that rate, or 3%, while for the top 0.01%, tax evasion is less than 1% of income. To us, the raw data suggest that the system works: penalties for tax evasion become more severe as the amounts evaded increase, with jail time being a realistic prospect for 7-figure evasion. Not to mention that legal ways to minimize the tax burden through deferral and shelters increase with incomes. Therefore, we would expect that the top of the income pyramid has very little evasion.

Of course, the data runs counter to the narrative that the rich don't pay their fair share. To make the data fit the narrative, the authors of the study took the percentage of tax evasion found by those IRS auditors who come across the most tax evasion and applied that rate to everyone. The assumption behind that approach is that the rate of tax evasion is the same for every income group. The outcome is the headline-grabbing result that the top 1% evade 20% of their taxes.

However, as we pointed out, penalties increase as the amounts evaded become larger, so the assumption of a uniform rate of tax evasion for all income groups is highly questionable. Moreover, it runs counter to the actual IRS data. In fact, the methodology is a simple trick that will always yield sensational headlines. For example, if we take those police officers who encounter the highest incidence of violent crime and then apply that percentage to all demographic groups, we find that the “adjusted” violent crime rate shows massive “undetected” crime. With this dubious approach, the top 1% of earners will commit massive amounts of “undetected” violent crimes, as do the university professors who create these types of nonsense studies. The differential between actual and theoretical will be largest in the group that has the smallest actual incidence. The policy response will be to increase policing of those groups who have the lowest actual incidence, because that's where the most supposedly “undetected” violent crimes happen. Most likely, this will reduce policing and exacerbate problems in those areas where the actual incidence is the highest.

The methodology is arguably useless and purely of academic interest because it applies the worst case scenario to everyone. Basing policy, in particular tax policy, on a worst-case scenario based on unrealistic assumptions is a bad idea.

The myth of offshore tax evasion

Finally, we would like to clarify a myth about offshore tax evasion that underlies many other studies. The fact is that most industrialized countries impose withholding taxes on dividends and interest on foreign-held accounts. For example, the U.S. generally imposes withholding taxes of 30% on foreigners, while Switzerland, supposedly a tax haven, imposes 35%. That means that anyone stashing away their investments in Switzerland faces a tax rate of 35%. Of course, you can get these foreign taxes back under most tax treaties. But that requires you to declare the income to your own tax authority, who will then issue a certificate that can be used with the foreign tax authority for a refund. So any American hiding money in Switzerland faces a 35% tax rate on dividends. If the person invests their hidden Swiss money in U.S. stocks, they face a 30% U.S. withholding tax on dividends, more than the 20% federal tax rate they would pay on qualified dividends on investments fully disclosed to the IRS. Of course, that's the point of withholding taxes: they are supposed to make hiding assets uneconomic. And because the assets are undeclared, their owners cannot claim a refund for the withholding taxes. In light of these heavy disincentives, we doubt the claims about the exorbitant amounts of taxes supposedly evaded by the rich through offshore accounts.

In fact, for smaller investors, the cheapest option is to simply pay the withholding tax and forego the refund. This is not because they are hiding assets, but because the cost and complexity of the refund process exceeds what they expect to recover. Therefore, if someone doesn't request a refund of their withholding, that alone cannot be taken as evidence of tax evasion, but is simply a cost-benefit tradeoff.

Moreover, in our experience, few financial advisers are familiar with the intricacies of holding foreign stocks and withholding taxes and refunds, so that many end clients probably forego significant refunds due to such ignorance.

To the extent that undeclared offshore wealth actually exists, overall tax receipts would not necessarily increase if all of it were to be declared. As discussed above, the U.S. government already withholds taxes on dividend and interest payments paid to foreign accounts. If these assets were declared, these withholding taxes would no longer be collected. Moreover, to the extent that these accounts are invested in stocks listed in other countries, taxpayers would be able to claim a tax credit for withholding taxes paid in such other countries. Depending on how the net effect of all of this would play out, U.S. tax receipts may actually decline if all currently undeclared offshore wealth were to be declared. The absence of considerations of withholding taxes in academic studies on offshore tax evasion is a red flag that these academics lack a good understanding of the complexities underlying offshore investments.

How it will end

Taxes are a hot button topic. A significant proportion of the population is convinced that the rich do not pay their fair share. Much of that is based on myths, which are reinforced by questionable studies and statistics.

Overall, there may be plenty of legal ways to defer and reduce taxes, from special IRA accounts, MLPs and REITs, 1099 exchanges or insurance wrappers to a myriad of other structures. American investors have no need to go into illegality to reduce their tax burden.

Moreover, the increase in individual tax rates may lead to a revival of the C Corp for small businesses. Rather than passing through all income to the owners, who pay a high tax rate on that income, it will make sense for many highly profitable closely-held businesses to become C Corporations and pay salaries to their owners, while the majority of profits are kept in the corporation, where they are taxed at a much lower tax rate and can grow, with these gains also taxed only at the (lower) corporate tax rate. The result of the reduction in pass-through entities would be lower income inequality, because the income is no longer reported by the taxpayer but by the corporation. This effect may be one of the reasons why the White House is adopting such tax policies.

For the tax hikes themselves, we foresee three scenarios: in a worst-case scenario, a confiscatory tax regime will be implemented. In this case, the economic boom will end. Depending on the length of such a tax regime, America may no longer be seen as the land of opportunity and IPOs by the world's most talented technologists, but as the land of confiscatory taxes. This will do long-term damage to the tech industry and, by extension, the economy as a whole. In a best-case scenario, taxes will be raised only moderately. In the third, most likely scenario, taxes will be hiked substantially but this will be undone by future elections, as the economic consequences become apparent.

[i] Greg Iacurci: “Biden wants to raise $1.5 trillion by taxing the rich. Here’s how.” CNBC.com, April 29, 2021.
[ii] Camelot calculations.
[iii] Jon Hartley; “Hollande's 75% 'Supertax' Failure A Blow To Piketty's Economics.” Forbes, Feb 2, 2015.
[iv] John Lichfield: “President Hollande bids adieu to French 'supertax' detested by the country's millionaires” The Independent, January 6, 2015.
[v] Alejandro Badel and Mark Huggett: “Taxing Top Earners: A Human Capital Perspective.” Federal Reserve Bank of St. Louis, Working Paper 2014-017B.
[vi] John Guyton, Patrick Langetieg, Daniel Reck, Max Risch, Gabriel Zucman: “Tax Evasion at the Top of the Income Distribution:Theory and Evidence.” NBER Working Paper 28542, March 2021.

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EVENT-DRIVEN CALL
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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B216

Disclosures:
•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
•       Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

SPAC's: Obituary

by Thomas Kirchner, CFA

• SPACs no longer trade at premiums.

• Their total size exceeds potential merger opportunities.

• Many SPACs will liquidate unglamorously.

We last discussed SPACs in November, a few weeks before the mania went into overdrive. Since the beginning of April, however, issuance has crashed, as have SPAC prices. Despite being only one third into 2021, this year has already beaten prior year records with 308 SPACs raising just over $100 billion[i], so a pause should not surprise anyone. Recent SPACs feature fashionable terms in their names such as “decarbonization” , “digital”, “climate” or “infrastructure” and often celebrities endorse the SPAC. Elon Musk seems to be the only celebrity not yet involved with a SPAC. But we believe he should, as we will explain below.

Return to rationality

Since late March, the market has found some sanity in pricing SPACs after their IPO and has returned to historical norms. While many SPACs traded at a premium to their $10 issuance price earlier this year, they have now returned to being priced at a discount to the per-share value of the trust account. (For readers not familiar with the mechanics of SPACs: IPO proceeds are placed in a trust account, which results in SPACs holding cash that is generally worth around $10 per share).

SPACs did not always trade at a premium to the issuance price, or to a premium to the cash trust. The return to this rational pricing alone could be called a bursting of a bubble. The mispricing earlier in the year was a strong sign of ignorance of many participants in the SPAC bubble. Moreover, while most SPACs traded at a premium to both the $10 issuance price and the value of the cash in trust, a small minority of SPACs held more than $10 in trust and had other shareholder-friendly features which would have justified a decent premium to $10. Yet, these SPACs traded at a discount to trust, albeit over $10. Clearly, many buyers bought SPACs without a rational understanding of the cash value.

… but what is rational can be debated

The problem is: a case can be made for both that SPACs should trade at discounts or premia to trust cash. Which one is right depends on the bigger picture.

On average, SPACs rise by 11% after the announcement of a merger [ii] . Therefore, it would be rational for SPACs to trade at a premium to cash to anticipate some of that future upside.

However, if you expect that most SPACs will fail to complete an eventual merger and will liquidate and pay out its trust cash, then SPACs should trade at a discount to trust cash.

If we work backward, then we can conclude from many SPACs trading at a discount to trust cash that the market expects the liquidation of most of them. This is consistent with press reports that cast doubt on the availability of sufficient private companies to complete SPAC deals.

Too many SPACs?

It is a sign of a bubble that market participants overestimate the potential size of the market. We believe that this is the case in the current SPAC market. Companies seeking to go public have multiple options. SPACs are not just competing with traditional IPOs, but also with direct listings, of which we have seen several examples during the last few years.

427 SPACs with a total of $138 billion in cash are currently looking to do deals. This includes 57 large SPACs with more than $500 million cash each, whose firepower totals $40 billion [iii]. These large companies are competing directly with the traditional IPO, where the bookbuilding process can actually add value in establishing relationships with investors, something that is lacking in a SPAC merger.

If you consider that SPAC mergers are done only in part for cash and that some of the target company's pre-merger stock is rolled into the post-merger listed company, the total value of potential transactions is a multiple of the cash held by current SPACs. We see many SPAC mergers completed at enterprise valuations that amount to 3-5 times the amount of cash held in trust. Therefore, the current $138 billion held in trust could complete mergers with a total valuation of $414-$690 billion.

How plausible is it that this can happen? For comparison, total IPO volume in 2019 was $46.3 billion spread over 235 companies [iv]. We use 2019 as a reference instead of 2020 because that year was not yet impacted by the Covid crisis. This number represents the cash raised in IPOs, not the aggregate valuation of the companies taken public. This means that SPACs currently looking for companies to take private would have to find enough targets to result in three times the 2019 IPO volume.

This is unlikely to happen. Therefore, many SPACs will have to liquidate after failing to find a suitable target. It makes sense if the majority of SPACs trade at a discount to cash.

Which SPACs are likely to fail and liquidate?

We can take this thought one step further and try to determine which SPACs are most likely to liquidate. SPACtrack.net has a helpful table that organizes SPACs by industry of prospective targets [v}:
 

Industry Trust cash searching targets ($bn)

Tech 67.2

Cannabis 0.8

Energy 8

Healthcare 17.7

Fintech 15.3

Tech, Media, Telecom 2.8

Sustainability 7.1

Source: SPACtrack.net

SPACs are heavily geared to the technology sector, which is not a surprise because technology stocks tend to dominate the IPO market generally. With $67.2 billion currently in SPACs targeting this sector, technology alone would have to be twice the 2019 IPO volume. However, there is also ample supply of technology firms that need cash and would love to go public. Therefore, we believe that many of the SPACs in this group will complete a merger, although we would not expect them to be successful in the aggregate over a longer period of time as many of the targets will not be too early stage and will have low survival rates as they are common in venture capital-backed firms.

Particularly excessive also seems the dollar amount looking for fintech targets. While we have no doubt that there will more companies like Coinbase that will try to enter the public markets at very high valuations, we doubt that there are enough to allow SPACs to put $15 billion cash to work. Healthcare, energy and sustainability are capital-intensive sectors where we believe that a few billion dollars can be invested without sponsors having to lower their standards and do bad deals for the sake of doing a deal.

What we find particularly striking is the small number of SPACs that target more traditional sectors such as finance (not fintech), mining and natural resources, consumer products and industrials (other than energy). Because of this scarcity, we believe that sponsors with expertise in these sectors should have an above-average likelihood of completing mergers that will turn out to be successful in the long run.

If Elon Musk had a SPAC for industrial and consumer products with a focus on the automotive industry we believe it could find a merger that could be successful long-term.

spacresearch.com as of April 23, 2021.
[ii] Jason Draho,, Barry McAlinden, Jay Lee, Vincent Amaru: “SPACs: Investment considerations.” UBS, October 2, 2020. The analysis is based on SPACs that had an IPO and completed a merger between January 2018 and June 2020.
[iii] Camelot calculations based on spactrack.net data as of 4/23/21.
[iv] Source: Factset.
[v] spactrack.net/home/spacstats/ as of 4/23/21.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016) and has earned the right to use the CFA designation.

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Disclosures:
•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
•       Camelot Portfolios, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Portfolios, LLC’s disclosure document, ADV Firm Brochure is available at www.camelotportfolios.com
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DEFINITIONS & DISCLOSURES: Inception of the Camelot Event-Driven Fund, Class A shares is November 21, 2003. U.S. DOMESTIC EQUITIES: Included in 2,075 funds in the the U.S. Equity category determined by Morningstar are: Large Value, Large Blend, Large Growth, Mid-Cap Value, Mid-Cap Blend, Mid-Cap Growth, Small Value, Small Blend, Small Growth, Leveraged Net Long. Correlation is a statistical measure of how two securities move in relation to each other as measured by the correlation coefficient, a statistic that ranges in value from -1 to +1, indicating a perfect negative correlation at -1, absence of correlation at zero, and perfect positive correlation at +1. The Morningstar Rating for funds, or “star rating”, is calculated for managed products (including mutual funds, variable annuity and variable life sub-accounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The Morningstar Rating does not include any adjustment for sales loads. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics.

Share Class Information:

Class A: Inception: 11/21/03 Net Expense*: 1.99% Gross Expense: 3.04%

Class I: Inception: 06/07/10 Net Expense*: 1.74% Gross Expense: 2.80%

*The Fund’s advisor has contractually agreed to waive fees and/or reimburse expenses of the Fund to the extent necessary to limit operating expenses. This contract expires on October 31, 2021.

RISK CONSIDERATIONS: You cannot invest directly in an index. Accordingly, performance results for investment indexes do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. The S&P 500 measures the performance of 500 widely held stocks in US equity market. Standard and Poor’s chooses member companies for the index based on market size, liquidity and industry group representation. Included are the stocks of industrial, financial, utility, and transportation companies. Since mid-1989, this composition has been more flexible and the number of issues in each sector has varied. It is market capitalization-weighted. We believe this measure is appropriate because the strategies focus the use of option writing premiums, dividend and interest to generate return. Indices are reported to give a point of comparison only. This fund is not necessarily appropriate for any particular client or investor. Accordingly, any reader of the attached description should not interpret the attached as investment advice. All investments bear a risk of loss, including the loss of principal that the investor should be prepared to bear.

The use of any chart or graph in the attached is not intended to be viewed as a singular aid in determining investment strategy. Such visual aids are instead intended as a complement to other data, and like such other data, should be considered in light of consultations with professional investment tax and legal advisors. Past performance may not be indicative of future results. No current or prospective client should assume that the future performance of any specific investment, investment strategy (including investments and/or investment strategies recommended by the adviser), or fund performance will be equal to past performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio.

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Mutual Fund investing involves risk. Such risks associated with the Camelot Event Driven Fund include but is not limited to Merger Arbitrage Risk, Capital Structure Arbitrage Risk, Distressed Securities Risk, Debt Instruments Risk, Interest Rate Risk, Structured Note Investment Risk, Proxy Fight Risk, Short Selling Risk, Management Risk, Foreign Securities Risk, Derivative Investments Risks (Including Futures, Options, and Swaps), Counter Party Risk, Special Situations Risk, Initial Public Offering (“IPO”) Risk, Liquidity Risk, Limited History of Operations Risk, and Portfolio Turn Over Risk.

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