Written by: Laura Stine
“Be unafraid to criticize those who reach for the lowest common denominator, and who sometimes succeed in finding it.” – Christopher Hitchens, Letters to a Young Contrarian
In the world of finance contrarians play a unique role, tempering speculation and exuberance with skepticism and doubt. Contrarian investing styles are often associated with hedge funds – privately managed investment vehicles that pool large amounts of capital and utilize complex, deep value trading instruments like short sales, derivatives, futures contracts and private equity to generate wealth for their clients.
Whereas most investors purchase securities in hope they rise in value, contrarian hedge funds more often try to capture profit from securities as they decline.
What is a short position?
The funds assume a “short” position by borrowing shares of a specific security they believe is overvalued and then selling those shares into the market with an obligation to repurchase and return them (referred to as “covering”) at some point in the future.
Hedge funds sometimes work together to short exorbitant amounts of shares of a single company, driving the stock’s value so low they force the company into bankruptcy. If this proves successful the shares of the bankrupt company become worthless and the fund does not have to return them to the lender, thus booking 100% gains on the transaction.
While a short position could technically remain open indefinitely, borrowers pay fees and interest on the loaned shares that can erode profitability, so there remains incentive to cover even as a stock continues to decline.
If the shares are repurchased at a lower price the fund profits off the difference in the spread. Conversely, if the stock rises in value the trade can result in exponentially larger losses, as the value of a security can theoretically rise indefinitely.
These high-risk investment strategies are generally utilized by hedge fund managers and professional investors, the so called “smart money” as they like to call themselves. Contrarian hedge funds also profiteer off “distressed debt” investing, generating significant returns from restructuring the debt loads of bankrupt and financially struggling companies.
Intro to corporate bonds
The most straightforward form of distressed debt investing is to directly purchase corporate debt through the bond market often at steep discounts to face value due to the high probability of default.
This strategy presumes either the bonds will increase in value if the distressed company recovers, or the bond holders will receive preferential claims to the corporation’s equity in bankruptcy court and will be able to recover all or most of their investment.
Hedge funds can also gain exposure to distressed debt by extending credit directly to a floundering entity, or by purchasing convertible notes that can be redeemed for a specified number of shares of common stock at some point in the future.
What is a direct lending agreement?
Direct lending agreements may also grant hedge funds access to governance boards and corporate officers to help them navigate the recovery, bankruptcy, or restructuring process.
Who is Jason Mudrick?
With a passion for contrarian investing, Jason Mudrick is a distressed debt specialist and founder of Mudrick Capital Management, a successful hedge fund with a reported $3.8 billion worth of assets under management.
After receiving a graduate degree from Harvard Law School, Jason cut his teeth on Wall Street during the dot-com crisis. He started his career at Merrill Lynch in the Mergers and Acquisitions department and then joined the firm Contrarian Capital Management in 2001 the day that Enron filed for bankruptcy.
Mudrick Capital Management
Jason left Contrarian in 2008 after Lehman Bros. filed for bankruptcy, forming Mudrick Capital Management to capitalize off the explosion of distressed debt during the great financial crisis.
During the course of his career the value of assets managed by hedge funds worldwide ballooned from about $200 billion in 2000 to over $3.8 trillion in 2020.
In a SALT podcast interview recorded in July 2020, Jason described witnessing the institutionalization of the industry as “a great time to be in the business.”
Mudrick made a name for himself in 2017 after joining investing legend Carl Icahn in making a notoriously contrarian bet against America’s brick-and-mortar shopping malls by shorting the CMBX.6 index and other distressed commercial real estate securities.
As shopping malls continued to lose market share to e-commerce giants, this proved be a highly profitable trade.
At the time opportunities in the distressed debt market were still limited as a recovering economy, low interest rates and a strong bull market had helped shore up corporate balance sheets. Corporations were also taking advantage of the cheap debt to grow their underlying businesses, and when COVID emerged during the beginning of 2020 many of these companies were severely overleveraged.
To a contrarian like Jason Mudrick, events like the COVID lockdowns present once in a lifetime investing opportunities. As pandemic fear spread across the globe, Mudrick wasted no time in scouting for potentially distressed targets as well as capitalizing off his existing investments, one of which happened to be a gold mine in northern Nevada.
Mudrick had purchased the Hycroft Gold Mine out of bankruptcy in 2015 and in the SALT podcast described the investment as “dead money for a long time – and then Covid happened.”
Foreseeing a spike in gold prices brought on by pandemic driven panic, Mudrick decided it was an opportune time to take Hycroft public. To further this end, Mudrick Capital just so happened to have on the books a blank check SPAC (special purpose acquisition corporation) that had gone public in 2018 under the ticker symbol MUDS with a stipulation that it must merge with a debt distressed target within 24-months or return the funds to investors.
In January 2020 – with the MUDS merger deadline just three weeks away – Mudrick’s SPAC announced it would be taking it’s very own Hycroft Gold Mine public, instantly enhancing the liquidity and worth of the two dormant holdings.
In discussing Hycroft’s merger in the podcast, Jason astutely notes: “investors in SPACs tend to not care about the companies that are merging.”
The deal was finalized in May 2020 and Hycroft shares began trading in June at just under $10. Jason claimed to be bullish on the mine during the podcast, stating “if we traded close to comps, it would be a $20-$30 stock” yet admitted the security was “very illiquid.”
Shares briefly spiked up to $16 after the merger and were trading around $10 before Hycroft announced an additional 8.3 million share capital raise that diluted the price by 16%. Hycroft’s share price continued to bleed throughout 2021 and was last trading in the $3 range, down 80% from their peak, as investors begin to question when and if the mine will ever turn a profit.
Despite what came to be for early investors in MUDS, the shotgun marriage between two of Mudrick’s biggest duds was certainly a win for the firm at the time.
Owning companies through loans
With new liquidity available from that and the small short continuing to be a profitable trade, Mudrick began looking for pandemic-related distressed
opportunities outside of his own firm.
On April 1, Bloomberg’s Bankruptcy Law reported that he had compiled a list of 100 “beaten-down distressed-debt targets” that the firm was eyeing up.
Bloomberg’s reporter noted, “His playbook is the same as always: buy up debt in the hope of taking control as the business fails to make debt payments and is forced to restructure its balance sheet. Mudrick, whose distressed-credit hedge fund returned 22% in 2019, said he hopes to make as many as 10 new investments in the coming weeks. ‘We want to own these businesses through the loans,’ he said. ‘If the market recovers, we’ll make some money and move on.’”
Jason went into much greater detail about this playbook during his SALT interview, discussing at length how the highly complex process works.
Ultimately the funds seek to take a controlling share of the company through debtor in possession loans and by taking advantage of loose covenants in restructuring agreements. “It is a very resource intense investment strategy…it’s very advantageous to get to 51% in a lot of these documents, which are very covenant lite…there is an optimal size where you have the resources, you can own enough of this stuff to drive the boat.”
It’s part of the playbook
In other words, Mudrick’s aim is to acquire a controlling stake in the company through loans, as opposed to owning a majority stake of the company’s stock.
In fact, diluting and depreciating the value of the stock is part of the playbook. Then they lead the company though bankruptcy proceedings, which can take years, and flip the company at the end of the process for an enormous profit. Jason also discusses the usefulness of SPACs in the relisting process on account of the regulatory hurdles facing initial public offerings (IPOs) since the great financial crisis.
“It’s hard to just re-list that company, which is what we used to do in ’01, ’08. You would take the company through bankruptcy, and just re-list it on the New York Stock Exchange. And liquidity would come back to the name, and you would exit. Today, the holding period is much longer.”
Mudrick and AMC Entertainment
One of the top targets on Mudrick’s list was AMC Entertainment Holdings Inc., a 100-year old business that had recently expanded to become the largest theatre company in the world. At the time AMC was controlled by Wanda Group, a Chinese conglomerate that had assumed a majority stake in the company prior to taking it public through an IPO in 2013.
In the years preceding the COVID lockdowns AMC was one of those businesses taking advantage of low interest loans and was rapidly expanding its operations, acquiring theatres throughout the globe. When lockdowns shuttered the entire industry overnight, debt heavy AMC started bleeding cash at an unsustainable pace. From Mudrick’s perspective is was an ideal candidate for a loan-to-own acquisition.
The playbook hedge funds use to drive companies into bankruptcy is relatively uniform and it almost always begins with capital infusions through high interest loans. In bankruptcy court debt holders always get paid before equity holders, so while investors in the stock of a struggling company may assume a total loss in the event of bankruptcy, lenders will most often recover their losses in equity.
Hedge funds usually position themselves to gain from the deal either way (hence the term hedge) by adding convertibility features to their notes so the fund can convert the debt into common stock in the event the business recovers.
The death spiral
But convertibility features can also be used to leverage a company into bankruptcy through a phenomenon called “death spiral financing” whereby lenders exercising share conversions drive down the price of the security through the dilution, then sell their stake, further exacerbating the price decline.
This value depreciation attracts short sellers who add even more selling pressure, causing long-term investors to cut their losses, and even further compounding the problem.
The hedge fund then steps in and offers more convertible loans, repeating the cycle until a company’s stock is rendered worthless. Investopedia.com makes a point to highlight that pretty much the only reason a company would issue convertible bonds is if they are in desperate need of cash to stay afloat.
“The only hope for the company to interrupt the death spiral is to improve its operational results. If it can effectively invest the proceeds of the convertible bond issue in its underlying business, it may be able to thwart the short sellers and even stick them with the losses.”
AMC Entertainment’s, Adam Aron
AMC’s CEO Adam Aron had taken the job in 2015 and enjoyed a few years of acquisitions and growth before the theatre business fell victim to the same slump as America’s shopping malls. Under Adam’s leadership AMC’s share price rose to a high of $35 in 2017 before taking a nosedive and closing the year down over 50%.
Bearish sentiment simultaneously took hold among analysts covering the entertainment industry, forecasting falling demand for the theatre experience as viewers opted for stay-at-home streaming services, and further discouraging new investors.
In January 2020 before COVID hit, AMC shares were trading in the $7 range and by the time the lockdowns took hold, shares had fallen to just $2, off 95% from previous highs. As the lockdowns stretched on Adam Aron was in a seemingly impossible bind: he was running out of cash and he was already leveraged to the gills, having already borrowed hundreds of millions of dollars from numerous stakeholders just to survive.
Adam meets Mudrick Capital
At the end of 2020 when Mudrick Capital approached Adam with a lifeline, he took it, borrowing $100 million in cash and entering into a complex debt restructuring agreement with the fund, ultimately refinancing $2.6 billion worth of AMC’s liabilities and providing enough liquidity for AMC to survive through 2021. Once the deal with Mudrick was made public, Adam Aron turned to AMC investors to assure them the bills would be paid and that a bankruptcy filing was, at least temporarily, off the table.
While presumably this all sounded good to shareholders, the unintended consequence of the debt restructuring was a credit downgrade by S&P Global and an onslaught of fear inducing headlines suggesting that AMC would never dig themselves out of the hole. As COVID spiked demand for in-home entertainment, the national narrative suggested that the 100-year old tradition of movie going may never be revived.
Mudrick backstabs AMC Entertainment
Adam did a share offering to raise capital, adding $125 million to the balance sheet in two months, but further diluting the share price. Then he was forced to borrow another $100 million from Mudrick, who exercised the conversion on the firm’s initial investment, granting the fund 13.7 million common shares of AMC that Mudrick turned around and sold.
At this point AMC’s finances were deeply entrenched in the gallows of the death spiral. Most CEO’s would have buckled under this kind of immense pressure, but Adam beat back. Certainly one motivating factor was to protect his own substantial investment in AMC stock that had been provided to him as part of his annual salary.
Until the theatres reopened and AMC could earn revenue there was nothing he could do but keep kicking the bankruptcy can down the road. Another 178 million AMC shares were sold off, this time raising $500 million as the share price crept lower and lower.
Share prices dipped below $2 as short sellers crowded into the trade and analysts continued to attack the company. And just when it looked like the hedge funds had won, an unforeseen group of investors showed up and disrupted the entire plan.
Short sellers have a major incentive to exit a trade early if it begins to go the wrong direction, as losses can be orders of magnitude larger than limited gains should the stock price suddenly go up. It is considered a very high risk investing strategy, and to limit loss exposure the brokerage firms handling these trades require traders to maintain cash collateral and lines of credit (more leverage) in a margin account, the amount varying depending on the fundamentals of the trade and the perceived risk to the brokerage.
When cash reserves fall short the accountholder receives a “margin call” requiring a deposit to meet the maintenance levels. If the accountholder cannot deliver the cash by the specified time the account can be subject to liquidation and realized losses can be significant.
Short trades in effect occur backwards – sell high, buy low being the winning strategy – and the shares must be purchased to close out the position. Should something unexpected cause a stock’s price to rise sharply, shorts will rush to exit the trade, further accelerating the price increase.
This triggers margin calls, which if left unmet trigger liquidations. Liquidations trigger more price volatility, as brokerages may close out both short and long positions to satisfy margin requirements, creating volatility throughout the whole market.
This effect is magnified considerably in securities with a high percentage of short interest and can culminate in a “short squeeze,” where a stock price soars to absurdly high levels for a matter of days before crashing back down again once short positions have all been covered.
Just as the potential demise of shopping malls and movie theatres presented opportunities to hedge funds, the possibility of initiating short squeezes presented opportunities to a very small group of investors participating in an online discussion forum on Reddit.
While screening struggling stocks for potential investments, the group noticed some unusual trading activity in a handful of heavily shorted holdings – most notably mall retailer GameStop – and also AMC Entertainment.
Reddit retail investors make a move
Speculation began to form around GameStop in particular, that large hedge funds had borrowed and sold short more shares than were available in the float (the sum of all shares in circulation) causing the price to be artificially depressed.
In theory this should not be possible as short sellers are not supposed to sell shares without legally borrowing them first, but every day unknown numbers of fraudulent shares, referred to as “naked shorts,” are sold into the markets in poorly regulated, illicit transactions between brokerage firms, market makers and clearing houses.
The beginning of the beginning
To Main Street traders GameStop had all the makings of a darling underdog, including relatively good fundamentals to support the underlying business. Plenty of Americans still enjoy the instant gratification of the brick-and-mortar shopping experience, and GameStop in particular had nurtured a generation of brand loyal gamers that (perhaps not coincidentally) have also embraced the emergence
of online stock and cryptocurrency trading platforms.
They genuinely liked the company and saw potential for it to thrive in a post-pandemic the future. Many of these investors had been adversely impacted by the great financial crisis of 2008 and they despised the thought of greedy hedge funds leveraging their favorite businesses into bankruptcy.
As time passed a promising thesis formed around the GameStop trade and they started buying up the stock. Others joined in, and slowly GameStop’s share price began to rise.
A movement is sparked
AMC quickly got swept up in the excitement and as more and more people started buying the stock it started rising too, putting short sellers (who had been patiently waiting for the bankruptcy proceedings to commence) on high alert. But they did not cover their positions. Adam Aron meanwhile took advantage of the stock’s valuation by issuing even more shares and was able to restructure AMC’s debt with better terms.
In a press release to investors dated January 25, he announced: “Today, the sun is shining on AMC. After securing more than $1 billion of cash between April and November of 2020, through equity and debt raises along with a modest amount of asset sales, we are proud to announce today that over the past six weeks AMC has raised an additional $917 million capital infusion to bolster and solidify our liquidity and financial position. This means that any talk of an imminent bankruptcy for AMC is completely off the table.”
Robinhood sparks outrage
At the end of January GameStop investors finally succeeded in initiating a short squeeze, causing shares to jump from their yearly low below $4 to a peak of $483 – a whopping 12,811% gain – and AMC enjoyed a nice bump up into the $20 range at the same time.
Both stocks appeared positioned to rise even higher the next day when suddenly Robinhood and a number of other online brokerage firms halted the buy side of the trade in these securities because they lacked the liquidity (and possibly the desire) to settle the transactions.
Share prices plummeted on the news and many retail investors found themselves on the wrong side of the trade with significant losses, otherwise known as “holding the bag.” The move was perceived by retail traders and market observers to be a significant screwing by the brokerages, hedge funds, market makers, and regulatory agencies alike.
Planet of the apes
It was around this sense of injustice that a much larger community of investors began to form, along with hope that those holding shares with large paper losses could potentially recover them in time. They did a lot of research and due diligence, concluding that most of the shorts had not covered their positions, but had increased them instead.
They began to unearth a treasure trove of instances of market manipulation, collusion and illegal trading activity, all while they were being mocked by the press and frowned upon by Wall Street pundits.
It became clear that the institutionalization of hedge funds over the past two decades had allowed these entities to further their own self-interests at the expense of not just retail traders, but pension funds, corporations, communities, and working-class people throughout the country.
Examples of such activity were too many to count. When the dust settled after the thwarted squeeze, Bloomberg reported that Mudrick capital had booked over $200 million in gains from debt and derivative holdings in AMC, including $50 million from the sale of out-of-the-money $40 call options on AMC and some additional call options on GameStop.
What are out-of-the money calls?
Out-of-the-money calls are risky bets where the buyer pays a premium for the right to purchase shares of a security on a future date at a set price (the strike) above where the stock is currently trading. If on that date the share price exceeds the strike price on the call, the purchaser can cash out and collect the shares or sell the contract and bank the profits.
The $40 calls that Mudrick was selling presumably seemed like a safe bet to capitalize off the volatility, as even in the best of times AMC stock had never reached such lofty valuations.
Mudrick and naked calls
It was also reported by Bloomberg News Network that prior to the price jump Mudrick had already sold the 21.7 million AMC common shares the firm had acquired through the debt restructuring (8 million from the initial deal, followed by another 13.7 million shares from the second convertible bond) at $3-4. By selling those shares into weakness, Mudrick missed out on the potential for 1000% gains in those shares in the run up from $2 to $20.
This also meant the options Mudrick sold were “naked calls,” meaning the seller does not own the shares of the underlying security and if they exercised he would have to repurchase those shares at significantly higher prices (unlike naked shorts, naked calls are perfectly legal, albeit extremely risky). Mudrick obviously did not think they would exercise, or he would never have sold $50 million worth of them.
Despite the reports that Mudrick had cashed out the fund’s AMC shares near all-time lows and placed a large bearish bet against the stock price rising in the future, financial news outlets were quick to admire his profits and quoted him as saying: “The market did not believe AMC would be able to get through the downturn – we did.”
A new force to be reckoned with
Ironically, Mudrick may very well have saved AMC from bankruptcy, but it was retail traders who would go on to save AMC from him. In the weeks and months that followed, enthusiasm for GameStop and AMC spread across social media and investors in these stocks became a force to be reckoned with.
They rebranded themselves as neither bulls nor bears, but “apes” and spammed the internet with video clips, charts, news and humorous memes regarding their two favorite holdings. By the end of May both stocks were on the move again, and AMC especially was on a tear.
Apes had spent the month renting billboards, flying banners behind airplanes and building connections that spanned the depths of race, politics, nationality and economic status to rally around a common goal. For some of the apes, sharing their love for AMC and GameStop while exposing the inner workings of a corrupt financial market had become a full-time job.
Mudrick continues to stab retail investors
And with this backdrop in mind, Mudrick was fixing to lose a lot of money on those $40 calls he had sold back in January. The last day of trading in May was the Friday before Memorial Day weekend, and AMC shares had climbed all the way to $36.72 during intraday trading and then fell dramatically to close at $26.12, still up over 200% for the week.
The apes were on fire, and while they were celebrating the holiday with their families, Mudrick spent the weekend negotiating the purchase of another 8.5 million AMC shares from Adam Aron, who was quietly arranging an additional 11.5 million share offering for the following week in his quest to shore up AMC’s finances.
Mudrick agreed to purchase the 8.5 million shares over the weekend for $27.12 each, a dollar premium above Friday’s closing price, adding another $230.5 million to AMC’s balance sheet. When the market opened on June 1 following the three-day weekend, Mudrick sold all 8.5 million shares before news of the deal even broke, instantly netting a few million dollars in cash for the firm and temporarily stalling the morning price rally.
Most investors learned about the transaction from a widely circulated Bloomberg article that claimed Mudrick had sold the shares because they were “overvalued.” AMC also released a statement about the deal that contained a similar warning to investors regarding the stock’s valuation. Regarding the highly unusual nature of the move, Bloomberg’s reporters noted:
“Raising cash through an equity sale to a single holder is relatively rare in U.S. markets. Having the holder flip the stock right after buying it is almost unheard of – usually the buyer is an existing stakeholder trying to send a message of stability to the market.”
About the only logical explanation is that Mudrick was desperately trying to keep AMC’s share price below the $40 strike on his outstanding calls (also known as market manipulation).
Market manipulation goes unnoticed
Nonetheless the message of instability was totally ignored. AMC’s share price dipped briefly on the news midday and then soared up another 23% to close at $32.04.
Given an 8.5 million share dilution was met by such a steep rise in price (when the exact opposite should have happened) this would have been the best time for Mudrick to exit the trade, albeit at a very significant loss.
Mudrick instead kept the calls overnight, perhaps hoping AMC’s upcoming share offering would drive the price down later in the week, but that did not happen. The following day the stock blew past $40 in a matter of hours, triggering a gamma squeeze that sent the share price soaring over 100% in one trading session.
Mudrick reportedly closed out the firm’s entire position in AMC that day of both debt and derivative holdings which further accelerated the upward price movement.
Mudrick loses hundreds of millions
Over a week later the Wall Street Journal reported that his flagship $3.8 billion fund had shed 10% as AMC’s soaring stock price cratered their “complex trading strategy” and Mudrick had lost hundreds of millions of dollars betting against AMC.
WSJ reporters described Mudrick Capital as “the latest hedge fund to fall victim to swarming day traders,” as though a contrarian who managed to lose that much money betting against a business he claimed to believe in was a victim of anything short of his own foolish agenda.
Over 4 million individual investors from around the globe now own shares in AMC, controlling more than 80% of the stock’s total float. There are still unknown numbers of naked and synthetic shares in circulation, unknown numbers of shares traded back and forth between high frequency algorithms, and massive amounts of shares trading hands in off-shore exchanges, literally called “dark pools.”
There remains a huge volume of open short interest in both AMC and GameStop, with short sellers down billions of dollars on their positions. For months now the media has been trying to foster a narrative to squash the momentum, and none of it seems to be working. The apes are still buying and holding, and the shorts are still digging their holes even deeper.
There are not a lot of rules in the game, and few people around to enforce them. But thankfully in dealing with people like Mudrick: there’s always karma.
Thank you Laura
From Frank Nez
Laura Stine is an off-the-grid retail investor who has been involved in numerous projects in efforts to fight corruption. She makes time to write when injustice demands it and has long been an advocate in Alaska against sled dog abuse and government corruption.
I want to personally thank Laura for this amazing publication. This article will be archived in what seems to be a historic moment in time.
Laura will be writing for Franknez.com from time to time. You will know if an article is written by Laura because the publication will say it was written by her and it will contain her image.
No, I am not letting my foot off the gas pedal. I figured this is a great way to provide even more value to the community. Be sure to share this article and welcome Laura in the comment section below! You can follow Laura on Twitter here. 🤝✨