Unapologetically Canadian Episode 10: Alternative Investing with Bradley Semmelhaack

This week, I’m publishing my interview with Brad Semmelhack, a portfolio manager with Crystalline Management, an alternative investment house in Montreal. Crystalline celebrates 20 years of existence this month. Congratulations, Mark, Brad and the team.

Brad and I spoke in a room at the top of a tower on Sherbrooke Street looking out over the city. It was stunningly beautiful.

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A transcript of our conversation follows, but if, like me, you want to brush up on some finance industry basics first, check out investment basics from the Financial Consumer Agency, the pdf “Investment at a glance” from the Canadian Securities Administrators and the Bank of Canada’s portrait of hedge funds in Canada.

Here’s the transcript:

[00:01:25] Thank you Tracey. Yeah, Crystalline. We’re actually celebrating our 20th year and it was founded by my partner and CEO Marc Amirault who had worked for 15 years at the Caisse de dépôt et placement du Québec and decided to take the strategy that he was implementing at the Caisse to a smaller business to fulfill a dream if you will and to be able to have more flexibility and do his own thing really and be independent.

Brad’s Career

[00:02:00] I come from a background where my dad started on the floor of the Montreal exchange in 1955. I joined him in 1994 after having planted trees for six years and then was hired ten years later when Mark was able to he actually got tired of having me call him about 10 or 15 times a day with an idea and thought it’d be much simpler if I just turned around and given the ideas that I had to pick up the phone.

[00:02:27] So anyway that’s sort of how I got here. I started covering my dad’s clients in 94 and then when these hedge fund things started becoming more prevalent, as a salesman I decided to go with the new thing whereas all the other salesmen decided to stick with the old stuff and when I started pulling in some decent numbers, heads started turning and I was able to capitalize on the positioning I’d had made in the innovative fashion but ultimately got got picked up and moved from what we call the sell side, which is the brokers, to the buy side, which is the money managers and I’ve been here for 14 years now and will be celebrating as I said 20 years of Lane in September we have our party. So that’s a little bit of how I got here.

[00:03:18] Wow. And when you say innovative I don’t know what. So tell me what kinds of innovations are.

[00:03:26] Well it was I mean hedge funds were trying to innovate in general.

Money Management Styles

[00:03:34] The traditional money management is what we call a long only. You go and you invest in an instrument of public debt or equity. And if it goes up you mark your wealth up and if it goes down well you mark your wealth down and then it depends on where you sell if you crystallize that profit or loss.

[00:04:05] What we what we do here is more we call it arbitrage and the irony of all this is when I was doing finance at McGill there was a professor who said ‘arbitrage, there is no arbitrage. There is no free lunch you never find this.”

[00:04:25] And I always wanted to go back and tell and well you know what I’ve been doing arbitration for 14 years. And in fact, it does exist and I think with the prevalence of high-frequency trading, which is pure pure arbitrage, there are ways of–it’s not really riskless it’s never a riskless profit–but certainly you can hedge out or you can…

[00:04:51] Really what it is a different silo of risk where you’re using different instruments and the relative legal attachment that each one has to that designate how one is priced relative to the other. And in that way, you can pull out inefficiencies in the market between different all the different actors in capital markets because each one works in a different silo typically and don’t always look at these relationships.

[00:05:28] So if you can straddle all the different players, you can often you can often eek out a small profit from inefficiencies and people say oh wow you’re you’re you’re strategies are so complex and it’s so complicated and I just don’t understand the math and I fire back ‘you know these people who do long only, they typically research companies for a month or two or three or years before investing and then they have to follow those companies on a day-to-day basis. The news, what’s going on what’s going on in the industry what’s going on in the economy, who the actors are in capital markets, what the Mr. Market thinks. You know.

[00:06:14] I just look at relative pricing. Really it’s a mathematical equation really understood understanding in a very detailed fashion the relationship between different instruments in the capital structure of a company and that is available in capital markets where, whether it be options or we don’t do futures, but options or bonds or convertible bonds or equities or preference shares.

[00:06:44] So you try and tie all those things together whereas in general all those different instruments are only looked at by people only looking at that one piece of the capital structure.

[00:07:00] So you’re actually doing entire groups of investments in order to take advantage of all that. Is that what you mean?

[00:07:06] Yeah you pair off or sometimes in one case we have 12 lines on one company. So you have the convertible bond, you’re long on the convertible bond and then you’re short a whole series of calls and then you’re short the equity. In another case, I’m long one bond short another bond and along the equity. You know in some cases, I’ll just do the preferreds. I’ve done one preferred against another that’s a little bit more common. One bond against another. There are quite a few people doing that. That’s more or more typical but I won’t go sort of like a long short fund would be long one bank versus the other thinking that one bank is going to outperform the other somehow. We don’t…there’s no real attachment there and legal attachment whereas, in the case of a convertible bond or a warrant or an option, there’s a legal attachment between the two. In the case of merger arbitrage there is a legally binding deal between two parties that, should it be consumed based on certain criteria, one security will become the other or cash.

Risk

[00:08:16] So that’s the other type of that’s the other type of I mean there’s always where when I said before, there’s always risk while the risk there is that the is consumed as we saw in the case of AECON last month I believe.

[00:08:30] You know the Canadian Government did not allow a Chinese entity to take over a Canadian engineering firm so that there was the risk there.

[00:08:40] In other cases, it can be as simple as just this morning Superior Propane bought the assets of a US company that had propane distribution and the result of that was that that company was able to redeem their bonds. So now I took the position that that transaction was going to be consumed so I bought the bonds that the company had suggested maybe repurchased should the transaction be consumed.

[00:09:15] Okay so that when they were reported…

[00:09:18] Yeah. So once the deal is consumed, they go and then they officially make the announcement.

[00:09:25] So what have really what it really boils down to is the different investment vehicles land you in different risk buckets so that’s when typically money managers talk about a split. They talk of a 65 35 stock-bond split and then within the stocks you have big cap, small cap, foreign holdings, etc.

[00:09:49] We’re a different risk bucket, so we allow investors that choose to invest with us a third alternative which is a further diversification out of that bond stock typical you know very tried and true if you would that’s been around forever the versification mix. You can broaden that out and in certain cases they broaden it out very wide into different buckets and there’s private equity and there are infrastructure and real estate commodities and then you can different plan sponsors break those out in different ways but basically we fall the we fall sometimes in the bond allocation sometimes in the alternative allocation sometimes in the hedge fund allocation but our clients typically you know they have they have and they have an allocation for that allows for they have a mandate to diversify their investments in order to try and control the chance of loss of capital.

Who are your clients?

[00:11:08] Well we have we have mom and pops and we have retirees and we have big pension funds. It goes across the gamut just people that want to diversify outside or within depending on your philosophy that that mix depend just depending on how they want to allocate to their asset mix what asset mix they determine and how they how they want to implement it.

[00:11:37] So at some places, you’re it to creating a kind of a new movement in a different kind of investing.

[00:11:43] Yeah I mean and alternatives you know it’s it’s it’s not really new. Keeping up with the Joneses from the 50s is actually Jones had a hedge fund.

[00:11:51] Oh really. I didn’t know that.

[00:11:54] And he wasn’t even the first hedge fund. The term hedge fund is a misnomer really because a lot of people don’t do any hedging. It simply usually falls under a different rule that allows people to invest.

[00:12:16] So you have certain rules that you invest that anyone can invest and hedge funds are somewhat more restricted in who can invest and what those vehicles and the rules under which those vehicles exist. So that the rules are both very onerous and are very well-defined but are just not the same. There are very similar rules for the most part.

[00:12:44] And then when it gets into the fine print in the details, the rules are not quite the same.

[00:12:50] So we fall under the private placement rules and so our potential investors are more restricted whereas say a mutual fund or anything that’s on the listed stock market it falls under the anyone can invest in them. And there are just two different sets of rules they fall under two different sections of the investment acts and the and the regulations.

Typical Day

[00:13:16] Okay. And so in terms of a typical day when I arrived, I was kind of surprised you have six screens in front of you. Pretty much everybody in the place has six screens in front of them. What does a typical day look like? Other than, when I arrived there were only two screens of the six that were on.  [Note: my photo belies my words, as all 6 screens are clearly on.]

[00:13:39] I might have been to just come back and get a coffee. But yeah I know all six. Typically I mean I try and put different things on different screens but often I might have a spreadsheet that takes up even more than all of the six screens.

[00:13:54] So, is it all math? What do you as a person.

What do you actually do?

[00:14:01] Math is a model. But you need to read a lot of an awful lot of text before you can before you can see how to put into mathematical into a mathematical model or programming language what that those documents what that reading is telling you. Like I was going through the the the indentures which are hundreds of pages long to try and figure out how to model the Superior Propane and New Alta how to model how the what math to use to figure out how much I can pay for those bonds. And you got you’ve got an awful lot of text to go through to try and figure out what numbers to put where. And then once you figure that out, then you can put the numbers in. But I had discussions with three different dealers who give me three different interpretations of those documents and it was up to me to finally read them and decide how I was going to interpret it. And when you when you actually walked in I was trying to get the person on the phone who could answer that question at the company because the company put out a press release that said we will call them in the normal course according to the indenture period. And the indenture being 150 pages long and cross-referencing between six different sections and subsections and sub-articles and definitions and preambles and supplemental indentures and revisions. It got rather complicated rather quickly.

[00:15:33] So like many jobs, you turned into a detective.

[00:15:35] That’s a good way of putting it. You really have to be a detective because there are a lot of things that companies can say and a lot of things companies cannot say. And you have to do a whole lot of a whole lot of thinking and a whole lot of deductive use a whole lot of detective work to find the information and then a whole lot of reasoning to come to a likely set of outcomes and the likelihood each of them is going to come to pass and then making a decision as to whether you can live with the possibilities for the different outcomes.

[00:16:17] Wow OK. That’s a cool way of putting it. Anything else about your day that you want to describe?

[00:16:25] Well first thing first is that you always come in and have a great big cup of coffee.

[00:16:30] The coffee machine here is good I suppose.

[00:16:33] We actually have five of them. Very important to have coffee.

How many employees do you have?

[00:16:40] We started Mark started alone and then he hired one more and one more and then we were after that we were four and then six and then we got up to with interns about 20 and now we are 16 and we’ll probably end up around 18 by the end of the year. That is kind of the vision for now. Plus or minus maybe some part-time or interns or what have you. But yeah I mean there’s everything a big part of any organization is compliance. You know there’s maybe five or six people who are actual full-time job is investing and then five actually right now and then everybody else–the other 11–do accounting, compliance, sales marketing and what have you.

[00:17:40] So it’s it’s really it’s really a big process to keep to keep track of all this and then that’s not to that’s not even to mention all the people in prime brokerage and all the dealers who call me all day long and then all our suppliers in terms of lawyers and accountants consultants and you know then all the

Regulatory Oversight

You know there’s got to be five or six different regulators that oversee us between people who are looking for tax evaders in the United States, terrorists who are trying and trying to hide their money in different places, etc. The AMF we’re trying to make sure that we do things according to the rules the RCMP are making sure that we’re not that there are no fraudsters.

[00:18:29] You know we get an awful lot of people. I’m often told. Hey, you hedge funds you’re not you’re not regulated. Nobody oversees you and I’m like OK how many times you’ve been audited in the last 20 years? And they’ll say oh I don’t know auditors by the AMF. Well, maybe once or twice and I’ll say they typically come in here every four years. And the last time they spent three weeks, four of them.

[00:18:48] So wow. So please don’t tell me that I am not regulated because they went through every single piece of paper we had with a fine tooth comb and they made sure that everything was was on the level and copacetic and cross-referenced.

What do you want people to know about the financial industry and how it works?

[00:19:18] Well I mean.

[00:19:19] This is a Canadian company. It’s you know it’s in the middle of Montreal but you work internationally.

[00:19:28] Yeah we invest in. We specialize. We initially specialized in Canadian arbitrage when we started out with one point five million dollars and then pretty much when we hit 50 we had to start looking outside of Canada because you really want to take the very best ideas. We don’t you know we don’t have to invest in anything. There are no constraints really. We can take. We like to be able to take really the cream creme de la creme the very top easiest fruit we can take. It takes you know maybe a little more time to research but they really have a strong conviction about even though there may be 500 positions in the portfolio, you know like I said there can be 12 positions that makeup one strategy or investment in one more pointed idea really. So you have to have a pretty broad universe to go and find those ideas and then and then be able to follow them and have public information and so on. It’s really yeah so past 50 till now, there’s a little more in the US and we broadened bit by bit what we do in each of those markets.

[00:20:58] So that now there’s probably you know maybe 20 sub-strategies I think we have that are defined in three large silos of fixed income arbitrage, merger arbitrage and convertible arbitrage. I don’t know if I answered your question.

[00:21:20] No you didn’t. Good.

[00:21:21] Good aside you explain to me how your work within the financial industry but you didn’t tell me what you want people to know about that.

[00:21:29] OK so yeah I mean I think I mentioned before that you know hedge funds are regulated just like everybody else.

[00:21:38] And in my in my estimation, more so but I think my many of my competitors would disagree. Everybody is overseen. Everybody has a different spin on how they’re doing things and you know for that for the hugest part everybody is really trying to do their best and offer something that is in the best interest of the clients. But everybody is doing a jaw. It’s like it’s like going into it it’s like going into any store and buying anything. I mean you go into a food store and the greengrocer does not want you to get sick on his cabbages.

[00:22:22] But you know sometimes cabbages get in there that might be a little bit rotten.

[00:22:26] And he didn’t see it or you know maybe he’s got a bad cabbage and he paid for them and he’s got to get rid of them.

[00:22:35] He knows they’re going to be bad in a week. So he puts them in the front to try and get rid of those ones first. But really the freshest ones are at the bottom or if you go into a depanneur or you know the freshest milk is in the back and the less fresh milk is in the front. I mean is that unethical?

[00:22:53] You know I’m trying to find an anecdote to you know people do act in the best interest, but at the end of the day no matter how many consultants and advisers and everything you’ve got to you’ve got to be able to have a good gut feel about who you are who you’re dealing with and check them out.

[00:23:15] I mean you know there are you’ve got you got to make sure you feel comfortable because you know it’s really hard to stay away from it’s usually no. It’s usually pretty easy to stay away from the Earl Joneses and the Madoff’s but they do creep in there every once in a while. But it’s more ending up with someone who you feel uncomfortable dealing with and you’re not quite sure who is who interests there are there where the balance is sitting on their best interest and just being comfortable with the service you’re getting. I mean you know it always comes down to a buyer beware. Never forget that no matter how many consultants and lawyers and accountants and everything.

[00:24:08] It’s almost like if you ask for too much advice someone is going to say no to something. So you know at the end of the day it’s going to be you.

[00:24:16] So you have to have you do have to put on your thinking cap when you’re choosing the right adviser or the right investment.

[00:24:24] And and and make sure you are comfortable at all times and as time goes on.

[00:24:34] I mean a good anecdote is my life partner who I think it took me it took about four people we had to go through before we finally found someone that she liked dealing with. And they’re all doing a good job there all honest. Know most of them are banks and banks have about the biggest compliance departments in the world. And she you know but it took it took three or four different advisers until she finally found somebody with whom she was comfortable and I’ve recommended you know I’d try and help out friends who ask and I know often give them three or four or five different choices and they’ll choose the person with whom they feel the most comfortable.

[00:25:13] And you know once you’ve gone through are they registered and you know are they offering me a product that I that from my best gut makes sense to me and a good plan that that is going to meet my financial goals. You know after that do I actually like sitting down and discussing investments with the person and they seem to be listening to me and do they seem to be acting in my best in my in my self-interest while still carrying on their business. And you know there better not be too much of a conflict of interest there how do you feel about that.

[00:25:49] And you know read about conflict of interest and read about how much they’re being paid.

[00:25:55] I mean everybody gets paid. You know lawyers get paid up to a thousand dollars an hour you never think twice. Doctors get paid huge amounts. You don’t think of how much you’re paying your accountant or many advisers. You know in the finance industry we do get paid and it’s not. It is becoming much much more transparent as time goes on.

[00:26:15] But there is a lot of work that goes on behind it. And you know somebody has to pay for all that compliance and all that oversight. And unfortunately, like most industries, it comes out of the user and that is all part and package of investing in public investments.

[00:26:33] Do you go private.

[00:26:35] No you can always invest in your own company but then you’re you’re open to the sharks and there’s no one overseeing it.

[00:26:43] The public markets are overseen by so many different people and you know there is a premium to pay for that and it all comes out in the wash but in that you have a much better feeling than you can go to bed at night knowing that you’ve excluded ninety-nine point nine nine nine nine nine you know six sigma of the of the bad folks.

[00:27:12] It’s interesting that it sort of reminds me of the thing we’re learning about social media which is that if you’re not paying for something if you’re not paying for a product then you are the product so basically you have to have to keep in mind when you’re doing financial purchases as well.

[00:27:28] You know when I whenever I talk to someone whenever we have a company and whenever I look at an investment the first thing I have to consider is OK

The person giving me this information, where do they benefit from this?

What is their stake in this and what outcome is best for them? Who has control over this outcome and what’s the best outcome for them. And how much control do they have on making that outcome happen?

[00:27:59] And that’s usually that’s usually the best path towards the most likely outcome no matter how difficult it is to get to that outcome or how unlikely it might seem. That’s usually what comes about.

[00:28:16] That’s an awesome answer. It’s a philosophical answer too that it fits into many things, not just finances.

[00:28:22] Well it’s just you know it’s amazing that you know the people who control the company if they have a lot of stock that stock that company is not going bankrupt. If they have no stock, the company is likely to go bankrupt. If they own bonds, that portion of the capital structure will be protected. If there’s a bank in there, and the bank owns management, well the bank’s going to be protected.

[00:28:59] And anything is possible. And you know even with all the regulatory oversight, it’s very often there are fait accomplit that happens and then once you’re put into that situation, it doesn’t really matter what came before, there’s a new reality and that’s the new reality.

[00:29:19] A good example was in the case of Bell Canada when they were supposed to be taken over. Way back over 10 years ago. That was a case that went all the way to the Supreme Court where the bondholders had been assured with personal knowledge personally in their offices staring in the eyes from the management of the company that the company would never ever do anything that would that would risk their investment grade credit. And that’s why it was not necessary to put into writing and legal form protections against a leveraged buyout that would that would compromise the value of those bonds.

[00:30:01] And it went all the way to the Supreme Court that the company was allowed to go against the word that they gave. It went back and forth.

[00:30:09] That was it was that was the so-so verbal contracts no longer exist at least not, in that case, one or even written contracts today can go against Oh no no.

[00:30:21] If any legal laws. I mean we had a bankruptcy where we had to go to court and prove that there was a there where the bank was going to charge for a loan for a loan in bankruptcy too much.

[00:30:40] And the judge had approved that because it was a very big company within a very tight spot.

[00:30:48] And that was the only option for the company was to accept the terms of that loan and we had to really do an awful lot of legal work in that court to have that amount reduced. Wow.

[00:31:05] And it was it was like the judge said yes this loan is too expensive but I’m going to accept it because that’s the company’s the money tomorrow morning if not it stops the company from operating.

[00:31:19] And that is you know that is often an overriding principle. And.

[00:31:25] OK. So whether that company that is very much like bankruptcy law or whether they were in bankruptcy.

[00:31:31] And yeah you have to you know a lot of a lot is often said about capital markets and you know investors want this and investors want that.

[00:31:39] But in Canada the responsibility of the people running the company which is ultimately the directors who are who are responsible. Their responsibility is to the corporation and its stakeholders and in the law, that is often applied as being very much including suppliers and employees and the business and the I mean the whole point to law is to allow businesses to continue. So it makes sense that when something comes before a court that the overriding philosophy of a judge should be how is this going to continue? How is this process going to end so that it has the best outcome for the Canadian economy and that is the judges really go to a lot of trouble to try and see through what all the lawyers are trying to do because the lawyers are just acting and you know they’re trying to prove their case and that’s their job too. And then the judge has to really cut through that and understand all what the lawyers were telling them over the days and days and days that they have to listen to all this and then you know give a judgment on how you know what the best outcome is for all the parties concerned depending on what all the promises that were made before each of them.

[00:33:02] Right. So that’s for Canada as a whole which leads to my last question is about you personally as well. I like how you go into the philosophy world away from getting on you know who you are. And your last question is

Do you consider yourself a Canadian and if so why?

[00:33:22] Yeah I mean I do consider myself a Canadian even though you know you don’t go back too far to find when I when my grandparents and great grandparents immigrated to this country.

[00:33:37] But you know the why.

[00:33:45] I just feel that I I try and you know you I don’t know if it’s I act on how I think it is to be Canadian or I think I’m just part of a mosaic of what it is to be Canadian and I think in Canada more of a mosaic. But I think people here are pretty happy and you know try and do things that they can have their life, liberty and pursuit happiness but without really impeding on anybody else’s.

[00:34:18] And if anything I think we’re very much Canadian as Canadians and every Canadian you know really think several times before acting so that everything we do does not only does not hurt anybody else but things that we do are not only in our self-interest but enhance the people around us and that we try and make that as broad as possible.

[00:34:48] Even at my high school is their motto what they try and what they try and teach their students is to be a man for others. And you know with boys-only school so far. But you know I think that to a great extent to some extent is is what it is to be Canadian. Not only living for me but also you know how my life positively impacts others.

[00:35:17] I think it’s is it Winston Churchill that said you as you take your life that you made you make your life with what you give for others or something like that. Anyway that might be British but anyway I certainly think it applies to Canadians and I identify with that and try and carry that out.

[00:35:37] So it’s not you know it’s not just giving money it’s how you act. Every single day.

[00:35:42] I remember a company that came in here that wanted to build a gold mine and he was like I’m like Oh how. What’s going to happen when you say drained. What do you mean draining like all the lakes above the mine are going to be drained lake or what do you do with all the fish.

[00:35:53] And like oh we don’t care about the fish. I’m like well what about the environmental protection. We can get all those permits is not a problem we’re just going to drain those and you know whatever happens the fish, they can take care of themselves like well I’m not investing your company. Thank you very much. Goodbye. I’m a fisherman and my dad’s a fisherman and everybody I know is a fisherman and you’re not just going to drain those lakes and let all those fish die. Give me a break. Get out of here. You’ve gotta have a better plan than that.

[00:36:22] Well you could have left Canada if you had wanted to. So you had opportunities to go pretty much anywhere.

[00:36:28] Well yeah but you know I was sitting around one of our favourite tables and actually there was one of my interns had come from Latvia it was and I was trying to I was asking around you know where should where should he go and work. Shouldn’t he go to China or should he go and work in Europe or should he go back to his own you know where he comes from. And and and the people I was talking to were like well know the best place for him. What is a better country than Canada to live in? Where can you possibly have so much freedom, so much safety, so much access to health care and education and safety really, have a say in your what goes down in the laws and with happens with the government and opportunity in terms of what to do with your life you know where to go to school, what you can take and then what you can then do with that education and how you can act on an everyday basis. And you know Montreal with its festivals and its diverse mosaic of people and restaurants and things to do and green spaces…I lived in the States for two years and I loved it. I just it was it was it was a cultural shock more so than I expected. There were different ways I could have stayed there. It played out that it was easier actually for me to come back. I’ve been to Europe a few times. I have a few people that have been there. I’ve considered going there a few times but I always end up being happy to be here. So, for now, I’m going to be here I’d like to do some more travelling if I can get myself away from my six screens that each seemed to have six tentacles that hold on to me.

[00:38:21] The right. That was a great conversation. I appreciate it. Thanks very much.