- September 7, 2010
Bill Ackman is buying BP CDS
William (Bill) Ackman of Pershing Square Capital Management LP recently sent out their 2010 Q2 financial performance letter updating investors on the firm’s changes in investments and its current stable of holdings. Besides some of the changes in its portfolio such as the divestiture of YUM Brands and the addition of commercial mortgage debt tied to Peter Cooper Village/Stuyvesant Town in New York City, Mr. Ackman also announced his investment (or ‘attack’ as the NY Post put it) in British Petroleum credit default swaps.
Here is the excerpt from the actual Pershing Square investment letter (that has been made available thanks to DealBreaker) outlining their investment in BP CDS. Bloomberg added in its story that BP CDS rose 631 basis points and priced in almost 40% probability of default on June 16 from 42 basis points the day before the rig explosion, and have currently declined to 255 basis points “after BP sealed the well that spewed an estimated 4.9 million barrels of crude into the Gulf of Mexico.”
“Historically, we have purchased single-name CDS on companies where we believe the credit markets have an overstated perception of the credit quality of an issuer, or where we believe event risk has been mispriced by the CDS market. Our investment in BP CDS fits this paradigm.
In early May, we initiated a short position in BP credit through the purchase of credit default swaps. We began purchasing BP CDS at spreads of 60 basis points per annum and continued to buy protection at levels which brought our average cost to approximately 280 basis points per annum. Current BP CDS trades at approximately 250 basis points per annum and has traded as wide as 600 basis points per annum over the last few months.
Our investment thesis is predicated on our belief that the Gulf disaster has (1) likely permanently impaired the ability of BP to operate effectively in the US, (2) the clean-up costs, penalties, and legal liabilities of the spill will continue to impair the company’s credit for many years, and (3) there is a substantially greater probability than is reflected in the pricing of the CDS that the current liability estimates that have been publicly promulgated materially underestimate the ultimate costs to BP.
While it is unclear at this time whether or not our investment in BP CDS will prove profitable – because the legal liabilities will take substantial time to be adjudicated, the clean up costs are still unknown, and the amount of penalties have not been determined – we believe our investment in BP CDS is attractive – that is, at the price paid we believe we have a disproportionate opportunity for profit compared with the risk of loss. Because of the size of this investment – the annual cost of carry of this investment is a fraction of one percent per annum – our risk is minimal, while the opportunity for gain is many multiples of our commitment.
In the case of BP, we believe it is unlikely that credit spreads will return to the pre-crises levels for many years, if ever. As such, our downside risk should be limited. On the other hand, if BP is found to be grossly negligent, the Government imposes the contractual penalties required in a case where a driller is found grossly negligent, and clean up costs continue to rise along with the substantial legal and other contingent liabilities, this investment has the potential to be quite profitable.”