Q:  Would you provide a brief historical overview of the fund? A : The Pennsylvania Avenue Event-Driven Fund was launched in November 2003. The fund focuses on event-driven investment strategies which are typical for hedge funds as opposed to mutual funds. We are the first ever mutual funds to be in the event-driven category. We use a number of alternative strategies, primarily merger arbitrage, some distressed securities investing, and proxy fight investments. Q:  Would you explain the significance of the word “event-driven?” A : An event-driven fund exploits how publicly-announced corporate events influence stock prices in predictable short-term ways. Event-driven refers to corporate events such as reorganizations, mergers, or bankruptcies. In this strategy, we are investing across all market capitalizations in any sector in these specific corporate events. Event-driven investing is fundamentally different from other more traditional strategies that make investment decisions based on more classic metrics such as financial ratios or growth prospects. Q:  What is your investment philosophy? A : The underlying philosophy of the fund is to try to take advantage of situations like mergers or bankruptcies that are not very well understood by the market because the company is at the end of its life cycle. The basic philosophy is that we are dealing in an area that not everybody likes to participate in or understand as well as we can, which gives us an edge over other people and works to our advantage by generating better returns for us. Most investors look for companies with a long and prosperous future; we look at companies that will soon cease to exist and that everybody else wants to get out of. Q:  How does your investment philosophy translate into an investment strategy? A : The fund normally invests at least 80% of assets in the securities of companies which are undergoing a corporate “event” such as merger arbitrage, capital structure arbitrage, and distressed securities investments. It invests in the securities of companies of any size and uses derivatives both as a substitute for investing in the underlying securities, as well as for hedging purposes. We also invest in companies that outsiders seek to gain control of and then sell at a premium, typically because they think the stock is undervalued. Specifically, the fund focuses on four strategies. The first strategy is the merger arbitrage. In this strategy, the fund invests in the securities of companies subject to publicly announced mergers, takeovers, tender offers, and other corporate reorganizations. The second strategy is the capital structure arbitrage. In this strategy, the fund invests in different securities issued by the same issuer whose different securities are mispriced relative to each other. This could be A and B class shares of a company, or two classes of preferred stock. The third strategy is the distressed securities investments. In this strategy, the fund invests in distressed securities, which are securities of companies who are in or near bankruptcy or whose securities are otherwise undergoing extreme financial situations that put the continuation of the issuer as a going concern at risk. The fourth strategy is the proxy fight investments. In this strategy, the fund invests in securities of companies which are subject to a proxy fight over control over the company. Typically an activist wants to gain control of a firm with a view to selling it. I view this as an early stage merger arbitrage strategy. Q:  What metrics drive your selection of deals for this investment strategy? A : The fund will invest in securities of companies involved in mergers, takeovers, tender offers, leveraged buyouts, spin-offs, liquidations, or similar events ("corporate reorganizations"). After the announcement of such a reorganization, securities of the target typically trade at less than the full value implied by the transaction. This discount reflects uncertainty about the completion of the reorganization and its timing, as well as selling pressure from long-term investors who liquidate their holdings. A variety of strategies can be employed to take advantage of this discount. For example, in a leveraged buy-out shares are exchanged for cash, and prior to the closing the shares of the target company trade for less than the cash amount offered by the acquirer. Similarly, if a proposed transaction involves the exchange of stock, the fund typically would buy the stock of a merger target and sell short the shares of the acquiring company. This will lock in the difference in the valuation. Upon successful completion of the merger, the shares purchased will be exchanged for the shares sold short, thereby terminating the investment. If proceeds from the short sale exceed the cost of the purchase, the fund will realize a gain. Many companies issue different types of securities in addition to equity securities, and sometimes issue different types of equity securities. Capital structure arbitrage involves investing in two different types of securities issued by the same company if they are mispriced relative to each other. Typically, one of these securities is purchased, while the other is sold short. For example, the fund might purchase one class of common stock, while selling short a different class of common stock of the same issuer. It is expected that, over time, the relative mispricing of the securities will disappear, at which point the investment will be liquidated. In the meantime, while the fund holds the investment, the simultaneous purchase and short sale employed in this strategy seeks to reduce the effect of large movements of the issuer's stock. This year we have seen a pick up is corporate bankruptcies and there are now more opportunitities in distressed securities than a couple of years ago. What we are looking at in distressed securities are investments that have potential for a double-digit return. We are buying distressed bonds at a discount to what we think the recovery value is going to be once a company emerges from bankruptcy. And we are trying to buy these bonds at levels so that we can get a double-digit annualized return between the purchase date and the anticipated emergence from bankruptcy. Usually we hold them for anywhere from six months to two years. Examples of other companies that we were targeting are SPACs, special purpose acquisition companies that were set up between 2005 and 2007 that raised a large amount of money and promised their shareholders that they would use that money to buy other companies. SPACs only had a two or three-year life span and if they didn't find the target company within three years, they had to return their cash to their shareholders. We were able to buy SPACs at good discounts to their liquidation value. In 2008 as no more deals got on, many SPACs had to wind down. At the same time many hedge funds that owned these SPACs. When hedge funds received redemption requests from their investors they had to sell those SPACs. There are very few natural buyers of SPACs and we were able to buy some SPACs at very steep discounts to cash knowing that within a few months we would get our cash back. Those were very attractive situations in late 2008, early 2009. Unfortunately, these opportunities have largely disappeared after March 2009. Right now the spreads are no longer very attractive. So we no longer establish new SPAC positions. Q:  Would you illustrate with an example the advantage of investing in bankrupt companies? A : In bankruptcy we rarely ever buy equity, we normally buy the debt. There is a natural mismatch in bankruptcies because debt holders who are normally in the business of owning debt to get an income suddenly find themselves owning bonds that no longer pay interest and will be exchanged for equity. But owning that type of debt is not very attractive for a typical bond investor many of whom can only invest in quality investment grade bonds. There is a very limited market of buyers to buy defaulted bonds and that's what allows us to buy the debt at a discount to what we think the recovery value is going to be once the company emerges from bankruptcy. For example, General Growth Properties, Inc. is a publicly traded real estate investment trust that owns and operates regional shopping malls across the United States. They declared bankruptcy earlier this year, not because they are bankrupt operationally but because they had to pay back some debt - some of their bonds came due. And of course at that time the credit markets were locked. They were unable to raise new debt to pay back the old debt, even though they would have been able to pay the interest. At the same time, they just didn't have enough cash to pay back all the maturing debt. So, the only thing they could do is file for bankruptcy. However, the company is profitable. It does generate cash. It has enough cash to pay its interest. It just doesn't have enough cash to pay back all those loans all at once. Currently, the company is still in bankruptcy with the bonds somewhere around 80% of face value. And we expect to get full recovery on those bonds. General Growth's bankruptcy is probably going to last another year or so. And this is actually a situation where there might even be some recovery for the equity holders. But at this point, we don't have any equity, only bonds. Q:  What is your research process? A : For distressed securities the research process is similar to traditional equity research in that we are trying to figure out what the enterprise value is. And therefore, what the likely recovery is going to be on the bonds. The process becomes more complicated in the merger arbitrage and the capital structure arbitrage space because there we are really looking at other types of information than the usual financial metrics. We are looking at the likelihood of the deal going through. Other factors that we focus on are who the buyer is, do they have sufficient financing to do the deal, or are they likely to be able to issue equity to do the deal. We also look into considerations like the company may have to pay back some debt, there may be some change of control clauses in the debt or will they be able to refinance that debt? Is the shareholder vote likely to support the deal? And most importantly, what is the timeline going to be? There could be antitrust issues. We prefer situations where we don't have antitrust problems. Those are all factors that are very much different from the typical equity analysis. The research process for capital structure arbitrage is somewhere in between the distressed investing and the merger arbitrage processes, in that we are trying to understand where in the capital structure the investment is. And capital structure arbitrage research is also similar to equity research in that we are trying to understand where that mispricing comes from: is it event-driven or is there some other factor. Very often capital structure arbitrage deals with a mean reversion process. There could be a variety of factors that we look at for these investments. For instance, the fund invested in a Citigorup capital structure arbitrage during the first half of the year. Citigroup's preferred stock was converted into common stock. The fund sold short Citigroup common stock while acquiring a preferred that was going to be converted. A large spread between that price at which the preferred was trading and the value of the conversion persisted for a surprisingly long period of time. This was caused partly by the difficulty and cost of borrowing Citigroup stock to establish the short leg of the position. The conversion was completed in the second half of the year at the end of July, at which time we realized the spread that we had locked in earlier in the year. Q:  What happens when your expectations don't work out? A : Fortunately that does not happen too often because statistically, 90% to 95% of all mergers go through. But when they don't then we are usually sitting on a big loss. And then it is a question of trying to time the loss and to get out at some point where maybe there is going to be some recovery. We have found that it often pays to hold positions after a merger has collapsed because what happens is that there are lots of arbitrages and everybody is selling at the same time. There is no hope of selling quickly anywhere near the purchase price. We are likely to get a big loss right away. We have found that we have to wait for a few weeks possibly, hold positions for a few more months and usually that's when prices recover and we can cut the loss. The other advantage is occasionally after one deal has collapsed there might be another buyout that emerges. Moreover, if we are holding a stock a little bit longer we have some probability of being part of the next deal. So, the merger process could be extended even though the first deal collapses. 3Com is the example of a deal where the initial merger collapsed but another buyer emerged later. Q:  How do you do your portfolio construction? A : We are holding around 50 positions in the portfolio. Our investment horizon is anywhere from a few weeks to a couple of years. Currently, there are relatively few mergers, so we have somewhat small allocations to merger arbitrage and that means roughly 50%. We are getting more and more into distressed securities. The portfolio allocation is driven first by deal flow and second by the state of the economy. The two are closely correlated. In other words, allocation is driven to a large extent by what's going on externally rather than factors that we have influence over. Selling is one of the most difficult challenges for portfolio managers. The nice thing about event-driven investing is that selling is often automatic. In merger arbitrage the „sale” is automatic because as soon as the transaction closes, the investor is cashed out and doesn't own the stock anymore. So we do not have to worry about the behavioral biases that affect selling of positions. Similarly, in distressed the trigger for the sale is when the company emerges from bankruptcy. That makes a nice and relatively easy sell discipline because we don't have to pull the trigger; somebody else does it for us. Q:  What kinds of risk do you like to control and what steps do you take to achieve that? A : Risk is somewhat difficult in an event-driven fund to manage. The principal risk is deal risk, which is an event risk. And that is something we cannot hedge easily. You can not hedge against events. The only effective way to manage event risk is by diversification. So, we are trying to be in a large number of deals. We never have a position that gets so big that we cannot use more than a percent or two if it doesn't work out. The basic idea is that no collapse of a deal can hurt the portfolio severely. Q:  Are there certain industries or sectors that you specifically avoid based on your experience and metrics? A : First of all, for the vast majority we are only doing U.S deals. We rarely get involved in international deals. Secondly, in U.S. based deals we tend to stay away from any thing that has antitrust risk. We think that tactically at the moment there are two big areas of distressed - financial and automobile – that should be avoided for the most part. We stay away from automobile because we think that there are too many other things going on in the automobile sector like political demands, foreign competition and labor union costs and a number of other issues. With regards to the financial sector there are very few hard assets. Moreover, it's very difficult to evaluate a financial firm. So, in the bankruptcy situation it's better to stay clear of those. Lehman is probably one of the few exceptions that I would make to that rule.