Strategic Capital Management Write-Up

Josh Brodsky, Daniel Coltun, Joe Damisch, Alex Pochodylo, George Tsarwhas, and Cara Weingartner Case 4 – Strategic Capital Management April 13, 2015 1. What are the costs/benefits of investing in a hedge fund? Investing in a hedge fund can be very beneficial to investors. Using a hedge fund, they can pool their investment, cutting out transaction costs and allowing for more diversification through a very large portfolio. In addition, the managers of this fund are normally very intelligent investors who normally have a significant amount of experience in the industry. Finally, as many hedge funds include a strong investment from their principal partners, the fact that these organizations tend to be limited liability partnerships protects these partners from litigation should the fund severely underperform. Hedge fund investing also includes various costs. Most investors are institutional or are principal partners, so retail investors have limited access. Invested capital tends to have low liquidity, and investors are normally charged a high level of fees. There is also limited information available to investors, as the hedge fund wants to keep its competitive strategy a secret. This is can be very risky for investors. 2. What is the current stock market valuation of Creative Computers and of Ubid based on the stock prices as of December 9? Evaluate these valuations with respect to the assets associated with these firms. The current stock market valuation of Ubid is roughly $326,541,000. Creative Computers has a market valuation that is actually less than Ubid and less than Creative Computers’ ownership of Ubid (~$261,233,000) and is roughly $232,930,000. Ubid’s market valuation creates a goodwill account that is about 98% of its total assets, and Creative Computers has an investment in Ubid that makes up 56% of its total assets. This makes Ubid detrimentally risky to its equity holders (there’s nothing to liquidate to pay them if Ubid goes into bankruptcy) and puts Creative Computers in a position that is highly dependent on Ubid’s performance. 3. What should Elena do? Buy Creative Computers? Buy Ubid? Buy both Creative Computers and Ubid? Is there some other investment strategy involving Creative Computers and Ubid that you would suggest? We think Elena should not purchase Ubid or Creative Computers. Due to the fundamental risk of arbitrage, we think that we should stay away from purchasing Creative Computers and shorting Ubid, as the mispricing may exist or worsen longer than the hedge fund can remain solvent. We also wouldn’t want to purchase either stock, as Ubid’s stock is likely to crash when the mispricing corrects itself. In addition, Ubid has still not proven positive earnings and could eventually default on their loans. The fact that it “book-value-wise” has a negative stockholder’s equity value means that if Ubid does default, their equity holders would receive no compensation. Creative Computers owns a significant portion of Ubid’s equity and holds a market capitalization that is actually lower than its market value investment in Ubid. This could cause solvency problems for Creative Computers as well. We would suggest that Elena buy convertible debt in Creative Computers because of a small downside and a potentially huge upside. She would get an extremely high interest fee because convertible debt is lower in the capital structure and Creative Computers has a very high default risk premium (it is an

internet startup with risky investments). She would also have the opportunity to convert the debt to equity at a set price if the company does very well. Two general scenarios could happen: Ubid fails within the next few months, and Creative Computers is extremely negatively affected. Creative Computers is heavily invested in Ubid (has more of an investment in Ubid than its own market capitalization). Because Creative Computers possesses a good amount of assets, there is more collateral available from Creative Computers to help get new loans if the company is reorganized or to pay back holders if it is liquidated, while Ubid does not have nearly any assets to even pay back all of the debtholders, much less keep any value for the equity holders. If Ubid continues to produce negative earnings and default on its loans, it will probably have to liquidate its assets because it hasn’t proven its business model, and it probably won’t ever reach profitability. This could then could hurt Creative Computer’s stockholder’s equity value. If Creative Computers then breaches covenants due to a failure of its major investment, it will be forced to satisfy its debt holders. Because Creative Computers has numerous successful business lines, the restructuring would probably be a reorganization (Chapter 11). If Elena takes convertible debt and the company is able to pay off all of the senior debtholders and then can pay her, they will. If they can’t pay her, then she would take control of the company (which has been very successful in other core businesses) and equity holders will lose all value. If they can’t pay all of the senior holders, that holder would take control. In this case, her debt would either move up a few tranches (giving her higher priority on future restructurings) or she gets a new debt contract with more of a premium on the interest rate and principal payment or both. Ubid thrives and Creative Computers makes a ton of money on its investment. Ubid does very well and begins to make a profit. Creative Computers makes a ton of money on the sale of Ubid shares to its own shareholders (even if it’s at a slight discount). Elena will then have the option to convert her debt holding to an equity holding in Creative Computers at the agreed upon strike price and could take part in Ubid’s and Creative Computers’ massive mutual upside.

4. What could (potentially) go wrong with your suggested strategy? If higher priority (senior) debtholders or Elena take control of Creative Computers, Creative Computers could go bankrupt and be forced to liquidate without enough of a liquidation value for Elena to break even. Another possible consequence is if Elena converts the debt into equity and then CC fails while Strategic Capital Management is holding the equity. The hedge fund could then lose a significant amount of its investment.