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VARENNE CAPITAL PARTNERS

Investment Management Commentary

(January – December 2019)

March 15th, 2020

INTRODUCTION

Varenne Capital’s investment objective is to deliver superior long-term returns while taking the

minimum necessary risk.

We strive to achieve this goal by combining complementary investment frameworks – Long

Equity, Short Equity, Merger Arbitrage and Tail Risk Hedging – into a single strategy and by relying

exclusively on proprietary research.

Each framework is the result of years of research and development and comprises original

methodologies, formalized processes, a dedicated team of specialized analysts and bespoke information

systems.

By reading this document, we hope you will be convinced that, throughout the cycle, our approach

translates into a superior value proposition when compared to traditional long/short or long only

investing.

GENERAL PRINCIPLES

We believe in two basic principles: solving equations differently and adding value. Everything we

build stems from this and, as far as investment management goes, translates into the following:

Solving equations differently

- We combine investment strategies into a “structure” because it:

o is synergistic: Long Equity drives returns throughout the cycle, Short Equity adds

idiosyncratic performance, Merger Arbitrage reduces correlation to equity market indexes

and contributes to funding Tail Risk Hedging;

o copes with changing market and economic conditions in an adaptive portfolio;

o allows each team to focus on the most favorable opportunities available and relieves them of

the pressure to be “in play” all the time;

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o efficiently employs investment vehicles’ balance sheets. While we typically do not resort to

significant leverage on Long Equity and Short Equity combined, we benefit from it to fund

short term Merger Arbitrage trades and Tail Risk Hedging;

o optimizes risk profiles.

- We separate risks from opportunities and deal with them independently.

o On opportunities:

▪ Long Equity: most of the long-term returns come from the quality of the businesses

that we select in this pocket of the portfolio and the price that we pay for them. We

will always try to maximize our Long Equity allocation.

▪ Short Equity: short equity should be idiosyncratic and is meant to generate

performance - hedging longs with shorts is at best a very costly proposition leading to

sub-par long term returns.

▪ Merger Arbitrage: much like an insurance business, we underwrite risk only if we are

adequately compensated and are perfectly happy to stay on the sidelines when our

conditions are not met - typically at times of low volatility and strong equity market

performance.

o On risk and hedging:

▪ Market risk: equity market corrections and bear markets are natural events and should

be seen as opportunities for both longs and shorts. In our opinion, an investor is better

off accepting market risk within those boundaries and only hedging the residual risk.

▪ Hedging: residual market risk and its root causes can be hedged efficiently through

asymmetric risk/reward instruments or trades. Hedging more than that subtracts

performance disproportionately and deprives investors of long-term returns.

Adding value

- Research: we believe in 100% proprietary research. We follow a strict “brokers are not welcome”

policy and never employ sell-side research.

- Process: for each of the frameworks, our teams add value through proprietary research and a five-

step process encompassing universe reduction, idea generation, first-hand analysis, systematic

portfolio construction and direct market execution.

o Universe reduction: it pays dividends to define safer investment sub-universes where the odds

are in the investor’s favor and focus can be put on the best available opportunities. For

instance, we limit our Merger Arbitrage activity to announced and friendly deals in order to

maximize our team’s hit rate.

o Idea generation: we do not believe that receiving the 23rd call of the day from a sales-person

pitching the same idea adds any value. We generate original investment ideas internally

through our databases, scoring systems and screenings that cover more than 60 countries.

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o Analysis: first-hand analysis adds value when formalized within a sound investment

methodology. The latter ensures recurrence. For each of the frameworks, we have developed

specific investment principles and proprietary analytical tools to best implement them.

o Portfolio construction: systematic, rule-based, portfolio construction adds value as it forces

the teams to formalize decision metrics and to focus on the best available opportunities. It

also keeps emotions out of the equation.

o Execution: direct market execution reduces costs and enables best execution. No research

costs or any other commissions are borne by the investment vehicles.

- Information systems: bespoke information systems are essential at each step of the process as they

allow us to manage huge volumes of information and orientate each team’s priorities. We have

invested heavily in this area and continue to do so.

None of the above would mean much, though, without a great and talented team. At Varenne, we

are fortunate to rely on a highly competent, energetic and committed group of people. We made the

choice early on to specialize our teams by investment framework, Long Equity and Short Equity being

two different teams is probably the best example of this approach.

CAPABILITIES

We operate several investment frameworks within the Long Equity, Short Equity, Merger

Arbitrage and Tail Risk Hedging space. We refer internally to those as “capabilities”:

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Long Equity and Short Equity teams can express their views through individual stock selection

or purpose-built baskets based on fundamental and behavioral factors with the aim of optimizing the risk-

return profile of the portfolio.

Each book is independent with exposures determined by a rule-based portfolio construction

model comparing key investment merit metrics. The aim of the model is to maximize long-term returns,

reduce correlation to equity market indexes and to adapt portfolio composition to changing market and

macroeconomic conditions.

Unlike “pure player” single strategy funds, our approach allows investment teams to focus

exclusively on the most favorable opportunities and relieves them of the obligation to deploy capital

when they do not find ideas that meet or exceed our risk-reward criteria – we are happy to stay on the

side-lines on one or more of the frameworks when we believe that to be the most sensible decision.

In the following commentary, we will touch on the philosophy of each of the frameworks and

review their contribution for the year. But before we do that, an important update on ESG and

Responsible Investment progress at Varenne Capital Partners.

ESG AND RESPONSIBLE INVESTMENT

Over the years we have increasingly taken into account Environmental, Social and Governance

criteria in our investment activity.

What started as a somewhat informal set of responsible investment values got more explicit over

time and we are pleased to report that Varenne Capital Partners has now formally incorporated ESG

criteria in the due diligence processes carried out by our Enterprise Picking team. ESG analysis is now

an integral part of any business review and conclusions on more than forty scored criteria are discussed

within the Investment Committee prior to any investment.

Furthermore, we have formalized our Responsible Investment Policy and are proud of having

become a signatory of the United Nations Principles for Responsible Investment (UNPRI) protocol.

We consider these steps to be only the beginning of a long-term journey leading to contribute to

sustainability, human dignity and, in general, a higher degree of corporate social responsibility and

citizenship for both the businesses we invest in and our firm.

At Varenne, we want people to see themselves not only as market agents but also, and more

importantly, as proactive agents of change.

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CONTRIBUTION PER INVESTMENT STRATEGY

While we are certainly pleased with the performance for the year under review, we believe that it

is best read in conjunction with that of the previous one:

In fact, the combination of the resilience of 2018 and the satisfactory returns of 2019 are a perfect

example of the asymmetry in risk-return that we aim to achieve for the investors through our multi-layer

construction.

Focusing on the five quarters including Q4 2018, the variable geometry of our approach is easily

observable in the investment frameworks’ rotating ranking and contribution:

AIFs (non-UCITS) Funds – Value Active Fund

UCITS Funds – Varenne Valeur

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Now moving to the figures for the year:

Long Equity proved to be the largest contributor for the year under review. The Value Active Fund

and Varenne Selection – AIFs (i.e. non-UCITS) vehicles – benefited from the concentration on our best

ideas and from exposures that stayed constantly at around 100% of NAV.

The Value Active Fund took advantage of higher weighting on the best performing positions and

of better operating terms given its physical Prime Brokerage agreements and offshore set-up. Varenne

Selection has progressively caught-up during the year thanks to a great deal of operational improvement

delivered by the team.

With six “large spectrum” ISDA agreements now in place, ICE clearing and enhanced funding and

revised collateral terms, we expect Varenne Selection to behave very closely to The Value Active Fund

in the future and fully play its role as its pari-passu, onshore equivalent.

Short Equity and Tail Risk Hedging, which were our best performing strategies in Q4 2018,

contributed negatively in 2019 and were both significantly impacted by the undifferentiated rallies that

took place at the beginning and the end of the year. The Tail Risk Hedging’s book entered 2019 with

relatively high mark-to-market valuations which acted as a drag on the performance and added to the

consumption of its annual budget. As should be expected, the situation fully reversed at the end of the

year.

Finally, another year of positive risk-adjusted returns for our Merger Arbitrage strategy, albeit

on lower average exposure – more in the dedicated section further in the letter.

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LONG EQUITY

Philosophy

The Long Equity team applies private equity techniques to build a core concentrated portfolio of

high-quality businesses whose stocks, at the time of buying, trade at a significant discount to our estimate

of economic value.

After applying granular universe reduction, based on GICS sub-industry classifications, to exclude

highly cyclical or financial businesses, the origination team performs weekly fundamental and behavioral

screenings on proprietary databases and scoring systems in over 60 markets.

The goal is to search global developed and “emerged” geographies for highly cash generative

businesses boasting sustainable competitive advantage, superior management teams, autonomous value

creation dynamics and, whenever possible, positive net financial positions.

The analysis team takes the lead from origination and deploys a filter step aiming at quickly

discarding most of the ideas to focus only on a promising few. Only when a lead appears to be interesting

does a full-fledged due diligence process begin. The team combines conceptual, high-level analysis with

field investigation. This risk, business, financial and industrial analysis includes several company

interactions. While no use of sell-side research is made, the team is typically reinforced by the interaction

with at least two industry experts providing valuable advice.

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Upon finalization of all of the due diligence modules, the team determines an Intrinsic Value

Estimate (“IVE”) and assigns an Economic Quality Rating (“EQR”) to the business under review, based

on our proprietary scale illustrated below.

The portfolio construction model draws on both sets of metrics to determine the optimal portfolio

composition from all possible combinations of the available watch-list components. Most of the core

concentrated Long Equity book belongs to what we refer to as the industrial portfolio – stakes in highly

cash-generative businesses with good to excellent economic quality. Some noteworthy exceptions are

turnaround situations or sum-of-the-parts investments which typically have lesser weights and a shorter

life span.

Traditionally, we make use of this annual letter to review the positions that have made a significant

contribution to the latest annual performance.

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Main contributors in 2019

The main contributors in the Long Equity book have been the following: Greggs

(GB00B63QSB39), LVMH (FR0000121014), Sesa (IT0004729759), Accenture (IE00B4BNMY34) and

Givaudan (CH0010645932). Below are the top ten per fund.

We will discuss some of these investment cases in the following pages.

GREGGS (ISIN: GB00B63QSB39 – United Kingdom)

With a share price increase of 81.52%, Greggs represented by far the largest contributor to portfolio

performance in 2019 for our non-UCITS funds.

Source: Bloomberg – Data as at 14 January 2020

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We disclosed in our 2017 letter that we took advantage of the combined falls in the UK stock

market indexes and in the Pound Sterling that followed the Brexit referendum to initiate a position in

Greggs, the largest specialty take-away and “food-on-the-go” chain in the UK.

Since opening its first bakery in 1951, Greggs has steadily grown to employ more than 23,000

associates in approximately 2,050 retail outlets at the end of 2019. The business is unique in that it is not

only a retailer, but also an integrated producer thanks to its network of highly automated factories,

positioned throughout the UK, allowing Greggs to produce and retail food at lower unitary cost than its

competitors.

Furthermore, Greggs’ own supply chain and logistics management allows for maximum efficiency

and real-time response to what its shops and customers demand without compromising on quality. The

ability to produce in bulk and then distribute fresh products with high granularity to its points of sale

adds significantly to Greggs’ costing power.

The business is led by CEO Roger Whiteside and a team of very experienced executives. Mr.

Whiteside has a decades-long track record of success in food distribution as the Director of Marks and

Spencer’s Food Division, and as CEO at both Thresher Group and Punch Taverns where he successfully

engineered a text-book turnaround. He is also the founder of online supermarket Ocado.

Since assuming the role of CEO in 2013, Mr. Whiteside has accelerated Greggs’ transformation

from a traditional bakery model, many of whose products would be consumed in the home, to a “food-

on-the-go” specialty chain with meals primarily taken away or available for in-store consumption.

Everything from manufacturing, logistics, information systems, product development and shop

estate has been repositioned accordingly. As an example, the management team renewed Greggs’

traditional product range to include hot drinks, breakfast deals, hot meals, and more up-market options

such as burritos and high-quality coffee and expanded trading hours to fit with the new offering.

A healthy food range was added with the aim of increasing the company’s share in the food-on-

the-go market and to ensure that Greggs maintains a universal appeal.

The highlight for 2018, the launch of the first vegan sausage roll available on the market, was

followed by an extension of the range in 2019. A success from both a technical and marketing standpoint,

the vegan sausage roll was an instant hit and – along with an increased healthy and vegan-friendly

offering – has propelled Greggs’ comparable sales to an impressive +9.2% for the full year 2019.

Under Whiteside’s leadership, Greggs has continued to plan for the future by making significant

investments in its systems, industrial processes and refurbishing its shops. A factor in our choice to

initiate a position in 2016 was a major £100 million investment program, announced in March 2016.

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Source: Greggs (Presentation of 2016 interim results and 2017 half-year results) & Varenne Capital Partners

The plan is now coming to an end and has allowed Greggs to streamline and expand its

manufacturing processes and supply chain – thus removing in advance any potential barriers to the

company’s future expansion. Greggs’ 13 production plants have made way for 8 fully automated

manufacturing sites thus facilitating an accelerated multi-year expansion plan potentially leading to 3,000

points of sales.

At the start of 2020, Greggs introduced its next strategic roadmap: “Next Generation Greggs”. This

plan lays out ambitious targets for 2023 and beyond with a new emphasis placed on customer loyalty.

Stores will be “multi-format”, allowing customers to shop in a variety of different ways including

customized “click and collect” services and in-store digital touch pad ordering, alongside a newly

introduced exclusive delivery partnership with Just Eat. What’s more the company aims to reinforce its

CRM capabilities through its Greggs Rewards program in order to boost and sustain customer loyalty.

With momentum sustained in the first nine weeks of 2020 – +7.5% in like-for-like sales – cash

generation at an all-time high of £169.5 million and no financial debt on their balance sheet in 2019, the

company paid dividends totalling £72.6 million (£37.3 million ordinary plus £35.3 million special) and

£7 million one-off “thank you” payment to employees.

At the beginning of March, Greggs’ management team also announced it would declare a special

dividend for 2020 in line with that of 2019 (i.e. c. £35 million).

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LVMH (ISIN: FR0000121014 – France)

Once again, LVMH was one of the main contributors to our portfolio returns. Posting organic

revenue growth of 10% and a record operating profit from recurring operations of more than €11.5

billion, a 15% growth, the world leader in luxury goods continues to demonstrate solid growth across all

regions.

Source: Bloomberg – Data as at end 2019

With dominant positions in high-end wines and spirits (Cognac and Champagne), fashion and

leather goods (Louis Vuitton, Fendi, Loro Piana, Céline, Kenzo), perfumes and cosmetics (Dior,

Guerlain, Givenchy), watches and jewelry (Bvlgari, Tag Heuer, Hublot, Chaumet), as well as selective

retail (Sephora, DFS, Le Bon Marché), the company truly embodies the concept of pricing power.

Moreover, the management team around CEO Bernard Arnault is extremely competent on all

levels. We feel privileged to regularly exchange with LVMH teams. Rarely have we been able to invest

in companies whose human and financial resources and strategy can compare to those of LVMH in its

ability to combine long-term vision with exceptional results.

In addition to this, unlike other more cyclical players in the luxury goods space, LVMH has

repeatedly demonstrated resilience to economic slowdowns thanks to its geographic diversification and

business units such as perfumes and cosmetics distribution, which are typically less affected by business

cycles.

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While all segments of the company performed extremely well throughout 2019 and in all

geographies (USA +6%, Japan +8%, Asia ex-Japan +14% and Europe +11%), a highlight of this past

year was most certainly the acquisition by LVMH of Tiffany & Co., the iconic US jeweler. The deal was

announced in November 2019, approved early 2020 and closing is expected mid-2020. We feel that both

the business opportunities and the financing of this deal are compelling.

LVMH is to acquire Tiffany for an enterprise value of $16.9 billion and has raised €7.5 billion in

euro-denominated bonds and £1.55 billion in sterling-denominated bonds, over a range of maturities

from 2 to 11 years, to help finance this purchase. Interestingly, two out of the five euro-denominated

tranches were placed at negative yields, meaning investors would effectively pay LVMH to borrow

money. Even the longest maturity, an 11-year euro tranche, has a yield of just 0.43%.

We see great potential for LVMH to create long-lasting value at Tiffany. Today, the vast majority

of Tiffany’s sales are done through a directly-operated network of 321 stores (online sales represent c.

7% of sales and a smaller share is allocated to wholesale) and are mainly generated in the US and Asia

(especially Japan).

The integration of Tiffany will undeniably increase the weight of the under-represented Watch and

Jewelry segment (from 9% to 16% of total LVMH group sales) simultaneously increasing LVMH’s

market share in the fine jewelry market, while also broadening the group’s reach in the US and China.

On the other hand, if Bulgari’s acquisition is any indication of LVMH’s ability, the value creation

opportunities for Tiffany are significant. In fact, in the nine years since it acquired Bulgari, LVMH has

doubled sales and multiplied operating profits by five.

LVMH’s management intend to follow a similar roadmap by taking measures to control and protect

the brand – e.g. avoiding product discounting and reposition Tiffany’s core as a high-end luxury product.

Furthermore, we see major opportunities to expand the existing collections into adjacent categories such

as accessories. Finally, there is ample opportunity to expand the brand’s geographical reach, notably in

Asia and Europe (only 11% of sales).

Following the successful launch of Fenty Beauty, a make-up brand for women of all skin tones

developed with singer Rihanna, partnerships and collaborations have also been an area of focus for

LVMH in 2019.

The company expanded the original partnership with Rihanna to create Fenty Maison, a ready-

to-wear label designed for a young and diverse customer base adding clothing, shoes and accessories to

the original cosmetics range.

Similarly, in 2019 LVMH and Stella McCartney partnered to promote environmentally

responsible fashion. Ms. McCartney will also act as advisor to Mr. Arnault and the LVMH Executive

Committee to develop the group’s long-term commitment to sustainable development. Fitting with the

recent trend towards ethical and responsible luxury fashion, LVMH continues to innovate in the industry

and bring in new revenue streams through its various endeavors.

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NOVO NORDISK (ISIN: DK0060534915 – Denmark)

With a share price increase of 29.79%, another significant contributor to the portfolios’

performance in 2019 was Novo Nordisk.

Source: Bloomberg – Data as at end 2019

A Danish pharmaceutical company, Novo Nordisk is the largest global producer of insulin, the

main treatment for diabetes - a condition sadly affecting over 463 million people worldwide and forecast

to reach 700 million in 2045.

Novo Nordisk boasts a 28% share in the global diabetes market with 30 million patients around the

world using its diabetes care drugs. The company is the global leader in the insulin market with 45%

volume market share. The company also enjoys leading positions in the treatment of obesity (55% value

market share), growth deficiencies, menopausal conditions and hemophilia (a congenital coagulation

disorder). Novo Nordisk employs over 43,000 staff, sells its products in 170 countries and has R&D

centers in China, Denmark, India, the UK and the US.

With outstanding financials, including ROE of over 70%, Novo Nordisk matches all of the

investment criteria we require for longs, including very strong cash-flow generation enabling ambitious

R&D plans (c.12% of sales are reinvested in R&D) while returning cash to shareholders through massive

buyback programs.

Novo Nordisk has a history of being at the forefront of innovation and, as R&D milestones and

news-flow demonstrated, 2019 was no exception.

Two landmarks were reached in 2019. The first was Ozempic® (injectable Semaglutide) achieving

blockbuster status in record time – $1 billion in sales in the first nine months of 2019 – and the second

was the approval of the oral version of the same molecule, Rybelsus®.

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Given the efficacy of Semaglutide as a molecule, its high cardiovascular risk reduction in Type 2

diabetics as well as the convenience of tablets over injections, oral Semaglutide (Rybelsus®) has the

potential to become a game changer in the treatment of diabetes and a blockbuster for Novo Nordisk in

the coming years.

Source: Novo Nordisk – Q4 2019 Roadshow Presentation

Looking ahead, the company continues to rely on a strong pipeline of innovation, most notably in

obesity treatments where Novo Nordisk commands a clear lead in therapeutic treatments.

Today, in the obesity treatment market, the only available drug is Novo Nordisk’s Saxenda®. Out

of 1.9 billion currently overweight individuals, the WHO estimates that 650 million adults are obese,

equivalent to 10% of the world population. Due to sedentary lifestyles and the spread of Western eating

habits to Asian countries, the number of overweight people is predicted to rise to 3.3 billion by 2030.

As we look to the future, Novo Nordisk will bring more solutions to rein in this pandemic by

expanding the therapeutic uses of FDA-approved Semaglutide GLP-1 molecule (currently in Phase 3 for

obesity treatment) as well as developing new drugs such as Amylin AM833 (currently in Phase 2) or a

combination of both (currently in Phase1).

Semaglutide (GLP-1) enhances satiety (the feeling of fullness) while Amylin slows the digestion

process, blocks glucagon secretion and, similarly to GLP-1, helps to limit appetite. Both these molecules

have the potential to increase weight loss from a range of 3% to 9% (Saxenda®) to a range of 15% to

25%.

Given the urgency of the situation, it is most likely Novo Nordisk will be granted a fast track

regulatory submission in the US for the use of Semaglutide for obesity and that it will be commercially

available by 2021. Subsequently, other drugs will be gradually rolled out thus allowing the company to

double obesity treatment sales by 2025 both in North America and International operations.

Beyond the huge potential in the treatment of obesity, the Semaglutide molecule also offers

opportunities for innovation in NASH (fatty liver disease), Cardiovascular Disease (CVD), brain

disorders and Chronic Kidney Disease (CKD). To this day, these are all widely unmet medical issues.

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Key portfolio movements during the year

INVESTMENTS

During the period under review we initiated positions in ASML Holding (NL0010273215), Aritzia

(CA04045U1021) and Ryanair (IE00BYTBXV33).

DIVESTMENTS

We disposed of the following positions in 2019 in the Long Equity core concentrated book:

ASML Holding (NL0010273215), Booking Holdings (US09857L1089) and Ross Stores

(US7782961038).

ASML (ISIN: US90384S3031 – United States)

With a share price increase of approximately 75% during our holding period, ASML can be

regarded both as one of our new investments for the year as well as a significant contributor.

It is also a great illustration of the way our team adds value at the origination, analysis and execution

steps of our investment process. Let’s review these steps one by one:

Origination

Source: Varenne Capital Partners

Taking advantage of a fall in the stock price of more than 20%, President and CEO Peter Wennink,

CTO Martin van den Brink and CSO Frits van Hout all bought shares for the first time in 10 years. They

collectively put €2.5 million to work for an average price of €147.8 per share.

Transactions were flagged in our systems at the beginning of December 2018 as they activated

several of our patterns of interpretation: “industrial buy”, “buy on lows” and, importantly, “cluster

activity buy”.

The origination team confirmed that transactions were “unusual” and “significant” and

consequently passed on their findings to the long equity team asking them to analyze the business and

try to find an answer to a very simple question: why are senior executives collectively buying the stock?

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Analysis

With over 21,000 associates, ASML is the leading manufacturer of photolithography equipment

for the semiconductor industry. The company is headquartered in Veldhoven, the Netherlands, with

additional production and research and development sites in the United States, China, Taiwan and

South Korea.

Source: ASML - Company Filings

Beyond being a technology leader, ASML is also an extremely profitable business that invested

€1.9 billion just in 2019, or 17% of turnover, and a cumulated €8 billion from 2014 to 2019. Last twelve-

month figures show revenues of €11.82 billion, operating income of €2.8b billion and Free cash flow at

€2,509.8 million. System revenues account for approximately 76% and services for the remaining 24%.

The Company is a key supplier to almost all the integrated semiconductors manufacturers, such as

Intel and Samsung, and to the largest independent subcontractors such as TSMC, Global Foundries or

SK-Hynix. They operate under two market segments:

- Logic, i.e. integrated circuits for data processing, accounts for 55.5% of revenue and 73% of

systems sold in 2019.

- Memory, i.e. integrated circuits for data storage, represents 20.5% of revenue and 27% of

systems sold in 2019.

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ASML systems employ ultra-violet light emitted by proprietary, high-energy sources to engrave

the extremely miniaturized structure of a microchip on a silicon wafer through several layers of

photoresist coating. Light exposed areas of the coating become soluble and precision etching processes

remove them to reveal the pattern of each layer structure.

By providing their customers with more and more advanced processes and enabling further

miniaturization, ASML has over the years ensured that Moore’s law – i.e. doubling the number of

transistors every 2 years while reducing the cost – remained relevant and in the process become the

undisputed market leader with a 70% global market share.

At the turn of the century, the business had embarked in its most ambitious R&D project ever: the

utilization of ultra-high energy Extreme Ultra-violet rays (EUV) to attain a level of miniaturization many

times higher than previous generations of machines could achieve by enabling density of transistors

below the 10 nanometers barrier, an impossible target with previous technology.

The EUV “revolution” was an extremely bold, risky and costly endeavor that required huge

multiyear investments in internal R&D in combination with acquisitions including Cymer, the US leader

in the production of high-power light sources, for a total consideration of $3.1 billion and investments

such as a 24.9% stake in the equity capital of Carl Zeiss SMT GmbH of Switzerland for approximately

€1 billion.

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The complexity of developing the technology, and the associated risk of failure, were so high that

in 2012 ASML received financial backing from its clients, including €1.38 billion provided by Intel,

TSMC and Samsung through a Customer Co-Investment Program (CCIP) and €3.85 billion in the form

of a buy-back plan allowing the three firms to become significant ASML shareholders with, respectively,

15%, 5% and 3% stake in ASML’s equity capital.

Over the years, financial markets started to doubt the company’s ability to succeed with the

revolutionary EUV program and even of its viability and acceptance by the clients.

Combining in-house research, exchange with industry experts and corporate field visits in The

Netherlands, our team found irrefutable evidence that the company did manage to stabilize the

technology and that EUV would be a game changer at a time when clients were desperately needing

much more powerful chips to process and store data in the wake of the new 5G telecom standard.

After more than 20 years of research, over 30 EUV system orders forecast for 2019, and another 4

confirmed orders with down payments of 40% of the sale price plus 8 buy options with payments of €50

million per system for next-generation EUV systems (High-NA), our analysis demonstrated that at the

end of 2018 EUV had finally become a reality and ASML stood to reap the benefits of being the only

manufacturer in the world capable of providing that essential technology for many years to come.

As our due diligence developed, it also appeared clear to our team that the extremely rare monopoly

situation would provide ASML with a major business opportunity as pricing power allowed the business

to set list prices for the new EUV systems that were several times higher than those of the previous

generations (cf. table above).

Furthermore, the complexity of the new machines would require services that only ASML would

be in a position to provide, including specialized maintenance and metrology. Here again, a captive

installed base where clients have no alternative to ASML.

Also, in terms of costing power, barriers are unsurmountable as no business in the world could

come close to matching ASML’s ultra-specialized manufacturing supply chain and lead in research.

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Just as an example, creating an EUV light source that can be industrially exploitable is a prowess

in itself. Without entering technicalities, just think that Cymer’s technology had to be pushed to the

extreme and works out of a droplet allowing fifty thousand drops of tin per second (!) to be hit by a

powerful laser in order to transform the matter into plasma (!!) and in the process generate a tenuous

EUV light. One slight issue: the light is so low that it cannot travel and, in order to hit the photoresist

coating on the wafers, needs to be transported “virtually” by a series of unique mirrors developed by Carl

Zeiss exclusively for ASML.

Finally, and most importantly, our team had to evaluate the ASML management team. In all of our

analysis this is a binary, 0/1, variable that can lead to discard the best of businesses if we can’t trust the

executive team on the strategy that they have for their company, the ability to deploy it and a track record

of success that we can refer to in order to validate the first two points.

In the case of ASML, we were fortunate to find a very skilled, experienced and stable management

team built around long-serving CEO Peter Wennink, with many of the senior executives boasting multi-

decade careers at the company.

To summarize our team’s findings:

- At the end of 2018 ASML was a company at the inflection point of a major business

opportunity and enjoyed all of the economic characteristics required to be part of our

portfolios, including costing power, pricing power and proprietary value creation dynamics

and a successful management team.

- The commercial deployment of EUV was clearly the “reason why” executives had been

buying ASML stocks for the first time in ten years at the end of November 2018 – just as an

example, in April 2019 Samsung announced a 10-year, 110 billion dollars investment plan on

semiconductor development and production with EUV technology being at its core.

Execution

At Varenne we always have the choice of expressing our views through cash equity or equity

derivatives positions. The latter can be helpful in order to maximize return on capital employed on a

single position and/or minimize risk whenever we find that there is too much asymmetry between the

upside and the downside of a potential investment.

In ASML’s case we opted for a relatively simple optional strategy and plugged a derivative

instrument on the underlying asset in order to recoup the necessary upside/downside asymmetry. There

is a full array of considerations to be made when assessing the opportunity of derivative versus outright

investing and they all broadly fall into two categories, fundamental and technical.

On the technical side, it comes down to feasibility, liquidity and implied volatility in the option

market. We are fortunate to have a specialized in-house derivative execution team that can choose to

work with any of our six ISDA counterparties for derivatives trading and clearing.

21

On the fundamental side, the rationale is simple: ASML is certainly a great business with unique

economic characteristics but it’s also an equipment manufacturer for a very cyclical industry, namely

semiconductors. In good times the company will enjoy fast growth and disproportionate increase in

earnings and cash flows, but when semiconductor end customer demand dwindles, then ASML’s clients

won’t need additional capacity and orders will stop abruptly while ASML’s R&D investments will have

to be maintained. Typically this is a risk that we would not take on behalf of our investors and would

turn to derivatives in order to reduce the downside of the trade by putting 10 dollars on the table, rather

than 100 for an outright investment, while retaining upside optionality on a meaningful notional amount

and freeing 90 euros for another investment.

This is precisely what we did with ASML. We initiated the position in mid-January 2019, with

stock price at around 140 euros, by buying long dated June 2020 Call options with a 160 euros strike

price.

Source: Bloomberg – Data as at end October 2019

We were fortunate enough to be able to restrike the options several times as our thesis unfolded

and the stock price reached 240 euros, a level at which we fully exited the position with gains similar to

an outright investment but only a fraction of the capital and risk of loss.

22

Long Equity Baskets

Beyond individual stock selection, we can also resort to bespoke baskets or indexes in order to

optimize the risk profile and/or the behavior of the portfolios.

Baskets are typically designed thanks to the utilization of our proprietary behavioral and

fundamental factors and can give us access to themes, industries or situations absent from the selection

of individual businesses in our Enterprise Picking concentrated portfolio.

A perfect example is the GR/TR basket that we have employed throughout the year and whose role

has been to introduce diversified exposure to high growth or turnaround situations that typically would

not be part of the Enterprise Picking selection.

The basket comprising 25 to 50 names in developed and “emerged” markets – similar to the

Enterprise Picking’s geography – is equal-weighted and rebalanced monthly to a start-of-month exposure

of 5% on the AIFs (non-UCITS) funds and 4% on the UCITS.

The GR/TR basket returned 28.4% during the year under review. Below is the performance of each

individual component during their holding period:

Source: Varenne Capital Partners

23

SHORT EQUITY

Philosophy

At Varenne we short for performance and not for hedging. The goal is to be able to deploy capital

and generate returns in contexts when Long Equity may have difficulties to do so.

We focus on companies that have a high probability of facing a capital event - i.e. a recapitalization,

a capital restructuring or a bankruptcy/liquidation – within an 18 to 24-month timeframe.

The team has the option to express their views through idiosyncratic single short ideas or bespoke

baskets built on a combination of fundamental and behavioral factors.

Within Varenne Capital Partners, Short Equity is a separate activity from Long Equity and is

equipped with its own methodology, processes, information systems and a specialized team.

Contribution in 2019

2019 proved to be another “far from conducive” period to short strategies as extremely favorable

credit conditions allowed even virtually insolvent companies to refinance on very favorable terms.

As always at Varenne, we have the choice to stay on the sidelines if the odds are against us. Since

the second quarter of 2016, with our short opportunity indicators at historical lows, we made the decision

to refrain from engaging in single stocks shorting until deterioration in credit conditions or economic

activity occured. With hindsight, we believe our decision has proven to be correct.

Source: HFR – Data as at end 2019

24

As the above graph illustrates, short-bias funds could not generate positive performance since Q1

2016 – when we covered our successful short positions on US biotech and on a few shale oil-related

single shorts – with the short-lived exception of Q4 2018.

With monetary policies reversing course from the expected normalization of 2018, our short

exposures have remained limited throughout the year, peaking in August 2019 at roughly 10% on the

AIFs (non-UCITS) vehicles and 7.5% on the UCITS ones.

In continuation to what we did in 2018, shorting was effected through a basket of companies

presenting both unfavorable behavioral and fundamental factors such as problematic Free Cash Flow

yield levels.

Thirty companies were part of the selection as at January 1st, 2020. On average they were

generating cash equivalent to only 0.2% of their market capitalization, with 16 out of 30 not in a position

to pay dividends. Return on net assets was very poor and not enough to service their debt levels, on

average 59.8% of their equity capital.

After being the best performing strategy in Q4 2018, and despite noteworthy positive performance

in Q2 2019, Short Equity contributed negatively to the 2019 performance falling victim to strong

undifferentiated rallies occurring at the beginning and the end of the year.

Outlook

The implication on our shorts of extremely favorable credit market conditions - discussed in more

detail later in the letter – is that we can be right on the analysis but wrong on the outcome of the trade as

virtually bankrupt businesses will be able to refinance and avoid default and recapitalization.

With their solvency artificially enhanced, it is as if debt availability “crowded out” equity financing

in situations that would normally require equity capital injections or capital restructuring.

Now, monetary policies have conducted a spectacular about-turn and credit conditions have

remained extremely favorable until the recent Covid-19 outbreak and the collapse of the Saudi-Russian

negotiations on OPEC+ oil output quotas.

The former has proved to be a major source of concern regarding global economic growth while

the latter wreaked havoc in the already fragile US oil industry and high yield market.

25

Source: Varenne Capital Partners – Data as at 13 March 2020

At the time of writing the yield on US junk bonds has just breached the 7.5% rate threshold that

we regard as the minimum rate level of a functional market – i.e. one that correctly prices in default risk.

While this represents a favorable development for the Short Equity strategy’s prospects, it is one

that can reverse dramatically on the back of significant central bank interventions as observed in Q1 2019

after the yield on speculative grade credit briefly moved above the 7.5% threshold only to fall back again

immediately to extremely low levels after the Fed’s posture change.

Against this backdrop, we entered 2020 with short exposure of approximately 7.5% on our AIFs

(non-UCITS) funds and 5% on the UCITS ones and, as at the time of writing, we have increased them

materially through the selection of situations where the probability of default and capital event is the

highest in the current environment.

Should credit and economic conditions keep deteriorating we stand ready to deploy capital further

to our diversified selection and idiosyncratic single short positions during the year.

26

MERGER ARBITRAGE

Philosophy

A true “fund within the fund”, our Merger Arbitrage strategy aims at reducing the overall

correlation of the portfolios to equity indexes and providing additional returns during bearish market

phases. Furthermore, Merger Arbitrage returns contribute to funding the Tail Risk Hedging budget.

Using dedicated real-time information systems, our team detects new mergers and acquisitions

globally and focuses exclusively on announced and friendly deals, the ones that have the most attractive

risk-return profiles, only when spreads meet or exceed our minimum profitability thresholds.

Owing to correlation between volatility and merger arbitrage spreads, we expect this strategy to

contribute the most in agitated market conditions and, all other things being equal, portfolio exposure to

increase in the weeks following volatility spikes as it is usually at such times that our minimum

profitability requirements are met or exceeded.

Source: Varenne Capital Partners – Value Active Fund

Compared to “pure player” arbitrage funds, our portfolio construction model has a major

competitive advantage in that we are under no obligation to be “in play” – i.e. to invest – when our criteria

are not met. Exposure can vary from 0 to 100%, so we can be expected to stay on the sidelines in periods

when conditions are not favorable for the strategy and to be very active in deploying capital in conducive

ones.

27

Contribution in 2019

As discussed in our previous year letter, we anticipated exposure levels slightly below those of

2018 with comparable gross contribution to the overall portfolio performance. That happened to be the

case as interest rates were slightly higher, but volatility remained low throughout the year and spreads

were compressed by capacity strongly picking up again.

Source: Varenne Capital Partners – Value Active Fund – Data as at end 2019

The team entered the year with healthy exposure on the heel of Q4 2018 volatility and expectations

of monetary policy normalization, both effects leading to some widening of spreads. Momentum was

maintained through Q2, with some spread widening occurring in the month of May and Q3 before

opportunities literally dried up after central banks stepped in to reassure markets. We ended the year with

exposure slightly above 10%.

In this challenging environment, with fewer opportunities to seize, we managed to deliver a

performance contribution in line with 2018. We shifted our focus to more complex deals, where we were

able to add value through our in-depth analysis process, and benefited from stressed market conditions

and associated volatility spikes.

In last year’s letter, we wrote that increased risks could arise from political tensions and new

regulations. Consequently, the team sought to assess the potential impact from tariffs and trade

restrictions to determine whether supply chain disruption, material loss of business or critical security

issues could threaten deal completion.

28

This enabled us to take advantage of Sino-American trade war escalation in May by initiating

positions in Quantenna Communications (US74766D1000) and Versum Materials (US92532W1036)

after spreads had widened significantly.

Spreads Widening – May 2019

Source: Varenne Capital Partners

Top five contributors of 2019 include Red Hat (+19bps), Versum Materials (+8bps), Dun &

Bradstreet (+7bps), Tribune Media (+6bps) and Quantenna Communications (+5bps). We are pleased

with the performance of the strategy, with ten positive months and no deal-breaks.

29

Below are the main trades set up by our Merger Arbitrage team throughout the year, as well as their

profitability.

Source: Varenne Capital Partners – Value Active Fund

30

Outlook

The beginning of 2020 was off to a slow start and has characterized itself as one of those periods

during which there is probably more risk than potential return in merger arbitrage. The expected deal

flow, thanks to cheap financing and record amounts of private equity dry powder, was the sole positive

factor amid an unattractive environment characterized by a record level of capacity (almost at 2007

levels) and loose monetary policy.

Source: BarclayHedge – Data as at end 2019

We entered the year with very low exposure levels, patiently waiting on a funnel of situations

cleared for investment, keeping our powder dry for the right time.

At the end of February, the Covid-19 outbreak severely impacted markets. As at the time of writing,

volatility has spiked to record levels even widening the spreads on “safe” deals. Consequently, the team

is actively deploying capital in transactions presenting an attractive risk-reward profile with the aim of

un-correlating the portfolios, reducing overall volatility and generating performance.

Although so far, we have managed to increase our exposure to the strategy, we remain extremely

selective on the quality of the opportunities we pursue. Our visibility is limited and it would be highly

speculative to put into ink an outlook for the rest of the year, as the impact of the current market downturn

on the Merger Arbitrage environment is difficult to appraise.

The team stands ready to seize all opportunities and deploy significant amount of capital should

conditions prove conducive to the strategy.

31

TAIL RISK HEDGING

Introduction

Whereas corrections or even bear markets are natural events and present investors with excellent

long and short opportunities, major financial shocks or prolonged economic crises can drive risk assets

into hard-to-reverse negative returns.

In order to protect portfolios against the consequences of extreme events, we implement a “Tail

Risk Hedging” strategy. The aim is to identify root causes of risk that cannot be managed effectively

within our other frameworks, isolate them and where possible, find appropriate hedges in the form of

risk-reward asymmetric instruments or trades.

Hedges are built within a maximum annual budget linearly estimated at 1.5%. The team typically

deploys long dated (12 months to 5 years) optional strategies and resorts to shorter-term trades from time

to time. Assets and instruments include currencies, commodities, interest rates, indexes, credit and equity

derivatives.

The team determines different macroeconomic scenarii with the goal of ensuring that portfolios are

equipped to fare as well as possible in any one of them. As an example, nine such scenarios are shown

in the above matrix. In benign economic conditions, we expect portfolio returns to stem from the quality

of the businesses in the Long Equity book, the idiosyncrasies on the Short Equity side and the

opportunities that we will have, from time to time, on Merger Arbitrage.

In problematic, less likely, scenarios, Long Equity, Short Equity and Merger Arbitrage might not

prove enough to preserve invested capital. That is why, when our analyses demonstrate that imbalances

and risks are building in the global economic or financial system, we can discretionally deploy our

hedging budget of up to 1.5% in order to hedge residual market risk – i.e. market risk in excess of a bear

market defined as S&P down more than 20% from peak – and its root causes.

The following paragraphs outline our macroeconomic views and the hedges currently in place.

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Systemic risk

Since Bretton Woods and the end of the gold

standard in 1971, global debt has increased at a far

more rapid pace than economic growth.

Moreover, in preventing the “financial crisis”

from blowing into a global depression, the central

banks have since pursued ultra-accommodative

conventional and unconventional monetary policies,

aggravating the risks of instability in the financial

system.

After many years of asset purchases and low, or

negative, interest rates, a desperate quest for yield has

led economic agents towards riskier and riskier assets,

potentially causing misallocation of capital and mispricing. It is in this potentially meaningful

disconnection between prices and fundamentals that the largest financial instability risks reside.

Against this backdrop, imbalances kept growing in 2019 as the financial system has become

chronically addicted to monetary stimulus to the point that any monetary policy normalization process

will now prove extremely difficult.

Source: Bloomberg – Data as at end 2019

33

Faced with an acceleration in global economic activity and aware of the inflationary impact on

asset prices of almost a decade of ultra-loose monetary policies, monetary authorities indeed did try to

act in 2017.

Once again – and similarly to what happened with the so-called taper tantrum of 2011 or the

emerging markets scare of 2015/16 – they faced immediate market backlash in terms of asset price

deflation in Q4 2018.

Entering 2019, with the economic impact of self-inflicted damage from the Sino-American trade

war looming large, it did not take long before the Federal Reserve pressed the pause button on

normalization and reversed course altogether with several rate cuts.

As noted in previous letters: “normalization in monetary policies could expose the cascade of

financial excesses that started in sovereign bonds and progressively spread to asset classes including

investment grade and speculative grade credit, emerging market debt, real estate and finally equity.”

Let’s take the example of speculative non-financial debt, which includes various types of non-

investment grade credit such as leveraged loans and high-yield bonds, and emerging market debt.

Corporate High Yield – Default Rate

Source: Standard & Poor’s

In recent years, default rates on speculative grade debt have reached record lows while the

percentage of speculative rated issuers has increased to a record high of over 50%.

34

The huge availability and cheapness of credit have artificially enhanced short-term corporate

solvency. This in turn has reduced the perception of risk and led to ever more favorable credit terms, in

the end allowing even virtually insolvent entities to refinance easily.

In this context, the ability to repay debt is itself influenced by the availability of credit in a reflexive

relationship: default rates have remained historically low, not because borrowers are increasingly capable

of paying back interest and principal, but because of the market willingness to finance them regardless

of the likelihood of being paid back.

Beyond potentially mispricing credit, these exceptional monetary and credit conditions have been

transmitted to risk assets of all kinds including private and public equities by means of acquisitions and

buybacks.

Looking at geographies, emerging markets have probably been the largest beneficiaries of credit

exuberance when flows are expressed as a percentage of GDP.

In a comprehensive study presented in December 2019 by the World Bank, total debt in Emerging

and Developing Economies (EMDEs) is estimated to have reached a staggering $55 trillion after an eight-

year surge considered to be the largest, fastest and most broad-based instance of debt accumulation in

recent economic history.

The debt-to-GDP ratio of developing economies has climbed 54% since 2010, or seven percentage

points a year, to attain the level of 168% as at the end of 2018. To put this in perspective the pace is

nearly three times as fast as the one witnessed during the Latin America debt crisis build-up in the

1970s/1980s. China’s debt-to-GDP alone has risen 72 percentage points since 2010 to reach 255%. Even

stripping out China, debt levels as a percentage of GDP in emerging economies are still twice as much

as the nominal levels reached back in 2007.

The World Bank concludes that the current low levels of global interest rates provide temporary

protection from financial crisis, but the size, speed and breadth of this latest debt wave is concerning.

Furthermore, the nature of this accumulation differs from previous ones in that it involves a simultaneous

buildup in both public and private debt, funded by new types of non-traditional creditors and it is not

geographically limited to a few regions, contrary to the above mentioned Latin America debt crisis or

the Asian crisis of the 1990s.

Another effect of the post-financial crisis extreme monetary policies has been to incentivize loss

of discipline of the public and private agents embarking on debt thus making them more vulnerable to

rate rises or shocks than before the financial crisis. The study finds that current account deficits are four

times larger than in 2007, corporate debt denominated in foreign currencies much higher and non-

domestic investors own over 50% of the EMDEs total sovereign debt.

Ever more accommodative monetary policies might well seem the only option for central banks

around the world, but the impact on asset prices cannot be dismissed as it risks creating major difficulties

down the road. The risk is that misallocation of capital and mispricing have been artificially sustaining

valuations, providing investors with a false impression of much improved long-term fundamentals.

35

A few central banks have started to acknowledge the risk and act accordingly. In December 2019

the Riksbank, the Swedish central bank, decided to raise rates outside of the “subzero space” expressing

concerns about long term side effects of unconventional monetary policies penalizing prudent savers,

supporting insolvent – or “zombie” – businesses, damaging banks’ balance sheets and inflating asset

bubbles.

Policymakers worldwide keep trying to reflate economies by relying on credit-fueled investment

and wealth-effects as if this seemingly virtuous circle could never reverse.

But they are defying gravity. When prices and market conditions influence the fundamentals that

they are supposed to reflect, then there is a risk that reflexivity is at play and that unsustainable

equilibriums – read bubbles – are building.

If that is the case, the size of current imbalances will inevitably lead to economic, political and

social instability at some point.

When is that point?

Although we can confidently answer that from an economic history perspective that point will be

in the short term, from a human market agent perspective that might take much longer than we might

think simply because fifty years is a very, very short period of time for economic history standpoint but

a very long one for human market agents.

As a consequence of the above, all we know is that financial and economic systems are intrinsically

unstable and that there is a significant risk that imbalances that have been building for decades will

surface in the future and the consequences can be extremely serious.

This is the reason why we have decided to isolate the residual risk in excess of a bear market, as

well as its root causes, and deal with it specifically in the Tail Risk Hedging book.

36

Hedging policies

Similarly to our action in 2017, we took advantage of the extremely quiet market conditions

prevailing in the last months of 2019 to ramp up our hedging portfolio.

The decision paid dividends as, at the time of writing, hedges contributed significantly to insulating

the portfolios from the strong equity sell-off induced by the Covid-19 outbreak during the month of

February 2020 and the first fifteen days of March.

Considering significant and legitimate investor demand for information, we have decided to

provide additional color on our action until end of February 2020 and first half of March in this letter.

Current positions

At the time of publishing we have positions hedging market risk as well as root causes of market

risk, including credit risk, through the following positions:

Positions share a common philosophy as they all have a pre-defined maximum loss or premium

and are mid to long term in nature. Within this book, we distinguish between two different categories of

hedges:

- Mid-term hedging on market risk: typically, we hedge market risk with a mid-term time

horizon and always try to reduce the carrying cost of our trades by means of cheapening

strategies (cf. below).

- Long-term protection on root causes of market risk: positions on assets or instruments other

than equity based. The advantage of these is that we can take a longer time horizon as we do

not need to worry about market reference levels and can exploit other, more stable factors

such as the cost of production for a commodity or the long term credit default risk for a

business.

Let’s illustrate the above with some of the current positions.

37

MARKET RISK PROTECTION

Put on Euro Stoxx 50 conditional to USD appreciation

A good example of our approach to market risk hedging is a position that was initiated on all our

UCITS and AIFs vehicles during Q2 2019.

The Tail Risk Hedging team constantly monitors a very large number of alternatives for hedging

and attempts to identify the most cost efficient ones at any given time. Most of the ideas are discarded

but sometimes we find ourselves facing a compelling hedging opportunity.

We believe that was the case in 2019 when the team observed that the correlation between the Euro

Stoxx 50 and the EUR/USD, priced in the derivatives market, reached an extremely low level at the very

same time when interest rate differentials between the Euro and the US dollar provided for an interesting

opportunity on the forward curve:

EUR USD forward curve

Source: Varenne Capital Partners

In fact, while spot exchange rates hovered around 1.13 US dollar for one euro, the curve was

pointing to a much richer 1.185 dollars twenty-one months forward as a consequence of the steep interest

rate differential between the two currencies.

By combining these two dimensions, we requested quotes from our counterparties for out-of-the-

money put options on the Euro Stoxx 50 index and then condition the payout to the appreciation of the

US dollar versus the then current spot exchange rate – 1,1322 dollars per euro. Strikes include 2800,

3000, 3200 levels with a maturity set at March 2021.

38

Comparing the premium that we would have paid for the 20% out of the money “vanilla” option

to the best price that we were able to obtain from one of our six ISDA counterparties, the team achieved

a discount, or cheapening, amounting to a whopping -75.66%. We only paid a premium of 74 basis

points versus 304 for the unconditioned vanilla option.

As at the time of writing, we have sized the position in notional exposure terms at 12% on our

UCITS and 20% on the AIFs (non-UCITS) funds.

Put on Best: Euro Stoxx 50 and Nikkei 225

Another example is a “Put on Best” option on Euro Stoxx 50 and Nikkei 225 market indexes. The

rationale behind this trade is described below.

S&P 500 – 3-month Implied Volatility

Source: Varenne Capital Partners

39

As briefly discussed above, back in spring 2017, equity markets’ implied volatility reached a very

low level thus creating extremely favorable conditions to setting up long dated hedges.

Our team focused on two notoriously volatile indexes, the EuroStoxx 50 and the Nikkei 225, both

highly sensitive to macroeconomic activity because of the cyclicality of their export-oriented components

– think Japanese goods and German equipment exporters.

The idea of a put option on the best of the two indexes stems from the analysis of the correlation

between the two indexes observed during market crises. Taking the 2007-2009 financial crisis as an

example, all other things being equal an investor shorting one index or the other would have ended up

with pretty similar results.

EuroStoxx 50 & Nikkei 225

(Basis 100)

Source: Varenne Capital Partners

Although correlation between the two indexes is typically very high during crisis periods, that is

not necessarily the case at other times. Interestingly enough, short term past correlation between two

indexes is often extrapolated as a key input for pricing longer dated combined options.

40

Source: Varenne Capital Partners

On these grounds, in March 2017 the team requested our usual counterparties to provide quotes for

3 year, 20% out-of-the-money put options on each index in isolation and then asked them to combine the

two indexes under a best of put option structure.

Due to the exceptionally low implied volatility environment we received relatively reasonable

quotes at 6.60% and 7.5% as a starting point. Applying the “best of put” structure provided significant

additional discounting of 38.5% and 45.9%, respectively, which we found compelling.

We set up the trade at the very end of Q1 2017 and sized it, in notional terms, at 15% of the UCITS

vehicles’ net assets and 25% of the AIF ones. The option’s maturity was March 20, 2020.

In 2018 the two indexes once again followed a very similar path and provided positive contribution

to the overall portfolio despite time value decay.

20 March 2020 7.50% 6.60% 4.06% -45.87% -38.48%

Premium Put 80%

EuroStoxx 50

Premium Put 80%

Nikkei 225

Put on Best premium 80%

EuroStoxx 50 + Nikkei 225

Discount

EuroStoxx 50

Discount

Nikkei 225

41

Source: Varenne Capital Partners

As previously discussed, the team has been able to renew this position in early 2020 with a new

maturity of June 2021 and a target notional as a percentage of net assets – at the time of writing – of 7.5%

for the UCITS and 15% for AIFs (non-UCITS) vehicles.

42

ROOT CAUSES OF MARKET RISK PROTECTION

Credit Default Swaps (CDSs) on European Subordinated Financial Debt

CDSs on European Subordinated Financial Debt are a good example of multiyear positions that

present an asymmetric risk-reward profile and have no direct correlation to equity markets.

Our team has for some time employed CDS-linked instruments in order to mitigate the possible

negative consequences of credit and/or economic crises, in particular through positions on Credit Default

Swaps on European subordinated financial debt, i.e. junior debt issued by European financial institutions.

Subordinated debt absorbs losses immediately after equity but prior to any other instrument in the

capital structure. The picture below represents Deutsche Bank’s balance sheet as publicly disclosed:

Source: Deutsche Bank – Annual Report 2018

In case of an extended economic crisis or an exogenous shock, financial entities will have to face

losses with their equity and a very thin layer of subordinated debt – 0.53% in the example.

To better gauge the underlying risk, it may suffice to compare it to the more than 23% of the bank’s

balance sheet committed in derivatives - despite “netting accounting” adopted after the financial crisis

Our conviction is that, in a crisis scenario, European financial institutions will once again prove

the weakest links in the global financial system and, should such an unfortunate situation occur,

subordinated debt bondholders risk suffering disproportionately.

Our positions on CDS Subfin were a significant positive contributor to portfolio returns in the

second half of 2018, just after a combination of a better political climate, benign market conditions and

a general chase for yield on riskier and risk assets created an environment where investors were willing

to sell protection on subordinated financial debt for less than half the price the market required only a

few months before.

43

Source: Bloomberg – Varenne Capital Partners – Data as at January 2019

The aforementioned combination offered our team a rare window of opportunity to buy CDSs on

subordinated financial debt for an annual spread of less than 1%. Back then, the team focused first on

iTraxx Sub Fin Series 26 and then on the subsequent Series 27 until January 23rd, 2018.

Fast forward to 2019 and, after central banks’ monetary policies reversal, a similar situation in the

CDS market developed again at the end of the year.

44

Source: Bloomberg – Data as at 15 March 2020

Once again, the Tail Risk Hedging team lost no time and took advantage of the short window of

opportunity to increase notional exposure to 15% of net assets on our UCITS vehicles and 30% on the

AIFs (non-UCITS) while transitioning to Series 30 when CDS value started to rapidly re-rate as a

consequence of the COVID-19 outbreak.

45

CDX IG Tranche 7-15% (S29 – S31)

For quite some time our team had been looking for a way to hedge US credit tail risk to

geographically complement our positions on CDS on European Subordinated financial debt.

The idea is that US banks are generally more solvent than their European counterparts, whereas

excesses have probably developed in the North American corporate credit markets.

The team naturally started investigating the high yield space but quickly found that risk hedging

was adequately priced in. Finally, we took another route and explored the investment grade market in

2018.

In fact the team realized, that in less than ten years, the search for yield induced by the response

to the financial crisis altered some characteristics of the investment grade space and pushed BBB-rated

issues to represent roughly 50% of the overall market.

Source: Morgan Stanley, Citigroup

Even more interestingly, in just a few years, investment grade rated issuers’ leverage profile

changed dramatically, with close to 25% of them now leveraged more than 4 times EBITDA.

46

Source: Morgan Stanley – Data as at 7 September 2018

On these grounds, the team focused on the most leveraged components of the CDS index CDX, a

static index of 125 US investment grade entities, at inception.

Over 50% of the components were in effect rated BBB, half of them in very cyclical businesses.

Furthermore, the solvency indicator of the bottom quintile looked deteriorated with a Net Debt to

EBITDA ratio of 3.45 and a more worrying Net Debt to Free Cash Flow from operations ratio of 5.5.

In the event of a severe economic or financial shock, it is easy to imagine a reduction in operating

earnings and cash flow metrics leading to a decline in solvency indicators, spread widening and, for some

of the names, downgrade to high yield rating. And this, without mentioning the potential unsustainability

of pension obligations and the risk of outright restructuring for a significant percentage of the index

components.

While the economic quality of the investment grade portion deteriorated significantly, the

perception of risk did not and the CDS levels have remained roughly similar over the last few years thus

showing a potential inefficiency and, consequently, a tail risk hedging opportunity.

Source: Varenne Capital Partners – Data as at 9 January 2019

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Within the CDX index the team purchased protection in the form of a pay-off on the 7-15% loss

tranches of series 29 and series 31, expiring respectively, on December 2022 and December 2023.

Differently from a CDS, no notion of recovery applies and, in case of losses amounting to 15% in

the index the pay-off would equal 100% of the notional of the trade.

As at the time of writing the notional targets for this trade are 15% of AUM on our UCITS funds

and 30% on our AIFs (non-UCITS).

Put Brent Future March 2022

Unlike equity markets, commodities are perfectly suited to effectively building tail risk hedging

over several years. Historically we have preferred commodities whose demand is directly correlated to

economic activities and supply is abundant, such as Copper, Nickel or Oil.

As at the time of writing we have a series of Put options on March 2022 Brent Future.

As discussed in last year’s letter, we took advantage of a global bull run in oil price to set up a

contrarian long term trade on oil at the beginning of Q4 2018. There were several reasons for the trade

which are summarized below.

While OPEC and Russia are in a state of structural overcapacity, US shale production continues to

increase sharply because of widespread technical advances, which bring down marginal production costs.

Furthermore, producers such as Canada, Brazil and Guyana have a stated goal of becoming significant

oil exporters and are ramping up output.

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Also, we believe that Brent, the global oil standard and WTI, the American light sweet standard,

are in principle fungible commodities. Yet, in Q4 2018, Brent commanded a premium over the WTI of

a hefty 10$ a barrel despite lower intrinsic quality. As new pipeline and export capacity come online

during 2019-20 and the effects of the US export ban repeal materialize, Brent prices should start

converging towards those of the American benchmark.

In the case of a significant economic shock, we expect a drop in real and forecasted demand to

exert significant pressure on oil prices and, despite OPEC’s efforts, US producers will still be

incentivized to sell at marginal extraction cost, i.e. without being able to recover exploration and fixed

production costs. The price would decrease dramatically, and, in such a scenario, WTI-Brent

convergence should accelerate as the 10-dollar premium would translate into an unsustainable difference

in percentage terms and transportation costs for oil would simultaneously lower.

On the back of our analysis, we have bought deep out of the money Put options on March 2022

Brent Futures, at a strike price of $30, in a way trading moneyness for time. As discussed, a move like

this would not be possible on equity, simply because the option would be tied to a reference market level

that would risk making it ineffective a few years down the road.

Now, fast forward to the beginning of 2020 and a perfect storm is hitting oil markets. On the

demand side, the measures adopted to contain the Covid-19 outbreak have significantly reduced actual

and forecasted demand for 2020. In turn, this puts pressure on OPEC+ to drastically cut supply in order

to rebalance markets. However, Saudi Arabia and Russia have been unable to agree on further output

caps, causing front-end oil prices to experience their biggest one-day drop on Monday March 9th.

Should conditions remain as above, we expect forward prices to converge with spot price as market

players adjust supply forecasts, more so if a price war were to start.

The notional target for this trade is, at the time of writing, 15% of AUM for the non-UCITS funds

calculated at strike price.

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November 2019 to 15th March 2020

Although technically the S&P 500 did not cross the “20% down from peak” mark during the period,

the last week of February 2020 saw the steepest decline of global indexes since 2008 and both the UCITS

and AIF vehicles that we manage benefited from the contribution of the convexity and optionality of our

long dated hedging instruments.

In addition to that, we also resorted to short dated hedges as market volatility remained low – and

indexes sanguine – until mid-February despite the Covid-19 outbreak in China adding to major

uncertainty and a different kind of risk.

In the second half of January, our Tail Risk Hedging and Long Equity teams jointly analyzed the

potential threat of the Covid-19 outbreak – back then seemingly limited to China – and appeared clear

that some of our holdings in our long book would have been disproportionately impacted by the uncertain

prospect of a prolonged standstill in China.

On January 27th 2020 the Tail Risk Hedging team decided to act and, on top of the long term

hedges, started to add Coronavirus-specific short-dated protection opting for put options on European

equity indexes with strikes only 5% out-of-the-money – thus, in a way, trading time for moneyness.

In the meantime, the long-term book protections, such as the CDSs on European subordinated

financial debt, had been increased substantially to reach, respectively, 15% and 30% of AUM in UCITS

and AIFs (non-UCITS) vehicles. The same is true for the tranches of losses of CDX IG in the United

States.

In addition, we had a natural deadline in the March 2020 expiry of the Best of Put Nikkei 225 and

EuroStoxx 50. We decided not to wait and negotiated another Best of Put on the same indexes, expiry

June 2021, for a notional equating to 7.5% and 15% of AUM on UCITS and AIF vehicles.

Finally, on February 21st, we made the decision to further reduce the correlation of the portfolios

by selling European equity index futures.

In the week of February 24th global equity markets sold off on average by 11% and, on Friday 28th,

all short-dated Covid-19 specific instruments were monetized and replaced with an at the money Put

Spread on the EuroStoxx 50.

As at the time of writing, i.e. 15th of March 2020, the optionality and convexity of our mid to long

term positions have been playing out nicely during the month of March and, in the face of a worsening

global situation in response to the Covid-19 crisis, we have decided to replace the Put Spread on

EuroStoxx 50 with even more powerful delta one instruments by selling European equity index futures.

We plan to keep Covid-19 specific positions in place until the contagion risk for the USA is clarified.

On the following page we summarize our tail risk hedging movements since mid-November and

the contribution for month of February 2020.

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INSTRUMENT TAIL RISK HEDGING CONTRIBUTION – Feb 2020

UCITS Non-UCITS / AIF

Future CAC 0.69% 1.57%

Put CAC 0.41% 0.67%

Put on Best SX5E/NKY 0.26% 0.56%

CDS Europe SubFin (S27 - S30) 0.14% 0.31%

Put SX5E/USD 0.17% 0.30%

CDX IG Tranche 7-15 (S29 - S31) 0.07% 0.18%

Put Brent Fut - Mar 22 - 0.06%

Put Spread SX5E 0.01% 0.06%

Cap (Call) CMS 2s10s 0.01% 0.01%

Put JPY/USD 0.01% 0.01%

DATE BUY / SELL INSTRUMENT NOTIONAL

UCITS Non-UCITS / AIF

15 Nov 19 BUY CDX IG Tranche 7-15 S31 3.8% 7.7%

15 Nov 19 BUY Cap (Call) CMS 2s10s 20.2% 22.0%

15 Nov 19 BUY Put SX5E/USD 5.3% 6.9%

15 Jan 20 BUY CDX IG Tranche 7-15 S31 0.8% 7.2%

17 Jan 20 BUY Put SX5E/USD 2.2% 4.1%

23 Jan 20 BUY CDS Europe SubFin S30 1.0% 2.8%

24 Jan 20 BUY CDS Europe SubFin S30 1.0% 2.8%

27 Jan 20 BUY Put CAC 7.5% 12.0%

05 Feb 20 BUY CDS Europe SubFin S30 0.7% 2.6%

12 Feb 20 BUY Put Brent Fut - Mar 22 0.0% 1.5%

18 Feb 20 BUY Put on Best SX5E/NKY 7.5% 15.0%

24 Feb 20 SELL Future CAC 7.5% 15.0%

28 Feb 20 SELL Put CAC 7.5% 12.0%

28 Feb 20 BUY Future CAC 7.5% 15.0%

28 Feb 20 BUY Put Spread SX5E 7.5% 15.0%

04 Mar 20 SELL Put Spread SX5E 7.5% 15.0%

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A FINAL WORD OF THANKS TO GREAT INVESTORS…

We hope that you have found this document informative for both the investment decisions that we

have made throughout the year and the general philosophy that we employ. We are very fortunate in this

business as previous generations of great investors have shown us the way through their extensive

writings. All we need to do is take the time to learn from them and follow their steps. To us they are great

references and constant sources of inspiration and learning. Think of George Soros and Warren Buffett.

An odd couple by many standards, different in almost every respect, they have one trait in common: each

has developed a sound and unwavering investment framework that has guided them in every decision

made throughout their (very) long investment careers. Much like the Chairman of our Supervisory Board,

Jean-Marie Eveillard. Having sound and consistent investment principles and sticking to them in the long

run is the main characteristic of the investors whom we admire, those who have been able to deliver

results over decades. They epitomize the difference between added value and simple risk taking.

…AND OF ECONOMISTS’ ABILITY TO PREDICT RECESSIONS!

Source: Philadelphia FED – TS Lombard

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This document has been prepared for private and confidential use. It does not constitute, and should not

be deemed, an offer to buy or sell or a solicitation of an offer to buy or to sell an interest of any kind.

All information reported in this document is intended solely for illustration purposes and is subject to

change without notice.

Attribution and contribution figures are estimated, gross. Readers should be aware that attribution and

contribution calculations are indicative and entail significant assumptions and approximations.

No representation, warranty or undertaking expressed or implied is given as to the accuracy or

completeness of the information contained in this document and no liability is accepted by Varenne

Capital Partners, its members, partners or employees for the accuracy or completeness of any such

information.

This document includes forward-looking statements that are subject to risks and uncertainties. Actual

results may differ materially from those expressed or implied in the forward-looking statements in this

document.

Past performance is no guarantee of future results and no representation is made that an investor can

achieve similar results in the future.

Varenne Capital Partners is authorized and regulated by the Autorité des Marchés Financiers ("AMF").

Varenne Capital Partners, 42 Avenue Montaigne, 75008, Paris, France.

ir@varennecapital.com