Remember Melvin Capital during the pandemic? When day traders, leveraging social media, took down a massive $12.5 billion hedge fund. (They even made a decent movie about it). Meme stocks--those struggling, but nostalgic, small cap companies that suddenly surge in value because...(insert arbitrary reason here)--helped democratized the stock market and gave power to retail investors to compete with big institutions (sort of). So, we love them. Well, a couple of weeks ago, there was another meme stock rise and fall frenzy involving the 80-year old car rental company Avis that's also a cogent tutorial on the mechanics of 'short squeeze'.
The Avis Budget Group, which lost nearly $1 billion last year and carried more than $6 billion in debt on a market cap of $4.5 billion, soared more than 740% in April...before plummeting ~70% in 26 hours. It wasn't the first time Avis stock has gone parabolic. As Business Insider reminds us "in 2021, in the early days of the meme stock phenomenon, shares soared more than 200% from September to their peak in early November, before tumbling almost 50% in the following months." At the heart of the latest swing were two hedge funds: SRS Investment Management, founded by Karthik Sarma and Pentwater Capital Management run by Matthew Halbower. SRS has been a long-term investor in Avis (since 2010) and controls two board seats, while Pentwater had only begun building its stake in the company earlier this year. Per Matt Levine (Bloomberg Money Stuff, Apr 15), the two hedge funds together owned 69.3% of Avis shares: SRS (49.3%) and Pentwater (~20.0%).
But that's not all, Levin also notes that both funds also had other bets on Avis stock, including cash-settled total return swaps ("TRS") with Wall Street banks. TRS are financial derivatives that allow investors to gain economic exposure to an asset without actually owning it. In this case, SRS and Pentwater had contracts with investment banks that paid them any increase in the price of Avis stock, while the hedge funds would pay the banks any decrease in the price of the same. But because banks can’t/ won’t take on that much risk, they’ll hedge their position by purchasing an equivalent amount of shares. So, the banks own Avis stock but SRS and Pentwater gain/ lose based on the price action (of course the banks collect a nice fee for structuring the arrangement). The hedge funds do have to put up collateral (margin) to make sure they are good for the money if stock moves against them. Another way of thinking these swaps is that they are a leverage tool for hedge funds. The bank(s) "buys the stock and holds it on behalf of the hedge fund, which post collateral for part of the value of the stock." Based on Levin's calculations, SRS and Pentwater owned ~2.8M (8.1%) and ~10.1M (28.8%) Avis shares on swap. So, SRS and Pentwater owned ~106% of Avis stock? But, again, that's not all...because Avis is a public stock in various stock indexes (e.g., the Nasdaq GS) it has other institutional (e.g., BlackRock, Vanguard, State Street, etc.) and retail investors. In fact, Levin estimates just SRS, Pentwater, and those big three index investors owned at least 119% of Avis stock.
1. A company issues 100 shares. Four investors — call them A, B, C and D — each buy 25 shares.
2. Investor X wants to bet against the stock, so she borrows 20 shares from A and sells them to B.
3. Now A still owns 25 shares (she loaned 20 out to X, but expects them back), as do C and D, while B now owns 45 shares (25 she bought from the company and 20 she bought from X). Thus, people own a total of 120 shares.
4. But the books balance, because X owns negative 20 shares. There are 100 shares outstanding, and people are long a total of 120 and short a total of 20.
5. Investor Y can borrow 40 shares from B and sell them to C, etc., creating just as many shares as you want.
In the above example, the percentage the stock’s shares that have been sold short but not yet repurchased (aka short interest) in step 3 is 20%. In step 5 it would be 60% and so on. Short interest can rise substantially when investors are very bearish on a stock--data from MLQ.ai shows short interest on Avis stock reaching 86.2% on April 21. That's when things can get really exciting/risky depending on which side of the trade you're on. That's because stock borrowing "is usually open term, meaning that the owner can demand that you return it any time."
Typically, hedge funds or even retail investors will short a stock by borrowing it from a bank or broker, who will probably borrow it from an institutional investor (e.g., BlackRock, Vanguard, State Street, etc. or a pension fund). Who the end owner is matters...because if SRS and Pentwater own a disproportionate amount of Avis stock, then there is a good possibility some/a lot/ most of the Avis shares that were sold short were ultimately borrowed from them? In which case, if they demand those shares back, who would you buy it from? Them! Because they own (economically speaking) 108% of the company's stock! What would they charge you to allow to you meet your legal obligation to them? A lot!
It may not have happened exactly like that, but after Pentwater converted some of their derivative exposure to direct ownership and publicly updated stake in Avis at the beginning of April, it quickly became very difficult to continue borrowing the stock. Short sellers began cut their losses and buy back the stock, fanning a giant short squeeze. Per the WSJ, "at its peak on April 22, Avis’s shares reached $847.70 in intraday trading—nearly seven times higher than where the roughly $128 price at which stock started the year. Then just as quickly...it started to fall as Pentwater unloaded shares, with Avis’s stock losing 68% in just two trading days." Momentum/ retail interest also intensified in the run-up to the peak, which means a lot of day traders bought at or near the top once again...oops!
So, how much did Pentwater and SRS make and short sellers lose? Well, Pentwater sold 4.3M Avis shares on April 22–23 at an average price of $404, generating $1.75 billion in gross proceeds and leaving it with roughly 3.5M direct shares, representing 9.9% of Avis’ outstanding shares. But that's only small percentage of their total exposure. Per Octus, Pentwater also held a 29% synthetic stake via TRS, referencing ~10.2M shares with reference prices between $57 and $204. These swaps would have presumably generated very large mark‑to‑market gains during the April spike (though we don't have any profit figures). Similarly, SRS is estimated to have had ~$8.0 billion in mark-to-market gains by April 21 but may have gave back ~$5.6 billion of they held their positions. Sure, you win some, lose some...but it's always nice when you can ahead by ~$2.5 billion. Avis short sellers lost ~$4.1 billion in April, but retail investors did not suffer meaningful aggregate losses since they were net long Avis and benefited from the short squeeze. However, the surge in retailing volume in the days before the top suggests those who piled in late lost quite a bit. Oh well, you win some, you lose some.
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