I have been following Elysee Development Corp. recently and want to use them as an example to discuss my idea for including a market making strategy in a holding company. This idea applies broadly to long-only funds that focus on illiquid, exchange-traded stocks.

Elysee posts limited promotional material on their site but, thankfully, have had some good coverage recently by Caesers Report. The first piece was an interview with the chairman, here. The second provides an update after the Q2 earnings, assessing current NAV, changes to share count, and ongoing buyback here. For what it's worth, I would be curious to hear more about the public float in ELC. 

The balance sheet above is from May 31, 2016, and I would draw your attention to a couple things. One, total assets increased without a corresponding financing, which suggests their aggressive investments have been money well spent so far. Two, they have a large deficit, which reflects their long history as an oil and then gold exploration company. In passing, I will point out that I didn’t see any 'risk accounting' in their financial statements, which could attempt to include liquidity in the valuation of their holdings. I am not sure exactly what such risk accounting would look like, it might be as simple as using VWAP pricing for their quarterly portfolio valuation.

Now, I am somewhat new here and this might be a silly question, but why doesn’t Elysee engage in some market making activities in their best investments? They have a short list of five investments and some are illiquid, as shown below. See that both Niocorp and Focus Ventures traded approximately a dozen times in the entire day prior to writing this article, while IBC Advanced Alloys has fairly sparse size in their limit order book (10,000 offer at 0.14).   

It seems to me that you could enhance the quality of the market in each of these names by adding a relatively small amount of capital, even $50,000, to both sides of the order book. A holding company like Elysee could use some of their cash on hand to post bids, and some of their shares on hand to post offers. They could act as market makers, potentially earning profits on the spread and improving liquidity in their main investments.

The basic version of this idea is pretty straightforward, based off the NYSE Specialist. The holding company dedicates a portion of their cash and shares in one company for use in a market making strategy. They use the cash to post bids and the shares to post offers, and try to keep some kind of order on both sides of markets at all times. They can adjust the orders periodically in a way that tries to keep some balance between the proportion of cash and shares in the strategy over time.

A more technical description of the idea is as follows:

  • Post orders 25% outside BBO each Monday at noon. Cancel prior orders and place new ones each week. The value of the bids should be no more than 75% of the cash in the account, and offers no more than 75% of shares held in the account. 

My reason for each of these choices are as follows:

  • Posting 25% away from BBO means that you won't necessarily get hit each week. You are really trying to be there for the time when volume swamps the standing orders.
  • Updating orders each week helps ensure that you are a relatively sticky order. You want to show other participants that you are there for the long haul and committed to the valuation of the company.
  • Limiting the size of bids and offers to 75% of cash and stock on hand helps ensure that you never get to a point where your account is entirely in cash or shares. You don’t want to be entirely in cash or shares here in case that distorts your exposure to the investment across the entire holding company. 

I can even imagine a more exotic version of this strategy where you get into using the strategy to accumulate or disperse shares over time.

There are several risks related to this strategy:

  • If the holding company is registered as a reporting shareholder in the company, then they risk over-reporting from this strategy. It means this idea is likely to be impractical for some investments at some holding companies.
  • The holding company may increase or reduce their exposure to their investment at precisely the wrong time. This is a typical challenge of market making (market trending against you) and you can mitigate it by keeping the size of the strategy small relative to the entire position in the holding company, but not eliminate it entirely.
  • There are broader questions around the legality of churning your holdings in this way. In particular, there is a risk that you could be perceived to have undue influence on the valuation of your investment and be charged with 'window dressing' in some way. This is a big topic and I am not sure where to start with it.

The rationale for implementing this strategy in a holding company seems straight forward to me. I think there is something similar between the way brokers lend shares out for shorting, and the way holding companies could use their shares for market making. I appreciate that a holding company may not want to reduce their holdings in their best names, but will emphasize that some of these companies have poor liquidity and could benefit from increased presence of strong hands in the market. Elysee itself has helped support companies in the primary markets by participating in recent financings, and this begs the question: why not help support the same companies in the secondary markets?

Let me remind you all that several independent, resource-focused brokerages closed in 2015. This may have a big impact on liquidity for various juniors as we move forward in the new, apparent bull market. It may be that retail gets more run of the room, which may have happened already with some of the large runs this year in exploration plays with dedicated retail followings. Regardless, I think the changing landscape of junior markets in Canada gives holding companies an opportunity to step up and help provide some adult supervision in their own best interest.