Seth Klarman Notes from the CFA Institute

Last week Seth Klarman spoke at the CFA Institute in Boston. Below are 2 sets of notes. These are PURE GOLD. For more Seth Klarman, please see our Lesson from Seth Klarman series



Howard Marks on Risk

We are big fans of Oaktree's Howard Marks. If you have not read his most recent letter, you really have to read it here: Howard Marks on Risk.

Now I can not time the market. Actually I have no idea where the market is going today, tomorrow or some subjective time period. That being said, I do know when people get greedy, it is time to start de-risking. And with that, I have come up with a new investment philosophy I think all credit investors should adopt:

"When investor demand is so strong in the leveraged loan and high yield market that second lien dividend deals are being oversubscribed, it is time to start selling"

I think you would sleep a little better at night with that in hand.

Back to Marks. The paragraphs I cite below really left me in awe when I read it earlier this morning. It makes so much sense from a value investor's perspective but I feel like it gets lost in the weeds of the Mr. Market's of the world. Enjoy:
For about a year, I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one . . . and in so doing make the other the one deserving attention.
Followed by:
But when people get excited about the prospect of easy money – even if from assets or investment strategies that have become far too popular, turning into overpriced manias – they frequently drop their risk aversion and adopt risk tolerance instead. Thus they swarm into the investment du jour without concern for its elevated price and risk. This behavior should constitute an important warning flag for prudent investors.

In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity. When people refuse to buy assets regardless of their low prices, they miss out on the best, lowest-risk returns of the cycle.
Fantastic stuff.



Distressed Debt Investing: New Blogs Being Added

I am putting out a request for two people that would like to help me build out a new blog (adding a fourth to our family) on post re-org equities. In addition, I am also putting out a request for one person that would like to help me start a blog on Walter Schloss and his tenets on value investing.

If you would be interested in either of these ventures, please email me at hunter [at] distressed-debt-investing [dot] com and I will provide you with more details.




Distressed Debt: Value Investing Congress Notes

While not specific to distressed debt investing, we here enjoy reading thoughtful commentary on value investing. Below are notes, courtesy of The Innoculated Investor on the most recent Value Investing Congress. Great read. Enjoy!



Distressed Debt Analysis - Visteon (VSTNQ)

A few months ago we looked at the distressed debt of Visteon, given the enormous run-up in prices of the underlying securities. Since that post, and as expected, junior securities (equity and bonds) have rallied substantially as Visteon continues to put up strong numbers. In addition, there has been a number of negotiations behind the scene to get a better deal done. Let's take a stab and see if we can see what this thing is worth.

For reference: Here is Visteon's Bankruptcy Docket

Last week, Visteon ("the company") filed a new plan of reorganization with the bankruptcy court (Docket #3011). On the same day, the company filed a motion authorizing the debtors to enter into a plan support agreement, an equity commitment agreement, and a backstop agreement. In this document, the company gives us a little background of what has been going on in the case:
From the outset of these cases, Visteon has made clear that an expeditious exit from bankruptcy with a deleveraged capital structure supported by its OEM customers was its primary goal. To the end, Visteon has worked determinedly with its creditor constituents to develop a consensual plan of reorganization with all voting classes that would address its reorganization goals for the last several months. As a result of these efforts, Visteon has reached a milestone in putting forth a “toggle” plan of reorganization, filed contemporaneously with this Motion, that Visteon believes represents the best path toward a successful conclusion of these cases.

The Plan is comprised of two mutually exclusive sub plans—a rights offering plan (the “Rights Offering Sub Plan”), pursuant to which the holders of Visteon’s prepetition unsecured notes who are eligible to participate in the rights offering would have the opportunity to purchase 95% of the equity in reorganized Visteon in exchange for $1.25 billion in cash raised through a fully backstopped rights offering; and a claims conversion plan (the “Claims Conversion Sub Plan”), which is similar to the plan filed on March 15, 2010 in that the holders of Visteon’s term loan debt would receive approximately 85% of the equity in reorganized Visteon and unsecured note holders would receive approximately 15% of the equity in reorganized Visteon, while other general unsecured creditors would receive a cash payout. The fundamental tenet of the Plan is that if the note holders deliver $1.25 billion in cash plus an exit financing facility to pay the term lenders in full, the Debtors will move forward with the Rights Offering Sub Plan; while if the note holders do not deliver the capital, they will be required to support a “toggle” to the Claims Conversion Sub Plan pursuant to the terms of the Plan Support Agreement and Equity Commitment Agreement, except under very narrow circumstances that the Debtors largely control. In the Debtors’ view, the toggle plan offers the cleanest path to confirmation that would avoid a costly four-sided cram down fight and would localize and simplify a valuation fight to one between old equity, on the one hand, and everyone else, on the other. The “toggle” plan construct allows note holders to truly put their money where their mouth is, while minimizing the Debtors’ risk of being left at the confirmation altar without a confirmable plan if the note holders do not live up to their promise to deliver capital. The Plan also avoids what would be costly and protracted cram down litigation with the Debtors’ note holders and resolves disputes over valuation among all parties other than “out of the money” equity holders who will dispute any valuation that does not provide them with a recovery.

The Plan is fully supported by note holders holding more than two-thirds in amount of Visteon’s prepetition unsecured notes and the Debtors continue to work towards obtaining the support of the official committee of unsecured creditors, a proxy for the general unsecured creditor class. While the term lenders have not yet indicated a willingness to support the Plan, Visteon notes that the term lenders would receive the same, or an equivalent recovery, to which they would have recovered under the March 15, 2010 plan. Specifically, the term lenders would be paid in full, in cash, including accrued prepetition and postpetition interest, and therefore would be unimpaired, and without voting rights, under the Rights Offering Sub Plan and would receive virtually the same treatment under the Claims Conversion Sub Plan as was contemplated by the Debtors’ March 15, 2010 plan, for which they previously provided their support. Thus, the Debtors believe that the term lenders ultimately will support the Plan. Lastly, while the Debtors expect equity holders to oppose the Plan, such holders are deemed to reject the Plan and will not be entitled to vote—making their support irrelevant to Plan confirmation.
Now that is a mouthful I know. Let's break it down:
  • 2 possible paths: 1) Rights offering funded by bondholders after which they will get 95% of the equity and will pay down the term loan from the funds raised 2) If rights offering fails, old plan is the go where term lenders own the vast majority of the company 3) Equity gets nothing
What I found most interesting about this plan was point #3 above. Earlier in the month, the U.S. Trustee recommended the appointment of an examiner after the ad hoc equity committee requested one. From a recent court filing:
On February 26, 2010, the Debtors released 2009 year-end financial results that dramatically changed the course of these cases. The Debtors’ enormously improved financial performance, as well as the market’s reflection of the bright prospects for the automotive sector and the economy as a whole, have rendered the Debtors’ intended path for these cases illegal and improvident. Indeed, prior to the release of the 2009 financial results, the Debtors filed a plan that provided no recovery for unsecured debt, much less equity. Now, that same unsecured debt is trading above par plus accrued interest. To pretend that this is a typical case where the Debtor has worked over the course of a year towards an inevitable plan that extinguishes equity is disingenuous. Yet, despite these different circumstances, the Debtors remain on approximately the same path as before and continue to stand behind a plan that rests on erroneous valuations and projections simply unsupported and refuted by the currently improving financial landscape.

In addition, equity holders have filed a motion to terminate the debtor's exclusivity and to solicit votes their their own Chapter 11 plan. What is equity arguing specifically? Undervaluation. As a reference, most equity committee's argue for undervaluation, but in Visteon's case, the argument is fairly compelling: Why? Visteon has a massive amount of value in its JV and cash on its balance sheet which current plans are undervaluing (2.5x net income? HA).

The equity committee is proposing a new plan where the term loan lenders would be partially reinstated (paid down with an equity rights offering), bond holders would receive a new security, and equity would be reinstated. The downside of this plan: The company would be emerging with a significant amount of debt which in a judge's eyes would make it less favorable to a competing plan.

For reference, Visteon's EBITDA was $161M in 1Q 2010 vs $22M in 1Q 2009. Strong. Cash at year end is approximately $1 billion dollars. The trading level of securities:

  • Term Loan: 106-108
  • Visteon 8.25% of 2010: 111/112
  • Visteon 7% of 2014: 112/113
  • Visteon 12.25% of 106: 115/117
  • Equity: $1.70 resulting in a market cap of $221M.
Let's figure out how much this puppy is worth:
  • Halla: Visteon has a 70% position of a Korean auto supplier. The company today has a $1.4B USD market cap...$980M of value.
  • Other non consolidated JVs: Mostly Yanfeng: "The major products are automotive interior and exterior trim products. such as seat assembly. instrument panel assembly,door trim panel assembly, steering wheel assembly, sun visor assembly, color bumper, B pillar and C D pillar etc. " Visteon owns 50%. Assume $80M of attributable net income (meaning the 50% that the company gets) at a 10x multiple...$800M
  • Cash - $964M ... Assume 50% is retained...Approximately $500M of value
So before even looking at Visteon's underlying operations we have approximately $2.3B of value.

Because Halla is consolidated in Visteon's results, we need to back out their cash flow and then apply a multiple to stand-alone Visteon's EBITDA. Halla is doing right under $140M of EBITDA, so run-rate stand-alone Visteon is probably close to $300M on a VERY conservative case. At a 5x multiple, we get another $1.5B of value. Net, net...Total value is $3.8B.

For debt claims, I am using $3.2B. Therefore the excess value to equity is $600M against 130M shares outstanding leads to a share price between $4 and $5. This valuation also does not give them any credit for NOLs. But we like to be conservative here at Distressed Debt Investing.

So we think equity has value here - the question is...will they get any of it? It really depends on how the judge plays his hand. And I will save portfolio positioning for the next post. We will discuss the implications of the varying guarantees of the bonds (the 12.25% have certain guarantees that other notes do not have), the possibility of equity get a nuisance value claim and how that affects portfolio positioning. Finally, we will talk about par + accrued and possibly make-wholes to determine our downside on the bonds.



Another Berkshire Hathaway CIO Candidate?

A few months ago, we postulated that Michael Burry may be one of Berkshire Hathaway's future CIO candidates. Today, I read an absolutely incredible post by Tariq Ali of Street Capitalist on Li Lu, who many in the value investing community believe could be one of the next successors to Warren Buffett in allocating Berkshire Hathaway's capital.

Some background (notes to the meeting embedded below): A question was asked of WEB and Charlie Munger on how the 4 potential candidates for CIO fared in 2009. Warren Buffett, as usual, gave an answer without really answering anything (no offense WEB). Charlie Munger on the other hand laid out that one of the candidates was up 200% in 2009 with no leverage.

It is known that Li Lu manages some of Charlie Munger's billions of dollars. It is also known that Li Lu takes massive positions. And finally it is also known that Li Lu was long BYD, the Chinese company that Berkshire owns a large stake it, in size, in 2009. BYD was up over 400% in 2009.

Nonetheless, Tariq laid out some fascinating notes from a talk Li Lu gave at Columbia Business School a few years back. Here are some choice quotes (visit his site for the entire post).
  • "If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you."
  • "Download every court document lawsuit. Read it. You NEED a very curious mind to figure out WHAT is happening. Dig every single time. READ EVERYTHING."
  • "You make a mistake when you have not finished your work but like it enough. You start betting on probabilities instead of real analysis."
And to give you a sense of the legitimacy of Li Lu, here is a snippet from an old New York Observer article (my emphasis):
Mr. Li is 32 years old. He wears Armani suits that he buys at a factory outlet; he lives in one of those bland modern towers on the East Side. While other Wall Street hotshots his age may have endured the trauma of not getting into the business schools or investment banks of their choice, Mr. Li has survived poverty, separation from his family (his parents were forced into labor camps) and a devastating earthquake. When he escaped to America after hundreds of his fellow protestors were killed in Beijing, he was one of the most wanted dissidents in China.

His clients hope they'll see big profits, but they also seem to be investing in the future of Mr. Li himself. Jerome Kohlberg Jr., a founder of the leverage buyout monolith Kohlberg, Kravis, Roberts & Company, said his decision to invest with Mr. Li "wasn't my usual cautionary thing, but my admiration prevailed … I don't know about others, but I would like to see him succeed and eventually help bring China into the 21st century and be a democracy, and I think he, by then, will be uniquely qualified."

Others who have invested in Mr. Li's new hedge fund include: Stanley Shuman, executive vice president at Rupert Murdoch's deal maker, Allen & Company; Jack Nash, co-founder of Odyssey Partners L.P.; Robert Shaye, chief executive of New Line Cinema Corporation; Robert Bernstein, former chief executive of Random House Inc. and a founding chairman of Human Rights Watch; and his son, Tom Bernstein, president of Chelsea Piers Management Inc. And proving that it's a chic investment, there is also Sting, the sensitive rock star and rain forest activist, who has kicked in with at least a million of his own.
Talk about a strong list of investors to get your fund up and running. Does anyone have Sting's number? I am looking for some seed capital...

Enjoy the notes below.



hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.