Distressed Debt Investing: Systematic Risks

After we announced the hedge fund manager interview series last week, we reached out to one of the first hedge fund managers we interviewed here on Distressed Debt Investing: Peter Lupoff of Tiburon Capital Management (you can find Peter Lupoff's interview here).

With that said, we reached out to Peter to see if he would update us on how the markets have treated him in 2010 as well as any event-driven opportunities he is seeing currently in the market. We will be bringing you that interview early in 2011. Until then though, Peter pointed me to some fantastic resources on systematic risks and how it pertains to event driven and hedge fund asset allocation.

The first resource is an interview Peter did with Bloomberg News. You can view the interview here: Peter Lupoff on "Inside Track"

The second is a presentation Peter gave at a Fed/FMA Session on Systemic Risk in October:

And finally, Peter has penned an amazing piece entitled, "Systemic Risk – Curing the Disease and Killing the Patient" which can be found at Tiburon Capital's website here: Systemic Risk – Curing the Disease and Killing the Patient




Hedge Fund Resume Service

A little over a year ago, I launched the How to Get a Hedge Fund Job Blog. There, I help readers navigate the somewhat tumultuous maze that comes with getting a job on the buy-side ranging from resume tips, case study preparation, and success with interviews.

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This is a personalized service. I can only offer this service to three or four individuals at a time to provide the absolute best service possible.

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If you are thinking that this is something you want to take care of TODAY, and not months or years from now, then check out the details of our resume service offering by clicking here:

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Thanks again for all of your support. And as always, please email me if you have specific questions.



Hedge Fund Manager Interview Series - Harris Kupperman Part II

Yesterday, we brought you the first part of a two part series interviewing hedge fund manager Harris Kupperman. After the interview, for those interested, Harris runs a fantastic blog: http://adventuresincapitalism.com/ that I suggest you check out. Enjoy the second part of the interview!

Are there any other 5 year trends outside of precious metals ? What do you think is the next gold going forward?

I have some theories of my own going forward and I’m buying some stuff but I’d really rather not jump in there. The problem is that the world wide economy is looking weak. Some countries are good and some are mediocre but a lot of countries are in really bad shape and it is really hard to get too optimistic on global GDP overall. I don’t think we’ll see global GDP decline much but it could muddle along for a decade. So it’s really hard to find real growth industries because the world is just not growing.

I think it’s more exciting to look at the specific economies that are really growing. You have places in Latin America and Asia that are really growing fast. These are small economies that are not as inter connected with the global economy yet and the asset prices are cheap. As an investor in these countries you can pick up a tailwind of GDP growth of 5 or 10% yoy. They are small economies and people don’t talk about them much but I think it’s exciting and that is really where I focus my energy now.

I’m sure there are a lot of over looked companies there.

Exactly, but I think you need that macro tailwind. Which means you need an economy that is growing 10% a year because then you are going to have growth in the economy and even more growth at the company level. It is just going to be really hard to find industries or companies that can grow in a stagnant economy so if you can focus on the few economies that are growing I think you will do quite well. There will always be a few countries out there doing well but you really want to have that tailwind.

Even harder to find companies that have yet to be discovered.

Right. Which is why some of these smaller economies are so much more interesting. Because $1b+ hedge funds can’t go there. A lot of the companies are $50-100m market cap or even smaller. It’s a place for people like me to figure out, not the big guys. So the pricing is much better.

How do you get around the communication and accounting standards?

You need to just go in there and not think of it like a western investor. You should spend a month or 2-3 weeks there and just approach it with an open mind. You should read my post on Mongolia if you haven’t yet.

I read that and I thought it was great. I thought there was a particularly interesting point regarding the accounting where you said at a certain point you need to just take a leap of faith and invest even if you don’t know what the accounting is yet.

There is accounting. There are numbers. There is research to do. If you go in there and make investments you have to assume that you are going to have a few problems. However, if in aggregate you buy the companies cheap you are likely going to do all right as a whole. Another important point is that if you are in a country, like Mongolia, where they don’ t have investors showing up and they don’t talk to shareholders and things aren’t all cleaned up and pretty in the accounting there is a good chance that there is no incentive for people to over state things like there is here. Besides, their motive is to understate things for taxes, not to overstate so that their stock options go up in value.

That is an interesting commentary you rarely hear about emerging markets. What do you guys think of technical analysis? Do you use anything like this?

It’s really hard when you are a fund trying to buy millions of shares of a small company and it is hard for you to really have a view on the chart pattern of a $50m market cap company. If you go in there and buy a few million dollars of stock your buying alone could dramatically affect the price action and impact the chart.

What do you like and dislike about being a hedge fund manager?

Just don’t like the marketing but I love everything else. I have been able to meet and work with some great people. I have learned a lot and I have gotten to travel all over the world. It is really a great thing in my mind. I just really don’t like dealing with marketing but nearly everything else is great.

I have some of the best investors in the world and some of them I talk to routinely. The marketing thing is just pointless though. You go to NY and do 50 meetings and get 4 or 5 guys who seem interested and at the end of 3-4 weeks of effort you get one guy who writes a check. I’ve gotten to the point where the fund is closed to new investors and I just don’t want to market and deal with nonsense. Marketing and sales used to take a quarter of my time and now I spend none of my time on that and it is the greatest thing ever.

The best way to grow assets is to put up consistent returns?

You know, I don’t even want to grow the fund. The fund is closed. It is funny though, since I’ve closed the fund I’ve had more investors than ever offering to give me money than when it was open. I’ve turned away lots of money. It’s a strange thing.

Is this because you don’t want the fund to get bigger and lower your opportunity set?

I just don’t want to deal with investors really. I had a bad experience in 2008 with a lot of redemptions and I just don’t want to repeat that. You know, if you are a big fund with large caps you can deal with redemptions by just selling and moving on. If you are a small cap guy though and own 5% to 30% of a company it is really hard to get redemptions. You create your own worst monster because as you sell you keep pushing it lower which is bad for everyone.

What advice would you give to someone else starting a small fund?

Just focus on the track record and ignore raising capital. Hire the best people you possibly can also. Don’t try to save money because it always costs more in the long run.

What’s the most profitable investment you’ve ever made?

That is hard to say. I was really early on uranium. I was in it before $16 and it went up to $145. The little producers naturally went up much more in percentage terms, so that was pretty amazing.

What was the worst investment you ever had?

Oh man…. we saw piles of FNM, LEH and BSC puts expire worthless. 2008 was the hardest year for me though, we started out good but then when equities started falling we began buying too soon. Something we liked a lot would be down 40% and then we’d buy some and it would go down another 75%. Those weren’t necessarily bad investments but it was painful. Shorting in general is just very very hard and stressful though. Most of my worst investments have been on the short side.

Any other memorable trades worth mentioning?

Energold was an interesting one. We had a big position that we started building early in 2007. At the end of 2008 it went from $5 to .55 and was trading at less than cash despite no debt and being fcf positive. When it went down to 0.55 we were buying and now it is back to about $3. I couldn’t believe it could be that cheap when it happened. I mean, it was trading at $5 and we thought it was cheap then. It was one of those rare gifts in the investment world. We missed it the first time because we weren’t aggressive enough in chasing after it. We just didn’t realize how good it was. Then we got a second chance. We got to buy shares at a fraction of our cost basis. It was crazy.

How do you generate ideas?

Mostly I am just lucky to have many friends who are smarter than me! I am always talking to people in the industry and that gets me lots of interesting companies to look at. Just asking who is taking market share, who is most respected, this is a great way to generate investment ideas. I never look to Wall Street though, I don’t talk to wall street analysts and I only know like a dozen fund managers. The less I am influenced by Wall Street the better in my mind.

How do you decide when to sell an investment?

That is a tough question as I always sell to soon; if someone bought only the companies I sold they would be a rich rich man! Generally I try to decide what to hold based on the opportunity set in front of me. Sometimes an idea goes up dramatically or something happens that changed your thesis and that makes the decision easier but generally I sell something when I have a better idea I’d rather put the capital into.

What do you do when you’ve had many investments in a row move against you?

Ultimately we are fundamental investors and when a stock gets cut in half that is when you realize if you know the company well or not. If you like a company at x price then at 0.5x you should like it even more. So when things move against us we try to buy more. We also always keep some cash around to help us in these situations. In the past we have used margin as well, although I am a bit scared of it, if deemed necessary I will margin up to be a buyer.

What is the largest position you have ever taken as a % of capital?

We’ve had a few big investments go our way. I remember putting 25% into US global and watching it go from $5 to $75. If you really want to generate outsized returns you need to put your high confidence trades on in big size so you are there when the time is right. We don’t typically take a small position. That is a test of your knowledge and conviction of the idea. If an idea we have is not worth putting at least 5% or more of our capital on then we will pass on it. If you are really doing your homework and you are disciplined then you will not find many opportunities worth purchasing. There are just so few truly amazing companies; they are so rare, that when you find them cheap you need to buy a lot of them. We very rarely just jump into a 25% position though. It usually starts out smaller and so we typically buy some because we like the business and our research shows the company is good. Then we go talk to management and are impressed and so we buy some more. Then we see how the next quarter goes and it is even ahead of what we thought they’d do, so we’ll buy even more. So a 25% position grows into that size. We measure the 25% of capital based on cost also, so if something goes up a bunch we don’t necessarily trim it just because it is up a lot. I think that is a mistake because if you trimming your larger positions you are inherently selling the investments that are working out best for you.

So far we have not gotten a 25% investment wrong. We have gotten a few 10% of capital ideas wrong though. We really only find a 25% of capital idea every couple years and so we know when we have something that is valuable when we do. We probably find an idea worthy of 5% of capital a few times a year, an idea worth 10% of capital maybe once a year if we are lucky but a 25% of capital idea comes along very rarely.

Do you think it was easier to make money in the markets now or 30-40 years ago?

I think it is a bit harder now since you need to do better research. Screening software and tools are free and so powerful now that if you want to find amazing situations you need to look for situations that don’t show up in financials because once the situation becomes apparent in the financials and shows the earnings power of the company then there are already 100 people looking at it. There are always opportunities though. One way to deal with competition is you can go to other countries. You can find companies at 1/3 book value, trading at a 2 p/e with 20% dividend yield if you go to the right countries and know where to look.

What is the best investing book ever written?

I read mostly history and biographies now. I used to read finance and accounting in the past but now much less frequently. If I had to pick one though I’d say Marc Faber’s Tomorrow’s Gold is the best book ever for investing. That book really helps you understand big picture themes and it is very well written. You can make good money finding cheap companies and many investors do very well with this strategy. When you find a really cheap company you will generally double your money, which is not bad. However, to make 10x or more on your investment you need to find big picture themes as well. Once you get those big themes right, and then find companies that benefit from that with good management teams, that is how you get 5-10x+ returns on an idea.

What do you like to do in your free time?

I am lucky to do what I love so I have been able to blend my traveling and reading with my business. Most of my free time I spend reading and traveling. I will take a friend for a week or two and go see somewhere new and interesting. We will rent a car and drive around, meet with some companies and see some interesting stuff. I really like to travel, I am on the road at least a third of the time, and I enjoy reading so that is what I try to do as much as I can.

Do you think you’ll be investing professionally until you’re old or do you think you’ll hang up the hat and retire at some point?

I haven’t given it much thought. I am having a great time though and so I have no intent to retire anytime soon. Even if retired, I would probably continue to do this with my own money. Honestly, I am not sure what I would do if I retired but I really am having fun doing this.

Thank you for your time Harris



Hedge Fund Manager Interview Series

Over the last two of three months, I have toyed with the idea of doing something like Value Investor Insight for emerging hedge fund managers. Over the years I have met some truly incredible investors running smaller funds that most have never heard of. These investors are not trying to build an empire but are instead content to manage smaller pools of capital without the head ache or managing a $1b fund. Some of these investors have absolutely incredible track records and are full of investing wisdom. Because of a number of major projects I have going on across the sites (one will be announced Monday), I thought it better to start the series right here on the blog for all to see. I will be working with Shaun Noll, founder and managing partner of Stirling Capital Management -who did today's interview- to bring you a series of interviews over the next few months.

With that said, if you are a hedge fund manager with less than $100M of assets and would like exposure, please reach out to me (hunter [at] distressed-debt-investing.com). Or if you have a recommendation for a manager you would like to see interviewed, I can do the hard work and try to convince them to come on the site. Value, event driven, distressed - we welcome all!

I have been following Harris Kupperman for a while now and I am always impressed with his ability to foresee long term macro shifts and put those themes to work with deep fundamental company research. In addition to this, Harris is 100% self taught and built an incredible track record with a fund he started straight out of college. He is one of the best investors I have met when it comes to finding “small companies that will become big companies” and so it gives me great pleasure to introduce Harris Kupperman of Praetorian Capital. This is part 1 of the interview. Part 2 will go up tomorrow.

Please tell us how you got started investing Harris:

I had always been interested in economics and the markets but I first began investing in college. I started managing some family money and by the end of college was up more than tenfold on my money when the world was in free fall. After that, family and friends asked me to run their own money and the easiest way to do that was to start a hedge fund. So senior year of college I started my hedge fund.

So you started your fund very young. That is impressive and unusual.

The hedge fund kind of started itself in some ways. People would come to me and ask me to run $25k or $50k for them and so that is how I started the fund. We’ve done very well since the fund began and so here I am today.

So did you have any investment experience prior?

No previous investment experience, I just read a lot of books. I still read constantly, I typically read at least 10 books a month. In college, I was going to school but wasn’t putting much effort into my classes because I was so focused on investing.

I am completely self-taught though. When I was learning, one thing I would do is look at big investments made by great investors in the past that were successful. Then I would see how that idea performed over time and I learned what worked and why. I learned a tremendous amount by reverse engineering their trades and I think that helped me a lot.

How much money did you start the fund with If you don’t mind disclosing?

I started the fund with $90k but at the end of the first 6 months we were at $1m and then by the end of the first year we were at a few million. The fund’s size just ramped from there. I really never went out and tried to raise capital until 2008. I wanted to put together a 5 year track record first since I thought that would speak for itself. After a few years we had a very good track record though, in the top 1% of all funds out there. So we were making money for people and then people would come to me and say, “My friends want to invest in the fund also, what can you do?” and that is how the fund grew. I didn’t go to New York and do a lot of interviews and actively try to raise money, I probably should have in retrospect but I didn’t. I wasn’t trying to start a business for the sake of starting a business, I was doing it for the intellectual pursuit of what makes money in the market.

Of course spending time on investing money is better than spending time on marketing.

Yeah, I always thought that if the track record was good the money would come to you. And that is not quite the case. If you’re a contrarian it means you’re buying when other people hate it. So then when you go pitch the fund to potential investors they ask what you are buying and you tell them “X is what I’m buying and I know you don’t like it but here is why it makes sense”. It’s tough to raise money that way because you know they are going to think you are crazy.

I guess that is one of the natural side effects of being contrarian.

Of course and I’m also not investing in big companies people have heard of. I am investing in tiny esoteric situations nobody knows about that have a lot of upside potential. While there is great potential in these areas it just makes for a difficult sales pitch to your average New York investor or institution.

What kind of investing were you focused on when you started? Sounds like long/short equity?

Basically our specialty, and I say “our” since I have a couple people working for me, but our specialty is finding little companies that will become big companies. We look for a secular or macro trend where we have the wind at our back, then we try to find the best couple companies in that industry. We get to know management well and then we get to REALLY know the industry, and when we feel comfortable we take a big position. We are not a highly diversified fund, at any given point we hold somewhere between 10 and 20 stocks and the top 5 positions are more than half our capital. There just aren’t that many good situations out there. When you get to know a company and really like it, you want to have a big position. It takes a tremendous amount of work for each idea and so you want to be there in size when we find something we like.

We have always focused on small companies though. I simply feel that is the best way to compound returns over the long term. If you look at the 500 largest publicly traded companies in the US, over the last 100 years you would have compounded at roughly 7%. If you look at the next 1500 companies you would have seen compounded returns of nearly 12% and if you look at even smaller companies it gets better. The compounded average returns of the next 1000 companies are nearly 20%. The crazy thing is that everybody knows this as it has been demonstrated in academic studies over and over and over again. The problem is that in small caps you are going to have a year every 3 to 5 years where the entire sector gets wiped out and is down 20% or more. If you are trying to run a money management business you may not survive that year as investors redeem from your fund and you have to sell into declining and less liquid stocks. What if your fund’s first year is that year where small caps decline dramatically? Your fund will likely never get a second chance and that will be the end right there. So everyone knows that small companies generate higher returns over time but it is a difficult strategy to implement for these reasons and so we choose to focus in this area. There just isn’t as much competition.

Do you use leverage?

We have but it is not really what we like to do. A small amount of leverage won’t kill you but if you take on too much it gets very dangerous and makes the fund more difficult to manage.

So you are long only? You don’t talk very much about shorting stock.

No, in the past we have been very short. A few years ago, we saw a lot of the problems coming that hit in 2008, so from early 2006 we were actually net short. This was quite frustrating though as our long book would be up over 100% a year and then we’d give back a good chunk of that on the short side. This was a very frustrating experience because you see crazy frauds keep going up when it is so clear they are a disaster. We ended up being broadly right but after that experience I decided I never really want to be on the short side again. It is very easy to look at a cheap stock and say this thing is going to go higher because the company is growing earnings very fast. It is much more difficult however to time when an over leveraged or fraudulent business is going to finally fall apart. There are so many great little businesses out there also that we have decided to primarily focus on buying these companies as opposed to shorting.

I think that is understandable and we have heard similar thinking from other very successful investors. Not to mention that psychologically it is much harder to manage that side of the book.

Exactly, and if you are good you don’t necessarily need to look for bad companies. Since we are in small caps which are relatively binary, when you get one of these right you’re going to make 5-10x your money. This is not the way shorting works though as you’re not going to make 5x returns on the short side. Maybe you’ll make 50% instead. As a result of this and everything else we don’t focus on the short side anymore. Of course we always have some stuff we are looking at on the short side and if we came across something amazingly bad we might put on a smaller position but we are pretty much long only at this point.

Do you ever put on any macro hedges? There have been a lot of the more famous investors talking about this lately. This would be the Seth Klarman or David Einhorn approach with a generally long only strategy but with a few cheap insurance policies for protection.

The thing about insurance is that you have to pay a premium for it. If you think about it you are going to compound better if you don’t go out there and pay up for protection because protection is generally priced for the guy who is selling it. The fund is friend and family money and my own money is a big piece of the fund so we can take a lot of volatility and don’t have to focus on smoothing out our returns. I just don’t see a reason to be hedging and over paying for insurance since we are looking out and trying to figure out what is going to happen over the next 5-10 years and not trying to generate low vol returns so I can market to someone else. I’ve seen way too many funds try to do that try and squeeze out 200bps a month, every single month, just so they can go try and raise $2b. That may be a great business strategy but it is not very intellectually satisfying so we don’t focus on that.

Sounds like you’re style has changed quite a bit over last 10 years then?

I wouldn’t say it’s changed a whole lot. We don’t short much anymore because we just decided we didn’t want to be on the short side anymore. Honestly, I don’t think there is much money to be made on the short side anyway these days. If I felt like there was a very pregnant opportunity I’d probably put more energy into it but I just don’t feel like there is much downside from here generally.

Why do you say that? I would say that is pretty contrarian in itself. Do you think the global situation is pretty stable?

I don’t know. It was so obvious before, just so blatantly obvious. You had to be a fool not to see it. I just don’t feel like the problems are as obvious anymore. Companies have decent balance sheets more or less. There are lots of problems lurking out there but there is not the systemic risk in the same way.

I think the primary risks now are government issues and governments misbehaving. They are over leveraged, over regulating and just acting idiotic. I think the real risks for the next decade are governmental and macro and not really companies that are frauds. Basically any company that was over leveraged or a fraud got taken out in 2008 and 2009 and so we haven’t had a chance for new over-leveraged industries to be built. So I just don’t think there is that much downside. Maybe the market could drop a third from here, and it wouldn’t really be shocking. Overall though, I just don’t feel like there is a chance for a whole-sale slaughter as there was before. Especially with governments printing so much money and holding up asset prices forever.

So then naturally you must be bullish on precious metals?

I find macro or secular themes with a strong tailwind to them and go find the best companies in the industry and so I think precious metals are an interesting place to be right now. I got involved originally in precious metals back when gold was at $330 back in 2003, we got really active in 2004 and you know we are still involved. It changes from time to time but it is a macro theme that will go on for a long time. The problem is you won’t find the bargains in this space you found 5 years ago.

That makes sense though with so many people digging in that space now.

Right. The thing about these trends is that you need to discover them early when nobody cares about them and then take your position early and we’ve done that really well in precious metals and in the whole commodity sector really. I think the better trend now is not necessarily buying gold. It could go higher, I don’t know much. It could double or triple from here but it won’t go up 10 fold like it could when you’re buying it at $330. I think the more interesting trend to get into is buying into the mining services sector. This is our biggest sector bet right now. It’s a bet that companies have used up their resources at a much higher rate than they have discovered new deposits industry wide across the globe. You have seen a lot of industries where they are depleting their resources faster than they are being replaced, whether it is nickel or oil or any of these things. The numbers aren’t always the same but in some industries like copper you have just seen that nobody is putting money back into it. You drill holes and it costs money and you have to put that against your income statement and executives don’t want to do that. So instead companies have been spending a lot more on making acquisitions to replace reserves. The problem is that there just aren’t that many valuable little resource companies any more since nobody has really found anything big. If you look at global expenditures on the hard rock exploration spending it probably needs to run at $15b to replace what has been mined. This year should come in at $8-9b and last year was half of that and the peak in 2008 was at $12 or 13b. So the industry as a whole is clearly not replacing what is mined. Then taking into account that global GDP is growing a few percent a year and global population is growing at a few percent a year, it is clear that you need to do more than replace reserves you actually have to grow worldwide reserves. Before the play was to buy the commodities and commodities companies themselves but I think it now is more exciting to invest in the arms merchants, the guys selling the picks and shovels.

For the first time in a long time the mining companies are making good money, they’ve paid down a lot of the debt they acquired in the last decade in their acquisition binges. I think now that they have cash flow they are going to start spending on exploration, partially just because there is nothing truly valuable left to acquire. You look at some of the prices paid by some of these guys in the last few months on acquisitions and it is amazing. Kinross over paid on Rubicon, Goldcorp overpaid last week on Andean. You look at some of these and you realize that they either have to vastly overpay or they take their chances drilling holes and at some point drilling some holes just looks more attractive. I think that is the trend I’d rather bet on than betting on the price of gold going much higher, although I think it will.

Stay tuned tomorrow for Part 2 of our Hedge Fund Manager Interview Series with Harris Kupperman of Praetorian Capital.



What in God's Name is Going on in the Muni Market?

One of the reasons I have always enjoyed being involved in the high yield and distressed debt markets is the ability to really dig through things that have been completely beaten down and no one wants to touch.

In early 2008, there were a series of event that lead to a number of well regarded municipal issuers having to pay 10-20% on their auction rate securities. We bought as much of the vanilla issuers as we could- after it was announced that Warren Buffett was doing the same thing, the trade stopped working as municipalities got smart and started terming out their debt.

Well today, a friend emailed me, and told me to look at the charts on a number of levered muni closed end funds. Have you see these charts? Let's pull up the old 4x1 Bloomberg Graph, comparing with ETF and three different closed end muni funds:

For reference:
  • MUS: BlackRock MuniHoldings Quality Fund
  • PML: PIMCO Municipal Income Fund II
  • FMN: Federated Premier Municipal Income Fund
  • HYD: Market Vectors High Yield Municipal Index ETF
I thought to myself - it has to be the move in the treasury right? So I added the 30 year treasury bond to the graph:

As you can see, the sell off has been significantly more dramatic in the closed end and muni ETFs relative to the long bond. So what is going on?

I do not regularly invest in this market unless there is at least a little blood in the streets - little did I know there is a lot of blood in the streets. The muni markets was hit with a perfect storm of negativity over the past few weeks:
  1. A huge supply calendar: JP Morgan notes that next week could be the record for muni supply coming to market IN U.S. HISTORY (my emphasis added)
  2. Republicans win election means state budgets get less support from the federal government which means increasing stress on ability of municipalities to pay (and certain muni provision as part of President Obama's stimulus bill that need to be re-upped)
  3. Everyone and their mother front-running the Fed and the subsequent unwind (compounded by the unwind of the long end of the Treasury curve as well)
  4. Leverage, leverage, leverage. Most of these closed end muni ETFs are levered one way or the other. Further, and I really cannot believe they still exist after the debacle that was 2008, municipal arbitrage hedge funds probably were probably crushed with the recent moves in the curve. Borrow short to invest long? Even with hedging via swaps and swaptions, imbalances between the muni curve and treasury curve arise and when you are 20x levered disaster can strike.
  5. Concerns over BABs expiration: If you didn't know, the Build America Bonds program expire on December 31st. Issuers want to sell as much paper as possible to avoid the chance the interest credit gets removed - again more supply on the market.
  6. Muni mutual fund flow is nill at best: According to AMG, approximately $45M has been put to work in the last two weeks in municipal bond funds. The average weekly inflow this year is over $650M.
  7. The economy and general risk concerns (i.e. Allied Irish Bank, Asia raising rates, etc)
As would be expected in such an environment, the credit curve for tax exempt bonds is steeping - and FAST. We are talking unheard of moves.

But what is an investor to do in this sort of environment? I say average down. Supply is going to continue to stay high until clarity on BABs/Stimulus Provision (specifically the AMT provision - muni's issued in 2009/2010 are exempt from property and casualty insurers which are large buyers in this space) and demand will be tepid. I personally will be dipping my toes in some of the closed end New York muni funds (PNI, EVY, etc) sporting 6-7% yields (nearly 10% taxable equivalent). Hell - I live in New York - and if this ship is going down, I'm taking my tax exempt bonds with me.



13Fs and Post Reorg Equities

One of the my favorite times each quarter is the 45th day after quarter end when hedge funds report their holdings in stocks. My good friend Jay at Market Folly is far and away the best coverage of 13Fs out there and I strongly you suggest you frequently check his site for analysis of some of the best hedge funds in the world.

As a distressed/event-driven investor, I allocate a substantial amount of time to post reorg equities. Many distressed debt funds have a mandate to purchase companies emerging from bankruptcy or who have recently emerged from bankruptcy. Many funds stretch the "recently" to five, six, or even seven years so you will see many distressed funds in names that many people forget even went through the bankruptcy process.

With that said, I also like to look at companies which have recently emerged from Chapter 11 and have a substantial float to get a sense of what event driven and distressed debt funds are doing in these post reorg securities. Let's take a look at a company which recently emerged: Smurfit Stone (SSCC respectively).

Before we begin though, one caveat. Many distressed debt funds will play a reorg prior to a emergence, and then wait until the company is listed and possibly picked up by an index to sell the security into the index buying strength. As with all 13Fs, these filings are just a way to find more ideas and get a sense of what funds are doing out there in post reorg land.

On June 30th, SSCC announced its emergence from bankruptcy. Let's take a peak at their holders list (I've decided to include only the top 30 holders here):

As you can see, this list of 30 funds is a pretty diverse group. Just looking at the top 15 holders (top image), here are the funds I see:
  • Royal Capital Management: A well regarded long/short hedge fund that also has played in Lear.
  • Apollo Management: Self-explanatory - one of the best.
  • Wayzata Investment Partners: All over the distressed scene playing in recent bankruptcy emergences like Neff, Rath Gibson, and Merisant
  • Columbus Hill Capital: Started by a former Appaloosa partner (they are also located in Short Hills, NJ), their 13F has names like Dana, MGIC, PMI, Lear as well as some well known large caps like BAC and IP.
  • Elm Ridge: Started by Ron Gutfleish who spent time at Omega and GSAM, Barron's wrote in April 2004: "Gutfleish and his posse run their hedge-fund operation from an ultramodern New York office building on Third Avenue. They pride themselves on their ability to stir the pot of controversy. In the almost four years it has been in operation, Elm Ridge has won a reputation for being able to make money in all sorts of markets by aggressive analysis and bare-knuckle trading."
  • Brigade Capital: One of the newer members of the distressed pack but also highly highly regarded. Very smart group of portfolio managers and analysts there that play up and down the capital structure and strategies.
  • JGD Management i.e. York Capital: Blue chip and as best as they come.
  • P Schoenfeld Asset Management: Check their website. Great stuff.
  • Litespeed Management: Well regarded event-driven fun run by Jamie Zimmerman, playing in merger arb, distressed debt, and special situations.
Next quarter, after the 12/31/2010 13F filings are in we will re-visit this post re-reorg equity to see who stayed in versus who flipped the security after it emerged from bankruptcy.



Two Great Articles from Simoleon Sense

My good friend Miguel Barbosa has put up some absolutely amazing content at his blog Simoleon Sense.

The first is a no-holds barred, extensive interview with Alice Schroeder, author of The Snowball, THE (my emphasis) biography you have to read on Warren Buffett. In this interview, Alice releases some never-before talked about characteristics of WEB's investing style. It is an absolutely fascinating read.

The second document is a set of notes from the "Invest for Kids 2010 Conference." A fantastic charity, invest for kids features speakers including Bill Ackman, Josh Freidman, and Larry Robbins (among others). Enjoy!



Greenlight Capital: 3rd Quarter 2010 Letter

Greenlight Capital released their 3rd Quarter 2010 letter (courtesy of Dealbreaker) which you can see here: Greenlight Capital's 3rd Quarter 2010 Letter.

Outside of the fantastic commentary on the eventual failure of QE2 to actually accomplish anything substantial (a position I strongly agree with), one of the most interesting things I took away from the letter was Greenlight's activity in distressed debt.

In the letter, Greenlight points out that they purchased the debt and equity of ATP Oil & Gas, a recent favorite of many members of the distressed debt community. As an example, in June, two members of the Distressed Debt Investors Club both pitched the ATP debt as longs with sizable return potential. How have those bonds done since June? Pretty well:

What happened here. Let me see if I can give you a quick run-down of the situation:
  • Deep water drilling moratorium enacted in the Gulf due to the BP spill - a 6 month halt on drilling could cost lots of money for ATP as 60% of their reserves are located in deepwater GOM. That combined with a heavy capex program - people begin to worry about the future cash flow potential of this company. People even begin to mention a possibly bankruptcy due to a cash crunch. Sell side starts downgrading en masse (i.e. time to start looking at it as a long)
  • Bonds continue to weaken. On the 8th of June, bonds are down 4-6 points in thin trading. Reason: The purported second leak that didn't actually exist. A downgrade to CCC+ did not help either.
  • Bonds start moving higher as rumors that the drilling moratorium on deep water drilling could end sooner. Stock moving 10-15% a day up also seemed to help.
  • Louisiana judge lifts ban - bonds shoot up - felt like a short squeeze really as bonds felt heavy post.
  • ATP place a new $150M term loan (with an option to extend to $500M). Market begins to start pricing ATP as a going concern versus a liquidation (despite the possible increased priming)
  • Bonds weaken as representatives from the House begin discussing the $75M liability cap (i.e. insurance would be prohibitively expensive for someone like ATP) and a new moratorium is put into place.
  • Bonds move up on no volume/news until ATP releases disappointing 2Q numbers - then bonds move down on substantial volume
  • Beginning of September there was rumors on another rig explosion: One bold trader made a 75-80 market.
  • Bonds begin to drift higher on seemingly no news. Then company announces a $350M TL to monetize ATP Titan. Bonds continue to move higher.
  • Rumors that the deepwater drilling ban will end early keeps the bonds moving higher still. Sell side starts to get bullish again - i.e. time to possibly lock in some gains.
  • 2nd Telemark Hub begins production. Bonds and stock continue to climb.
  • More rumors about the lift in the drilling moratorium. Bonds and stock climb further.
  • Moratorium conditionally lifted - bonds go bid without (no sellers) in the mid 90s.
That takes us to about 2-3 weeks ago. There has been some positive and negative news since and bonds went out wrapped around 90 this afternoon.

During this entire timeline though, the company could have received at least $500M of assets for the Titan assets, had spent significant amounts of capital at both the Telemark and Gomez wells, had ~90MMbbl of Gulf of Mexico Reserves, and ~40M of North Sea Reserves, and nearly $300M of cash. Using sensible numbers, you could make a case for $2B for these assets vs. $1.65B of 1st lien and 2nd lien debt (before Titan monetization). Yes - you could have made the argument that GOM drilling was done for eternity, but then I would have called you crazy. It was a temporary problem that, yes, could have dragged on, but maybe to the detriment of $250M-$500M of ATP's value - still nearly covering the 2nd liens.

The above timeline shows you a typical distressed situation - sometimes they work out and other times they do not. As noted above and in previous posts, you have to compare how much your assets can be monetized for versus the claims against them. When the ATP bonds dropped to 70%, at market, there was about $1.2B of claims versus the aforementioned $2B of value - in my opinion, a pretty attractive margin of safety. If the moratorium had lasted into 2011, the company would have filed, and the bonds would have gone lower, but at the end of the day, the asset value would still be there and returns to the 2nd lien bonds may have been greater as they would have been the fulcrum security. Quite an interesting story indeed.



Advanced Distressed Debt Lesson - Permitted Holders Carveout

Over the past week, many high yield and credit strategist put out a number of pieces on the recent rise of LBOs. What has driven this renewed interest in the LBO space? Lower cost of debt capital in the form of all time low yields across the B and BB space. While we have not seen LBOs like we did in the first half of 2007, conditions are ripe for a dramatic increase in the number of take private transactions for the rest of the year and into 2011 - especially if the Fed continues keep the curve at near all time historic lows.

With that said, high yield investors have started to review the indentures and credit agreements of current outstanding debt to understand better what would happen if a portfolio investment was taken over in an LBO or an MBO. In market parlance, the protection most investors seem to rely on is the change of control covenant or CoC. While the definitions of a change of control vary dramatically between indentures, a change of control covenant, all else being equal means that if XYZ company gets taken over, bondholders have the option to put the bond back to the company at 101.

Before I begin to dig into further details on CoC covenants, one interesting dynamic has created an interesting situation for bond investors. That is, because the treasury curve is so tight, many BB and B credits are trading well above 101. I do not have the statistic in front of me but I believe the average BB credit is trading around 105 right now. If there are no other covenants protecting you (outside a change of control), and an LBO goes forward, you are then faced with the choice of losing, on average, 4 points on your portfolio (105-101) or letting it ride in a now more levered, more speculative credit. Fun.

Getting back to the change of control covenant, as noted above, indentures vary dramatically between issuers and even in different bonds of the same issuer. For instance, in many cuspier investment grade credits, the change of control covenant may be worded that not only must their be a new ownership structure, but the company must also be downgraded to below IG by all rating agencies. From here, all sorts of legal ramifications and irregularities start to take hold. For instance, what if at the time of the takeover, one rating agency already had the company at below IG - then the "Change of Control Event" may not be fully satisfied according to the indenture and hence you are SOL.

With that said, one of the biggest carve outs under the change of control covenant you will see in indentures are the "Permitted Holders" carve outs. Let's look at some language to see what I am talking about here.

In August 2010, Expedia placed a 5.95% Senior Note due 2020. In the 8K announcing the deal, here is what the company had to say about change of control:
"The Company may redeem the notes, in whole or in part, at any time or from time to time at a specified make-whole premium. Upon the occurrence of a change of control triggering event (as defined in the Indenture), each holder of notes will have the right to require the Company to repurchase such holder’s notes, in whole or in part, at a purchase price in cash equal to 101% of the principal amount thereof, plus any accrued and unpaid interest to the date of purchase. The Indenture contains covenants limiting the Company’s ability and the Company’s subsidiaries’ ability to create certain liens, enter into sale and lease-back transactions, and consolidate or merge with, or convey, transfer or lease all or substantially all the Company’s assets to, another person. However, each of these covenants is subject to certain exceptions."
Unfortunately, 8k's mean nothing in the legal world. For the real juice, we need to look at the indenture (my emphasis added)
Change of Control” means the occurrence of any of the following events:

(1) any “person” (as such term is used in Sections 13(d) and 14(d) of the Exchange Act), other than one or more Permitted Holders, is or becomes the “beneficial owner” (as defined in Rules 13d-3 and 13d-5 under the Exchange Act), directly or indirectly, of more than 50% of the total voting power of the Voting Stock of the Company;

(2) individuals who on the Issue Date constituted the Board of Directors of the Company (together with any new directors whose election by such Board of Directors or whose nomination for election by the shareholders of the Company was approved or ratified by a vote of a majority of the directors of the Company then still in office who were either directors on the Issue Date or whose election or nomination for election was previously so approved or ratified) cease for any reason to constitute a majority of the Board of Directors of the Company then in office;

(3) the adoption of a plan relating to the liquidation or dissolution of the Company; or

(4) the merger or consolidation of the Company with or into another Person or the merger of another Person with or into the Company, or the sale of all or substantially all the assets of the Company (determined on a consolidated basis) to another Person other than (i) a transaction in which the survivor or transferee is a Person that is controlled by the Permitted Holders or (ii) a transaction following which (A) in the case of a merger or consolidation transaction, holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the surviving Person in such merger or consolidation transaction immediately after such transaction and (B) in the case of a sale of assets transaction, each transferee becomes an obligor in respect of the Notes and either (i) each transferee becomes a Subsidiary of the transferor of such assets or (ii) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of the transferee.

Notwithstanding the foregoing, a transaction will not be deemed to involve a Change of Control if (1) the Company becomes a direct or indirect wholly-owned subsidiary (the “Sub Entity”) of a holding company and (2) holders of securities that represented 100% of the Voting Stock of the Company immediately prior to such transaction (or other securities into which such securities are converted as part of such merger or consolidation transaction) own directly or indirectly at least a majority of the voting power of the Voting Stock of such holding company; provided that, upon the consummation of any such transaction, “Change of Control” shall thereafter include any Change of Control of any direct or indirect parent of the Sub Entity.
Look at the differences from the 8K to the actual indenture language. Specifically look at the clause "other than Permitted Holders" - let's dive back into the indenture and find the definition of "Permitted Holders:"
“Permitted Holders” means Barry Diller, Liberty Media Corporation and their respective affiliates and any group (as such term is used in Section 13(d) and 14(d) of the Exchange Act) with respect to which any such persons collectively exercise a majority of the voting power.
So even if the company gets taken over, but Barry Diller or Liberty Media are the "buying party" the change of control put would not be triggered. All else being equal, if Barry Diller or Liberty Media wanted to lever up Expedia in an LBO, bond holders would see their relative credit metrics weaken dramatically and consequently spreads would widen.

Sometimes in these cases bond holders are protected by negative pledge covenants as well as incurrence covenants. But given how structures and indentures have progressively gotten weaker over the past 18 months, bond holders have little protection when the permitted holders carve out allows for a credit negative LBO or MBO. Read those indentures to make sure you and your investors are protected as I expect to see many more LBOs in the coming months.



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.