Some Lessons from 1Q 2012 Hedge Fund Letters

Distressed Debt Investing is back from vacation.

Over the past few weeks, I have received a number of hedge fund letters from managers large and small. Like I have done in past posts, I think drawing out some of the most salient or interesting takeaways is good exercise for the enterprising investor (while not discussing specific fund performance). Unfortunately, I cannot send a lot of these out as they are water-marked in some capacity. If you have any other letters that I may have missed, please send them my way to hunter [at] distressed-debt-investing [dot] com.

First off is Avenue Capital's letter to investors in their Avenue Investments, L.P. fund (this is the distressed fund that investment in the Milacron and MagnaChip bankruptcies in the past). After discussing some of their successes and thoughts on the quarter, specifically with Avenue taking some of their bets off the table, Avenue goes on to discuss their hedging strategy:

"We added to the Fund’s single-name short positions in the quarter as we continued to recognize certain negative secular trends and company-specific challenges. This reflects our cautionary stance regarding the approach 20% of the Fund on an exposure basis, versus less than 5% just a year ago. This growth is reflected in both the increased size of these positions, as well as more than doubling the number of singlename shorts in the portfolio...
...In summary, we are encouraged both by the current portfolio and our pipeline of opportunities. As of December 31, 2011, there were over 100 companies with approximately $400 billion debt outstanding with average gross leverage of greater than 9.0x in our pipeline.  Approximately 80% of these companies are in the middle market space. While we see opportunities across many sectors, the largest focus is within power and energy, retail and consumer products, and media-related companies."
Given the timing of the letter, the hedging strategy looks amazing prescient.  Personally, I allocated very little to the high yield / leveraged loan space from March - May as investors were "yield crazy" and deals that were marginal at best were coming to market from marginal dealers. This dynamic has changed significantly in just a few weeks with a number of high yield deals being pulled and terms being tightened up and IRRs improved fairly dramatically in the sell off of high yield. The last paragraph of Avenue's, which discusses, the up coming distressed opportunity set is mighty exciting.

Seth Klarman's Baupost Group's letter is, as usual, fascinating. In the letter, Klarman discusses the reach for yield across asset classes, spurred by governments across the globe pushing interest rates to zero. He then writes:

"The fact that this strong rally has been spurred by government policy--low interest rates forcing investors into risky instruments in search of yield--makes it riskier still. Government interventions in markets can be ephemeral, subject to the vicissitudes of politics, and at the mercy of market action that can force the government’s hand. The government is winking to investors that the coast is clear, that speculation should commence and will be rewarded. That is the kind of message that only a short-term trader can love. In a sense, investors are once again treating all news as good. Signs of strength are greeted with exuberant rallies. Signs of weakness are met with a few days of decline, followed by yet another rally as investors anticipate further government intervention.
We will not be tempted into making investments based on such absurdly short-term thinking, which sadly still dominate wall Street."
I have written in the past to friends and colleagues that an ECB Bond, QE 4, 5, 6, or an aggressive China FE isn't a viable investment strategy. While I may give up short term performance in a government fueled rally, the longer the can is kicked down the road (i.e. the more risks investors are taking), the more pain will be felt on the other side.

Larry Robbins' Glenview Capital's 1Q letter to investor is as usual full of goodies. It goes on to talk about the long hospital thesis Larry Robbins presented at the most recent Ira Sohn. Before that though, Robbins discusses the current "macro vs micro" argument quite prevalent in any discussion you have a with another buy-side analyst these days.

"While the market often debates about the two ends of the barbell – will Europe recover or implode – we think that a sound portfolio strategy needs to also take into account the option that economies in countries with bloated sovereign balance sheets and imbalanced income statements may limp along, wounded, for an extended period of time. As such, we are seeking strong alpha opportunities by owning companies which are high in quality, low in valuation, and supported by both intermediate term liquidity and strong free cash flow, while maintaining market hedges in those companies and equities that are less well positioned along each attribute."
Love it. I think if I was focused on running an equity book, the combination of a Tiger like approach of getting long the best companies in an industry that sport reasonable valuations and short the weakest, fundamentally broken companies, with an overlay of tail-risk portfolio hedges makes a lot of sense in this environment.

Greenlight Capital's 1Q letter made the rounds in the past week or so. David Einhorn uses the letter to discuss a number of their portfolio positions and as well as a review of some of their more macro-centric trades.  In addition, if you have not seen it, Einhorn spoke at the Grant Conference earlier in the year. His comments can be read here: Davin Einhorn comments at Grant's 2012. From the letter, my favorite take-away was his comments on Japan / Japanese Yen:
"The Japanese Yen finally showed some weakness, falling more than 7% during the quarter to Y82.79 per dollar. Several times during the past couple of years, we've though the Yen was on the verge of weakening, only to be proven wrong. While the long-term fundamentals of Japan's economy has not improved, the Yen has nonetheless continued to strengthen, to the point where many Japanese corporations can no long compete effectively. Last year, Panasonic, Sharp, NEC and Mazda all lost money. Industrial Japan is hurting and the country is no longer running a trade surplus. Politicians have taken note and are calling for a lower Yen and an end to deflation. The Bank of Japan (BOJ) has largely dragged its feet, but not it might have to capitulate. The mood at the BOJ is changing and, more importantly, so is the makeup of its Board. Within the next year, five of the nine governors, including the Chairman and both Deputy Chairmen, will be replaced. Two of those seats are currently vacant, and the Japanese legislature has already rejected one candidate because he was deemed unlikely to push for aggressive action to weaken the Yen. The Partnership remains positioned to benefit from a weakening Yen."
In previous reports it been suggested that, similar to Kyle Bass, Greenlight is expecting much higher interest rates in Japan along with being short the Yen. The thesis is well developed and the new make-up of the BOJ board could be the catalyst that moves the trade. I have heard everything from 10x10 swaps, swaptions, and long calls on interest rates as ways to express the trade, but I am sure there are more technical ways to maximize leverage while keeping carry costs low.

Third Point's 1Q letter has been out for some time. It is, as usual, a fantastic read.  The discussion on tail risk was the most enlightening to me, especially the idea of betting long term Aussie rates would fall in a China slow down.
"First, since 2009, we have maintained a basket of "tail" trades, usually amounting to about 50-100 basis points of protection. We try to cushion the portfolio against various tail event risks including a war in the Middle East, EU sovereign defaults, contagion from Eastern Europe peripheral countries' stress, Japanese fiscal weakness, the sustainability of China's pace of growth, pressure on the Fed's control over rates and its balance sheet, and a global growth slowdown. We structure these trades in a variety of warys including via commodities, currencies, rates, swaps, puts and calls. This "tail risk" portfolio has remained fairly steady in overall size since its inception, and we expect it to remain roughly in this range indefinitely. The key is that these positions should provide some insurance when and if we most need it, with limited costs in the (hoped for) event that the worst never materializes."
Just fantastic stuff. The examples he goes on to list are brilliant (again the Aussie rates falling if China slows down) and a clear example of second derivative thinking.  I.E. a less developed would be just to short China, but that is expensive with non optimal upside / downside characteristics. A friend commented to me that Dan Loeb could be the best manager out there these days given the breadth his bringing to the portfolio including mortgage related activities, distressed, event driven, macro-hedging, etc.

Finally, Bill Ackman's Pershing Square's 1Q letter was released this week.  I am currently reading The Alpha Masters (I'll be doing a thorough review soon). Coincidentally I finished the Ackman chapter on the subway today. Simply amazing - especially the part about contacting Seth Klarman when he was at HBS back in the day. So far I'd highly recommend the book.

Ackman leads off the letter with his discussion of time arbitrage, an issue we've covered on the blog in the past.

"In our investment approach, we wait for the opportunity to purchase a great business at a highly discounted valuation, when investors overreact to negative macro or company-specific events. This is the time arbitrage part of the strategy. Our time frame for value realization is long term so we don’t typically react to short-term factors that have little impact on long-term, intrinsic values. While the opportunity to take advantage of time arbitrage is a competitive advantage for Pershing Square, it is a limited one because there are other investors who share our longer-term horizon.
Our greatest competitive advantage is the ability to buy a stake in a company with the ability to intervene in the decision making, strategy, management, or structure of the business. We are one of the few investors in the world who can implement this approach at large corporations, which gives us an enormous long-term competitive advantage."
Ackman goes on to discuss some of the big changes going on at both CP and JCP (I am long various parts of each's capital structure), as well as a few others.  He does tease us with this:

"We have begun to build a large stake in a business that meets our high standards for business quality at a low valuation. We have also added an equity short position to the portfolio. We look forward to sharing our thinking about each of these investments when appropriate."
While its hard to get a sense of what name he is shorting, I was thinking of candidates for the long investment.  The name I keep coming back to is Walgreen's (WAG) which I am very very long and continue to get longer. The handling of the ESRX issue has been horrendous, they own a solid real estate portfolio (Ackman has gravitated to these), the stock has gone no where in 10 years, and their board owns basically no shares. At $26B of market cap, it might be too big though.  Other names that pop up in my head are Safeway (serial under-performer, real estate ownership, lots of cash flow), Avon Products, and Sysco.

We will have to wait to see. If you have thoughts, I'd love to hear them.

Given the market volatility in the past 6 weeks, it seems that the defensive positioning of some of the funds mentioned above will pay off. As usual, with a little blood in the water, it's getting more and more fun out there.


Anonymous,  6/14/2012  

Ackman's book on MBIA is really interesting, but left me wondering just how good of an investor he is. He made money by holding the CDS' against MBIA and exited the position instead of holding it through to expiration. Ultimately, it turns out that it was just a temporary spike and not as bad of a situation as he thought. They still had a really great insurance business, but the dabblings in mortgage related derivatives, including synthetic ones, didn't work out well at all.

He was right on a part of all of it, but there seemed to be some emotion, because he didn't seem to exercise much control over the size of his MBIA bet and it may have been too deep into capital structure.

I've been torn on how to think about that situation. His arguments against an insurer with no losses also seemed like he might have just not spent enough time in the industry. There are lines where you should have a 0% loss ratio, like surety. As it turned out, they played some games with reinsurance, and so that was definitely an issue, but it wasn't to the extent that Ackman seemed to be portraying.

As I said, I'm torn on how to think about his analysis and investing in general.

Anonymous,  6/14/2012  

When guys like Ackman or Einhorn go short, I think they tend to go into hyperbole and bombast -- and sometimes full blown conspiracy mongering -- to try to prove their position right.

But his long positions where they buy a substantial stake without the need to pay a control premium and then make management/structural changes is definitely a powerful investing strategy, if for no other reason than there are high barriers to entry. I'm less enthused about stuff like JCP which is a raw business turnaround play, but ones where it is more of a matter of unlocking value by pushing through a spin, refocusing internal investment, or simply pushing out ineffective management for what is otherwise a great business (not necessarily JCP) is a legitimate strategy. You get some elements of private equity investment without the expensive control premium or auctions.

JJ,  6/14/2012  

A general question about distressed debt investing from an inexperienced:

I recently read this blog post (and comments) about the mistake the blogger made in a bankruptcy situation. This is the first time I learned about due bill used in this context.

My question is, what books/resources would you suggest for getting oneself familiar with these little mechanics in bankruptcies? I'm currently reading Moyer's DDA. I did a quick text search on Amazon. I'm pretty sure it is not covered there.

Anonymous,  6/15/2012  

I don't know enough about MBIA's capital structure, but is it possible that Ackman actually saved the company from bankruptcy? My logic is that almost no one else was publicly pointing out the risks of the mono-line insurers, including the rating agencies. Ackman's vocal criticism led MBIA to raise additional capital that it otherwise would not have done, thus bolstering the balance sheet.

I don't know if the size of the capital raises was sufficient in itself to dodge bankruptcy, but at a minimum it improved the recovery value of the debt. So even though Ackman was "wrong" on MBIA CDS, his activism may have been the reason he was wrong. So did he earn the money or not? Good philosophical question for an investor.

Anonymous,  6/15/2012  

When you mention that you have a long position, are you long stock or debt? Thanks....

Thilo,  6/19/2012  

An interesting additional reading to the discussion citied from the Baupost letter could be an aritcle from David Einhorn in the Huff Pos



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.