Great Quotes from Elliott's Most Recent Letter and Some Thoughts on the Market

This weekend I read Elliott Management's Quarterly Letter for the period ending June 30th, 2012. The letter was penned a few weeks ago, amd I think it has some pretty interesting takeaways on the market climate investors are dealing with on a day to day basis. Here's an introductory paragraph:

"Global financial markets currently feel like they are in a period of calm before a storm, possibly centered on the European situation. The problem is that no one can foresee when the storm will make landfall, or how severe it will be. However, if history is any guide, serious economic and market disturbances are likely to provide us with a variety of complicated restructuring and other trading opportunities, so we are ready to don our foul weather gear. In the meantime, we are concentrating on adding some positions in real estate securities and structured products. In those markets, there still seems to be a sweet spot of labor intensive, complex, small- to medium-size situations which we are taking on at attractive prices, despite the general overpricing of mainstream or trophy properties."
I wrote about this in the past, but is "hope" an investment strategy? I am not sure. I often hear strategists using the central bank "put" to get long the market as the tide of never-ending stimulus continues to roll on in prompting investors to bid up financial assets to levels where the risk / return spectrum doesn't make sense. What is fascinating about this dynamic is that in the end, the pain is just going to be so much worth for the entire system. Except of course for distressed investors that know how to navigate through the choppy water of situations that other investors decry as too ugly or too complicated. The choice words: "complicated restructuring" always brings a smile to my face.

I try to distinguish distressed situations into a few buckets. Some are very valuation oriented in the sense that ultimate exit multiple will be the ultimate determinant of recovery. Some are very legal in nature where a few choice rulings by a judge can tilt recoveries dramatically. Some are a combination of both. And others are just simply situations where you have to be in the weeds, working diligently with all parties involved to even come close to having an idea of intrinsic value of securities. This year some of the best performing distressed assets are part of these last groups and specifically surplus notes and holdco notes of some of the financial guarantors. I would wager that if 50 funds were spending a significant amount of time on ATPG, 5 of those 50 had the capacity and capability to look at an Ambac or Syncora.

On government bonds:
"Safe haven" could be the two most expensive and painful words for investors in the financial lexicon this year. Indeed, long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You’ve had a great ride, don’t press your luck. From here it is basically all risk, with very little reward."
I wish there was a way to measure this but I generally believe that the market will hurt the most investors at any one time. It is the contrarian in me. If everyone is long tech in 99, the market will crush tech. If everyone is long real estate in 2005, the market will crush real estate. Ben Graham and Warren Buffett uses the analogy of Mr. Market, a manic depressant business department that will sell to you at high prices in times of glee and at low prices in times of gloom. I think of this manic depressant to also be a serial killer that enjoys pain and suffering of his counterparties.

Fixed income investors in long term government bonds have so many structural issues to contend with that pain is on the horizon. These investors are the opposite side of the same coin of the investors that get long the market due to hope of central bank actions. Both are relying on an third party to control their destiny, just in different fashions. I do understand the argument about being long treasuries as a disaster hedge, but a hedge is very different than an investment. I personally would never put money to work in SPY 100 puts as an investment, but I am long them as part of a holistic view on the portfolio (think portfolio insurance).

Final quote from Elliott's letter:
"Of course Elliott’s goal at all times is to construct a portfolio which is protected against both the foreseeable and the unpredictable adverse forces and surprises that afflict long term trading strategies and firms. That is what we have tried to do for 35 years, and for the most part we have been reasonably successful and consistent. One of the ways we accomplish this is to pursue a mix of activities which have different drivers of risk and reward than just assessing future business values or interest rate and inflation trends. We also seek a staggered profile for exits and cash-out events. That is why we especially favor “uncorrelated” positions which require lots of manual effort, as well as situations in which we have substantial degrees of control over our destiny. For this reason, it is often the case that substantial portions of our portfolio generate some exits and inflection points at times when many firms’ books are stuck."
I unfortunately have no idea how Elliott constructs their portfolio for the tail scenarios I spoke about above. In fact, I wish I knew more of their distressed analysts to be frank (contact if you ever want to chat ideas).

What I do like about this quote is the commentary on hard catalysts (exits and cash-out events). A friend once told me the difference between a value trap and a good investment is a catalyst. For distressed investors the number of catalysts are numerous. For example, entering bankruptcy itself could be a catalyst for either a long or short position. Let's say a company with a senior bond and a sub bond files for bankruptcy. Those senior bonds may rally as left value is flowing to sub bond coupons. A judges ruling itself could be a catalyst where the market might be pricing in a ruling far different than you anticipate. Patriot Coal's venue change ruling will be an interesting one in that sort of vein.

I talk to a lot of people on the buy side. Everyone is so blah now. Maybe its because its August and I don't particularly spend a lot of time looking at European situations which has been the Garden of Eden for distressed fund raising in the past year. More maybe its because the markets a bit a head of itself. If I had to rate it on Oaktree's risk scale I'd say we are approaching a 4. Not quite there yet, but very close.

One statistic thrown around often is how under invested funds are right now. And when funds are under invested, they under perform en masse. And that's whats happening right now. Especially on the long / short side. And with high yield being up nearly 10% this year, many credit / distressed funds are under performing there as well.  Does that mean market participants will bid up various risk assets throughout the 3rd and 4th quarter trying to chase performance? I'm note sure. I've always struggled with that argument because liquidity can turn on a dime and funds that were chasing can turn out to be the greater fool in hoping to sell to a greater fool.

This is a very very difficult market to be an active participant in. Every day you could wake up and Greece could have defaulted, or the Middle East could break out into a scuffle, or China's economic data could be worse. And as the markets bid up risk assets and push credit spreads down, its just going to be more painful on the other-side. So like Elliott I am looking for off the radar, complicated distressed situations (I've spent a ton of time on PMI, and less off the radar, but fascinating: EIX/EME) and protecting the gains I've made using way out of the money puts as well as spending a whole lot of time on the short side selling call spreads and buying puts when volatility isn't too high. And as usual, working on projects that I'll announce to readers shortly.



Distressed Debt Weekend Reading

Here are the items from around the web we are reading at Distressed Debt Investing

Lessons on position sizing from Mohnish Pabrai [Value Investing World]

The new board at SYMS includes a number of great investors [Ragnar is a Pirate]

The case for an investment in Dreamworks (DWA) [Whopper Investments]

A delay in the general solicitation rules changes mandated by the JOBS Act [Change Crowdfunding Law Blog]

Weil Bankruptcy Blog explores section 552 of the Bankruptcy Code [Weil Bankruptcy Blog]

Who owns govie bonds these days [Bond Vigilantes]

Commentary on Oaktree Capital [Brooklyn Investor]



Portfolio Management: Convex versus Concave Strategies

In the past few weeks, everyone has been talking about GSE preferred stock. The impetus for this was far better results reported by Freddie Mac last week where they reported a provision slightly over $150M, down over 90% from the previous quarter. There are various flavors of both Fannie and Freddie prefs with the more liquid instruments trading at a slight premium to others (also certain dividend language, par value, etc has its effects). Some of the smartest funds in the world are very long Freddie prefs in a very big way on a notional basis, and have been for some time. Now more and more people are picking up the idea and running with it (piling on)

A friend pointed this out to me today and its something I completely missed: Most distressed funds HAVE to have some leverage to the upside in GSE preferred because the return asymmetries are so large, if certain events play out, those not playing would be left behind in the dust in terms of returns. Let's say a distressed fund has a 3% allocation to Freddie Mac prefs and the securities are reinstated with 100% of their dividend. That fund just made ~30%+ (assuming buy FMCKJs at 2.5 for simplicity) and you are trailing them by the same amount if you are not involved.

Many people draw parallels between poker and investing. Some great investors are also great poker players. (David Einhorn being the most prominent - I still hate the way ESPN characterized Einhorn during the coverage of the Big One for One Drop tournament. I.E. he should have gotten a lot more credit). Poker is a game of odds and expected value. You calculate the odds the pot is laying you versus the chance you have the best of it using not just the cards in your hands but also the actions of players around the table in the current hand and hands played previously. I've played in the main event in a previous, post Moneymaker WSOP, and welcome any chance I get to play poker.

Investing is similar in that none of us have perfect information. We do not know the future. We do not know if an overcard will hit on the river when you have queens in the hole, blanks on the board, and two loose players sticking around for no logical reason. Instead we calculate expected values of plausible scenarios, using conservative estimates, and determine if a security's current price gives you a margin of safety. If my worst downside case is $20, with an expected value of $40, and a distressed bond is trading at $22, I think that's an investment you make all day long. Asymmetric risk / return profile with a margin of safety is the holy grail - these are the bets I make in my personal account with smaller distressed positions that have money left for shareholders under all scenarios.

Investment lore often discusses the transition Warren Buffett made from going from his time at Graham-Newman to the Warren Buffett we know today. It is often cited that the realization and input of Charlie Munger on the benefits of "high quality businesses" and their nature to generate massive internal capital for shareholders was the key difference. In effect, he replaced his cigar butt investing that are effectively concave bets with high quality business investing which are indeed convex bets.

Being long Freddie Mac prefs is a convex bet. I can make many many many times my money for the potential downside.(I know you could make the case that the curve should actually end with a flat line for par value, but I can envision scenarios things could get a little crazy). Being a distressed bond is similar. If I buy a bond at 20 cents on the dollar, my downside is 20 points, with my upside being many multiples of that. And the most famous example: Being long protection on subprime in 2006/2007 was most surely a convex bet.

Being long a bond at par is the opposite. I buy a bond at par, I risk 100 points down and maybe 20 points up (higher in the IG universe due to duration impacts) ex coupon. The reason high yield works as an asset class is that the default rate and expected recovery rate relative to coupons, yield, and spread makes for a positive expected value in certain scenarios. Vanilla merger arb investing is similar (risk a deal break for limited upside) and that's why you see some of the best option guys out there also doing the best in merger arb (options allow investors to change concave curves into convex curves via various strategies attempting to play overbids or deal breaks).

The argument can, and has been made, that convex bets are really lottery tickets. Freddie Mac prefs fit this bill. Is there a a real margin of safety in those preferreds? I'm not sure. The chance of permanent capital loss is a real number - some people think its very high and some think its very low. The expected value though is probably positive though as the positive tail is just so big. A huge recovery multiplied by a small chance moved the needle when you are buying that security at 10% of par.

Concave strategies are not all bad. It would be a fool's errand to believe every investment you make has limitless upside with minimal to no downside. In fact, a solid set of concave strategies can pay for aforementioned lottery tickets. The problem of course is that investors are overconfident and when applying probabilities to various scenarios can get themselves in trouble when return and risk profiles are inherently concave (i.e. limited upside for lots more downside). Betting on stressed issuers paying off their maturity profiles is a common example. Let's take an example:

SVU (Supervalue Inc) have 7.5% 2014 bonds that trade in the 96 context. If SVU pays off that maturity, I'll make 4 points. If they default, I'll recover 40 (Recovery locks 35/45). I risk 56 points to make 4. If you believe, SVU has less than a ~7% chance to default before the maturity, one could argue that you should make that bet. I think that's a crazy bet unless you are 100% they will not default on that obligation: You are not a calculator that can pinpoint to the decimal point if SVU will file. The jump risk makes this bet a suicide trade because there aren't a lot of scenarios where the bonds hang out in the 60s, 70s, or 80s if they default. You are hit by a train and forced to take a 60 point loss.

The flip side is different though. When buying a bond at 4 with a target price of 60, you risk 4 points to make 56 (mirror image of last example). What is different here is that more often than not the trade is not binary: Its not 0 or 60. In fact its probably a set of recoveries from 0-60 (or higher) with distinct probabilities that drive positive expected value. The downside is bracketed by zero whereas upside accelerates higher. Here's the graph:

And I think this is where money management and poker begins to diverge: A poker player's bank roll is determined by the skill of a player with volatility swings on account of bad luck. A good poker player will know how to manage his bank roll to avoid ruin. A money manager's bank roll, i.e. AUM, is not determined by the skill of the investment manager unless all their money is completely locked up. Instead, a money manager's AUM is determined by the vagaries and emotions of his or her investors, which are cued off of returns. Investors across the board always get out at the bottom and pile in at the top - a concave strategy if I've ever heard of one. Because of this, being wrong on too many concave bets where results can seriously be hampered by just a few misses can lead to investors withdrawing and you not having any chips left to play. I'd rather buy 24 different bonds at 4, than one bond at 96, especially if you've done the hard work to put yourself in the right position for real upside.



Distressed Debt Weekly Links of Interest

Here's what we're reading this weekend at Distressed Debt Investing:

Third Circuit revisits equitable mootness in Philly News [Weil Bankruptcy Blog]

W.R. Grace is getting closer to emerging [Weil Bankruptcy Blog, yes again]

Buffett is cutting his exposure to consumer stocks [Prof David Kass' Blog]

Earnings surprises and subsequent price reactions [Musing of Markets]

Incredible read on claims trading in the KB Toys bankruptcy [Jones Day Blog]

Thoughts from ValueX Vail 2012 conference [Contrarian Edge Blog]

Thesis on shorting Activision Blizzard [Stableboy Selections]

Bronte Capital going from long to short in MSFT [Bronte Capital]

An interesting set of random thoughts from the Brooklyn Investor [The Brooklyn Investor]



Distressed Debt Emerging Manager Series: Castle Union

In the past on Distressed Debt Investing, I have taken the time to interview emerging hedge fund managers - those managers just getting started running their books and who I personally think will be remarkable successes. I am pleased to bring you another such interview: Toan Tran and Steve White of Castle Union Partners. Castle Union will be focused on distressed opportunities and special situations - Toan and Steve's areas of expertise. The fund's goal is to generate strong absolute returns, uncorrelated with the market. For more information on Castle Union, please visit their website: Castle Union Partners. Enjoy the interview!

Could you two give us a brief run down on your backgrounds? How did you come together for the idea of Castle Union?

Steve: For the past few years, I managed a special situations fund at an independent RIA in Chicago called RMB Capital Management. The strategy was similar to the one we employ at Castle Union -- things like distressed and off-the-radar companies, although I would occasionally buy larger companies when warranted. Before that I was an analyst at a small hedge fund called Marlin Capital.

We met through some mutual friends who knew we were both members of the Value Investors Club. We quickly realized that we had nearly identical investment philosophies and interests, so we started talking more and more. Eventually we were effectively "working" together over IM most days, sharing ideas on various securities - Toan for his personal accounts, and me for my fund at RMB. After a while, we had collaborated on enough big wins that we said, "The two of us need to be in a room together, managing our own fund."

Toan: I was an attorney in a former life and distressed/special situation investing is something I’ve done personally for nearly a decade now. Finding way off-the-radar securities where you can make a lot of money because you’re the only one who bothered to read through a 300 page indenture suits my personality. Before Castle Union, my day job was in equity research at Morningstar. I headed the team of analysts that covered the technology industry.

Steve and I fit well as co-founders, both in our investment philosophies and how we want to run Castle Union as a business. Our guiding principle is that we want to treat our investors the way we would want to be treated if we were in their shoes, and I think you see that in our fund’s terms.

Pat Dorsey, who hired me at Morningstar, is now the vice-chairman of the Sanibel Captiva Trust Company. A Sanibel affiliate is a minority investor in Castle Union and we could not hope for better partners. Capital raising is a challenge as a start-up fund and this is an area where our partnership with Sanibel is invaluable.

Castle Union hopes to target smaller distressed and special situations opportunities. Do you think that market is ripe for potential investments in this space?

Steve: Based on the opportunities we've acted on, absolutely. I'm hesitant to discuss all of specifics at length since we’re not terribly interested in attracting more competition. However, it is surprising how little focus there is on smaller distressed situations.

One of our favorites is buying on the day of the bankruptcy filing, when there are forced sellers and ample liquidity. This is our “Big Puke” strategy. We love situations where people are selling something because they just need to get out, regardless of the underlying value. Investors end up selling because they cannot own bankrupt companies, or they believe the day of the filing is the only day when there will be enough liquidity (which ends up being a self-fulfilling prophecy), or bankrupt must mean worthless, plus all of the emotional factors that come with these things. There are times when the overwhelming majority of people aren’t doing much analysis when they place the sell order. Admittedly, a lot of the time there isn’t much to do, but occasionally a very attractive situation comes along.

Toan: We simply try to exploit the structural inefficiencies in the market and operate in those gaps. A large fund has the knowledge and resources to quickly understand a distressed situation, but is unable to meaningfully invest in smaller situations. What’s the use of allocating resources to a situation that at best may make up 10 basis points of the fund? That’s the gap we step into and where we occasionally find a real information edge.

For example, we were involved in the HearUSA bankruptcy and there was a court filing that hit the docket late one Friday evening. This court document unambiguously told anyone who bothered to read it that HearUSA shareholders were going to receive roughly $1/share as a result of a bid for the company’s assets. When trading opened on Monday morning, there was significant stock available for less than $0.50/share (we suspect the largest shareholder was liquidating its position). As you can imagine, we were heavy buyers that morning and the stock eventually closed at $0.90/share that day after the news of the bid hit Bloomberg about 15 minutes before the close. That entire day, the market was literally giving away free money to anyone who had bothered to read a simple court filing.

Who do you view as competitors in this space?

Steve: Most of the funds we run into are small and don't file 13F forms with the SEC. Of the ones we know, we've actually become friends and share ideas. We're not adversarial towards other funds, in certain cases we work together because it helps generate better returns.

Toan: Anyone who fishes in the same ponds we do, we would actually love to meet, so please get in touch. We’ve met a number of people in our distressed travels and these are valuable and fun relationships.

In recent years there has been an alarming trend in the hedge fund business where the larger funds have gotten large at the expense of returns. How do you view the future of emerging hedge fund managers like yourself?

Toan: We have committed to our investors to keep the fund, Castle Union Partners LP, permanently small because we understand our strategy is not scalable. We have a soft close at $100 million in AUM, where we will assess the situation. If we feel our asset size is hurting returns, we would not hesitate to close the fund and return capital if necessary. In any case, we have a hard close at $200 million.

Steve: In general, I think there are great opportunities for emerging manager fund-of-funds and family offices. For better or worse, there’s a hugely inefficient market for allocating capital to nascent funds. There are many startup funds that are run by exceptionally talented people who for a variety of reasons can’t raise much money. In some ways it’s almost exactly like the small, esoteric situations that we look at in the stock market, because there are structural biases that lead to the inefficiency. But that inefficiency creates an opportunity, and for the intrepid capital allocator there are some really interesting emerging manager hedge funds to investigate [loudly clears throat].

On the flip side, distressed funds need a certain size to effect changes in some of the companies they work with (providing financing, rights offering). How do you plan to manage the balance between being nimble and being available to maximize these sorts of opportunities?

Toan: You’re right -- many interesting transactions can be done privately in distressed. Even with our AUM now, we’ve had discussions to structure private transactions in very small bankruptcy cases. With $100-$200 million of assets, we would feel comfortable putting $10-$20 million in an appropriately structured transaction like a backstopped rights offering. If more capital was required, we would happily bring in our friends at other funds to participate.

Beyond private transactions, we are also willing to get actively involved to improve outcomes. I am currently serving as chairman of the official equity committee in the Trident Microsystems case and we have relationships with top bankruptcy attorneys. As you can tell by the tone of the interview, we try to not take ourselves too seriously, but when necessary, we are zealous advocates for our investors’ interests. Bankruptcy is at times a melee and we’re not afraid to be adversarial to maximize returns.

Which investors have shaped your collective investment style?

Toan: Graham and Buffett have to form the basis of any rational investment philosophy: the difference between price and value, the value of independent thinking, and the need for a margin of safety. I’ve also benefited from Munger, primarily his advice to never be timid in sizing a position when a major opportunity comes along.

Steve: My former boss, who trained me in security analysis, is a guy named Mark Egan. He established a small hedge fund in Chicago in 1989 called Marlin Capital. No one's ever heard of it since Mark prefers a low profile -- I'd describe him as a reclusive investment genius. He taught me the importance of looking beyond numbers in a spreadsheet and understanding that people will act in their own enlightened self-interest.

How do you think about concentration of your investments? Do you plan to run a net neutral book?

Steve: It's hard to be opportunistic when you've got net exposure targets, so we don't have them.  Net exposure mandates often lead to a bunch of low-conviction shorts. If there are securities we think will drop in value, we'll short them. If not, we'll just be long-only. It’s not a philosophy that many people are comfortable with, but it makes sense to us. Besides, many of our long positions have little correlation with the market, so we’re not trying to hedge long exposures.

Toan: We expect to the fund to have 20 or so positions, but be very top heavy. Our top five holdings, and by extension, best ideas will likely make up a majority of the fund. We will sprinkle smaller 1% or 2% positions in securities where we have a reasonable thesis, but there are uncertainties we cannot eliminate, but are compensated by highly asymmetric risk/reward. The Freddie Mac preferreds are an example of a smaller position we may take.

What happens when the two of you disagree on a particular investment?

Steve: If we disagree we just move on. We both have enough respect for each other that it doesn't bruise my ego when Toan says, "Steve, that idea sucks." which happens daily, if not hourly. If we can't convince each other to invest in something, it's probably not worth investing in. And if we miss something, so be it, the person who was wrong buys the other guy lunch.

Toan: I can’t remember the last time I had to buy my own lunch.

I will note that you have a unique structure in an incentive fee refund? What is the idea behind that?

Steve: Our fund is fairly unique in that we have an incentive fee refund if performance turns negative. It's a common feature for private equity funds, but virtually unheard of for hedge funds.  How hedge funds have managed to escape this, I have no idea. Recently, I've seen hedge funds turn to features like hurdle rates and scaling incentive fees, which are nice for investors but promote the wrong kind of risk-taking by the fund manager. The refund incentivizes the right kind of behavior for us: preservation of capital, selective risk-taking, and longer-term thinking.  It's healthy to be held financially accountable for losses.

Toan: The only thing I have to add is that we have the incentive fee refund because it’s the right thing to do for our investors.

Can you talk an investment you find particularly compelling today that fits into Castle Union's strategy?

Toan: We own Meru Networks (MERU), a maker of enterprise WLAN equipment (think WiFi for enterprises). MERU was a once hot IPO that peaked at over $27/share in early 2011, but fell on hard times as it embarked on a sales force expansion. We purchased the stock in the $1.60/share range where it bore many hallmarks of inefficiency: MERU was $30 million market cap broken IPO that was universally hated by Wall Street analysts.

In March, MERU appointed Bami Bastani as its new CEO. Bami was the CEO of Trident Microsystems and I met him through the Trident bankruptcy case. Given Bami’s strengths, I think it’s likely he was brought in to stabilize and groom the company for an eventual sale. In addition, MERU recently closed on $12 million of financing that gives the lender a $2 million “success fee” upon a change of control. Couple these factors with heavy insider buying on the open market, and all signs point toward a sale of the company within the next year or two.

The stock is up 80% since reporting Q2 earnings, but we still think it’s very attractive, given what MERU could be worth to a big tech company with established sales and distribution. MERU does $100 million in annual sales with 65% gross margins. A company like Dell could pay a multiple of MERU’s $65 million gross because Dell can rip out nearly all of MERU’s operating costs. We saw this same story play out with Isilon (acquired by EMC), 3Par (acquired by HP), and Data Domain (acquired by EMC), just to name a few examples.

Steve: Another idea worth mentioning is the Eagle Hospitality preferred (EHPTP). Eagle is a hotel REIT that was taken private by Apollo Group in 2007. Apollo orphaned the preferred and stopped paying the dividend in 2009, and the shares subsequently plummeted to a cent or two on the dollar. They trade at about $2.00 today with 4 million preferred shares outstanding.

Eagle owns 13 hotels that are performing surprisingly well -- well enough that they’ve been current on their $600 million in mortgage debt. That debt was originally purchased by Bear Stearns, and one of the Maiden Lane funds ended up owning it. Recently, Blackstone bought the loans from the Federal Reserve for about $470 million. Finally, it is worth mentioning is that there is an activist involved and the preferred class elected two directors to the board.

With the debt maturity looming in September, there are several scenarios that we could see playing out, but in most cases there seems to be an easier path than not towards the preferred seeing a recovery above today’s price. Recent hotel transactions on a price-per-key metric suggest that there could be substantial value for the preferreds in the event of a sale of refinance. There are a number of other complex issues involved that we are omitting, but the point is we believe this is an asymmetric opportunity.

Thank you two for your time and we wish you good luck with the fund.



Does the Rising Tide of Primary Credit Markets Lift All Boats?

If you were relegated to one news item daily, and that news item was the strength of the high yield and leveraged loan primary market, you'd think the world was awash in bullishness and optimism. You'd think: "This economy must be trucking along" or "Job growth must be just spectacular" or "Every stock must be hitting 52 week highs." Then someone hands you a few Wall Street journals from the past week and you think to yourself, "Well: Europe is a complete disaster, economic growth is mediocre at best, China is a black box that on the surface seems to be slowing down. Maybe things aren't as good as the primary market suggests."

High yield just reported its 8th consecutive weekly inflow. While this week was the lightest inflow for some time, it still came in at a robust $402M. Including funds that only report monthly, the last 8 weeks have seen $10B of high yield inflows. Year to date, inflows to high yield bond funds were over $27B versus a ~$15.5B for all of 2011. High yield is up 8.7% this year (CSFB) and retail is chasing the returns. These inflow numbers, combined with very light dealer positioning (=relatively illiquid markets), and a search for yield has catapulted most primary high yield and leveraged loan deals to be oversubscribed. Food fights and poor allocations have abound As an example, demand for the Patriot Coal DIP is quite robust with spreads being tightened 25 bps and OID going from 98 to 98.5.

I emphasize most in the previous paragraph as certain deals have struggled (and probably rightly so). The Supervalu term loan added 50 bps of spread and 2 points of OID to get done. Granted this was a covenant lite loan backed by marginal grocery stores, but the deal still got done. A few deals that got hung or shelved months ago are coming back to the market with revised terms and pricing.

And you guessed it: Dividend deals are coming back. Pilot, West Corp, Genpact, Dunkin' Brands (dividend or share buy backs), Red Prairie, and CHI Overhead just to name a few. The primary CLO market has been robust this year and arrangers are feeding the beast as it were.

The bullish argument for high yield is well understood: Corporate balance sheets are solid, high yield really grinds it out in muddle through economies, U.S. high yield issuers are generally heavily levered to the local U.S. economy which removes any Europe taint, etc. That is all well and good. But who gets excited about a steel distributor inside 6.5% unless someone that has too much 1) cash to put to work 2) time on their hands.

What is fascinating about this robust primary market, relative to similar ones we saw during both 2010 and 2011 that eventually sputtered out, is that the amount of pain (read: opportunity) in other one off situations is just staggering and frankly too much to dig through. Here is just a list of things I would like to spend significant amount of time on:

  • SVU/Albertsons/American Stores: American Stores, in theory, has a double dip because of the guarantee at SVU. I've attempted to build a waterfall here and nearly blacked out as the pensions can reach into every box, the lease rejection claims could be ahead of bonds, intercompany loans could or could not exist, etc.
  • ETFC equity
  • Mortgage Insurers: See MTG move today
  • Autos of all flavors: I'm particularly partial to GM and some of the suppliers
  • ATPG - started dusting off old notes
  • For profit education
  • EIX
  • Shipping
And those are just the on-the run names. There's a long list of illiquids too I'm keeping close to the vest.

(Editor Side Note: You will note I didn't mention Knight Capital Group. I have doing work on Knight. I got greedy (stingy) on the converts and didn't pick up any and hate myself for not chasing. My plan was to by the converts and hedge by buying near term 2.5 puts. Would have worked out nicely. This situation resolves itself fast as Knight will have to deliver security (read: losses) in T+3 from yesterday. I admire whoever was buying the converts in the 50s. I have chosen not to do a post yet on KCG as the ability to hedge is somewhat limited right now and the uncertainty over a white knight / full sale versus a bankruptcy followed by a sale / split of businesses is pretty opaque. I wish I had a few billion dollars of capital sitting around to provide a rescue package here. 'Rescuers' that come to mind: Leucadia, Citadel (though they shuttered / sold their bond broker business last year), Jefferies, Aquiline Holdings (Jeff Greenberg's private equity shop) - the list goes on and on. This is real business - the question we need to ask: "Is this a permanent problem, or a temporary on?." I think its a little of both, but with the right buyer here, the reputational risks fall by the way side and you are left with a company with fantastic businesses that earn over $100M a year that, at $2/share is trading for ~$200M market cap. If you are looking at it and want to chat, please send me an email.

Here is the org chart, devised from Exhibit 21.1 in the most recent 10K.

In the above chart, Knight Execution and Clearing Services LLC and Knight Capital Americas, L.P. are the domestic broker dealers. Knight Capital Europe Limited is also a registered foreign broker dealer.

The 10K notes that "Under the Term Credit Agreement, substantially all of the Company’s material subsidiaries (the “Guarantors”), other than its foreign subsidiaries, excluded regulated subsidiaries (which include registered broker-dealer subsidiaries) and subsidiaries thereof, guarantee the repayment of loans made pursuant to the Term Credit Agreement. The Term Credit Agreement is secured by substantially all of the assets of the Company and the Guarantors unless and until the Company obtains an investment grade rating." There is also a revolver, with borrowers, Knight Execution and Clearing Services LLC and Knight Capital Americas, L.P. the broker dealers. Knight Capital Europe Limited is also a broker deal. The converts are issued at the holding company, seemingly with no opco guarantees.)

So, there is a lot to work on in the secondary side, but I often ask myself: If the primary market is so good, when things turn (and they always turn), won't I be able to buy the aforementioned secondary assets cheaper. Does a robust primary market, naturally inflate the trading level of all assets? For example, if the primary market was terrible, where would the KCG converts shake out? I honestly do not know the answer to that so instead I try to find ways to mitigate a complete shut down of capital deployment:
  1. Focus on investment opportunities with a margin of safety, an asymmetric risk return profiles, and a hard, identifiable catalyst. Preferably where there is forced selling involved.
  2. Remember that markets are fickle due to the short term demands of the money management business and time arbitrage should be leveraged at all times (especially in personal accounts where time horizons can be LONG)
  3. Keep adding names that could be interesting at lower levels and monitoring for any drastic changes in market price 
  4. Raise cash in assets that are getting closer to fully valued. Historically selling has been the weakness of many great investors. Do you sell at 90% of IV or 80% or even 100+% ... I'd be less worried about getting every bit of juice out of particular investment in this type of environment.
These are interesting times to be a credit / distressed investor. Huge bifurcation between a plentiful secondary opportunity set that needs investigating and the painfully robust primary market that probably needs avoiding. Of course without a robust primary market, distressed wouldn't exist - bankruptcies are born in these types of markets; just we do not know it at the time. At some point though down the line investors will ask themselves: "Did I really underwrite a dividend deal for this pig? What was I thinking?"

I'll leave the reader with a great investor's thoughts on today's markets. In a letter to investors, Louis Bacon, founder and CEO of Moore Capital Management, wrote one of the best analogies I've read on the market we face today - hope as a strategy could be driving this primary robustness. On speaking of coordinated rounds of global stimulus we've seen in the past year(s) [my emphasis added]:
"Markets are increasingly distorted by central banks’ attempts to squeeze drops of growth from an over-indebted private sector across much of the developed world. These distortions stem from the central banks’ bias toward large-scale bond purchases along with super-low official interest rates, the demand for safe assets in a world still brimming with debt, and the discrediting of equities. It is increasingly apparent to market operators that these central bank-induced distortions are closer to reaching the end of their natural usefulness. Quantitative easing and its European cousin — long-term refinancing operations — have been useful and credible as a means of providing liquidity to markets and addressing systemic tail risk, at least temporarily. But as a way to boost growth from sub-trend to above-trend rates, and thereby facilitate deleveraging, such monetary policies have proven woefully inadequate, due to the politics around mounting public debt. In the U.S., a caustic political environment and an anti-business administration worry businesses and consumers as to how government is going to exit its fiscal stimulus policies in a coordinated and nonthreatening manner; whereas in Europe, a punitive fiscal retrenchment mandated by core countries has not yielded the weaker currency and the lower peripheral interest rates prescribed by a normal macro model. Markets have learned and, of course like junkies, now demand more frequent monetary hits in greater size"



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.