Distressed Debt Investors Club

As discussed in previous posts: Distressed Debt Investors Club - Intro and Distressed Debt Investors Club - FAQ and Distressed Debt Investors Club - Follow Up #2 we are very excited to say that the beta test (with real live users) is currently underway. Feedback has been remarkable. Development is tweaking some final design / technical flaws, but in a week or so, we will be ready to launch.

In the meantime, if you are planning to apply, get that investment idea ready. Here is what you will need: Company Name, Equity/Bond Ticker, a 4 sentence synopsis of the idea, and a longer write-up. The database allows you to upload a file (whether that be an image, XLS file) so if you want to include that, it is strongly encouraged. The User Base is anonymous meaning you are able to use an alias on the site - and no one will be able to see personal information.

Myself and two of my cohorts will read through each application and make a decision on an applicants status. My biggest concern with this entire boondoggle is the QUALITY OF INVESTMENT IDEAS. I want this to be a place where I can go and if I need to find an equity short, I can search the database for recent equity short ideas and trust that the user knows his shit.

Let me repeat: My #1 purpose for this site is to create the very fucking best community of investment thinkers in the distressed / high yield world.

Users will be able to interact with each other on a member only forum and with comments on each idea. Buy siders and sell siders alike are encouraged to apply. There will be a limited number of member spots for students, as I am hoping the vast majority of users (call it 95%) are currently practicing members and can talk about their investment ideas in the context of the larger market.

If you having questions on any of this, feel free to shoot me an email at hunter [at] distressed-debt-investing [dot] com. Stay tuned in a few weeks for when we open up the site for applications.

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Wisdom from Seth Klarman - Part 5

We continue today discussing Baupost's 2006 Annual Letter to Investors. As discussed previously on this blog, Seth Klarman is arguably our favorite investor and we hope to enlighten readers with some of his wisdom and "Klarman quotes."

"When people ask us about Baupost's risk controls, we have no glib answer. We have no risk control group we can trot out with a PowerPoint presentation. Risk control to us is a careful aligning of interests, a proper balance in our investing between greed and fear, experienced and collaborative senior management and investment teams that have worked together for quite some time, a consistent and disciplined investment approach where every opportunity is individually and meticulously evaluated on its fundamentals, a strict sell discipline, a willingness to hold cash when opportunity is scarce, a complete avoidance of recourse leverage, and a healthy level of fear."

Read that last sentence one more time. If that is not the way to run an investment partnership, then I don't know what is.

On discussing Baupost's edge (see some of our previous posts on this):

"...in today's competitive world, these edges do not ensure long term success. Our best ideas sometimes look a lot like other firms' best ideas and, at times, may even be identical. Yet our approach, if successfully executed, may enable us to outperform the crowd even if we have the exact same idea flow as everyone else. How might this be possible?

The answer is that we have worked hard to create an environment that lends itself to good decision-making. Simply put, we strive to make the most of each opportunity we have at hand. One way to do this, as mentioned earlier, is to avoid over-diversifying. Talking full advantage of our best ideas is a real no-brainer. The search for new opportunity is often times quite challenging; buying more of what we already know and like requires minimal additional effort. The teach approach that we have adopted at Baupost maximizes the probability that our best ideas will be effectively identified as such, and that a healthy overallocation of capital will be made to them. A firm that exploits its best ideas has superior returns, happier clients, better rewarded employees, and greater profitability."

Many people in the distressed debt world know circles exist among funds. Many people know which fund will put on positions just because another fund has the same position on. The problem is that only a few funds have the discipline to put a large portion of its capital in Enron or in 2007 sub-prime RMBS shorts. Those are the winners in my opinion.

A quick point on selling:

"Selling, in particular can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it."

On hedging the portfolio - and remember this was in early 2007 (read: GO GO GO market)

"In today's fully valued financial markets, one area remains quite inexpensive: disaster insurance. In general, disaster insurance is intended to offset portfolio losses from positions that are expected to suffer during or in the aftermath of extreme adversity or dislocation. Like any insurance, it usually expires worthless when the disaster fails to occur - but that doesn't mean it's not worth having. Financial disaster insurance can take many forms, including out-of-the money put options on individual stocks, baskets of stocks, or market indices. Call options on gold (a hard metal that has served as a store of value for centuries) or inexpensive out of the money options on interest rates or currencies, where a dramatic fluctuation could adversely affect our situation, are other forms of disaster insurance."

I remember watching an interview with Seth Klarman where he said he was buying credit protection on sovereign nations. It cost him approx 5-10bps a year. This was an incredible opportunity at the time as sovereigns blew out 100-300 bps depending on the country. And sub prime RMBS (whether the ABX or single-name) were a similar sort of trade...no real downside (cheap carry) and MASSIVE upside.

Speaking of Subprime:

The sub prime market is the canary in the coalmine of housing; a minor downward tremors in home prices could be felt with seismic force here, especially in the priced-almost-to perfection lower investment grade debt tranches. These tranches offer far too miserly a yield given the rather significant risk of principal impairment. Holders expect the real estate markets of tomorrow to closely resemble those of yesterday, and for Joe Sub prime to behave just like the average Joe. Should conditions worse, as they lately have been doing, and should the yield on these narrow slices of marginal credit risk to reflect this risks, as it currently happening, the financial Cuisinart that churns out sub prime tranches could become incapacitated. Then, then junior tranche trail could end up wagging the sub prime dog, causing the sub prime mortgage window to slam shut and thereby begin to restore sanity to the home lending market.

I think an interesting lesson to take from this: The area of excesses can be evidenced from which product Wall Street is pumping the most. Whether that be SIV's, Alt-A RMBS, CLO and levered loans, etc...this is where you have to worry.

Stay tuned in coming weeks as we explore the 2007 and 2008 Baupost Annual letter and discuss more about Seth Klarman and his fantastic investment record.

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Wisdom from Seth Klarman - Part 4

If you are new to the blog, here is part 1-3 from our "Wisdom from Seth Klarman" series.

Wisdom from Seth Klarman - Part 1

Wisdom from Seth Klarman - Part 2

Wisdom from Seth Klarman - Part 3

In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it, thank you to Andy for his donation (for those so inclined, a donation link is on the right rail, lower in the page). More donations = the better.

In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in comparison to the S&P which was up 15.8% that year. Gains were made from a number of categories with approximately 7% of absolute gain coming from performing and non performing debt - with the largest gain coming from "unnamed non-performing debt" which I speculated in last post was a position in Enron. These results are even more impressive given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over 40% during the year.

After discussing the party that was 2006, Klarman writes:

"We maintained our discipline throughout the year: disciplined buying when bargains emerged, and disciplined selling when prices approached full value. Despite fairly expensive markets, robust competition, and a near complete dearth of distressed debt opportunity, our tireless, highly capable, and experience team was able to fairly regularly uncover new opportunities. Considerable fundamental progress in many of our holdings, along with our strong selling discipline, triggered realizations during the year that were approximately equal to new purchases, resulting in relatively flat cash balances that masked substantial underlying activity.

One adverse in evidence during the year is that the markets proffered fewer extreme mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of the correction of these mispricings accelerated. In other words, fewer investments become really inexpensive, more become somewhat inexpensive, and the correction of these smaller mispricings happened faster than usual, enabling a particularly favorable overall result for us and for many value-oriented investors. It is impossible to know if this paradigm will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and increasingly private equity pool suggest that it could.

The old saw reminds us never to confuse genius with a bull market. Anyone can become "expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is lifting all boats often proves irresistible."

This guy must have a crystal ball. Remember he wrote this in January 2007. He is also somewhat pointing the finger (I am sure unintentionally) to many of the value investors that kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an interview with a prominent value investor saying that Freddie Mac was one of the cheapest stocks he had ever seen - and he just kept buying and buying it.

After talking about the sheer magnitude of capital flowing into alternative investments (hedge funds, venture capital, and private equity), fueled by demand from institutions and pensions:

"Many of today's institutional asset allocators are not evidently worried about the enormous amounts of capital surging into alternative investments. They are now asking the relevant bottoms-up question: Where are today's bargains? They are not following that thread to build, investment by investment, or one carefully chosen fund at a time, a diversified portfolio of undervalued investments. Instead, they are typically focused on the answer to three questions, each of which demonstrates a reluctance to think for themselves:

1. What has worked lately?
2. How can I diversify my way to investment success?
3. How can I invest like the institutional thought leader of this era; in other words, like Yale?

Here's why these questions range from remarkably foolish to largely irrelevant.

Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the sky. Sustained out performance in any particular sector of the markets is eventually borrowed from the future, to be given back either slowly through sustained under performance or quickly through price declines. What has worked lately is popular, widely owned, and bid up in price, and therefore generally anathema to good future results. But human nature makes it extremely difficult for people to embrace what has recently fared poorly."

And further down the letter...

"The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, what at least avoiding under performance. This is the best that you can hope to do in an efficient market.

For any fundamental-based investor, this is complete hogwash. Investment come in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either."

I love it. Too many times, each of us get caught up trying to look at some many things that our heads spin. A number of value investors suffer from a problem I fondly dub "Everything is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at everything, and lots of the things you look at you think are cheap. Any investor can rationalize a price target for any asset. The goal is to be patient and swing at those once in a lifetime opportunities, and then not dilute those returns with mediocre value traps.

"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not too distant future."

The first rule of investing is to not lose money. And the second rule is to not forget the first rule. When approaching situations, always look to the possibility and magnitude of permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an event a year or so ago and she mentioned that Warren Buffett will not invest in a situation where there is even a remote chance of permanent capital loss.

Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006 Baupost Annual Letter.

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Interview with Hedge Fund Manager Peter Lupoff - Part 2

Last week, we posted an exclusive interview with hedge fund manager Peter Lupoff. We continue the interview with Peter in the second part of the interview. As a reminder, you can find more here about Peter's hedge fund Tiburon Holdings

Talk about a current investment idea that is particularly compelling

I’d rather not talk about a specific idea at the moment but would rather talk about themes. We get ideas three ways:

• A top down “thematic” approach. From this, we delve deeply for those trade ideas that can survive the five prong methodology (see part 1 of interview)
• The gritty work the phones, contacts, read the news, watch the markets for leads way – old school
• “Mining the Portfolio” for ideas – that is, the deep work on any one name necessitates looking at comps and events, and in doing this, we uncover other trade ideas.

Let’s talk about themes for a moment. They can be grand in scope, given industry or economic circumstances or extremely narrow, given very rational and predicable behaviors (Rational Actor’s Assessment).

One major theme we played from ’07-’08 was shorting regional and community banks in the top 5 foreclosure markets, trading at (then) 3.5X tangible book and with 80% of their loans in home mortgages, HELOC’s, commercial mortgages and raw land. We then threw out those banks that had assets that could create events that could hurt the trade, i.e., SunTrust’s interest in the Coke trademark, etc.

Going into Summer, 2008, with a complete drought in the capital markets, we ran a screen for companies with ’08-’09 maturities and significant revolving credit availability, hypothesizing the wholesale draw down of the revolver and satisfaction of the near term maturities. Oh yeah, and the freak out of the equity over this action as well. I don’t recall what order it came in, but Apollo did coercive exchanges in Harrah’s and Realogy. Was it not predictable that doing one, they’d come with the other?

The inflow of significant retail money to Loan and High Yield bond funds is not only impacting secondary market prices, but stoking new issue markets opportunities for companies facing near term covenant issues or maturities. As some paper cycles out of portfolios due to refinancing, these technically driven investors are, in some instances, structurally compelled to replace with secondary market purchases or new issues. Assuming we properly do the Rational Actor’s Assessment (again, as part of the Five Pronged Methodology), we should be able to determine what company’s bank facilities have a majority of CDO holders. In those instances you can pretty well count on amendments passing that extend maturities. In those circumstances where near term maturities are extended beyond and once longer dated bond, there is upside in that bond.

I’d like to tell you that there’s a thematic trade that makes sense simply shorting “overvalued” securities in this, now overheated market. I don’t disagree with my friends and colleagues that say “the fundamentals don’t support these valuations” etc, but we live in the here and now, operating in real markets with money to be made or lost daily. How different is the refrain of investors that are short today on fundamentals from the deep value types that were long last year.

Fundamentals will matter and that work is necessary and valuable, however it isn’t what is driving these markets at the moment. Without an outward looking component to your methodology (“Process, Legal and Technical”), you can miss this. I’d hate to be the manager explaining to investors how we’re right and the markets are wrong.

I mentioned what I learned from Marty Whitman, but here’s what I learned from Izzy Englander: as mentioned, I was short regional and community banks in the top five foreclosure markets with 80% of loans in resi and commercial mortgages and raw land, when, in 2Q08, every bank CEO, as if handed a script from Hank Paulson, recited on Quarterly calls, “We will not cut the dividend today, we will not raise new money today”. I gave up half my gains on that theme in a matter of days. I spoke to Izzy about it, explaining why I was right and he reminded me that “you may be, but we are not in the being right business, we are in the money management business, and those are two different things.” You are a fiduciary and have a covenantal bond with the investor and their capital. DO NOT LOSE MONEY. The fund is not a weapon to prove right or wrong. Why not try to be right every day, rather than “eventually”?

Any advice for those looking to get into the distressed debt investing field?

Be a student of the business. What I mean by that is read everything. Not research per se, read books on the relevant topics. Read the sell-side strategist’s materials. Talk to people that have been around. I have worked with some of the best known, best regarded, often perceived to be difficult people in this business. Actively covet dialog with such people.

Don’t be in a rush to do things before you have any real experience. Do what it takes to get real experience. No one has time to train in the traditional sense, so when you get yourself in the right place, be sure you have the base minimum requisite skills to do your job.

Check your ego at the door and don’t get defensive about disagreement. In the right organizations, that dynamism is how the best decisions are arrived at. You are doing your part.

Don’t believe you have a monopoly on brain power or perspective. Be open to the unique and odd places you might learn things that make you better at what you do and that can help you make money or avoid losses.

On trade ideas, know what you know, know what you don’t know and consider that there are things that you don’t know that you don’t know.

At this juncture in life, what motivates you?

My wife, Kelly and little boy Max are everything.

But as to work: I am at heart, a competitive person. I like team sports, played a lot of football and basketball as a kid. This business gives us an opportunity to constantly take on competition whether its beating an index, convincing an investor to make an allocation, or having conviction about our trade theses to make returns uncorrelated to our peers. Internally focused, I am constantly evaluating how to make more civil, professional and productive work environment.

Now that I have my own thing in Tiburon, I can tinker and build on this as long as I am able. That’s exciting to me. I stepped away from the business in 1998 for a short hiatus and when I came back, very few people were there to help, with the expansion of the business, no one knew who I was. I started from scratch more or less. Faced with that, I conceived the strategy for how I could make it work and executed.

Thank you Peter for the great content! Stay tuned in the coming weeks as we have lined up a few more interviews with players in the distressed debt world.

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New Layout at How to Get a Hedge Fund Job

After much pestering from my wife and other people that claim I need to look "professional", I decided on working with some templates to see what readers think.

You can check the new look out How To Get a Hedge Fund Job .... all comments / flames welcome. You can email me (hunter [at] distressed-debt-investing.com) or leave a comment below. If no one has too much concern, I will use a similar, more beefed up look here.

Many posts scheduled for next week as I am on vacation the following week. Have a great weekend folks.

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