Pershing Square Investor Letter
Lots of discussion on GGP's bankruptcy (a favorite of distressed debt investors) in the letter.
Enjoy:
Pershing Square Third Quarter Investor Letter 12.07.2009
12.02.2009
Wisdom from Seth Klarman - Part 6
This is the 6th installment of our "Wisdom from Seth Klarman" Series:
In this edition, we will be discussing the 2007 Baupost Annual Letter. 2007 was a monster year for Baupost: Up ~52% for all their respective funds. Given how large their asset base was in the beginning of the year, as well as the amount of cash that was held on the sidelines, this is an incredibly impressive result. Baupost breaks out their return by asset class each year: In this year, like many other funds, benefited largely from gains from credit protection - i.e. shorting sub prime MBS.
Before getting the fund commentary, Klarman discusses Baupost's use of cash in the portfolio.
"Turbulent and declining markets have increased our opportunity set, and we have put considerable cash to work in recent months. We remind you that our cash balances are determined not from any top-down asset allocation decision, but as a residual of our bottom-up search for investment opportunity. Our willingness to hold cash in the absence of compelling opportunity seems once again vindicated in light of the negligible impact that the difficult markets of the past six months have had on our portfolios."
Running with cash is not a bad thing. Think about all the companies that bought back massive amounts of their stock in 2006 and 2007 at prices well above today's levels. A lot of companies may not have seen their credit ratings dropped if they were better stewards of shareholder (and creditors) capital.
An interesting point to note in their holdings is that Special purpose acquisition companies (SPACs) represented a nice chunk of the portfolio. If you look at Baupost's current 13F you will still see many of these SPACs. There are so many strategies that funds have employed with SPACs (long warrant, short common; long common, block vote, get paid back at a boosted treasury yield, etc) that it is hard to speculate what they were actually doing here.
On the rating agencies and CDOs:
"Credit rating agencies were central to the disaster that played out. These formerly trusted assessors of credit quality had completely let down their guard over the last several years, blessing as investment grade a shocking large volume of securities backed by loans that should never have been made. One of their biggest mistakes was not understanding their central place in the virtuous circle that enabled, and even encouraged, the uncreditworthy to falsify loan applications to become homeowners. When these mortgages were pooled, sliced and diced, and securitized, they allowed dross to briefly become investment grade gold. CDOs holding junior tranches of subprime mortgage securities were able to carve up BBB- subprime mortgage tranches into large slugs of AAA rated paper, a modern-day financial alchemy based on backward-looking computer models and credulous buyers. Yield gluttons foolishly trusted these ratings enough to risk complete loss of principal for a handful of basis points of promised incremental return."
Ouch. As Klarman has said in previous letters, investors need to focus on risk (i.e. the amount of probability of permanent loss of capital) instead of return.
If you remember 2007 (what a year), around late summer there was news everyday about another quant fund blowing up. Klarman, on these events:
"Many quants said what was happening was virtually impossible, ignoring their own prominent role in making it so. Goldman's CFO, David Viniar, noted at the time in a conference call, "We are seeing thats that were 25-standard deviation events, several days in a row." For many companies in August 2007, the volatility of their stock price suddenly had nothing whatsoever to do with the company itself, but simply its shareholder list. Clearly, value investors such as ourselves, who view the manic nature of the financial markets as a source of opportunity rather than an accurate metric of risk, stand to benefit from such foolishness. As Ben Graham suggested three quarters of a century ago, those who view the market as a weighing machine - an accurate assessor of value - are destined to lose money. They who see it as a voting machine - a collection of ephemeral opinions - can derive from the volatility profitably opportunities to buy and to sell."
I see so often the weighing machine quote of Ben Graham tossed around. Klarman brings to light how value investors should view the market - not as a guide, but as something that presents your current opportunity set.
On investing throughout the cycle:
"One of the ongoing complexities of security analysis is that you can never satisfactorily determine where you are in a cycle. How long might a bull or bear market last? Had you avoided the upward frenzy of 1929 and miss the great crash only to jump into the market in early 1930, the pain you would have felt by 1933 would hardly have been different from the agony of those who invested at the 1929 peak. We will not be certain until much later whether the so-called bargains of January, 2008 were truly undervalued or merely dangerous temptations to value-starved investors."
In a word, and with the benefit of hindsight (see: Freddie, Fannie, Lehman): dangerous. I have actually heard Klarman use this 1930 analogy before - i.e. one of the most difficult things to do as an investor is figure out where you are at in the cycle...are things going down another 40%? Or are we at the 666 S&P bottom? He continues:
"Some stocks and corporate bonds fell to levels that looked tempting, but in most cases the declines merely matched deteriorating fundamentals - especially in the financial, housing, and retail sectors - and were no real bargain. One of the greatest risks we-and all investors-face is the danger of catching falling knives: expensive securities that decline without reaching bargain levels. Often, the near absence of bargains works as a reverse market indicator for us; when we find little that is worth buying, there may be much that is worth selling. Indeed, we maintained a strong sell discipline throughout the year to good effect."
It has been reported that Klarman does not short securities because the risk is unlimited (see: VOW / PAH3 stub trade for a killer short squeeze). That being said, in a credit default swap, versus a short sale, risk is contained to the loss of premium on the contract. Yes, if you shorted the ABX 2006 BBB- at 80 point up-front, you exposed yourself to heavy losses (but in the end would have still made money). But Baupost looks like they were putting these trades on at ridiculously tight levels...I'd venture a guess (depending on vintage, single vs index) of 150-300 bps running. So the most they could lose in any one year was the notional value of their contract times 1.5%-3.0%. If you wanted to limit your total portfolio loss to 1.00% and had to pay 300bps on the contract, you could of effectively bet 33% of your total portfolio in notional value in these contracts...and the most you could lose (outside of mark-market tightening) was 1% in return....Talk about upside, downside.
On his performance in 2007, and a caution to investors (similar to something WEB has said in the past):
"As we enter 2008, we face the normal challenges of the investment business, as well as a few related to our success in 2007. Our 2007 profitability has resulted in an unprecedented one-year increase in our capital base. It could take some time to carefully build our team to a size that will allow us to consistently deploy it, and we cannot afford to become impatient in our approach. Despite a fabulous 2007, we know that we must remain humble, learning lessons both from our winners and our mistakes. We need to remember that we are usually a team of single hitters with a high-on base percentage, and remain resolute in following the low-risk strategy that has enabled us to grind out good results for over a quarter of a century.The next 25 years won't look like the last 25. If they did, our $11 plus billion under management today would approach or exceed $1 trillion by the end. Expectations will have to be lowered, ours as well as yours."
In the next few days, I will follow up with more Wisdom from Seth Klarman, continuing with Baupost's 2007 letter where Klarman discusses the pitfalls of leveraged investors, disaster hedging, and Baupost's culture among other things.
Read more...
12.01.2009
Maybe I should call the blog "High Yield Investing"
Earlier today, Peter Acciavatti, J.P. Morgan's head of High Yield Strategy gave a presentation at JPM's 2010 US Fixed Income Outlook Conference. Some key take-aways from the call:
- High yield and leveraged loans remain attractive with solid expected returns. He pointed to a slide a ~12% expected return for high yield and a ~13.5% expected return on leveraged loans.
- These returns are driven by spread tightening, modestly offset on the high yield side of the world by the treasury curve widening (bank debt is floating and hence would not be negatively affected by rising rates)
- In the high yield market, demand has modestly outpaced supply. In loans, demand is dramatically higher than supply due to limited levered loan issuance this year.
The saddest slide for me, and I am sure my readers, was one pointing out how small the distressed universe is right now.
In November of 2008, there was over $230B of corporate debt trading below 50% of par. Today there is less than $10B. As a percent of the market, 31.4% was distressed in November and now only approximately 1%. Hence the reason for the title of the post: There is no more distressed - just a lot of high yield.
What compounds this situation, which Peter correctly alluded to in his presentation, is distressed funds have had a huge year. A huge year is generally followed by capital raising - more capital to the distressed space means asset prices being bid up and IRR's decreasing.
Of course, as mentioned in previous months, I believe this is a long drawn out cycle and distressed debt will return in force when the wall of maturities in 2012, 2013, and 2014 begin to tumble onto a weaker market where structured credit buyers are no longer forceful participants. But it could happen sooner if economic growth continues to be lukewarm at best. To position myself I am buying event-driven names with a definite catalyst: Six Flags' bank debt for instance, which was weaker earlier in the week on a new plan by the HoldCo note holders (full write-up at the DDIC).
John Hussman puts it best:
We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.
Maybe I would not use the term "terrific second act." Though if it happens soon, it will surely be bad for all those buying CCC+ bonds at a 11% yield.
More high yield versus distressed debt posts in the future? Given the animal spirits in the market these days, I'd would venture a disappointing yes.
11.25.2009
Distressed Debt Concessions
When investing in distressed debt, one has to be aware that negotiations can affect a creditor's ultimate recovery - for the good or the bad.
Why does this dynamic occur? More appropriately, what influences a creditor's decision to negotiate in a bankruptcy proceeding? As noted quite often in this blog, the bankruptcy process is expensive. Lawyers are billing upwards of $1000/hour. If a certain creditor class wants to expedite the bankruptcy approval process, they may give up some "nuisance value" to junior creditors to get their support.
In addition, in the wake of fraudulent conveyance rulings, senior creditors, specifically at the bank debt level, do not want to see their liens extinguished by a litigation from subordinated creditors. So they have even more incentive to offer up a little value to get junior creditors to play ball with a confirming bankruptcy plan.
The bankruptcy case of Idearc, which we spoke about quite a long time ago (Idearc Bankruptcy), is an example of negotiations among various creditor classes. Here is the new proposed Idearc bankruptcy plan.
As you can see on page 22 of 50 of the file, the plan outlines the treatment of Class 4 Claims, which in this case represents, the unsecured bond holders. Furthermore, we can see the edits on this document:
- Bondholders were to get 5% of the new common stock - They are now getting 15%
- Bondholders were to receive no cash - They are now getting $120M
Why did this happen? If you have been following the Idearc bankruptcy, you would have known that MatlinPatterson and the unsecured creditors, via the Unsecured Creditor Committee, was challenging the bank debt lenders and the bank debt agent on possible unencumbered assets at Idearc (from the docket):
The Creditors’ Committee commenced this adversary proceeding in order to challenge certain of the Agent’s liens and the valuation and allocation of the Debtors’ unencumbered property, if any, pursuant to the Debtors’ proposed plan of reorganization. The Creditors’ Committee contended that there are significant unencumbered assets, including the Debtors’ copyrights and related revenue streams, and rights to use the Verizon brand, as well as post-petition revenue streams, and that the value of such assets should be distributed to unsecured creditors. The Agent rejected the Creditors’ Committee’s contentions, maintaining that (a) the Agent held a perfected pre-petition lien, for the benefit of the Lenders, on substantially all of the Debtors’ assets, (b) the Creditors’ Committee’s challenges to the Agent’s liens on the Verizon brand and the revenues associated with the Debtors’ copyrights were without any merit, (c) the value of the Debtors’ copyrights were de minimis, and (d) the challenge to the Agent’s lien on post-petition revenues was defeated, among other things, by the diminution in value of the Debtors’ estates since the bankruptcy filing, and the Agent’s right to be adequately protected by receiving a post-petition replacement lien on whatever unencumbered property existed. This litigation ensued, extensive discovery was taken, and trial commenced and was conducted on November 9th and 10th.
Now, I have no opinion one way or the other on the validity of these claims. I do know, though, that these claims brought the various creditor parties to the table to work out an "amicable" solution. A lengthy litigation may have dragged the bankruptcy process on substantially longer, thereby accruing more lawyer fees, and possibly harming the underlying business of Idearc
The docket continues:
Now, following the commencement of trial on the myriad legal and factual issues implicated in this dispute, the Parties have reached a global resolution of all issues. The Settlement described herein preserves a significant recovery to the Lenders on account of their secured claims, while significantly increasing the consideration to be paid to Class 4 unsecured creditors under the Debtors’ plan of reorganization, and paves the way for the Debtors’ prompt emergence from Chapter 11.
So, to drop their dispute, the Class 4 creditors (the bond holders), got the aforementioned benefits: $120M in cash and a large percentage of the post-re org equity. In addition, the new bankruptcy plan has the support of a large creditor class thereby bringing the confirmation of the case that much closer.
Who won out in this exchange? In all honesty, probably everyone won out - except the bankruptcy lawyers. Note holders get a bump in recovery (the bonds have been gradually trading up over the last 3 months), bank debt holders do not have to worry about losing massive value, and the company will emerge from bankruptcy faster. Win/Win for all.
Happy Thanksgiving from Distressed Debt Investing!
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