Third Avenue Focused Credit Fund

If you have been reading this blog for any sort of time, you would know I am a big fan of Marty Whitman and the Third Avenue family of fund (especially the new Third Avenue Focused Credit Fund). Marty has penned a number of fantastic books on value investing and distressed debt investing:

Distress Investing: Principles and Techniques

Value Investing: A Balanced Approach

The Aggressive Conservative Investor

I have read all three of these books and I can personally recommend each of them. I actually will eventually do a whole series on Distress Investing - as I think a lot can be learned from the book and from Marty's wisdom.

This morning, a colleague of mine sent me the Third Avenue Four Quarter 2009 Portfolio Manager Commentary. It is a quarterly ritual of mine to read the various fund manager's commentary on the market and new positions entered / exited throughout the quarter.

As many are aware, Third Avenue launched the Third Avenue Focused Credit Fund earlier this year. I think this is a fantastic vehicle for individual investors investing in the credit space. Their commentary this quarter is also full of gems. Here are some quotes / paragraphs I particularly enjoyed:

INVESTMENT OBJECTIVE AND FUND STRATEGY

The genesis for the Fund was driven by a market opportunity in credit that Third Avenue had not seen since the early 1990s. As our colleagues have written about in the other Third Avenue Funds Shareholder Letters, debt became a bigger focus in 2008 and early 2009. Indeed, due to our history and credit heritage, Third Avenue has always had a proclivity to invest in credit and special situations. However, what was occurring in the credit markets were, as Marty Whitman so aptly put it, “investments of a lifetime.” Similarly, it was clear that you, our shareholders, were making inquiries about a credit only product. We believed that a differentiated credit fund with daily liquidity where the Fund Manager would pick the best investments across the bank loan, high-yield bond and busted convertible bond universe was the best structure. Clients also wanted some exposure to distressed investments, given the higher default rates and Third Avenue’s twenty-three year track record of distressed investing.

We designed the Fund to be differentiated from other credit and high-yield mutual funds in the following ways:

1) The Fund utilizes a value-oriented investment process that relies on extremely thorough and intensive fundamental research;

2) We focus our capital on our highest conviction ideas based upon our fundamental credit research – the Fund will normally have 50-70 investments;

3) The Fund has an opportunistic mandate that can invest in any part of the credit spectrum;

a. Bank loans, high-yield bonds, busted converts or distressed securities;

b. Invest in the security with the best upside potential versus downside risk;

4) The investment team must identify an event or catalyst to drive value and the security price higher.

I honestly could not of put it better myself. Point 4 is so important to my investment process that it bears repeating - I always look for a catalyst when I go out and seek compelling ideas - I do not want to be in a situation where a security may be undervalued by 20-30% but it takes 4 or 5 years to get there.

The letter then goes on to detail a number of situations, according to how they categorize the security, in which I have historically or currently been involved in (I will not differentiate between the two to keep you guessing): These include: HCA, Swift, Aleris, CIT, and Marsisco. Every reader should read this section as it details the rationale behind investing in performing bonds and loans, stressed credit, capital infusions, distressed credit, and debt for equity reorganizations. Again the letter can be found here: Third Avenue Shareholder Letter

In relation to CIT, I will write up a very long and detailed post about it before the holidays. We have looked up and down the capital structure for a number of months and think some of the securities could be appealing.

And finally, on the outlook for the future for distressed debt opportunities:

Notwithstanding that the high-yield market returned 49% and the lowest-rated CCC debt issuances returned more than 90% in 2009, we believe there are significant investment opportunities for the Fund on the horizon. In particular, we believe we are still in the early-to-middle innings for distressed investment opportunities.

The strong high-yield markets have certainly enabled some larger companies to temporarily delay the inevitable default, while giving others a chance to grow into their capital structure. During the first nine months of 2009, $121 billion of high-yield debt has been issued. This has predominately been used to repay existing shorter-dated bank and bond debt. As a result, the near-term maturities of some companies have been pushed out. Nonetheless, we note that the net debt position has not improved and, in fact, free cash flow has deteriorated due to the relatively higher interest rates associated with the new issuances. For some companies, this will provide enough time for their businesses to grow into their overleveraged capital structures. However, for others it will simply delay the liquidity event and need to restructure.

I couldn't agree more. Please visit Third Avenue's Website and spend some time reading past commentary as well as the great things going on with Marty Whitman and his team. You will not be disappointed.

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Finding Opportunities in Distressed Bank Debt

A few times each week, the various dealers, like Goldman Sachs or CSFB, will send out a list of all their bank debt names (including distressed bank debt paper). These names range from the very on the run - to the very off the run situation - in some case situations I have never even come across or seen.

Unfortunately, for most retail investors, it is difficult to gain exposure to bank debt unless you invest via a number of open end or closed end mutual funds. Complicating this, many times on a private deal, potential investors will be asked to sign a confidentiality agreement as to keep the debtors financial situation away from the prying eyes of competitors, suppliers and the likes.

But what if these structural issues create opportunities for investors? We all know the hordes of value investors out there that try to find companies uncovered and deserted by Wall Street to find diamonds in the rough...i.e. The number of analysts covering a particular stock is inversely proportion to the amount of mis-pricing in the security. 22 analysts covering Microsoft may mean very little inefficiency in the the stock price...But what about Bexil Corp (Symbol: BXLC)? No analysts covering the company, a market cap of $20M vs $37M of cash on the balance sheet...

The point I am trying to make - a lot of times in distressed debt land many people are looking at the same situation. Do you know how many calls / emails I got from other people on the buy side about Nakheel the last few weeks? Probably 30. (Note: Someone has written up Nakheel on the Distressed Debt Investors Club). Why not go looking for those uncovered gems?

There are few arguments against hunting for diamonds in the rough in the corporate debt world:

1. Many of the uncovered situations are so illiquid that only a fund with locked up capital / side cars would ever dream of taking a meaningful position because the mark-market is brutal.
2. In tandem with #1, if you want to be an activist in distressed debt land, you need to be able to source the paper - lots of paper is locked up in structure (CLOs, insurance companies) that do not mark to market and would rather not sell you the paper as to not take the mark.

For me, these two reasons are all the more reason to get excited about these sorts of situations. I forgot a third reason: You will not be the belle of the ball at every distressed debt holiday party / cocktail hour unless you are talking about First Data (FDC) or Harrah's (HET)...

What about Advancstar? Or Graceway's 1st or 2nd lien? Or Suburban Propane's Revolver? Who is pitching those at Houlihan's Distressed Holiday Party?

I could go on like this forever. I think the position a potential distressed debt investor has to take is why are these securities mispriced? Why was Spansion's Senior Secured Floating Rate note trading less than 10 a year ago and now is over par? (I will write a post on that a little later). Where are the mis-pricings? What does the market have WRONG...That is where you should spend your time, and then go out and exploit it.

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Bill Ackman on Mall REITS

Fantastic Presentation. Enjoy!
ICSC Mall REIT Presentation 12-7-2009

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Wisdom from Seth Klarman - Part 7

Last time, in our Wisdom from Seth Klarman series, we grabbed quotes and commentary from Baupost's 2007 Annual Letter. In this edition, we continue with the 2nd half of the 2007 letter. As usual expect some gems from Klarman - who I consider the best hedge fund manager out there.

While investors will obviously achieve the best result by remaining rational thinkers at all times, this is easier said than done. In the financial markets, emotion often takes over, and greed and fear come to dominate investor behavior. Even those who are aware of this, who expect always to invest rationally and to be able to resist their own greedy temptations and panicky reactions, cannot always carry through on their plans.

A top-down or momentum investor - especially if leveraged - is at a loss when confronting the unexpected. Should they hang on and risk ruin, or capitulate and lock in painful losses? Even those with the benefit of a value investing roadmap - which ensures a fundamental, long-term oriented approach to investing, a disciplined pursuit of bargains, and an imperative to view the market as an irrational creator of opportunity - may blink when faced with the unexpected. When you buy bargains, and they become far better bargains, it is easy to question yourself, which can impair your judgement. Real or imagined concerns - about client redemptions, employee defections, and even a firm's viability - can greatly influence behavior away from the rational.

One of the concepts that so impresses me with Klarman's investment approach is his position that some buyers and sellers are irrational and it his his job, at Baupost, to capitalize on those investment opportunities. I remember him buying a number of MLPs which were believed to be widely held by Lehman Brothers - as Lehman's prop book unwound, this created uneconomic pressure on the stock - i.e. the connection between price and value disintegrated for no reason other than Lehman had to dump the stock on the market. I know he has also talked about in speeches at Columbia that Baupost has an analyst who's sole job is to follow index additions and deletions...That blew my mind.

Every day, every investor squints into the murkiness of present-day ambiguity and an unknowable future and has to make decisions. Even when these decisions are made for the right reason-not based on greed, not under undue pressure, not from intellectually dishonest motives, but because the investments appear sound and secure - much can still go wrong. Despite a strong first 25 years, our performance in the years ahead is unknowable; however, with aligned interests, a long-term approach, sound judgement, a keen sense of risk aversion, a nose for value, valuable experience on the front lines, an unwavering alertness, a successful result seems reasonably likely.

This is such a wonderful quote statement because it lays out what Klarman believes are the requirements for success for a hedge fund. IMO Aligned interests is so important: I.E. You eat your own cooking. I believe Baupost's employees are the largest holders of the fund.

He continues:

We tried to remember that investing is a marathon and not a spring, and we conditioned ourselves to go the distance.

We have consistently prepared for the worst, incurring significant hedging costs on an ongoing basis. Sometimes these were designed to protect single investments, and other times they provided downside protection for the broader portfolio. While many of our holdings did not truly require hedges in order to be attractive, and while many of our hedges ultimately proved unnecessary because the anticipated risks failed to materialize, our hedges were quite valuable as enablers, in that they gave us the comfort and the confidence to, at times, incur fairly concentration positions that have produced such excellent long-term, risk adjusted returns for Baupost.

That first quote, about investing being a marathon, is something I pound on repeatedly on this blog. It is so important, especially when allocating outside capital, to remember that the rug could be pulled out from under your whenever those quarterly redemptions hit. A string of big numbers multiplied by zero is equal to zero. Do not lose money. That is the first rule.

And on hedging: That is one of the reasons I believe looking at Baupost's 13F is somewhat a futile effort. Their equity portfolio is so small relative to their assets under management that it would be impossible to mirror the performance. Further, you have no idea what hedges have been put in place, or whether being long News Corp was just a dual-class arbitrage play.

I am going to make it a mission of mine to better understand how they hedge individual investments. Would they for instance go long a distressed bond and long a put on the equity? Or long an equity and long credit protection? I'll report back when I have more information in the future.

Our strict value discipline has been a critical component of our success.. When you have carefully analyzed what you own, and buy at a sufficient discount to underlying value to ensure a significant margin of safety, you are likely to do well. Our willingness to hold cash during fallow periods has enabled us to maintain a strict sell discipline regardless of whether we had anything promising to replace what we sold. This view on cash, combined with a truly long-term investment perspective, has also enabled us to avoid the gun-to the-head mentality that pressures many investors to own less than stellar investments.

Cash is king? One complaint I hear from a number of my peers is that fact that their portfolio managers abhor holding cash - especially now the expectations for inflation are sky high. And I understand the reasoning that if you are not fully invested, and the market rips, you will get redemptions. I believe if you can manage your investors expectations better (i.e. like 1950s Warren Buffet), you would be able to use cash as a valuable asset versus a potential liability.

And my favorite quote thus far in all of the series:

We have a culture of intellectual honesty and curiosity, always looking for more information to confirm a thesis or disprove it; never settling for good-enough investments, but always striving to find the best ones; not satisfied with the knowledge that our investments are bargain-priced but always searching to discover why they are undervalued so as to remove as much risk as possible from the investment equation. We strive to eliminate biases in our decision-making that could cause us to reject new information or cling to erroneous beliefs. We pride ourselves on making tough and sometimes painful decisions to exit from investments where prospects have soured. This curiosity extends fully to the operations side of Baupost, where we always want to find smarter and more effective procedures and processes, to identify new ways to serve our clients better, and to know not only that something is the case but why it is so.

Stay tuned for future editions of our Seth Klarman series - we will analyze a few videos and audios of Klarman speeches. After that we will look at the 2008 Baupost letter (but only after the 2009 Baupost letter is published).

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Distressed Debt Investors Club Update

First off, I wanted to thank all the members and applicants of the Distressed Debt Investors Club. The site is currently populated with nearly 50 ideas (corresponding to 50 members) ranging from spin off analysis, merger arbitrage, distressed municipal bonds, and many straight bond and bank debt ideas. If you are like me, finding yourself scratching your head, looking for relevant, alpha-generating ideas in this market where good ideas are hard to come by, the Distressed Debt Investors Club provides you with a community of professional investors pitching and discussing long and short ideas, up and down the capital structure, on a daily basis.

The goal of the site is simple: To create the very best community of distressed debt and credit investing professionals out there. The site is structured so that new members are given access to all ideas presented in the database meaning from Day 1 you are exposed to a litany of due diligence performed by vetted professionals that will give you a head start when looking and researching new ideas.

I know it's a different idea than anything out there right now because this site is focused on credit and distressed debt investing. Other "investment club" websites may have one or two ideas in the span of a few months related to a high yield or distressed debt situation. Over 75% of our ideas are credit / distressed related with the balance being event-driven equities and equity shorts. I guarantee that you will find no other place where buy-siders and sell-siders alike are exchanging ideas of this quality in the credit space.

If you would like to apply, please click the logo below. For tips on applying, please visit the FAQ as well as our post on tips when applying to the DDIC. Hope to see you on the site.

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