How do you think about the margin of safety on a distressed investment?
In my opinion, margin of safety is the safe return of principal under even the most dire of circumstances / events / conclusions to the investment thesis. Unfortunately, in the distressed investing process, one can never really predict with 100% accuracy what a judge will do. You can get a good sense based on their previous decisions and the rule of law, but the wild-card that is the judge can really alter recoveries.
That being said, Ben Graham really cared about return of capital (principal with respect to bonds) versus return on capital. This is where an investor has to fully understand the structure and covenants of a particular investment to get comfortable. How many ways can you be primed and by how much? How loose is the permitted indebtedness definition? What murky ways can an acquirer get around the change of control / poison put? Where are the carve-outs for additional liens? All these questions, and many more, are essential in understand how likely it is you will get capital back. Almost always, as second nature now I guess, the first thing I do when looking at a potential investment is draw out the corporate structure, how much debt and cash flow is at each entity, what security is granted to what instrument, and how much debt can be layered on through either "loose" covenants and permitted indebtedness.
I generally will not invest in a security if the chance or risk of permanent capital loss is anything more than diminimus. Yes, there are cooky variables (as mentioned prior, judge opinions), that are nearly impossible to handicap. And in cases like that, I may not even play the game. Maybe I am more risk averse, but I want to be around to see who finishes the race. I want to bet big when the deck is stacked in my favor. I might have to wait around for a lot of pitches, but when things like HCA's bank debt trades in the low 70s, yielding 15+%...you just have to take big swings, because you might not ever see that pitch again.
Intense litigation seems to be a major theme of this cycle as well. Will this have any impact on returns from distressed investments?
Given the way creditors have been diced up in this past credit boom, meaning a vanilla corporate structure of say first lien and subordinated bonds turned into first lien ABL, first lien Term Loan B, second lien Term loan, senior uns, senior subs, HoldCo Piks, etc, I think it is inevitable for litigation to rear its ugly head in big ways. There are so many more stakeholders. And each of those stakeholders are answering to an investor group. If traditional recovery metrics imply that you are getting 0 back on your principal, why wouldn't you litigate? Docs were so sloppily written in 2003-2005 before second lien and inter creditor agreements became more standardized. Lien perfection has really been a hot topic recently which is astounding to me.
In terms of impact on returns, I would have to say its going to benefit the junior creditor. If you assume that 5% of all litigation are successful, the sheer financial leverage at certain borrowers could boost recoveries 3 or 4 or 5 fold for the subordinated tranches. Might as well swing for the fences if I am getting jammed with a zero / warrant recovery.
The increased competition you reference is perhaps a reflection of the size of the opportunity in this distressed cycle. How do you envision the near-term growth and success of the distressed fund industry?
There was an interview with Dan Loeb where he said the total high yield / levered loan market was $1 trillion dollars and the entire non-agency mbs / cmbs market was $1.5 trillion dollars. Taking just the corporate side now, assume default rates continue at around the 10% clip. We are talking about $100B of new distressed supply (notional). Now granted some securities trade for 5 cents on the dollar and others trade for 160 cents on the dollar (W.R. Grace bank debt), so it's hard to pinpoint how many capital dollars can be put to work. It is a lot though.
In addition, I believe opportunities exist as you move into smaller and smaller enterprise values. If a debtor has call it $20M of debt outstanding, I doubt some of the bigger boys play as the investment will not move the needle. Further, the seller of this paper, many times regional / super regional banks can be forced sellers further deviating prices from their intrinsic value.
But if I were to set up my fund today, I would not dictate size constraints in the OM. There have been incredibly profitable situations when the EV of the debtor has been spectacular (see: Enron). The buyers of Rouse bonds (in the 40s) have seen a large windfall and EVERYONE knew that situation well. If you told me, that $1 trillion dollars was to come into the distressed market to soak up $100B of supply, yes all boats will rise with the tide, but I promise you the market will be anything but efficient.
Are there any specific strategies that will return more than others or garner more attention from potential capital?
If I knew that, I'd be living on a beach in the South Pacific, drinking Jose' and making trades from my blackberry. But if I had to handicap it, I would say that performing first lien bank debt will see the weaker return simply given how tight the short end is, and how fast the run-up has been. Select special first-lien situations (bank debt in re-org, close to re-org) should still see nice returns with adequate principal protection. RMBS and CMBS, are not my forte and thus I have nothing meaningful to add (and if you are an expert, and want to contribute to the blog, please email me). Whole loan mortgages are probably pretty interesting. Bonds of complex issuers (CIT, AIG) are a real wild-card and need lots of work, but could be very compelling in certain situations. Every one in the world I know is playing the short end of the curve, hence maybe their are real opportunities further out. Markets are probably decently close to fair value, but that never stopped me from finding very attractive investments. Markets can be flat for a very long time, and opportunistic and hungry investors, like myself, will still generate excess returns.
How do you approach the search process for generating investment ideas?
I use the
What I find interesting about the high yield / distressed / levered loan market is that it is very repetitive in the sense that many times borrowers will forever be branded with the sub BBB- high yield notation. Hence, the more situations the study, the more useful you will be when the same issuer stumbles along the lines. That being said, constantly learning about new companies and industries is crucial to succeed in this business. Furthermore, learning the rule of law, the way bankruptcy proceedings are shaking out in court, the various stakeholders and their motivations, is also imperative to succeed.
DIP (Debtor in Possession) financing has made a slow re-entry into the markets. What has to happen before DIP loans become readily available to firms filing Chapter 11?
I get a three emails a day asking to talk about DIP financing. I am going to write a very comprehensive review in the coming weeks as I think it is a fantastic part of the market to play if you know what you are doing. So I'll leave that answer for then.
Aside from your book what would you consider as required reading for today’s distressed value investor?
Distressed-Debt-Investing.com of course. In addition, I would read and keep up to speed on as many dockets as possible. I would try to connect with as many advisory firms as possible and try to get their pitch books to learn up on situations. I would read my distressed debt recommended book list. I would read as many client bulletins put out by law firms like Latham which are invaluable learning tools (I will aggregate these one day and put them up as links).
Finally, if you were a young analyst graduating from business school today, what would you look for in a firm when recruiting?
Besides having locked up capital, which in my opinion, is the holy grail of investing, I would look for a shop that has a fairly broad mandate. You do not want to be limited to your investment choices because that is not the way capital is meant to flow. Small or big...it doesn't really matter unless pedigree is a major concern for you. I would say non-formulaic investment process (i.e. you could buy an asset with 3 minutes of work if it was compelling enough), but I know and appreciate the merits to the slow and steady approach. Finally, you want to work for a portfolio manager you can learn from and who will challenge you to become a better analyst.
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