FAQ: Distressed Debt Investors Club

The Distressed Debt Investors Club is currently in development. My developers have the back end largely completed, with the front end being worked on next. I am hoping a beta launch will occur at the end of September. I am still working out a number of debatable issues; some that readers have proposed and others that inherently arose from developing a site from the ground up. With that being said, the objective is still the same: To foster a strong community where high-quality investors can share / vet out investment ideas. This community will be high caliber. I promise you that. Now on to some FAQ.

When can I send you my application for the DDIC ? - Right now, we are working on a system to have all the applications go directly through the website. If that doesn't pan out, I will set up a unique email address where you can send them. The beta test for the site will last probably 1 month. That being said, I will take applications for beta sometime in mid-late September, and applications for full-blown membership in October, once all the kinks have been worked out.

Who can apply ? - Theoretically anyone can apply. That being said, I am limiting the number of members to 250 for at least the first year. There will be an unlimited number of guest spots that will have a 50 day delay to the database.

How will you evaluate the application ? - On a few criteria really. While the site is completely anonymous, when you apply, you will have to provide your real name to me, and the number of years you worked in the industry (buy-side or sell side). This information will be kept solely by me and will not be released. I do not want to discriminate against MBA students or recent graduates, but tenure and quality of investing experience will be weighed in the application. Outside of that, it really is going to come down to your write-up, which I will discuss in great detail next week.

Do the ideas on the site have to be distressed related? - Not distressed related specifically. The site will have a number of categories: Distressed, Stressed, High Yield, Investment Grade, Post-Reorg Equity, Liquidation (for the Greenbackd in you), Special Situation, Other (Credit Related), Other (Equity Related). As you can see, undervalued/overvalued equities do not really impress me and unfortunately that is not what this site is about. This site is specifically geared to what I have written about on this blog and to investors that follow it. While members will be able to contribute equity related ideas, they will not count to the annual requirements and probably should not be submitted for the application process.

Tell me a little bit more about the guest access? - Guests will be able to read the database on a 50 day delay, similar in nature to VIC. They will not be able to comment on investment ideas, but will be able to read the comments in full.

Will you continue with the blog after DDIC is launched? - Yes. Absolutely. In fact, each month, I will take a particular write up (with the member's permission) and post it on the blog.

Why are you making it anonymous? What if I want to network with the investors on the site? - I run this blog anonymously. I would never ask someone to reveal their identity/background to the general public. For networking, there will be a messenging system for Members (makes my life a lot easier as administrator) that will fascilitate offline conversations.

Will the DDIC membership cost anything? In all honesty, I have struggled with this one. Sadly, I am not Joel Greenblatt or Divya Narendra (first here, then look up the story of ConnectU), so I am going to have to charge a nominal amount to cover future development, maintenance, and site fees. This will amount to somewhere less than $40/year if I have done my math right. That equates to 5 beers in Manhattan (4 Red Bull vodkas to all you investment banking analysts) which I think is well worth the sacrifice. Guests will also be asked to contribute a nominal amount annually - nothing required though. I will not collect any $$ until January to give members / guests the time to opt out in the small chance the site fails miserably.

Why only 250 members? There are a few reasons for this, but the main one is that I believe a number of the situations that will be proposed on the site will have minimal liquidity. I have seen in the past few months a number of VIC ideas that have just taken off because everyone was bid-without. Secondly, I want to keep the quality of members and ideas at the highest level and do not want to dilute the offering with a barrage of ideas that are merely presented to pump a stock/bond price. Member will only be required to post 2 ideas on the topics I mentioned above a year. If it works out the way I hope, member will post more than that and comment significantly more, so there should be a constant stream of information. One idea will be in the first half of the year and the second in the second half (or two in the first half)...I have never liked that so many people throw up ideas at the same time when annual requirement are just being met.

Will members be able to offer suggestions / make changes to the siet? Yes. While I might seem like a dictator now, once the site gets up and running, any major change will be proposed to the members for commenting / discussion (in tandem with the site will be an internal forum where users can talk about whatever they please). New ideas can be suggested and assuming my developers can make the change, we will be fluid and hopefully, constantly improving.

I am very excited of everything that is going on and I want to thank the twenty or so of you that sent me comment / suggestions on what would make the site better. If you have any questions or further comments, please email me at hunter [at] distressed-debt-investing.com.

Distressed Debt Conference

If you remember, a few months ago I posted about a distressed debt networking event at the Harvard Club. I regularly attend these conferences and events for three reasons:

1. Learning about investment ideas and themes in the current market
2. Meeting with other distressed debt investors
3. Getting my name out there for future capital raising endeavors

All three of these are quite vital in the current environment. Even if you follow a number of situations very closely, you never know what alpha generating ideas people are digging up in their corner of the sandbox. And in an environment like today (Madoff, hedge fund gates, etc), canvassing more like-minded pools of capital is a win-win for those trying to start their own fund or investment vehicle.

One such networking event / conference coming up in September is the Global Distressed Debt Investing Conference right here in New York City. I know, or have worked with a number of the presenters in one capacity or the other (one presenter, currently not shown on the agenda is arguably the best distressed investor out there right now, and he rarely speaks in public - more from him in a few weeks). Looking like this is going to be a top notch conference.

Hope to see you there!

How to Become a Better Investor and Privacy Policy

A few months ago, I read Malcolm Gladwell's Outliers and Geoff Colvin's Talent is Overrated. Both books explore what it takes to become an expert, or even the best at something. Examples such as Tiger Woods, Grandmaster Chess Players, Steve Balmer and Bill Gates, fill the pages of the books. Did you know when Tiger Woods was an infant, like 6 months old, his father would sit Tiger in his highchair and then proceed to hit hundred of golf balls in front of Tiger - Tiger would be fixated on his father and somehow, maybe that exercise, helped begin to wire the fundamentals of a golf swing into Tiger's head.

Both books draw heavily from the research of K. Anders Ericsson of Florida State University. He is the thought to be the world's expert on expertise. Most of what Ericsson postulates (there is a enormous body of his research on the web via Google Search) comes back to the fact that expertise comes from something he refers to as dedicated practice. This is a very specific type of work that is repeatable, offers quick feedback, and adjustments can be made. Again drawing on Tiger woods, when he was 15 years old, his father would pick a target for Tiger to swing at. Maybe this target was 150 yards out. Tiger then had to meticulously hit each of his clubs ranging from driver to pitching wedge that exact distance. Then, he had to do the same exercise, but this time each time he swung he had to hit the ball with a low fade, then a high fade, then a low draw, and finally a high draw. He did this for hours on end. Constant repition, with measurable results, and quick feedback.

I began to think, how can this exercise of dedicated practice be applied to investing. I began to try devising techniques to improve my investment instincts and feel. And you know what? I came up short. I then read a quote somewhere that Warren Buffett generally reads the financials of a company, and then tries to guess its stock price. I wondered if this could be turned into some repetitive exercise and again I fell up short.

I then came across a very specific piece of research that Ericsson penned. It is entitled: The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets. You can read the article yourself (I very much enjoyed it). One of the big take-aways comes from the abstract: "...data suggests that financial expertise is highly specialized (e.g. by sector) rather than general." Of course, this flies in the face of Warren Buffett's The Superinvestors of Graham-and-Doddsville. Actually, maybe it doesn't.

Now for the record, I think the efficient market hypothesis is just something that keeps economists busy between their 6 hour a week class load, golf, flirting with undergrads, and summer vacations on Martha's Vineyard. It's like CAPM: Assume not taxes, transaction costs, etc. What world are we living in? So, I for one think that markets are wholly inefficient due to the random variable that is human emotions (loosely behavioral finance).

In the paper, Ericcson point out that: "Expertise is the final reslt of the gradual improvement of performance by additions of new patterns acquired during extended experience in a domain, and thus is attainable by highly motivated, normal and healthy individuals without any requirement for innate talents. These finding have lead to the "10-year" rule sggesting that winning at an international level in many if not most domains occurs only after at least 10 years or 10,000 hours of deliberate practice." Further, Ericcson throughtout a lot of his research, refers back to an expert identifiying patterns and making decisions based on them. If you throw a bunch of random chess pieces on a board, a Grandmaster will see his skill diminish greatly versus having an actual game piece positioning, where his performance will skyrocket.

Maybe this is why Warren Buffett and Seth Klarman are so good at what they do? They have seen the patterns and playbooks before. It is said that Warren Buffett reads multiple annual reports a day - maybe after reading so many, his brain has somehow made the connection that this combination of factors, combined with this valuation, leads to superior investment performance. Maybe Seth Klarman has seen so many bankruptcies and reorganization, he can accurately predict the probability of XYZ occurence, its payoff, and therefore his potential gain vs downside risk.

Further down the paper, Ericcson postulates some other reasons how investors can get superior market beating returns. Fund managers have abnormal returns for stocks that they are geographically near (attributed to better contacts and information). Maybe this is why the Burkenroad Reports seem to always outperform (fantastic reading there by the way). And the one that I find most fascinating, managers who concentrate on stocks in a few industries exhibit superior investment performance (vs. diversified managers). In depth (insider) knowledge about specific companies also produces superior investment performance.

What do the three of these all have in common: They share the link of better, more specific information about a certain company. When Warren Buffett was younger, he focused a lot of his attention on companies that were near Omaha. In addition, and I may be reaching here, but WEB has seen the most success out of three industries: Insurance/Financial Institutions, Consumer Products, and Utilities.

Over the past year, I have taken on one industry in particular, and focused on it greatly. This has been outside my duties at my job where I cover a number of industries (including this aforementioned one which I have covered loosely for over 5 years now). I have focused on the domestic companies only which number somewhere nearly 100 companies with market caps over $5M. In addition, many companies in this industry tap the debt markets across the rating spectrum, allowing me to bring my experience in high yield and distressed investing to the forefront.

And to what end? Many people that have spoken with me in the past, know I want to eventually get seeded and run my own show. While I sometime have thought in the past that limiting your investment universe in any one way can hinder long term performance, I believe a long/short, up and down the capital structure, industry (assuming its broad enough) focused fund could produce outsized returns for investors with low volatility. If you need any examples, look at Healthcor or any of the niche specific Tiger Cubs.

If you have any thoughts on methods of dedicated practice as it relates to investing, leave a comment or send me an email.

As a quick aside, a reader asked about our privacy policy: Unless you tell us otherwise, we treat the email address, name, physical address, and/or phone number of those submitting information and content (hedge fund letters, research, etc) as confidential and will never share it with third parties.

Guest Post - American Axle

Contributor Nathan, has penned an ex-post facto distressed debt analysis of American Axle. We had been working on the case study and all the big news hit - timing is a bitch sometimes. Hope you enjoy.

AMERICAN AXLE – DISTRESSED SCENARIO ANALYSIS

For this entry we will be doing an ex post facto analysis of the American Axle situation as it existed in early August. Those that have followed this situation know that it appears Axle has escaped bankruptcy (for now), which obviously takes a lot of the fun out of presenting this case study. However, we think this entry will provide a good example of some core distressed investing concepts, namely capital structure trading and scenario analysis. The remainder of this entry will refer to the Axle situation as it existed August 5th, which is when the author initiated his positions in the bonds (long) and stock (short) following the company’s 2Q earnings announcement. On that date Axle stock closed at $3.75, up some 43% on the day, while the unsecured bonds ended the day quoted 42-44 (w/o accrued).

American Axle (“Axle”)—along with the vast majority of its auto parts supplier peers—has reached the crossroads of default thanks to the unprecedented decline in new vehicle production. Axle’s acute bankruptcy risk manifested itself in the form of a credit agreement covenant violation for the period ended June 30th. Shortly after quarter-end the company announced via an 8-K (July 7th 8-K) that it had entered an agreement with its bank lenders to waive the covenant violations through July 30th, in exchange for a security interest in its cash collateral, among other things. The waiver was subsequently extended to August 20th.

So unlike a case where bankruptcy is either existing or unavoidable, it is necessary to determine both the probability of bankruptcy and the approximate security prices in both survival and bankruptcy scenarios. Starting with the probability estimate, it is important to note some of the offsetting factors unique to the Axle situation that gave conflicting signals as to whether or not the banks would ultimately push the company into bankruptcy.

The reasons not to accelerate are fairly straight forward. First and foremost banks generally do not want to force bankruptcies if there are any feasible alternatives. Also, Axle’s secured leverage is reasonable relative to industry multiples, implying decent asset coverage for the bank lenders. Assuming a fully drawn revolver, Axle’s secured leverage is approximately 3.0x the 2010E consensus EBITDA estimate compared to the standard industry multiple of 4.0x-5.0x.

On the other hand there are other reasons that make a filing a real possibility. For starters, last November Axle and most of its revolving credit lenders agreed to extend $370 mln of its $475 mln revolving credit commitments to December 2011 from April 2010. This created a fairly unique dynamic whereby the non-extending creditors will mature before their extending peers. This is a big problem for Axle because there is nothing the banks despise more than pari passu or junior creditors getting paid before them. Along the same lines, Axle is expected to burn cash in 2H09 due to working capital outflows and a $40 mln buy-down payment to its remaining UAW employees. Obviously, the worst case scenario for the banks would see Axle narrowly redeem the April 2010 revolver and then file shortly after, avoidable preference notwithstanding.

So after examining the most prominent pros and cons of a bankruptcy filing (from the bank’s perspective) we assign a “highly scientific” near-term probability of default of 50%. Now we will estimate Axle’s security prices under the two scenarios. Starting with the non-bankruptcy scenario we estimate that the bonds would rally to $68 (with accrued), which with a 15% YTM would leave Axle’s bonds a little cheap to similarly rated issues of TRW and ArvinMeritor. With regard to the stock I assumed the market would assign Axle an enterprise value of approximately $1.5 bln ($300 mln 2011E EBITDA * 5.0x multiple). I further assumed net debt would increase by $50 mln to $1.1 bln, leaving $420 mln of equity value divided by 55.4 mln shares for a $7.50 price.

For the bankruptcy scenario we will assume that the stock goes to $0.75 and did a recovery analysis for the bonds (Appendix 1). Based on a base case unsecured recovery value of 47%, discounted at 25% for 1.5 years, we think the bonds will fall to 34% (32/34 bid/offer) if Axle is forced to file. So with the final piece of the puzzle in place we can now take a look at what a cap structure trade would look like.

Based on my assumptions Axle’s bonds and stocks are clearly mispriced relative to each other. By putting this trade on in the above sizes, I have an expected value of over $200K per $1 mln of capital. Now, you might be asking, if you really think the probability of a bankruptcy is 50/50, why wouldn’t you size the positions to maximize profitability in each scenario? The short answer is that I thought the probability of a bankruptcy was lower than 50%, with the unseen scenario of Axle pulling off some form of dilutive equity deal (probably involving GM). This scenario would obviously be good for our bond position and “less good” for the stock.

Fast forwarding a week to August 12th, Axle made the coupon payment on their 5.25% ’14 Notes, which sparked a huge rally in the bonds, while the equity really didn’t budge. The next day we sold our bonds (7.875% ’17) at $60.50 ($57+165 days of accrued) and covered the stock at $3.48 for a nice 75% return on capital, less the borrowing costs on the stock (L+350 for five trading days). Not bad for a week’s work.

Admittedly, this type of analysis is more art than science. I’ve taken a dynamic situation with several potential outcomes and (over)simplified it into a binary framework. I’ve also made highly subjective estimates about forward security prices. The very fact that I made a 75% return on a trade where my “best case” scenario targeted only a 30% return shows how imprecise these exercises can be. However, I believe I used reasonable judgment in shading the inputs to the conservative side for each scenario and firmly believe the risk of a permanent loss of capital was very low given the attractive entry prices. And as a doctor friend of mine once remarked, “Everything is more art than science, even science.”

	AMERICAN AXLE & MANUFACTURING, INC.
	Bankruptcy assumptions:				Duration	1.5 yrs
	Company files on Sept 30, 2009				Exit lev	3.0x
	New money DIP				DIP amt	250.0
	Trade payables, Pension and OPEB rolled				DIP rate	10.0%
	Intercompany payable pledged to secured creditors
	RECOVERY WATERFALL			Base
	2011E EBITDA	225	250	275	300	325
	Multiple	4.00x	4.00x	4.00x	4.00x	4.00x
	Asset Value	900	1,000	1,100	1,200	1,300
	Cash at filing	280	280	280	280	280
	+ New money DIP	250	250	250	250	250
	+/- Op cash burn	-160	-160	-160	-160	-160
	- Admin fees (5% of base EV)	-55	-55	-55	-55	-55
	- Less DIP interest	-38	-38	-38	-38	-38
	Net cash build / (burn)	-253	-253	-253	-253	-253
	Minimum cash	150	150	150	150	150
	Excess cash	128	128	128	128	128
	Distributable value	1,028	1,128	1,228	1,328	1,428
	DIP Facility	250	250	250	250	250
	Remaining value	778	878	978	1,078	1,178
	Domestic ops (33% of value)	257	290	323	356	389
	Foreign ops (67% of value)	521	588	655	722	789
	Intercompany notes	308	308	308	308	308
	Equity	213	280	347	414	481
	Equity value of foreign ops at 66%	141	185	229	273	317
	Domestic ops	257	290	323	356	389
	Total value to secured claims	705	782	860	937	1,014
	Pre-petition secured creditors	720	720	720	720	720
	Secured creditor recovery %	98%	100%	100%	100%	100%
	Residual value to unsecured	0	62	140	217	294
	Value of ops not pledged	72	95	118	141	164
	Total distributable value to unsecured	72	158	258	358	458
	Senior unsecured bonds	550	550	550	550	550
	Recovery %	13%	29%	47%	65%	83%
	Discounted recovery at 25%	9%	20%	34%	47%	60%
	TRADE P&L
8/6/2009	Buy 7.875% (flat)	-44	-44	-44	-44	-44
9/30/2009	Company files	0.00	0.00	0.00	0.00	0.00
3/31/2011	New Co. Emerges	13.16	28.64	46.82	65.00	83.18
	IRR %	(51.9%)	(22.9%)	3.8%	26.7%	47.1%