Pershing Square 2nd Quarter 2009 Letter

Thanks to Jay at MarketFolly for posting this.

Pershing Square Q2 Letter

Some quick points an analysis, from my perspective:

• I actually saw Bill Ackman speak last year and was thoroughly impressed with the work he did with FSA - a bond insurer. Interestingly, we were already short FSA at the time. Strong analysis and presentation.
• I analyzed EMCsometime in June, and unfortunately, missed the opportunity. Error of not pulling the trigger.
• McDonald's is probably quite cheap here. 13x earnings for that sort of business makes no sense to me - especially when the general market is trading around 20+x forward earnings. They have not participated in the rally as the opposite of the Walmart effect has been occuring in the stock market.

GGP gets its own paragraph. I just don't know with this one and am not thoroughly convinced. My analysis is still coming up with 50-60ish on the Rouse bonds (discounted back two years at 20%...i.e basically where it is trading today), and it has been that way for nearly a year now. Maybe I am suffering from some kind of anchoring mechanism. I have seen all the sell-side models out there: At a 9% cap rate, and call it $850M on NOI, then add in some love for land and JV value you get $10-$11B value for Rouse less $7.4B of secured debt leaves a recovery for the Rouse bonds well in excess of par.

Do I think the 9% cap rate is correct? That is a broad statement. I think some malls could go for 7% and other malls could go for 15%. I would say it is close to correct. Do I think the $850M of NOI is correct? Frankly, I think it is lower. I also think that ascribing a billion dollars to the ancillary assets only makes sense if someone will actually buy them at that level. Also - And this is more a theoretical question: But are CRE lenders just going to extend the maturity on the mall loans? Won't some of them want more security / rate to compensate them? Some of the GGP and Rouse malls were financed at a 3-4% cap rate. These lenders are significantly underwater. In a number of stressed CRE's situations this year, borrowers have added collateral and upped rate to make lenders happy. How does that factor into the equation?

Here is the Pershing Square GGP Presentation. It is well thought out. I suggest everyone interested read.

GGP Presentation 5.27.2009

The Credit Rally of 2009

I commented on a previous post about how I think index funds could be driving the high yield / credit rally that we have seen in distressed debt and on-the run vanilla high yield in the past 6 months.

Accrued Interest, one of my favorite blogs out there, posted a fantastic piece on mutual fund flows over the past two years, and what effects these might have had on the credit rally:

"So far this year investors have added virtually nothing to equity funds. There is no mania there, at least not when it comes to retail mutual fund investors. Now there is significant variation month-by-month. In the first three months of 2009, investors withdrew $40 billion only to add $53 billion since. But even there, it doesn't look like a mania at all. Over the last 6 weeks, there have been $4 billion in net redemptions. Even the $53 in net purchases over the last 6-months seems paltry compared with the $233 billion in redemptions last year.

By contrast, take a look at bond funds. Fund investors have made net purchases to the tune of $253 billion so far this year. That is just about double the last two years of net purchases combined.

And unlike stocks, bond investors don't have any need to "catch up." If anything, mutual fund investors would seem to have come into 2009 over weighted in bonds. Not only did mutual fund investors redeem $233 billion in equity funds in 2008, those same funds plunged in market value during the year. If retail investors followed any kind of rebalancing discipline (no laughing back there anyone who deals with retail investors... I said "if"), there would be the need to redeem bond funds and buy stock funds. Right now the opposite is happening.

So it makes one wonder. If there is a bubble, isn't it more likely in bonds? If there is an asset class that is getting more than its fair share of the excess liquidity, it isn't stocks. Its debt."

What a fantastic posts. I wonder how much of the fund flows have been to index funds who apparently cannot get their hands on bands in the primary and hence are pushing up prices after the break? Is that why we are seeing IG bonds trade 20-30 basis points tighter than when issued or high yield bonds trade up 3 - 6 points on the break?

Distressed Debt Investor Club Beta Test Follow Up

First off - I am humbled by the amount of emails I received today regarding the distressed debt investor club beta test. Over 125 people sent me an email asking to be a beta tester. I sent an email out to the first five that were in my inbox (was out of the office at a few meetings and a roadshow today). If you did not receive an email, please stay tuned in the next few weeks. I very much appreciate your support in this boondoggle I am trying to accomplish.

Thanks again

-Hunter

Distressed Debt Investor Club

Development for the Distressed Debt Investor Club is nearly complete (call it 90%). Final launch date is still TBD, but think soon. That being said, I thought I would put a post up on how I expect things to unfold in the next few weeks, and what you should be thinking about if you are planning to join / apply.

It really boils down to having an investment idea (that is actionable today) ready to submit. This idea could range from anything to a long bank debt idea, a merger arb opportunity, a spin-off, a short bond idea, stub play, post-reorg equity, a trade claim, etc. And I don't want the idea to be a "post-mortem" analysis...I want to be able to trade on the idea right now. The format that we will be using, similar to the Tiger Management process: A four sentence synopsis of the idea, followed by a more thorough write-up explaining the investment opportunity. On the site, you will be able to attach a file to your write-up, and if you think it appropriate, reference the attachment in your write-up. The write-up doesn't have to be more than 2 pages (I'd prefer 1 page...but understand some ideas need more vetting than others).

When the site is live, we will have a small beta test, and then launch the site to all after all the kinks are worked out. If you are interested in the beta test, please email me (first 5 to email me will be selected - benefits include free membership for 2010...hunter [at] distressed-debt-investing.com).

I really hope everyone applies. We are targeting 250 members by the end of the year, and will stagger the acceptance process up until then. From the 2 or 300 emails I have received on it, this will be a very high caliber group, with a number of the best distressed debt / event-driven hedge funds represented (anonymously of course).

Howard Marks: A Legend

I have spent the last four hours reading this collection. The amount of investing gold from Howard Marks of Oaktree Capital is incredible. I would download and save in case this is taken down. Enjoy.

Edit: Already taken down. Here is direct URL: http://www.oaktreecapital.com/memo.aspx

Distressed Debt Conference Notes

Nathan, a contributor to Distressed Debt Investing, attended the Global Distressed Debt Investing Conference in New York City. He graciously took some notes for our readers. These are his notes from the guys focused on the distressed corporate markets (as opposed to the CRE markets). Enjoy.

Josh Abramowitz – Deep Creek Capital

Makes 2 types of investments: 1) Business itself is undervalued 2) Process based bets

View of the market – The “panic period” of early ’09 was the time for a market based bet on distressed. This is no longer the case given current price levels. That said he thinks if you look back 5 years from now the bulk of the profits (for distressed guys) will be made from 2010-2014. Notes that not a lot of bonds traded at the lows, so much of the rebound has just been profit recovery for a lot of guys that stayed invested in the same names.

Going forward investors will be rewarded for taking on complexity. Used Lehman Brothers as an example b/c there could be a lot of value but you need to do global due diligence. Focus on these type of situations b/c the market as a whole is not attractive.

Sectors: Financials are big, liquid and interesting situations but you need bigger risk adjusted returns because of the opacity of the companies. Autos are a tough, ugly business that a lot of people are afraid of. Other opportunities are more scattered, this isn’t like past downturns (telecom bubble) where you had to be big in one sector.

Politics: GM situation won’t happen again b/c it was a special case where you had an iconic company that employed a lot of people and not many other companies would have been saved that way.

Global Distressed Investing: When looking at US based, but global companies you need to know whether the foreign subs themselves are healthy. With regard to foreign bankruptcy law there has been some standardization, but you still need local lawyers. You can’t just wander into a country and expect to get your way. He says that his firm picks certain lawyers for certain situations based on what they need. (conciliator versus fighter, etc.)

Potential for a “W”: He doesn’t predict the economy and tries to hedge out as much macro/market risk as possible. That said, he thinks any signs that the recovery is overstated will freak the market b/c there is still a lot of mental fragility. Next big question (for credit mkts) is what happens w/ CLOs.

Rob Koltai – Hain Capital

He invests (and makes markets in) trade claims and prefers liquidations b/c they are easier to analyze.

- You have to careful w/ claims b/c once you own them there is no exit (other than thru the POR or liquidation)

- No way to value the Lehman trade claims accurately despite the incredible amount of gunslinging

- He is the only hedge fund guy around who is a member of the Better Business Bureau

- He targets 35% IRRs

- No leverage on TCs

- Hedges (sometimes) w/ unsecured bonds

- Key factor is turning the capital every 18 months, focusing on arbitrage situations

- More sellers today b/c CFOs don’t want to spend the time dealing w/ committees when they need to run their companies; also they just need cash

- Focuses on short-term, low complexity trades

- Does not want to own equity

- Sectors don’t matter to him

- “I am the market (for trade claims)”

Joel Klein (PPM America)

- European distressed market will never be that big b/c there bankruptcy regimes are too rudimentary

- Icelandic banks made the GM process look fair. They will never get foreign capital again and probably have to revert to a fishing boat economy

- He was offended by the Chrysler cash but not so much GM

- There is 1 rock solid rule in bankruptcy and that’s the Golden Rule: He who has the gold makes the rules

- Another 3rd party would have been treated the same way if they had put up the capital

- He doesn’t see any massive catharsis b/c of GM setting some new precedent

- The Supreme Court hates bankruptcy law b/c it’s too boring for them

Ethan Schwartz – Contrarian Capital Management

- 60-70% of what he does is standard value investing w/ an understanding of legal aspects

- 30-40% are pure legal plays on complicated situations that most people don’t understand b/c of intercompany dynamics.

- He will do jurisdictional analysis, but it is a good way to get burned too

- Judge analysis is important

Thanks Nathan!

Exclusive Interview with Hedge Fund Manager Peter Lupoff

It is our pleasure at Distressed Debt Investing to bring you an exclusive interview with hedge fund manager Peter Lupoff. To give you a little background, Peter and I have worked on a number of projects together in the past, specifically in the distressed debt and event-driven arena. And for some more background, Bloomberg wrote a story about the founding of his new firm, Tiburon Holdings. For more information on Peter and his firm/fund, please visit their website: Peter Lupoff's Tiburon Holdings

I asked Peter a few weeks ago if he could enlighten our readers with a Q and A session regarding his process and background. He happily obliged. This is Part 1 of a 2 part series with Peter. Enjoy.

Start us off by describing your investing strategy and process.

We are an Event-Oriented Credit Opportunities manager, for internal allocation bases, sub-divided into Distressed/Stressed, Special Situations and Capital Structure Arb. We will go long or short anywhere in the capital structure, making dynamic allocation decisions across these three sub-strategies.

I talk about our “Five-Pronged Investment Methodology”. This is the linchpin of our historic low vol, peer-beating returns.

A friend says we should re-dub it “DRACO” for 1) Deep Value (Company & Industry Analysis), 2) Revaluation Catalyst, 3) Rational Actor’s Assessment, 4) Capital Structure Review and 5) Outward Looking (Process, Legal, Technical). Everything we look at, is looked at through this lens. Every aspect of the 5 prongs must be addressed:

Company & Industry Analysis is simply the bottom-up deep value approach many of us employ, particularly with my history of working 7 years with Marty Whitman. We value the entire capital structure from senior bank debt through equity and glean from appropriate metrics, what’s cheap or rich in the capital structure. This is where it starts and stops for many, but not us.

From there we move to what I call the "Revaluation Catalyst" – we want some plausible, predictable event that will move the securities in which we are short and/or long, based on the bottom-up review, in a step-function change to expected value. Revaluation Catalysts are hard events (asset sales, divestitures, law suits won or lost, maturities that might or might not be met by access to capital markets or asset sales, etc). It’s easier to define by what it is not: it is not an earnings surprise.

Rational Actor’s Assessment is a game theory approach where we identify every rational financial actor and consider their anticipated behaviors if pursuing their own rational self-interest. Rational Actor’s are Management, Bond Holders (perhaps a new, activist bondholder), Bank Debt Holders, Private Equity, Competitors, the Trade, Unions, Biggest Shareholder, etc. Any constituent group whose behaviors can influence outcomes. Rational Actor’s Assessment does two things for us – one, it can allow us to more nimbly trade around our core positions to take gains and/or mitigate risks where predictable behaviors will impact prices. Many long only oriented deep value and distressed investors make the mistake of thinking that all risks are priced in – If you see events that will impact a current price – as a fiduciary, why would you not mitigate? Secondly, Rational Actor’s Assessment can give us increased conviction level about the Revaluation Catalyst. It is this conviction level that shapes the sizing of the position (initially).

Capital Structure refers to the deep dive we do on covenant and indenture review. You say you like the unsecured bonds? Great, there are five of them trading on the same yield basis. If you don’t read the underlying indentures, you don’t know if in fact, they are pari passu in all cases. This work is a shield in that we won’t make a mistake and be in the wrong bond, given a thesis. It’s also a sword in that every year we find a few cap arb trades where bond will converge or widen based on a single event benefiting and/or hurting one of the bonds in a long/short.

Finally, Process, Technical, Legal is the outward looking aspect of the methodology. We operate in markets and despite our inward focus and deep knowledge of the companies we’ll trade, I want to know critical dates (legal docket dates, interest payment dates, maturities, etc) and want to know about BWICs and the like that cause technical pressures in markets. What hedge fund investor wants to hear a manager say we were right on this but didn’t know XYZ Fund was liquidating its massive position? It matters, and as best we can find out, we learn such things.

Tell us a little about your background. You used to work with Marty Whitman at Third Avenue. Any lessons taken from that experience?

Yes, I spent 1990-97 with Marty. It was a terrific education. Marty is an academic at heart, still teaches at Yale School of Management, and the firm, in those days, was his laboratory, where we’d see his textbook approach play out. I remain close to him and think of him as a mentor. I did many things there in those days from buying for our funds, to running businesses that traded bank debt, privates, trade claims, etc. I ran a fund there too, did some restructuring advisory, led some rescue financing. It was a great experience and I remain in touch with many of my friends from those days as well as with Marty.

I’ve done a number of things since then, including Lehman’s Distressed Prop business early in the life of Prop, started some entertainment businesses including a hip-hop record label and then came back to the buyside, most recently with Robeco WPG and Millennium Management. We are a product of our experiences and I have taken something from everything I’ve done to be who I am today. In 1990, when the world was going to hell one day, Marty walked into the trading room and calmly, forcefully stated, “We’ve done the work, we know what we own is money good, go into the market and buy more”. These are the two most important lessons: Where you have conviction, remain ardent, and DON’T LOSE MONEY. I think the duality in these is simply reflected by our penchant for trading around core positions. Take gains, mitigate loses.

What it is about distressed and event driven investing that draws you to it? Do you find with some much capital chasing so few opportunities, the "home-runs" are really few and far between?

I like that it is very unforgiving. Over time, winners outperform consistently. There are a lot of people that work very hard - I also like the intangible aspect – that somehow, with some regularity, we manage to identify unique trends or thesis. Hard work, smarts matters to a large degree, but out performance is often something intangible, i.e., not easily replicated by others. Your unique edge. The biggest firms do not really have a edge unless you do exactly what they do. Why do that? There’s a wealth of unique situations to delve into. You get there sooner, and dive a little deeper, you have an edge. Some of my biggest home-runs came from buying from the largest, best known distressed investors (Horizon Coal, reorganized as ICO for example). Loans bought between 17-30 ultimately traded through 120.

We don’t try to hit home runs. You find an attractive risk-adjusted circumstance that can generate 20%+ under base case assumptions and the technicals change in your favor (multiple expansion, access to capital markets, private equity buyers, commodity demand, etc) and the two-bagger becomes a home-run. Horizon Coal initially had a target price of 50-55. The reason I looked at it (and Steel) was a macro view on China and a buyer of coal and steel. It happened to work out that way.

How do you manage your book? Do you have position limits or rules when it comes to selling if a position has gone against you?

Every trade has a target price. Absent a change in assumptions, if the Revaluation Catalyst occurs, we get out no matter if it is at the target price or not. If we achieve the target price prior to the occurrence of the Revaluation Catalyst, we are out. When asked about how he made his money, Bernard Baruch once said, “by selling too soon”.

When things go wrong, we have a 30% stop-loss, which is real though not always easy to execute. NEVER VIOLATE A RISK RULE. Deal with the problem, do the forensics on how we were wrong on the trade, and you can always come back to it. We certainly learn from it as we move forward. Hope is not a strategy and neither is hiding or ignoring positions.

Does today’s market remind you of others you’ve invested through in the past?

This is an odd market. In some respects it reminds me of 2006-7 with the ardor to get invested getting in the way of judgment. A few differences, the technicals are scary: the majority of money coming into markets are retail. With this circumstance, companies are tapping public markets. The bond funds and CDOs that are forced to come in to participate in these financing, given their cash positions, can be equally ardent in bolting given some of the remaining technicals in the credit market to unfold (credit funds opening gates and additional bankruptcy filings lead to forced selling) and this happening in an economy where investors are mistaking inventory replacement with real economic growth. I don’t see another February or October 2008, but I want to see these technicals clear before I am in less liquid situations.

Further, many investors are saying that “this is the greatest opportunity of a lifetime”. It’s amazing how many of these people were down 45% last year!! Well this is the SECOND best opportunity of my lifetime. 1990 was infinitely easier in my view. In 2009-10, we have myriad of new, problematic issues (CDS exposures, CDO bank loan ownership vs banks once upon a time, inter-creditor issues between 1st, 2nd, 3rd lienholders). We also have newish/naïve, participants in this market, creating unpredictability in secondary market trading. This is all before we get to the fact, that unlike any other cycle, we are not likely promptly reorganizing these companies in a more sanguine capital markets. Multiple expansion and access to capital markets makes everyone look like a genius just by ignoring their book.

Stay tuned in the coming week for the second part of our interview with hedge fund manager Peter Lupoff.

Edit: Here is Part 2 with hedge fund manager Peter Lupoff

Distressed Debt News - Eastman Kodak

Over the past week, I have been absolutely stunned by the amount of news hitting the tape related to distressed debt investing and pricey debt financings. Delta, Blockbuster, Felcor, Eastman Kodak, MGM, Kimco, Toll all announced / completed deals this past week. Look at that list one more time and let it just sink in for a little bit. If that doesn't feel like a credit top, I do not know what does.

The one situation I would most like to quick point to is Eastman Kodak. Many distressed debt investors have looked at this one in one shape or another over the past few months. The converts, which were puttable next year, was a topic of interest at any cocktail hour I attended. Here is a 1 - year price chart:

The big run up in price over the past few days came on the heels of this announcement: Kodak to Raise Capital from KKR. Those that I talked to knew it was possible: the indenture on other outstanding bonds allowed for it; the ABL needed an amendment, and generally that's assumed to go through - one just needed to figure out where/if the capital was going to come through.

The proposed financing consists of $400M 7% convertible senior notes and up to $300M of senior secured second lien notes (the ones KKR will step up to the plate for - and get warrants in the process)

What were the intentions here? Well, for one, the notes KKR will invest in (second lien) will most surely be the fulcrum security if there is a reorganization down the road. And if Eastman Kodak does well, not only do they clip a potential fat coupon on the second lien note, but they also participate in the equity up-side via the warrants.

Before dismissing EK's future prospects, take a look at their geographical sales break down:

REGION/CNTRY 2006 2007 2008 AVG 2-YR GROWTH

1.The United States 4,700.00 4,403.00 3,834.00 -9.62%

2.Europe, Middle East 3,118.00 3,264.00 3,089.00 -.34%

3.Asia Pacific 1,694.00 1,592.00 1,500.00 -5.90%

4.Canada and Latin Ame 1,056.00 1,042.00 993.00 -3.01%

What I see here is a company that is not doing THAT bad overseas. Massive restructuring programs have streamlined the cost structure of the business. Also, there are rumors that EK may have a favorable position in a number of lawsuits that could reap potential monetary benefits for the company. The company is much leaner from an asset perspective (look how working capital is coming down) and the pension expense / funded status could provide an interesting financial engineering solution in the event of a restructuring.

Nonetheless, do not dismiss a business you once thought a dinosaur, especially if you can get KKR to structure the deal for you.

Companies that Might Go Bankrupt?

Interesting Reuters story: Audit Integrity Announces Results of Corporate Bankruptcy Study; Identifies Companies Most Likely to Declare Bankruptcy.

Essentially, this company has attempted to model out future predictions of bankruptcy, and do it better than Altman's Z Score (something I have never used in the past). This company found TV and Publishing companies to be the most at risk, with autos and airlines slightly less risky.

Here is a quote from the CEO:

"Evidence shows that bankruptcy filings tend to lag after an economic downturn so its extremely important that investors and those concerned with the risks around corporate failure mitigate their exposure to companies likely to collapse," said Jack Zwingli, CEO of Audit Integrity. "Market volatility and sudden downturns such as we have been experiencing must be factored into bankruptcy risk. Fraud also plays a part, especially when companies are faced with survival decisions. These are the toughest companies to identify because, on paper, they appear solvent. Our model uncovers the underlying fraud that can be behind seemingly healthy financial statements."

I agree with the above statement. The question remains: Do prices already reflect the higher probability of default going into a Chapter 11 proceeding?

For those that are lazy, here is the list:

* Advanced Micro Devices, Inc.

* Amkor Technology, Inc.

* AMR Corporation

* Apartment Investment and Management Co.

* CBS Corporation

* Continental Airlines, Inc.

* Federal-Mogul Corporation

* Hertz Global Holdings, Inc.

* Interpublic Group of Companies, Inc.

* Las Vegas Sands Corp.

* Liberty Media Corporation (Capital)

* Macy's, Inc.

* Mylan Inc.

* Oshkosh Corporation

* Redwood Trust, Inc.

* Rite Aid Corporation

* Sirius XM Radio Inc.

* Sprint Nextel Corporation

* Textron Inc.

* The Goodyear Tire & Rubber Company

Admittedly, I have long exposure in a few of these names. And maybe I have been around too long, but I know the stories on about 17 of the 20 mentioned above (personally have never looked at: Mylan, Redwood Trust, and Textron). That being said, it is hard for me to back into a bankruptcy filing for a number of these companies, which begs caution on the overall list. It does bring up some interesting ideas to pursue further for possible distressed debt opportunities or possibly some potential equity shorts.

High Yield Indices = Roller Coaster

While I am having trouble finding an intra-day graph of the HY12 Index, I would like to point out to readers that that High Yield market has been NUTTY over the past 7-10 trading days. Here is the graph (prices) since the beginning of this month:

To give you context, 8 points is a MASSIVE move. Today, I walked into the office, and the market was up nearly 2 points. A few hours later it was up only 1/4 of a point and ended the day up 3/4 of a point. Over $2.5B of the HY indices traded today.

Most traders and analysts get 1000s of Bloomberg runs a day. What I find particularly interesting is the comments that the Index traders make throughout the day. Here is just a snippet of what went on today.

Tommy Leung at UBS says:

Yesterday I said "ride the long until trend turns", which luckily has worked quite ell. But having seen today's price action, I think the short-term rally that started last week is mostly done for now. If I have a 3-month horizon, I'd still hold my long positions, but if my focus is day-to-day trading, I'd close my long here.

Why? Fundamentals haven't changed in the past 7 days, so we can ignore that. In terms of technicals, I think we might have seen the dealer capitulation trades today. We have seen HY moving up $1-$1.5 everyday for the last few days, but the move this morning is simply extraordinary. At 9:32am, HY12 was 96-96 1/2, already up $2. At 9:35am, 96 1/2 got lifted. Buyer didn't try to show 1/8or 1/4bid, he/she just lifted the offer outright. This smells like the "I-am-short-and-I-got-tapped-on-the-shoulder-by-manager" short covering trade, which usually marks the short-term peak of a rally. Don't forget the "trapped longs" who bought at $96 or $96 1/4... they are probably a little nervous too.

So I'd start closing long positions here. But don't short yet, fighting the trend seems very risky, might as well wait for the trend to turn first before going short.

Trades to think about:

1) HY/LCDX - The price differential is back to $3-$3.30 area. Spread differential is around 75bps. You're basically paying 75 bps to go long senior secured and short unsecured (not a perfect match given the difference in constituents). Downside is probably $0.5 and upside about $2. I think it makes sense to buy LCDX and sell HY here.

2) IG/Main - This has been a great pair to trade the range - sell IG buy main at 25 or wider, buy IG sell main at 18 or tighter. The pair is back to around 17/18, but I think the range is broken by the ongoing compression. Leave it alone and wait for the spread differential to get back to >22, then it probably makes sense to sell IG vs. buy main again

Andrew Goldman at MS says:

HV12 213/223 -7 IG12 98½/99½ -5 HY12 94⅞/95⅛ + ⅝ ***Craziest day in a long time. HY traded in a 1¾ point range all before noon. Off the run IGs closed as much as 31 bps tighter (IG4). IG 5x10 curves steepened as much as 18 bps

(IG3-5). At this point, I think there is going to be a lot of recalcing and F9ing overnight to determine where everyone stands positionally and to figure the right moves. Some of these front end points are pricing in a shockingly low # of

defaults and are probably cheap options at this point. With that said, if you dare to buy front end CDS right now you are staring a very very mean technical square in the face..

Jeffrey Chang at MS says:

LCDX12 97.90/98.20 +0.65 LCDX10

95.70/96.10 HY12 94⅞/95⅛ +⅝

*** Very heavy volumes traded today in HY with over 2.25

billion going through across HY8 through HY12. The violent

range in HY still has everyone's head spinning. The one

interesting thing in HY (different from IG) though is that

today front end curves resisted steepening as profit taking

keep the off the run HY indices in check. Also saw profit

taking of LCDX10 3y. Today felt a little like the market had

turned long recently and was trying to ride the momentum up

...

once HY looked like it wasn't going to bust through 96½

sellers came out of the woodworks despite stocks rallying

another 12 pts. Will be interesting to see what happens tom.

And finally, Roman Shukhman at JPM, who generally everyone on my desk agrees has the best sense out there of anyone on the street, at 1:00 PM today:

1.3bln HY traded so far today.. The range has been 94 3/4 - 96 1/2 which is one of the widest i've seen in a while. Right now it finally feels like credit may underperform stocks going fwd. While we may still rally I am starting to find more sellers of risk as we go higher and the gap we saw this morning isnt repeating itself even as SPX sets new highs...

Like most of my credit brethren...this is what I feel like:

Oaktree Likes Senior Loans

Oaktree remains one of the better distressed debt shops out there. My favorite quote in last paragraph, responding the bullishness in the credit markets: "Even if the optimists are proven correct, we believe it is not prudent to stretch for yield by taking higher risks with the portfolio."

Enjoy the letter.

Oaktree Senior Loan Fund - 2Q Letter

Advanced Distressed Debt Lesson #1

Over the next few months, in addition to regular postings, I would like to delve into some of the more archaic distressed debt investing concepts and technicalities. While a strong ability to value companies (especially those that are facing tough times) will get one far in this business, being able to see the intracies of bankruptcy rulings, credit agreements, indentures, etc will enable you to looks at more delicate and difficult situations where many investors will avoid due to the sheer complexity. At times I will use current or past examples, and at others I will speak conceptually of lessons I have learned over the years. Remember, I am not a lawyer - just a practicing professional investor that has a few thoughts and opinions.

We will begin with negative pledges. A negative pledge is a restriction, embedded in a bond's covenants that prohibits liens on certain properties unless the bonds are equally and ratably secured. The key with a negative pledge is defining "certain properties." In all indentures and credit agreements, capitalized terms will be defined in a "Definitions" section. For example, in one of Darden's Indenture:

"The Company will not, and will not permit any Restricted Subsidiary to, incur, issue, assume or guarantee Indebtedness secured by any Liens of the Company or any Restricted Subsidiary upon any Principal Property, or upon shares of capital stock or evidences of Indebtedness issued by any Restricted Subsidiary and owned by the Company or any Restricted Subsidiary, whether owned at the date of this Indenture or thereafter acquired, without making, or causing such Restricted Subsidiary to make, effective provision to secure all of the Securities then Outstanding by such Lien, equally and ratably with any and all other Indebtedness thereby secured, so long as such Indebtedness shall be so secured."

The problem with this statement is that every capitalized term has a definition, and those definitions may be wide open. Let's see what Principal Property means. Going to the definition section:

“Principal Property” means all restaurant or related equipment and real property, in each case which is owned by the Company or a Subsidiary and which constitutes all or part of any restaurant located within the United States or Canada.

Hmm. What about assets overseas (if there are any?). What about intellectual property? What about accounts receivable? What about stock? A stock pledge can be very valuable at times. Seems like quite a bit of things could be pledged to secure debt if things got bad.

Not only is the defintion aspect of this game difficult, but the carveouts compound them further. In the above example, let me just go through and list the carveouts (for those now aware, carveouts are exceptions to explicity stated covenants). Skip this part if you are bored easily - the takeaway, which I will expand on further below, is that their are a lot of carveouts in these documents.

The foregoing restrictions shall not apply to indebtedness secured by Liens existing on the date of this Indenture or to any of the following:

(1) Liens on any Principal Property acquired, constructed or improved by the Company or any Restricted Subsidiary after the date of this Indenture which are created or assumed contemporaneously with such acquisition, construction or improvement, or within 180 days before or after the completion thereof, to secure or provide for the payment of all or any part of the cost of such acquisition, construction or improvement (including related expenditures capitalized for Federal income tax purposes in connection therewith) incurred after the date of this Indenture;

(2) Liens of or upon any property, shares of capital stock or Indebtedness existing at the time of acquisition thereof, whether by merger, consolidation, purchase, lease or otherwise (including Liens of or upon property, shares of capital stock or Indebtedness of a corporation existing at the time such corporation becomes a Restricted Subsidiary);

(3) Liens in favor of the Company or any Restricted Subsidiary;

(4) Liens in favor of the United States of America or any State thereof, or any department, agency or instrumentality or political subdivision of the United States of America or any State thereof or political entity affiliated therewith, or in favor of Canada, or any political subdivision thereof, to secure partial, progress, advance or other payments, or other obligations, pursuant to any contract or statute or to secure any Indebtedness incurred for the purpose of financing all or any part of the cost of acquiring, constructing or improving the property subject to such Liens (including Liens incurred in connection with pollution control, industrial revenue or similar financings);

(5) Liens on any property created, assumed or otherwise brought into existence in contemplation of the sale or other disposition of the underlying property, whether directly or indirectly, by way of share disposition or otherwise; provided that 180 days from the creation of such Liens the Company must have disposed of such property and any Indebtedness secured by such Liens shall be without recourse to the Company or any Subsidiary;

(6) Liens imposed by law, such as mechanics’, workmen’s, repairmen’s, materialmen’s, carriers’, warehousemen’s, vendors’ or other similar liens arising in the ordinary course of business, or governmental (federal, state or municipal) liens arising out of contracts for the sale of products or services by the Company or any Restricted Subsidiary, or deposits or pledges to obtain the release of any of the foregoing;

(7) pledges or deposits under workmen’s compensation laws or similar legislation and Liens of judgments thereunder which are not currently dischargeable, or good faith deposits in connection with bids, tenders, contracts (other than for the payment of money) or leases to which the Company or any Restricted Subsidiary is a party, or deposits to secure public or statutory obligations of the Company or any Restricted Subsidiary, or deposits in connection with obtaining or maintaining self-insurance or to obtain the benefits of any law, regulation or arrangement pertaining to unemployment insurance, old age pensions, social security or similar matters, or deposits of cash or obligations of the United States of America to secure surety, appeal or customs bonds to which the Company or any Restricted Subsidiary is a party, or deposits in litigation or other proceedings such as, but not limited to, interpleader proceedings;

(8) Liens created by or resulting from any litigation or other proceeding which is being contested in good faith by appropriate proceedings, including Liens arising out of judgments or awards against the Company or any Restricted Subsidiary with respect to which the Company or such Restricted Subsidiary is in good faith prosecuting an appeal or proceedings for review; or Liens incurred by the Company or any Restricted Subsidiary for the purpose of obtaining a stay or discharge in the course of any litigation or other proceeding to which the Company or such Restricted Subsidiary is a party;

(9) Liens for taxes or assessments or governmental charges or levies not yet due or delinquent, or which can thereafter be paid without penalty, or which are being contested in good faith by appropriate proceedings;

(10) Liens consisting of easements, rights-of-way, zoning restrictions, restrictions on the use of real property, and defects and irregularities in the title thereto, landlords’ liens and other similar liens and encumbrances none of which interfere materially with the use of the property covered thereby in the ordinary course of the business of the Company or such Restricted Subsidiary and which do not, in the opinion of the Company, materially detract from the value of such properties; or

(11) any extension, renewal or replacement (or successive extensions, renewals or replacements), as a whole or in part, of any Lien existing on the date of this Indenture or of any Lien referred to in the foregoing clauses (1), (2) or (5) to (10), inclusive; provided, that (i) such extension, renewal or replacement Lien shall be limited to all or a part of the same property, shares of stock or Indebtedness that secured the Lien extended, renewed or replaced (plus improvements on such property) and (ii) the Indebtedness secured by such Lien at such time is not increased.

Notwithstanding the foregoing, the Company and its Restricted Subsidiaries, or any of them, may incur, issue, assume or guarantee Indebtedness secured by Liens without equally and ratably securing the Securities of each series then Outstanding, provided, that at the time of such incurrence, issuance, assumption or guarantee of Indebtedness, after giving effect thereto and to the retirement of any Indebtedness which is concurrently being retired, the sum of (i) the aggregate amount of all outstanding Indebtedness secured by Liens which could not have been incurred, issued, assumed or guaranteed by the Company or a Restricted Subsidiary without equally or ratably securing the Securities of each series then Outstanding, except for the provisions of this paragraph, plus (ii) the Attributable Value of Sale and Leaseback Transactions entered into pursuant to the penultimate paragraph of Section 1009, does not at such time exceed the greater of (x) 10% of Consolidated Capitalization of the Company or (y) $250,000,000.

That less paragraph will be the one you generally want to focus on. Let's try to break it down just a little bit. "Notwithstanding the foregoing" means if we missed it above, here it is. And if you read it closely, you can decipher that it means that we CAN secure indebtedness, and not secure the bonds, if the amount of debt secured by liens plus a possible sale leaseback does not exceed 10% of Consolidated Capitalization or $250,000,000. Then you have to go to Consolidated Capitalization and figure out that definition, and the cycle repeats itself.

Why is this all important? Companies file for banrkuptcy for a few reasons, but the main one being they run out of money. Trade wants cash up front, banks want their money back, wages need to be paid...but there just isn't any money left. Before this cycle of doom arrives, a company will look to the capital markets to raise capital, sometimes at any expense.

And that means the company is going to be look for ANY asset it can pledge to make loan to values look good in an offering document. But if you have already bought the bonds hoping to be the first or second creditor out in a bankruptcy, and the company comes in and lops on another 1 or 2 turns of secured debt, you relative position in both valuation and bargaining strength drops dramatically.

You have to understand what the company has to prime you. Because they will if things get bad and they want to stave off bankruptcy. If there is a loophole in the covenants or indenture, it is your job as an investor to find it and either avoid the bonds (or short the bonds if the negative pledge is too restrictive) or understand the risks in holding the security.

No one truly enjoys reading indentures and credit agreements. But I promise you, some distressed debt investors out there are doing it right now, looking for loopholes to get an edge.

Distressed Debt Investing Ideas

Many investment banks retain a force of desk analysts that assist clients in answering questions on certain investment ideas and recommending trades to the banks clients. The arena for distressed debt in the same. Of course, buy-siders need to be wary that the respective analysts are talking their own book (i.e. the trading desk has a position, while at the same time the analysts are touting the idea). That being said, many of the desk can be a strong resource when ideas are running dry, like the situation I find myself in today.

The distressed research analysts at CSFB have always impressed me. They made a number of strong calls in 2008 which played out nicely. Earlier in the week, I received a run from our CSFB salesman on their Top Loan Picks, for the Fall, in the Distressed World. While I have not included the entire list (contact your CSFB sales rep for the message if you missed it) I will point out a few that I think are interesting and could be potential longs. As always, if we have time, we will do a case study on one or two of the ideas presented below (if you would like to contribute your ideas on any of the names mentioned below, email me). I have tried to include names that have public information, and have linked to pertinent sites, in case you want to start working:

1. Hawaiian Telecom; Hawaiian Telecom Investor Relations
2. Claire's Stores; Claire's Stores Investor Relations
3. Boston Gen (1st and 2nd lien)
4. Lear...as discussed in our Lear Case Study.
5. Federal Mogul; Federal Mogul Investor Relations
6. Las Vegas Sands; LVS Investor Relations
7. Buffets (bank debt and equity); Buffets' Bankruptcy Information

Lots of digging to do in these 7 distressed debt situations (plus the other 18 they recommended). If nothing else, investors can sharpen their pencils, and wait for names to trade off to more respectable yields.

Simplified Distressed Debt Recovery Analysis

Distressed Debt Investing requires a lot of assumptions. Every investor can look at a certain situation and come up with radically different conclusions based on seemingly minuscule differences in EBITDA and exit multiples. When I do an analysis of a credit, I run a number of different models to come up with recoveries. These models will be industry specific sometimes and other times will be very general.

Assets are valued differently in a bankruptcy court depending on who is doing the valuation. If you have time, read through some old dockets where Financial Advisers (creditor or debtor) give testimony on how the valuation of the enterprise was determined. In reality, it is determined in a fashion to approximate the recovery (what type, how much, etc) that the hiring parties want the financial advisers to come up with: If the unsecured committee wants the post-reorg equity, their financial advisor will argue to the court that the enterprise in question is worth a lot and can support a fair amount of debt. In that way, senior secured lenders are reinstated or paid back from an exit facility and the unsecured class retains the equity and captures the levered upside.

As stressed in previous posts: It's all about incentives. Know the incentives, and you are on your way.

As analysts we need to do our own valuation of the assets/enterprise, no matter how granular. I have had cases where my Excel file had 40 or 50 tabs and others when there is one tab with a simple recovery grid. It all depends on the situation at hand.

For those that do not know, let me explain the simple recovery grid. This is where you have multiples on the vertical axis, and EBITDA or cash flow on the horizontal axis. It looks something like this:

All things being equal, the above chart tells me how much the enterprise is worth. From here, I can walk through the waterfall, and get to a point where I can back into what the recovery on a particular bond. For example, if there was $2.0B of debt outstanding in the above case, the recovery on the debt would be:

Now, admittedly this is a simplified analysis. What is important though is that if this bond were trading in the market at say 77, you could zero in on what the market is expecting for both EBITDA and multiples. In the above example, if your EBITDA forecast was coming in at $185M, you would be a SELLER of these bonds unless you believed multiples were going to increase above 7.0x which is a hard-sell in a lot of bankruptcy cases.

Without blatantly posting one of my "go-to" models on the interweb, I thought I would walk readers through the next few steps in the process; or better yet, vet this process out a little bit.

First, you need your EBITDA forecast. This can be a range like above. That being said, the range I have above ($185M-$300M) is laughable. If you really understood a business, you should be able to approximate run-rate EBITDA in a much tighter range. This is where your work on market share, pricing dynamics, wage inflation, demographic trends, cost controls, etc come into play. You will spend a lot of your time working on this, and maybe at the same time finding ways that the company could be more profitable in the future, especially if you are in a control position. This is where talking to competitors, suppliers, distrubutors is essential. Why does XYZ turn its inventory 2x faster than our ABC bankrupt company? Why has SG&A always been 50 bps higher than the industry average? Etc.

From here, you are going to need a range of comps. I can confidently say I have read more proxies and bankruptcy valuation reports from financial advisors than most. Everyone has their own method: Adjusted EBITDA, EBIT before stock option expense, OCF less Capex, etc all times some multiple that can be construed by selectively pulling together certain comps. Do you want a high valuation? Well then remove all capex heavy companies from the industry and call our bankrupt company "asset-lite". Magic sometimes happens when applying multiples. Unfortunately, you have to play the game and throw up some multiples to at least see where market assumptions are. Even if you do not use the final product from your analysis, you will have another valuation tool in your tool bet.

So you have your multiples, your EBITDA forecast, and thus your Enterprise Value. From here you add ancillary assets whether that be cash generated during the bankruptcy process, patents, trademarks, land, etc. You now need to guesstimate what kind of capital structure this pig will have when it emerges. What are other companies in the industry levered? What do the economics of the business (stickiness, low capex, high asset turnover) allow for leverage? Let's say you are confident this company should be 3x levered. How much will that be senior bank debt? How about bonds?

From here, you then work out what the interest expense would be for said enterprise given an oscillating scale of more bank debt or more bonds. Generally speaking, EBITDA less capex less interest expense has to be moderately positive for a bankruptcy judge to approve a plan/projections otherwise the debtor faces the risk of Chapter 22. Let's say that after you have determined 3x leverage works, where 2x turns of it will be bank debt, and the remaing 1.0x turns unsecured bonds.

You then work your waterfall. Do not forget taxes, post-petition interest that may be accruing, professional fees (use 3-5% of debt outstanding), rejected lease administrative claims, critical vendors, 20day AP, etc. All of these are admin expenses and generally need to be paid out in cash before a plan can be approved. This is what an exit facility is sometimes used for. Let's say all of those expense equated to 1x turn of EBITDA and that 1x turn will be financed with an exit facility. So of your 3.0x turn enterpise, 1.0x has been used up for admin.

With the remaining available leverage, the new bank debt and bonds will be used to either pay down pre-petition bank debt lenders or provide capital to the business (generally with the help of a rights offering etc). If you were a pre-petition bank debt holder you can now determine how much of your recovery will be in senior bank debt and how much in sub bonds.

After the 3.0x leverage threshold in our example has been extinguished, the rest of the value would accrue to equity. How much is this equity worth? Well you have to do a DCF of sorts. Work the post-petition cash flows with the new capital structure, and your projections for capex and working capital. After you get your FCF, apply a discount rate (make it nice and HUGE to ensure a large margin of safety - think 25%), and value your equity.

At this point, you should have a good sense of who is getting what in the re-org. You will also be able to determine what percentage of your recovery is cash, new bank debt, new bonds, or new equity (again with the help of a potential rights offering). Run a number of scenarios, and apply probabilities to each, to come up with a weighted average recovery.

If this recovery is materially higher from where your preferred debt instrument (or equity even in the case of PPC) is trading, you may have yourself a distressed debt winner. Rinse. Repeat.

Wisdom from Seth Klarman - Part 3

If you remember, in the beginning of August, we grabbed some quotes from the Baupost letter from 2005. We continue with that same letter, as it provided a number of fantastic investing gems.

"...Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market out performance by one investor is necessarily offset by another's under performance. Consequently, you keenly watch your competitors to see not only what they are doing right, but what they are doing wrong. You observe carefully to identify their investment constraints and limitations, their time horizon and liquidity requirements, areas that they ignore and areas that they avoid. It is in these areas that opportunity is often greatest; that is where bargains regularly surface, with your best competitors not only failing to compete but sometimes serving as the seller. It is here, where others panic, sell mindlessly, neglect, or fear to tread that investors have a chance to develop and sustain an edge."

From a speech that Seth Klarman gave to a group of Professor Greenwald's Value Investing Class, we know that he has analysts that just focus on spin offs, changes in indexing, bankruptcy etc. These create vacuums where force sellers rule the day due to investment constraints. In the example of an index fund trade, imagine a somewhat illiquid stock dropping from an index. Index funds across the board need to sell the holding to maintain their index match which creates a situation of uneconomic selling which in turn may create a dispersion between price and intrinsic value. It is also rumored that Baupost's investments in MLPs in late 2008/early 2009 stemmed from the fact that Lehman brothers held 20% of the float of the companies and were forced sellers as their prop desk unwound.

"The single greatest edge an investor can have is a long-term orientation. In a world where performance comparisons are made not only annually and quarterly but even monthly and daily, it is more crucial that ever to take the long view. In order to avoid a mismatch between the time horizon of the investments and that of the investors, one's clients must share this orientation. Ours do."

It is a sad, but true fact in the investment industry that limited partners and general partners, specifically in the context of a hedge fund, have different investment and liquidity time constraints. Many analysts reading the blog today will have experienced a situation where an investment looks particularly compelling, but the idea was kibashed, or sold early, because the portfolio manager had to raise cash, or was painting the monthly numbers. Despite their obviously strong investment skills, an advantage of Baupost is how sticky the capital is as opposed to a number of other funds that have had to put the gates up. I do not know who said it, but I remember hearing a quote: "You deserve the capital you attract." Unfortunately, for a small manager, any capital is good to get the ball rolling. And that creates a mismatch which is one of the fundamental flaws of this business.

"We are able and willing to concentrate our capital into our best ideas. These days, other investors' idea of "risk control" is to own literally hundreds of small positions while making no size able bets, a strategy that might also be labeled "return control". It is clearly an advantage, but by no means without risk, to be able to concentrate our exposures. We work exceptionally hard to ensure that our largest positions are indeed our most worthwhile opportunities on a risk-adjusted basis."

What is interesting, is that this quote somewhat ties in with the previous two. Having a large diversified book helps when capital it quick to exit. Further, a massive position in two or three stocks when limited partners are redeeming can cause returns to become even worse as you put pressure on the stock. The opportunistic investors should see this and buy the stock you are selling (uneconomically I might add) on the cheap. But they will wait until you are fully out, further depressing returns, and inciting more limited partners to redeem.

This is where portfolio management becomes so important. Managing the book to allow for sufficient liquidity in case of redemptions, but at the same time placing your bets in a way to maximize risk return. This is where people discuss the Kelly Formula...or better yet, the modified Kelly Formula. As has been reported in many places, Monish Pabrai moved his allocations to 10% per position to a smaller number. I think this makes sense, but there will be times (like Enron for example) where a 10% position makes sense.

Now remember, Klarman wrote these words in early 2006:

"The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly ever investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedented low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. "

Take about having a crystal ball.

Stay tuned for the next part of the Seth Klarman series where we dig into the 2006 Baupost annual letter.

Interesting events this past week in the Distressed Debt World

Distressed Debt Investing contributor Nathan, on this week's past events:

The week before Labor Day is a notoriously slow one in the credit markets as many, if not most, people vacation for at least part of the week. I spoke with a couple of folks this week who noted that this was the first “normal” pre-Labor Day week in a couple of years as most people were afraid to leave their desks in ’07 and ’08. That said, there were a couple of interesting—albeit disparate—items that caught my eye this week and when considered together they have important implications for the distressed market.

On Wednesday the Wall Street Journal reported that Brazil’s JBS SA may make a $2.5 billion stalking horse bid for the assets of bankrupt poultry purveyor Pilgrim’s Pride. BRC §363 Use, sale, or lease of property governs asset sales of bankrupt corporations and the “stalking horse” auction is one of the ways a debtor can sell some or all of its assets in order to maximize creditor recoveries. Basically, the stalking horse bidder (acquirer) will guarantee to pay a minimum acceptable amount for the debtor’s assets and then the debtor will conduct an auction where other bidders may top the minimum bid (by a certain amount—this isn’t The Price Is Right). If another bidder wins the auction then the stalking horse bidder is paid a break-up fee for its troubles.

In the case of Pilgrim’s Pride, the JBS SA potential bid is enough to pay its unsecured bondholders par plus accrued interest. Allegedly the bid even includes compensation for the equity holders, which is pretty rare. Following the news PPC bonds traded up about 15 points to $105, which is a far cry from the $10 price when the company filed in early December. Of course, nearly every asset on the planet is up since then, but still this move is pretty remarkable.

The second item I found interesting was a Bloomberg News article entitled KKR Turns Vulture Investor as Distressed Debt Beckons. The article talks about how KKR and other private equity guys are using bankruptcy purchases to acquire companies. This in and of itself is far from shocking as anybody who has followed private equity’s fund raising success over the last decade or so had to see this coming.

So where am I going with this? My takeaway from these two articles is that there is a deep and growing bid for distressed assets right now, from a variety of players, some of which are just mobilizing their capital. In the case of Pilgrim’s Pride it was a strategic player and a foreign one at that. The KKR story tells us that there are financial buyers in the market as well. And of course we already knew about distressed hedge funds. I am not trying to call a bubble here, but clearly the salad days of early ’09 are behind us and the combination of higher prices and greater competition for assets mean that the pickings will be a little slimmer, at least until the “W” kicks-in and the bank loan maturity wall gets closer.

Side note on Pilgrim’s Pride / JBS SA:

I also found it interesting that an emerging market company—even a BRIC one—was purchasing an American food processor. This isn’t an industry where JBS will just skip back to Brazil with some intangible assets and resource the labor base to its lower cost country. Protein is a local/regional industry where JBS will have to operate in the US (they already did, but now they will be #2 behind Tyson). At the risk of sounding like Jim Grant, my point is that decades of current account deficits have armed our trade partners with capital that needs to be put to work and in this case they were more willing/able to invest in a market leading American company than anyone else. I mean come on, Brazil is a country that devalued its currency just ten years ago. This adds credence to Mohamed El-Erian’s “New Normal” calls. Okay that is the end of my little semi-patriotic rant. I hope everyone enjoys their Labor Day weekend.