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
Judging by some of my current experiences, an issue for us as credit investors is that most new actors in the field are basically market-timers with gregarious equities-like mentality. In other words, retail investors and new funds were massively attracted by the idea that the high yield class had been decimated and should recover (with misconceptions about recovery values). As such, the rally has been indiscriminate while the economics of most high yield issuers have not changed that much. Therefore (even more so for European credits,where investors are more naive than here) for the next months, the challenge is doing the granular work at the companys' level to separate the wheat from the chaff. Also cap arb, pure event driven investing (see my Orco trade) and even basis trades will probably be more heavily weighted in our portfolios than just deep value home-runs.
ReplyDeleteAn important aspect to think about when pondering this rally is the role that index funds have played. I have read so much fluff out there about strategists telling their clients to allocate money to passive high yield. And the AMG data has shown that a lot of capital has moved to HY and Levered Loans. This has had a definitive effect on the market - sadly I feel the passive guys are going to get smoked.
ReplyDeleteIf only they were sophisticated investors, they could get out of some of the riskiest positions. But I fear they are not. They are buy and hold investors, non high yield specialists for the most part. Also, we see a real appetite for high yield issuances (feeding the ducks again like it is 2006-07 all over again), but bank loans ? do you see banks lending for private equity operations ? I just see in the USA as well as in Europe bankers pitching high yield bond issuances to stretch maturities and repay bank debt maturing soon, but no real new bank debt.
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