Distressed Debt Investors Club FAQ

This post will serve as the running FAQ for the Distressed Debt Investors Club (URL soon to follow). There will be a link on the new site, pointing back to this post for easy updating / commenting.

Overview/Application Process

What is the Distressed Debt Investors Club (DDIC)?

The Distressed Debt Investors Club is a community of buy side and sell side professionals that focus on distressed, high yield, credit, fixed income, and special situations. For too long, most investing forums / sites have overly relied on equity driven ideas. Our site will be the first focused on the fixed income aspect of the investment business which, by our estimation, is far larger than the equity markets.

What are the benefits of the DDIC?

Currently, idea generation in the fixed income world really boils down from sell-side recommendations and building a community of like minded professionals. This, in my opinion, will be the strongest community out there.

In addition to the ideas presented to the site, the member forum will be a place for members to share their thoughts on current happenings in the credit / fixed income markets.

And finally, going forward, I am going to post case studies exclusively to the DDIC. The blog will be a place where I discuss current events as well as value investing and distressed debt concepts (don't worry ... more Seth Klarman content will be coming). But full blown case studies will solely be found on the DDIC. That being said, I expect to post more frequently to the blog, with richer content, upon the launch of the site.

How does one become a member of DDIC?

Members will be chosen via an application process. Potentials members will submit an idea that they find particularly compelling, current and relevant. Myself and two of my colleagues will go through each application. If we have questions on the idea, we will email you and wait for a response back. If you are accepted, you will be given membership access to the site as well as the member forum. If you are not accepted, your status will be set to "guest" until you submit another application.

How does one become a guest of DDIC?

Guests will apply in the same fashion as potential members, except for submitting an idea, they will simply write a note in the text fields that they are applying as a guest. Guests will not be approved until after Jan 1, 2010. In the future, guests will be set on a 50 day delay. This means that when a member submits an idea, guests will not see the idea or the comments of the idea until 50 days after the idea has been posted. Guests will also not be able to access the forums on the site.

Do I have to provide my real name or firm on the site?

Yes. But no users will be able to see this information. I am collecting this information for book keeping purposes. Users will only be identifiable via their user name (i.e. mine is Hunter) The Distressed Debt Investors Club is committed to protecting your privacy. We will not sell, trade or rent your personal information to other companies or third-parties.

What type of ideas are considered "fair game" on the site?

In no particular order:

• High Yield
• Distressed/Bankruptcy
• Investment Grade
• Agency / Government Securities
• Structured Product
• Equity or Credit Short
• Post Reorg Equity
• Undervalued Equity
• Special Situation

I thought you said this site was fixed income focused? Why allow any type of equity?

There comes a time in any fixed income professionals life where he/she finds an equity situation that is too good to pass up. We do not want to handcuff our members in the chance they find a particularly compelling opportunity. Further, and we will expand on this below, but each user must submit 1 idea per every half year (in addition to their application that will also be visible to users once accepted), but undervalued equity will not count towards this total.

How many members will be admitted?

For 2010, the number of active members will be capped at 250. In the future, this may decrease or increase depending on how the user base is interacting and whether a solid community is already functioning. If we feel we can handle more users, then we may accept another 50 in 2011 for example.

What is the format of the application / idea submission?

The two main components of the application are the "Synopsis" and "Investment Write-Up." The Synopsis is no more than 4 sentences explaining why this is a particularly compelling investment. In the synopsis you should include your target price and potential IRR on the investment. The synopsis is your "elevator pitch" if you will.

The Investment Idea Write Up section is the meat of the thesis. This is where you will expand and defend your synopsis. The site will enable (90% of the time) to cut and copy from word with near exact formatting.

In addition to the Synopsis and Write Up, you may attach a file to each idea (no larger than 300kb). You should reference this file in your write-up if you feel it is justified.

How long between application and decision on membership?

In the first few weeks, expect at least 4 or 5 days. In the future, I expect applications to come in at a slower pace, and therefore status could be decided that same day. Also -if you have no received an email yet, check your Spam filter.

How much does it cost to be a member?

The annual cost for 2010 is $49.95 dollars. No fees will be collected until January 2010 to give users and members a chance to see the benefits of the site. Therefore, no money is required up front in the application process. If you do not like the site and want to revoke your membership, all you have to do is contact me. In the future, fees will be collected via PayPal.

How much does it cost to be a guest?

Guests will not be charged an annual fee in 2010.

What if I become a member, and decide this boondoggle is not for me?

I, more so than most, know how busy and time consuming the investment world is today. If you feel you cannot contribute enough to the site to remain a member, or feel that you just are not deriving any value from the site, you can contact me to change your status to a guest. Please make this decision prior to January 2010, as 2010 refunds will be given after that time.

Site Navigation

How do I submit an idea?

In the upper right of the member page, you will see the Submit an Idea button. Here you will see something similar to the application page, with synopsis and write-up text. Fill those out and add an attachment if you see fit (remember 300 kbs). You then will preview the idea. Make necessary changes and then submit the idea.

The formatting is showing up all strange when I preview the idea...

Unfortunately, web based editors sometime like to make me angry and you will see certain errors (like ";nbsp") throughout your idea submission. To offset this, open up WordPad or another simple text based editor, and copy your idea into WordPad (from Word for example). Then from WordPad cut and copy right back into the DDIC. This has been the reason the site has been delayed for two weeks and there are still kinks. If you are completely frustrated, email me and I will help you out.

Can I edit an idea after I have submitted it?

Yes. You are able to edit your ideas in the future if need be.

Can I comment on/ rate other users' ideas?

Yes. Ideas are scored on a 0-5 basis with the site aggregating the best ideas on a weekly / monthly and yearly basis. To see the best ideas from the week, simply click "Last 7 days" ... to see the most recent ideas, ranked in chronological order, click "Recent." On the right rail, you will see a section for Highest Rated Investment Ideas. Currently, that section will feature the highest rated ideas ever submitted to the site.

In terms of commenting, all members may comment on one another member's ideas. Comments should be tasteful and more than likely, pose questions to the original author of the idea.

What is the User Profile?

Admittedly a work in progress. In the future, this section will be a place where users can send messages with one another. Currently, messaging is delivered via the member forum.

How will the Search Function Work?

The search function is VERY robust. You can find a needle in a haystack with that thing. You can search anything ranging from company name, idea/synopsis text, rating, date, etc.

Tell me about the Forum

The forum will be a place where members can discuss whatever they please. Whether it be concepts, news, passing around hedge fund letters, idea discussion, making fun of me, setting up meet and greets, etc. While it will not be a lawless wild west, I will be more apt to be a "hands off referee." Users can also let me know if they want new forums set up, or other taken down, etc.

Other General Questions / Info

What are the "rules" of membership?

Each user will be required to submit an idea for their application. If approved, this idea will go into the database and count as one idea for the site. Each member thereafter will be required to post 1 idea per half year, as well as rate 15 ideas per half year. I do not want a situation where everyone is submitting 2 ideas at the end of the year and hence have split the requirement into half year increments.

Why are you doing this?

I have been absolutely humbled by the response to Distressed Debt Investing. I have always been awed by the success of other investment club websites yet feel like one devoted solely to credit and fixed income would be an invaluable tool to its members. The credit markets are so deep and wide that the diamonds in the rough are countless: you just have to know where to find them. And I know that this site will accomplish that goal. That means a lot of people are going to make a lot of money from the ideas presented on the site.

So I ask you: Why wouldn't I be doing this?

Last Updated: 10/27/2009

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Advanced Distressed Debt Lesson #2

In our first edition of Advanced Distressed Debt learning / knowledge base, we discussed negative pledges. In this post, we will discuss the issue of exclusivity.

The exclusivity period is the period after the bankruptcy petition date in which only the debtor can file its Chapter 11 plan. This is advantageous in that the company can work out its own version of how it sees fit in financing itself going forward - without creditors pressing for actions / solutions that may peril the debtor, but also peril the debtor's management team.

Section 1121 of the bankruptcy code gives exclusivity to the debt for the first 120 days after the bankruptcy petition is filed. If a plan is filed in this period, the debtor is given another 60 days (i.e. a total of 180 days), where no other plan may be filed. The judge of the case, as usual in most bankruptcy cases, can make this period longer if the debtor so requests, or can shorten it if creditors move against the debtor's exclusivity.

Before the new 2005 bankruptcy rules, exclusivity could of lasted for a very very long time. Companies that filed prior to the new bankruptcy rules are still able to drag out the bankruptcy process many times to the chagrin of creditors. Very few of those cases remain (W.R. Grace is one as an example). Any filings after the 2005 rule changes, the exclusivity period (i.e. 120 and 180 days respectively) may not be extended past 18 months and 20 months respectively.

If the debtor fails to file a plan AND get creditors on board within these aforementioned periods, Wild West sets on the bankruptcy court, and anyone may file a plan.

Why is this all important? Given that the window of time for a debtor to file a plan has been maxed out to the 18-20 month period, management many times has to really reach out and deal with creditors if they want to keep their jobs. Further, 363 sales, because of the swiftness in which they can be accomplished, are being pursued a lot more frequently than prior to the new 2005 bankruptcy law changes. But most importantly: It creates an avenue for distressed debt investors to position themselves better than being handcuffed by obstinate management teams intent of keeping their positions.

We have discussed Six Flags' bankruptcy at length on this blog. The company has proposed a plan (within their exclusivity rights) to give over 90% of the new equity to bank debt lenders. Unfortunately, the subordinated OpCo notes do not like this plan and have laid out its own ideas what the restructuring should look like. And the market has concurred: Six Flags' OpCo notes have marched to the high 80s (from 50s earlier in the summer), as the market anticipated that the currently filed plan will not be accepted and more than likely amended to give some juice to the OpCo notes.

It turns out that the company has been working on a new plan. But at the same time, it has asked for an extension of exclusivity, which everyone and their mother has objected to (I very much enjoyed and suggest you read this entire document: Six Flags' Exclusivity Objection)

I do not know who will win the battle here. I have been invested in the Six Flags' bank debt since I first posted about it in April when it was trading in the low 70s. The return is significantly lower, but the downside risk is also quite muted. If management's plan is confirmed, you are creating the company at a ridiculously low valuation, and if the OpCo note holders plan is confirmed you get taken out at par (make some carry and a few points here). To me, that is still the best place to play in the capital structure, from a risk/return, especially given the run-up of the OpCo notes.

Later in the weak, I am going to do a two part series on fraudulent conveyance - an issue ripe for a Distressed Debt Investing post given the recent ruling at Tousa.

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Distressed Debt Analysis with Stephen Moyer

This past Thursday, Stephen G. Moyer—portfolio manager at PIMCO and author of Distressed Debt Analysis—taught a seminar at NYSSA on, you guessed it, distressed investing. Mr. Moyer’s aforementioned book is considered the bible of distressed investing by most practitioners, and is one of the most “readable” financial texts available. His half-day seminar was a condensed presentation of the key concepts from the book, as well as some interactive Q&A with the audience.

The seminar was geared towards—and mostly attended by—investors fairly new to distressed investing. From conversations with other attendees it seemed the majority were “equity guys” who wanted to get involved with distressed investing. For the handful of experienced distressed investors the seminar served more as a review. And while the “distressed guys” may not have been exposed to any new concepts, it was both very interesting and highly impressive to hear Steve discuss numerous bankruptcy cases. From his examples it seemed like he was involved in every meaningful case for the last two decades, which probably isn’t that far from the truth.

Rather than summarizing the bulk of his presentation we will again refer our readers to his book, which we previously recommended as a top pick in our reading list. (See link above) However, there were a couple of interesting interchanges during the Q&A that warrant discussion.

First, the topic of supply and demand for distressed assets in the coming years was discussed. As previously discussed on this blog, most of the distressed community expects default rates to remain elevated for the next several years. However, unlike many past high-default periods, there has been an unprecedented amount of capital raised by distressed investing vehicles (hedge funds, asset managers, private equity) prior to the peak in defaults. Mr. Moyer believes the total amount of “new capital” raised for distressed investing to be in the $60-80 billion range. That said, he believes this level of distressed demand will be commiserate with the amount of future distressed opportunities and shouldn’t cause undue pressure on returns.

The second interesting topic was Steve’s discussion of the GM/Chrysler bankruptcies and their potential role as precedents for future bankruptcies. On this topic he was relatively “bearish” in that he thinks there is a good chance that future bankruptcy cases will cite the GM/Chrysler decisions as precedents for screwing different classes of claims. His advice, predictably, was to more carefully analyze and/or avoid situations where the government may be involved. Pressed further though, he also seemed a bit concerned that there could be problems with cases not involving the government. Now, as a disclaimer, it’s important to note that PIMCO was one of, if not the largest GM bondholder and his comments are probably colored as such. His opinion on this matter stands in stark contrast to those expressed by several participants at the Global Distressed Investing Forum, where the consensus was that GM/Chrysler as case law would be a non-event.

Anecdotally, Mr. Moyer made an ironic comment regarding the “holdout problem” in debt exchanges. For those unfamiliar, when a company proposes a debt exchange existing holders are often asked to take a haircut on their principal amount, among other things, in exchange for the company improving its balance sheet and hopefully staying out of bankruptcy court. However, assuming the exchange is successful bondholders who do not exchange will be (economically) advantaged relative to their non-exchanging peers. Paradoxically, if there are too many holdouts then the exchange will fail. While discussing this very issue, Steve lamented that when he thinks of the holdout problem, he “always pictures some New York slicksters” [as the holdouts]. I thought this was pretty ballsy considering PIMCO pulled off the mother-of-all holdouts when they backed out of the GMAC exchange at the last minute, leaving the company short of its minimum participation level.

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Notes from Best Ideas Symposium

Do not know if these are all over the interweb yet, but a friend sent me a great compilation of notes from the Great Investors' Best Ideas symposium - an event held in Dallas last week. For an overview, please see this: Great Investor's Investment Ideas

TRADES: EINHORN, ACKMAN, PRICE, BARROW, HART & GABELLI

Einhorn

• Obama’s September speech on financial reform had many good points….he should have relayed them to his policy team.
• Making these institutions (banks) and products “safer” is like making safer asbestos.
• (extremely negative on existence of the banks in their current form, government’s weakness to banking lobby, the pervasive moral hazard our policies have created, and the institutionalization of “too big to fail”.)
• Banks are earning oligopolistic profits on mortgage spreads.
• Romer and others in the administration seem intent on maintaining the fiscal stimulus and cite 1937 as their basis…. But GDP created by fiscal stimulus is artificial.
• Deficit accounting is on a cash basis, if done on a future basis our deficit is in the ~5 trillion range and future obligations are $60 trillion (already committed).
• US fiscal scenario mirrors countries that have defaulted on sovereign debt (citing data from American Enterprise Institute).
• Japan is well on its way to hyperinflation/default.
• Rating agencies continue to lag crisis and they don’t rate sovereign debt any better than they do corporate.
• How to manage risk:

1. Long gold, gold related. Does well when monetary policy is poor/vice versa.
2. Long dated int rate options US/JAP. Prefer these v. short bonds; limits loss/creates leverage.

Mark L. Hart (partial notes)

• China has not had growth in actual wealth to match GDP.
• Capital flows into China: trade; foreign investment; net speculation…all leads to dilution, further printing of RMB
• Endless cycle of printing RMB and buying foreign treasuries etc; gives appearance of constantly growing foreign reserves.
• To play as individual: Short Chinese ADR ‘s with RMB denominated assets.

Gabelli

• Long idea: NFG
• Own Seneca, 4th largest acreage holder in Marcellus shale.
• 4.4b enterprise value.
• PMV ex-Marcellus = $42

James Barrow

• Don’t buy fat CEO’s, those with Napoleon complex, or high pay v. the industry.
• Bubble Concerns: Speculation in industrial raw materials. Asia Bond Inflows
• 3 Stocks he likes: Cooper Industries (14x dep earnings, 3% yield, infrastructure play); Sysco (4% y, good balance sheet, recovery play); Conoco (Nat gas play, killed by its refining biz, multiple <>

Michael Price

• Blue chips (KFT, DIS, XRX, BHI) are strategically buying and paying 30-50% premiums, thinks this trend will continue, $ is cheap.
• Ride longs even those a bit ahead of themselves from a valuation perspective (eg. EBAY)
• Looks for industries that have been battered, layoffs, etc.
• TV, Newspapers - content is still rich but the medium is the question (paper v. Kindle). Doesn’t know how this will play out.
• Long WPO due to the Kaplan ownership, the paper itself bleeds.
• Would buy NYT but not at current levels.
• Also likes Smithfield Foods (SFD) (13b revs, hog and corn prices becoming more favorable, 2 board members left when they sold stock to pay down debt.)
• Short VNO (smart guys but overvalued at present levels (~$62), the company sold stock at $47, 40% above NAV)

Bill Ackman

• Entire presentation (with slides) was on shorting Realty Income Corp (letter O).
• With disclaimer that he could be wrong, literally said it cannot go up.
• Operate triple net leases.
• (Pictures of select properties) all complete dumps. Typically “specialty use”, Buffet’s, local video stores, etc.
• Will not disclose ID of tenants (had several excerpts of analyst calls, when a tenant had been determined, the company declined to comment).
• Entire purpose is to “grow monthly dividend”. Reiterate several times, add thousandth of a penny monthly.
• Pays out all cash flow to sustain the dividend.
• If valued at 9.5% cap rate (generous) would fall by half.
• Tenants that are identifiable are mostly junk rated; Ryan’s Buffet’s, Rite Aid’s; some B’s.
• Every time stock reaches 25-26, the company sells.
• Executives own less than 1%, haven’t bot any in 6 years.
• Vesting program accelerates with age; never seen such a thing. Immediate vesting at 60. (CEO is 56).
• Says is borrowable.
• Positive caveats: No debt maturity til 2013, 350mm revolver but if forced to mark to market they would lose access.

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Distressed Debt Investors Club

As discussed in previous posts: Distressed Debt Investors Club - Intro and Distressed Debt Investors Club - FAQ and Distressed Debt Investors Club - Follow Up #2 we are very excited to say that the beta test (with real live users) is currently underway. Feedback has been remarkable. Development is tweaking some final design / technical flaws, but in a week or so, we will be ready to launch.

In the meantime, if you are planning to apply, get that investment idea ready. Here is what you will need: Company Name, Equity/Bond Ticker, a 4 sentence synopsis of the idea, and a longer write-up. The database allows you to upload a file (whether that be an image, XLS file) so if you want to include that, it is strongly encouraged. The User Base is anonymous meaning you are able to use an alias on the site - and no one will be able to see personal information.

Myself and two of my cohorts will read through each application and make a decision on an applicants status. My biggest concern with this entire boondoggle is the QUALITY OF INVESTMENT IDEAS. I want this to be a place where I can go and if I need to find an equity short, I can search the database for recent equity short ideas and trust that the user knows his shit.

Let me repeat: My #1 purpose for this site is to create the very fucking best community of investment thinkers in the distressed / high yield world.

Users will be able to interact with each other on a member only forum and with comments on each idea. Buy siders and sell siders alike are encouraged to apply. There will be a limited number of member spots for students, as I am hoping the vast majority of users (call it 95%) are currently practicing members and can talk about their investment ideas in the context of the larger market.

If you having questions on any of this, feel free to shoot me an email at hunter [at] distressed-debt-investing [dot] com. Stay tuned in a few weeks for when we open up the site for applications.

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Wisdom from Seth Klarman - Part 5

We continue today discussing Baupost's 2006 Annual Letter to Investors. As discussed previously on this blog, Seth Klarman is arguably our favorite investor and we hope to enlighten readers with some of his wisdom and "Klarman quotes."

"When people ask us about Baupost's risk controls, we have no glib answer. We have no risk control group we can trot out with a PowerPoint presentation. Risk control to us is a careful aligning of interests, a proper balance in our investing between greed and fear, experienced and collaborative senior management and investment teams that have worked together for quite some time, a consistent and disciplined investment approach where every opportunity is individually and meticulously evaluated on its fundamentals, a strict sell discipline, a willingness to hold cash when opportunity is scarce, a complete avoidance of recourse leverage, and a healthy level of fear."

Read that last sentence one more time. If that is not the way to run an investment partnership, then I don't know what is.

On discussing Baupost's edge (see some of our previous posts on this):

"...in today's competitive world, these edges do not ensure long term success. Our best ideas sometimes look a lot like other firms' best ideas and, at times, may even be identical. Yet our approach, if successfully executed, may enable us to outperform the crowd even if we have the exact same idea flow as everyone else. How might this be possible?

The answer is that we have worked hard to create an environment that lends itself to good decision-making. Simply put, we strive to make the most of each opportunity we have at hand. One way to do this, as mentioned earlier, is to avoid over-diversifying. Talking full advantage of our best ideas is a real no-brainer. The search for new opportunity is often times quite challenging; buying more of what we already know and like requires minimal additional effort. The teach approach that we have adopted at Baupost maximizes the probability that our best ideas will be effectively identified as such, and that a healthy overallocation of capital will be made to them. A firm that exploits its best ideas has superior returns, happier clients, better rewarded employees, and greater profitability."

Many people in the distressed debt world know circles exist among funds. Many people know which fund will put on positions just because another fund has the same position on. The problem is that only a few funds have the discipline to put a large portion of its capital in Enron or in 2007 sub-prime RMBS shorts. Those are the winners in my opinion.

A quick point on selling:

"Selling, in particular can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it."

On hedging the portfolio - and remember this was in early 2007 (read: GO GO GO market)

"In today's fully valued financial markets, one area remains quite inexpensive: disaster insurance. In general, disaster insurance is intended to offset portfolio losses from positions that are expected to suffer during or in the aftermath of extreme adversity or dislocation. Like any insurance, it usually expires worthless when the disaster fails to occur - but that doesn't mean it's not worth having. Financial disaster insurance can take many forms, including out-of-the money put options on individual stocks, baskets of stocks, or market indices. Call options on gold (a hard metal that has served as a store of value for centuries) or inexpensive out of the money options on interest rates or currencies, where a dramatic fluctuation could adversely affect our situation, are other forms of disaster insurance."

I remember watching an interview with Seth Klarman where he said he was buying credit protection on sovereign nations. It cost him approx 5-10bps a year. This was an incredible opportunity at the time as sovereigns blew out 100-300 bps depending on the country. And sub prime RMBS (whether the ABX or single-name) were a similar sort of trade...no real downside (cheap carry) and MASSIVE upside.

Speaking of Subprime:

The sub prime market is the canary in the coalmine of housing; a minor downward tremors in home prices could be felt with seismic force here, especially in the priced-almost-to perfection lower investment grade debt tranches. These tranches offer far too miserly a yield given the rather significant risk of principal impairment. Holders expect the real estate markets of tomorrow to closely resemble those of yesterday, and for Joe Sub prime to behave just like the average Joe. Should conditions worse, as they lately have been doing, and should the yield on these narrow slices of marginal credit risk to reflect this risks, as it currently happening, the financial Cuisinart that churns out sub prime tranches could become incapacitated. Then, then junior tranche trail could end up wagging the sub prime dog, causing the sub prime mortgage window to slam shut and thereby begin to restore sanity to the home lending market.

I think an interesting lesson to take from this: The area of excesses can be evidenced from which product Wall Street is pumping the most. Whether that be SIV's, Alt-A RMBS, CLO and levered loans, etc...this is where you have to worry.

Stay tuned in coming weeks as we explore the 2007 and 2008 Baupost Annual letter and discuss more about Seth Klarman and his fantastic investment record.

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Wisdom from Seth Klarman - Part 4

If you are new to the blog, here is part 1-3 from our "Wisdom from Seth Klarman" series.

Wisdom from Seth Klarman - Part 1

Wisdom from Seth Klarman - Part 2

Wisdom from Seth Klarman - Part 3

In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it, thank you to Andy for his donation (for those so inclined, a donation link is on the right rail, lower in the page). More donations = the better.

In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in comparison to the S&P which was up 15.8% that year. Gains were made from a number of categories with approximately 7% of absolute gain coming from performing and non performing debt - with the largest gain coming from "unnamed non-performing debt" which I speculated in last post was a position in Enron. These results are even more impressive given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over 40% during the year.

After discussing the party that was 2006, Klarman writes:

"We maintained our discipline throughout the year: disciplined buying when bargains emerged, and disciplined selling when prices approached full value. Despite fairly expensive markets, robust competition, and a near complete dearth of distressed debt opportunity, our tireless, highly capable, and experience team was able to fairly regularly uncover new opportunities. Considerable fundamental progress in many of our holdings, along with our strong selling discipline, triggered realizations during the year that were approximately equal to new purchases, resulting in relatively flat cash balances that masked substantial underlying activity.

One adverse in evidence during the year is that the markets proffered fewer extreme mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of the correction of these mispricings accelerated. In other words, fewer investments become really inexpensive, more become somewhat inexpensive, and the correction of these smaller mispricings happened faster than usual, enabling a particularly favorable overall result for us and for many value-oriented investors. It is impossible to know if this paradigm will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and increasingly private equity pool suggest that it could.

The old saw reminds us never to confuse genius with a bull market. Anyone can become "expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is lifting all boats often proves irresistible."

This guy must have a crystal ball. Remember he wrote this in January 2007. He is also somewhat pointing the finger (I am sure unintentionally) to many of the value investors that kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an interview with a prominent value investor saying that Freddie Mac was one of the cheapest stocks he had ever seen - and he just kept buying and buying it.

After talking about the sheer magnitude of capital flowing into alternative investments (hedge funds, venture capital, and private equity), fueled by demand from institutions and pensions:

"Many of today's institutional asset allocators are not evidently worried about the enormous amounts of capital surging into alternative investments. They are now asking the relevant bottoms-up question: Where are today's bargains? They are not following that thread to build, investment by investment, or one carefully chosen fund at a time, a diversified portfolio of undervalued investments. Instead, they are typically focused on the answer to three questions, each of which demonstrates a reluctance to think for themselves:

1. What has worked lately?
2. How can I diversify my way to investment success?
3. How can I invest like the institutional thought leader of this era; in other words, like Yale?

Here's why these questions range from remarkably foolish to largely irrelevant.

Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the sky. Sustained out performance in any particular sector of the markets is eventually borrowed from the future, to be given back either slowly through sustained under performance or quickly through price declines. What has worked lately is popular, widely owned, and bid up in price, and therefore generally anathema to good future results. But human nature makes it extremely difficult for people to embrace what has recently fared poorly."

And further down the letter...

"The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, what at least avoiding under performance. This is the best that you can hope to do in an efficient market.

For any fundamental-based investor, this is complete hogwash. Investment come in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either."

I love it. Too many times, each of us get caught up trying to look at some many things that our heads spin. A number of value investors suffer from a problem I fondly dub "Everything is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at everything, and lots of the things you look at you think are cheap. Any investor can rationalize a price target for any asset. The goal is to be patient and swing at those once in a lifetime opportunities, and then not dilute those returns with mediocre value traps.

"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not too distant future."

The first rule of investing is to not lose money. And the second rule is to not forget the first rule. When approaching situations, always look to the possibility and magnitude of permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an event a year or so ago and she mentioned that Warren Buffett will not invest in a situation where there is even a remote chance of permanent capital loss.

Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006 Baupost Annual Letter.

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Interview with Hedge Fund Manager Peter Lupoff - Part 2

Last week, we posted an exclusive interview with hedge fund manager Peter Lupoff. We continue the interview with Peter in the second part of the interview. As a reminder, you can find more here about Peter's hedge fund Tiburon Holdings

Talk about a current investment idea that is particularly compelling

I’d rather not talk about a specific idea at the moment but would rather talk about themes. We get ideas three ways:

• A top down “thematic” approach. From this, we delve deeply for those trade ideas that can survive the five prong methodology (see part 1 of interview)
• The gritty work the phones, contacts, read the news, watch the markets for leads way – old school
• “Mining the Portfolio” for ideas – that is, the deep work on any one name necessitates looking at comps and events, and in doing this, we uncover other trade ideas.

Let’s talk about themes for a moment. They can be grand in scope, given industry or economic circumstances or extremely narrow, given very rational and predicable behaviors (Rational Actor’s Assessment).

One major theme we played from ’07-’08 was shorting regional and community banks in the top 5 foreclosure markets, trading at (then) 3.5X tangible book and with 80% of their loans in home mortgages, HELOC’s, commercial mortgages and raw land. We then threw out those banks that had assets that could create events that could hurt the trade, i.e., SunTrust’s interest in the Coke trademark, etc.

Going into Summer, 2008, with a complete drought in the capital markets, we ran a screen for companies with ’08-’09 maturities and significant revolving credit availability, hypothesizing the wholesale draw down of the revolver and satisfaction of the near term maturities. Oh yeah, and the freak out of the equity over this action as well. I don’t recall what order it came in, but Apollo did coercive exchanges in Harrah’s and Realogy. Was it not predictable that doing one, they’d come with the other?

The inflow of significant retail money to Loan and High Yield bond funds is not only impacting secondary market prices, but stoking new issue markets opportunities for companies facing near term covenant issues or maturities. As some paper cycles out of portfolios due to refinancing, these technically driven investors are, in some instances, structurally compelled to replace with secondary market purchases or new issues. Assuming we properly do the Rational Actor’s Assessment (again, as part of the Five Pronged Methodology), we should be able to determine what company’s bank facilities have a majority of CDO holders. In those instances you can pretty well count on amendments passing that extend maturities. In those circumstances where near term maturities are extended beyond and once longer dated bond, there is upside in that bond.

I’d like to tell you that there’s a thematic trade that makes sense simply shorting “overvalued” securities in this, now overheated market. I don’t disagree with my friends and colleagues that say “the fundamentals don’t support these valuations” etc, but we live in the here and now, operating in real markets with money to be made or lost daily. How different is the refrain of investors that are short today on fundamentals from the deep value types that were long last year.

Fundamentals will matter and that work is necessary and valuable, however it isn’t what is driving these markets at the moment. Without an outward looking component to your methodology (“Process, Legal and Technical”), you can miss this. I’d hate to be the manager explaining to investors how we’re right and the markets are wrong.

I mentioned what I learned from Marty Whitman, but here’s what I learned from Izzy Englander: as mentioned, I was short regional and community banks in the top five foreclosure markets with 80% of loans in resi and commercial mortgages and raw land, when, in 2Q08, every bank CEO, as if handed a script from Hank Paulson, recited on Quarterly calls, “We will not cut the dividend today, we will not raise new money today”. I gave up half my gains on that theme in a matter of days. I spoke to Izzy about it, explaining why I was right and he reminded me that “you may be, but we are not in the being right business, we are in the money management business, and those are two different things.” You are a fiduciary and have a covenantal bond with the investor and their capital. DO NOT LOSE MONEY. The fund is not a weapon to prove right or wrong. Why not try to be right every day, rather than “eventually”?

Any advice for those looking to get into the distressed debt investing field?

Be a student of the business. What I mean by that is read everything. Not research per se, read books on the relevant topics. Read the sell-side strategist’s materials. Talk to people that have been around. I have worked with some of the best known, best regarded, often perceived to be difficult people in this business. Actively covet dialog with such people.

Don’t be in a rush to do things before you have any real experience. Do what it takes to get real experience. No one has time to train in the traditional sense, so when you get yourself in the right place, be sure you have the base minimum requisite skills to do your job.

Check your ego at the door and don’t get defensive about disagreement. In the right organizations, that dynamism is how the best decisions are arrived at. You are doing your part.

Don’t believe you have a monopoly on brain power or perspective. Be open to the unique and odd places you might learn things that make you better at what you do and that can help you make money or avoid losses.

On trade ideas, know what you know, know what you don’t know and consider that there are things that you don’t know that you don’t know.

At this juncture in life, what motivates you?

My wife, Kelly and little boy Max are everything.

But as to work: I am at heart, a competitive person. I like team sports, played a lot of football and basketball as a kid. This business gives us an opportunity to constantly take on competition whether its beating an index, convincing an investor to make an allocation, or having conviction about our trade theses to make returns uncorrelated to our peers. Internally focused, I am constantly evaluating how to make more civil, professional and productive work environment.

Now that I have my own thing in Tiburon, I can tinker and build on this as long as I am able. That’s exciting to me. I stepped away from the business in 1998 for a short hiatus and when I came back, very few people were there to help, with the expansion of the business, no one knew who I was. I started from scratch more or less. Faced with that, I conceived the strategy for how I could make it work and executed.

Thank you Peter for the great content! Stay tuned in the coming weeks as we have lined up a few more interviews with players in the distressed debt world.

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New Layout at How to Get a Hedge Fund Job

After much pestering from my wife and other people that claim I need to look "professional", I decided on working with some templates to see what readers think.

You can check the new look out How To Get a Hedge Fund Job .... all comments / flames welcome. You can email me (hunter [at] distressed-debt-investing.com) or leave a comment below. If no one has too much concern, I will use a similar, more beefed up look here.

Many posts scheduled for next week as I am on vacation the following week. Have a great weekend folks.

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