Advanced Distressed Debt Lesson #4

It has been a few months since we had our last advanced distressed debt lesson. More the previous editions, here you go: Advanced Distressed Debt Lesson #1, Advanced Distressed Debt Lesson #2, Advanced Distressed Debt Lesson #3 (needs a follow-up post).

A friend asked me my opinion of something Whitney Tilson said in his most recent email regarding GGP. Here is the relevant text.

"Hovde’s most serious mistake is misunderstanding (or misrepresenting) what will likely happen to GGP’s unsecured debt. Hovde assumes that it either remains outstanding (throughout its presentation, Hovde calculates GGP’s leverage and interest payments assuming that the debt remains outstanding, which is the main reason its analysis differs from Pershing’s and ours – see page 63, for example) or that it converts to equity, which will result in “significant dilution” (page 72). Hovde makes explicit this assumption when it claims that Pershing “does not use consistent assumptions” regarding what happens to the unsecured debt on page 35 of its report.

Hovde doesn’t appear to understand bankruptcy law and what will likely happen to the unsecured debt. There is almost no chance that it will remain outstanding: it will either be refinanced or, more likely, be converted into equity (this is what Pershing assumes – there is no inconsistency). But here’s the key: it will NOT BE DILUTIVE because it will convert AT FAIR VALUE, as determined by the bankruptcy judge. Of course, if the judge determines that fair value is $1/share, then it would be massively dilutive, but that’s not going to happen. The judge has a great deal of discretion in determining fair value, but will certainly take into consideration the current stock price, comps and the price of any equity offering(s) GGP might do.

For example, as soon as GGP exits bankruptcy and its stock is relisted (it currently trades on the pink sheets, which means most institutional investors can’t own it), it will be a must-own stock for every REIT fund (a big catalyst Hovde misses). To meet this demand and pay down some debt, GGP might issue equity – and the negotiated price at which this stock is sold would likely weigh heavily on the judge’s determination of fair value (and would not be dilutive). Of course, if someone like Simon were to buy GGP at, say, $20, the debt would convert at this price – and again, it wouldn’t be dilutive."

This in response to Hovde's response to Pershing Square's response to Hovde's short thesis on GGP. What a mouthful! And like a lot of financial bloggers out there, I love the back and forth. And why not jump into the fray and learn something here? For all those following along at home, I have embedded Hovde's presentation below.

There has been a number of press reports recently about Brookfield Properties buying GGP's unsecured debt. Here is a WSJ article that also mentions Simon Properties buying GGP's debt. Now, who knows what instrument either enterprise is buying. It could be the Rouse bonds or it could be GGP's unsecured term loan on the GGPLP LLC side.

We know from the original Rouse proxy (when GGP acquired Rouse in 2004), that there was indeed a bidding war for Rouse's assets. Read the background of the merger here: Rouse and GGP background of merger. So it is likely that yes, assuming that Company A or Company B in the merger agreement were Simon or Brookfield, people indeed have interest in Rouse. Why would Brookfield or Simon buy the unsecured debt of GGP or Rouse? Well, they could be making an investment thinking the bonds are undervalued and will be taken out at par+accrued.

Or they could be positioning themselves to have a nice big seat at the table.

Let's talk about incentives for just a little bit, because it is crucially important to any analysis of a possible distressed debt investment. Rational players want to maximize their return on capital given like amounts of risk. They would much rather have a 100% return than a 10% return on the same amount of capital. Who wouldn't? An example that has been discussed on this blog in the past is Six Flags. The HoldCo note holders want to maximize their return, and not get rail-roaded by the Op-Co note holders plan, so they propose their own plan, backstopping an equity rights offering taking out the opco note holders, reinstating the bank debt, and getting the vast majority of the equity. Likewise, the op-co holders want the equity (they believe they are creating it cheap), have offered a plan to take out the bank debt, de-lever the company with a rights-offering, get the majority of the equity and give a sliver of the equity to the holdco.

Similar to what is going on in the Trump bankruptcy between Carl Icahn/Beal Bank and the Ad-hoc Committee / Donald Trump. Both parties want the equity. Owning the equity of levered company in an economic recovery can be lucrative (see: DTG stock). Both have submitted plans, objected to one another plans, maybe a compromise is made, votes are cast, votes are tabulated, judge approves, plan confirmed, and off we go.

Trouble is, valuation is always subject to disagreement. As noted in a previous post on this blog (Now you too can value GGP's equity), small changes in cap rates have enormous effects on the valuation of GGP's common stock. I can argue just as well that cap rates should be 6%, as I can that they should be 9%. In the very fun case back in 2007, Nellson Nutraceutical, had 4 different valuation experts representing the company, and three different creditors group (each with their own). These valuation experts did what we all do: They applied assumptions to discounted cash flow analysis along with using multiples applied to different metrics and came up with a value for Nellson. The debtor's valuation of its own business was ~$75M higher than the other valuation business - why? It is my belief, that the equity sponsor wanted to be in the money. Higher valuation accretes value to lower claimants...i.e. stockholders.

Valuation is rarely litigated in the court. More often, different creditor or equity constituents will offer submit a plan of re-org and disclosure statement that has an implicit valuation based on testimony/work of a valuation expert. For example, from an earlier disclosure statement from the Trump bankruptcy:

"Solely for purposes of providing a distribution for Allowed Second Lien Note Secured Claims and Allowed General Unsecured Claims as set forth in the Plan, and in order to avoid a lengthy and expensive litigation process in these cases, the Plan Proponents refer to the valuation analysis prepared by the Ad Hoc Committee in connection with the AHC Plan (the “AHC Valuation Analysis”), which estimates the range of reorganization value of the Debtors to be approximately $464 million to $534 million (with a midpoint value of $499 million) as of September 17, 2009"

What is interesting: in the Trump case, Icahn and Beal Bank use the valuation proposed by the Ad-Hoc equity committee. The difference lies in who gets what via the plan. And how well they argue their case. For example, Icahn/Beal may say that the plan proposed by the Ad-Hoc committee may put too much debt on the company or maybe the fees proposed are too high etc etc. In one hand, the subscription/rights offering winds up in Icahn/Beal's hands, in the other, in the hands of the Ad-Hoc committee...the winner gets control of the company.

So what does this all mean for GGP? Unsecured debt sometimes is not converted at fair value. If it were converted at fair value, why would distressed debt investing even exist? Why would I buy a distressed piece of paper that I think is fully valued? And using prevailing security prices to determine where a judge may/may not confirm a plan is foolish. See: Delphi's bonds and equity circa Jan 1, 2007. Security prices do changes when different plans are filed. See: Visteon in the last few weeks...Term Loan skyrockets, bonds get hammered. Why? Because current plan proposes the vast majority of the equity goes to the Term Loan lender. No doubt this will be fought.

So why would Simon or Brookfield be buying unsecured debt? Like I said, to get a seat at the table. Let's take a hypothetical example here. Shall we? And as noted in previous posts, I have no position one way or the other, and am just laying out an instructive scenario that may or may not occur in the future.

Let's say the rumors are true. Brookfield and Simon have bought $1 billion of GGP unsecured debt. And let's say specifically they bought $1 billion of the Rouse bonds. They do not want to overburden their investment grade ratings, so they want Rouse to emerge with less debt. So they offer to backstop a $1.5 billion dollar rights offering, and cancel their bonds for, lets say 75%, of the equity at Rouse. Remember, you cannot look at GGP as one consolidated entity ... you have to bifurcate between Rouse and GGPLP LLC.

What did they do here? They spent (call it) 80 cents on the dollar for the Rouse bonds (so $800m spent) and put up an additional $1.5B to retire the remaining Rouse bonds they do not own. They spent $2.3B of value to acquire 75% of Rouse's equity.

How much did GGP's stock holder get from this transaction - They are left with 25% of Rouse. And that affects valuation greatly.

Could this happen? Maybe. Simon and Brookfield want to buy this asset on the cheap, NOT at fair value. Once exclusivity is done, they could propose their own plan (i.e. backstopping a rights offering to buy Rouse), arguing that the Debtor (Rouse in this case) would be woefully over-levered upon emergence. If the equity holders do not like it, then they should do an equity offering to take them out...$2.7B of claims ($2.44B of face at 110%...par+accrued)...versus a current market cap of $3.6B. You do the math.

In the bull case of course, which is also just as likely, every piece of debt gets reinstated (or unsecured bonds across the cap structure get refinanced by committed bond financing, and the judge does not think the company overly levered), operating results shoot to the moon, equity holders see their stock go to $40 and some acquirer top-ticks it. Pershing looks like a miracle worker and Hovde ends up flat out wrong. Look to Pilgrim's Pride as an example of an acquisition a Chapter 11 company where equity holders kept their interest, but got diluted (current ownership now 36%), where the stock could be really cheap (trading at 4.0x EV) and could surely take off...it definitely can happen.

Remember distressed debt valuation is only one piece of the puzzle - figuring out which plan will get confirmed and what / how much of the pie they are getting is really where the money is made in this business.

General Growth Properties - 2 - Hovde

Help Wanted: Merger Arbitrage Blogger

One of my goals for 2010 is to launch a few more sites to cater to a wider audience (for this post specifically, a risk arbitrage blog). Distressed Debt Investing had its 250,000th page view today (as well as its 150,000th unique visitor) and is about to tick over the 2000 RSS subscriber mark. I am incredibly humbled and thank all my readers for their continued support.

With that out of the way, I know there are many people out there that enjoy writing and teaching, like I do, and would like to contribute in some sort of fashion. One of the sites I am currently contemplating is a merger arbitrage blog. This site's main reason for existing will be teaching/instructing the intricacies of merger arbitrage/risk arb whether that be reading merger documents, calculating spreads, estimating probabilities, etc. In addition, this site will have a weekly update on current M&A deals in the market. Other bells/whistles will be announced when the site goes live.

What I need is an analyst, that likes to write (and writes well) and teach, that would be willing to post 2-3 times a week. I can offer lots of exposure. Terms of compensation will be discussed offline. If you would like to help out, or know someone that would like to help out with our new merger arbitrage blog, please contact me at hunter [at] distressed-debt-investing [dot] com

GGP - A Distressed Investment Opportunity

Last week, I wrote a post on valuing the distressed investing situation that is GGP. A quick point to clarify: The numbers in the spreadsheet I created was simply an example. When the likes of Todd Sullivan and Whitney Tilson claim I value GGP's equity at $5, this is my response (cut/pasted from a comment I left on ValuePlays.net)

Todd - As always, great analysis. A few points I would like to clarify: 1) My post was not to peg GGP's equity value. I have no idea what the value of GGP's equity is worth, hence the reason I can be neither short nor long the name. The only security I have had conviction on in this case was the Rouse bonds when they were trading in the 30s-40s as they offered substantial margin of safety (alas, I sold them way too early). The $5 you reference was essentially the midpoint of the numbers I threw in the mini-valuation grids. If I were less lazy I would of made the grids 10x10 for even more fun

Now that that is out of the way, I thought I would also post Pershing Square's response to Hovde Capital's short thesis. As always, this is an interesting situation. The easy money has been made in my opinion.

Pershing Square's Latest Presentation on General Growth Properties

Now you too can value GGP's Equity

Everyone likes talking about GGP's equity these days. So I thought I would take my massive model that I have been working with for over a year now, and condense it to the bare essentials to value GGP's equity. Now you too can value GGP's equity.

Please follow this link to a quick model I brewed up: Value GGP's equity. The best thing to do, as I locked it so crazies can't play with this masterpiece, is download as an Excel and play around with the highlighted values.

Here are the listings of highlighted values, and the rationale behind them.

1. The first highlighted value is the "Mall Value" of Rouse. You can see slightly above the input box a quick and dirty valuation matrix based on various cap rates and NOI.
2. Further down the page, you will see the next assumption, which is the implied value of all non Rouse malls and properties. I.E. Malls at GGPLP, LLC etc. Again, you can see a quick and dirty valuation matrix to choose whichever value you like. You may notice that I am using slightly higher cap rates for the non-Rouse malls. It has been discussed by consultants and real estate professionals alike that the Rouse portfolio contains better malls on the whole than the GGP side of the fence.
3. Next is cash. Now technically, you would not net out admin fees here because they would be spread around various entities, but I was not trying to be perfect here. You can look at GGP's most recent Monthly Operating Results (linked here), to see how much cash is on the balance sheet (remember not to double count Rouse's cash) and how much fees have been accrued.
4. Finally is payables. This would also include any tax claims at the company. Again it is quite hard to pin down this number, so I will let you cook your own dinner on this one.

Note: The NOI numbers I am using are the CONSOLIDATED NOI. I.E. Ex unconsolidated entities.

Now, theoretically speaking, there are hundreds of other assumptions in this case. A big one I hear about touted is the value of the master plan communities. If you want to know how that business is doing, please check out GGP's 3rd quarter 2009 supplemental. I do not think it worth much at all.

Again, another assumption you have to make is how much leverage the judge will let the entity emerge with. Under this spreadsheet, all debt and preferred equity is reinstated at current terms. I doubt this happens. More likely, GGP will sell equity, or a creditor class will do a rights offering to raise cash and pay off some of the Rouse bonds or the 2006 credit facility. This obviously changes the dynamic of the spreadsheet (more shares outstanding for example). A big possible twist for equity holders would be if a strategic buyer backstopped an equity rights offering - maybe by being in the converts or another creditor class.

And finally, you may simply hate all the numbers I hard coded in there for value of ancillary assets. Well you know what? It doesn't really matter. According to my simple calculations, and you can play with this yourself, a 50 bps change in Rouse cap rates, moves the stock ~$2.00.

Again, this is a simple model. I know. But it gets to the point that whether you believe Hovde's analysis or Pershing/Tilson/Sullivan's analysis, the needle swings wildly on this one. Have fun valuing GGP's equity. And let me know any thoughts/suggested changes in the comments.

Short Case for GGP

In one corner, Bill Ackman and Pershing Square's Long Thesis on GGP. In the other corner, Hovde Capital's Short Case for GGP.

A very well laid out presentation. For full disclosure, I am completely flat in the name.

General Growth Properties - Short Case

Third Avenue Focused Credit Fund

If you have been reading this blog for any sort of time, you would know I am a big fan of Marty Whitman and the Third Avenue family of fund (especially the new Third Avenue Focused Credit Fund). Marty has penned a number of fantastic books on value investing and distressed debt investing:

Distress Investing: Principles and Techniques

Value Investing: A Balanced Approach

The Aggressive Conservative Investor

I have read all three of these books and I can personally recommend each of them. I actually will eventually do a whole series on Distress Investing - as I think a lot can be learned from the book and from Marty's wisdom.

This morning, a colleague of mine sent me the Third Avenue Four Quarter 2009 Portfolio Manager Commentary. It is a quarterly ritual of mine to read the various fund manager's commentary on the market and new positions entered / exited throughout the quarter.

As many are aware, Third Avenue launched the Third Avenue Focused Credit Fund earlier this year. I think this is a fantastic vehicle for individual investors investing in the credit space. Their commentary this quarter is also full of gems. Here are some quotes / paragraphs I particularly enjoyed:

INVESTMENT OBJECTIVE AND FUND STRATEGY

The genesis for the Fund was driven by a market opportunity in credit that Third Avenue had not seen since the early 1990s. As our colleagues have written about in the other Third Avenue Funds Shareholder Letters, debt became a bigger focus in 2008 and early 2009. Indeed, due to our history and credit heritage, Third Avenue has always had a proclivity to invest in credit and special situations. However, what was occurring in the credit markets were, as Marty Whitman so aptly put it, “investments of a lifetime.” Similarly, it was clear that you, our shareholders, were making inquiries about a credit only product. We believed that a differentiated credit fund with daily liquidity where the Fund Manager would pick the best investments across the bank loan, high-yield bond and busted convertible bond universe was the best structure. Clients also wanted some exposure to distressed investments, given the higher default rates and Third Avenue’s twenty-three year track record of distressed investing.

We designed the Fund to be differentiated from other credit and high-yield mutual funds in the following ways:

1) The Fund utilizes a value-oriented investment process that relies on extremely thorough and intensive fundamental research;

2) We focus our capital on our highest conviction ideas based upon our fundamental credit research – the Fund will normally have 50-70 investments;

3) The Fund has an opportunistic mandate that can invest in any part of the credit spectrum;

a. Bank loans, high-yield bonds, busted converts or distressed securities;

b. Invest in the security with the best upside potential versus downside risk;

4) The investment team must identify an event or catalyst to drive value and the security price higher.

I honestly could not of put it better myself. Point 4 is so important to my investment process that it bears repeating - I always look for a catalyst when I go out and seek compelling ideas - I do not want to be in a situation where a security may be undervalued by 20-30% but it takes 4 or 5 years to get there.

The letter then goes on to detail a number of situations, according to how they categorize the security, in which I have historically or currently been involved in (I will not differentiate between the two to keep you guessing): These include: HCA, Swift, Aleris, CIT, and Marsisco. Every reader should read this section as it details the rationale behind investing in performing bonds and loans, stressed credit, capital infusions, distressed credit, and debt for equity reorganizations. Again the letter can be found here: Third Avenue Shareholder Letter

In relation to CIT, I will write up a very long and detailed post about it before the holidays. We have looked up and down the capital structure for a number of months and think some of the securities could be appealing.

And finally, on the outlook for the future for distressed debt opportunities:

Notwithstanding that the high-yield market returned 49% and the lowest-rated CCC debt issuances returned more than 90% in 2009, we believe there are significant investment opportunities for the Fund on the horizon. In particular, we believe we are still in the early-to-middle innings for distressed investment opportunities.

The strong high-yield markets have certainly enabled some larger companies to temporarily delay the inevitable default, while giving others a chance to grow into their capital structure. During the first nine months of 2009, $121 billion of high-yield debt has been issued. This has predominately been used to repay existing shorter-dated bank and bond debt. As a result, the near-term maturities of some companies have been pushed out. Nonetheless, we note that the net debt position has not improved and, in fact, free cash flow has deteriorated due to the relatively higher interest rates associated with the new issuances. For some companies, this will provide enough time for their businesses to grow into their overleveraged capital structures. However, for others it will simply delay the liquidity event and need to restructure.

I couldn't agree more. Please visit Third Avenue's Website and spend some time reading past commentary as well as the great things going on with Marty Whitman and his team. You will not be disappointed.

Finding Opportunities in Distressed Bank Debt

A few times each week, the various dealers, like Goldman Sachs or CSFB, will send out a list of all their bank debt names (including distressed bank debt paper). These names range from the very on the run - to the very off the run situation - in some case situations I have never even come across or seen.

Unfortunately, for most retail investors, it is difficult to gain exposure to bank debt unless you invest via a number of open end or closed end mutual funds. Complicating this, many times on a private deal, potential investors will be asked to sign a confidentiality agreement as to keep the debtors financial situation away from the prying eyes of competitors, suppliers and the likes.

But what if these structural issues create opportunities for investors? We all know the hordes of value investors out there that try to find companies uncovered and deserted by Wall Street to find diamonds in the rough...i.e. The number of analysts covering a particular stock is inversely proportion to the amount of mis-pricing in the security. 22 analysts covering Microsoft may mean very little inefficiency in the the stock price...But what about Bexil Corp (Symbol: BXLC)? No analysts covering the company, a market cap of $20M vs $37M of cash on the balance sheet...

The point I am trying to make - a lot of times in distressed debt land many people are looking at the same situation. Do you know how many calls / emails I got from other people on the buy side about Nakheel the last few weeks? Probably 30. (Note: Someone has written up Nakheel on the Distressed Debt Investors Club). Why not go looking for those uncovered gems?

There are few arguments against hunting for diamonds in the rough in the corporate debt world:

1. Many of the uncovered situations are so illiquid that only a fund with locked up capital / side cars would ever dream of taking a meaningful position because the mark-market is brutal.
2. In tandem with #1, if you want to be an activist in distressed debt land, you need to be able to source the paper - lots of paper is locked up in structure (CLOs, insurance companies) that do not mark to market and would rather not sell you the paper as to not take the mark.

For me, these two reasons are all the more reason to get excited about these sorts of situations. I forgot a third reason: You will not be the belle of the ball at every distressed debt holiday party / cocktail hour unless you are talking about First Data (FDC) or Harrah's (HET)...

What about Advancstar? Or Graceway's 1st or 2nd lien? Or Suburban Propane's Revolver? Who is pitching those at Houlihan's Distressed Holiday Party?

I could go on like this forever. I think the position a potential distressed debt investor has to take is why are these securities mispriced? Why was Spansion's Senior Secured Floating Rate note trading less than 10 a year ago and now is over par? (I will write a post on that a little later). Where are the mis-pricings? What does the market have WRONG...That is where you should spend your time, and then go out and exploit it.

Bill Ackman on Mall REITS

Fantastic Presentation. Enjoy!
ICSC Mall REIT Presentation 12-7-2009

Wisdom from Seth Klarman - Part 7

Last time, in our Wisdom from Seth Klarman series, we grabbed quotes and commentary from Baupost's 2007 Annual Letter. In this edition, we continue with the 2nd half of the 2007 letter. As usual expect some gems from Klarman - who I consider the best hedge fund manager out there.

While investors will obviously achieve the best result by remaining rational thinkers at all times, this is easier said than done. In the financial markets, emotion often takes over, and greed and fear come to dominate investor behavior. Even those who are aware of this, who expect always to invest rationally and to be able to resist their own greedy temptations and panicky reactions, cannot always carry through on their plans.

A top-down or momentum investor - especially if leveraged - is at a loss when confronting the unexpected. Should they hang on and risk ruin, or capitulate and lock in painful losses? Even those with the benefit of a value investing roadmap - which ensures a fundamental, long-term oriented approach to investing, a disciplined pursuit of bargains, and an imperative to view the market as an irrational creator of opportunity - may blink when faced with the unexpected. When you buy bargains, and they become far better bargains, it is easy to question yourself, which can impair your judgement. Real or imagined concerns - about client redemptions, employee defections, and even a firm's viability - can greatly influence behavior away from the rational.

One of the concepts that so impresses me with Klarman's investment approach is his position that some buyers and sellers are irrational and it his his job, at Baupost, to capitalize on those investment opportunities. I remember him buying a number of MLPs which were believed to be widely held by Lehman Brothers - as Lehman's prop book unwound, this created uneconomic pressure on the stock - i.e. the connection between price and value disintegrated for no reason other than Lehman had to dump the stock on the market. I know he has also talked about in speeches at Columbia that Baupost has an analyst who's sole job is to follow index additions and deletions...That blew my mind.

Every day, every investor squints into the murkiness of present-day ambiguity and an unknowable future and has to make decisions. Even when these decisions are made for the right reason-not based on greed, not under undue pressure, not from intellectually dishonest motives, but because the investments appear sound and secure - much can still go wrong. Despite a strong first 25 years, our performance in the years ahead is unknowable; however, with aligned interests, a long-term approach, sound judgement, a keen sense of risk aversion, a nose for value, valuable experience on the front lines, an unwavering alertness, a successful result seems reasonably likely.

This is such a wonderful quote statement because it lays out what Klarman believes are the requirements for success for a hedge fund. IMO Aligned interests is so important: I.E. You eat your own cooking. I believe Baupost's employees are the largest holders of the fund.

He continues:

We tried to remember that investing is a marathon and not a spring, and we conditioned ourselves to go the distance.

We have consistently prepared for the worst, incurring significant hedging costs on an ongoing basis. Sometimes these were designed to protect single investments, and other times they provided downside protection for the broader portfolio. While many of our holdings did not truly require hedges in order to be attractive, and while many of our hedges ultimately proved unnecessary because the anticipated risks failed to materialize, our hedges were quite valuable as enablers, in that they gave us the comfort and the confidence to, at times, incur fairly concentration positions that have produced such excellent long-term, risk adjusted returns for Baupost.

That first quote, about investing being a marathon, is something I pound on repeatedly on this blog. It is so important, especially when allocating outside capital, to remember that the rug could be pulled out from under your whenever those quarterly redemptions hit. A string of big numbers multiplied by zero is equal to zero. Do not lose money. That is the first rule.

And on hedging: That is one of the reasons I believe looking at Baupost's 13F is somewhat a futile effort. Their equity portfolio is so small relative to their assets under management that it would be impossible to mirror the performance. Further, you have no idea what hedges have been put in place, or whether being long News Corp was just a dual-class arbitrage play.

I am going to make it a mission of mine to better understand how they hedge individual investments. Would they for instance go long a distressed bond and long a put on the equity? Or long an equity and long credit protection? I'll report back when I have more information in the future.

Our strict value discipline has been a critical component of our success.. When you have carefully analyzed what you own, and buy at a sufficient discount to underlying value to ensure a significant margin of safety, you are likely to do well. Our willingness to hold cash during fallow periods has enabled us to maintain a strict sell discipline regardless of whether we had anything promising to replace what we sold. This view on cash, combined with a truly long-term investment perspective, has also enabled us to avoid the gun-to the-head mentality that pressures many investors to own less than stellar investments.

Cash is king? One complaint I hear from a number of my peers is that fact that their portfolio managers abhor holding cash - especially now the expectations for inflation are sky high. And I understand the reasoning that if you are not fully invested, and the market rips, you will get redemptions. I believe if you can manage your investors expectations better (i.e. like 1950s Warren Buffet), you would be able to use cash as a valuable asset versus a potential liability.

And my favorite quote thus far in all of the series:

We have a culture of intellectual honesty and curiosity, always looking for more information to confirm a thesis or disprove it; never settling for good-enough investments, but always striving to find the best ones; not satisfied with the knowledge that our investments are bargain-priced but always searching to discover why they are undervalued so as to remove as much risk as possible from the investment equation. We strive to eliminate biases in our decision-making that could cause us to reject new information or cling to erroneous beliefs. We pride ourselves on making tough and sometimes painful decisions to exit from investments where prospects have soured. This curiosity extends fully to the operations side of Baupost, where we always want to find smarter and more effective procedures and processes, to identify new ways to serve our clients better, and to know not only that something is the case but why it is so.

Stay tuned for future editions of our Seth Klarman series - we will analyze a few videos and audios of Klarman speeches. After that we will look at the 2008 Baupost letter (but only after the 2009 Baupost letter is published).

Distressed Debt Investors Club Update

First off, I wanted to thank all the members and applicants of the Distressed Debt Investors Club. The site is currently populated with nearly 50 ideas (corresponding to 50 members) ranging from spin off analysis, merger arbitrage, distressed municipal bonds, and many straight bond and bank debt ideas. If you are like me, finding yourself scratching your head, looking for relevant, alpha-generating ideas in this market where good ideas are hard to come by, the Distressed Debt Investors Club provides you with a community of professional investors pitching and discussing long and short ideas, up and down the capital structure, on a daily basis.

The goal of the site is simple: To create the very best community of distressed debt and credit investing professionals out there. The site is structured so that new members are given access to all ideas presented in the database meaning from Day 1 you are exposed to a litany of due diligence performed by vetted professionals that will give you a head start when looking and researching new ideas.

I know it's a different idea than anything out there right now because this site is focused on credit and distressed debt investing. Other "investment club" websites may have one or two ideas in the span of a few months related to a high yield or distressed debt situation. Over 75% of our ideas are credit / distressed related with the balance being event-driven equities and equity shorts. I guarantee that you will find no other place where buy-siders and sell-siders alike are exchanging ideas of this quality in the credit space.

If you would like to apply, please click the logo below. For tips on applying, please visit the FAQ as well as our post on tips when applying to the DDIC. Hope to see you on the site.

Pershing Square Investor Letter

Lots of discussion on GGP's bankruptcy (a favorite of distressed debt investors) in the letter.

Enjoy:

Pershing Square Third Quarter Investor Letter

Wisdom from Seth Klarman - Part 6

This is the 6th installment of our "Wisdom from Seth Klarman" Series:

Wisdom from Seth Klarman - Part 1

Wisdom from Seth Klarman - Part 2

Wisdom from Seth Klarman - Part 3

Wisdom from Seth Klarman - Part 4

Wisdom from Seth Klarman - Part 5

In this edition, we will be discussing the 2007 Baupost Annual Letter. 2007 was a monster year for Baupost: Up ~52% for all their respective funds. Given how large their asset base was in the beginning of the year, as well as the amount of cash that was held on the sidelines, this is an incredibly impressive result. Baupost breaks out their return by asset class each year: In this year, like many other funds, benefited largely from gains from credit protection - i.e. shorting sub prime MBS.

Before getting the fund commentary, Klarman discusses Baupost's use of cash in the portfolio.

"Turbulent and declining markets have increased our opportunity set, and we have put considerable cash to work in recent months. We remind you that our cash balances are determined not from any top-down asset allocation decision, but as a residual of our bottom-up search for investment opportunity. Our willingness to hold cash in the absence of compelling opportunity seems once again vindicated in light of the negligible impact that the difficult markets of the past six months have had on our portfolios."

Running with cash is not a bad thing. Think about all the companies that bought back massive amounts of their stock in 2006 and 2007 at prices well above today's levels. A lot of companies may not have seen their credit ratings dropped if they were better stewards of shareholder (and creditors) capital.

An interesting point to note in their holdings is that Special purpose acquisition companies (SPACs) represented a nice chunk of the portfolio. If you look at Baupost's current 13F you will still see many of these SPACs. There are so many strategies that funds have employed with SPACs (long warrant, short common; long common, block vote, get paid back at a boosted treasury yield, etc) that it is hard to speculate what they were actually doing here.

On the rating agencies and CDOs:

"Credit rating agencies were central to the disaster that played out. These formerly trusted assessors of credit quality had completely let down their guard over the last several years, blessing as investment grade a shocking large volume of securities backed by loans that should never have been made. One of their biggest mistakes was not understanding their central place in the virtuous circle that enabled, and even encouraged, the uncreditworthy to falsify loan applications to become homeowners. When these mortgages were pooled, sliced and diced, and securitized, they allowed dross to briefly become investment grade gold. CDOs holding junior tranches of subprime mortgage securities were able to carve up BBB- subprime mortgage tranches into large slugs of AAA rated paper, a modern-day financial alchemy based on backward-looking computer models and credulous buyers. Yield gluttons foolishly trusted these ratings enough to risk complete loss of principal for a handful of basis points of promised incremental return."

Ouch. As Klarman has said in previous letters, investors need to focus on risk (i.e. the amount of probability of permanent loss of capital) instead of return.

If you remember 2007 (what a year), around late summer there was news everyday about another quant fund blowing up. Klarman, on these events:

"Many quants said what was happening was virtually impossible, ignoring their own prominent role in making it so. Goldman's CFO, David Viniar, noted at the time in a conference call, "We are seeing thats that were 25-standard deviation events, several days in a row." For many companies in August 2007, the volatility of their stock price suddenly had nothing whatsoever to do with the company itself, but simply its shareholder list. Clearly, value investors such as ourselves, who view the manic nature of the financial markets as a source of opportunity rather than an accurate metric of risk, stand to benefit from such foolishness. As Ben Graham suggested three quarters of a century ago, those who view the market as a weighing machine - an accurate assessor of value - are destined to lose money. They who see it as a voting machine - a collection of ephemeral opinions - can derive from the volatility profitably opportunities to buy and to sell."

I see so often the weighing machine quote of Ben Graham tossed around. Klarman brings to light how value investors should view the market - not as a guide, but as something that presents your current opportunity set.

On investing throughout the cycle:

"One of the ongoing complexities of security analysis is that you can never satisfactorily determine where you are in a cycle. How long might a bull or bear market last? Had you avoided the upward frenzy of 1929 and miss the great crash only to jump into the market in early 1930, the pain you would have felt by 1933 would hardly have been different from the agony of those who invested at the 1929 peak. We will not be certain until much later whether the so-called bargains of January, 2008 were truly undervalued or merely dangerous temptations to value-starved investors."

In a word, and with the benefit of hindsight (see: Freddie, Fannie, Lehman): dangerous. I have actually heard Klarman use this 1930 analogy before - i.e. one of the most difficult things to do as an investor is figure out where you are at in the cycle...are things going down another 40%? Or are we at the 666 S&P bottom? He continues:

"Some stocks and corporate bonds fell to levels that looked tempting, but in most cases the declines merely matched deteriorating fundamentals - especially in the financial, housing, and retail sectors - and were no real bargain. One of the greatest risks we-and all investors-face is the danger of catching falling knives: expensive securities that decline without reaching bargain levels. Often, the near absence of bargains works as a reverse market indicator for us; when we find little that is worth buying, there may be much that is worth selling. Indeed, we maintained a strong sell discipline throughout the year to good effect."

It has been reported that Klarman does not short securities because the risk is unlimited (see: VOW / PAH3 stub trade for a killer short squeeze). That being said, in a credit default swap, versus a short sale, risk is contained to the loss of premium on the contract. Yes, if you shorted the ABX 2006 BBB- at 80 point up-front, you exposed yourself to heavy losses (but in the end would have still made money). But Baupost looks like they were putting these trades on at ridiculously tight levels...I'd venture a guess (depending on vintage, single vs index) of 150-300 bps running. So the most they could lose in any one year was the notional value of their contract times 1.5%-3.0%. If you wanted to limit your total portfolio loss to 1.00% and had to pay 300bps on the contract, you could of effectively bet 33% of your total portfolio in notional value in these contracts...and the most you could lose (outside of mark-market tightening) was 1% in return....Talk about upside, downside.

On his performance in 2007, and a caution to investors (similar to something WEB has said in the past):

"As we enter 2008, we face the normal challenges of the investment business, as well as a few related to our success in 2007. Our 2007 profitability has resulted in an unprecedented one-year increase in our capital base. It could take some time to carefully build our team to a size that will allow us to consistently deploy it, and we cannot afford to become impatient in our approach. Despite a fabulous 2007, we know that we must remain humble, learning lessons both from our winners and our mistakes. We need to remember that we are usually a team of single hitters with a high-on base percentage, and remain resolute in following the low-risk strategy that has enabled us to grind out good results for over a quarter of a century.

The next 25 years won't look like the last 25. If they did, our $11 plus billion under management today would approach or exceed $1 trillion by the end. Expectations will have to be lowered, ours as well as yours."

In the next few days, I will follow up with more Wisdom from Seth Klarman, continuing with Baupost's 2007 letter where Klarman discusses the pitfalls of leveraged investors, disaster hedging, and Baupost's culture among other things.

Third Point's Investor Letter - Hint: They like distressed debt

Third Point Investor Letter Q3 09

Maybe I should call the blog "High Yield Investing"

Earlier today, Peter Acciavatti, J.P. Morgan's head of High Yield Strategy gave a presentation at JPM's 2010 US Fixed Income Outlook Conference. Some key take-aways from the call:

• High yield and leveraged loans remain attractive with solid expected returns. He pointed to a slide a ~12% expected return for high yield and a ~13.5% expected return on leveraged loans.
• These returns are driven by spread tightening, modestly offset on the high yield side of the world by the treasury curve widening (bank debt is floating and hence would not be negatively affected by rising rates)
• In the high yield market, demand has modestly outpaced supply. In loans, demand is dramatically higher than supply due to limited levered loan issuance this year.

The saddest slide for me, and I am sure my readers, was one pointing out how small the distressed universe is right now.

In November of 2008, there was over $230B of corporate debt trading below 50% of par. Today there is less than $10B. As a percent of the market, 31.4% was distressed in November and now only approximately 1%. Hence the reason for the title of the post: There is no more distressed - just a lot of high yield.

What compounds this situation, which Peter correctly alluded to in his presentation, is distressed funds have had a huge year. A huge year is generally followed by capital raising - more capital to the distressed space means asset prices being bid up and IRR's decreasing.

Of course, as mentioned in previous months, I believe this is a long drawn out cycle and distressed debt will return in force when the wall of maturities in 2012, 2013, and 2014 begin to tumble onto a weaker market where structured credit buyers are no longer forceful participants. But it could happen sooner if economic growth continues to be lukewarm at best. To position myself I am buying event-driven names with a definite catalyst: Six Flags' bank debt for instance, which was weaker earlier in the week on a new plan by the HoldCo note holders (full write-up at the DDIC).

John Hussman puts it best:

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Maybe I would not use the term "terrific second act." Though if it happens soon, it will surely be bad for all those buying CCC+ bonds at a 11% yield.

More high yield versus distressed debt posts in the future? Given the animal spirits in the market these days, I'd would venture a disappointing yes.