Some Great Slides from the LSTA on the Leveraged Loan Market and CLOs

The LSTA is becoming one of my favorite sites on the web for the amount of information they provide to the public. For example, see below for some fantastic slides they put out from their recent conference and my commentary (Note - I have picked and chosen from a number of different presentation ... net/net all presentations are worth the read). Before I do that, I want to just post something I read from Hussman Funds "Weekly Market Commentary" as a backdrop:

"In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.

Moreover, from a valuation standpoint, a further market trough would not even be "out of sample" in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms."

Those of the weak stomach should probably close their browser at this point...

Over the last 12 months, we have seen a dramatic issuance of senior secured and senior unsecured bonds in the high yield market. As can be seen on the chart below to the right, this has come at the expense of a drop in leveraged loans outstanding. Technically speaking, combined with the steady inflows of retail capital to the loan markets, the market has been quite strong: As most CLO's are in their reinvestment period, a reduction in aggregate supply of leveraged loans mean investors need to reinvest proceeds into existing secondary bonds where supply has been reduced thereby lifting prices across the board.

With that said, corporate issuance (loans and bonds) has been nutty up until April 2010:

As can see in the chart above, around April / May 2009, investors started adding corporate risk to their portfolio, and companies obliged them with high coupon paper that now still trades above par. In March 2010, things got very crazy and since have cooled down. From a loan perspective demand was very strong throughout that entire period. In my opinion, the reason for this comes from the following chart:

As can be seen, total LBO leverage in the US (I can not really speak to Europe here) is lower than it has ever been in the measured periods. That combined with healthy coupons, legitimate covenant packages, and a dearth of secondary supply has led to 9/10 leverage loan deals being well well oversubscribed.

The combined effects of increased issuance of bonds relative to loans, and generally speaking, a very healthy credit market in general up to April, has resulted in the "maturity wall" being extended:

Essentially what this chart is telling me is that 2011 and 2012 maturities have been pushed to 2014 and 2015. That may give us a bit of breathing room if we do go into another recession. Here is the aggregate maturity data:

Unfortunately, my favorite chart:

CLOs have a finite reinvestment period meaning that CLO managers can reinvest coupon / principal payments back into the market for a certain amount of time. Most deals are structured with a 5 or 6 year reinvestment period. With all the CLO issuance of 2006 and 2007, those reinvestment periods are ending.

This gets even more scary when you consider the make-up of the leveraged loan market and how CLOs have dominated in the past:

So what does this all mean> There are only a few logical conclusions that follow. Here are the facts in my opinion, supported by the charts above:

1. There is a significant amount of loan paper that needs to be refinanced in 2014.
2. Unfortunately, CLO's are currently structured will not be there to refinance said paper in 2014 because of reinvestment lock-ups. CLO 2014 refinancing capability is essentially nil.

With that in mind, what has to happen? There are a few possibilities:

• Other investor types (hedge fund, retail, etc) grow dramatically to soak up CLO wind-downs
• Loan issuers use equity issuance to de-lever balance sheets
• CLOs return to their pre-Lehman glory
• The amount of bonds in a capital structure increases dramatically relative to loans
• Loan issues using the bankruptcy process to rid themselves of over levered balance sheets.

The only two realistic conclusions are the the last two above: Either there will be a significant amount of high yield unsecured and secured bonds issued or default rates will have to spike up.

In my opinion, it is hard to rationalize that bonds will soak up the needed supply. Given a stagnant economic growth rate and possibly another recession, I cannot justify investors adding exposure lower in the capital structure unless teased with a very high yields. If that were the case, and companies do "pay to play" as it were by offering very high coupon debt, default rates will naturally spike up as interest coverages will be extinguished by higher fixed costs. Taking it a step further, aggregate earning will be lower and hence forward valuations should be lower for the market (higher interest expense leads to lower earnings, higher interest expense leads to higher chance of default and a lower multiple).

So in the end, what do we have? More defaults. A lot more defaults. It won't happen in 2011 but will begin to tick up in 2012-2014. With that in mind, what kind of discount rate must one apply to recoveries for bonds maturing post this default cycle? Shouldn't the credit curve be massively steep for all but the safest issuer? I think so and I think that is what you will start seeing in the high yield market in the coming year. Short duration wins the day in my opinion.

How could I be wrong? Well, the three choices I believe are implausible at this point in time. Nonetheless, they are not a zero probability. Always invert. "How could default rates go lower in 2014?" - Economy roars back from a stagnant 2011/2012, investors are risk hungry again, and secured bonds wins the day - It is not a scenario I believe will pan out, but for full disclosure, I need to lay it out there. I'd be curious to our reader thoughts.

Quick Update: A reader writes in with a pretty decent argument....

One factor which is not exposed in “The Cliff Refined” chart is a CLO’s ability to push out loan maturities even after the reinvestment period has expired. Typically a CLO can hold loan maturities 6-7 years after the reinvestment period. While you can’t “repaper” the loan, you can push out the maturity through an amendment even after the CLO has gone “dark”. So what you will likely see is another round of amend/extends for the 2012/2013 maturities beginning shortly.

Couple that with your last chart and you have 75%+ of the loan market buyer incented to push out maturities. CLOs, to keep AUM high and push out equity option value; Banks/Insurance/FinCos, to avoid a default and capital write down; Prime Funds will be able to reinvest at a higher/market rate.

With all that said, this only applies to existing loans outstanding. Agree with you in that new loan creation will be hindered which should put a damper on the LBO market and M&A activity in general. And certainly interest burden is going up for everyone.

ACAS and the Distressed Debt Investors Club Update

I wanted to give all our readers a quick update on the Distressed Debt Investors Club. Each week we are getting more and more member and guest application and we could not be any happier with the growth and progress of the site. Throughout the second half of the year I plan on devoting a significant amount of resources to expand the functionality and membership of the site. Currently we have nearly 1500 guests and 140 members. As mentioned in previous posts, the membership for the site closes when we get to 250 members so I encourage those that are interested to apply - you get access to all the previous posted ideas and the Distressed Debt Investors Club forum, a place where I am posting 2 to 3 times a day.

With that, and I try to do this once every few months, I provide you with a recent idea submitted to the site: American Capital (ACAS) [Note - All attachments have not been included in the below write-up. You will just have to join the site to get the 17 page supporting attachment]

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Investment Thesis

ACAS is potentially undervalued relative to the fair value ("FV") of its investment portfolio and its earnings potential as measured by NOI. Meaningfully more leveraged than its peers, ACAS is currently going through a balance sheet restructuring. In the past management was able to leverage the business through issuance of on-balance sheet unsecured obligations-- a capital structure strategy that is unsustainable given the volatility of the underlying assets. The reorganization plan calls for the use of the company's large cash position to pay down debt and exchange unsecured debt for secured issues. More equity has been raised (including appx. 58mm shares 75% of which was sold to Paulson & Co. -- on appx. 280 mm existing) Additionally, in the future, management hopes to sustain leverage through securitization trusts, which has been a successful source of low-cost funds in the past.

There are several catalysts that may realize value in the short term/medium term:

(1) Finalization of the exchange offer/presentation by management with PF-capital structure and business projections.

(2) Continued realization of its current investment portfolio at or greater than FV.

(3) Eventual reinstatement of the dividend on a cash basis.

(4) Mark up of European subsidiary European Capital "ECAS."

Business Model

ACAS is a business development company "BDC," a form of publicly traded private equity vehicle in the United States. Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.

Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors.

Relative to other BDCs, ACAS's investment portfolio has a higher concentration of equities leading to a more volatile asset base. BDCs generally trade as a multiple of book relative to the FV/Cost of the investment portfolio.

Valuation

Valuation was looked at three different ways:

(1) Current NAV/Share

(a) 5% discount

(b) 15% discount

(c) 35% discount

This indicates potential upside of (-3.4% to +41.2%) or an expected value of (+21%)

(2) Multiple of FYE 2011 NOI:

(a) Base Case: Asset leverage of 45%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 5.5%

(b) Low Case: Asset leverage of 40%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 4.0%

(c) High Case: Asset leverage of 50%. Asset Interest Income Yield of 14%. Equity Dividend Yield of 6.5%

This indicates potential upside of (-32.2% to +90.4%) or an expected value of (+23.3%)

(3) Comparable Basis:

(a) Min, Max, & Median multiples of NAV/share

(a) Min, Max, & Median multiples of FYE 2011 NOI

This indicates potential upside of (-1.3% to +135.5%) or an expected value of (+45.0%)

Taking it all together:

Risks

(1) Even if the reorganization is successful, a worsening of the macroeconomy will negatively effect the fundamental performance of ACAS's investment portfolio companies. Coupled with a further contraction in middle-market transaction multiples, there may be an even more significant decline in the FV of the portfolio.

(2) It is unclear how an inflationary environment will affect the business:

(a) On the one hand, the interest income will rise as rates rise, but,

(b) Inflation may erode fundamental value at the portfolio level.

(3) Any liquidity crisis will make portfolio realizations and further balance sheet restructuring difficult to execute.

(4) It is unclear how dilutive future equity offerings may be (esp. at a discount to book) although it seems that management is very valuation sensitive to this risk.

Li Lu's Foreword to Poor Charlie's Almanac

This week, I found two fantastic links on Li Lu, someone I am now nearly convinced will be one of Berkshire Hathaway's future CIOs.

First, Li Lu wrote a foreword to Poor Charlie's Almanac overseas - the complete translation can be found here: http://blog.enochko.com/2010/06/my-teacher-charlie-munger-english.html. Here are a few choice quotes:

"With Charlie’s help, I completely reorganized the company I founded. The structure was changed into that of the early investment partnerships of Buffett and Munger (note: Buffett and Munger each had partnerships to manage their own investment portfolios) and all the shortcomings of the typical hedge funds were eliminated. Investors who stayed made long-term investment guarantees and we no longer accepted new investors.

Thus I entered another golden period in my investment career. I was no longer restricted by the various limitations of Wall Street. The numbers still fluctuate as before, but eventual result is substantial growth. From the fourth quarter of 2004 to the end of 2009, the new fund returned an annual compound growth rate of 36% after deducting operating costs. From the inception of the fund in January 1998, the fund returned an annual compound growth rate in excess of 29%. In 12 years, the capital grew more than 20 folds."

Good lord. I have seen only a few investors put up numbers like theses...one in particular comes to mind...

...achieved by Warren Buffett during the Buffet-Partnership years.

On Charlie Munger:

"When Charlie thinks about things, he starts by inverting. To understand how to be happy in life, Charlie will study how to make life miserable; to examine how business become big and strong, Charlie first studies how businesses decline and die; most people care more about how to succeed in the stock market, Charlie is most concerned about why most have failed in the stock market. His way of thinking comes from the saying in the farmer’s philosophy: I want to know is where I’m going to die, so I will never go there."

The first thing that quote brought to mind was Seth Klarman's investment style.

Never ever lose money - also worry about the downside and the upside will take care of itself.

The next link is from Tariq Ali's Street Capitalist, a blog I find myself reading more and more often. If you remember the last time we featured his blog was with a summary of a Li Lu lecture at Columbia. Tariq has done it again with a 2010 lecture given by Li Lu. Some more choice quotes:

From Bruce Greenwald:

Warren Buffett says that when he retires, there are three people he would like to manage his money. First is Seth Klarman of the Baupost Group, who you will hear from later in the course. Next is Greg Alexander. Third is Li Lu. He happens to manage all of Charlie Munger’s money. I have a small investment with him and in four years it is up 400%.

What a statement. And I have never heard WEB say anything about Seth Klarman - I wonder if they talk about investment ideas??

Finding an edge really only comes from a right frame of mind and years of continuous study. But when you find those insights along the road of study, you need to have the guts and courage to back up the truck and ignore the opinions of everyone else. To be a better investor, you have to stand on your own. You just can’t copy other people’s insights. Sooner or later, the position turns against you. If you don’t have any insights into the business, when it goes from $100 to $50 you aren’t going to know if it will back to $100 or $200.

So this is really difficult, but on the other hand, the rewards are huge. Warren says that if you only come up with 10 good investments in your 40 year career, you will be extraordinarily rich. That’s really what it is. This shows how different value investing is than any other subject.

I love it.

And finally, one how to evaluate businesses:

So how do you really understand and gain that great insight? Pick one business. Any business. And truly understand it. I tell my interns to work through this exercise – imagine a distant relative passes away and you find out that you have inherited 100% of a business they owned. What are you going to do about it? That is the mentality to take when looking at any business. I strongly encourage you to start and understand 1 business, inside out. That is better than any training possible. It does not have to be a great business, it could be any business. You need to be able to get a feel for how you would do as a 100% owner. If you can do that, you will have a tremendous leg up against the competition. Most people don’t take that first concept correctly and it is quite sad. People view it as a piece of paper and just trade because it is easy to trade. But if it was a business you inherited, you would not be trading. You would really seek out knowledge on how it should be run, how it works. If you start with that, you will eventually know how much that business is worth.

Distressed Debt Analysis: Reader's Digest

On February 22nd, Reader's Digest emerged from bankruptcy. For those that are interested, the bankruptcy docket for Reader's Digest can be found here: Reader's Digest bankruptcy docket

Before I get to any analysis, I thought it would be interesting to note to readers that even though Reader's Digest has emerged from bankruptcy, there are still a number of things going on in the bankruptcy court. Some of these filings deal with advisor fees, or tax issues and sometimes things out of left field. For instance, according to docket 764:

Shortly after the occurrence of the Plan Effective Date, Canyon contacted counsel for the Reorganized Debtors regarding its distribution of New Warrants pursuant to the Plan because the Canyon Funds had not received any such distribution. Canyon timely submitted its Class 3 ballots and voted to accept the Plan and has advised the Reorganized Debtors that its funds holding Senior Subordinated Note Claims in the aggregate face amount of approximately $51.3 million intended to submit Class 6 ballots in favor of the Plan, but neither the Reorganized Debtors nor Canyon have evidence of such ballots being submitted prior to the Voting Deadline.

Based on their Class 6 claim amounts, the Canyon Funds are entitled to receive 163,567 New Warrants. Issuing the additional warrants will result in a total of 1,863,394 New Warrants being issued under the Plan (reflecting rights to acquire 6.3% of the New Common Stock issued as of the Effective Date, subject to the terms and conditions of the New Warrant Agreement).

Generally speaking, a lot of these post-confirmation proceedings will not help in our analysis. Sometimes, where there is litigation, there could be updates posted in the bankruptcy court that will update the court on the state of the litigation - but you can follow the litigation generally on its own docket (remember a lot of junior creditors these days are receiving funds from litigation as part of their recovery, so it is important to follow said cases).

Back to RDA. Reader's Digest's equity is traded off quite a few of the distressed desks. For example, JP Morgan was making a market 20.00-20.50 around the close on Friday. In addition to RDA's equity, they have a $525M Senior Secured Note that trades right around par (L+650, 3% Floor). The bond was initially priced at 97, so has done decently well in the high yield market. As of 3/31/2010, the company has $189M of cash on hand, and an a nearly unused $50M revolver. All this results in gross leverage and net leverage of 3.1x and 2.0x respectively.

One thing I like when analyzing a new credit like this is a sufficient amount of disclosure. Their first quarter announcement is incredibly detailed which gives us a good amount of information on their various businesses. In addition, the conference call transcript was quite informative. This tells me management does not have much to hide at this point and is doing its best to communicate with investors. As well they should, as management has warrants to receive 7.5% of the stock.

Management commented on the conference call that given current EBITDA levels ($167M) its low level of capex and cash taxes as well as moderate interest expense, the company "yields high free cash flow." With that said, if EBITDA materially declines, or the company needs to invest substantial amounts of fixed capital to stem revenue declines, the value proposition here might be less attractive.

Reader's Digest operates out of 4 segments: Reader's Digest United States, Reader's Digest International, Lifestyle and Entertainment Direct, and Other. Of the four groups, only Lifestyle and Entertainment Direct showed signs of increasing revenue in 1Q 2010. According to the company's website: "Lifestyle & Entertainment Direct is a global direct marketing business that sells an array of products, including Time Life products under license, primarily through DRTV." Despite revenues being down in 3 out of 4 segments, EBITDA margins expanded in the quarter by approximately 200bps.

For those that do not know what DRTV is - it stands for direct response television - TV advertisers put up a website or a 1-800 number and consumers respond - Reader's Digest Fitness Product has shown significant strength in this market. On the conference call, Mary Berner, the company's CEO stated: "We have an exceptional marketing channel in DRTV, and we intend to more aggressively exploit this robust channel by selling more of our own brands

through it, as well as continuing to work with partner brands."

Currently, RDA's comps trade on the order of 5-6.5x. With that in mind, and using the LTM EBITDA of $167M we can back into what valuation the market is implying for RDA:

Now there are two things we have to do to complete this analysis: 1) How much EBITDA is going to decline? and 2) How much cash flow will be generated in the interim period?

I am going to be conservative and use 3 cases: An annual 15% drop in EBITDA, a 7.5% EBITDA decrease, and a flat EBITDA over the next two years.

So using 5.5x, in 2 years, RDA is worth between 16 and 28 dollars a share. If you are confident that either EBITDA will be flat or that the resulting multiple is more than 5.5x (I am confident of neither), than you would be a buyer of this stock. At a trading level of 20.5, I find RDA as fairly valued here and would neither buy nor sell the stock.

That being said, given the situation above, cash levels at RDA will be near $300M (all else being equal). With debt outstanding of $525M, the debt looks pretty attractive here and probably trades at a discount to peers because of high yield investors typically being fearful of post reorg fixed income instruments.

Reader's Digest presents an interesting distressed debt opportunity and we will keep our reader's updated in the coming months.

Global Forum on Distressed Debt

It gives me great pleasure to announce a partnership between Distressed Debt Investing and IQPC in the upcoming 6th annual Global Forum on Investing in Distressed Debt. Over the last 3 months, I have worked with the organizers of this fantastic event in bringing together a group of speakers and presenters that I feel will be a significant value add to Distressed Debt Investing readers.

Over the next few months, we will bringing you interviews with participants in the conference. These people come from a variety of backgrounds ranging from lawyers to analysts to portfolio managers. In each conversation, I hope to bring our readers a unique perspective to the distressed debt investing process.

We encourage you to visit the conference homepage by clicking on the banner ad to the left. If you have any questions about the conference, its organizers, or its speakers, please shoot me an email at hunter [at] distressed-debt-investing.com.

Interview with Greenstone Value Opportunity Fund Part 2

Here is the second part of the interview from yesterday. For more information on Greenstone, contact Chris White (chris [at] greenstonefund [dot] com).

In managing a book, how do you hedge? What are your thoughts on shorting?

We don’t hold ourselves out as short guys, and Greenstone is long-biased from a standpoint of individual holdings in the portfolio. However we view it as necessary to hedge out the portfolio. Our view is that if we’re going to do it, we’re looking to generate Alpha. We look at individual shorts, as well as broad-based hedging through market or sector ETFs. We really only started shorting in April 2009. Our shorts lost us only 4% in face of a 60%+ broad-market rally, so maybe we should hold ourselves out as short guys. It felt a lot more painful at the time, and to us it’s somewhat of a miserable effort. For example, there are 2-3 shorts we know far better than any name we should from a fundamental perspective, but the market loves the story, so ultimately it does not matter how well we know the story and the stocks continue to move higher. Ultimately we’d like to try and put forth the same amount of patience we show our longs. It can be hard to not to get emotional about stocks that are over-hyped and fooling the market when you’re a deep value investor. We try not to short individual companies on valuation multiples alone, hoping to find something with a relatively near-term catalyst, like a patent roll-off, one off sales, a new entrant to the market, questionable accounting; essentially something in addition to just valuation alone. A lot of times we find what we think are good short candidates when evaluating the competition during our due diligence process on the long side. This often leads to something akin to a pair’s trade, where we are long the cheapest issuer in a group, and short the priciest issuer. In addition to individual shorts, we use sector and broad market ETFs to hedge the broad-market exposure of the portfolio, particularly when the technicals tell us it is prudent to do so. We use sector ETFs if we are over-exposed to certain sectors, such as energy, and broad-market ETFs like SPY or TNA to simply reduce the gross long exposure of the portfolio as a whole. We have also found the leveraged ETFs to be particularly interesting, as their structure inevitably dictates that they destroy their NAVs over time. Because of leverage, it seems to us they are constantly forced to buy high and sell low in order to maintain the proper leverage ratios. Therefore, we constantly monitor the market for the new issuance of these securities to try and take advantage of them and add the right exposure for the portfolio. As an example, if we wanted to short small caps, we might short TNA (3X small caps). That way, we have two ways we can win on the trade: 1) if small caps decline, and 2) if the NAV of the fund is eroded over time due the required rebalancing of its portfolio.

In your opinion, why do assets get mispriced?

In our opinion, emotions are the most defining reason why assets become mispriced, and the most common emotions that impact markets are fear and greed. Fear is an amazingly powerful thing, and it can work both ways. Losing is one of the most painful feelings we can describe, and the fear of losing one's hard earned money can make people do uncharacteristically stupid things. Like sell at the bottom of the market, just when the talking heads on TV are panicking the most and valuations have become the most interesting for long-term investors. Greed, or the “fear of missing out” can work the other way, though, and cause investors to move too much with the crowd, have an unhealthy herd mentality, and help fuel asset bubbles to dangerously high levels. It is amazing to us how quickly investor sentiment can shift from euphoria one moment, to a depressed outlook with nothing but trouble ahead. These emotions cause people to lose the ability to accurately define changes in news, earnings, or whatever in either favorable or unfavorable directions.

We try and filter out the nonsense from people like TV commentators, and essentially just invest in valuations of tangible assets and cash flows, knowing that at some point the market will want to court us at the dance again. If we couple good business judgment with an ability to insulate our thoughts and behavior from the super contagious emotions that swirl about the market place, we think we can be successful. We tend to use sentiment readings as contrary indicators, becoming more bullish when others are scared and vice versa. We actually think one of our key strengths is not getting carried away in any direction because we’re naturally very skeptical individuals. There have been economic bubbles or asset class bubbles since the beginning of time; markets overshoot and then over-correct, but ultimately that is what provides the mispricing opportunities.

If you could have lunch with anyone - alive or dead, who would it be and why?

Buffett, because he is legend. But unfortunately it’s gotten too overpriced to have lunch with him. We’d just take a DQ cheeseburger…shoot we’d even drive to Omaha, and pay!

If you were to peg one valuation technique you really rely on - what would it be? And why?

We track 400 companies across different market capitalizations and industries in a proprietary universe of companies that we feel have at least a chance to be a “deep value.” Underlying each company is a unique spreadsheet where the company’s financials are massaged by us to adjust for one-time events, seasonality, cyclicality, and so on. All of the underlying company-specific spreadsheets flow into a master valuation sheet, using real-time pricing data, that sorts the universe based on what we call a reward-risk ratio. This is a calculation of the multiple of the potential upside from current market if it reaches fair value relative to the potential downside from current market in a worst case scenario. All this model really does is stop us from spinning our wheels looking at companies when we should be focusing elsewhere. Because the universe we follow is very diverse, it also alerts us to flows in and out of certain industries and capitalizations. The other thing about the model is that sometimes companies get cheap for days, months, or just a few minutes. If it’s just a few minutes, it can be harder for us to react if we haven’t done the work…you win some you lose some…but if we stick to our process and discipline we’ll make it work more often than not. From there the valuation technique goes down another tier to EV/EBITDA and Market Cap/Free Cash Flow. We use an adjusted annualized number of the most recent quarter’s EBITDA or FCF, and we rarely if ever rely on forward estimates. What we are looking for are companies that are trading at 5X or less of these two multiples, and the process helps us focus us on the stocks that are the cheapest. Once we're alerted, then the fundamental hard work begins.

How do you generate ideas?

As I mentioned previously, we track a proprietary universe of around 400 individual companies in a real-time valuation model. The goal is to have the right 400 companies in this universe. If there are too many companies, it becomes too much work to accurately track, and the quality of the process is eroded. If there are not enough names in the model, then the breadth and scope of the process is not sufficient to produce enough ideas and give us a feel for where money is flowing. So a big part of what we do every day is make decisions on what companies need to be added to the model, and which ones need to be removed. For every new idea we get, we try and remove a company that we have concluded is a broken story, a value trap, will never get cheap enough, has an unfixable balance sheet, etc.

We use a variety of methods to try and identify new opportunities. We are members of and track high-value websites, such as the value investors club and the distressed investors club. We obviously have a number of like-minded friends and buy-side associates that we exchange information and ideas with. We do a lot of screening with services such as Capital IQ, and we try to read everything we can get our hands on in order to stay informed. Because we are trying to identify companies that are flying under the radar and trading at deep value multiples, we rarely find new ideas at sell-side conferences, where sponsorship already exists. At the end of the day, we think it is about having an open mind towards new opportunities, and more importantly constantly expanding our network of people, places and websites that share our investment approach.

We noticed some distressed debt ideas in your top holdings and commentary. Is that a matter of style or are you seeing interesting opportunities in the distressed space?

It is both a function of style and the opportunities we saw last year. Obviously, from a deep value investor’s perspective, the opportunity to invest in something based on an analysis of liquidation value relative to tangible assets can be very compelling. The economic slowdown and financial crisis also produced a lot of names to look at. However, we aren’t actually seeing as many attractive opportunities in the distressed space right now as we would like. We are probably seeing more post emerging opportunities right now. But that’s today. There was a tremendous amount of high yield debt issued in the 2005-2008 period, with a lot of that coming due in the near future. A lot of this debt was taken on in the thought of continued growth and with too rosey of an outlook going forward With choppy markets ahead, the slowdown in business fundamentals from 2005-’08, and a slow growth environment for the foreseeable future, distressed investing should more than hold it’s own going forward.

We saw where Pimco recently published a piece about dollar percentage default rates increasing for mid cap companies. While corporate America has done a tremendous job in curtailing capex spending throughout the recent crisis, we doubt this can continue for too long without impacting their underlying businesses, and the point from the PIMCo piece is that mid and small cap companies are more constrained to take further capex out of their businesses. Banks are now also recovering to the extent that they will actually call on companies that violate loan covenants. For instance, last year we had a crude tanker investment, and the company was asked the questions “are you breaking any loan covenants, are you hearing from your lenders?” Their response was that “the banks don’t call us, we have not heard from them in over a year.” With NAVs off 50% in a year, the banks didn’t want to create another run on assets, and end up owning boats.

We like the distressed space because quite often more information is available to us when a company is in chapter 11. The monthly operating results requirement, as well as the ability to monitor the items filed on the court docket, make it seem that the information flow is better than what would otherwise show up in the K’s and Q's. Obviously, there are other nuances that create risk: who the judge is, can the creditors wear down the equity holders, does the debtor have access to capital markets, who are the financial advisors, how much will be eaten up in fees, etc. But we think for people willing to spend the time and do the work, the variables can be broken down and this creates opportunity.

Talk about one or two ideas your find particularly compelling. Why are they mispriced? Where is the market wrong?

Tronox Inc. (TRXAQ and TRXBQ)

I should probably first say that we own both the debt and the equity in Tronox. However, given the industry bottoming after a 2 ½ year trough market in TiO2, the restocking of inventories, and recent price increases, we think Tronox’s MORs will improve going into the seasonally strong Q2 and Q3. Therefore, there probably is greater upside/downside for the equity right now than at any time in this process.

The reason we think the market is wrong about this company is the bankruptcy process risk and disclosure. We recently sent a letter to the Judge in the case regarding Tronox’s unfulfilled obligation to file periodic results of the operations of its Non-Debtor subsidiaries, as required under §2015.3(a) of the Federal Rules of Bankruptcy Procedure. There are 18 wholly owned non-debtor subs, and an undivided 50% interest in the assets of four non-debtor entities comprising a joint venture in Australia. It really seems to us that the debtors have dragged their feet exceptionally well on this issue, as we’ve seen no operational disclosure for these entities since the case started 19 months ago. It would be very interesting to see where cash is accruing on the balance sheets of some of these non-debtor subsidiaries.

Even in spite of this game of “hide the ball” on behalf of the debtor, if we annualize the most recent April MOR, we get $175mm in EBITDA, $58mm in free cash flow, and working capital north of $550mm. In Huntsman’s stalking horse bid from last year, they only requested $300mm in working capital; one would assume that number was aggressive given that they were not bidding against anyone else. Just applying a 5X multiple on EBITDA, which we don’t think is aggressive, and adding the $250mm in excess working capital, we get a $1.125bn enterprise value. After subtracting liabilities of $436mm, post petition debt of $423mm, and environmental obligations of $122mm, you get roughly $3.42 in potential equity value. This analysis doesn’t give any value to the non-debtor subsidiaries or their Australian joint venture, and it still yields upside potential of 5-7X current market price.

There is an informative blog on Tronox http://tronoxequity.blogspot.com/

Hawaiian Holdings (HA)

Hawaiian Holdings is the parent of Hawaiian Airlines, which I mentioned earlier. The company is the a beneficiary of the bankruptcy process; not only has it emerged unencumbered, in fact it has net cash of close to $100mm, which is unheard of the in the airline industry. The company has very sound management, and a sound strategy going forward in accessing emerging international markets. With airlines, the big three things to consider are labor costs, fuel costs, and leverage. Their labor negations are complete, not hanging over them anymore, and Mark Dunkerley just resigned his contract. Their fuel is hedged roughly 41% for the remainder of 2010, and they’re unlevered. From a multiple perspective, annualizing last year’s quarterly EBITDA yields approximately $130 million. Based on this earnings power, the company is trading today at roughly 2.1X EV/EBITDA.

The other wild card that investors don’t probably fully understand, or don’t care about because of the market cap, is the recent Haenda approval and the opening up of discretionary recreational visas from China and other Asian countries to the United States. The company recently won approval for a direct route between Haenda, which is a preferred airport out of Tokyo, and Honolulu. South Korea also just relaxed their visa stance, and it will be interesting to see how this models for Hawaiian. Basically, they’re an unlevered player in a consolidating industry that has access to key Asian markets. I would note that the company’s term A and B loans are due late this year, and early next, but we are not concerned about their ability to find attractively priced replacement facilities.

Thank you to the Greenstone team for such an informative interview! We wish you the best of luck in your capital allocating endeavors...

Exclusive Interview: Greenstone Value Opportunity Fund

A few months ago, I received in my inbox the 1Q 2010 letter for the Greenstone Value Opportunity Fund. Not only were their returns spectacular but also their largest position at the time was Tronox, a company we did a distressed debt research piece on earlier in the year. Needless to say, with their candor, their value investing mindset, and their ability to see the forest through the trees in a number of highly complicated situations, I was incredibly impressed. I reached out to founders Chris White and Tim Stobaugh, and asked them a number of questions in the interview below. I was split the interview into two parts, and will post the second part later in the week. Enjoy!

Of the prominent investors (Seth Klarman, WEB, Graham, etc) out there, who would you say your styles most mirror? And why?

We tend to think about other investors as being in a variety of different categories, and we try to glean from them opportunities or ideas in those areas where we think they are the strongest. Mark Faber or Jim Grant, for example, are not necessarily known for being very good stock pickers, but they make incredible calls time and time again from a broad macro perspective. Obviously a Seth Klaram has a go anywhere, anytime style, it’s just that he’s a large relevant investor with a superb track record; we like to think we mirror him in some ways from the perspective of liking tangible assets and free cash flow, but we realize any comparison at this point is more than a bit premature. Outside of David Einhorn, who we think is phenomenal, we actually think some of our own limited partners are the best investors we know. Michael Scholten of Clear Harbor Asset Management is the best ‘common sense’ value manager we know, and Brad Radoff of Fondren Capital has an amazing ability to get up to speed on an idea; he’s quicker than anyone we know, with a diverse style and breadth of knowledge that is truly impressive. In addition to these two, who are LP’s, we are proud of our limited partner base, and have a lot of talent there that can provide immeasurable advice. We try to take note of what Jerome Simon and Keith Cockrum of Lonestar Capital Management are up to. Julian Robertson has influenced our industry more than any investor, so we always try to keep tabs when he offers perspective on the news of the day (we might also point out that he’s the inaugural winner of the Friend of New Zealand Tall Poppy Award).

At the end of the day, we’re a young, small friends and family hedge fund, and we can definitely play in ideas where others face too much liquidity risk and/or don’t have the ability to put a relevant amount of AUM to work. But, we’re also not afraid to invest in large caps when we think their capitalizations represent the best risk/reward. We really just try to learn from everyone, and try not to put ourselves into a box; if asset values and FCF’s are telling us to go to a particular sector, then that’s what we do. In addition to continually learning from our mistakes, we let our deep value philosophy, with a focus on underlying free cash flows and tangible assets, and investment process dictate what we do.

You run a fairly concentrated book. Talk about your thinking behind diversification and running a fund.

We try to have about 80% of our long portfolio structured in what we consider our classic (deep) value investments. We try to run a concentrated book of between 15-30 investments because we want positions to be significant from a return standpoint to the portfolio; the game is hard enough that if we pick winners, we want them to be meaningful. These core positions are generally sized in the 3-6% range in terms of AUM. The other 20% of the long portfolio is comprised of special situations, where maybe the valuation doesn’t meet our hard and fast criteria, but they have the potential to provide outsized returns (i.e. 3-10X returns). These positions are generally sized in the 0.5-1.5% range in terms of AUM, but we consider it relevant to take a position because they can prove meaningful to the portfolio due to the implied leverage in investment. This level of concentration can go against us too, and we fully expect to have losing positions. While the portfolio might take a more significant hit when a core position declines relative to someone running a book of 100 names, we try to be brutal when deciding on whether to stay with a holding. Our bottom-up, rigorous due diligence process allows us to be highly familiar with the underlying issuers, especially the core names, so when positions move either way we feel we can make informed decisions regarding the portfolio.

We are definitely conscious about diversification and the hedging we need to employ in the portfolio. As an example, from an industry perspective we try not to have exposure of greater than 16-18% of AUM. While we have approached these levels several times in the past, primarily through appreciation, our disciplined approach required that we scale back these positions as they moved higher. We also sometimes look for “interesting” ways to hedge certain positions. For example, as our oil-related holdings started climbing last year, we thought a pullback was certainly possible. So, we hedged our exposure to oil with long positions in regional airlines like Republic Airways (RJET) and Hawaiian Holdings (HA), which were trading at valuations of less than 4X EBITDA and FCF. Not only did we pick up what we thought were great value investments, there was an obvious hedge if oil prices declined. We also put a huge premium on liquidity. Tim previously managed a fund that was comprised of highly illiquid investments, and he took some great lessons from that experience. Typically, 80% of our holdings are NYSE or NASDAQ listed companies and we could trade out of our positions in a day or two. This also gives us comfort when owning such a relatively concentrated portfolio.

In your opinion, what is the hardest aspect of running a hedge fund?

Time. Because we are a small fund, and there are just the two of us, there are many times when it does not seem there is enough time in the day. It’s not just about running a fund and generating returns, it’s about building a business, and all the things that go on outside of just pure investing. Whether it’s taking advantage of a 10-minute 8% correction window, returning a call to a limited partner, or just having enough hours in the day to keep everything in balance outside of running a hedge fund, there are personal sacrifices to be made. We work in close proximity on a trading desk environment where there are no fancy titles or big offices; there is little time for personal phone calls, and it’s about being productive when we’re in the office. We also try and think about every decision as if we were a much larger fund, whether that’s how we set up our offshore fund, who we chose as third party service providers, or how we communicate with our limited partners. All of this requires that Tim and I wear multiple hats every day, including fund manager, compliance officer, capital raiser, risk manager, and investor relations. The other hard part is ignoring all the ‘noise’ we hear every day on the likes of CNBC. It is hard sometimes to avoid all the noise and panic around you, and have the confidence to wade into the waters and take a position when the process tells us it is time. When we are pressed for time, our processes tends to bail us out. We have quantifiable metrics for some things, i.e. do we make a certain amount of phone calls every day, are we increasing our LP base every quarter, etc. With regard to investing, we definitely rely on our process to tell us when the valuations make sense. We think the other very important part is in communicating with your LP base. If you constantly communicate your ideas and philosophy, and reach out to them every month or two, then when the tough times occur they’re more likely to stick with you, because they understand the process better. Buffett used to quote something like he wanted LP’s to “measure us, as we measure ourselves.” We agree with this and think it’s more important than ever to have the right LP base.

Talk a little bit about your background. How did the two of you come together to launch Greenstone?

Tim has worked his entire career in the financial services industry. He spent over 11 years on the sell-side at a boutique investment bank helping raise capital for small and micro-cap public companies. During that time, he helped raise over $300 million in almost 50 different transactions. The great thing about being at a single-office boutique was the amazing breadth of experience he received while there. At some point during his tenure, he was an analyst, investment banker, institutional salesman, trader, compliance officer, and head bottle washer. More recently, prior to joining me to launch Greenstone, Tim was with a buy-side hedge fund with around $75 million in assets. Again here, the breadth of experience included all aspects of running a small fund: portfolio management, trading, CFO, investor relations, etc. In addition to the operational expertise that he brings to the table, he has essentially spent the last 15 years or so analyzing capital structures, negotiating deals with management, and investing and trading micro, small and medium-cap stocks. I was born and raised in New Zealand, and started investing as a 16 year old after reading my first Warren Buffett book. It was from that point on I knew I would be an investor in public markets. It was my dream to come to the United States, and work on Wall Street. Originally I thought Wall Street was the place to be, until I took a job offer in Dallas, and spent 7 years on the buy and sell side, investing and raising money for public companies. The story of how I actually got from New Zealand to Dallas is humorous to some. . When I arrived stateside I had a total of $400 on me, so I negotiated to buy a car and a mattress for $175. I still remember driving that Mazda 323 down the road with a mattress strapped to the roof and no air conditioning. I eventually sold that car two years later for more than $175. I still remember those lean times, and it keeps me motivated.

Our careers eventually overlapped for about 2 years at the small investment bank I mentioned earlier, and we became great friends. Not only did we become friends, but we spent a great deal of time, both during our tenure together and after Tim left to move over to the buy-side, discussing investment outlooks, philosophy, trading styles, etc. We came to realize that we shared two things in common: similar personalities and similar investment styles. We are both highly competitive, brutally honest people who are motivated to succeed. We know we can trust each other to do the right thing, and you may as well not go into business with someone if there isn’t 100% trust. There will be ups and downs, times of pressure, and you have to know that your partner is there completely there for you. It’s also about humility and intellectual honesty. As we constantly reevaluate our positions, say when a position moves against us, we ask ourselves: Are we early, or are we wrong? Is this conviction or pigheadedness? We are not afraid to say we made a mistake.

What has been one of your biggest investment mistakes of the past? Biggest investment success?

Blockbuster (BBI) is a story we spent a lot of time on, and felt very comfortable with regarding our knowledge base and the valuation. We traded the common equity and exited successfully, but we bought a position in the unsecured debt post refinancing of their senior facility. Late in 2009 we walked out of a meeting with senior management thinking we should sell the bonds, but we noticed an insatiable desire in the market for high yield, with investors chasing yield to unsustainable levels. We thought we could game the market and hold onto the bonds, selling the position before they announced their Q4 earnings in March 2010. Of course, the company pre-announced poor results, and the bonds declined 50% in a week. I think we learned that once you lose confidence in a position and determine you’re a seller, you need to get out and not try to game the market. We constantly kick ourselves for our losses, more often than not it seems on our shorts, or it’s a timing issue where we’re wrong for an unbearable amount of time. We truly believe you learn more from your mistakes than from your winners. They’re extremely painful, and it’s a feeling only people managing their own money, along with friends and family dollars, can truly relate to.

As far as investment successes, we think entering the Trust preferred securities of the major money center banks in late 2009/ early 2010 was a successful trade. Entering the auto bailout mess was another interesting time for us, with the Hayes Lemmerz (HAYZQ) bankruptcy, and Exide Technologies (XIDE) providing valuations that gave us comfort. Entering the airline sector in late 2009 when oil was increasing was hard to do, but the valuations told us we needed to be there. From a pure percentage return standpoint we have almost a 100 point gain on our Tronox Bonds, representing a return of close to 300%. This was definitely the first time we’ve earned over 100 points on a bond, and while it’s probably not our best investment ever, to earn 100 points on a bond is a rare event…for us anyway. The hard part about the bankruptcy process is being able to have enough information to take a position when no one else wants too. The timing of the return opportunity is critical. As with all our investing, and particularly with these we have mentioned, we try to first and foremost define the downside potential. For example, before taking a position in Tronox we did a tremendous amount of work on the environmental liabilities, talking to the EPA, lawyers, Superfund employees, doing analysis of past EPA and Superfund settlements versus the original claims, etc. After all these discussions we formed a probability analysis of what we thought the potential environmental liability would be (our work showed a 20-28% eventual loss). It was understanding the liabilities early on that provided the comfort for us to take a position. The other fundamental analysis on TiO2 recovery, industry processes/dynamics, inventories, pricing, etc was easier… the wildcard was the environmental liabilities. With the wildcard essentially defined and off the table, the process became easier for us to get comfortable with, and we even eventually took an equity position as well. Whether you are talking about the preferred securities of the money center banks during the financial crisis, the automotive suppliers during the bailout, the airlines during a recession, or a Tronox during bankruptcy, our best investments have been when the panic has been the highest, the blood in the streets has been excessive, and panic-selling has been the norm. These are events we look for to trust our process to find good buying opportunities.

When allocating capital, must discussion in the past few years has been on value investor’s transition to start taking a look at the larger/macro picture. If anything, how does the general economy and macro trends play into your investing style and how you run the fund?

That’s a very interesting question and it certainly involves more work than in living memory, but we try not to over think each and every position. We focus on tangible assets and free cash flow. Our limited partner investors don’t come to us to invest in Coca-Cola; they come to us to invest in deep value, distressed companies that very few people are looking at. So, something we have to remind ourselves is that by the time we’re interested from the multiples we look at, the issuer typically already has significant downside protection built into the valuation. But before taking a position we take into account the technicals of the market and the underlying company because black box trading has become so significant.

Having backgrounds in economics, we do tend to have broad-based themes when investing, in addition to simply monitoring the market for mispriced securities. For example, we think China and India are going to be among the largest drivers going forward due to their GDP growth potential and the fact they make up 40% of the world population. When you consider that the current per capita consumption of these countries is now at very low levels but growing, as well as the future industrialization of these countries and the development of a middle class, we tend to look at their import needs in terms of certain commodities (coal, oil, gas, iron ore), and the mode in which they will receive those commodities (tanker and dry bulk). We think China will be by far the bigger factor in the equation than ever before, and prices will ultimately move more on Chinese demand than in the US. Having said that, we would never try to trade commodities; instead, we would attempt to find issuers with significant commodity exposure at very attractive deep value multiples.

We also think the power shift from Wall Street to Washington is something to keep an eye on. We feel Washington is somewhat broken because of the influence of special interest groups, and the political process requires Washington to remain beholden to these entities. The scary part is that fiscal responsibility ultimately only comes about by being forced to take action. For example, New Zealand lived in fiscal denial for decades, and then in 1984 was forced to go cold turkey from a fiscal and monetary standpoint. It was a painful transitional of ten to fifteen years, but there were plenty of opportunities to pick up assets when no one else wanted them. If we don’t have some sort of fiscal responsibility from the Obama administration, the 2008/200909 credit crisis will be a small issue compared to the day that the US cannot print anymore money, or there is no buyer for US government debt. For these reasons, we’re partial to countries like Australia and Canada, who are commodity-rich, with stable monetary policy, friendly corporate tax policies, and in close proximity to Asian countries with insatiable desires for their primary products. So, I’d say we definitely more than ever take into account a certain amount of governmental control, future interpretations of the law, and general macroeconomic policy analysis. Whereas macro/political used to make up around 10-15% of your decision making, it’ probably double that today. The recent banning of existing drilling in the GOM by the Obama administration was pretty fascinating, and we think some interesting legal precedents could come out of that action.

Request for Distressed Debt Investing Readers

Hey guys - As I am sure many of you know, I also publish the Merger Arbitrage Blog. I have been working with a very strong analyst since the launch of the blog (he wrote the most recent post on Javelin Pharmaceuticals). This analyst is looking to join a buy-side shop as an arb analyst. He is very talented and I would highly recommend him. If you are looking for an analyst, and want to speak with him, shoot me an email at hunter [at] distressed-debt-investing [dot] com and I will make it happen. Thanks!

Debt Investing Concept: Credit Curves

While this post is more particular to high yield and investment grade bonds, than to distressed investing, I believe it is an important concept considering what is going on in certain pockets of the market today. A credit curve is essentially the spread over treasuries of various maturities for a single bond issuer. The greater the difference between the front end (near term maturities) versus the long end (longer maturities) determines the steepness of the credit curve.

Generally speaking, more cyclical industries will have a steeper credit curve. Retail for instance will generally have a pretty steep credit curve. This reflects the fact that the probability of default increases cumulatively over time. This can also be seen on CDS curves. For example, see below for the CDS term structure for Home Depot (HD) as of today and last year at this time.

The top line above represents the curve as of last year. And the upward sloping one represents as of today. What is this telling us?

When a curve is flat, it is essentially saying that the probability of default is fairly uniform through the tenure of the projection periods. When it is upward sloping it signifies that the probability of default in the near term is far less likely than the outer years.

Look at the chart below:

This is the BP curve. Again the yellowish line represents last year, with the red line representing the current term structure. The curve is inverted which means that investors believe that there is a higher likelihood that BP default in the near term relative to the outer years.

If you have access to a Bloomberg, you can run the function CDSW on any single name CDS to determine the implied default probability of the underlying credit. For example, in BP's case, the 1 year CDS is trading at (who knows where it opens) 550, which implies a 1 year default probability of near 10%.

If an investor has an opinion on the relative likelihoods of default probabilities / credit spread widening across a credit curve, he or she can reflect it in a curve steepener trade or a flattener trade. If I thought all this press commentary about BP filing was just speculation, I could sell the near term CDS and buy the longer dated CDS. If BP files for bankruptcy tomorrow, I would be net hedged (both swaps trigger, I would receive a dollar amount from my buying of protection and then deliver it as I sell protection). If BP makes it a few years, my 1 year CDS sale expires worthless and I collect the premium.

The problem with this though arises as you are duration mismatched. Similar to bonds, the further you go out in maturity, the more sensitivity a particular CDS contract has to spread changes. A general rule of thumb is divide the number of years to maturity of a CDS contract by 100 and that is how many basis points of spread represents 1 point of price movement (important for mark to market). So if I buy 5 year HD protection, each 20 bps of movement will change the contract market value by 1 point (100/5 years = 20 bps).

Many people in the fixed income world live and down by these trades. They are taking very little risk by entering into many offsetting contracts, collecting premiums off the basis, and doing it in size.

By looking at the credit curve and CDS term structure, an investor can find relative value in the fixed income space. For example, if I look out into the market and see that Home Depot's 5-30 is 100 bps steep whereas Lowe's is 50 bps steep, there could be a relative value opportunity there. This is even more magnified by given how steep the treasury curve is.

Now distressed is a little bit different. As distressed investors we can play a certain situation very differently considering how we view the credit.

If I feel a credit can make it next year, but not the following few years, I may buy the nearest term bond and hedge myself with buying slightly longer duration CDS or purchasing puts on the equity.

If I think all will by rosy, I may play either the near term or the long end depending on how steep the credit curve is.

If I feel a credit is doomed to failure, I would buy the LOWEST priced bond. Because bonds similar in nature (i.e. pari passu) are treated equally in a reorganization, I want to try to "create" the investment at the lowest cost possible to capture the most upside. If I think I am getting 80 in a re-org, and I have the choice between identical bonds, one maturing in 5 years and one maturing in 30 years, at 60 and 40 respectively, I would always by the 40 dollar bond because I will make 100% on my investment versus 33%.

As companies get closer and closer to distressed, their bonds will begin to trade on an a level where their recoveries are identical. Discrepancies arise based on accrued interest. If a company has a bond with a 5% coupon and another with a 10% coupon, the latter will be entitled to more accrued interest and thus his claim will be higher and market prices will reflect this.

The point of all this is that there is a wealth of information in credit curves for investors ranging from IG to distressed. One needs to understand why a curve is shaped a particular way and how it got there. Most importantly though, an investor needs to understand what the credit curve is saying about risks reflected in the market price of the underlying securities and whether the market is overestimating, or underestimating, the credit / default risk of this company. You can look up the odds using "CDSW" - and with those odds you can place wagers when you truly disagree with the market.

When does Distressed Debt get cheap again?

About 6 weeks ago I posted a graph on the amount of distressed debt outstanding according to Bloomberg. Here is that post: Amount of Distressed Debt Outstanding as of April 2010

Here are those two graphs today, from index inception:

Distressed Debt Issuers Outstanding:

And now Distressed Debt Bonds Outstanding (again from inception)

All in all, it looks like bonds are marginally cheaper.

In his recent interview with Seth Klarman, Absolute Returns magazine,

"And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market's surge from its March 2009 bottom. "The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years," he says.

I fully agree with that assessment. That doesn't mean I am sitting idly on the sidelines. We still sharpen our pencils as investment opportunities come our way.

That being said, one thing that is UTTERLY TERRIFYING: the vast majority of the major sell side firms are telling clients in their published reports that this pull back should be viewed as a buying opportunity.

Look at those charts above one more time. Does that look like "blood in the streets?" I do not think we get back to the peaks of that chart (one reason: a lot of those bonds never really traded there in size combined with Lehman's prop book selling everything at any bid) but I think its hard to classify this market as "full of opportunities."

A few months ago I posted one of my value screens on Bloomberg - These are not mechanical screens. They are simply idea generators. The screen doesn't do the work; but it points you in the right direction. On March 30th, 2010, 5 companies passed the test. Today, 13 companies pass:

Post Properties

Hovnanian

YRCW

Standard Pacific

Alon USA

Blockbuster

K-Sea Transport

Eastman Kodak

Delta Petroleum

Poniard Pharma

HRPT Properties

Cohen & Steers

Jackson Hewitt

So, at least we are moving in the right direction. Post Lehman filing (it takes some time for the sell side to downgrade stocks when the world is coming to an end), the list had nearly 100 names on it. There wasn't enough time in the day to look at it all. It was glorious. It still does not feel that way unless you are an oil analyst, and that might even be stretching it (full disclosure: I have purchased RIG for my personal account).

All in all, stocks and less so bonds are cheaper. But they aren't cheap yet in size. The 60 day redemption window (most hedge funds have a 60 day redemption window) passed at the end of April for a lot June 30th withdrawals. Things were pretty rosy then. If performance continues even remotely close to what it did in May, we could see lots of redemptions coming for the 3rd quarter which funds will begin preparing for in late summer when no one is around. Bid/Offer spreads will widen and things could get ugly.

Yes - There are some pockets of value and event driven opportunities we have dabbled in, but nothing en masse. We steadily try to deploy capital with a bottoms up perspective in situations where the margin of safety is so great that our capital investment will be protected in all conceivable scenarios and where we can earn an adequate return on that capital. We want the market values of businesses and capital structures to become cheaper. We want the press to have front page articles of newspapers and magazines with graphs of the Dow and S&P going down with headlines like "Financial World Reels...", "Dow Tumbles...", and "Are you ready for the next bear?". We want the sell side to come out and say, "Ok clients, it is time to start selling..."

Does this make us filthy capitalists? Of course it does. But I'd much rather be patient and wait for the fat pitch than take a stab at a fastball away and at the knees. Tough pitch to hit in my opinion...

Some good hedge fund material I missed apparently

For Distressed Debt Investing readers and my personal files...

The Value of Seth Klarman June 2010 - Absolute Return + Alpha

Steve Eisman - Ira Sohn Conference - May 2010

GGP - Ackman Presentation at Ira Sohn Monference - May 2010

David Einhorn's 2010 Ira Sohn Investment Conference Presentation

Forbes on Buffett