Thoughts from Third Avenue's Special Situations Fund

At Distressed Debt Investing we have discussed (in detail) Third Avenue Credit Focused Fund, a group I very much respect. What a lot of people don't know though, is that Third Avenue also has a special situations fund (fund name = Third Avenue Special Situations Fund) run by Michael Fineman. While I will not post the entire letter, I will grab snippets which I think are particularly insightful.

On Chrysler Financial (a favorite among many distressed funds)

"During the quarter we greatly expanded our interest in a private company (“FinCo”) that indirectly owns 100% of Chrysler Financial. At our purchase price we believe we are buying a well-seasoned portfolio of automotive loans and leases at roughly two-thirds of run-off value. Importantly, the underlying portfolio has a very short duration, as the overwhelming majority of the book is expected to be liquidated in approximately two years.

By way of background, before the April 2009 bankruptcy filing of automotive manufacturer Chrysler LLC (“CarCo”), FinCo was the captive finance provider for CarCo. During the peak of the crisis and rumors of bankruptcy, FinCo equity was marked in the low to mid 20s. However, since CarCo’s bankruptcy and emergence in later summer 2009, Ally/GMAC has assumed FinCo’s previous duties as the primary provider of retail, lease, and wholesale financing for CarCo-manufactured vehicles. As such, FinCo is currently in run-off, with assets turning into cash on an accelerated basis.

Given the seasoning of FinCo’s book, consumer/wholesale default stabilization, and a remarkable turnaround in used vehicle prices, we are confident FinCo’s reported balance sheet is conservatively marked and we have a large margin of safety when you consider the significance of our purchase price discount. The primary uncertainty associated with this investment is the timing of when capital will be returned, which may be dictated by how the managing partner of this private equity interest seeks to re-deploy these funds. Given what we perceive to be an acceptable alignment of interests, we view the downside to this investment to be a mediocre IRR and the upside to be a holding period return in excess of 60% from current levels after already experiencing material appreciation."

Another distressed debt special: GMAC Preferred's

Ally 7% Cumulative Perpetual Preferred Stock (“PS”) pricing was volatile during the quarter, and we added to our position (while still leaving substantial room to buy more) as prices have fallen. Regular readers of our letters will recall in 2008 and 2009 that we successfully invested in the unsecured bonds of GMAC on multiple occasions. Now, with the prospect of an Ally Financial IPO over a one-to-two year horizon we believe our preferred shares are well situated in the capital stack: Preferred share pricing results in a 9%+ current yield to us, with upside on an early par takeout if Ally management and the majority common shareholder (United States Treasury) look to facilitate a smooth S-1 filing by redeeming us and removing our common dividend blocker.

Of course, we do not hold a contractual right to early redemption, and it is entirely possible Ally could execute a successful IPO with our preferred share common dividend restriction in place. However, even in this downside case we believe we are likely to be credit-enhanced in advance of an IPO when the Treasury converts some or all of its $11.4 billion of mandatorily convertible preferred stock (currently pari passu with our $2.7 billion of PS) into common stock to thicken the common layer and increase Tier 1 common levels to a more acceptable range.

And on their general outlook:

The Fund remains focused on both distressed performing credit and debt-for-equity investments. Since the start of the year we’ve been telling investors that the middle market (companies with total debt less than $3 billion, but less than $1 billion the real sweet spot) is the most attractive environment for debt-for-equity investments. These companies have typically relied on leveraged loans provided by collateralized loan obligations (CLOs) and regional banks for their financing needs, rather than the high yield markets, which serves larger companies who issue larger amounts of debt. The continued shortage of capital available from CLOs and regional banks has made it difficult for middle market companies to refinance or extend the maturities of their existing debt, even as their larger competitors go to the high yield markets to take advantage of still low interest rates. When so many leveraged companies are facing real hard maturities in the near term it creates opportunities for distressed investors.

The second quarter saw increased volatility in both the credit and equity markets as investors absorbed news of the Eurozone’s sovereign debt problems and China’s attempts to manage and slow its economic growth. Third Avenue’s “Safe and Cheap” approach to investing serves us well in times like these by providing strong risk adjusted returns. We analyze many companies and attempt to determine the optimum security within the capital structure and at the appropriate pricing level that limits our downside. Such volatility as the markets experienced recently has helped to create those buying opportunities for the fund.

We continue to size our positions based on our risk analysis of each issue which has provided for several high-conviction, highly concentrated positions that we believe have limited downside. Fund management has also implemented certain inexpensive hedges to hopefully mitigate the tail risk associated with specific companies as well as macro hedges. Finally, we have initiated and increased certain positions that have hard scheduled events and therefore are capable of generating strong returns no matter how the market behaves.

The macro backdrop supporting this middle market thesis remains the same as we had written about in our First Quarter 2010 letter; but recent events noted below seem to further support our thesis:

• Sovereign default risk has expanded from one EU country to several, not to mention austerity measures being taken by many other countries;
• The FDIC list of problem banks has grown from 702 to 775;
• Unemployment rates continue to remain just under 10%;
• Some $1 trillion dollars of maturities come due over 5 years, albeit back end loaded; and
• Many balance sheets remain highly leveraged as earnings are first fighting to return to the levels of 2005-2007; let alone grow into those balance sheets.

We could not agree more. The Unwinding of the CLO bubble, is going to make it a very interesting couple of years for distressed debt investors.