Mark will be speaking at the upcoming Global Forum on Investing in Distressed Debt, coming up this month in NYC. If you remember, this is an event I have helped to organize. I really hope all my readers will attend.
Enjoy the interview!
Mark - Could you give us a little bit of background on yourself and MB Family Advisors?
Sure. In a former life I started my career as an M&A attorney at Skadden, Arps but I’ve been a principal investor since 1994, mostly in firms where I was a Founder or Co-Founder and invested substantial personal capital alongside my investors. Initially I focused on small and mid-market buyout investing and had some great success as well as luck (for instance our marquee buyout transaction generated a return of almost 60x our equity investment). I started investing in hedge funds in 1997, both single manager and fund-of-funds. In 2001, seeing the inefficiencies in the private equity secondary market I co-founded a fund firm that purchased in the secondary market limited partnership interests in real estate private equity funds. The common theme to my investing career has been to focus on finding inefficient markets where a provider of scarce capital can generate outsized returns.
The search for inefficient markets required that I develop deep experience across multiple asset classes – private equity, hedge funds, credit markets, real estate etc. This broad experience led to the launch of MB Family Advisors, LLC in mid-2008 when I formalized a relationship with an anchor investor to manage his family’s investment portfolio across asset class. The anchor investor has a low 9-figure net worth. The intention has been that over time I would add additional family clients and on occasion offer specialized investment products that could opportunistically target particularly inefficient opportunities.
The first investment product came in January 2009 when I launched the MB Dislocation Opportunity Fund, LP, a dislocation/distressed credit fund-of-funds. The Fund is intended to provide investors with diverse exposure across a variety of different credit, distressed and other niche strategies including traditional long/short corporate distressed; asset based lending; structured credit; merger arbitrage; and mortgage debt markets (RMBS/CMBS & whole loans), among other strategies. The common denominator in all the Fund’s allocations is that we invest in strategies positioned to benefit from ways the capital markets have changed since the 2008 financial crisis.
We have to say, a January 2009 launch of a distressed credit fund-of-funds seems incredibly prescient. When you were looking out at the world at that time, why did you think that was the opportune time to invest?
Well, for starters I’d note that it’s more of a “dislocation” fund than pure distressed credit. As indicated, we’ll invest in any strategy we think has benefited from the 2008 financial crisis. Distressed debt is just one of the underlying strategies.
As for timing of the Fund’s launch, as I alluded to I think the best investment opportunities come from inefficient markets. As capital markets imploded in the Fall of 2008 credit markets in particular became so highly dislocated. Credit completely froze. While there was substantial continuing uncertainty regarding the severity of the recession it was already clear by year-end 2008 that the US and other developed country governments would not allow the complete collapse of the financial system. However, the complete lack of liquidity and fear associated with uncertainty created forced and/or highly motivated sellers resulting in substantially mis-priced securities and assets.
The mis-pricing existed across multiple markets including leveraged loans, ABS, DIP lending, ABL lending and others where all of a sudden you could target high, equity like returns or better investing at the most senior, least risky part of the capital structure. I wanted in on that action.
To get sufficient diversity of strategy and manager I decided to launch the fund-of-funds and take in outside investor capital. In hindsight our timing was good. It’s still early but we’ve enjoyed great success thus far and have generated positive returns in 18 of the 20 months since launch.
We see you have had tremendous success to date - What are your thoughts on the distressed market today? Do you worry that so much capital has entered the space over the past 12 months that returns going forward could be squeezed out?
The nature of the opportunity set has changed. Initially the opportunity existed to get 20%+ returns on high quality, performing assets that were not distressed but were trading at distressed prices. That trade is over.
For reasons I’ll describe, over the next 12-18 months I think there are other niche strategies more compelling than distressed corporate debt. However, there are attractive opportunities currently in some mid-market distressed names and beginning in late 2011 or early 2012 the overall distressed market will become extremely compelling again.
To me it’s clear that we’re in the midst of what will be a multi-year distressed cycle. The upcoming wall of debt maturities has over $1 Trillion in corporate debt coming due (and this excludes mortgage debt), much of which was issued in the go go years of 2005-07 and is stuck in unsustainable capital structures. Sure, “amend and extend” has kicked the can down the road but for many of these companies the day of reckoning will nevertheless come. At that point there will be a huge supply/demand imbalance in favor of distressed debt investors and 20%+ return potential will exist again.
Several high yield analysts have recently opined that all the debt extensions are solving the wall of debt maturity problem but I think they are misguided. High yield issuance is at record levels but something like 70% - 80% of the issuance has been for tenders to replace existing debt and extend out maturities. Yes, this has resulted in default rates coming way down for large cap companies that can access the high yield market. It’s true that this makes the distressed opportunity set much less attractive in the near term --say over the next 12-18 months -- but this is a temporary phenomenon. While you can solve a liquidity problem with more debt you generally can’t solve a balance sheet problem by issuing more debt unless growth is so robust that substantially higher cash flow can meaningfully shrink leverage and coverage ratios. (Unfortunately this is a lesson our government hasn’t yet learned but that’s a topic for another day.) The prospects for this type of hyper growth in cash flow are quite slim.
So, in the near term there will be fewer large on-the-run names in the distressed space and returns will be squeezed but with a little patience distressed debt will be quite compelling again. In any case, it’s important to appreciate that through Q2 of this year default rates for small and mid-cap companies were still in excess of 10%. These companies do not have access to the high yield market and have far fewer options to kick the can down the road. Therefore, in my view the most attractive distressed opportunities for the next year or two will be in the mid-market. This is an important consideration when assessing who to allocate distressed capital to.
Perhaps that’s a lot to digest but the bottom line is that I think (A) over the next 12-18 months there is more opportunity in other niche credit strategies like direct and asset based lending, (B) within distressed the best opportunities in the next 12-18 months are going to be in mid-market names and (C) as the day of reckoning on the wall of debt maturities gets closer, the overall distressed market will become extremely compelling again and offer 20%+ potential returns.
When you are looking to allocate capital to a manager, what do you look for? Do you tend to allocate across smaller funds or larger funds?
We take a portfolio approach so it’s very important the individual component allocations fit together well. To some extent this means limiting correlation among underlying managers, each of whom has to bring something different to make it into our portfolio. We intentionally have a mix of small and large funds. Generally speaking our bias is for funds that use no or limited leverage; that don’t have 2008 legacy problems either in their portfolio or business; and have a stable underlying capital base.
With regard to individual manager decisions, like most allocators it’s important for us to understand what the particular manager’s “edge” is and get comfortable with the manager’s superior talent, ability to source ideas, integrity, commitment to best practices in back office and reporting, and passion generally for what they do.
In addition, three super important hot buttons for us are (i) interest alignment, (ii) risk management and (iii) world class investment process. If we aren’t 100% comfortable with these issues then nothing else matters. I’d note that process generally is under-appreciated among many investors. Great results come out of great process, period. We’re much more focused on seeing a rigorous, disciplined and repeatable process than we are on recent historical performance.
Continuing on allocation, when looking at your group of portfolio managers in which you have invested, how do you determine which manager will get the next dollar of your investor's capital? Does it depend on the underlying portfolio manager's strategies?
Yes, strategy is critical. Going forward I believe the best investors will distinguish themselves by being in the right strategies, as the environment will be ripe to reward certain strategies and punish others. While there’s no substitute for talent and motivation, a B+ manager in a strategy with substantial wind at its back will substantially outperform an A+ manager in a strategy with headwinds. I am extremely attuned to this in portfolio construction and it does heavily influence the allocation of incremental investment dollars.
It also drives occasional redemption decisions. Early this year I redeemed from a credit fund that generated net returns of 45% in 2009. It was a difficult decision in that the manager was talented and had really delivered for us. However, it was a long-only fund focused on a particular segment of the credit markets. That segment had rallied so substantially to the point that the opportunity set going forward no longer presented a compelling risk-reward profile– so I redeemed.
The other consideration that’s also critical is liquidity. Different funds have different lock-up and notice requirements and, at least in managing the Dislocation Fund, we have to make sure we don’t risk an asset/liability mis-match. This is less important in managing the family office portfolios but even there you want to make sure you are being compensated if you’re giving up liquidity.
Among the strategies in which you allocate capital (traditional long/short corporate distressed; DIP lending; merger arbitrage; asset based lending; fixed income arbitrage; asset backed securities; structured finance; and mortgage debt markets), where do you see the most opportunity today? The least opportunity?
Our strategy allocations are driven by the broad thesis that the dislocation experienced since the 2008 financial crisis will persist for multiple years, creating both opportunities (and risks). There are three primary drivers of our opportunity set:
(1) The wall of debt maturities – as discussed earlier there is over $1 trillion of high yield debt and leveraged loans coming due (nearly $4 trillion if you include mortgage debt). Much of this will eventually need to be restructured which feeds classic distressed debt investment strategies;
(2) The availability of capital is highly bifurcated: for companies large enough to tap high yield, credit is widely available -- but for companies with less than $50M in EBITDA and those looking for asset based loans credit is still extremely scarce. This creates opportunity for those managing direct lending and ABL funds to invest at the most senior, least risky top of capital structure but still get high equity like returns; and
(3) Certain strategies are positioned to benefit from the deleveraging because far less capital is chasing the spreads. An example of this would be low risk merger arbitrage where spreads are materially higher than what they were a few years ago because prop desks have shrunken and hedge funds have far less leverage available.
Over the next 12-18 months I think the most attractive strategies fall out of the 2nd and 3rd drivers – i.e. those that can be a provider of scarce capital and/or those benefiting from deleveraging. In particular I think direct lending, asset based lending and merger arbitrage are quite attractive right now – offering the potential to generate equity like returns without equity risk. In addition to the attractive return profile, if executed properly they are relatively low risk and, importantly, come with little or no correlation to the public equity or fixed income markets.
We know many emerging distressed and credit hedge fund managers will be attending the IQPC Global Forum on Distressed Debt coming up in September. We know many smaller managers have difficulty attracting the attention of fund of funds. Could you shed some light on things emerging managers could improve to better attract outside investor capital?
Fundraising is difficult for emerging managers. In my view the best positioned emerging managers are those with a differentiated strategy. If it’s not differentiated the bar is so much higher as new funds do have higher business and operational risk.
That said, the data is clear that as AUM increases manager returns decrease. Emerging managers could do a better job of highlighting this data – it’s strange but I don’t see it that often in emerging manager pitch books. Many talk about their ability to focus on off the run names but don’t necessarily draw the cause and effect relationship supported by empirical data. Good allocators should already be aware of this but I think emerging managers would be well served by highlighting it more. Emerging managers that are committed to capping AUM at a certain size for a defined period of time may also send a message to investors that they are more focused on generating high returns than on high fees.
Of course, in today’s environment an emerging manager has to be committed to best practices with respect to back office, operational and reporting functions. Operational due diligence has taken on a heightened level of importance and it’s easy to say no to a good investor with only mediocre controls. This can be challenging for an emerging manager who has less resources than a larger fund but nevertheless the emerging manager needs to demonstrate this commitment if they want to attract institutional capital. Likewise, having a highly credible Administrator, Auditor and Prime Broker is also important.
Finally, for me interest alignment is critical with all managers but even more so for an emerging manager. That means it’s often a non-starter if a substantial majority of the manager’s net worth isn’t invested in their fund. You take a little bit of a leap with any emerging manager but can get a higher level of comfort if the manager has a larger investment than you do in his or her fund and is essentially managing their own capital and you’re along for the ride.
When we do invest with an emerging manager we’ll generally start small and build the relationship over time.
You have been incredibly successful in setting up a number of investment partnerships. What is next for you?
Never say never, and I suppose it’s possible the umbrella I operate under could change, but at this point it’s hard to see me doing anything else. This is an incredibly fascinating time to be an investor. The investment landscape has changed dramatically since the 2008 financial crisis. There are so many opportunities and so many landmines, and the intellectual exercise of navigating that balance is more challenging and rewarding than anything I’ve done professionally to-date. I love how I spend my days. The challenges and uncertainty also place a higher premium on talent, which I hope accrues to my benefit.
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