Distressed Debt: MF Global Bankruptcy

This morning, MF Global filed for Chapter 11 bankruptcy protection in SDNY. For those interested in following along, the Claims Agent page can be found here:

MF Global Claims Agent Site

And the actual bankruptcy docket can be found here:

MF Global Bankruptcy Docket

Over the weekend, I heard from analysts and traders that MF Global was shopping their corporate bond portfolio via a dealer to large buy side institutions. This portfolio was not large to any extent, but it seemed like a desperation act that portended talks falling through. Then this morning, with the announcement from the New York Fed and ICE it was simply a matter of minutes before the filing was coming down.

For those interested, here is the intraday chart for the 6.25% of 16'"

I'd like to call that a wild ride. Initially it felt like short covering, then felt like people were buying a few bonds here and there to get involved. Of course, all this action happened before the New York Times reported that hundreds of millions of dollars in customer money has disappeared in the last few days (Update Tuesday morning - bonds opening 36-40 ie down 10-15 points):

"Federal regulators have discovered that hundreds of millions of dollars in customer money have gone missing from MF Global in recent days, prompting an investigation into the company’s operations as it filed for bankruptcy on Monday, according to several people briefed on the matter.

The revelation of the missing money scuttled an 11th hour deal for MF Global to sell a major part of itself to a rival brokerage firm."

For those that want to get into the gritty details, here is the org chart for MF Global:

To be fair, I am using the term "MF Global" too liberally. In fact, the SDNY filing is for MF Global Holdings, Ltd. (i.e. the ultimate holding company), and MF Global Finance USA Inc. (i.e. the intermediate holding company). Subsidiaries in the UK and Australia have also filed for their respective protection. On the other hand, MF Global, Inc, which is, in fact, the actual broker dealer, has not filed.

There are many, many flavors to play in MF Global:

• Holding Company Bonds: 1.875% converts, 9% converts, 6.25% senior uns (priced in August!), 9% senior uns (NOT guaranteed by subsidiaries)
• Extended and Non-Extended Revolver (2014 and 2012 respectively) (NOT guaranteed by broker dealer, but issued out of MF Global Finance USA Inc and the holding company as co-borrower )
• Secured Revolver of 2012 (at the broker dealer, and also guaranteed by holdco and intermediate holdco)

How did this all start? While I'm not going to blame "reaching for yield" on the filing itself, you have to wonder about some of the moves here. From the filing:

On September 1, 2011, MF Holdings announced that FINRA informed it that its regulated U.S. operating subsidiary, MFGI, was required to modify its capital treatment of certain repurchase transactions to maturity collateralized with European sovereign debt and thus increase its required net capital pursuant to SEC Rule 15c3-1. MFGI increased its required net capital to comply with FINRA’s requirement...

Dissatisfied with the September announcement by MF Holdings of MFGI’s position in European sovereign debt, FINRA demanded that MF Holdings announce that MFGI held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity, including Belgium, Italy, Spain, Portugal and Ireland. MF Holdings made such announcement on October 25, 2011. These countries have some of the most troubled economies that use the euro. Concerns over euro-zone sovereign debt have caused global market fluctuations in the past months and, in particular, in the past week. These concerns ultimately led last week to downgrades by various ratings agencies of MF Global’s ratings to “junk” status. This sparked an increase in margin calls against MFGI, threatening overall liquidity.

In actuality, back in May, MF Global listed $6.3B in holdings in European sovereign debt in their 10K. In their recent earnings call, the company laid out specifically what they owned:

Here is what Jon Corzine said on their Q2 2012 earnings call just last week:

"Now let me turn to a subject which has understandably clouded perceptions with respect to our profits, that is our repurchase to maturity sovereign positions as noted on slide five. As we have pointed out over the past year in our disclosures and quarterly calls, we have taken advantage of the dislocations in the European sovereign debt market by buying short dated debt in European peripherals and financing those securities to their exact maturity date. Therefore, the term repoed to maturity.

The spread between interest earned and the financing cost of the underlying repurchase agreement has often been attractive even as the structure of the transaction themselves essentially eliminates market and financing risk. At the inception of these positions, we made the judgment that the securities we financed to maturity would repay, given their high credit rating and short duration – that is all securities mature before 12/31/2012 – and later reinforced by the commitments of European and international institutions in supporting the solvency of the issuing countries. Again, in the timeframe of our exposures, the full RTM portfolio we hold is seen on slide five. We specifically tiered the maturity of our holdings to reflect credit ratings at the time of inception, and reassessed our risk based on the EFSF and IMF support programs, that significantly enhanced the probability and the ability of Portugal and Ireland to meet their obligations on schedule, again, within the context of their maturities, in Ireland and Portugal's case, June 2012.

The positions in our portfolio of higher rated countries, Italy, Spain and Belgium, have also benefited from support from European institutional actions, although not direct solvency packages. These same countries' credit positions are now the subject of the ongoing public debates taking place regarding future systemic support from the European community. Again, in the maturity timeframe of our holdings, 12/31/2012, we expect any of the actions proposed to give additional support to an already strong probability and ability of these nations to meet their obligations.

So, in short, our judgment is that our positions have relatively little underlying principle risk in the timeframe of our exposure. We continually reassess that judgment and are prepared to take offsetting actions if conditions or circumstances change. We are not adding to this portfolio and we will allow it to roll off as the staggered maturities are reached. I would also note that we carry little exposure to these countries' banking systems and no derivative exposures dependent on a country's credit worthiness.

In addition, consistent with prior quarters, there is no mark-to-market associated with the derivative value of these positions.

Overall, the Debtor stated in the disclosure: "Debtors submit that the Company had consolidated assets and liabilities, as of the quarterly period ended September 30, 2011, of approximately $41.0 billion and $39.7 billion, respectively."

Here is what is concerning to me: The automatic stay does not cover repos in bankruptcy. In effect, the counterparties to MF Global's $6.3B European investment, or any other asset financed with secured repo, could go out in the open market and sell it to get their money back. Given the amount of leverage here ($41 billion of assets, versus $1.3B of equity), it doesn't take many trades at 95 cents on the dollar to wipe equity away from the firm.

Another interesting tidbit: Skadden Arps who is representing MF Global in the Chapter 11 filing also represented Refco during its bankruptcy. Man Group won the bankruptcy auction of Refco's customer accounts paying 7 cents on the dollar per customer account ($323 million total consideration). Man Group then spun out MF Global in 2007, so in effect we are all at the Refco assets once again.

For those looking to brush up on your Refco knowledge: Key Refco Bankruptcy Documents

The problem with a situation like this is that the longer it takes for the company to sell all or parts of its business, the faster the business value declines. But there is value here if customers stay. MF Global can be thought of two different sorts of businesses: A broker dealer and a futures commission merchant. To me, the value really lies in the futures commission merchant as we've seen a number of broker dealers shutter its door in the past few months, and any potential purchasers would have to take the aforementioned Eurozone sovreign risk. On mitigating factor here though is that as customer accounts leave the door, assuming no mark down on repos sales, MF will be required to hold less capital. In fact, if MF sells its entire futures business, it could free up a substantial amount of capital depending on how the deal was structured.

Complicating things further are the subordinated intercompany loans granted to the broker dealer from MF Global, LTD ($130M) and MF Global Finance USA Inc. ($425M). These are assets of these entities and assuming residual value flows up from MF Global, Inc, this would factor into the recoveries of the various securities -> hence why the extended and non-extended revolver are trading at a premium to the unsecured bonds and converts (i.e. the credit facility benefits from the MF Global Finance USA Inc.'s $425M intercompany loan whereas the bonds do not).

Net / Net, I'm still working through this one (and jamming on the Tribune decision, which I'll post on tomorrow). Questions I am working on really revolver around a range of values for both the future commissions merchant and the broker dealer (which ultimately depends how many accounts are still in the building as it were) and how a sale could free up required capital.

If you are working on this one, would love to hear from you. Fun times.

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On Sell Side Research...

Over the weekend, in response to my post regarding the CSFB's Special Situation Conference, a reader sent me this lovely sentiment (my redaction):

I think this conference should be renamed the "annual clear our ****** inventory conference"

In Security Analysis, Ben Graham wrote this:

Advice from Investment Banking Houses: There are objections of another kind to the advisory service of an investment banking house. An institution with securities of its own to sell cannot be looked to for entirely impartial guidance. However ethical it aims may be, the compelling force of self-interest is bound to affect its judgement. This is particularly true when the advice is supplied by a bonds salesman whose livelihood depends on persuading his customers to buy the securities that his firm has "on its shelves."

Do not get me wrong: Some of the best business analysts and close friends of mine work on both the dealer and broker side as desk or publishing analysts. A number of them have made legendary calls and pointed me to situations that I wouldn't have taken a second look at if it were not for his / her recommendation.

But investment banks and brokerages make money off of trading. If a hedge fund has a large block of 30-50M bonds that they would like to sell through a broker, I can pretty much guarantee you that that broker will be putting out some piece of literature at the very least advocating some of the benefits of the investment. On the dealer side, research analysts sometimes have functioned as the analyst for the prop book which leads to a whole other series of conflicts.

With that said, a buyer of a security needs to ask himself "Why is the seller selling?" If its for uneconomic reasons, the buyer, in theory, should have an advantage in the situation. But if it is not, a buyer needs to tread carefully as a seller has probably held the position significantly longer than you have researched it and therefore has a sort of informational advantage. Of course, this informational advantage could tilted to erroneous opinions or biased by behavioral finance concepts discussed in the past. Which is all the better for the buyer.

When I am researching a situation, this is a typical sequence of events:

1. Read all Ks, Qs, 8ks, proxies
2. Read all transcripts from quarterly reports, events, etc
3. Read news items about specific company and competitors going back the past year +
4. Talk to competitors, people in the supply chain, former employees, etc
5. Determine a reasonable set of assumptions for business and the associated value of the business. Write these numbers down before proceeding to step 6.
6. Talk to the sell side/ read sell side reports to see if the "market" assumptions are dramatically different than my own
7. Buy / Sell

Of course, this is somewhat simplified, and I can't give away all my tricks, but the reader gets the point. In no way, shape or form, am I using a sell side recommendation of overweight, underweight, buy, sell, etc in my purchase decision. Instead, I am using the sell side to provide the market sentiment on a particular name which is inclusive of concerns the larger investment community might have for a situation, assumptions for growth going forward, opinions on future capital allocation decisions, etc.

There will be disparity in these numbers. In the Nortel case, before they sold the IP to the consortium, you could read 6-8 different reports with values ranging from the stalking horse bid of $800M to $3 billion. That is the market assumption. If it comes in at the high end of that range, you'll do ok. If you it comes in the low end of the range, you'll probably lose some money. But if you did your work and came up with a number closer to the actual purchase price, you had a winner.

Julian Robertson used to invite two sell side analysts to Tiger Management to come in and talk about the same situation at the same time. One of these analysts would be a bull, and the other bear. Julian would sit back and listen to the prevailing argument and soak up tons of information on not just the underlying businesses, but also what the positive and negative scenarios were. Every time you look to purchase a security, you should have the intellectual integrity to say to yourself "How could I be wrong...what is the bear case here?" Charlie Munger is famous for recommending the simple, but rarely implemented advice of, "Always invert."

Under the "Always Invert" doctrine, what makes a great sell side analyst?

• Instead of conflicts, he/she would always be independent
• Instead of opinions, he/she would provide the most salient, unearthed facts that no one else was talking about
• Instead of hugging the consensus or guidance, he/she would step out and make a call that was bold and unique
• Instead of pitching the same ideas investors hear every day, he/she would present unique situations to investors
• Etc Etc

Some analysts already do this, and these are the ones that will most receive my business. If you have any thoughts on the great analysts out there (on the high yield / distressed desk & publishing side), would love to hear them (hunter [at] distressed-debt-investing.com)

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CSFB's Special Situation Conference

Yesterday, CSFB held its annual Special Situation conference. As usual, the event showed me the sheer number of people I have to compete with on a daily basis in distressed land. I saw a run from a CSFB trader that mentioned there were over 700 people in attendance! That's a lot of capital chasing after a fairly small set of opportunities. Nonetheless, I have the utmost respect for the desk analysts at Credit Suisse and think they are some of the best in the business. Because there was a multiple series of tracks going on, I couldn't make it to each of the presentations. With that said, for those that are interested in the names the desks are talking about these days, here are the list of credits that were discussed:

Lightsquared

AMF Bowling

Penton Media

Quiznos

Contech

Spirit

Marsico

Coach America,

Oriental Trading

Cargo 360

Wastequip

Yellow Roadway

Hawker Beechcraft

Vitruvian

US Powergen

Education Media

ATPG

OTE

Norske Skog

Tronox

Harrah's

TXU

Clear Channel

Cengage

Travelport

Eastman Kodak

Lehman Brothers

First Data

EIX

If you were in attendance, and thought one of the presentations was particularly compelling, and would allow me to use your notes (anonymously of course), it would be greatly appreciated. More importantly, I would like to post on each of these names (excluding the ones I/affiliated parties have an interest in) and would love help from other distressed analysts. If you are interested, let me know.

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Longacre's Vladimir Jelisavcic's Presentation on Dryships

A few weeks ago, we discussed the opportunity set in the shipping sector. This week at the Value Investing Congress, Vladimir (Vlad) Jelisavcic, a founder at legendary distressed debt firm Longacre, did a remarkable presentation on the situation at DryShips and Ocean Rig UDW. I've spoken to Vlad a number of times and have always come away impressed by the due diligence he brings to the table. Longacre has been in the news as of late, but nonetheless, I have no doubt that with work and ideas like this, we haven't seen the last of this strong group of talent. And here's to hoping Brecker keeps the end of year distressed parties going.

Enjoy the presentation (hat-tip to Market Folly)

Vlad-Jelisavcic

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Randy Smith of Alden Global

Last week, DeMatteo Monness invited clients to hear Randy Smith of Alden Global Capital talk about his current views on the distressed debt and broader market. Moderated by Jim Grant of Grant's Interest Rate Observer, Randy touched on a number of issues pertinent to the current investing landscape. For those not aware, Randy Smith is a legend in the distressed debt world. He, and Alden Global, have participated in a number of prominent restructuring in the past few years including Tribune, Visteon, Reader's Digest, Journal Register, Freedom Communications, Lehman Brothers, and Philadelphia News. This is the first time that I have heard him speak and it was an absolute pleasure. Simply amazing. Here are some notes I took during the evening:

Randy Smith of Alden Global Capital

• When comparing the current marketplace versus 2009 and 2007, Randy believes this market has "uncomfortable similarities" to 2007 with shades of 2008. A key, and ominousness factor in that pronouncement is the largess of undifferentiated risk in the market. In essence there is no different between good and bad securities - everything goes up and down with very high correlations. This reminds him of 1987. During that entire year, it was very similar leading up to the market crash in October. This sort of situation can only go on for so long.

• Today, there is a kind of shutting down of some parts of access to capital for certain troubled companies. In contrast, in 2007, anyone could access the equity or debt markets to alleviate troubles. Right now, if you are in good shape, you can borrow at very good rates. If you are in mediocre shapes, you can still borrow, but at high rates. If you are in bad shape, you can't borrow. You're shut out. If this lasts for much longer, we'll begin to get a big upsurge in distress.

• Looking at trailing default rates is not the thing to do. What you should do is figure out what are the conditions that will prevail in the coming period. If a maturity is coming up, and the window is shut, that provides real opportunities for rescue financing and distressed investing.

• Some situations they are involved in today: Gannett, Lehman, Delphi, Tribune. All these are "really, really good."

• The long thesis for Gannett ($GCI): GCI is the most undervalued security that Randy knows of. It's trading at a stable 30% free cash flow yield. Only $2 billion of debt. It has a newspaper operation, for which it is unfortunately known, which attaches a stigma to the company. The newspaper operation has very healthy free cash flow and $700M of EBITDA. $4 billion valuation for the newspaper. It has probably the best collection of network stations in the country (20 stations). EBITDA going to $430M next year driven by the good political year (big source of advertising). Recent trade at 10x EBITDA, implies $4 billion value for the stations. Then they have $2 billion of digital assets (Career Builder, Classified Ventures). Aggregated value of $10 billion, less $2 billion of debt or $8 billion of value versus a $2.5 billion market cap. If you look at it that way, very cheap.

• What should Gannett being doing? Paying a big dividend perhaps. They could literally buy back a 1/3 of their shares each year. One thing that Randy thinks they should do is spin off their TV operations b/c it's being valued like a newspaper. They could also sell USA Today to someone who wants a national newspaper. There is an awful lot they can do. So far management has only made small moves in these directions. They just had a management change so maybe new leadership brings real change to the company.

• Question: Is distressed debt investing facing too much competition from very cheap blue chip stocks? In a way that is true, but in most things we do there is some sort of catalyst (Delphi = IPO, Lehman and Tribune = processing through bankruptcies). Though in 1974, things like Royal Dutch was trading at 2x. But back then it was a fruitful times for both distressed and value investing in general.

• Question: Thesis on Visteon? Alden didn't have the cards to sustain a serious fight to unlock shareholder value. The board coming out of bankruptcy was not fighting for shareholder value. Alden was able to nominate 2 additional directors to the board. The values are huge at Visteon. It has a European and US automotive business that are low margin, but has a great business in Korea and an even better business in China. Management has been Detroit-centric though - they should be operating in Asia. There are simple things they could do to unlock value, and Randy is opening to do that.

• Question: View on macro environment and the how it affects Alden's investment process: Randy Smith ideally tries to look at distressed from a micro basis. Their expertise is looking at a particular credit or company and assessing the risk and if that risk differs from the current perception as expressed by the price. With that said, you can't divorce yourself from the macro environment. Even if Gannett is very, very cheap, if there are significant defaults in Europe, and if that spills over to the U.S. it will adversely affect Gannett.

• Question: Are you looking in Europe? Alden does not have a lot of the long side in Europe; more on the short side. They are long sub debt in Lloyds and Commerzbank bank. It seems to Randy that we have a ways to go before the Europe situation is corrected and they have a real chance to do something. European banks are going to be selling assets and those will be an opportunity.

• Question: Are you looking in Asia? Like in Europe, they are short a "fraud bucket" and "property bucket" in China (stocks and bonds). Alden thinks they have differentiated between them and really found ones that have accounting problems. They first started with the reverse mergers and then began to realize the companies in Hong Kong have the same problems. A lot of the successful enterprises in China have been private or state-owned. Right now, we are seeing an undifferentiated BUYING of those companies, albeit from a low basis. They are buying the good and bad - similar to the high correlation that he discussed earlier.

• Question: Thoughts on U.S. Banks? Alden has been in and out of banks. They are currently out, not because they are expensive (he thinks they are VERY cheap). On their basis business they are very cheap. Even understanding, the business model has been adversely affected by regulation, they are still very cheap. With that said, its pretty tough. Banc of America is being attacked by the government on all fronts. AIG, Freddie and Fannie (all three U.S. owned companies), and state's attorney generals are suing them. That is hard to fight against. That will wane shortly. Randy was expecting a selling climax in October or maybe as late as November, and that would provide them an opportunity to get into the banks at the end of the year at an even better price than today. The internal debate is to buy them now or wait for a washout. He is betting on a washout now.

• More questions on European banks: Long the Lloyds must pay bonds. Lloyds is in pretty good shape. Though people are worried that the sub bonds, like Allied Irish, will be forced into equity but Randy thinks that is unlikely in the case of Lloyds. Conversely, they are short banks in Spain, Greece, Portugal - particularly in those countries, the solution there is going to be nationalization or some kind of national contribution to equity that will be massive dilutions to the current stockholders.

• Europe has the wherewithal to solve their problems. The solution is on the way with the under-capitalization of the banks, THEN they can deal with Greece and maybe Portugal. Ireland is not even on the table. They have to then defend Spain and Italy. It will require a lot of money - maybe even a trillion dollars. He thinks though they've shown a hesitancy to act aggressively. It will not be a neat solution - it will be a bumpy road that at times will be scary. He thinks their hand may be forced by some untoward event like Dexia. Something that is off the radar screen that could force the timetable. It's solvable, but fraught with possibilities of shocks in between.

• Question: Can you summarize your bullish views on newspapers? The first thing you need to accept is that print is declining. What's good though is the digital migration. The decline in print revenues is being offset by the increase in digital. In addition, newspaper companies have a lot of assets that probably aren't being fully utilized and could be sold off. Across the board, newspapers are cutting costs very rapidly and most have positive free cash flow due to the low capex requirement of the business.

• Question: What worries you the most? Randy is worried about a washout coming from left field. Something off the table that no one is talking about now. Maybe the Mideast which has somewhat died down in the news as of late? Or a bank or major fund blowing up. He doesn't know, but he expects the shock to come from something that no one is reporting on today.

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What type of value investor are you?

Geoff Gannon wrote a great article over the weekend entitled "The 4 Questions to Ask Before Buying a Stock." In the post he writes:

"I think there are really 4 questions you answer before buying any stock:

• Is it safe?
• Is it a great business?
• Am I getting a great price?
• Can I hold this stock for as long as it takes?

The ideal stock would get 4 “yes” answers."

He then goes on to and compares prominent value investor Monish Pabrai to Ben Graham in relation to their value investment styles:

"A lot of differences in style come down to how you answer these 4 questions. Someone emailed me saying he thought Mohnish Pabrai was more of a Ben Graham investor than a Warren Buffett investor.

Not really. Graham was obsessed with question #1. He wanted to know a stock was safe. Pabrai cares less about #1 and more about #3. Pabrai’s overwhelming focus is on getting a great price.

Graham wanted a great price. But safety always came first.

There are stocks Pabrai has owned that Graham wouldn’t. Nothing wrong with that. Different people invest differently.

We all rank these 4 questions a little differently. We obsess about one. And our standards are a little too loose on one of the others."

As investors in distressed debt and post re-org equities, many of the businesses we are buying into are not great businesses. Eastman Kodak, one of the topics du jour, is not a great business. In a very, very old memo from Oaktree's Howard Marks:

"We are less concerned with the absolute quality of our companies than with the price we pay for whatever it is we're getting. In short, we feel “everything is triple-A at the right price”. We have many reasons for following this approach, including the fact that relatively few people compete with us to do so. But we feel buying any asset for less than it's worth virtually assures success. Identifying top quality assets does not; the risk of overpaying for that quality still remains."

Of course, this is, on some level, a matter of personal preference and client needs. For example, I run an equity portfolio for a client whose investment mandate is quality, quality, quality. Some of the best companies in the world are in that portfolio, and luckily, I can sit on my hands for a long time before putting money to work due to the long term nature of the capital. That enables me to buy at a FAIR price; not a great price, but a FAIR price where I expect to earn mid teens return on capital.

My father-in-law loves talking about stocks. He has no conceptual understanding of free cash flow yields, tangible asset valuations, or anything to give him a semblance for a range of values a security is worth. He understands businesses (he runs one), is terrified of debt, and can hold securities for a long, long time. In essence, he has ticked off 3 of the 4 requirements mentioned above.

Does that mean he will be successful? Far from it, because price, more so than anything, is the single largest determinant of investment success. If you overpay for the best company in the world, your results will struggle. If you pay a fair price for the best company in the world, you will generate fair returns. And if you pay a remarkably low price for the best company in the world, and can sit and watch the company compound your capital many times over, you will get remarkable results.

But those situations are few and far between. The greatest investors will inevitably be the ones that find those situations and bet the truck as it were. Under that caveat, it then becomes a situation of playing to your strengths.

Some of us are better business analysts. I am often amazed when I go to small group management meetings and analysts are asking questions that floor with me an outstanding level of detail. Things not talked about in the news or analysts reports that require an intimate level of understanding of a business. While I am impressed with this skill and the level of due diligence it requires, I worry that analysts and portfolio managers lull themselves into a sense of security because they know everything there is to know about a business. Or worse, behavioral finance starts coming into play, and people become tied to / in love with their ideas and do not want to see it leave the portfolio, or worst, not enter the portfolio after hours and hours of research has been poured into the idea.

"Is it safe" is the question credit and distressed debt analysts are most likely to have an edge relative to their equity counterparts. We know capital structures. We know covenants. We can adjust EBITDA for credit agreement add-backs. We can calculate restricted payment baskets. We know what a permitted investment is and the implications of leakage of collateral. We read security and pledge and guarantee agreements. We try our best to ascertain how much we can be primed. We understand when underwriters are trying to be sleazy with change of control agreements (i.e public company carve out). Playing up in the capital structure is our best defense to maintain "safeness."

"Can I hold this stock for as long as it takes" is a tricky one. Why is locked up capital the best sort of capital? You can wait. One of my favorite investment stories is Carl Icahn's investment in The Stratosphere in Las Vegas. In 1997, he bought a controlling position in the mortgage bonds at a discount to par. He spent some money on the casino, bought a number of other casinos at a discount, and then waited. He waited 10 years until gaming multiples were through the roof and then sold the operation to Whitehall (an affiliate of Goldman Sachs). And made nearly a 10x return on his equity. Now if Carl had serious issues in the market rout of 2002, he may have had to sell the property to meet fund redemptions, and thus forgo an impressive gain.

We never really know WHEN our investments are going to work out. It's why so many funds are labeled and run with the "value with a catalyst" as a moniker. The catalyst serves as a stop gap on time and hence lowers the risk of selling out at the lows. Further, catalysts, generally speaking, create probabilistic scenarios with expected value ranges that will vary wildly among market participants. And again, generally speaking, these situations are market agnostic which dampens volatility of a portfolio which is something many fund of fund, endowment, and other large capital allocators are looking for in managers.

Finally, some are better than most at estimating intrinsic value of securities. This can be in the run of the mill S&P 500 company, or it could be the liquidation of a distressed issuer. When you read any news report or sell side research piece on Eastman Kodak, inevitably someone will be quoting or re-reporting on the valuation of an "IP Expert." Different businesses should be valued differently. One person may value XYZ company one way, while another may use a whole different set of metrics, and come up with similar valuations.

And let me be clear: I am speaking about a range of values. The conceptual underpinnings of a "price target" flabbergast me to say the least. How can you be so convinced this stock is worth $20 dollars a share? If you change any multiple, or revenue growth forecast, or margin assumption, on the order of basis points, that number is going to change. Better to be approximately right than precisely wrong. (Caveat for credit analysts: I can conceptually understand when you say a price target on a bond is par because you think it gets paid off). To me, on a vanilla company, this range will come from a conservative multiples of run rate cash flow (derived from conservative assumptions on things like margins).

Naturally, you are to buy securities at prices BELOW the low point of these range of values. That is hard to do many times, but with patience, and a terrified market, good things can happen. "What is priced" in is a question we should all be asking ourselves in every investment. If lots of future growth and margin expansion is priced in, you may want to avoid. And if you every bad aspect of a company is touted relentlessly by the buy-side and sell-side peers alike, without regards to price, well that is something you may want to get up to speed on.

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Having Fun Yet...Part III

In early August, I wrote: "It still feels like to me that high yield credit just hasn't felt near the pain of equities on the aggregate or on a single name basis." I can confidently say that that pain is now being felt in the high yield market.

Whether it be the story about credit funds that had a currency overlay selling to meet redemptions on a ridiculous Brazilian Real move, or the fact that dealers are carrying VERY low inventory right now and the market is very illiquid, or maybe the research piece from Moody's citing certain credits with significant refinancing risk through 2015, or the opinion that the entire world is repricing risk - this market feels night and day versus early August.

One of the best buy-siders I know told me a few weeks ago that the head of his fund organized the entire investment team and said: "There are easier markets to make money in." Whitney Tilson, of T2 Partners, stated in his most recent email that they are "hearing a large number of hedge funds are going to cash, unable to figure out this market and trying to avoid further loss."

This market is clearly treacherous. You hear the term "being pretzeled" thrown around frequently. Just look at the S&P 20 day intraday chart, capped off by today's out of no-where really to finish the today hugely positive:

Pretzeling is effectively getting short and long at the most inopportune times. Right when the market is crashing, and you put on shorts to protect yourself, you get whipsawed by a ferocious rally. I also like the term "getting your face ripped off."

Most certainly, the macro environment (Europe specifically) is the tail wagging the dog as it were. The Reformed Broker put up notes from a speech Jeff Gundlach gave at the New York Yacht Club. Regarding Europe:

"I don't know what's going to happen in Europe but there is one thing I am certain about - eventually, someone is going to take a big loss. As investors, the most important thing we can do is to make sure that we aren't the parties taking that loss."

I do know, that watching the crisis unfold in Europe is like pulling a bandage off at a snail like pace. It's frustrating to say the least. The last thing the market likes is uncertainty - and I, in my career as an investor, have probably never seen a situation that was both so uncertain and had such a large ramification on investor risk appetites globally.

Moving back to high yield, today on CNBC, Jeff Gundlach had this to say (you can see the entire video here Jeff Gundlach on CNBC):

"We are getting to where it is not easy anymore. We talked about 6 months ago - it was so easy to avoid this junky credit. I remember in March and April, we were talking high yield bonds and CMBX was the most overvalued in history and it was easy to avoid. Now, it has dropped so much, the way we look at it at Doubleline, from a valuation perspective, junk bonds are actually cheap now...

Now is the tough part, because the valuation is there, but the technicals and the momentum are terrible. And because of that, it is too early to buy. It is now very difficult because the valuation side of it is supportive of the market.

But I think that this thing is going to get a little bit cheaper, particularly as we move forward and we rethinking the earning and default situation, which won't be an imminent turnaround, but when you think about late 2012 or 2013, you are going to be facing higher default rates. And its just not that likely that you are going to get a sustained rally in credit, when defaults are about to move to the upside. It's too early to buy, but the valuation is okay. It's a lot trickier now."

Like the shipping industry pieces I was reading a few weeks ago, the general sentiment is that while the market is cheap, the next move is lower. If you read strategy pieces across street, you hear that general sort of theme. This is what Peter Acciavatti said in his most recently high yield strategy piece:

"On the one hand, high-yield bonds and loans look cheap on a relative value basis, effectively already pricing in a high chance of a recession—current high yield bond spreads estimate a 60% chance of recession versus our economists placing the odds at 40%—while implied default rates for bonds and loans based on today’s spread levels are 8.5% and 16.7%, respectively, versus our belief that default rates, in the event of a recession, would only rise to 5-6%. On the other hand, regardless of any perceived value, both markets remain vulnerable to further selling pressure in the near-term while broader market volatility and uncertainty remain extremely high."

Yet, then he goes on to say:

If we extend our focus to longer holding periods of one to five years, high yield if purchased from a spread base of 800bp has historically performed quite well. For example, high-yield bonds have provided average annualized returns on a one, two, three, four, and five-year basis of 10%, 14%, 14%, 13%, and 12%, respectively. During the 1-year horizon returns were positive in all 6 examples, albeit with nearly flat returns in the 12-months following the October 2000 and June 2001 examples, a result of a market enduring fits and starts amidst the 9/11 terrorist attacks and corporate fraud situations in 2000 and 2001. Notably, if you had invested in high yield bonds in September 2008 as spreads were first crossing 800bp, you would have endured spreads widening to a record high 1900bp during the next 12 months and still managed to record a +5.7% return."

I will be the first to tell you that it will be hard to replicate those two, three, four and five year average return numbers simply because the curve is so tight and (I have been saying this for a 6 months now) is business fundamentals improve, in theory the treasury curve will widen causing a headwind for long term total return numbers. And on the flip side, I do not see a massive forced seller of credit / distressed credit that we saw coming from Lehman's prop book in 2008, so spreads probably don't widen to post-Lehman levels.

Nonetheless, it is hard for an investor that must report monthly returns to investors to be anything but myopic.

Here is my favorite chart on the current sentiment of the high yield / distressed market:

This is a chart of the number of distressed issuers traded on Trace (a distressed issuer is defined as a company with a bond trading 1000 off the benchmark treasury). The chart is probably worse than this because a number of bonds are being quoted way too high. Nonetheless, relative to the same chart just 6 weeks ago, you can see sentiment is getting worse and assets are getting cheaper. What has astounded me is the number of news stories about restructurings / distressed exchanges hitting the tape: AMR, HOV, GMR, EK, etc. A distressed investor has A LOT to do these days.

What am I doing? As usual, up in the capital structure, with large margins of safety. I even bought my first primary secured bank deal in some time in the past week. I've bought some over-collateralized EETC at low double digit deals recently, some stressed pieces of first lien bank debt, and a few DIPs that I never got fully allocated on. I'd expect the average return on those assets to be in the 10% range with little downside risk - acceptable in the face of what Jeff Gundlach was referencing above (i.e. higher defaults coming down the pipeline).

If a full allocation was a strong nine-inning game, I'm probably just finishing the third inning in terms of allocating capital. In terms of unsecured pieces of paper / equities, I've bought one bond that has gotten unfairly walloped due to its exposure to China, and bought one or two high quality equities, and a few insurance stocks, where I think a recession and low rate environment, respectively, are more than priced in. My largest PA investment, well known on the Distressed Debt Investors Club, is a liquidation play where the deal is closed, and my recovery will be higher than today's stock price - I'm just waiting for the cash now.

The pendulum has swung to a real level of anxiety in the market. I wouldn't say all out fear yet and think a failure or three of large European institutions (triggered by a surprise Greek default perhaps) would be the tipping point as it were. Though a Euro-bond is just as likely: markets rally hard on that news, and risk taking is back on the table. Even with that though, defaults in the high yield market is increase precipitously over the next 36 months, and the astute investor who understand the landscape, should be able to make better risk adjusted returns than today. Still though, there are, in my humble opinion, investments TODAY, that will provide you both a return of capital and a sufficient return on that capital, with large margins of safety. Just have to dig to find them.

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