David Einhorn and Levered Equities

Last week, the Financial Services Authority released its transcript that they used (as evidence) to fine David Einhorn 7.2 million pounds in relation to Greenlight selling its stake in Punch Taverns after a conference call with Punch's CEO.  I have tremendous respect for David Einhorn and Greenlight Capital and am a huge fan of Einhorn's book Fooling Some of the People All of the Time.  I think opining on the subject matter at hand is impossible given the one sided nature of the news flow / information (i.e. FSA is in the power position here).  With that said, I thought one of Einhorn's comments on the conference call was quite interesting for our readers.

In the conference call, Einhorn comments on his opinion that on a levered balance sheet, the equity is really an option on the debt part of the capital structure:

"Right.  You know, it seems to me that -- that much of the potential attractiveness of coming and selling equity at this point stems from probably the fact that a few months ago the equity was at 40 pence, and now it’s at a £1.60 or something like this.  And so, it’s up from the bottom.  On the other hand, if you look back a couple of years ago, it’s -- the equity is really down a lot.  It trades at a very low multiple of the book value and, you know, the comp – the company -- the equity continues to trade as if it’s really an option on the debt side of the  capital structure.  That’s -- that’s the way that we look at it.  And we think it’s a very cheap option because of the types of things that you’ve been -- already been able to execute on, and I think that you’re going to be likely to be able to execute on, uh, going forward. I think that in -- if the equity was -- was overpriced and you had an  opportunity to reduce the financial risk of the company, I think it would make some sense to considering equity at that point.  But I think, if you just looked in a slightly different world and thought “Jeez”, if the stock had come from where it was and it had never gone to 40 pence but instead was sitting at 1.60, then 1.60 represented a new low, down from whatever previous higher price it had used to have been at, I don’t even think you would be considering selling equity at this point."

He then goes on to give a rule of thumb on how he looks at this sort of option:

I would say as a -- I would say as a rule of thumb, if the market capitalization of the equity is less than half of the face value of the debt, the -- the stock remains sort of in an option area.

In the previous cycle, and in previous letters, David Einhorn commented that Greenlight put to work capital in a basket of these sorts of options.  The basket as a whole generated a substantial gain.  In a letter dated January 19th, 2010, Einhorn, commenting on his "levered stub basket" which generated a 227% (!) return wrote:

"We bought small stakes in 22 companies in late 2008 that we thought would survive, even though they traded as if they would fail.  They all survived."

I ran a screen in Bloomberg using this aforementioned rule of thumb (excluding financials) on companies with a market cap of $100M.  The usual suspects turn up: HCA, Sprint, Hertz, CYH, CZR, lots of shipping names, RAD, HOV, most of the airlines.  Frankly most of these names are well studied and followed by the high yield community.  I wanted to get a sense of the weighted average (by market cap) return of these names this year.  I thought the number would be good - but didn't realize it would be this good:  17.3%. The biggest winners on the list were EGLE and HOV, followed by a number of ADR Solar companies and airlines.

There have been many academic papers written about the concept of equity as an option in regards to debt. Because equity is at the bottom rung of the ladder, as the value of the firm increases, the call option of equity becomes more in the money.  If a firm is liquidated, and you receive zero, you are out the premium you paid, which is in effect the price of the stock.  The exercise price in this example is the amount of debt outstanding.

In theory this is all well and good.  A better way to think about it, in my opinion, is to think of a number of expected values for a number of scenarios.  Let's use something like Hovnanian's equity.  We can construct a myriad of scenarios for recovery of the various parts of the capital structure.  For simplicity, let's take three examples:  1) Housing roars back, HOV crushes it and generates a ton of cash flow, 2) Housing meanders where it is, and HOV muddles along until it runs out of cash, 3) Housing falls off a cliff, and HOV is forced to liquidate.  As the probability of scenario 1 increases, the value of HOV's equity should also increase.  When the stock was at a dollar just a few months ago, the market's view of the plausibility of scenario 1 was very low, with the balance allocated to scenarios 2 and 3 which have more consequence for recoveries of the right side of the balance sheet.

There is a bit of wrinkle though with the above analysis:  The availability of credit dramatically influences the probability of survival for levered issuers.  As credit investors, we should always be on top of how "open" the debt markets are, specifically the high yield and levered loan markets.  Let's think of the absolute extreme scenarios:

1. Credit markets are completely frozen for everyone
2. Credit markets are wide open and any company, of any shape or size could issue debt

Under scenario 1, the default rate would spike to historic levels:  Remember, very few issuers ever pay off their debts - they just constantly refinance them.  Under scenario 2, there would be no defaults as companies could just issue debt to refinance maturities, plug cash shortfalls, etc.

The last few years have been amazingly volatile in terms of the openness of the credit markets.  Currently they are pretty open (again a 4ish on the risk spectrum), but still doesn't feel like early 2007.  But over the past 36 months we've seen credit markets that felt very frictional - only the best issuers could issue into the market.  And this volatility of the availability of credit is, in my estimation, a major driver of returns of many players participating in junior parts of the capital structure (include sub debt).  Unfortunately, this is a macro construct that is hard, if not impossible, to forecast.

Valuation is always of the utmost importance.  We want to buy 50 cent dollars all day long.  In a perfect world, with locked up capital, no redemptions, and no monthly/quarterly performance numbers to defend, we could do that and probably do a fine job at it.  Unfortunately, only few funds have that luxury.  With that in mind, at times like these when levered equities have massively outperformed the major indices, each of us should be watching closely the spigot that is credit for signs of a pullback that could ultimately hurt otherwise well positioned companies.