Distressed Debt Emerging Manager Series: Castle Union

In the past on Distressed Debt Investing, I have taken the time to interview emerging hedge fund managers - those managers just getting started running their books and who I personally think will be remarkable successes. I am pleased to bring you another such interview: Toan Tran and Steve White of Castle Union Partners. Castle Union will be focused on distressed opportunities and special situations - Toan and Steve's areas of expertise. The fund's goal is to generate strong absolute returns, uncorrelated with the market. For more information on Castle Union, please visit their website: Castle Union Partners. Enjoy the interview!

Could you two give us a brief run down on your backgrounds? How did you come together for the idea of Castle Union?

Steve: For the past few years, I managed a special situations fund at an independent RIA in Chicago called RMB Capital Management. The strategy was similar to the one we employ at Castle Union -- things like distressed and off-the-radar companies, although I would occasionally buy larger companies when warranted. Before that I was an analyst at a small hedge fund called Marlin Capital.

We met through some mutual friends who knew we were both members of the Value Investors Club. We quickly realized that we had nearly identical investment philosophies and interests, so we started talking more and more. Eventually we were effectively "working" together over IM most days, sharing ideas on various securities - Toan for his personal accounts, and me for my fund at RMB. After a while, we had collaborated on enough big wins that we said, "The two of us need to be in a room together, managing our own fund."

Toan: I was an attorney in a former life and distressed/special situation investing is something I’ve done personally for nearly a decade now. Finding way off-the-radar securities where you can make a lot of money because you’re the only one who bothered to read through a 300 page indenture suits my personality. Before Castle Union, my day job was in equity research at Morningstar. I headed the team of analysts that covered the technology industry.

Steve and I fit well as co-founders, both in our investment philosophies and how we want to run Castle Union as a business. Our guiding principle is that we want to treat our investors the way we would want to be treated if we were in their shoes, and I think you see that in our fund’s terms.

Pat Dorsey, who hired me at Morningstar, is now the vice-chairman of the Sanibel Captiva Trust Company. A Sanibel affiliate is a minority investor in Castle Union and we could not hope for better partners. Capital raising is a challenge as a start-up fund and this is an area where our partnership with Sanibel is invaluable.

Castle Union hopes to target smaller distressed and special situations opportunities. Do you think that market is ripe for potential investments in this space?

Steve: Based on the opportunities we've acted on, absolutely. I'm hesitant to discuss all of specifics at length since we’re not terribly interested in attracting more competition. However, it is surprising how little focus there is on smaller distressed situations.

One of our favorites is buying on the day of the bankruptcy filing, when there are forced sellers and ample liquidity. This is our “Big Puke” strategy. We love situations where people are selling something because they just need to get out, regardless of the underlying value. Investors end up selling because they cannot own bankrupt companies, or they believe the day of the filing is the only day when there will be enough liquidity (which ends up being a self-fulfilling prophecy), or bankrupt must mean worthless, plus all of the emotional factors that come with these things. There are times when the overwhelming majority of people aren’t doing much analysis when they place the sell order. Admittedly, a lot of the time there isn’t much to do, but occasionally a very attractive situation comes along.

Toan: We simply try to exploit the structural inefficiencies in the market and operate in those gaps. A large fund has the knowledge and resources to quickly understand a distressed situation, but is unable to meaningfully invest in smaller situations. What’s the use of allocating resources to a situation that at best may make up 10 basis points of the fund? That’s the gap we step into and where we occasionally find a real information edge.

For example, we were involved in the HearUSA bankruptcy and there was a court filing that hit the docket late one Friday evening. This court document unambiguously told anyone who bothered to read it that HearUSA shareholders were going to receive roughly $1/share as a result of a bid for the company’s assets. When trading opened on Monday morning, there was significant stock available for less than $0.50/share (we suspect the largest shareholder was liquidating its position). As you can imagine, we were heavy buyers that morning and the stock eventually closed at $0.90/share that day after the news of the bid hit Bloomberg about 15 minutes before the close. That entire day, the market was literally giving away free money to anyone who had bothered to read a simple court filing.

Who do you view as competitors in this space?

Steve: Most of the funds we run into are small and don't file 13F forms with the SEC. Of the ones we know, we've actually become friends and share ideas. We're not adversarial towards other funds, in certain cases we work together because it helps generate better returns.

Toan: Anyone who fishes in the same ponds we do, we would actually love to meet, so please get in touch. We’ve met a number of people in our distressed travels and these are valuable and fun relationships.

In recent years there has been an alarming trend in the hedge fund business where the larger funds have gotten large at the expense of returns. How do you view the future of emerging hedge fund managers like yourself?

Toan: We have committed to our investors to keep the fund, Castle Union Partners LP, permanently small because we understand our strategy is not scalable. We have a soft close at $100 million in AUM, where we will assess the situation. If we feel our asset size is hurting returns, we would not hesitate to close the fund and return capital if necessary. In any case, we have a hard close at $200 million.

Steve: In general, I think there are great opportunities for emerging manager fund-of-funds and family offices. For better or worse, there’s a hugely inefficient market for allocating capital to nascent funds. There are many startup funds that are run by exceptionally talented people who for a variety of reasons can’t raise much money. In some ways it’s almost exactly like the small, esoteric situations that we look at in the stock market, because there are structural biases that lead to the inefficiency. But that inefficiency creates an opportunity, and for the intrepid capital allocator there are some really interesting emerging manager hedge funds to investigate [loudly clears throat].

On the flip side, distressed funds need a certain size to effect changes in some of the companies they work with (providing financing, rights offering). How do you plan to manage the balance between being nimble and being available to maximize these sorts of opportunities?

Toan: You’re right -- many interesting transactions can be done privately in distressed. Even with our AUM now, we’ve had discussions to structure private transactions in very small bankruptcy cases. With $100-$200 million of assets, we would feel comfortable putting $10-$20 million in an appropriately structured transaction like a backstopped rights offering. If more capital was required, we would happily bring in our friends at other funds to participate.

Beyond private transactions, we are also willing to get actively involved to improve outcomes. I am currently serving as chairman of the official equity committee in the Trident Microsystems case and we have relationships with top bankruptcy attorneys. As you can tell by the tone of the interview, we try to not take ourselves too seriously, but when necessary, we are zealous advocates for our investors’ interests. Bankruptcy is at times a melee and we’re not afraid to be adversarial to maximize returns.

Which investors have shaped your collective investment style?

Toan: Graham and Buffett have to form the basis of any rational investment philosophy: the difference between price and value, the value of independent thinking, and the need for a margin of safety. I’ve also benefited from Munger, primarily his advice to never be timid in sizing a position when a major opportunity comes along.

Steve: My former boss, who trained me in security analysis, is a guy named Mark Egan. He established a small hedge fund in Chicago in 1989 called Marlin Capital. No one's ever heard of it since Mark prefers a low profile -- I'd describe him as a reclusive investment genius. He taught me the importance of looking beyond numbers in a spreadsheet and understanding that people will act in their own enlightened self-interest.

How do you think about concentration of your investments? Do you plan to run a net neutral book?

Steve: It's hard to be opportunistic when you've got net exposure targets, so we don't have them.  Net exposure mandates often lead to a bunch of low-conviction shorts. If there are securities we think will drop in value, we'll short them. If not, we'll just be long-only. It’s not a philosophy that many people are comfortable with, but it makes sense to us. Besides, many of our long positions have little correlation with the market, so we’re not trying to hedge long exposures.

Toan: We expect to the fund to have 20 or so positions, but be very top heavy. Our top five holdings, and by extension, best ideas will likely make up a majority of the fund. We will sprinkle smaller 1% or 2% positions in securities where we have a reasonable thesis, but there are uncertainties we cannot eliminate, but are compensated by highly asymmetric risk/reward. The Freddie Mac preferreds are an example of a smaller position we may take.

What happens when the two of you disagree on a particular investment?

Steve: If we disagree we just move on. We both have enough respect for each other that it doesn't bruise my ego when Toan says, "Steve, that idea sucks." which happens daily, if not hourly. If we can't convince each other to invest in something, it's probably not worth investing in. And if we miss something, so be it, the person who was wrong buys the other guy lunch.

Toan: I can’t remember the last time I had to buy my own lunch.

I will note that you have a unique structure in an incentive fee refund? What is the idea behind that?

Steve: Our fund is fairly unique in that we have an incentive fee refund if performance turns negative. It's a common feature for private equity funds, but virtually unheard of for hedge funds.  How hedge funds have managed to escape this, I have no idea. Recently, I've seen hedge funds turn to features like hurdle rates and scaling incentive fees, which are nice for investors but promote the wrong kind of risk-taking by the fund manager. The refund incentivizes the right kind of behavior for us: preservation of capital, selective risk-taking, and longer-term thinking.  It's healthy to be held financially accountable for losses.

Toan: The only thing I have to add is that we have the incentive fee refund because it’s the right thing to do for our investors.

Can you talk an investment you find particularly compelling today that fits into Castle Union's strategy?

Toan: We own Meru Networks (MERU), a maker of enterprise WLAN equipment (think WiFi for enterprises). MERU was a once hot IPO that peaked at over $27/share in early 2011, but fell on hard times as it embarked on a sales force expansion. We purchased the stock in the $1.60/share range where it bore many hallmarks of inefficiency: MERU was $30 million market cap broken IPO that was universally hated by Wall Street analysts.

In March, MERU appointed Bami Bastani as its new CEO. Bami was the CEO of Trident Microsystems and I met him through the Trident bankruptcy case. Given Bami’s strengths, I think it’s likely he was brought in to stabilize and groom the company for an eventual sale. In addition, MERU recently closed on $12 million of financing that gives the lender a $2 million “success fee” upon a change of control. Couple these factors with heavy insider buying on the open market, and all signs point toward a sale of the company within the next year or two.

The stock is up 80% since reporting Q2 earnings, but we still think it’s very attractive, given what MERU could be worth to a big tech company with established sales and distribution. MERU does $100 million in annual sales with 65% gross margins. A company like Dell could pay a multiple of MERU’s $65 million gross because Dell can rip out nearly all of MERU’s operating costs. We saw this same story play out with Isilon (acquired by EMC), 3Par (acquired by HP), and Data Domain (acquired by EMC), just to name a few examples.

Steve: Another idea worth mentioning is the Eagle Hospitality preferred (EHPTP). Eagle is a hotel REIT that was taken private by Apollo Group in 2007. Apollo orphaned the preferred and stopped paying the dividend in 2009, and the shares subsequently plummeted to a cent or two on the dollar. They trade at about $2.00 today with 4 million preferred shares outstanding.

Eagle owns 13 hotels that are performing surprisingly well -- well enough that they’ve been current on their $600 million in mortgage debt. That debt was originally purchased by Bear Stearns, and one of the Maiden Lane funds ended up owning it. Recently, Blackstone bought the loans from the Federal Reserve for about $470 million. Finally, it is worth mentioning is that there is an activist involved and the preferred class elected two directors to the board.

With the debt maturity looming in September, there are several scenarios that we could see playing out, but in most cases there seems to be an easier path than not towards the preferred seeing a recovery above today’s price. Recent hotel transactions on a price-per-key metric suggest that there could be substantial value for the preferreds in the event of a sale of refinance. There are a number of other complex issues involved that we are omitting, but the point is we believe this is an asymmetric opportunity.

Thank you two for your time and we wish you good luck with the fund.