Two Great Interviews with Two Distressed Fund Managers

Last week, Bloomberg interviewed two of the best managers in the distressed business: Avenue Capital's Marc Lasry and Knighthead Capital's Thomas Wagner. Knighthead was recently in the news for their position in Euro denominated Argentine bonds and Avenue Capital has made an appearance in many current bankruptcy situations including AMR, Newpage, and Houghton.  For those that missed the interviews, our notes are below:

Thomas Wagner, co-founder of Knighthead Capital

• There is over $300 billion of stressed and distressed debt just in the United States (excluding Lehman). Definition of stressed / distressed = loans trading below 80, high yield or converts yielding over 15%
• Means there are still a lot of companies in trouble. This is due to the fact that leverage was put on in anticipation of a robust economy that never panned out. Companies have been unable to grow into their capital structures
• Wagner is frustrated to watch the world's economies kick the can down the road and not deal their problems but it hasn't affected Knighthead's ability to find interesting opportunities
• Distressed investors that have been doing this for a long time (and have been successful at it) are astute at finding good "value with catalysts" opportunities in a variety of markets
• Best opportunities right now: Knighthead is finding a lot of new investments in the energy space broadly defined (coal, power plants). Shipping is a focus in which they were short the past two years but now are looking at opportunities on the long side. Still waiting for healthcare opportunities. Financials are an ever present opportunity since the crisis
• Knighthead thinks that there will be an increased opportunity set of opportunities over the next year and a half (which will used to soak up Lehman distributions)
• Knighthead's investments are many times businesses that right themselves (turn things around) and begin to operate better versus simply liquidate / go insolvent
• Discussed coal as an example: Coal companies need to go into bankruptcy to fix some of the inherent problems in their business (reduce contracts, right size operations). These business become healthier and stronger down the road as a result
• When the fiscal cliff / "day of reckoning" actually comes it will be an amazing investing opportunities. But Wagner doesn't think it is coming anytime soon. He anticipates some deal getting done, but not the grand bargain people are hoping for - and that in itself won't create a large opportunity set of investments
• By being in debt, you're investing with a margin of safety given its place in the capital structure. This is especially important when macro swings can affect things like growth and how companies allocate their capital
• "Investing in distressed at the end of the day is seeing through the uncertainty and trying to forecast how things look on the other side." - fantastic quote!
• It is all about free cash flows. Can a company generate free cash flow in a tough environment? If they can, you only benefit when normalcy returns.
• Knighthead typically investment in the top at the top of a company's capital structure. Not in the equity where they would be exposed to variability in cash flows and sales that can be swung around from macroeconomic factors
• Majority of most hedge funds' investors are offshore investments not subject to U.S. taxation (cited pensions, endowments)
• A fund's lockup must match its strategy. Knighthead has capital that is locked up due the timeline of their investments that require them to work through multi-year periods
• That doesn't mean they are only in illiquid securities - they are actually in liquid structure that trade everyday but they want to go from initiation of investment -> catalyst -> value realization
• On the question of uncertainty in the market: Wagner notes that the uncertainties that investors face have the prospect of making BIGGER impacts on investors than probably ever before
• Because of this, pushing investors like Knighthead (I assume he meant bottom ups players) to consider macro in their investment thesis
• Discussed in general the opportunity set in distressed financial liquidations and tier one investments in Europe with a legal nuance they find attractive

 Marc Lasry. founder of Avenue Capital

• A few weeks ago, Lasry led a group of hedge fund managers to meet with members of the Treasury and the National Economic Council.  Purpose: Gain a better understanding of the issues; brainstorm potential ways to come to agreement on the fiscal cliff.  Group included Republicans critical of the administration including Barry Sternlicht of Starwood Capital
• Conclusion: We need to get this thing resolved, regardless of political affiliation.  “Everyone who was there understands that taxes have to go up.”  
• Ideas that came from it: If taxes have to go up, where are the taxes going – that is the issue.   Tax Credit for businesses in exchange for hiring people and training them, use extra income to rebuild infrastructure and invest in the future, education etc
• Lasry thinks there will be a last minute compromise on fiscal cliff – How do you position your portfolio to take advantage of that?
• Normally, if there is a problem, you try to solve it as quickly as possible because it has an impact on everything you’re doing; you don’t wait for the last minute.
• Problem in DC – nobody wants to appear weak.  Perception game.  Will be harmful to economy, but that’s how DC works.
• Lasry is going into the end of the year with 20-25% cash (vs. average of 15%)  -- Hopes to take advantage of nervousness that deal will not get done and buy some things on the cheap
• When asked about the overall opportunity set, Lasry thinks that there will be upside surprise in the US:  “   
• 70% of GDP is consumer spending – if people are feeling better, they will spend more and that’s good for the economy. Consensus GDP growth was 1.5-2.0%; Looks now closer to 2-3%
• These numbers are ok for equity guys, but great if you’re a debt guy.  Debt guys happy with anything over 1.5%; Equity likes closer to 3-4%+
• Currently $1.2 trillion of distressed debt trading – very large number.  Huge amount of paper with a lot to do spread across many different industries and situations
• With an economy that is picking up, thinks distressed will do well in 2013
• In 2008 – 75-80% of HY market trading at distressed levels.  2009 – 31% with default rate of 5-6%; Today – 1% default rate; 26% of HY trading at distressed levels
• Larry goes on to talk about how difficult the environment is right now with interest rates close to zero, with your pension clients wanting an 8% return. Characterized it as a hard investing environment
• Pension and Endowments face a problem: In 2007, with 2-yr treasury at 4%, you could stay in cash and make half your “bogie” of 7-8%.  Market would expect Lasry to generate 15-20%, or 4-5x risk free rate -- The environment was a lot easier
• Risk free rate today is 25bps – Hedge funds (and pensions) have to generate 40x the risk free rate to make the bogie – and by the way, don’t take risk, and make sure its liquid.  Environment is substantially harder.
• The only way you can make money today in situations where the “perceived risk is substantially greater than the actual risk” - probably my favorite quote out of the interview; worthy of a post even
• Sees a lot of this in Europe – Perceived risk of whether the ECB will continue funding; Lasry thinks they will.
• People are demanding same level returns in a much more difficult environment.  Funds are taking on substantially more risk to achieve those returns
• There is a rush towards liquidity – everyone wants to be liquid.  The problem is, if you want to make money, you have to move to illiquid things because that is where there is less capital.
• In this environment, if you’re not providing returns, investors will move on.  If you want to keep your capital, you need to show investors that you are capable of finding those opportunities by looking where others are not.
• Europe – Where specifically are the opportunities? One year ago the opportunities were in: corporate debt, NPLs, private equity  Today: ECB gave banks access to liquidity and allowed banks to delever at their own pace. This in turn knocked out NPL market – can’t go out and by $2-$5bn portfolio because banks no longer feel the pressure to sell
• On private equity in Europe, Lasry doesn’t believe you’re receiving an adequate premium to invest in illiquid private equity over public equities. Avenue is therefore focused on corporate debt
• Avenue’s Europe portfolio is 90% senior secured securities. 80-90% Northern Europe, 10-15% Southern Europe
• They are buying loans between 50-75 cents on the dollar – being overpaid for the risk in his opinion. As long as Europe muddles through, you should be able to do very well in senior secured debt
• Lasry’s view is that Europe will take 2 years to play out, but the senior secured status gives you luxury that if it takes a little longer, you won’t get hurt
• Question: Thoughts on funds raised to invest in Europe.  Will that make opportunities disappear more quickly? Lasry thinks banks will be required to sell more over the next couple of years.
• Trillions of dollars of paper for sale in Europe compared with $10-$20 billion raised by funds and the capital raised is focused more on investing in real estate and equities vs. corporate debt
• You have to do your work.  “It’s not a macro trade, it’s a credit trade.”  Have to know the company, the legal system. Southern Europe – beautiful place to visit, but legal system is not there. Northern Europe – legal systems are more solid than the US