About a year ago I was introduced to Prasad Phatak and Chris Koranda of Tappan Street Partners while working through the valuation of an off the run distressed situation. I was immediately impressed by the depth and intelligence they brought to the conversation. After getting to know them, I thought they would be a great subject for our next emerging manager series. Enjoy the fantastic commentary below!
Talk about the background of Tappan Street. How did you guys connect?
[Chris] We’ve known each other now for about 13 years. We were in the same section—actually the same group in many cases—at the Undergraduate Business School at the University of Michigan. Incidentally it’s also the origin of the name Tappan Street Partners: 701 Tappan Street is the address for Michigan’s business school. Basically, for the first few years Prasad and I look the same on paper. We both were undergrads at UofM. Then we both went on to Blackstone, with Prasad in the Restructuring and Reorganization group and me in the M&A group. After that Prasad spent about 6 years at Eton Park in the US Fundamental Long/Short team and I spent a couple years at Perry Capital in the Healthcare group before going on to get my MBA at Stanford. During the course of looking at potential employment opportunities post MBA and finding ideas to pitch during interviews, I was finding so many attractive investment opportunities that might not make sense if you’re running many billions, like our former employers, but are great risk/reward opportunities for smaller amounts of capital and for things that don’t fit into the more rigid silos of other firms. For this reason the competition is just a lot lower in some of the special situations and small and mid-cap companies that we have focused on.
[Prasad] We had always kicked around the idea of starting something together since our time at Blackstone, and discussing some of the investments Chris was finding sparked those discussions again. In my case, I couldn’t act on these opportunities for the fund and my personal investment options were limited given my ongoing employment at a hedge fund. Ultimately, as we thought about launching a fund, we concluded that we could compound our personal savings at very high rates of return and we would also get the benefit of developing an intangible asset in our track record and brand name in the process. 100% of our liquid net worth is in the fund alongside our investors. We view this as a compounding vehicle for our savings over time and are looking to attract like-minded investors that understand our approach. Over the long haul, we view the quality of our LPs as our greatest asset.
Can you talk about your investment process? How does an idea go from being a potential investment to become a portfolio holding?
[Chris] In terms of sourcing ideas we have a pretty heavy focus on special situations and, as a result, we try to take a systematic approach to certain investment opportunities. A few of the things we emphasize: evaluate all spin-offs, all bankruptcies, all post-reorg equities, and all non-traditional securities issued in mergers. These are all categories that frequently experience forced selling and, wherever possible, we’d prefer to buy from a seller that is acting for non-economic reasons. In addition we like to look at asset sales, division shutdowns, and management changes. These sorts of actions are sometimes an indicator that the earnings power of a business is about to change, sometimes substantially. Overall, we think securities in these verticals are more likely to be mispriced due to some combination of non-economic selling and complexity, and thus our return on time / hit rate is likely to be higher as well. While we emphasize special situations, we also have a number of investments that we would deem to be fundamentally sound businesses that don’t fall into the categories above and this was our focus at our past employers. Ultimately, we are doing deep fundamental analysis on special situations, largely because we think our hit rate will be much higher over time.
[Prasad] On the process side, we start every potential investment by first focusing on the downside. In markets that seem to go up every day, we tend to think people become much more relaxed on the risks they are taking. Eventually, having a focus on the downside and not losing money goes a long way if the goal is to compound capital over long periods of time. During the process, we will obviously do the traditional blocking and tackling of reading every piece of public information we can find (Ks, Qs, transcripts, proxies, press, etc.), reading up on competitors and talking to various industry participants. We will come up with base and downside valuations on everything we look at, and both Chris and I will take independent looks at the investments we’re evaluating if it has the potential to be a position greater than 5% of AUM. We think having a second set of eyes on the analysis is valuable and results in better decisions over the long-run. Once we get comfortable that the investment is an attractive return potential for the risk we are taking, we will start to buy (or sell in the case of shorts). After that, we are constantly monitoring our positions and we think every day we should be evaluating new ideas against things that are already in the portfolio. We run a concentrated portfolio with a goal of 10-20 long positions, so it is very important that we love everything in the portfolio. We are looking for “great” ideas and not just “good”. In the absence of great ideas, we’d rather hold cash and wait for the fat pitch.
Tappan emphasizes investments with a clear catalyst in the next 12 to 24 months. What are recent examples of situations in which you invested had a clear catalyst?
[Prasad] Wherever possible, we prefer to invest in situations with a clear catalyst where our thesis will be either proven correct or incorrect. Over time, we think this reduces our correlation to broader market moves. Two investments we’ve made recently were Liberty Media and EnergySolutions. In the case of Liberty Media, the company had announced the spin-off of Starz Network for early January. We believed we were buying the shares at a discount to the net asset value remaining at Liberty Media and we were getting Starz Network for free. We believed that the spin-off of Starz would a) highlight the value of Starz to the market and b) provide a clear path for Liberty Media’s holding company discount to close. Subsequent to the spin-off of Starz, Liberty Media’s holding company discount did indeed diminish and we were able to sell our stake in Liberty Media in order to increase our exposure to Starz Network as we felt the Starz Network piece was more undervalued. Starz has appreciated over 50% from the price at which we purchased the shares post the spin-off.
On EnergySolutions, the Company was involved in an asset sale process at the end of last year that we thought would unlock value in segments that were not being appropriately valued. As it turns out, a private equity bidder emerged for the entire Company in early January, albeit at a price that we believed undervalued the company for a variety of reasons, not least of which was an issue surrounding the company’s restricted cash balance. We have expressed our displeasure with the deal price in two letters we sent to the Board of Directors (both of which are public). More recently, the bidder has increased their offer price, although we still believe it undervalues the assets of the company.
Both portfolio managers at TSP have experience both on the advisory side (either restructuring or M&A) and the investing side (with either hedge funds or private equity). How has such background helped shape the investment model for TSP?
[Chris] We’ve both been fortunate to have received training at larger organizations on both the advisory side and the principal side and we leverage this training frequently. Our experience on the advisory side has certainly helped inform our current investment process in a number of ways. The Blackstone analyst experience was a very rigorous one and we gained a strong grounding in fundamental analysis, particularly the analytical side of things. Prasad’s experience navigating the bankruptcy process on the advisory side obviously provided him with an in-depth knowledge of bankruptcy law and process—as well as industry contacts—and we leverage his experience and contacts in every distressed investment we make. My experience in M&A certainly provided helpful context around how decisions on major corporate actions are made by management and boards. I think having been involved in these sorts of processes in the past also helps serve as a constant reminder that major corporate actions don’t just sort of materialize—they result from the decisions and actions of a few individuals and it’s important to think through the incentives of those individuals.
On the principal side both of us were again fortunate to have worked with and learned from some incredibly talented people. Beyond that training, though, we had a chance to witness firsthand the type of opportunities that might not make as much sense for larger funds. We’ve tried to structure our fund to capitalize on some of these opportunities where competition is not as fierce. Conversely, we also avoid some other segments where we may see interesting ideas but where we know that funds with significantly more resources have an advantage (e.g., merger arbitrage, activism where a proxy contest is necessary). Our experience over the past 18 months managing Tappan Street has been invaluable in shaping the investment approach going forward. There is no real substitute to developing your own track record and managing a portfolio independently.
How do you think so much of the market became focused on short-term performance and what are you able to do to take advantage with a time-arbitrage strategy?
[Prasad] It isn’t that people wouldn’t prefer to—or don’t understand how to—think long-term when evaluating investments, it is simply that we think many funds have put in place structural barriers that prevent them from pursuing that objective. Such structural impediments include having to manage to monthly liquidity and marketing low volatility returns as opposed to returns generated with a low risk of capital loss. From an investor’s standpoint we also think that many funds are opaque. As a result, when a fund suffers from poor performance it’s difficult to have the confidence as an investor to stick with that manager. As a result of these structural impediments we think a lot of the market has become focused on what works next month or next quarter. We think that if you have the ability to look out over a multi-year period, you will find a lot of stocks that have been left for dead because more and more investors have begun to ignore things that won’t work in the short-term. As we said earlier, we think our most valuable asset over the long-run will be our limited partners. We try to be very transparent with our investors so that they understand our strategy, specific investments we hold, and the opportunity set we see at a given time. We hope this level of transparency gives our investors the confidence to remain with us for many years.
You have spent significant time with distressed debt investing. Are you seeing opportunities out there?
[Prasad] Right now, we’re not finding all that much in distressed. There are many distressed funds and few attractive distressed situations in our view. Companies are able to refinance nearly anything at the moment and rates are quite low. So broadly speaking there is very little for us to do in distressed right now, and apart from two post-reorg equities that we hold we have no exposure to distressed at the moment. With that said, there is certainly evidence that lenders are relaxing underwriting standards and there are companies taking on leverage beyond levels that are prudent. It’s a question of when, not if, the distressed cycle will turn again and we are excited by the prospects of participating when that time arrives. This is also why we think it is important that we have a broad mandate. If we were limited to only distressed investments, we think we could potentially be forced into investments that don’t adequately compensate us for the risks being taken.
[Chris] On a more granular level, we think of the distressed opportunity set in three buckets: performing, non-performing (i.e., bankrupt), and post-reorganization. On a one-off basis there will always be a few opportunities in performing distressed credit. For instance, we were able to purchase EnergySolutions 10.75% Senior Notes in the mid 80s last year as a reduction in guidance and a change in the management team caused a significant dislocation in both the equity and debt of the company. We were ultimately able to exit those notes at 103 when a private equity buyer made an offer for the company. At this point in the cycle, though, situations like ES senior notes are truly one-off. Finally, on a bankruptcy and post-reorganization basis there is very little recent supply, and we tend to think businesses that file for bankruptcy in more rosy economic environments have fundamental business problems and not capital structure problems. We think the latter make for better post-reorg equity opportunities.
What is the ideal size fund for your type of strategy and why does that help you compete with funds of different size?
[Prasad] We think our sweet spot will be in small and mid-cap special situations over time, although we are certainly not against larger capitalization companies if we see value. Based on the opportunities that we’ve seen so far, we think we can manage several hundred million in assets without changing our strategy or opportunity set. But the opportunity set will always be the driver. We never want to grow to be too large, or grow too quickly because we think that often can jeopardize the investment process and the investment universe potentially overnight. We think that this size allows us to play in situations that can’t move the needle for larger funds. Our biggest winner from last year, Marriott Vacations Worldwide (VAC), is a perfect example. The Company was spun out of Marriott, a $10bn Company, with a market capitalization of approximately $600mm. A lot of interested players may not have been able to look because it was too small, and certainly the existing shareholder base received what amounted to a small position in a new business. VAC is up roughly 150% since the spinoff in late 2011.
Why would you say your risk profile is substantially lower than the general equity market?
[Chris] On an individual company level I think there are a number of characteristics that we look for in investments that makes them lower risk versus the broader market. Our emphasis on downside means that many of the investments we favor trade at a discount to net asset value or the value one would receive in an orderly liquidation. Other investments we make trade at high current free cash flow yields and positive investment results are not predicated on rosy growth projections. Wherever possible we like to invest in situations where we get paid to wait, either in the form of a dividend or a company buying its own shares at what we view to be attractive prices. We prefer companies that use leverage prudently or hold net cash positions. Finally, we prefer investments with a catalyst to close what we view to be the gap between price and value, or investments where we take idiosyncratic risk as opposed to market risk.
[Prasad] From a portfolio perspective I’d add a few things. First of all, while our results to date have not been very volatile, we do not believe volatility is the appropriate measure of risk. We think the risk of permanent capital loss is a much better way of thinking about risk when making investments. Assembling a portfolio of companies that have the characteristics Chris mentioned substantially lowers our risk of permanent capital loss. Our preference for investments with a catalyst has also limited our correlation to broader market moves. In addition, we also reduce our net exposure through our short positions. While we aren’t suggesting that you can’t lose money on shorts, we do believe they will help insulate the portfolio during market dislocations; moreover, we think there is a lot of opportunity for a fund of our size to generate returns on shorts even absent market selloffs.
Can you describe some of your best upcoming investment ideas?
One new special situation investment that we are excited about is a company called Harvard Biosciences (HBIO). The company is a niche provider of life science research tools, selling primarily to researchers at universities and pharmaceutical companies. Additionally, the company has a regenerative medicine business, Harvard Apparatus, which was started in the past two years and makes medical devices used to repair damaged organs and grow organs outside of the body for transplant.
For the past several years the increasing R&D spend on the Harvard Apparatus (HART) segment has masked the underlying profitability—and value—of the life science research tools segment, and at today’s price you are able to purchase the entire business at a discount to the value of the life science research tools business alone. We believe a spin-off of the company’s HART division is likely and will serve as the catalyst for investors to properly value the two segments. In December 2012, HBIO announced its intent to separate its money-losing regenerative medicine business, HART, from the profitable life science research tools segment. Originally, the Company wanted to raise capital for the regenerative medicine business by selling 20% of the HART segment in an IPO, and then spinning off the remaining 80% of the business within 3 months. While the company originally intended to IPO the business at an implied valuation of $100mm, we think the market during the IPO process was closer to $50-$60mm given the business is still developmental and burns roughly $6.5mm in cash per year. More importantly, for our purposes, we ascribe zero value to the regenerative medicine piece, largely because we do not think our core competency is in biotech or emerging device investing. As far as we are concerned, we are better off valuing only the parent company (HBIO), which generates roughly $10mm per year in standalone free cash flow and 38 cents in EPS. Under reasonable valuation scenarios for the parent business, we concluded that investors are getting HART shares for free. Given the sequencing of an IPO first and spin-off later, some prospective investors in the HART IPO were wary of the overhang from the subsequent spin while others elected instead to purchase HBIO and gain exposure to HART at a discount to the IPO price. Ultimately, this dynamic put downward pressure on the IPO valuation and resulted in the Company deciding not to proceed with the IPO. As you can imagine, news of pulling the IPO caused confusion in the market regarding the Company’s intent to separate the two segments and sent the shares down roughly 20% over the last month. However, we think this provides patient investors an attractive entry point. We still believe that the Company will separate the two businesses. The issue was not the company’s intention to separate the two businesses, but rather the sequencing of an initial IPO for HART followed by the spin-off of the remaining stake from HBIO that made the transaction difficult.
Briefly, we think the core research tools business is a high quality business. They compete in many niche products that individually are not large enough to warrant material competition from the larger players in the market. In fact, Thermo Fisher and GE Healthcare both distribute products for HBIO instead of competing directly in some areas, which we think is validation that they have a good set of niche products and a strong customer base. The industry is also characterized by relatively infrequent switching as most researchers get used to a particular brand name for both consumables and hardware and continue to order predictably. The business requires very little capital to grow organically. Additionally, HBIO has been an aggressive buyer of other businesses over time. By serving as the source of liquidity for even smaller niche providers of tools businesses, they are able to purchase companies at 4x – 6x EBITDA and the transactions are immediately accretive. These are companies that have up to $10mm in annual sales, so they are immaterial to the major players, but they can really make a difference to a company like HBIO, both in terms of savings on the cost side and synergies on the revenue side as HBIO leverages its distribution network to sell the acquired products. Over the long-run, HBIO has grown its tools business revenue and EPS at a mid-teens and low double digit rate on average, respectively. In the short-term, there might be some pressure from sequestration cuts, but our research indicates research grants tend to be well insulated over the long-run and are one of the few things that both sides of Congress agree on.
The other things worth mentioning are the management incentives. The management team of HBIO owns 14% of the shares outstanding and repurchased almost 10% of the company in 2010 at attractive prices. The management team has been with the business since 1996 when it purchased the company with a group of investors and has been operating and acquiring other pieces ever since. We also think the failed IPO has some informational content. We believe the market value being ascribed to HART was $50-$60mm, and the company was unwilling to sell shares at that price. Also interesting is the fact that the company’s current President, who has been with the company since 1996, will be moving on to the HART business and was going to receive 6% of the equity in HART. We believe it is a strong signal that he is willing to leave the more stable tools business and have a large amount of equity compensation in HART, which on the surface appears to be much more speculative. Again, for our purposes we value HART at $0 so this gives us confidence that we are likely being conservative.
From a valuation perspective, the current stock price implies a multiple of 12.5x EPS for the research tools business alone (after removing losses at HART). However, for a business of this quality and growth potential, we believe a higher valuation is justifiable, and indeed tools businesses trade in the high teens to low 20s from a P/E perspective. LIFE was just acquired by TMO at an implied multiple of ~19.1x 2012 EPS. For what it is worth, historically HBIO has also traded at multiples in the high teens on a P/E basis. Using a P/E multiple of 17.5x 2012 EPS, HBIO would be worth over 39% more than where it is today, ascribing no value for HART. We think investors today are incorrectly capitalizing the losses at HART, implying negative value for the business. Because stocks can’t trade at negative prices, we feel pretty good about the situation and unlocking value post a potential spin-off. A $50mm valuation for HART would result in ~35% upside assuming the tools business trades at 12.5x EPS, as it does today. We think after a spin-off, people will more clearly be able to see the value in the research tools business which is currently obscured by losses at HART. Additionally, we suspect the company trades at a depressed price today because of uncertainty post the pulled IPO, but we are confident that they still intend to spin off the HART business, and we like how the incentives are aligned with shareholders. Taken together, we think the spin has the potential to unlock almost 75% upside in HBIO stock.
Finally, longer-term, just as HBIO is the source of liquidity for smaller tools businesses, we think it would make sense if HBIO’s research tools business was acquired in the future. The CEO is 74 years old, and we suspect he will continue to build through acquisitions and improve operations until the company is eventually acquired. We think the business can get to $125mm - $150mm in revenue over the next 2 – 3 years from roughly $110mm today and a buyer doesn’t need to keep much of the corporate overhead. At margins in the high teens the numbers start to look pretty good relative to the current market cap.
For more information on Tappan Street, you can visit their website at: http://tappanst.com/