Street Capitalist: Event Driven Value Investments

Howard Marks of Oaktree Capital has a new memo that is great as usual. I particularly liked his point about inflation:

When Paul Volcker left the Fed in 1987, he was asked at his first public appearance, “Will interest rates go up or down?” He answered presciently: “Yes.” Of course, his answer is still the right one. But from today’s levels, I think rates are more likely to go up than down (there’s so little room for the latter).

Reduced faith in the dollar means it would take higher interest rates to attract non-U.S. buyers to dollar investments. And, even domestically, (a) one of these days the government will stop holding rates down and (b) higher inflation would require rates to rise to compensate for the fact that the dollars with which debts are repaid will buy less. For all these reasons, I think investors must consider the prospect of higher inflation, dollar weakness and higher interest rates.

What to do about them? The list of possibilities is long:

· Buy TIPS.
· Buy floating rate debt.
· Buy gold (but only at the “right” price, and what’s that?)
· Buy real assets, such as commodities, oil and real estate (ditto).
· Buy foreign currencies.
· Make investments denominated in foreign currencies.
· Buy the securities of companies that will be able to pass on increased costs.
· Buy the securities of companies that own commodities, or that own assets denominated in foreign currencies.
· Buy the securities of companies that earn their profits outside the U.S.
· Hold cash (to invest once interest rates have risen).
· Sell long-term bonds (and possibly go short).

These are the actions that can profit from – or that provide the flexibility to adjust to – increased inflation, a decline in the dollar and increased interest rates, all of which are interconnected. The most important one is the last one: long-term bonds could suffer worst in an inflationary, higher-rate environment, especially given today’s low starting yields.

One final point: When I provide this answer to the frequent question about inflation, I ask people whether they agree. Usually they do. Then I ask how much of their portfolio they’re willing to devote to protecting against these macro forces. If their answer is 5%, 10% or 15%, I point out that that’s pretty close to doing nothing. The question is whether you’re willing to devote at least 30-40%. Few people are.

But that’s the thing: It’s easy to say, “I’m worried about inflation.” It’s something very different to say, “I’m worried enough about inflation to do something meaningful about it.” Let me know when you decide how much you’re willing to devote.

Howard Marks: Tell Me I’m Wrong (Oaktree Capital)

Marks makes an excellent point about whether managers are taking on superficial hedges — only investing a small, meaningless amount in their hedges. These positions make great talking points in quarterly letters but offer nothing by way of actual protection for their partners.

The best hedging opportunities usually come in the form of missed priced insurance. Nassim Taleb’s option trading seems to fit this description. The most recent example is the CDS trade that worked beautifully during the crisis. Credit default swaps were so mispriced that even a small position offered massive returns.

When things look dangerous, great investors are always ready to significantly protect themselves. Warren Buffett’s hoarding of cash provided Berkshire with great opportunities to invest in companies that were temporarily weakened by the crisis. Investors like Seth Klarman sometimes move 50% into cash if opportunities dry up. That is a meaningful move that protects investors from potential losses versus those who complain about overheated markets while keeping their partners hopelessly fully invested.

I’ve been thinking about hedging a lot these days and plan on having a comprehensive post up soon.

Yesterday, as far as I know, Oaktree Capital decided to make all of their existing memos from Howard Marks available. Marks is a great writer and has a knack for forming clear and concise thoughts on financial markets and investing. I decided to put the memos together in one big pdf:

Oak Tree Capital: Memos from our Chairman 1990 – 2009 (PDF)
Source: Oaktree Capital

While many investors are questioning whether the current rally in equity markets is sustainable, one area I’m seeing a lot of activity by noted value investors is in the distressed debt market. In general, the best deals here are being made on terms that are simply unavailable to the ordinary investor. Still, I think these are worth studying, they might be useful lessons for future investments.

The CIT deal is particularly interesting because the funds doing the deal are led by some of the best people in the investment business. Bill Gross – PIMCO, Seth Klarman – the Baupost Group, Howard Marks – Oaktree Capital, and Jeff Aronson – Centebridge Partners. In special situations like these, investors are sometimes able to create extremely preferential terms that limit their downside, creating a wide margin of safety.

Here’s a look at CIT’s 8-K:

The Credit Facility has a two and a half year maturity and bears interest at LIBOR plus 10%, with a 3% LIBOR floor, payable monthly. It provides for (i) a commitment fee of 5% of the total advances made thereunder, payable upon the funding of each advance, (ii) an unused line fee with respect to undrawn commitments at the rate of 1% per annum and (iii) a 2% exit fee on amounts prepaid or repaid and the unused portion of any commitment.

The Credit Facility will be secured by a perfected first priority lien on substantially all unencumbered assets of the Guarantors, which shall include 100% of the stock of CIT Aerospace International, and 65% of the voting and 100% of the non-voting stock of other first-tier foreign subsidiaries (other than direct subsidiaries of the Company), in each case owned by a Guarantor.

Borrowings under the Credit Facility will be used for general corporate purposes and working capital needs and to purchase notes accepted for payment in the Offer (as defined below); provided that, except with the consent of a committee of lenders under the Credit Facility (the “Steering Committee”), no portion of the proceeds of the Credit Facility or collateral securing the Credit Facility may be used to pay principal or interest on the August 17 Notes (as defined below), other than pursuant to the Offer (as defined below), or, following the consummation of the Offer, on the maturity date of the August 17 Notes.

The Credit Facility includes a minimum collateral coverage covenant. The covenant requires the ratio of the book value of the collateral securing the Credit Facility to the loans outstanding thereunder to exceed 5:1 as of the end of each fiscal quarter commencing as of the fiscal quarter ending September 30, 2009, and the ratio of the fair value of the collateral securing the Credit Facility to the loans outstanding thereunder to exceed 3:1 as of the end of each fiscal year commencing with the fiscal year ending December 31, 2009. The Credit Facility also contains customary affirmative and negative covenants, including, among other things and subject to certain exceptions, limitations on the ability of Borrowers and subsidiaries to incur additional indebtedness, incur liens, make material non-ordinary course asset sales, make certain restricted payments (including paying any dividends on any of the Company’s preferred or common stock without the consent of a majority in number of the members of the Steering Committee), make investments, engage in certain fundamental changes, engage in sale and leaseback transactions, engage in transactions with affiliates, and prepay certain indebtedness.

CIT Group (8k)

So far, the consensus is that Baupost and others got a steal of a deal.

Caroline Salas and Pierre Paulden of Bloomberg have a great article that stresses the limited downside of the deal:

Pacific Investment Management Co., Centerbridge Partners LP and the four other bondholders that put up $2 billion in financing for CIT Group Inc. made an instant $100 million on an investment analysts say is almost risk free…

Bondholders made $2 billion available immediately and promised another $1 billion by the end of the month. The group received a 5 percent commitment fee on the 2 ½ year loan, amounting to $100 million on the $2 billion already provided. They will receive a 1 percent annual payment on the amount that’s not drawn upon, the company said.

And some choice words by Sean Egan:

The book value of the collateral must be more than five times the amount of the loan and the so-called fair value must be more than triple the debt, the filing said. If CIT wants to retire the loan early, it must pay a 2 percent exit fee in addition to a prepayment premium of 6.5 percent on the amount it wants to reduce, the filing said. The 6.5 percent will decline to zero over 18 months.

Interest will be set at 10 percentage points more than the London interbank offered rate, which will have a floor of 3 percent. Three-month Libor was set at 0.502 percent today.

Even if CIT fails, the bondholder group will probably make money because of the collateral, according to Sean Egan, president of Egan-Jones Ratings Co. in Haverford, Pennsylvania. The lenders have “virtually 100 percent assurance” they’d be able to recoup all their money in a bankruptcy, said Sameer Gokhale, an analyst with Keefe Bruyette & Woods Inc. in New York.

‘Don Corleone Financing’

“This is called Don Corleone financing,” Egan said, referring to the patriarch in the organized-crime family depicted in the 1972 film, “The Godfather.” “You can’t lose money on this deal.”

Outside of the “urban underworld,” Egan, 52, said he couldn’t recall seeing a loan backed by as much collateral that paid interest rates so high. “These terms would make a pawn- shop operator blush.”

CIT Hit With Interest Rate More Than 25 Times Libor (Update2)

Deals like this, while unavailable to ordinary investors will likely serve as lessons for what happens when an over leveraged company faces problems with financing. Liquidity crunches seem to be creating a number of great opportunities for investors who are willing to remain rational. Often, as management is threatened by bankruptcy, they’re more than willing to bend over backwards to cede terms in order to secure the capital that they desperately need.

I’ve only recently been turned on to Howard Marks of Oaktree Capital, but so far I like a lot of what he says. You can find his latest memo The Long View here. Today’s NYTimes features an article about the inclusion of private capital allocators in Geithner’s bailout plan:

Mr. Marks is a former banker who became a pioneer in the graveyard of Wall Street. He is one of the biggest players in distressed investing — putting money into risky investments that few others will touch.

But he and other potential investors are wary of the risk in this case.

With its plan to shore up banks that was announced on Tuesday, the Obama administration hopes to entice investors like Mr. Marks, who has $55 billion at his command, to buy troubled assets from the nation’s banks and enable them to make the loans needed to jump-start the economy…

But Mr. Marks and other investors like him said they were in no hurry to wade into this mess. Distressed investors — “vultures” is the Wall Street term for them — aim to buy investments on the cheap in hopes of reaping big returns.

Yet even for the vultures, the risks — political as well as financial — seem daunting. Some worry about being seen as profiteers who benefit at taxpayers’ expense, even though the economy could get worse unless they swoop in.

“You have to ask whether this is an attractive deal,” said Mr. Marks, the chairman of Oaktree Capital Management, a big money management firm in Los Angeles. It all depends on the price, the terms and the risks, he said. Wall Street, of course, wants what it always wants: a lot of potential profit on the upside, and not much risk of losses on the downside. But as Treasury Secretary Timothy F. Geithner outlined his sweeping rescue plan on Tuesday, the questions kept piling up.

What kind of assets would the banks sell, and at what price? What role would the government play? And, of course, the big one: what are these investments really worth? The banks themselves are struggling to place values on them.

Washington Hopes ‘Vulture’ Investors Will Buy Bad Assets (NYTimes)

I think the main sticking point of the plan has to do with the pricing of assets. Geithner’s terse presentation yesterday did little to remedy that aspect and we saw markets fall. This makes me think that maybe they still haven’t figured out how to do it, and until they do there will be some hesitancy by private market participants. Michael J. de la Merced and Zachery Kouwe do bring up the IndyMac plan, where the government basically offered to step in and take on losses after a 20% decline.

While this plan may appear good on paper, it still poses an issue for institutional fund managers. In order to get paid, these managers need to have positive returns. A loss of 20%, which may seem like only a little, can actually be a lot when you realize that many of these guys were down 30 to 50% for 2008. Losing 20% would only increase that gap and make it more difficult to earn fees.

I’d like to point you all to a recent interview with Marks (LA Business Journal):

Q: You recently sent out a memo called “The Long View” with your thoughts on the turmoil in the financial markets. What do you think was the cause?
A: If you have to single out one thing, (leverage) was probably the greatest part. There’s an old saying in Las Vegas that the more you bet, the more you win when you win. But they always leave out the part about the more you lose when you lose. That’s what leverage is. Leverage does not add value to an investment – it doesn’t make it a better investment; it only magnifies the outcomes.

Q: And the long view?
A: These things never change. It will always be the case that when borrowed money is too easily available and people do not concern themselves with the downside, they will leverage their activities to levels where if something goes wrong they won’t survive. One of my favorite quotes in the world is from John Kenneth Galbraith. He says that one of the outstanding characteristics of financial markets is “the extreme brevity of the financial memory.”

Q: Why did you decide to stay in Los Angeles? Is there a benefit to being away from a financial center like New York?
A: The main reason that I stayed is because this is a great place to live. But we often theorize, especially at times of chaos, that it’s a help to be outside New York because you can see the real outline of things better from the outside than from the inside. New York is so overwhelmingly an investment community that I think it’s easier to have a broad perspective if you’re observing it rather than in the middle of it.

Q: What does it take to excel in investment management?
A: You obviously need to be to some degree numerically facile. You have to have a certain perceptiveness and an ability to look at a picture and see more than the average person sees. It’s so easy to see that the average person will do average. And if a client wanted to do average, they can put their money in an index fund. You just can’t swallow the same story that the average investor swallows and expect to be above average.

Q: Like what?
A: For one example, there’s an article by Charlie Ellis that I think was called “Winning the Loser’s Game.” What I took from that article was the way to succeed in investing – just like the way to succeed at being a B-level tennis player, which I am – is to not make mistakes. The champs win by hitting winners; the B player at a country club wins by not hitting losers. So that resonated with me and that’s one of the things we do. Oaktree’s motto is that if we avoid the losers, the winners take care of themselves.

Pay attention to that last answer, I think it tells us a lot about how to think successfully when looking at opportunities right now. When I discussed Geithner’s new plan, I noted that even a 20% loss may be too much. Marks seems to affirm that with his tennis player analogy, the idea is to dodge losers all together rather than simply limit how much damage the losers can do to your portfolio. I’m also reminded of Warren Buffett’s rule: Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. That’s likely to be the main reason that there’s still a high level of skepticism being offered by investors right now of these new bailout plan. Until more information is released, it’s likely that we’ll continue to be in an environment with shaky confidence and little involvement from private investors.