Street Capitalist: Event Driven Value Investments

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.

Jeffrey Goldberg of The Atlantic has this great article which asks what the average investor is supposed to do right now. I often discuss investing with everyone I meet, it’s a passion — but I’m often shocked by the preconceptions that people have about it. The ordinary investor has really been misinformed which unfortunately leads to bad decisions and negative returns. Goldberg’s article sets a lot of things straight and would be good reading for anyone you know who is interested in investing but knows little about it. What I liked most about Goldberg’s article was the quotes from Seth Klarman:

Klarman is an acolyte of Ben Graham, the original value investor. Value investors—Warren Buffett is the most famous—seek out distressed, underappreciated assets, buy them, and wait until the rest of the world realizes that they’re worth something.

“The overwhelming majority of people are comfortable with consensus, but successful investors tend to have a contrarian bent,” Klarman said over lunch one day in an empty Boston restaurant. “Successful investors like stocks better when they’re going down. When you go to a department store or a supermarket, you like to buy merchandise on sale, but it doesn’t work that way in the stock market. In the stock market, people panic when stocks are going down, so they like them less when they should like them more. When prices go down, you shouldn’t panic, but it’s hard to control your emotions when you’re overextended, when you see your net worth drop in half and you worry that you won’t have enough money to pay for your kids’ college.”

One theme of Margin of Safety is that people like me aren’t equipped to be investors. “No one knows what he’s doing unless he’s a full-time professional,” he said. “As in many professions, full-time experts have an enormous advantage. Investing is highly sophisticated and nuanced. The average person would have an incredibly hard time competing.”

On the troubles of the small investor:

He agreed with Robert Soros that the financial-services industry treats the small investor not as a client but as a source of ready cash. “The average person can’t really trust anybody. They can’t trust a broker, because the broker is interested in churning commissions. They can’t trust a mutual fund, because the mutual fund is interested in gathering a lot of assets and keeping them. And now it’s even worse because even the most sophisticated people have no idea what’s going on.”

After 15 years of pabulum, I was enjoying, in a perverse sort of way, receiving straight talk from masters of finance.

“Everybody these days is a just-in-time investor. People say, ‘I’m going to leave my money in the market as long as possible, and then pull it out of the market just before I have to write the tuition check.’ But I think we’re seeing that the day you need to pull it out of the market, the market might be down 50 percent. It’s critical not to be greedy. Avoid leverage and don’t invest money that you can’t stand to lose.”

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged. Why are you keeping your money in the market?”

“Because—”

“It’s because you think you’re going to make more money in the market than you’re paying in interest on your mortgage.”

“Yup.”

“Well, are you?”

“Uhh, no. But I’m getting the mortgage-interest deduction.”

“Yes, the interest is deductible. But if you had capital gains in the market, you’d pay taxes on those. In the aftermath of this financial crisis, I think everyone needs to look deep within themselves and ask how they want to live their lives. Do they want to live close to the edge, or do they want stability? In my view, people should have a year or two of living expenses in cash if possible, and they shouldn’t use leverage anywhere in their lives.”

“But if I dump my portfolio now, I make my losses real.”

“How are you going to feel if the market drops another 50 percent?”

Klarman brings up an interesting argument. I feel like when people decide they want to invest, they do not properly weigh their actions in the context of their overall financial situation. I have a feeling that many people invest simply to say that they’re invested. As a result, they usually make poor or mediocre decisions. At the very least, they end up investing money in the market when they may have been better suited by paying down debt. The kind of arbitrage practiced, where someone takes out a mortgage but invests in the market is highly risky. But I don’t think many people weigh investing in the market versus their mortgage.

Finally, Klarman’s question to ask anyone who is interested in investing:

“Here’s how to know if you have the makeup to be an investor. How would you handle the following situation? Let’s say you own a Procter & Gamble in your portfolio and the stock price goes down by half. Do you like it better? If it falls in half, do you reinvest dividends? Do you take cash out of savings to buy more? If you have the confidence to do that, then you’re an investor. If you don’t, you’re not an investor, you’re a speculator, and you shouldn’t be in the stock market in the first place.”

Be sure to read the entire article, there are excellent insights from Bill Ackman and Robert Soros among others.

Sorry for the thin posting recently, I’ve been going through final exams. This morning I had a chance to watch Charlie Rose’s interview with Nassim Taleb. Like always with Charlie Rose, the interview was top notch:

One of the things that struck me as interesting in the interview was the fact that the prospect of deflation. Nassim Taleb seems to think that that’s where our economy is heading:

CHARLIE ROSE: But let me go — you mentioned Nouriel Roubini, who has been here and who has become well-known as someone who has predicted this and saw it coming, and scares the hell out of people when he comes and sits where you do, because he sees it as getting worse, and even suggests sometimes it may mark the decline of America. How bad do you think…

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I — I had the same story, haven’t changed my story since — and what convinced me of this is that we switched from an environment of inflation, hyperinflation, where people are afraid of commodity prices rising, to a total deflation in no time. Look at inflation bonds…

… I know that we are going have massive deflation. The overhang of debt, massive deflation. Debt needs to be reduced. And I think Paulson seems to be doing a good job, particularly that they were part of the cause of what happened, you know, it is quite commendable.

That got me wondering – what is the best way to invest when you think that deflation is coming? When we, as value investors, invest we look for margins of safety. But if asset prices are falling, the margin of safety quickly contracts. So what are we to do?

Seth Klarman of the Baupost Group touches of this in his book, Margin of Safety. We’re lucky because the book was written only a few years after the junk bond craze, these kinds of topics were on the mind of investors. Here is what Klarman had to say on deflation:

In a deflationary environment assets tend to decline in value. Buying a dollar at 50 cents may not be a bargain if the asset value is dropping. Historically, investors have found attractive opportunities in companies with substantial “hidden assets,” such as an overfunded pension, real estate carried on the balance sheet below market value, or a profitable finance subsidiary that could be sold at a significant gain. Amidst a broad-based decline in business and asset values, however, some hidden assets become less value and in case may become hidden liabilities. A decline in the stock market will reduce the value of pension fund assets; previously overfunded plans may become underfunded. Real estate, carried on companies’ balance sheets at a historical cost, may no longer be undervalued. Overlooked subsidiaries that were once hidden jewels may lose their luster…

The possibility of sustained decreases in business value is a dagger in the heart of value investing (and is not a barrel of laughs for the other investment approaches either).

Which is really the heart of the problem with deflation, especially for value investors. We have to be cautious and not forget the fact that underlying values can indeed decline. This may have been one of the mistakes that some fund managers made when investing in banks while using book value to approximate business value. Book value was simply written down each quarter, ruining whatever margin of safety existed.

Klarman gives us three ways to invest if we think that business value may decline:

First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or hold current positions. This means that normally selected investors would probably let even more pitches than usual go by.

Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or not you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause to diminish become moot.

These rules are telling us that we need to be even more conservative if we wish to protect against deflation. That means increasing our margin of safety to compensate, and sticking with areas we’re more certain about. Sometimes value investors like to relax their standards so that they can join in the action of the market. They end up buying dollars for 70 or 80 cents and dip their toes in industries outside of their circle of competence. Maybe they’ll invest an an industry where the asset values are much harder to determine, they may make the error of overestimating and skewing their valuations as a whole. So we must become more conservative as the market becomes more turbulent.

With respect to the third factor, I really see this from a special situations perspective. Workouts like risk arbitrage, odd-lot tenders, and so on may be helpful because the price changes should be independent of the market’s precise movements and determined more by the transaction itself usually with a fixed time interval. This gives you the luxury of figuring out when the transaction will be completed so that you can compare it against what the market is doing.

Maybe you’re thinking about investing in an arbitrage situation but you think that asset values will decline over the course of the year. This could affect debt covenants or trigger a material adverse clause and kill the transaction. So you have to keep time in mind. The longer a transaction is supposed to take, the more you risk your capital, especially if you think the value of businesses will be declining.

Investing with macro issues in mind is always a tough thing, especially because its practically impossible to predict exactly what the economy will do. I don’t think that we need to study or spend too much time focusing on the economy though. We simply need to stick close to our principles and maybe exercise more caution that usual. If we do this, our returns should reward us well.

I mentioned Seth Klarman and inflation hedging previously in my post about his talk at the CIMA conference. Here is another quote, this time from a recent article on MarketWatch:

Seth Klarman, a top-performing value investor and head of The Baupost Group LLC, told clients in an Oct. 10 letter that the economic downturn could be “vicious and protracted.”
“The financial market collapse and bailout makes us sick,” he wrote. “There is likely more carnage to come.”

The U.S. dollar will likely weaken and its reign as the world’s reserve currency could end, Klarman predicted. Longer-term, U.S. interest rates may rise as foreigners have to be enticed more to invest in dollar-denominated assets, he added.

The recent Treasury Department bailout has yet to be paid for and should add to inflationary pressures over time, especially when the economy begins to recover, he said.

I still haven’t figured out what his inflation hedge might be, but it’s something worth thinking about. Here’s a line from his book Margin of Safety, which hints a bit at inflation hedges:

…value investing can work very well in an inflationary environment. If for fifty cents you buy a dollar of value in the form of an asset, such as natural resource properties or real estate, which increases in value with inflation, a fifty-cent investment today can result in the realization of value appreciably greater than one dollar.

What might he be looking at? Timberland? Oil and gas properties? Or maybe land itself, domestically or abroad.

Note: these notes come from BenGrahamMan at the Motley Fool Boards, the original thread is here.

Seth Klarman runs the Baupost Group, a prominent value investing fund that has had stellar performance since inception. What’s really amazing about Klarman is how risk averse he is, I’ve heard that sometimes he will convert nearly 50% of his portfolio into cash while still still posting strong returns. In my previous post, I mentioned the Buffett quote where he says that they look for people with risk aversion programmed into their DNA, I think Klarman fits the bill.

He’s the author of Margin of Safety, the expensive and out of print value investing book, and has recently contributed an entry to the new edition of Security Analysis.

1. The biggest fear was buying too soon and on way down, from up in over-valued levels. We knew market collapse was possible and sometimes imagined I was back in 1930. Surely there were tempting bargains and just as surely would have been crushed after decline of next 3 years. A fall from 70 to 20 and fall from 100 to 20, would feel almost exactly the same. At some point being too early becomes indistinguishable from being wrong.

2. Getting in too soon brings risk to all investors. After a stock market has dropped 20% – 30% there is no way to tell when the tides will change. It would be silly to expect that every bear market will turn into a great depression. Yet fair value from under-valued can’t be predicted, and would be equally wrong.

3. As market descends you are tempted with purchasing companies. You will be bombarded with tempting opportunities. You never know how low things will go. When credit contracts and tide goes out on liquidity. At these times recall the wisdom of Graham and Dodd. At this time, you should not market time, but stick to your value convictions. You will see tempting bargains and value imposters. Ignore macro and look to buy cheap.

4. In a market like we have been experiencing. Most investors lose their rudders. They become unwilling to part with cash. They start working on macro economic level. Investors look to pull out of market and wait for a clear signal of change. Value investors should be able to keep their focus and remember Graham and Dodd of 1934.

5. If you can maintain your focus, resist business pressures and have a multifaceted tool kit, you can expect to prosper, even in difficult times.

A. Always recall road map of Graham and Dodd. Revisit this road map when times get difficult. Maintain discipline and value with a margin of safety. This doesn’t mean you won’t lose money. It means if there are drops in price, you have even more of a bargain.

B. Avoid highly leveraged stocks, junk bonds and shaky financials.

C. Look for bargains in various industries and nations.

D. Look at value, not great companies and great management.

E. Listen to Warren Buffett when he states you should buy a stock as if the market would close for a long period of time after you bought the stock.

6. Remain focused on the long run. Graham and Dodd motivate our diligence. They are like silent sentinels. Navigate the best you can and Graham and Dodd are the North Star for value investors.

7. Stand against the prevailing winds, selectively and resolutely. Yet for a while a value investor will under-perform. Interim price declines allow you to average down. Do not suffer the interim losses, relish and appreciate them.

8. Value investing at its core is the marriage between a contrarian streak and a calculator. Buying what is in favor is ensuring long-term under-performance.

9. It is critical to remind your clients, investment team and as often as necessary yourself, that you can only control your process and approach. Understand that you cannot control or forecast the vagaries of the market. Then you should invest in what you believe and what your research dictates. Be indifferent if you lose your short-term oriented clients, remembering that they are their own worst enemies.

10. Controlling your process is essential.

A. Be focused on process, not outcome.

B. Do not judge a decision based on its outcome.

C. During periods of under-performance it is easy to change your process.

D. When a firm is worried about tempers, second-guessing and fear, the process will fail. Look for long-term results; anything else will corrupt the process.

11. Value investing is an art and not a precise science. It is dealing with the fact that we do not work with perfect information.

12. Mechanical rules are dangerous. Graham and Dodd principles should serve as a screen.

Q&A

1. How do you see current investment climate?

A. James Grant - Look at some MBS and beaten down bonds. Some are priced to yield teens. They are priced for a further 25% decline. Also unsecured debentures of nations top retailers. These are priced at 5% to 7%. Hence, short the retailers at 6% and go long the beaten down mortgages.

B. Seth Klarman – Unusual amount of forced sellers, via margin calls. This could breed opportunity. We see a lot of money managers staying on the sideline. We finds this to be an opportunity to buy. Buy when others react to news or false news. Our experience is when people give away stocks out of need, due to fear or margin calls, that sounds like a great buying opportunity. In this environment you are playing against very smart people.

C. Bruce Greenwald – Take a deep breath. All the doomsday talking is not being reflected in stock prices. Stocks are basically down 25%, but unemployment is not great like early 1940’s. You need to put this into perspective like 1991 or 1982.

2. Klarman discussed buying one security at a time. Not everything is a bargain out there. Be selective. Many of us have seen opportunities now, and history says to buy them. We bought knowing that banks are going to fail, that real estate would drop, but that certain mortgage backed securities were under-valued. Never leverage, where you can have an opportunity to buy and not be able to take advantage of it because of leverage.

3. James Grant – Treasuries are yielding less than expected future CPI. Treasuries are now being priced as a macro-economic play. Treasuries are not intrinsically safe. They are not safe based on valuation.

4. What factors do you look at in sizing a position?

Seth Klarman – We think this has been missed over the last 15 years. Most of the diversified risk is done via 20 to 25th position. We have had a 10% or so concentrated position about a dozen times over the last 20 years. Most of the time we have 3,5 and 6% position. We will take it higher if we see a catalyst for increased value. We would not own 10% position in a common stock, only because it seemed under-valued. We would have a greater than 10% position if there was a margin of safety. I see managers make mistakes with concentrated positions in similar industries. Small positions of say 1% are nonsensical. We do not use macro views, yet when we hedge, we will use a macro view. We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don’t own gold as a commodity. We won’t disclose our inflation hedge, yet with enough work, you can find true inflation hedges.

I have to wonder what Klarman’s inflation hedge is. I know that Warren Buffett believes that one of the better ways to navigate through inflationary times is to own companies that can increase prices (think See’s Candies) with little worry for losing market share. On the other hand, some investors choose to look towards commodities. David Swensen of Yale’s Endowment fund is pretty famous for investing in timber and Prem Watsa of Fairfax Financial (NYSE:FFH) made a recent investment in that area as well. Anyone out there have an idea?