As public markets become “frothy,” with competition driving equity prices high and sovereign debt yields in once risky markets such as Greece to strange new lows – competing with the U.S. in terms of yield, Seth Klarman‘s Baupost Group, like fellow hedge fund icons John Paulson and David Einhorn, is now looking to private investments to uncover opportunity without significant public competition.
Baupost investing in Lehman Brothers after the crash
Baupost was successful at picking up good investments by picking through the bones of the Lehman Brothers estate. In 2013, as in the past two years, the Lehman positions “had the largest impact on results in 2013,” Baupost partner Jim Mooney wrote in an appendix to their fourth quarter investment letter, a copy of which was reviewed by ValueWalk. In 2013 the Lehman positions accounted for a massive 23% of the fund’s net asset value.
“We received significant distributions from the various Lehman estates during the course of the year,” Mooney wrote. “Life to date, the IRR on all of our Lehman investments is approximately 30%. Lehman has, by any measure, produced a wonderful investment result.”
However, all good things must come to an end, including investments. Baupost had opportunity to additionally invest in Lehman debt but chose to remain on the sidelines. “The Lehman story going forward will be far more about maximizing the value of our remaining positions than adding significantly to them – the inevitable conclusion to any successful liquidation. We still expect to earn attractive risk-adjusted returns on our remaining Lehman Brothers Holdings Inc Plan Trust (OTCMKTS:LEHMQ) positions as distributions continue over the next few years.”
Baupost invests in Greek debt during dark days
Other non-stock related investments came from a handful of opportunistic investments in structured products, with nearly every position profitable. Overall, the structured product category returned nearly 50%, with special mention going to the Greek debt, which “rallied substantially as fears that the country would leave the euro dissipated.” Baupost exited more than half their exposure in 2013.
In the wake of a crippling debt crisis, Greek bond yields climbed to relative high yields. Baupost bought the yields during the scare, and now “Greek bond yields have dropped and bond prices have risen. One sell- side analyst recently declared that ‘the recovery is here,’ a sharp reversal from his view in July 2012 that Greece had a 90% chance of leaving the Euro by the end of 2013,” Seth Klarman, Baupost’s founder, wrote in the fourth quarter investment letter. “Greek government bond prices have nearly quintupled in price from the mid-2012 lows. Yet, despite six years of painful structural adjustments, Greece’s government debt-to-GDP ratio currently stands at 157%, up from 105% in 2008. Germany’s own government debt-to-GDP ratio stands at 81%, up from 65% in 2008. That doesn’t look fixed to us.” Baupost purchased a portfolio of consumer loans and a portfolio of residential mortgages in Greece, which it is now unwinding along with other structured products.
Baupost: Not a value investor’s paradise
We expect to confront an investing environment that remains both competitive and characterized by an ambient optimism. Equity markets hover around all-time highs, many structured product bonds are trading at yields below 5%, the distressed debt market is in hibernation, and most investors appear to believe the most severe hazards have been marginalized, or at least are well over the horizon. This is not a value investor’s paradise.
Public markets “frothy,” Baupost turns to private investment
As competition has driven public markets to new heights, Baupost addresses this competitive (and low yielding) environment by searching for private investment deals. “Amidst frothy public market conditions like today’s, private investments sometimes become more attractive than public for these exact reasons – fewer competitors and better risk-adjusted returns,” wrote Tom Blumenthal and George Rizk, partners and co-head of the fund’s Private Investment Group.
To accomplish this, the fund looks to real estate as well as private investments such as that made in Arby’s.
Real estate investments generated profits of $350 million to the fund in 2013, as they sold into strength. Investments included office buildings, hotels and multifamily properties to even Japanese self storage facilities, which the fund exited recently at a slight loss. “We built the company after having successfully converted obsolete but well-located office buildings acquired in distressed transactions into Class A self-storage properties. Quraz became the market leader in Japanese self-storage, but we underestimated the challenges associated with starting the business in Japan. Operational mistakes along the way and lack of institutional buyers for stabilized self-storage assets led to our disappointing result. Sometimes it’s best to monetize an investment and move on.”
According to the letter “One of the largest transactions of the year was the non-recourse, cash-out refinancing of our San Francisco apartment portfolio. This transaction locked-in a high-teens internal rate of return on our investment, which will be the minimum that we can earn even if we do not receive further cash flow.”
Going forward the fund “continues to sell U.S. condominium and land holdings into an improving market,” a second appendix to the fourth quarter 2013 investment letter said. “Given low interest rates and continued turmoil and concern among investors in other parts of the world – the Middle East, Asia and Latin America – investors’ interest in real estate assets in the U.S. and Europe seems likely to grow. Without a disruption of some sort, either through higher interest rates or signs that the economic recovery is only a QE mirage, the U.S. is likely to continue to experience slowly-improving fundamentals and robust competition for opportunistic and stabilized real estate assets.”
Baupost: Arby’s contributor to private equity profitability
In a private equity deal, Baupost purchased a “significant equity stake” in Arby’s for $80 million in 2011. As of the fourth quarter of 2013, the investment has returned $165 million to the fund. “Apart from capital leases, the business was unleveraged at the time of acquisition, and our equity investment was covered by the value of real estate assets that were owned free and clear. With strong downside protection, we were well positioned to benefit from basic ‘blocking and tackling’ improvements to products and operations that significantly enhanced the financial performance of the business.”
Baupost’s public equities portfolio works well in 2013
Although valuations look lofty, Baupost’s public equity portfolio was another bright spot in 2013, with the firm producing a 45% return in 2013. Many of their gains were in well known stocks, such as American International Group Inc (NYSE:AIG), BP plc (ADR) (NYSE:BP) (LON:BP), Vivendi SA (EPA:VIV) (OTCMKTS:VIVHY), Bollore SA (EPA:BOL), while other investments were of the less traditional variety.