Graham & Doddsville Spring 2016 issue – Q&A with John Phelan of MSD Capital, Alex Magaro of Meritage Group, Adam Wyden ’10 of ADW Capital and Mark Cohodes.

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We are pleased to bring you the 27th edition of Graham & Doddsville. This student-led investment publication of Columbia  Business School (CBS) is cosponsored by the Heilbrunn Center for Graham & Dodd Investing and the Columbia Student Investment Management Association (CSIMA).

In this issue, we were fortunate to speak with four investors  who offer a range of perspectives based on their unique paths to and careers in investing.

John Phelan of MSD Capital discusses lessons learned over  decades of investing with mentors such as Richard Rainwater, Sam Zell, Eddie Lampert, and Michael Dell. John offers insights into the development of MSD Capital as well as his own development as an investor and PM, while shedding light on challenges he sees today in the investment management industry.

Alex Magaro of Meritage Group discusses his many experiences, from running a business as an owner-operator to investing in early stage companies,  which led him to co-manage Meritage Group. Alex talks to G&D about long-term investment horizons across asset classes and the return potential of businesses with durable competitive advantages.

Adam Wyden ’10 of ADW Capital discusses the influence of an entrepreneurial spirit on his firm and investment process. Adam walks through past ideas such as IDT and Imvescor Restaurant Group (IRG.TO) as well as current theses on Ferrari (RACE) and Fiat (BIT:FCA).

Mark Cohodes shares his experiences from a lifetime of short-selling. He offers his perspective on the discipline and temperament required as well as the intellectual rewards of a career in short-selling. Marc discusses ideas such as Home Capital Group (HCG) and Tempur Sealy (TPX).

This issue also highlights photos from the 19th annual CSIMA Conference as well as the 9th annual Pershing Square Challenge.

Lastly, we are proud to include in this issue finalist pitches from current students at CBS who competed in this year’s Pershing Square Challenge.

When we inherited Graham & Doddsville as editors last year, we wanted to continue the tradition of providing our readership with high quality interviews and investment ideas. We sought to provide diversity of thought and experiences via our interviews. We hope we have lived up to those objectives.

We are honored and privileged to have continued the Graham & Doddsville legacy, and we  look forward to reading thenext generation of issues, helmed by three outstanding individuals in Brandon Cheong ’17, Eric Laidlow ’17, and Ben Ostrow ’17. We want to thank Brandon, Eric, and Ben for their commitment and dedication to Graham & Doddsville over the last year.

As always, we thank our interviewees for contributing their time and insights not only to us, but also to the investment community as a whole, and we thank you for reading.

- G&Dsville Editors

Graham & Doddsville Spring 2016 Issue - John Phelan; Adam Wyden; Mark Cohodes

John Phelan of MSD Capital

John Phelan is Co-Managing Partner of MSD and Co-Founder of the firm. Prior to forming MSD, he was a Principal from 1992 to 1997 at ESL Investments, a Greenwich, Connecticut based investment firm. At ESL, Mr. Phelan was responsible for ESL’s Special Situation Investments and helped grow the firm from $50 million to over $2.0 billion in assets under management. Prior to ESL, Mr. Phelan was Vice President in charge of Acquisitions (Western Region) for the Zell-Merrill Lynch Real Estate Opportunity Funds.

John Phelan began his career at Goldman, Sachs & Co. where he worked as an Analyst in the Investment Banking Division.

John Phelan received his M.B.A. from Harvard Business School and graduated cum laude with distinction and Phi Beta Kappa from Southern Methodist University with a B.A. in Economics and Political Science. Mr. Phelan also holds a General Course degree with an emphasis in Economics and International Relations from the London School of Economics.

Q&A with John Phelan

Graham & Doddsville: To start off, talk about your background and your path to investing, including mentors and influences along the way.

John Phelan: My mother was a very big influence on my development as an investor. My father was a doctor and, like most doctors unfortunately, not a very good investor. My mother, on the other hand, came from a real estate background and focused very much on cash flow. My parents gave me a Disney stock certificate for a birthday present when I was five years old. That got me hooked—I was fascinated by numbers and seeing something trade every day. That's what got me into stocks.

I initially went into real estate, where my mother taught me quite a bit, including two principles: make sure you can always pay your bills and debt service and the importance of free cash flow for levered assets like real estate. She also encouraged me to go find good mentors. She said one of the things about good mentors is you can learn on someone else's nickel. It's something you don't realize when you’re younger. But it struck me at a very early age to try to go find people that were the best in their particular businesses, and I think my mother pushed me towards that.

In my real first job, I worked with an uncle rehabbing apartments in New York. I was doing that during college. That was an eye-opening experience that forced me to focus on cash flow every minute of the day. It was a very tough business and I was doing a number of different things. The work ranged from running the numbers to actually doing construction work. That teaches you a lot. I also learned I didn't want to break my back doing that for my entire career.

I was fortunate enough to get a job with Goldman Sachs, which was really the first big company I worked for. At the time, Goldman was still a private partnership. I learned a ton and I had a number of great mentors at Goldman Sachs. I worked with truly exceptional people there.

As great as my experience at Goldman was, it did make me realize that I did not want a career in investment banking. Instead of being the person who is on call 24/7 to serve my client I wanted to be the client. I preferred being a principal as opposed to an advisor. I decided to attend business school and was accepted into Harvard Business School. The summer between my first and second years at business school I worked for Richard Rainwater, and that's where I met Eddie Lampert. Richard introduced me to Eddie. Of those ten weeks that summer, I spent about three or four with Richard and the rest with Eddie.

Graham & Doddsville: How did you connect with Richard?

John Phelan: I had been hoping to get back to Texas after business school and I wrote Richard a letter. In that letter I told him I would be willing to work for free and one of my professors at Southern Methodist University had suggested I contact him. I told him I just wanted to learn from one of the best and was willing to invest in myself.

Richard called me on a Friday at like 4:00pm. He said “Hey John, this is Richard Rainwater.” I thought it was one of my classmates playing a joke on me. I used a curse word I shouldn't have and just hung up the phone. A minute later the phone rang again: “I think we got disconnected.” I'm thinking, “Oh my God, this is Richard Rainwater. I cannot believe I just hung up on this guy.” I said, “I'm really sorry, but my classmates have been playing jokes on each other, and I thought you were one of them.” “Oh that's a pretty good one,” he laughed—he was very good about it.

I flew down to Fort Worth on my own dime and met with Richard. He said, “Meet with these different guys. You can work with me for a bit and see if one of them will take you as well.” I met with Eddie and a couple of other guys who were with Richard at the time. I didn't know a lot about risk arbitrage, but I knew they were analyzing stocks and that was something I really wanted to do. It was a tremendous learning experience. I really enjoyed working with Richard and Eddie that summer, and I fell in love with the risk arbitrage business. One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside.

I graduated in 1990—not a very good year to graduate from business school, as you can imagine. The markets were bad, the RTC/bank crisis was accelerating and most money managers were having a bad year. It was a rough year. Eddie said, “Listen, I don't know if I'm going to be in business much less have a job for you. It's not clear. You should go find something.”

Graham & Doddsville: Did you end up working with Eddie?

John Phelan: I actually graduated without a job. It was depressing because I didn't expect to be jobless, in debt, and living at home with my parents after graduating from Harvard Business School. I knew I did not want to go back to banking, so I did not do that. Luckily a couple of the guys I had worked with at Goldman in Chicago left the firm to go work for Sam Zell. Bob Lurie had died and he was really Sam's right-hand man—they were partners. Sam hired Randy Rowe, who was the main person I worked with at Goldman in Chicago. Randy was kind enough to offer me a job. Sam had just raised his second distressed real estate investment fund and was one of the few people who had capital. It was a good time to have capital. The RTC was formed after a number of S&L’s failed, there were a lot of distressed loans, the trading market for loans was just starting to develop, and the illiquidity was incredible. Having capital at that time and being a liquidity provider to the banks was a unique and good place to be.

If you go back and study the great investors throughout history—the Medicis, the Morgans, the Rothschilds, and recently Buffett—these great investors with terrific records share a common trait: they were always in a position to be liquidity providers. Each was willing to hold cash until someone was in distress or under duress, and they could provide liquidity at very attractive prices. We have run
our firm without leverage and have only been 100% invested once in our 18 year history, the first quarter 2009. I actually consider cash to be an asset class.

About nine months into the job, Zell through his Zell-Chilmark fund started taking a hard look at Executive Life, which had a large junk bond portfolio. I was asked to work on credits that had large real estate components: RiteAid (RAD), Carson Pirie Scott, Charter Medical—any company that had a big real estate component to it. We were trying to value both the real estate and going concern value as that was what the debt was secured by and the real estate provided your downside protection. We lost the Executive Life auction to Apollo. It was a fascinating experience and I really learned a lot. I remember looking at Charter Medical debt which was secured by a large number of hospitals. I called Chase Manhattan and said, “Hey, we see you guys are the lead bank on this.” They said, “We've got plenty of debt for sale, we can sell you at 20-30 cents on the dollar.” We came to the conclusion we could've sold four or five hospitals and gotten all our money back at that price. That's how bad and illiquid the market was.

Understanding where you are in terms of seniority in the capital structure and identifying the fulcrum security was critical, so I started auditing a bankruptcy class at University of Chicago because I wanted to learn bankruptcy law. I thought it was an important aspect of the work I was doing. I put together a business plan on the side, while I was still working at Zell. I pitched Sam on the idea of setting up a junk bond operation to buy the debt of distressed companies. We had done a lot of work on over 100 companies. Exec Life owned only pieces of the debt, so there was a big opportunity to make a lot of money. Sam got up and slapped me on the back and said, “You know what, congratulations. I wish you a lot of luck—this is a fantastic idea. I think this is great.” I asked, “Did I just get fired?” He said, “No, you don't have to leave. But you're going to leave. I already know it. This is a great idea. I don't want to do this because I want to own and control companies. I'm not interested in owning pieces of companies anymore. I actually want to buy and control them. But you've got a great idea and I think you should go pursue it.”

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