Maglan Capital increased in value by 1.93% (net of all fees) during the month of May.
For 2015, Maglan Capital has increased 22.29% (net).
In the most recent 3 years, Maglan Capital has averaged an annual gain of 51.92% (net).
Seth Klarman On Margin Of Safety Investing
This is part nine of a ten-part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m taking a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers. All of the material Read More
The US market is currently in a mature phase of the economic cycle (arguably, we have been there for some time, and we may be there for another year or two). Over the past 5 years, the size of investment targets that satisfy Maglan Capital's “core investment” return criteria1 has come down, from well over $1B to closer to $250mm. That is representative of other data points, which indicate that we are nearing the end of deep-undervalue in equity investments. Therefore, although our current core investments continue to have sizable room for growth, we are vigilant about the circumstances that will frame the next downturn. And, therein we are seeking solid investment opportunities (short and long) for our portfolio.
Maglan Capital - Investment priorities since the Financial Crisis
In the wake of 2008, there have been a number of priorities that have shaped the ensuing regulatory and legal reforms and recalibrated investor sentiment, including, transparency, liquidity and systemic risk. These priorities are especially true as they relate to securities’ investments (directly or indirectly).
The foregoing priorities have led to changes in investment banks’ trading and investing activities and their required capital cushion. These same factors have led to more transparency and regulation of investment managers. On the whole, investment banks and traditional investment managers involved in securities, form the middle of the liquidity and transparency spectrums. They have received the brunt of the scrutiny since the crisis.
In contrast, since the crisis, investors have flocked en-masse to the ends of those spectrums, chasing “liquid” products to no end and encouraging unregulated asset managers in unregulated illiquid and opaque assets (e.g. real estate, peer-to-peer lending, venture capital). Furthermore, they have induced some investments to be morphed into “liquid” instruments and they have fueled frenzied valuations in illiquid assets.
In every financial product cycle, if technical drivers are strong enough or the herd mentality is pervasive enough, or both, there will be a point of indiscriminate demand. In response, financial product designers and marketers are always happy to oblige.
Maglan Capital - "Liquid" Products
One fear that gripped the investing public in 2008 was illiquidity. Instantly, the ability to quickly convert assets to cash (which isn’t always to an investor’s benefit) became a top priority, which hasn’t worn off. Moreover, as long as a product is packaged and sold as "liquid", many complacent investors have come to rely on packaging and solely thereby achieve the necessary level of comfort.
Charged with the demand for liquid products, financial product designers and marketers have sought to provide investors with more "liquid" investment products. Now, 6 years into a rising market and an economic recovery, desire for "liquid" products hasn't abated and financial product designers and marketers have taken almost every conceivable product- liquid and illiquid- and have attempted to package it as liquid, in the form of ETFs (exchange-traded fund), UCITS funds2 or a "liquid alternative" (an alternative '40 Act fund; “LiquidAlt”).
Maglan Capital - Liquid offerings with Illiquid underlying assets
One of the cardinal rules of investing is that an investing vehicle can never be sold on more liquid terms than the underlying asset. When the getting is good, only a smart investor discriminates. When the proverbial s--t hits the fan, and the herd demands to cash out, only then do the masses realize their folly.
Many ETFs, UCITs funds and LiquidAlts have truly liquid underlying assets and are properly structured. However, as the recovery has worn on, there are more of each that are being constructed that do not have underlying assets that are as liquid as the derivative product or are not as liquid as advertised. Currently, there are thousands of ETFs, over 500 LiquidAlts and the total UCITS funds’ AUM is greater than €200B, representing one-third of the total AUM of the Alternative category in Europe. Although by definition LiquidAlts and UCITS funds are alternatives and are supposed to mimic alternatives, like hedge funds, all three products have current offerings which include many less liquid and illiquid underlying assets. Moreover, there is now an ETF for every asset class flavor, some that are way off the path of liquidity, and some ETFs are thinly capitalized and traded.
Some of these offerings will seize-up even upon the mere feeling of a chill in the market, let alone what will happen in the event of an all-out freeze. Moreover, as long as the heat runs high, product developers and marketers will venture further afield to satisfy investors' appetite.
Maglan Capital - The Search for Fixed-Income in a No-Income debt environment
As a result of the Financial Crisis many fixed-income products offered by banks and others as more liquid than their underlying assets came under fire and scrutiny, such as, CLOs, CDOs, hard-money/direct lending funds, and auction-rate securities. The Financial Crisis proved to be the ultimate in illiquid environments. And, as a result, many of these products became illiquid and subsequently were either outlawed for banks, obsolete or reformed.
Since that time, these products have risen again. Some are being offered with better controls (CLOs and CDOs), but some are now offered and controlled by unregulated, unconstrained non-banks or “shadow” banks and are packaged in a more dangerous way than before. The investing public's desire for liquid products and the exclusion (by choice or by regulatory force) of regulated participants from the businesses has driven the resurgence. However, the most important factor for growth in these “yielding” products is the Fed's rescue package for the economy, which has included an extended low-rate policy that has fueled an unending quest for a fixed-return of decent size (which isn't a high bar these days; but it will be getting higher).
As evidence of the power and size of non-banks, in April, 53% of the Government-backed securities originated in the residential home-loan market, came from non-bank mortgage originators, such as Quicken Loans and LoanDepot.com. That is the highest percentage ever. These entities have less regulation because they are funded by investors, rather than by capital from bank depositors. In the commercial loan market, direct-lending funds, which also don't use depositors' capital, surged to $30B in 2014. And, BDCs (business development corporations), many of which have credit-lines with banks (which could cut back on lending at any time), jumped to $55B in 2014, from $17B in 2010.5 All of these "shadow bank" activities are not constrained by federal lending guidelines, like the Fed's leverage-lending guidelines issued with the Office of the Comptroller of the Currency and the FDIC, and many smaller participants are not even regulated by the SEC.
The most extreme form of the lending frenzy in our view is peer-to-peer lending. Peer-to-peer lending (P2P) has grown like wildfire due to the desire for yield and the ease of transacting through the use of technology. P2P is expected to reach $77B this year, a 15x increase from 2012. In our view, peer-to-peer lending is hard-money lending for the masses, and portions of the hard-money lending business were rocked very hard in the Crisis. The growth in the strategy has been explosive and many unsophisticated investors are going with the attitude that “the idiosyncrasies of ‘my deals’ will allow me to survive a downturn". Some investors won't be correct on this assumption, others will need capital and be forced to liquidate an illiquid asset, and others have already executed "bad" deals because rampant proliferation of the product has already led to the rise of some bad actors. Moreover, absent any changes, volume growth should rise because securitization of these loans has recently begun.
Maglan Capital - Hug Those Bricks
The asset-class that arguably sustained the most minimal realized setback in the Financial Crisis, which roared back quickly thereafter, and which hasn't stopped its stratospheric rise, is commercial real estate. Rising interest-rates and the realization that every transaction can't be predicated on the "flip" will soon serve as a wake-up.
On the flip side of a desire for liquidity, in the wake of the Financial Crisis, many investors have also taken the position that illiquid assets are better for riding out a storm, and therefore they have had an insatiable desire for illiquid investments, such as real estate and venture capital. For commercial real estate, in addition to the demand and the unprecedented ease of access to investments, the Fed’s low rates have provided the steroids to property values.
However, the fact is that as time goes on and technology advances, businesses will employ fewer people (commercial office real estate) and less retail shopping will occur in physical locations (commercial retail real estate) and more will occur on-line. We have already started to see this tectonic shift.
Moreover, interest rates will rise. Probably slowly; but, they and cap rates will rise.
In the real estate frenzy, we have been witnesses to many newbies- investors and managers. Unlike hedge funds, where terms are standard within boundaries, terms for real estate “deals” between managers and investors vary widely from transaction to transaction, including as they relate to expenses, preferred returns, dormancy, fees, penalties, etc. We have been witnesses to passive investors holding over 30 line-items in their real estate portfolio, with no geographic commonality, no use commonality and no clarity on terms. It’s scary.
The fact that real estate is principally a fixed-income investment is no longer recognized. When the “flip” is no longer an option, the asset-class and investors will come back to basics.
Maglan Capital - The Great “Unicorns” and #FOMO (Fear Of Missing Out)
One of the most impactful lessons of the Financial Crisis on many investors, in addition to the blows taken from losses, is failure to identify the incredible investment opportunity that the Crisis created. Many investors kick themselves because they did not take adequate advantage of investing when things were bleak.
The fear of missing out (“FOMO”) is pervasive in the market. It has been present at every major dip (for the S&P, Dow, etc.) in the past few years and it is present for every asset class and business that has had blockbuster growth lately. The FOMO is most pervasive in venture capital.
The number of private, start-up, technology-based companies valued at $1B or more (a “Unicorn”) has doubled from 40 in late 2013 to 80 today. The lure of investing comes not only from the fundamentals of the underlying business but also from the private, clubby nature of the investment and the possibility of being invested in the next world-changing technology.
As an example of how hot the environment is and evidence that tech executives are aware of the ease of raising venture capital, the CEO of Slack, a newly minted Unicorn, recently said:
I’ve been in this industry for 20 years. This is the best time to raise money ever. It might be the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians. It’s certainly the best time for late-stage start-ups to raise money from venture capitalists since this dynamic has been around.
Slack is an office communications app, which was recently valued at $2.8B, 180% more than it was valued at one-month prior. And, the company has been in business for a total of one year.
This certainly cannot continue and will end very badly for some. These investments are entirely illiquid and are being made on the basis of a very robust investing environment and generous assumptions about future growth and profitability, in a world of minute-to-minute technological progression and change.
Self-restraint by investors is elusive and the current robust demand coupled with the Fed's low interest-rate policy will continue drive growth for these products until such time as a forced correction is unavoidable.
It is our belief that within the foregoing elements lie some of the makings of the next downturn. We will continue to explore them and, if appropriate, exploit at the right time for the benefit of our investors.
Maglan Capital is an event-driven investment fund with a concentrated portfolio of investments across the capital structure of small- and mid-cap companies with core focus on financial distress, restructuring and operational turnaround.
We appreciate your support and confidence in our team.
Steven Azarbad, Chief Investment Officer and David D. Tawil, President