A Question and Answer Session With John D. Freeman, Lee S. Ainslie III, Marc Lasry on portfolio construction and risk management.
Question: When doing investment analysis, do you consider how long a company will be in bankruptcy?
Marc Lasry: Yes. Our hardest task at Avenue Capital Group is to try to figure out how long a company will be in bankruptcy. We are trying to decide whether we want to invest at the beginning, middle, or end of the process. The time value of the investment affects the return the most. We have experienced situations in which we think the company will be in bankruptcy proceedings for one year, but it turns out to be a five-year bankruptcy because of the number of appeals. If that time in bankruptcy is longer than we expected, our return can suffer.
Question: Does litigation slow down the bankruptcy process?
Marc Lasry: In the bankruptcy format, unsecured creditors can vote on a proposed reorganization plan. If the most senior creditor is impaired (i.e., not expected to be fully paid under the reorganization plan) and that creditor votes in favor of the plan, then the plan is accepted. And if the plan provides for unsecured debt to get 90 cents or 80 cents on the dollar and unsecured debt votes in favor of the plan, then the plan is accepted. But the threat that unsecured creditors can tie up the proceedings by filing a lawsuit always exists.
In 1990–1992, the bankruptcy courts were flooded with cases in which they had to decide the value of a company in bankruptcy. These valuation hearings would last anywhere from three months to one-and-a-half years. These valuation hearings simply don’t occur much anymore, and when they do, they last about two weeks. Courts are no longer worried about getting reversed on appeal, so today a bankruptcy process may last only 18–24 months.
For example, the Pacific Gas and Electric Company (PG&E) bankruptcy looked like it might last three to five years because of the large number of lawsuits. Originally when investors were buying the PG&E distressed debt, it was trading at 50–60 cents on the dollar because everybody was assuming a four-year bankruptcy.The bondholders have been pleasantly surprised that the situation has turned out to be only a two-year bankruptcy.
Question: Do you work with the bankrupt company’s management?
Marc Lasry: It depends on whether the company went into bankruptcy because of the management or because of outside factors. If it was because of the management team, then the creditors will most likely work very hard to make sure a different management team is put in place, which will take a little longer. If it was because of outside factors, then we will work with management, which makes the process quicker because the debtor and the creditors’ committees are on the same side.
Question: Which is more astute, the debt market or the equity market?
Marc Lasry: That is a tough question because the equity market looks more at future value whereas the debt market looks more at what is happening today. Those in the debt market want to know when they’re getting paid—over the course of the next year or the next two years.
If I had to make a bet, though, I would bet on the debt market simply because at the end of the day, if the debt market is trading at huge discounts, I know what that means: In the short run conditions look pretty bleak. I can’t understand how the equity market continues to value certain companies the way it does.
For example, do equity analysts really know what’s going on with Lucent and other similar situations? At Avenue Capital Group, we have shorted Lucent because we believe the stock is overpriced. We did the same thing for Xerox Corporation and had our head handed to us on a plate. I can look at Lucent and have an opinion that if the share price goes from $6 to $12, for example, the price of Lucent’s debt should move up to par. The problem is that the stock price can move from $6 to $12, and the debt can only go from 60 cents to 80 cents on the dollar. So, I have lost a lot of money on my short stock position and have not made much money on my bond position.
We are not comfortable shorting a stock because many irrational investors in the market get pretty excited over the fact that Lucent is going from an EBITDA (earnings before interest, taxes, depreciation, and amortization) of –$5 billion to an EBITDA of –$2 billion. Based on news like that (and when we look at that situation, we have to ask ourselves what that means in terms of real changes in the asset value of the company), the stock can move up 5 or 6 points and the debt can move up also, maybe 5 or 10 points. We just don’t short a stock and simultaneously buy its debt. Although we’d like to pursue that strategy at times, we found that in the past it has hurt more often than it has helped.
Question: Do you lock in a spread after a plan of reorganization has been filed?
Marc Lasry: Yes, we do that quite frequently. We can short the stock then because we know what price we’ve created for it. We also know that we have stock that can be delivered against the short position. The question is: When is that stock going to be deliverable?
Question: If long-short management trumps long-only management even with a mediocre manager, why shouldn’t more managers jump into the long–short boat?
John Freeman: There is plenty of liquidity in the equity markets for more people to do the same kind of things we do at Freeman Associates, and we do need to make the pie bigger—to attract more people to long–short. We can do that by having a more diversified family of long–short investors. As a group, we need to cultivate more diversification of active strategies. There is definitely more room on the value side of long-short, but there’s also a need to make long-short successful with strategies that have low correlations with quantitative value strategies.
Lee Ainslie: I disagree about our need to attract more managers into the long–short equity world. The fee structure is attractive, and many new managers are pouring into the business. But only a few have experience on the short side, which is a bit of a different animal from the long side. In my mind, the hedge fund fee structure is the modern-day equivalent of “heads I win; tails you lose.” The view of most hedge fund managers is “Let’s take your money and take some risk. If we generate profits, then I will take my cut. But if we lose money, sorry, it’s your money.” People argue that the high-water mark compensates for that situation, but in reality, when managers are down significantly, they typically go out of business and the high-water mark is worthless. This asymmetric profile motivates managers to take risk that may not be appropriate.
I do not worry about any of today’s larger funds running into difficulty, like we have seen more than once over the past three or four years. My fears