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.
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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 for the hedge fund industry are that a number of newer, smaller managers do not quite understand the risks they are taking or they are taking inappropriate risks. I worry that such new managers will be the fodder for forthcoming headlines.
Question: Given what occurred in the past few years, aren’t the big hedge funds taking on more risk than the new small boutique managers?
Lee Ainslie:: There is a vast difference between the type of risk and the degree of risk that many of the large funds are taking today compared with a decade ago. The leverage and the directional bets that the largest funds were taking just five years ago are staggering by today’s standards. Fortunately, some very talented individuals made decisions that were proven correct more often than not. But these managers would only have had to make a few missteps to generate very disappointing results. For the larger funds today, the returns probably will not be as impressive as the returns of the large funds of the past, but I doubt that any of the major funds will have significantly negative returns either.
There are certainly some advantages to being smaller, but my fear is that many people who are starting funds do not have a strong grasp of the risks they are taking. Risks on the short side, in leverage, and in position concentrations are new for many. Investors need to be wary and do thorough due diligence on these smaller funds.
Marc Lasry: There’s a world of difference between managing money and managing a business. The problem with small funds is that in the beginning, the person managing the money is also the person managing the business. If you can’t do both, you will have significant problems. In the past few years, many people have raised money and are running $50 million–$200 million funds. These people have never been in a bear market or a market with a great deal of volatility. If you don’t know how to manage those risks, you’re going to find a lot of surprises.
Question: Is distressed-debt investing different now, with the large concentration of issues in the telecom industry, than in the past, when specific company problems were spread among various industries?
Marc Lasry: It is different. In 1990-1991, the majority of the companies with major problems ended up filing for bankruptcy, whereas today, even though a large number of companies are filing or defaulting, a massive number of companies are trading at distressed levels. The challenge is to make a credit decision as to which companies will not file.
If you can buy debt at 50 cents on the dollar and if your credit analysis says the issuing company is a good bet and the analysis is correct, the debt’s price should rise to maybe 80 cents on the dollar and the company will never enter bankruptcy proceedings. That’s something that didn’t occur in 1990–1991. On the telecom side, we’ve been extremely comfortable buying Juniper Networks, Ciena Technologies, and Nextel Communications at 60 cents or 50 cents on the dollar. These companies are not in bankruptcy, and we don’t think they’re going to file for bankruptcy even though their debt is trading at distressed-debt levels.
Question: What portion of your return comes from style bets on the long and the short sides?
Lee Ainslie: Over time, the vast majority of our return has been generated by the alpha of our stock picking.
Question: How about growth and value, those traditional styles?
Lee Ainslie: I have a hard time thinking of us as a value or a growth manager. By being hedged within each industry sector, growth and value biases are largely hedged. So, when one style goes in or out of favor, it has little impact on us.
We certainly think of ourselves as managers who understand and respect the economic values implied by stock prices and enterprise values, and we certainly value growth and are willing to pay what we believe is an appropriate premium for growth. But I have a hard time saying that we are either a growth or a value manager. In fact, in 1994, a consultant attempted to answer this question. He took the long side of our publicly filed portfolio, ran it through an analytical program, and pronounced that we were a growth investor because our average P/E was greater than that of the S&P 500 while our dividend yield was less. In 1999, we went through the exact same exercise, but this time we were pronounced to be a value investor. While our P/Es and our dividend yield had hardly changed from 1994 to 1999, the market had changed markedly. So, whether or not we are value or growth investors is clearly relative.
Question: Do you know of any formal studies that look at a single long–short manager versus hiring two managers-one on the long side and one on the short side?
John Freeman: No, I don’t. There aren’t that many pure short-sell managers to make that type of study worthwhile anyway. They certainly weren’t popular at the end of the 1980s, having gotten run over by the 1980s bull market, and they haven’t done much to establish themselves in the 1990s.
And in terms of risk, if you have a separate long manager and a separate short manager, you’re basically throwing away the opportunity to get the benefits of diversification. You also lose the benefits of the prime brokerage arrangement and the capital efficiency gained by shedding the deadweight of active traditional management when you undertake a long–short approach. I have to believe that doing long-short in a combined setting is far more effective.
Question: What keeps you up at night?
Lee Ainslie: Individual stock decisions. That is really all we care about. I am thinking about individual positions and where we could be doing a better job in the risks we are taking and trying to make sure the investments we have are appropriate for what we are trying to achieve. Macro concerns do not worry me at all.
Question: Are you seeing more problems with well-established companies or with dot-com-types that never had real numbers to begin with?
Marc Lasry: What we’re seeing today, at least on the distressed side, is that world-class companies, such as Macy’s, are having problems. We’re seeing established companies with real cash flows and exceptionally large companies either filing for bankruptcy or having substantial financial problems. PG&E filed for bankruptcy, and it certainly is an established company, as is Enron.
When you can buy a company such as AEI, which is the fourth largest coal producer in the United States with about 200 million of EBITDA, between 2.0 and 2.5 times earnings, real opportunities exist in the market. Nextel has cash flow of $2 billion—that’s its EBITDA number. It does have $14 billion of debt, but based on where it is trading in the marketplace, you’re buying it at a 3–4 multiple. So, real opportunities are out there today, and I think that they’re going to continue. These opportunities are actually greater today than they were in the early 1990s.
Question: Do you ever short distressed debt?
Marc Lasry: We often ask ourselves hether we should also be short. Rarely do we short, and the maximum value of our funds that we have shorted was about 5 percent. It is very hard for us to find compelling shorts, and most shorts that we look at are around 50 cents on the dollar. So, if we’re going to go short a bond at 50 cents, we’re doing that because we think ultimately it is worth 20 cents on the dollar. At least with shorting distressed debt we know what our downside is—par. But the problem is that we’re already starting at a –20 percent current yield because if the bond has a 10 percent coupon, that bond has to drop at least to 40 cents for us to just break even. If we could come up with great shorts at par, we would. But you don’t really know about them when they’re trading at par. You find out about them when they’re trading at 50–60 cents, and it is much harder for us to short those.
Question: What is your strategy with regard to the stock that is created in a reorganization plan of your distressed companies?
Marc Lasry: We sell it. Our average holding period is about 18–24 months. We’re not very good at valuing stock, and to me, once a company comes out of bankruptcy, its stock is once again in the universe of all other stocks. Although I may think it is a cheap stock relative to where we created it, 5,000 other stocks are in the universe, and I just don’t know where those are traded. We’re not equity guys. We’re distressed-debt guys. So, we get out of a stock pretty quickly.
Question: How long do you hold a distressed issue if the company’s financial situation begins to improve and the value of the bond increases?
Marc Lasry: If one of our distressed issues starts trading at 12–14 percent of par, we get out. But if one of our holdings is trading at 20 percent or 15 percent of par, we’ll hold on. I think we’re very good at valuing when an issue should be trading in the 20–80 cents range. When the issue starts moving above 80 cents and then suddenly trades at 12 percent of par, that’s no longer within our level of expertise. We can do it, but other people do a far better job than we can.
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