Maglan Capital letter to investors for the month ended 31, 2015.
Maglan Capital increased in value by 6.55% (net of all fees) during the month of October.
For 2015, Maglan Capital has decreased 5.43% (net).
In the most recent 3 years, Maglan Capital has averaged an annual gain of 21.72% (net).
At this moment, many event-driven, value-oriented investment managers can be criticized for sending mixed messages. On the one hand, most will say that they are getting ready for the number of corporate defaults to rise and for the next distressed wave to begin; on the other hand, they are all almost fully invested in current situations, many of which are equity-based. What gives? Indeed, we live in interesting times.
As we’ve seen during the past few years, the Fed’s zero interest-rate policy has encouraged, and in some cases, forced, investors to chase risk assets, including, equities, real-estate and unicorns. And, as long as this policy doesn’t seem to be coming to an end, investors will be encouraged (or forced) to continue with much of the same.
That said, the tumult of August and September solidly proved the notion of and enforced the mindfulness of the illiquidity and fragility of the markets, especially the high-yield debt market. The current illiquid and fragile state of the high-yield market could further exacerbate losses and selling (and create distressed buying opportunities) during the next fear streak or during the next true downturn. As a result of the Dodd-Frank Act and other bank-related regulations, since 2008, risk-taking has shifted from banks to being more concentrated among hedge funds and assets managers, which have a much less stable capital base than public financial institutions, which could force investment liquidations and untimely exit from investments.
Therefore, based on the current state of limbo and the closest we’ve gotten thus far to an interest-rate hike, the best active investment strategy is one with an immediate value-driven focus in equity positions, with an eye toward dislocation in debt markets, incited by a Fed rate-hike.
Consequently, Maglan’s portfolio of legacy positions consists of equity-based, value investments (as opposed to fixed income-based or growth equity investments), and each investment represents a deep discounts to peers and is predicated on high confidence in identifiable catalysts that are expected to unlock value. However, we are feverishly combing through a myriad of highly-levered capital structures and we are adding debt investments to our radar daily, in anticipation of fixed-income dislocation triggered by an interest-rate hike.
Unlike 2008, we don’t expect the next period of balance-sheet stress to be broadly triggered by either by fundamental liquidity issues or maturities/refinancing difficulties. Most companies are carrying adequate cash balances and have access to deep revolver liquidity and, the previous years’ refinancing activities were so robust that, there are scant debt maturities on the near-term horizon. Rather, we expect that a Fed interest-rate hike will cause considerable concern surrounding the yield of existing debt instruments. And, when prospective, fearful sellers of debt instruments seek to access the market, they will find a radically reshaped broker-dealer marketplace, which is very shallow in comparison to pre-2008. Furthermore, fears of global slowdown stoked by the actual drop in demand for natural resources will put particular, increased pressure on issuers connected to the energy, metals and mining industries.
Maglan Capital – Fragility in High-Yield
From 2005 through 2009, we, the founders of Maglan, were Directors in Credit Suisse’s Leveraged-Finance Sales & Trading Group. During that time, the Group was one of the most profitable hubs of the bank. In both bonds and bank-debt, the bank made deep markets, by carrying inventory and by utilizing considerable balance-sheet capacity. Although Credit Suisse was a general leader on the Street in this respect, it had adequate company (JPM, MS, Citi, DB, GS, UBS, ML, Lehman, Bear).
The post-crisis financial industry consolidation coupled with the vice-like tightening of balance-sheet flexibility, attributable to new laws and regulations and self-imposed, conservative measures, has radically changed the depth and liquidity in the high-yield debt market. Evidence of that was front-and-center in the month of September, when we witnessed near-par and stressed bonds from various issuers gap down 5-10+ points on a few trades and no related news. And, that activity was NOT limited to energy, metals and mining; it stretched to telecom, cable, industrials, healthcare and chemicals.
Recent activity by big financial firms confirms that September’s paradigm is likely to get more violent going forward, due to a waning number of participants that are increasingly hampered by capital constraints. According to recent news reports, broker-dealers, including Jefferies, Goldman Sachs and Morgan Stanley, are watching trading profits dwindle with no real clue if or when they will ever come back. Giant banks, including Wells Fargo and Credit Suisse, are raising new capital. J.P. Morgan is selling off a chunk of its private equity business. AIG is contemplating breaking into smaller pieces. And, General Electric is getting out of the financial services business entirely. A senior executive at a large Wall Street bank, recently summed it up in saying “Dodd-Frank, no matter what Bernie Sanders or anyone else says, has put a tax on the size of banks, you pay more if you are bigger and there is real change because of it. Everyone wants to be more bank-like and less trading-like. People want to get more boring and smaller. No one is looking to bulk up.”
Recently, however, the high yield market has seen dramatic in-flows. The last week of October saw a $2.03b inflow into high yield funds, which followed the prior week’s $3.343b (the second biggest inflow on record, according to AMG/Lipper). That figure was topped only by the $4.25b in the week ended Oct. 26, 2011, and was also the biggest inflow seen so far this year, beating the $2.935b in the week ended Feb. 11. There have now been four straight weeks of inflows, with the most recent two weeks mentioned above having followed a $1.476b inflow reported for the week ended October 14 and a $735mm in the week ended October 7.
Therefore, we may still be distant from a persistent risk-off environment and an extended period of market contraction. So, although the market is fundamentally weak, right now, fighting the powerful, technical tide of demand would be a futile effort. Moreover, we are cognizant of how much dry-powder is waiting for the downturn. As Bruce Karsh of distressed giant Oaktree Capital recently boasted, Oaktree can “deploy billions of dollars in a short period of time at the right time.” Therefore, even at the right time, we will be patient and very selective with our targets.
For now, we’re watching and waiting for the right distressed entry points.
As for the immediate outlook for our portfolio, traditionally mega- and large-caps lead the way in a recovery, however, once the market achieves some stability, mid- and small-caps recover and excel beyond their large-cap peers. We have already started to see signs of the recovery and acceleration.
Maglan Capital – Madalena Energy (MVN; MDLNF)
Since our last update, the macro environment in Argentina is looking much brighter and the company’s prospects have also taken strides forward. Finally, in the next few months we are expecting major, potentially blockbuster, gas and oil well results.
Maglan Capital – Argentina Presidential elections
In late October, Argentina held its Presidential election. As we’ve stated in the past, based on the platforms of each of the leading candidates, Madalena is set to operate under more favorable circumstances after the election of a new President than in the environment currently in place under the leadership of President Cristina Fernandez de Kirchner, regardless of the winning candidate. Leading up to October’s election, it was widely believed that Daniel Scioli, a Kirchner-party member, would secure the presidency. In a surprise result, Mauricio Macri, the present Mayor of Buenos Aires, who has advocated for swift and far-reaching financial reforms for Argentina, was able to force a run-off election, which his scheduled for November 22.
More importantly, the results of the first-round of the Presidential election were shockingly good for the Argentine economy. The biggest takeaway from the results of the first-round (and the fact that there will be a second-round in late November) is that a very big portion of the public supports Mauricio Macri and wants fiscal and economic reform. Although we’ve always assumed that Scioli is going to win, a Macri win in the runoff will be even more positive for the country and its economy. Moreover, either winning candidate will take to heart the public’s sentiment for financial reform and legislate and govern appropriately. That bodes very well for currency reform, debt-default settlement and resulting external investment in Argentina. All of those things would be positive for private enterprise in Argentina.
In addition, specifically as it relates to Madalena, these developments will help the company secure the credit facility the company has previously discussed, once the final election results are settled.
Maglan Capital – Madalena Contingent and Prospective resource report
During the first week of November, Madalena released the results of a resource survey of three of its concessions in Argentina. In short, there is ONLY increasingly positive information in the report. The report is validating of Madalena’s recent focus and activity and further increases the attainable blockbuster value in its assets and operations. Immediately, the report, highlighting Madalena’s success and intrinsic value, will help the company in its ongoing discussions to secure financing to exploit its resources and, to the extent that it is strategically appealing, in discussions with potential partners.
First, for purposes of context, this report focuses only on 3 of the company’s 12 drilling concessions in Argentina (Coiron Amargo (Vaca Muerta shale), Valle Morado and Curamhuele (Lower Agrio Shale and Vaca Muerta Shale)). Only 2 of the 3 concessions are being worked on currently (Curamhuele and Coiron Amargo). In addition, the company is actively drilling and producing in other concessions not covered by the report (e.g. Puesto Morales (which we visited in the spring) and Surubi). Until now, Madalena assigned a “non-producing, no reserve” status to the Valle Morado block. In our company valuation, previously, we have assigned scant value to the Valle Morado assets.
In September, Madalena began drilling a high-impact, large well in Curamhuele, targeting oil in the Lower Agrio shale and liquids-rich natural gas in the Mulichinco tight sandstone. We expect that the company will release details on this well by the end of November.
In addition, Madalena is currently active in the Vaca Muerta shale formation in the Coiron Amargo block, directly adjacent to YPF’s Loma Campana block and YPF’s recent “Super Well” (in total, YPF is currently producing 40,000-50,000boe/d in the block). Madalena expects to drill two to three Vaca Muerta horizontal multi-frac wells over the next two years. Madalena is currently evaluating extensive 3D seismic information over the entire Coiron Amargo block and collaborating with Shell, in preparation to drill its first horizontal multi-stage frac well in the Vaca Muerta in 1Q 2016. This activity comes on the heels of Shell being awarded a 35-year exploitation contract in blocks immediately adjacent to Madalena’s Coiron Amargo block and pledging to invest US$250 million in exploration on those blocks.
Maglan Capital – Bottom Line
The report, assessing Contingent and Prospective resources, produced a resource estimate for the Vaca Muerta shale at Coiron Amargo that is 374% higher than the previous report in December 2012. Moreover, based on exploration data from Madalena and E&P majors (Shell, Chevron and YPF) in the area, the “Chance of a Discovery” is set at 100%. The “Chance of Development” is set at 60%, which is based upon accessing the capital required to develop the resource, commodity prices, and political risk. In other words, the engineers assigned a 60% chance that Madalena will convert 91.5 MMBoe into reserves. The high probability of success is attractive to the major and supermajor oil and gas companies that surround Madalena’s Coiron Amargo block. Similar to the capacity of the Coiron Amargo block, the report estimated the Lower Agrio shale at Curamhuele at 99.4 MMBoe and 92.6 MMBoe for the Vaca Muerta shale at Curamhuele.
Practically, the timing of the report is important because it is separate from and unique to Madalena’s annual year-end Reserve assessment.
Madalena’s success to date in advancing its Argentinian resource plays appears to be paying off with exponentially increasing resource estimates. Aggregation of the latest best case scenario estimates (P50) reveals total risked Contingent resources of 105.2 MMBoe (172.7 MMBoe unrisked) and 192.0 MMBoe (1,522.5 MMBoe unrisked) of total risked Prospective resources. Continued drilling and delineation success should eventually move these Prospective and Contingent resources into bankable Reserves
Immediately, these reports, highlighting Madalena’s success and intrinsic value, will help the company in its ongoing discussions to secure financing to exploit its resources and, to the extent that it is strategically appealing, in discussions with potential partners.
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