Mark Kronfeld of Plymouth Lane Capital spoke with NYU about activist investing. He runs the special situations strategy at the fund. Here’s the highlights.
What are the key indicators or criteria you use to help identify businesses and circumstances in which you can create and extract value as an activist investor?
My focus is on distressed and special situations investing with an emphasis on complex legal, litigation, structural and process value-drivers and activism. Our primary investment thesis is not primarily driven by what we think the underlying business is worth or macroeconomic factors. Rather, this style is designed to be highly idiosyncratic and we try to focus on investment returns that are as uncorrelated as possible to the broad market. This is not a play on beta. When I think about valuing a situation and the assets that will be distributed to creditors, our value drivers are quite different. I use my background as an exlitigator and an ex-bankruptcy lawyer to find mispricing in particular situations that are driven by complex legal issues that are not widely understood. For example, some may look at a mining company and look at EBITDA, PP&E, performance projections etc. But there are lots of other things that could drive value for creditors. For example, there could be tax assets, litigation recoveries, or substantial disagreement about how existing value ought to be distributed, to whom, and in what order. These are things driven by legal analysis as much as by valuation analysis, if not more so. These legal value-drivers could create incremental value that exceeds the value of the underlying operating business. The bankruptcy process itself can also make a business more valuable. One has to understand the interplay between investment analysis and legal analysis. In the world of distressed investing – they are inextricably interwoven.
How do you source ideas and screen opportunities?
In my opinion, the single most important key to investment success is time management. I am always asking myself: How do I get the highest IRR for the use of my time? Distressed situations generally tend to be less efficiently priced than other investment areas, usually because the right skill set is not being applied. These situations are so complex and there is so much going on, that in many cases, even in well-covered distressed situations, many things remain unanalyzed for a long time. We source ideas in different ways. We screen the news and research services including Reorg Research and Bloomberg for distressed events or companies facing restructuring or possible restructuring or other legally driven special situations. There are certain patterns I look for and that attract my attention. For example, as a company becomes more stressed, they may desperately start to raise more capital, or they may start to negotiate with existing lenders, or they may start selling assets – often to the detriment of one or more parts of the capital structure. There are often corporate actions designed to benefit equity to the detriment of creditors. Sometimes, we see actions that benefit one group of creditors to the detriment of another. There are legal consequences to such actions and analysis of these patterns may lead us to believe that the market has misinterpreted the propriety of such actions. There may also be conditions that are driving the problem – too much leverage, pending lawsuits, or even conflicts of interest or poor corporate governance. Also – whenever a company is doing desperate things – they tend to push the envelope of what is appropriate as outlined in the indentures and credit agreements and applicable state and federal law, and sometimes even foreign law. All these instances have the opportunity to create legal opportunities and pitfalls for investors. A lot of our idea generation is organic and comes from our analysis of a particular event or pricing structure. For example, I will look at how the market prices various parts of the capital structure and the factual and situational context of a distressed borrower or issuer (e.g., a company, municipality, or sovereign) and this tells a big story. Give me an organizational chart, a capital structure page with pricing and a timeline of events and something will typically stick out begging for further analysis and a preliminary investment thesis. Another big source of ideas is fellow investors. Distressed investing is highly collaborative and distressed investors often join forces in ad hoc committees. Likeminded investors who own a similar part of the capital structure will get together and hire a common counsel, a common advisor and will negotiate collectively. This allows the parties to share the costs of these services. The terms of credit documents also creates the need for a critical mass of investors with a specific voting percentage to combine forces to cause an event to occur not occur. For example, if you want to direct a trustee to take a particular action on behalf of your class of creditors, you may require a 25% vote. Or if you would like to do a coercive bond exchange offer, you may need the majority of the bondholders to agree to the terms. A lot of what you do requires collaboration. There is a lot of complexity and we bring each other in to supplement our own analysis and collaborate on an idea. Also – concentration of ownership makes it easier to negotiate and creates a more efficient and value creative process.
Can you give us an example of what your due diligence process looks like before pulling the trigger on an investment? In other words, what are the most important questions you need to get answers for?
After a preliminary analysis designed to assess interest level and “actionability”, the next step is a deeper dive analysis that ensures we have a solid understanding of the legal documents, the inter-creditor dynamic, and the rights of our class of securities. There are 3 critical questions that must be answered: What is the expected value and optimal structure of the company or estate? How does one maximize the distributable value of the estate? Who is entitled to the value and in what order and amount? Basically, we ask what is the pie? How can we make the pie as big as possible? And how should, under the law, the pie be distributed? And then, under the facts and specific situation, how will the pie be distributed. How something should happen isn’t always how something will happen. This is a reality that we are very aware of and plan for. I am very downside risk focused. We are always asking: How can I lose money? Where in the process can things go wrong? Can I as a creditor be disenfranchised? Is it possible that a court could rule in a way that is inconsistent with my legal analysis? How can I mitigate that risk? What is my worst case outcome? What is the liquidation value? I want to understand exactly where our worst case is. Are we buying at a price that already implies close to certainty that the worst possible outcome occurs? If so, then there is significant upside optionality. Next, I do a decision or probability tree to depict the wide range of potential paths and outcomes that are possible. I will work through every possible outcome and think about the probability associated with each outcome. We try to select an opportunity that has a very high expected value and a very high return. We look for significant upside and very limited downside. The riskreward profile has to be very attractive. The upside-downside profile has to be attractive. And if there is a way to create a paired-trade with no risk at all and attractive upside, that’s something we will do. Once this is done, the next big task is to execute and move it forward as an activist.
Can you share with us an example of an investment that didn’t go as planned?
Generally, there has rarely been an investment where something completely unexpected occurred. Because I always identify the downside risks, these aren’t a surprise. But having said that, I may still have thought that the court was more likely to rule a certain way, although I knew it was possible it may rule differently. So, I have been disappointed by a legal decision, I wasn’t surprised. Thankfully, this doesn’t happen often and even when it does, the investment can still be quite successful because we seek investments that have multiple uncorrelated drivers and not an investment driven by a single binary outcome driver.
Can you share with us an example of a successful investment?
Washington Mutual, Inc. was the holding company of its subsidiary Washington Mutual Bank. In 2008, there was run on Washington Mutual Bank and it was seized by regulators. The assets of the subsidiary bank were sold to JP Morgan, leaving behind the bondholders of both the bank (“the operating company / WMB”) and the holding company (“Washington Mutual Inc/WMI”). The holding company subsequently filed for chapter 11 – a major catalyst for value creation. At this point, we started buying the senior, subordinated and junior subordinated bonds the holding company for cents on the dollar. In our estimation, there were quite a few sources of value that, based on our legal analysis, were owned by the holding company and not the operating company. For example, we determined that, based on analysis of regulatory filings, the holding company had a $4 billion deposit in the subsidiary bank that was sufficient to pay the senior bonds at our cost basis, with material upside optionality on a number of highly valuable assets that belonged to the holding company. The operating company also had a large net operating loss which gave rise to a $5 billion tax refund to which we determined that the holding company was entitled. In addition to the cash deposit and tax refund, the holding company owned an insurance subsidiary, shares of Visa, material litigation claims against the U.S. government as well as fraudulent transfer claims against WMB and JP Morgan, and a massive NOL carryforward. After extensive litigation and negotiation, we successfully arrived at a global settlement agreement. By 2012, the senior and subordinated bonds of the holding company traded above par. The junior subordinated debt of the operating company also ended up trading at many multiples of where we first entered the trade.
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