One of our favorite investors at The Acquirer’s Multiple – Stock Screener is Howard Marks.
Howard Marks is Chairman and Co-Founder of Oaktree Capital Management, the world’s biggest distressed-debt investor. He’s known in the investment community for his “Oaktree memos” to clients which detail investment strategies and insight into the economy, and in 2011 he published the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor.
One of our favorite memos is his February 2007 piece in which Marks discusses examples of lenders and investors departing from time-honored disciplines when cycles move to extremes. It’s a must read for all investors.
Here’s an excerpt from that memo:
Lenders and investors invariably depart from time-honored disciplines when cycles move to extremes, out of a belief that current conditions are different from those that prevailed in the past, when those disciplines were appropriate. And just as invariably, they’re shown that cycles repeat and nothing really changes.
Everyone’s Got a Favorite
A lot of Oaktree’s activities center around buying bonds, making loans and trying to profit when debt that others hold goes bad. So who better than my colleagues for me to turn to for examples of mistakes in the making? I asked for examples of the race to the bottom, and the response was immediate and substantial. I won’t embarrass individual issuers or borrowers by describing specific transactions; the names have been omitted to protect the guilty. But here are some of the themes our people told me about:
Hot potato – There’s big money today in buying companies and then having them borrow money with which to pay you a dividend, even if doing so reduces the companies’ creditworthiness. Just a few years back, companies generally wouldn’t have been able to issue bonds or loans where the projected use of proceeds was dividends to their equity owners. But since people are so eager to invest today, they’ll lend to companies where much or all of the equity paid in – or maybe more than all of it – will be dividended out. They’re doing so on the expectation that they’ll be able to exit before risk turns into loss. “If things take a turn for the worse, I’ll get out” is a refrain that accompanies most market excesses (tech stocks in 1999 and condos in 2005 come immediately to mind), but rarely does it turn out that way.
Heads We Win/Tails You Lose – Part of being willing to pay more for less relates to the balance between upside potential, downside risk and who gets what. SPACs – or Special Purpose Acquisition Companies, also known as “blank check companies” or “blind pools” – seem like a good example of miscalibration. People put equity capital into a SPAC with no certainty as to what will be done with it. The SPAC’s “portfolio” is likely to consist of just one company. And the investors will get no return on their money as long as it remains unspent, which can be up to 18 or 24 months. The sponsor, on the other hand, gets 20% of any profits, as there’s no preferred return. It does so through warrants, which it can liquidate even without having sold the acquired company. And if it can’t make an acquisition, it just returns the money without penalty – usually reduced by banking and other fees.
Not My Problem – One of the stories I was told pertained to a company whose accounting problems had prevented it from issuing audited financial statements for a relatively long period of time. After the company went bankrupt, we were determined to learn more about its accounting issues than anyone else and then intelligently make a debtor-in-possession loan, through which we might gain ownership of the company. But before we could make the loan, someone else made the company a better offer: more leverage on cheaper terms, with no provision for accounting due diligence. When later we were able to ask about why we had lost out, we were told that one reason the other lender was able to be more aggressive than Oaktree was the fact that it had “pre-syndicated” most of the loan to hedge funds. This was accomplished in the absence of financial statements or accounting due diligence, but with validation from the high trading price of the company’s public securities (which was being set, again, in a financial-statement void). Okay, so the lender’s risk was limited. But how about the funds that bought the loan?
Complexity Outruns Analysis – Wall Street is incredibly inventive. It’s staffed by bright people, pursuing massive incentives, trying to out-think their competitors in order to win assignments to serve companies’ financial needs. Sometimes this results in structures that few people understand, fraught with hidden risks. My latest nominee is the CPDO, or Constant Proportion Debt Obligation. CPDOs provide capital to finance structured entities writing credit insurance on investment grade debt. Because this debt entails little credit risk, the returns that can be earned from writing credit insurance on it are similarly low. Thus, these entities have to lever up substantially – typically 15-to-1 – to provide the LIBOR+200 returns promised on the bottom-tier CPDO. The rating agencies bestow triple-A ratings on the CPDOs because (a) the riskiness of investment grade bonds is low and (b) the projected interest spreads and the net asset values initially are far more than sufficient to satisfy the covenants. But because the portfolios are so highly leveraged, these cushions can evaporate quickly.
I find two things about CPDOs worthy of particular note. First, this is the first-loss equity piece beneath a highly leveraged entity where consequences can be triggered by breaches of income and market value covenants. Thus, the equity beneath a portfolio of bonds averaging single-A, leveraged up 15-to-1, gets a triple-A rating. Huh? Second, as the Financial Times wrote on November 13, “if there are losses and the CPDO’s net asset value begins to fall from its target, the leverage is increased to try to earn more at a faster rate.” In other words, if you did a little of something and it didn’t work, try to recoup your losses by doing a lot.
What Due Diligence? – The other day, Orin Kramer (see “Pigweed”) observed skeptically that “the most profitable way to be a lender today is to have no underwriting department.” In other words, default rates are too low, and the market is too competitive, for credit analysis to be worth paying for. In December, Reuters described a takeover bid whose competitiveness was enhanced by a reduced due diligence period and a short list of information requirements. And most interestingly, one of the major investment banks told us recently that on most syndicated loans, about 70% of the buyers never visit the data rooms set up to facilitate due diligence.
Put the Pedal Down – FT.com pointed out on January 21 that, “One-tenth of the capital committed [to private equity funds] in 2002 was . . . put to work within one year. For funds invested in 2005, the corresponding proportion was almost 30 percent.” If the amount raised in 2005 was triple the 2002 level, as I believe was the case, that means private equity funds deployed capital in 2005 roughly nine times as fast as they had in 2002.
No one of these is evidence of misfeasance or terminal laxness by itself. But together they describe a market where a desire for quantity and speed has taken over from an insistence on quality and caution. And with that insistence goes the margin of safety that Warren Buffett urges investors to demand.
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