On the back of what I consider negative M&A for our portfolio (see prior post), another position reported yesterday that it is being acquired for roughly $67, while currently trading for $55. The market reaction is, not positive, mostly because it is a fully taxable event.
The stock in question is an MLP that is able to fully shield distributions from taxation, so long as you don’t sell. I’m simplifying the tax consequences, but that’s roughly the idea. The result is a holder has to pay taxes on the depreciation recapture, or more simply, the difference in basis and buyout price, as adjusted by distributions over time. If you owned it starting Friday, this is of no consequence. If you’re an aging boomer and have owned it for a decade, it is more meaningful.
We will have to pay taxes, but especially in light of getting taken out at a discount on another position last week, the context for me is positive money is better than negative money. So don’t get married to companies, don’t get into situations in size where you don’t control the outcome, and expect the unexpected.
An active week has passed. From surviving the chaotic LAX Terminal 6 with kids, to handling M&A transactions within the portfolio, to ending my Twitter account @the_red_deer, it’s good to be home. Moreover, it’s even more exciting with summer arriving in Seattle, and the installation of central A/C. I’m ready for warm weather.
In a previous post, I mentioned four investments that we own classified as code red, indicating my concern about their ability to maintain current distributions. Two of them resolved within the quarter, one by reporting updated financials, which reduced the key uncertainties, and sent the stock 30% higher. The other resolved by announcing the sale of the asset – a retail shopping center. However, a third red-listed investment resolved this week, but not positively.
Franchise Group revealed that it signed a definitive agreement to be acquired by its management team at a disappointing price. As expected, the company adjusted its earnings to support the idea that the discounted takeout offer is reasonable. Although treating stock investments as owning the whole business isn’t entirely false, it’s not entirely true either. As a minority holder, risks exist that don’t exist when you own the entire company.
In this case, when management sees itself as a keen capital allocator, that applies to their situation, not always to that of the shareholder. The CEO is most certainly maximizing value for himself by taking the company private, which is legal. One may not think it’s fair, but it’s a lesson that financial markets are a dog-eat-dog world, and if you expect someone to take care of you, you won’t make it far.
So what’s the lesson here? One is diversification. An index investor won’t ever have to write this post in the extreme. In our case, taking a 30% loss on a 3% position doesn’t really move the needle. Second, one has to beware of backing “capital allocator” management teams. They say the things shareholders want to hear but aren’t necessarily on your team. And three, there are ways to own things that reduce such risk. Size, regulated businesses, and shareholder structure may limit this specific take-under risk, but they may open other risks.
Replacing an 8% yielding security with equity level duration isn’t an easy task. But sometimes life takes away and gives back. Good portfolio management involves pulling the thread of one’s interests without an explicit goal. For me, this led to finding companies that I would like to own, but whose valuations seem a bit high. On the same day as Franchise Group’s announcement, a company I track reported earnings and fell north of 20%. Ironically, the distribution was equal (on a dollars-per-share basis) to Franchise.
Lastly, I announced the closure of my Twitter handle @the_red_deer, which had over 5,500 followers. With the growth of my account came an influx of garbage in direct messages and responses. Twitter has been my mentor in a world without a real one, but the interaction from entry-level retail investors created substantial noise and distraction. Furthermore, I found that 90% of the value really came from interaction with perhaps 25 people and following fewer than 200 people. Being human means being influenced by likes/retweets/responses, and even though I didn’t care about engagement, I knew that my subconscious did. I can confidently say that I don’t feel the subconscious influence anymore after shutting down my account. Nonetheless, shutting down @the_red_deer doesn’t mean I won’t be on Twitter. In fact, I’ve already rebooted and am sure that I’ll re-engage with those that I’ve found mutually beneficial.
The above Twitter thread was promoted by well known hedge fund manager Boaz Weinstein, who I’ve written about prior. The major conclusion is that private credit is going to have its leverage pulled as a result of deteriorating portfolio metrics, and the result will be major dislocation. It got strong airplay, predictably, as Weinstein effectively vouched for the original poster as highly credible.
The following was my initial reaction (via Twitter), with further commentary following.
Everyone wants to paint private credit as a binary scenario. Certainly Boaz has an interest in doing so given the instruments he bets with. It’s also much more exciting to think about a replay of ’08.
In reality it’s likely shades of gray and less calamitous.
1) Everyone talks of defaults. But levered issuer earnings have gone up in ’22, and signs point to the same in 1Q. While interest is squeezing margins, absolute earnings dollars are up. Thus companies are *de-levering*. Doesn’t mean they have a hard time refinancing.
2) It’s shades of gray. There are some real garbage private credit lenders out there (in terms of quality), and some that care about not losing money. But all you see are top-line metrics that look the same on the back of low rates / defaults.
Things with giant asset managers on top tend to have shadow support from the manager – meaning their financials aren’t reflective of the financial support they have. There are many examples of support being extended in a quiet way.
3) It isn’t a one way street in which lenders get scared and pull lines. Often times, these warehouse lenders make their overall revenue lines in large part from fees derived from these same clients in other lines of business. So it isn’t all that simple.
I’ll finish my unorganized soap box with – the scary events happen where nobody is talking about, always. Things like private credit, lev loans, CLOs have been in BBG headlines at least every month as the next thing to blow. Just food for thought.
So that guy thinks that there may be a major dislocation in junk credit. But what of the equity that sits on top of it? I think people, lazily, have for the most part assumed that PE equity was trash to start with and is worth less than zero today. A few things…
Interest coverage. Interest coverage at PE companies is somewhere between 1.5-2 times on average, based on what middle market lenders report. That is down from near 3 times before interest rates rose, but still comfortably above 1x. So while there’s some smoke, there’s no fire.
Growth. PE owned companies are…growing. Private credit lenders often report portfolio company growth to gauge portfolio health. Midcap reported 1Q23 revenue growth at low double digits with EBITDA growth in the high single digits. So margins are shrinking but absolute profit dollars are rising. Diameter Capital wrote the following in their 3Q-22 letter [my edits]:
To start with some context, it’s helpful to consider the way that inflation has impacted earnings.
…Consider a business that in 2021 had $100 in revenue and $50 in variable costs. It was hit hard by inflation, with costs up 10% to $55. Revenues were up, but only by 6% to $106. The company’s profit margins were arithmetically down. It’s return on capital is also lower. But its earnings grew year-over-year by 2%.
This encapsulates the second quarter earnings that were delivered throughout the summer, as inflation yielded nominal earnings growth despite margin difficulties.
To get the kind of real capitulation that the bears have been waiting for, you need earnings to retreat, which only happens in recessions and hasn’t yet materialized.
Midcap’s CEO also commented in early 2022:
Just sort of at the risk of being a little back of the napkin here, but just generally to the market for us and other senior lenders, if you have a 5x senior loan, when LIBOR or SOFR was below 1, say our book had an average interest coverage, a senior interest coverage of 2-3x.
If those equivalent rates go up on a 500 overspread to 250-300, you’re going to move to 1.9 or 2x on average, apples to apples which no doubt (interrupted: probably that’s even the fixed charge coverage, so interest is even…) even more so, but that’s the quantum move which is not an irrelevent move, but obviously the other issues like you know, EBITDA getting compressed because of supply chain and inflation and labor costs, that’s a much more significant item.
The interest cost is just sort of like a cherry on top. So, like the performance of the companies is what matters a lot more. Again, it’s not irrelevant, but it’s just an input, and it’s not probably the most important input when you think about how all these floating rate portfolios – I mean obviously if [base] rates went up to 800 points, that would be differerent, but there would be a whole different set of reasons that that would occur. We are still in a historically low to moderate [range of] interest rates. I mean, it’s a long way from kind of where it was even 20 years ago, let alone the peak of 40 years ago. It started at zero. So yes, it’s still relatively low in terms of debt service costs, we’ll see what happens.
Today, the economy is strong. I think people hate to admit it, but cutting out speculation of the future state, all current numbers point to a tight labor market and economic growth. Specifically, UE is 3.4% and the Atlanta Fed is predicting 2Q23 GDP to clock in at 2.7%. In this frame it’s really hard to envision wholesale capitulation, especially in the debt, of said portfolio companies.
What would you guess a B+ rated company that is PE owned, net leverage of 5.5x, EBITDA of $1.7B and about $10B in debt outstanding would price $3.5B in loans and bonds in today’s sort of market? It’s an unfair question because that is not enough information.
Clarios is a Brookfield owned carve-out from Johnson Controls that sells car batteries for ICE and next generation vehicles. Last week it priced $2.75B in term loans at S+375 and senior secured bonds at 6.75%. All in pricing for the package was about 7%. Keep in mind for issuers in the $250M zip-code and below, loans are going out at around S+700 (perhaps B/B- issuers).
What does this mean? For me, it simply means that it’s difficult to paint an entire market with one brush. As mentioned before, it’s shades of gray. CCC debt is trading somewhere north of S+1000, in some cases far north of that. Until EBITDA turns materially negative across the board (a real recession), we’re just shaking out some players that happened to be swimming naked, not throwing out the proverbial babies with the bathwater. Clarios is case in point of great pricing for well situated junk issuers.
And in a market that is waiting for the most hotly anticipated recession in this generation’s memory, the current data are not pointing towards one that causes dislocation, liquidation, and associated deep distress. It may come, but in my opinion, the reason for such an event won’t be what is talked about today, and the epicenter won’t likely be near where most are watching.
In a long-standing debate over which yields more career satisfaction, passion or hard work, Steve Schwartzman offers his perspective:
Each individual possesses their own unique perspective on what is correct. In my opinion, based on personal experience, developing self-assurance (as opposed to insecurity) is a key driver towards achieving happiness, both in one’s career and in life.
It took me quite some time to discover my true identity, mainly because I was overly preoccupied with striving to become what I believed others would view favorably. I exerted considerable effort in this direction, yet I was simply chasing the wrong objective. The outcome was a perpetual sense of discontent that I could not quite comprehend. This resulted in a lack of longevity in my chosen careers, relationships, hobbies, and more.
Now, at the cusp of forty years of age, things have become clear to me. I have a better understanding of how I like to spend my time intellectually, what I desire in a relationship (and fortunately, I have it!), and my own financial values. Although one might ask whether this understanding is a result of age, the answer is both yes and no. Wisdom does come with time, and experiences help to gain it. However, I believe that if I had focused on answering questions for myself instead of trying to impress others, I would have discovered the intersection of passion and natural ability at an earlier stage in life.
Nevertheless, life is not about dwelling on the past. Looking forward, with the lens of self-assurance, I have much to look forward to where passion intersects opportunities across all parts of life.
As we returned to the rainy land of Seattle and I resumed my high-dose vitamin D supplements to cope, I found myself without a strong bias as to where markets may sail to next, like many others.
Both IG and HY spreads have tightened significantly since the “March Madness” in banking. Stocks have drifted higher, with certain sectors showing interesting movements (such as homebuilders making 52-week highs despite mortgage rates being over 6%). Unemployment continues to print well below 4%.
The above are just a few head-scratchers amidst the fear present in markets. Nevertheless, there’s always something to do, and my current interests include consumer and mortgage credit.
On the consumer side, both banks and non-banks have been geared up for an unemployment rate of 5% or higher for almost a year now. Credit has been expanding, but mainly on the back of balance expansions rather than swift new customer additions. However, delinquency trends suggest they may be turning lower, and with each day that passes with sub 4% unemployment rate, the downside scenario for these firms becomes smaller.
On the mortgage side, numerous mortgage originators have exited the market or gone out of business. While it’s difficult for me to understand whether companies like United Wholesale or Rocket are worth buying, there are places to play around the perimeter that offer less torque but more certainty of outcomes on the downside. Select hybrid m-REITs may fall into this bucket.
Apart from that, we’re slowly building dry powder as distributions roll in and have a shopping list at the ready.
Currently lacking a good book to read at night, I have returned to an off-the-run investment resource that I revisit from time to time. Last night, I came across a discussion of Japan’s currency in 2017, a topic I’m not particularly interested in. However, the author boiled it down to something that resonated with me. Though the author mainly referred to a long-term view on the Yen versus the consensus view that the Yen is a natural short due to Japan’s monetary policy, it may apply to most public security investing.
Most investors believe the correct approach to investing is to figure out what you think is going to happen in the future, and then position yourself accordingly. I don’t. I think you should figure out what other people think is going to happen, and then look for ways in which they may be wrong. This is because it is changes of opinion that drive financial market asset prices, not the future as it is currently envisaged. All the big money in markets is made and lost in the tails – things that people generally do not expect to occur that nevertheless end up occurring. You make money by being positioned to benefit from major changes in aggregate opinion. That is why (intelligently implemented) contrarianism pays.
Put simply, the question to ask is: What is the public market pricing in terms of outcomes? And then, what potential outcomes that would cause a dramatic change of opinion could happen, that seem improbable and not priced in today?
One example that fit this framework is the one coal name we hold. When we purchased it in 2020, the global price for coal was in the doldrums, and there wasn’t any good visibility on when the industry might come out the other side, if at all. At the time, it almost seemed like a run-off investment at best. To compound matters, the name went down by 75% not more than a few weeks post-purchase.
Fast forward to today, and coal experienced an unexpected rocket ship ride (that has since come back to earth), and the company booked multi-year contracts to lock in volumes, something it hadn’t been able to do for a long time. It now generates roughly a 30% yield on cost.
I would never claim to have foreseen such an outcome. However, though with a less experienced mindset, I may have inadvertently provided myself with a cheap shot on goal for the outlook for such a hated name to change. And when the change of opinion happened, the tail opened up for the big money to be quickly made.
Over time, our investments in real estate limited partnerships have shifted from mainly investing in apartments to open-air shopping centers. Prior to the rise in interest rates in 2022, high-quality shopping centers were trading at cap rates between 6-8%, and financing was available long-term at 2-4%. The spread between the un-levered yield and funding cost was healthy. While there was always some turnover related to retailer failures, such failures were mostly accounted for in our underwriting process.
Overall, our experience investing in retail real estate has been fruitful. During a challenging time for yield investors, retail offered double-digit yields with relatively stable assets and associated revenues. However, the current environment appears materially different, largely due to higher interest rates.
Recently, I received a pitch from a sponsor I like for a portfolio of shopping centers being sold by a real estate investment trust (REIT). The assets are considered high quality on the retail spectrum, with cap rates in line with the past but with simple property improvement opportunities that have not been pursued by the REIT. This is because the REIT is in liquidation. The value-add is as simple as answering tenants’ calls for leasing or re-leasing. It’s simple, boring, and generally what I should be looking for.
However, the issue I grapple with is the spread between funding and un-levered yield in today’s environment. In the past, one could secure a spread of 2-4% going in, and even closer to the higher end. Today, the spread appears to be more like 1-3%, and closer to the lower end. While the stabilized spread may end up at more like 3-4% after improvement plans are completed, that assumes everything goes according to plan. Simply put, the selling prices or gross incomes haven’t changed to the same degree as funding costs have, a phenomenon common throughout not only real estate but many other rate sensitive industries as participants grapple with future expectations of funding costs.
Outside of real estate, non-bank financials’ equity is priced as if unemployment has already pushed over 5% (figuratively speaking), while they have prepared their balance sheets for worse. Energy infrastructure companies may never trade similarly to high-quality real estate or utilities, and rightly so, but the degree of conservatism baked into their business valuations today offers substantially more cushion to weather a wider band of outcomes, versus real real estate today.
In conclusion, while I generally like the idea of adding to my portfolio of retail real estate, now is not the best time to do so, based on my comfort level with other investment options. It’s important to note that what’s best for me may be the opposite for other market participants. Ultimately, investment decisions are like snowflakes – unique to each individual’s goals, risk tolerance, and interests, as well as the particular investment being considered.
The current market based estimate for inflation over the next 12 months is 2.1% (as of March 2023), providing a low bogey relative to the recent past to outpace inflation, if correct.
Investment income was up 29% compared to the prior-year quarter, due to timing mismatches of current and prior quarter distributions. Gains in income over the prior year quarter will trend lower for each subsequent quarter and turn negative for Q4-23, counterbalancing the large Q1-23 increase. Estimated full-year 2023 investment income is tracking at +11% versus 2022, backed by increased dividends, reinvestment of excess cash, and reallocation of lower-yielding investments.
There is investment specific downside risk to the current estimate (in addition to macroeconomic driven downside risk). Two investments were added to the red-coded watchlist as their fundamental performance has deteriorated in this economic environment. One is suffering from trough capital markets activity, while the other made missteps in inventory purchasing during peak global supply chain bottlenecking. Both have affirmed dividend payouts, however dividend coverage is thinner than prior years, and thus both are at some risk of reductions if their condition deteriorates further.
The previous red-listed investment confirmed a reduction in distribution from roughly a 12% distribution on equity to 5%. This open-air shopping center was funded with floating-rate debt in January 2020, with a rate cap that expired in January 2023. The value-add components of the investment have met or exceeded plan, and thus the property has a cushion despite the higher rate environment. While the sponsor is looking to sell the asset in 2023, it is unlikely to transact until capital markets calm, perhaps in 2024.
Reinvestment opportunities are strong on the back of fear of a pending trough in the economic cycle. Select companies or ETFs within the following areas appear interesting for reinvestment, as the aim is to maintain a balanced exposure across the risk spectrum during the current non-recession recession:
Name
Yield
Reasoning
Energy Infrastructure MLPs
8-10%
– Stable business model – Boost from de-globalization – Tax advantaged yield
Non-Bank Financials
7-10%
– Best in niche leaders are cheap – Capitalized for recession – Prio. profit over growth – Low payout ratio
Open Air Shopping Centers
7-10%
– High relative spread to funding – Modest new supply – Stable anchor tenants
When there is no current crisis, much attention is given to predicting the next one. It is common for people to scrutinize riskier activities in search of the cracks that may lead to the next market cycle break.
This time around, assets such as leveraged loans, private credit, and low-income borrowers – among others – have been identified as potential sources of concern. However, it is important to note that the factors that could break the system are often unknown and unknowable to most.
what's unprecedented about this situation is that it's AAA rated assets getting banks in trouble. who would've thought that could happen.
The above comment was made in jest, as the Global Financial Crisis (GFC) was caused by seemingly safe AAA MBS tranches that wreaked havoc on financial institutions. Similarly, the current banking headlines are also the result of highly rated, mostly government or municipal-backed securities that are backing banks into a corner as depositors look for higher-yielding pastures.
Put simply, when everyone is focused on a particular issue, it becomes more difficult for that issue to cause a surprise. Dislocation is often caused by surprise, by definition. Consider constant subprime fear-based headlines, which are likely in part due to the lingering effects of the GFC.
The saying goes that “price is what you pay, and value is what you get.” The point of the above chart is that while higher quality credit may feel safer, a severe dislocation may leave you without appropriate reserves relative to a calmer period. On the other hand, if you lend to subprime borrowers and price correctly, the volatility of these already low-quality customers may not be as severe. Of course, being a subprime lender and pricing poorly can lead to self-destruction.
A senior investor commented last fall, somewhat morbidly yet presciently, that what concerned him was not the cancer risk of a credit default cycle, but the heart attack risk of asset-liability mismatches in light of a rapid tightening cycle. What we are witnessing in real-time are asset-liability mismatches in banks, UK pensions, and other areas that have been the source of recent dislocation. While it remains to be seen whether more asset-liability mismatch-related dislocations will occur, it is likely that they will happen in the least expected places.
The investment industry poses an interesting conundrum. Active public stock investment managers meticulously scrutinize each investment’s growth potential, revenue predictability, margin potential, competitive positioning, full risk set, and more. Yet, if we consider these managers as individual businesses, they would probably fail to pass their own scrutiny.
To clarify, investment managers evaluate a company’s revenue potential and certainty over the next three to five years. They assess the likelihood of delivering value to customers within a reasonable timeframe and compare the company’s unique positioning and products to others in the industry. They also consider whether the industry is saturated with similar businesses.
An alternative way to examine the situation is through the lens of private asset fund fee structures. A public stock manager would likely generate negligible fee revenue from their portfolio companies (dividends) and rely heavily on performance revenue, which can be highly volatile and unpredictable. If an alternatives manager had a similar revenue profile, they would receive a poor public valuation due to the uncertainty and instability of earnings.
Ironically, public stock managers often criticize financial advisors, not realizing that their core value proposition includes planning, education, optimization, and financial therapy. Real estate investors also face condescension from public stock managers, although real estate investments typically generate tax-efficient returns from income or fees rather than revaluation of the asset.
When I tell people I solely manage our own savings, many have asked why I do not take on third-party money. At first, I lacked a satisfactory answer, but now it is clearer to me that forming a business based solely on gain-on-sale profits is not a business model I could look someone in the eye and feel confident of a positive future outcome.
