Feature interview
Green Knight is a distressed, event-driven, special situations, deep value long/short fund manager with investments across the capital structure. We emailed with Green Knight about the huge asymmetric upside in Dell Technologies (DVMT), what to look for in bankruptcy documents, and why investors should stay away from frac sand players.
Seeking Alpha: Where are you finding distressed opportunities? How has the favorable financing market impacted the space, and what are the implications going forward?
Green Knight: Distressed opportunities are very limited right now. Credit markets are still buoyant and willing to fund just about anything. Basically, the only companies going bankrupt right now are bad businesses with some fundamental flaw or negative secular industry growth. If it is growing, though, no matter how unsustainable the capital structure, the credit markets will find a way to keep the show going. It doesn't seem like this will stop until we get a recession. That severely limits the opportunity set and makes shorting companies you expect to file especially hazardous.
Our search methods haven't changed too much, but we spend a lot more time on it now, much more than we do on research. The best place to look for distressed investing opportunities is monitoring bankruptcy filings and dockets. Additionally, just reading the news whether it be Bloomberg stories or bankruptcy industry newsletters can give you an idea of which companies are in trouble and where to focus your efforts. The implications going forward are the same as they have been for past downturns: companies that have overextended and levered up will go bankrupt and a lot of junior creditors will be wiped out. While there are certainly a lot of garbage projects in this country that should no longer be funded that we need to deal with, the real action will be in China where their entire financial system is at risk. I don't think we will experience anything like what is due Chinese investors.
SA: Can you discuss what you look for in your ideal event-driven or special situation trade, how you find them and give a few examples of ones that worked out (or didn't)? How do you evaluate them from a risk/reward standpoint?
GK: The investments we look at tend to cluster around two extremes: they either provide a good return and are essentially risk-free (or some very small degree of exogenous risk inherent to any investment) or the rest of the market thinks they are worthless, but we see a path where there is a decent chance that we make many multiples of our investment. Basically, we invest in things at prices which are a fraction of their probability-adjusted expected value. A recent investment that serves as an example of the first category was the arbitrage in Portage Biotech (PTGEF) and Biohaven Pharmaceutical (BHVN). Portage's main asset was ownership of over 6mm BHVN shares. The value of these shares exceeded the market cap of PTGEF minus all liabilities. When PTGEF announced in December that it was going to dividend out the majority of those shares in January, we were able to build a long position in PTGEF and a short in BHVN corresponding to the number of shares that PTGEF was going to dividend out. We were able to guarantee a gain of 6% after returning our shorted BHVN shares with an average holding period of a couple of weeks if PTGEF traded at zero after the dividend. Although we would almost never be unhedged owners of these types of biotechs, we knew that they are very popular among a certain investor base. Therefore, it was likely that PTGEF would not trade at 0, and just counting the retained BHVN shares minus all liabilities would be good for another 6% gain. The returns turned out to be even better than that: for a completely hedged position and holding period of around two weeks, it returned almost 24%.
An example of the second category was a liquidation of an energy company we'll call PipeCo that we completed at the end of last year. PipeCo filed for bankruptcy early last year with a stalking horse bid that nearly paid off all its liabilities. The stock however was only trading for pennies with a very low share count. We immediately recognized that if another bidder showed up at the 363 auction, it could turn the equity into a home run and began buying shares. PipeCo's type of assets were in demand in general especially with the rebound in energy last year. We engaged our law firm to represent us in trying to get an equity committee appointed. The auction occurred and a second bidder won with an amount that would put the equity in the money by a significant amount, possibly up to 10x our investment amount, if one just subtracted the liabilities outlined by the debtors in their filings. The next week it traded up 400% and we began taking some profits. It is a good thing we did as the week after that, the debtors published their disclosure statement that predicted zero vote and zero recovery from the plan for the equity. The stock fell right back to where it was previously, and we increased our position to nearly 10% of the company. It became apparent that the debtors were going to squander this windfall through bonuses to the executives, potential unearned payments to the private sponsor, and a massive amount of legal fees paid to three different top flight law firms, which was way out of line compared to what other bankrupt companies of this small size pay to run a short bankruptcy case. We redoubled our efforts to get an equity committee appointed, and after getting rejected by the DoJ bankruptcy trustee twice, we made an emergency motion to have the judge decide. We directed other holders to start a letter writing campaign to the judge, and thankfully, the judge sided with us. We formed an equity committee (which pays for all legal fees) which we led and got the debtors to change some things in the disclosure statement to our benefit. We then objected to the plan and the bonuses and ended up compromising with the debtors at the last moment, since, if we lost, we likely would have been wiped out. Once the plan was confirmed, the liquidation phase started. The lenders had control of the process until they were paid off which happened far sooner than projected. Then, the debtors answered to us, as we were appointed the equity representative during the wind-down. The relationship was still adversarial, however, and there were a number of things we disagreed with such as the elevated legal fees which the debtors did not contest with their law firms. To object to these things, however, we would have needed to go to court on our own dime, and if we won the $20K, let's say, contested matter it would have been almost entirely eaten up by the fees from the debtors' lawyers to answer the objection and argue in court. So, much of it was a lost cause because we were not talking about huge dollars. There were some areas where we saved the debtors some money, including negotiating with their law firms over their fees, and we sped up the process to get all creditors paid and a distribution to equity made before the end of the year. So, while it was not the monstrous ten- or twenty-bagger we had originally hoped for, it still generated an over 120% IRR during our 9-10 month holding period.
One investment which has not worked out yet is ResCap Liquidating Trust (OTC:RESCU). This was a trust set up for the benefit of Residential Capital creditors (mainly RMBS trusts and monoline insurers) at the end of that company's bankruptcy to whom RESCU sold faulty mortgages. RESCU owns some mortgages, cash and other assets which make up the current NAV of $1.24, but its main assets are the litigation claims it has against all originating banks which it bought those faulty mortgages from. It also has maybe the ultimate precedential case in the Minnesota district where it is litigating these cases: it brought a case against a different bank in 2009 which was operating under the same "Client Guide" agreement that almost all the rest of the banks it is suing signed with ResCap. ResCap won this case on summary judgment on all counts and was awarded losses, attorneys' fees and interest. The bank appealed this case to the 8th circuit court and lost there as well in 2012. We do not expect any different outcome from the court in these new cases. However, RESCU has been settling many of these cases at rates that have disappointed holders: around 2% of the original principal balance of the mortgages that RESCU bought. It is possible that the reason RESCU is doing this is because either the banks it is settling with did not have a large percentage of mortgages it sold to RESCU that were faulty, or they were not operating under the standard Client Guide, which made the case weaker, or there was ability to pay issues if it was a small bank or successor liability issues such as when the subsidiary of the bank that RESCU had a claim against was shut down at some point in the past. But even if RESCU just continues the 2% rate, with over $30B in mortgage OPB sold by the banks it is still suing, they would recover over $600mm. Along with current NAV, this would equate to over $7.30 per share, which would be return of over 45% from these levels. The alternative explanation would lead one to believe that RESCU is just leaving its best, most solid cases where damages and ability to pay are the highest. According to experts who testified in the case, these banks in total likely caused RESCU over $8B in losses which under the 8th circuit court they would be entitled to recover in full with interest and attorneys' fees. $8B would translate into an $80 stock price. We are likely to get some idea of which way this is going soon, which makes this idea even more attractive. Motions for summary judgment will take place in Q2 most likely, and trials are scheduled to begin in Q4. We will hopefully have a decision early next year and a damages award soon thereafter. So, thus far, we are up a tiny bit on this position, but we think the downside is small, and we could make multiples of our investment on the upside. This investment is not option value like PipeCo, but it is certainly closer to that end of the spectrum.
Our investments come from a diverse range of areas. Riskier, or investments perceived as riskier because they are priced at pennies on the dollar or have higher potential return, we think, are perpetually undervalued. Bankruptcies and trade claims are still inefficient investment areas, and smaller companies and situations can provide high returns no matter the market. We do spinoffs, bankruptcies, mergers, demutualizations, liquidations, litigation plays, post-reorg, levered and underfollowed small caps. We will buy trade claims, small issue bonds and bond stubs/liquidating trust certificates, private securities of public and private companies, warrants, options, preferred stock, rights, OTC equities or frontier securities. Basically, we will go wherever and do anything if it seems interesting and profitable. Unfortunately, because of all the market calm, there have not been a lot of these types of securities issued lately, and those that are outstanding are usually pretty fully priced.
SA: As you invest across the capital structure, currently, where do you see the most asymmetric opportunities (e.g. debt, equity)? Are there any key themes you've noticed?
GK: As we got into a little earlier, there is not a lot that is attractive right now. Even with the recent pullback in the equity markets and high-yield, there is not much to get excited about. Things would have to come down way more for us to starting putting a lot more cash to work or cover shorts. When you consider that multiples are at record highs as well as corporate margins (which have been greatly helped by low wage inflation and interest rates which are both reversing now), you can foresee scenarios when the stock market is down over 50%. Relatively speaking, though, bank debt is an attractive option when compared to high yield. You get floating rates, higher priority, and security in the capital structure if there are a lot of bankruptcies, lower leverage, much less duration risk, and you don't give up much yield compared to HY. Spreads on US HY is about 400 bps vs. loans that have spreads around 390. Bank debt is even more attractive when you consider the trend towards weaker covenants. While bank debt has been affected by this too, bond investors seem to have been the quickest to surrender their rights, and any control over assets precisely when leverage is increasing.
One situation which could have potential huge asymmetric upside is Dell Technologies Class V stock which tracks VMW shares which we recently published a write-up on Seeking Alpha. We will refer you to the write-up for all the details, but all the news since then seems to comport with our thesis. We think within the next month, Dell is likely to make a proposal for a reverse merger with VMware (VMW) and offer DVMT substantially similar terms. The option that people are most scared of, that Dell instead does an IPO and exchanges DVMT shares for Dell shares is overblown because Dell's valuation would be very low in an IPO now, and converting DVMT shares at a low Dell Class C price would hurt Dell, give a majority of the company to DVMT holders because of the poor exchange ratio, and thus DVMT holders would get most of the upside from the LBO. It is too much risk for Dell to wait to do this transaction and instead buy back more DVMT because VMW valuation could increase a lot in the future, and the DVMT share price spread could collapse, potentially hurting Dell. It is better to do it now and give DVMT holders a little less than VMW holders since Dell is losing money with the new tax if they wait as well. Dell's offer is likely going to have some cash component to it so that Dell can anchor the VMW price and thus the Dell stock price to it such as $160 and offer DVMT an exchange ratio with no cash option at the equivalent of $130 per DVMT share, thus capturing that spread today. The cash amount will be small so that if all holders elect it, it will just be a small pro-rata piece, but it will help stabilize the stock price. With our options position, we could be looking at a 100-600x payout.
SA: In your excellent call on Implant Sciences (which rose ~60% the week after publication - also featured on the Bloomberg Terminal), you mentioned that this was "almost free money" due partly to the idea that the retail investor base didn't know how to value a company in bankruptcy - can you discuss how investors can perform this type of valuation analysis?
GK: Implant Sciences may be one that you can chalk up to the "ones that didn't work out" column that you asked about earlier. After the last 10-Q was filed but before the bankruptcy, a creditor had converted $7mm in debt to preferred stock. The debtors detailed their debt when they filed but didn't disclose anything about preferred stock anywhere as is typical in bankruptcy cases. So, we missed this extra $7mm which definitely hurt returns, but because we built in such a margin of safety, there was still the possibility to make nearly 100%. Unfortunately, management burnt a lot of cash on its attempts to maintain control and its jobs by trying to buy a hoverboard company which fell through thankfully. I've never seen this before in bankruptcy and the equity committee had to fight against these loopy ideas. This burnt more cash and finally equityholders were offered 7 cents or let management buy a pharmaceutical company. Equity intelligently opted for the 7 cents.
This type of analysis certainly isn't simple and takes many years of going through bankruptcy documents to know what to look for. Basically what you are doing is adding up all the assets and liabilities and then providing an estimate for a cash burnt or built from the business and then any professional and DIP loan fees among other things. You also have to adjust for lease rejection claims or contract damages. Then, you have to understand how the bankruptcy code will affect the value distribution based on the individual facts of that bankruptcy and company, individual creditor parties, and even the court district and judge. For someone who is interested, I would recommend searching for a bankruptcy docket on a claims agent website. Read through the petition, the 1st day declaration, the DIP loan motion, the 363 motion if there is one and the disclosure statement if one has been filed yet. Those should give you the basics then you can go through the schedules and statements of assets and liabilities and any other motions than are filed on the docket.
SA: Are the frac sand players a potential buying opportunity given the significant stock declines (as projected in your great call on Emerge Energy Services (EMES)) and negative sentiment towards the energy space or are they a value trap?
GK: I don't think they are even cheap when looking at current multiples so they don't even qualify for the dubious value trap honor. Our thinking hasn't changed much since that article was published although we covered our shorts a while ago. They are enjoying the bounce back in drilling activity, but if there is any hiccup in demand, the weakness of their competitive position will become apparent. With no barriers to entry, margins will collapse. These companies are all over-levered, so while they have more scale than many of their competitors, I still expect to see bankruptcies in the future.
SA: How can investors capitalize on mutual conversions? Where do they find them, and what are the typical catalysts and time frames? Will this always be a source of alpha, given its niche and general investor misunderstanding of how to value and/or screen for them?
GK: Mutual conversions are potentially great investments for individuals. A number of people have made lists of them that one can probably find with an internet search or one can search banks that have a majority owner: the MHC will own over 50% of these banks. There's only a little over a couple dozen trading on the market that have completed their "first step" conversion, but you can become a depositor at any mutually-held bank of which there are over 600 and then get the right to buy preferentially priced shares in the first-step IPO. Because you are buying at such a low book value, you don't need a catalyst right away since that value is just compounding, and the banks are buying back shares on top of that. Many stay outstanding for years with an average of 3.9 years until their "second step" conversion when the MHC shares are sold to depositors and the public. The time between steps seems to have lengthened recently probably as a result of low valuations for banks brought about by low interest rates. You can read about the whole process in my write-up, but the general misunderstanding comes down to the MHC shares that make up majority ownership not really existing or having any economic consequence which causes the banks to screen badly and be tough to value. It may always be a source of alpha because these banks are just too small for most institutional investors even though they have consistently outperformed. Probably for these reasons, they will never be priced appropriately.
SA: What's one of your highest conviction ideas right now?
GK: Right now, my highest conviction idea is Syncora (OTC:SYCRF), which is a monoline insurer that was left for dead after its large losses in the downturn. It has performed many restructurings and liability management exercises and gotten the business to the point where it is more than stable: it is the least levered monoline in the public markets. Just last month, it entered into a reinsurance transaction with Assured Guaranty (AGO), which assumed 91% of SYCRF's remaining exposures and took over all the administrative costs associated with monitoring the portfolio for a $30mm payment beyond the reserves and unearned premium revenue that were also transferred to AGO. So, now, SYCRF's insured book is less than 3x its claim paying resources. That leverage number is reduced further when counting the $335mm payment from a litigation settlement in February that is not included on its latest balance sheet and was $283mm more than they accrued for. That settlement, when including the AGO reinsurance payment, should increase book value from $4 as of 9/30 to about $7. Their remaining exposures are mainly municipals, the largest of which is Puerto Rico by far and within that mainly PREPA, the electric utility. Others have written much more extensively about PR and the creditor litigation, but at this point, bond prices in the 20s are baked into SYCRF's stock price, so there is a lot more potential upside than downside. And with all the hurricane rebuilding support and a potential infrastructure bill in the works, PR could get a lot of cash to modernize which is only good news for creditors. The island's position does not seem as dire as it did in the fall especially after a multibillion-dollar secret fund was discovered. The full net par outstanding of PR exposure would be about $2.50 per share, but that is before counting reserves which likely brings exposure down to around 75 cents assuming a complete 0 for their bonds. So, that is the past. The thing which makes this interesting and timely right now is management says it will announce the results of its competitive auction for its American Roads private toll road subsidiary by the end of this quarter. American Roads is valued on SYCRF's books for $172mm but by way of comparison, before SYCRF took it over out of bankruptcy American Roads had $830mm of bonds outstanding. The difference could be over $7.50 in book value. But that's not all. SYCRF is suing the former owner Macquarie because it believes Macquarie fraudulently induced them into insuring those bonds by inflating traffic projections. SYCRF could be owed interest and attorneys' fees if they were to win their lawsuit which could be in addition to the proceeds from the sale. With over $30mm in revenue, American Roads could be valued at over $500mm based on recent multiples and the fact that over 65% of that revenue is likely EBITDA with potentially more if it were part of a larger company. The sale could potentially add $3.70 to $6.30 in book value to SYCRF. Interestingly, Macquarie is one of the many bidders in the auction according to news sources. We believe that it is likely that as part of the sale or before it, Syncora settles its litigation with Macquarie since the sale price could limit damages. This could make for a very big one day announcement. Once it has completed the sale and settlement, SYCRF is likely to start using its last big asset: a $2.5B NOL. At a 21% corporate rate, this is worth $525mm or $6 in book value. Most analysts typically value it at 5-10% of the NOL amount, which would be $1.50-3. SYCRF is likely to next be on an acquisition hunt for a cash flowing business that can take advantage of these tax assets. By the end of the year, SYCRF could be a completely different operating business. Adding it all up, SYCRF could be worth $12-24. Even if it trades at 50% of book, that could be quite a return in a short amount of time from current levels of $3.65.
***
Thanks to Green Knight for the interview. If you'd like to check out or follow their work, you can find the profile here.
