When Dotting Your I’s and Crossing Your T’s isn’t Enough

It’s amazing the difference that one word can make in an 80,000 word document. Last month it came out that the fate of a $450m bond issued by Caesars Entertainment may be determined by an “and” that probably was meant to be an “or” in the loan documentation.

Read about the background of the story here:
http://www.bloomberg.com/news/2014-05-12/caesars-makes-and-four-letter-word-to-lenders-distressed-debt.html

http://www.bloombergview.com/articles/2014-05-13/caesars-and-the-450-million-and

It has often surprised me how little attention senior investment professionals pay to the intricate details of loan and investment documentation. The typical approach is to agree on the broad terms of the deal and let the lawyers and a junior member of the investment team handle the details. By the time the final redline is circulated days, weeks, or months later, the deal’s principal has moved on to the next transaction. But the minutiae of the documents are critical; they often are what save you, or bury you, in the event things don’t work out as planned. I feel that the common approach leaves a lot of potential value, optionality, or accuracy on the table.

For Catalus I personally read from beginning to end every investment related document that I sign or I will be bound to. I have hazy memories of one instance where that approach left me pulling an all-nighter because we had to close the investment the next morning. I find that level of involvement to be unusual in the industry and sometimes I get pressure to “just sign it already” because there are (often artificial) deadlines or people are fatigued from the legal process. But over the years I’ve been able to benefit our investors by catching errors and identifying areas where we can improve our position due to some extra scrutiny.

The Caesars example is pretty extreme. Would I have caught the “and” that was supposed to be an “or”? No Way. I’m assuming that this clause was buried somewhere deep into the agreement, and by the time I’d get to that page I’d be struggling to focus on what I was reading. Even in the context of this article I had to read the clause 2-3 times before I understood the issue. 

So maybe the typical approach isn’t so bad after all, even if you read every word you’re likely to miss stuff. But why not put in the effort to try to weed out as much as you can?

Catalus Leases Sirenusa to Inspirato with American Express

Catalus Capital is pleased to announce that it has entered into a long term lease of its Sirenusa Residences in St. John, US Virgin Islands. All 14 of Catalus's villas will now exclusively be available to members of Inspirato with American Express, a luxury travel club with over 400 premier properties, 100 destinations, and 7,000 members. The villas will remain listed for sale by Sea Glass Properties, who also brokered the lease.

Catalus Bought What? Where?

I’ve gotten a lot of questions lately about our most recent investment, and rightfully so.  The deal marks little resemblance to transactions that we’ve done in the past.  Our acquisition of the Sirenusa Residences in St. John, US Virgin Islands, is an example of the flexibility that Catalus has to pursue unique opportunities and of an evolution that our fund’s focus has undergone. 

When Michael Freeburg and I founded Catalus almost three years ago, we purposefully structured the fund so that we could evolve and react to shifts in the market.  Our goal was to always be identifying the most attractive risk/reward weighted opportunities for our investors. 

We originally set out with a focus on middle market mezzanine lending, as we believed there was an opportunity in an under-invested niche.  A massive change has occurred in the debt markets since our inception, which has proven our investment thesis to be correct, but also has caused it to be no longer valid.  Mezzanine lending has enjoyed tremendous performance in the last three years, resulting in a flood of capital to be raised by new and existing firms.  Our assessment of the market is that it is experiencing high competition, declining pricing, deteriorating credit profiles, and increasingly aggressive lenders – so basically everything that we try to avoid.

Catalus has evolved into a special situation focused investment fund which identifies under-served niches.  Here are some examples of deals we look at frequently:

• Distressed assets and businesses
• Bankruptcy
• Litigation
• Partner disputes
• Unique geographies and/or business models
• Companies focused on a specific and/or unpopular niche
• Bridge loans
• Cash flow light/asset heavy capital raises
• High level of general complexity

While we like to be in a debt position, we’ve been increasingly considering preferred equity and equity co-investment deals.  In some rare cases we’ll even consider acquiring something, as we did in St. John, but that won’t happen often. 

 

After all, who can resist the most prestigious property on the #1 ranked Caribbean island?  More details to come…

 

Catalus Capital Acquires the Sirenusa Residences in St. John, US Virgin Islands

October 2nd, 2013 - Catalus Capital is pleased to announce its acquisition of the majority of the Sirenusa Residences in St. John, US Virgin Islands. Sirenusa is a premier luxury resort featuring expansive views and top of the line finishes and amenities. The property is located near the island's finest dining, shopping, and beaches and St. John was recently ranked the #1 Caribbean destination by TripAdvisor.

Catalus is offering the units as vacation rentals and will consider individual condo sales. "We're excited about Sirenusa and about St. John. We believe that buyers can find deep value in the USVI for world class properties." - Marek Olszewski, Managing Partner

Get 25% off non-holiday bookings until Feb with code Catalus.

Notable Quotes

I read a lot, and I pick up a lot of great quotes along the way from investors, traders, researchers, and other interesting people.  Below is part one of my favorite quotes:

In risk assets you make 80% of your money, 20% of the time.  Jeffrey Gundlach

When you find yourself in a leaky vessel, switching boats can be more rewarding than bailing.  - Bill Ackman paraphrasing Warren Buffett

There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have insight to appreciate the incredible wonders of the present. - John Kenneth Galbraith 

What do you call a stock that’s down 90%? A stock that was down 80% and then got cut in half. - David Einhorn 

It was never my thinking that made the big money. It was always my sitting. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. - Jesse Livermore (from the book Reminiscences of a Stock Market Operator)

You learn in this business: It you want a friend, get a dog. - Carl Icahn 

Common sense is not that common. – Debatable Original Source

There is a significant difference between probability and outcome.  Things that are unlikely to happen occur all the time and things are likely to occur don't happen. -Howard Marks

What you measure is what you'll achieve. Jeff Smisek

Invest first. Investigate later. – George Soros

Based on my own personal experience… rarely do more than three or four variables really count. Everything else is noise. – Marty Whitman

Better 3 hours too soon than 1 minute too late.  - Shakespeare (about selling)

The four most dangerous words in investing are 'This time it's different.' – John Templeton

I am as proud of what we don't do as of what we do. - Steve jobs

It's All About Duration

I’ve been seriously concerned about the state of the credit markets for quite some time, as chronicled in my posts.  A dramatic reduction in interest rates in all classes of credit (Treasuries, leveraged loans, high yield, mezzanine, bank loans…) has been coupled with a significant deterioration in credit quality (manifesting as higher leverage and looser terms).  This is being driven by a number of factors including a wave of capital that has entered into the asset class.  Investors recognize corporate credit performed very well during the crisis and, given the Fed’s policies, are forced to move out in the risk curve to find suitable yield.  Much of this is well comprehended by students of the markets, but others may not understand that recent events don’t necessarily have historical precedent and could result in significant future disruption.

Let’s talk about duration.  It is the weighted average number of years it takes for a bondholder to get back the purchase price of that bond, including both scheduled interest and principal payments.  Duration is an indicator of a debt’s sensitivity to interest rates.  The longer it takes to get your money back, the more volatile price changes of the bond will be to interest rates.  The lower your current coupon, the slower you get your money back, the higher your duration, and the higher your sensitivity to changes in interest rates.  With interest rates and coupons at all-time historical lows, duration has become quite elevated, resulting in the market’s correlation to interest rates being higher than ever.  It’s helps to conceptualize this visibly.

Many market participants brush off the duration issue by claiming historically when interest rates rose risk spreads compressed, so a significant move in bonds prices shouldn’t be expected.  Maybe… but is this conventional wisdom really true and applicable? The risk spread measures the incremental yield generated for owning debt that is riskier than a Treasury bond with the same maturity.  Without even looking at the data, my first rebuttal is that those prices have moved up significantly in the last few years as a result of interest rate declines.  Intuitively the reverse should be true when they rise.  More concretely, interest rates and spreads have had positive correlation in the past.  For example, from 1950 to 1981 it was +.54.  We can also look at the last two cycles of Fed increases in 1994 and 2004.  In the latter, spreads tightened as the Fed hiked, but in the former spreads rose for almost two years after the Fed’s tightening began.* Finally, the correlation has been positive since April of this year. The chart below shows High Yield bond spreads and nominal yields being almost equal for the first time in history… sure to cause some surprises when rates eventually rise.

These are some of the fun things we think about at Catalus.  In addition to our core structured debt investments, we’ve been spending a lot more time on preferred equity and equity co-investments.  We’re always happy to consider interesting deals so send ‘em our way!

** Morgan Stanley

*Morgan Stanley

The Myth of the Underfinanced Lower Middle Market

Over the last year there has been a consistent theme communicated by the larger private equity and alternative investment funds: there is a significant under exploited opportunity to invest in smaller companies. Pursuing a more attractively priced market seems like a perfect solution when facing tepid deal flow and a highly competitive market where substantial capital has been raised.  However, these funds do not appreciate the fact that this price differential exists for a reason.  Investing in smaller companies entails a unique set of risks and this segment is already highly efficient.

The lower middle market has lower acquisition multiples and more expensive financing, but it is more risky for a myriad of reasons.  Smaller companies often find themselves with significant customer or supplier concentration, do not have robust accounting systems, rely heavily on one or two key individuals, have limited ability to invest to maintain their competitive advantage, and don’t have the benefits of economies of scale.  Additionally, one cancelled order or the bankruptcy of a key customer can have a draconian impact on the company.

In my opinion the most significant characteristic of the lower middle market the mega funds are underappreciating is the competition.  It is one of the most efficient markets in the world, despite common anecdotal assertions to the contrary.  There are thousands of lenders serving this sector including banks, second lien lenders, unitranche providers, mezzanine funds, sale/leaseback firms, and other specialty finance companies.  Countless private equity firms and strategic acquirers are actively seeking to buy smaller businesses.  The SBA’s (Small Business Administration, a federal agency) SBIC program has become a massively popular structure and offers a plethora of financing options to creditworthy companies.  It provides heavily subsidized long term financing to specialty and mezzanine lenders that target the lower middle market.  Today there are 300 SBIC's managing $17 billion. 

I view this trend of larger funds turning to smaller company investments as an impulse response to difficult market conditions.  Ironically, Catalus is currently facing the same challenge.  Given the flexibility in our fund mandate we've decided to pursue larger and more creative deal structures, keeping in mind, of course, the grass is always greener…