CHAPTER 8

A Vulture’s Philosophy

In all countries where the vulture lives it is protected by law, and in many places the destruction of so useful a bird is visited with a heavy fine.

—Reverend John George Wood, Birds and Beasts

Despite their unattractive appearance and gruesome occupation, vultures perform an important function in nature, which, throughout history, discerning people have always appreciated. I hope that this book has given you a similar appreciation for the function that vulture investing serves in the corporate lifecycle.

Perhaps you may decide to try it for yourself, if you have the resources to do so. Now may be a particularly good time to get into the field, since more companies than ever are going through reorganization, or have done so recently. These reorganizations, in part, are a result of the global credit crisis that started in the United States and continues in Europe now. More often than in most previous credit cycles, we now see inefficiently priced securities across many different industries trading well below their intrinsic fundamental value.

Unfortunately, it appears that more and more governments, from municipalities and states to the U.S. federal government—as well as many governments in other countries—are also overleveraged. In the future, we may well see more government defaults as we saw with Greece during 2012.

As I have outlined in this volume, reorganizations offer opportunities to invest in a variety of ways at different stages in the process. But since many aspects of distressed investing would be tricky to pursue as an individual investor, it may be best to do so under professional guidance. More convoluted bankruptcy proceedings, conflicts of interest, and even government intervention have made the field harder for the inexperienced to negotiate.

Over the course of my career I have learned a number of lessons, from which I have derived an investment philosophy of sorts. While vultures are essentially simple creatures that do one thing well, vulture investors should embrace both simplicity and complexity. Simplicity should be your guide when choosing the form of your investments, while complexity can be your friend when choosing where to invest.

By its very nature, investing in distressed companies is already a com-plex and risky process, so adding to that complexity by using arcane instruments and strategies is just asking for trouble. As I have said, I prefer the liquid and plain vanilla to the illiquid and hard to value. That’s why for the most part I steer clear of derivatives and structured products, sticking chiefly to stocks, bonds, and syndicated loans.

Although derivatives can be a powerful instrument for increasing financial leverage, most true vultures avoid this form of leverage since they know that’s usually what causes companies to get into distress in the first place. Derivatives and structured products are also harder to value and manage than simpler products, and that makes them riskier. Moreover, counterparty risk becomes a major concern, as we saw recently with MF Global and in 2008 with the Lehman Brothers bankruptcy.

That is also why I think it’s best to avoid making combined long/short trades, which supposedly hedge your primary position and allow you to take on more leverage—probably a bad idea. Instead, I manage the risk of portfolio volatility by controlling the size of my positions.

While illiquid investments such as loan-to-own and private equity can be very profitable, and should be part of a vulture’s repertoire, they are also inherently riskier than tradable securities. You can’t value them easily using current market prices or sell out quickly if something goes wrong. While I sometimes get involved in loan-to-own and private equity situations, I approach these investments with extreme caution and a lot of due diligence.

Having said that, I believe anything is interesting at the right price. Many vulture investors are beginning to branch out into tempting illiquid situations that are well worth considering. These include litigation trust interests, trade claims, and distressed real estate, among other illiquid assets. Anything can make for good investing, provided you have the patience to wait for your payoff and the experience and time to do the necessary work to understand them.

When it comes to picking companies in which to invest, however, don’t let the structural and legal complexities of the distressed-securities market scare you. They serve to create greater inefficiencies than in many other investment fields, which give you many more opportunities for outsize returns.

A successful vulture doesn’t mind dealing with a messy situation, while other investors usually shy away from complex reorganizations, highly regulated companies, and those embroiled in litigation. Nonetheless, these investments may eventually yield extraordinary profits.

This is especially true in situations where you can take advantage of the differences between your own incentives and those of other investors, particularly a company’s original-issue lenders. While they have little flexibility and look mainly to minimize their losses, as a vulture you have more room to maneuver and should aim to maximize your returns in whatever form they take.

To find and exploit these opportunities, however, you must really do your research. You need to truly understand each investment and be able to clearly explain your reasoning—even to a child. Once you understand the company and its position, you must develop a talent for recognizing the fulcrum security of a failing company, whatever it may be.

You should remember as well that the markets are apt to overreact to challenging circumstances, especially litigation. The markets generally give up on a company targeted in class action or other large lawsuits long before the courts determine the actual extent of its legal liabilities.

Vulture investors, on the other hand, should regard legal liabilities as just another form of leverage to be calculated into the equation along with a company’s other forms of debt. Uncertainty creates opportunities for big profits, partly because it deters other investors.

A good vulture should never be afraid to get actively involved. Many distressed managers do not assume an active role in a restructuring because they would officially become insiders, and therefore be unable to sell the position at will. However, I believe that the long-term returns can be worth the sacrifice of liquidity.

Ideally, a vulture should seek to join a creditors’ committee, preferably later in the process, after the fulcrum security’s price has dropped substantially. That allows you to get in at a lower cost and less risk than other committee members, giving you more flexibility.

To succeed with an activist strategy, you can’t be active just for the sake of it. The key is finding, through painstaking fundamental research and analysis, something that should be changed to increase value for the class of securities you own. As an extension of your due diligence, you must then persuade others that you are right.

You also need to become an experienced negotiator, or retain one. Good negotiators have a real edge in complex situations, bringing to bear insights developed over many years and asking the right questions at the right time. Experience can help you to keep your eyes open for pitfalls, such as conflicts of interest, which are common not only in bankruptcies but in the financial markets generally.

It’s important for a vulture to be confident and flexible, willing to take a contrarian position and go up against the market. But you also have to recognize when you have made a mistake and be willing to get out of a losing investment promptly. If you remember the 80/20 rule, you’ll see that there is no shame in this; all investors, even the best, make most of their money in a very small percentage of their trades.

Most investors find it hard to cut their losses. They will often stick with, or even add to, a failing position until they can no longer ignore the truth—at which point they tend to sell out in a panic. If you exercise discipline yourself, you can exploit this tendency and buy in at a big discount.

It requires a lot of patience to succeed as a vulture. Distressed companies offer many different opportunities for investment, either long or short, often over a period of years. Patience pays off if you wait for the optimal entry point—usually when emotional sellers are least focused on fundamental value.

As in any successful enterprise, it’s important to work with people who show talent and enthusiasm for the job, regardless of the position they fill. You should surround yourself with such people and develop a network of contacts throughout the industry.

Seeking out good professional advisors is also crucial. The more challenging the situation, the more you will need great advice. (But bear in mind that professionals who charge by the hour, including lawyers, accountants, and other financial advisors, will likely try to maximize their billings by dragging things out—so it pays to keep an eye on them.)

I’m a great believer in the rule of law and in letting nature take its course. In most U.S. credit cycles, the government doesn’t interfere with private enterprise, and bankruptcy laws are allowed to work in their normal way. When companies go bankrupt, creditors holding the fulcrum security become the new owners.

One good thing about this process is that it naturally reallocates capital to companies that are successful—since lenders are forced to write down the value of their loans, and former junior creditors or equity investors lose their capital. This can be a salutary lesson, forcing lenders and/or equity investors to be more careful in the future.

Unfortunately, politics can prevent investors, and companies, from learning this lesson by introducing ill-considered bailouts into the equation. In general, I think bailouts are a bad idea.

It’s better not to try to resuscitate dead industries with subsidies. Take the pain now or you will surely face more pain later. The problem with bailing out companies that are too big to fail is that once you start, it’s hard to stop. You end up in a game picking winners and losers—and not always fairly.

We saw this principle in operation with the Chrysler and GM bankruptcies. Certainly, the subsidies helped ameliorate the pain during a rapid downsizing of the U.S. automobile industry. They may also have temporarily saved the Pension Benefit Guarantee Corporation from a major hit.

But such bailouts are fundamentally unfair to those who didn’t get one. By bailing out GM and Chrysler, the government potentially has put Ford, which didn’t ask for taxpayer funds, in a worse long-run strategic position. Why should its shareholders and unions suffer?

Bailouts also raise the sticky question of who decides—should bureaucrats choose which company and industry should get taxpayer funds? In the financial sphere these decisions have been pretty arbitrary, keeping AIG alive (and letting it pay huge bonuses to its staff), while leaving Refco (a New York-based commodities and futures broker) and Lehman Brothers to die.

I believe that if AIG’s failure had indeed brought down Goldman Sachs and Morgan Stanley (one reason given for saving it) it might have been better. They should have borne that consequences of their excessive risk taking; the world wouldn’t have ended if Goldman and Morgan had vanished—just as it hasn’t now that Lehman, Refco, and more recently, MF Global have gone.

The result would have likely been painful in the short term but much better in the long term. By bailing out those too big to fail, we have created a moral hazard and made a repeat performance more likely. In any case, we already have a perfectly good mechanism for dealing with companies that fail. It is called the United States Bankruptcy Code.

The statute already has protections built in to allow companies the temporary breathing room they need to continue operating while restructuring. The bankruptcy code’s automatic stay prevents the rush to foreclose on collateral by varied classes of creditors and litigants when a company is struggling. The code also includes provisions, such as the automatic stay as well as the “grant of administrative claim” status to current wages and benefits, designed to protect a distressed company’s employees.

The decision to shield certain companies from the well-established restructuring process puts those who stick to it at a disadvantage. We didn’t bail out many other industries that have restructured en masse, including the textile industry, the airline industry, telecommunications companies, retailers, and electric utility companies.

Employees lost jobs in each of these industries, but many of them retrained or became more competitive as their industry changed with the changing marketplace. Capital was redeployed from these troubled industries to let new and more efficient ones take over.

The best thing for the continued health of our economic system is simply to give companies to their creditors when they fail. This may feel wrong at first, but it gives a better result than subsidizing failure, which ultimately penalizes success and hurts much more than it helps. We shouldn’t be afraid of change, but rather embrace it.

So stay flexible: A successful vulture must be ready to invest long or short, as well as up and down the capital structure. Find your own comfort zone: While I prefer simplicity, sometimes highly complex restructurings of highly regulated companies can yield outsized profits. And stay humble: Successful vultures are willing to admit they are wrong and get out of losing investments.

Happy hunting!