Thursday, December 13, 2012

Investing like a lender

I recently wrote a post where I discussed using a bond investor approach to evaluating equities.  I've continued to think about that post since writing it, and wanted to write a follow up extending that line of thinking further.  This post could really be thought of as the second half to my bond investor post.

A bond investor is buying a security issued by a company on the market.  The bond investor is worried about losing money and ensuring the business has enough operating earnings to cover interest costs.

A lender is one step closer to the business than a bond investor.  The bond investor is buying what the company is offering, a lender is taking a look at a given company and evaluating what to offer them.  A company wants or needs capital and they're at the mercy of the lender.  The bond investor is at the mercy of the company.  Thinking through this subtle difference can be helpful in making investment decisions.

The best way to apply this thinking is to ask the question "would I loan this company money, how much, and where on the seniority ladder?" when looking at a potential investment.  Asking questions like this can root out all sorts of seemingly tiny problems that have the potential to grow into large problems.

I like to take the lender approach when looking at net-nets if possible.  Obviously net-nets have large unencumbered asset balances, so it would be relatively simple to make them a loan correct?  Not exactly.  A lender is worried about collateral quality and the borrower's ability to pay.  The ability to pay concerns the borrower's operations.  If operations are slowly melting away, the company's current assets could be at risk.  It's hard without having a frame of reference to know if current assets are at risk in a poorly performing net-net.  Using the lending framework makes it easier.  Think through how much you'd potentially lend to a given net-net, and think about how long the company would be able to pay your rate.  Next think about what might have to happen before your money is at risk.  It seems like a bit of a jump for an equity investment, but it really isn't.  Given a net-net that doesn't have debt, the equity is the most senior claim.  The "interest" you'd receive is the earnings yield.  Maybe the company isn't earning anything, would you be happy loaning a company money for no return?  The loan would be similar to a zero-coupon bond, would you issue something like that to the company?

Often using the lending framework I'm able to flush out small details that make me really uncomfortable with an investment.  There have been two investments recently where using this framework would have been very helpful.  In the first instance I didn't think like this and I ended up with a slight loss.  The loss could have been greater but I realized my mistake quickly and sold very quickly.  The second, which I'll detail below was an investment where I wasn't completely comfortable and I avoided a loss.

Some readers will be familiar with Eagle Hospitality Trust.  The company was a REIT that owned a series of hotels in the Midwest.  The trust fell on hard times and cancelled their common stock and began to run into problems with their lender.  A lot of things happened during the financial crisis, but their debt eventually ended up with the Fed who sold it to Blackstone.  Operations never righted themselves and Blackstone threatened to foreclose on the properties if the trust couldn't sell them first.

The trust had some preferred shares outstanding, and writeups I'd seen online talked about how the preferreds could be worth up to $15 per share depending on the outcome of the hotel sale.  This was really enticing because the shares were trading at $5 apiece.  To add to the intrigue the trust is a dark company, requiring a share purchase and proof of ownership to get financial statements.  When the company distributed the financials they included a disclaimer stating that the following information was confidential and shareholders weren't allowed to discuss or share it with anyone.  So all online writeups were of the cloak and dagger variety.  As I stated, I have the financials, my email is below, hint hint.

The thesis on Eagle was that the hotels would sell for some rich valuation and the remaining cash and receivables would end up going to the preferred shareholders.  The potential reward on this investment was significant, it was exciting.  I kept looking at it and thinking that I could double or triple my money in a short period of time.  Then I started to look at Eagle from the lender perspective.

My first thought was why would Blackstone agree to let Eagle sell the properties and pay back their loan at a discount?  Some people thought it was because Blackstone were a bunch of nice guys, and by doing so Blackstone would juice their fund's IRR.  My concern was that the hotels might not be worth as much, or be as salable as initially thought.  I thought about this from the perspective of would I lend Eagle any of my own money, and how much, and at what rate, and what asset would back it?

The problem is when I started to think like a lender I couldn't get comfortable that I'd be guaranteed to get my money back.  The company was losing money so they wouldn't be able to pay any interest.  The hotels were spoken for by Blackstone and I was left with some cash and miscellaneous items that might or might not have value.  What I couldn't escape was that while there was the potential for a huge upside there was also the potential for a complete loss.  Not just a 5% or 10% loss, but a 100% loss.  If the hotels went to Blackstone, Eagle would be left with nothing.  As a claim holder at the bottom of the chain I had a claim on nothing if the hotels didn't sell for a high value.  Eagle would have been a great investment if I was in Blackstone's shoes, buying cash producing hotels at a discounted valuation.

I never got comfortable with Eagle and never increased my tracker position.  I owned 10 shares at $5, so I was in for $50.  This week the news came out that Eagle was unable to sell their properties and just turned them over to Blackstone.  They stated they expected to deplete the rest of their cash winding down operations and expected to make no distributions.  I sold my 10 shares for $.12 apiece. No need to feel bad, I can handle a $50 loss, the lessons learned were worth much more than $50.

I'm happy that I avoided a bigger loss, but it was just as likely that a positive outcome could have happened with Eagle.  Alternatively I could have been sitting here with my $50 that turned into $150 wishing I mortgaged the house to invest.  The truth is we never know the future, but in the face of uncertainty I want to work on what I can control, avoiding losses, instead of shooting for large gains.

Talk to Nate

4 comments:

  1. Think like a lender eh? You think that the investors that were involved in this name, many of whom are experienced distressed and real estate investors didn't get this concept?

    Or perhaps you're suggesting that they didn't really think there was a scenario where they could get wiped out?

    Let me explain what the average preferred investor was likely thinking:

    1) Even though the odds were stacked against them from the start (trading at 2/25 gives this away!), this was an asymmetric return opportunity where you could make multiples of your investment assuming a few things went your way. And its not as if there wasn't a lot of fundamental work done on the assets - cap rates, real estate analysis, etc. - to get them comfortable with the opportunity.

    2) Because total loss of principal was high, they invested a small portion of their portfolio in the name so they didn't go broke, say 1-2% of capital. And so, like you, they don't feel all that bad losing that even though they're likely disappointed with the outcome.

    3) Maybe this is not the way you invest but in my opinion that many likely share, there is absolutely a place in a portfolio for positions like this where you will have limited information, where the odds are against you from the very start, and where you may lose all your money, and where you may make a lot of money if your thesis works out. The key is to size these opportunities appropriately, i.e. small.

    So, congratulations on avoiding a loss. But lets not infer that investors didn't understand the obvious/basic risks that you've mentioned in this article. They did! Investing in distressed situations comes with a lot of risk, especially when you're dealing with the absolute bottom of the cap structure - but if you get your fair share right, the returns will be there.

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    1. All good points. My feeling with Eagle wasn't that I was smarter than any professionals but that I was at a huge disadvantage and there was some piece of critical information I was missing.

      I understand the asymmetric risk well, why do you think net-nets are so attractive? Limited downside and potentially large upside if one or two things go right.

      The distressed stuff seems like it has a lot of potential for savvy investors. Personally I'm going to stick to simple situations, and let funds with large bankrolls deal in the complex stuff.

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  2. Looking at the discussion at Value Investors' Club, it seems that some of the professionals fell victim to the same temptation as amateurs--in the face of limited information, assuming favorable rather than unfavorable outcomes. I had a fairly large position in EHPTP with a cost basis around $1.90 (after I watched in annoyance as it migrated up from the 10 cent range) and sold a little more than half around $4, to ensure I'd break even after taxes. As the debt deadline approached, I just couldn't get comfortable with the idea that there would be residual value; it seemed like a crapshoot, as it always had, but with a maybe-firmer deadline. So I sold the rest around $2, right before it shot up, again, past $4. Oh, the regrets! But I was still uncomfortable, and decided that even with the prospect of a major payout there wasn't enough to go on. Turned out that was a good move. I could ascribe all this to my wisdom, but really it was just luck. People who argued it was worth $15+ were also dealing with luck, but on the other side.

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