Bad research KPN edition (and why my readers are a lot smarter than professional analysts)

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This is “research” directly from Bloomberg:

KPN NA: 2.74 TARGET: 2.20-2.40
April 25, 2013
We recommend shorting KPN on the share issue announcement. The equilibrium price is Eur 2.04/share and the stock price should trend toward this level in the near future.
Equilibrium Price = (price pre-cap raising announcement x # shares + price cap raising x # shares) / total # shares.
The shares were trading at around 4.0 pre-announcement and there were 1.431 bn shares outs.
The company is issuing 2.84bn shares at 1.06. This works out 2.04/share. Let’s imagine that thanks to the cap raising the
fundamentals are slightly better now than they were before, and we set our target at 2.20-2.40, or 10-20% lower than the current price. The stock should be sold/shorted.

Let’s look at their “formula”:

Equilibrium Price = (price pre-cap raising announcement x # shares + price cap raising x # shares) / total # shares

“Wow, they are professionals and have a formula, this must be right” was my first thought and I briefly thought that I have made a mistake. Although I had a nagging feeling that the formula (or the application of it) was not right.

Enter readers JM and Martin in the comments of the last KPN post:

26. April 2013 um 09:57 | #8 Antwort | Zitat | Bearbeiten
ok…I join the game. When the capital increase was announced the share price was Euro 3,1…so 3,1+1,06+1,06/3 = 1,74. If the dust settles this share price is my personal target…more I do not expect .

memyselfandi007
26. April 2013 um 10:35 | #9 Antwort | Zitat | Bearbeiten
The day BEFORE the capital increase was announced, the stock price was 4.10 EUR.

Martin
26. April 2013 um 10:55 | #10 Zitat | Bearbeiten
(4.10+1.06+1.06)/3=2,073
price today 1,56
discount 24,7%
As there were cost for KPN real economic discount is somewhat lower.

Martin and JM (by the way, thank you for your many helpful comments) are using the very same formula, however with one big difference: They compare the result with the stock price AFTER the rights have been split of.

So the question is: Who is right ? The “professional” reasearch on Bloomberg or the comments on my amateur blog ?

Well, if you are a KPN shareholder before and KPN would sell the new shares directly to new shareholders at 1.03 EUR per share, then of course the old shareholders would be massively diluted.

In reality however, no one is able to by the shares directly at 1.03. You can only access those cheap new shares by buying the subscription rights which have been giving to the old shareholders as compensation for the dilution.

So the big mistake made by the “professional” analyst was that he somehow forgot to account for the subscription right. as the subscription right was worth 1 EUR pr share, suddenly an overvalued share according to the “professional” is an undervalued share.

How can a “professional” be so stupid ?

My guess is that the “analyst” mixed u a rights issue with an issue of shares without rights. Companies usually can issue a certain amount of shares (usually max. 10%) directly to new shareholders without any rights to old shareholders.

In those cases, the announcement is usually made shortly before the trading day starts and then the formula above is applied to the price the day before and the price for the new shares.

Nevertheless it is really embarrassing for any institution that such a mistake slipped through and this report gets actually published on Bloomberg

Applying the formula to a rights issue

The “formula” rests on 3 critical assumptions:

1) The price of the shares on the day before the announcement is exactly the right (and efficient) price. There was no information out there before about the capital increase

2) Nothing happened in between

3) the additional capital will not create any additional value

I think all three assumptions are quite difficult to hold for the KPN rights issue. Talk about the issue started already in September last year, so at the time of the announcement (Feb. 5th), the stock price reflected already a part of that.

Also, the time period between announcement and pricing of the issue is quite long with 6-7 weeks.

Summary:

It is amazing, how bad some of the “professional” research actually is. In that case the analyst used a formula without accounting for the subscription rights. However this also shows that in those situations, the price discovery might be not fully efficient.

I wouldn’t put too much faith into the “formula”, as the application towards rights issues really stretches the implied assumptions.

Book review: Antifragile – Nassim Taleb

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In his third popular book (after “Fooled by Randomness” and “black Swan”), Taleb now introduces a new concept called “antifragilty”. As in the first two books, in his opinion on the big scale, the world is shaped by “black swans”, totally unpredictable events.

Something that gets hurt by those Black Swans is fragile. Someone/Something that is not hurt by Black Swans is robust. Antifragile finally is something/someone that gains from the chaos a Black Swan event is creating.

So far so good, however if one would have expected some implications for an investment strategy, one gets almost completely disappointed. At some points, financial markets are mentioned, but not very often.

Instead, the book is more a “Paleo” style nutrition and work out guide than a finance or investment book. Taleb shares his never ending wisdom with the readers, on topics like why the Greek philosophers were idiots (or not so smart as Taleb) to all kind of medical advice and why you shouldn’t eat oranges because the are much sweeter than 3000 years ago (hint: the only way is to eat the stuff a cave man would have had access to…).

From time to time he looks at two fictional characters called Nemo and Fat Tony. If we assume that Nemo is his alter ago, we know now at least that Taleb made a “low 2 digit million” amount of money when he bet against the financial crisis.

Don’t get me wrong, there is some good “common sense” wisdom in the book, for instance that one should not take medical studies to seriously, but in total I found the book pretty much a waste of time.

Maybe I am not intelligent enough to appreciate Taleb’s genius, but for a pure mortal like me the book looks like the attempt, to cash in on the same idea for the third time.

In the view passages about investing, Taleb promoted very vaguely a style he calls the “barbel” style: Invest most of your money in “safe” assets (whatever that is) and a small part in risky stuff with lots of optionality. Although he mentions that financial options is not what he means because they are mostly overpriced.

I think this kind of “advice” shows the major issue with Taleb: He is by heart a trader, not an investor. Otherwise he migth have mentioned that “Buffet style” long term compounding plus margin of safety is a much easier way to become “antifragile”. But that wouldn’t sell as many books and create invitations to speaker events and hobnobbing at the Davos Forums.

Summary:
Unless you are a big Taleb fan and you need his advice on how and what to eat and work out, don’t buy the book. Save your time and money for something more interesting.

KPN rights issue: Final terms

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I have covered KPN as a potential “deeply discounted risghts issue” special situation in the past.

Today, KPN announced the final terms for their rights issue (bold marks mine):

2 for 1 rights issue of 2,838,732,182 new ordinary shares at an issue price of EUR 1.06 for each ordinary share
• Issue price represents a 35.1% discount to the theoretical ex-rights price, based on the closing price of KPN’s ordinary shares on NYSE Euronext in Amsterdam at 24 April 2013
• AMX has committed to subscribe for the Rights pro rata to its current participation in the issued share capital (excluding treasury shares) of 29.77%
• Record Date for Offering is set at 25 April 2013 at 5.40 pm CET
• Exercise Period runs from 9.00 am CET on 26 April 2013 until 3.00 pm CET on 14 May 2013• Rump Offering (if any) is expected to take place on 15 May 2013

What I find very remarkable is that there is only a very short time period between announcement of the terms and the start of the trading of the rights. Basically they announced today and trading starts tomorrow.

For the portfolio, I will start with a 1% investment as a rather “short term” special situation based on current prices of around 2.61 EUR per share. Lets wait and see how that one works out.

IVG again (and again and again)

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disclaimer: The discussed investment is very risky and not recommended for any investor. There are strong hints of insider trading and permanent loss of capital and permanent loss of principal is quite likely. The author owns the investment and is clearly biased towards a positive outcome

Thanks to a reader, I received some “research” about IVG directly out of London, HF and “predator” capital (highlights are mine):

IVG – Further Thoughts

I had the opportunity to talk to the company late on Friday. I remain public on the name and have not received private information…

As one would expect, the company would not give any details of proposals being discussed with stakeholders; however, the company admitted that it had considered a number of options for repaying the convertible and deleveraging the company (which became necessary when the synloan holders indicated they wouldn’t be able to refi in September 2014)… including a rights issue which wouldn’t work due to the size required and the status of the hybrid and a quickie disposal of the SQUAIRE which would have seen a very significant discount to book.

A couple of things became clear:

· The company views the equitisation of the convertible and the hybrid as being the necessary first step in a restructuring process
· The haircut may also have to apply to the syndicated loans – especially SynLoan 1 which is under-collateralised
· The company’s fervent hope is to avoid any type of insolvency through a consensual agreement. Any type of restructuring under insolvency is currently considered a distant ‘Plan B’
· The company believes that significant value could be generated for equity investors through the continued management of the SQUAIRE and in the unencumbered caverns currently due to be delivered to Cavern Fund II in c. four years
· The company’s major shareholders are supporting the restructuring proposals – at least from their position on the Supervisory Board; that doesn’t mean that they will vote for restructuring at the AGM…
· Any new capital would require 75% approval at the new AGM
· The convertible bonds will require 100% vote of those attending a general meeting (quorum 50%); but that could be lowered to 75% under a new German Scheme
· It looks like Plan B may well be the more realistic proposition…

The German market is relatively short of ‘prime’ office space… prime would mean significant property located in the centre of major cities like Berlin, Frankfurt, Hamburg and Munich. IVG categorises most of its property as located in these cities. However, more properly it should be described as near one of these cities and very little of the investment portfolio could be described as prime… Prime properties still command premium rentals, non-prime properties face significant competition and rents are likely to fall on the renewal of tenancy agreements. The company states that €2.25bn is core/core+, €690mn is value add (needs work or on short tenancy) and €250mn is workout… in an insolvency the core/core+ valuations would come under pressure; the latter two categories may well be reflective of a going concern but I believe could well be significantly haircut in an insolvency… Furthermore I place little value in the €264mn ‘future caverns’ given the lack of interest from utilities; the fund valuations could come under pressure if EuroSelect 14 does indeed default; and tax assets are hard to transfer.

The company confirmed that:

· The debt on the SQUAIRE represent c. 60% LTV; the rental currently covers interest and the cover will improve. The company expects this debt to roll when it falls due at the end of the year
· The company also has a Core Financing: currently €570mn vs. assets valued at €800mn
· The Pegasus loan is currently €140mn and is secured on a variety of properties situated all over Germany and valued at €300mn
· SynLoan 1 is under-collateralised; I got the impression that less than 75% of the loan had collateral
· SynLoan 2 is over-collateralised but I have the impression that not by much… c. 90% LTV; obviously it benefits from the caverns disposals which should generate €300mn by the end of 2014

It would seem that it would be in the best interests of all of the stakeholders to keep the company a going concern, otherwise one can make a case that even the collateralised parts of the syndicated loans could be haircut.

Andrew Carrie ** 22nd April 2013 ** acarrie@knight.com ** +44 20 7997 2066

In my opinion only 2 parts of that “research” is interesting:

Number 1:

The company views the equitisation of the convertible and the hybrid as being the necessary first step in a restructuring process

This is the same kind of b…s… I have heard in the first few Praktiker calls. The answer is simple: Nope. The first step is that equity gets wiped out, then Hybrid then senior. However it clearly shows that will go down the same path as Praktiker tried and ask the bondholders for deferral.

If for some reason, they would succeed, this would in my opinion kill the complete (high yield) corporate bond market. If it is suddenly possible to change the sequence in teh capital structure, why should then be corporate spreads where they are at the moment ?

Number 2:

This is the really interesting part:

SynLoan 1 is under-collateralised; I got the impression that less than 75% of the loan had collateral

In some boards people were arguing: If a collateralized loan is sold at 85%, this is the proof that the senior is worthless, as even the collateral for the first priority loans is not sufficient. To be honest, I was struggling with that one most.

Well, this argument now doesn’t hold anymore. If in reality, the Synloan is only collaterallized at 75%, then a price of ~85% is in line with the current pricing of the convertible.

The uncollateralized part of the Synloan is “pari passu” with the convertible. So in case of the bankruptcy, synloan holders would get full repayment on the collateralized part (75%) plus pro rata repayment with the convertible which trades around 55%. The “fair value” of such a Synloan would therefore be 75% + (25%*0.55)= 87.5% and therefore absolutely consistent with current convertible prices.

If we assume that the buyers have quite high return requirements, then I think the fear of a zero recovery for the convertible gets even more unrealistic.

Summary:

If only for this one piece of information, the “research” as superficial as it is has greatly increased my confidence in the IVG convertible, because suddenly the prices paid for the more senior but partly uncolateralised loans makes sense.

One should still expect a very bumpy ride with “Praktiker style” attempts to bail in the convertible holders before anyone else, but at current prices, the risk/return relationship looks very good to me.

Again a disclaimer: “Don’t do this at home” and I might be subject to confirmation bias.

Guest post: Book review – “Playing to win”

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Thanks to reader N. for submitting this !!!

In this book-review I would like to recommend you the book: “Playing to Win” which is written by Lafley and Martin. The content of this book focuses on the transformation of Procter&Gamble (P&G) between 2000 and 2009, and discusses the approach to strategy that led to this transformation, leading to a doubling of sales, a quadrupling of profits, and an increased share price of more than 80 percent during that decade. And focus especially on how strategy really works. Most of the time it doesn’t and reasons vary. However, Lafley and Martin identify these familiar troublemakers, when leaders tend to approach strategy in one of the following ineffective ways:

(1) they define strategy as a vision,
(2) they define strategy as a plan,
(3) they deny that long-term (or even medium-term) strategy is possible,
(4) they define strategy as the optimization of the status quo, or
(5) they define strategy as following best practices.

Lafley and Martin suggest that a strategy “is a coordinated and integrated set of five choices: a winning aspiration, where to play, how to win, core capabilities, and management systems.” The authors argue that what really matters is winning, and that the play book discussed in this book, which provides five choices, a framework, and a process, is what is needed to win.

In subsequent chapters, the authors present the “strategic logic flow” framework, designed to direct thinking to the key analyses that inform any strategy, and the “reverse engineering” methodology, designed to make sense of conflicting strategic options. In the former, there are four dimensions to be considered: (1) the industry, (2) customers, (3) relative position, and (4) competition. In the latter, which contrasts with traditional approaches to generating buy-in, there exist seven steps that involve exploring different ways forward and a wider variety of possible strategic choices.

If strategy is a set of choices, how the author write it “that uniquely positions the given enterprise so as to create sustainable advantage and superior value relative to the competition,” and I believe it is, then quality of judgment is imperative, not only when making a specific choice but throughout a continuous and cohesive decision-making process.

As a conclusion of their book, A.G. Lafley and Roger Martin acknowledge, “All strategy entails risk. But operating in a slow-growing, fast-changing, intensely competitive world without a strategy to guide you is far riskier. Leaders lead, and a good place to start leading is in strategy development for your business. But they state also, and I think that this is most importantly, “no strategy lasts forever”. So one of the best takeaways from what the author writes in that book is that “strategy is a highly dynamic area, full of fads and fashions that come and go”, and that “copying ideas that ‘work’ for others is unlikely to be a winning strategy”, because “success can only be based on being different from (existing or potential) competitors”.

In addition, I appreciated the “Dos and Don’ts” sections at the end of each chapter, which clearly summarize the material from a practical context, as well as the strategic lessons learned side bars following these sections at the end of most of the chapters. At some level, I find the book a little bit to repetitive.

I don’t think that a brief review such as mine, can possibly do full justice to the scope of material that A.G. Lafley and Roger Martin provide in this volume at as they did in it in their book. Also, I hope that those who read this review will be better prepared to determine whether or not they wish to read the book. I truly can recommend this book because you will have at least some idea of how an enriched and enlightened understanding of what strategy really is and the book perfectly fits to “Competition Demystified” from Bruce Greenwald.

Weekly links

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Prem Watsa’s Fairfax annual meeting notes from Cove Street Capital

Good interview with Peter Cundill disciple and Deep Value investor Jeroen Boes

Some simple but very good thoughts about Apple from the Brooklyn investor. By the way: This is one of the best value investment blogs in my opinion !!

Recommended: Entertaining post about the investment process at Eastcoast Management

Interesting special situation from Wexboy: EIIB (Ex-Bank)

Longish but very interesting interview script with Markel’s Tom Gayner

Rare interview with Cable Cowboy John Malone

Via Gurufocus: A KPN analysis with lots of data.

When you get congratualations from your broker (indirectly)

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I use CortalConsors as my broker for the non-German part of my portfolio, especially as they don’t charge any extra fees for French stocks. Some months ago, they started to send out performance and risk reports with some more or less usefull stuff on it.

One interesting feature is a return/standard deviation graph comparing the portfolio against several benchmarks. I was really surprised how well the portfolio is doing:

risk return consors

Explanation: The vertical axis is the return in the last 12 months (until end of March 2013), the horizontal one is the volatility meassured as standard deviation. The portfolio is (of course) the lonely light orange dot in the upper part of the chart….

Clearly, this will not go on like this forever. Nevertheless, I think it also shows that value investing is not dead yet, at least for the little guys 😉

If I would do this professionally, now would be the time to make a big advertising effort …….. It doens’t get much better than that.

“The death of value investing”

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There was a quite provocative article with the same headline “The death of value investing” on Business Insider a few days ago.

Why should one take such a Business Insider article serious at all ?

Well, at first, this was not written by some lowly paid BI staff but from Marc Andreesen and Ben Horowitz, two venture capital legends with currently 3 bn under management. Andreesen by the way was one of the creators of MOsaic, the first web browser and founded Netscape.

Let’s look at their article:

Most of the best investors in the world are considered value investors. Well, times are changing — the destructive power of technology is starting to break down companies faster than ever.
Value investing is an investment philosophy that evolved based on the ideas that Ben Graham and David Dodd started teaching at Columbia Business School in 1928. Since I started my career as an investor, value investing was the holy grail of investing.

Hmm, I am not sure about that one. I always thought that value investing is rather a minority strategy…but ok.

There are many interpretations of what value investing is, but the basic concept is as follows: essentially you want to buy stocks at a discount to their intrinsic value. Intrinsic value is calculated by taking a discount to future cash flows. If the stock price of a company is lower than the intrinsic value by a “margin of safety” (normally ~30% of intrinsic value), then the company is undervalued and worth investing in.

That part is OK although I am not sure where have the 30% “margin of safety”. But then it gets interesting:

Generally, value stocks are companies that are in decline but the market has overreacted to their situation and the stock is trading lower than their intrinsic value.

Hmm, that is in my opinion only true for the original Graham “Cigar Butts”, but lets move on:

The classic case is Research in Motion (RIM). In January 2007, RIM was trading at a high 55x PE multiple. Over in Cupertino, a computer company called Apple had reinvented itself as an MP3 player company and was now unveiling a new phone set to launch in the summer. By the end of December 2009, market share for Apple’s iPhone iOS as a percentage of US smartphone OS was 25% while RIM had increased from 28% to 41% in that same period. Though RIM had grown market share, fears of iOS growth had toppled the PE multiple to ~17x.

Many traditional, value investors sat back and thought, “Well, RIM is holding up pretty well compared to the iPhone, yet their PE multiple is getting destroyed.” It’s trading at near the historical average S&P 500 PE multiple of 15x. Apple hasn’t historically been strong in the enterprise, so maybe iPhone will just be a consumer phenomenon that doesn’t break through to business users. Android is irrelevant with 5% market share. The smartphone market is growing rapidly and RIM is the clear leader. RIM is still growing north of 35% and generating nearly $2.5B in net income. I think RIM looks cheap!
Two years later, RIM was trading at a 3.5x PE multiple and topline growth had screeched to a halt. Market share for RIM had contracted to 16% while iOS and Android combined for 77% market share. In fact, in 2012, RIM posted a net income loss of $847mm. Investors lost a ton of cash and were left scratching their heads.
How did this happen so quickly? Why did net income fall off a cliff? Why now?

They then go on to explain that technology changes faster and faster, mostly because of

1. Technology adoption accelerating
2. Internet way of life
and what they call: 3. Software Eating the World

Their final verdict is clear:

With technology upending markets, remaining a value investor is a death sentence. In the case of RIM, the company thought that their scale was defensible and stopped innovating on the operating system, favoring battery life instead. Apple’s iPhone operating system and associated software was an order of magnitude better than RIM and attracted consumers. Interestingly enough, Apple is dangerously close to losing their own software battle to Google with mobile versions of Google Maps, Gmail and Google voice being far better than their iOS counterparts.

While there may still be opportunities for value investing, you need to be cautious of businesses that appear to be on a slow decline. With the rate of technology adoption accelerating, Internet being a way of life and software consuming the world, businesses who refuse to embrace or adapt don’t just slowly decline; they fall off a cliff and take their cash flows with them.

The final statement in my opinion is both, partly wrong and partly very important for value investors.

What A&H describe is what is known to value investors as a Value Trap. A superficially cheap stock, which however for different reasons is in terminal decline. This is clearly not restricted to technology stocks, although there it is quite obvious.

Even the most famous value investors are not immune against this, as Seth Klarmann’s unsuccessful investment in Hewlett Packard showed.

Interestingly, short seller Jim Chanos (who I consider to be one of the best value investors ever) basically says the same thing:

You have to be very careful, because we looked at our returns over the past 10 years, and, particularly since the advent of the digital age, some of our very best shorts have been so-called value stocks. One of the differences in the value game now versus, say, 15 or 20 years ago, is that declining businesses, while they often throw off cash early in their decline, find that cash flow actually reaches a tipping point and goes negative much faster than it used to.

I think this is a very important point here: Low valuation (low P/E, low P/B) and/or high FCF yields based on past data are by no means a guarantee for superior investment returns. He directly confirms A&H in this paragraph:

The advent of digitization in lots of businesses also means that the timing gets compressed, meaning that you need to move quickly or you are roadkill on the digital highway. That’s true whether you look at companies like Eastman Kodak, or Blockbuster, or the newspapers. Value investors have been drawn to these companies like moths to the flame, only to find out that the business has declined a lot faster than they thought and that the valuation cushion proved to be anything but.

I think this is also one of the reasons, why many of the older “Quantitative Value strategies”, such as Dreman’s or O’Shaugnessey don’t work so well any more.

To summarize it bluntly up to this point: If you think value investing is only about buying low P/E and/or low P/B or low P/FCF stocks, then you will most likely be in for a quite nasty surprise, especially if you invest in anything that is subject to the technological changes as described above. Many of thse companies will drop off much more quickly than in the past and reversion to the mean will not happen.

On the other hand, I don’t think that value investing is dead, but it has rather evolved. If you look at Warren Bufft (and Todd Combs and Ted Weschler of course), Buffet style value investing looks of course very different. He invests at much higher P/Es and P/B, however still with a lot of margin of safety as he is able to factor in the value of potential “moats”.

Other value investors like Seth Klarmann for instance go into other asset classes or “special situation” investing where “margins of safety” are created via forced selling of market participants.

Funnily enough, when I was googling “The death of value investing”, an article with exactly the same title popped up from 2008, written by the quite famous author Edward Chancelor.

He refers to mistakes made by some “value investors” at that time:

The housing bubble, however, changed many facts. But some of the world’s leading investors appeared not to have noticed. First, several prominent names piled into housing stocks when they were selling at around book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for homebuilders. Then, some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.

As we know now, Value investing made it at least another 5 years and 2008 and 2009 provided the best opportunities for open minded value investors in a generation.

Summary:

Clearly, Value Investing is not dead. It was not dead in 2008 and it is not dead now. But as the A&H well describe, “simple value” investing, i.e. just buying low P/E and P/B stocks is much more dangerous now that it was in the past.

For the “Normal” value investor, this means to put more effort in to identifying potential value traps. There is strong support to the thesis that declining companies, especially those subject to technological change, will “drop over the cliff” much faster than ever. So buying HP/Apple/ Micrososft/Intel/Solar/Media because it is so cheap at single digit trailing P/E minus cash should not considered to be a value investment unless you are really sure that sales and profits will not drop off similar to Nokia and RIM.

Value investing willneed to further evolve, but buying investments at a discount to a (carefully) determined intrinsic value will always be a good investment startegy.

IVG Convertible and distressed debt in general: Beware the “predators” – but don’t panic either…

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It is quite interesting to read the comments to my latest IVG post and elsewhere. The overall sentiment seems to be quite negative. I think this is also partly due to some recent bankruptcies in Germany’s fledgling “Mittelstand” corporate bond market, where a couple of companies with really bad balance sheets issued bonds and defaulted quite soon afterwords. Very often, recovery rates were low double digits or even single digits.

Investing and evaluating bankruptcy situations is very complex. You have to figure out two things in order to come up with a value:

1. The probability of the company going bankrupt
2. The recovery in case of bancruptcy

The valuation of the bond is then pretty straight forward. However, before going there, maybe we should take step back and

Why do companies go bankrupt ?

In general, companies do not go bankrupt voluntarily because first and foremost the equity holders and owners will object strongly. Once a company is in bankruptcy, the game is over for equity owners, however as long as the company “lives” there is always a chance (or technically the option) that things turn around. So an equity holder will always try to stay in business.

Also management usually has not a lot to gain from bankruptcy and will try to hang on as long as they can to their posts and receive salaries. This is also one of the reasons why in many jurisdictions, not filing for bankruptcy although you are in a unsolvable position is considered a crime. In German, this for instance would be called “Insolvenzverschleppung”.

Usually, it is creditors who “pull the plug”, either by not rolling debt or by enforcing covenants which usually are part of standard bank loans. “Normal creditors” like banks and normal bond holders also don’t really like bankruptcies, they prefer their bonds being paid or rolled over. For a normal bank for instance, there is no upside to simply enforce a loan covenant if there is still a high chance that the company can survive. Enforcing a covenant for a normal bank usually means that they have to swap their loan into an asset with a much higher capital requirement.

So what banks normally do is that they will press for more equity and/or a higher coupon but normally they prefer the company to stay in business because seizing the assets does not provide a lot of upside, as the bank at max gets its notional back.

However “normal” creditors get nervous if a debtor is loosing money and the underlying assets pool is shrinking fast. If a bankruptcy is more or less unavoidable and the asset pool is shrinking, than the logical way is to press for bankruptcy as fast as possible in order to protect the downside.

Introducing the “predators”

However there is also another group of creditors: So called “vulture funds”. Those guy usually come in if a company is in some kind of trouble, but there is still enough collateral.

Their strategy is quite simple: They try to enter the capital structure at the most senior level at a discount. Those discounts often appear, if for example a bad bank is set up and people want to dispose legacy assets as soon as possible.

Example:

Assume, secured loans of a troubled company with a maturity of 5 years are sold to a “distressed debt” fund at 60% of nominal. The interest rate is 5%. By holding it until maturity, the fund will earn 13.7% p.a. if everything goes OK. This is nice, however distressed debt claims to earn as their Private equity investors more like 20-30% ROEs.

So how can they increase their annual returns ? The answer is simple: Try to enforce bankruptcy as quickly as possible and sell the collateral. So for the example from above I made two further scenarios: either bankruptcy after one year or direct bankruptcy.

Period 0 1 2 3 4 5
HTM -70 5 5 5 5 105
IRR 13.7%          
Bankruptcy after 1 year -70 5 0 100    
IRR 15.1%          
Direct bankruptcy -70 0 100      
IRR 19.5%        

So in this simple example, the principle is quite easy to see: For a “distressed secured” buyer, the earlier the bankruptcy, the higher the returns.

How can a predator enforce bankruptcy ?

The usual way to do this is to enforce “broken” loan covenants. Normal bank loans contain certain minimum thresholds, often with regard to debt/equity or debt/asset ratios as well as interest/income. If those thresholds are not met anymore, usually the debtor has a certain “cure period” to fix things. Otherwise, the loans will become “due”. In normal cases, banks will not have an incentive to enforce the covenant. So they will renegotiate the covenants but demand extra collateral and/or a higher coupon.

A “predator” however, wil try to enforce the covenant in order to get his hands on the collateral.

In general, syndicated loans (i.e. a big loan which has been split up between a group of banks) will require a majority vote to actually renegotiate loan covenants. And that is where it gets interesting.

“Distressed debt” funds normally apply 2 strategies to accelerate their returns:

1) Enforcing bankruptcy
2) Blackmailing the loan syndicate

The second strategy is basically a game theory thing. If you have enough share of a syndicate to block decisions, sometimes those creditors who cannot afford a bankruptcy process will buy off th “predators”. This is often even better than going through the liquidation process.

Back to IVG: What does it mean here ?

Well, that’s easy: Look out for the predators !!!

As those guys smell the blood quite early, they have of course already arrived, at least according to this interesting piece of news from Reuters:

German property company IVG Immobilien is attracting attention from distressed debt investors as some lenders seek to cut their exposure to avoid potential heavy losses in a restructuring of its 4 billion euro ($5.3 billion) debts.

Between 400 million euros and 500 million in loans have been sold in three trades recently by banks looking to reduce or exit their positions in IVG and more trades are expected to occur in the coming weeks, bankers said on Friday.

And even more interesting:

IVG was not immediately available to comment.

The loans were sold to investors at around mid-80 percent of face value, a level considered to be distressed in Europe’s secondary loan market, bankers added.

IVG had outstanding debt of almost 4 billion euros at the end of 2012, comprising mostly bank loans, 3.16 billion euros of which are due to be refinanced by the end of 2014. IVG is close to breaching covenants on its debts.

So the predators are there, time to panic and sell the convertible ?

Not so fast. In my opinion there are 4 reasons why one should not panic:

1. The covenants are not broken yet, so there is no way to enforce the covenant here and now.
2. The price levels mentioned here does not justify a liquidation in my opinion. If you buy at 85% and you liquidate, then you will get money only within 2-3 years. This would be a single digit return at this levels
3. The amount traded does not provide a majority in any of the loan tranches.
4. There is a lot of money in the market chasing “high yield” paper, therefore improving IVG’s chance for refinancing

So for me it looks at the moment rather like a blackmailing strategy as discussed above, where the syndicate banks shall be forced to buy out the predators. Even if the predators go for liquidation, the question is how quickly they will be able to enforce the covenants.

Sometimes, “predators” run even more sophisticated schemes errrh strategies. One strategy for example would be Blackmailing as described above plus then investing in other parts of the capital structure at even more distressed prices. So the funds mentioned above could threaten the company and hold up the negotiation process only to purchase for instance the convertible at a very low price. At the last moment, they could then agree to a restructuring (or sell to the other banks) and harvesting the upside on the convertible.

Summary:

With the arrival of the “predators”, renegotiation for IVG will become more difficult. For the time being, it rather looks like a typical distressed debt “blackmailing” strategy, aimed at the other consortium banks. However this could change.

On the other hand, at current levels (66%-67%), a lot of bad news seems to be priced in, giving convertible holders an upside of > 50% in less than a year if the convertible gets paid in full.

Even in a liquidation scenario, I do not believe that we see such low recoveries as in other German cases in the recent past.

So for the time being, I am considering if I add carefully to my position if the (expected) bad news arrives. I am pretty sure the next call with management will be a disaster, so this could be a good entry point.

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