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Posts Tagged ‘Seth Klarman’

Jay at Market Folly has introduced a quarterly newsletter “Hedge Fund Wisdom,” which Jay bills as a “complete guide to what hedge funds have been buying and selling.” The newsletter includes:

  • Complete portfolio updates on 20 prominent hedge funds
  • Commentary and analysis of each fund’s moves
  • Consensus buys & sells among the hedge funds profiled
  • In-depth analysis of 3 stocks hedge funds were buying. We take you inside the head of a hedge fund manager to examine the investment thesis, upside & downside, potential catalysts, market valuation, contrarian viewpoint, company background & more

Here is an example of the holdings of Seth Klarman:

To celebrate the launch, Jay is providing two special introductory offers:

  • HFW Member – Annual (most popular choice! lock in additional cost savings before rates go up!) @ $199 / year
  • HFW Member – Quarterly (limited time offer, rates going up soon!)@ $60 / quarter

If you have any questions or issues, please send Jay an e-mail atinfo@hedgefundwisdom.com and he will get back to you.

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In The value of Seth Klarman (free registration required), Absolute Return has a rare interview with the president and portfolio manager of the 28-year-old Baupost Group. In the interview, Klarman discusses several of Baupost’s positions over the last twelve months, including the fund’s stake in Facet Biotech, which I fumbled last year:

Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

Here Klarman discusses his strategy more broadly:

Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management.

And his view on the market

The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses.

Baupost is 30% in cash now, its long-time average. Klarman stresses that the cash position is residual—the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”

And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.

Click here to see the remainder of the interview (free registration required).

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Following on from the Klarman sees another lost decade for stocks post, here are the full notes of Seth Klarman’s interview with Jason Zweig at the CFA Institutes Annual Conference (via ZeroHedge):

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The incredible Zero Hedge has an article on Seth Klarman’s address to the CFA Institute:

Seth Klarman was speaking at the CFA Institute earlier, and in typical fashion cut to the chase: in summarizing the current market, the Baupost founder said he “sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.” And the punchline: his description of market conditions which he compared to “a Hostess Twinkie snack cake because everything is being manipulated by the government and appears artificial.” Such facility with words, there is a reason the man runs a $22 billion fund and his book “Margin of Safety” has been out of print for years, and sells for a $1000 on ebay.

Sayeth Seth (via Reuters):

“Given the recent run-up, I’d be worried that we’ll have another 10 years of zero returns,” Klarman, who rarely speaks in public, said at the CFA Institute’s annual conference in Boston.

“I’m more worried about the world broadly than I’ve ever been in my whole career,” Klarman said.

Inflation is a risk that Klarman said he is particularly concerned with given the government’s high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.

The puts, which Klarman said he viewed as “cheap insurance,” will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

Typically, Baupost focuses on out-of-favor stocks and bonds. Klarman cleaned up in 2007 and 2008 buying distressed debt and mortgage securities that later recovered.

One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have “rallied enormously” and are “quite unattractive,” he said.

“We’d rather underperform a huge bull market than get clobbered in a bear market,” he said.

For those of you who don’t want to shell out $1,000 on eBay for Seth’s out-of-print Margin of Safety and have only recently become aware that the Internet is available on computers, the Zero Hedge article includes a link to a scanned copy of the book, available at a price even an anarcho-capitalist could embrace.

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Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

  1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
  4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
  6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
  7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
  8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
  9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
  12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
  14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
  15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
  16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  18. When a government official says a problem has been “contained,” pay no attention.
  19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

See also Klarman’s False Lessons of 2009.

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Facet Biotech Corporation (NASDAQ:FACT) is a new category of investment for us: special situations. It’s an activist play with a catalyst in the form of Dr. Roderick Wong’s nomination for the annual meeting of an alternative slate of directors, including well-known activist investor Robert. L. Chapman. The dissident slate has called for a cash dividend of up to $15 per share and demanded the sale of the other non-cash assets, estimating they may be worth an additional $8 to $16 per share, which represents a substantial upside at FACT’s $9.13 closing price yesterday. The company currently has a market capitalization of $216.8M. We estimate the liquidation value to be anywhere from nil to $259M or ~$10.85 per share and the net cash value from nil to $228M or $10.54 per share. The company is burning through its cash at a rapid rate, so the main risk to the investment is that the status quo is maintained. Although Wong et al hold only 0.5% of FACT’s outstanding stock, we think the presence of Bob Chapman and other noted activist and deep value investors on the register (Baupost Group holds ~18%) indicates a good chance of success for the dissidents. It’s not one for the Greenbackd Portfolio, but it’s an interesting play, so we’re creating a new Special Situations portfolio and adding FACT as our first holding.

About FACT

FACT is a biotechnology company spun out of PDL Biopharma, Inc. (PDL) in December last year. It operates what previously had been PDL’s biotechnology business. In the spin-off, PDL contributed to FACT certain intellectual property associated with the biotechnology business, $405 million in cash, an assignment of future payments from Biogen Idec Inc. and Bristol-Myers Squibb Company (BMS) and royalty and milestone revenues from certain other agreements. FACT is now engaged in “identifying and developing oncology therapeutics.” It has four antibodies in the clinic for “oncology and immunologic disease indications,” of which two are in phase II and two in phase I. The company has several “investigational compounds in various stages of development” for the treatment of cancer and immunologic diseases, three of which it is developing with Biogen Idec and one with BMS. The company’s investor relations website is here.

The value proposition

The company’s hard asset value (which excludes the PDL biotechnology business intellectual property) rests mainly on its holding of cash and equivalents contributed by PDL (the “Book Value” column shows the assets as they are carried in the financial statements, and the “Liquidating Value” column shows our estimate of the value of the assets in a liquidation):

fact-summary1

Balance sheet adjustments

We need to make the following adjustments to the balance sheet estimates above:

  • Cash burn: We’ve assumed cash burn to the annual meeting on May 26 of $40M (management estimates $90M for the year).
  • Off-balance sheet arrangements and contractual obligations: According to FACT’s 10K, it has no off-balance sheet arrangements, but its contractual obligations are extensive, including $220M in lease payments and related obligations, $10M in contract manufacturing obligations and $2M in equipment operating leases for a grand total of $234M.
  • Termination payments: If Wong’s nominees are elected to the board at the annual meeting, five officers will receive around $10M in termination payments. Not bad for a few quarters work. Those payments are pretty obscene, so we’ve set them out below:fact-termination1

If the company sustains another twelve months of cash burn and must pay out all its contractual obligations, it has next to no value in liquidation aside from the intellectual property associated with PDL’s biotechnology business, the value of which we can’t estimate. On that view, we estimate the liquidation to be nil. If the dissidents get control quickly, stop the cash burn and can sublease or assign the leases or otherwise negotiate the contractual obligations away, then we estimate liquidation value of around $259M or ~$10.85 per share and net cash value of $228M or $10.54 per share plus whatever PDL’s biotechnology IP is worth (the dissidents estimate between $8 and $16 per share). Of course, the dissidents have a different plan in mind, calling for an immediate cash dividend of up to $15 plus the sale of the company to crystalize the value of the non-cash assets.

The catalyst

The FACT situation kicked off with the dissident slate’s March 30 press release:

Facet Alternate Director Slate Proposed

Cash Dividend, Sale of Company Demanded

NEW YORK, March 30 /PRNewswire/ —

* Alternate Slate Delivered to Facet: On March 26, 2009, a proposed alternate slate of directors (the “Alternate Slate”) was delivered to Facet Biotech Corporation (“Facet,” or the “Company”; http://www.facetbiotech.com) CEO and President Faheem Hasnain (“Mr. Hasnain”), and to the Facet Board of Directors (the “Incumbent Board”), with a stated platform of maximizing shareholder value via a substantial cash dividend followed by a sale of the Company. Facet apparently has determined not to make immediate public disclosure to its owners that such an alternative to the Incumbent Board now is available.
* Alternate Slate Concern Heightened Following Dialog with Facet Management: Following receipt of notice of the Alternate Slate, Mr. Hasnain and CFO Andrew Guggenhime held a conference call with three members of the Alternate Slate, including nominating shareholder Dr. Roderick Wong. On the call, Dr. Wong expressed extreme dissatisfaction with the rapid cash-depleting business plan of the Company, expected to approach $100 million in 2009 alone. Moreover, the Alternate Slate made clear its view that a substantial cash dividend, followed by a sale of the Company, is favored by a preponderance of Facet’s owners. Based on the unsatisfactory response from Facet management to these presented views, the Alternate Slate determined it prudent to make public disclosure of its formation and of its conference call with the Company.
* Immediate And Substantial Cash Dividend Of Up To $15 Per Share Demanded: Subject to a review of the Facet 2008 Form 10-K, which should be released by the Company on March 31, 2009, the Alternate Slate is seeking the immediate distribution of a substantial portion – up to $15 per share – of the approximately $17 per share on the Company’s balance sheet as of December 31, 2008, followed by a sale of Facet.
* Non-Cash Assets May Be Worth An Additional $8 – $16 Per Share: Subject to further review, the Alternate Slate currently estimates that the Company’s non-cash assets, including the antibody technology platform and the drug candidates, could yield an additional $8 – $16 per share via a sale of the Company.
* Liquidation Demand From Alternate Slate Follows Similar Action At Other Companies: The Alternate Slate notes that similar demands were made of management at Northstar Neuroscience, Inc. and, most recently, at Avigen, Inc. As with Facet, investors in these two companies insisted upon and, appropriately, were rewarded with corporate liquidations.

As demonstrated by the Company’s public valuation near the low end of the range within the biotech sector, as measured by a variety of metrics, the Alternate Slate believes the preponderance of Facet shareholders have little confidence in the strategic plans supported by management and the Incumbent Board. Moreover, given that the top five (by percentage ownership per Securities and Exchange Commission public filings) Facet owners appear to represent over 45% of the outstanding shares, the Alternate Slate believes that the Company’s management and Incumbent Board may, with only modest effort, conclude that the majority of Facet investors agree with the cash dividend and sale platform endorsed by the Alternate Slate.

According to S.E.C. filings, these top-five holders are:

1. Baupost Group, LLC 16.68%
2. Iridian Asset Management, LLC 12.39%
3. Goldman Sachs Group, Inc. 6.20%
4. AXA 5.29%
5. Barclays Global Investors 4.82%

Dr. Roderick Wong then nominated an alternative slate of directors, including Philip R. Broenniman, Robert L. Chapman, Jr., David Gale, Bradd Gold and Roderick Wong. While we don’t know much about Wong, we’ve written about Bob Chapman before (see our earlier post, Where in the world is Chapman Capital). In response to Wong’s nomination, FACT sent the following letter to Wong on April 6:

Dear Dr. Wong:

We are in receipt of your letter dated March 26, 2009 and the accompanying notice of your intent to nominate directors at our 2009 Annual Meeting of Stockholders. We welcome the input of our stockholders, and our Board has considered the suggestions articulated in your letter and March 30, 2009 press release.

Our Board and management remain firmly committed to increasing the value of the Company to our stockholders. To this end, our Board has regularly evaluated the Company’s business plan as well as strategic alternatives to create value for our stockholders since the Company’s spin-off less than four months ago. In this regard, we note the following:

· Facet has undergone a rigorous analysis of its strategy, both in connection with our recent spin-off and subsequently.

· Our goal has been to focus on therapeutic areas that we believe hold the greatest opportunity for us to create meaningful value for our stockholders. As a result of our continued review and analysis, we are focusing our efforts on oncology.

· We believe our development programs and technology capabilities represent substantial potential value for our stockholders. Indeed, our collaborations with Bristol-Myers Squibb and Biogen Idec on certain of our development programs validate the value of these programs. We firmly believe that by continuing to advance these and other programs, as well as our proprietary protein engineering technology platform, we can enhance value for our stockholders.

· Furthermore, in an effort to maintain strict financial discipline, we have aggressively lowered our cost structure. In particular, as we recently announced, we have reduced our headcount and our overall anticipated cash utilization in 2009, thereby extending the time period for which we have funding.

We believe that our current Board, comprised of four independent directors and Faheem Hasnain, our President and Chief Executive Officer, and the management of the Company have a record of working to advance the interests of all stockholders, consistent with their fiduciary duty.

Based on our strategic review and ongoing analyses, the Board believes that our current strategic plan is the right plan to build value for our stockholders. Since we are committed to considering all

alternatives to creating value, we have reviewed your proposal for the liquidation of the Company. We have, however, unanimously concluded that the interests of our stockholders are best served by continuing to focus on executing our current strategy. Moreover, the Board believes that the assumptions stated in your March 30 press release with regard to the Company’s ability to distribute a significant cash dividend do not properly take into account, among other things, the Company’s significant lease and other obligations, which are detailed in the Company’s 2008 Annual Report on Form 10-K. Further, we believe that in this current economic environment, your proposals would significantly impair the Company’s ability to realize appropriate value for its existing assets.

Accordingly, we do not believe that your suggestions are in the best interests of our stockholders. We intend to maintain an open and active dialogue with our stockholders as we continue to work to enhance stockholder value.

Sincerely,

Brad Goodwin

Chairperson of the Board

Seth Klarman’s Baupost Group filed its 13D notice on April 8, disclosing a 17.8% holding in FACT. We’ve written extensively about Klarman’s liquidation value investment process (see our Klarman post archive here). Klarman is a noted deep value investor. While the Baupost Group’s position was built at a lower price than persists today, we feel reasonably comfortable following Klarman into a position.

Conclusion

FACT is a special situation: an activist play with an upside of $15 per share in a special cash dividend and an additional $8 to $16 per share upon the sale of the other non-cash assets. The downside is potentially unlimited. The dissidents appear to be led by Dr. Roderick Wong, and include noted activist investor Robert. L. Chapman. Seth Klarman’s Baupost Group, holds 17.8% according to its most recent 13D notice. The dissidents’ initial press release seems to imply that they have the support of stockholders representing 45% of the outstanding stock, although this is not independently verifiable. At its $9.13 closing price yesterday, the company has a market capitalization of $216.8M. We estimate the liquidation value to be anywhere from nil to $259M or ~$10.85 per share and the net cash value from nil to $228M or $10.54 per share. The company is burning through its cash at a rapid rate, so the main risk to the investment is that the status quo is maintained. We think the presence of Bob Chapman on the slate and Klarman’s Baupost Group on the register bodes well for the dissidents, so we’re adding FACT to our new Special Situations portfolio.

FACT closed yesterday at $9.13.

The S&P500 Index closed yesterday at 850.08.

Hat tip to John Allen.

[Full Disclosure:  We do not have a holding in FACT. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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Today we complete our series on Seth Klarman, the founder of The Baupost Group, a deep value-oriented private investment partnership that has generated an annual compound return of 20% over the past 25 years, and the author of an iconic book on value investing, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Following on from our earlier posts, Seth Klarman on Liquidation Value, and Seth Klarman on Catalysts, we present Seth Klarman’s application of liquidation value investment principles to a specific case: the City Investment Liquidating Trust (from Chapter 10 Areas of Opportunity for Value Investors: Catalysts, Ineficiences, and Institutional Constraints):

Investing in Corporate Liquidations

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders’ investments. Other, more interesting corporate liquidations are motivated by tax considerations, persistent stock market undervaluation, or the desire to escape the grasp of a corporate raider. A company involved in only one profitable line of business would typically prefer selling out to liquidating because possible double taxation (taxes both at the corporate and shareholder level) would be avoided. A company operating in diverse business lines, however, might find a liquidation or breakup to be the value-maximizing alternative, particularly if the liquidation process triggers a loss that results in a tax refund. Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies.

Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or protracted. Indeed, investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

City Investing Liquidating Trust

In 1984 shareholders of City Investing Company voted to liquidate. The assets of this conglomerate were diverse, and the most valuable subsidiary, Home Insurance Company, was particularly difficult for investors to appraise. Efforts to sell Home Insurance failed, and it was instead spun off to City Investing shareholders. The remaining assets were put into a newly formed entity called City Investing Liquidating Trust, which became a wonderful investment opportunity.

Table 2

table-2-margin-of-safetyAs shown in table 2, City Investing Liquidating Trust was a hodgepodge of assets. Few investors had the inclination or stamina to evaluate these assets or the willingness to own them for the duration of a liquidation likely to take several years. Thus, while the units were ignored by most potential buyers, they sold in high volume at approximately $3, or substantially below underlying value.

The shares of City Investing Liquidating Trust traded initially at depressed levels for a number of additional reasons. Many investors in the liquidation of City Investing had been disappointed with the prices received for assets sold previously and with City’s apparent inability to sell Home Insurance and complete its liquidation. Consequently many disgruntled investors in City Investing quickly dumped the liquidating trust units to move on to other opportunities. Once the intended spinoff of Home Insurance was announced, many investors purchased City Investing shares as a way of establishing an investment in Home Insurance before it began trading on its own, buying in at what they perceived to be a bargain price. Most of these investors were not interested in the liquidating trust, and sold their units upon receipt of the Home Insurance spinoff. In addition, the per unit market price of City Investing Liquidating Trust was below the minimum price threshold of many institutional investors. Since City Investing Company had been widely held by institutional investors, those who hadn’t sold earlier became natural sellers of the liquidating trust due to the low market price. Finally, after the Home Insurance spinoff, City Investing Liquidating Trust was delisted from the New York Stock Exchange. Trading initially only in the over-the-counter pink-sheet market, the units had no ticker symbol. Quotes were unobtainable either on-line or in most newspapers. This prompted further selling while simultaneously discouraging potential buyers.

The calculation of City Investing Liquidating Trust’s underlying value in table 2 is deliberately conservative. An important component of the eventual liquidating proceeds, and something investors mostly overlooked (a hidden value), was that City’s investment in the stock of Pace Industries, Inc., was at the time almost certainly worth more than historical cost. Pace was a company formed by Kohlberg, Kravis and Roberts (KKR) to purchase the Rheem, Uarco, and World Color Press businesses of City Investing in a December 1984 leveraged buyout. This buyout was profitable and performing well nine months later when the City Investing Liquidating Trust was formed.

The businesses of Pace had been purchased by KKR from City Investing in a financial environment quite different from the one that existed in September 1985. The interest rate on U.S. government bonds had declined by several hundred basis points in the intervening nine months, and the major stock market indexes had spurted sharply higher. These changes had almost certainly increased the value of City’s equity interest in Pace. This increased the apparent value of City Investing Liquidating Trust units well above the $5.02 estimate, making them an even more attractive bargain.

As with any value investment, the greater the undervaluation, the greater the margin of safety to investors. Moreover, approximately half of City’s value was comprised of liquid assets and marketable securities, further reducing the risk of a serious decline in value. Investors could reduce risk even more if they chose by selling short publicly traded General Development Corporation (GDV) shares in an amount equal to the number of GDV shares underlying their investment in the trust in order to lock in the value of City’s GDV holdings.

As it turned out, City Investing Liquidating Trust made rapid progress in liquidating. GDV shares surged in price and were distributed directly to unitholders. Wood Brothers Homes was sold, various receivables were collected, and most lucrative of all, City Investing received large cash distributions when Pace Industries sold its Rheem and Uarco subsidiaries at a substantial gain. The Pace Group debentures were redeemed prior to maturity with proceeds from the same asset sales. Meanwhile a number of the trust’s contingent liabilities were extinguished at little or no cost. By 1991 investors who purchased City Investing Liquidating Trust at inception had received several liquidating distributions with a combined value of approximately nine dollars per unit, or three times the September 1985 market price, with much of the value received in the early years of the liquidation process.

That concludes our series on Seth Klarman.

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