By Jason Mudrick
I used to wonder why I would see professional poker players on television playing in poker games with other professionals. As a card player myself, logic told me that the advantage one pro could have over another pro would be so small as to make the exercise futile. The likely result had to be that the pros passed chips back and forth amongst each other based on the luck of the cards, and not the result of any competitive advantage.
I’ve met poker pros and they confirmed my hunch – these tournaments are essentially even matches. Their advantage is created because they are playing with other people's money. Good players find investors to "stake" them and the player negotiates a deal that lets him or her take a larger percentage of their wins than the amount of the capital they risk. The more television time and celebrity status, the more sponsorship players receive and the better deals they negotiate with investors.
If poker pros had to play with their own money and could not generate other revenue from poker besides their net wins, they would not play against other pros. They would keep a low profile and play in games with amateurs where they believed they had a decisive performance advantage.
This brings me to distressed debt investing. In the 90s and even the early part of the last decade, there were only a handful of distressed debt investment firms. These firms managed pools of capital measured in the hundreds of millions, not billions. When a company became distressed, large inefficiencies were created because there was forced selling out of traditional par lenders such as vendors that held trade claims, commercial banks, high yield mutual funds and insurance companies. The distressed company became difficult to analyze due to an information vacuum and the additional complexity of turnarounds, negotiating dynamics and bankruptcy law. These distressed debt managers had the skill set and risk tolerance to invest, and real alpha was generated as these inefficiencies were capitalized upon.
As is the case with most market inefficiencies, the number of distressed debt specialists multiplied, and the amount of capital these firms managed multiplied even faster. The pendulum has swung too far. Today, I estimate that over 90% of the distressed debt focused capital is controlled by firms that manage in excess of $10 billion. The sheer size of these firms limits what they can invest in to large capital structures as they cannot invest enough money in smaller capital structures to move the needle on their funds. Do names like Lehman Brothers, Tribune, Harrahs, Clear Channel Communications, Realogy, TXU and First Data ring a bell? The other investors in these capital structures are other distressed debt specialists – pros trading amongst pros. Today there are very few inefficiencies in these capital structures and thus very little alpha creation. But it makes sense as investments for these larger managers because they are trading with other people's money, and charging 2% management fees and 20% incentive fees.
If good distressed debt managers were investing their own money and could not generate fees managing other institutions’ capital, they would not invest in these large efficient capital structures. They would search for investment opportunities where others were not looking.
Investment banks playing with their own capital acted differently. The proprietary trading desks at these banks focused their own capital on the middle market distressed names where they could recognize real inefficiencies because the larger managers were not focused on them. However, these proprietary trading desks have been forced to reduce capital significantly, if not entirely, due to the changing regulatory landscape. These desks have gone from being buyers to sellers.
With large distressed managers focused on large capital structures and the theoretical opportunity coming out of Europe, and the proprietary trading desks shutting down due to a focus on liquidity and the coming Volcker Rule, a supply demand imbalance has been created in middle market distressed debt. Inefficiencies are identifiable and able to be capitalized upon by smaller distressed debt firms. We believe that middle market distressed is one of the last pockets of real alpha in distressed credit today.
Our job as an investment manager is to identify inefficiencies so that we can produce alpha for our investors in a risk controlled fashion. We focus where others are not, cannot or dare not, because here we are more likely to find inefficiencies. We want to buy from traditional lenders, not other distressed debt specialists. We want to play poker with amateurs, not pros.
There's an expression in poker, "If you sit down at a game and after 30 minutes don't know who the sucker is, the sucker is you." The same is true in distressed investing.
Jason Mudrick is the chief investment officer of Mudrick Capital Management, a New York hedge fund.
Also by Jason Mudrick: Zombie companies roam LBO land in a long distressed cycle