Baupost Navigates a Tough, Yet Still Profitable, 2012

February 07, 2013   Stephen Taub

Despite a dearth of new investment opportunities, Seth Klarman’s Boston firm finished up 7 percent from last year.

   
   Baupost's Seth Klarman
About a year ago, Seth Klarman, founder and president of Baupost Group, wrote in his year-end letter to clients that 2011 was like "playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake."

Last year was nothing so perilous. Entering 2012, Klarman sounded a more upbeat tone, saying his firm was poised to scoop up bargains. His Boston hedge fund firm's cash balance stood at 21 percent of capital at the end of 2011, slightly less than 30 percent earlier that year. (Cash balances at the firm average around 33 percent and have been known to range up to 50 percent).

Alas, the investor found it difficult to part with cash. "We were all dressed up with no place to go," Klarman told clients in his year-end letter dated January 24, 2013, describing the year as "frustrating."

The trouble was, he explains, there wasn't enough supply of securities and assets just as buy-side competitors became increasingly aggressive. The bargains that came in the wake of the 2008 and 2009 selloffs are long gone.

Instead, he says, Baupost, known for its eclectic taste in undervalued assets ranging from equities, to distressed securities to real estate, had to contend with potential opportunities that were priced too high for the bargain-obsessed firm.

Nonetheless, Klarman - who has returned a compounded annual rate of at about 18 percent since he helped to launch Baupost in 1982 - tells clients that, all things considered, he was "quite pleased" with how the annual performance turned out. Despite the dearth of new investment opportunities, Baupost, now with about $26 billion in assets under management, finished 2012 up around 7.6 percent on a consolidated basis. By way of comparison, the firm posted gains of just 4.5 percent to 5 percent in 2011.

"While our return for the year was not scintillating, we regard it as acceptable considering the limited risk incurred to achieve it, including the consistent maintenance of cash balances that hovered around 30 percent of capital all year before ending somewhat higher," writes Klarman.

In a separate report, Baupost managing director James Mooney, head of the firm's public investment group, says his team generated solid results in 2012, with significant gains coming from several core positions.

The biggest gains came from its investment in the debt of Lehman Brothers, which, all told, accounts for slightly more than 20 percent of Baupost's net asset value. This include Lehman entities in the United States and in administrative proceedings in foreign jurisdictions, including Lehman Brothers International Europe, or LBIE, Lehman's U.K. broker-dealer.

"The Lehman story continues to evolve towards resolution both in the U.K. and in the U.S., and, during 2012, we received significant distributions from both estates," Mooney informs clients.

Altogether, Baupost received nearly $1.5 billion and expects to receive "significant additional distributions" in 2013.

In the fourth quarter of 2012 alone, Baupost invested nearly $1 billion in two major claims against LBIE. "Although the market for claims remains competitive, we continued to reap the benefits of the extraordinary analytical efforts of our Lehman team, which allowed us to understand and value claims with highly complex underlying transaction structures," Mooney writes. During the year it also swooped in and bought Lehman paper when prices fell.

Looking at 2013, opportunities for new investment in Lehman won't be nearly as attractive, adds Mooney.

Baupost's structured products portfolio also fared very well in 2012, even though its allocation in the firm's overall portfolio fell from more than 20 percent of assets at the end of 2009 to less than 8 percent as a result of sales. "All positions in this segment of the portfolio were profitable," Mooney states.

These included interest-only securities and collateralized debt obligations, although such securities are losing their appeal for 2013. "This is due both to a prevailing view among market participants that the housing market is beginning to recover as well as to the fact that investors, in general, are willing to bid up risky assets to yields that we no longer see as attractive relative to the inherent underlying risks," Mooney explains.

Looking ahead, he says, the firm expects to see increasingly less chances of investing in structured products space, and it will likely be a net over the course of this year. The one exception may be Europe.

As for equities, 2012 had mixed results, resulting in a flat performance, with a few notable exceptions. News Corp., Oracle and Vivendi generated "substantial dollar profits," the letter says. The firm also enjoyed solid contributions from a few other, smaller positions.

Baupost's Hewlett Packard investment took a big hit, and by year end the firm had unloaded most of its position.

On the other hand, the gold portfolio lost money, especially one unnamed investment that Mooney says "fell sharply" because an expected permit was indefinitely delayed. However, the firm added to its exposure in cases where it thinks the returns remain attractive, he adds.

Mooney also discloses that in 2012 Baupost had invested in Greek sovereign debt, but it no longer holds this position as a result of sales made before the government tendered for its bonds in December and contractual maturities it received from government loans repaid prior to year end.

"This was Baupost's first foray into sovereign credit and we were very pleased to have generated a healthy profit," Mooney states.

Separately, Tom Blumenthal and George Rizk, co-heads of private investments, report that the firm's private equity portfolio had a good year last year, and the real estate portfolio's contribution to profitability was in line with its expectations.

How is Baupost's deck of cards positioned for 2013? Klarman believes U.S. stock market valuations are increasingly expensive but not extreme. He says he is encouraged by the country's moves toward becoming energy-independent and by signs that low-cost natural gas is setting the stage for a manufacturing recovery.

Klarman even waxes philosophically on the country's debt crisis: "Our national debt is entirely denominated in our own currency, so we cannot actually default. And the solution to our irresponsible deficit spending lies in our own hands. Unlike peripheral Eurozone countries, we are still the masters of our fate."

Mooney, for his part, expresses concerns over the "insatiable investor appetite" for corporate credit. While some would argue that the market isn't that overheated because credit spreads remain near historical averages, Baupost maintains that, "at best, the level of absolute yields is yet another manifestation of the overall interest rate bubble and, at worst, is evidence that investors are accepting insufficient returns for the risk they are taking."

Still, Europe is particularly interesting for the potential distressed investment opportunities that it presents, Mooney observes. He argues that the fundamental issues facing European economies remain "ominously beneath the surface: exceedingly high debt/GDP ratios, persistent budget deficits, and hundreds of billions of euros of stranded assets on bank balance sheets."

Thus, he says, his firm is sifting through leveraged companies and sovereign credits looking for the shakiest situations.

His conclusion: Baupost's portfolio holdings are "quite compelling as we enter 2013," and the firm is confident it will achieve "solid long-term returns with limited downside risk under any of the aforementioned scenarios."



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