Readers know in the past we have covered Seth Klarman's letter to investors numerous times (here is one such post: Wisdom from Seth Klarman). This week, we received Baupost's 2011 Letter to Investor where Seth Klarman, along with heads of the public investing, private investing, and operations group talk about everything from the investment climate, the government policy, and Europe among many topics. A special emphasis, like we've seen in past years, was on the process, culture, and modus operandi of Baupost. It is a fantastic letter.
While I will not post or quote the entire letter, as a distressed debt investor, I found one set of paragraphs particularly relevant:
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While I will not post or quote the entire letter, as a distressed debt investor, I found one set of paragraphs particularly relevant:
"But in a field where the vast majority of our competitors spend their time looking exclusively at equities to buy or sell short, we are truly fortunate to have a broad mandate and stable, long-term oriented client base that allows us to emphasize in our portfolio more complex, less liquid, and less widely analyzed investments, such as distressed debt--and the ability to concentrate our capital in the areas of greatest opportunity, which inevitably evolve over time.
A follow-up question was asked: Why, if distressed debt is such an attractive arena, didn't many more funds sprout up to take advantage of the excess returns there? I replied that there were indeed very capable competitors in this space, but that opportunities in distressed debt ebb and flow with economic cycles. At the not infrequent moments when there is literally no distressed debt worth purchasing, these competitors (especially narrowly siloed ones) often stray (dangerously) into origination of new debt instruments at par. They are unable to sit on their hands, fearing that their businesses would wither and their people would depart. While the yield expectations for newly-issued debt may, at times, superficially appear similar to the returns on distressed debt, new origination occupies a very different place on the risk/return spectrum, and also requires an extraordinary underwriting discipline that few firms have. Sometimes, the competition moves into highly subordinated junk bonds, reaching for current yield while ramping up risk. Such diversions usually end badly, leaving these competitors wounded and mostly on the sidelines when the distressed opportunity set once again becomes compelling."This is an amazing quote. While a distressed fund investing in new issues may not represent "style drift", to me it does represent "upside/downside drift."
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