Seth Klarman (Trades, Portfolio) is one of the most celebrated value investors of all time.
His $30 billion Boston-based value hedge fund Baupost has achieved annualized returns of more than 20% for investors since inception thanks to his steady hand and devotion to finding value.
Seth Klarman (Trades, Portfolio) is focused on finding securities that offer a deep margin of safety and limited downside. In fact, he attributes his performance record to concentrating solely on the downside, finding investments where the risk of permanent capital impairment is almost non-existent, but the potential reward if the thesis plays out is substantial.
However, with tens of billions of dollars in assets under management, Klarman is limited in where he can invest. Undervalued small-cap stocks may be attractive for the average value investor, but they are too small to move the needle for someone who needs to generate a billion dollars or more in profit every year -- you would need potentially hundreds of these opportunities every year.
So, as well as equity investing, Klarman and team also invest in distressed debt. Here the pond is deeper and fewer competitors are chasing limited opportunities.
"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." -- Seth Klarman Baupost's 2011 Letter to Investor
Some of the most prominent debt trades Klarman has executed in recent years include the distressed debt of Lehman Brothers, the distressed debt of Icelandic Banks Kaupthing, Glitnir, and Landsbanki and, more recently, the distressed debt of Puerto Rico.
All of these situations have allowed Baupost to act at the scale it needs, with the margin of safety required to generate 20% and higher annual returns for investors. That being said, some of these trades have attracted more criticism than others, mainly from campaigners who argue that private hedge funds should not be benefiting from public bailouts, but that's a different side to the argument.
What is interesting is the way that Klarman has been using distressed debt to generate the bulk of his returns over the years. None of these cases has been a simple buy and forget situation.
Plenty of specialis and costly legal work has been required, and lawsuits often drag on for years, which means only deep-pocketed, highly experienced investors can play the game.
Nevertheless, if you can hold your nerve and wait for the perfect opportunity, investing in distressed debt can be tremendously lucrative. The problem is, most investors just can't wait, and it's here where the opportunity is to be found if you have the skills and access to required infrastructure to profit from this opportunity.
"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." -- Seth Klarman (Trades, Portfolio) Baupost's 2011 Letter to investors
Disclosure: The author owns no stock mentioned.
