In a similar light to my past post, I came across another quarterly letter that I thought was worth reading. Owl Creek is a macro hedge fund and they do a good job of explaining their thinking. Enjoy.
Owl Creek - 8-17-10
Friday, August 27, 2010
Pershing Square Q2 2010 Letter
Here is Pershing Square's Q2 2010 letter. In it, among other things, they discuss their position in BP CDS (basically a bet the company will have hard times ahead). I felt this would be good for readers to see the counter point to my original BP trade posted a while back. Enjoy.
Pershing Square - 8-26-10
Pershing Square - 8-26-10
Tuesday, August 24, 2010
GM
With all the chatter about the upcoming GM IPO. I thought now would be a good time to post up a recent idea I read on investing in GM Bonds. It does a good job of walking through the framework of how to evaluate distressed debt and shows how powerful catalyst investing can be. Enjoy:
Introduction:
The distressed market is often inefficient due to the complicated nature of the product, lack of information and illiquid trading. In some cases, this allows for significant arbitrage, and an investment in the bonds of Motors Liquidation Company (“MLC”), the former General Motors, allows for just such an opportunity. Understanding a couple of key distressed concepts – namely accrued interest and how foreign currency is treated in bankruptcy – reveals that one can generate a gross return of 11% (less borrowing cost) and an IRR of over 20% based on current market levels by establishing a long / short position in the bonds of MLC. Specifically, we advocate a long position in the Euro Notes and a short position in the Dollar Notes at a ratio of 1.000:1.123 in terms of capital invested, which results in a neutral position on a claim basis, and given that both the long and short sides of the trade involve the same claim in bankruptcy, we believe this return involves no real fundamental risk.
Situation Overview:
The former General Motors filed for bankruptcy in June 2009. The governments of the United States and Canada sponsored an asset sale of the company in bankruptcy under Section 363 of the bankruptcy code by capitalizing a new company to purchase most of the assets. This “new” General Motors is currently private, with the equity owned by the US and Canadian governments, an employee benefit trust and MLC. When the 363 sale was completed, the “old” General Motors was renamed Motors Liquidation Company and is being wound down over time as part of the bankruptcy estate. The unsecured claims at MLC are set to receive common stock and warrants of the new General Motors, and it is this value of new GM equity that comprises the vast majority of MLC’s value and will determine the price of the bonds.
Bond Valuation and Trade Details:
The proposed trade requires the purchase of Euro Notes (offered at 34.50%) and the short sale of Dollar Notes (bid at 31.50%). Despite the optically higher price of the Euro Notes, they are cheaper than the Dollar Notes by 11% on a claim basis. The reason for this is two-fold:
• The pre-petition accrued interest, which is part of the bankruptcy claim, is much higher in the Euro Note than in the Dollar Note. Since these bonds trade flat (i.e. without accrued interest), the buyer does not pay for accrued interest as with a current-pay bond, but bond prices should generally reflect this. In this case, part of the arbitrage is that the difference in accrued interest is not fully accounted for in the prices of these bonds. Euro-denominated bonds generally pay interest annually, as opposed to the domestic market, where the convention is to pay interest semi-annually, as is the case with each of these bonds. The last interest payment made on the Euro Note was on July 5, 2008, and there are ~7.58 points of pre-petition accrued interest in that note (8.375% coupon * 326 days from last payment to bankruptcy filing / 360 days used for bond year). However, since the Dollar Note last paid interest on January 15, 2009, the pre-petition accrued interest is only ~3.16 points (8.375% coupon * 136 days from last payment to bankruptcy filing / 360 days used for bond year).
• A weaker Euro has benefited the Euro Notes since a claim denominated in foreign currency is fixed at $1.4159 / Euro (exchange rate as of the date of filing, pursuant to section 502(b) of the U.S. Bankruptcy Code) but the notes are bought at the current exchange rate ($1.2000 / Euro).
Each Euro Note (face value of €1,000) is bought for $414 (€1,000 face value * 34.50% price * 1.200 current USD / EUR exchange rate), and what is purchased is a claim of $1,523 (€1,000 face value * 1.0758 to account for pre-petition accrued interest * 1.4159 USD / EUR exchange rate at time of filing). Therefore, the claim-adjusted price is 27.2% via purchase of the Euro Note.
Each Dollar Note (face value of $1,000) is bought for $315 ($1,000 face value * 31.50% price), and what is purchased is a claim of $1,032 ($1,000 face value * 1.0316 to account for pre-petition accrued interest). Therefore, the claim-adjusted price is 30.5% via purchase of the Dollar Note.
By investing the amount of dollars required to be neutral on a claim basis (a capital invested ratio of short $1.123 in Dollar Notes for each $1.000 purchased of Euro Notes), one will collect the difference in spread when the bonds are cancelled and new securities are issued. As an example, in conducting a short sale of $1,000 worth of claim via the Dollar Note, $305 in proceeds would be collected ($1000 * 30.5% claim-adjusted price). In order to satisfy the $1,000 of claim being borrowed, an investment in the Euro Notes of $272 ($1000 * 27.2% claim-adjusted price) is required. The difference of $33 would then be left over once the borrowed position on the Dollar Notes is covered using the claim proceeds from the Euro Notes.
Risks:
While we do not believe there is fundamental risk associated with this position, there are several risks to be aware of:
• Availability of borrow on the Dollar Notes
o There is currently ample borrow on the Dollar Notes – it is a $3 billion issue and generally the most liquid of the MLC bonds that trade. However, there is always the risk that the borrow might become unavailable in the future, and a short position may be called. If this occurs, and the other side of the trade (long Euro Notes) needs to be closed, it may be at an unattractive level. The borrow rate on the bonds is currently 2% per annum (or 1% over our estimated holding period).
• Timing and form of securities
o There is no definitive end date for the trade, as it requires a distribution of value based on claims in order to close. This will occur when the equity of new GM is distributed from MLC to the bondholders and other unsecured claimants. Press reports indicate that new GM will likely try and file for an IPO in early Q4 2010, although there may not be a full distribution at that time as MLC may hold back some value until it is wound down. We assume a scenario where 70-80% of the stock is distributed immediately, with the remaining stock to be distributed at a later date. There is a chance that the bonds could remain outstanding after this distribution, and so the trade may not fully close, but MLC is incentivized to wind down and claimants could instead receive new equity in a liquidating trust. This has been done in previous bankruptcies and could collapse the proposed trade even without a full distribution of new GM shares. We believe a full collapse of the trade before year-end is the most likely outcome.
• Mark to market risk on Euro Notes
o Holding the trade to completion should not result in any foreign currency issues, but in the interim there is risk that the price of the Euro Notes does not reflect the change in the value of the Euro (which has been very volatile and may continue to be so). This may result in some interim mark-to-market fluctuations, but should not be material over time.
Alternative Trade:
Depending on the viewpoint one has on new GM stock, the trade can be set up in a different ratio to create “free” shares in the new GM when the long and short ends of the trade collapse and new securities are issued. This can be accomplished by investing the same amount of dollars on each side of the trade (a capital invested ratio of short $1.000 in Dollar Notes for each $1.000 purchased of Euro Notes). As an example, investing $1,000 in Euro Notes buys $3,679 of claim value ($1,000 invested / 27.2% claim-adjusted price), while shorting $1,000 in Dollar Notes results in being short $3,275 of claim value ($1,000 invested / 30.50% claim-adjusted price). The difference, $404, is what would be kept in claim value once the trade closes and the GM stock is received, and at a market price of 27% (based on the price paid for the claim), is worth $110 against $1,000 invested in the long position.
While we believe that we are creating GM equity cheaply based on current bond prices, as we believe there is 50% upside from current levels, we acknowledge that the investment is speculative and may not be for everyone. The trade also requires significant capital to be put to work on a gross basis. However, investing in the equity theoretically removes the timing risk involved in the trade – to the extent that the trade takes longer than expected, the company should continue to accrue equity value as the operations are improving at a very fast rate. This is offset by the fundamental risks associated with owning the equity, rather than receiving cash. We have included a very brief valuation discussion on the new GM for those interested.
New GM Valuation:
The main source of value at GM is its auto manufacturing operations. With a streamlined focus on four brands (Buick, Cadillac, Chevrolet and GMC), an improved cost structure and positive outlook on vehicle sales, we estimate GM will generate $13 billion of EBITDA in 2011. We gain comfort in this estimate not only from our top-down model but also based on projections from GM’s financial advisor and recent performance. In May 2009, Evercore estimated that GM would be able to achieve $13 billion in EBITDA in 2012, but since that time, results have been much stronger than anticipated, so we do not consider achieving those results a year ahead of schedule to be significantly optimistic (disclosure statement projections, especially recently, have also historically proven to be conservative). Moreover, GM generated $3 billion of EBITDA in Q1 2010, so on a run-rate basis is already tracking close to our 2011 estimate a year ahead of schedule, and this was achieved with European operations being a drag on earnings.
We value GM on a sum-of-parts basis and use the valuation of Ford as a blueprint. While Ford is a better-run company with a stronger lineup over the next few years, we believe that GM has significant cost-cutting opportunities (particularly in Europe) and top-line projections also have more upside, so a similar multiple to Ford on our projections is warranted. Additionally, there will be some technical support for GM shares upon issuance, as it will likely be added to major indices.
• GM’s core OEM operations are worth $65 billion, based on a 5x multiple on 2011 EBITDA. This multiple is in line with Ford, after adjusting for that company’s non-core assets in a similar sum-of-parts methodology (Toyota also trades at a similar multiple based on consensus estimates).
• JV interests in Asian operations generated over $500 mm in net income in the second half of 2009 and over $400 mm in Q1 2010 – these results are not consolidated in GM’s income statement and so are not included in its reported EBITDA. Assuming that on a full-year basis these operations can contribute $1.6 billion in net income (based on Q1 2010 run-rate) and applying a 12.5x P/E multiple indicates $20 billion of value
• GM owns an equity stake in Delphi. While information on Delphi’s performance is private, we know that GM invested $2.8 billion in cash in November 2009 to purchase Delphi equity, and value the stake at the purchase price.
• GM also has a stake in both the common and preferred equity of Ally Financial (formerly GMAC). As of March 31, 2010, GM estimated the fair value of the common stock to be $1.093 billion and the preferred to be $1.002 billion, for a total value of $2.1 billion.
• GM was overcapitalized given the difficulty in obtaining financing in the markets, and thus has a strong balance sheet. As of March 31, 2010, the company had cash and investments of $23.5 billion, as well as restricted cash related to the US Treasury credit agreement of $11.3 billion (since the loans were repaid in April 2010 these funds are no longer subject to restriction, and so should be included on a pro forma basis as available cash), for a total of $34.7 billion. This amount excludes ~$1.5 billion of other restricted cash, much of which is related to a Canadian health care trust. With respect to debt, the company shows total debt of $14.2 billion as of March 31, 2010, but we believe this includes a discount of $1.6 billion and have added that amount to the balance (this was included in disclosures in the 10-K for the period ended December 31, 2009 and we have no reason to believe this number has changed). Additionally, the company had $9 billion of preferred stock. In aggregate, the company has a net cash position of $10 billion (while some debt was repaid after the reporting period, this will not change the net debt figure).
• New GM has significant underfunded pension and OPEB liabilities – as of December 31, 2009, these broke down as follows:
o $17.1 billion in underfunded U.S. pension
o $10.3 billion in underfunded non-U.S. pension
o $5.8 billion in underfunded U.S. OPEB
o $3.8 billion in underfunded non-U.S. OPEB
We do not believe that General Motors will end up being liable for this entire amount, particularly with respect to some non-U.S. and/or OPEB liabilities. Additionally, were the amounts to be paid off, the company would generate a massive deferred tax asset. Our base case conservatively assumes the entire liability is paid and discounts both the U.S. and non-U.S. amounts by 35% to account for the value of the tax shield. This results in a total liability of $24 billion.
Adding up these numbers gets to a total equity value of $75.8 billion. Based on an estimated $37 billion in unsecured claims (this is the amount estimated in the company’s SEC filings, although its monthly operating reports filed with the bankruptcy courts show liabilities subject to compromise of $32.2 billion), MLC is entitled to 52.9 million shares of new GM stock, as well as two series of warrants to purchase 45.5 million shares at implied equity values of $15 billion and $20 billion, respectively. Using the treasury method (the warrants are well in-the-money and so we ignore option value), MLC will own 115.9 million shares of new GM at an implied share price (based on total equity value of $75.8 billion) of $134, resulting in total value of $15.4 billion. Based on a total claims pool of $37 billion, this implies a recovery of 41.7%, against the current claim-adjusted price of the Euro Notes of 27.2%. In May 2009, Evercore estimated a recovery of 26.5% - however, they assumed cash at GM would be $15.3 billion, while the company has nearly $20 billion more than that. This would imply a recovery of 37.3%, holding all else equal, and performance has also been better than expected in the year since that analysis was done. While there is a wide range of opinions on what the ultimate recovery will be worth, we note that Street estimates have recovery values as high as 47 to 50%.
Introduction:
The distressed market is often inefficient due to the complicated nature of the product, lack of information and illiquid trading. In some cases, this allows for significant arbitrage, and an investment in the bonds of Motors Liquidation Company (“MLC”), the former General Motors, allows for just such an opportunity. Understanding a couple of key distressed concepts – namely accrued interest and how foreign currency is treated in bankruptcy – reveals that one can generate a gross return of 11% (less borrowing cost) and an IRR of over 20% based on current market levels by establishing a long / short position in the bonds of MLC. Specifically, we advocate a long position in the Euro Notes and a short position in the Dollar Notes at a ratio of 1.000:1.123 in terms of capital invested, which results in a neutral position on a claim basis, and given that both the long and short sides of the trade involve the same claim in bankruptcy, we believe this return involves no real fundamental risk.
Situation Overview:
The former General Motors filed for bankruptcy in June 2009. The governments of the United States and Canada sponsored an asset sale of the company in bankruptcy under Section 363 of the bankruptcy code by capitalizing a new company to purchase most of the assets. This “new” General Motors is currently private, with the equity owned by the US and Canadian governments, an employee benefit trust and MLC. When the 363 sale was completed, the “old” General Motors was renamed Motors Liquidation Company and is being wound down over time as part of the bankruptcy estate. The unsecured claims at MLC are set to receive common stock and warrants of the new General Motors, and it is this value of new GM equity that comprises the vast majority of MLC’s value and will determine the price of the bonds.
Bond Valuation and Trade Details:
The proposed trade requires the purchase of Euro Notes (offered at 34.50%) and the short sale of Dollar Notes (bid at 31.50%). Despite the optically higher price of the Euro Notes, they are cheaper than the Dollar Notes by 11% on a claim basis. The reason for this is two-fold:
• The pre-petition accrued interest, which is part of the bankruptcy claim, is much higher in the Euro Note than in the Dollar Note. Since these bonds trade flat (i.e. without accrued interest), the buyer does not pay for accrued interest as with a current-pay bond, but bond prices should generally reflect this. In this case, part of the arbitrage is that the difference in accrued interest is not fully accounted for in the prices of these bonds. Euro-denominated bonds generally pay interest annually, as opposed to the domestic market, where the convention is to pay interest semi-annually, as is the case with each of these bonds. The last interest payment made on the Euro Note was on July 5, 2008, and there are ~7.58 points of pre-petition accrued interest in that note (8.375% coupon * 326 days from last payment to bankruptcy filing / 360 days used for bond year). However, since the Dollar Note last paid interest on January 15, 2009, the pre-petition accrued interest is only ~3.16 points (8.375% coupon * 136 days from last payment to bankruptcy filing / 360 days used for bond year).
• A weaker Euro has benefited the Euro Notes since a claim denominated in foreign currency is fixed at $1.4159 / Euro (exchange rate as of the date of filing, pursuant to section 502(b) of the U.S. Bankruptcy Code) but the notes are bought at the current exchange rate ($1.2000 / Euro).
Each Euro Note (face value of €1,000) is bought for $414 (€1,000 face value * 34.50% price * 1.200 current USD / EUR exchange rate), and what is purchased is a claim of $1,523 (€1,000 face value * 1.0758 to account for pre-petition accrued interest * 1.4159 USD / EUR exchange rate at time of filing). Therefore, the claim-adjusted price is 27.2% via purchase of the Euro Note.
Each Dollar Note (face value of $1,000) is bought for $315 ($1,000 face value * 31.50% price), and what is purchased is a claim of $1,032 ($1,000 face value * 1.0316 to account for pre-petition accrued interest). Therefore, the claim-adjusted price is 30.5% via purchase of the Dollar Note.
By investing the amount of dollars required to be neutral on a claim basis (a capital invested ratio of short $1.123 in Dollar Notes for each $1.000 purchased of Euro Notes), one will collect the difference in spread when the bonds are cancelled and new securities are issued. As an example, in conducting a short sale of $1,000 worth of claim via the Dollar Note, $305 in proceeds would be collected ($1000 * 30.5% claim-adjusted price). In order to satisfy the $1,000 of claim being borrowed, an investment in the Euro Notes of $272 ($1000 * 27.2% claim-adjusted price) is required. The difference of $33 would then be left over once the borrowed position on the Dollar Notes is covered using the claim proceeds from the Euro Notes.
Risks:
While we do not believe there is fundamental risk associated with this position, there are several risks to be aware of:
• Availability of borrow on the Dollar Notes
o There is currently ample borrow on the Dollar Notes – it is a $3 billion issue and generally the most liquid of the MLC bonds that trade. However, there is always the risk that the borrow might become unavailable in the future, and a short position may be called. If this occurs, and the other side of the trade (long Euro Notes) needs to be closed, it may be at an unattractive level. The borrow rate on the bonds is currently 2% per annum (or 1% over our estimated holding period).
• Timing and form of securities
o There is no definitive end date for the trade, as it requires a distribution of value based on claims in order to close. This will occur when the equity of new GM is distributed from MLC to the bondholders and other unsecured claimants. Press reports indicate that new GM will likely try and file for an IPO in early Q4 2010, although there may not be a full distribution at that time as MLC may hold back some value until it is wound down. We assume a scenario where 70-80% of the stock is distributed immediately, with the remaining stock to be distributed at a later date. There is a chance that the bonds could remain outstanding after this distribution, and so the trade may not fully close, but MLC is incentivized to wind down and claimants could instead receive new equity in a liquidating trust. This has been done in previous bankruptcies and could collapse the proposed trade even without a full distribution of new GM shares. We believe a full collapse of the trade before year-end is the most likely outcome.
• Mark to market risk on Euro Notes
o Holding the trade to completion should not result in any foreign currency issues, but in the interim there is risk that the price of the Euro Notes does not reflect the change in the value of the Euro (which has been very volatile and may continue to be so). This may result in some interim mark-to-market fluctuations, but should not be material over time.
Alternative Trade:
Depending on the viewpoint one has on new GM stock, the trade can be set up in a different ratio to create “free” shares in the new GM when the long and short ends of the trade collapse and new securities are issued. This can be accomplished by investing the same amount of dollars on each side of the trade (a capital invested ratio of short $1.000 in Dollar Notes for each $1.000 purchased of Euro Notes). As an example, investing $1,000 in Euro Notes buys $3,679 of claim value ($1,000 invested / 27.2% claim-adjusted price), while shorting $1,000 in Dollar Notes results in being short $3,275 of claim value ($1,000 invested / 30.50% claim-adjusted price). The difference, $404, is what would be kept in claim value once the trade closes and the GM stock is received, and at a market price of 27% (based on the price paid for the claim), is worth $110 against $1,000 invested in the long position.
While we believe that we are creating GM equity cheaply based on current bond prices, as we believe there is 50% upside from current levels, we acknowledge that the investment is speculative and may not be for everyone. The trade also requires significant capital to be put to work on a gross basis. However, investing in the equity theoretically removes the timing risk involved in the trade – to the extent that the trade takes longer than expected, the company should continue to accrue equity value as the operations are improving at a very fast rate. This is offset by the fundamental risks associated with owning the equity, rather than receiving cash. We have included a very brief valuation discussion on the new GM for those interested.
New GM Valuation:
The main source of value at GM is its auto manufacturing operations. With a streamlined focus on four brands (Buick, Cadillac, Chevrolet and GMC), an improved cost structure and positive outlook on vehicle sales, we estimate GM will generate $13 billion of EBITDA in 2011. We gain comfort in this estimate not only from our top-down model but also based on projections from GM’s financial advisor and recent performance. In May 2009, Evercore estimated that GM would be able to achieve $13 billion in EBITDA in 2012, but since that time, results have been much stronger than anticipated, so we do not consider achieving those results a year ahead of schedule to be significantly optimistic (disclosure statement projections, especially recently, have also historically proven to be conservative). Moreover, GM generated $3 billion of EBITDA in Q1 2010, so on a run-rate basis is already tracking close to our 2011 estimate a year ahead of schedule, and this was achieved with European operations being a drag on earnings.
We value GM on a sum-of-parts basis and use the valuation of Ford as a blueprint. While Ford is a better-run company with a stronger lineup over the next few years, we believe that GM has significant cost-cutting opportunities (particularly in Europe) and top-line projections also have more upside, so a similar multiple to Ford on our projections is warranted. Additionally, there will be some technical support for GM shares upon issuance, as it will likely be added to major indices.
• GM’s core OEM operations are worth $65 billion, based on a 5x multiple on 2011 EBITDA. This multiple is in line with Ford, after adjusting for that company’s non-core assets in a similar sum-of-parts methodology (Toyota also trades at a similar multiple based on consensus estimates).
• JV interests in Asian operations generated over $500 mm in net income in the second half of 2009 and over $400 mm in Q1 2010 – these results are not consolidated in GM’s income statement and so are not included in its reported EBITDA. Assuming that on a full-year basis these operations can contribute $1.6 billion in net income (based on Q1 2010 run-rate) and applying a 12.5x P/E multiple indicates $20 billion of value
• GM owns an equity stake in Delphi. While information on Delphi’s performance is private, we know that GM invested $2.8 billion in cash in November 2009 to purchase Delphi equity, and value the stake at the purchase price.
• GM also has a stake in both the common and preferred equity of Ally Financial (formerly GMAC). As of March 31, 2010, GM estimated the fair value of the common stock to be $1.093 billion and the preferred to be $1.002 billion, for a total value of $2.1 billion.
• GM was overcapitalized given the difficulty in obtaining financing in the markets, and thus has a strong balance sheet. As of March 31, 2010, the company had cash and investments of $23.5 billion, as well as restricted cash related to the US Treasury credit agreement of $11.3 billion (since the loans were repaid in April 2010 these funds are no longer subject to restriction, and so should be included on a pro forma basis as available cash), for a total of $34.7 billion. This amount excludes ~$1.5 billion of other restricted cash, much of which is related to a Canadian health care trust. With respect to debt, the company shows total debt of $14.2 billion as of March 31, 2010, but we believe this includes a discount of $1.6 billion and have added that amount to the balance (this was included in disclosures in the 10-K for the period ended December 31, 2009 and we have no reason to believe this number has changed). Additionally, the company had $9 billion of preferred stock. In aggregate, the company has a net cash position of $10 billion (while some debt was repaid after the reporting period, this will not change the net debt figure).
• New GM has significant underfunded pension and OPEB liabilities – as of December 31, 2009, these broke down as follows:
o $17.1 billion in underfunded U.S. pension
o $10.3 billion in underfunded non-U.S. pension
o $5.8 billion in underfunded U.S. OPEB
o $3.8 billion in underfunded non-U.S. OPEB
We do not believe that General Motors will end up being liable for this entire amount, particularly with respect to some non-U.S. and/or OPEB liabilities. Additionally, were the amounts to be paid off, the company would generate a massive deferred tax asset. Our base case conservatively assumes the entire liability is paid and discounts both the U.S. and non-U.S. amounts by 35% to account for the value of the tax shield. This results in a total liability of $24 billion.
Adding up these numbers gets to a total equity value of $75.8 billion. Based on an estimated $37 billion in unsecured claims (this is the amount estimated in the company’s SEC filings, although its monthly operating reports filed with the bankruptcy courts show liabilities subject to compromise of $32.2 billion), MLC is entitled to 52.9 million shares of new GM stock, as well as two series of warrants to purchase 45.5 million shares at implied equity values of $15 billion and $20 billion, respectively. Using the treasury method (the warrants are well in-the-money and so we ignore option value), MLC will own 115.9 million shares of new GM at an implied share price (based on total equity value of $75.8 billion) of $134, resulting in total value of $15.4 billion. Based on a total claims pool of $37 billion, this implies a recovery of 41.7%, against the current claim-adjusted price of the Euro Notes of 27.2%. In May 2009, Evercore estimated a recovery of 26.5% - however, they assumed cash at GM would be $15.3 billion, while the company has nearly $20 billion more than that. This would imply a recovery of 37.3%, holding all else equal, and performance has also been better than expected in the year since that analysis was done. While there is a wide range of opinions on what the ultimate recovery will be worth, we note that Street estimates have recovery values as high as 47 to 50%.
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