The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds (17 page)

Killer Combination

By 1995, the Amroc distressed brokerage firm was facing new competition as big players like Goldman Sachs, Merrill Lynch, and Citibank entered the market. As a hedge against their brokerage business, Lasry and Gardner formed their first Avenue fund using capital from friends and family. They wanted another “A” name, and this time they named it after Madison Avenue, where their offices were located. They started Avenue with less than $10 million in 1995, building it into a $1 billion hedge fund firm over the next five years.

Two years later, in 1997, they formed their second Avenue fund, Avenue International, an offshore fund that attracted U.S. tax exempt and non-U.S. investors. Also in 1997, David Bonderman of TPG, their former Bass colleague, approached Lasry to run an institutional distressed fund—a partnership that heralded their new strategy of offering institutional funds with a private equity structure. TPG would be a general partner of the fund and receive a share of the profits. With TPG’s help, they quickly raised Avenue Special Situations Fund LP, a $130 million, seven-year lock-up fund.

By 2001, Avenue’s assets under management had grown substantially and they were also still running Amroc Securities, their distressed brokerage. Lasry and Gardner were at a crossroads, as they realized they could no longer operate both businesses if they wanted to continue to meet the standards they had set for themselves. So, in August of that year, they decided to close Amroc to focus all their energies on Avenue. They moved the Amroc trade-claims employees over to the Avenue side, retaining their visible presence in the market. Their database alone was worth keeping the business running. “We were viewed as the Merrill Lynch of the trade-claim world. We were the biggest and most active player in that market and everybody knew who we were,” says Gardner.

In 2004, Avenue launched a European-focused distressed business with Rich Furst as the senior portfolio manager. In addition to buying distressed debt, the firm in Europe writes loans for small companies unable to obtain financing, an important offering because that region’s high-yield bond markets are less developed than those in the United States. Today, Avenue has most of its assets in its U.S. and European strategies, including more than $3.5 billion allocated to Europe investments overseen by Furst and a team of 20 dedicated investment professionals in London and Munich. The rest of the firm’s assets are invested in Asia, where Avenue began operating in 1999, and several other businesses.

“People think we got to $20 billion overnight, but it wasn’t as easy as it seems,” Lasry says. “We had the background. We had good returns. We had the infrastructure, and we had good people. And, importantly, we had high-quality, stable, long-term investors that allowed us to raise money in a difficult fundraising environment. We were also lucky that we were in the right place at the right time.”

It was a lot more than luck, of course. The siblings’ characteristic methodical investment approach was paying off. Gardner explains, “We made the decision when we started Avenue that we were going to build the infrastructure before raising the money. Funds that do it backwards typically get into trouble. We always made sure we were well staffed, and we spent the money so that on day one of each fund, we had the back office set up, as well as the front office. And, obviously, we would add more staff and other resources over time.”

Gardner now spends most of her time overseeing all aspects of Avenue’s global business operations. “I think some funds don’t place enough importance on establishing institutional-quality infrastructure—in terms of accounting, compliance, legal, investor relations, and information technology capabilities,” says Gardner. “They just pay attention to the front office. But you can have great returns and then you have a blowup in the back office, and you’re out of business.”

She emphasizes a best-in-class compliance culture. “The ethical tone from the top is what drives your organization—it has to be engrained in the culture,” Gardner says. “That’s true whether you have one employee, hundreds, or even thousands.”

Darcy Bradbury, a D. E. Shaw & Co. managing director who met Gardner in 2007 while working with her on the President’s Working Group on Financial Markets, recalls Gardner’s sense of ethics and focus on the basics. “It was our responsibility to produce a report on sound practices for the industry for asset managers and investors,” Bradbury says. “Sonia always had a very strong sense of integrity and ethics and really brought that into the discussion. She taught us about best practices for building a business over the long term, how you can’t cut corners and you have to have a very clear focus and that, at the end of the day, your investors have to trust you.”

Lasry and Gardner complement each other by having different strengths. In fact, their killer combination has worked so well that Lasry was named one of the 50 most influential people in hedge funds by industry trade publication
HFMWeek
in 2010.

Detecting Diamonds in the Rough

While Wall Street concentrates largely on investing in strong, healthy companies, Lasry feels perfectly comfortable looking at companies in distress. Unlike most investors, he’s not afraid of being in the middle of an investment where credit conditions could get progressively worse before they get better. “We are constantly searching, trying to find value, typically in troubled companies,” he says. “And then we try to buy those assets at a discount. In contrast, most investors try to find companies that have no problems. And, when companies have problems, people get nervous. We look at the world very differently than most investors.”

For Lasry, with his long history of distressed investing, sifting through distressed companies is second nature. When he sees a troubled company he asks himself, “What’s the value of the company? What assets does this company have? And where do we want to be in the capital structure?” He gives a simple example of a company with $1 billion of liabilities and only $100 million of value.

Lasry continues, “If you happen to be a secured creditor and have the first $25 million, then you’re safe. If you’re at the bottom of the capital structure and there’s $900 million ahead of you before you get paid, it’s a different story. It’s fine to be an unsecured creditor if you believe the value of the company is enough to pay off all the unsecured creditors in the capital structure,” says Lasry.

Next, says Lasry, you need to take a look at the liability side. “Say you have liabilities of $1 billion, $200 million of secured debt, $300 million of senior unsecured debt, and $500 million of subordinated debt. If the company is worth only $200 million, as an unsecured creditor you’ll walk away empty-handed. It all goes to the secured investors. But if the company’s worth $500 million, then the secured will receive par and the senior unsecured may also get a full recovery. You have to analyze the value of the company, and then compare it to the liabilities to determine where you are in the stack and what your remaining values may be.”

Distressed investing is often perceived to be more risky than equity investing, but Lasry believes it actually presents less risk. He only pursues investment ideas where he’s comfortable that his downside is protected. So, when his investment professionals do their homework, he wants to know the worst-case scenario. “I don’t want to hear how great the investment is—I want to hear how we could get hurt. Once we know that our downside is protected, then we look at the upside potential.”

Avenue typically has 40 to 50 positions at any time. As a general matter, Lasry wants to be about 80 percent invested with 10 percent to 20 percent in available cash in order to opportunistically take advantage of market opportunities. The firm has never employed leverage to enhance its returns. “A leveraged portfolio forces you to act irrationally when markets are irrational, as opposed to acting rationally when markets are irrational,” Lasry says.

The private equity–like structure of many of Avenue’s funds is appealing to institutions because it limits the potential cash drag as well as providing a stable capital base that is less prone to short-term, irrational market movements. Investors also receive a preferential return before Avenue receives any incentive allocation.

“We’re conservative,” says Lasry, especially compared to other prominent managers in the distressed sector. “Sometimes we find ourselves alone in buying the debt of a certain credit.” Lasry names Oaktree, Angelo Gordon, and Centerbridge as competitors, “but what you’ll find is that there are far fewer folks in our space than there are in the equity space.”

Lasry believes Avenue’s real edge over its peers is the firm’s experienced investment team, and its deep, fundamental understanding of all the ramifications and risks of bankruptcy proceedings and restructurings. Avenue’s team is adept at recognizing the potential value of companies struggling with financial distress, at gauging the risks inherent in the bankruptcy process itself, and at evaluating the opportunities that will emerge after restructuring. The Avenue team prides itself on its comprehensive approach and broad experience across a large number of distressed opportunities as well as cycles over the past 20-plus years. Understanding the fundamental value of companies in distress as well as the unique risks and opportunities of bankruptcy is a particular strength of Lasry’s investment team. As a result, the firm has captured outsized risk-adjusted returns in the distressed investing space.

“You need to understand how a company’s going to operate in the bankruptcy process and how that’s going to affect its ongoing operations,” says Lasry. “You’ve got to mesh many different disciplines into one. That’s our edge. We have the expertise to understand those different disciplines better than others.”

“What has made Buffett successful, what has made other people very, very good, is their ability to see things in the available data that others don’t see,” Lasry continues. “It’s the same thing in the distressed world. The information is all public, but I think we do a better job of analyzing the intricacies and assessing the risks. We have exceptional investment professionals with many years of experience in the business, and ultimately, that’s the reason we’ve done well.”

Avenue did so well, in fact, that in October 2006, Morgan Stanley Investment Management bought a 15 percent stake in the firm for approximately $250 million. Before the financial crisis, having a major investment bank as a stakeholder in the firm seemed like a dream come true. Gardner, who negotiated the deal, recalls that they were approached by many investment banks that wanted to buy a much higher percentage of the firm, but signed with Morgan Stanley because the deal allowed them to retain control of their business. They invested 100 percent of the proceeds they received from Morgan Stanley back into the Avenue funds. Stuart Bohart, co-head of the alternatives division of Morgan Stanley Investment Management at the time, had hoped to expand Morgan Stanley’s capabilities.

“We had a strong presence across private equity, real estate and Fund of Funds, but not hedge funds,” says Bohart. “We wanted to create that with a hedge fund partnership.” But the credit crisis ended up hitting financial institutions like Morgan Stanley the hardest, forcing them to focus on their own survival above all else.

Extracting the Value

For Lasry, it’s about a lot more than the next hot investment—he thinks independently. “I look at myself as a value investor. I’m trying to constantly find mispriced investments and add value in a situation. For Avenue, investing means having conviction in your work and companies where you invest, even when the Street has written them off.”

Many times, as a distressed investor, an industry outlook or thesis is critical to having a full understanding of a specific company’s management and balance sheet. That was the case with Avenue’s successful investment in Six Flags, the largest regional theme park operator in the world. Similar to Avenue’s investment in Ford, the firm’s analysts and restructuring experts covering the leisure industry dove into Six Flags and did their work. The team thought Avenue could invest in the bonds and secured bank debt at a big discount to where the public comparables were trading. “It’s very company specific,” says Lasry. “You have to look at the entire capital structure and value all the assets and figure out the real values, and then put on your restructuring hat and figure out how you think distributions will be made, and in what form. Will it be cash or post-reorganization equity? Will the debt get reinstated? With respect to the theme park industry, we knew where competitors were trading and we had researched historical sales in the industry, and we thought we would be able to invest as low as a 50 percent discount to the public comparables. So we thought we were getting paid for the risk/reward of this investment.”

In 2007, Avenue aggressively started buying Six Flags’ bonds due in 2010 at very significant discounts to par. In order to help the company manage the refinancing of this early maturity, Avenue offered to backstop a debt for debt exchange of their 2010 bonds into a longer dated senior note with a significantly higher coupon. The new senior notes’ priority status allowed Avenue to leapfrog approximately $1 billion of now structurally junior notes that had not participated in the exchange. This vastly improved Avenue’s asset coverage and associated risk profile. It also squarely positioned Avenue with a blocking position in the new fulcrum security. As the financial crisis gained momentum in 2008, Avenue began to aggressively purchase secured bank debt at also at very distressed prices. This provided a complimentary barbell strategy to the existing senior note investment.