The Securities Litigation Expert Blog

The Third Avenue Focused Credit Fund Implosion

Posted by Jack Duval

Dec 21, 2015 8:12:56 AM

This blog post continues our series on the ongoing crisis in high yield and distressed debt bond funds.  For our previous coverage, see: "What's Going on in High Yield and Distressed Debt?".

History, Rhyming

It is said that history does not repeat itself but does rhyme.  If true, we are hearing history rhyming a tune that sounds a lot like the two Bear Stearns hedge CDO hedge funds that went bust on July 16, 2007: the Bear Stearns High-Grade Structured Credit Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Master Fund.[1]

Just like the Fed-induced housing bubble in 2007, the Fed has blown another bubble in high yield debt. The first canary to go happens to be in the energy sector, where master limited partnership structures required continuous refinancing (see our previous posts on this here), a reliance on hydraulic fracturing techniques that resulted in 80 percent well depletions in three years, and years of malinvestment all leading to massive oversupply of oil and gas.

If one chart can tell it all, it is the one below.

Chart 1.  U.S. Oil Rig Count[2]

 12-11-15-oil-rig-chart

Credit Cycle Gears Reversing

Some commentators have tried to make the case that the distress in the high yield debt markets is purely an energy sector phenomenon.  While this may have been true a year ago, this is no longer the case.

Banks and bond buyers that have lost a few fingers in the energy sector will be tightening credit everywhere as they try to reduce risk.  This will lead to much tougher lending conditions (higher rates, more covenants, etc.) for the rest of the high yield/distressed world.  Which in turn will lead to more defaults and more tightening.

This is the credit cycle gears reversing from a virtuous cycle of lower and lower loses and looser credit to a vicious cycle of higher and higher loses and tighter credit.

Keep in mind that this has been occurring before the Federal Reserve's 25 basis point tightening from last week.

Third Avenue Focused Credit Fund

The Focused Credit Fund invested in junk bonds and high risk loans to low quality borrowers.  They also invested in the debt of distressed or bankrupt companies.  Remarkably, the fund would buy 10 percent (or more) of smaller bond offerings, which made exiting those positions difficult.[3]

All of these investments are relatively illiquid even in the best of times, however, in declining markets, they trade by appointment, and with severe markdowns.  As the Focused Credit Fund’s energy and other bets went bad, this illiquidity became an albatross that drug the fund further down as redemptions increased.

As of April 2015, $400M of the Focused Credit Fund was invested in Level 3 assets, those with no quoted prices and no observable inputs that could be modeled. (Level 3 assets have values that are essentially made up by a firm's management.  During the financial crisis of 2008-9 these types of assets were referred to as "mark to make believe", when banks carried their mortgage-backed bonds at cost.)

Level 3 assets are deadly in credit cycle downturns.  For example, Bear Stearns was carrying more than $28B in Level 3 assets at the end of 2007.[4]  The same was (and is) true of the Focused Credit Fund’s holdings.  Once you have to get out of Level 3 assets, you can’t.

TABLE 1: Level 3 Assets owned by the Third Avenue Focused Credit Fund[5] 

Level 3: Significant Unobservable Inputs 4/30/15  
Investments in Securities:    
Common Stocks & Warrants:  
Consumer Products  
Energy 46,622,165  
Financial Insurance  
Manufacturing 1,737,318  
Services 602,563  
Transportation Services 3,767,928  
U.S. Real Estate Operating Companies  
Limited Partnerships:  
Insurance & Reinsurance  
Convertible Preferred Stocks:  
Transportation Services 13,035,278  
Preferred Stocks:  
Energy 3,120,358  
Financials 18,646,543  
Non-U.S. Real Estate Operating Companies  
Corporate Bonds & Notes 138,366,650  
Term Loans 142,059,322  
Claims 6,474,869  
Private Equities:  
Automotive 11,250,000  
Chemicals 9,965,778  
Consumer Products 3,952,674  
Energy 1,043,306  
U.S. Real Estate Operating Companies  
Total 400,644,752  
   
Despite all the illiquid and distressed holdings, the Third Avenue Focused Credit Fund underperformed the Barclays Capital High Yield Index from inception.

Chart 2: Third Avenue Focused Credit Fund Total Return[6] 

Fund_TR_Comparison

Lehman Brothers SIPA Claims

One of the most exotic flowers in the Focused Credit Fund’s junk bond hothouse was the Lehman Brothers SIPA claims, which were among the top 10 holdings of the fund (representing 4.8% of fund assets).  The SIPA claims were brought to market by the bankruptcy Trustee for Lehman in Dutch auctions at slightly less than 25 percent of face value.[7]

Below is a chart of Lehman Brothers Senior Unsecured debt, which is indicative of how the SIPA claims have been trading.

Chart 3: Lehman Brothers Senior Unsecured Debt[8]

 LEH_Sr._Unsec._Debt

In my next post, I will examine what has happened to liquidity in the fixed income markets.

__________

Notes:

[1]       Wikipedia; s.v. “Bear Stearns”.  Available at: https://en.wikipedia.org/wiki/Bear_Stearns.  Accessed December 13, 2015.

[2]       Business Insider; “Oil Rig Count Collapses for 9th Straight Week; Akin Oyedele.  Available at: http://www.businessinsider.com/baker-hughes-rig-count-october-30-2015-10;  Accessed December 14, 2015.

[3]       Bloomberg; “Third Avenue Seen by Top Investors as Fueling more Carnage; John Gittelsohn; December 14, 2015.

[4]       Wikipedia; s.v. “Bear Stearns”.  Available at: https://en.wikipedia.org/wiki/Bear_Stearns;  Accessed December 14, 2015.

[5]       Third Avenue Focused Credit Fund Form N-CSR, as of April 30, 2015. Available on EDGAR, accessed December 21, 2015.

[6]       Source: Bloomberg.

[7]       Law360. “Lehman To Sell $2.5B More in Unsecured Bankruptcy Claims.  Available at: http://www.law360.com/articles/611360/lehman-to-sell-2-5b-more-in-unsecured-bankruptcy-claims;  Accessed on December 14, 2015.

[8]       Source: Bloomberg.

 

For information about high yield and distressed debt expert Jack Duval, click here.

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Topics: high yield, Senior Loans, Third Avenue Focused Credit Fund, Lehman Brothers Unsecured Debt, Level 3 Assets, distressed debt, Lehman Brothers SIPA Claims

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