Second Quarter Review | July 20, 2009
Despite maintaining a cautious view as evidenced by our cash position and well-hedgedportfolio, we are pleased to report a Q2 return of 8.55%. Our top performers for the quarterwere our auto finance bank debt positions – specifically Chrysler Financial, Ford MotorCredit, and GMAC. These credits were the most compelling corporate distressedopportunities we have seen so far in this cycle. The market was pricing in losses in eachcompany’s retail and wholesale loan portfolios well in excess of our most bearishscenarios. Despite retail losses running between 2% - 4% and dealer losses beingnegligible, market prices appeared to be discounting losses of 25% - 50% depending on thespecific security. Each of these companies faced distinct challenges and was tethered toautomotive companies of varying health. These positions were all profitable during thequarter despite the bankruptcy filings of both Chrysler Automotive and General Motors.A critical component of Chrysler’s bankruptcy plan involved GMAC taking the place of Chrysler Financial to provide financing for new Chrysler vehicles. In essence, ChryslerAutomotive will continue manufacturing vehicles with retail customers and dealers financedby GMAC – thereby leaving Chrysler Financial in run-off mode. Despite the disruptions atChrysler Automotive, Chrysler Financial’s results have remained solid with losses remaininglow while the company generates significant cash flow as the portfolio quickly shrinks. Westill have a large position in Chrysler Financial first and second lien bank debt, and despitesignificant price appreciation, we believe that the market continues to underestimate yieldsby not fully pricing in how quickly par recoveries may be achieved.An investment in Rite Aid bonds was also profitable during the quarter. Rite Aid is the thirdlargest drugstore chain in the country, which, a few years ago purchased the U.S.operations of Jean Coutu, a Canadian pharmacy chain. The significant challenges of integrating a large acquisition made with considerable leverage at a time when theeconomy was in freefall created a near perfect storm and the entire capital structure soldoff significantly. Last fall new management was brought in to oversee this integration andimprove operating performance. Since their arrival, cash management has strengthened,expenses are decreasing, margins are improving, and the acquired stores are performingbetter. Rite Aid has also refinanced its balance sheet which has served to push the nextmaturity out for several years giving them adequate time to fix the business operations.These bonds traded up significantly and we have reduced our position.During Q2, we built a position in E*Trade bonds. E*Trade operates 2 primary businesses,an online brokerage and a bank. While the brokerage side of the company was performingwell, E*Trade Bank was struggling to remain well-capitalized due to its mortgage portfolio.Despite this concern, we found the bonds attractive for several reasons. First, we believedthe size of the bank’s capital hole to be manageable and small relative to the Company’strue enterprise value. Second, all parties involved including management, the financialsponsor, bondholders and most importantly its primary regulator were incentivized toensure the Company remained a going concern. Third, we did not believe E*Trade had an
imminent liquidity situation, especially as its brokerage business continued to thrive.Finally, we found the event-driven nature of the situation with an identifiable, near-termpositive catalyst very attractive. On June 17th, E*Trade announced a capital plan thatincluded a large debt-for-equity exchange and equity offering to satisfy regulators andsolidify its capital base at both E*Trade Bank and the parent, driving bond prices across thecapital structure significantly higher. Consequently, we sold our bonds that will not beexchangeable into equity.We also participated in the Debtor-In-Possession (DIP) financing for General GrowthProperties (GGP) and made profitable investments in several parts of the capital structure.GGP filed for bankruptcy with an agreement to receive DIP financing from its largestshareholder on what can only be described as egregious terms. The Company and theiradvisors reportedly had difficulty finding more attractive DIP terms. However, publicdisclosure of the original DIP proposal resulted in a two week competitive bidding process.In the end our group prevailed with a creative structure that provides us significantcoverage, a good base case rate of return, and some interesting optionality. After thebankruptcy filing, we invested in bonds and bank debt of various GGP entities. During thequarter the entire capital structure traded up significantly and we reduced some exposure.The fund begins Q3 with a 10% exposure to Residential Mortgage Backed Securities(RMBS). This portfolio was also profitable for the quarter. We added to our mortgageposition in March and through April. The prices of RMBS securities have risen substantiallyto levels where we are no longer adding aggressively but continue to maintain our position.We believe that despite tepid signs of stabilization, the housing and mortgage marketsremain under significant stress and we expect there to be continued attractiveopportunities in the space. However, we were positively surprised by the amount of principal repayments in our portfolio. Additionally, as the commercial real estate andconsumer sectors continue to deteriorate, we have been preparing ourselves to takeadvantage of what are likely to be very attractive distressed opportunities in thosestructured credit markets.Our sovereign CDS position was the biggest detractor for the quarter on a mark to marketbasis. Notwithstanding the IMF and EU bailouts of the Baltics, spreads tightenedthroughout Q2. We expect the credit profile of European sovereign governments tocontinue to deteriorate and accordingly we feel that owning protection at current levelsoffers a compelling risk/reward opportunity.We still believe this credit cycle will take several years to resolve. First, we expect thatcommercial real estate is still in the very early stages of a prolonged downturn. Theperformance of most property types continues to be stressed. As debt on propertiesmatures, we expect that repayment will be unlikely in many cases. Therefore, debt willneed to be rescheduled or restructured. The size of this opportunity is very large and webelieve that our capital will potentially be able to generate excellent returns in this space.Second, corporate debt maturities will be very heavy in the next three years. Similarly,
some percentage of this debt will not be repaid and will need to be restructured. We arealready observing higher default rates in Q2. Several large companies such as ExtendedStay, Six Flags, General Motors, and General Growth Properties recently filed for bankruptcyand we anticipate this trend will continue.We increased our equities exposure slightly in Q2 by adding selectively to positions such asDell and Humana. At its lows in March, Dell was an $8 stock with roughly $4 in net cash pershare. Based upon an aggressive cost-cutting program, we believed that the worst case EPSfor 2009 would be higher than $1 which provided us with a large margin of safety on theinvestment. Our enthusiasm for the name was bolstered by the potential for a corporatehardware upgrade cycle with the launch of Microsoft’s new operating system this fall. Dellreported a strong first quarter and the stock traded up in June as the magnitude of the cost-cutting activities became evident to the street.We also believe that our positions in the managed care sector represent compellingopportunities given the fears surrounding the new administration's potential healthcarereform policies. In our opinion the healthcare insurers will be key participants in thereform, and while these companies will clearly be impacted, the situation will not be nearlyas dire as their stock prices reflected in March.The reinsurance sector also remains a significant part of the equity book. At the start of Q2,reinsurers were, on average, trading at a greater than 15% discount to Q1 book value. Withaverage leverage of approximately 3x and significantly more conservative investmentportfolios than other financial stocks, this discount seems unwarranted. Additionally, giventhe stresses on insurance industry balance sheets in 2008, as well as the inability to accesscapital markets, prices for hurricane protection have increased materially this year. In lightof this, we helped capitalize a reinsurance sidecar this quarter, covering Florida windexposure.We continue to run a well hedged portfolio in Asia. We grew our allocation to Tier 1 and Tier2 hybrid bank paper of a small group of Asian and Australian banks during the first twomonths of the quarter and these positions contributed meaningful profits. We alsobenefited from our exposure to leveraged loans in the region and participated in a fewrecapitalization transactions in Australia that performed well. Although we decreased ourcredit exposure during the last few weeks of the quarter, we are hopeful that we will getanother opportunity during the second half of the year as foreign banks, particularly inAustralia, will be focused on reducing their exposure to highly levered entities.Several years ago we made the decision to empower a number of portfolio managers –primarily in the equity area – to allocate silos of capital to distinct industries subject tospecific risk controls. This approach had some success at the outset but never fully met ourexpectations – both in terms of performance and the organization. In the summer of 2007we decided to downsize our equity business and further build up our credit group. Our goalwas to restructure the investment process to reflect a single pool of opportunistic capital
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Perry Q2 Letter
Perry Partners' Hedge Fund Investor Letter Q2 2009
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