Third Avenue Management, an investment manager that runs hedge funds, mutual funds, and other portfolios, is located at 622 Third Avenue in Manhattan, an address that makes sense given the firm’s name. But considering how outrageously stupid we now know these people are, it’s a surprise that Third Avenue isn’t on First, Second or even Lexington Avenue.
On December 9, Third Avenue’s CEO David Barse, who’s since been sacked, announced that, in a possibly illegal move, the firm was closing its Focused Credit Fund (“FCF”) and barring the fund’s investors from cashing out, the latter move a shocker because the ironically abbreviated FCF (a finance-speak acronym for what is clearly lacking here: ‘free cash flow’) is structured as a mutual fund, which by definition allows investors to liquidate their positions on a daily basis. FCF’s assets were transferred out of the mutual fund into a liquidating trust to manage the gradual sale of the remaining rubbish. To explain why they shuttered the fund, Barse ever so graciously issued a letter to the fund’s shareholders, part of which is below:
Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders…Third Avenue will manage the Liquidating Trust in order to obtain the best overall outcome for the beneficiaries. Third Avenue will not charge any fee for those services.
Where to start? In layman’s terms, the letter was an admission that, in a rapacious reach for richer return, the firm had loaded up on so much illiquid, high risk/high reward debt that it couldn’t meet daily redemption requests. Because FCF is a mutual fund, its holdings are publicly reported on a quarterly basis, so the whole high yield investing community, which is as gossipy (and about as ethical) as a fishwife trying to pass off spoiled sturgeon at the market, knows exactly what Barse and his buffoons have for sale in order to raise money, leaving Third Avenue facing fire sale prices like an overstocked bikini salesman on the weekend after Memorial Day.
The wording of the letter is interesting: “Investor requests for redemption…have made it impracticable…” It’s not Barse’s fault this happened; if it weren’t for those pesky investors, everything would be fine. For Barse to refer to this turd of a fund as “FCF” is particularly obnoxious. We at Bud Fox News can just picture him and his stooges, yukking it up in a conference room, Gucci loafers up on the table, throwing fund names around until they finally came up with one that elegantly sums up this situation: “FCF” is a play on words and a nasty joke of incompetence.
As far as Barse’s benevolent willingness to waive fees associated with winding down this catastrophe, well, as the old timers say, that’s rich. This is like a kidnapper telling you that he’s only charging your family ransom, not the rent implied while both of you occupy his apartment. What lesson do even empty-head undergrads learn about the Savings & Loan crisis in their Money & Banking (aka Boredom & Banking) class? Don’t borrow short and lend long. Well, that’s effectively what Barse did by using mutual fund investor money to buy illiquid distressed bonds and loans. Of course, all fixed income mutual funds have a duration mismatch but not with the crack addict indiscretion of Third Avenue’s FCF. The key is that as long as the bonds are liquid, they can be sold before maturity in order to satisfy redemptions, but FCF’s debt was not of the liquid ilk. Regardless, we probably shouldn’t dismiss this disgrace by saying that FCF’s investors should have known better because FCF recently held 89% of its $788 million of assets in either CCC or Not Rated debt (vs, astoundingly, about 18% for the average high yield fund) with its ten largest holdings representing about 28% of the total: Many mutual fund investors aren’t savvy enough to know that such a concentrated portfolio is not a strategy; given the daily redemption feature, it’s financial suicide.
Fitch, the red-headed stepchild of the three main US ratings agencies (S&P and Moody’s the other two), defines the CCC rating as “default is a real possibility,” CC as “default of some kind appears probable,” and C as “default is imminent or inevitable.” On page 32 of this Moody’s report, the 5 year cumulative default rate (1970 -2010) for the Caa-C ratings categories was about 54%, which means that, during that interval, 54% of thus rated bonds defaulted half a decade later. The same Moody’s report shows the recovery on a senior unsecured bond rated in the Caa-C range one year before default was 36%, which means you got paid back 36 cents per dollar of bond principal, not bad if you paid 10 cents on the dollar for the bond. Now Barse, who was a bankruptcy attorney before joining Third Avenue in 1991, certainly knows that such “three-bagger” returns are possible in the distressed arena, but he must also know that these bonds and loans can be hard to sell, sometimes for months at a time.
As a matter of fact, you only need to spend about 15 minutes on a high yield trading desk before you realize that it’s a prevaricator’s paradise and that trading distressed bonds from buyer to seller is a slimy, lie-laden practice that makes purchasing a used car seem like a God-blessed, quick and easy process. Things might start with a seller telling his salesman he has, say, $5 million par amount of bonds to sell at 55 (invariably a lie, he might have $15 million with a 50 limit). The salesman, having let his trader know about the order, will then join the other salesmen in calling potential buyers and telling them that the desk has $5 million to sell at, say, 57 (looking to trade the bonds for 2 points). When a potential buyer asks our salesman whether the seller has “more behind it” (which could drive the price down), the salesman will hucksterishly say something like, “This is his whole position, it’s a peanut account,” despite suspecting that the seller has market-moving “size for sale.” The potential buyer will then lie through his teeth and say that he’s looking to “round out a position” and would buy the $5 million at 52 (he probably has twice that to buy and a higher limit; if he steps up to 55, the market would be “locked on the inside”). The buyer and seller are thus “engaged,” a weird expression that’s part of bond-trading “protocol” and means that the salesman, for a limited time, now has the exclusive right on the trading floor to see this particular exchange through to a sale. The lying will continue, and a trade might happen, then again it might not, or it might get revisited the next day. Only the most talented salesmen can keep all the lies straight.
Distressed bonds (often defined as trading 1,000 basis points wide of the most liquid T-bond with similar maturity) are hard to trade because restructurings, turnarounds, and bankruptcies can drag on for months before you know your recovery. Meanwhile, defaulted bonds often don’t pay current interest, so most natural high yield buyers, who want current income, aren’t interested in these bonds. Moreover, some high yield bond funds as a rule can’t even hold bonds rated D (for default) or anywhere in the C range (eg: the T Rowe Price High Yield Fund “focuses primarily on the higher-quality range (BB and B) of the high-yield market”). Distressed buyers frequently place their bets and wait, so the bonds don’t trade until something happens.
Even in a best case scenario, this type of investing shouldn’t be done via a mutual fund. Barse apparently didn’t have to worry too often about optimum outcomes: year-to-date through November 30, FCF was down 22% vs a loss of 2% for the BofAML High Yield Index; since the fund’s inception (8/31/09), it is up about 3% vs up about 9% for the index. According to this Bloomberg article, Third Avenue in general has become a revolving door for crappy portfolio managers, a job where an incompetent operative can often have a decent run if his rough-shod-ridden analysts (who do all the spreadsheet/modeling work) make him look smarter than he is. The firm’s flagship Third Avenue Value Fund (plainly a misnomer) was down 21% in 2011, a remarkable achievement considering that the overall high yield market was up about 5.5% that year.
When asked for comment about this fiasco, Yu So Dum, Professor of Finance at Beaver College and author of the soon-to-be published Talk Dirty to Me: How to Trade Crack Spreads, had this to say:
Barse is a lawyer. Who does he sue? Himself?
On December 16, Third Avenue announced that it had obtained “exemptive relief” from the SEC, which allows Third Avenue to return the fund’s assets to the mutual fund (from the liquidating trust) but continue to block redemptions. From the strangely self-congratulatory press release:
Third Avenue Management LLC (“Third Avenue” or the “Adviser”), an investment adviser to private and institutional clients, today announced that the Adviser and the Third Avenue Focused Credit Fund (“FCF”) have obtained exemptive relief from the Securities and Exchange Commission (“SEC”) to continue to protect shareholders of FCF following modification of the Plan of Liquidation for FCF.
Haven’t they protected shareholders enough already?