Einhorn on Equities That Trade Like Options, "Levered Stubs" (Punch Taverns Call)

Source: Reuters Blogs
First, some background on what happened between GreenLight Capital and Punch Taverns. David Einhorn's hedge fund GreenLight Capital was recently fined £7.2 million by the U.K Financial Services Authority for trading off inside information that was disclosed during a (non-wall crossed) conference call with former Punch Taverns (PUB.LSE) CEO, its CFO, and Punch's Merrill Lynch broker Andrew Osborne in 2009, who was also fined (read the full transcript at fsa.gov.uk (pdf), and read Greenlight Capital's response to the fine).

At the time, Punch wanted to raise capital to repay £220 million of convertible bonds, and have "10% headroom" on covenant ratios attached to securitization vehicles. For more info on how pub securitization works, read this paper by Fitch Ratings (2003). Osborne mentioned in the call that Punch would need to issue £350 million, which would dilute Einhorn's 13.3% position in the company significantly. So, Einhorn dumped his shares after the call, avoided a £5.8 million loss when the stock tanked, and was fined for insider dealing. So that happened. But the whole point of this post is to show you what Einhorn said during the conference call.

Einhorn, one of the top value fund managers out there, who publicly releases extensive research at times (recently GreenLight and T2 Partners went publicly short St. Joe Co. and defeated the Fairholme Fund), gave his views on how to manage Punch Taverns' capital structure during the call, and explained how highly levered equities "trading at less than 50% of the face value of debt" are essentially "options on the debt-side of the capital structure", which was interesting. The blog Distressed Debt Investing had an interesting post on this as well. He mentioned that Einhorn made a successful investment in a "Levered Stub Basket" at the end of 2008, which ended up making 227%. I actually found GreenLight's year-end 2009 letter that mentioned this (courtesy of DealBreaker):

"We bought small stakes in 22 companies in late 2008 that we thought would survive, even though they traded as if they would fail. They all survived."

DDI also mentioned how these plays are essentially timing the availability of credit during economic cycles. And we remember 2008 when the credit market completely froze and all of the large investment banks collapsed, and there was no liquidity available for banks or even large corporations. So, the Fed and government stepped in to bail out the banks and provide liquidity to the system. But, under normal circumstances in capitalism, bankers and institutional investors holding the debt of highly levered companies in distress determine their fate. And with the introduction of credit default swaps, the sole motive of these holders could be to just force a bankruptcy filing to collect a lump sum payment from counterparties at par (killing a company to collect financial life insurance), rather than restructure. So that's an external risk to take into account when holding distressed levered stubs. And what would have happened to the debt and derivative holders of these companies if the government and Fed didn't step in?

I mentioned on Twitter that I should start a mutual fund that invests in a highly levered distressed stub basket, call option kickers, and credit default swap hedges! A win-win if every stock isn't diluted to zero, no? I used to use stock screeners to find companies to analyze based on financial trends and valuation ratios, and then would chart out trends and look at historical and competitor comparables (as well as analyze earnings calls, news and chart technicals). At some point I want to follow a list of simple micro-to-small cap (or sometimes mid-cap) companies and do research updates in blog posts. I could look at a levered stub basket and/or a value-growth basket. It would probably require another analyst and more time, and maybe a different format. We'll see.

Here is Einhorn at work:

"DAVID EINHORN: Right. You know, it seems to me that -- that much of the potential attractiveness of coming and selling equity at this point stems from probably the fact that a few months ago the equity was at 40 pence, and now it’s at a £1.60 or something like this. And so, it’s up from the bottom. On the other hand, if you look back a couple of years ago, it’s -- the equity is really down a lot. It trades at a very low multiple of the book value and, you know, the comp – the company -- the equity continues to trade as if it’s really an option on the debt side of the capital structure. That’s -- that’s the way that we look at it. And we think it’s a very cheap option because of the types of things that you’ve been -- already been able to execute on, and I think that you’re going to be likely to be able to execute on, uh, going forward. I think that in -- if the equity was -- was overpriced and you had an opportunity to reduce the financial risk of the company, I think it would make some sense to considering equity at that point. But I think, if you just looked in a slightly different world and thought “Jeez”, if the stock had come from where it was and it had never gone to 40 pence but instead was sitting at 1.60, then 1.60 represented a new low, down from whatever previous higher price it had used to have been at, I don’t even think you would be considering selling equity at this point. And -- and so, I think the mere fact that the stock went to some lower price is not reason to -- to dilute the -- to dilute the equity in a substantial way, you know, at this time. The -- the next point would relate to, I guess, the amount, and I guess that would look -- you could look at that two ways. I suppose if it was a very small amount of equity being raised it would not be all that dilutive, and so there wouldn’t be a reason to have a very big concern about it. But, on the other hand, if there was a small amount of equity that was being raised, it wouldn’t really solve any of the company’s intermediate or longer term risks. And if there’s a large amount of equity to be raised, well, then it’s massively dilutive, then it -- it will dramatically -- I -- from my perspective, worsen the risk/reward from -- from owning the stock. So, I -- I would -- I would suggest continuing executing what you’re doing right now, which seems to be doing very well. I agree with you, it seems like there’s going to be a lot of debt in different parts of the capital structure that seems like it’s going to be available at attractive prices, and I -- and I wouldn’t allow myself to get browbeaten by convertible bondholders or, excuse me, Merrill Lynch investment bankers or whatever else, you know, that -- that is more transaction oriented. I think we create a tremendous amount of value by selling, you know, by selling pubs at reasonable multiples of EBITDA and then repurchasing debt at big discounts, and we’re hoping as equity participants not to make 10 or 15 percent of a year, you know, as market equity, but we’re looking for a significant revaluation of this company on the basis that at some point the world looks at it and says, “Yes, you are -- you -- you -- you have -- you are clearly solvent, and you clearly deserve some kind of a multiple,” and -- and the thing that would cut that off would be issuing so many equity shares that, you know, that – that -- that the upside disappears.

"DAVID EINHORN: I -- I would -- sorry. I would say as a -- I would say as a rule of thumb, if the market capitalisation of the equity is less than half of the face value of the debt, the -- the stock remains sort of in an option area"

Updates on the company: According to EuroMoney in January 2011, Punch Taverns had 97% of its pubs securitized and they were "now on life support". So, a few months later Punch "de-merged" with its Spirit division (thisismoney.co.uk, proactiveinvestors) to re-position the company and pay down debt. According to ShareCast, on 3/9/2012 Punch was still selling off pubs to meet covenant requirements. Just now Punch announced that Q2 sales were up 4.6%. Here's the 3-year trend line that needs to break.

PUB on LSE (source: Bloomberg.com)