Common Sense From Uncommon Investors

Event Overview

• Date and Moderator: The panel "Common Sense from Uncommon Investors" took place on May 1, 2018, moderated by Michael Milken.
• Panelists: The session featured five leading investors: Mitch Jewett (Canyon Partners), George Hicks (Barney Partners), John Donahue (KKR), Mark Schwartz (Crescent Capital), and Manny Medina (Manny Medina, formerly of CIBC).
• Core Theme: A recurring theme was the opportunity to find value in complex, distressed, or misunderstood market situations by utilizing specialized knowledge, global reach, and capital flexibility.

Investor Backgrounds and Motivations

• Mitch Jewett: Transitioned from law to finance after realizing litigation was less challenging than applying legal principles to corporate restructurings at Drexel Burnham Lambert.
• George Hicks: Left a legal career to join the investment side after observing lawyers working excessive hours to finalize deals negotiated by others; entered the market during the 1990 default cycle and the Resolution Trust Corporation's asset sales.
• Manny Medina: Was captivated by investing at age 15 after his first stock purchase (P. Lorillard) rose 2.625 points overnight; previously studied pre-med before switching to economics following a soccer accident.
• Mark Schwartz: Moved from law to Solomon Brothers and later Drexel Burnham to get closer to the operational heart of financing and mergers rather than the "boring" aspects of legal work.
• John Donahue: Previously pre-med at Cal, switched to economics after a soccer injury; later transitioned to private equity at KKR, citing it as the "highest calling" for job creation.

Investment Philosophy and Process

• Complexity as Opportunity: Canyon Partners embraces complexity in debt and equity, viewing "toxicity" as a market fear rather than an asset flaw, allowing them to buy when others sell.
• Global Diversification: Barney Partners utilizes a team of 90 investment professionals across the U.S., London, and Singapore to ensure diverse viewpoints and global risk assessment.
• Selectivity in Private Equity: Crescent Capital reviews 1,300–1,500 transactions annually to make only 30 investments, emphasizing strict discipline similar to player selection in baseball (a business Donahue manages via the Milwaukee Brewers).
• Regulatory Arbitrage: Manny Medina argues that current U.S. banking regulations (e.g., cybersecurity fears) favor small and medium-sized banks over large institutions, creating a "7-Eleven vs. supermarket" advantage for smaller players.
• Capital Structure Flexibility: Panelists highlight the ability to operate across the entire capital structure (debt, mezzanine, equity) to maximize returns, particularly during restructuring events.

Market Views and Specific Situations

• The Caesars Entertainment Restructuring:
  • Canyon Partners invested in debt trading at 14–15 cents on the dollar during the 2008 recession.
  • The firm helped restructure the company by separating operating assets (OpCo) from real estate (PropCo/Verde).
  • Outcome: Creditors received cash, new debt at par, and equity, resulting in a sevenfold return on the original investment.
  • Disagreement on Cause: John Donahue argues the success was due to analyzing EBITDA flaws (ignoring capital expenditures in gaming), while Manny Medina attributes it to the inability of banks to handle the complexity, not just their balance sheet constraints.
• Spain and European Distress:
  • Barney Partners increased exposure to Spanish distressed assets in 2017, betting on a recovery in the housing market and utilizing local language speakers and on-the-ground presence to navigate legal complexities.
  • The firm acquired an asset management platform to create a barrier to entry for competitors.
• Private Equity vs. Public Markets:
  • Private Equity firms are acquiring targets at 11–12x EBITDA, while the S&P 500 trades at roughly 14x, creating a spread that favors private equity.
  • KKR's portfolio companies grew at a 19% compound annual growth rate over the last four years, significantly outperforming the S&P 500's 3.4% growth.
• Banking Sector Outlook:
  • Manny Medina: Predicts a swing away from the post-2008 credit crunch; cites $250 billion in excess bank capital and regulatory changes (subordinated debt counting as equity) that will drive consolidation and yield opportunities.
  • Mitch Jewett: Disagrees with the immediacy of the turnaround, noting that regulatory overhang (and the potential for stricter rules from future administrations like Elizabeth Warren's) continues to limit bank lending to complex structures, keeping opportunities open for alternative lenders.
  • Market Volume: Direct lending is now estimated at $16–18 trillion, double the size of traditional bank lending.

Structural Trends and Risks

• ETF Influence and Liquidity Risk:
  • Barney Partners warns that the massive growth of ETFs (currently 60–65% of REIT transactions) creates a potential "uneconomic decision" point.
  • If ETF flows reverse, forced selling could create massive opportunities for active investors, provided the market does not hit saturation (e.g., 90–99% ETF ownership of a security).
• Regulatory Impact on Small Banks:
  • New rules allow subordinated debt to count as equity, facilitating the sale of small banks to larger entities (e.g., George Hicks' hypothetical acquisition model).
  • A bill expected to pass by Memorial Day 2018 aims to further favor these consolidation opportunities.
• Investment Grade vs. Distressed:
  • Corporate leverage ratios are declining, with seven consecutive quarters of leverage reduction, challenging the typical view of an imminent credit cycle downturn.
  • The "unit tranche" financing model is simplifying deals, replacing traditional tranches with single-debt/single-equity structures to support growth companies.

Forward-Looking Statements and Decisions

• KKR's Impact Fund: KKR is launching its first impact investment fund, aiming to generate social good alongside financial returns.
• Future of Banking: Manny Medina predicts the "gigantic openings" of the 2008–2009 crisis will disappear over the next four to five years as regulatory chains are removed from banks.
• Private Equity Valuation: John Donahue remains unconcerned about the "dry powder" ($1 trillion) in the private equity sector, citing the superior growth profiles and lower multiples of private assets compared to public markets.
• Market Disconnects: Panelists note a disconnection between bond and equity markets, where credit risk sometimes moves inversely to equity risk, suggesting inefficiencies that active managers can exploit.
• Long-Term Horizon: The panel concludes that the structural opportunities in alternative credit and private equity are expected to last 5–10 years, driven by the need to fill gaps left by compressed bank balance sheets and complex corporate transformations.