Interview 011_Brook Taube
Sep 18, 2012
byInvestment in Japan
Company: Medley Management Inc.
Mr. Taube is a Managing Director and Chief Investment Officer of Medley and the Chief Executive Officer and Chairman of the Board of Directors of Medley Capital Corporation (NYSE: MCC). Prior to forming Medley, Mr. Taube was a Partner with CN Opportunity Fund. Prior to CN Opportunity Fund, Mr. Taube founded T3 Group, a principal and advisory firm focused on distressed asset and credit investments. Before T3, Mr. Taube was a Partner with Griphon Capital Management. Mr. Taube began his career at Bankers Trust in 1992, where his last role was Vice President in Structured Finance and Capital Markets. Mr. Taube received a B.A. from Harvard University and currently serves as a Board member of the New Amsterdam Symphony Orchestra.?
Please describe your investment philosophy, specifically how you can achieve ‘equity-like’ returns by taking secured positions against high quality assets.
Middle market private debt, originated through bilateral direct lending, combines the downside protection of senior secured bank loans with the attractive upside participation typically provided by mezzanine and other equity-like instruments.. Furthermore, the senior position in a borrower’s capital structure allows middle market debt providers to have priority of return as well as control over any restructuring process, asset sales, capital raises and insurance proceeds.
Private debt investments have either a fixed or variable coupon due periodically, typically monthly or quarterly. While common equity holders typically receive no cash or other periodic returns on their investments until a liquidity event occurs, regular interest payments on private debt investments, combined with amortization payments over time, reduce the overall level of risk exposure for the investor in private debt.
Private debt investment portfolios also incorporate additional equity “kickers,” which have historically generated as much as an additional 5-10% IRR enhancement to overall returns. Such equity participation may take the form of options, warrants, cash flow sharing, co-investment rights or other participation features. Option and warrant agreements generally carry standard protective features, including anti-dilution protection, tag-along rights and piggyback registration rights. Cash-flow sharing arrangements typically involve waterfall structures in which the lender participates in cash distributions after satisfactory debt service.
Private debt has become increasingly attractive because it offers low volatility and steady returns with low correlation with public capital markets. Notably, because they rely on contractually determined, periodic payments of principal and interest, private debt investments do not depend on the existence of robust M&A or public equity markets to achieve realized returns. The baseline returns on private debt investments can be achieved even if public markets remain challenging for an extended period of time.
Investors in illiquid assets, such as private equity, usually wait a significant period of time before receiving investment returns while continuing to fund capital contributions (including management fees), a condition called the “J Curve.” However, because private debt investments offer regular (monthly or quarterly) cash payments of principal and interest, private debt can mitigate this J Curve effect.
By providing capital to private borrowers that are underserved by the public credit markets or traditional banking system, private debt firms can earn a premium to those lenders in the syndicated loan market. Furthermore, because of the private and less efficient nature of this market, lenders are often able to command terms and conditions on loans that are highly favorable. As a result of these factors, private debt investments offer investors a meaningful way to diversify a portfolio by providing attractive equity-like returns with the risk profile of senior secured debt.
Describe today’s current investment opportunities. Why senior loans versus other asset classes i.e. HY bonds, Investment-grade bonds etc.?
When evaluating different investment opportunities in the credit arena, there are four areas of focus:
1.Pricing and Yield: The recovery in the banking system and central bank liquidity has forced investors into fixed income instruments and pushed yields on sovereign and corporate debt to historic low levels and tight spreads. However, this liquidity has not returned to the lower end of the corporate market due to structural problems in the banking system, re-regulations and the loss of many traditional lenders who no longer have access to long term capital. As a result, the middle market segment of the credit markets has not kept pace with the larger market segment and offers significant yield and spread advantages to other alternative fixed income investments.
2.Leverage or Risk: Middle market debt is less risky than large market debt. They have less complicated balance sheets which allows for less risk in bankruptcy and a faster workout and recovery process. Middle market loans are underwritten at lower multiples to EBITDA than larger companies at overall lower LTV’s. Middle market loans have historically lower default rates and higher recovery values than larger companies resulting in lower loss rates during both normal and stressed times.
3.Seniority and Security: Direct lending to middle market borrowers are senior secured claims against assets and/or to the enterprise. Other forms of corporate debt such as general investment grade obligations are typically senior and unsecured. High yield bonds can vary in structure but generally offer junior or mezzanine priority in the capital structure of a company.
4.Liquidity and Predictability of Return: To earn yield and return, there is a trade-off with immediate liquidity. However, a diversified portfolio of direct loans has significant visibility and transparency to the underlying assets and also to their amortization and maturity schedules. This allows an investor to predictably plan around current cash yields and return of capital during the investment period. Furthermore, the average lives of the loans are approximately 4 years.
Please explain why you have decided to be a portfolio manager.
After graduating college I worked at Bankers Trust Corporation, eventually becoming a banker in the leverage loan department. Bankers Trust was one of the last remaining nationwide banks in the United States to use their balance sheet to extend credit to middle market borrowers across the range of growth industries. I eventually retired from Bankers Trust which, like many great corporate banks, became part of the consolidation wave that has transformed the role and activities of banks in corporate finance. Foremost in my mind were the opportunities to provide capital to great businesses that were increasingly leaving the traditional banking system to finance their businesses and growth capital needs. This eventually led to the formation of Medley Capital in the early part of the last decade. As my colleagues can attest, I truly enjoy working with clients and finding solutions to their strategic challenges. My favorite activity since forming my own investment management company has been working with companies to help find solutions to their liquidity requirements and sources of growth capital. Over the past 10 years, we have completed 130 financings for various companies across industries and geographies throughout North America. This has been a very satisfying and enjoyable aspect to what I do for a living.
Typically, investors have to take one or both of two primary risks in fixed income investing: credit risk and interest rate risk. How, if at all, does the senior loan asset class mitigate those risks?
The primary risk facing a lender is credit risk. This risk involves the inability of a borrower to perform under the contractual obligations of the loan. This risk is mitigated in four ways:
1.Origination Sourcing and Transaction Structuring,
2.Due Diligence and Good Underwriting,
3.Asset Management and Loan Monitoring,
4.Geographic and Industry Diversification.
Interest rate exposure is a minor risk facing a direct lender. Direct Lending is a hold to maturity strategy thereby mitigating the main sources of interest rate risk. Roughly half of the loans in the portfolio will be priced at a spread to floating Libor and will re-set with rising changes in underlying short term interest rates. The average life of a loan is approximately 4 years maturity thus mitigating the sensitivity of interest rate changes to the value of the loans.
What is your belief as a portfolio manager? What do you try to achieve and what would you never do?
As a portfolio manager I am a fiduciary to my clients. This means very clearly and simply that I must treat the interests of my clients ahead of my own and make decisions only in their interests. This is my main obligation as a portfolio manager. As a portfolio manager, I try to achieve consistent returns and low volatility in an investment strategy that is transparent to investors and easy to explain. I have seen many investment “fads” that claim to use complex technologies and models as the basis of their value proposition. I have personally never been comfortable with those strategies because I cannot understand how they make money consistently. Like all businesses, mine is difficult to execute but it should not be difficult to explain to investors. In many respect, lending money to credit worthy borrowers is one of the oldest businesses in the world and can be easily explained and understood by clients. What I try to achieve is a deeper understanding of how we do our business and why it is worthy of entrusting us with client capital.
What I will never to is to promise investors something we cannot achieve. We are clear in how we discuss our business; the types of risks we take and how we generate returns and, most importantly, how we return capital to investors. It is critical to not attempt to compete with every other strategy in the market by telling people you can achieve things that are not possible.
How best would you protect clients assets?
In any credit strategy, whether executed by a bank or an investment fund, there are three critical components to protecting capital:
1.Originate good loans. This means source loans from reliable channels and from people you know and understand. Only make loans to companies whose business is stable through the business cycle and whose business processes, products and clients can be explained. This is the single most important component to protecting capital when making credit investments.
2.Good underwriting and strong transaction structures. This means far more than simply performing good due diligence. Of course we do this and it is critical. However, what is far more critical is to control the documentation and covenant controls on the borrowers. This is a benefit we have in the direct lending arena that bond holders do not have in the larger public corporate markets. We can customize our documents and choose the controls we require to manage risk as opposed to having them imposed on us by other investors or by Wall Street. In those cases, they are often issuer friendly and do not serve our risk management requirements of making and holding a credit instrument. This is a significant risk mitigate and advantage to direct lending that does not exist in the larger public credit arena.
3.Strong asset management processes and portfolio monitoring systems. It is critically important to be able to systemically monitor your investments for covenant breaches, cash controls and the overall trajectory of the business. We do this through a proprietary system build over the years which track each portfolio holding and their adherence to document controls. However, we also speak to our borrowers regularly and we perform site visits regularly in order to see firsthand what is happening on the ground. Good systems must be augmented with human face to face contact and physical evaluation of the business.
Please recommend your favorite books on investments, and the reasons you favor them.
I have read dozens of books on investing over the years. Frankly speaking, most of them cover the same material. However, there are two books that I have read, both very different and written at different times, which are connected in important ways. Reminiscences of a Stock Operator, 1923 by American Author Edwin Lefevre is a biography of the famous stock speculator named Jesse Livermore. This is a classic book on trading and speculation and, in fact, has been called the “font of investing wisdom” by none other than Alan Greenspan. In this book I learned to respect the critical role of human energy in speculation and the immediate link to price discovery in efficient properly functioning markets. The personalities and culture of the 1920’s in American finance is fascinating to me. These were men who lived in simpler times who used only their brains and personal energies to make money investing. Too Big to Fail, 2009 by Andrew Ross Sorkin, is the story of how Wall Street and Washington fought to save the US financial system in 2008 in the immediate days leading up to and following the collapse of Lehman Brothers. Less a book about investing, this story had a particularly important impact on me as an investor and student of Wall Street over the past two decades. Sorkin had an inside seat for many of the important meetings at the US Treasury, Fed and at all the individual companies and players during that critical time. Like all financial crises, this one was borne from too much leverage and massive asset liability mismatching in the system. It was particularly instructive for me to see the distortions that existed in the banking system and the pernicious effects from so many similar assumptions and conflicting roles played by these institutions.
Please recommend any media source (newspaper, journals and website) you check on a regular basis.
I read the Financial Times and Wall Street Journal every day. I am connected to Bloomberg online 24 hours a day. I review most other national newspapers through online news websites that I review, including Pulse News, Slate, The Onion. Away from news I regularly read books across a wide range of personal interests, including history, social sciences, business and interesting personal life stories.
Managing Director, Investment and Research
This article originally appeared on March 16, 2012. Any views presented in this article are as of such date and are subject to change
This article and the information provided therein is not a recommendation to purchase or sell any security, nor is it intended to constitute the marketing of, or a solicitation for investment in, any investment product.