Treasure Hunters of the Financial Crisis

November 9, 2013

Treasure Hunters of the Financial Crisis

By PETER LATTMAN

Five years ago, the global financial system was falling apart. Lehman Brothers had imploded. Banks had stopped lending. Foreclosure signs were as common as weeds on the front lawns of suburban homes. And Bruce A. Karsh saw the buying opportunity of a lifetime. Mr. Karsh, a low-key money manager from Los Angeles, had spent his career analyzing and trading the debt of companies. With the world economy buckling, the prices of corporate debt had plunged to levels suggesting that much of American industry was hurtling toward bankruptcy. So Mr. Karsh, through his Oaktree Capital Management firm, plowed money into distressed debt at a torrid pace, investing more than $6 billion over a three-month stretch.“Unless the second Great Depression lies ahead,” Howard S. Marks, Oaktree’s chairman, wrote to their clients on Oct. 6, 2008, “today’s purchases should produce substantial returns, and in a few years we’ll reminisce together about how easy it was to take advantage of the bargains of 2008-09.”

It paid off. With the help of an extraordinary government bailout and stimulus, the second Great Depression never came and a global recession eventually faded. A half-decade later, Mr. Marks’s prediction has come to pass. Virtually all of the debt bought on the cheap has fully recovered in value. The trade yielded spectacular profits, earning about $6 billion in gains for Oaktree’s investors and $1.5 billion for Mr. Karsh, Mr. Marks and their partners.

Much attention has been lavished on the speculators who reaped huge paydays betting against the subprime mortgages that stoked the financial crisis. Doomsayers like the hedge fund manager John Paulson and the cast of characters in “The Big Short,” the Michael Lewis book, saw calamity coming, and their contrarian bets delivered when the housing market collapsed.

But what about the big long? During the dark days of late 2008, while other investors dumped their holdings or sat paralyzed on the sidelines, who decided that it was time to put money on the line? Who bought low and then sold high?

Warren E. Buffett, of course, increased his fortune during the crisis with well-publicized investments in embattled blue-chip companies like Goldman Sachs and General Electric. But a number of other, lower-profile financiers also made billions by obeying one of Mr. Buffett’s favorite aphorisms: “Be fearful when others are greedy, and be greedy when others are fearful.”

Jonathan D. Sokoloff and his colleagues at Leonard Green & Partners acquired a huge ownership stake in Whole Foods Market at a time when many thought that this upscale grocer might not survive the downturn. Joshua J. Harris, a founder of Apollo Global Management, doubled down on a big chemical company that stood on the brink of liquidation. Oaktree scooped up corporate debt that others were discarding.

Each of these bottom-of-the-market wagers offers enduring investment lessons. But Horatio Alger stories they are not. The moneymen at the center of these trades are in the 0.01 percent — and among the most highly regarded investors on Wall Street. Their success benefited the public pension funds, endowments and foundations that have money with their firms.

It also made the firms’ partners, who receive about 20 percent of their funds’ gains, substantially richer than they already were. Mr. Harris recently led the purchase of two professional sports teams: the Philadelphia 76ers of the N.B.A. and the New Jersey Devils of the N.H.L. Last spring, Mr. Marks and his wife paid $52.5 million for a 30-room apartment at 740 Park Avenue in Manhattan.

These investors all also happen to have roots connecting them to Drexel Burnham Lambert, the swashbuckling investment bank, and its fabled — and convicted — junk-bond trader, Michael R. Milken.

Before they started Apollo, Mr. Harris and his co-founders were Drexel bankers. So were Mr. Sokoloff and his fellow managing partners. And as a young high-yield bond manager at Citibank, Mr. Marks became a Milken disciple and a client of Drexel.

Although Drexel dissolved in 1990 after pleading guilty to securities fraud, and Mr. Milken also admitted to crimes, the bank’s alumni are proud of their heritage and Mr. Milken’s gimlet-eyed approach to risk-taking.

“What we learned at Drexel underpins our investment philosophy: Protect your downside and don’t lose money,” Mr. Sokoloff said. “Milken would say invest in times of chaos and harvest in times of prosperity.”

In retrospect, it’s easy to say “Of course Whole Foods was going to recover” or “Surely corporate America would eventually turn around.” But during the frenzied fall of 2008, the uncertainty was so great that most investors were immobilized by fear. If these trades were so obvious, more would have made them.

Biting Into Whole Foods

On a mid-October morning in 2008, Jon Sokoloff was in his Los Angeles office when he received a call from Kip Tindell, chief executive of the Container Store. A year earlier, Mr. Sokoloff’s private equity firm had acquired the Container Store, but this call was not about that. Mr. Tindell was calling on behalf of the co-founder of Whole Foods, John Mackey, who in the 1970s had been his college roommate at the University of Texas.

“This is the call you’ve been waiting for,” Mr. Tindell told Mr. Sokoloff. “I’m here with John, and there may be a window for you to help Whole Foods out.”

Mr. Sokoloff had been asking Mr. Tindell for just such a meeting. His firm, Leonard Green & Partners, owned companies that were among the most recognizable names in retailing: J. Crew, Neiman Marcus, Petco, Topshop. Whole Foods, which had reinvented the supermarket as a high-priced emporium of aesthetically displayed organic products, fit squarely within the firm’s investment parameters: it was a leader in its market niche and still in an early phase of growth.

But that fall, the grocery store chain faced a looming crisis. The company had been buffeted by the slowing economy and the costly acquisition of its rival, Wild Oats. Investors were dumping Whole Foods shares. Shoppers who had once paid for grass-fed beef and locally sourced apples were now husbanding cash and trading down to generic brands and discount stores. Over the previous 12 months, shares of Whole Foods fell 80 percent.

With the company’s business deteriorating and the economy in a tailspin, Mr. Mackey and his management team decided they needed to raise outside money. Beyond the cash infusion, they felt that they could use a vote of confidence from a respected investor, something akin to Mr. Buffett’s investments in Goldman and G.E. made the month before.

Mr. Mackey sought advice from Mr. Tindell, who suggested a meeting with Mr. Sokoloff. He and his firm were good partners, Mr. Tindell told his old friend, low-maintenance investors that would not micromanage.

The day after Mr. Tindell’s call, Mr. Sokoloff and his colleagues flew to Austin, Tex. That evening, over a company-catered dinner at the Whole Foods headquarters with company management, they discussed a possible investment.

“I don’t remember exactly what we ate,” said Mr. Sokoloff, now 56. “but it was a very healthy meal.”

He and his partners, Peter J. Nolan and John G. Danhakl, knew they had to act fast. They had an inside edge on a promising deal. If they waited too long in such a tumultuous market, the opportunity could pass or a competitor might swoop in. Back in Los Angeles, they pored over the company’s financials; they also combed the aisles of nearby Whole Foods outposts — in Venice, Beverly Hills and West Hollywood. A few days later, Mr. Sokoloff emailed a proposal to Mr. Mackey.

On Nov. 5, Whole Foods announced a deal. Leonard Green pumped $425 million into Whole Foods, effectively giving it a 17 percent stake in the company. The firm also negotiated downside protection, guaranteeing itself an 8 percent annual dividend payment if Whole Foods’s stock price languished. Mr. Sokoloff and his colleague, Jonathan A. Seiffer, took seats on the board.

“There was no Carl Icahn drama getting this deal done,” said Walter Robb, a Whole Foods co-chief executive, referring to the gadfly activist investor. “They made a gutsy call when everyone else was panicking, and the investment allowed us to focus on rebuilding our business.”

As the country sank into its economic slump, Mr. Sokoloff’s firm expected Whole Foods to struggle for at least a few years. During the opening months of 2009, its stock price dropped on continued poor results. But the firm had taken the long view, and by the second half of the year, business turned. The company, whose high prices had earned it the moniker “Whole Paycheck,” cut expenses and offered more discounted items. And it turned out that the popularity of organic kale and quinoa was more than a fad.

The company’s shares snapped back, too. As the stock rose, Mr. Sokoloff’s firm took profits by methodically selling its stake. Last November, with shares trading more than 800 percent higher than when it invested, it exited its position. All told, the firm and its investors made about $1.7 billion, or more than five times its money.

Shares of Whole Foods have continued to rise on the company’s rapid growth. It is now a “tenbagger,” a term coined by the mutual fund manager Peter Lynch for an investment that appreciates tenfold. Though Mr. Sokoloff’s firm left several billion dollars on the table by unloading shares as they traded higher, he defended the sales as prudent risk management.

“Being a disciplined seller is as important as being a disciplined buyer,” said Mr. Sokoloff, who remains a Whole Foods director and still personally owns about $50 million of the company’s stock.

Mr. Sokoloff’s relationship with Whole Foods led to his firm’s latest food-industry deal. In 2011, Mr. Robb of Whole Foods invited Mr. Sokoloff, who was in New York, to stop by Gramercy Tavern, where he was dining with Mr. Tindell and Danny Meyer, the restaurant’s owner. A year later, Leonard Green acquired a stake in Mr. Meyer’s company, the Union Square Hospitality Group. The investment is helping to fuel the growth of Shake Shack, Mr. Meyer’s burger chain; this winter, it plans to open an outpost in Moscow.

The Right Chemistry

During the stock market boom of the late 1990s, with the rest of Wall Street irrationally exuberant over tech and telecom companies, Joshua Harris was fixated on chemicals. A co-founder of Apollo, the private equity firm based in New York, Mr. Harris believed that the chemical industry was ignored and grossly undervalued. Epoxy resins, acrylic monomers and urethane additives became his obsessions. He also liked the cyclical nature of the business because it could provide big buying opportunities during downturns.

Apollo started investing in chemicals, and made numerous acquisitions over the next decade. But a favorite that had eluded his grasp was Lyondell, a polypropylene maker based in Houston. Mr. Harris had courted the company whenever he was in Texas, but to no avail.

In December 2007, Lyondell was acquired by Len Blavatnik, a friend and business rival of Mr. Harris. The two men had battled over other chemical makers in the past. Mr. Blavatnik, a Ukrainian-born, Harvard-educated industrialist, merged Lyondell with one of those prizes — Basell, a European company. The combination created LyondellBasell, the world’s third-largest chemical manufacturer with about 15,000 employees and $34 billion in sales.

The deal also created a company with too much debt at the very moment when the credit markets began seizing up and the chemical industry started to weaken. Just months after the transaction closed, it became clear to Mr. Harris that Mr. Blavatnik had overpaid, and that LyondellBasell was at risk of bankruptcy. On Wall Street, other peoples’ failures carry the seeds of success.

Mr. Harris, now 48, decided to make a run for LyondellBasell. He saw the company as a great business with a terrible balance sheet. Its chemicals were used to make everyday products from food packaging to vacuum cleaners to car parts. If it could restructure, he reasoned, it would recover with the broader economy. So he began acquiring the company’s senior secured loans, which would be paid back first in any bankruptcy and would thus provide protection in case it went under.

“We bought the debt at 60 cents on the dollar,” Mr. Harris said. “We bought more at 50, and then at 40. The low was 20. People were either panicked or forced sellers, and we bought from them all the way down.”

Mr. Harris’s strategy, known as a “loan to own” investment, was to purchase corporate debt at a discount and then try to take over the company in a restructuring. By the end of 2008, Apollo had acquired about $2 billion of LyondellBasell’s debt, becoming its largest creditor.

Business continued to worsen, and in December 2008, LyondellBasell was suffocating. Its cash was rapidly running out. A factory was idled. Some company managers stopped showing up for work. Apollo was sitting on paper losses of more than $500 million.

During the final week of the year, with the company and the markets melting down, Mr. Harris and Mr. Blavatnik both found themselves on family vacations in Anguilla, the island of choice for Wall Streeters, a sort of Hamptons of the Caribbean.

Mr. Harris visited Mr. Blavatnik on his 164-foot yacht, the Odessa. Over dinner, they brainstormed about how to save the company. Their best option was to put LyondellBasell into bankruptcy and secure emergency financing so it could continue to operate. Mr. Blavatnik knew that a reorganization might wipe out his investment, but hoped to salvage some value if the company survived.

Back in New York, the two butted heads over who controlled the bankruptcy financing. Mr. Harris ultimately prevailed, and secured the lead role providing loans to the company. This turned out to be a key victory for Mr. Harris, as it gave him leverage in the protracted restructuring negotiations.

In April 2010, after 15 months in Chapter 11, the company came out of bankruptcy in much better financial shape, shedding $17 billion in debt. Apollo’s loans were converted into a roughly 30 percent ownership stake in LyondellBasell.

Mr. Blavatnik, through his conglomerate, Access Industries, also participated in the recapitalization, buying $1.8 billion worth of newly issued shares in the revamped company.

LyondellBasell’s earnings recovered along with the rest of the chemical industry, more than tripling from a 2009 low. Its stock has followed suit, and Mr. Blavatnik has recouped his losses.

Apollo did even better. It has gradually been selling off its stake; it also paid itself dividends, taking advantage of the company’s cleaned-up finances. Mr. Harris’s firm has turned its $2 billion investment into a profit of more than $10 billion, which, according to Bloomberg data, is the largest gain ever on a private equity deal.

Without his skill in maneuvering through the complex bankruptcy process, Mr. Harris would never have amassed such huge gains. But the mental side of investing played an equally important role.

“Many others ran for the hills during that scary time, cut their losses, doubted their own theses,” said Kenneth D. Moelis, a banker who helped restructure the company. “Josh never did.”

‘Grabbing at Falling Knives’

Howard Marks’s memos to his Oaktree clients have a cultlike following among the professional-investing cognoscenti. “Howard is a superb writer and a master of logical thinking,” Warren Buffett said in an email. “That combination makes his memos a must-read for me.”

Like Mr. Buffett’s much-anticipated annual letters, Mr. Marks’s memos are chockablock with observations on the financial markets and investor psychology. But Mr. Marks’s wife teases him that they are all pretty much the same. And she’s basically right. The dispatches — as well as a book, “The Most Important Thing” — harp on recurring themes: the paramount importance of price, the danger of hubris, the value of contrarianism, the inevitability of cycles.

In early 2007, cycles were at the top of his mind. If Mr. Marks, who is now 67, had come to believe anything in his four decades on Wall Street, it was that financial markets go from peak to trough, and back again. And as housing prices soared, banks’ lending standards loosened and cash sloshed around the world, he grew increasingly pessimistic.

“In terms of amplitude, breadth and potential ramifications, I consider it the strongest, most heated upswing I’ve witnessed,” Mr. Marks wrote in a July 2007 memo. “A lot of this is because people seem to think everything’s good and likely to stay that way.”

For much of that year, Mr. Marks flew around the globe, hat in hand, raising money for a new fund to buy the debt of troubled companies. As he met with clients in London, in Dubai, in Beijing, his message was the same: The market’s excesses were setting the stage for a major fall, and would create an ideal time in which to invest.

“In the period ahead, cash will be king, and those able and willing to provide it will be holding the cards,” Mr. Marks wrote to his clients in January 2008.

By May 2008, Oaktree had raised its largest-ever distressed-debt fund, totaling $11 billion. Its coffers filled, the firm now looked to Bruce Karsh to put the money to work. Mr. Karsh, a former lawyer, once served as an appellate clerk to Anthony M. Kennedy, now a Supreme Court justice. Now, he was Oaktree’s investment chief and started steadily deploying the money, spending almost $1.5 billion by September.

The week of Lehman’s demise, Mr. Karsh huddled with his team. As the financial world unraveled, Oaktree found itself deep in the red. But Mr. Karsh had been investing in distressed debt for two decades, and had never seen bargains like the ones flashing across his Bloomberg terminal. Senior bank loans — the ones first in line to be paid in a bankruptcy — were trading at lows of 60 cents on the dollar and offering annual yields of about 30 percent.

“Either this is the greatest buying opportunity of my career or the world is going to end,” Mr. Karsh told his staff. “And if it ends, our clients will have much bigger problems on their hands.”

With the markets reeling, Mr. Karsh turned aggressive. The steep downslide had produced a long list of great businesses saddled with too much debt. From mid-September through year-end, Mr. Karsh spent more than $6 billion on distressed loans of companies like Clear Channel Communications, Freescale Semiconductor and Univision. It was, by far, the fastest pace at which Oaktree had ever put money to work.

Clients grew anxious. Calls began streaming in to check Oaktree’s performance. In October, Mr. Marks tapped out another memo to assuage them.

“Our assets are declining in value like everything else, but we’re comfortable that we’re doing exactly what you hired us to do,” he wrote. “We’re grabbing at falling knives. The best bargains are always found in frightening environments.”

In some ways, Mr. Karsh was replicating a successful trade from earlier in the decade. In 2002, after the telecom sector cratered, he bought bonds of Lucent, Nortel, Qwest and Corning at fire-sale prices. The companies never missed an interest payment, the bonds recovered and Mr. Karsh racked up huge gains.

But the crisis in the fall of 2008 was on a whole other order of magnitude. For months, Oaktree continued to lose money. Mr. Marks tried to reassure his clients, saying it was inevitable that they would be buying on the way down, that even the most experienced investors couldn’t pinpoint when the market would stop dropping.

Looking back, Mr. Karsh, now 58, said that if had he waited until March 2009, the eventual market nadir, Oaktree would not have been able to invest as much as it did. By then, all of the hysterical selling had run its course, and there were fewer bonds to buy.

“If God had told us to wait until March 9, 2009, because that would be the low, and we waited to buy then, we never would’ve been able to put that much money to work,” Mr. Karsh said.

Soon after that low, the markets stabilized, the chaos subsided and the prices of Oaktree’s debt investments eventually recovered in value. They became, in trading parlance, “money good,” yielding billions in profits.

Last year, partly on the strength of the trade and the performance of the distressed-debt fund, Oaktree sold shares in its own initial public offering. Today, the stock market values the firm at $8.4 billion; its assets under management have swelled to $80 billion.

Mr. Marks has also contemplated a new book. His theme? How to identify market cycles and the pendulum swings of investor psychology.

Today, he sees the markets as neither dangerously expensive nor extraordinarily cheap. He sees some signs of excessive risk-taking, but also sees continued uncertainty. As a result of the muddy outlook, Oaktree is investing with caution. For Mr. Marks, it’s easier to know what to do at the extremes than it is in the middle.

“Moments like 2008 will continue to present great opportunities for as long as emotion rules the markets,” Mr. Marks said. “In other words, forever.”