At the decline stage, companies experience deteriorating profit and loss of market share. As they suffer from the declining performance, they also face external problems such as the emergence of new competitors, fierce rivalry, and falling prices. In addition, internal issues like overstaffing, increasing expenses, and exhausted innovation dulls their motivation to stay in the industry. All of this could provoke the demise of the firms unless they are determined to fight for their survival through transformative changes. The process of change always starts with some form of survival anxiety. Management will need to relinquish the status quo, unlearn the things that worked in the past but no longer apply, and commit itself to new and effective organizational learning.

The revival stage is typically one of diversification and expansion of scope. The focus is on innovation rather than imitation of the strategies of competitors. It requires strong leadership and also increased investment, to finance capex, R&D, or acquisition. Cost-cutting and product rationalization during the decline stage may have stabilized operations and reduced losses, but retained earnings have been exhausted and companies will need to rely on external sources of capital. Equity is permanent and at this stage can be intrusive and extremely expensive. Traditional bank debt would likely not be available in sufficient amounts given poor recent history through the decline stage and the risks and uncertainties of transformative change efforts. Ideally, companies in this stage are able to attract credit from alternative investors that are accustomed to managing such complex and heterogeneous risks. For companies’ owners, immediate access to and availability of capital becomes more important than its cost, which is temporary and in absolute terms much less than the costs of other options, including the opportunity costs of abandoning the change effort or liquidating assets.

Transformative change is a daunting task and many companies fail because the path to revival is obstructed by established behavior patterns, processes, and cultural norms. Leadership at these companies must not be paralyzed by the risks but rather encourage risk-taking and non-traditional ideas, actions, and activities. Take the example of Marvel Entertainment. It emerged from bankruptcy in 1999 with a heavy debt burden, limited cash, and a corporate culture resistant to change. The cultural orthodoxy at Marvel was to own every form of exploitation of the company’s library of popular superhero characters like Spiderman, the Incredible Hulk, and the X Men. A new chief executive adopted a licensing model for movies, television shows, and video games, and for consumer products such as clothing, school supplies, toys, and even pool tables. He used the proceeds to retire high-yield debt and then with the help of an asset-based debt facility secured by the strength of the character library, the chief executive launched a movie studio which eventually generated blockbuster hits such as Iron Man, The Incredible Hulk, Thor, and The Avengers. Marvel was sold to Disney in 2009 for over $4 Billion, a nearly 60-fold increase in value from when the transformative change effort began.

Marvel is an extraordinary example of how companies can successfully transition from decline to revival and eventually prosperity. Companies move from one stage to another because they are misaligned with the needs of their environment and must adapt in order to survive. Marvel never declared victory or rested on its laurels while undergoing transformative change. It used the credibility of short-term wins to tackle bigger problems, and anchored changes in the company’s culture by showing how new approaches, behaviors and attitudes led to improved performance.

One of these new approaches was looking at alternative sources of financing. Companies undergoing a similar transition must find investors that are champions of the change effort and are willing to structure their investment to promote the revival. This is a heroic task for traditional lenders, still suffering from the after effects of the financial crisis, but alternative lenders, like Marvel’s superheroes, are accustomed to battling all types of risks and providing rescue when others cannot.

Excerpted from Third Eye Capital Management Inc.’s Q4 2012 Annual Investor Letter.

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Valuation is highly subjective, even when there is a determined price. That is because as individuals, we make valuation judgments based on time, context, and our own unique perspective. It may be theoretically expedient to apply fuzzy mathematical models that generate seemingly precise value estimates, but failing to appreciate the subjectivity of valuation can be dangerous.

Take the example of the “expert appraisal”. The expert will apply various quantitative approaches to measuring value of an asset, including (i) determining the costs incurred to develop a similar asset, also known as cost-based value; (ii) observing prices of comparable assets traded between parties, also known as market-based value; and (iii) computing the present value of future cash flows of the asset over its useful life, also known as income-based value. Each of these approaches relies on assumptions of the expert and inputs that are subjective and uncertain. The expert retained will usually have direct experience in trading the asset or representing relevant industry buyers and sellers in similar transactions for which the appraisal is used. However, using an expert appraisal privileges the biases and assumptions of the expert over others, and the notion that the expert’s determination of value is “better” is purely theoretical.

Lenders rely on expert appraisals to determine the value of their security, a process that has become more heavily scrutinized in the aftermath of the financial crisis when many lenders learned the difficult lesson that realized prices can deviate substantially from appraised values. Asset appraisals are generally considered by lenders to be an insurance policy for their credit decisions, and are therefore used more frequently in lending situations that are collateral-dependent, such as for asset-based loans and during distress, default, or impairment. Of course, it is in situations like these that such an insurance policy will most likely have to provide cover, and the expert appraisal may be the lender’s best hope for an objective valuation.

The expert appraisal can be helpful but it ignores the perspectives, circumstances, and risk thresholds that are unique to the individuals making the choices. Time, context, and perspective are dynamic factors, and can quickly render an expert appraisal to be a utopian standard of value that is difficult to achieve. Trying to handicap the value of an asset is one of the biggest challenges faced by lenders today, especially since many companies’ most critical assets are intangible or even invisible on a balance sheet. We consider expert appraisals to be a proxy measure that establishes a mere starting point for estimating value. Expert appraisals should be the result of a lending decision, not the other way around. We develop real-world scenarios reflecting specific buyer behavior to determine the price that will be ultimately paid for our collateral assets, and update these scenarios on a periodic basis. We do this through discussions with liquidators, suppliers, competitors, and consumers of the assets being valued. This incorporates the factors of time, context, and perspective into our analysis, which can avoid us subjugating to the subjectivity of experts.

Value and price are rarely the same, but recognizing that value is unique and subjective can free lenders from the abstractions and models of expert appraisals, and achieve collateral price estimates that are married to reality. Lenders face a myriad of challenges and properly valuing assets should not be one of them.

Excerpted from Third Eye Capital Management Inc.’s Q3 2012 Investor Letter.

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Household balance sheets in the U.S. are still under repair after the destruction wrought by the collapse of the housing market. Disposable income has also remained sluggish, taking the savings rate down with it. In a ZIRP world, households are forced to reach for yield and speculative gains in more aggressive assets.

Extended periods of low interest rates not only create vulnerabilities in the balance sheets of investors, but breeds new products and mutations of old ones with seemingly prudent investment strategies that involve hidden risks. The high yield and leveraged loan markets for instance, which have traditionally been suitable for sophisticated investors with a penchant for analyzing and evaluating discrete credit risks, have suddenly become retail darlings. Year-to-date inflows into high yield bond funds are over $27 Billion, versus approximately $15.5 Billion for all of 2011, mostly driven by retail funds. The CSFB High Yield Index is up 8.7% already this year, despite several technical and fundamental indicators showing the rally is overextended and overbought. Risk premiums have also shrunk in primary markets where deals are oversubscribed and investors are fighting for basis points rather than percentage points.

A plethora of other alien products are invading investment portfolios. Google, for instance, is using a large part of its $50 Billion cash hoard to invest in automobile loans from Honda and Hyundai, a marked departure from the company’s historical investments in corporate bonds and U.S. Treasuries. Goldman Sachs is packaging up royalty income from music by Bob Dylan, Neil Diamond, Rush, and Cassandra Wilson into five-year bonds yielding 5.25%. Waypoint Homes is purchasing foreclosed homes and converting the rental income into securities for investors that can yield 6% or more. ZIRP has created an illusory market for these products and leading investors to underestimate their inherent risks.

Private credit and direct lending strategies have also seen a boom in asset inflows. We know that loans contain idiosyncratic risks because each loan is unique for a specified purpose and period in time, and needs to be evaluated and structured individually. Direct lending is also dependent on deal access and origination, making the strategy capacity constrained and more illiquid than their traditional asset counterparts such as high yield and leveraged loans. The disparity in private credit returns is dramatic, accentuating the large difference in skill among managers and the importance of manager selection. Many of the new direct lending funds being launched are from former investment bankers with little or no experience in credit analysis, structuring, and collection. In other cases, direct lending managers are coining fancy terms such as “senior second lien loans” that give the specious appearance of safety. ZIRP is the culprit behind the resurging interest in private credit, and sadly most investors in this strategy will face lower than expected returns and higher than expected risks.

Investors need to avoid complacency about persistently low interest rates, and resist investing in high yielding products and strategies without carefully understanding the risks. Investors are understandably exhausted by directionless markets and low yields, but their desire to expand exposure into high yielding strategies should be focused on observable measures (such as proven manager experience and process), not on some faith in unknown aliens.

Excerpted from Third Eye Capital Management Inc.’s Q2 2012 Investor Letter.

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Assessing and measuring character requires judgment and experience. Prior to the Industrial Revolution, lenders and borrowers were intimately familiar with one another and staked their personal relationships, not just their business motives, behind the credit decision. Today, in an environment when loans are still made to be sold, and transactions are sourced in large volumes from around the world, lenders are challenged in making character determinations. This is further exacerbated inside a troubled company, where management is reluctance to communicate due to fear and denial.

We assess management character by examining two components: competency and integrity. Competency is checked through independent verifications of education, career experience, historical business performance, any criminal convictions and civil litigation, and personal credit scores. Any inconsistency between our checks and management representations are flagged for further investigation. Personal credit scores are an especially useful indicator because they demonstrate management’s attitude toward debt repayment. Our experience shows that credit information for management of a company explains a significant amount of variation in the performance of that company’s credit.

Indicators of management integrity are less easily observed and can take significant time to accumulate. However, the manner in which management communicates information provides important clues into their integrity. Examples include pattern of delays in information reporting, reluctance to provide disclosure, failure to provide specific and complete answers to questions, providing evasive information or being excessively defensive, destroying key documents, and overly complex transactions in the circumstances. We not only need to be able to understand the information we receive from management but should be able to trust it. Consistently failing to meet projections is a quick way to lose our trust. While companies cannot be expected to see into the future, flawed assumptions and unrealistic targets put management integrity into question.

We tend to avoid situations where company leaders have excessive control over the dissemination of information and there is fear (along with high turnover) among finance and accounting staff. Another red flag is if management has less to lose than we do, in relative terms, from a company failure. Any deception, misrepresentation, or lie is a clear and strong warning signal, and usually results in a permanent fracture of our relationship with management. In an ideal world, we can make accurate assessments of management character at the onset of a loan; however, more often, as unexpected crisis occur, or as a company and industry evolve, management’s true competence and integrity gets revealed.

Too many warning signs are an indication of distress. In such circumstances, many lenders simply revise the loan covenants. However, if management character is flawed, then loan covenants, no matter how often they are revised, will inevitably be breached. Liquidation is the only viable solution when management’s “promise” no longer holds meaning.

Excerpted from Third Eye Capital Management Inc.’s Q1 2012 Investor Letter.

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