Third Eye Capital
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Toronto, Ontario, M5J 2T3

CEO Insights

CEO Insights

Stocks Matter (Q2-13)

Stocks Matter (Q2-13)

Jun 30th, 2013

The following was excerpted from Third Eye Capital Management Inc.’s Q2 2013 Investor Letter.

Credit analysis is a dynamic process that involves quantitative and qualitative factors that are fundamentally concerned about underlying asset value. The ability of a borrower to repay its debt is dependent upon the future market value of its assets. If the assets of the borrower have sufficient market value, the borrower can easily raise cash it needs by selling off a portion of its assets. If the assets are immovable, then the borrower can sell them indirectly by issuing additional equity or debt. In any case, it is the market value of the borrower’s assets that determine the borrower’s value, and by extension the value of its debt which constitutes a claim against such assets.

Equity markets, which are more liquid and transparent than the inefficient and opaque corporate credit markets, are an excellent source of information and, because of their ubiquity, provide a relatively quick and easy method to estimate underlying asset value. Equity markets are also important barometers of investor sentiment and perceptions about a given industry sector. Equity market volatility can provide a check on whether a particular company or sector is out-of-favour, and if underlying asset values are stable. For these reasons, credit portfolio managers should pay attention to stock prices even when their borrowers are private. The liquidity and news flow on public equities means that the active monitoring of a borrower’s publicly-traded peers can provide insight into sudden or unusual industry activity and key events that could impact credit fundamentals. In the context of the current rate environment, equities may have even greater predictive power for credit investors. According to Barclays Capital, over the past twenty years stocks have been more likely to rally when rates are rising, and strong equity markets tend to support corporate credit prices by reducing default risks.

Stock market data is very useful in calculating a benchmark enterprise value, a proxy for a company’s underlying asset value. Whether determining the enterprise value for a private company, or validating the enterprise value for a public one, the analysis begins by choosing a comparable set of publicly-traded peers based on size, geographic, and industry criteria. Then one or more key valuation metrics must be selected. For simplicity sake, most credit investors calculate enterprise value based on a multiple of some observable quantity, usually revenue or EBITDA but these traditional multiples are not always useful (or relevant) for certain types of companies. At TEC, where loans are strictly based on our opinion of the borrower’s assets, we assess asset values directly through audits of receivables, expert appraisals of inventory and fixed assets, review of intellectual property, and discussions with customers, suppliers, competitors, and liquidators. However, we also gain insight into the broader market’s opinion of firm asset value by looking at key valuation multiples of comparable peers that vary by industry. Some of the non-traditional valuation metrics we have found to be especially effective in determining benchmark enterprise values for companies in our portfolio include:

Industry Sector
Key Valuation Metrics to Calculate EV

Oil and Gas
EV to Proved and Probable Reserves (BOE)

Mining
EV to Measured and Indicated Resources

Software
EV to Recurring Revenues

Media
EV to Subscribers

Financials
EV to Book Value

Multiple-based valuations reflect the mood of the market, which means value estimates can sometimes be too high when stock markets overheat. Using the equity market to determine asset values relies on a belief in market values and the efficiency of the market to reflect all available information in equity prices. But an efficient market is not the same as a rationale one, and as the great financial analyst Benjamin Graham once proposed, the price of every stock contains a “speculative element” driven by sentiment and emotion, fear and greed. The speculative element in pricing is prone to extreme swings that can distort equity valuations and give false comfort to lenders who derive asset values only from the market price of the stock of their borrowers or peers.

Equity markets provide valuable information to credit investors about underlying asset valuation, peer comparisons, industry trends, and market sentiment. Lenders that ignore the cues provided by equity markets do so at their own peril.



Domestic (Canadian) Advisor registration form:

If you are an advisor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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Domestic (Canadian) Investor registration form:

If you are an existing or prospective accredited investor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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International Investor registration form:

For US persons
If you are an existing or prospective accredited investor or an advisor that distributes or is interested in distributing a fund advised by Third Eye Capital Management Inc. you can register to request a call or meeting. You will be asked to provide information to confirm your qualifications to invest in or distribute the funds. This brief registration process allows us to conform to applicable securities laws and to obtain some basic information about you. Once we have qualified and approved your registration, we will get in contact with you to schedule a meeting.

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Fund of FundsFamily OfficeBankOther (specify)
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Instructions for the following sections: Individuals please answer Part A of Sections I and II; Institutions please have an authorized person answer Part B of Sections I and II.

Section I - Accredited Investor Threshold Questions:

Part A - For Individuals:

1. I certify that I have an individual net worth, or my spouse and I have a combined net worth in excess of $1,000,000.

2. I certify that I am highly a sophisticated investor who routinely invests sums of $250,000 or more.

Part B - For Institutions:

1. The submitter certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company.

2. The submitter certifies that it is a charitable organization, corporation or partnership with assets exceeding $5 million, and that was not formed to invest the Fund.

3. The submitter certifies that it is a corporation, partnership or trust with assets of at least $5 million, that was not formed to invest in the Fund, and whose purchases are directed by a sophisticated person.

4. The undersigned certifies that all of its equity owners are “accredited investors” as defined in United States Securities and Exchange Commission Rule 501(a) and who can satisfy the higher criteria for the same set forth in Section I, Part A above.

Section II - Qualified Purchaser Questions:

Part A - For Individuals:

1. I certify that I own not less than $1,000,000 in securities investments.

Part B - For Institutions:

1. The undersigned certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company

2. The undersigned certifies that it is a "family owned company" (as defined below) that owns not less than $5,000,000 in securities investments. A "family owned company" is defined as a company that is owned directly or indirectly by or for two or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendents by birth or adoption, spouses of such persons, the estate of such persons, or foundations, charitable organizations, or trust established by or for the benefit of such persons

3. The undersigned certifies that it is a trust that was not formed to invest in the Fund, the trustee or decision-making authority of which, and every person contributing assets to the same, is a “Qualified Purchaser” under one of the other definitions of this Section

4. The undersigned certifies that it is a person acting for its own account or for the accounts of other Qualified Purchasers who in the aggregate own and invest on a discretionary basis at least $5,000,000 in securities investments.

Questionnaire Submission:

Thank you for your patience in completing this questionnaire.

If you have any questions, please contact Chris Vokes, VP of Investor Relations at Third Eye Capital:

T 416-601-2270 ext 242
E chris@thirdeyecapital.com