Recalibrating the Watt: Barron’s Hedge Fund Profile of Venor Capital
Jeffrey Bersh and Michael Wartell, co-founders of hedge fund Venor Capital Management, know how to invest in energy. I didn’t get a chance to re-post the profile of Venor for Barron’s which I wrote just before year end.
Venor Capital’s name is derived from the Latin word for “hunt,” and that’s what the firm’s co-founders, Jeffrey Bersh and Michael Wartell, do: They hunt for value in bonds and occasionally stocks, sometimes in unfamiliar places.
Their hedge fund, with $875 million in assets, covers a lot of ground. It makes investments based on specific events, like improvements at a power plant, but also plays potential credit-rating changes, defaults, and distressed situations. High-yield bonds are another specialty. The firm focuses on middle-market companies with anywhere from $250 million to $2.5 billion in equity-market valuation. Although this represents only about a third of the $1.7 trillion high-yield market, Bersh and Wartell believe competition for smaller deals is less heated than it is for mega-transactions.
“We think of ourselves as a special-situation investor within the credit space,” says Bersh. “We look for asymmetric upside, meaning we feel there’s little to no downside. We also look for hard-asset collateral that offers a margin of safety in the intrinsic value. In other words, we value the company knowing that we would be fine with owning those assets. And we look for a catalyst.”
Bersh, 42, and Wartell, 43, started out working together in the high-yield debt unit of Merrill Lynch in 1993. Bersh had just graduated from Emory University and Wartell from Wharton’s college program at the University of Pennsylvania. They each moved on to other firms, Bersh to Credit Suisse, where he rose to become head of distressed trading, and Wartell to Deutsche Bank, where he eventually was named co-head of distressed research. The two friends kept in touch over the years and joined forces in 2005. New York-based Venor Capital now has 15 employees.
Their partnership has worked out well. Venor’s offshore fund has generated annualized returns of 9.49% since inception, and 10.9% in the three years ended October 2012.
EXTREMELY LOW NATURAL-GAS prices and new power regulations have pointed Venor toward merchant power in the past year. Another important theme is buying companies in “run-off” mode, or winding down their operations. First, the electricity play.
President Obama’s re-election ensured that the Environmental Protection Agency likely will press ahead with regulations forcing coal-powered plants either to “scrub” their operations to meet stricter pollution standards or to shut down. The new measures are expected to lead to a significant number of coal-plant closures by the end of 2015 and potentially higher energy prices.
That’s one of the reasons it’s held on to a stake in Dynegy (ticker: DYN), the Houston electric utility with a tumultuous recent history that’s included management convictions for financial fraud; bankruptcy and near-bankruptcy; and at least a couple of takeover battles. Venor started out as an investor in the company’s debt in early 2012, and is now an equity holder with Dynegy’s re-emergence from bankruptcy in recent weeks. It originally bought the debt at around 60 cents on the dollar. “We viewed it as an inexpensive call option on a power-market recovery,” Wartell explains. “We saw little or no downside, since we valued the power plants at significant discounts to replacement value.”
Wartell and Venor analyst Harlan Cherniak were part of Dynegy’s bankruptcy creditors’ committee, which negotiated conversion of the debt into equity plus some cash. Bondholders ended up with 99% of the equity plus $200 million in cash. The bonds, meanwhile, had risen to around 64 cents on the dollar.
But they decided not to walk away with a profit on the debt. “We view it as an 18-to-24-month investment. Our thesis is that, with its balance sheet cleaned up, Dynegy is much more able to capitalize on the post-EPA regulatory regime,” Wartell says. Dynegy’s plants, including both natural-gas-fired and coal-fired, already comply with the new regulations. As a result, they’ll be more competitive as the EPA closes or mandates expensive upgrades of older coal-powered plants.
Post-reorganization stocks tend to be volatile, and Dynegy is no exception. The share price has been stuck between $17 and $20.75 since they emerged from bankruptcy, less than Venor’s purchase price. But the firm has added to its position, believing that Wall Street misvalues the company’s assets. “The consensus view values merchant power on a cash-flow multiple,” says Wartell. “We view that as unfair, because we take into account EPA regulations that leverage the gas assets.”
Applying its own valuation to five key Dynegy gas plants and ascribing zero value to its coal assets, Venor says the stock is worth $26 a share. Adding leverage from a potential price increase in natural gas translates to $30-to-$35 a share, Venor believes. “We’re getting paid to hold the gas assets and we get coal assets for free,” Wartell adds.
Dynegy management will hold its analyst day in January, and Venor is eager to see what happens. “Some look at the enterprise value and compare Dynegy to traditional multiples of Ebitda [earnings before interest, taxes, depreciation, and amortization],” says analyst Cherniak, “but that’s like comparing GM to Apple. No two megawatts are created equal.”
For some of the same reasons, Venor early in 2012 bought the bonds of Homer City Generation, another merchant power play, for roughly 85 cents on the dollar. Based in Homer City, Pa., the company operates three coal-fired electric-generating units and sells energy to power marketers in the Midwest and on the East Coast. It filed a prepackaged bankruptcy in November, and by that time, the bonds were already trading at $1.10 on the dollar. An affiliate of GE Capital, the finance unit of General Electric, had put up $750 million to scrub the Homer City plants, and that investment helped boost the price of the debt. The company emerged from bankruptcy earlier this month.
Venor held the 8.137% senior secured bonds due in 2019 and the 8.734% senior secured bonds due in 2026, both of which have now been exchanged for new bonds. The issues have an option for payment-in-kind plus a premium, and are callable at $1.15 until Aug. 1, 2013, and at various prices beyond that date. Investors expect that the bonds could be retired, or called, because GE is now the parent of Homer City.
ASIDE FROM MERCHANT-ENERGY plays, Venor targets middle-market liquidations because they typically return 12%-to-15% over the life of the investment, and unlike mega-deals such as Lehman Brothers, they offer higher returns for a fund of Venor’s size. A typical one is Cattles Ltd., a private U.K.-based payday and subprime lender that was forced to wind down its business because of the credit crisis of 2008.
“It’s a fairly low risk relative to return,” says Wartell. “There’s little to no downside, because if things go wrong, it just takes longer for us to collect.” Venor receives monthly payouts on Cattles’ bank debt, which trades at roughly 27 cents on the dollar.
“We also like liquidations because they have low beta [are not correlated] to the market,” Wartell adds. “Headlines don’t move liquidations, and prices aren’t changing because of P/E ratios or enterprise value. It’s all based on cash flows.”
The fund does buy stock, including that of Two Harbors Investment (TWO), a real-estate investment trust focused on residential mortgage-backed securities and related investments. Venor is generally bullish on an anticipated rebound in the U.S. housing market.
“It’s a liquid way to play the theme,” says Wartell, who notes Two Harbors’ 12% dividend yield. “If interest rates stay where they are and housing recovers, it’s attractive.”
Venor bought the stock at a discount to its book value of $10.90, and would buy more if it drops below book again. Currently the stock trades at $11.12 a share.
Most mortgage REITs trade at 1.1 or 1.2 times book value, but have been hit by fears of tax increases on dividends. Venor’s portfolio managers note that Two Harbors’ dividends have always been treated as ordinary income, and therefore any 2013 tax consequences should be minimal. It’s just the kind of investment they hunt for.