Cladrius Partners: Credit Special Situations

Legal and capital structure arbitrage sweet spot

Hamlin Lovell
Originally published in the September 2019 issue

When some hedge fund managers say they await “the next distressed cycle” before launching a dedicated fund, they’re usually referring to a widespread spike in corporate defaults and bankruptcies. This is generally associated with a recession, though it could be driven by accounting and other frauds as in 2002. While Cladrius founder, Dennis Ruggere, envisages that a recession and associated market volatility could increase the scalability of his strategy, in some respects the opportunity set for his distinctive style of credit special situations investing – which only partly involves distressed situations – is already close to a sweet spot in 2019.

Whereas traditional distressed debt strategies are directionally long-biased or long-only, and so may require deep value to generate outsized returns, Ruggere, who featured in The Hedge Fund Journal’s Tomorrow’s Titans 2019 report, runs low net exposure (typically between 0% and 30%). This averaged 10% for his previous mandate, which Ruggere designed as co-CIO of Dhalion LP and which generated annualised double-digit returns with volatility around 4% between September 2016 and March 2018.

Our definitive philosophy is that 50 cent dollars do exist in the legally complex world.

Dennis Ruggere, Founder, Cladrius Partners

The limited directionality is due to trade construction and position level hedging but mostly because the ideas are inherently arbitrage based. Many of his trades are legal and structural focused investments between credit-oriented instruments, such as bonds, loans and CDS, pinpointing superficially similar instruments that can decouple due to different covenants combined with an event. “We invest in legally and structurally complex situations, and can deploy capital throughout the cycle,” says Ruggere. He can invest across the whole capital structure, covering a variety of event-driven special situations globally.

Some investors may perceive special situations credit as an illiquid and litigation intensive strategy, but Ruggere’s particular approach does not fit this mould. His average holding periods are 12-18 months and some situations conclude in six months or less, making it more liquid and shorter duration than a classic distressed debt strategy. Ruggere is unlikely to be going through the multi-year workout processes that can entail sitting on a committee and becoming restricted from trading, something he experienced earlier in his career. Most of Cladrius’s book is reasonably liquid and is classified as “level 1” (broadly, marked to market) or “level 2” (broadly, marked to broker quote) for valuation purposes, rather than “level 3” (broadly, marked to model). His approach may require intensive legal analysis, but seldom requires litigation to assert or enforce creditor rights. The key domiciles have a reputation for predictability: the US jurisdictions are usually New York or Delaware law. In Europe, they are mainly UK law, though various other legal systems may also govern some legs of trade structures.

Dennis Ruggere, Founder, Cladrius Partners

Mixed covenant capital structures and M&A

Currently, the unprecedented growth of covenant-lite securities (“cov-lite”) is exciting Ruggere: “Cov-lite loans were a record 90% of the $700bn in US leveraged loans issued in 2018 vs just 5% in 2010. As of year-end 2018, they constitute an all-time high of 80%+ of loans outstanding, up from just 12% in 2010,” he points out, citing JP Morgan and S&P Global Market Intelligence data. But cov-lite per se is not a source of standalone trades; rather, the attraction is that cov-lite securities now coexist alongside legacy securities that do have covenants. This results in mixed covenant capital structures that are unprecedented in terms of both size and covenant quality differential. This can be a rich source of investment opportunities.

What makes this all the more compelling is corporate event activities that bring covenants into play. Corporate events can trigger a change of control clause, which may result in some bonds being “made whole” or otherwise compensated while others could be redeemed at – or even below – their current market price, which may well be significantly above par in some cases. “For instance, an M&A deal in 2017 saw an investment grade A rated Japanese company (Komatsu) acquire a high-quality high yield issuer. Some of the target’s bonds contained covenants which had certain provisions we viewed as restrictive for the acquirer post-close. We established a notional neutral convex trade set-up based on fundamental analysis and the differences in covenants between two bonds in the capital structure. The deal was consummated, and after initially providing us with a parent guarantee through a consent solicitation process the acquirer made whole the bonds as the restrictive covenant we identified couldn’t be amended away. The investment made about 30 bond points on the long side, losing only one point on the short side,” he explains. “I take a fundamental view and then look to obtain added convexity by leveraging legal nuances in complex situations. Our definitive philosophy is that 50 cent dollars do exist in the legally complex world.”

Re-financings and liquidity management exercises throw up similar divergences, as they might be permitted by recent cov-lite bonds but could be precluded – or require compensatory payments – by older bonds with stricter covenants. In other situations, some types of paper may go to zero while other issues from the same firm have some recovery value.

Banking regulation

Whereas some more traditional distressed debt investors are presently focused on either idiosyncratic corporate collapses or sectors, such as retail, which exhibit a high incidence of corporate failure, Ruggere is roving across all industries in search of opportunities. The banking industry is a source of specific opportunities, due to regulation that can result in securities becoming mispriced. “Basel III rules have reduced the effective maturity of some $40bn of paper issued by banks. It is sometimes possible to find bonds that are likely to be redeemed or refinanced at par, which could even be paired with a short in other bonds with no maturity date that can become in effect stranded if they have no redemption provision,” he points out.

The best investment of 2017 within the predecessor strategy combined an understanding of covenants with a grasp of local banking regulation. Ruggere effectively constructed a synthetic put at much lower cost than an equity put, which profited from what ultimately proved to be a terminal short. “A Portuguese bank (Banco Popular) had been taken over by the Portuguese Government and we had a strong fundamental view it had to be recapitalised. Our fundamental analysis combined with identifying differences in covenant thresholds for triggering write-downs created a potential pay-off that was massively convex. We were short the AT1 and LT2 securities, close to par, versus long positions in more senior paper and some equity. The short legs of the trade went to zero, generating a big profit. For the first time in my career, the ISIN codes were extinguished by the regulator, so I did not even have to cover the short. We did the fundamental work, reading the documents, identifying the mispriced structural risks and specifically noted that the AT1 bonds were under local, Portuguese law. We efficiently leveraged our fundamental work by distinguishing between the structural and legal differences in the documents,” he explains.

In another investment that hinged on differences between local and foreign law bonds, Ruggere and team took a view on the relative value of government bonds and those of a quasi-sovereign company. Bonds of a state-owned railway company (Hellenic Railways) had a claim against all of the company’s assets and were further underpinned by a sovereign guarantee (from the Greek Government). “As the market was ascribing very little value to the guarantee, it was possible to buy the UK law railway bonds, hedge out the Greek government risk, and in effect isolate the railway company credit risk for free,” he explains.

I take a fundamental view and then look to obtain added convexity by leveraging legal nuances in complex situations.

Dennis Ruggere, Founder, Cladrius Partners

Capital structure transition and special situations

Transitioning capital structures create compelling opportunities for the strategy. In one investment, Ruggere purchased a mandatory convertible preferred in a stressed issuer while concurrently buying put options and front-end jump to default CDS protection. “We were able to create a highly convex payoff, truncating our downside and providing us with a hedged 20% IRR over a 9-month period,” he noted. “These situations combine fundamental understating of the issuers, deep covenant work and capital market analysis. It’s the type of situation we consistently look for.”

In another construct that blended fundamental and legal analysis, Ruggere shorted a beleaguered European consumer goods company, which faced fundamental challenges and was over-levered; having big pension liabilities; facing a government investigation and needing to refinance. That much was clear to everyone else; Ruggere’s edge came from the fact that he also thought the firm’s covenants were misunderstood. He identified provisions in the covenants, which limited the company’s ability to direct cash flow from asset sales limiting its runway to ensure survival.

Evolution of the process

Ruggere has been investing in distressed debt for over 20 years. He started with rigorous legal training and adhered to a very traditional process before developing, honing and refining his own approach. While cross-studying at NYU School of Law under Harvey Miller, one of the most prominent bankruptcy lawyers in the world, was formative – he considers the late Miller to be a mentor. “Harvey’s teaching provided a formal, intensive, academic training in the nuts and bolts of bankruptcy and contract law. He also used case studies to explain the many novel and pioneering things he did over his long 55-year career. We relived his experiences with in-depth, free flowing war stories that would not have been possible in a public forum. The key lesson learned was: do not take anything at face value. There is always a potential to find nuances in drafting due to changes in legal technology, templates and vintages. He taught me to be creative in my approach to investing.” Ruggere also has business and financial training in the form of an MBA from New York University.

His distressed investing career started at Concordia Advisors (now Mariner Investment Group), which launched a distressed fund in the early 2000s. “This was very much traditional distressed investing, following a mostly long-only approach, heavy on legal processes, restructurings, court processes, steering committees, and analysis of covenants. The approach thrived on some of the most complicated capital and corporate structures the market has ever seen to date, such as WorldCom, Adelphia and Enron, and provided a great learning ground,” he recalls.

Ruggere began his style of distressed investing at Fir Tree, which created a mandate to ferret out 50 cent dollars from legally and structurally nuanced opportunities, broadening out the investment universe beyond pure distressed to include all areas of credit, including structured credit, indices and tranches. Fir Tree was also where Ruggere finessed his skills in trade construction, capital structure arbitrage and risk management. He then moved to an investment bank, where he co-founded the UBS Global Event-Driven Opportunities Group, managing teams in New York and London, and pursuing a similar style of management, including a number of trades centred around the European sovereign debt crisis.

Today, the Cladrius process makes use of proprietary screens, which recognise recurring patterns of corporate events that could warrant further research, but the process does not run on autopilot by any means. The screens are adapted to market climates and cycles. The culture of the firm encourages extensive reading of books, spanning classic investment philosophy to market psychology including past investment memorandums, as well as documenting mistakes to learn from them. Most of the legal analysis is done in house, making use of Ruggere’s legal background. He forms an opinion on whether covenants, pledges and provisions are likely to be worth anything, or could be deemed moot or invalid. He uses external counsel selectively to confirm analysis. Ruggere prefers to pick and choose legal expert gurus for each situation rather than employ a large legal team internally on a permanent basis.

“Skillsets are very customised,” he explains. “This month we may be looking at a Delaware corporate situation, and next month it might be a sovereign restructuring in Europe. Gurus need to be in the field to stay at the cutting edge of their area of expertise. We might need them for a few hours and then we move onto the next legal technology.”

Two seeder structure

Cladrius will soon have four investment staff, and Managing Director Eric Gordon, who worked with Ruggere at Dhalion, runs the business side. Cladrius has seed capital from two firms which have both made a long-term commitment but play different roles. These are M.D. Sass and Fir Tree via FTP Investment I LLC, an entity sponsored by senior partners of Fir Tree Partners. M.D. Sass, which was founded in March of 1972 by Martin D Sass, an industry icon, is a tenured boutique asset management firm which has incubated 33 asset managers (both traditional and hedge fund managers) over its 47-year history. This includes Waterfall Asset Management an $8.5bn investment firm, which was sold to Dyal. The firm provides operating capital, seed capital shared offices and shared staff. There are around 15 people who help support Cladrius, including general counsel, CCO, marketing support, and administration. Fir Tree, where Ruggere worked, which has been in business for 25+ years is also a seeder. Cladrius benefits from the infrastructure of a larger hedge fund,  while maintaining a boutique ethos focusing on niche situations.

Ruggere envisages capacity of $1bn for the strategy in the current environment. His focus on bottom-up situations means he does not have strong macro views, but does expect that, “we are now in a pre-distressed cycle. A rescue financing cycle could delay outright defaults. But we do expect more corporate stress and volatility in the markets as companies sell assets, restructure or refinance.” Since defaults are only one of many types of events that he invests in, the outlook is strong as the pre-bankruptcy and pre-distressed event cycle is rich for him. Ruggere’s biggest fear is that if there were no corporate events for an extended period, he would struggle to generate strong returns. But given the broadly market neutral stance, he would not expect big drawdowns under this scenario.