Serone Capital Management LLP Head of Special Situations, Ralph Herrgott, has been consistently applying his investment principles and process since 2004, investing through four major credit cycles: the aftermath of the TMT bubble, the GFC, the European sovereign debt crisis, and launching Serone European Special Situations (ESS) in March 2020 amid the Covid pandemic.
Herrgott started his career at Morgan Stanley and spent seven years doing investment banking and restructuring advisory work at various firms. In 2004 Herrgott started his buyside career as a senior analyst (European distressed team) in JP Morgan’s Proprietary Positioning Business which was run by Patrick Edsparr (who featured in the 2019 edition of Tomorrow’s Titans).
In 2008, Herrgott together with JP Morgan’s distressed team spun out into Sothic Capital Management. At Sothic, Herrgott was the largest profit contributor of the firm and has a personal trade-level track record between 2008 and 2016 annualising at 19.2%. His trades were profitable in seven years out of eight and produced an impressive win:loss ratio: 27 winning trades made €181 million while 16 losing trades collectively lost just €12 million. The strategy is reasonably concentrated, but Herrgott only hit the 15% position size limit once at Sothic when equity attached to a bond kept appreciating. Sothic formally returned capital in September 2016, but Herrgott oversaw a large part of the tail end liquidation until 2018, which was also profitable.
Serone are becoming leading investors in the complex, under-followed and under-researched niche markets of European corporate credit special situations.
Ralph Herrgott, Portfolio Manager, Serone European Special Situations
Shortly after leaving Sothic, he joined Serone in late 2018 to lay the foundations for ESS, which complements Serone’s top-notch ten-year track record in structured credit via flagship Serone Key Opportunities Fund (SKOF). “With ESS, Serone are becoming leading investors in the complex, under-followed and under-researched niche markets of European corporate credit special situations,” says Herrgott. ESS trades single name European corporates with hard event catalysts such as defaults, bond tenders, refinancing, restructuring, M&A, spin-offs, or equity issuance, typically envisaged within 12 months. Herrgott generates ideas primarily from credit but can invest across the capital structure and some trades will have a capital structure arbitrage flavour with legs in different instruments from the same issuer. Senior, subordinated, first lien, and second lien paper can be owned, as can post-reorganisation equity.
Amongst many synergies between ESS and SKOF, the most valuable is perhaps the technical intelligence emanating from Serone’s structured credit business. “When I started talking to Serone founder and CEO, Neil Servis, I realized the mutual synergies of working side by side with the structured credit investment team. They would get our internal credit views on more complex CLO assets, and we would have a sense of what is sitting in CCC buckets of CLOs and what might trigger sales. Having a clearer idea of supply lets us optimize entry points. The CLO watchlist has generated ideas as well as sourcing advantages for the special situations strategy,” says Herrgott. “Our structured debt colleagues can also provide valuable insights into businesses, for example fee development for debt service providers, which can be relevant if we buy bonds of debt collectors or servicers. We have only just started scratching the surface of the synergies, which are unusual in a firm of our size.” Serone runs about $1 billion in total.
The European high yield market has grown enormously over Herrgott’s career, to more than €750 billion and the European stressed debt space is now worth about €50 billion but yields on much of this are far too low to be long candidates for ESS: “The first quantitative screen is simply for yields to maturity over 9%,” says Herrgott. “We also stay away from the largest “distressed index trades” that are dominated by big US funds where we cannot influence outcomes. We focus on mid cap structures between $100 million and $1 billion”. There is still plenty of choice for a strategy that might have 20 or 30 positions: “As of April 2021 ESS is tracking about 200 individual issuers in the long universe and another 230 in the short universe”.
The ESS watchlist offer yields, and expected total returns, many times more than more plain vanilla paper, for various reasons. The simplest inefficiency is many credit ratings-driven investors cannot buy the unrated paper that makes up about 30% of ESS’ universe.
“Busted convertibles” can become somewhat orphaned since many convertible investors are equity investors who do not have an appetite for instruments with little or no equity sensitivity. “Once convertibles become a credit story, they no longer have a natural investor base. We have long relationships with CB desks, and we look at every busted convert,” says Herrgott.
Firms with a history of restructuring, or that operate in cyclical industries, can also be acquired at quite pessimistic prices – and mis-pricings have been identified through high frequency and alternative data. This alerted Serone to improving revenue trends at a Dutch DIY retailer well above what was discounted by market pricing. “We are actively building out the high frequency data and investing in technology to automate it up to a point, because high yield research in Europe is too model oriented. Piotr Ossowicz, who leads ESS’ research team, has experience of analysing alternative business data from his time at Boston Consulting Group. Alternative data could also become useful for our short book,” says Herrgott.
ESS has a wider opportunity set than some funds because it does not rule out any countries or sectors. “The strategy is opportunistic in selecting from all sectors and countries in the European Economic Area. Our research analysts are generalists,” says Herrgott, whose degree program in the 1990s involved a year in each of Berlin, Oxford and Paris. He retains a pan-European perspective. Whereas many credit managers avoid Southern Europe because it is less creditor friendly than Northern Europe, France and Spain are his largest two country weights in March 2021 and he has exposure to one Greek situation. “Differences between legal systems and levels of disclosure within Europe are a source of inefficiency to be taken advantage of. We take jurisdictions into account in pricing and expect a higher discount in creditor unfriendly jurisdictions. If it is difficult to see a consensual restructuring, we may even find a short.”
Herrgott expects that the strategy will generate average annual returns of 12-15% through a full cycle, with a good year normally above 20% and a bad year perhaps 5-8%. In its first year, between March 2020 and March 2021, ESS has actually annualised more than 40%. Extraordinary opportunities in 2020 have allowed for higher portfolio turnover than normal. The fund realised some 43% of its gains in 2020 implying annualized turnover above 200%.
“In the pandemic many senior secured issues moved towards restructurings. We would normally expect turnover of 100% to 150% per year,” points out Herrgott. The 90% of returns that came from capital gains in 2020 is also higher than usual: “While the majority of returns would normally come from capital gains, a more typical year might see 15-20% of returns from clipping coupons”.
The strategy combines “core” positions, generally in stressed senior paper that may pull to par, with an anticipated IRR of 10-15% and “upside” positions, often in distressed names or special situations such as post-reorganisation equity with more optionality, targeting as much as 15-30%. In 2020 however, even some “core” situations have surpassed the “upside” return target.
“We cannot annualize at 40% indefinitely, and there has been some repricing, but nonetheless we see a strong opportunity set,” says Herrgott. Higher defaults are one driver: “We expect default ratios could for at least 24 to 36 months normalize at much higher levels than the very depressed levels seen in 2017, 2018, and 2019. A default rate of 3% to 4% is more normal for European high yield, based on a 20-year view. But whether default rates are 2% or 4% we will have plenty of opportunities. The key corporate events in early 2021 are debt re-financings, including bond issues, exchange offers, and restructurings. For instance, companies extending maturities may need to offer a higher coupon. M&A can provide optionality in some cases, but it is less predictable”.
The strategy will adapt and evolve according to the opportunity set. In 2020 Herrgott has been tactically cautious on the short side, fearing equity short squeezes and noting the buoyant new issue market for bonds. Much of his short exposure was legs of event hedged trades: “Equity shorts ahead of restructurings were collapsed into long exposure obtained through debt for equity swaps. We only do these trades if we are confident in a full debt for equity swap, and if we can find stable stock borrow. Our prime brokers have good access to an illiquid stock borrow pool,” explains Herrgott.
In early 2021 the pure short book is still quite small but that could change. “Some firms in competitive sectors were over-levered and had pressured business models even before Covid. It is still uncertain what the secondary effects of the pandemic may be on them, particularly once government support is withdrawn. These businesses got an extraordinary and temporary boost from government support but the competitive landscape has not really changed, and the question remains whether their capital structures, with bonds at or above par and low coupons, are sustainable. Government loan support and loan guarantee schemes have been adding artificial liquidity and layering on leverage, but once they are withdrawn, we would expect a larger short book,” says Herrgott.
Quantitative screens on the short side look for profits warnings, red flags, high debt to EBITDA ratios, EBITDA adjustments, a high short interest in equity, and use the Beneish M-Score accounting score, which aims to identify manipulated earnings. “We generally want to see aggressive accounting and at least one more risk factor. A typical short could be trading at or above par, unsecured or junior in the capital structure, and paying a low coupon,” says Herrgott.
Up to 1% or 1.5% per year could also be spent on tail risk hedges in future. “We have been spending much less than that recently, because having more idiosyncratic events in the book in itself protects us against market drawdowns,” says Herrgott.
The strategy may also evolve as assets grow. Herrgott has sat on creditor and restructuring committees in most European jurisdictions before and envisages doing so again: “Positions on a restructuring committee can create incremental value when we can help to shape the deal, build relationships with management, and encourage brokers to provide research coverage, especially post restructuring. At Sothic, I headed the restructuring of Concordia Bus/Nobina AB, the largest bus operator in the Nordics. We did a partial debt for equity swap, appointed one board member, ran the nominations committee and listed the business in an IPO. Though we were never the majority owner, we drove the restructuring and the value creation following it,” says Herrgott. Liquidity remains important however: “We generally would not want to be restricted from trading for an extended period, and creditor committees can avoid restrictions by releasing MNPI,” he adds.
The strategy received day one capital from investors including a large US endowment and a large single-family office and has attracted inflows every month. It currently manages $120 million. Herrgott estimates capacity of at least $500 million and is also constructive on the broader corporate outlook for Serone.