The CIT deal became one of last year's highest-profile hedge fund trades, but Klarman was way ahead of the crowd. He began to buy distressed credits, especially in the reeling financial sector, during spring 2008, and thought the senior debt of the shaky middle-market lender, looked especially attractive. After all, he remembered that he'd made a successful investment 10 years earlier in another diversified loan company, Finova Group. So Klarman's team scooped up CIT's bonds, which were yielding 12% to 14%, for 65 cents to 75 cents on the dollar.
"It had some loan problems, decent quality assets and an equity cushion that would need to be burned through before the bondholders would be impaired, which made for an attractive risk-return," says Klarman, recalling his initial thinking on the CIT trade on a recent morning in early April at his office on St. James Ave., just a few blocks from Boston Common.
During 2008 the bonds fell to the low 40s, and Baupost bought more all the way down. But by July 2009, CIT was in such poor shape that Baupost and five other hedge funds ended up lending it an additional $3 billion. To help buy some time, the facility was expanded by an additional $4.5 billion.
Klarman says he was confident the deal would offer him a comfortable margin of safety. A first-lien loan, the debt was collateralized by assets worth four times more than the face amount of the debt, and in exchange Baupost got a fat 12% yield. "We don't usually lend money at par," concedes Klarman, who for a short period agreed to sit on an unofficial steering committee of CIT's creditors before it went into bankruptcy. "But how often do you make a loan that is exceptionally safe and you get to make 12%?" Nor did the prospect of bankruptcy worry him. If it were to occur, Baupost calculated that the assets would recover at least 80 cents on the dollar to the unsecured bondholders.
In late October, as CIT seemed headed for a prepackaged bankruptcy, the deal looked so good to Icahn, who claimed to own $2 billion in CIT bonds, that he opposed it. Icahn called it a sweetheart deal for the large bondholders like Baupost and the other five hedge funds and countered with a $6 billion loan for CIT.
But a week later Icahn backed down, paving the way for CIT to enter into a prepackaged bankruptcy from which it emerged in just 38 days. And Klarman's analysis turned out to be spot-on: Baupost wound up receiving a package of securities with a market value of about 80 cents on the dollar for its CIT debt.
Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn't make that timely payment, an investor can take action. "Catalysts can reduce your dependence on the level of the market or action of the market," he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.