Seth Klarman on Voluntary Liquidations

January 19, 2010 · Leave a Comment

Continuing with our discussion of investments in voluntary liquidations, we now highlight Seth Klarman’s methodology for investing in liquidating businesses. The following paragraphs are taken from Margin of Safety, written by Seth Klarman himself.

Market Inefficiencies: Investing in Corporate Liquidations (Chapter 10)

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders’ investments. Other, more interesting corporate liquidations are motivated by tax considerations, persistent stock market undervaluation, or the desire to escape the grasp of a corporate raider. A company involved in only profitable line of business would typically prefer selling out to liquidating because possible double taxation (at the corporate and shareholder level) would be avoided. A company operating in a diverse line of business, however, might find a liquidation or breakup to be the value maximizing alternative, particularly if the liquidation triggers a loss that results in a tax refund. Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies.

Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or too protracted. Indeed, investing in liquidations is sometimes despairingly referred to as cigar-butt investing, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

Case Study: City Investing Liquidating Trust

In 1984 shareholders of City Investing Company voted to liquidate. The assets of this conglomerate were diverse, and the most valuable subsidiary, Home Insurance Company, was particularly difficult for investors to appraise. Efforts to sell Home Insurance failed, and it was instead spun off to City Investing shareholders. The remaining assets were put into a newly formed entity called City Investing Liquidating Trust, which became a wonderful investment opportunity.

As shown in Table 2, City Investing Liquidating Trust was a hodgepodge of assets. Few investors had the inclination or stamina to evaluate these assets or the willingness to own them for the duration of liquidation likely to take several years. Thus, while the units were ignored by most potential buyers, they sold in high volume at approximately $3, or substantially below underlying value.

The shares of City Investing Liquidating Trust traded initially at depressed levels for a number of additional reasons. Many disgruntled investors quickly dumped the liquidating trust units to move on to other opportunities. Finally, after the Home Insurance spinoff, City Investing Liquidating Trust was delisted from NYSE. Trading initially only in the over-the-counter pink-sheet market, the units had no ticker symbol. Quotes were unobtainable either online or in most newspapers. This prompted further selling while simultaneously discouraging potential buyers.

The underlying value calculation on Table 2 is deliberately conservative. An important component of the eventual liquidating proceeds, and something investors mostly overlooked (a hidden value), was that City’s investment in the stock of Pace Industries Inc. was at the time almost certainly worth more than the historical cost. The apparent value of City Investing Liquidating Trust units was therefore well above the estimated $5.02 in Table 2, making them an attractive bargain.  Moreover, approximately half of City’s value was comprised of liquid assets and marketable securities, further reducing the risk of a decline in value.

By 1991 investors who purchased City Investing Liquidating Trust at inception had received several liquidating distributions with a comprised value of approximately $9 per unit, or three times the 1985 market price, with much of the value received in the early years of the liquidation process.

Tomorrow, we highlight Benjamin Graham’s opinions on voluntary liquidations.

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Categories: Liquidation · News · Special Situations
Tagged: City Investing Liquidating Trust, Liquidation, margin of safety, Market inefficiency, seth klarman, Voluntary Liquidation

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