Corsair Capital — Investing on Change

Winter 2015

Jay Petschek and Steve Major ’94 are the co-portfolio managers of Corsair Capital Management, a value-oriented, event-driven, long/ short equity investment firm with $1.4 billion in assets under management. The firm’s strategy focuses on small to mid-cap companies predominantly in the US and Canada going through strategic and/or structural change with impending catalysts. Corsair Capital Partners, L.P., the firm’s flagship fund, was founded in 1991 and has yielded an annualized net return of 14% since inception.

Graham & Doddsville (G&D): How did you first become interested in investing?

Jay Petschek (JP): My dad was an investment banker and we talked stocks constantly when I was growing up. I’ve also always been good with numbers and liked games and puzzles where you have to guess an outcome based on partial information. Investing is similar, only this “puzzle” is based on financial data. You’re trying to estimate, with only a company’s past financial information, how well it can perform in the future. You have to invest on what isn’t fully appreciated and isn’t fully understood. That’s how you get an edge.

Steve Major ’94 (SM): I worked as an investment banking analyst at Goldman Sachs after college. But I ended up realizing that investment banking wasn’t where my passion was. In those days, there was no internet, so Goldman would distribute on a daily basis printed copies of the firm’s equity research. I found myself really excited every morning to come into work and read equity research reports that were left in my inbox bin — a plastic, rectangular, black, physical tray; not a Microsoft Outlook inbox. Company analysis and stock valuation ignited a spark inside me. After banking, I went to Columbia Business School and took classes on leveraged buyouts, investing, and stock-picking with Bill Comfort, Paul Johnson, and Jim Rodgers. That’s where it all came together.

G&D: Who were some of your earliest influences? Were there any early career experiences that were important to your development as an investor?

JP: My dad was my earliest influence. He always approached the world from a quantitative perspective. He taught us the binary system at a young age and joked that there are 10 types of people in the world — those who understand the binary system and those who don’t. I developed a similar quantitative sharpness as my father, and that has helped me throughout my career. I later attended the Sloan School at MIT to get an MBA in finance and investing. Robert Merton, the famed Nobel Prize winner, one day told our class that he would buy 10% of our future income for $50,000. Of course, we were all students trying to figure out how we’d pay for dinner that night, so to hear that we’re worth half a million dollars was sort of a novel concept. That day we learned that you’re not worth what your bank account says you’re worth, you’re worth your future earnings potential. Another professor I had was Fischer Black. He taught us about his options model, but the real takeaway for me was the importance of change. Future volatility can be very different than past volatility, especially when an unexpected event occurs. If you just used historical volatility, you would get the wrong value of an option. He helped us understand the potential valuation discrepancies and investment opportunities that can arise when change has occurred.

SM: While I was at Columbia, I worked as a summer intern at Millennium and fell in love with spin-offs, value investing, and situations with companies going through change and transition. I ended up at Oppenheimer where I wrote research on post-reorg equities. But my good fortune really started when I met Jay in 1996 at Ladenburg Thalmann. Who would have known that Jay and I would quickly become investing soul mates and close friends. We shared a common philosophy and approach to valuing spin-offs, companies coming out of bankruptcy, multi-divisional companies, and companies with a change in corporate activity. At the age of 28, I was given the incredible opportunity to manage money on my own, and that was unusual. Jay and I became partners over time and the rest is history.

G&D: How have those experiences shaped Corsair’s approach to investing?

JP: Corsair has a philosophy of long-term investing in good businesses at discounted valuations. Good businesses will increase in value over time. Time is working for you. This is what has allowed us to act as real investors — our average holding period for a core position is two years and almost all of our gains since 1991 have been long-term in nature and tax efficient for our investors. Likewise, we want to short bad businesses when they’re fully priced because their values degrade over time. It’s a very simple concept: own good businesses at really good prices and sell bad businesses at full prices. What’s a really good business to us? A business with recurring revenue, a good moat, high returns on invested capital, and a management team that is focused on working for the shareholder.

We believe you can find opportunities when these companies are going through change and transition. When a company goes through a major acquisition, spin-off, privatization, new product introduction, new regulation, post-bankruptcy, new management, or a recapitalization of the balance sheet, future results could be much better than past results. The opportunity presents itself when the market does not recognize this inflection point of change and/or does not reflect that future financials will be materially better or worse as a result of this transition.

G&D: What else are you typically looking for?

JP: We also want a signal from the management team that they care about their stock price and believe their business is undervalued. We look for insider buying, companies initiating or increasing a dividend, stock buybacks, and new employment agreements with a heavy emphasis on stock compensation. Those are a few of the things that signal that management believes in the business and will, at least going forward, care about their stock price. When we see those factors intersect – a company with a really good business going through change, with an undervalued stock price, and signals by management that they care about their stock price – we look for an opportunity to invest. On the short side, we look for the opposite signals – bad businesses where management seems interested in getting out.

G&D: Has that been the philosophy since day one, or are there parts of it that have evolved over the last 20+ years?

That's always been the underlying philosophy. The guiding principles we laid out in our January 1991 initial letter have remained consistent. One, increase our capital at a rate comfortably ahead of inflation and the effect of taxes. Two, take prudent risks while maintaining a diversified portfolio. And three, good investment ideas are hard to find and deserve the time to work out. I will say that, while not in our original guiding principles, a management team we are comfortable being partners with has proven to be critical.

We also like to try to keep in mind that it’s not where the stock has been, it’s where the stock is going. One of the early examples of this for me was Cott Corporation (COTT) in the early 1990’s. Considering purchasing the stock at $18 per share was psychologically difficult as it had risen from a price of $3 in less than a year. But over the next two years, the stock went to around $350 when adjusted for stock splits. We emphasize that even though the initial human reaction is to feel like you’ve already missed out on a big move, the key is where we think the stock is going from here.

G&D: In working together, how is your decision process structured? For example, what would you do if there's any disagreement on an investment?

SM: We have a very strong discipline in place at the firm. It’s not about Jay. It’s not about me. It’s about the Corsair philosophy and methodology, rooted in three principles: finding a good business with strong cash flows, a solid balance sheet, and a winning management team with a proven track record of creating shareholder value. We may disagree around the edges on relative quality or on how big a position should be, but it’s rare that we disagree on whether a particular stock should be in the portfolio. To help our process we use a rating model to evaluate and standardize the potential quality of an idea. Our Corsair Rating Model uses a combination of 1) our probability-adjusted expected return and 2) a quantitative score to reflect qualitative factors. As far as modeling is concerned, we want to determine what we think the company is worth today, what it could be worth on the upside if management executes its business plan, and what the downside could be if the company stumbles. On the qualitative side, we focus on four questions: How good is the business overall? How is the balance sheet? Is it a good management team? What is our conviction level? The overall goal in using the Corsair Rating Model is to score how good the risk/ reward is for an individual stock. When a company hits our screen — because it’s executing an acquisition, spinoff, restructuring, or any other corporate action — we typically outline why this company looks different through our lens versus the market’s lens (i.e., what is the market missing?).

If the company passes our quality test and we think it is materially undervalued, we take our research to the next level and try to meet with or speak to management to gain more conviction. In the end, it’s a question of whether a stock has low risk and really good reward.

G&D: What was the original impetus for starting Corsair?

JP: After working in the corporate finance department of Bankers Trust following business school, I realized that I wanted to do something more directly stock related and I had an opportunity to join Ladenburg Thalmann & Co, which was a small investment banking firm akin to a smaller-sized Bear Stearns back then. You could do a little bit of everything there, so I learned everything from being a retail stock broker to corporate finance, and I ended up running their investment management and research departments.

In 1988, I joined a group with some friends to buy a 24.9% position in a company called Tri-State Motor Transit of Delaware, a specialty trucking company which we thought was highly undervalued. Tri- State owned a lot of real estate that we thought was valuable, and management was doing nothing to optimize the business. We actually formed a hostile bid and ended up losing a very close proxy contest.

Ultimately, because we were still pressuring the management team, they sold themselves in a leveraged buyout. We made a great return but I realized that I didn’t like hostile investing. I decided to form Corsair Capital Partners in January 1991 while still at Ladenburg with money from friends and family. The idea was that we wouldn’t put all our eggs in one basket like the Tri-State Motor deal — we’d spread them around. It would be the same core philosophy of looking for a company that was undervalued and was going through a transition, but I also wanted management teams that would work for me instead of against me. So it started with this one-off situation, but we’ve been fortunate to grow it over the last 24 years.

G&D: Would you be willing to walk us through an example of your investment process?

JP: The Shaw Group (SHAW) is a good example. While covering one sub-contractor working on the clean-up of the BP oil spill, we came across Shaw, a company that had a $2 billion market cap and more than $1 billion unencumbered cash on the balance sheet that was the lead contractor on that project. It had a nuclear power plant maintenance business and was building two new nuclear reactors in the U.S., so the Fukushima plant disaster in Japan had been weighing on the stock in 2011.

There was a reason why we saw it and others didn’t. It screened terribly on Bloomberg due to complicated financials and investors were afraid of owning anything nuclear related but there were several misconceptions we could identify. Bears argued that the Fukushima disaster would slow the development of nuclear power globally.

Instead, we saw a plant maintenance business, with 50% market share in the U.S., which would stand to benefit from potentially tighter industry regulation. Investors also seemed to be worried that Shaw was taking write- downs on two construction projects which were nearing completion. Our approach focused on pro forma earnings once those two bad projects rolled off.

Another misunderstanding about the company related to its balance sheet. Due to a JV with Toshiba in a nuclear technology company, Shaw had to consolidate $1.6 billion of debt on its balance sheet. This debt, however, was non- recourse and the entire investment could be put back to Toshiba at Shaw’s request. So when you adjusted for that noise, the company actually had over $1 billion in unencumbered cash and no debt. Then there still was the question of management. As we did our digging, we saw that the CEO, Jim Bernhard, had started Shaw as a small fabrication business in 1986 and grew it into a diversified Engineering & Construction company with $6 billion in revenue. He seemed like a guy who did an amazing job in building a business.

Furthermore, Shaw’s management put their money where their mouth was, buying back $500 million of stock in the aftermath of the tsunami and announcing another $500 million program later in 2011 as the stock slumped. They clearly believed in the value of the business. The stock traded for $25 per share, and, for the next year or so, despite several positive developments, the stock faded down to as low as $20. We only saw the company announce good news over this time and still the stock traded lower.

G&D: Did you add to your position?

JP: Our conviction allowed us to average down. You better know your stocks well to avoid getting shaken out. We do not have an automatic stop- loss rule. A lot of firms do. If your thesis is intact, we think that’s actually an opportunity to average down. I think if you’re a trading oriented firm, it probably does make sense to cover and move on. Everyone has to be true to their own discipline. It is not fun to average down, unless it ultimately works out. Fortunately for us, we woke up in late July 2012 and Chicago Bridge & Iron (CBI) made a bid for the company at a very nice premium.

G&D: What have you learned over time about identifying good management teams?

JP: A proven record of success is critical. If someone’s been successful before, that’s a very good indicator of a management team you want to partner with the next time.

And there are two reasons for that. One, he’s successful, and, two, the shareholders did well. We love to find managers like Jim Reid-Anderson of Six Flags (SIX), who was very successful in turning around Dade Behring. When he came out of retirement to take over Six Flags, we immediately wanted to hear why. He laid out plans as to what he thought was achievable. Given his past accomplishments and reasonable plan, we invested as Six Flags was coming out of bankruptcy and did very well. A proven track record at the CEO level means a lot to us.

G&D: Do you always meet with CEOs or are there cases where the track-record alone is enough?

JP: In almost all cases, we’ve met with, or at least spoken to, management before making an investment a core position. We can read transcripts and take a small initial position, what we call a “farm team” position. However, in order to establish a name as a core holding, we want to speak to management.

In the case of a John Malone and Greg Maffei type of management team, we know the track record they’ve put together and can read the transcripts. Their success is already well-known and they typically outline their thinking, so we might not need to have the one-on-one to hear it. But for the overwhelming majority of our portfolio, we meet with and try to get to know management well.

G&D: One of the key tenets of the Corsair philosophy is clearly management and shareholder alignment. Are there other situations you could discuss that highlight your focus on good stewards of capital?

SM: You always have to look at the empirical data and fundamentals of a business to increase the probability of being right. But we also ask ourselves: what has this CEO done in the past? Is he personally buying stock in the open market? What is he doing with the cash? Has he created value and sold a business or is he just an empire builder who doesn’t care about shareholders very much?

That’s all important.

With Clearwater Paper (CLW), which was spun off a few years ago, we liked the private label tissue business and the stock was cheap, but management was investing in what appeared to be very low ROI projects and M&A. So we passed. However, we came back to it because our screens showed a new CEO and CFO had joined. We took another look at the company and identified change. We saw a new slide in their investor presentation about how undervalued the stock was. It seemed like some sort of new religion might be taking hold. At that point, you had new capacity ramping up, excess legacy costs being stripped out, and EBITDA rising — it looked like an inflection point in earnings power. Then we saw the company add two new board members, including Kevin Hunt, who was the CEO of Ralcorp (RAH) and a protégé of Bill Stiritz, one of the great value creators of our day. Now we’re thinking this could potentially lead to another catalyst. Two weeks later CLW announced an accelerated share repurchase program. Since then, in about two years, CLW has bought back more than 20% of the company on a market cap basis. CLW is a perfect example of a business we always liked but couldn’t get involved with under previous management. Once we spoke to the new CEO and CFO, we gained conviction that value would be created.

Another example of this is Orora (ORA AU), a classic spin-off from a much larger company in Australia called Amcor (AMC AU). Orora was one tenth the size of Amcor and shareholders wanted to own the big packaging conglomerate, not the much smaller Orora. When we approached the stock, it had just spun off with a market cap of approximately $1.4 billion, yet there was no U.S. analyst coverage and large shareholders in Australia were punting it. We saw a company that was number one or two in its markets, with stable cash flow, a manageable balance sheet, and a management team with a track record of creating shareholder value. Orora CEO Nigel Garrard arrived to Amcor in 2009 after being CEO of another publicly traded company in Australia which he sold to a strategic buyer. Garrard tripled the value of the company in his four years as CEO — he is a winner.

We saw other signals, too. There was a big cost cutting program that we thought would change the earnings complexion as a standalone company. And we saw insider buying of the stock in the open market immediately following the spinoff. The CEO bought over $1 million worth of stock and another director was also buying stock. Besides trading at single-digit multiple of pro forma free cash flow and with a management team that wants to create shareholder value, they’re paying out 70% of their earnings in dividends. We think they understand capital allocation and will do the right thing. When you think of the premise of spin-offs, it’s the creation of value — that’s why we look at spin-offs. And ORA is another prime example of management having a history of creating value with a credible plan to unlock more in the future.

Investing can be a humbling business, and it’s important to have the insight that you’re going to make mistakes. Fortunately, over our 24 years, we’ve had many more ORA’s and CLW’s than we’ve had material negative performers. Choosing great management teams is a key ingredient to hitting at a high batting average.

G&D: Building on your investment framework, are there ways that you think you’ve really differentiated your process or sourcing methodology versus other special situations investors?

SM: There are a lot of people looking at the companies that we’re evaluating, but it’s a question of how you look at something. More competition actually might even help us by potentially creating more dislocation. Nobody has the same lens. Everybody has his or her own biases and ways of looking at data. Maybe everybody has the same screens, but it’s really the lens, the philosophy and the ability to see something that the market doesn’t see.

The “Corsair Lens” allows us to focus on what we think is important when the market is focused on other factors. The “Corsair Lens” picks up on signals that others might not appreciate. We understand what the market sees, but we’re able to look past it. I’m thinking of Republic Airways (RJET) as an example. The stock’s been in the $13-$14 range, and the market sees a management team that previously made a bad acquisition in Frontier Airlines, a potential pilot shortage, and the recent struggles of competitors in the industry.

We see a management team that restructured Frontier Airlines to profitability and sold it from a position of strength to Indigo Partners. What remains is the core business — a fixed fee operator of short flights for United Airlines, American Airlines, and Delta, that has been in business for 40 years and has never had a quarterly loss.

After purchasing Frontier in 2009, RJET posted losses from the rising price of oil and the market underappreciated the steady, profitable fixed-fee operation. All you had to do was get rid of Frontier and refocus on the fixed fee business, with its long term contracts and stable cash flow.

Today, the market sees a leveraged balance sheet from debt associated with the jets. We actually see unrestricted cash of approximately $4 per share on a $13-$14 stock with a business that will generate more than $2.50 per share of cash earnings in 2015. With the new business that they’ll be taking on over the next couple of years for United Airlines and the business they’ve been ramping for American Airlines more recently, you can get to over $3.50 per share of cash earnings in 2017. Put a 10x multiple on that and you can have a $35 stock. The market just doesn’t see it yet because it is focused on RJET’s labor situation with its pilots. We have watched management execute very well for three years and are confident they will reach a deal with the newly elected union leadership over the next 6–12 months.

CEO Bryan Bedford is also an innovator, thinking several steps ahead of the competition. We expect him to creatively separate RJET’s profitable large jet business from its breakeven small jets business (50 seats or less). These two overhangs should be lifted over the next year and the market will then be able to focus on $3.50 per share in pro forma cash earnings power. RJET stock has done notably well since being a $5 stock in 2011, but we believe it is a better buy today as earnings are quickly ramping and management has proven its ability to execute. We’re looking for these types of low risk opportunities, where our lens can detect asymmetric risk/reward.

G&D: A key challenge of investing is getting the timing right. With Republic, you outlined a few catalysts. What is your level of patience if these catalysts don’t turn out?

SM: We need catalysts because we need to make money for our investors every year. But we also need to have patience across a portfolio of ideas with catalysts. Some will happen earlier than we think, others later. Sometimes the market is very stubborn and that is why discipline is so important. It’s also why our Corsair Rating Model is so valuable. As much as we love a business or a management team, it’s important to be disciplined and ask: do we want to own it here? Perhaps we really love it 10%-20% lower, so we should be patient. Entry price is crucial. RJET is a good example of entry points, patience, and the need for margin of safety. We entered the stock in 2011, when the sell-side was focused on losses at Frontier and could neither recognize the value of the fixed-fee segment nor what we thought was a great fundamental environment for the company, as peers consolidated through mergers and bankruptcies. We had conviction and enough margin of safety to be patient and ride out a bumpy road — it paid off. As management executed, earnings power tripled and the stock reacted positively. We believe it’s a better buy today than it was three years ago.

G&D: How does Corsair compare potential opportunities and think about sizing?

JP: From a portfolio construction point of view, we balance four factors into position size. One is risk versus reward. Two is risk by itself. Three is correlation with other names in the portfolio. Four is liquidity in the name.

The riskier the name, the less we will invest overall. Again, these are qualitative judgments, but if the company is highly leveraged and it is not very liquid, obviously you can lose a lot even if you only assume small changes to the value of the company. Good management, good balance sheet, and good business model — these allow you to take bigger positions.

Typically, we hold roughly 25 core positions in our portfolio. Through this diversification with very manageable position sizes and no leverage, we believe our investors are protected. Basically, the margin of safety we look for in every stock we invest in is the same margin of safety all of our investors have with their investment in Corsair. In fact, we’re actually able to buy stocks when other funds are being forced to unwind or de- lever positions. With many hedge funds, even though they might be hedged or have low net exposures, the problem is that their gross exposures are quite high. They’re certainly over 100%, and that’s what forces them in difficult situations to retreat and bring it down.

G&D: Do you also take into account concentration by strategy type when looking at new investments? For instance, would you care if all the positions in the portfolio were spin-offs or bankruptcies?

JP: We don’t worry about where the idea came from, so to speak. We do care about what business they’re in. If it happens that we have three, five, or ten ideas that were post-bankruptcy, or were spin- offs, or privatizations, that’s okay — we really care more about whether or not the underlying businesses are correlated.

G&D: Some of these investments you’ve discussed have a macro component to them. How much does the macro picture influence your thought process and ideas over time?

JP: We’re definitely bottom-up stock pickers. Ideas, as we said, come through change and management signaling.

Having said that, we’re cognizant of what’s going on in the world, and we react to macro events as opposed to projecting them. If there is a change in the world, for example natural gas plummets from $10/Mcf to $2, we’re going to look at whom that helps and whom that hurts. We won’t make the investment bet that natural gas is going to go from $10 to $2, but once it’s happened, one could argue the world has changed and, if the forward curve says gas stays at $2 for many years, a company like LyondellBasell (LYB) may really benefit.

G&D: Part of the reason we ask is that we had noticed your investor letters often start with a discussion of the macro.

JP: Our letters include some macro thoughts just because that’s how we started doing it historically in order to give our investors — mostly friends and family — a sense of the macro environment. In the beginning, we gave very little information on the names we owned and didn’t give out performance numbers monthly. Over time, we grew, and different investors have different requirements. Now we have monthly reporting.

But investors also want to get a flavor of what you really own and hear more about the thesis. That’s both good and bad. It definitely helps them understand the type of ideas we invest in. It also shows that Corsair doesn’t own the market, but that we have some idiosyncratic names. The downside is that it focuses investors on those names day- to-day or week-to-week, and that shorter-term thinking is not real investing. We are in it for the long-term.

G&D: Before we end, do you have any final words of advice for our readers?

JP: There is a tremendous amount of luck in this business, being in the right place and at the right time. Having said that, it is definitely a case of the harder you work, the luckier you get. It’s not an original thought, but I truly believe that. You make your own luck.

SM: Tommy Lasorda said, “The difference between the impossible and possible lies in a man’s determination.” You have to work hard and have lots of grit. You also have to make good judgment calls and use your common sense. This was instilled in me by my parents, who, as Holocaust survivors, immigrated to this country in 1956 without any money or any knowledge of the English language. To me, it’s not about how smart you are — it’s really what choices and judgment calls you’re making. As J.K. Rowling wrote, “It is our choices, Harry, that show what we truly are… far more than our abilities.” But you also have to be aggressive when you are presented with an opportunity. Think out of the box, have conviction in your views, have the confidence to take risk and take ownership of your decisions — own it. Taking risk is the only way to getting lots of reward. As a mentor of mine loves to point out, not taking risk is actually taking lots of risk. But, always understand your downside before you focus on your upside.Remember, upside is seductive. There is no such thing as a free lunch. By sticking to your knitting, staying disciplined, taking prudent risk and not using leverage, you can position yourself to make investment decisions based on good judgment. At the end of the day, good judgment plus working hard is a winning formula.

G&D: Thanks to you both for taking the time to talk with us.