ECF Value Fund

Author: Eric Uhlfelder

20 May 2011, Barrons

Having just landed in the 18th spot of Barron’s top 100 Hedge Fund Survey, the ECF Value Fund may be the most accomplished hedge fund you’ve never heard of.

That may be no surprise, considering it’s run by Midwesterners [operating out of a midtown Manhattan skyscraper] who are clearly more interested in performance than press. In fact, they’ve avoided media until this interview, figuring that after delivering average annualized gains of 17.5% since the fund started 15 years ago, it was time to mark the anniversary.

Founding partner and portfolio manager Jeff Gates, who set up the event driven fund in 1996, has a penchant for digging into numbers and finding value.

When he was just a teenager living in Derby Kansas, years before he first came to New York to research high-yield credits at several brokerages, Gates precociously convinced local townships to allow him to run a series of food concessions. He had done very well, except in one venue where sales and profits didn’t add up. He soon discovered a particular employee was skimming profits.

Whether it’s a hotdog stand or a global supplier of drilling products, Gates, who’s now 48, has proven he can find value that others miss.

A key to Gates’ success is his focus. His research team of 9—including partners Dax Vlassis, 40, director of event-driven research and Justin Boisseau, 37, who’s in charge of equity research–draw a firm line around the kind of businesses they will invest in. “Financials are off the table,” explains Vlassis, “because banks and insurance companies can have opaque balance sheets.”

The group avoids technology and bio-tech firms because of fates tied to short product cycles. And it generally doesn’t invest in “buried” resources, such as oil and gas companies because it finds their intrinsic value hard to determine.

Instead, the $814 million fund looks at nuts and bolts types of businesses. The reason, explains Gates, is that “we want to be able to understand cash flow and how it affects various securities across the capital structure, especially when a firm has been smacked by a disruptive event.”

Take Providence, RI-based Nortek [OTC: NTKS], a leading manufacturer of residential and commercial building products. Its interests were hit hard by the recession as well as by dislocation in the credit markets. Gates, who had followed the firm since 1992, took note of it again in September 2008 when there were serious doubts surrounding the company’s ability to make a large principle payment due in March 2010. Gates’ team determined that the company would likely survive due to retained intrinsic value.

In February 2009, the fund started building a significant position in 10% senior secured notes selling around 42 cents on the dollar. Two months later, it added smaller exposure to 8.5% senior subordinated notes that were selling below 20 cents.

In June Nortek hired Blackstone to help it restructure through a pre-packaged bankruptcy, from which it emerged in December 2009.

In the process, the security was converted into new 11% notes that were called last month at 105. Conversion also gave Gates an equity stake, which has increased from $33 to $42, boosting combined return to date above 200%.

Restructuring sent the senior subordinated debt rising to 72 before it was converted into stock, eventually quadrupling the value of this investment.

Looking out the next 12 months, Gates believes that Nortek shares will likely be a leading contributor to the fund’s returns.

Gates executed a similar play investing in Flotek Industries [NYSE: FTK], the Houston-based supplier of chemicals and pumping systems for natural gas and oil drilling.

The company got into trouble when it made an ill-advised purchase of tool rental business Teledrift in February 2008 near the peak of the market, then accounting for more than 40% of the firm’s revenue. The acquisition was funded with a $115 million convertible note with a 5.25% coupon. But when the economy slowed, rental revenue and profitability plummeted.

“During the recession, the market was focused on the problems of the tool rental division,” recalls Gates. In April 2009, he started buying the convertibles around 30 cents, eventually acquiring one-third of the issue. Gates felt the market was drastically undervaluing the chemical and pumping businesses, which alone he believed were worth more than his position.

Then in February 2010, Wells Fargo, the holder of $32 million in bank debt, threatened to drag the company into bankruptcy. But Gates saw an opportunity.

He teamed up with another hedge fund to replace the bank facility with a $40 million secured loan paying 12.5%. In the process, a portion of the fund’s unsecured convertibles were exchanged into a new second lien note senior to existing convertibles. And for his efforts, Gates received 10% of the company’s stock at a value of $1.27 a share.

Bankruptcy was avoided. New management has been cutting costs and benefitting from growing global demand for its chemicals and tools. And in mid May, the stock was trading around $8.

Proving threat of bankruptcy isn’t essential for finding value, Gates is keen on little-known Copart [Nasdaq: CPRT], an on-line reseller of vehicles that insurance companies don’t want to repair. “Last year,” says Gates, “3.5 million cars in the US were salvaged, and the number is increasing as cars become more sophisticated, packed with technology that’s sometimes uneconomical to repair after accidents.”

Additional pros: Copart has a nationwide exclusive arrangement with AllState–the first ever realized by a reseller. The US industry is consolidating, with Copart controlling 37%, suggesting increasing pricing power. The firm recently bought back 15% of its shares. And the company is exporting its strategy, having acquired Britain’s Universal Salvage in 2007.

The fund started buying shares in May 2009 at around $30. Copart is currently trading at $45, and Gates thinks there is more growth to come domestically and abroad.

One place Gates has stumbled, ironically, is in a casino. When Delaware-based Dover Downs Gaming & Entertainment [NYSE: DDE] was spunoff from its parent company in 2002, Gates got into the stock in the single-digits and sold as shares peaked near 20 in 2006.

In 2007, investors started selling as neighboring Maryland gave approval for casino development. Gates thought such fears were overblown. “Dover Downs is a superior casino and hotel complex,” he says, “and we didn’t think development across the state line would materially affect turnover.”

Purchasing shares in the low-teens proved expensive as the economy started to slow and the recession came, sticking it to the stock by reducing visitors and hitting the state’s finances. Lawmakers responded by drastically raising casino licensing fees, which is the main reason the firm’s EBITDA has declined from $55 million in 2007 to less than $30 million in 2010.

Instead of bailing on the stock, Gates doubled down. His average cost is now $5.59. But the stock is currently trading around $3.50. With the company paying a 3.4% dividend and in being a first-rate operation, Gates’s betting he’ll be able to get out around $7.

The fund’s solid returns are grounded in a common sense approach to risk. It generally avoids significantly leveraged operations, seeks positions high up the capital structure, buys put protection against market sell-offs, and uses informal stops to trigger additional reviews when positions are not performing.

If one has doubts about a fund that can consistently deliver annualized returns in the high teens for more than a decade, investors should note the three partners have over 90% of their personal net worth in the fund. Gates employees first-tier service providers: UBS is its prime broker, GlobeOp its administrator, JP Morgan its banking agent, and Ernst & Young does its auditing.

But if that’s not enough, Justin Boisseau suggests looking at the fund’s 2008 performance. “Having lost more than 38% should satisfy skeptics who may wonder if our numbers are accurate,” quips Boisseau. And rising 131% the following year amply rewarded investors who believed.


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