The Point of Deception
The recent story of First Brands is a good example of what will inevitably happen should you lever up deception. If you’re not familiar, First Brands was a roll-up of auto parts makers that filed for bankruptcy last September, collapsing under a load of more than $10B of on- and off-balance sheet debt and alleged management misappropriation of funds.
An interesting player in all of this is Diameter Capital Partners, one of a number of distressed debt investors that started buying First Brands debt at what they thought was a deep discount to the amount that would ultimately be recovered. What’s interesting about Diameter is that before the firm started buying First Brands debt, it was short it because, according to investor letters that have made the rounds online, they sensed fraud.
They were right about that and made money, but then went long because they believed there was a real business there despite the fraud, had studied it deeply, and thought they could make more.
This has been a losing proposition to the tune of $100M as First Brands creditors try to squeeze whatever they can out of a deeply troubled enterprise.
Diameter wrote in its letter that “There are few exercises more satisfying than turning a successful short into a profitable long.” But talk about degree of difficulty!
That’s because in my experience two things are true. First, when something starts to go poorly at a business, a lot more is likely to go poorly alongside it. That’s because when bad starts to happen, the only people who tend to stick around are the ones that have to and the ones that don’t have to – customers, suppliers, employees, etc. – start looking for ways to take advantage. Customers stop paying, suppliers demand payment in advance, and employees even start stealing office supplies and looking for new jobs while on the clock.
Correlation and momentum are as powerful on the way down as they are on the way up. Phase locking, for the win.
Second, no matter how much work one does, once there’s fraud, it’s nearly impossible to know its true depth or extent. After all, that’s the whole point of deception.
– Tim
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