The short seller's guide to credit, with Carson Block
Sep 25, 2023
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Experienced short seller Carson Block shares insights on shorting credit, discusses techniques to uncover fraud, and reflects on past successes and setbacks. The podcast explores the differences between shorting credit and equity, challenges in evaluating credit risk, and manipulation tactics used by companies to appear less leveraged. Additionally, there is a fun comparison between short sellers and the New York Jets' challenges.
Shorting credit offers leverage advantages over equities, exposing potential fraud and financial manipulation.
Credit investing rewards pessimism over optimism, emphasizing the need to scrutinize financial practices.
EBITDA adjustments and lack of transparency in financial reporting raise concerns about credit market accuracy.
Understanding management incentives and transparency helps in identifying potential credit risks and fraud.
Deep dives
Shorting Credit: An Attractive Strategy
Shorting credit can offer advantages over shorting equities, as credit dynamics can provide more leverage without needing to worry about equity appreciation. Companies with manipulated financials or outright fraud can present excellent short opportunities, especially in the credit space. Manipulating metrics to maintain an investment-grade rating, especially for companies on the verge of losing that rating, can lead to significant downsides for bondholders.
Cultural Shifts in Credit Investing
Credit investing often rewards pessimism over optimism, a stark contrast to the equity market's focus on ignoring red flags. The credit market experienced complacency among investors, particularly banks, with a tendency towards extend and pretend strategies. The shift towards holding companies accountable involves revisiting covenant agreements and red flags in credit documentation.
EBITDA Adjustments and Transparency Concerns
The widespread use of EBITDA adjustments in financial reporting, stemming from the late '90s, highlights a lack of transparency in credit markets. Companies often inflate earnings by manipulating EBITDA through various adjustments, raising concerns about the accuracy of reported financials. Investors should scrutinize unnecessary complexity, management's transparency, and their responses to inquiries for signs of financial manipulation.
Identifying Red Flags in Credit Analysis
When analyzing new credits, investors should pay attention to where management is incentivized to manipulate, often focused on appearances of leverage and profitability. Complexity in corporate structures, opacity in financial reporting, and reluctance to provide relevant information can serve as warning signs of potential financial manipulation. By understanding incentives and assessing transparency, investors can better navigate credit risks and identify potential fraud.
Investor Accountability and Due Diligence
Investors face challenges in conducting thorough due diligence amid pressure to invest in multiple deals quickly. Red flags in credit analysis include unnecessary complexity, lack of transparency, and management's responsiveness to inquiries. By focusing on incentives, transparency, and red flags, investors can better assess credit risks and hold companies accountable.
Personal Insights and Unique Perspective
Carson Block's personal connection to the New York Jets reflects a sense of kinship with the team's challenging journey, akin to the trials faced by short sellers. His experience with sports and investment parallels the unpredictability and occasional victories amidst adversity, mirroring the dynamic nature of financial markets and individual challenges in navigating investments.
Conclusion and Podcast Recap
Carson Block's insights shed light on the complexities and vulnerabilities in credit markets, emphasizing the importance of diligence and transparency to navigate potential risks of financial manipulation. The episode delves into cultural shifts in credit investing, challenges in due diligence, and red flags to watch for in credit analysis. By understanding market dynamics and scrutinizing financial practices, investors can make informed decisions and mitigate risks in credit investments.
Carson Block is not an unfamiliar name, at least in the equity markets. He and his short-activism fund Muddy Waters Research have been at the center of many notable trades in recent years — so notable, in fact, that the SEC began investigating him last year.
He’s talked publicly about the covert techniques he and his colleagues use to uncover fraud, and about the impacts of short selling on his health. Amongst his successes have been some setbacks, like when Chinook was acquired by Novartis just after Muddy Waters doubled down on its short position.
But shorting credit is a different ball game, and one that doesn’t get as much visibility as public stocks.
Muddy Waters has experience in that arena too, with short bets on names like Casino and Vivion, so we wanted to know what advice Block had for debt investors trying to spot which names to stay away from. Welcome to the short seller’s guide to credit!
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