No Economy is too small, no political crisis is too dire, and no country is too bankrupt for a solo operator like me to find riches among the ruins.

-Robert Smith

Riches Among the Ruins: Adventures in the Dark Corners of the Global Economy is an incredibly entertaining bottom up look at frontier market crises over the last 3 decades from the perspective of a travelling distressed debt trader.  Each chapter is dedicated to Robert Smith’s experience in a particular country: El Salvador, Turkey, Russia, Nigeria, Iraq, etc, etc. Each country is unique, but Smith’s weaves several key lessons throughout his memoir.

Anyone who seeks  profits in inefficient markets could benefit from Smith’s experience.

Information vacuums are key for middleman and arbitrageurs

In the mid 1980s no one had any idea what an El Salvador bond was worth- which is to say, they had no idea what value others might attach to it. The ignorance, this information vacuum, was my bliss. The seller’s price was simply a measure of how desperately he wanted to dispose of a paper promise of the government of El Salvador, and the buyer’s measure of how eager he was to convert his local currency into a glimmer of hope and seeing dollars down the road. The spread, my profit, was the difference between the two. In a fledgling market, with no reporting mechanisms and precious little information floating around, the spread can be enormous, and there was no regulatory or legal restrictions on how much you could make on a transaction.

Though my sellers and buyers, usually the representative of foreign companies doing business in El Salvador, often knew each other , played golf together, or broke bread together at American Chamber of Commerce breakfasts, I knew it would take some time before they eventually started to compare notes. At the beginning I doubt any of them even mentioned they were trying to sell or buy El Salvador bonds because the market didn’t exist yet. But until the market matured it was a gold rush, and I developed a monopoly on that most precious of all commodities in any market: information. I found out who wanted to sell, who wanted to buy and their price, and I held that information very tight to the vest.

In some cases buyers and sellers were on different floors in the same office building, or different divisions of the same global corporation.  The biggest challenges for foreign companies doing business in the developing world was converting local currency revenues back into dollars.  One way to get money out was to buy dollar bonds at fixed exchange rate and over time collect principal and interest in dollars.

Creativity and information edge: Struggles over bondholder lists

In almost every country, Smith, goes through difficulty to get the list of people holding the bonds in which he was seeking to make a market. Arbitrageurs and brokers who had access to the list guarded it aggressively, because it gave them an edge in acquiring positions at a discount, or profiting as a middleman. This was a key bit of information, available from connections at the Central Bank or other places.

His experience of trading nonperforming notes(NPNs) in Nigeria exemplifies the struggle over bondholder lists.

At one point Smith worked with a counterparty who was himself tasked with acquiring as many of the NPNs as possible. Smith was hired as a broker on this mission. The counterparty gave him a list that literally had physical holes. His counterparty had cut out names of big holders, limiting Smith to chasing down small holders(keeping larger investors to himself). Of course, in those small illiquid assets portfolio aggregation had value, so smaller the note better the price from buyer perspective. However, building up the portfolio was an arduous process. Smith was interested in maximizing profit, but his counterparty was tasked with acquiring as many NPNs as possible.

The Nigerian situation was interesting because the NPNs were spread out to investors around the world. The Nigerian bank held a meeting in the UK with countries trade creditors ostensibly to announce terms of payment. Prior to getting the list, a key bit of information Smith tried to get was simply who was in attendance at the meeting(unfortunately his lawyer failed to get it).

He ultimately tracked down the full list- it was actually quite easy once he learned where to ask. He called up a friend at the bank serving as the paying agent on the notes. It turned out that by law that only the Law Debenture Corporation, the official registrar could provide the list with one call to London. Ironically, Smith ultimately learned that each holder of an NPN was legally entitled to the whole list.

In the case of Iraq, it turned out information on holders of the debt instrument he was looking to acquire could be pieced together from information on the UN website. This highlights another a subtle change from Smith’s earlier glory years. Now information is theoretically less precious than it used to be. However, often few people know how to use it/find it/analyze it. Sometimes “publicly available” information is known by so few people, that it can lead to a significant edge.

Few who fancy themselves international mavens of finance want to do the grunt work.

Smith’s struggles parallel the adventures of investors in nanocap equities, real estate private partnerships, and other thinly traded securities, especially investors interested in activism or tender offers. Rules on getting the lists of asset holders vary between companies, and jurisdictions. Sometimes you buy one token share and demand it, but the company might make it difficult. In some jurisdictions , you can find shareholder lists online or from other public sources. A little creativity and extra knowledge of the rules can be a huge edge.

The role of misperception

At one point El Salvador had bonds that were objectively as low risk as Treasuries, but trading at 75-85 cents on the dollar because of political instability in the country. Smith was one of the few brokers making a market in these bonds, and he also cherry picked a few of the best bonds for his own account.

How was this possible? The answer was widely held misperception. Few people looked at a key detail:

I noticed something very interesting something other savvy buyers also noticed, no doubt. The principal and interest being paid to the bondholders was coming not from the central Bank of El Salvador but, but in the form of checks from the United States Treasury Department. To bolster the government of El Salvador, its client, and to protect its interest in the country, the US was going to ensure that El Salvador did not default. The real risk in these bonds was practically nil. The US was virtually guaranteeing they would be paid – and paid on time. On top of that, the bonds with the earliest maturities were often being called and paid in full before the due date. With the big boys at Citibank, Morgan Stanley, and the other major investment banks out of the game — too dangerous– stakes too small— I had the playing field to myself and what a field of dreams it proved to be.

Nigeria was another key example of how misperceptions influence markets:

Nigeria also taught me the value of circumspection. Even today when there is so much more financial information readily available in real time on computer screens throughout our world, circumspection is essential in a business such as ours. The Nigerian buyback succeeded in part, because everyone involved kept their own counsel about what was unfolding. There was nothing fraudulent or even unethical about, at least not by the commonly accepted standards of institutional finance. In our business, everyone is secretive because information is truly power in the zero-sum game of making money. Therefore those who know don’t say, and those who know don’t say.

…the larger point however, is that I was able to thrive precisely because there was not yet any real market in these instruments back then. Everyone was stumbling around in the dark with no information. Everyone, that is, but me. I had just enough to make a go of this business.

Origins of distressed debt exchanges

A distressed company or country can reduce its leverage by purchasing or otherwise acquiring its existing debt instruments at a discount to face value. The company may (discreetly) buy back its debt on an open market, or make a cash tender offer. Alternatively it may negotiate with lenders to exchange debt for equity. (See Distressed Debt Analysis: Strategies for Speculative Investors for more detail on the mechanics of distressed debt exchanges and other techniques distressed companies can use to reduce leverage)

These techniques are widespread in developed world distressed debt markets today, but according to Smith, the original development of these techniques came in response to blocked currency problems of companies doing business in countries where it was difficult to convert local profits into a hard currency such as dollars. Turkey was one of the first countries to use this technique to address foreign debt problem and attract new foreign investment. Many emerging market companies did this as a way of realizing value from non-performing loans.

The idea was to retire dollar debt by exchanging it with the Central Bank of the country for local currency that would then be invested in a company, factory ,or real estate in the country. Indeed some countries , to bolster certain segments of its economy, might, by the terms of the deal, restrict the equity investment to specific types of investments.

These methods can be applied to trade creditors as well as bank loans. For example, if Ford  sells  car parts to Turkey, and the buyer defaults on the dollar invoice due to currency restrictions, the trade claim can be swapped for equity ownership in real estate or an operating company. That ownership can be sold to other party for higher price than it would get for trade claim.

For more detail on the early use of debt for equity swaps by emerging markets, see The Global Bankers by Roy Smith.

Dynamics of negotiations impacted how the value got distributed, but in most cases, all parties ended up at least slightly better than they would have been otherwise. Seller of debt gets higher price than secondary market, and local currency investment might be more profitable in long run, but would still have difficult problem of converting currency out. The country would get debt swapped at a discount, and get new capital investment in. From a macroeconomic perspective in a small frontier economy, there is, however, risk of adding to inflation.

Nigeria was Smith’s exposure to the debt equity buyback as a technique for reducing indebtedness and improving a balance sheet. Now the technique was widely used. Sometimes the operations are initially kept secret so the debtor can buyback as much as possible at a low price.

More on the nuances of middleman

Smith operated as a middleman and is justifiably proud/cynical about the middleman’s ability to extract value from markets. When he spoke with buyers he would be optimistic about the country, when he spoke with sellers he would be pessimistic. He never introduced his buyer and seller. However, a middlemen often proved to be essential in the areas in which Smith operated.

Here are three scenarios in financial markets where middleman are genuinely very useful or essential:

• Market doesn’t exist yet. Smith created markets where none had existed. Many times his sellers were stuck with seemingly useless paper without him. Sometimes the buyers and sellers knew each other, but without Smith had no idea it was possible to trade. Smith did millions USD in transactions from simply placing advertisements in newspapers such as WSJ and FT saying he wanted to buy assets, and  placing advertisements in local frontier market papers saying he was selling.
• Buyer wants to be discrete.  In illiquid markets, its critical for a buyer to be discrete. This is where a middleman can be of significant value, because even after collecting their fee, the buyer still gets a better average cost. When Nigeria was buying back NPNs, it was essential to keep actions secret by spreading purchases around middleman, and spreading purchases out over time. Middleman asking to buy does not arouse suspicion.  However, an entity affiliated with Nigerian central bank buying would drive up prices.  Plus being able to chase down buyers/sellers was valuable since Smith was more willing and able to do grunt work than people affiliated with large financial institutions.

Once people understand what you’re doing, the price goes up. Why? DuPont might be happy with $300,000 for a million dollar claim, but if they realize it would still be a great deal for [the buyer] at twice that price, they might not part with their claim so readily. Having a middleman is essential. With a middleman, DuPont and the buyer would never meet.

• Legal restrictions on foreigners. Some countries have restrictions on foreigners buying trade claims, so foreign need to find a foreign partner. Smith experienced this in Turkey.

What makes a market ripe for a lone operator

Smith operated mostly alone out of dilapidated hotel rooms in various countries around the globe. Even as he built up his business he still stayed independent from all of the major investment banks. Indeed he targeted markets that were ignored by the larger players.

Two factors make a market ideal for a small, lone operator:

• Sums to be made relatively modest.
  

  “When the big boys saw me running around San Salvador trying to make a deal, they thought it was a joke. At first I thought they might be right. But I was happy to pick up the crumbs they wouldn’t touch. “

  The six figure/ low seven figure transactions he made were far too small for major financial institutions to bother with, but they were relatively large from the perspective of his one man operation.

•  Extremely dangerous. Smith took the “go where others are afraid to go” to the extreme. At the time he visited Nigeria, it was in such disarray that many westerners had taxi cabs get hijacked in broad daylight. He traveled to El Salvador in the middle of a civil war and a deadly leftist insurgency brought violence close to his operations. It wouldn’t be the last time he traveled into a war zone to make investments.

 Lessons from struggles/failures.

• Smith tried to launch a remittance and check cashing business, but it didn’t work. He shares several things he learned from the experience:
  • The business didn’t have didn’t have enough locations on sending side. Most of the locations on the sending side were located in a main city, but customers were scattered throughout the countryside. The only way they could use the services was to make the long journey into town.
  • The failed remittance business also taught Smith not to be overly impressed by people with wealth and power. His partner was wealthy and powerful, but he was still unreliable, so the business didn’t work.
  • He wasn’t comfortable profiting from the poor. He was fine profiting from the blind large institutions as a trader in obscure debt instruments.
  • One thing he did right was cut his losses early. He passed on an opportunity to throw more money into the business because he saw it wasn’t going to work.
• No permanent allies, only permanent interests He had falling out with people and did business with them again later when interests realigned.
• Like many frontier and emerging market investors He made the mistake of investing in Russia right before it defaulted. His holdings dropped to almost zero on a mark to market basis. Although he ended up making his money back, its not clear that his IRR was anywhere close to what he would normally seek. His fateful decision to invest in Russia occurred after taking a bank sponsored trip to Russia, where in retrospect there were many red flags. Two quotes stand out as lessons from the problems he experienced in Russia:

If you’ve been in the market a long time and you see that nothing is clear that corporate governance isn’t transparent, that there isn’t a legitimate tax systems and no rules or regulations to protect investors you are not made to feel better by drinking lots of wine, eating good food, and flying in a private jet.

If Wall Street is saying this is the best thing since sliced bread, the juice is all runout.