The Law Is An Asset Class

Here's a new asset class - investing in litigation. It's not yet legal in the US, but in other countires, it's possible to fund a lawsuit in exchange for a stake in the proceeds. This seems like a logical progression - there's already divorce settlement financing. This just extends the range of claims on litigation to equity stakes.

My guess is that the investment (if it ever catches on) would have pretty low covariance with most other asset classes, so it could be a good hedging mechanism.

What's next - derivatives on lawsuits?

HT: Marginal Revolution

Interview With Myron Scholes

Holman Jenkins recently conducted a must-read interview of Nobel Prize Winner Myron Scholes. It's available in today's OpinionJournal.com. Here are a few choice nuggets:

...Why can't things always be smooth and nice and predictable? Myron Scholes, operator of the hedge fund Platinum Grove Asset Management, says you wouldn't like it if they were.

...Start with the commonplace that risk is one side of a coin whose other side is reward. "We all have a taste for it," he says. "In life, it would be kind of boring if there was no risk. On the other hand if there's too much risk, too much uncertainty, too much chaos, we can't handle it either. We simultaneously want order and disorder, simultaneously want risk and quiescence."

And my favorite, when asked about the now-famous (infamous?) Long Term Capital Management failure (note: emphasis is mine)

He readily acknowledges that the episode was financially and personally embarrassing: "In life you pay tuition, right? Sometimes you pay too much tuition. Sometimes learning is costly."

Read the whole thing here. All in all, it's a fascinating look at one of the most influential financial thinkers of our times, and an easy read to boot.

You can pick your frends, you can pick your nose, and you can PIK your bonds

Wednesday's WSJ had a very interesting piece on "PIK " or "Payment In Kind" bonds, titled "What's Aiding Buyout Boom: Toggle Notes." It's perfect to bring into the classroom if you're teaching about capital structure, M&A, financial engineering, or derivatives.

For the unitiated, a payment in kind toggle (I'll just call them PIK bonds from here on out) bond gives the issuer the option of not paying coupon payments. If they exercise the option (i.e. "flip the toggle"), the liability for the missed payments payments accrues (at an interest rate higher than the coupon rate) and is repaid at maturity. The article notes the recent PIK bond issued in the takeover of Neiman-Marcus - it has a 9% coupon, and a 75 basis point higher (i.e. 9.75%) rate on "toggled" payments.

In a Miller and Modigliani 1958 world, there aren't any costs to financial distress. In the real world, there are serious consequences to missing a coupon payment. Even more, actions taken to avoid this eventuality can cause distortions in firms investment and disclosure activities. So PIK bonds are a creative financial engineering solution to the problem.

It's not surprising that PIK toggle bonds have been seen mostly in the PE world. These deals end up highly leveraged. So, there's a significant risk that a target firm could get driven under by an external shock completely out of their control (the article uses 9-11 as an example). And the "insurance" seems pretty cheap at 75 basis points.

It's also interesting in terms of how you'd price the option. Since the option would be exercised if the firm was underwater on its debt payments, it's actually an option on the cash flows of the firm rather than on a traded security. Since the issuing firm has a much better feel for those numbers than the credit markets do, there should be a significant adverse selection problem with these securities. My guess is that the insurance (the 75 b.p. spread on the toggled payments) will turn out to be way too low.

There's some good commentary on the topic from the usual suspects: Abnormal Returns has a nice roundup of PE/credit related posts, and Going Private analyzes the effects of PIK financing on the PE firms equity returns.

And if you have no clue about what a PE firm is and does, here's a pretty good video primer on Private Equity from CNNMoney.com