Question mark over MatlinPatterson

Limited partners are concerned about the future of MatlinPatterson.

The firm’s second and third funds have failed to meet investors’ expectations – and some LPs have questioned the firm’s ability to make the funds profitable. 

As of 31 March, Fund II, which collected $1.6 billion in 2004, was generating a .63x multiple and a negative 13.7 percent internal rate of return. The third fund, which raised $5 billion in 2007, was producing a .81x multiple.

However, other LPs and market sources say it’s too early to judge the future of the firm, which specialises in turning around the riskiest investments and making them profitable. MatlinPatterson’s ultimate performance is riding on a number of investments in the second and third fund that have yet to be realised.

“I wouldn’t count MatlinPatterson out,” one LP says. “They’ve had some massive hits, and some big disasters. Especially in this environment, let’s see how this thing turns out.”

The firm declined to comment.

BIG RISKS, BIG HITS

The firm was founded by distressed investment specialists David Matlin and Mark Patterson, who spun out of what was then Credit Suisse First Boston in 2001 and raised $2.2 billion for their debut fund.

Fund I highlighted the two men’s ability to dive into dangerous situations and recover profits. The firm had several big hits in the first fund, including a 3.5x return on its investment in chemical company Huntsman. It scored about a 2.3x return on its investment in MCI Worldcom, the remnants of the WorldCom collapse in 2002, and about 3.1x on bankrupt energy company NRG Energy.

These investments represented a big exposure risk. Combined, the three deals accounted for more than 50 percent of Fund I, a person with knowledge of the situation told Private Equity International.

Fund I, which has sold all its portfolio companies, was generating a respectable net 1.75x return multiple and a net 16.3 percent internal rate of return as of 31 March, according to sources. This helped cement the reputation of Patterson and Matlin, who one LP described as “swing for the fences type guys”. In other words, they like to go for the big hits.

ROUGH PATCHES

Unfortunately, the firm’s subsequent funds have not produced similar results. Fund II has been marked below cost for some time, though it has distributed about $665 million to LPs and still has eight portfolio companies left to exit.

In 2009, the firm raised about $165 million to support investments in the second fund. When the firm raised this annex vehicle, it also ceased to collect any fees from Fund II, according to a person with knowledge of the situation.

The firm’s third fund, which closed on $5 billion in 2007, was marked at a .81x multiple as of 31 March. The success of Fund III is now heavily dependent on three investments: Flagstar Bancorp, homebuilder Standard Pacific and XLHealth Corporation.

XLHealth is the strongest of the three investments. MatlinPatterson acquired the chronic illness care provider in 2007 with a $290 million investment, in which it bought out most of the ownership stake of Goldman Sachs. The firm’s total exposure is $330 million after additional capital infusions, and the company was valued at about $730 million as of March, according to sources.

FLAGSTAR FLAGS

Flagstar is the business that worries LPs most these days. The company’s share price has plunged from between $6 and $7 in December 2008 and January 2009 to around 65 cents on 15 August, including a fall of about 60 percent this year. The firm began making capital infusions into the bank starting in January 2009, and has now invested a total of $1 billion.

Flagstar, which had large exposure to mortgages, has been attempting to expand into commercial lending.

The company reported a net loss of $75 million in the second quarter. On the plus side, it is well-capitalised, with a 9-plus percent Tier 1 capital ratio and a $1.6 billion liquidity position including cash, interest earning deposits and marketable securities, according to its latest earnings report.

It also reported some positive news for the third quarter, with increases in three key metrics, including rate-lock mortgage commitments. The bank also agreed in August to sell its Indiana retail bank franchise, which could generate a one-time gain of $23 million.

Investment bank KBW said the positive earnings trends could, if continued, help the bank reach profitability sooner than expected.

STANDARD NOT POOR

As for Standard Pacific, this is “an interesting play” that “will turn out OK”, according to one of the firm’s LPs. Another market source described the company as the “best-positioned US home builder with the highest gross margins” and the “leading presence in California”.

The firm, which owned debt in the company, provided a rescue package worth more than $510 million in 2008 at a time when it was reporting major losses. The package involved the firm converting $128 million of debt it owned in the company into equity, equal to $4.10 per share, and also the purchase of $381 million of senior convertible preferred stock at $3.05 per share. After the firm exercised a warrant last year for the purchase of up to $187.5 million in shares in December, Standard Pacific's weighted average share price was $2.96. The company’s share price hovered around $2.40 on 17 August; in the last year it has been as high at $4.98 and as low as $2.08.

The company is in a strong liquidity position after the recapitalisation and the addition of a $210 million unsecured line of credit in March. All significant debt maturities have been pushed out to 2016 or beyond, and the company has a cushion even if new home sales stagnate for an extended period, according to a June ratings report from Standard & Poor’s. Moody’s rated the company as stable in December.

Fund III also contains other, smaller, investments, including a recent shale-related acquisition in Canada and a bet on the shipping sector via an investment in Oceanus.

FUTURE FUNDS

The firm has talked to LPs about raising a fourth fund that would launch in 2012 or 2013, but sources all agree it needs to show some exits from the third fund before going to market with its next vehicle. Fund III is fully invested apart from some left-over capital for reserves, sources say.

“Realistically, you need to realise two or three major investments … the firm is not in the comfortable area with a realised set of sales that will let them go out,” a person with knowledge of the firm told PEI.

It’s worth remembering that MatlinPatterson invests in some of the riskiest assets in the market – turning them around is tough, so they look great when they come off, and not so great when they don’t. And although LPs have been disappointed in recent performance, there’s clearly a way to go before any kind of judgement can be made on its two most recent funds. The future of the firm is now dependent on various factors, some of which are out of its control – notably the stability of the US housing market and banking system. That’s a tough situation to be in; but if history is any gauge, it may be the kind of situation on which the firm thrives.