The following interview of the 3 principals of First Southern Securities, Benjamin T. Eiler, Vasileios A. Sfyris and W. Heath Hawk was conducted by phone and email in the week ended May 8, 2015. The views expressed in the answers are entirely that of the above mentioned partners. I have no investment in the fund discussed below. – Peter Epstein, CFA, MBA

Peter Epstein, CFA, MBA has no prior or existing relationship with any investment vehicle described in this articles or with the named principals of First Southern Securities.

Interview :

Q: Please give a brief background and description of First Southern Securities “FSS”? How is First Securities different from other small, boutique Muni firms?

A: Please see link to FSS above. We are is a research intensive boutique Muni firm that specializes in extracting value from under-followed tax-exempt entities (credits). W get under the hood and try to identify credits that are, “diamonds in the rough.” When we find attractively valued Muni bonds, we buy them cheaply. Our firm frequently buys smaller, “odd lots” than hedge funds, mutual funds and Exchange Trade Funds would ever consider. This approach helps boost total returns.

First Southern Securities recently launched its first bond Fund for high net worth investors and small hedge funds. Can readers get an overview of the Fund?

Phorcys Opportunities I, LLC offers a fresh twist on distressed debt investing: an opportunity to achieve superior tax-advantaged returns by investing in distressed or defaulted asset-backed micro-issue municipal bonds which offer significant upside when the issuing entities are turned around or managed more efficiently. We also view ourselves as bond activists since we can push borrowers for change if certain targets or covenants are not met.

Q: What’s the current assets under management in the Fund, how large could the Fund grow? What’s the minimum investment in the Fund?

A: First off, we are early on in the process of attracting capital into the Fund. However, we are quite encouraged by the level of interest we are seeing. The Fund is size is approaching $3 million. We are still deploying our seed investor’s capital. We deploy capital at a prudent pace, relying on our proven investment process. That’s why it takes time to find attractively priced securities. All of our Fund acquisitions must go through an investment committee meeting. We think that our strategy can support a Fund in excess of $250 million over time. The minimum investment size is $250k.

Q: What’s the benefit of investing in your actively managed Muni Fund compared to a “professionally managed” Muni fund or Exchange Traded Fund “ETF” bond fund?

A: Our Fund is an opportunistic total return vehicle. Outside of the Fund we have been able to, and hope to continue, generating attractive risk-adjusted returns. Not just attractive returns, but in many cases tax-free returns. Strong returns by acquiring credits that don’t fit into regular current return portfolios, returns that have a low correlation to other asset classes, most notably stocks. Many passively managed bond funds and ETFs have mostly long-dated bonds which expose investors to downside risk if interest rates were to rise. For example an ETF bond fund with a duration of 12 years would fall by roughly 12% if long-term interest rates were to rise by 1.0%. By contrast, our portfolio would fall considerably less. In fact we would welcome a rise in interest rates as that would provide us a larger universe of attractive, high yielding bonds to choose from.

Q: What kind of proprietary research does your team do? Is it extensive or fairly routine?

A: It all depends on the credit. Some credits need more hand-holding than others. We frequently visit with property managers and other interested parties. We often look at the physical asset and we consult with industry/asset experts prior to acquiring bonds of the issuer. Our firm has grown to over 20 investment professionals including traders, analysts and 3 principals. Therefore, we encompass a wide range of experience and points of view when doing due diligence on an issuer. A specific comment from Mr. Ben Eiler is that, ‘…we are going places. Our staff is up 80% in the past 12 months. We are up in every category, Assets Under Management, Gross & Net revenue, trade volume etc…. People are starting to notice our skills and reputation.’

Q: Are you able to provide an example of a good investment made before the initiation of the Fund?

A: Sure, a credit we have been accumulating is representative the Issuer’s Bond Rating at Fitch is BB. This is a 1st mortgage on a building in a good part of town. There will be some tenants exiting in 2015 but management does not expect it to be a significant problem. We agree. The owner is a successful developer in this part of town. The original issue size was around $60 million. We believe that many secured, single-asset entity bonds in unpopular States are trading with, ‘guilt by association,’ and the market has unfairly punished them. This building remains a stable, ‘Class A’ building with strong tenants in a desirable area. Opportunities like this are not common, but finding these, ‘diamonds in the rough’ is possible with hard work, persistence and our proven ability to move fast when necessary.

Q: Can readers have an example of a less successful investment and how it came about? Did FSS exit the investment and minimize the loss?

A: An example of a bad trade was a General Obligation bond for a troubled city. We were aware that the city had its share of financial problems but we did not anticipate things moving as quickly as they did. We had a small position in the General Obligation bonds when the emergency manager in proposed to pay bondholders 10 cents on the dollar. At that point, the bonds started trading lower, even though the market did not factor in an ugly bankruptcy scenario. We thought that in the mid-50s the bonds were still aggressively priced and their fair market value was in the low-to-mid 30s, expecting that the bonds would get worked out in the 60s for a nice gain. Over time we were able to lower our cost basis into the high-40s. The bankruptcy proceeding was pretty ugly though. The workout level was only $0.34 and stub bonds which reduced our loss by roughly half.

Q: Does your Muni Fund have specific investment guidelines (risk mitigation) such as limits per State, bond sector, sub-investment grade bonds?

A: That Fund’s specific mandate is to be an opportunistic as necessary to achieve attractive risk-adjusted total returns. When there are a lot of attractive investment opportunities, we may be more fully invested, (less cash in the portfolio). When the Muni issues of select jurisdictions such as PR, California or Michigan become oversold due largely to headline risk and unwarranted fear in the market, we may buy more of those mis-valued securities. Sometimes odd lots of sub-investment grade issues become highly attractively priced simply because as ‘fallen angles’ many insurance and pension funds are mandated to sell them.

This is a way in which we can source bonds at fire sale prices. Importantly, our Fund stands ready to sell illiquid holdings if prices improve sufficiently to allow us to redeploy the proceeds into a better risk-adjusted opportunity. However, if our cheaply priced issue remains undervalued we will either buy more or hold it until maturity. Many funds, for a number of reasons, do not have the stomach or in some cases the mandate to hold these issues until maturity. So in short, while we don’t have many restrictions on our management activities, the 3 principals are personally invested and therefore 100% aligned with other Fund investors. To be clear, a Fund without investment guidelines could be more volatile than other funds and be considered more risky. We never swing for the fences and risk strikeouts, that’s simply not the nature of our Fund.

Q: Is the Fund permitted to use leverage?

A: Yes, the Fund is permitted to use modest leverage. Typically, the Fund will probably not be using much if any leverage.

Q: Will the Fund make annual distributions?

A: We get asked that a lot. No, the Fund will not be making annual distributions. We believe an arbitrary rule to return capital once a year would be disruptive to our portfolio management process. For more information on FSS and our new Fund, please see First Southern Securities “FSS”.

Q: Will the Fund maintain a cash balance for safety or be fully invested at all times?

A: While intuitively it makes sense that holding excess cash in the Fund mitigates downside risk, but it also diminishes upside potential. Investors into the Fund are seeking exposure to a reasonably diversified, high yielding Muni bond portfolio. The Fund’s mandate is not to make bets on interest rates or movements in underlying Muni bond prices.Our only guidelines regarding cash will be based upon the universe of investment opportunities and the prudent investment of new investor capital.

Peter Epstein, CFA, MBA has no prior or existing relationship with any investment vehicle described in this articles or with the named principals of First Southern Securities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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