Seth Klarman's Baupost Group first bought shares in Maryland-based commercial lender CapitalSource (NYSE:CSE) in the second quarter of 2008, purchasing 2.3 million shares. In addition, Baupost has gone on to invest in two subordinated debentures issued by the company including a 7.25% senior subordinated debenture due in 2037 but redeemable anytime after July 20, 2012. Baupost currently owns 20.3 million shares of CapitalSource common stock and $46 million of the 7.25% debenture.

When Klarman first got involved with CapitalSource, it operated as a real estate investment trust. Last year it revoked its REIT status and today operates primarily as a real estate lender through its California bank. Baupost has accumulated a 6.3% ownership position over the past two years. Read on to find out why some of the biggest names in investing are banking on this company.

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What It Got
In 2007, CapitalSource went looking for a bank to buy to complement its existing mid-market commercial lending. It originally had a deal to acquire TierOne Bank, until the Lincoln-based company's stock collapsed due to bad loans. TierOne was taken over by federal regulators in June of this year and then sold to Great Western Bank. CapitalSource ultimately bought Los Angeles-based Fremont Investment and Loan, a 22-branch community bank with $5.6 billion in deposits. Federal regulators forced Fremont to exit the subprime business.

As part of the April 2008 deal, CapitalSource lent $200 million to the bank to shore up its capital. Its clients at the time of acquisition included shoe designer Jimmy Choo and fractional real estate giant Exclusive Resorts, run by former AOL CEO Steve Case. With a bank in tow, it could expand its commercial lending footprint using deposits held there. Unfortunately, the economy went south about the same time and is only beginning to show slight signs of recovery. CapitalSource bought the bank to further its leadership position among small and mid-sized businesses. Klarman's original investment was approximately $54 million. Today, it's over $150 million. He obviously sees the potential of combining a bank with a strong commercial lender. The move hasn't paid off just yet but it should. (Learn more about detecting distressed banks in Banking Stress Tests: Would Yours Pass?)

The Transformation
In November, CapitalSource's CEO, John Delaney, announced he would become executive chairman with two other officers becoming co-CEOs. Delaney wanted to focus on the company's transformation into a bank holding company. Several steps were taken late in 2009 and into this year that will make the move a profitable one. At the same time it announced a change in management, the company also announced a three-step deal to sell its 143 healthcare facilities to Omega Health Care Investors (NYSE:OHI) for approximately $857 million. Of this, $279 million was cash, $522 million represented debt assumption and $56 million was Omega stock. The final part of the deal closed June 29. Then CapitalSource sold its interest in a $1.1 billion collateral debt obligation to North Star Realty Finance (NYSE:NRF) for $7 million. The cash isn't the important point here - it's the removal of the debt from CapitalSource's balance sheet that matters.

At the end of the first quarter, CapitalSource had $159 million in loan loss reserves to protect against losses from the CDO. Finally, in April, it bought Main Street Lender LLC for $100 million. The purchase came with a $111 million portfolio of small-balance SBA loans as well as conventional loans. Already very familiar with the middle-market, this brings an experienced team of small business lenders to the fold. Now, all CapitalSource has to do is execute its lending plan.

Bottom Line
It turns out that Seth Klarman isn't the only value investor interested in CapitalSource's resurrection. Mohnish Pabrai owns 2.8 million shares of the commercial lender. His other financial holdings include Berkshire Hathaway (NYSE:BRK.B) and Leucadia National (NYSE:LUK), both of which are excellent companies. So, if two of the smartest investors in business are making big bets on this company's turnaround, the question is: why aren't you?

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