4.02.2009

Distressed Debt Investing - Example 1

So back to our example. Let me just grab what I just wrote so it's easy to access...

But for now, let us use a hypothetical example. Let's say I am involved in distressed debt investing. A company that I am looking at has 100M of EBITDA. EBITDA is Operating Earnings + Depreciation and Amortization - non recurring one time items. And let's say I think this company is worth 5x EBITDA, therefore I think that if the entire enterprise was sold, someone would pay somewhere around 500M. Now let's say that this company, we will call it Overlevered Co. has 2 billion dollars of debt.
Ok. Now let's say in this particular example, the company decides to pursue a Chapter 11 reorganization. In distressed debt investing, we are familiar with this process as we sit in the Delaware courts often. Unfortunately, many of us are not lawyers, so we rely on counsel or our judgement in helping us make better investment decisions.

Ok. Let's say the bankruptcy process is fairly standard because there is only a few class of creditors:
  1. The lawyers and other admin, who get paid first
  2. The bond holders
  3. The equity holders
In a bankruptcy process, there is something called an administrative claim which must be paid in cash and gets paid out first before anyone else. That is why being a bankruptcy lawyer is so appealing (1000 dollars an hour...). If the admin claims cannot be paid in cash, more than likely the case turns into a Chapter 7 liqudiation which we will talk about in future posts. That is a whole other distressed debt investing topic.

In a bankruptcy, generally interest is not paid on the pre-petition bankruptcy debt claims unless the judge grants it to you. He/She would only do that if you were way more than covered. But in our example, let's say no one is getting paid interest.

The bankruptcy, for simplicity purposes goes on for one year. In that year, the company generated enough free cash flow to pay out all the administrative claims in cash. So now you, the owner of 2 billion worth of bonds, which you paid 10 cents on the dollar for (200M), want your take.

There is a valuation hearing, restructuring bankers argue (again we will dig into all these issues in the future), and the judge decides that this company is worth $400M. Less than you had hoped, but you are still looking pretty. In addition, everyone agress that this company can take on 200M of debt after the bankruptcy in a new note (That would make it 2x levered...2ooM debt / 100M of EBITDA) which will be distributed to you the sole bond holder. In addition, the bond holders will get 75% of the equity, management will get 15%, and old stock holders will get 10% of the new companies equity.

Why do you ask do we not get all the equity? Well management needs some incentive to stick around and former equity holders can sometimes be a nuisance. If our capital structure were more complicated, then I doubt they would get anything. Again, a topic for another post down the road.

The company finally emerges from bankruptcy, with 200M debt that you are the sole owner of and new equity owners, mainly you. This company is now private. You and your people from your fund go on the board and try to make things (magic) happen. And let's say your company invents a new product and its EBITDA doubles. Now its EBITDA is 200M. But now, with all the great opportunities this new product has to offer, people are willing to buy this company from you at 7x EBITDA. So now your company that you own 75% of is worth 1.4B dollars. Subtract the 200M of debt you own...the equity is worth 1.2B...you own 75% meaning your equity is worth $900M. Your total investment is worth $1.1B (900M of equity + 200M of debt)

Let me break this down for everyone that has not been following along. You paid $200M, and wll be getting back $1.1B in a few years. Let's say the WHOLE process takes 3 years.

That is ~75% annualized return. Distressed debt investing FOR THE WIN.

Now if you are also in the field of distressed debt investing, I apologize for the simplicity of this post. It does make a pretty interesting case study. Now I just have to find this exact same investment in the real world.

In the next post, I am going to talk about a real distressed debt investing example. One that many of my colleagues have been following for quite a while now. And I will follow that one up with more distressed debt investing concepts.

3 comments:

Theodore 4/03/2009  

Let's say you want to ride along passively as a small corporate bondholder of a company that just filed Ch 11. If you buy the bonds AFTER the filing date, do you have the same claim rights as those who owned the bonds BEFORE the filing date? Also, if the company is restructuring nicely and not headed to Ch 7, is there any advantage to filing a proof of claim form or will the Trustee treat all bondholders as a "class?" Thanks in advance!

Lawrence D. Loeb 4/11/2009  

It is my understanding that bondholders will be treated the same, regardless of when they purchased the security.

Holders who purchase the bonds in distress may sometimes have divergent interests from those who purchased at par. This can complicate negotiations.

I am not certain about the proof of claim, but as I understand it, many parties will file to protect their interests (even though their interest may have been claimed on their behalf by another party). This creates some confusion in the process as claims often exceed the actual debt.

Sharat,  8/24/2009  

Once the company has a new product that doubles EBITDA, why do the bonds still trade at 10%? Wouldn't the market value these bonds higher since the company is in better financial condition?

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I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.