Distressed Investing Concept

It has been too long since we wrote a lengthy post on a particular distressed debt investing concept for some of our newer readers. As most types of investing, distressed debt investing has some certain intricacies that morph from situation to situation. One action by a high yield issuer might portend something completely different from the next high yield issuer. If it were the case that doing a certain action, meant XYZ was going to happen, it would be mechanical and more than likely boring. What makes it interesting (and my opinion, damn near fascinating) is making the educated guesses, placing your bets, and making money in the long term.

It was reported late last week, that a favorite company in the distressed debt world, drew down the entirety of its revolver. Now, I cannot confirm nor deny this. I am just reporting what has already been reported. On the news, the bank debt rallied 4 or 5 points. Why would this be you ask?

To start, and for those that are experienced, please skip ahead, a revolving credit facility is a bank debt instrument whereas the company can draw down, like a credit card, on a revolving basis. Sometimes this revolving credit facility is secured, and sometimes, in many investment grade cases, it is unsecured. Sometimes a revolver has limitations based on a borrowing base. For example, a certain borrowing base may be 80% of Accouts Receivables and 50% of Inventory. If company ABC has $100M of AR and $100M of Inventory, they could only draw down $130M of their revolver. This mechanism protects banks in the event of a credit default.

A revolver is generally used for seasonal liquidity. If a certain company builds inventory in the first two quarters of the year, it may use its revolver to fund those working capital purposes. Then in the final two quarters of the year it will pay down the revolving credit facility and the process repeats itself.

Now banks don't offer this instrument for free. There is something called a ticking fee that is attached to the revolver. It is generally a fairly nominal amount...call it LIBOR + 25 bps on all unused committments. It is very very easy money for the banks. And the amount that is borrowed, well that is like any old instrument, paying an interest rate genearlly based on LIBOR.

Generally speaking, and this is not solely to distressed and high yield issuers, liquidity comes from two sources: 1) Cash on hand and 2) The Revolving Credit Facility. Most companies need a certain amount of cash on hand to run the business. This issue is further complicated when you take into account foreign subsidiaries that need their own cash to run, but at the same time do not want to repatriate cash back to the United States in order to avoid taxes. A crucial component in fundamental analysis is figuring how much cash a company needs, both domestically and internationally, to fully function. When a company is low on cash they may stretch payables or not build inventory - both techniques that cannot be carried into perpetuity.

Now that we understand revolving credit facilities, why on earth would bank debt increase when a revolver was drawn? Think about it, 9 times out of 10, term loans and revolving credit facilities are pari passu. And if they are not the only difference is the security granted. Oftentimes, the revolving credit facility will have a first lien (claim) on the working capital and a second lien on the PP&E. In this example, the term loan will have a first lien on the PP&E and a second lien on the working capital. So assuming this revolver in question is pari, with a larger denominator and theoretically the same numerator (recovery = value / debt outstanding), why did the bank debt trade higher?

Investing is a game of probabilities. Charlie Munger and Warren Buffett both refer to it as a pari-mutual betting system. It is basically a horsetrack. You are given odds (price), you calculate odds (your expectations), and you compare the two. If I am 50% sure I am getting 100 on a certain deal, and 50% sure I am getting 0 on a deal, the expected value is 50. If the market was pricing this deal at 40, well theoretically I should take this bet. Me personally though, there really is no margin of safety there. If the market was pricing this thing at 20 though, then I'd get excited.

In the aforementioned example, there are a few distinct possibilites that could occur. And in each of those possibilities, there is a distinct payoff to the various stakeholders. If the business survives, the returns to bank debt are decent. If the business goes Chapter, and the bank debt gets the equity, and the re-org is fairly smooth, then the bank debt could make a killing. Many different paths with many different payoffs. Sometimes it is easier to narrow it down to 3 or 4 outcomes.

With the drawing down of a revolver, what is a company, more often than now, telling us. They are telling us they need liquidity. What is very interesting though about revolving credit facilities, and the covenants that govern them is such: If a company has an inkling that business will be weak in a few quarters, and that they might not be in compliance with their covenants at that time, then they should draw the revolver (liquidity) now, just in case. The banks have agreed to lend to them if they are in compliance, and at this point in time they are. Having liquidity is far superior from having none. It gives you more of a lifeline...but really, the writing is on the wall at that point, unless some miracle of a business turnaround manifests.

So, with the likelihood of a re-organization increased, the potential payoffs to various constiuents also changes. The chance of paying junior creditors interest for a substantial amount of time is decreased, and hence that value flows to the senior creditors. So that is the first reason. Second, uncertainty is reduced. Markets, whatever you are trading, hates uncertainty. Why? Dispersion of expected value makes making sensible and reasonable guesses far more difficult. Third, and this is specific to investing in bank debt, specifically control situations, you will get your hands on the wheel faster. As a passive investor, it is like riding in the passenger seat of a runaway vehicle. Now the time to take control is closer at hand, hence upping the probability (at least we all hope) of a positive outcome.

Now of course, there are certain intracies to this specific case. There will always be intracies. In future posts we are going to talk about some more public ones. I do expect that more revolving credit facilities will be drawn in the coming years as the wall of maturities begins to crest (yes, some management teams even use their revolver to pay off subordinated creditors). And that will give us more opportunities to deploy capital in distressed debt investing situations...our favorite.



Hedge Fund Jobs

Here at Distressed Debt Investing, we get a lot of requests for advice on getting hedge fund jobs or better yet breaking into the hedge fund industry.

Over the next few weeks, I am going to try to walk our readers through the process that is getting a hedge fund job. As a primary caveat, I am not the definitive source. Some of the ads that I put up to the right (surprisingly) have decent information in them as well. So please do not use this post as the be-all end-all definitive guide to breaking into the the hedge fund industry and making a quadrillion dollars.

In general, there are two ways to become a hedge fund analyst:
  1. Use your network
  2. Get lucky
Now, when you read the above, you might say: "HA...That can't be possible." Unfortunately, that is the way the cookie crumbles. My first fund job came through a friend. My second, also through a friend. Again, generally speaking, knowing someone who knows someone will get you a long way in this world.

And I do not want to discourage anyone here. It is very easy to expand your network in the investment world if you can offer some kind of value. If you constantly are taking value, no one will respond to your emails or voice mails. I have a quote from Guy Spier on my desk. It reads:

"A few keys to effective networking are:
  1. First: Don't waste the other person's time - always demonstrate that you have respect for their goals in life and that you want to help them to further their goals.
  2. Second: Look for ways in which you can help them.
  3. Lastly: Get in touch with them when you have something for them that is tangible, desirable and relevant."
Those are some damn wise words.

I had drinks with a hedge fund manager that is starting up in a few weeks (I will post about him more soon). There was some press about his launch and he told me he had literally 300 people asking for a job. Now I know times are tough. But you know how many of those 300 people offered some kind of investment idea (i.e. the value add?): 2 did. And he called those 2 back promptly.

Let me tell you a quick story. I have a friend that was a damn fine analyst at a mutual fund company doing high yield. I mean probably one of the better buy side guys I know. So he is trying to make moves, and starts pinging his network to see if anyone he knows is hiring (he does this via phone, email, Link'd In).

After 3 moths, he catches a break: One of his old bosses knows a few guys that are starting up a fund. He interview, is obviously smart, and gets the job. Now, if he was just smart, and didn't have the connection...well he'd still be looking for that same job he just got offered.

You have to utilize your network. You have to ADD value to that network. You have to help XYZ person earn more on his capital than before, when he hadn't the foggiest clue who you were.

In the future, I am going to post on my new blog, Hedge Fund Jobs, as to focus the content and not dilute the distressd debt investing =]



Six Flags Bankruptcy

If you remember, a while back, we discussed the distressed debt opportunity that was Six Flag's bank debt. Well since then, and as expected, Six Flags filed for Chapter 11. Here is an update.

Just for a little bankruptcy lesson before we get started – when a company files, it has entered an “exclusivity period”, in which it has 180 days to put together a plan of reorganization, although the plan can be extended by the bankruptcy court almost indefinitely if they feel the debtor is acting in good faith. After such time, if the company does not come up with anything, or the plan is disputed by too many creditors and cannot be confirmed, competing plans may be submitted by creditors. Ad an additive point, this is part of the new bankruptcy law that was enacted in 2005/2006.

The proposed “Support Plan”, yet to be confirmed, contemplates the existing secured bank lenders receive consideration upon confirmation of the plan composed of $600 million in new term loans with a L+700 margin, and the balance paid in equity which would represent 92% of the total equity in the reorganized firm. The Opco Notes (SFO) would receive 7% equity, the remaining Holdco Notes (SFI) would receive 1%.

This is a stark contrast from the proposed out of court restructuring that was abruptly abandoned after a holdout caused a lack of voting support to effect an out of court debt for equity exchange. Under this previously proposed exchange, the secured bank debt and the Opco Notes would have been unimpaired, and continue receiving interest payments as if nothing had changed. The Holdco notes would receive 85% of the equity, the Preferreds would receive 10%, and the remaining 5% would have gone to the existing shareholders.

For a judge to confirm this plan, Six Flags is going to have to prove that after paying bankruptcy fees and taking care of the secured bank debt, there will be a *very* marginal amount of value left to distribute to the junior creditors. I find it hard to believe that not more than 2 months ago Six could afford to reinstate the bank debt and the Opco Notes, implying they probably think the company is worth around $1.5 Billion (close to the book value of PPE, and 5.5x 2008 EBITDA), but now, they claim to have only enough residual value left to pay 1% to the Opco Notes?
Even taking into account bankruptcy costs which will dilute recovery from what it would have been out of court (I am assuming $150 million value, or 10% Enterprise Value), Six would still have $1.35 Billion left, which is enough to cover the approximate $1.1 Billion secure bank debt, with $250 Million left to distribute among the Opco and or Holdco Notes.

Six Flags stated in it’s 8-K that it had the unanimous support of the secured lender Steering Committee, however this may be misleading to some because although this is true, the steering committee represents only 50% of the secured bank lenders. For this plan to even have a shot in hell, 50% in number as well as 66% in dollar amount is needed, and this is not even taking into account the objections that will surely come from the unsecureds who will basically be hung out to dry. Avenue Capital, as a matter of fact, holds Six Flags secured bank debt, and it has openly stated it does not plan to consent to the plan (they were not represented on the Steering Committee). Avenue deemed the proposed Support Plan a “sweetheart deal” for secured lenders, leaving little for the unsecureds. While I’m sure Avenue had it’s philanthropist duties in mind when it released this statement, some of us would probably be inclined to think they hold a portion of the unsecureds.

As of close today, the Term Loan was quoted in the 95-96 context, the Opco Notes where around 61-62, and the unsecuredes were all around 10-11. Before the filing, the Term Loan was quoted around 76-78, the unsecuredes 18-20, and the Opco Notes 69-70. Obviously the market has responded favorably for the Term Lenders at the prospect of owning the company if this plan is somehow confirmed, and as should be expected, the unsecuredes fell on the news. If one were to believe, as I do, that this plan has a very slim chance of going anywhere, it may be interesting to consider playing some capital structure arbitrage and longing the unsecuredes while buying LCDS on the Term Debt. The idea is that the deal will be recut to give the unsecuredes more recovery (there can only be upside from 1% if it’s recut), which will likely take away from some of the secured bank debt’s “sweetheart” package.

Now, what is interesting to me is how well the opco bonds have hung in. I am very excited about this case for the simple reason that this will be a real fight. Bondholders and bank debt holders both have reasonable arguments - it now depends on how well they present their case.

Nonetheless, as we mentioned in our original recommendation, the bank debt in the low 70's was a "no brainer." This is a perfect situation for a bank lender in that: more than likely we are getting par back and there is a chance, albeit small, that we might get equity, which could push our recovery well over 100% of par.

This will be an interesting distressed debt case study to follow. We will update you with any big information that comes out of the docket.



Distressed Debt Reading List

Many readers of Distressed Debt Investing have asked what books to read to get a better understanding of the principles behind distressed debt investing.

Now, as a personal disclaimer, I think the best way to learn about distressed debt investing is at a fund or a credit shop, getting your hands dirty in bankruptcy filings, talking to advisers, reading 10Ks, etc. One of the reasons I am so interested in this field, is that every situation is truly different. Judges vary on interpretation of law and due course, credit agreements and security documents are quite unique, and different creditor groups have conflicting agendas.

Now, I know that I have readers of varying interests / skill levels. That is why I am going to break this down into four different levels. I have read all these books, and recommend them all. If you are new to the field, start with the 101s. If you are experienced, start with the 301s. If you are John Paulson, skip the reading, and hire me.

Distressed Debt Investing 101

The Vulture Investors - While not technical in nature, this book gives you a very very good understanding of the qualitative aspects of distressed debt investing. It is a collection of "war stories" from the eighties and nineties featuring stars like Marty Whitman and Wilbur Ross.

Bankruptcy Investing - This is another good introduction to investing in distressed companies. It is very basic so possibly a good starting block for those VERY new to the game.

Distressed Debt Analysis - For those that have some familiarity with distressed debt, this would be my the choice of books to read. I think the author could of done a better job explaining certain concepts, but I enjoy some of his commentary. I have also heard him speak, and think him very competent in the subject matter.

Distressed Debt Investing 201

Bankruptcy and Related Law in a Nutshell - I refer to this book quite often when some lawyer is drawing some random bankruptcy provision out of thin air. It's not one of those "sit down and read for fun" books, but it is a great handy resource.

Buyout - You are probably asking yourself: "Why would a book about leveraged buyouts be in this reading list?" Well...for one, I loved the book. Two, a lot of bankruptcies are a result of LBOs. And three, it teaches you how to do an LBO model. BOOM.

Corporate Financial Distress and Bankruptcy - Some of my colleagues have never read an Edward Altman book. I call them failures. This book is stock full of historical data which gives the reader interesting context (relative to today). Plus, very heavy in terms of fundamental credit analysis which should be the black belt of a distressed debt analyst.

Distressed Debt Investing 301

Creating Value Through Corporate Restructuring: Case Studies in Bankruptcy, Buyouts, and Breakups - This was one of my favorite books on bankruptcies. It takes a behind the scenes look at the operations of a distressed organization and ways that advisers can unlock value. I think it imperative that investors understand the difference between a temporary and permanent problem and this book sheds the light on how to differentiate between the two.

Restructuring and Workouts - Pricey I know. And international in nature. Two quick turn-offs. But I enjoyed the text and found some of the examples enlightening.

Note: I have not had the time to read Marty Whitman's new book. When I do, I will post a thorough review.

Important: If you have a book that you think is interesting, please send me an email. This list above is far from exhaustive, and I am always looking for good summer time reading. Nothing like a tome on complex Chapter 11 proceedings to impress the ladies at the beach.

If you have any questions on distressed debt investing, or want to contribute, or have an idea for a story, or just want to get my opinion on a certain situation, please contact me: hunter [at] distressed-debt-investing [dot] com.


Where in the world is Distressed Debt Investing?

Distressed Debt Investing apologizes for the lack of posting. I was on a much needed vacation. As it were, going forward, I will try to post one to two times a week. If bond and bank debt prices get back to early March levels, there will be a lot more to write about and you can expect possibly multiple posts per day. In the meantime, I am working on a side project that I am very excited about (which I will talk about in the coming weeks).

Fortunately, in my "real life job" we have participated in the credit run, specifically at the senior secured levels. That being said, it is my humble opinion, that high yield bond prices, especially for very low quality issuers, are significantly above their intrinsic value. The reason for this is two fold: 1) Credit markets have opened up and various channels of refinancing are now available to lower quality borrowers 2) Given the dearth of supply in the October 2008 - February 2009 time frame, asset managers (traditional or not) found themselves with very high levels of cash, from a combination of interest payments and defensive posturing.

As credit markets opened, the option value that is a very very low priced bond became significantly more valuable (smaller chance of default leads to higher expected values of cash flows). Combining that with asset managers using cash to "chase return" leads us to a situation where a number of bonds are up 3 or 4x from the bottom despite no real change in operating / underlying fundamentals.

Bank debt has seen a very strong run-up in prices which makes more sense to me in that I believe syndicated loans in late February / early March were probably one of the most compelling investment opportunities I will ever see for the rest of my life. That being said, when on the run bank debt is trading at a price of 90 on a L+250 asset with LIBOR at 0.2%, you need a lot of leverage to meet our standard 20% IRR. The CLO machine, with its crazy magic rule of 80, have fueled the flames, especially considering the broadly syndicated primary loan market was dead for six months and many CLO structures of the 2007 vintage have not passed their lockout period (i.e. they need to keep investing in assets with their underlying cash flows). This has led to a situation where bank debt is up somewhere on the order of 31% YTD. Nutty.

This all being said, there is a lot to do on the investing side. Investors right now can lock in fairly secure yields by playing the basis between buying protection and underlying spreads. There are a few interesting DIP opportunities out there. Shorting consumer discretionary stocks is still appealing to me. And as always, you can spend countless hours arguing the value of Rouse bonds. - always the hobby of a distressed debt hedge fund analyst.



Notes from the HBSCNY Distressed Investing Roundtable

Last week we posted a quick note on the HBSCNY distressed debt round table. Well, our spies have performed, and now we some notes from the event. Enjoy.

• Eric Edidin, Managing Partner, Archer Capital Management (“EE”)
• Jed A. Hart, Senior Managing Director, Centerbridge Partners (“JH”)
• Tiffany Kosch, Managing Director, H.I.G. (“TK”)
• Victor Khosla, CIO and Managing Partner, Strategic Value Partners ("VK")
• John Reiss, Partner, White & Case ("JR")

JR opened by pointing out the enormous uncertainty and asked panel about their firms and what they were doing:

VK opened by saying they manage $3.3 billion and have 165 people globally (they have some CEO and CFO types that they can drop into operational roles, if necessary). He said they are not US centric and see lots of opportunities in Europe. They have 60 people in London and Frankfurt. They are salivating over the opportunities.

TK said that her group overall manages about $3.5 billion. She invests the Bayside Fund. They are also in London, Germany, and Paris. She said that Europe had greater dislocations and, thus, offered more opportunities. It wasn’t a contagion – it hit all at once. She commented that they look at deals like PE investments (not trades) and they focus on enterprise value and the potential optimal capital structure.

JH said that Centerbridge was formed 3 years ago by people from Angelo Gordon and Blackstone. They have about $7.5 billion of which $3.2 billion is control and about $4.0 billion is non-control focused (can’t reconcile the missing $300 million). They are currently only in NY and have 35 investment professionals. They are looking at non-control distressed investments. They are focusing on credit investing on a control or non-control basis.

EE said that Archer is a Hedge Fund that focuses on middle market. They primarily focus on secondary purchases, but do have some direct lending capacity (for DIP/Exit/Bridge). He said it’s a great time to be a capital provider. Noted that this cycle is different from prior cycles due to changes in Code and changed dynamics (shortened exclusivity, lack of DIP). Also the health of the primary investor is different (harder for them to inject additional capital). Expects cycle to be different.

VK noted that any investments made prior to Lehman bankruptcy (September) are hurting and it will take time for those to return to cost. He mentioned that they had purchased First Lien loans of a German company for $0.50 on the Dollar. The company will soon blow through covenants. He mentioned something about debt being priced at 2x EBITDA. Noted that Europe is less efficient since fewer experienced investors and less money chasing deals. Pointed out that there was still tail risk. If the economy gets worse, if the borrower has had fraud, etc. He said he manages these types of risks (although not overall economy) by having some diversification.

TK said they her firm tries to look at companies differently from others so as to create an advantage. She gave an example of a company that needed cash. She purchased the 2nd lien from a hedge fund. The company was losing $35 mm in EBITDA. They put in an executive who quickly was able to stop the burn and bring to break-even. The company was complicated (screwed up balance sheet, fraud claims, etc.) but it was resolvable. She said they need to look at lots of deals (reading lots of credit documents) to identify opportunities.

JH said they are focusing on cyclical versus secular declines. They identified a world class construction company with tremendous operating leverage that was suffering a cyclical decline in the building market. The company had been LBOed in 2005. Now had BEV of 25% of 2005 cost. PE firm walked away. Expected that his cost will end up being 1x EBITDA when the market recovers (thus >100% potential returns). They look for situations where they will get >100% through getting equity participation.

EE stated that they are trying to be market neutral. They have a sourcing effort where they look to private deals, call on PE firms and private companies. They were able to get great returns by loaning money to a company that had GECC as their lender. GECC wouldn’t extend the lines, so Archer lent money secured by the receivable of customer (Eastman Chemical). Had 20% IRR on project, and they purchased a CDS on Eastman from Morgan Stanley that cost only 1% (leaving their credit risk with MS). Seeing arbitrage opportunities in bankruptcy (like WaMu, and arb on liquidation/litigation). Can buy Chrysler Financial bank loans with 30% IRR (not part of Chrysler bankruptcy, in run-down mode).

JH said that they try to build a portfolio of companies that WILL DEFAULT. Looking for near term defaults. The increased speed of the process makes these investments attractive. Thinks Chrysler would have gone Government’s way regardless (not a good party to challenge).

TK said she spends a lot of time reading credit docs (remarked about not expecting to need a legal degree). Looking for shorter time frame. Look to avoid bankruptcy, which is a costly process, and negotiate out of court restructurings. Invested with a firm that services ATMs for banks. Since they hold cash for the banks to resupply the ATMs, the banks DID NOT WANT A BANKRUPTCY. She mentioned that there are a lot of people who think they can do the business and think they know companies because they read docs; but they respond “no” when asked if they’ve spoken with the companies themselves or their customers.

VK said that his firm does event driven investing. They buy in expectation of default. If the restructuring can’t be done outside of court, then they are not afraid to go through process. Typical time frame is 2 years with multiple upside.

JR mentioned that White & Case is finding that strategic investors (corporate) are willing to play the distressed game now, while PE firms are less willing.

TK said that she only sees strategics in 363 sales. She noted that many more PE firms are attempting to invest in the distressed space, but they have problems (their analysts are used to running models with stable or rising earnings – they are NOT used to projecting a period of deterioration in margins – which is typical in distressed/bankruptcy).

The panel discussed Europe. There have been big changes. In 1996-98 one of them had a bad experience in France where labor was put ahead of the secured lenders. They note that the UK is doable and similar to the US. Germany changed four years ago and now doable. The Netherlands is okay. France, Spain and Italy are not good spots for this type of investment (local laws not predictable/friendly).

Incredible stuff on the distressed debt market. If anyone else attended and can shoot me their notes, it would be greatly appreciated!



hunter [at] distressed-debt-investing [dot] com

About Me

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.