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.