7.24.2009

Distressed Debt Case Study

Contributor Mark has been working diligently on our next distressed debt example. We hope you enjoy:

Introduction:

One of the reasons that distressed debt investing has the propensity for generating significant alpha is the fact that the distressed market is less efficient than other markets such as equity markets. Imperfect information and access to this information results in inefficiencies where astute investors can take advantage of market pricing anomalies and thereby earn substantial returns.

To take things a step further, illiquid or small cap issuers can result in even greater inefficiencies, and thus even greater alpha. Take, for instance, a small cap company that issues a term loan which subsequently trades in the secondary market with an 8 point bid/ask spread. There are two important things here to note:

1.) The small size of the issuer will likely result in many funds not being able to invest based on their policy statements (IE they may not be permitted to delve into issuers with market caps of say, less than $100 mm), and also based on the fact that small size loans and issuers are just plain overlooked by larger funds that need to put more money to work.

2.) The wide bid/ask spread means the issue doesn’t trade often. Although a bank might quote you 80/88, you likely could lowball it closer to the bid size and get a bite, thus creating a lower entry point than you would if the issue traded like water at a bid ask of 87/88. This is particularly advantageous if you plan to hold the security until maturity since you won’t have to deal with the heartburn of trying to sell an illiquid security when it’s time to take profits.

There are funds out there that specifically deal with odd lot small size deals specifically because of the opportunities the inefficiencies create. Generally larger funds chase larger deals, and view the effort and due diligence needed on small issues as a waste of time. This foregone investment can be a golden opportunity for others, and with this in mind, I would like to present a term loan issued by Interstate FiberNet, a subsidiary of ITC Deltacom (ITCD).

Structure:

The first thing we will do is address the structure of the deal, for those of us who don’t recall the lesson on structural subordination, this will be a brief refresher. Interstate FiberNet is the main operating subsidiary of ITCD, and thus is where the assets are held. Since the term loan was issued at the opco level, and is secured by all the assets & guaranteed by such opco, we know that structural subordination is not an issue. Additionally there is what we call an ‘upstream guarantee’, where the parent (ITCD), provides a full guarantee with respect to the loan. ITCD also provided a pledge of all of it’s assets to secure the term loan.

Business:

ITCD is a Competitive Local Exchange Carrier (CLEC) providing voice, data, and internet services strictly to business customers over it’s fiber backbone spanning across the southeastern United States. CLECS compete with Incumbent Local Exchange Carriers (ILECS), which are the more dominant larger companies that have been in existence providing telephone service in their given markets since the time of the Telecommunications Act of 1996. In this particularly deal we are analyzing today, AT&T would be the primary ILEC with whom ITCD competes with.

ILECS are required to offer collocation of facilities with other carriers, where such carriers can use network elements of the ILEC to provide their own facilities. The rates at which these Unbundled Network Equipment Platform (UNE-P) lines that ILECS must provide are set ‘reasonably and commercially in good faith’, and regulated by the FCC.

Investment Considerations:

To illustrate the purpose of such an agreement, think of a CLEC who does not have many of their own facilities, in order to even reach certain markets, they would need to effectively ‘piggy back’, on the network of the ILEC at the UNE-P rates. Another example is the final local loops or “last mile” copper lines. It would be economically unfeasible for a small carrier to outlay the funds needed in order to replicate such a structure, thus it must rely on one already in existence. ITCD is a facilities-based provider, and as such provides the majority of its services over its owned and operated network. It costs ITCD less to operate over its own lines than to pay the UNE-P rates, and as such ITCD has been effectively reducing its cost structure and increasing margins by increasing the lines offered on it’s own network versus through the more expensive commercially negotiated lines. Specifically as of Q1 2009 the company had 428,800 voice lines in service of which 86.2% were provided through its own network, up from 82.5% in Q1 2008. ITCD has also been reducing headcount, down 3.5% from FYE 2008. The following cost reductions along with a few others were able to increase margins enough that despite a decline in overall voice lines and drop in revenue of 2.25% from Q1 2008, EBITDA actually increased to $22.4 mm in Q1 09 from $20.8 mm in Q1 08, or 7.3%.

In my analysis I assume that revenue further declines due to an extended recession, resulting in a decrease of approximately 4% of annualized Q1 numbers for FYE 2009, and EBITDA margins contract 16% (the same as FYE 2008, down 2% from Q1 2009). This would result in FYE 2009 EBITDA of around $75 mm, which is probably a bit on the conservative side. At this level I expect levered free cash flow to be relatively flat or ever so slightly down, say between $0 mm and -$5 mm, as CAPEX should be down to more historical levels of around $45 mm after the company’s network investment in 2008 and Q1 2009. ITCD also has a ‘plain vanilla’ interest rate swap on it’s term loan with a notional amount of $210 mm, in which it has locked LIBOR in at 4.995%. When this hedge rolls off I expect the company to negotiate a new hedge at more economical rates, which will likely save a couple $mm of interest expense for the year.

With an assumed forward EBITDA for FYE 2009 of $75 mm, and applying an extremely conservative 2x multiple, we arrive at the following valuation and recovery prospects:


Enterprise Value @ 2.5x EBITDA¹ $ 187,500,000

Amount available to Pre-Petition Claims $ 187,500,000

Term Loan ($230 mm at issuance) $ 224,585,000
Revolver $ 10,000,000
Capital Leases $ 19,000,000
Total 1st Lien Secured Claims $ 253,585,000

Amount available to Second Lien Claims $ 0

Second Lien Credit Facility $ 75,000,000

Recovery
Forecasted 1st Lien Recovery 74%
Forecasted Second Lien Recovery 0%

Recovery @ different EBITDA multiples Recovery
@3.0x 89%
@3.5x 104%
@4.0x 118%

¹ S&P assumes 2 X Multiple and a 30% decline in EBITDA, which is how they arrived at their 5 recovery rating. Most recent comparables indicate 5 X is average for the industry, 2 X is a very bearish implication. A transaction for a similar network 9 months before the recovery report was issued traded at 11 X.

*RCL currently has 8.5M Drawn and 10M is total size

What the above analysis shows us is that at $75 mm EBITDA and applying only a 2.5 multiple, we are at 74% recovery. The term loan is currently pricing 73/78 so if we were to invest today our cost basis would be just about fully recovered as the loan is fairly valued. The above set of conditions is what I would consider to be a worst-case scenario, indicating that this pricing level would be the bottom for the loan. Several months ago the loan was actually pricing in the mid – high 50’s, and I commend any investors who snagged it at those levels. Now in reality I believe the appropriate multiple for this company to be closer to 4x-5x, and as you can see above the recovery prospects are well north of 100% resulting in an IRR of 13.4% and a current yield of 6.03% at current LIBOR of 0.51%.

In the analysis above is a footnote referencing S&P’s recovery ratings, a 5 recovery rating translates to 10-30% recovery prospects, the assumptions S&P used to outline their ranking are described in the footnote. To illustrate why I disagree with the assumptions provided by S&P, a brief synopsis of how their recovery rankings are produced is worth discussing.

S&P’s Recovery Analysis:

S&P recovery rankings are designed to show the prospects of recovery in a default situation, in order to arrive at a default, S&P almost always (with certain exceptions) stresses EBITDA to a level where covenants break. The next step is routinely to put a DIP Loan in front of the debt stack based on liquidity that will be needed to emerge from this simulated bankruptcy, this DIP primes all the other debt, and thus dilutes recovery. Additionally, after already stressing EBITDA down to low levels, S&P uses what I would consider to be ultra-conservative multiples.

There are two issues I have with this approach. First off, stressed EBITDA is not always the reason that a company may face default. Say for instance, a company was producing $100 mm in EBITDA, had $30 mm in interest expense, and $50 mm CAPEX, and thus generated $20 mm Free Cash Flow annualy. Now lets say there are no signs indicating a catastrophic dropoff in revenue, however there are several large maturities amounting to $200 mm total over the next two years. The reason for default here is likely the maturities if the company cannot refinance them as their FCF only allows them to pay down $40 mm leaving $160 to account for. However, the EBITDA and overall cash generating prospects of the company have not changed. Now if we were looking at a recovery ranking, they may have squashed EBITDA down by 30% to produce a default, and then apply a lowball multiple to an already unnecessarily stressed EBITDA. Doing this will produce an artificially low Enterprise Value. Secondarily, mathematically speaking, EBITDA multiples represent the relation between the discount rate and growth rate of a company, just like P/E multiples for equity. The higher the growth rate of cash flows, the higher the dollar amount an investor will pay for each dollar of earnings, similarly the more these cash flows are discounted, or the higher the discount rate, the lower amount an investor will pay for each dollar of cash flows as the present value is worth less. The above statement can be illustrated by analyzing the following formula for a cash flow multiple:

∑ [CF * (1+g)ⁿ / (1+k)ⁿ] ÷ CF

where “CF” is the initial cash flow, “g” is growth rate, “k” is the discount rate, and “n” is the number of periods. Now if you are already flexing EBITDA down to create a simulated default, you have already taken care of the low growth rate, so why would you take it a step further and apply an uncharacteristically low multiple (compared to industry trading averages)? I know this may seem like a lot of detail to explain a simple rating, but in this particular case study, I feel it is worth discussing due to the fact that the only real wall street coverage on this credit is from S&P, and their rating is pretty dismal. The fact that the only analysis out there is very negative is, in my opinion, a likely reason the debt is still trading at distressed levels.

Skin in the Game:

This deal is the product of a recapitalization that took place in 2007, where the company exchanged equity and used the proceeds of new debt to refinance and retire substantially all of their then outstanding debt. At the of the recap the company had a First Lien and Second Lien Facility outstanding, as well as Third Lien notes and various classes of Preferred Stock. The First and Second Lien Facilities were fully repaid with the proceeds of the new debt that was issued (the new debt refers to the $230 mm Term Loan we are analyzing in this case study, as well as the $10 mm Revolver secured and guaranteed equally and ratably with the Term Loan, and the $75 mm Second Lien Facility), and the third lien notes were paid off mostly with the residual proceeds from the new debt as well as a small portion of equity for the balance. Preferred’s got equity.

The original First Lien and Second Lien Facility were provided by funds affiliated with Tennenbaum Capital Partners (“TCP”), who also held a portion of the Third Lien Notes and Series D Warrants. Prior to the recap TCP held no equity interest in ITCD, but post-exchange TCP had approximately 20% of the equity in the company, as well as the ability to appoint 2 board members, which they have. Even further, the entire new $75 mm Second Lien Facility was issued by TCP and subsequent to issuance of the First Lien Term Loan TCP received a syndication interest in a portion of the Term Loan. Additionally after the syndication TCP purchased some of the First Lien Term Loan in the open market, and has recently been purchasing equity in the open market (to be exact 1,070,569 shares at a weighted average price of $0.55 for total cash consideration of $612,404.40) from November 28, 2008 until as recent as June 10, 2008. While in absolute dollar amount this may not appear a large position, it did increase their stake by about 10% as they currently hold 11.6 million shares, and with only 80 million shares outstanding, this is a 15% stake in the company.

The point of all of this is to show that the TCP funds have what I would consider to be considerable “skin in the game”. If you were a fund who provided credit to an issuer which later went through a recap, would you be willing to participate in their subsequent refinancing and recapitalization unless you were pretty confident in the future of the company? There is a very big aversion in the investment industry to “throw good money after bad”, IE continue to escalate a position that is likely to ultimately fail in hopes that it will turn around. Most companies will only keep throwing money in an investment if they are fairly certain of a profitable outcome, and the folks at TCP are no dummies. To me the fact that they went through one recap, provided funding to refinance their loans they made the first time around, and continue to purchase the equity in the open market says to me that they believe in this company, and you better believe with the amount of capital they have invested that they have done substantial due diligence. It is also probably worth mentioning that Welsh Carlson beneficially owned the majority of ITCD’s equity pre recap, and due to their position in some of the Third Lien Notes as well as various series of Preferred Stock, they received even more equity during the recap. Currently they hold about 48% of the equity and thus are the controlling holder. They have 3 board seats, TCP funds as mentioned earlier have 2, and the board as a whole has 9 seats. This company is essentially being run by two funds both with a lot at stake, and a lot of financial savvy to help move this company in the right direction. Additionally one of the funds is still throwing cash into the company.

Conclusion:

There are a couple of factors that play into this deal. Given the complete lack of coverage by all but S&P’s draconian Recovery Analyses, and the small-cap status of the Issuer, I feel the deal has likely been under the radar to most investors. The lack of eyes reviewing the security and thus the relative illiquidity evidenced by the bid/ask spread has resulted in a price that is what I believe to be below intrinsic value. Assuming a price of 75 which is around the midpoint of the bid/ask spread, and with a coupon of L+400 at current LIBOR of 51 BPS, the IRR on this Term Loan is 13.4% with a CY of 6.03%. Given the recent run-up in the high yield markets I feel this is an attractive yield given the improving credit metrics for the company. The most restrictive of the Company’s covenants is it’s 1st Lien Leverage Covenant, which is 3.00:1.00 until the end of 2009, then stepping down to 2.75:1.00 for the period 1/1/2010-9/30/2010, and finally 2.50:1.00 for the period 10/1/2010 and thereafter. The company is currently in compliance and I anticipate they will be able to maintain compliance due to their substantial liquidity ($65.8 million cash on the balance sheet for Q1 2009), and estimated flat to mildly decreasing FCF position over the course of the next year.

Questions / Comments / Thoughts always welcome here at Distressed Debt Investing

15 comments:

Lawrence D. Loeb 7/24/2009  

Given that you have two funds controlling the company, one of which is pumping money into the public equity (and which you say is a well managed fund), and there is no imminent prospect of default, it seems like the first lien should be pretty safe.

The threat of IP telephony could be a problem, but I'm not an expert in the field.

Forgetting the quant analysis for the moment, insiders putting new money in; no default prospect; and the ability to put new money in should there be a short term squeeze seems to limit your downside.

I am concerned with the IRR, however. Was the 13.4% IRR based on a price of 74? If so, isn't that a bit low for a distressed investment?

The risk/return may be aligned, but the return profile would seem unattractive without leverage, which you would tend to avoid in a distressed strategy (right?).

Anonymous,  7/24/2009  

Hey Hunter, there's something wrong with the links in your posts. Like in this one, the link to Mark's distresed debt example points to the blog's frontpage. I've seen this several times in your blog.

Anyway, thanks for a great and informative blog with truly unique content. Way too few of those in the world.

ronagt 7/24/2009  

Low current yield, middling IRR and inability to put on size will clearly limit appetite for distressed players. $75MM EBITDA is very conserviative given they had best quarter since Telecom Bubble burst in Mar09; also an oligopoly competing against sleepy Bells who don't know how to sell to SME, though competing on price isn't an advantage to get too excited about. The analysis neglected to mention the company is sitting on $67MM in cash and has $20MM less in secured debt (less cap leases and 2d lien, more firs when inc unamortized discount). If you're the type you like leverage to juice returns, its a good safe bet. Then again, if you think 5x is the right multiple, just buy the equity which has much more upside.

Anonymous,  7/24/2009  

I don't understand your calculation of the 1st lien recovery in the 4.0x EBITDA multiple case: why wouldn't the 1st lien get paid back at par (you have them getting 114) and the second lien get equity?

Anonymous,  7/24/2009  

Ronagt: "Middling" IRR, given the general performance chase that is just now abating, is probably not quite accurate. The cash balance is mentioned in the conclusion paragraph at the end. I spoke to the CFO and asked why they didn't go out and purchase the Term Debt when it was at 59 cents a few months back, they said they were restricted by their covenants and before I could rebuttle followed with "but we can always seek to amend", which is what they should have done unless there is some plans for the cash. The only thing they told me is that their customers liked them having a large cash balance,however I'm sure their securities holders would prefer they do something with it.

As per the most recent 10-Q, there is $75 mm out under the 2nd lien. However you are right on the cap leases, they should be 11 not 19, that was a bust left from the 10-K.

Anon: The 1st lien recovery is just a simple calculation it's not meant to show what would happen in an actual restructuring, just if you get full recovery. It's simply cash available to 1st lien divided by 1st lien. If this was an 11, yes, the secured would get taken out at par and the balance would go to the 2nd lien in either cash, new notes, equity, or a mix.

Anonymous,  7/24/2009  

As for the comment about why not to buy equity if 5x is the appropriate multiple: At 5x our Enterprise Value is $375 mm (using the conservative $75 mm). Subtract out our 1st lien of $224.6 mm,capital leases of $11 mm second lien of $75 mm, you get implied equity of $64.4 mm. Divided by their outstanding shares of 80.9 mm, your implied trading value is $0.80. The equity is currently at about $1.20 last I checked, meaning it's overvalued if we think its 5x. There is a disconnect between the equity and the debt, the equity is giving an implied 5.4-5.5, and the 1st lien is implying 2.1-2.2 at the current run rate EBITDA

ronagt 7/25/2009  

Anon in the post on 7/24 makes several errors and also shows a tolerance for chasing returns that is not well suited for investing in small, distressed situations where liquidity can dry up very quickly. But if you are going to chase, do so to win (hence the equity call).
The cap lease is $11M not $11MM or $19MM; Even if they wanted to, the first lien limits them to $7.5MM. In addition, the draw on the revolver is $8.5MM, with $600M in availability after LCs. The cash balance is actually $1.1MM higher when you include the payout received on the First Reserve cash (listed as a portion of the ST investment on BS). The first lien is $226.5MM (real #, not just pulling from balance sheet without reading notes)
75MMx5=375mm-310mm+67.3MM=132.3MM mkt cap, or $1.63/sh. However, they did over $22MM in EBITDA in March and continue taking out cost, so even if did just $80MM in EBITDA during this miserable year (7% better), the stock @ 5x is just shy of $2/sh (20% higher) - demonstrating the huge leverage in this business.

Anonymous,  7/26/2009  

Ronagt, you have a good eye. Follow the name much? Anyhow, I agree with everything you said, but I think adding the cash to the market cap is a bit of a leap of faith (it implies your assuming that money goes to pay down debt, no?). I don't doubt the FY will be better than $75 mm, but at our fund I always like to show downside, call me a sandbagger if you must. In any event we both can agree the debt is undervalued. If 13% is low in today's market, what would you consider a sufficient return given the run-up in the high-yield market?

Anonymous,  7/27/2009  

Absent the cash which could be used in lieu of a DIP loan to fund operations in chapter 11, I would be less sanguine about this name. In these situations the pre-petition bank debt can get screwed by a DIP that quickly forces a 363 a la Foamex. You have to control collateral post petition, and if you don't you are at the mercy of the DIP lender. IF the DIP lender is the stalking horse he is going to collude with management and get the company. Pre-petition creditors would have to either step-up and take out the DIP or face getting nothing.

Lawrence D. Loeb 7/27/2009  

Actually, the DIP lender can only get security if there are assets that haven't been secured or if there is excess value in the existing secured assets. The debtor must provide proof that there is "adequate protection" for the existing secured claims before the DIP can be secured against the same assets, let alone prime the secured creditors (see Section 364(d)).

Of course, if the value of the loan is greater than the value of the security, then the excess is unsecured.

This is why so many DIPs have been roll-ups by existing secured creditors (judges usually frown on the practice) and why, under Delphi's plan with Platinum some of the DIP lenders were to recover only 30% (they had adminstrative status but insufficient security).

Hunter 7/28/2009  

I leave for a few days, and you guys are having all the fun. The question remainds, does ITDC need a DIP in bankruptcy? Maintenance capex is quite light relative to run rate cash flows.

Anonymous,  7/30/2009  

ITDC may not need a DIP, that is why I said absent the cash. However, with respect to the comment about the DIP. The court can grant super-priming liens on the debtor's existing collateral for a DIP, regardless or whether the pre-petition is undersecured. Since the adequate protection payments and liens (to the extent there is secuirty for them) are not going to have super-priority or administrative status, a roll-up is a better strategy for the creditor.

Lawrence D. Loeb 7/30/2009  

The court cannot and will not prime a lien that is not adequately protected because of 364(d). If the full value of all of a debtor's assets are liened, the court can only provide super priority administrative status.

Super priority administrative status provides a DIP lender with the right to be paid at the end of the case (or at the end of the loan term), but if there are not enough assets to pay the super priority administrative claims (for example, no exit financing), they do not prime the secureds.

If the exit is to a continuing operation, an unsecured DIP lender can roll over the loan (or take some other form of continuing interest - equity, etc.) - of course the existing secureds wouldn't be paid in that case either, but their standing relative to their liens wouldn't change (except in very unusual circumstances). If it's a liquidation, then the DIP lender takes the chance that there may not be sufficient assets to pay the DIP after satisfying the secured claims.

Section 364(d) gives the court NO DISCRETION and requires that the trustee (or debtor in possession) prove that there is adequate protection before a lien can be primed.

The Delphi plan that included Platinum would have paid the unsecured DIP lenders only 20% of their principal. That's an unusual case, but it's an unusual situation.

If you look at the Dayton Superior case, the unsecured bondholders challenged the roll-up offered by the secured lender - but eventually settled. Prior to the settlement, the debtor's argument was that a priming fight would be futile and costly, leading them to select the less attractive economic terms offered by GECC (as opposed to the bondholders' proposal).

A debtor that has no assets left to offer as security is at the mercy of their existing secured lenders - if they can convince them to provide a roll-up.

The lack of exit financing has made DIP loans, where there are no assets to provide security, almost solely the province of the existing lenders (secured and, sometimes, parties further down in the capital structure looking to increase their leverage). This is why the courts have accepted roll-ups, which they generally frown against.

An existing secured lender who participated in the roll-up is in a better position than a non-participant, but only because they would be first in line to get paid upon a successful exit.

Lawrence D. Loeb 7/31/2009  

This Bloomberg article shows what is currently going on in the DIP market.

In relation to the 364(d) issue, the article notes that the unsecured Lyondell DIP is trading at almost half of the price of the secured DIP (identified in the article as the "DIP roll-up" versus "portion of the DIP that wasn’t rolled up").

Anonymous,  8/03/2009  
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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.