A Hypothetical Distressed Debt Interview - Questions Continued...

In the first hypothetical distressed debt interview, we tackled a number of questions the authors of Graham and Doddsville's posed to Stephen Moyer. What follows is the remainder of the interview, with my answers to the questions posed. Enjoy!

How do you think about the margin of safety on a distressed investment?

In my opinion, margin of safety is the safe return of principal under even the most dire of circumstances / events / conclusions to the investment thesis. Unfortunately, in the distressed investing process, one can never really predict with 100% accuracy what a judge will do. You can get a good sense based on their previous decisions and the rule of law, but the wild-card that is the judge can really alter recoveries.

That being said, Ben Graham really cared about return of capital (principal with respect to bonds) versus return on capital. This is where an investor has to fully understand the structure and covenants of a particular investment to get comfortable. How many ways can you be primed and by how much? How loose is the permitted indebtedness definition? What murky ways can an acquirer get around the change of control / poison put? Where are the carve-outs for additional liens? All these questions, and many more, are essential in understand how likely it is you will get capital back. Almost always, as second nature now I guess, the first thing I do when looking at a potential investment is draw out the corporate structure, how much debt and cash flow is at each entity, what security is granted to what instrument, and how much debt can be layered on through either "loose" covenants and permitted indebtedness.

I generally will not invest in a security if the chance or risk of permanent capital loss is anything more than diminimus. Yes, there are cooky variables (as mentioned prior, judge opinions), that are nearly impossible to handicap. And in cases like that, I may not even play the game. Maybe I am more risk averse, but I want to be around to see who finishes the race. I want to bet big when the deck is stacked in my favor. I might have to wait around for a lot of pitches, but when things like HCA's bank debt trades in the low 70s, yielding 15+%...you just have to take big swings, because you might not ever see that pitch again.

Intense litigation seems to be a major theme of this cycle as well. Will this have any impact on returns from distressed investments?

Given the way creditors have been diced up in this past credit boom, meaning a vanilla corporate structure of say first lien and subordinated bonds turned into first lien ABL, first lien Term Loan B, second lien Term loan, senior uns, senior subs, HoldCo Piks, etc, I think it is inevitable for litigation to rear its ugly head in big ways. There are so many more stakeholders. And each of those stakeholders are answering to an investor group. If traditional recovery metrics imply that you are getting 0 back on your principal, why wouldn't you litigate? Docs were so sloppily written in 2003-2005 before second lien and inter creditor agreements became more standardized. Lien perfection has really been a hot topic recently which is astounding to me.

In terms of impact on returns, I would have to say its going to benefit the junior creditor. If you assume that 5% of all litigation are successful, the sheer financial leverage at certain borrowers could boost recoveries 3 or 4 or 5 fold for the subordinated tranches. Might as well swing for the fences if I am getting jammed with a zero / warrant recovery.

The increased competition you reference is perhaps a reflection of the size of the opportunity in this distressed cycle. How do you envision the near-term growth and success of the distressed fund industry?

There was an interview with Dan Loeb where he said the total high yield / levered loan market was $1 trillion dollars and the entire non-agency mbs / cmbs market was $1.5 trillion dollars. Taking just the corporate side now, assume default rates continue at around the 10% clip. We are talking about $100B of new distressed supply (notional). Now granted some securities trade for 5 cents on the dollar and others trade for 160 cents on the dollar (W.R. Grace bank debt), so it's hard to pinpoint how many capital dollars can be put to work. It is a lot though.

In addition, I believe opportunities exist as you move into smaller and smaller enterprise values. If a debtor has call it $20M of debt outstanding, I doubt some of the bigger boys play as the investment will not move the needle. Further, the seller of this paper, many times regional / super regional banks can be forced sellers further deviating prices from their intrinsic value.

But if I were to set up my fund today, I would not dictate size constraints in the OM. There have been incredibly profitable situations when the EV of the debtor has been spectacular (see: Enron). The buyers of Rouse bonds (in the 40s) have seen a large windfall and EVERYONE knew that situation well. If you told me, that $1 trillion dollars was to come into the distressed market to soak up $100B of supply, yes all boats will rise with the tide, but I promise you the market will be anything but efficient.

Are there any specific strategies that will return more than others or garner more attention from potential capital?

If I knew that, I'd be living on a beach in the South Pacific, drinking Jose' and making trades from my blackberry. But if I had to handicap it, I would say that performing first lien bank debt will see the weaker return simply given how tight the short end is, and how fast the run-up has been. Select special first-lien situations (bank debt in re-org, close to re-org) should still see nice returns with adequate principal protection. RMBS and CMBS, are not my forte and thus I have nothing meaningful to add (and if you are an expert, and want to contribute to the blog, please email me). Whole loan mortgages are probably pretty interesting. Bonds of complex issuers (CIT, AIG) are a real wild-card and need lots of work, but could be very compelling in certain situations. Every one in the world I know is playing the short end of the curve, hence maybe their are real opportunities further out. Markets are probably decently close to fair value, but that never stopped me from finding very attractive investments. Markets can be flat for a very long time, and opportunistic and hungry investors, like myself, will still generate excess returns.

How do you approach the search process for generating investment ideas?

I use the function way too much on Bloomberg. This shows the list of all bonds yielding over 10%. As mentioned in earlier posts, I get about 4000 Bloomberg messages a day with broker and dealer runs. I talk to people on the buy side regularly during the day. I am starting a distressed debt investor club.

What I find interesting about the high yield / distressed / levered loan market is that it is very repetitive in the sense that many times borrowers will forever be branded with the sub BBB- high yield notation. Hence, the more situations the study, the more useful you will be when the same issuer stumbles along the lines. That being said, constantly learning about new companies and industries is crucial to succeed in this business. Furthermore, learning the rule of law, the way bankruptcy proceedings are shaking out in court, the various stakeholders and their motivations, is also imperative to succeed.

DIP (Debtor in Possession) financing has made a slow re-entry into the markets. What has to happen before DIP loans become readily available to firms filing Chapter 11?

I get a three emails a day asking to talk about DIP financing. I am going to write a very comprehensive review in the coming weeks as I think it is a fantastic part of the market to play if you know what you are doing. So I'll leave that answer for then.

Aside from your book what would you consider as required reading for today’s distressed value investor?

Distressed-Debt-Investing.com of course. In addition, I would read and keep up to speed on as many dockets as possible. I would try to connect with as many advisory firms as possible and try to get their pitch books to learn up on situations. I would read my distressed debt recommended book list. I would read as many client bulletins put out by law firms like Latham which are invaluable learning tools (I will aggregate these one day and put them up as links).

Finally, if you were a young analyst graduating from business school today, what would you look for in a firm when recruiting?

Besides having locked up capital, which in my opinion, is the holy grail of investing, I would look for a shop that has a fairly broad mandate. You do not want to be limited to your investment choices because that is not the way capital is meant to flow. Small or big...it doesn't really matter unless pedigree is a major concern for you. I would say non-formulaic investment process (i.e. you could buy an asset with 3 minutes of work if it was compelling enough), but I know and appreciate the merits to the slow and steady approach. Finally, you want to work for a portfolio manager you can learn from and who will challenge you to become a better analyst.



A Hypothetical Distressed Debt Interview

I mentioned to readers in the past that one of the distressed debt books they should start out with, in learning the distressed debt investing process, is Stephen Moyer's Distressed Debt Analysis. Moyer was interviewed in the most recent issue of Columbia Business School's Graham and Doddsville and I thought, for kicks, and to answer some of the emails I have not gotten around to, I would take a shot at answering the questions the authors posed to Moyer. Enjoy.

Distressed investors were touting the arrival of the next cycle as early as 2006 but to what degree did they expect it to take the shape we see today and how have the rules of engagement changed when compared to previous distressed cycles?

In 2007, Bloomberg hosted a panel on distressed debt with Marc Lasry of Avenue Capital and Mark Patterson of MatlinPatterson as the keynote attendees. It was standing room only and packed to the gills. At many of the holiday parties in 2006, for example, the Goldman Sach's Restructuring Party at the Time Warner Center, it was so crowded you could barely move. Many people saw this coming, but they didn't know what straw would break the camel's back. They were ready in 2006, and thus bought early in late 2007 ("Let's lever up senior secured bank debt at 95, at 5x") and early 2008. Little did market participants know that yields would go from 12-15% for on the run stressed names to 30-50%. They were ready and they expected it. The securitization market, that fueled credit tightening, had to slow at some point, and LIBOR + 200 was just not going to cut it for deals 5x levered through the senior tranches.

The rules of engagement have changed because capital structures are much more top heavy in this cycle than previous ones. Historically, banks like to play ball and roll their loans in a restructuring. In this cycle, I think you are going to see the fulcrum move to up the capital structure, thereby reducing recoveries at the unsecured tranches. This creates an interesting dynamic given the fundamental innefficiencies of CLO asset vs liability management in a distressed situation.

Comparing the lower volatility approach of investing in secured debt vs. the potentially asymmetric returns of buying bonds how do you think of value and rates of recovery in today’s distressed capital structures?

As mentioned above, it stands to reason that given leverage is so much higher through the secured level, recoveries on the unsecured tranches should theoretically be lower. That being said, there will be a number of situations, where, given a reasonable basis, investors moving down the capital structure makes perfect ecnomic sense. If a borrower emerges from chapter, with its senior secured bank debt reinstated at some level, let's call it 4.0x, and an investor is confident in the business prospects, buying into the junior tranches could create enormous value relative to purchasing a performing Libor + 500ish asset.

Is it a fair statement, then, to say that the fulcrum security today lies somewhere within secured debt?

All else being equal, yes. But, and I have pointed this out in the past, you have to look at motivations. If the senior secured tranche of XYZ borrowers is held 90% by CLOs, they may want to take back coupon paying paper versus equity. Now, that is not to say, that the senior secured lenders might not try to cram you down, take equity, AND paper (see: Six Flags). If I was a betting man, which I am, I would say more secured lenders will be holding re-org equity as you look through this cyle.

As for the ease of access to capital during the bubble what kind of changes do you expect going forward?

While not really prevalent now, and practically dead a few months ago, I do think you will begin to see a number of funds solely focused on the DIP game. Despite what is happening with Delphi (DIP C trading in the 30s), there is a case to be made for how attractive the "DIP asset class" is. As for more on the run financing...well, the beast is dead. Bankers will try to revive it because fees are fees, but in my mind, I do not see how the CLO model, at 12x levered, gets started again. Maybe 4-5x I can live with. With that said, a significant amount of capital has moved back to the unsecured market, where new deals are announced daily. So the tide is turning from more top heavy capital structure to a more normalized structure. A more normalized structure as compared to 2005-2007 structures would also mean less/weaker covenants with higher cash flow going out the door (to pay interest). Do those two factors offset one another? I don't know the answer to that, but it will be intersting to see how it plays out.

Given that I have been up for 16 hours working on CIT (no where near an answer yet), I'll finish the rest of the distressed debt interview over the weekend. Comments welcome.



Distressed Debt Case Study

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


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).


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.


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

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.


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



Wisdom from Seth Klarman - Part 1

Seth Klarman and Baupost are in the news lately regarding the CIT bailout. While I do not want to delve into specifics, I will say that, outside the chance of fraudulent transfer / conveyance / some other quirky bankruptcy ruling dealing with the rescue financing, I would buy the new L+1000 loan (3% floor) all day long...especially if I was getting a 5 point advance fee. Currently in the grey market (when-issued) it is trading at 104-105 without the fee.

As we have not discussed Klarman or Baupost in the past few months, I thought I would take a few moments to pull out some of the more educational quotes from his fund letters through 2004-2007 (note: I do not have the fund letter from 2008...just the portions that were posted in a recent issue of Value Investor Insight).

Before I start pulling out some of my more favorite Seth Klarman quotes, I want to point our reader to a post by Sivaram Velauthapillai, at his contrarian investment blog, where he discusses Seth Klarman's performance in relation to Warren Buffett (WEB). Now admittedly, Sivaram admits he does not know much about Seth Klarman, and really was pulling information from a document I alerted readers to a while back: old Seth Klarman Fund Letters. A few comments have already corrected him, but just to reiterate: As of the end of 2007, Klarman was CRUSHING the S&P since the inception of the fund. The lowest return of the three classes of his funds, from inception, was 5903.7% cumulative return (10434.2% for the largest inception return). And no I did not place the decimal in the wrong point. The S&P in the same period return came in at 1828.4%. So despite lagging the S&P in the go/go years of the 90s, he maintained his capital base when the market gave a lot back in 2000-2002 and the rest is history. In 2008, press reports stated that Klarman was down low double digits. I can neither confirm nor deny this. Nonetheless, the S&P was down ~38.5% ... further extending Baupost's lead.

In response to the blog post specificially: I understand the point about Klarman under-performing the S&P in the go-go years. I get it. But, the problem in looking at any one's record at any one point in time is that the past is the past. If you had looked at John Paulson's merger arbitrage flagship fund in the beginning of 2007 you may say to yourself: "Well, this fund...you know, it has been just doing OK" ... and then he goes out and throws a +50% net to investors year in 2007 versus a nearly flat market. On the flip side you could look to any number of funds that were putting up annualized returns in the high 20s to low 30s up to 2008 and were down 50-60% last year bringing their cumulative returns to mere marginal levels.

Extending this to fundamental analysis, take a guess who's returns these are:

1991: 14.9%
1992: 28.1%
1993: 27.7%
1994: 22.3%
1995: 11.3%
1996: 21.2%
1997: 22.1%
1998: 19.2%
1999: 16.1%
2000: 15.9%
2001: 11.7%
2002: 15.7%
2003: 17.7%
2004: 17.0%
2005: 15.2%
2006: 18.3%
2007: 1.8%

They are the reported return on equity of Bear Stearn (as reported from Bloomberg)...right up until the very end. As Seth Klarman writes in his 2004 letter, "While others attempt to win every lap around the track, it is crucial to remember that to succeed at investing, you have to be around at the finish."

Now onto some more Seth Klarman wisdom. I am going to a few quotes from each letter (2004-2007) that I find particularly insightful regarding the investment and portfolio management process.

From the Baupost 2004 letter:

"By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, "I would rather lose half our shareholders...than lose half our shareholder's money..."
That is just a spectacular quote (both Klarman's and Eveillard's). It's also why, as my readers are more than aware, I prefer current paying, senior-secured bank debt. Risk of permanent capital is low, I am getting paid to wait, there is a definite catalyst in emergence, and I have some control over the process. More quotes from the 2004 letter:
"We continue to adhere to a common-sense view of risk - how much we can lose and the probability of losing it. While this perspective may seem over simplistic or even hopelessly outdated, we believe it provides a vital clarity about the true risks in investing."
Another great quote from Seth Klarman. Risk is not beta or standard deviation...it is how much you can lose on an investment and what the chance is that "loss" scenario is going to play out.

And finally, from the 2004 letter (I am going to jump around on this one for full effect):

"Markets are inefficient because of human nature - innate, deep-rooted, permanent. People don't consciously choose to invest with emotion - they simply can't help it.

"So if the entire country became securities analysts, memorized Benjamin Graham's Intelligent Investor and regularly attended Warren Buffett's shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads...People would, in short, still be attracted to short-term, get rich quick schemes.

"In short, we believe market efficiency is a fine academic theory that is unlikely ever to bear meaningful resemblance to the real world of investing."
Take that Burton Malkiel.

In the next few weeks, we will offer more wisdom from Seth Klarman, from both his fund letters, and other public sources. Stay tuned.



Balance Sheet Analysis: Cash

If you remember, right when this blog got started, we did a post on balance sheet analysis and told readers that we would do a whole Distressed Debt Investing series on it. I intend to focus this series on non financial companies as the balance sheet of financial companies requires a completely seperate analysis (burn-downs)...so think of your typical industrial, retailer, transport, gaming company for our financial statement analysis discuss.

The first line item we are going to discuss on the balance sheet is cash. You may be asking yourself: "Hunter - Cash seems pretty simple...let's move on to deferred taxes and pensions." While I agree to some extent, the nuances revolving around cash analysis can be fairly intricate and tricky. I hope to point out some of the more salient points to consider when you are looking at plain old vanilla "cash."

Cash is 9 times out of 10 listed as the first asset on the balance sheet. It may or may not be combined with short term investments. In a company's 10K, usually in the first note of the financial statement, a company will list what the company believes cash equivalents are...for example, from a very well known hard-line retailer: "The Company considers all highly liquid investments purchased with original maturities of three months or less to be cash equivalents. The Company's Cash Equivalents are carried at fair market value and consist primarily of high-grade commercial paper, money market funds and U.S. government agency securities."

Now, this is all well and good until you get a situation that occured in 2007 and 2008 with Auction Rate Securities and money market funds that broke the buck. For example, from Pinnacle Airlines' (PNCL) most recent 10K:

"We continue to own approximately $133.7 million par amount of auction rate securities (“ARS”). Due to unprecedented events in the credit markets during 2008, these investments became illiquid and have suffered a decline in fair value. We reported these investments as noncurrent assets on our consolidated balance sheet at December 31, 2008 at their estimated fair value of $116.9 million. We continue to earn interest on all of our ARS, and the majority of our ARS are still rated AAA/Aaa by the credit rating agencies. Most of the banks that structured and sold ARS to investors have entered into settlement agreements with various state and federal regulatory authorities that provide for the repurchase of ARS at par value from retail

investors and small businesses over the next 24 months. In addition, some banks have made offers to larger institutional investors to repurchase ARS at par value in 2009 and 2010 to the extent that institutional investors have been unable to sell their ARS. We have not yet received such an offer from the financial institution that structured and sold to us our ARS, and we have no assurance that we will receive such an offer. However, we anticipate that to the extent most major banks make settlement offers to their institutional clients, we would be made a similar offer for settlement related to our ARS holdings.

The collapse of the ARS market has had a significantly negative impact on our liquidity and the strength of our balance sheet. To partially offset this effect, we arranged for a $90.0 million margin loan facility (the “Credit Facility”) to be used to support our aircraft purchases and other working capital requirements. Although the Credit Facility has a maturity date in January 2010, we anticipate that the Credit Facility will remain outstanding until we receive an offer to repurchase our ARS or otherwise monetize our ARS portfolio. While we have effectively obtained the use of $90.0 million of our ARS through this Credit Facility, we do not have access to the remaining $43.7 million par amount of our ARS to support our liquidity needs. We do not know when we will be able to monetize our ARS portfolio, and we may have no choice but to sell our ARS at current distressed prices or to hold our securities until maturity, which could be 17 years or longer."
From lots of liquidity, to virtually none. Do I think an investor could of spotted this before Pinnacle made its disclosure? Yes. In previous 10Ks (for example, the 2005 10K before anyone knew what an ARS was) the company fully disclosed that they had invested in auction rate securities. I am sorry too keep pounding the table, but you have to do your homework. You have to read the last 3 or 4 10Ks to really understand what has been going on in the business for the past 5 or 6 years. This will put you about 95% ahead of the competition.

So, at this point, you should have a fairly good understanding what the definition of cash is for XYZ business. Fairly self-explanatory.

From here where do we go? We need to figure out the minimum amount of cash needed to operate the business. Cash requirements can arise from regulatory issues to the way working capital flows through the business, to covenant issues, etc. For example, many gaming companies need to maintain adequate cash to cover as some percentage/multiple the total amount of chips on the floor. Some credit agreements require a company to maintain a certain amount of cash less than be subject to more stringent covenants. Some companies (especially the very seasonal ones), need to build cash in certain periods of the year to buy inventory for the big seasonal sales. Cash, at its core, is liquidity. Liquidity is precious - especially in times like today - and more so in late 2008/early 2009.

Where do you find this information? Well, besides doing your doc work, you can call and ask the company, look at historical cash holdings and a quarter over quarter basis, calculate their cash conversion cycle versus sales. Why is this all important though?

When you know the amount of minimum cash a company must hold, you can calculate their excess cash holdings. Better yet, you can forecast their excess cash holdings in the future (conservative assumptions only). With that information, i.e. their expected free cash flow, you can build in assumptions for how much stock a company is able to buy back, how much debt they can pay off, what kind of expansion capex they can complete, what acquisitions are feasible, etc. A company's intrinsic value is the difference of cash in versus cash out for a business discounted back at a cost of capital. How would you ever figure this out if you didn't know the minimum amount of cash needed to run the business?

As an example, think of a widget company that needs to maintain 10M of cash on its balance sheet for working capital swings. If you project the company to generate, in aggregate, 1M of free cash per annum, you know that the company has 1M of excess capital to make moves with. From here, try to get a sense for the incremental return on capital a company has and you are one step closer to getting an adequate picture of what the future looks like for our widget company.

So after you know what the definition of cash is, how much cash the company is required to hold on the balance sheet, you need to know where this cash is. Seriously. Where is the cash located? Is the cash located in an overseas domicile where incremental returns on capital are significantly less than the United States? If so, the compay wants to repatriate that cash. But then they may get taxed on that repatriation. So now you have to discount your cash number. Confused yet?

Many times, at the near end of a company's 10K, there will be a listing of seperate financial statements either broken out by domicile or in the case of many levered borrowers by guarantors / non guarantors. Foreign subs are more likely than not guarantors of various debt agreements, and this can be a first clue to figuring out where the cash is located it. If a company is generating a substantial amount of its cash flow overseas, but has limited investment opportunities abroad, and no NOLs to shield the tax gains, you may have to adjust your carrying cash down. If you cannot find the information you are looking for, call the company. Asking the company for factual information is fine - asking them what their prospects are is a different matter: you decide that yourself, not based on a CEO talking his book.

Finally, and I will harp on this in the future, one of the most important questions you have to ask yourself as an analyst is: What is the company going to do with its cash? You know what cash means, you know where it is located, you know how much is required to run the business...but the $64,000 question is: What are the stewards of the capital going to do with it?

A management team compensated on sales is more than likely going to expand via discretionary capex. A management team compensated on EPS may be more likely to buy back stock. A management team earning 3% on incremental capital, when they have 8% bonds outstanding may buy back debt. Of course, I am assuming a management team does what is logically right based on incentives given...this is sometimes (actually, come to think of it, usually) not the case. It is sometimes comical to lay out what a management team has done with their excess capital (cash) ... I just looked at a lodging company that spent $1.5B of shareholder capital in 2006 and 2007 buying back stock at 22x forward EBITDA. How do you think that return on capital played out? Seriously.

And this is why gentle reader, it is imperative you know your management team. You HAVE to look at their track record of allocating shareholder (and lender) capital. You have to look at their past track records of companies they were at previously. You want to know how XYZ CEO is compensated as that will give you a first guess of where his interests lie. You need to get a sense for what opportunties are out there (from an IRR perspective) and how that will shape management decision making.

Yes, this is hard hard work. And we are only the balance sheet analysis of cash. But, remember what Alice Schroeder said about Buffett: "...he works like a demon from morning until night and he’s been doing that for 70 years." Security Analysis is hard, hard work. But, if you really have a passion for it, and get better a little bit every day, you can excel with the best of them.



Distressed Debt Case Study: Lear

Before we get to the Lear distressed debt case study, I want to let everyone know that I received their email regarding the Distressed Debt Investor Club. I am happy to say I have received approximately 50 emails already. Please, if you don't mind, spread the word! I will talk about the application process in the coming weeks.

Now on to the fun stuff: Lear. For reference, here is the docket: Lear Docket.

Lear, like many auto suppliers before it, filed for bankruptcy protection due to declining auto sales (SAAR from 15M in 2007 to projected 8M in 2009) and its higher debt load. Knowing that the writing was on the wall, Lear and its lenders/bondholders worked out a pre-packaged bankruptcy (pre-pack) to allow for emergence as soon as feasible. The longer in Chapter 11, the more the lawyers and advisors get paid. No one wants that.

Lear detailed its proposed restructuring via an 8K that can be found here: Lear Proposed Restructuring. This is by no means a final agreement. As the 8K states: "agreement in principle" so there could be changes in the future. Summarizing:
  • Restructuring approximately $2.3B of bank debt and hedging claims and $1.3B of bonds.
  • $500M DIP consisting of a Term Loan that matures in a year and has a 15 month extension (needed if the case goes awry). Proceeds will be used for W/C and other corporate needs. The DIP is convertible into a $500M exit facility (rolled into) that matures 3 years after a plan is approved.
  • The new Lear would consist of: 1) This $500M exit facility 2) A $600M second lien 3) $500M of preferred stock 4) And stock with certain management incentives and warrants to unsecured and lenders.
  • The pre-petition bank debt lenders will receive, on a pro-rata basis: i) $600M second lien, ii) $500M of preferred stock which is convertible into 26% of common stock (excluding management incentive dilution) iii) approximately 26% of common stock (excluding managment incentive dilution). Their unsecured claim would be treated in the unsecured bucket (as an aside, this is an interesting point we haven't talked about...a bank debt lender is only secured up to the point that the collateral merits. So for instance, if there is $100M of senior secured bank debt and $100M of bonds, and the company's value is only $50M...lenders would have a secured claim for $50M, and an unsecured claim for $50M which they would share with the $100M of bonds...for a total unsecured basket of $150M...confusing I know)
  • In the case Lear has more than $1B of liquidity at plan confirmation, certain excess liquidity will be used to pay down preferred, second lien, and the exit (in that order, respectively)
  • Trade will be paid in cash
  • Senior notes and other unsecured claims are getting 46% of stock (again fully diluted outside management grants) and warrants to purchase 15% of stock.
  • Equity getting wiped out.
  • Management getting an incentive plan to possibly own 10% of the post-reorg stock. This is HUGE in my opinion.
The 8K also goes on to list the value of Lear at $3.054B. From Bloomberg, the median EBITDA estimate for 2010 and 2011 is $511M and $550M respectively. With $1.2B of cash on the balance sheet today, this implies an EBITDA multiple of 3.6x and 3.4x respectively. To put this in perspective, in the middle of 2008, the sell side was estimating Lear would do over $1B in EBITDA for both 2010 and 2011. Further, EBITDA in 2007 was over $1.1B Management projected to lenders that Lear would do $450M of EBITDAR in 2009.

But can we really believe them?

Let's think about this for a second. Actually better yet, let's think about the incentives for a second. You can find these incentives in the same 8K, almost all the way to the bottom.
  • Number of shares: 10% of new common stock
  • Upon emergence, 2.7% of new stock...SO JUST FOR EMERGING THEY ARE GETTING 2.7% of the company. The CEO gets 18.25% of this or nearly 50bps of the new company.
  • The remaining incentives will be performance based...i.e. meeting certain hurdles.
Now if you are management, are you going to go out there and say "Yea. We are going to crush it in 2010" even if you are 95% certain you would? Of course not. Setting a low hurdle when equity options are at stake is par for the course. So I would wager than $450M of EBITDAR in 2010 might be a lowball. Now remember, the CEO gets 18.25% of equity awards, so at some point in the future, he could own 1.825% of Lear. As of 3/14/2009, he only owned 0.565% of Lear...a much worse Lear with a lot more leverage. I have to say he is getting a pretty sweet deal.

So, now that we have all the technicals out of the way...let's see if there is anywhere we can make money? The pre-petition bank debt is trading at 70 cents on the dollar (was as high at 78 right after the filing). Currently, Lear has $1.2B of cash on the balance sheet and $2.25B of senior secured bank debt. Now we all know this year is going to be bad. They are going to burn cash. No doubt about it. Let's just assume, for simplicity, that they burn cash to that $1B liquidity trigger...i.e. they would emerge with $500M of cash.

Before I jump into what I think the bank debt is worth, I want to point out a few interesting / salient points about Lear. Lear has been a darling of the value investment circles. I believe Monish Pabrai (at least his consensus alias) wrote it up in Value Investor Club a few years ago. Rich Pzena has talked about it at Joel Greenblatt's Columbia class as a good investment. Franlin Resource, some of the best opportunistic value investors out there, is the 3rd largest holder. What gives?

Lear's main business, seating, is a duopoly in North America (Lear #2 supplier behind Johnson Controls). Both Lear and Johnson Controls have played nice and not gone into any sort of price war and surprisingly, have pricing power with the OEMs. Same thing in Europe with Lear #3 behind JCI and Faurecia. Further, the seating business really is not that terribly capital intensive relative to some other auto supplier businesses. EBIT Margins are tight right now given auto sale volumes, but management has led a fantastic cost cutting effort, and I believe a conservative run rate would be approximately 5% with definitely lots of room for upside. 50% of business is domestic, 50% overseas. Lear's electronics business is a smaller portion of the business, about 1/5 of total revenue. I am going to value this entire business at 0. Again, let's be conservative here.

Seating revenue in the past 5 years has been:

2008: $10.7B
2007: $12.2B
2006: $11.6B
2005: $11.0B
2004: $11.3B

Remember, we said this business should do at least 5% EBIT margins. Using a low of $10B of seat sales and a high of $11B, gets us to EBIT of between $500M and $550M. D&A at seating is approximately $175M giving us EBITDA of $675-$725M. Corporate expenses should trend around $175M (run-rate) implying total EBITDA of $500-$550M, in line with the sell side, and meaningfully over management. A quick point here...look at the leverage this company has. A 1% increase in EBITDA margins = $100M incremental EBITDA. BOOYA.

Again, let's say for the sake of argument, that cash is zero at emergence. I think Lear is worth somewhere around 5.0x, given the dynamics of the business. Let's use 4.0x, 4.5x, and 5.0x on our $500 - $550M EBITDA forecasts

At 4.0x on the $500M we are coming up with $2.0B of value. At 5.0x on the $550M of EBITDA we are coming up with $2.75B of value. So for our intent and purpose, lets figure out where the range of $2.0B-$2.75B puts us.

Now, I am going to make an an assumption here that all warrants, preferred conversions, awards are granted. What I am coming up with, as mentioned before, gives management 10% of the equity, and bank debt lenders 58% of the equity. So, all in all, the bank debt lenders are getting a $600M second lien note and 58% of the equity of the company (once preferred is converted).

With our range of $2B-$2.75B we need to deduct the $500M DIP and $600M second lien, and add back $500M of cash, to get to equity value. This gives an equity range of $1.40B to $2.15B. 58% of that plus $600M of second liens gets us to a recovery value of $1.41B to $1.85B. This versus a claim of $2.25B for, wait for it, a recovery of 63 cents - 82 cents. As an aside, bond holders are getting 32% of the company, giving them a recovery of 32% of our calculated equity value of $1.4B-$2.15B or ~$450M to $688M. This versus a claim of $1.3B implying a value of 35-52 cents on the dollar (bonds are currently trading at 40).

A few things to point out. Remember, we used a conservative seating margin, gave 0 value to the electronics business, used fairly conservative multiples, burned a lot of cash, etc. We may have been too conservative. At say $700M of EBITDA at 5.0x, bank debt lenders would recover north of par (~110 to be exact). The bond holders at these levels would be bigger winners.

In all honesty, I kind of like both securities. But not just yet.

Looking at Exhibit 10.1 in the 8K Lear filed outlining its plan, we can get a sense of who the lenders are. It definitely is an interesting mix. One thing that sticks out: Lots of CLO names on that list. CLOs do not like to hold equity (no cash flow relative to their liabilities). CLOs like it when recovery is granted via other cash paying debt securities - not equity, like in Lear's case. So, what I think you will see, or are seeing now, are CLO's selling down their paper, knowing that a large portion of their recovery is coming from equity. So when would I buy this thing? I would buy the equity, after it emerges and after the CLO dump is finished. I'd then be getting a conservatively levered (~2x) autosupplier, with solid prospects, and massive operating leverage at the bottom of the cycle, at probably a better discount than I am getting today. Now if they bank debt got to say, the mid 50s, or the bonds in the low 30s, then I'd be buying this paper. When the equity is free to trade, I think I am going to put on a position (assuming the puke is done in an orderly fashion)

Of course, I may miss it if it never gets to that level. But there will be more opportunities in the future. Have to watch a lot of pitches go by before you take your swings. This will indeed be an interesting distressed debt case to follow.



Distressed Debt Investors Club

As some of you are aware, one of the reasons for the lack of posting in the last month (despite the dearth of solid investment opportunities) is that I have been working on a side project related to the site; more specifically related to Distressed Debt. Since the information seems to be spreading (I am getting requests about it), I might as well go ahead and discuss it in a public forum.

Many of us are either Value Investor Club Members or SumZero members (and some both). Both sites are incredible. That being said, they both have their advantages and disadvantages. But overall, they are fantastic resources.

In my opinion though, a member contributed site, in a similar vein to VIC or SumZero, focused on credit, distressed, and fixed income special situation opportunities (make whole take-outs, CDS arbitrage, fixed income arb, etc) would be incredibly beneficial to its members.

So that is what I have been working on. And here is a little FAQ I put together:

Is that all you can tell us?
- No. Here are a few more salient points:

  • The site will be set up very similar to VIC. 250 members with real time access, guests will have read-only access on a 60 day delay window. Members will be asked to contribute, like VIC, 2 credit related posts per year. Again like VIC, but unlike SumZero, (and because I love anonymity), we will be using aliases instead of our real names - so members do not have to worry about posting their fund information or their real identities. There will be more details in the coming months.
How can I become a member? - Potential members will be asked to write a 2-3 page write up on a credit or investment opportunity of their choosing. There will be no template for this. I hate templates and so should you. Myself, and two of my colleagues will go through each one, offer questions to each applicant, and then take it from there. In the next month or two, there will be more and more posts about all this, which leads us too...

When is this launching? - 3Q 2009. Exact date depending on beta tests and all that good stuff. Therefore, hold off on sending me anything until I ask =]

I am already a member of VIC and SumZero. Why do I need another community of hedgies talking their book? - Good question. As I mentioned earlier, this site will be credit focused (not to say that equity ideas will be forbidden...but in general I hope we are talking credit / fixed income special sits 90% of the time). I would like us to carve out a little niche here and make lots of money. Plus, given how small the site will be (I am talking about members here), it should be an incredible networking opportunity.

Further, on launching, the site will have 250 ideas (the applications) ready for all members to pounce on. If you can't find one or two ideas out of 250 to make a killing on...well you sir, are a better man that I.

Can anyone join? Theoretically yes. As long as you add LOTS of value. That being said, I have to think that their will be a heavy weighting of credit / fixed income professionals in the mix.

Where can I find out more information? You can email me or leave a comment. And stay tuned for future posts.

I'm hoping this distressed debt boondoggle gets off the ground in a timely fashion. Support, hate, or praise can be left via comments.

Thanks -



Distressed Investing: How to Read a Credit Agreeement?

Devoted reader Tom B sent me an INCREDIBLE overview on how to read a credit agreement. We are going to be talking about this A LOT more in coming posts. Documents are crucial when you are investing in distressed debt...Pay close attention. This is a fantastic overview...

If you plan to invest in distressed debt instruments (loans or bonds), you need to know the terms of the debt agreements. Ultimately, the only thing that gives you a claim to an issuer’s cash flows is the contract governing the issuer - lender relationship. These contracts are where you’ll find things such as maturity, rates, covenants and events of default along with the rights you have as a creditor. So it’s vitally important to understand the terms of your debt contract.

These documents (credit agreements in the case of loans, indentures in the case of bonds) are written by lawyers and are not easy reading, but it’s essential that you parse through them to understand the terms of the transaction. Many key terms of the loan / bond are highlighted on Bloomberg, but it is always wise to check the source document.

Let’s start with a loan. The primary document to review is the credit agreement. It contains all of the information you’ll need to understand the features of the loan. If it is a secured loan, you’ll need to review the Security and Collateral Agreement to learn which assets secure your claim. You can find the loan agreement on Bloomberg or, if you don’t have access to Bloomberg, in the company’s SEC filings (it’s normally filed as an exhibit to the 10K or 10Q filed nearest to the closing of the loan). The loan agreement typically has the following sections (though not necessarily in this order – different law firms have different templates for this document). The section you’ll spend the most time with – by far - is the negative covenants section.

1. Title page. Here you’ll find info such as the closing date of the loan, name of the borrower (legal entity), and the agent banks on the loan.

2. Table of contents.

3. Recitals. This section will tell you, again, the date of closing as well as the borrower(s) and guarantor(s) of the facility. The names of the borrowers and guarantors are enormously important because they are the only entities that are required to pay you principal and interest. Sometime, the terms Borrower and Guarantor are listed without naming legal entities. Then, you’ll have to consult the Definitions section of the agreement to see who the Borrower(s) and Guarantor(s) are. Which leads us to….

4. Definitions. You’ll need this section handy as you review the rest of the document. Every capitalized term in the document is usually defined in this section. And get used to working your way through definitions. Want to know the total leverage covenant? Ah, it’s Total Debt to Consolidated EBITDA, per the negative covenants. But, how are those terms defined? Is Total Debt reduced by the amount of Cash and Cash Equivalents? And what counts as Cash and Cash Equivalents? And how about Consolidated EBITDA? It starts with Consolidated Net Income. Is that just the net income figure from the company’s income statement or are their adjustments to make (there are ALWAYS adjustments to be made). You get the idea. But a few important definitions to always review include Applicable Margin (tells you the margin of interest you’ll earn above a base rate, such as LIBOR) and Maturity Dates. If you purchase a Term Loan B, you’ll consult the Term Loan B Maturity Date definition to see when the Term Loan B matures.

5. Amount and terms of the credits. This section includes such items as the amount of the facility as well as the amount of each tranche of the facility (so if a facility has a revolving credit and a term loan, it has 2 tranches). It will also include the amortization schedule of the facility, the amount of letters of credit that are permitted to be issued and a host of other items, many of which you really won’t have to consider. However, two items that you will have to review have to do with prepayments: mandatory and voluntary. What if the company sells an asset for cash, does it have to repay the loan? Or how about if it issues equity? What if an insured plant is destroyed by a fire, do the insurance proceeds repay the loan? Or what if the company, after satisfying all of its obligations (capital expenditures, interest, taxes, etc.) has Excess Cashflow (yes, that’s another defined term)? These questions are all typically addressed in the mandatory prepayments section. Voluntary prepayments are just as you’d guess – the company has excess cash that it would like to use to repay the loan. How can the company do that? Does it have to pay the loan back at par? Or maybe at a premium to par, like 101 in the first year of the agreement? All of this is found in the voluntary prepayments section.

6. Representations and warranties. These are a list of items that the Borrower and Guarantor state are true as of a certain date (items such as there are no material legal or environmental issues not previously disclosed to the lenders, etc.). Typically, you won’t spend a lot of time here.

7. Conditions. These are the conditions that allow the borrower to use the facility. There are usually two sets of conditions – conditions on the initial closing date and then each subsequent borrowing (for example, each revolving credit borrowing would be subject to meeting the conditions). The overriding principle here is that the borrower must be in compliance with the terms of the agreement each time it borrows. Again, not a place you’ll likely spend a ton of time.

8. Affirmative covenants. These are things the borrower must do to remain in compliance with the agreement. These include payment of principal and interest when do, delivery of financial statements within a certain amount of days after a quarter/ year end. You’ll look here to know when you must receive financial information, when the company is required to provide budgets, etc.

9. Negative covenants. This is the section you’ll spend the most time reading. It contains all of the things a Borrower CANNOT do. The big items include prohibitions on debt incurrence, prohibitions on lien incurrence, prohibitions on restricted payments (payments to junior capital providers such as dividends or share repurchases), limitations on investments and limitations on capital expenditures. A typical covenant will state that the borrower cannot incur, for example, any debt other than the debt outstanding at close SUBJECT TO the exceptions that follow. It’s the exceptions you need to know well. Can a borrower increase the amount of secured debt (thus diluting your claim on collateral)? Or can it raise an unlimited amount of unsecured debt? There are many other important issues addressed in this section. You’ll need to read each covenant carefully and have the definitions section handy, as you’ll be referring to it very frequently. I’d say that I spend 80% of the time reviewing a credit agreement on the negative covenants. A thorough discussion of negative covenants would be an entirely separate post.

10. Financial covenants. This is a section in the negative covenants, but it’s so important I’m discussing it separately. Historically, you could expect to find, at a minimum, a leverage covenant and an interest coverage covenant in most loan agreements. As the credit markets peaked in 2006 and early 2007, a good number of agreements were struck without maintenance covenants. Instead, they had incurrence covenants (for example, an issuer could issue debt provided they were in compliance with a 2.0x interest coverage ratio pro forma for the issuance). Complicating matters further, some agreements had maintenance covenants that applied only to the revolving credit facility and not the term loan. If that wasn’t bad enough, the revolver covenants only were operative if the company borrowed under the facility. So read the covenant carefully, including the preamble to the covenant. Don’t simply go straight to the table listing the relevant ratios. And, again, you’ll need the definitions section handy to accurately calculate the components of each ratio. A further note – another feature you’ll find in a number of 2006 and 2007 agreements is something called an Equity Cure. This is a provision that allows a financial sponsor to inject an amount of equity into the company to “cure” a financial ratio default. For example, if the company needed an extra $5 million of EBITDA to be in compliance with its leverage ratio, a sponsor would have the right (but not the obligation) to inject $5 million of equity and have that count as EBITDA for that quarter as well as the subsequent 3 quarters. Why is equity counted the same as cash flow from the company’s business? Good question. But things did get pretty silly in the loan market for quite some time.

11. Events of Default. Ok, here are the things that cause the company to be in default under the agreement. Non-compliance with negative or affirmative covenants, for example, or failure to pay interest or principal. Pay close attention to the cure periods. For example, a failure to pay principal when due is an immediate event of default, but there may be a period of days where the company can make an interest payment after it was due and still be in compliance (this would be the cure period).

12. The rest of the sections are fairly boilerplate and you’ll likely not spend much time reviewing them. They include a description of the role of the agent banks (as well as circumstances where a bank might be in default under the agreement) and other notices / miscellaneous items. These are not normally relevant to distressed situations.

Of course, this is intended to be a high level guide to reviewing a loan agreement. If you are going to invest in a distressed situation, it’s advisable to have a lawyer review the document as well. But this should give you a high-level roadmap to reading a credit agreement.


How to Get a Hedge Fund Job

As some of you have discovered, I started a new blog to help answer the question I get more often than any other: "How do I get a hedge fund job?" I doubt there will be more than 10 or 15 posts ever on the blog so do not get too jealous. Any ways, I just threw up a post that I think will be an interest to some readers: A listing of Julian Robertson's Tiger Cubs...at least as many as me and a few friends, with too much time on our hands, could could up. Enjoy!



Distressed Investing News

So let's say you are a distressed debt investor already, where do you go for distressed investing news? Admittedly, it took me a long time to figure out how to best stay on top of all the happenings in the distressed debt community (outside of working the phones and talking to advisers).

So here is just a sample of what I do to make sure I am in the know on the various stories coming across the tape in relation to distressed investing news.

  1. I set up my Bloomberg Launchpad with lots of news panels: Now, I know not all of us are fortunate enough to have a Bloomberg. But if you do, for reference, I currently have a number of News Panels running: Forbearance Agreements / Credit Waivers, High Yield Bonds, AmendedLoans, Syndicated Loans, Distressed Corporate Bonds to name just a few. I also have one for my main monitor which shows me all new stories related to the equity and bond tickers that we own, and all the comps for the companies.
  2. In relation to #1 above, I always read Bill Rochelle's column on Bloomberg. I have done this every morning for over 3 years now. To access the article type in: NSE ROCHELLE ... now if you do not have a Bloomberg, you can access the stories at the Bloomberg Bankruptcy News page
  3. Like most people that trade / invest in corporate bonds, I get approximately 3,000 runs from brokers and dealers. A lot of time it is just noise, but every now and then something will come across the tape that adds value. Therefore, I am checking that screen intermittently. For example, on the day before Lear filed for bankruptcy, the bank debt was up 7 point on no news. Obviously something was happening behind the scenes. The equity market and the corporate market weren't really responding. If I had any balls, I would of shorted the equity (at 0.50)...and be up 50% in a day and a half.
  4. I read CreditSights and BondHub research pretty much every day. Now I know some people are going to moan this: "Who cares what the sell side thinks" ... well a lot of idiots do, and in my experience, idiots are pricing the market. If you do your research, and you are coming up with an EBITDA number that is materially lower than the forecasts or published research numbers, well that is a potential short candidate. In terms of news though, every now and then there might be something that missed our radar screen and an analyst will talk about it...there could (or could not) be an investment opportunity there.
  5. I check Pacer and various Court Dockets so many times it makes me sick: No seriously. It is such a tedious process. If anyone knows a way to automate this or wants to start a company that automates this with me, let me know. This is important because rulings move markets, new information from court filings move markets, you want to be ahead of the news.
  6. I know when my companies are reporting, what the consensus is, and what to do if there is any crazy price action. I know this sounds more traderesque, but if you were forecasting $100M of EBITDA in the quarter, and the company comes out with $10M what are you going to do? These are important questions in illiquid markets like the corporate and levered loan markets.
So those are just some of my methods to stay on top of distressed investing news. There probably is a few more ways people stay in the know of what is going on in this nutty world. If you know of any more distressed investing news resources, please post a comment and share. Happy 4th!



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.