We would like to welcome a new writer to Distressed Debt Investing - Julia Bykhovskaia, CFA will be joining us as we start discussing more post reorg equities on the site. Enjoy!
INVESTING IN POST-REORG EQUITIES
Post-reorg equities can often present compelling risk-reward opportunities for a value investor. However, even though stocks of the companies that recently emerged from Chapter 11 provide fertile ground for bargain hunting, blindly investing in post-reorg equities (as in any other securities) certainly does not guarantee investment success.
There were a few studies performed that focused on the price performance of the post-reorganization stocks. For example, in their 2004 study “A Chapter after Chapter 11”, Lee and Cunney of JP Morgan looked at 117 companies that came out of Chapter 11 between 1988 and 2003. They found that relative performance (to the S&P 500) of these companies’ stocks averaged 85% in the first year after emergence. However, the same study showed that volatility of these stocks had been very high, with only 50% of the equities outperforming during the period.
Thus, while it is clear that opportunity for outsized returns exists, as with any kind of investing, investors are well-advised to conduct a thorough due-diligence and to be selective in their stock picking. Not all post-reorg equities are created equal; some companies emerge from Chapter 11 without accomplishing any substantial operational turnaround or debt restructuring – only to file for Chapter 22 not too long after original emergence (Bally Total Fitness, Foamex, Movie Gallery, Trump Entertainment are just some such examples).
Yet, there are a number of reasons for post-reorg equities to be inefficiently priced and such market inefficiency creates opportunities for investors hunting for bargains. Let’s look at some of the reasons why such mispricing can exist and why these stocks can have a potential for generating attractive returns.
Composition of the Equity Holders
The original holders of most post-reorg equities are former creditors (with some exceptions where former stockholders continue to own stock in the company post-bankruptcy; e.g. General Growth, Pilgrim’s Pride) – usually the holders of the company’s bank debt, bonds and trade claims and executory contract-rejection claims. Some of these newly minted equityholders are not in the business of managing money; they entered a distressed situation unintentionally and may not even be allowed to hold equities under their mandates. Banks and insurance companies, for instance, prefer to receive cash or cash-paying debt as a distribution in bankruptcy rather than common stock for regulatory and economic reasons. Landlords who received shares in the new company in exchange for their lease-rejection claims or vendors of the company who received their shares as a distribution for their trade claims may also be part of this category. High Yield funds may not be allowed to hold equities by their charters. All these holders can become “motivated sellers” and may be forced to sell the shares in the newly emerged company for noneconomic reasons and without giving consideration to valuation or potential returns – and thus creating mispricing.
Small Market Capitalization and Illiquidity
Many post-reorg equities are small cap names. Therefore, large institutional investors, which are often looking to place hundreds million dollar bets on each company, will not have these companies on their investment radar. Reorganized companies are simply too small for them to invest in. Similarly, post-reorg equities are often illiquid. Not only do they tend to be small cap names, but trading float can be small as well. Distressed control-type investors can be long-term holders of these equities and thus might be unwilling to trade their positions. Since liquidity and size are important considerations for many portfolio managers, these relatively illiquid small cap stocks are quite often simply ignored by many professional investors.
Lack of coverage by Wall Street equity analysts
As we mentioned before, the equities of formerly bankrupt companies often have small market capitalization and tend to be illiquid, at least at the beginning of trading. Since Wall Street generates more commissions from trading larger cap, very liquid names, Street analysts are not incentivized to spend time and resources to cover post-reorg equities given that the potential for generating substantial commissions or investment banking business is low. This is why post-reorg equities are often referred to as “orphan equities” – nobody cares to look at them. There are a handful of boutique sell-side firms which provide research on some post-reorg names; however their coverage is limited.
Gathering information on post-reorg equities might be challenging as well. During the bankruptcy process, companies generally don’t host conference calls, rarely make public appearances at the conferences and sometimes do not file 10Ks and 10Qs with the SEC. To understand the company’s post-emergence capital structure and newly issued securities, it is imperative for an analyst to read the Disclosure Statement filed with the bankruptcy court which includes financial projections, the company’s new capital structure as well as liquidation and valuation analyses. Analysts can also look at the company’s Monthly Operating Reports, also filed with the court, for more detailed monthly financial data. All these documents are available to the public from the electronic court filing system PACER (http://www.pacer.gov/) for a small fee. However, even though the information is accessible, most non-distressed investors tend to be unfamiliar with PACER and bankruptcy documents, thus often neglecting post-reorg equities altogether.
One of the indirect bankruptcy costs is a stigma directed towards the companies which have gone through Chapter 11. Oftentimes there is a perception that a firm which is or was in bankruptcy has irreparable damage to its brand name and will have trouble retaining old customers and acquiring new ones, getting good payment terms from its vendors, and keeping its key personnel. While this view might be partially true in some situations, it is not rare to see a company do quite well after Chapter 11. It is especially true if the main reason for bankruptcy was overleverage and not underlying business problems. Moreover, bankruptcy process can often become a positive catalyst for a company – the company can use Chapter 11 to reject leases, renegotiate more favorable contracts with suppliers, rationalize workforce, sell underperforming assets, close unprofitable stores, install new management as well as substantially reduce debt load and in some instances get new capital injection. Many companies emerging from bankruptcy also have substantial NOLs which can be used to offset taxes due in the future. All these actions can allow the company to emerge as a healthier, more profitable firm with improved business model and reduced risk profile.
Conservative Projections in the Plan of Reorganization
Since management is often getting stock options (as well as warrants and some percentage of the new equity) in the reorganized company, they can be enticed to provide conservative projections in the Plan of Reorganization so they could price their stock options at a lower price and also outperform their own projections in the future to equity analysts applause. Another reason for preference of a low valuation by management is that it allows the firm to emerge with less debt on its balance sheet. While not always the case, the practice of providing overly conservative financial projections is not uncommon and analysts should be on a look out for such situations.
To conclude, post-reorg equities are often ignored and misunderstood by investors. Every year, 20-30 firms usually emerge from Chapter 11 as publicly traded companies (to name just a few examples, such companies as Tronox, Chemtura, Lyondell Chemical, W R Grace are expected to come out of bankruptcy in the next 12 months). Because many investors are unwilling or unable to invest in these stocks, equities of formerly bankrupt companies can provide attractive value-investment opportunities. Outsized returns may be achieved by wisely investing in select post-reorg equities and we hope that this blog will provide our readers with some guidance and advice on post-bankruptcy investing and help better understand and value these situations.