Third Point 2Q 2010 Letter

In the past, we have discussed Dan Loeb's hedge fund: Third Point. I have always enjoyed Loeb's commentary on the market and certain distressed debt positions (a place I know they enjoy to play). Below you will find their most recent letter, and below that some commentary from me. Enjoy!

Hunter Commentary
  • Wow. Blames the market pullback on Goldman Sachs (disclosure: I am long the equity - actually bought it the day after the SEC investigation was announced). You know what: I tend to partially agree with this - It definitely left jitters in the market - I get daily runs from BNP with the title "CDS: Where we are since the GS annoyance" (see below). That being said, I do think the market ran way too hard into April and we were do for a pullback, no matter the catalyst.

  • Agree with his point about spreading the "punitive" costs across the general population. The card program is just one example - The health care bill is of course the prime example.
  • As many money managers have pointed out, its hard to invest when the rules are changing nearly EVERY SINGLE DAY.
  • Commentary on corporate boards: Spot on. 8 times out of 10 I am disgusted when I read XYZ company's proxy.
  • Third Point was short the for-profit education sector that has gotten annihilated recently.
  • Lowest gross and net exposure since March 2009. Looking for ideas with hard catalysts (think emergence from bankruptcy...)
  • Put in place some Baupost like 'blow up' hedges
  • "...the sidelines is perhaps the most 'crowded trade.'" I have never thought about it like that but he is spot on
  • Significant positions in post-reorg equities hurt performance during the quarter - still has "high convictions" in the names
  • As he notes beautifully in the letter, post-reorg equities are sometimes referred to as "roach motels" - i.e. easy to get in and impossible to get out.
  • Incredible discussion on REMICs and Re-REMICS, a place we are also invested. Something everyone should read. The upside/downside of the Alt A trades have been spectacular.
As always, an incredible read from Dan Loeb.



Pershing Square 2Q 2010 Letter

Here is Pershing Square's 2Q 2010 Letter to Investors. See below for some commentary:

  • I have been following the Landry's Restaurant situation with earnest, as I have been looking at some of their debt securities. Mick McGuire strikes again.
  • ADP: I have spent a lot of time on this one as well. In my opinion, undervalued, but not enough to get me allocating any more than a small bit of capital.
  • Very much like how they phrase their upside downside bets: "In light of this greater risk, we require the potential for a materially greater reward if we are successful, and we size the investments appropriately. Depending upon the risk of loss, these investments may individually comprise a few percent or less of capital, and often less than one percent of the portfolio. "
  • Interesting to see them being long protection in BP versus Whitney Tilson, who in the past has invested in similar situations to Pershing, being long the stock. Yes different capital structures - but reading the thesis doesn't look good for the equity.
  • Peter Cooper Village: This is going to be such an interesting case study - The bankruptcy proceedings have been fascinating up to this point and with Pershing Square's involvement will only get better (no position at this time).
  • As always, I am always impressed with Bill Ackman's writing. Great read.


Profiting from Short Duration Opportunities

When I first started on the buy side, investing in high yield and distressed debt, my boss gave me a book on Michael Milken (Fall From Grace for all those that are interested). In the book, there is a passage, and I am not quoting directly here, on Milken's take on corporate insolvency. Essentially, his take was: It is very hard for a company to file for bankruptcy.

There are really only a few reasons for a company to file for bankruptcy: 1) They run out of cash 2) There is an "unforgiven" covenant default 3) They are trying to eliminate a legacy liability 4) They can't refinance maturing debt and enter in some sort of pre-pack/exchange/etc. In my experience, I have seen very few companies truly run out of cash, have seen very little "pressure" from lenders of covenant defaults (MGM Studios has been in forbearance for nearly a year now), and legacy liability filings get smaller every year.

With that said, a lot of bankruptcies are the result of an over leveraged balance sheet that cannot refinance maturing debt (or cannot conceive of a situation where in the future they WILL be able to refinance said debt). Over levered balance sheets are the result of boom cycles of past, where senior and sub lenders would lever corporations at 80% of inflated LTVs. Gaming historically trades at 8x cash flow, but in 2006 it traded for 14x cash flow, so people levered the entities to 12x. An obvious mismatch of normalized cash flow generation and run-rate leverage.

With that in mind, why do default rates peak and then (generally) decline significantly within 12-18 months of the peak? Because the capital markets open up and corporations can get in front of maturing debt. And with that, there are lots of opportunities to make very high cash on cash returns, if you can use this dynamic to your advantage.

For instance, a few months ago, we posted a DDIC entry on Tembec. At the time, the debt was trading at 86, with two years until maturity. Last week, Tembec announced a refinancing of the debt (http://ca.news.finance.yahoo.com/s/17082010/30/link-f-cnw-tembec-announces-closing-senior-secured-notes-offering-achieves.html). 14 points, on 86 of invested capital in five months...I am sure I don't have to tell you but those are nice returns.

The question the naturally becomes: How do you know which debtors will be able to refinance existing debt versus the debtors that will be blocked from the capital markets? This is where the art comes in but I want to try to give readers a flavor of how I approach these situations?

First, what is the health of the industry? Are there other similar companies doing equity or debt deals? If so, what were the leverage on those deals? Ratings? Spread? Weak covenants? Why covenants? A struggling debtor has a better chance of raising debt capital with tight covenants. It sometimes even gets the deal across the proverbial "goal line." The debtors most assuredly hate this, but nevertheless, the debt is refinanced and they get breathing room.

Second, who holds the debt? Who holds the equity? If there is a large equity holder, there may be a reverse inquiry to also do a debt deal. This gives the equity a long runway to turn its operations around or just wait for the recession to subside. Is the debt held by hedge funds? CLOs? How would you find this out? By developing relationships with your sales coverage and other buy side investors.

Third, the company itself. Is there a story to the EBITDA decline? Did the whole industry decline? Melting ice cube or a cyclical? Is leverage at least reasonable under the new structure? Could sub debt be more easily refinanced into senior debt and if so, will outstanding covenants allow it? A company that is 6x levered with 1 turn of bank leverage and 5 turns of senior leverage may find that doing a 3x and 3x deal respectively may make it easier to raise capital (assuming senior lenders are on board). What is the company's market cap? Could they raise equity? Converts? Remember, bankers are talking to these companies all the time - giving them intel on the various markets - the bankers want them to do a deal for the fees, and the company wants to do a deal to survive (even if management can make more in a bankruptcy via management compensation plans).

Fourth, and really a natural extension to the third point above, what do covenants allow? Will the company be tripped up by tight debt incurrence baskets? Is the current debt outstanding guaranteed by all the subsidiaries? If not, maybe the company could get a guaranteed deal done easier. As noted above, would investors be more "approachable" if the covenants were tighter? If the deal was secured? Etc.

With all this in mind, you still want to focus on the downside. Let's say you are wrong and the company does file: What will be your worst case recovery? If its a zero, stay away - I tend to only do these situations high up in the capital structure. Remember - always focus on the downside.

Is this post a recommendation to get long a lot of short dated paper? No - but I will say that a lot of my time has been spent on these sort of situations - especially given where the curve is and how investors are not getting compensated whatsoever (in terms of total return) for moving further out the curve.



Distressed Debt Analysis - Fairpoint

Every few months, I post a recent idea from the distressed debt investors club. As a reference to readers, there are about 150 members on the site with over 2000 guests (guests see the ideas on a 50 day delay). In addition, over the past month, over 20 ideas have been submitted to the site. I really could not be happier with the success and encourage all those able to apply. Remember, at 250 members, I will close the application process. With that in mind, here is a recent distressed debt idea on Fairpoint Communications.

Fairpoint Communications: Distressed Debt Analysis

FairPoint ("Company") is a rural telephone company with over 1.2M access line equivalents (ALE). Company is based in Charlotte, NC and operates 33 Local Exchange Carriers (LECs) in 18 states. Company offers telephony, high speed and video services to its customers. Approximately 63% of access lines provide service to residential customers, 29% serve business customers and the rest are wholesale lines.

Prior to acquisition of the Verizon New England lines in March 2008, Company was a public company with a little over 300K lines. FairPoint acquired 1.6M lines from Verizon which were located in Maine, New Hampshire and Vermont. The $2.7B acquisition was funded with $1.8B term loan, $551M of bonds and 54M of Fairpoint shares (pro-forma, Verizon owned 60% of Fairpoint). The agreement with Verizon allowed Fairpoint to use Verizon systems for operating functions (including IT, accounting, HR, billing etc) under a Transition Services Agreement (TSA) while the Company built new systems to accommodate the acquisition. Capgemini was hired to build the new systems under a $160M contract.

The original transition date was September 2008. The new systems were not ready for transition in September and the cut-over date was pushed out to January 2009. Fairpoint started experiencing problems following the January cut-over. Processing times for new orders spiked and billing and collection systems experienced serious issues. Customer service call volumes increased and Company was overwhelmed. Customer frustration translated to increased churn and attracted regulatory attention. As quality of service slipped, the Public Utility Commissions (PUC) (regulate the telecom companies) in Maine, New Hampshire and Vermont imposed penalties on Fairpoint. FairPoint started incurring large incremental expenses as it threw all resources it could to deal with cutover issues. Bad debt due to poor collection, additional expenses to solve the transition issues and penalties caused the Company’s EBITDA margins to drop meaningfully below its peers.

Fairpoint had approximately $2.5bn of pro forma debt outstanding. Financial leverage issues coupled with the problems it incurred in its transition process are the primary reasons Fairpoint found itself in financial distress. The Company exchanged a portion of its bonds for PIK bonds to comply with financial covenants in the bank debt. But increased costs and transition problems made a bankruptcy filing inevitable. The Company filed for Chapter 11 on October 26, 2009 in the Southern District of New York. In the initial plan proposed by the Company, the bank debt holders were to receive 98% of the equity and the bond holders were to receive the remaining 2%. The bond holders started throwing roadblocks into the bankruptcy process, including a request to appoint an examiner. The company filed a new plan on Feb, 08 2010 which has the support of bank debt holders and bond holders. Under the new plan bank debt holders and bond holders received 92% and 8% of the equity respectively ( In addition the bank debt holders will receive excess cash at emergence and bond holders will receive warrants for an additional 12% of the Company at a strike price implied by $2.3B enterprise value). Further, the company renegotiated the union deal to freeze wages until 2013 and reached a deal with the state PUCs on revised capital investments and penalties. On March 11, 2010, the Bankruptcy Court approved the adequacy of the Disclosure Statement and the Company was expected to emerge from bankruptcy in summer of 2010. The plan confirmation required approvals from the PUCs of Maine, New Hampshire, Vermont and other 15 states. Vermont rejected the plan even as the other 17 states approved it. Vermont acknowledged that the Company had made material improvement in its service but believes that the projections were too rosy, inconsistent with Fairpoint’s recent performance and that the Company will overleveraged post-emergence. New Hampshire in its order of approval also noted that while the Company had resolved a number of issues and improved customer satisfaction since the cutover issue, its projections appeared optimistic. Fairpoint does not want to make any changes to the plan at this late stage and is exploring all possible options to address this late surprise. In early August Fairpoint indicated it was going back to Vermont with new information to try and get the board’s approval. The lingering uncertainty and a chance that the whole plan might blow up caused the bank debt to trade down to mid 60s from 80s in early May (it was around 73-74 in late June before the Vermont order came out).

At the current price you are basically creating the company at 4.8x 2009 EBITDA where the average comparable Rural LEC (RLEC) trades for 5.7x EBITDA. Moreover, Company’s EBITDA is loaded with extra costs due to cutover issues and penalties as evidenced by its margin of 26.9% (as opposed to average industry margin of 42.8%). Hence, it trades at half the valuation of the comparables on an access line and revenue multiple basis (see comparables table in the valuation section for details). While the number of RLEC voice lines is declining, Companies have replaced some of the lost voice line revenue with growth in broadband subscriptions and created value through acquisition of other RLECs and cost reduction. Windstream’s recent acquisition of Iowa telecom and CenturyLink’s pending acquisition of Qwest fit this pattern. Fairpoint is unlikely to remain an independent company for long after it emerges from bankruptcy. The current discounted multiple and opportunity to realize higher EBITDA margin presents an opportunity to buy the Fairpoint pre-petition bank debt. Whether the Company emerges with lower than currently proposed debt or a slightly different plan, there is enough margin of safety to realize value once it emerges from bankruptcy. If the plan falls apart and the assets are sold in the bankruptcy, a strategic acquirer should be able to pay more than the value implied by the current price of the bank debt.

  • Fairpoint’s footprint quality is not very different from other RLECs. From the company's annual reports you can see that the Company’s access line density and the cable telephony competition it faces are comparable to other RLECs. Fairpoint’s larger than average line losses and EBITDA decline has been largely a result of poor management of the systems and the transition problems
  • Fairpoint has lower DSL penetration of its access lines compared to the industry. This is mainly because Verizon did not upgrade the New England systems to provide data services. Company has invested in upgrades and started selling data product in region since the middle of last year and has an upside revenue opportunity from increasing data penetration.
  • Company’s EBITDA margin is significantly lower than peers due to inefficiencies and additional costs resulting from transition problems. Fairpoint’s EBITDA margin was about 40% pre-cutover but has declined dramatically in the last year indicating that Company has an opportunity to increase its margins meaningfully as it resolves its systems transition issues.
  • The plan calls for a recovery of 88 points to the term loan holders (48 pts in new bank debt and the rest in equity) based on 5.4x multiple of 2009 estimated EBITDA of $362. Peers on an average trade at 5.7x EBITDA (see comparables in valuation section). However the pre-petition debt trades around 66 implying a 4.8x multiple of projected 2010 EBITDA. The recovery should be 90 pts based on a normalized EBITDA of $350M and multiple of 5.7x.
  • This is a consolidating industry and Fairpoint will likely be acquired by one of the other RLECs. Windstream recently acquired two companies in 2009 and CenturyLink has announced a merger with Qwest (see Appendix for transaction comparables)
  • Company’s recent performance has been worse than industry – access lines declined 12.4% YOY in 1Q10 vs. 6.8% decline for the industry. Anecdotal information from the New England PUCs indicates that the Company has meaningfully improved its service metrics as system issues have been resolved over the past year. This should improve churn metrics and stabilize revenue. Current valuation is already pricing in significantly more deterioration so investors are getting paid to wait for a turnaround.
  • Industry has been losing retail lines due to competition from cable and wireless. There were meaningful losses to wireless and cable telephony when the competing products were first introduced to the market and access line loss metric has improved as the competitive landscape has stabilized. Verizon did not market aggressively to business customers in the assets acquired by Fairpoint, which presents an upside revenue opportunity. Other RLECs have been making up for line losses by selling data services. Companies generate a significant amount of free cash flow allowing them to pay large dividends, which has kept the EBTIDA multiple around 6x for a number of years.
  • Stock will initially trade without dividends due to restrictions from exit facility (leverage has to be below 2x to pay any dividend and starting leverage should be around 3.0x)
  • Plan projections were put together in the summer/fall of 2009. Company’s performance since has been worse than projections. Fairpoint has not updated its projections and actual 2009 performance is below initial projections. It is hard to figure out the precise proforma 2009 EBITDA since one time costs are not all disclosed in the filings. We have revised the projections with an estimate of 2009 EBITDA and modest turn-around expectations going forward. With some EBITDA margin expansion, Company should be able reach about $350M in EBITDA and generate cumulative FCF of $300M+ within three years.
  • Vermont’s rejection of the plan creates additional uncertainty in timing and threatens to blow up the deal. It is not exactly clear whether Vermont wants leverage reduced or if they want payment or penalties or something else. But the state realizes (acknowledged clearly in the PUC order) that a Fairpoint stuck in bankruptcy court creates a lot of risk and potentially more problems for telecom customers in its state so Vermont is incentivized to cut a deal.

The valuation put forth by the Company’s advisor, Rothschild values the company based on 2009 projected EBITDA and multiple slightly below the trading and transaction multiples for comparable companies. Comparable public companies trade at an average EBITDA multiple of 5.7x. Recent transaction comps support an EBITDA multiple of 6.0x and above



Distressed Debt Investing Interviews Tanja Aalto

It gives me great pleasure to bring to our readers an exclusive Distressed Debt Investing interview with Tanja Aalto, a Managing Director with the Global Restructuring Group of Barclays Capital. She joined Barclays Capital in October 2009 after more than 12 years spent in the Financial Restructuring Group at Houlihan Lokey. Ms. Aalto has extensive domestic and international distressed experience having represented companies, creditors’ committees and ad hoc groups in connection with in-court and out-of-court restructurings, distressed sale processes and financings. She has advised clients across a range of industries with more recent focus on financial, retail and automotive companies.

In addition, Ms. Aalto will be speaking at the upcoming Global Forum on Investing in Distressed Debt in New York coming up in September - An event we are encouraging all readers to attend.

This interview has incredible amounts of information from someone on the ground, doing deals on a daily basis. Enjoy the read.

Tanja - Give us a little background on yourself

I started at Barclays Capital in the Restructuring & Finance group in October 2009 after more than 13 years in the restructuring group at Houlihan Lokey. In aggregate, I have worked on well over 50 large restructuring transactions, in addition to other smaller and/or shorter engagements, representing companies, secured creditors, unsecured creditors and even shareholders in Chapter 11 and out-of-court processes. While at Houlihan, I also did a meaningful amount of work in Europe and Brazil in the 2000 through 2005 time period as those markets were busy with “distressed” work. I joined Houlihan in 1997 out of business school, and was at the time fascinated by the idea of focusing on distressed situations to help companies and stakeholders maximize value (have remained hooked ever since). Prior to business school, I worked at a boutique consulting firm focused on competitive strategy and new market entry for Fortune 500 companies. I graduated from Princeton University with a B.A. in Economics in 1992, and subsequently graduated from the Darden School of Management with an M.B.A. in 1997.

You were an advisor to the bond holding steering committee in CIT's bankruptcy. Given the speed that CIT emerged from Chapter 11, combined with the 2005 changes to the bankruptcy code, it is your sense that negotiated pre-packs will be the norm going forward and what does that mean for various creditor constituencies "giving up" value to facilitate a quit bankruptcy exit?

Each situation is unique in that liquidity need, capital structure, regulatory influence, composition of stakeholders and other variables will inevitably influence a restructuring process. CIT was one of those unique situations where the structure of the transaction and the associated timing reflected the outcome of extensive negotiations between and among the company and the ad hoc committee of bondholders. The possibility of an out-of-court exchange offer was preserved in the dual path plan, which solicited votes for both the exchange offer and a pre-packaged Chapter 11 plan simultaneously to ensure certainty in a timely manner upon the expiry of the solicitation period. The exchange offer satisfied the company’s desire for an out-of-court alternative while the pre-packaged Chapter 11 plan provided the “back-stop” needed to ensure a successful transaction. Speed was perceived to be critical in the CIT situation given concerns regarding the potential dilutive effect on value of prolonged uncertainty on CIT Bank and the company’s vendor and trade finance businesses. The concept of “giving up” value is fairly complex as I suspect many stakeholders viewed the exchange/restructuring as one of exchanging the form of value (debt-for-equity conversion) to preserve and/or ultimately create opportunities for higher value with a deleveraged post-transaction CIT.

As you note, pre-packaged Chapter 11 processes have become more prevalent than at any other time in my own experience working on distressed situations. One reason pre-packs were often challenging was that companies did not have adequate liquidity to continue to fund operations through what was frequently a protracted time period of negotiations with stakeholders. Additionally, the presence of a “blocking” position in a key voting security can also complicate the success of a pre-pack restructuring to the extent that the larger holder(s) have an agenda that differs from the company and/or other stakeholders. Capital structure layering frequently complicates reaching a quick agreement with stakeholders as intercreditor issues often prove to be a distraction. Companies tend to prefer out-of-court exchange offers to the extent requisite deleveraging can be successfully negotiating with high enough participation levels. A pre-packaged Chapter 11 is the ‘middle ground’ where a company is concerned about the “holdout” risk inherent in most exchange offers, but has the requisite votes for a plan of reorganization pre-filing to satisfy confirmation standards. While it is true that pre-packs are less costly than the typical longer Chapter 11 process (thus preserving additional value), the implementation of a restructuring through a pre-packaged process is more frequently dictated by stakeholder negotiating dynamics and the company’s liquidity cushion rather than any “give up” of value. That said, there are businesses (such as CIT) for which the potential value loss related to a prolonged bankruptcy process is meaningful enough that stakeholders are motivated to reach a speedier agreement for a more expedited process.

Can you give us a sense of the state of the DIP market today? We know from cases like GGP that rate has come down dramatically, but are lenders still driving the process in negotiating terms or has the market overshot itself where debtors are really the one calling the shots?

The DIP market generally fluctuates in line with the overall financing markets as it relates to economics. Year-to-date leveraged loan and high yield volumes underscore the fact that we are currently in a very robust financing market. While competition for the fewer large DIPs and exit financings is certainly more intense now than it was when there were more opportunities in the market, banks still fundamentally base their proposals on prevailing market rates for comparable perceived risk. While a debtor/company may be more able to solicit a higher number of financing proposals in the current market environment, I have not myself seen situations where our fellow lending institutions are willing to propose below market terms to “win” the financing.

How have you found the transition to expand Barclays' restructuring group, where restructuring is one of many revenue drivers, versus Houlihan, where restructuring was THE business driver?

The two platforms are very different. While restructuring is certainly a key practice area for Houlihan, it is worth noting that Houlihan also has strong financial advisory and corporate finance practices that have historically served to support the firm’s steady growth through economic and market cycles. After more than 13 years at Houlihan, I was attracted by the broader array of strategic and financing services that the Barclays platform can offer stressed and distressed clients. The group I joined at Barclays has the ability to strategically deploy capital in distressed situations in addition to more traditional restructuring advisory services. Additionally, the ability to offer a client access to the resources of the full bank is something I find to be invaluable. Many over-leveraged and/or liquidity constrained companies have alternatives available to them that do not fall within the core expertise of boutique restructuring firms such as Houlihan (i.e., deleveraging equity offerings, refinancing, securitizations, etc.). The Barclays platform is premised on a “team” approach where the restructuring group is appreciated for its specific expertise by other product, coverage and industry groups. It is this “team” approach that creates a significant opportunity for my group to leverage its skill set in assisting a greater number of both existing and new clients.

Of all the bankruptcies you have been a part of (Globopar, Delphi, XO, Fruit of the Loom) which did you find most interesting and why?

While the Globopar restructuring process was fascinating due to its cross-border nature and the myriad large funds that accumulated enough debt to be influential in assisting or complicating the process, it admittedly was not an in-court process. Picking the most interesting bankruptcy process is very difficult as they are all very different, which hits on the crux of why I continue to remain excited about what could prove to be one of the largest distressed cycles within the next few years. I will focus here on the Chapter 11 restructuring of United Artists Theatre Company back in 2000 as it was the first transaction I worked on where investors leveraged ownership in the fulcrum security to gain control of the company post-emergence. As you may recall, Anschutz Corp. purchased stakes in both the bank and bond debt at a meaningful discount, which resulted in an implied purchase valuation for the company of ~4.0x. While hedge fund ownership strategies are more commonplace now across restructuring transactions, Anschutz’s strategy in United Artists was the first time I myself directly watched a smart and opportunistic outside investor map out a path to control through a Chapter 11 process. Anschutz subsequently applied a similar strategy in the Regal Cinemas bankruptcy process along with additional investors that were eager to replicate Anschutz’s success in the sector.

Given the amount of capital that has migrated to the distressed space, do you believe that recoveries will be substantially higher than previous cycles? How is this impacted by more intricate capital structures (1st lien loans, 1st lien bonds, 2nd lien bonds, etc)

Recoveries are ultimately dependent on valuation and, perhaps more importantly, on valuation relative to the blended average purchase price of the stakeholder. The elevated amount of capital parsing through Chapter 11 situations, over-leveraged securities and distressed industries in general appears to contribute to what I perceive to be somewhat of a “distressed asset bubble” in the current market place. What this means is that I am running across over-leveraged situations where securities continue to trade at higher implied valuation multiples than historical averages. While there is certainly some logic to pricing in a rebound for companies negatively impacted by the prevailing soft economy, I do see valuation multiples that continue to exceed what I would myself deem to be an appropriate inflation for recovery “option” value. The uptick in distressed company security valuations will have some impact on implied recoveries to the extent that higher valuation multiples are not sustained and/or company performance does not rebound from current reduced levels. Previous cycles had their own disaster scenarios where valuations fell far short of original expectations. It is unfortunately difficult for me to provide a definitive prospective perspective on how the next cycle will average out relative to history.

Capital structure layering is absolutely another variable that will impact recoveries in the next restructuring cycle. Second lien securities are more prevalent, and are often “silent second” positions relative to senior first lien debt. The existence of multiple tranches of debt adds to complexity in negotiating a consensual restructuring to the extent that there is debate regarding the “fulcrum” security. The impact on recoveries will be case specific, but there are scenarios where a senior security may try to crowd out junior securities in an effort to gain control of the company post-emergence. Additionally, we are now seeing cases where junior stakeholders step up with rights offerings to facilitate a repayment in full of senior claims. Recoveries in either scenario will ultimately depend on the company’s performance and prevailing sector valuation multiples relative to the timing of an investor’s sale of post-emergence ownership interests.

We do not know if you have an opinion - but what is your outlook for defaults over the next few years - will the maturity wall in 2013 and 2014 lead to a rapid increase in pre-packs and distressed exchange offers over the next two to three years?

Most seasoned restructuring professionals did not anticipate the resurgence in capital markets activity that pushed out what was originally anticipated to be a year of double-digit default rates in 2010. The significant amount of amend-to-extend volume during the first quarter of 2010 added to the already staggering wall of debt maturing in the 2012 through 2014 time period. My own expectation is that the restructuring market will remain quieter into 2011 as highly leveraged companies continue to manage through the economic downturn with existing balance sheet liquidity. Activity should pick up in 2012 and thereafter as companies seek to actively manage upcoming debt maturities through opportunistic exchange offers and/or refinancing efforts. However, I will caveat that all remains highly dependent on the state of the capital markets. I do not specifically expect a rapid increase in pre-packs in 2012 as an expedited solution for management of over-leveraged companies as any Chapter 11 process (pre-packaged, pre-arranged or free-fall) tends to carry some taint from the perspective of most management teams. The ability to implement a pre-packaged Chapter 11 plan is generally determined by a company’s liquidity profile and stakeholder dynamics rather than by prevailing and expected default rates.

If you were to recommend one book to an aspiring distressed debt investor, which would it be and why?

I would recommend Martin Whitman’s book on Distressed Investing. The book is a great primer that provides an introduction to how to think about anticipating distressed cycles and evaluate over-leveraged situations. Additionally, the overview of bankruptcy processes and associated case examples provide additional background context for someone who may be new to investing in distressed assets. Understanding valuation waterfalls, creditor rights and the overall process is critical (in addition to having a perspective on valuation) to having a solid framework to evaluate any distressed security.

Thank you so much for your time with Distressed Debt Investing Tanja!



European Distressed Debt Conference

I have received a number of email requests about European Distressed Debt Events. With that in mind, I wanted to point all readers (including those reading from the States), to the 2010 European Investing in Distressed Debt Forum which is taking place in London in the coming months. This looks to be a pretty spectacular distressed debt conference with speakers from Strategic Value Partners, Oaktree, Blackstone, and a number of the top distressed debt hedge funds in Europe.

Given the situation going on in the EU these days, combined with varying bankruptcy regimes across the continent, the opportunities for distressed debt investing across Europe could be incredibly lucrative over the next three to five years. The conference looks to have an incredible agenda - I really hope our readers make an effort to attend.



Any distressed debt or high yield professionals in Denver?

On vacation for the next few days, but in the meantime, wanted to see if we have any readers from Denver that are involved in distressed debt or high yield (or value investing for that matter). Send me an email: hunter [at] distressed-debt-investing.com



Advanced Distressed Debt Lesson - Double Dip

One of the key determinants of recovery in a Chapter 11 bankruptcy or distressed debt situation are the specific guarantees embedded in an indentures of a corporate bond. Like a guarantee on a home purchase or rental agreement, XYZ party guarantees the liability of ABC person. In corporate finance, these guarantees are carried by the various operating subsidiaries and holding companies of certain issuers. A less than diligent analyst may misread a guarantee into thinking it is more than it is and sometimes may not realize an entity has guaranteed a certain bond.

Let's take a theoretical example before we dive into Lehman Brothers, which I will be using as an example for this lesson. Let's say a WidgetCo has issued two senior unsecured bonds. WidgetCo, as the issuer, has no operations of its own. Instead it relies on its two subsidiaries, WidgetCo A and WidgetCo B, for upstream dividends to make its interest payments. Both operation contribute 50% of the cash flow (let's use $50M each).

Now WidgetCo gets in trouble for whatever reason. You as an analyst start digging through the documents and realize Senior Unsecured Bond 1 is guaranteed by both subsidiaries while Senior Unsecured Bond 2 is only guaranteed by one of those subsidiaries. In this instance...which bond would you like to own? Of course the bond guaranteed by both subs.

WidgetCo inevitably files. Holders of Senior Unsecured Bond 2 can only look at one sub for their recovery, while Senior Unsecured Bond 1 holders can look to both subsidiaries.

What does this have to do with a double dip? Generally speaking, a double dip is when a certain bond issue, generally issued at an operating subsidiary, looks to both the issuing operating subsidiary as well as the holding company for a recovery. In this case the holding company has guaranteed the debt. Let's take a look at a practical example.

For this, I point reader's to a recent filing in the Lehman bankruptcy. This motion was filed by the ad hoc group of Lehman Brothers creditors, which by their own admission hold $15.5 billion claims against LBHI (Lehman Brothers holdings). Here are their members:
  • Calpers
  • Canyon Capital
  • Fir Tree
  • Fortress
  • Gruss
  • King Street
  • Owl Creek
  • Paulson & Co
  • Taconic
  • Western Asset Management
Needless to say, in my opinion, there are some of the best names in distressed right there. And here is the motion which we will go through step by step....

And here is the chart of the benchmark LBHI bond (LBHI 5.625% due 2013):

For those that are too lazy to read, here is the jist of the objection:
  • The current Lehman Brothers Plan and Disclosure Statement is set up so that creditors of each individual debtor of Lehman (LBSF, LBIE, LBCS, etc) looks to that debtor and its guarantors for value.
  • The holding company of Lehman Brothers (LBHI) though, guaranteed most of the operating subsidiaries debt
  • That said...from the motion:
"Based on Disclosure Statement analysis of the claims pool, claims of creditors of most, if not all, Debtors and other affiliates of LBHI will be permitted to participate to the full extent of their allowed amount in distributions under the Plan from both their primary obligor, and against LBHI, their purported guarantor."
There's your double dip claim.

So what is the ad-hoc committee arguing for? For substantive consolidation. Remember, in substantive consolidation, a debtor pools all its assets across individual entities against the entire spectrum of liabilities. With that in mind, these inter company guarantees are effectively eliminated. According to the motion:
"Based upon its own analysis of publicly available information, the Ad Hoc Lehman Group believes that resolution of the Inter-Debtor Issues could impact creditor recoveries in the tens of billions of dollars. A substantive consolidation of the Debtors’ U.S. subsidiaries alone would increase recoveries for LBHI creditors by billions, and litigation with respect to other intercompany claims could involve additional billions."
And given where the bonds are trading today, these additional billions translate into 5-10 point moves which, right off the top, is an additional 25-50% return. On $15.5B notional, 5-10 bond points is a lovely pay day. We do not know how this case will play out, but we will sure to keep you updated.



Distressed Debt Investing's Book Recommendations: Equity Shorts

This past week, ValueWalk conducted an interview with Dr. Howard Schilit, author of Financial Shenanigans and founder of CFRA which used to be one of my favorite resources for independent research related to dubious accounting. Given the current state of the market (overbought), I thought I would take a few minutes and give my thoughts on each of the books that I have learned from in regards to equity shorts.

My favorite quote from the interview (on how to begin the process of detecting earnings quality issues):
Start with reading the actual financial statements (Balance Sheet, Statement of Income and Cash Flows) and accompanying footnotes for at least two periods and look for changes -- in account titles, accounting principles, estimates. After you have concluded your analysis and evaluation, then read the commentaries found in the MD&A, Letter from the President, other subjective reports by "friendly" sell-side analyst. Also, interview management when you have read all these documents and be alert when management is giving an evasive or untruthful answers.
Before I begin with the recommendations, I think there needs to be a quick point made. While I think that the majority of the accounting disclosure books can be used for shorts, they can also be used to determine if a management team is prudent and conservative. That being said, the books listed below have greatly increased my ability in shorting common e equities (as well as buying protection on a number of issuer).

Many of these books cover the same topics in nature (i.e. growth of sales versus growth of AR), but each presents ideas in a unique spin that I think all investors can learn greatly from. I personally have read each of these books below multiple times and recommend each of them highly. I will give a flavor with bullet points for each of them below:

  • Recommended by Blue Ridge Capital's John Griffin to Columbia Business School Students
  • The book title spells it out: The book is 100% devoted to short selling and the categories that go along with that: "Bubble Stocks", high growth companies with low returns on capital, companies that can't internally finance themselves
  • Unlike the other books below, this book deals less with accounting disclosure and more with the short sale process that a long/short hedge fund might engage in (it is also less technical)
  • If you had to read one of the books on the list, I would recommend this one
  • Written by Michelle Leder, of Footnoted.com fame
  • Very good introduction to basic financial statement analysis and understanding of corporate footnotes
  • Michelle does an incredible job at providing a substantial amount of case studies throughout the book
  • If you want a quick read to polish up your "accounting gimmicks" skills, I would recommend this one
  • Of all books in this post, this one is BY FAR the most comprehensive
  • That being said, this book is not for the faint of heart: It is HIGHLY technical and sometimes a very tough read. But, I promise you, you will learn more about "sustainable financial performance" and accounting disclosure than any other book on the list
  • This book also does an incredible job at really digging into the cash flow statement and has helped me better understand a company's free cash flow potential
  • If you think you are an expert in this detecting earnings mismanagement, and want to further sharpen your skills, I would recommend this book.
  • To give you a sense of how much I enjoy this book: I own both the second and third editions, and have read them both multiple times
  • Relies heavily on case studies with actual short recommendations from CFRA - I.E. The back their claims up with solid performance
  • Very focused on accounting disclosure and management - depreciation rates, AR charge offs, etc
  • I very much like Dr. Schilit's writing style which made the book a fairly quick read despite clocking in at ~300 pages
  • If you want a deep dive into accounting mismanagement and want a read that is not too easy but not technical, I would recommend this book
  • In my opinion: The original book on accounting disclosures and mismanagement. If you have not read it yet, you are really missing something special
  • This was the first book I read on "Quality of Earnings" - I have read it so many times that my copy is falling apart. I use it as a reference very often.
  • Goes through the major ways a management team can manipulate earnings.
  • Delves into some of the intangibles. For instance, there is a whole chapter on parsing a Chairman's Annual Letter that comes with the annual report. While the book heavily relies on number, it also shows you how to think about those numbers in a holistic way.
  • For the best treatise on the quality of earnings, I would recommend this book.



New Value Investing Blog

I am sure some of you have seen it, but if you have not, I have launched a new value investing blog, specifically targeting Walter Schloss, Irving Kahn, Warren Buffett, and others from the Graham-Newman Corporation. Enjoy!


Seth Klarman from 1992

We have covered Seth Klarman in depth on Distressed Debt Investing. Seth Klarman is the investor I really think I respect the most and try to learn as much as I can from him and his style of investing. Frankly, if I could work anywhere, I would work at Baupost (HINT HINT READERS FROM BAUPOST).

Yesterday, I talked to about the high yield credit market of 2010. I received a number of response of people agreeing and disagreeing with me. That being said, one reader sent me a fascinating article penned by Seth Klarman in 1992 in Forbes. If you replace some of the names and dates, it really sounds like he is talking about today's credit markets. Enjoy!

Don't be a yield pig. (seeking high current rates in investments)

Seth A. Klarman

Brief Summary: Some investors seek high yields with no thought of the risk. In today's stock market situation, it is better to use up some acquired capital funds than to risk major loss.

I HAVE THOROUGHLY reviewed the U.S. Constitution (and the Bill of Rights for good measure) and, contrary to popular belief, there is no mention of a right for savers to earn high rates of interest on government-guaranteed principal. Nevertheless, it comes as a terrible shock to a lot of people that some current short-term interest rates are only one-third of early 1980s levels. The correct response to this shock can be crucial to your financial health.

There is always a tension in the financial markets between greed and fear. During the 1980s investor greed frequently got the better of fear, with the result that yield-seeking investors, known among Wall Streeters as "yield pigs," were susceptible to any investment product that promised a high current rate of return, the associated risk notwithstanding. Naturally, Wall Street responded by introducing a variety of new instruments--junk bonds, option-income mutual funds, international money market funds, preferred equity return certificates (PERCS)--anything that promised high current yields to investors.

Unless they are deluding themselves, investors understand that to achieve incremental yield above that available from U.S. government securities (the "risk-free" rate), they must incur increasing levels of principal risk. There is no risk-free yield enhancement on Wall Street. The painful result: Higher risk investments often erose one's capital and produce lower returns--the worst of al investment worlds. Higher-returns-for-higher risks only applies on average and over time.

Investors must carefully examine alternative investments to assess when they are being adequately compensated for bearing risk and when they are not. When the yield differential between riskless and more risky securities is sufficiently large, ven a conservative investor might reasonably venture beyond U.S. government securities. Thus, for example, it made sense to buy the Federated Department Stores senior secured bonds, Harcourt Brace debentures and Manville preferred stock when panic hit the junk bond market in late 1990 and early 1991.

These days, however, I don't believe investors are being compensated sufficiently to venture beyond risk-free instruments. Yield spreads between government bonds and corporate credits have contracted sharply this year from levels a year ago. Some bonds of such highly leveraged issuers are Burlington Industries and Unisys now trade above par. A year ago the sold at substantial discounts from par.

Yield-starved investors also have been bidding up the bonds of such deeply troubled issuers as Chrysler, Stone Container and Marriott. The General Motors PERCS--a newly created instrument that only a yield pig could love--recently traded at a level so high that the common stock became a better buy no matter where GM common traded and no matter what action GM's board took on its dividend.

Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one--common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.

How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms.

In my view, it is only a matter of time before today's yield pigs are led to the slaughterhouse. The shares of good companeis and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today's investment-grade issues will be downgraded to junk status if the economy doesn't begin to recover soon.

What if you depend on a higher return on your money and can't live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consumer some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss.

Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital rooting around for incremental yield that is simply not attainable.

I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the getting is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.



Credit Market Quite Possibly Insane

Last week, I said the high yield market was hot. Today I am saying the entire credit market is quite possible insane. Toro's Running of the Bulls has been one of my favorite investing blogs for a long time. He recently penned an incredible piece entitled: The Bond Market Has Lost It's Mind. As you can tell, I am less than original in the title of my post. That being said, I would like to provide some "on the ground" intelligence if you will of what I am talking about.

As anyone in the credit markets are well aware, the primary market is running hotter than I can ever remember (except maybe bank debt in 1Q 2007...go CLO machine go!). And this turned on a complete dime relative to where it was just 6 or 7 weeks ago. I cannot recall a high yield deal (or investment grade deal for that matter) that was not oversubscribed and didn't trade up at least 1 point on the break.

Allocations are disgusting. Seriously. Unless you are Oaktree, Pimco, Franklin, etc, you are getting a couple million bonds here and there. Last week on the Distressed Debt Investors Club Forum, I posted a new topic about the Borgata deal currently in the market. At that time it was being talked at 10.5% which I found attractive given the risks inherent in investing in a single site casino in Atlantic City.

So I get a Bloomberg early this morning saying pricing is coming 75 bps tighter on the 5 year and 50ish tighter on the 8 year. And then I hear from my sales coverage: There is $5 billion in the book for an $800M deal. I will probably get 1/10th or 1/20 of my initial commitment.

Deals are pricing just incredulously tight. Teck Resources was in the market today and got a 7 year deal done at a 160 spread versus the curve translating into an all in yield of 3.858%. That's a low BBB issuer folks whose bonds were trading at 40-50 (Yield of 14-16%) about a year ago....

Now, I understand the bullish arguments. Rates are going to stay low, and possibly go lower if deflation kicks in, corporate balance sheets are healthy, earnings are coming in higher than consensus, excess liquidity in the market, investors are reaching for yield...

From a Bloomberg Article this evening (on Bloomberg you get high yield news with the function HYLN :
Investors are putting cash into junk-bond mutual funds as money market funds from companies such as Federated Investors Inc. and JPMorgan Chase & Co. offer yields at or below 0.25 percent, according to data compiled by Bloomberg.

"The average retail customer can’t live on 1 percent and that’s the issue,” said Jon Budish, senior vice president of high yield at Jefferies & Co. in Short Hills, New Jersey. “Until the default rate changes or you get a lot of downgrades, or until the Fed says something different, high-yield seems pretty interesting.”
Now, I do not invest top down. I look at securities across the capital structure (bank debt, investment grade, high yield, equities, and distressed) and determine my downside risk and if I am being compensated for taking that risk (as defined as permanent loss of capital). And frankly, while the upside / downside was quite favorable in 1Q and 2Q 2009 and to a lesser extend in the back half of the year, now things are just ludicrous.

I would venture to guess that my "new issue hit rate" is less than 10% in 2010. And you know what? I look like an idiot. And when new issues are up 2-5 points, it is my experience these things feed on themselves. Flippers start piling in when they know deals are oversubscribed, complicating allocations, and effectively "window dressing" the analysis of the issuer at hand. Rinse, repeat, and oh yea, put me in for $50M of XYZ bond even though I'll probably only get $3 or 4 million but I can probably sell it at 102 and make an easy 80k-100k.

Surprisingly, a lot of distressed credits seems to be very much under performing the on-the run credit markets. At least it feels that way. According to JPM, YTD performance for CCC bonds is 10.3% and BB bonds is 8.4%. From a yield to worst perspective, we are way below the long term average, yet from a spread to worst perspective we are 20-30 bps wide of the long term average.

Given where coupons have been printing, duration is creeping higher and higher as more treasurers are doing 30 year deals at very low coupons. And given where rates are today, doesn't that scare anyone else other than me? The 30 year Teck bond has a duration of 14 (using round numbers). That means a 7 or 8 bps move in rate or spreads is equivalent to 1 point change in bond value. Am I the only one that thinks that at least one of those two will definitely be wider in the next 4 or 5 years? Let me know your thoughts.


Quick Housekeeping Item

Some of you know this, but I started the Distressed Debt Investing group on Linked In. You can (and should) join it here: Join Distressed Debt Investing Linked In Group ... We have about 650 members and going forward I am going to make sure the discussion stays on point with distressed corporate debt as opposed to CRE.



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.