Over the past few weeks I have received a number of emails on the status of the Distressed Debt Investors Club. And because I have not provided an update here for sometime, I thought I would take a few minutes to talk about the amazing success of the site.
The Kelly Formula, and its application to investing has been discussed by Charlie Munger, Monish Pabrai, and other legends in the value investing community. A few months ago, we presented commentary from Peter Lupoff, founder of Tiburon Capital Management. We saw some of his new commentary on the Kelly Formula and Event-Driven Investing and he allowed me to share it on the site. Enjoy.
- Kelly applies to sequential bets with, therefore, no correlation. Professionally run pools of capital are done so in a portfolio with underlying “bets” influenced by macro factors, markets and each other. There is some inherent correlation.
- Gambling games are won and lost in ways that can be statistically derived. Movement and terminal value of investments have idiosyncratic properties.
- Determining the “edge” in gambling is quantitative and precise. Determining the “edge” in investments is most often qualitative and based on personal perspective, and therefore hard to define precisely.
- Professionally run investment pools rarely have the ability to place highly concentrated bets with no care for short term volatility, while seeking long term absolute returns. In the real world, there are competing objectives.
Every now and then I stumble upon a letter from an investment advisor/hedge fund that I enjoy reading and decide to share with readers. This letter below, from Downtown Associates has some great words of wisdom. My favorite:
We will not “chase” performance – when stocks are expensive the ensuing returns are likely to be subpar. Instead we prefer to hold cash, remain liquid and wait for attractive opportunities. Why should today’s opportunity set be the only one we consider when tomorrow’s is likely to be more fertile? By remaining disciplined in our purchase decisions, we seek to maximize future returns while limiting our downside risk (the possibility of a permanent loss of investment capital).We prefer the risk of lost opportunity to the risk of lost capital.
Last week it was reported that Symphony Asset Management is launching a $500M CLO. To give you some historical context of CLO issuance, please see the chart below from an 2009 LSTA conference:
When analyzing a distressed debt investment, it always helps to remember that the presiding judge on a case will be the final arbiter on a number of decisions that may sway the direction of a case and consequently, recovery and return to distressed debt investors. For example, today in Tribune's bankruptcy, the bankruptcy judge extended the exclusivity period of the debtor, shutting down the ad-hoc lenders plans of filing its own plan of reorganization.
I conclude that the AHC/Debtor Plan meets the requirements of section 1129(a) and (b), and is confirmable, subject to the following modifications:(A) The plan provision releasing Trump from the Trump Personal Guaranty must be deleted from the plan.(B) The plan provision releasing the Second Lien Noteholders from liability for any alleged violations of the Intercreditor Agreement must be deleted from the plan.(C) The plan provision offering the Backstop Parties indemnification must be clarified and limited, per the discussion supra.(D) The AHC, the Backstop Parties and the Indenture Trustee must apply under section 503(b) for reimbursement of fees and expenses as substantial contributors to the case.(E) The New Term Loan must be modified to afford the First Lien Lenders a 12% rate of interest, and an 1111(b) premium.(F) The plan is confirmable subject to approval of DIP financing.
I conclude that the Beal/Icahn Plan meets the requirements of section 1129(a) and (b), and is confirmable, subject to the following modifications:(A) The plan provision for exculpation must be modified to provide for acts or omissions constituting gross negligence, willful misconduct or fraud.(B) The plan provision providing for a severance payment to certain employees must be stricken.(C) The plan provision placing a cap on administrative and priority expenses, and requiring acceptance of post-confirmation claims determinations of the bankruptcy court by the proponents, must be stricken.(D) The plan provision cancelling the Indenture dated May 20, 2005, applies only to the debtors’ obligations, and does not affect the relationship between the Indenture Trustee and the Noteholders and guarantors.(E) The bar date for filing administrative claims must be extended to thirty (30) days after the date of confirmation.
As to the treatment of creditors, both plans provide for a full recovery to First Lien Lenders, one through conversion of the debt to equity, and the other through deferred cash payments at present value. But the two plans differ markedly otherwise, particularly as to the treatment of Second Lien Noteholders. Except for providing a pro rata share of $500,000 to the Convenience Class, the Beal/Icahn Plan provides no distribution to any other stakeholders in the case. In contrast, the AHC/Debtor Plan provides for a nominal recovery of cash, subscription rights and liquid stock to the Second Lien Noteholders and General Unsecured Creditors. More importantly, the plan provides, to a large number of the Second Lien Noteholders, (approximately 61% of the Noteholders), the opportunity to receive the only value that is left in the case after satisfaction of the First Lien Lenders’ claims. That value is the potential future benefit of the reorganization, if the reorganization succeeds. The Ad Hoc Committee is making a substantial payment of $225 million for the opportunity to participate in the future upside potential of the debtors, which would otherwise inure to the exclusive benefit of the First Lien Lenders. The treatment of creditors favors the AHC/Debtor Plan in this regard.
The end result of the voting is that an overwhelmingly number of creditors voted in favor of the AHC/Debtor Plan and against the Beal/Icahn Plan. Of course, it must be recalled that both the AHC members and the Icahn parties obviously support their own plans. But the significant support for the AHC/Debtor Plan by the largest creditor constituency, coupled with the treatment of creditors and feasibility considerations noted above, compels the conclusion that the AHC/Debtor Plan, as modified, should be confirmed. Confirmation of the AHC/Debtor Plan will allow the debtor to shed approximately $1.4 billion in secured debt, to pay the First Lien Lenders in full, and to offer to creditors the opportunity to participate in the upside potential of the debtors.
A pivotal aspect of distressed debt investing is the negotiations among opposing (read: warring) creditor factions. Senior creditors may want one thing, but subordinated bond holders want another. Sometimes people throw the "cram down" rule as a gauntlet in negotiations when in fact they may not even have the necessary stipulations as required by 1129 of the bankruptcy code to cram down a dissenting creditor class. Many of these negotiations are worked out behind the scenes - when evaluating an investment in a bankrupt creditor, it is prudent to play out all likely scenarios to see where ultimate recovery will come out.
Under section 1126(c) of the Bankruptcy Code, an entire class of claims is deemed to accept a plan if the plan is accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in the class.
A few months ago, we took some time out to profile Third Avenue's Focused Credit Fund. We were particularly impressed with some of the commentary coming out of the manager's letter.
Energy XXI Senior Notes represent the Fund’s second debt investment in a U.S. Gulf of Mexico-focused oil and gas producer. Securities valuations of Gulf of Mexico (“GOM”) energy companies like Energy XXI had been decimated in late 2008 following the disruption brought on by Hurricanes Ike and Gustav. The dramatic collapse in commodity prices during that period further pressured the industry’s operating results and, in many cases, led to dramatic accounting-based asset impairments. Energy XXI’s production levels, for example, fell more than 26% in the first quarter following the hurricanes and GAAP accounting resulted in a $580 million impairment of the company’s oil and gas reserves. The opportunity in Energy XXI Notes surfaced at the end of last year while the company was in the midst of a debt exchange offer designed to address a capital structure ill prepared for these sorts of adverse developments. We believed that the company’s “troubles” – both financial and operational – were temporary and fixable, that our capital, as creditors, was well protected and the investment had a number of ways to win:• the proposed exchange offer and a coincident private financing included a credit-enhancing common stock offer that also extended the company’s debt maturities;• production that had been interrupted because of the hurricanes would return, in time, along with additional production pending completion on more recent projects, bolstering both cash flow and reserves; the company was due to collect the proceeds of a substantial insurance settlement, further enhancing corporate liquidity;• our multi-pronged valuation work, which relied on asset-based production and cash flow metrics, suggested our downside was well protected (i.e., the probability of a loss of capital seemed remote) while the Notes, trading at a price of around 81% of face value at the time of acquisition, provided an equitylike return of more than 17% and a current yield of approximately 12%;• creditors like the Fund could get further comfort from the relatively strong covenants within the terms of the Notes and those in the company’s bank credit facility;• While unnecessary for a successful investment, the company’s exposure to a potentially large exploratory success would further enhance overall corporate value;• finally, other facts, taken together, strongly suggested to us that management was intent on improving the balance sheet. These clues included i) the company’s most recent proxy statement that requested a sizable expansion of the company’s authorized share capital, signaling a potential future equity raise; ii) new “change of control” language within the new notes indenture that seemed to contemplate the impact of an expanded equity base; iii) the fact that the company itself had repurchased $126 million face amount of Notes at a cost of $94 million1, suggesting a proactive approach toward enhancing the corporation’s financial flexibility; and iv) comments on the company’s recent conference calls and presentations committing to “debt reduction” and “further strengthening of the balance sheet.”While subsequent events at the company largely support our thesis (a thesis developed with our colleagues on the Third Avenue credit team), the investment continues to face a number of hard-to-handicap risks, chief among them: i) operational risk (hurricane season starts in June!); ii) political risk (uncertainty related to how the Obama administration might change the industry tax regime or rules on access to reserves); and iii) deal risk (the possibility that significant new leverage is introduced as the result of either a debt-financed acquisition or a takeover of the company by a highly leveraged acquirer).
Market returns were led by CCC-rated issues which returned nearly two times the index return in the most recent quarter. This included a number of higher-risk Finance company bonds. The Finance sector had the highest return in the high-yield index for the quarter, with a return of 9.25%. For many of the Finance sector bonds that performed well, Fund Management determined there was not adequate information or transparency available on specific companies to be able to obtain a high enough conviction level that there would be minimal downside risk. These bonds included AIG, ILFC, Rescap, Aiful, Takefuji, as well as several hybrid/perpetual preferre stocks of U.S. and European banks.
We view this market pullback, which has continued into February, as constructive and a good opportunity for us as investors. As we have said in the past, “Trees don’t grow to the sky” and this is especially true in the credit markets. It seems that investors are finally paying attention to thefundamentals and capital structure of specific companies since the rally in the credit markets began in March 2009. In general, during this rally, the riskiest securities benefitted the most. Returns on CCC-rated high-yield bonds exceeded 100% in 2009, despite the fact that many of these companies have over-leveraged balance sheets and their cash flows from operations have declined meaningfully.Risk appetites for these types of companies appear to be diminishing. Companies that report disappointing earnings or have uncertain outlooks have seen their security prices decline recently. This is the type of market we favor and believe we can excel in – it is what we call a “Credit Picker’s” market. We believe that investors should be invested with a manager that focuses on credit selection and carefully measures the upside potential versus downside risk of each security, as opposed to investing with a manager that just buys the riskiest securities in hopes that they will increase.
Energy XXI (“EXXI”) is an independent oil and natural gas exploration and production company with operations focused in the U.S. Gulf Coast and the Gulf of Mexico. (This credit is also discussed in the Third Avenue Small-Cap Value Fund shareholders’ letter, which you can refer to for additional information.)Due to hurricanes which disrupted production in the Gulf of Mexico and the collapse in commodity prices, EXXI ran into liquidity issues. During the fourth quarter, EXXI attempted to do a debt exchange whereby it would exchange approximately 50% of its $625 million 10% Senior Notes for new 16% second lien secured notes at a price of 80% of par. Additionally, EXXI planned to retire the $125 million in 10% bonds the company had purchased to reduce its overall debt load.Based on our proprietary research, we determined that EXXI’s oil reserves more than covered the value of its debt at par and the 10% notes were trading in the low 80 dollar price range. When we discussed the rationale for the debt exchange with management, they said there were two key reasons. First, it would reduce slightly its overall debt. Second, they wanted to modify the “Change of Control” provision in the new 16% second lien notes so it would be different than the 10% Notes. A “Change of Control” provision is standard in high-yield bonds and provides that if a company is bought out by another company, then the bondholders can force the company to repurchase their bonds at a price of 101% of par.EXXI wanted the flexibility to be able to issue more than 50% of their outstanding common stock in a new acquisition deal. This would have triggered a “Change of Control” in the 10% notes. This led us to conclude that management wanted to do an acquisition funded with almost all equity, in order to substantially reduce its ratio of debt to equity. If this happened it would positively impact the bonds. We purchased the 10% senior notes and agreed to the debt exchange. Following the debt exchange, the combination of the new notes traded at a higher price than our cost basis.In November 2009, EXXI announced that it was purchasing interests in oil properties from Mitsui & Co. for $283 million. These are interests in oil fields that EXXI already owns and operates. They were able to negotiate a favorable purchase price and will incur almost no additional operating costs. EXXI then completed an equity and convertible bond offering to fund the entire transaction.EXXI owns interests in two deepwater exploration fields being drilled and operated by McMoran. Our analysis attributed no value to these fields, since there was no discovery yet but they were drilling the wells and had incurred costs. In January, EXXI and McMoran announced favorable findings for one of these wells. The stock now has a market capitalization of $1 billion and the 10% and 16% notes we own now trade at par and 115% of par, respectively.
The following is a list of Third Avenue Focused Credit Fund’s 10 largest issuers and the percentage of the total net assets each represented, as of January 31, 2010: Swift Transportation, 4.2%; Energy XXI Gulf Coast, Inc., 3.8%; CIT Group, Inc., 3.0%; TXU Corp., 2.9%; Lyondell Chemical Co., 2.9%; Pinnacle Foods Finance LLC, 2.8%; First Data Corp., 2.7%; FMG Finance Ltd., 2.7%; Georgia Gulf Corp., 2.5%; and Culligan International Co., 2.3%.
As I have noted in previous posts, the opportunity set for distressed debt has fallen immaculately over the past 12 months. Two charts from Bloomberg confirm this.
In the distressed debt world, it is helpful to know who you are up against and who's side you are playing for in a particular deal. But how do you find this information out? Let's use Tribune as an example.
...3. HBD and YCST represent a number of individual creditors in connection with holdings of indebtedness governed by the Credit Agreement, dated as of May 17, 2007 (as amended, the “Credit Agreement”), by and among Tribune, each lender from time to time party thereto, and certain financial institutions as administrative agent, syndication agent, codocumentation agents, and joint lead arrangers and joint bookrunners.4. The names and addresses of the creditors currently represented by HBD and YCST (collectively, the “Lenders”) are identified on Exhibit A, attached hereto. The aggregate principal amount of claims held by the Lenders against the Debtors currently totals approximately $3.8 billion.
In April 2009, I thought it would be an interesting exercise to bring together some of my thoughts on distressed debt investing, the hedge fund world, value investing, and whatever else I may be thinking at the time in a blog format. And after 1 year, I could not be happier with our successes:
- 350,000 page views on this site, and another 100,000 on my ancillary sites
- Over 2500 RSS Subscribers
- The Distressed Debt Investor Club was launched and in my opinion is a fantastic success that continues to get a steady stream of member and guest applications